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Introduction
Economic performance is attributed to the association between various socio-political and legal institutions that have specific contributions to gross domestic products (GDPs) of different countries. The role of institutions in the society has been studied in different disciplines including social sciences, economics, philosophy, politics, and geography. This essay provides a critical insight into the meaning of institutions by critiquing the evidence of their formal effects on economic performance.
What are Institutions?
The term institution has been broadly used in social sciences as mirrored in the emergence of intuitional economics. Many definitions have been put forward about the term institution. However, this paper adopts the Norths definition of institutions as humanly devised rules constraints that shape peoples interactions. They are rules of the game prevalent in the society that control human interactions (Efendic, Pugh, & Adnett, 2011). Also, North elaborates institutions as formal constraints comprising laws, formal rules, and constitutions. It also comprises informal constraints encompassing norms of behavior conventions and code of conduct (Efendic, Pugh, & Adnett, 2011). The formal and informal constraints have enforcement characteristics. Additional works of literature show that the rules are devised by humans with a view of constraining and enabling specific actions. Indeed, a substantial amount of literature reveals a consensus that institutions have a great influence on the economic performances of nations. Institutional determinants of economic growth fall under political, legal, executive and social categories as manifested through the international trade openness, court systems, financial regulation, corruption, democracy, protection of property rights, and general market principles. The institutional factors have been deemed as crucial contingencies that leverage the economic performances of different countries around the world. Efendic, Pugh, and Adnett (2011) suggest that the economic parity that exists between the developed and less developed nations is contingent on the aforementioned institutional factors. An effective institutional environment is characterized by the economic integration that results in a generally positive performance.
Institutions are significant elements that shape the degree of economic freedom in many countries to create an ample and conducive environment for progressive macroeconomic growth (Tamilina & Tamilina 2014). Various empirical studies that have analyzed the relationship between economic freedom and economic growth confirm their positive effects on macroeconomic performance. A measurement of the economic growth is obtained from the gross domestic product (GDP) per capita income of a country (Elgin & Oztunali, 2014). In this regard, countries that have favorable economic freedom portray higher GDP dynamics compared to those countries whose institutions have not created a favorable climate for economic freedom. Policymakers in different nations across the world influence the degree of economic freedom. Those policies can either improve or reduce the economic freedom. This state of affairs affects the economic development (Elgin & Oztunali, 2014). The following is an in-depth analysis of institutional implications on economic performance as empirically manifested in selected countries.
Political Institutions
Political institutions have a sound effect on the economic performances of diverse countries. The effect of political stability has been shown empirically to influence economic performance. For instance, several studies carried out in Greece during 1960-1995 revealed that the relationship between economic performance and political instability was negative. However, political stability had a positive correlation with economic development. Political institutions that are characterized by political strikes, coups, assassinations, and terrorist attacks have shown negative economic growth (Efendic, Pugh, & Adnett, 2011). This observation can be explained economically in that both local and foreign investors tend to avoid countries where the political climate is unfavorable for business operations. Investment is contingent on the prevailing political temperatures of a country. In countries where terrorism is a major challenge, venture capitalists scare away to politically viable countries. In such countries, the unemployment rate remains high given the low rate of investment. In such situations, investments that lead to job creation in politically unstable environments tend to below. Instability has local implications in that the producers and feeders of the countrys economy only seem to care about their lives rather than the economic activities. Political regimes dictate the legal systems of a country (Tamilina & Tamilina 2014).
