How institutions undermine the economy

An interesting article was published today on The Conversation web site about the role of corporate law in the demise of BHS, a British retail corporation that was deliberated bankrupted by its main shareholder and director, Philip Green. All in all, it is a horrendous case of how corporate law facilitates the undermining of economic wealth generation in favour of the extraction of extreme wealth for a few powerful individuals.

As set out by the author, Professor Lorraine Talbot, BHS was deliberately loaded with debt to transfer the value of its assets to other corporations that paid out significant dividends to the family of Philip Green. All of this is not illegal and fits within the framework of the law. Therefore, this case clearly shows how bad institutions, in particular the law, undermine the proper functioning of the social division of labour as an economic wealth generator in the contemporary global economy.

Another aspect of this case is that this same corporate law was created in the past at a time that greed was less of an issue and provided the flexibility of the system to support entrepreneurial activity. Thus, institutions that functioned reasonably well in the past might falter completely if behavioural attitudes change. In this case, the rise of extreme greed as an accepted behavioural norm, caused these institutions to fail spectacularly.

I note that selfishness and greed themselves are social norms and as such foundational social institutions. In this regard, how institutions attune with each other impacts economic performance and wealth generation.

Understanding the role of institutions in the economy: A mathematical approach

Over the past couple of decades it has become more and more recognised in economics that socio-economic institutions are essential for the functioning of the economy. This research has emanated from the seminal work of Douglas North in his study of various economic systems throughout economic history and of Ronald Coase in the understanding of hierarchical organisations and mechanisms in market economies.

This reasoning has recently been extended by Daron Acemoglu to a wide variety of environments, the main one being the influence of political institutions on economic performance in his work with James Robinson. (I refer here to the very accessible account of this work in their book Why Nations Fail: The Origins of Power, Prosperity and Poverty.)

Together with Emiliya Lazarova and Pieter Ruys, I have been working on a mathematical theory that gives expression to the essential nature of institutions. We interpret institutions mainly as guidelines or rules that people apply to build socio-economic relationships. These rules should provide economic stability in the sense that the economy tends to a stable state in which prosperity can be achieved regardless of how exactly the production technologies or preferences in the economy change. Thus, while production technologies and preferences evolve, the institutions are in some sense timeless and provide the possibility to achieve stability regardless of these changes.

Our mathematical analysis shows that the institutional structure of the economies that humans devised throughout history are indeed the ones that provide stability. There are three major institutional structures that provide such stability:

  • The creation and assumption of socio-economic roles through specialisation of human capital. By assuming professional roles in the economy and following certain well-established rules of how one should act in these professional roles, all of us together provide a stable foundation for economic development. This started out as hunters and gatherers in the most primitive, tribal economies and it evolved into our highly complex 21st century global economy in which we assume a multitude of diverse socio-economic roles through professional specialisation.
  • The second major institution is that of social hierarchy. By assigning individuals to positions of authority over other individuals, the economy is stabilised and is able to prosper. Social hierarchies have been around from the dawn of mankind. Political leadership usually coincides with economic power and control. Kings, knights, bishops and monastic priors used to exercise control over large groups of productive individuals, resulting in wealth creation in the medieval, feudal economy. This evolved into capitalist systems of democratic governmental authority and hierarchical social production systems in which leaders control subordinates. Our conclusion is that social hierarchies are very effective institutional structures that provide stability irrespective of the productive abilities of these individuals.
  • Finally, the role of market makers and platform entrepreneurs is crucial in the functioning of the economy. By binding the economy across differentiated local markets and creating a global economy, the economy again provides a foundation of stability and the accommodation of wealth creation through a wide variety of socio-economic processes. It is recognised here that “markets” do not emerge naturally, but are explicitly created by market makers and platform providers. (These platforms include markets as centralised trading places, operating systems, chain stores and systems of laws and rules that conduct how we interact with each other.)

Our mathematical theory shows that these three fundamental forms of socio-economic institutions are effective stabilisers of the processes that occur in any economy. This points away from the point of view promoted in traditional neoclassical economics that wealth creation is driven only by markets and the incentives emanating from market institutional arrangements. It is also an indication that we still are far away from a deep understanding of how the economy functions and that lessons for our ongoing economic crisis should be drawn from an institutional perspective.

