Economic Development, Importance of Institutions in and Social Aspects of

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ECONOMIC DEVELOPMENT, IMPORTANCE OF INSTITUTIONS IN AND SOCIAL ASPECTS OF A recent major advance in the analysis of economic development is the recognition of the importance of institutions. This has moved us beyond sterile debates such as whether the economy should be left to the market or should be thought of as the responsibility of government. It is now recognized that government and markets are not alternatives between which we choose, but that government—in particular, good governance—is a prerequisite for the market to function effectively; and that, for an economy to progress, it may not be enough to raise savings and investment rates, improve trade policy, and control fiscal deficits if we do not have good institutions.

One has to be careful about this kind of analysis because "institution" is not a well-defined term. In this article, "institutions" will refer to the social and political settings within which the economy is embedded. Thus the word will encompass not only the structure of government and its legal institutions but also the cultural and social norms within which the human beings of a nation function, and which can be even more important than the formally enacted laws of a nation.

The significance of institutions thus defined is easy to see. Trade, exchange, investment, and business almost always involve transactions performed over time. You supply a commodity today, and your trading partner will pay for it tomorrow or may have paid for it yesterday. You, as the owner of an enterprise, send a salesperson to market your good in distant lands, and the salesperson is expected to pay you back on his or her return. Even when you take a taxi, you usually pay after you have taken the ride. If traders and ordinary citizens did not feel confident that, after they had done their share, their trading partners or business associates would fulfill their obligations, they would refuse to do business or make investments. In such a nation, the market would be stunted and development would remain a distant dream.

If, on the other hand, a society's laws are effective, and contracts are enforced by the state without individuals having to incur too large a cost, then trade, business, and investment will grow, leading to greater economic prosperity. Even in the absence of law enforcement, if a nation's citizens are naturally trusting of one another, or its social norms are such that individuals keep their promises, then this society could also progress. Indeed, a disposition toward keeping one's promise could be even better than the case in which contracts are enforced by formal legal machinery, which requires costly courts and enforcement bureaucracies.

One of the basic premises on which a market economy is founded is the principle of free contract. The principle asserts that adults who voluntarily agree to a contract, which has no negative impact on others, should not have the contract nullified by the government and, in an ideal situation, should be able to seek governmental or societal help to prevent anyone from reneging on the contract. A major role of institutions is to provide a setting in which the principle of free contract is upheld.

For India, it can be argued that the roots of its prolonged economic stagnation (and the optimism observed in recent years) cannot be fully understood if one ignores such variables as the social norms, collective beliefs, and the structure of polity and law—basically, the range of institutions. An understanding of the role of culture and institutions in the life of a nation can help in the design of better and more appropriate economic policy. In the case of Russia, for example, it is now recognized that standard economic policies designed to speed transition did poorly because they amounted to changes that Russian society was not prepared to accept; the requisite culture and institutions for the market economy were not in place. The failure to adopt recommended economic policies (as in Tanzania or Venezuela), or the abortion of economic polices due to social instability (as in Indonesia or Yugoslavia), is often caused by a lack of understanding of the social and political context in which the policies were implemented.

It is also arguable that a nation's collective beliefs shape what is politically and economically feasible. In the case of independent India, the early economic policies were marked by deep mistrust of the market and big business. In a democracy, one cannot simply overrule such popularly held views, and it is not surprising that until quite recently, India remained burdened by a gargantuan bureaucracy appointed to plan and control the economy but which in reality had become the cause of India's stagnation.

Centuries earlier, the British had come to India not to rule but to trade. The initial contact that India had with Britain was not with the Crown but with one of the earliest multinational corporations of the world, the British East India Company. Later, British commercial interests merged with imperial conquests that proved more lucrative, and gradually, without much serious resistance, a huge subcontinent passed into the control of the British Empire, the center of which was thousands of miles removed from South Asia. Thenceforth, the Indians would be relieved of their resources not only through asymmetric trade and currency exchange, but also by taxation and state-sponsored extortion. Fears of multinationals and a general mistrust of business and trade were soon deeply etched into India's collective memory. Independent India would design its economic policy in the shadow of this memory. And it is not surprising that it took decades of debate and ultimately the shock of recession in the early 1990s to shake the country out of its policy stupor.

