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This blog post is a little different from most we have written but we consider it to be extremely important at the systemic level. At its most basic, it can be said that all institutions require confidence in them for them to function effectively. Of central importance to that confidence is the Rule of Law. We now also know that the trait most positively correlated with a country's GDP growth is the strength of its rule of law. In other words, a country will perform better economically if it has a sound, functioning and respected set of laws which are enforced broadly.
Experts such as Michael Porter of Harvard Business School define "economic competitiveness" to include the ability of the government to pass effective laws; the protection of physical and intellectual property rights and lack of corruption; the efficiency of the legal framework, including modest costs and swift adjudication; the ease of setting up new businesses; and effective and predictable regulations.
The USA now fares markedly worse than Hong Kong in all 15 of the measures of the rule of law shown in the World Economic Forum's annual Global Competitiveness Index. These measures range from the protection of private property rights to the policing of corruption and the control of organised crime. In the Heritage Foundation's Freedom Index the USA now ranks 21st in the world in terms of freedom from corruption, a considerable distance behind Hong Kong and Singapore (Australia ranks #3) and in the World Bank's Indicators on World Governance, since 1996 the USA has suffered a decline in the quality of its governance in three different dimensions: government effectiveness, regulatory quality and control of corruption.
Niall Ferguson, Professor of History at Harvard and Oxford Universities, makes the argument in his 2012 Reith Lecture (you can read it here) that these indicators show that the USA, and to an extent, the UK are suffering a deterioration in the rule of law.
China is now the most talked- about country whose future economic prosperity will depend on whether impartial legal institutions can replace personal and particular network- based mechanisms for ensuring compliance in commercial contracts.
The Rule of law and economic development was considered by Michael Heller, on Project Syndicate July 3, 2012. He states:
The quality of enforcement matters more than substantive content of law in developing countries. Good or good-enough law dealing with even sophisticated financial, corporate, or bankruptcy regulation is often already on the books. What is frequently absent is a credible expectation that law should and will work.Structural and behavioural independence of the judiciary is seen to be a critical factor in the ability for laws to be enforced.
A number of other authors offer China as an example of a dictatorship that achieves economic growth by prioritizing good-enough security for property rights. Others question whether China will improve economic governance fast enough to avoid disaster. These are familiar arguments. Kenneth Dam, on the other hand, detects a promising ‘guided evolutionary approach’ to rule of law that could allow China to avoid serious economic crises. Political leaders, he thinks, seem to be coming around to an awareness of the need to enforce market rules.
Niall Ferguson has also considered this issue recently. He considers the problems of the "West" characterised as "excessive debt, mismanaged banks, widening inequality" are rather, symptoms of underlying institutional malaise.
He turns to English history and cites the establishment of the institution of Parliament as a seminal moment empowering economic and social change:
From 1689, Parliament controlled and improved taxation, audited royal expenditures, protected private property rights and effectively prohibited debt default. This arrangement, they argued, was ‘self-reinforcing’, not least because property owners were overwhelmingly the class represented in Parliament. As a result, the English state was able to borrow money on a scale that had previously been impossible because of the sovereign’s habit of defaulting or arbitrarily taxing or expropriating. The late 17th and early 18th Century thus ushered in a period of rapid accumulation of public debt without any rise in borrowing costs – rather the reverse.and
Not only did it enable England to become Great Britain and, indeed, the British Empire, by giving the English state unrivalled financial resources for making – and winning – war. By accustoming the wealthy to investment in paper securities, it also paved the way to a financial revolution that would channel English savings into everything from canals to railways, commerce to colonisation, ironworks to textile mills. Though the national debt grew enormously in the course of England’s many wars with France and others, reaching a peak of more than 260 per cent of GDP in the decade after 1815, this leverage earned a handsome return, because on the other side of the balance sheet, acquired largely with a debt-financed navy, was a global empire. Moreover, in the century after Waterloo, the debt was successfully reduced with a combination of sustained growth and primary budget surpluses. There was no default. There was no inflation. And Britannia bestrode the globe.Fast forward to today and he identifies:
The heart of the matter is the way public debt allows the current generation of voters to live at the expense of those as yet too young to vote or as yet unborn.Ferguson opines that the biggest challenge facing mature democracies is how to restore the social contract between the generations and that there are three possible solutions:
But the official debts in the form of bonds do not include the often far larger unfunded liabilities of welfare schemes like – to give the biggest American programs – Medicare, Medicaid and Social Security. The most recent estimate for the difference between the net present value of federal government liabilities and the net present value of future federal revenues is $200 trillion - nearly thirteen times the debt as stated by the U.S. Treasury. Notice that these figures, too, are incomplete, since they omit the unfunded liabilities of state and local governments, which are estimated to be around $38 trillion.
- The proponents of reform succeed, through a heroic effort of leadership, in persuading not only the young but also a significant proportion of their parents and grandparents to vote for a more responsible fiscal policy
- Public sector balance sheets can - and should be - drawn up so that the liabilities of governments can be compared with their assets. That would help clarify the difference between deficits to finance investment and deficits to finance current consumption. Governments should also follow the lead of business and adopt the Generally Accepted Accounting Principles. And, above all, generational accounts should be prepared on a regular basis to make absolutely clear the inter-generational implications of current policy; or
- The debt continues to mount up. But deflationary fears, central bank bond purchases and flight to safety from the rest of the world keeps government borrowing costs down at unprecedented lows. The trouble with this scenario is that it also implies low to zero growth over decades: a new version of Adam Smith’s stationary state - only now it is the West that is stationary.
Debt is just a symptom of a chronic inability to take difficult decisions in the present when it is so much easier to pass the cheque to a future generation that isn’t represented.The laws of nations must be upheld in the face of financial crimes whatever the extent or cost. Further, the economic benefits of doing so will be positive.
