The Relationship Between Institutions and Economic Development Essay

The Relationship Between Institutions and Economic Development - Essay Example Neoclassical growth theory limits to identify the prerequisites of economic performance, such as capital accumulation and technical progress. To explain why people save, invest, learn and seek knowledge, different institutional systems and values that success or failures are based on must be paid special attention. The relationship between institutions and economic growth has been a central debate of the economic arena for a long time. A century ago, the free society realized that the institutional system plays a fundamental role in economic development-no longer seen as an inevitable gradual transition from local autarky to specialization and division of labor. The establishment and the functioning of institutions reflect the transition from chaos to order by the creation and enforcement of rules or procedures guiding economic and social life. Thus, the institutional system ensures the normal course of real and nominal economy. However, only efficient institutions are growth-promoti ng (Milo, 2007, p.23). There is a vast empirical literature that studies the impact of institutions on economic performance, particularly on growth (Easterly and Levine (2003), Acemoglu et al. (2001), Fukuyama (2006)). From the reverse connection perspective, the first hypothesis stating that economic growth enhances the good functioning of institutions is associated with the name of Martin Lipset, who argued that increased income and human capital accumulation are the best ways to have effective institutions. The second hypothesis states that limited central authorities and therefore, good institutions, lead to superior economic performance. This point of view is also included in the works of Montesquieu and Adam Smith and, later, in those of the ambassadors of neo-institutionalism (Buchanan, Coase, North, and Williamson). In short, the basic idea of institutionalism is that institutions create the rules of economic game; the latter provide economic incentives and thus influence th e behavior of economic agents. Competition, productivity, innovation and private firms develop in an institutional environment that fosters efficient behaviors and penalizes inefficiency. If economic performance is unsatisfactory, ultimately, institutions will be changed. Reformulated, economic and social changes are institutional changes. One of the most important issues that influence the analyses of linkages between institutions and economic development is that there is no general consensus on the definition of institutions. Chang (2005) highlights three key functions of institution in fostering economic performance: Coordination and administration; Learning and innovation; Income redistribution and social cohesion. In some Asian economies in transition from socialism to capitalism, the rapid progress of free market institutions has reduced the transaction costs. In other situations, they have remained high as a result of insufficient knowledge of market mechanisms, of ambiguous rules and bureaucracy, weak legal system and corruption. Stable political structures, well-defined and recognized property rights and legal enforcement of contracts have reduced transaction costs, explaining the success of the world’s most powerful economies. Transaction cost theory was used in the analysis of general interest issues such as the role and governance practices, definition of market institutions or in explaining the differences between economic performances of nations. Related to the last element mentioned, the theory developed in close connection with the role of institutions in fostering economic efficiency by reducing trading costs. North concluded that capitalist and democratic institutions (free market, state, justice) are the result of efforts to minimize transaction costs (North 1991,