John Kay - Prosperity requires more than rule of law

Prosperity requires more than rule of law

The idea that “institutions matter” is a relatively recent amendment to the standard corpus of economic thinking. Only in the past two decades has it become a mantra of development economists.

The trigger was the recognition that plans to promote growth after decolonisation had failed. The continued poverty of many countries could not be fully explained by a shortage of capital or the legacy of foreign exploitation. Economic historians emphasised that the industrial revolution was the product not just of technological change and related investment in plant and machinery; it had also required the contemporaneous evolution of political and economic institutions.

A visit to Hong Kong is a reminder of how much institutions matter. A Chinese population under British administration created an island of prosperity, while the mainland stagnated under warlords and erratic dictators. When Chinese institutions achieved greater stability after the death of Mao Zedong, Hong Kong became a hub for the spectacular growth of the whole country.

But to say institutions matter is to beg the question: which institutions? The conventional reply emphasises property rights and rule of law. This excludes the arbitrary rule of the mad dictator or the king who enjoys power by divine right – but provides little further guidance.

Is security of property rights either necessary or sufficient to promote investment and innovation? The perceived illegitimacy of the distribution of property rights has often obstructed the achievement of these economic goals – as in Latin America and post-communist Russia.

And it makes no sense to talk of the rule of law in isolation from the nature of the laws and the processes through which they are promulgated and enforced. Many of the nastiest totalitarian regimes have had legal codes and constitutions that would on paper win plaudits from the most demanding of human rights activists.

Joseph Tainter, the anthropologist, attributed the decline of civilisations to their inability to manage the complexity they accreted. And at the Institute for New Economic Thinking conference I attended last week in Hong Kong, historian Niall Ferguson described the economic disadvantage for the US of too many property rights and too much law.

The conference offered numerous illustrations of the problem. There was an address by a spokesman for a leading patent troll, which buys and asserts patents in the hope of forcing companies to pay royalties. Another talk reminded the audience that the value of outstanding derivatives contracts exceeds by a considerable margin the value of all underlying assets to which they might relate. The spiralling costs of litigation establish an environment in which the rule of law operates in favour of bullies and the rich and privileged – a process whose outcomes closely resemble those of dispute resolution in very primitive societies. The rule of law is to be welcomed, but not the rule of lawyers.

Of course, even with legal costs absorbing almost 2 per cent of gross domestic product, the US is an affluent country. But, like its European counterparts, it suffers from the impediments to growth identified by economic historian Mancur Olson; sclerosis arising from the conflicting demands of too many established vested interests.

So when the Chinese ask how to establish the institutions to support a stable, prosperous economy, it is not enough to mumble: “Property rights and rule of law – go to Denmark and see.” There are many versions of the successful formula of lightly regulated capitalism and liberal democracy, each with its own challenges. While there are common principles, there is no blueprint that can be enshrined in a Washington consensus or proclaimed “the end of history”.

Nor is there an established blueprint for a transition from anarchy or traditional society to the institutions that today’s development economists understand matter. Hong Kong in the 19th century experienced one such transition – the importing of institutions from another jurisdiction with the support of the Royal Navy and a garrison of troops. But that model for the most part did not prove acceptable, or permanent, elsewhere. Its resilience in Hong Kong was the result of a unique context. Institutions matter – but perhaps histories matter even more. And while countries can learn from history, they cannot reproduce histories.

 

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