Effect of Financial Institutions on Economic Performance
According to Ahmed and Mmolainyane (2014), financial policies can stimulate or slow the economic growth of a country. Financial liberalization can leverage the economic performance of a country to a great effect (Ahmed & Mmolainyane, 2014). It refers to the policy of removing regulations that restrict how the financial systems operate (Compton & Giedeman, 2011). Financial liberalization encompasses numerous reform-based aspects that have been deemed the major contributors to the economic emergence in China. This part brings an evidence-based overview of the effect of financial liberalization on the economic performance of China. First, diversification of financial institutions is a phenomenon experienced in the country. For instance, in 1978, the formal financial system consisted of one bank, the PBC, whereby deposit receivership, acceptance, and channeling was a government credit allocation policy development (Ahmed & Mmolainyane, 2014). The following three decades saw a major reform of the financial system with the emergence of the four state-owned banks (SOBs), urban credit cooperatives, regional shareholding banks, rural credit co-operatives, and city commercial banks. Also, China joined the World Trade Organisation (WTO), the joint-stock reform of state-owned banks. Secondly, China experienced the development of a financial legal framework that facilitated the transition from a bureaucratically controlled system to one with a high degree of transparency, particularly under the impetus of policies to scale monetary relations internationally (Law & Azman-Saini, 2013).
Moreover, the reform of credit quotas was a noticeable milestone in China that realized a change over from a centralized tool of the government to an autonomous credit allocation role of the state-owned banks in 1984. The specialized banks had a degree of freedom in the use and allocation of funds although it was not until in 1998 that the PBC scrapped the credit quotas altogether to adopt the state-owned banks. This reform was a major boost for the local Chinese investors who wished to seize loans and credits. The deregulation of the interest rate is an inevitable reform that propelled the economic growth of China (Compton & Giedeman, 2011). In this regard, the state-owned banks were allowed to vary rates within a band that was slowly broadened and eventually relaxed in 2004. The deregulation of the SOBs gives them an autonomous status in determining the interest rates. This situation improved the flexibility that extended to borrowers and prospective investors. More people were encouraged to access the funds for economic development.
Over the recent decades, China has intensified its openness to the rest of the world. This significant achievement was realized through the relaxation of strict foreign exchange controls. This relaxation encouraged foreign direct investment (FDI) for fourteen coastal cities during the 1984-85 as part of the opening process to the rest of the world. Under the impetus of the world trade organization (WTO), Chinas membership was outspread to encompass its banking, foreign exchange, and capital markets (Compton & Giedeman, 2011). From the foregoing, it is worth noting that countries whose financial institutions are characterized by liberalization experience a far higher economic performance than those that have strict financial regulations. In the 1950s and 1960s, it was widely perceived that maintaining interest rates artificially low induced economic development (Law, S & Azman-Saini, 2013).
Protection of Property Rights
The protection of private property rights is a vital component of economic institutions. The degree of its effectiveness can either stimulate or derail the economic performance. For instance, the effective protection of private property rights enables economic players to make viable plans as it gives them sufficient incentives to invest in capital. Also, it shrinks transaction costs both in the economic transactions and political decision-making (Qerimi & Sergi, 2012). The economic actors are willing to enter exchanges that they anticipate reaping mutual benefits. In this regard, well-protected property rights in conjunction with interference-free markets are enough reasons to woo the economic investors to venture confidently as the retrieval of gains remains certain. This situation extends the economic values to the society who benefit from more jobs, increased productivity, and availability of goods. Economic theorists such as Sahakyan and Stiegert (2012) assert that economic growth holds that the actions and interactions of human resources are productive. A regime that acknowledges the significance of well-defined property rights is an important incentive for people to indulge in productive behavior and trade rather than in disparaging, manipulative, and purely redistributive practices (Sahakyan & Stiegert, 2012). As a result, a system that provides favorable policies regarding the protection of property rights aligns the investors interests with the societys preferences to encourage cooperation; hence, it fosters the economic growth (Qerimi & Sergi, 2012). On the other hand, predatory behavior limits economic growth for the levels of productivity is low.
