THE late Chicago economist Ronald Coase posed this basic question in a 1937 paper entitled “The Nature of the Firm”: Why do people create companies to produce goods or services and what determines their size and scope?

Coase introduced the notion of “transaction costs” in answering the question — the costs associated with participating in the market, such as information and search costs, bargaining costs, and governance and enforcement costs. The conclusion was that firms are set up to internalise such transaction costs and their boundary is determined by the balance between internal and market costs. So began a branch of economics that would eventually be known as institutional economics.

A major contributor to the field, Douglas North, defines institutions as “humanly devised constraints that structure political, economic and social interactions”. Constraints, as North describes, are devised as formal rules (constitutions, laws, property rights) and informal restraints (sanctions, taboos, customs, traditions, codes of conduct), which usually contribute to the perpetuation of order and safety within a market or society. This definition broadened the scope of how rules define institutions and relate them to developmental outcomes.

Timur Kuran’s The Long Divergence: How Islamic Law Held Back the Middle East, for example, looked at how Muslim societies declined economically and more broadly, civilisationally, from their peak in the early middle ages because they failed to develop institutions that could propagate as well as participate in new forms of economic value creation, and new structures of businesses and their funding framework as well as contracts on agency relationships. The development of the capital markets also allowed European businesses to grow inter-generationally while exploiting production specialisations, mass consumption and distant markets.

The reason for this, according to Kuran, was that so-called Islamic legal institutions that had benefited the Middle Eastern economy in the first few centuries of Islam became stumbling blocks to innovation and creativity, thereby stagnating the economy that eventually resulted in its subsequent social backwardness.

More recently, Daron Acemoglu and James Robinson’s Why Nations Fail: The Origins of Power, Prosperity, and Poverty emphasised that it is the nature of economic and political institutions that explains why some nations are rich while others are poor. Inclusive and participative political institutions do better than authoritarian ones. And institutions that protect property rights and reward innovations spur economic activity that also tends to be more equally distributed.

A production view of economic growth and development is mechanical — what inputs are needed to produce what goods and services to generate what level of income. What is more important, however, is the incentive structure facing decision-makers, be they capital owners or labour. As North pointed out, these constraints define institutions which, in turn, determine the kinds of decisions economic agents will take. These decisions are what will determine economic outcomes.

The evidence is therefore clear — only countries that are able to build the right sorts of institutions will be developed. Ignoring the city-states of Hong Kong and Singapore, South Korea and Taiwan are the only Asian countries able to join Japan as developed economies, not just from an empirical point of view but also from an institutional perspective.

Their institutional framework, their systems, are able to produce globally competitive companies, the right schools and world-class universities and public institutions that have evolved into being participative and inclusive. These are indications that they have the right “rules of the game” in place that incentivise the right sort of behaviour to obtain the right type of developmental outcomes.

The right set of institutions makes things work for people who may have competing interests. It protects contesting property rights. There will be more trust between people. That is why transaction costs are low and there is greater efficiency and productivity. It is also resilient — it encounters problems and improves itself and will be better in facing the next crisis. It is not just about the right things happening but also about preventing the bad things from happening.

So, it was a shock to me that there were mass graves in Malaysia and though already abandoned, they had been around for some time — some five years, according to the authorities. These were campsites for trafficking human beings where people were treated like commodities — indentured, exploited and literally traded. More than 100 bodies were found buried in these graves. So many things must have gone wrong for a wrong thing like this to happen. Unfortunately, it says a lot about the state of our institutions, none of it complimentary.

For years, Malaysia has been classified as a Tier 3 country in human trafficking reports — the lowest possible rating. It was not a situation where there was no suspicion of human trafficking. One would have thought someone somewhere knew something that justified Malaysia’s ranking and that we too were interested to know why.

That Malaysia is inundated with millions of illegal workers and immigrants already suggests that all is not well at our borders but to actually have human trafficking camps operating in the country is taking things to another level. That these campsites went undetected despite having operated all those years is a travesty.

Whenever too many wrongs happen or are allowed to happen, a shadow is cast on all of us, on all our institutions and, by summation, on the country as a whole. They testify to a breakdown of law, process and governance and to the sorry state of our collective values.

The kinds of crises that happen and how well we handle them depends on how strong our institutions are. How we react to natural disasters such as floods or earthquakes depends on the integrity of the same institutional framework, the same personnel and the same ethics and values.

I see a parallel between sport and institutional strength, for example. That Malaysian football is ranked 162nd in the world, ahead of only little islands in the Pacific, has something to do with this institutional failure. We simply cannot get our collective act together to improve a sport the whole nation is crazy about. We may have deteriorated from having the desire to improve without the ability to do so and now we have to accept the mediocrity.

We should be reminded that Malaysia was ahead of South Korea on per capita GDP basis as late as 1980. South Korea thereafter shot ahead, almost tripling its per capita by 1990. The country was partly under martial law right until full political liberalisation in 1987.

Today, South Korea’s per capita GDP is 2½ times larger than ours. It has developed strong and stable institutions. Politically, it directly elected a woman president in 2013 in Park Geun-hye. Its schools are highly ranked in international tests and it has built a few world-class universities as well as some popular global brands in consumer products, automobiles and heavy industries. Of late, it has discovered its soft side and turned arts and entertainment into a major industry.

These achievements are not accidental but deliberate outcomes of having made the right decisions based on the right values. Of having the right constraints, quoting North again, and playing by those rules. By the way, the South Korean football team has slid as well, from 17th place to 58th, but it is still more than 100 notches above ours.

If breakdowns such as mass graves is a barometer of our institutional health, how we react to those breakdowns determines our resolve: Do we want to let things slide further or arrest the decline? Do we care?

If we do, we have to change our ways in some fundamental ways. If we continue to compromise on the integrity of institutions, they will be further debased and we will continue to deteriorate. The signs are looking ominous.

Dr Nungsari Radhi is an economist and managing director of Prokhas Sdn Bhd, a Ministry of Finance advisory company. The views expressed here are his own.

This article first appeared in Forum, The Edge Malaysia Weekly, on June 29 - July 5 , 2015.

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