Building better institutions.

• Author: de Rato, Rodrigo

It is a pleasure to be here today at the Cato Institute. I know that Cato believes in competition. Perhaps it is this spirit of competition that led you to schedule today's conference to coincide with the International Monetary Fund's research conference and steal the IMF's managing director and its current and past directors of research as participants. But while you have missed out on our research conference you will not miss out on our research: my talk today is based to a large extent on the findings of our latest World Economic Outlook, which conveniently has the theme "Building Institutions" [IMF 2005a].

My remarks address three questions. First, what have we learned about the importance of institutions in promoting economic development? Second, how we can accelerate the transition to better institutions? And, third, what reforms of international organizations, the IMF in particular, are needed to help this transition?

The Importance of Institutions

Let me begin with what we have learned about the importance of good institutions. By good institutions, I mean the adoption of policy frameworks in which there is acceptance of several broad principles:

* First, the private sector is recognized as the main actor on the economic stage, with the state stepping in to provide appropriate regulation of markets.

* Second, there is a commitment to protecting property rights and creating an environment where innovation can thrive.

* Third, the rule of law prevails, and corruption is not tolerated in either the public or private arenas.

* And, fourth, there is a stable macroeconomic environment, reflected in low inflation and a sustainable fiscal position.

All this sounds to us today like common sense. But it is the evidence that has accumulated over the last few decades that has led to universal acceptance of these propositions. Forty years ago, with the Soviet Union still standing, many countries were tempted to give the state control over the commanding heights of the economy. That is not the case today.

It took a resurgence of interest among economists in the 1960s and 1970s to improve our understanding of how vested interests block economic growth. One of those economists was my colleague Anne Krueger who coined the term "rent seeking" in a famous paper published in 1974.

Attitudes toward corruption were also different then. In many countries, corruption was not just tolerated but almost welcomed as necessary to grease the wheels of commerce. Today, these same countries are engaged in a difficult but necessary battle to eliminate corruption.

Finally, the idea of seeking salvation through inflation has also been abandoned in recent decades. In the 1960s inflation was tolerated in the belief that it helped lower unemployment. Inflating one's way out of trouble was politically tempting for governments around the world and was regarded as imposing relatively few long-term economic costs. Indeed, as late as the early 1990s, annual inflation averaged more than 40 percent in Africa and more than 200 percent in Latin America, compared with the single-digit rates in both regions today. Clearly, attitudes and institutional frameworks have changed, as reflected in the sharp decline in inflation rates all over the globe and the independence of central banks.

It is not easy to quantify these changes in attitudes but it can be done. By combining information of the prevalence of the rule of law, the extent of regulatory burdens, the degree of corruption, the independence of central banks, and so on, one can create indexes of the quality of institutions. The work by IMF staff on the role of institutions relies quite heavily on these indexes, particularly the index of economic freedom published by the Fraser Institute in Canada in conjunction with the Cato Institute and other think tanks worldwide (see Gwartney and Lawson...