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ISET Economist Blog

A blog about economics in the South Caucasus.

Institutions, Politics, and Development

How can a society become more prosperous? This question has been on the minds of economists and policymakers for centuries. More than two hundred years ago, Adam Smith wrote that “little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice, all the rest being brought about by the natural course of things.” Yet, still today, many societies around the world are characterized not by peace, easy taxes, and a tolerable administration of justice, but by civil conflict, weak or predatory tax administrations, and endemic corruption.

Differences in the quality of formal economic and political institutions explain much of the variation in living standards around the world. How these institutions are structured and enforced has a tremendous influence on quality of life and the opportunities available to people.

Generally, institutions can be structured and enforced in such a way that they are market-supporting and promote productive entrepreneurship, investment, and broad-based prosperity. Conversely, institutions can be structured and enforced in such a way that they promote unproductive entrepreneurship, like the seeking of privileges through the political process, and prosperity for only an elite group.

While there are many aspects to market-supporting institutions, such institutions define and protect private property rights and impartially enforce contracts. These institutions also constrain political actors from giving preferential treatment to well-connected businesses or engaging in predatory behaviors toward businesses without similar connections. Lastly, such institutions are the ones which support the rule of law, a free media environment, and transparency of government.

When one thinks about the welfare implications of how institutions are structured and enforced, it’s hard not to wonder why market-supporting institutions have not been established in all societies. While economists generally agree on the importance of the institutional environment in underpinning the effective operation of markets, there’s still much research under way about the historical determinants of different institutional structures and the complicated politics of institutional change.

One answer to this puzzle, albeit one among many, is that the political actors who choose how to build institutions or influence existing ones do not have the incentive to develop them in such a way that they are market-supporting. This may be the case when political actors personally benefit from maintaining the institutional status quo or when they are otherwise politically constrained.


THE CASE OF GEORGIA

In Georgia, it seems that the strengthening of institutions should be at the top of the new government’s priority list. Over the past few years there have been serious violations of property rights, including vanishing property titles. There has been weak support for the rule of law and due process. There have also been reports of discretionary tax raids. Additionally, there was seemingly no firewall between business and the government.

Insights from the political economics literature suggest that the weak institutional environment in Georgia will constrain future development and growth. This is precisely the result of the growth diagnostics study by Yaroslava Babych and Michael Fuenfzig, which suggests that weak property rights and political instability are indeed the main impediments to growth in Georgia.

Weak institutions lead to much uncertainty and political risk for current and potential investors and reduce the likelihood that investors will be able to fully realize the returns on their investments. In the eyes of potential investors, land grabs and violations of property rights also reduce the credibility of the government’s commitment to market reforms.

The strengthening of existing institutions could move Georgia away from being a place where “politics is everything, and everything is political” to a place where political actors are institutionally constrained and businesses can rely on predictable policy and institutional environments.

Ultimately, while much steel and glass has been used in the construction of new public buildings over the past decade, strong, transparent buildings are not necessarily strong, transparent institutions. Building the latter is much more challenging work and requires extraordinary political leadership. 


Key Resources

Acemoglu, Daron, Simon Johnson, and James Robinson. (2001). “The Colonial Origins of Comparative Development: An Empirical Investigation.” American Economic Review, 91(5): 1369-1401.

Acemoglu, Daron, Simon Johnson, and James Robinson. (2004). “Institutions as the Fundamental Cause of Long-Run Growth.” NBER Working Paper, 10481.

Acemoglu, Daron and James Robinson (2012). Why Nations Fail: The Origins of Power, Prosperity, and Poverty. Profile Books.

Besley, Timothy and Torsten Persson. (2011). Pillars of Prosperity: The Political Economics of Development Clusters. Princeton University Press.

North, Douglass. (1990). Institutions, Institutional Change, and Economic Performance. Cambridge University Press.

Olson, Mancur. (2000). Power and Prosperity: Outgrowing Communist and Capitalist Dictatorships. Basic Books.

Rodrik, Dani, Arvind Subramanian, and Francesco Trebbi. (2002). “Institutions Rule: The Primacy of Institutions over Geography and Integration in Economic Development.” NBER Working Paper No. 9305.

Smith, Adam. (1776 [1904]). An Inquiry into the Nature and Causes of the Wealth of Nations.

Williamson, Oliver. (2000). “The New Institutional Economics: Taking Stock, Looking Ahead.” Journal of Economic Literature, 38: 595-613.

