How Institutions Affect the Economy

Douglass North in his book, Institutions, Institutional Change, and Economic Performance, defines institutions as “the rules of the game in a society…They structure incentives in human exchange, whether political, social or economic.” While North’s definition may sound cynical, institutions are responsible for contract enforcement, protection of property rights, the rule of law, government bureaucracies, and financial markets and do play a very large part in society.

 

In my Market Development and Global Strategy class (IBUS 435), as seen in my notes at the bottom of the page, we talked about 4 myths of corruption: Structuralism, Behavioralism, Institutionalism, and Culturalism, but I am going to connect my experiences with Institutionalism. The myth of Institutionalism goes on to say that institutions are constructed and reproduced by humans, and thus are open for policy-induced change. As Pinochet took over the presidency in 1973, the Chilean economy was facing high levels of inflation, as in 400 percent and it continued to rise to 600 percent in 1974.[1] The administration has been criticized for their method of trying to combat inflation as they fixed the exchange rate, which did stabilize inflation, but in addition, it also opened the economy to foreign investment, but the country was unable to pay back these debts and as a result, inflation began to rise again, and salaries were indexed to past inflation.

           

The result of these adjustments eventually led to a historic banking crisis in 1982-1983, but it left a lot of citizens unemployed and with a lot less money, on top of the continuation of the human rights violations. As the country would later recover and flourish into the economy today, it allowed those who had money back then to grow their money as the economy bounced back, but those who were not as well off financially were not able to recover. This is incredibly prevalent today as income inequality is such a large issue leading to drastic changes of income disparities in the city. In addition, there has been an influx of immigration, and the city of Santiago has seen crime rates increase, especially in petty theft.

 

During my first week of orientation, my advisor announced to the large group of international students that 50% of students would get their phones stolen by the end of the semester. At the end of orientation, we found out the next morning that 4 students had their phones stolen right after the meeting. Phone theft is incredibly popular because of modern-day dependability, especially in Chile where all citizens communicate through Instagram or WhatsApp as a way to text, call, or video chat. Stolen phones are then sold in a grey market, or an area where consumers can buy knockoff versions of designer brands, stolen goods like phones or laptops, or sell their own made goods. It was such a common addition to their society that it was mentioned quite often by my professors in English and Spanish-taught classes that it played a large part in their economic environment.

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One of the biggest areas that held these grey markets was a neighborhood named Bío-Bío. Especially on the weekends, the streets were blocked off and filled with tents that housed everything from secondhand clothes, knock-off designer accessories, knock-off brand name shoes, house furniture, kitchen cutlery, etc. We arrived one weekend just to see the extent of these grey markets and try to reason how so many people would get their phones stolen that the natives called it an “initiation” when it happened. As seen in my journal down below, it was an experience that was overwhelming and had every ounce of my person on edge. We had gone to help my friend buy a pair of knock-off Nike shoes for an upcoming trip she had, and we left with an old map of Santiago, knock-off Prada sunglasses, and a pair of fake Nike Air Force Ones. When we returned home to our host family, we were lectured about how dangerous it was for us to go. It was not a place we should be supporting since many things were stolen goods and it encouraged the buying of fake merchandise, but we had finally had the chance to see why these grey markets were so essential to the economy.

 

Participating in these grey markets is a way for the lower class to make additional money as minimum wages are not sustainable for the living costs in Santiago, or it may be their only source of income since transactions are made in bank transfers or with cash.  As these activities are associated with the lower class, there is a very large segregation between the classes in social circles. At the university I attended, those from higher economic classes would not be in the same social circle as those in lower classes, and those in lower classes were looked down upon quite often in conversations or in group settings.

 

The segregation of the economic classes as well as the ever-growing income inequalities are continuing problems that were rooted in the economic decisions made by the Pinochet administration. As the economy grows and has become a presence in the global economy, the government has tried to relax immigration laws as a way to bring more workers to the labor force, but as a result, there is not enough housing in Santiago to hold the new migrates and has resulted in a 4% increase in homelessness in the last decade. The institutions set in place during the Pinochet administration led to the development and dependencies on these grey markets. As a result, the current institutions struggle to enforce the closure of the markets as more and more people move to the city.

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In my Market Development and Global Strategy class, my professor explained that there is a common example to explain the inner workings of institutions. Good institutions will act as fertile ground by creating trust and offering cooperation. This, leads to a healthy environment for seeds, or good policies, to grow and as a result, the country will flourish with capital accumulation and innovation. Continuing the analogy, Pinochet had a dry and unforgiving ground that resulted in policies that would lead to some economic growth, but it wasn’t until the ground had been tilled and fertilized that it was truly able to foster good policies and true economic growth.

 

Today, Chile continues to debate and develop a new constitution to replace the one from the Pinochet era, but without those same institutions in place, they have already seen economic development and growth since the dictatorship. When I learned about the effect that institutions can have on economic growth, it was something that I immediately connected with living abroad. Having strong institutions in place that can produce good policies, leads to a high level of growth and economic development as well as increase the level of economic stability in the long term. Many of my classes talked about the evolution of the Chilean economy, and today it has shown significant growth since the end of the Pinochet dictatorship and has proven to be economically stable.  

 

After studying abroad, I understand how institutions can change the outcome of the game. Social institutions shape norms and values, but economic institutions can change the future for everyone. Chile found growth and prosperity once they broke away from the restrictive and domineering institutions that the Pinochet administration had set. Moving forward, I aim to assess these situations further and create a more prosperous community domestically and abroad. In the future, I hope to work closely with international branches that are located in Latin America and successfully evaluate the economic status of the countries I will be doing business with. After being able to study and observe the changes to institutions in Chile, I am more confident in my ability to assess the economic stability of a country from the institutions in place and make business decisions from my assessments.

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Sources:

[1] Caputo, Rodrigo, and Diego Saravia. The Case of Chile. 2019