Three Lessons on Institutions and Incentives (Part 8): Conclusion

Far from the custom of assigning to cultural factors, or educational, or geographic or relative to the particular constitution of the ruling elites, the three works reviewed – Institutions, Institutional Change and Economic Performance, by Douglass C. North; The Elusive Quest for Growth, by William Easterly and Why Nations Fail, by Daron Acemoglu & James A. Robinson, state an explanation of the progress and decline of nations articulated on abstract incentives, which serve as a structure in which frame the rational agent makes his choices. The four authors have a common reference to methodological individualism, but such an individual agent does not make decisions in a vacuum, but inserted within a framework of incentives.

That such incentives, to act as points of reference for individual action, should materialize historically, does not mean that such conditions for action come from a particular circumstance of time and place, but that they depend on an abstract structure that relates to different terms and that is present in every phenomenon of human interaction.

To finish, it is worth referring to the conclusions reached by North in his referenced work: the case of the two successive Spanish Americas, the Habsburg and the Bourbons. The first extended from the discovery and colonization of America to the early eighteenth century. The viceroyalties of America enjoyed great political autonomy – Spanish immigration had been little and a “Creole” elite had developed – and they were closed to trade, which was limited to the “export” of gold to Spain. With the arrival of the Bourbons at the beginning of the 18th century and the implementation of their Reforms – which from the economic point of view were a resounding success both in Spain and in America – the relationship was reversed: political power passed into the hands of the “Peninsular Spaniards” and an opening of a more fluid trade between the metropolis and its colonies was launched. North explains that the independence movements could be successful due to a transitory alliance between the sectors that wanted to return to the Habsburg system and those who wanted to deepen the modernizing and free-market impulse of the Bourbons. Once achieved independence, these two currents came into conflict, which, according to the author, would extend until today.

According to North’s thesis on Spanish America, there would be two political patterns in tension: on the one hand, an elitist politician who is open to the economy and on the other a “popular” current that is traditionally protectionist. In the second half of the 19th century, success belonged to the “Bourbon pattern” and, in the 20th Century, the “Habsburg pattern” prevailed. In terms of Acemoglu & Robinson, it would be the dispute between a combination of extractive political institutions with inclusive economic institutions and another combination of inclusive political institutions with extractive economic institutions. Of course, in practice, moments of extractive political and economic institutions were also known, as well as short-lived experiences of inclusive institutions, both politically and economically.

The notion of polarized societies used by Easterly can serve as a way to deepen this analysis. It is much clearer to find problems of countries with societies divided into distant and dissimilar regions, in which the policy is expressly articulated as a function of tribes or ethnic groups and which the dispute over public policies expressly favors or harms a another ethnic group. However, as it has been stated, it is not ethnicity or nationality that determines the low economic and institutional performance of a country, but the polarization structure itself, whatever the functions in which such polarization is expressed (language, religion, ethnicity, ideology, etc.). Understanding these latter is fundamental to be able to provide a common thread for a principle of solution.

Just as on the political level an express agreement can be reached on the way to choose who exercises public power and under what conditions, Easterly states a series of conditions related to economic institutions whose agreement would allow for economic growth, regardless of the region, culture, or education of the ruling class of each country. Throughout The Elusive Quest for Growth you can find mentioned to free trade as a main factor of progress, monetary stability and exchange freedom as examples of clear and equitable rules, a state that participates in large infrastructure works but that refrain from arbitrating in the distribution of economic rents among various groups, a low level of public indebtedness, stability in property rights and an independent justice that allows individuals to innovate and save, as well as support programs and incentives to members of society who are immersed in poverty traps.

As mentioned, many times the policy -especially when, in the terms of Acemoglu & Robinson, it is inclusive- consists of the composition of interests of various kinds for the purpose of articulating a government program. From the work of the authors commented here, it can be inferred that, just as there is an agreement on the political plane regarding the rules of the democratic game, which include periodic elections, limited re-elections and division of powers, among others, there should also be a consensus in a body of economic institutions that should be left out of political negotiation, so that economic policy is as neutral as possible against the conflicting interests of which a country with a polarized society is composed.

[Editor’s note: Here is Part 7, and here is the entire, Longform Essay.]

Three Lessons on Institutions and Incentives (Part 7): Breaking the mold

This role of entrepreneurs also depends on an abstract characteristic of technological knowledge: it works in a manner contrary to that of most goods, since it is more productive to the extent that it is more widespread in the population. This characteristic of the abstract nature of technological knowledge is related to the phenomenon of the combination of skills (matching of skills): the negative side of creative destruction lies in substitution phenomena (a computer program of inventory management increases the productivity of work saving the salaries of the army of employees who used to carry them with pencil and paper), but the positive side comes from the phenomena of complementarity.

