Institutional structure matters for the success of an economy

Niall Ferguson has written a provocative short book on what he calls The Great Degeneration. It is an institutional economics argument for economic development or in the case of the US, economic decline. He believes that the the great divergence between Western and Eastern economic development has now moved not just to a significant convergence in growth but reversal of fortune for the West. The degeneration of Western structures and the acceptance of some key structures by the East will lead to further convergence of income and wealth levels. There have been a growing number of works on the Great Convergence of income levels and there has been a new focus in history on the development of the East and West over the last few years. The conclusion of many, as embodied in the great book Why Nations Fail, is that institutional structures matter. Niall Ferguson wants to provide his take from the view of a historian with an economic focus. 

Ferguson focuses on four black boxes which drive Western civilization: democracy, capitalism, the rule of law, and civil society. These help form the institutions we live in. Institutions are like the hive that bees live in. They determine whether there is limited or open access for individuals to thrive or be successful. Institutions determine whether the government is extractive or inclusive. Ferguson starts with the foundational observations by Adam Smith that stagnation occurs when an economy is in stationary state and this state is a function of the institutional arrangement of the economy. A really good set of institutions for growth are hard to achieve, so an economy has to be  careful with how institutional arrangements develop and change. The economic structure and society is a contract or partnership between citizens. If the governed allow for bad laws and incentives change, behavior of economic players will also change. This can place an economy in a stationary state which will not allow opportunities for growth.

Democracy determines the inclusiveness of citizens and creates the opportunity for limits on government. Capitalism is needed to allow for failure and the taking of chances for new opportunities. The rule of law allows for a system of justice, and a civil society creates an environment of trust. If these key drivers of Western civilization are changed, it will have impact on the potential for economic growth. Politics determine institutions which drive growth. 

Long-term growth is more about incentives and structures than it is about fiscal and monetary policy. Fiscal and monetary policy will fail if the institutions for growth fail. We will be in a slow growth economy, the stationary state,  if we allow our institutions to  degenerate.