Institutions…What are they?…Why are they important?

I had hinted in previous posts about the need to do a series on institutions and the critical role they play in development. This is the first of such posts and perhaps there is no better place to start than to ask what are institutions anyway?

An institution is a humanly devised structure of rules and norms that shape and constrain individual behavior [1]. Institutions are building blocks of social order: they represent socially sanctioned, that is, collectively enforced expectations with respect to the behavior of specific categories of actors or to the performance of certain activities [2].

Laws, rules, social conventions and norms are all examples of institutions. Institutions occupy a very wide spectrum ranging from the highly informal (like shaking someone’s hand after being introduced to them), to the semi-formal (like policemen stopping cars at a legal checkpoint in order to extract an illegal bribe), to the highly formal (the written constitution governing a country).

Throughout history, institutions have been devised by human beings to create order and reduce uncertainty. In successful modern societies, institutions play one very crucial role; They reduce the transaction costs for carrying out the large-scale industrial production necessary for mass prosperity. This perhaps needs some elaboration. All economies have transaction costs-the myriad costs that go into doing business. How successfully an economy develops significantly depends on how well it can create institutions that minimize those transaction costs [3]. Institutions and the way they evolve shape economic performance. Together with the technology employed, they determine the cost of transacting and producing goods and services [4]. A set of political and economic institutions that provide low-cost transacting makes possible the efficient industrial production that underlies economic growth [5]. If you notice, a lot of the professions in modern society involve work that don’t produce tangible goods that individuals consume (production of tangible goods is typically done by scientists and engineers. They are the production layer of an economy). Some of those professions are lawyers, bankers, politicians, accountants, civil servants, to name a few but are yet an important part of a modern economy (Okay, some people may not agree that politicians do anything useful for society but I digress…). These occupations form the transaction layer of an economy. They are there largely to design the institutions that reduce the transaction costs of industrial production carried out by manufacturers. You can understand this division of labour better using the computer analogy. The transaction layer is like the operating system (OS) like Windows or for the show offs among you, MacOS (if you like, call me jealous. I don’t bloody care), while the production layer is like the actual programs installed in order to do something useful like Microsoft Office for preparing all manner of documents, programming languages like C++, Java, Python, Rust, Go etc. for writing computer programs and graphics packages like Adobe Photoshop, CorelDraw etc. for graphics design. You don’t use the OS directly to do anything useful, but it goes without saying that if the OS is not working, nothing useful can be done.

It is extremely important for a society to pay close attention to the design and operation of its institutions. Institutions have this habit of making themselves invisible. That is what makes them so powerful. Institutions exert enormous influence on the thought processes of individuals without them realizing it. People instead tend to think their thoughts as just being “natural” [6]. Some social scientists even contend that it is impossible for people to have thoughts outside those that have been made possible by their society’s institutional constraints. They refer to these as a society’s unthinkable thoughts (or what Donald Rumsfeld, Defence Secretary under George Bush Jnr, famously described as unknown unknowns). In short, a society’s institutions do much of the thinking in any given society [7]. It is imperative for any society that wants continuous progress to constantly question the nature of their institutions with the goal of improving them. To do that though, one must first be aware of how much they influence one’s thinking. Developing quality institutions by the way, is actually what some of us mean when we say “Government needs to create an enabling environment.” You don’t create an enabling environment simply to have an enabling environment. You create it because you want to enable something. That thing is industrial production.

One should note though, that improving institutions is by nature a slow and incremental process, not least of all because institutions to a large extent determine the distribution of benefits in a society and thus, those enjoying the best of the benefits will fight to maintain the status quo [8]. Resistance from those benefiting from the status quo is not the only reason institutions change slowly. Since institutions are meant to bring stability, order and create certainty where there is uncertainty, there is a natural bias for institutions to only change slowly [9]. Too much institutional change could lead to anarchy. Nevertheless, institutions do evolve, though there is no guarantee that their evolution will lead to a social arrangement that is of greater benefit to the greater mass of society. The opportunities thrown up by the natural stresses and strains that force institutional change have to be seized by social reformers working for the greater benefit of society for that to happen [10].

It is important for me to point out that there is some ambiguity as regards the definition of institutions. They also refer to organizations as well as rules and norms. Very often in the public sector, organizations are brought into existence to enforce certain rules and norms (e.g. Ministries, Agencies, Departments, the courts etc.)