As William Easterly exemplifies, the cardiac surgeon will be more productive in a first world hospital, where he will have specialized nurses, other qualified doctors like him, a sophisticated system of hospital administration, and so on, being the only cardiac surgeon in a hospital. city ​​of the third world, where it does not have professionalized nurses, nor the help of other medical colleagues, working in a hospital in which he himself has to deal with administrative issues. If there were only substitution relations, it would be convenient for a doctor to practice his profession in the most remote place possible. However, as relations of complementarity of knowledge exponentially increase the productivity of the professionals involved, the doctor will find it more convenient to practice in a health center that has the largest number of doctors and paramedics possible.

The latter does lead to the phenomenon of “traps”: any rational agent, who maximizes the utility of their choices will be discouraged to deepen their studies if they perceive that they can not give any use to their education. There are the cases in which a person discovers that in his country there is no technology or the necessary number of professionals to develop a specific activity, or that, existing, you will find prohibited the exercise of their profession based on restrictions regarding their race, caste, social class, sex, etc. Since, rationally, a person who is included in a particular group under which he will be found forbidden or will be hindered the exercise of his profession, he will find as the most rational of their alternatives to abandon their studies, so that their chances of progress will no longer be limited only by legal or social barriers, but because of their lack of suitability for high-paying functions. Such are the so-called “poverty traps.”

There are also wealth traps. There are those cases in which the individual knows that he is within a favored group or in which he knows a large number of professionals and, therefore, invests time and money in his education because he knows that he has high chances of success, which will then be confirmed. Obviously, such phenomena of divergence generates another problem, addressed both by Easterly and by Daron Acemoglu & James Robinson, which is that of polarized societies.

Easterly affirms that it is the exchange of goods and services, through the mutual benefits that they report to the parties that participate in it, the main source of wealth generation. Where individuals are allowed to exchange, in a stable institutional framework with a stable currency, is where prosperity flourishes. However, Easterly recognizes that bad luck can devastate nations, as are the cases of geological and climatic phenomena such as earthquakes, tsunamis or mudslides, as well as recognizing that the situations of individuals involved in a poverty trap can only be resolved through an active public policy that not only provides education, but also establishes the conditions so that the recipients of that educational system can count on certain expectations that they will be able to apply that knowledge acquired through education and that, consequently, it is reasonable to study.

Just as the bad star can affect the economic performance of the countries, so can a favorable conjuncture, such as the case of a transitory improvement in terms of exchange of a given country. But this favorable circumstance can become a counter-march. Easterly explains that, for a simple statistical matter, it is very difficult for both a nation and an individual to always remain on the crest of the wave, over the years everything tends to return to the average. The problem occurs when a country -or a person, too- got used to a certain level of spending in the boom years and intends to maintain it through debt or emisionism. We come to the cases in which, according to Easterly, the government can “kill the growth.” Public debt and inflation generate capital consumption and, consequently, poverty.

Another way that governments have to discourage growth is through corruption. Not only because it means a transfer of resources from productive activities to unproductive activities, but because it also means a bad signal for citizens. However, in cases of corruption, as noted above, wealth at least changes hands. There is another case, even more pernicious, in which the government’s actions, whether motivated by corruption or inspired by good intentions, destroy wealth, without even redistributing it: this is the case of inconsistent public policies derived from highly polarized societies.

Public policies that aim to favor a given industry, but at the same time need to agree on measures with other sectors of the economy, whose purpose is to compensate for the losses generated by those policies, can lead to a tangle of inconsistent regulations that, instead of transfer riches from one sector to another, directly destroy them. For example: exchange controls harm the export sector, since they generate black markets. The exporters will have costs that will be partly quoted according to the black market prices (which are higher) and they will have to liquidate the value of their exports at the official exchange rate, which will be lower. Regulations of this kind may not involve acts of corruption, but they do destroy wealth, which there is no way to recover.

Easterly lists numerous examples of everything that needs to be done to destroy growth. However, there is something that deserves to be especially highlighted: the progress or stagnation of nations does not depend on educational, cultural or geographic factors, but rather on the incentive framework that predominates. This incentive framework will always be abstract, that is, it can be applied at any time and place.

[Editor’s note: Here is Part 6, and here is the entire, Longform Essay.]

