Role of institutions in economic development

There is now general consensus that the government should move from doing too many things inefficiently to doing essential tasks competently and honestly

By Aftab Ahmad Khan

No theme in the contemporary history of man has aroused so much debate and controversy as the subject of development. The subject has been explored and examined from every possible angle and in all its dimensions. There are conferences and seminars galore on development and every year thousands of entries are added to its bibliography.

At present, notwithstanding varying approaches to development, there is wide-spread agreement among economists, which is endorsed by international financial institutions about the supreme importance of strong and effective institutions for ensuring good governance and promoting growth with equity and stability.

Institutions refer to norms, rules of conduct and to well defined and formal organizations that govern the way the society operates e.g. role of the state in economic life, administrative system, judicial system, mechanism of getting into power, laws relating to private property and contracts, agencies for regulating economic and financial system, educational structure, labour market relationships, laws of taxation and inheritance and arrangements for provision of credit.

It has now become crystal clear that many problems of the developing world can be attributed to the rot that has set in the institutional framework of society. Institutional erosion has to be stopped, renovation should be undertaken where possible and innovation where necessary. Without weakening the state system, the political system in many developing countries needs to be renovated so that it reflects and attends to aspirations of the people. It should have built-in self-correctives so that non-performers do not endure on the basis of worthless slogans and empty promises. At the same time, functionally specific associational groups will have to be developed in different areas of life.

The dominant development paradigm in the quarter century after World War-II assigned a major role for the state in the poor lands by assuming the state to have certain characteristics that it turned out not to have. In the name of planning, a regulatory framework and mechanisms for allocating resources were created to control private decisions. In exercising such controls, quantitative restrictions rather than price based measures mediated through the market were often used. A chaotic incentive structure and the unleashing of rapacious rent seeking and resource diversion were the outcomes.

Free market prices in recent years have received powerful support from the International Monetary Fund (IMF) and the World Bank. A large number of countries which are receiving assistance from the IMF under its Poverty Reduction and Growth Facility (PRGF) and sector adjustment loans from the World Bank have to abide by the conditionality of pulling back the interventionist state.

Notwithstanding the current swoon over the charms of the market and disillusion with government, it is an indisputable fact that a liberal market oriented economy can yield positive results only in a milieu characterized by good governance and effective institutions.

Governance may be taken as connoting how people are ruled and how the affairs of the state are administered and regulated. It implies that public authorities play an indispensable and creative role in establishing an environment conducive to growth and in determining an equitable distribution of assets and benefits. Furthermore, there should be adequate funding for capacity building of institutions that provide social safety nets for the vulnerable and the poor.

An essential feature of good governance is an efficient and honest system of public administration. The successful carrying out of tasks of both development and democratization require on the part of  administrators not only qualities of initiative, leadership and taking of responsibility, but also emotional and intellectual integration into what may be called social values i.e. habits of democratic thought and living, of subordinating sectoral interests to considerations of public good.

An area of special significance for good governance is that of regulatory administration particularly for the financial sector where fraud and unsound management could have profoundly de-stabilising consequences for the economy. Regulatory administration is the main instrument available to the government to enforce compliance with nationally established standards in various economic and social spheres and with national development objectives. The regulatory systems have to be designed and constantly watched to ensure that these activities do not become conservative and begin to create bottlenecks in the development process.

Notwithstanding the dominant position of the private sector in Pakistan and a large number of countries in the Third World, the government’s role in providing some public goods and services and in framing the basic rules of economic activity in terms of safety standards, pollution control, provision of basic social services, protecting the vulnerable segments of society and maintaining a non-distortionary policy including macroeconomic stability continues to be important.

Distilling the lessons of history, the 1997 World Development Report (prepared by the World Bank) has indicated that the government can improve development outcomes in the following ways:

(a) By providing macro-economic and micro-economic environment that sets the right incentives for efficient economic activity.

(b) By providing institutional infra-structure – property rights, peace and order and rules that encourage long-term investments.

(c) By ensuring the provision of basic health, education and physical infrastructure required for economic activity.

The report has emphasized that the largest source of state inflicted damage is uncertainty. If the state changes the rules often and does not clarify the rules by which the state itself will behave, businesses and individuals will adopt costly strategies to insure against an uncertain future by entering into informal economy for example, or by sending capital abroad – all of which impede development.

The 2003 World Development Report has highlighted the importance of institutions such as property rights and rule of law for the efficient operation of markets and for the creation of human made assets. The report has emphasized the need for the creation of institutions to ensure an adequate supply of assets that are not spontaneously provided by markets: environmental assets (clean water, clean air, fisheries and forestries) and social assets (mutual trust, ability to network and security of persons and property). Furthermore, the report has urged governments to create competent institutions for coordination of pick up signals about problems, and for formulating and executing policies in a transparent and accountable fashion.

There is now general consensus that the government should move from doing too many things inefficiently to doing essential tasks competently and honestly.