Catalog

Institutions as Rules

Douglas North, the Nobel Laureate, made clear that institutions are the rules of the game in a society. They define, for example, a system of property rights, regulations that curb the worst forms of fraud and anticompetitive behavior, the rule of law, and sociopolitical arrangements that mitigate risk and manage social conflicts. Characteristically, each rule performs a distinct function. But its effectiveness hinges on being complemented and supplemented by others. Together, the rules form a hierarchic structure of mutually supporting directives that influence jointly and can impact decisively the development of nations.

At the top of this institutional hierarchy is a set of policies that mark the workings of an economy in the short term. Next comes a set of regulations that should support the functioning of markets, while legal codes and laws that define property and other rights would in turn underpin this regulatory system. These should be founded on transparent institutions, such as the judiciary, that would enforce the long-term security of property rights and adjudicate claims of right violations. All these layers would be supported by base institutions that foster political participation and external enforcement, and maintain civil and social order. This perspective of seeing institutions in a hierarchic order—for their social and economic functions—offers important insights into the process of reform and restructuring now taking place in East Asia.

Realigning Institutions

Realigning institutions, following the hierarchy outlined, is a significant feature of a process of reforms. Changes in one set of policies or institutions lead typically to the need to overhaul related institutions. This process can be observed in the series of changes taking place as the countries affected by the Asian financial crisis attempt to deal with corporate debt restructuring. For example, the problems of corporate debt overhang and insolvency have led to measures for financial liquidation and bankruptcy proceedings that have also required changes in existing laws and judiciary systems. And, new rules on corporate governance are being developed to improve standards of corporate practice.

Overall, the crisis has accentuated the importance of institutional change and underscored the need for more. One important area concerns social protection systems. In the past, governments in the region relied heavily on growth to resolve social welfare questions. They invested in human capital but provided limited formal social insurance. Still, the severe social dislocations caused by the crisis stress-tested the limits of this approach. They have generated debate over the need to revise the implicit social contract between the state and society to cushion more social groups from future shocks.

Recognizing the continuing significance of growth, the debate also focuses on new institutional responses for providing social insurance, reform of industrial relations and labor market issues, education, decentralization, and persistent or structural poverty.

Time Dimension of Institutional Change

Time lags between initiating changes and their ultimate impact can be long. Governance reforms can be especially time-consuming because of vested interests. And changes at lower layers of the institutional hierarchy will take longer to make themselves felt. Because various institutions evolve at different speeds, conflicts and contradictions among them will arise.

Depending on the institutional circumstances, some can be addressed smoothly while others cause major and sometimes violent frictions. Indonesia is perhaps the most pronounced example. But, paradoxically, the political and social difficulties observed in that country are part of the painful process of institutional reform.

So despite the many problems it faces, postcrisis Indonesia is more transparent than before and demand for broad participation in policy making is increasing. Indonesia needs to sustain its incipient economic recovery and manage conflicts over changes. The scale of institutional change is massive and the process is complex. A key challenge facing the countries affected by the crisis is managing the institutional realignment while minimizing the associated social costs.

CHANGING THE RULES: Tackling cross-border problems at the regional level will help contribute to global security and prosperity.

Strategies for Institutional Change

Popular views that the policy changes and reforms being implemented in East Asia are externally driven reveal misguided perceptions. Institutional change is part of social and economic transformation. It takes place as a process of evolution and adaptation and it involves broad participation and consensus building. No one set of institutional arrangements can be claimed as superior to the others in terms of overall performance.

Strategically, institutions need to be developed locally, based on local knowledge and hands-on experience and experimentation. In the past, East Asian countries have shown a remarkable capacity for adapting to and undertaking institutional change. The crisis is not—and should not lead to rejection of—what made East Asia a success and the institutional capacity that was built along the way. This capacity to initiate and facilitate change needs to continue if only because transformations are taking place regionally and globally.

Regional Responses for Change

Since the crisis, countries in the region have been devoting more attention to the regional aspects of institutional building. Besides the Association of Southeast Asian Nations (ASEAN) and the Asia-Pacific Economic Cooperation (which were already in place prior to the crisis), new regional initiatives are being pursued. These include the Manila Framework Group, ASEAN regional surveillance process, and Chiang Mai Initiative for an expanded regional currency-swap network. These intensified efforts at regional cooperation in East Asia reflect growing awareness of the need for joint institutional approaches to deal with issues of common interest.

In general, promoting greater regional cooperation enables the participating countries to jointly explore economic opportunities and gain from complementarities. A regional approach is also effective in tackling cross-border problems arising from security conflicts, environmental issues, drug trafficking, and migration. Addressing these issues at the regional level will help contribute to global security and prosperity.

Conclusion

The challenge of institutional change in East Asia is demanding. Effectively managing the changes will pay off because, in the end, institutional capacity to do so will decide whether a country succeeds in bringing lasting prosperity to its people. With the multilateral development banks being important partners in this process of change, they also need to address a key internal institutional issue: how to balance the role of development banker and that of institutional development advisor.

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Read the news release -- Policy Vigilance Needed to Minimize East Asian Economic Turbulence, ADB Report Says

Read the ADB Review article - "Slower Recovery for East Asia"

Review the following Asian Economic Monitor reports on East Asia's economic recovery:

• "East Asian Recovery Outlook: Bleak or Better?"

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