Laws introduced to protect privilege distort the incentives and disincentives to such an extent that the normal market mechanisms lose their efficiency

The Declaration of Independence of the United States contains a false assumption. Although it might be agreed that people are endowed with certain unalienable rights, it is absurd to believe that they were created equal. Some people are more intelligent or better looking or more verbal or better coordinated than others. Some people were born to wealth. Some were born to be kings or princes, while others are born into poverty. The random nature of birth for any country has little to do with economic growth. What is important are the possibilities during life. Potential individual merit is often limited by lack of personal connections.
 
In game theory there are two types of systems, rule-based systems and relationship-based systems. In rule-based systems agreements, laws and regulations are dependent upon enforced rules. In relationship-based systems outcomes are determined by networks. One system is not morally better than the other. Both systems co-exist in all countries. What is true is that rule-based systems are more economically efficient.
 
The distinctions between rule-based and relationship-based systems are not black and white. Instead there is a spectrum. Even in law obsessed countries like the United States and France, relationships are exceptionally important. In France, seven of the past 12 prime ministers, and two of the past three presidents, including both current incumbents, went to one of the “grandes écoles” as did 50% of the chief executive officers (CEOs) of the CAC 40 index companies.
 
Emerging markets are more on the relationship end of the spectrum. The economic impact can be enormous. The Philippines, in theory, has a democratic system. It has a lively press and regular elections. In contrast, China has an authoritarian one-party state where information and speech is regulated and suppressed.
 
It would seem that these countries have little in common. China has been growing rapidly over the past twenty years in a seemingly unstoppable drive on the road to development. In contrast the Philippines seem stuck. Their per capita income is less than half of the income for Thailand, less than a quarter of Malaysia and only a tenth of the average income of Taiwan. This was not always the case. In the 1950s Philippines and Japan were considered prime candidates for rapid economic growth.
 
What has gone wrong? One possibility was suggested by the great economist Mancur Olson. Olson argued that certain elite power groups tended to subvert laws and institutions to their benefit. They take more of the economic pie rather than enlarging it. The real damage is not the extra money that the elite garner, in any economy certain commodities including talent are worth more than other commodities. What slows the economy and eventually decreases the pie are the laws. The laws introduced to protect privilege distort the incentives and disincentives to such an extent that the normal market mechanisms lose their efficiency. The result is that over time the economy slows.
 
The Philippines, like many Latin American economies, has a very few spectacularly rich citizens and masses of the abjectly poor. With the odds stacked in their favour, the rich have huge economic incentives to maintain the system— often at any cost. Worse they become rent seekers, so the system keeps getting worse. The only potential limit is the law itself. Since the law is controlled by the elite, its function is reversed and it is used to extend their power rather than restrict it.
 
In emerging market after emerging market the pattern repeats although by different names. In Russia the present ruling elite are known as “siloviki”, "strong guys" from the security services who surround prime minister Putin. In Africa they are known as Big Men, who utilize regulations to monopolize imports like petrol for Nigeria. India must labour under the caste system and now a new generation of political heirs from the Gandhi progeny to alumni of the Doon School, Stanford, Harvard Business, and investment banking continue a system that distorts investment.
 
Still Russia, Nigeria and India are all as least nominally democratic and all three countries have multiple parties and some speech is protected in widely varying degrees. The laws that allow these rights provide some limits to the power of the elites. Not so in China. In this nominally socialist country the higher ranks are dominated by so called taizidang or "princelings".
 
These children of senior Communist party officials are blessed with superior connections denied mere mortals and foreign investors. In an unstable and often arbitrary legal environment these connections are often the only way to get things done, so the princelings are on the A list of every western investment bank and have amassed wealth to match their status.
 
When capital is limited to connections, it fails to find the most economical efficient path. Over time these decisions will slow the economy as has occurred in the Philippines and will eventually occur in China.

(The writer, William Gamble, is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected]).