Institutions rule, but which ones?

A couple of pieces published last week – one by John Herbst, director of the Dinu Patriciu Eurasia Center of the Atlantic Council, and the other by Forbes’ Russian affairs blogger Mark Adomanis – provide a neat contrast which aptly displays the illusions of many Western liberals about the prerequisites of economic progress. Before getting to them, however, we first need to make a little digression into economic history.

As I explained in my book Aiding Afghanistan, in the 1950s, 60s, and to a lesser extent 70s, economists on both sides of the Iron Curtain tended to believe that economic development was a simple matter of capital accumulation. The reason why underdeveloped states were poor was thought to be that they lacked the capital to get the process of accumulation going. Development assistance therefore consisted of providing them with financial capital (normally in the form of loans) or physical capital (dams, roads, factories, etc) in order to kick-start the process.

By the 1980s it had become blindingly obvious to almost all concerned that this wasn’t working. Economists therefore had to revise their theories. Rather than capital, what matters, some concluded, is ‘institutions’, a word which is somewhat misleading as it includes not just what ordinary people consider to be institutions (government, banks, etc), but also less tangible matters such as laws and culture. You can pour almost any amount of capital into a country, but if the correct institutions are not in place, it won’t make a jot of difference.

But which institutions? To those in the West, the answer was evident – Western ones. Clearly, the prerequisite for economic growth must be the establishment of a set of institutions similar to those in Western Europe and North America. That meant that in order to prosper, underdeveloped states first had to introduce democracy (multi-party elections, a free press, transparent government, etc), liberalize their economies (via privatization, elimination of price controls, the opening of borders, etc), and liberalize their societies (granting equal rights to women, racial minorities, etc). Success would surely follow.

Following the collapse of communism, the purveyors of institutional economics found a market for their ideas in Eastern Europe. Things did not quite work out as planned. Institution-building is a slow process and inevitably involves a transition period in which some institutions are present and others are not. This can create some strange incentives as well as significant distortions in the economy. Meanwhile, the establishment of a new set of institutions requires the destruction of the old set, but if these are destroyed too rapidly before the new ones are in place, economic and social collapse may ensue. This is indeed what happened in many post-communist countries.

At that point, the logical response might have been a pause to reflect whether one size really does fit all. Instead, the West has by and large chosen to redouble its efforts in the same direction as before. If institution-building hasn’t worked as planned, then that must be because it wasn’t pushed hard enough. Thus, the European Union’s Association Agreement with Ukraine obliges Kiev to liberalize faster, to accelerate the building of the institutions which will make Ukraine a Western, and thus prosperous, country.

It is here that John Herbst fits in. According to Herbst, commentators are mistaken in viewing Ukraine as facing a choice between Russia and Europe. Rather the choice is between the past and the future. As Herbst says:

Civil society in Ukraine which has been a factor since the first days of independence, or the pre-days of independence, has driven this country towards Europe (in a current phrase). But it is really driving this country towards openness, towards empowerment of its citizens. That is precisely the opposite direction that Mr. Putin has been leading Russia for the last ten years. Since he’s not an idiot, he poses this as a question of Russian values versus Western values. But it is really reaction versus the future. … Russia only has the GDP per capita that it has because of hydrocarbons. Without hydrocarbons  its GDP per capita would be less than Ukraine’s. Because talent there is not allowed to develop.

This is, in essence, an institutional argument. Ukraine will succeed where Russia is failing, because it has more liberal institutions. Only ‘openness’ and ‘empowerment of citizens’ can foster economic growth.

In theory, the argument is compelling. However, Mark Adomanis demonstrates that Herbst’s facts are wrong. It simply isn’t true that ‘Without hydrocarbons [Russia’s] GDP would be less than Ukraine’s.’ In a recent post, Adomanis analyzed how large Russia’s economy would be without ‘resource rents’ from the oil and gas industries. He concludes that, ‘Russia, despite what you often hear, is more than just a gas station. … after adjusting for resource rents, Russia’s GDP per capita would be roughly $19,000, a level that is broadly similar to post-communist countries like Bulgaria ($15,600), Poland ($22,800), and Romania ($18,000).’ In contrast, according to the World Bank, Ukraine’s GDP in the period 2010-2014 averaged a measly $3,900 per capita. In other words, without hydrocarbons Russia’s per capita GDP wouldn’t be less than Ukraine’s, it would be more than four times larger!