Three Lessons on Institutions and Incentives (Part 4): Institutions and the Rule of Law

Daron Acemoglu & James Robinson call the set of regulations that obstruct innovation “extractive institutions.” Of course, here again, extractive institutions are less harmful than the total absence of institutions. Not every change in the status quo can be interpreted as “creative destruction” or “entrepreneurship.” As Friedrich Hayek pointed out in Law, Legislation and Freedom, so that the most mutually compatible plans can be carried out, it is necessary that a well-defined set of expectations be systematically frustrated: the usurpations, the frauds, collusions, the paramilitary bands, etc., etc. The main thing is to have institutions that guarantee a minimum of order. Now, many times the institutions manage to be put into effect as a result of having the consensus of a certain number of interests that see in the law an opportunity to extract benefits. It is the distinction between Acemoglu & Robinson between the already mentioned “extractive institutions” and “inclusive institutions.” The latter are constituted by that set of rules that formally are equal for all and that materially protect private property, the value of money, competition understood as freedom of entry to markets, among other values ​​of modern capitalism.

The distinction between extractive and inclusive institutions can find its parallelism in the expressions of “Rule by Law” and “Rule of Law.” The first consists on the accommodation of general and abstract normative statements with a second intention: to benefit a group at the expense of society as a whole. It is common to hear the criticism that the law has a false neutrality and that therefore any defense of the “Rule of Law” must be ideological (in the Marxist sense of the term). However, what distinguishes the concept of “Rule of Law” from “Rule by Law” is that, for the first of the terms, the consequences are unlikely to be predicted in terms of their particular and even more individual, while the second has an intentionality, declared or hidden.

To give an example, the procedural due process has such a degree of abstraction that it can hardly be predicted who will benefit from those proceedings. However, a law that prohibits the importation of a product of domestic manufacture clearly aims to redistribute resources from consumers to the local producers (although this type of regulation usually also generates consequences that are very difficult to foresee and often contrary to its original intentional).

Critics of the Rule of Law state that it is not neutral, because it protects exclusively the interests of the proprietors. However, such criticism loses sight of the fact that in the Modernity, any inhabitant, even those who are not citizens, can have access to the right to property, regardless of whether or not they belong to a certain caste, class, or social class. This, unlike the legal and political systems of the so-called Ancien Régime, which limited access to private property in perpetuity and irrevocably to a certain group of people, or even more, to a certain clan or group of families. It does not matter if, in Modernity, a person does not own any particular good, as long as he can count on the expectation of being able to become one at some time. In this sense, private property understood in the modern sense as that right that any inhabitant can enjoy from having stability in their possessions to the point of only being stripped of it by their own consent or by following the procedural due process.

This unlike laws protecting infant industries, professions or trades, or promotion of certain activities that are deemed as socially necessary or valuable, which establish a regime of transfers of resources from one sector of society to another. As the School of Public Choice indicates, such laws encourage “lobbying” and reduce the efficiency in the allocation of resources. In such institutional arrangements, individuals and businesses do not prosper through the discipline of serving the consumer, but through political agreements. Economic agents continue to maximize, but at the expense of regulations that deliberately establish certain winners (the owners of protected activities) and certain losers (consumers and potential producers who are denied access to protected activities). Under these circumstances, the citizenry begins to perceive an arbitrary sense in the norms and have no moral issues with challenging them (any contraband, without commercial purposes, is a clear example of this). Obviously, when non-compliance with standards becomes so extensive, regulations become ineffective. Moreover, as James M. Buchanan put it in his brief essay “A policy in the interests of producers,” the stagnation generated by protectionism means that the winners of such a system – the protected producers – turn out to be less rich than they would be in an open and competitive institutional framework.

Sometimes protectionism seeks its foundation in a mistaken theory of “original accumulation.” (Joseph Schumpeter ruled out the validity of such proposals by pointing out that, although those could have had some basis until the 19th century, the development of capital markets made this theory completely obsolete.)

However, neither Douglass North, nor William Easterly, nor Acemoglu & Robinson, deal with the problem of original accumulation. They prefer to encompass such phenomena within the set of erroneous theories that serve to justify policies arising from political agreements in polarized societies. This means that a certain institutional arrangement, an economic growth policy, a stabilization program, a constitutional reform, foreign policy and so on, in a polarized society is not inspired by abstract and formal principles but in concrete goals that benefit certain sectors of society above others.

The examples of polarized societies, to which Easterly and Acemoglu & Robinson turn, come mostly from African countries since these are mostly created in the process of decolonization and comprise different ethnic groups and languages ​​within themselves, so polarization is much more evident: certain policies benefit a certain ethnic group over another. Easterly specifically cites the case of an African nation in which an ethnic group that represents 10% of the population lives in the region where a certain commodity is produced and whose export generates large revenues and, in the meantime, the government is elected, with some exceptions, by 90% of the remaining population, which imposes export rights on the said commodity, whose collection is destined to industrialization plans that systematically fail.

