Why strong institutions are necessary for economic growth

Back in 2007, on a frigid morning, Professor Mansoob Murshed was delivering a lecture on ‘the long-run determinants of economic growth’ at the International Institute of Social Studies of Erasmus University in The Hague — the author’s alma mater. Originally hailing from Bangladesh, Prof Murshed was highlighting various development strategies owing to which growth rates have historically, and at present, varied considerably across countries. In the short run, growth is traditionally seen largely as a function of investment in infrastructure, technology, business and health and education sectors; in the long run, however, there are a few more non-traditional strategies for economic growth, according to Prof Murshed. These strategies thematically revolved around three main areas: geography, culture and institutions. A deeper analysis of the three factors suggested that similar economic growth strategies, when applied in different geographical, cultural and institutional environments yielded different economic growth outcomes across developed and developing countries.

Against this backdrop, an enticing question is: what determines productivity and investment climate in a country like Pakistan? This question is particularly crucial in the wake of Moody’s recent cut on Pakistan’s sovereign credit rating by one notch further into junk territory Caa1 from B3. That means, it is now harder for the country to secure funds from international markets. Although Pakistan strongly contested the downgrading, per media reports, the agency cited increased government liquidity and external vulnerability risks after the recent flooding. Moody’s cut may further add to the rising concerns about the health of Pakistan’s economy as inflation rises, local currency gets weaker and foreign exchange reserves run lower despite financial assistance from international development agencies. In this context, it would be too naïve to just rely on traditional determinants of growth in explaining Pakistan’s economic performance. The scenario demands an informed analysis of geography, culture and institutions — as long-run determinants of economic growth — in Pakistan’s context.

First, Pakistan is geographically located at the intersection of South Asia, Western China, Central Asia and West Asia. Many analysts vehemently cite Pakistan’s geostrategic location as a great strength. However, it could be a big misunderstanding. Let’s not forget that the areas constituting today’s Pakistan mostly experience hot temperate climate. While referring to Montesquieu’s 1748 treatise ‘The Spirit of the Laws’, Prof Murshed highlighted that in cold climates, people are industrious and brave. However, hot temperate climates may cause people to be lazy and timorous. In such economies, despotism could be the political outcome. Given a long history of dictatorship in the country, Montesquieu’s observation seems true for Pakistan. Furthermore, due to geographical woes, Pakistan remained the frontline state both in the Cold War and the so-called war on terror. These factors have actually transformed Pakistan’s geostrategic importance into a locational ‘paradox of plenty’ that promotes reliance on aid, rent-seeking behaviour, and kleptocratic practices making the entire society despotic. In other words, Pakistan’s geostrategic location could actually be inhibiting its economic growth prospects. Such ossified bottlenecks need to be cleared through vigorous institutional checks.

Second, Pakistan is culturally trapped between regional and socio-religious practices, values, norms and ethos. Religious misinterpretations have prompted a culture of superstition and uncertainty in businesses, innovation and entrepreneurship. Consequently, lack of mutual trust in businesses and diminishing social capital are the natural outcomes. Many people openly oppose innovations and new practices in businesses, as being anti-religion acts, thus creating religious, social and sectarian conflicts. Many other people, for example, seem unwilling to unpack the scientific reasons behind disasters, like massive floods, in the country treating them as mere divine chastisement. These factors have made the cultural environment of the country very congested and unfriendly for businesses. Such cultural impediments create economic growth bottlenecks to be cleared by institutional intercessions. However, most governments are unable to handle the issues emanating from the religion-based politics of the interest groups. In this regard, Professor Yang Yao, from China Centre for Economic Research of Peking University, skims some lessons for developing countries including Pakistan. He argues that economic policymakers should be immune to conflicts and invincible pressure from interest groups that attempt to derail institutional and policy reforms. As the Chinese society is relatively less religious, it receives less pressure from interest groups. Pakistani institutions may need to create such environment in the country. Another enzymatic strategy is to pursue Pareto-improving business reforms referring to ‘making no one worse off while making at least one person better off’. The Chinese experience also connotes that when reforms change the distribution of wealth and/or power in a society, the government institutions must handle the challenges faced by the poor and the powerless. This is possible through internal institutional torque ensuring balance of power.

Third, institutions remain the most critical factor for strengthening long-run economic growth prospects in Pakistan. Thematically the notion of ‘institutions’ revolves around good governance, rule of law, political stability and social cohesion. The literature on development economics underlines the collective role of institutions in promoting economic growth. That means, Pakistan must have a strong multi-institutional governance framework that could effectively address the challenges associated with its geography and culture. Absence of multi-institutional governance system means the supremacy of one, or few, institution(s) with the result that it may end up in despotism as a political outcome. It may also create institutional monopoly detrimental for long-run determinants of economic growth. It is because the collective institutional functioning determines how all other factors mentioned earlier interact with growth prospects. Institutional efficacy, according to Prof Yao, is more important than institutional purity. No institution should, therefore, claim to be pure. Furthermore, constructive criticism of institutions is not bad at all as it brings in the elements of collective wisdom in socioeconomic debates necessary for economic growth. In a multi-institutional governance system, institutions function in a coherent manner complementing each other’s power. However, institutions are effective only when they provide incentives to businesses in right-aligning the personal and individual interests of agents with the country and society at large. Such institutional interventions will not strengthen Pakistan’s sovereign credit rating credibility but also provide a launching pad for an economic ‘take-off’ necessary for attaining long-term growth in the country.

Published in The Express Tribune, October 22^nd, 2022.

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