India's policy was born out of two conflicting systems of beliefs and ideas—those of Mahatma Gandhi and Jawaharlal Nehru—held together precariously, their differences often denied. The differences had roots that go back to well before 1947. Nehru's education at Harrow and Cambridge helped forge his commitment to Fabian socialism; Gandhi's ideas emerged from his grassroots struggles and his experiments in alternative communal village (ashram) lifestyles. The economic policies they envisaged for India were very different. In the 1930s and even the early 1940s, Nehru was enamored of Karl Marx and V. I. Lenin (though not of Russian Communism), referring to their works repeatedly in his diary and in letters to friends. He had shed his Marxism-Leninism, and even socialism, by the time India attained independence, but his faith in planning, heavy industry, modern science and technology would persist. Along with Prasanta Mahalanobis, he would try to give shape to those ideas in the form of what came to be called the Mahalanobis-Nehru strategy of development. Gandhi's vision, on the other hand, was deeply rooted in rural hand labor, primarily cotton spinning and weaving, and the revitalization of India's village handicrafts.

The actual policy regime that India followed in its early days of independence was a mixture of these two competing institutional visions. A Soviet-style planning system was developed, but without the state having a monopoly of control over resources. Capitalism was allowed to flourish, but a large bureaucracy was nurtured. Huge investments were made in basic industries, but at the same time, several sectors were protected as belonging to the small-scale "Gandhian" sector. Capitalism was criticized, but it was at the same time relied upon. Socialism was never practiced, but the rhetoric of socialism was constantly reiterated. A burgeoning bureaucracy became the surrogate for socialism.

Advisers from Washington and many economists recommend that Third World nations must have democracy and that they must open up their economy and privatize, oblivious of the fact that to ask for a democracy and then to insist what the democracy should choose could amount to a contradiction. Since most developing countries are not democracies they did not face the problem, but India did. Once people's opinion had been shaped (and Nehru was instrumental in this), there was no way that policies could be easily dictated to them. Opinion would have to be molded before major policy shifts were possible.

Institutional changes are probably the hardest policies to effect. When India's reforms started in 1991, they began with standard economic policies. Thus ceilings on import tariffs were first brought down to 150 percent, and thereafter reduced steadily, virtually every year. The industrial licensing system was dismantled, fiscal deficits were curtailed, and controls on foreign exchange transactions were eased. Economic reforms, however, have not been able to alter India's legal system and other institutions.

Consider India's labor laws, especially those enshrined in the Industrial Disputes Act of 1947. This law was a direct outcome of India's mistrust of the market and a result of its own historical experience. When can a worker be fired, under what conditions can workers be retrenched, when can a firm be closed down? These were all matters that were written down as law, leaving very little room for the principle of free contract by which workers and employers could use their own judgment, bargaining power, and information about their specific industries to reach independent agreements. This has now become a handicap. A fashion industry with variable demands may want to pay its workers more than the "market" but retain the freedom to close down its operations at short notice. The workers themselves may agree to such terms, but Indian law makes such a contract difficult to uphold, thereby having a dampening affect on the demand for labor, and thereby holding wages down. Clearly, in the next generations of reforms, India will need to take on these institutional matters, amending many of its labor laws, rent control laws, and contract legislation, and reducing delays in its courts and the bureaucracy. Such reforms could bolster economic growth, even without raising investment and savings or reducing the fiscal deficit.

There is another class of policies, which only partly entail institutional change, but which should not be omitted from a discussion of development policy. This is what Jean Drèze and Amartya Sen broadly define as "social opportunity." In order to be able to partake in market activities, individuals need a minimal amount of education (and what constitutes "minimal" is steadily increasing in today's world of advanced technology) and to be in reasonably good health. Government has a major responsibility in ensuring that people are able to have access to basic health care and education. These are domains in which markets function poorly. In some sense, these are the prerequisites for the market to function well, rather than being what the market can deliver on its own. Hence, along with the role of providing good governance and better laws, a government has the responsibility to provide certain basic needs of its population, especially its poor, who are unable to marshal these for themselves.

Kaushik Basu


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Clifford, Mark. Troubled Tiger. London: M. E. Sharpe, 1994.

Drèze, Jean, and Amartya Sen. India: Economic Development and Social Opportunity. Oxford: Oxford University Press, 1995.

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