It is often tempting to explain the failure of such industrialization plans for the corruption evidenced in their execution. In fact, corruption cases are verified, but public policy would also fail even if those involved were incorruptible. Many times bad policies destroy much more wealth than political corruption. Corruption implies a transfer of resources and, therefore, an inefficient allocation of resources, while bad public policies result in the destruction of wealth.

However, examples of polarized societies in African countries can generate confusion around the main message of The Elusive Quest for Growth and Why Nations Fail. The economic performance of nations has nothing to do with geography, culture, or lack of preparation of the ruling elites to draw the plans of government. Easterly holds the main responsibility for the rise and fall of nations in incentives, while Acemoglu & Robinson point to the institutions that establish such incentive schemes. Regarding the opinion of Douglass C. North, although his line of research can lend itself to a “culturalist” interpretation, he himself recognizes the disruptive change of formal institutions as a determining factor of economic performance.

In summary, the three works discussed here have as a common denominator the role of incentives as a determinant of the economic performance of countries, above culture (which North would call “informal institutions”), geography, or the level of education of its elites. However, the case of polarized societies is presented as a critical point of such approaches.

José Luis de Imaz in Los que mandan (The ones who command) had defined politics as the activity consisting of articulating diverse interests according to a coherent plan of government. The definition of Imaz deserves to be put back into use, since it addresses the problem of polarization and also because its double edge allows to tie the loose ends left by the visions that we can group, with greater or lesser precision, under the “neo- institutionalist” (clearly the case of North, although it would be pending to discuss the label for Easterly and Acemoglu & Robinson).

Notwithstanding, that polarization is manifest in tribal or caste societies does not mean that it is not present in other societal forms. In the United States, the north and south; in Europe, the separatist movements; in Argentina, the interior and Buenos Aires. With greater or lesser intensity, manifestly or latently, politics is always structured on a space of tension of interests in competition for resources. Those who frequent the work of Carl Schmitt often claim that trade and law are “civilized” means for the exchange and dispute of such resources, politics and war are on the other side of the same question in terms of intensity of the conflict.

However, the term institutions – which define incentives – does not refer only to deliberate political agreements in pursuit of a specific purpose, such as a given public policy. The concept of institution also concerns a series of abstract and general principles whose final result at a particular level no one can foresee, because their level of abstraction imposes an insurmountable limit for the knowledge of its concrete consequences.

[Editor’s note: Here is Part 3; Here is the entire, Longform Essay]

Nightcap

  1. What are the real fault lines diving Americans? George Hawley, Law & Liberty
  2. Beliefs and interests Chris Dillow, Stumbling & Mumbling
  3. Can we trust deliberation priests? Robin Hanson, Overcoming Bias
  4. R. Kelly and mob justice Irfan Khawaja, Policy of Truth

It’s no longer the economy, but we are still stupid

Motivated Reasoning, Public Opinion, and Presidential Approval‘, an interesting new paper forthcoming in the journal Political Behavior (summarized here), by Kathleen M. Donovan, Paul M. Kellstedt, Ellen M. Key, Matthew J. Lebo finds that support for sitting presidents has become increasingly misaligned with national economic expectations. Rather than being a sign of voters realizing that presidents play little role determining economic performance, they attribute this to increased partisan polarization.

I think this is a compelling account. All I would add is a potential causal mechanism. My current favorite dimensions for analyzing democratic trends in the developed world is demography. Voters are ageing. When retired, they tend to have much less direct involvement with the productive economy than when they were working. On average, the elderly are quite rich and living off entitlements they have acquired during their working lives. So they are both less reliant on current economic opportunities and less knowledgeable of them. This means their personal costs of partisanship, relative to good policy, is lower than it used to be. And this is what lets all the culture-war nonsense creep into people’s decision functions.

Nightcap

  1. A clash of the sacred and the secular Nader Hashemi, Liberty Forum
  2. The perks and perils of having a state-run church James Robinson, Cato Unbound
  3. Dutch pasts and the American archive Derek Kane O’Leary, JHIBlog
  4. Liberalism, democracy, and polarization Edwin van de Haar, NOL

Nightcap

  1. Was Hayek a One-Worlder? Garreth Bloor, Law & Liberty
  2. George Washington’s maritime world BJ Armstrong, War on the Rocks
  3. Cable TV really does matter for political outcomes Tyler Cowen, Marginal Revolution
  4. Sovietology Sheila Fitzpatrick, London Review of Books