Lee has a thought provoking post about institutions over at his blog. Responding to criticisms that the idea is too diffuse and difficult to pin down, he expresses admiration for Paul Romer’s use of the term ‘rules’ rather than the vaguer terms ‘institutions’ and ‘good governance’ (though this is ancillary to his main point, that migration reduces the importance of institutional change). He’s right – it is a more concrete term, but I still take great issue with the way the concept has been used by Romer.
Romer has made rules the centrepiece of his Charter Cities idea. For him, rules are the laws, regulations and norms that govern an economy and society. The Charter Cities idea runs on two central premises: one is that developing country Governments don’t have the right rules or the capacity to enforce them properly. The second is that the ‘correct’ rules are known and can be imported, as can enforcement capacity.
I don’t for a second doubt that rules and enforcement are deeply important for economic development, whether you want to call the bundle of policy associated with all of this institutional economics or governance reform. There are a great number of examples of this historically. When historians debate why the Great Transformation of the Industrial Revolution and rapid economic development occurred in the West and not in other historical centres of commerce such as China, India and parts of the Middle and Near East, one of the most important factors is the emergence of a clear set of rules relating to property and financial intermediation, as well as the improving functioning of the legal system in Britain and the US in particular. Another example is the emergence of property law in the US, which Hernando De Soto has convincingly argued was central to the development of capitalism in the US.
There are also examples of rules that were imported to power economic progress. In particular, when the British brought their banking and legal system to India, it caused a massive spark in Indian businesses: increased investment and hence a more dynamic economy emerged out of the ability to lend and borrow against clear rules.
That said, the reality of how rules emerge and are enforced is far more complex than Romer and many advocates of good governance and institutional approaches to economics recognise. I’ve seen a lot of people write some variation of ‘we know what good rules are’ or ‘we have a good understanding of what institutions stimulate development’. Despite this, I’ve never seen anyone actually set down on paper exactly what the correct legal framework and institutional makeup for development is. If we really did know what worked, surly someone would have written a fairly uncontroversial but best-selling book about this, right?
The basic problem is that we have a fairly good knowledge of what rules and institutions work pretty well where we live, and we assume that these are objectively ‘good’ rules and institutions. Not enough consideration is given to matters of variance across time and space. This is extremely important when considering rules and institutional policy for developing countries.
The first point to make is that rules vary in important ways across space. This is obvious. When people say that ‘we know the rules that make for good development’ do they think that rules (any rules) are the same in all places? A passing interest in world affairs will demonstrate that very important rules are different in different places. Take laws on rape. Most people would assume that laws on something as awful as rape would be relatively straightforward. They’re not. The legal framework around constitutes rape varies across countries quite significantly. Statutory rape is a good example of this. In France, in order to be convicted of statutory rape, it has to be proven that the accused knew the age of the victim. In other words, it’s actually a legitimate legal argument in France to say ‘well, she sure looked old enough!’ Such knowledge does not need to be proven under UK law, for example. Even the basic set of possible verdicts can vary. In some countries, a case can return a verdict of ‘not proven’ – which is different to saying the defendant is guilty or innocent.
It may be argued that some rules are well known and understood, for example, those relating to property rights. However, even here, there are important differences in how different countries rule on property law. What constitutes property, proof of ownership and infringements thereon vary, even among developed countries. Couple this with different rules on financial intermediation and even the limited argument that ‘some of the rules relating to some of the economic factors’ are known becomes weaker.
It’s also important to note that there are good reasons why these rules vary. It is not simply path dependency, which would imply that we could choose any rules that work and import them to new places. Rules have developed to respond to social, political and even geographical stimuli. In other words, the differences between rule sets in different countries may mean that those rule sets cannot be suddenly substituted with different rules on the same topics. They may be changed towards other rules, but this generally takes time, debate and may incur a great deal of acrimony, even when the rule change is likely to be socially positive. France could change its laws on statutory rape without collapsing in on itself, sure. But it’s likely to be a time consuming process.
This brings up the time element: we are forever refining and revising our rules and institutions to better suit our societies as they change, and to better capture our intentions when setting rules. In other words, getting the rules right is a process of trial, error and refinement. Again, this should be obvious to anyone with a passing knowledge of law. We are constantly revising our legal structures with new laws, amendments to law, new precedents and even removal of laws. Regulation goes through similar changes, as do institutional structures, as with the creation or destruction of regulatory bodies and ministries.
This shouldn’t be a surprise. The principle of law drafting is essentially to express a complex idea (the rule) in as precise language as we can find to express that idea (the law). Many times, we find that our language wasn’t quite right the first time around. This leads to loopholes or laws that have unintended consequences. We then often need to go back and tighten the law. This happens even when the intention behind the law does not change. Even more commonly our views on what is acceptable in society changes, and with that, changes are made to laws, regulations and so on. Right now one of the biggest debates in economics is the correct role of regulation in financial markets. It’s almost certain that the outcome of these debates will be some further changes to the institutional structure surrounding credit markets, and that these changes will be revisited further down the line as conditions and opinion changes.
This stylized fact holds two very important messages for us. Firstly, it shows us that while we are quite good at identifying useful rules ex post, we are not good at it ex ante, or at least not good enough not to have to change them later. It also tells us that it takes a long time to get the rules right for a specific time and place, and indeed, we can never say that the law has been finalised and finished – it’s always evolving. This is true even for completely new places: when you create a charter city, the regulatory system and laws cannot be there before the people: it will need to respond to the precise social make-up of the place. It’s different when you consider a place which already has a pretty well-functioning legal and institutional structure, as India did when the British introduced their financial intermediation systems – in such a case, the adjustments will be easier.
In addition to all of this, norms also exist surrounding enforcement. Everyone knows there are rules or laws that are enforced, and those that are not. What’s more the way in which rules are enforced can vary significantly. This introduces another layer of complexity to the issue.
No-one is going to argue that rule of law, institutional frameworks and enforcement don’t matter. They do. However, moving from this point to a prescriptive policy for how developing countries should evolve new laws and institutions or how new places should be governed is far trickier than it’s made out to be. Even if rules and institutions are the key to development and even if we have the best will and practitioners to implement them, it will still take time to get them right and for them to show rewards. It’s not simply a question of knowing how to implement the ‘right’ rules. It’s a question of how to find the right rules for the right place.