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Are liberalized institutions better for economic development?



Even restricting the direction of causality to the one running from institutions to

economic development, the theories about the relationship between the two that the currently dominant discourse on institutions and development provides are rather simplistic.

These theories basically argue that ‘liberalized’ (or what most Europeans may call ‘liberal’) institutions that protect private property rights most strongly and provide maximum economic freedom (especially business freedom to seek profits) will best promote investment and thus economic growth (e.g., Acemogul et al., 2001; La Porta et al., 2008). So, for example, the (Anglo-American) common-law legal system is seen as more encouraging of enterprise, and thus economic growth, than the (Continental, especially French) civil-law system because it provides better protection of investors and creditors while minimizing state regulation. For another example, it is argued that a shareholder-oriented (once again, essentially Anglo-American) corporate governance system promotes investment and thus growth by giving assurance to investors that they will not be ripped off by other stakeholders in the company they invest in – the managers, the workers, and the suppliers, who will get the same fixed compensation regardless of the profit performance of the company and thus have no incentive to maximize profit. However, the relationship between institutions and economic development is far more complex than that.

Do institutions that provide greater economic freedom lead to faster growth?

Let us first examine the proposition that institutions that guarantee the highest

degree of economic freedom will be the best for promoting economic growth

and development.4

4 I will not go into the complex and difficult question regarding the relationship between economic growth and economic development. Suffice it to say here that economic growth, at least when it is

generated through a transformation of the productive structure of the economy, is the key driver of economic development and therefore that economic development without economic growth is impossible,

although economic growth without economic development is possible, if not desirable or sustainable. For

a critique of today’s mainstream concept of development, see Chang (2010).

To begin with, even if we agree that the freest market is the best for economic

development, there is actually no objective way to determine what is in fact the freest market (for a further theoretical exploration of this point, see Chang, 2002b; for empirical details of the following examples, see Chang, 2002a).

If you want the freest financial market, should we allow people to set up banks

without minimum amount of capital and issue their own currency? The followers of the American free-banking school would say so, while others, including many free-market economists, would say that we should not. Should a country pursuing the maximum degree of freedom in the labour market allow child labour? That is what 19th century free-market economists thought, but today few defenders of free labour market in the rich countries would say that. Until the early 20th century, many people thought it unacceptable for the government to put any legal limits to working hours, at least of adult men – for example, in 1905, the US Supreme Court ruled a New York state law limiting the working hours of the bakers to 10 hours as unconstitutional because it ‘deprived the baker of the liberty of working as long as he wished’ (Garraty and Carnes, 2000: 607).

Today, most people would accept such restriction as perfectly normal. In the 19th century, most free-market economists thought that patents, by restricting competition in the markets for ideas, goes against free-market principles. Today, many, although not all, of them defend patents.

These examples show that the very definition of a free market depends on whether an observer accepts the political and ethical values embodied in the institutions that gird the market. In other words, different people with different values will see different degrees of freedom in the same market. If it is impossible to objectively define the boundary of the free market, we cannot know which institutional arrangements will maximize economic freedom (whatever its impact on economic growth and development may be).

Second, even ignoring the impossibility of objectively defining the free market,

various theories tell us that an institutional structure that gives maximum business freedom is unlikely to be the most efficient from the social point of view. This is said not just by heterodox economists but also by neoclassical economists in the market-failure tradition. For a classic example, accepted by many mainstream neoclassical economists, allowing business to acquire any company it wants may lead to a degree of monopoly that may be good for the company concerned but imposes social costs of monopoly. For another example, the 2008 global financial crisis has shown that giving financial firms the freedom to accumulate individual risk without regard to systemic risk is definitely not good for the overall economy.

Third, it is not even that giving maximum freedom to business firms is good, at least for the business sector as a whole. There are regulations that may restrict business freedom in the short run but may promote the long-term interest of all firms. For example, individual firms may benefit from using child labour (and thus child labour regulation will hurt them) in the short run, but that may harm all firms in the long run, by harming children’s health and education and thereby reducing the quality of the future labour force. In this instance, it will be actually pro-business for the government to regulate child labour and many capitalists would support it – they do not mind accepting such a regulation as ar as the government ensures that every company respects it. In other words, restricting individual business freedom may be good for the business sector itself, especially in the long run, regardless of its impact on the rest of the economy.

