Although I list institutions as the seventh factor in this series on the factors of economic growth, I believe that it is the most important. Some of the factors that are included in the first six factors are actually a subset of “institutions”.
In the context of economics, institutions refer to the structures or mechanisms of social order such as economic policies, governmental programs, educational systems, family traditions and religious practices. It includes systems of justice, academic curricula, ethics, cultures and just about everything that guides the ways that people interact. Clearly many of the previous factors that I have discussed (fiscal policy, monetary policy, regulations, cronyism…) are institutions since they are government mechanisms. Another key institution is our system of property rights – our belief that a person who makes something is entitled to the fruits of his/her labor rather than having the benefits controlled by a dictator, committee, tribal leader or criminal.
The great economic success stories of U.S. history are dominated by driven individuals such as Andrew Carnegie, Walt Disney, George Eastman, Thomas Edison, Henry Ford, Steve Jobs, Ray Kroc, Charles Schwab, Sam Walton, and Oprah Winfrey to name just a few. I am continually amazed by the extent to which American entrepreneurs (not necessarily American-born) have economically dominated the innovations of the world. To what can we attribute their success? Without doubt the success rate is driven by one factor: America has very successful institutions. And the economic failures of many regions throughout the world today and in previous decades are caused primarily by dysfunctional institutions.
At the core of long term economic growth and success is the extent to which people are recognized as possessing inalienable individual rights versus the extent to which people are viewed as being subject to the unlimited will and reach of authorities. The foundation of an economy’s long term success is private property rights. Private property rights allow trade to take place based on the de-centralized decisions of the individuals directly involved. If an individual makes good decisions, that individual’s economic power grows, and vice versa. Trade leads to specialization, specialization leads to efficiency, efficiency leads to production, and production allows an economy to meet its needs and goals.
Milton Friedman said that when everybody owns a thing then nobody owns it. We take care of our own houses and cars since we bear the cost of any damage or losses to those items. But individually each of us loses little when public buildings or government vehicles are damaged. It is known in economics as the ‘tragedy of the commons’. Private property rights can be crushed not only by governments that seize property – they can be crushed by governments that dictate some or all of the ways in which an individual can use that property. Take land, for instance. Does someone really own a piece of land when government can unpredictably change the rules as to what can be done with that land? To the extent that governmental institutions inject uncertainty into private property rights, long term economic growth is stunted.
Importance of factor in general: A+
Prospective influence of this factor on the U.S. economy: B