We can now take a brief look at the major institutions that affect economic growth. They can roughly be divided into four. They are the legal, political, economic and social institutions. We shall take each one in turn:

Legal Institutions

There is a general consensus that the quality of legal institutions correlates with levels of economic growth, though there is some ambiguity as to which causes which [11]. Most likely, they coevolve and reinforce one another. There is also general consensus that the most important aspects of legal institutions for economic development pertain to the ‘Rule of law’ particularly the enforcement of property rights [12]. An environment where investors, both local and foreign believe that their investments are safe from expropriation by government and other powerful elites, is one in which they are likely to invest.

A major challenge with building legal institutions in the developing world is that western-style legal systems inherited from colonial masters often conflict with traditional customary law. One area where this problem is particularly stark is in the area of land ownership. Western legal systems emphasize individual ownership of land, while traditional customary law emphasizes communal ownership. Western nations once too, many centuries ago operated along the lines of communal land ownership but slowly changed to an individual system because they found an individual system to better suit the needs of modern capitalism. Imagine you want collect a loan from a bank to expand your business and you want to put up a piece of land you share with your brothers and sisters as collateral. Perhaps one of your brothers wants to use it as farmland, one of your sisters wants to put a container on the land and turn it to a beer parlour, another brother says that the land should just be sold outright and all of you share the money. Every single brother and sister has his/her own idea of what to do with the land. You would agree with me that there is a decent chance that absolutely nothing would be done with that land since you can’t all agree on a single course of action. Much work still needs to be done to harmonize western style systems with customary law.

Political Institutions

Human development has been positively linked with state capacity. By state capacity, I mean the technical skills and administrative reach of government apparatus. Thus it is generally accepted that government policies intended to improve the welfare of citizens on a national scale can only be achieved the effective bureaucracies [13]. Lack of effective bureaucracies is a major problem in Africa. One that observers say threatens almost all development efforts as well as basic public administration [14].

In general, the world is increasingly converging on an ideal institutional framework. This framework consists of a democratic polity with decentralized markets with well-specified and enforced property rights [15], though there is understandably, a great deal of variation, in how well countries have implemented this framework.

Economic Institutions

Every society needs to make effective use of the scarce resources. Goods and services have to be produced to meet the basic needs such as food, clothing, shelter, etc. While the institutional set up of a country in general has a profound effect on its economic performance, there are specifically economic institutions that are tasked with the optimal organization of the production, exchange, distribution and consumption of goods and services [16]. These economic institutions can be roughly divided into three groups namely:

· Those establishing and protecting property rights

· Those facilitating transactions

· Those permitting economic co-operation and organization (through formal companies and informal organizations like cooperatives)

Examples of the property rights group would include intellectual property rights, patents, copyrights etc. Those of the facilitating transactions group would include measures, weights, standards, public information on markets, physical provision and organization of markets (e.g. stock exchanges, auction rings), banking conventions, auditing and accounting conventions etc. Those of the economic cooperation group would include laws on limited liability and bankruptcy, competition policy, regulations on charities, cooperatives and civil associations, employment regulations etc. [17].

Social Institutions

Here we have some of the most fundamental institutions in society; family, marriage, kinship, religion and education. The part they play in relation to economic development is in producing people with the right values and formal skills needed to make them productive members of society. Values such as thrift, hard work, a love of learning etc. and the scientific and technical skills required to boost national productivity, hence creating wealth.

In the next post, we shall take a critical look at bureaucracies.

BEFORE YOU GO: Please share this post with as many people as possible and check out my book Why Africa is not rich like America and Europe on Amazon.

References

1. Wikipedia Article on Institutions https://en.wikipedia.org/wiki/Institution

2. Ibid

3. North, Douglass. 1992 ‘Transaction Costs, Institutions and Economic Performance’ International Center for Economic Growth

4. Ibid

5. Ibid

6. Douglas, Mary. 1986 How Institutions Think. New York: Syracuse University Press

7. Ibid

8. Douglass North. 1992 ‘Transaction Costs, Institutions and Economic Performance’ International Center for Economic Growth

9. Ibid

10. Ibid

11. Ogus, Anthony. June 2004 ‘The Importance of Legal Structure for Regulation (and Deregulation) in Developing Countries’ http://idpm.man.ac.uk/crc/

12. Ibid

13. Gerring, John et al. March 2002 ‘Political Institutions and Human Development’

14. Ibid

15. Douglass North. 1992 ‘Transaction Costs, Institutions and Economic Performance’ International Center for Economic Growth

16. Economic Institutions II

17. Wiggins, Steve et al. July 2006 ‘Economic Institutions’ www.ippg.org.uk