Fourth, it is highly debatable whether greater market freedom is better for economic development. To begin with, as the Lipsey–Lancaster Second Best Theorem shows, we cannot judge a priori whether a higher degree of market liberalization will bring result in (allocative) efficiency, unless all markets are completely liberalized (Lipsey and Lancaster, 1956). Moreover, even if a more liberalized economy is allocatively more efficient, it cannot be argued that such an economy will grows faster, as even some prominent neoclassical economists admit (e.g., Krueger, 1980). On top of that, there are many non-neoclassical economic

theories that say that free markets may be less good at generating growth than markets that are, depending on the circumstances, protected, regulated, managed, or monopolized – such as the infant industry argument of Alexander Hamilton (1789) and Friedrich List (1841; List, 1885), Joseph Schumpeter’s (1987) theory of innovation, and the more recent literature on the economics of technology (see Freeman, 1982; Nelson and Winter, 1982; Lundvall, 1992; Lall and Teubal, 1998; Kim and Nelson, 2000; Cimoli et al., 2009).

Is a stronger protection of private property rights better for growth?

Similar things can be said about the proposition that a stronger protection of private property rights is better for growth. The currently dominant discourse on institutions and development assumes that this proposition is indisputable, but there are a number of reasons to question it.

First of all, the currently dominant discourse fails to give full attention to forms of property rights other than private, state, and open-access. The superiority of private ownership is asserted on the around that state ownership is inefficient due to the restrictions on competition and the principal–agent problem, while open access leads to the ‘tragedy of commons’. However, in reality, there is a wide variety of property rights not fitting into this scheme. One example is the communal property right over common-pool resources with ‘public goods’ characteristics. Research, notably by Ostrom (1990, 2007), shows that what may look like an open-access property rights system (e.g., village forest) often in fact involves intricate rules on who can do what and when. The recent debate on ‘shareware’ has also shown how this involves a communal property rights system, where there are rules on how people can use it (e.g., they cannot make commercial gains with versions of the software that they have improved). There are also hybrid forms of property rights. The agricultural cooperative, which combines private property in some inputs (e.g., land, livestock) with communal property in others (e.g., creamery, tractors), is a classic example. The so-called township and village enterprise (TVE) of China is another, more recent, example.

The ultimate ownership control of TVEs remains with the local states (townships and villages), but they are often run as if they are privately owned – by the local

political bosses and enterprise managers.

Second, there are many theories that show why state or communal ownerships may be superior to private ownership in achieving social efficiency and economic growth under a range of circumstances, and the evidence to back them. I have already discussed the case of communal ownership, but various theories of market failure – especially capital market failure, natural monopoly, and externalities – show that state ownership may be more efficient in certain circumstances (for a review of these theories, see Chang, 2008). Indeed, there are many examples of state-owned enterprises (SOEs) in countries such as Singapore, France, Finland, Norway and Taiwan that were not just efficient in the narrow allocative sense but also led their country’s economic growth process through technological dynamism and export successes (for further details, see Chang,2008).

Third, as emphasized by Hodgson (2009), the very notion of ‘property’ – not mere possession but institutionalized possession – is based on the existence of a third-party that can legitimate, adjudicate and enforce the relevant rights of the property owners. This means that the relationship between private property owners and the state cannot be seen as an antagonistic one, as it is typically assumed in the dominant discourse. For example, the Singaporean state is well known as a strong state that protects private property rights very well. However, the very strength of the Singaporean state that enables it to offer such protection is founded upon a very high degree of state ownership. First, the Singaporean state’s strength owes a great deal to its strong fiscal position thanks to highly efficient SOEs, which collectively produce over 20% of the country’s GDP. Second, an important basis for the Singaporean state’s high political legitimacy is its ability to supply high-quality affordable housing, which in turn is possible because it owns all the land in the country and operates a giant public housing corporation that supplies 85% of the country’s housing. In other words, a high degree of state ownership may in some cases be exactly what enables the country to offer strong protection of private property rights.

