In what follows we shall analyse the role of civic institutions and organisations in the creation and sustenance of long term financial markets – a key component of high income status.
The under-supply of products and services in the market for long-term finance is well known. In fact, the institutional evolution that is needed – so as to have well functioning long term financial markets – is perhaps the biggest challenge faced by middle income economies. Those countries that make progress in meeting this challenge, transition from low to being high middle income countries. Those societies that actually manage to successfully evolve nation-specific institutions to escape from this quagmire, go on to become high income countries. Those unable to evolve such liberating country specific institutions, become stuck in the ‘middle-income trap’.
One fundamental necessity in all of finance – and even more so in long-term finance – is that of trustworthy behaviour by both the providers and users of finance. This is a necessity for individuals, whether acting on their own or as representatives of organisations; so as to minimise the impact of moral hazard or that of opportunistic exploitation that is embedded in the very structure of asymmetric information transactions. A society
[a] that has evolved institutions that foster the formation of long-term trust
[b] will thereby foster long-term finance and
[c] the the consequent – distinctively high productivity long term project investments and [d] will therefore benefit from high income levels.
However, it is also well known that the governments are severely limited in their ability to evolve such ‘individual values fostering’ and ‘trust building’ institutions. This is the reason that authoritarian countries have never [except maybe Singapore] been able to become high income countries. The main reason behind this is that the evolution of these institutions that build up ‘social capital’ is significantly dependent on the civic society to evolve the individual values that create and sustain the appropriate behaviours; with the governments being able to play a supporting role at best. The fundamental problem with authoritarian governments is that they
[a] tend to either ‘crowd out’ the very formation of most socially beneficial civic institutions either because of ‘governmental paternalism’ or
[b] worse still, actually ‘stamp out’ based on the fear that they could become subversive.
Casual empiricism, when looking at the post-Soviet history of the transition economies for example, verifies the necessity of ‘social-capital-building’ civic institutions for the creation of long term credit markets. Everyday psychology would also suggest that it is in these formal and informal civic institutions that trustworthy behaviour – and the values that manifest it – is best inculcated in the population. For proof that these behaviours are grounded in Institutions that take time to evolve, and also have long-lasting effects, one only needs to look at the example of East Germany.
Since these civic organisations operate more freely in a democracy, it therefore appears that democracy is a pre-requisite for high income status. However, populist and ‘extractive’ democracies can easily ‘kill’ these high-performance civic institutions as well, making a democracy no guarantee for high income in that society. It’s the freely functioning trustworthy behaviour-building civic institutions alone – and not merely being a democracy – that are a guarantee for creating and sustaining high income status.
Another significant limitation for governments – including capable authoritarian ones – to be credible suppliers in the market for long-term finance is; ‘government failure’ in the prevention and management financial crises. The importance for governments in managing through financial crises rests on the empirical observation that only those middle income countries that managed successfully through a financial crisis [that originated elsewhere] have been able to achieve high income status. Countries that participated in the creation of a financial crisis or were unable to manage it well are and will be stuck in the ‘middle income trap’.
Moreover, as a well documented study of 800 years of economic history shows, most governments have an abysmal track record in managing their own finances in the long term, let alone serving as credible stewards of long-term financial markets. For example, in 2020, how few would choose either the U.S or Europe or Japan or China to be a credible trustworthy steward for the planet’s long-term financial needs. Which one of these countries can credibly claim to have managed their own finances well enough to be qualified to be the global hub in the market for long term finance? [Singapore is the clear winner in this test].
In thinking about the institutional requirements of a high income society, a clue that we have is that while transition from low income to middle income status can be rapid – accomplished in a generation in a variety of countries – the transition from middle to high income status seems to take at least a couple of generations, if not more. In other words, this challenge seems to call for the evolution of newer ways of thinking and behaviour – a notorious obstacle for human beings.