Property rights are deemed secure when the industry actors are entitled to use and transfer what they rightfully own without any aggression whatsoever including the government itself. They are manifested in different perspectives including a cluster of institutions that ensure efficient enforcement against public and private predation such as constitutional restrictions to expropriation, taxation limitations, and parliamentary procedures. Sahakyan and Stiegert (2012) positively correlate property rights with the economic performance of a country. However, various pieces of literature have also revealed that such correlations are weak or non-existent. The improvements in property rights rankings do not correlate with economic performance since different countries exhibit varying results that are crucially contingent on other economic parameters (Sahakyan & Stiegert, 2012). All in all, a strong government should enforce the property rights to promote social and economic interactions. However, the strength of the government or political regime cannot be overlooked as it has the potential of influencing policies regarding property rights. Some regimes can pose a threat to the property rights that it is supposed to safeguard. This situation is well-explained when the actions of a new regime seem to reverse the actions of the previous regime (Zoogah, Peng, & Woldu, 2015).
This practice can encompass imposing restrictions that infringe peoples freedom of ownership of private property thereby posing a threat to the industry actors who can view the constraints as mechanisms to narrow their profitability margins and scaling. The ultimate impact of such reversal practices is reduced economic growth as employers reduce the workforce expenditure in a bid to retain their profitability. This situation results in unemployment in the society and country as a whole. Countries where property rights are highly respected post promising economic growth statistics compared to those countries with weak policies.
Separation of powers and change of political regimes are two crucial topics of discussion as they influence the protection of private property rights (V+tola & Senfelde, 2012). The existence of veto powers that determine the change-over of political powers can leverage the decision-making processes of important economic policies in the country. Indeed, many institutional veto players existing in the incumbent political regime of any country tend to derail the decision-making processes besides increasing the transaction costs involved in the government policy formulation processes. This slow process adversely affects the economic growth since some policies can take too long before a consensus is reached. In contrast, other researchers such as V+tola and Senfelde (2012) associate many veto players in decision-making with favorable outcomes on the part of the formulated policies because different viewpoints are brought into consideration. In such situations, many inclusive policies are likely to be discussed. V+tola and Senfelde (2012) posit that the more veto players get involved in the government decision making processes, the higher the chances of coming up with favorable policies that can stimulate economic growth, as bad policies are strongly resisted by a bigger representation.
It is undoubtedly true to say that policies made by a single veto player have a high probability of influencing the economic growth negatively as the levels of consultation are low in the decision-making process. The structure of property rights and the presence of perfection of markets determine the willingness of people to invest in both human and physical capital. Protection against the expropriation is a great incentive to invest, particularly in physical capital and durable assets. In this regard, regimes that manifest a proactive support for the physical and intellectual property rights can pull tech-savvy industries that complement specialized and durable assets. Numerous qualitative studies indicate that institutions have a profound impact on the physical capital compared to human capital accumulation and productivity.
How Political Rights and democracy Leverage Economic Growth
Political freedom has both direct and indirect impacts on foreign direct investment (FDI). Political rights and civil liberties have typically been conflated under political freedom. They have divergent implications on a countrys economic growth. The economic importance of foreign investors and international trade cannot be underrated. For a country to maximize benefits from these two international relations aspects, it has to hold political rights highly important as they influence the decisions made by international traders and investors in a particular country. The participation of a country in international trade is important as it contributes greatly to the earning of foreign exchange that in turn boosts its balance of payments (Islam, 2012). The magnitude of foreign direct investment (FDI) and international trade is contingent on the degree of political rights (Islam, 2012). A country whose political institutions are highly associated with autocratic practices will scare away investors. This situation hampers its economic development. However, democratic political processes tend to be attractive even to investors as their level of confidence in the country remains high.
