Economic Structures,Institutions and Finance

The causality between economic structures and institutions forms one of the most glaring criticisms of developing economies. Lack of independent institutions such as property rights, patents etc are said to be the primary reason why rich countries grow rich and poor countries remain poor. However, in this article we try and explore how the causality runs from economic structures/production processes to institutions and not the other way with a strong manufacturing increasing return sector forming the genesis of modern democratic institutions.

It therefore becomes unclear that the Masai engage in subsistence activities because they lack property rights or its because of the latter that they continue to remain poor. Clearly in their situation, property rights have no meaning till their productive structures are transformed i.e. shift from subsistence-based agriculture (with diminishing returns) to a diversified structure that enjoys increasing returns propelling growth and well-being. It is this policy of diversification away from raw materials to an industrial system that forms the genesis of developed countries. Italian economists Botero and Serra explain how the large division of labour in Italian cities compared to the country side (engaged in agriculture) led to institutions protecting property rights, political freedom and rule of law.

Historically, the transition from land-based feudal economy to money-based capitalist economies in Europe was the change in economic structures which caused not just a change in the economic accumulation process but shaped political ideals and institutions. ‘The city air makes free’ was the common adage whereby one could escape from the traditional political conservatism of feudal land lords to the city- hub of industrial revolution. The city was budding with trade, commerce founded on principles of liberal markets that gave rise to a flourishing middle class. Cities also became a hub of left-wing politics whereby the urban proletariat provided a breeding ground for collective calls of worker rights. It thus becomes clear how Land grab or enclosure movements of England necessitated the need for property rights; the industrial revolution and need for domestic industrial protection generated barriers to trade such as tariffs among the most advanced countries (against liberal principles of free trade) and so on.

Democratic transitions are more likely to occur in increasing returns economies with a complex set of production structures which helps in diffusing technical knowledge (Acemoglu, 2008) that propels growth. Within economic structures, Institutions of Production i.e. State Policies help in providing dynamic and synergetic growth whereas Institutions of Exchange (dealing with patents, rule of law etc) provide stable equilibrium devoid of increasing returns that cannot culminate into advanced economic structures but merely maintain static efficiency within the present one. Moreover, a mismatch between productive structures and institutions of exchange may produce counter effective results. For example, enforcement of agricultural contracts with the Masai will not lead to long term accumulation because of a number of reasons. Firstly, the unequal relations of power between an agriculturalist and a corporate will only favour the latter. Moreover, if at all the bargain was to be fair, the exchange would only restore static equilibrium and not higher returns within the production process. This happens because of both the nature of economic activity (diminishing returns) and nature of institutions. This is the critique behind the Bretton Woods Institutions in imposing conditionalities against underdeveloped and resource rich countries who have not reached the economic sophistication to withstand the same institutions emanating from advanced economies.

Consider the experience of developing countries. For centuries these countries have witnessed the role of ‘extractive’ institutions that perpetuated their role as a raw material provider to the factories in London and Manchester. These extractive institutions put the elite in these economies (zamindar) in-charge of collecting resources from a diminishing returns sector that allows for the vicious cycle of under production and under development to perpetuate. Even after independence and re-distributive changes in the agrarian sector (Land reforms, bank nationalisation) a large share of economic transactions took place through extra-market routes as opposed to the liberal free market principles. This was because the monetary gains from diminishing return sector was not large enough to enforce private contracts through formal institutions. This causes corruption, disregard for rule of law and other inefficiencies associated with institutions in developing countries. In the developed nations on the other hand, politics is built around private interest because with increasing returns in production activities, the cost of flouting private contracts become high over the cost of enforcing them. Good will becomes an important factor in profit line of the firms and good institutions are easily enforced.

If we look at agrarian reforms in Indian agriculture in the past couple of years, most of them have dealt with reforms in agricultural markets involving liberalisation and operation of market forces. However, the deregulation in agricultural markets and electronic trading of produce has not caused significant benefits for this sector as much as investment projects (Gulati et al) or agricultural stimulus spending would have. This is because the bargaining strength of farmers are too small compared to private retailers or corporates who can defect on their contracts without much cost to them but debilitating the farmers. Any enforcement of mutual exchange becomes exploitative even within free markets if over-riding socio-economic inequalities are ignored and institutions are imposed from the top. Hence any reforms within the institutions of exchange already pre-supposes that the problem of production has been solved which is not true in the Indian case as over half of our farmers depend on bounties of nature for a good harvest. Also, in rural India most of the rural workers are farm labourers and the role of state has failed as inclusive institutions in providing property rights for ownership of the land they till.

What is then the role of state in motivating these glaringly erroneous allocations within a system of exchange? The answer is the dominance of capital and finance. When a land-based economy is democratised, the transition depends upon redistribution cost to the elites who can now be easily taxed by the emerging class of empowered peasants/workers. Hence, the elites choose repression to avoid the democratisation process. Among the industrialists, democratic transition is supported because it is difficult to tax capital and entrepreneurship in capital intensive structures (Acemoglu and Robinson). The inability to tax capital is evident in the reluctance to impose wealth tax and the ostensible need to gratify capital with lower corporate taxes every time the economy witnesses a downslide. Finance creates its own rules as it goes along and has numerous laws protecting the rights of finance at the behest of capitalists. These laws are imposed on fledgling economies where the role of state is reduced to a protector of finance than a protector of economic rights of domestic population.

