Friday, April 18, 2014
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Economic Development Before the Law

One of the most pervasive and apparently self-evident assumptions of development economics is that sustainable investment and growth requires the rule of law. Without impersonal, general norms and their enforcement by independent judicial authorities, according to this view, little development, if any, is possible, because the risks facing both labor and capital – including corruption, arbitrariness, and rigid traditions – will be too high. But is this conventional wisdom always right?

Consider an admittedly limited but nonetheless revealing counter-example: South Africa’s booming mini-bus taxi industry. The mini-bus taxis developed in response to severe shortcomings in the country’s public transport system, one characterized by high prices, low-quality service, and a chaotic operating network, but they operate entirely outside of formal laws and regulations. What makes the industry work is a commonly agreed informal business “culture” that is flexible, innovative, and keeps operating costs down.

The results are undeniable: at peak times, mini-bus taxis hold 65% of the entire commuter market. The mini-bus taxi industry thus illustrates the importance of informal conventions. Local culture and traditions not only matter, but they are decisive in shaping the behavior of people – all the more so in developing countries, particularly those that are labeled failed or fragile states, where the courts don’t work and regulations, assuming they exist, thus are inadequately enforced. But malfunctioning formal institutions do not mean that there are no functioning structures at all.

In these societies, the social order is predominantly shaped by informal agreements rather than formal laws and regulations. As the South African example shows, such agreements can even promote a country’s development. In many developing countries, village associations that are solely based on trust and peer pressure provide access to credit and insurance, guarantee help in times of distress, and facilitate the construction of public roads and sewage systems. The community-based health insurance schemes that are prospering all over Africa are a good example of this.

Even so, while informal institutions can improve people’s lives, they can also be detrimental to development. The very resources that form the basis of informal security systems – solidarity, social capital, and collective action, for example, can have perverse effects. For example, forced solidarity will oblige any hard-working farmer in Benin who has accumulated some wealth over the years to share the fruit of his labor with his enlarged family, including distant relatives.

In economic terms, the “informal institution of sharing” may become a disincentive to invest and thus result in opportunistic behavior, because there is no obligation to reciprocate. For all of their success, South Africa’s mini-taxis could not escape high accident rates, violent incidents over un-commissioned routes and fare levels, and tax evasion, which imposed high costs on society, prompting the government to regulate the service.

Moreover, some informal institutions based on longstanding cultural traditions lead to discrimination and violation of human rights, while undermining the authority of formal institutions like the judiciary, police, or military. In these cases, women are often the victims. They might be excluded from participation in informal networks, or have limited influence in appropriating the accrued benefits of collective action. The reported abuse of micro-credits to pay dowries is one alarming example. Likewise, the tradition of female circumcision is still a common practice in African countries such as Guinea, Sudan, Mali, Somalia, and Eritrea, where more than 85 % of young women suffer from it.

Abolishing such customs is a moral obligation, but in other instances, the international community often needs to decide which institutions to change and how. Indeed, one of the most difficult tasks for policymakers is to identify correctly those institutions that are conducive to development and those that may be harmful. Even then, successfully changing institutions is easier said than done, as they are rooted in deeply enshrined norms and values.

Neither the “romantic preservationist” nor the “bulldozing modernizer” approach promises an adequate solution. Institutional reform is a delicate affair that needs to be done with caution and sometimes against the conventional reform dogma. In some cases, good intentions may even aggravate the status quo. For example, trying to eliminate corruption in environments with strong patronage-based power and redistribution mechanisms while failing to address the root problems can do more harm than good, and might lead to violent conflicts over new resources.

Reforms need to acknowledge the mindsets of people and the incentive structures that govern their behavior. Thus, those who benefit from reforms may champion the process, but losers must be adequately compensated in order to prevent them from resisting the transformation. Without building public support and providing proper enforcement mechanisms, changing laws alone is bound to be ineffective. Sometimes it might even pose high costs for the alleged beneficiaries.

Given the complexity of institutional reform, striving for what appears to be optimal might not always be the best approach. Reforms must be adapted to the specific context of each country, and be applied within the boundaries of what is possible. Institutional change requires a long, tedious, and modest implementation of multiple small steps, in which the correct sequencing of reform is crucial. To obtain sustainable results, policymakers need to accept that sometimes “good enough is enough.”

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