Effect of Corruption on Economic Performance
According to North (1991), another institutional determinant of economic freedom and development is the quality of governance exhibited by the country itself. Governance that is highly defined by corruption has been empirically shown to hamper economic development (Ionescu, 2014). Corruption slows down the economic growth in several ways. First, it diminishes investment in physical capital and human capital levels. Secondly, corruption promotes political imbalance. Foreign direct investment is hampered when investors are aware of corruption motives of the incumbent government. The investors express a high degree of uncertainty of reaping proportionate returns on their investment undertakings in the country (Ionescu, 2014). When corruption stands out in the economy, additional supplementary costs are feasible as investors undergo bribery procedures to obtain particular favors from the government. The costs are not low as some scale up to approximately a quarter of the projected profitability of the firms awarded with those favors over others. For example, in some African countries, the exploration of oil that is done by multinational corporations and the awarding of tenders has been deemed highly corrupt and costly for the winners. Bad governance takes the ultimate blame for the adverse effects of corruption on economic growth (Ionescu, 2014). This situation happens when the rate of market openness is higher than the rate of institutional improvement necessary to regulate the transaction costs and address market deficiencies.
Corruption, which is an institutional attribute, affects the economic growth adversely by taking out monetary resources that can be attainable under rightful circumstances for economic scaling. Once perpetuated in subsequent government or political regimes, the effects move from worse to worst as more economic resources are utilized for personal rather than entire economic gain. Resources that can be deployed profitably in the country are dispersed poorly to attract personal gains at the expense of the countrys economy. Institutions marred by corruption are characterized by undemocratic processes whereby decisions are made and implemented by top officials only. Such decisions are unquestionable by the public despite the deteriorating effects they have on the economic growth of the countries. Corruption can influence the amount and configuration of public costs in ways that intimidate the development besides increasing inequality (Ionescu, 2014). Corrupt deals can be traced in the spheres of monopolistic powers and public procurement deals that encompass enormous costs and intricate technologies.
Some authors have associated corruption with beneficial economic effects. They hold that it enables citizens to elude inefficient and bad governance. Corruption stimulates the public quest for governance issues and the quality of leadership. In some situations, the citizens of countries with corrupt regimes and poor governance have been manifested engaging in reform-based demonstrations. Most of the widespread demonstrations have been an economic turning point for some countries since corrupt governance is exposed and eluded (Ionescu, 2014). Some African countries such as South Africa have reached the economic heights due to the exposition of corrupt political institutions. Nevertheless, the benefits of corruption are perceived to decline gradually as the economic institutional settings advance. As institutions shift towards achieving the economic freedom that marks the optimum point of attaining high economic performance, the demand for corruption diminishes (Lorisio & Gurrieri, 2014). The prevalence of corruption in governance is a sure sign of unsatisfactory institutional quality and shortcomings intensifying them through the irregular compensation for optimal standards and implementation procedures. In this regard, it negatively affects the decisions of economic actors via misrepresentations (Ionescu, 2014). Corruption is beneficial when economic freedom is irrelevant. In contrast, when the economic freedom is significant, corruption curtails economic performance.
According to North (1991), the quality of governance is an important determinant of the national and/or regional economic performance. The link between corruption and economic growth is determined by political economy attributes, configuration, and the prevailing degree of development. If corruption is highly centralized or configured in the government or regimes, the economic performance for such the country will remain low and highly inhibited as there exist no incentives for investment and trade. The governments that deal with corruption effectively can attract foreign direct investment besides setting up domestic and international trade involvements (Kova
evi & Borovi, 2014). The ultimate result is improved economic development in the country. Highly developed countries including the western European countries and the United States have comparatively lower levels of corruption as opposed to the underdeveloped countries that occupy higher positions in the global corruption ranking. According to annual reports on economic and corruption indices, political corruption is the prerequisite to the economic underdevelopment of countries that take the higher corruption positions (Kova
evi & Borovi, 2014). Most of the significant development projects that determine the economic growth of a country are controlled by political powers. In this regard, given a corrupt incumbent government, the levels of economic growth will continue to be very low (Lorisio & Gurrieri, 2014).
