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The importance of institutions for growth

The title of the book encapsulates the severity of the risk facing South Africa. Why Nations Fail. The Origins of Power, Prosperity and Poverty is indeed a dire warning that South Africa finds itself on a slippery slope that could end in total failure if the current direction in institutional drift is not stopped.

A&R's opening statement is that "countries differ in their economic success because of their different institutions, the rules influencing how the economy works, and the incentives that motivate people". A fundamental difference is that between inclusive and extractive institutions because of their influence on progress and poverty through the incentives they create.

Inclusive vs. extractive institutions

Inclusive institutions are the bedrock of economic prosperity. They provide economic opportunities (e.g. the space to create new businesses or follow the career of one's choice), not just for the elite but for a broad cross-section of society. They are characterised by guaranteed property rights (vital for investment and productivity growth), an impartial legal system that upholds contracts, and the effective provision of public services and infrastructure to create a level playing field.

Inclusive institutions pave the way for the driving forces of prosperity, in particular technological progress and education, which jointly form the basis of innovation. They address the fear of the implications of the process of creative destruction that causes different interest groups to endeavour to protect and maintain their position. Inclusive institutions need the state to exercise its coercive powers of coordination to impose order, provide public services, and to put a basic regulatory framework in place.

According to A&R "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" (my emphasis).

Institutions and political power

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 ̶ when there is conflict over institutions, who wins depends on the distribution of power in society.

Under absolutist political institutions those in power can use their power to set up institutions to enrich themselves at the expense of society. What is particularly worrisome, according to A&R, is that "political institutions enable the elites controlling political power to choose economic institutions with few constraints or opposing forces. They also enable the elites to structure future political institutions and their evolution. Extractive economic institutions, in turn, enrich the same elites, and their economic wealth and power help consolidate their political dominance" (my emphasis). In short, the power of self-perpetuation is embedded in extractive political and economic institutions.

In contrast, 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 prosperity. Extractive political institutions with strong centralised power can be accompanied by high growth rates for a period of time, but they are not sustainable in the long term, inter alia because of infighting over the spoils. Inclusive economic institutions will not support extractive political institutions or be supported by them.

The problem is that it is not in the interest of powerful elites to create fully inclusive institutions that are likely to reduce their power and their ability to benefit from extractive institutions. Put differently, such elites will not be susceptible to policies that would lead to higher economic growth because of the natural link between economic growth and inclusive institutions. The incentives to accept the process of creative destruction that is an inherent part of economic growth and development, often the result of technological change, will just not be there. Furthermore, extractive institutions will not create the incentives for people to save, invest and innovate.

Institutions and critical junctures

Societies are not for ever trapped in a specific institutional set-up with its associated implications for economic prosperity. "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 or more extractive institutions" (my emphasis). This will be determined, among others, by the interaction between critical junctures and the process of institutional drift, which depends on how society resolves economic and political conflict.

A&R 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" (my emphasis).

When looking at South Africa's history prior to 1994, A&R came to the conclusion that extractive political and economic institutions were the order of the day. It therefore does not come as a surprise that prosperity was not sustainable and that the economy gradually stagnated.

According to A&R the political transition to a democracy in South Africa in 1994 was a critical juncture as defined above that brought about more inclusive political institutions. This went hand in hand with the adoption of more inclusive economic institutions, which resulted in a radical change of direction that placed the economy on a higher growth path.

South Africa today

South Africa once again finds itself at such a critical juncture, with its institutional fabric drifting in the opposite direction compared with the initial post-1994 period, viz. from inclusive to extractive institutions. Not only are extractive institutions in their own right to the detriment of the economy, but they also undermine the formation and functioning of what inclusive institutions may remain. In short, political leaders who benefit from extractive institutions have no interest in encouraging the development of inclusive institutions that can create the right incentives for people to act on.

What does the A&R thesis tell us about the present state in which South Africa finds itself?

Firstly, South Africa is not an isolated case in history - after all the thesis was developed only after studying numerous examples from different parts of the world at different times. History shows that there is a certain inevitability about the consequences of extractive institutions.

Secondly, one should not be too optimistic about the possibility of extractive economic institutions being replaced by inclusive institutions. The latter would require extractive political institutions to be replaced with inclusive political institutions, and as A&R argue the capacity of the elite that benefits from extractive institutions to hold on to power must not be underestimated.

Thirdly, extractive institutions undermine economic growth. For South Africa to escape from the low growth trajectory on which it finds itself will require nothing less than a fundamental refocusing in institutional development.

Fourthly, although South Africa may still be characterised by a combination of extractive and inclusive institutions, such a combination is unstable under the A&R thesis. Something will have to give.

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