The importance of appropriate institutions

The American economist and Nobel Prize winner Robert Lucas once wrote about economic growth that “the consequences for human welfare involved in questions like these are simply staggering. Once one starts to think about them, it is hard to think about anything else.”

These words are extremely relevant in a South African context of large-scale unemployment, poverty and inequality that cannot be resolved successfully unless there is a marked acceleration in economic growth, even though this is not the complete solution to these problems. No wonder that since 1994 the South African government has introduced one growth plan after another – from GEAR to ASGISA and more recently the New Growth Path (NGP) – with increasingly idealistic expectations of what each plan would achieve. GEAR and ASGISA envisaged a growth rate of 6%, while the NGP wants to create 5 million jobs by 2020.

Although the National Development Plan is not an explicit growth strategy, a sustained high growth rate of 5,4% per annum is an integral part of the achievement of its goal of 11 million new jobs by 2030. And last but not least, the alternative policy strategy recently announced by the Democratic Alliance promises a growth rate of 8% if its proposals are implemented.

From this one infers that South African policy makers finds themselves at a loss on how to promote economic growth. But perhaps the starting point is for them to realise how little direct control they really have over economic growth. They could take a leaf out of the book of the well-known economist, Jeffrey Sachs. He recently stated in the Financial Times that economic growth is not a policy, but an outcome. Elhanan Helpman of Harvard University even went as far as calling his book that appeared in 2004 The Mystery of Economic Growth.

There are several approaches to the question of economic growth. One such approach that has gained popularity in the past three decades is to focus on the relationship between political and economic institutions and economic growth. A recent new contribution in this regard is the book Why Nations Fail. The Origins of Power, Prosperity and Poverty by Daron Acemoglu and James A Robinson (hereafter A&R), in which they also put South Africa under the microscope.

A&R’s hypothesis is that progress and poverty are determined by incentives created by institutions. Institutions in turn are a function of a country’s political dispensation. According to them the difference between inclusive and extractive institutions is the deciding factor.

Inclusive institutions are characterised by guaranteed property rights (vital for investment and productivity growth), an impartial legal system that upholds contracts, the effective provision of public services to create a level playing field, space to create new businesses, and the freedom to choose one’s career.Inclusive institutions pave the way for two other driving forces of prosperity, namely technological progress and education, which jointly form the basis of innovation. Fear of the implications of the process of creative destruction is inclusive institutions’ greatest enemy, as different interest groups endeavour to protect and maintain their position.

Only the government has the power to guarantee the existence of inclusive institutions.

Extractive institutions, on the other hand, are aimed at extracting income and wealth from one section of society to the benefit of another section of society, usually the elite. In fact, extractive political institutions are the means by which the elite enrich themselves and consolidate their political dominance.

Economic institutions are created by society, and politics is the process whereby the rules in accordance with which society functions, are laid down. The distribution of political power is therefore crucial. Pluralistic political institutions that widely disseminate power in society and subject it to restrictions, but which at the same time are sufficiently centralised to be effective, can be regarded as inclusive. Inclusive political institutions in turn are a prerequisite for stable, sustainable, inclusive economic institutions.

It is obvious that extractive economic and political institutions are not conducive to economic growth. Extractive political institutions with strong centralised power can be accompanied by high growth rates for a period of time, but these are not sustainable in the long term. Inclusive economic institutions will not support extractive political institutions or be supported by them. A&R make the point that small differences in institutions could have significant consequences.

When looking at South Africa’s history prior to 1994, A&R come to the conclusion that extractive political and economic institutions were the order of the day. Therefore they are not surprised that economic growth was not sustainable and gradually stagnated. The accompanying graph shows clearly how South Africa’s growth rate declined systematically from the 1960s to the early nineties.

History shows that countries are not always trapped in a specific institutional set-up with its associated implications for growth. From time to time society reaches a critical juncture that could result in a sharp change in its future trajectory, whether negative or positive. The critical question is whether the juncture will result in more inclusive institutions or not. This will be determined, among others, by the interaction between critical junctures and the process of institutional drift, which depends on how a community resolves economic and political conflict.

A&R then state that “there should be no presumption that any critical juncture will lead to a successful political revolution or to change for the better. History is full of examples of revolutions and radical movements replacing one tyranny with another.”

According to A&R the political transition to a democracy in South Africa in 1994 was such a critical juncture that brought about more inclusive political institutions. Without making a detailed analysis of South Africa post 1994, they then assume that these went hand in hand with more inclusive economic institutions, which resulted in a radical change of direction that inevitably placed the economy on a higher growth trajectory. A&R’s conclusion is apparently once again supported by the accompanying graph, although one should bear in mind that multiple factors affect the growth rate in a specific period.

However, the question is whether South Africa, in terms of A&R’s paradigm, has fully exploited the opportunity for a more inclusive economy presented by the transition in 1994. Factors such as the continued high levels of unemployment and poverty, increasing inequality, in particular within the black community, the inability of the education system to equip learners for a technologically challenging work environment, and the country’s poor performance in international comparisons of entrepreneurial activity are indicative of a lack of success.

Perhaps the focus should shift from the proximate sources of growth such as saving and investment, to questioning the adequacy of South Africa’s institutions in promoting higher growth. The challenge lies in creating inclusive political and economic institutions that provide the appropriate incentives to support a dynamic, growing economy.