Legal Systems and Law Enforcement Institutions
According to North (1991), the economic performance is determined by the government institutions of countries including the legal systems such as the courts (Cappiello, 2010). The legal system is charged with the responsibility of overseeing the allocation of resources. The equitable allocation of resources can foster an ample economic environment that can stimulate more growth and high performance. Cappiello (2010) posits that the features and attributes of the legal systems of countries have both direct and indirect effects on the peoples economic behavior. A legal system is a system of inter-related formal institutions converging to execute three important functions including setting up rules and standards through laws and regulations for the country, reconciliation procedures, and law enforcement (Heckelman & Wilson, 2013). The legal systems extend to cater to international rules of the game including foreign market entry procedures, labor market outcomes, overseer of unofficial economies, and stock market development (Cappiello, 2010). The characteristics of the legal systems are correlated with economic performance based on a causality perspective in that their extent and functionality determine the resultant economic outcomes in those countries. The effectiveness of legal systems in countries in matters about land rights among other owners of property rights determines the peoples level of confidence and motivation to engage in economic activities that contribute towards economic growth (Qerimi & Sergi, 2012). The judicial system whose primary roles encompass conflict resolution through court cases can affect the economic development through fair and timely determination of cases. Cases that take too long can affect the economy of the country adversely, particularly when they involve investor-related issues. Unfair judgment can also scare away prospective investment activities; hence, prevent economic influx (Heckelman & Wilson, 2013).
Effects of Culture on Economic Growth
While substantial literature emphasizes the role of institutions on economic growth, Chambers and Hamer (2012) assert culture mirrors peoples way of lives including norms, beliefs, and values regarding human behavior that defines their actions. These norms have been shown to have significant effects on a countrys economic growth. The relationship between culture and economic development dates back to the Weberian Protestant ethics among other schools of thought. Weber held that the rise of Protestantism was an important event in modernizing Europe (Chambers & Hamer, 2012). Protestantism was perceived as an opposition to Christian norms that inhibited the economic accumulation and growth. It was regarded as an erosion wave of the highly held Christian norms and values of obedience, faith, and trust that characterizes the preindustrial economies with little or no economic growth (Chambers & Hamer, 2012). The emphasis of preindustrial economies was that economic development only occurred at the expense of someone else. The social-economic status and social positions in this cultural setting were regarded as hereditary and ascribed rather than achieved as suggested by the protestant ethics.
Today, these primitive cultural beliefs are still inherent in many societies. Such societies are underdeveloped and not willing to indulge in economic practices that go against the sacredly held beliefs against economic accumulation. Countries in which such cultural tendencies and practices are common to portray low economic performance. They rely on simple farming that is influenced by seasonal weather patterns. This way, the countries are marked by high levels of poverty, hunger, and little infrastructural development. Due to the globalization effects that are revolutionizing human behavior today, the primitive tendencies are declining rapidly as people embrace modernity and change. As a result, there has been a marked economic growth in such countries since people focus on personal achievement through capitalism (Chambers & Hamer, 2012).
On the other hand, Weber stressed the importance of Protestantism whose effects are experienced today by the highly developed economies such as the Western European countries and emerging economies including China and Taiwan among others. Repressive cultural norms and values have been confronted by capitalistic practices such as capital accumulation, intense individual, and firm competition over resources and markets. Modern Europe manifests the reality of Protestantism and opposition of the medieval Christianity. Individual wealth accumulation was no longer rejected mainly among the Protestant regions of Europe. The situation resulted in a subsequent economic dynamism. Similarly, it is worth noting that due to the reformative protestant effect in Europe, the Industrial revolution and development took place entirely in the Protestant regions. Webers concept has been accepted and acknowledged by many economics scholars for proving an important insight on the cultural factors that influence the economic performance. Today, it is inevitable that there exists a cultural parity between the developed economies and developing economies. Developed countries manifest cultural acceptance and significance of savings, population control, and employment of technology in production whilst underdeveloped economies still debate on practices such as population control mechanisms based on cultural beliefs and values.
