Institutional successes of the modern world

What are the great institutional successes of the modern world? Democracy, rule of law, fiscal policy and monetary policy. How do we know these have been successes? Rules or constraints at the level of the state have been followed by individuals to co-ordinate on an equilibrium such that there is little uncertainty and more opportunities for growth. There is greater power for the individual in a constrained political framework where the executive has constraints on the power and repression. Where the individuals can compete to become leaders and have information about the political parties which compete in an open and transparent manner. These measures are hallmarks of a state that does not have to tinker with exogenous rules to maintain growth. The changes to rules come from within. However, these are examples of political institutions. There can be institutions that work to promote law and order, to collect taxes and to affect the efficiency and equity of the banking system. What I would like to talk more about are the institutions governing the expenditure of taxes. These can in the extreme case go to the leader’s pocket if there are no restrictions – either constitutional (in terms of getting re-elected) or de facto power that the leader exerts by virtue of the weakness of other institutions – such as that of independence of judiciary or media. This is the case in many African countries (like Zimbabwe). How do these institutions change to bring about better targeting of expenditures. To reduce poverty, to improve the quality of life and to bring peace and prosperity into the lives of the national population. Does change come from external sources like conditional aid? Does it come from within – through revolutions and coups? Does it come with time naturally?

Now take a developing country with fairly strong democratic traditions (like India). Here, how should expenditures be targeted. Of course, health and education would take precedence. Within health, how should health workers be compensated? How much to spend on new equipment? How much should be spent on building more hospitals and improving access? These are institutions that are again linked to other political and economic institutions (for example, democracy and how effective the tax system is or if law and order is a problem). There can be failures at this level of institutions if the targeting of expenditures does not have a desired impact. These failures can be sustained if there is a lack of knowledge on the demand side (for example, the population) or even if there is no lack of knowledge – there could be problems of collective action. On the other hand, there could be a supply-side problem too. Here, the workers may not be motivated enough by what the government is paying them and they end up demotivated and reduce their quantity and quality of effort. Successful fixing of such institutions can then mean making workers motivated and improving knowledge among the beneficiaries or by solving collective action through community-based interventions. An example of solving both demand-side and supply-side problems is the microfinance model a la Grameen Bank. Here supply-side problems of adverse selection and moral hazard that lead to high non-performing assets are solved by group credit (social capital is the collateral) and also promising more credit if the loan is repaid. The demand-side problem of inadequate information (about saving, financial instruments, investment opportunities) as well as self-control issues are addressed through regular meetings with stakeholders. Another example could be paying performance pay to child health workers and at the same time educating mothers about health and nutrition. If only performance pay is offered to workers and they improve their inputs, there could be an endogenous feedback such that mothers may reduce their feeding to the children. Similarly, workers may reduce their efforts if mothers increase the inputs at home. Incentivizing workers and mothers to improve their inputs would fix both types of market failures simultaneously and help sustain an institutional equilibrium that improves lives of both health workers and beneficiaries without any negative spillover effects on political and economic institutions.