A preliminary draft of the paper can be found on my economic theory page.

The paper has now been published in the Journal of Economic Behavior & Organization.

New paper on partial cooperation

I just added a new working paper on partial cooperation in non-cooperative games on the economic theory page. It addresses how to consider a group of decision makers to coordinate certain strategic actions, while all other actions remain purely non-cooperative. The paper generalises the existing contributions to this partial cooperation problem to include more complex decision situations.

We provide two applications of this framework. First, we look at cartel formation in a multi-market oligopoly. In this case the cartel operates only in one market, while all cartel members and other firms remain competitive in the other markets. Interestingly, we show that the merger paradox vanishes if the cartel takes a leadership position in determining its actions.

Second, we consider the writing of international treaties to curb environmental pollution. In particular, in our framework we can now study how a group of countries can agree on emissions control, while other countries do not participate. Furthermore, all countries remain competitive in the production of non-polluting goods. We show that even when few countries participate, emissions control efforts are Pareto improving.

Freedom in our contemporary global economy

What is freedom? It seems that this question has become very important in the age of neoliberal decline of civic society. Recently, in an interview with the Guardian newspaper, the marxist philosopher Slavoj Zizek discussed freedom in our age of the Arab Spring and the Occupy movement. Zizek is as usual rather fuzzy about what exactly freedom is, but he points out a very valid point, namely that the ultimate form of freedom is to question the institutions that determine our society and economy.

I want to elaborate a bit on this by enhancing the discussion and linking this form of institutional freedom with the type of freedom that so dominates our economic and neoliberal perspective on our economy, namely individual freedom. In fact, I distinguish three related notions of freedom:

Individual freedom

The most basic form of freedom is the one that prevails in our thinking since enlightenment and the industrial revolution: The ability to be allowed to freely choose between multiple alternatives. This individual form of freedom is seen rather primitively and linked strongly with the acts of consumption or production. But it is never truly satisfactorily considered in the discussion in economics beyond these rather straightforward considerations.

Indeed, what exactly does this individual freedom mean? If it is simply the act of selecting freely from a set of alternatives, then it can be rather meaningless. What if the set of alternatives is very small? This important aspect of individual freedom is usually avoided.

A simple thought experiment clarifies here: Consider an individual completely by herself in a desert. She can do anything she wants and as such is completely individually free. But this setting renders this freedom meaningless, since it is not in context of interaction with other humans. Thus, freedom only has meaning in a social context. So, individual freedom should only be considered in the context of a society. In fact, the size of the set of alternatives that one can choose from is usually determined socially; it are institutional settings and actions of others that determine what one can actually choose from.
So, the discussion of individual freedom is really one that goes far beyond the individual and considers the social and institutional environment of the individual rather than just the individual herself.

Social freedom

This brings us to think about a second form of freedom, namely one that goes beyond individualism: A form of freedom considering an individual in her social environment. Social freedom refers to the freedom to engage with other individuals and freely build one’s social networks. Thus, this form of freedom is really about influencing others’ choice sets and to give up some of one’s individual freedom by restricting one’s choice sets to create new choice or choice sets.

Engaging with another human being usually means that one restricts choice, simply by spending time and effort to engage, excluding other uses of that time and effort. However, other choices might emerge from this engagement, which were not possible before that engagement. For example, engaging with a potential business partner or collaborator reduces one’s productive time, but creates new opportunities to build a business venture or to develop a common project. Social freedom in all respects is the antithesis to individual freedom.

Institutional freedom

The highest form of freedom stands above the two forms of freedom that I discussed thus far. Institutional freedom directly addresses and confronts the institutional environment in which one exercises these individual and social freedoms. It is this form of freedom that Zizek debates in the Guardian interview.

Institutions determine individuals’ ability to exercise their individual and social freedoms and provide a framework that constrains as well as liberates people. What form of these institutions should we strive for and implement in our society? How far can we go in restricting individuals’ exercise of their individual and social freedoms? How far can one go in modifying the institutions that form the basis of society?

It is these important questions that are asked in the exercise of one’s institutional freedom. The ability to question and debate is exactly what institutional freedom facilitates. And is exactly this form of freedom that has always been important during enlightenment and more recently in our contemporary global economy. It is the erosion of this highest form of freedom in our western societies with the rise of the security state that should worry us.