Chambers and Hamer (2012) reveal that cultural parity is the reason why identical formal institutions functioning similarly in terms of positions, policies, regulations, and procedures to achieve different economic heights in Europe and other countries around the world. Moreover, factors such as urbanization, literacy levels, and access to information can be utilized to explain the differences in economic performances among countries operating under the same formal institutions. For instance, most countries colonized by the European countries use the same structure of formal governance, legal, and social institutions. However, the countries cannot match the economic development and performance of the respective colonial masters due to cultural factors (Chambers & Hamer, 2012). For instance, long after the European colonization, most Africans have not changed some cultural practices that inhibit economic growth such has corruption and uncontrolled demographic dynamics. The urbanization rates, as exemplified in the modernization theory, remain slow in the underdeveloped countries due to stubborn cultural factors that act antagonistically towards globalization and modernization. As a result, individual, national, and regional economic statuses remain away below par as compared to the developed countries (Chambers & Hamer, 2012).
Effect of Geography on Economic Growth
The subject of economic growth disparity among nations can be considered incomplete without bringing forward the geographical factor that takes a central role in international economics. Geography is a natural determinant of climate, endowment of natural resources, transportation costs, infrastructural development, disease burden, sharing of knowledge, and diffusion of technology among nations (Clipa, PohoAc, & Clipa, 2012). This part analyses how geography directly or indirectly affects the economic performance of countries about the aforementioned institutional factors. Tropical countries exhibit an average income per capita of approximately only a third that of non-tropical countries (Clipa, PohoAc, & Clipa, 2012). First, geography can have inevitably influence the incomes through its effect on agricultural production and morbidity. Geography affects the accessibility of a region particularly by sea, which gives some countries a competitive advantage over others. For instance, landlocked countries have to depend on those that have coastlines for transportation services that attract heavy transportation and custom tax costs. Goods have to pass through the countries that have seaports before they undergo other handling undertakings before transportation to the landlocked countries. Even with increasing and advancing air cargo industry, shipping services, and sea transport remain for use in the modern international trade (Clipa, PohoAc, & Clipa, 2012). Countries with access to water transport are economically better placed than landlocked countries. This situation creates an economic disparity between the two groups of nations.
Also, agricultural productivity highly depends on geographical factors. For instance, the temperate and tropical ecological zones are deemed to have an economic advantage due to their favorable agricultural climatic conditions, weather patterns, and soil features. Due to the geographical factors, different regions and countries are favored to produce particular raw materials and agricultural products that other countries cannot. This difference in resource endowment brings a disparity in the economic progress of the countries in the different ecological zones. Furthermore, due to their geographical location, some regions are characterized by natural disasters including earthquakes and hurricanes. Once such disasters occur, they cause disparaging effects on the peoples lives and the countrys economy at large. Various catastrophic effects have been caused by hurricanes and earthquakes that have crippled the countrys economies including the Haitian and Chilean earthquakes of 2010 that left the countries in dire economic needs. Endogenous growth models view natural disasters as the causal agents of negative growth progress to the affected economies. For instance, they cause massive damage to expensive infrastructural developments including roads and railways that are the backbone of the countrys trade and industry.
Besides, it leads to the death of populations of people resulting in loss of intellectual property, workforce, and leaders. According to the endogenous growth models, natural disasters result in slower growth and sometimes the economies affected consequently suffer from a deviation from the growth paths. Contrastingly, the neo-classical growth models predict that natural disasters destroy both physical and human capital. However, they do not affect the rate of technological development. They result in the convergence of nations as they display their technological capabilities in a bid to help raise the fallen economies. Geography determines disease and vector presence in different ecological zones. Governments for countries geographically positioned in areas prone to dangerous killer diseases such as Malaria spend more percentages of their GDPs on disease control and treatment. The expenditure on healthcare, which sometimes is enormous, can otherwise be utilized on other development projects.
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