Finally, and perhaps most importantly for our purpose here, even if we focus only on private ownership, we cannot say that a stronger protection of private property rights will lead to higher investment and thus higher growth. It will depend on the kinds of property rights that are being protected. For example, strong protection of landlord property rights has proven harmful for economic development in many – although not all – countries. For another example, an excessive protection of the holders of company shares and other liquid assets can actually reduce real investment and thus growth, by putting short-term pressures on the managers, who have to cater to the impatience of highly mobile asset owners. For yet another example, as we have seen in the recent financial crisis, if wrong kinds of assets are created, more strongly protecting investor rights may actually harm economic growth.

Is the relationship between institutions and economic development always the same?

In addition to being simplistic about the way in which institutions can affect economic development, today’s dominant discourse on institutions and development fails to recognize that the relationship is not linear, differs across societies, and changes over time even in the same society.

First, even if an institution in some dose promotes growth, it may actually hamper economic growth in a larger dose. So, while some protection of property rights is absolutely necessary for there to be investment and growth at all, an overly strong protection of property rights may reduce growth. This point has been highlighted by the recent debate on IPRs. The debate has revealed that, while some protection of IPRs may be necessary to motivate firms to invest in knowledge generation, at least in certain industries (e.g., chemicals, pharmaceutical, software), too much protection of IPRs may be bad for the society (Chang, 2001; Stiglitz, 2007: chapter 4). A stronger protection of IPRs increases the costs from (artificial) monopoly, which may more than offset the benefits from greater innovation that it may (but then may not, as innovation is an inherently uncertain process) bring. Moreover, if excessive, protection of IPRs may hinder innovation itself by making technological diffusion overly costly, by preventing cross-fertilization of ideas and by increasing the chance of technological deadlock caused by disputes between holders of inter-related patents (Chang, 2007a: chapter 6).

Second, even the same institution in the same dose may be good for one country but bad for another. So, using the IPR example again, a level of protection of IPRs that may bring net benefit to a rich country may be harmful for a developing country. Whatever the exact level of IPRs protection is, a developing country is likely to have few economic agents capable of responding to the incentives provided by the protection through technological innovation.

At the same time, it has to pay, in proportional terms, higher costs of IPR protection (e.g., licensing royalties) than the rich countries have to, given that it owns few patents and other intellectual property (Chang, 2001). So what is an optimal degree of IPR protection for a developed country may be too strong for a developing country, and vice versa.

Third, even in the same dose and in the same country, the same institution may promote growth at one point in time but not in another. For example, it is widely agreed that concentrated land ownership promoted agricultural development in Japan until around the First World War, when landlords were personally involved in cultivation and thus invested in irrigation and technological improvement, but that it then turned into an obstacle to development after the First World War, as most landlords became absentees who were not interested in investing in raising agricultural productivity (FAO, 1966). This meant that the over-riding of landlord property rights in the post-Second World War land reform helped subsequent economic development of Japan, while the same exercise in the late 19th century would have had negative economic consequences. One does not have to be a Marxist to see that institutions (or the relations of production in Marxist terms) that once promoted the development of a society’s productive capabilities (or the forces of production in Marxist terms) can turn into an obstacle to it over time.

Concluding remarks

I have shown that mainstream institutional theories have a highly problematic understanding of the relationship between institutions and economic development. First, they more or less ignore the impacts of economic development on institutions and focus exclusively on how institutions affect development. Second, they believe that institutions that provide a higher degree of business freedom and stronger protection of private property rights lead to higher growth, when there are many theories, including some neoclassical theories, which argue otherwise. Third, mainstream institutional theories wrongly see the relationship between institutions and economic developmentas linear and uniform across time and space. These are serious shortcoming for theories that purport to offer explanations of growth and structural change across the world over long periods of time.

 




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