This is a troublesome conclusion. For in many respects Herbst is right when he says that Ukraine has a more vibrant civil society than Russia. Certainly, its elections have always been far more competitive, and its press (until recently) more varied in its political opinions. Ukraine can indeed be described as more ‘liberal’ than Russia. And yet it is much, much poorer. If ‘openness’ and ‘empowerment of citizens’ was what mattered, then Ukraine would be richer than Belarus – the ‘last dictatorship in Europe’. Yet Belarusan per capita GDP averaged $7575 in 2010-14, almost twice that of Ukraine. Despite being illiberal, Belarusan institutions clearly work better than Ukrainian ones.

None of this is to say that Western institutions are not desirable. They are. But they are a product of development as much as a prerequisite for it. Nor is it to say that institutional economics is completely wrong. It isn’t. Institutions matter enormously. But the question of which institutions best fit any given country at any given time is more complicated than many Western liberals are willing to admit.

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5 thoughts on “Institutions rule, but which ones?”

  1. All these arguments that the “widespread liberalization in all spheres” (which were chief mantras not only of the current Ukrainian “leadership”, but also of the “new liberals” in Russia’s 90s) had always appeared to me as deeply misguided. As if those people, who demanded such course of action were incapable of distinguishing between the causes and effects. For them, apparently, the wind blows because weather vane is moving.

    The only analogy that comes to my mind, when seeing this blind devotion to “liberalization or death” attitude is… the cargo cult. And I’m absolutely serious here. It’s especially evident now in Ukraine, but instead of “cargo” it’s “credits”.

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  2. I actually believe that Ukraines centralism, in combination with rapid and often unpredictable goverment changes, is in part to blame for Ukraines mess.

    To make it as short as possible:

    -Goverment changes in Ukraine are frequent.
    -Who gains power is strongly correlated with who possesses the best economic base.
    -Since business and politics are not seperated in Ukraine at all, a politician will strive to increase his, or his groupings, economic power while attempting to starve or destroy the economic base of his opponents.
    -Because power changes are frequent, and happen often, and because destroying/reducing someone elses economy is far easier then improving you own economy, so power brokers often did just that.

    Ukraines over federalism comes in here:
    -In order to win an Ukrainian election, formal or informal coalitions are assembled which contribute various things (money, manpower, logistics, organisation) into the elective campaign.
    -After they win, these contributers demand a payoff.
    -In a federalized system, this payoff would propably involve some measure of tailormade laws etc.
    -In the centralized system of Ukraine, this payoff is assigning gubernational or other positions to such contributers. These assigned positions are often those that rule over the areas that are the base of the respective opposition. The newly appointed governor (or the grouping to which he belongs) now attempts to recoup the investment he comitted as a contributor by extracting assets from the area he now rules over. The appointed governor also knows that he solely depends on his coalition in Kiev and that he will not have this position for long. He thus has every incentive to “make hay while the sun shines”, and extract/rob/loot as much as possible.This causes massive economic privation in the affected areas.
    -For the ruling coalition which includes the grouping of this governor, this deprivation is not a bug but a feature. By causing privation in areas that did not vote for this goverment, the governor weakens the economic base of this areas, and since these areas voted for the opposition, this is just working as intended. Ukraine has a few swing states, which could go either way and where the local governors are a bit more circumspect, but especially the foundation of the major state level blocks (Donbass for PoR and Lviv for the Nationalists) got looted relentlessly by appointed officials whenever “their sides” were not in power.
    -Add to this the fact that, after a change of goverment in Eastern Europe, the first thing that happens is that the new goverment, which is not yet rich, loots to become rich. Russia and Kazakhstan had the same goverment in place for decades, compared to Ukraine (which is now suffering its 5th or so post Soviet looting spree), they were only looted once in the case of Kazakhstan and Belarus and 2-3 times in the case of Russia.
    -There are two other advantadge to rulers with long terms: The first is that experience matters, and f.e. Putin is vastly more experienced and has seen far more things than most of his opponents on the world scale.
    The second advantadge is, amusingly enough, an incentive to be a bit less corrupt. Corruption is generally a choice between a long term and a short term trade off. If there is stability, people begin to plan long term, and long term, corruption may be not that economical for the official. An official who can look to a decently long term, and perhaps to some kind of retirement, objectivly risks much more when he accepts a bribe then an official who could be fired/lustrated/purged based on factors completely outside of his control.

    That was pretty long, and I may actually write it up as an annotated essay at some point.

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