How Institutional Quality Shapes Our World – OpEd

By Sergio Martínez

What is institutional quality, and why is it important for economic progress?

Institutions are therules of the gamethat shape human behavior. They include laws, codes of conduct, and both formal and informal customs that structure interactions between people. Our expectations of how others will act in different situations depend on institutions. Stable institutions reduce uncertainty and make economic activity easier.

However, not all institutions promote productive behavior. InWhy Nations Fail, Daron Acemoglu and James Robinson distinguish between two types: inclusive institutions and extractive institutions. Inclusive institutions encourage broad participation in wealth creation, while extractive institutions benefit a small elite at the expense of the majority. Inclusive institutions protect private property rights and shield individuals from government overreach, whereas extractive institutions are characterized by rent-seeking, coercion, and human rights abuses.

A country’s institutional quality is higher when it fosters inclusive institutions. These institutions are more productive because they support open markets and align the interests of entrepreneurs with those of consumers. Extractive institutions, on the other hand, are unproductive because they reward zero-sum strategies.

The Red Liberal de América Latina (RELIAL) recently released the 2024 edition of itsInstitutional Quality Index(ICI), authored by economist Martín Krause. The ICI ranks 183 countries based on their institutional quality, using indicators of economic and political freedom. The index measures how well a country protects property rights, supports free markets, fosters innovation and entrepreneurship, and upholds a participatory democracy with checks and balances.

Denmark, Switzerland, Finland, and New Zealand took the top four spots, while the United States ranked 18th, having dropped four places since 2021. At the bottom of the list were North Korea, Yemen, Syria, and Venezuela. The Nordic countries, which have high levels of both political and economic freedom, exemplify a commitment to inclusive institutions. Countries with higher institutional quality also tend to have higher per capita incomes. For example, Denmark ranks eighth in per capita GDP according to the World Bank. Chile, a country historically known for its pro-market reforms, has one of the highest institutional quality rankings in Latin America, with a GDP per capita 58% higher than the regional average.

As Martín Krause notes, institutional change tends to be slow, and the ICI reflects this by showing little movement in the top 20 countries over the past four years. Institutional stability in prosperous countries is key to their well-being. As George Leef points out, good institutions “economize virtue.” In a well-functioning market economy, individuals can contribute to the welfare of others without requiring extraordinary levels of altruism. For example, a grocer is honest not because he is virtuous, but because honesty is good for business.

Market institutions create order and discipline without relying on people to be exceptionally virtuous. In societies where market institutions prevail, people not only follow the rules of the game but also internalize values like respect and persuasion in their daily lives. It’s no surprise that the countries embracing these institutions tend to be the most prosperous and virtuous.

Why are institutions essential for economic growth?

Economic growth relies on a country’s ability to combine resources (labor, capital, and land) and techniques (technology and knowledge) efficiently to produce goods and services that meet the needs of its people. However, this process only works well when there is a stable framework of expectations, where the rules of the game are clear and predictable. Institutions are essential because they allow individuals to plan, innovate, and take risks—key ingredients for economic growth.

Unstable institutions, on the other hand, create uncertainty that stifles investment and trade. People lose the ability to predict the outcomes of their actions, making them less likely to take risks or invest in long-term projects. In contrast, stable institutions that protect private property and uphold voluntary contracts give individuals the confidence to plan their economic activities. This encourages innovation, savings, and capital accumulation—all crucial elements of economic growth.

Conclusion

Institutions are a cornerstone of a functioning economy. They not only establish the rules that enable cooperation but also reduce uncertainty and create an environment conducive to economic growth. Without strong institutions, economies become chaotic, inefficient, and unequal. With stable institutions, however, innovation and investment thrive. Both history and economic theory teach us that countries with strong institutions that protect private property and contracts experience the greatest long-term prosperity and development.

• About the author: Sergio Martínez works as a Content Editor at the Foundation for Economic Education. He has taught courses on economics and the History of Economic Thought.
• Source: This article was published by FEE