Role of State and other national and international institutions have evolved around the need of finance and upholding laws most favourable to it. It has moved away from its role of an inclusive institution that provides economic opportunities to all under well-defined laws. In this context, the role of state becomes important in regulating finance within its territory to prevent national interests becoming subservient to interest of finance. State intervention refers to changing market incentives, creation and destruction of markets. The experience of the emerging markets in East Asia and of old Europe during the nineteenth and twentieth centuries are examples of growth-enhancing state intervention (Chang 2003). However, any state intervention in structural transformation is incomplete if it ignores the inter-linkages with agriculture. A high wage agricultural system has to persist around the industrial periphery to generate sufficient wage good demand that can sustain local industries. State can subsidise heavy and public goods industries that require favourable industrial policies and tax breaks for their sustenance. Role of state can therefore be imagined in harmony with domestic targets. However, the timing of protection is crucial for industrial expansion. At the time of its inception of new production processes, its protection was more important than market access (or opening up for free trade). However, once the industry reached appropriate scale, it needed larger market access to increase profits. Hence initially even though the consumers suffered under a protected regime vis-à-vis the consumers, opening up at a mature stage was pareto efficient as overall income levels in the economy increased. These decisions ideally have to be taken by states under national interests and have historically been followed by all major advanced nations. However, in a globalised world, these decisions end up being taken by finance-as evident by the strict conditionalities imposed by Washington consensus.

The primary focus of developmental activity should be to promote economic activities that promote growth and then these structures would give rise to a demand for institutions. By looking at institutions in isolation, irrespective of productive structures, important processes such as synergies, knowledge and cumulative causation are ignored. By ignoring the qualitative understanding of production and confusing it with barter, trade etc, neo classical economics has lost the connection between production and institutions.

Does following domestic policy necessarily entail non-selection by financial investments into your country’s markets? The Chinese experience is a profound example in showcasing how financial activities have been steered by the State and not the other way round. The capacity of State to use finance to serve its social objectives is best shown in the Chinese case with capital and exchange controls as breaks on the power of Finance to dominate state policy. The political economy of China makes the Communist party responsible for authoritarian capitalism even with their deep love for markets. Exchanges have played a crucial role in China in setting rules of game and deciding upon the extent, range and degree of financialization. However, this does not mean finance does not flow into China at the risk of being regulated. When the Chinese manufacturing was booming, China received maximum capital inflows whose movement it controlled and directed to development goals under market infrastructure using finance as a means to solve policy uncertainty. The exchanges became intermediaries between state, society and finance. Hence, attraction of finance requires sound and booming economic structures more than good institutions that facilitate its movement.

Pistor in her seminal book talks about ‘legal codification’ of assets that transforms it into capital. The purpose of property rights has changed from addressing socio economic needs to evolving according to the needs of capital. Complex process of financialization has created debts, collaterals, credit swaps under laws which have been suited to their most neo liberal adoption. The use of such laws by private interests favours the process of accumulation compromising the rule of law upholding public good. Legal coding thus helps in transforming assets to capital and creation of wealth out of this capital which ultimately widens the disparity and successive inequality between classes. These institutions are not inclusive and clearly not developmental (as even the most advanced nations battle with grappling unemployment figures).

The ongoing crisis has thrown all global institutions into disarray highlighting their stark failure in establishing a sound world order. With advanced countries resorting to zero interest rates again and loose finance looking to park itself in developing countries poses another opportunity or disaster for developing countries. Imposing capital controls can help strengthening national economic and institutional foundations or we usher into alternate bilateral arrangements between unequal countries (US’s credit default swap arrangement with handful of other countries) steeped in conservatism to make development a zero-sum game.

Notes
Diminishing return activities are nature based activities that produce less and less returns as their scale of operation increases due to fixity in resources. Eg agriculture, mining etc.

Increasing return activities harness economies of scale and grow with high rates of productivity. Eg. manufacturing

Excessive liquidity in advanced nations and near zero interest rates at home causes finance to move from advanced countries to emerging economies. In these instances, the emerging economies ‘get discovered’ by finance as they park themselves in these countries, dictating policies that the host has to oblige. At the onset of a slight trigger, however, finance flies back to safety to advanced economies rendering the host country in a financial mess. The developing nations can barely direct the finance into developmental process as the terms of finance is strict fiscal discipline.

US credit default swap is bilateral arrangement between countries such as US, South Korea and other countries chosen by US to extend a line of credit to deal with the present crisis. This is the alternative route o funding chosen by advanced countries to cement their role as hegemons as they direct finance as a bilateral favour and not through multilateral institutions (World Bank).

References
Acemoglu D (2008): ‘Oligarchic vs Democratic Societies’
Acemoglu D and Robinson (2013): ‘Why nations fail: The origin of Power, Prosperity and Poverty’
Chang JH (2003): ‘Kicking Away the Ladder: development strategy in historical perspective’
Constantine Collin: ‘Economic structures, Institutions and Economic Performance
Petry J (2020): ‘Financializing State Capitalism: Exchanges, Financial infrastructure and Active Management of capital markets in China’
Reinert Erik: ‘A Historical Perspective on Institutions and Uneven Development’, July 2006
Reinert Erik: ‘Evolutionary Economics, Classical Development Economics and the History of Economic Policy: A Plea for Theorizing by Inclusion.
Sundaram J (June, 2020): Best Law Capital can Buy.