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Guest - Vusal Mammadrzayev on Wednesday, 16 January 2013 01:12

Adam, you mentioned that the weak institutions, less transparency and political instability is the main constraint in the economic growth in Georgia. But it is interesting that how the Georgia achieved the drastic growth in economy and foreign investment in presence of this political instability.

Adam, you mentioned that the weak institutions, less transparency and political instability is the main constraint in the economic growth in Georgia. But it is interesting that how the Georgia achieved the drastic growth in economy and foreign investment in presence of this political instability.
Guest - NP on Thursday, 17 January 2013 15:21

I like a lot this piece. Actually, I believe Georgia went through a very active process of modernization in many areas under the push of the previous government. And this, maybe, was exactly possible thanks to a very strong and relatively unaccountable executive. What is good in the short run, however, is not necessarily good in the long run. Then main challenge, for any country that has gone through great difficulties and had to work hard to jump back on his feet, is to move from an "emergency" or "post-emergency" state to a sustainable path.
This means to develop an institutional structure able to renew itself and to respond quickly and effectively to an ever changing environment. This, unfortunately, requires much more than extemporaneous enthusiasm and heavily centralized (relatively unaccountable) decision making. It requires stronger institutions and a system of checks and balances that make sure the country functions well regardless of who is in power. This, however, in many cases means that those who got so much power in the beginning and who were fit for running the country in an emergency might have to step down in favor of others with different skills (or anyway to see their personal role diminished as institutions become stronger).
Obviously the transition between the two states is not trivial. Those in power have the tendency to cling to it more the more they stay, and to stop (even if they start with the best intentions) perceiving themselves as those "who serve the country for as long as their skills are necessary" to start feeling themselves as "the country" (or as "those who know better") and "the institution" they represent.
In this second phase, unfortunately, they can sometimes end up damaging the same positive things they have been doing. Georgia proved good (and maybe lucky) enough to be able to have a change in power without too much struggle.
If those in power now will show vision and work to strenghten the country's institutions, this could be a turning point in the right direction. Failure to do so could prevent the future development of the country. In this situation it is of the utmost importance that civil society continues being involved and scrutinizing the activities of those in power, contributing to the political debate.

Concerning Vusal's point. I believe the improvements that took place in Georgia are undeniable. They were both boosted by (and attracting new) foreign investment. What is interesting however is to see whether these capital flows will continue in the future and whether the country will be able to use them in the most effective way, to ensure sustained (and sustainable) development.

I like a lot this piece. Actually, I believe Georgia went through a very active process of modernization in many areas under the push of the previous government. And this, maybe, was exactly possible thanks to a very strong and relatively unaccountable executive. What is good in the short run, however, is not necessarily good in the long run. Then main challenge, for any country that has gone through great difficulties and had to work hard to jump back on his feet, is to move from an "emergency" or "post-emergency" state to a sustainable path. This means to develop an institutional structure able to renew itself and to respond quickly and effectively to an ever changing environment. This, unfortunately, requires much more than extemporaneous enthusiasm and heavily centralized (relatively unaccountable) decision making. It requires stronger institutions and a system of checks and balances that make sure the country functions well regardless of who is in power. This, however, in many cases means that those who got so much power in the beginning and who were fit for running the country in an emergency might have to step down in favor of others with different skills (or anyway to see their personal role diminished as institutions become stronger). Obviously the transition between the two states is not trivial. Those in power have the tendency to cling to it more the more they stay, and to stop (even if they start with the best intentions) perceiving themselves as those "who serve the country for as long as their skills are necessary" to start feeling themselves as "the country" (or as "those who know better") and "the institution" they represent. In this second phase, unfortunately, they can sometimes end up damaging the same positive things they have been doing. Georgia proved good (and maybe lucky) enough to be able to have a change in power without too much struggle. If those in power now will show vision and work to strenghten the country's institutions, this could be a turning point in the right direction. Failure to do so could prevent the future development of the country. In this situation it is of the utmost importance that civil society continues being involved and scrutinizing the activities of those in power, contributing to the political debate. Concerning Vusal's point. I believe the improvements that took place in Georgia are undeniable. They were both boosted by (and attracting new) foreign investment. What is interesting however is to see whether these capital flows will continue in the future and whether the country will be able to use them in the most effective way, to ensure sustained (and sustainable) development.
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