Stranger than Fiction?

Institutions and Economic Development

by Ha-Joon Chang

Mainstream economists used to treat institutions as mere ‘details’ that gets in the way of good economics. Then from the mid-1990s, everyone, including the IMF and the World Bank, suddenly started to emphasize the role of institutions in economic development. There are a few reasons behind this rather dramatic change. First, the institution-free technocratic reform programmes of the 1980s have almost universally failed. Second, a number of devastating largescale financial crises in developing countries around the turn of the century have prompted debates on the need for reforming financial and other institutions in order to prevent and deal with such crises. Third, there have been increasing attempts by the developed countries to introduce ‘global-standard’ institutions to developing countries. Fourth, there have been some important theoretical developments in institutional economics—both orthodox and heterodox.

Stranger than Fiction?

Despite the heightened interests in institutions, there are still some important gaps in our understanding. First of all, we still do not know what institutions in exactly which forms are useful for economic development in which contexts. For example, everyone may agree that a ‘good’ property rights system is essential for economic development, but there is no agreement on what a ‘good’ property rights system is. Second, even when we can identify a particular institution as beneficial in a given context, we often do not know how we can build such institution. 

A recent WIDER volume (1) argues that, in order to fill these intellectual gaps, we first need to develop new discourses on what may be called the ‘technology of institution building’. For example, it is not enough to say that developing countries need better fiscal institutions. We need to be able to tell them how to build such institutions. Second, we need more case studies of institution building— historical and more recent. Real life experiences of institution building are often ‘stranger than fiction’—that is, they are often more imaginative than what theoreticians have suggested on the basis of broad generalization and abstract reasoning.

Against ‘Institutional Mono-tasking’

Institutions can, and do, serve multiple functions. Unfortunately, in the mainstream discourse, there has been a tendency to assign a single function to each institutional form, described as ‘institutional monotasking’.

The failure to understand the functional multiplicity of institutions means a failure to fully exploit the potential of an institution. For example there are many developmental functions of a central bank that are neglected because of the currently dominant view that the sole function of the central bank is to guarantee price stability.

Institutional mono-tasking also makes it easier for particular interest groups to hijack certain institutions and make them work mainly to their advantages. Shareholder-oriented institutions of corporate governance have often allowed shareholders to assert their interests over those of other stakeholders in the firm and of the broader society.

Politics of Institutional Change

Institution building cannot simply be a technocratic exercise. All institutions, including the market (which is often assumed by mainstream economists not to be an institution) are defined in relation to the structure of the rights and obligations of the relevant actors. As the definition of those rights and obligations is ultimately a political act, no institution, including the market, can be seen as being free from politics.

The politics involved in institution building process can often be very unpleasant. The efficient tax institutions of early modern Britain fuelled its imperialist expansion and repression of lower classes at home in the name of protecting private property. At one level, this ‘dark’ origin of certain institutions limits their applicability. For example, few would recommend that developing countries create institutions that repress the poor to emulate the British economic success in the eighteenth century. However, institutions can be used for purposes that were not originally intended, and therefore the ‘darkness’ of their origins need not keep us from using them for better purposes.

Structure vs. Human Agency

In the mainstream theory of institutional change, there is no real human agency, because what a rational actor will choose is already structurally determined. However, case studies show that history has developed the way it has because someone somewhere made choices that were not obvious according to the structural parameters.

If human actors are not automata responding to structurally determined incentives, their ideas matter a great deal. Sometimes ideas can be used as tools by human agents in their attempt to change institutions in the way that they prefer. The American professional managerial class has been able to use the shareholder-value ideology, which identifies it as main targets of restraint, in a way that allowed it to build institutions that enrich itself (e.g. stock options). However, ideas are not merely tools that human actors cynically manipulate in order to make the institutional changes that they prefer. Institutions affect the ideas that human actors hold, and therefore they shape the human actors. 

Unintended Consequences and Intended Perversions

Emphasizing human agency does not imply that those who plan and implement institutional changes are in full control of the situation. There are unintended consequences of institutional change—positive or negative.

However, the failures of certain institutions to serve their original functions may not always be unintended. Some actors may deliberately choose to use them for purposes other than the original ones. Patents for instance may be turned into vehicles of rent-seeking (as in the case of Britain at the time of Adam Smith) or even an obstacle to innovation (as in the recent extension of patents to the genetic level).

Such institutional perversion need not be a negative thing. It has been shown that despite its apartheid origins, the rather effective institutions of taxation in South Africa are slowly beginning to be used for redistributive purposes. 

The Technology of Institution Building

Although there is a diversity of institutions across time and place it should not be taken to imply that there are no common principles in the technology of institution building that can be applied across countries.

Institutional reform may be more effectively initiated by introducing desired economic activities than by introducing the desired institutions, as the current orthodoxy goes. In other words policy-makers should target the kind of activities that would bring the right kinds of institutions, not the other way around. 

Moreover, even when we agree that some institution is likely to be good, there is always a danger of ‘institutional overdose’. For example, even if some protection of private property is absolutely necessary, it is wrong to infer from that the stronger the protection is the better it is, as the conventional wisdom goes.

Concluding Remarks

The recent WIDER volume shows that there is no universal formula for institutional change that will promote economic development. Functional multiplicity, the importance of informal institutions, unintended consequences, and intended perversion of institutions all imply that importation of best practice formal institutions does not guarantee any particular positive outcome, even assuming that the imported institution can actually take root in the importing country. The fact that there is no set formula, however, should not make us think that there is nothing we can do to improve the quality of institutions in developing countries.

First of all, being late-comers, developing countries have the benefit of being able to imitate institutions that exist in the more developed countries–of course, with due local adaptations–and thus cut down the costs associated with developing new institutions de novo. Second, historical experiences show that countries do not have to start with high-quality institutions. It is perfectly possible to improve the quality of institutions while the country is developing its economies, with economic development and institutional development feeding into each other.

There is no universal formula for institutional development. However, even in this inherently complex area, it is possible to extract some general principles and enrich our empirical knowledge, especially if we are willing to go beyond the rather narrow theoretical and empirical confines of today’s orthodox discourse on institutions.​

angle-2007-2_img10.jpg(1) Institutional Change and Economic Development Edited by Ha-Joon Chang October 2007 UNU Press (paperback) 9789280811438 – North America / Geneva edition Anthem Press (paperback) 9781843312819 – UK / Europe / South Asian edition

Ha-Joon Chang is Reader in the Political Economy of Development, University of Cambridge, and directed the WIDER research project ‘Institutions for Economic Development: Theory, History, and Contemporary Experiences’.