It's the politics, stupid!

The Nepali media has lately been regularly reporting that the country’s economy has become as shaky as its politics, meaning that now we have the twin responsibilities of fixing both.

It is well-known that over a course of time, countries have moved into different paths of political and economic development. Due to the differences in their chosen paths, some countries have become well-off while others have not done well. Though there could be several reasons behind the ups and downs, in this write-up, I am trying to discuss the importance of institutions – political and economic – for a country’s growth and prosperity.

Let me present some examples of successful as well as failed economies. South Korea stepped on the path on development at around the same time that Nepal did. However, now South Korea is a member of G20 with a per capita income of about US$ 20,000 per annum while Nepal is one of the poorest countries in the world.

Until 200 years ago, Britain was a fairly poor country. But around the same time, one of the Caribbean countries – Haiti – was opulent and used to be known as the ‘pearl of the Caribbean’. But over time, Britain went on to become one of the most prosperous countries but Haiti’s fate took a different turn; its per capita started declining and the country experienced massive political instability, social chaos and civil wars. Now, Haiti is desperately poor and its politics is extremely vulnerable. Even India and China were said to be affluent until 200 years ago, but then they slid down from their opulence, and stayed in the most-poor category until their recent economic acceleration. What is the reason behind such twists and turns?

It is unlikely that we will have a better economy, until we have better political institutions. However, the question is: How do we shape the kind of political institutions that will develop better economic institutions? The crux is to have an effective controlling mechanism in place.

Traditionally, a country’s physical or human capital, level of investment, and adoption of technologies, were considered as the main sources of growth and prosperity. However, presently, the variation among the countries is said to be largely contingent upon the long-run historical process of the delivery of their institutions. Over time, how countries shape up their institutions has a strong bearing on the condition of their state today.

Daron Acemoglu and James Robinson, thinkers of political economy, have developed a framework to explain the paths of economic and political development. They argue that economic institutions matter for economic growth because they shape incentives for the investment in physical and human capital as well as in technology. However, the legitimacy of the economic institutions comes from political institutions. So the political and economic institutions work complementarily. Although cultural and geographical differences are also held responsible for the prosperity or penury of countries, however, the underlying differences in the institutions between countries are the major sources of cross country differences in economic growth and prosperity.

Nevertheless, institutions cannot be created in a vacuum, rather they are endogenous products. Institutions are determined through the collective choice of a society and the collective choice stems from a political process involving different political actors active in the society. As there would be many people and many groups acting as political actors in a society, there is no guarantee that all political actors agree on the same set of economic institutions. Such differences in the society lead to a conflict of interest among the different political actors over the choice of economic institutions.

Now, when there are differences of opinion in the choice of economic institutions, then the question that obviously arises is: Which group’s choice will prevail? The answer mostly depends on the political power. Although the efficiency of one group of institutions compared to the other may play a role in the choice, but it is the political power which will be the deciding factor for the selection of a set of institutions over the other ones. Whichever group has a deciding political power will secure the set of economic institutions that it prefers.

Let me relate a recent incident of Nepal in this connection. There was a news that to save the state-owned enterprises (SOEs) from being perpetual white elephants for their line ministries, effort was made to establish a holding company, put all the SOEs under its scope, and thereby allow these SOEs to run independently. Certainly, such an institutional set-up would keep the public enterprises out of the reach of political interference, prevent the misuse of their scarce resources, and enhance overall efficiency in these institutions. The Ministry of Finance (MoF), which has the responsibility of managing public resources, was pushing for this change. However, the line ministries currently holding the administrative controls over these SOEs strongly opposed the idea. Since letting them go under the scope of an independent entity would mean losing lucrative control over SOEs’ resources, they did not agree with the proposal of running SOEs under a holding company. The collective political power of the line ministries was bigger than that of the MoF and the proposal for change in SOE governance could not materialize. This is a glaring example of how political power determines the fate of economic institutions.

The distribution of political power in a society is also endogenous. The political institutions are determined as a collective choice of a society. As there will be different groups in a society, and different political actors, obviously there will be conflict of interest in the choice of the set of political institutions as well. The powerful political players establish and maintain the set of political institutions that maximizes their power, despite the fact that such a set of choice may lead to inefficiency. Why do they do so? One of the reasons is the inherent problem of commitments. The groups that have deciding political power cannot stop themselves using the political power to fulfill their commitment. In a country like Nepal, where there is no effective system of distribution and compensation, the power owners cannot offset the gap of not meeting their commitments.

This paradox can be equally explained in terms of inherent “principal agent problem” in the management of political economy. The groups that have deciding political power cannot stop themselves using the power for their “private” financial as well as economic gains without worrying too much about huge “social” or public costs. The monopoly of political power provides opportunity for the politically-strong individuals or groups to reap “private” benefits at huge “social” costs. This phenomenon is much likely to happen when a country is in political transition where political institutions are weak but the political players are strong.

So, it is unlikely that we will have a better economy, until we have better political institutions. However, the question is: How do we shape the kind of political institutions that will develop better economic institutions? The crux is to have an effective controlling mechanism in place. The political institutions that place checks on those who hold political power by creating a balance of power in a society will create good economic institutions. With checks on political power, power holders are more likely to go for a set of economic institutions that will lead the society or say the nation as a whole to a win-win situation. Otherwise, they will create economic institutions, which are beneficial for themselves but detrimental for the rest of the society. Sometimes the scale of available rents also makes difference in institution making. When there are limited rents that the power holders can extract, there will be a comparative advantage for them to go for building good economic institutions. Otherwise, it works in an opposite direction.

Good political institutions not only establish a system of rule of laws but also enforce them effectively. Such political institutions open the path for the establishment of economic institutions that protect property rights, ensure impartial enforcement of contracts, promote smooth functioning of markets, and safeguard the fruits of entrepreneurship, innovation, investment, and hard work. So, the underlying differences in the political and economic institutions are the major sources of cross country differences in economic growth and prosperity. Hence, economic well-being of our country can only happen if political and economic institutions complement each other. The effort of economic players alone is not enough to safeguard the economy.