Raghuram Rajan | Conflict management and economic growth

Societies with well-functioning institutions allocate the burden of distress in predictable ways. Photo: Pradeep Gaur/Mint
Live Mint :Raghuram Rajan :Fri, May 31 2013. 04 05 PM IST

Can countries without a reliable and effective legislature or legal system do better to protect against downturns?

One of the most interesting aspects of the prolonged economic crisis in Europe, and of the even longer crisis in Japan, is the absence of serious social conflict—at least thus far. Yes, there have been strikes, marches, and growing anger at political leaders, but protests have been largely peaceful.

While that may change, the credit for social peace must go to institutions such as elections (“throwing the rascals out” is a non-violent way to vent popular anger), responsive democratic legislatures, and effective judiciaries. All of these institutions have successfully mediated political conflict during a time of great adversity in advanced countries.

This suggests that a major reason for underdevelopment may be that such institutions, which allow countries to cope with distress, are missing in poor economies. Economic growth permits conflict between social actors to be papered over. A downturn, however, usually exposes or sharpens latent social tension.

Why do the benefits of growth seem to be easier to share than are the burdens of adversity? This is not a trivial question. Perhaps the answer lies in human psychology. If consumption is shaped by habit, an income loss is very hard to bear and one might fight to avoid it, while fighting for additional gain when one is doing well is less important. Also, because conflict may destroy growth opportunities, it may be seen as costlier when growth is strong. For example, squabbling between workers and management may drive away investors—and thus the chance to start new projects. But if there are no new investment opportunities on the horizon, squabbling is less costly, because the existing plant and machinery are already sunk costs.

Regardless of why conflicts are greater in times of economic adversity, how a society deals with them depends on the scope and quality of its conflict-management institutions. The Oxford University economist Paul Collier has shown that years of weak economic growth typically precede civil war in poor countries. Even after establishing peace, the probability that these countries will relapse into conflict is high.

Not surprisingly, these states typically have weak conflict-management institutions—patchy law enforcement, limited adherence to democratic principles, and few meaningful checks and balances on the government. Similarly, Dani Rodrik of Harvard University has found that the countries that experienced the sharpest declines in growth after 1975 had divided societies and weak conflict-management institutions.

Societies with well-functioning institutions allocate the burden of distress in predictable ways. For example, people who suffer the most adversity can fall back on an explicit social safety net—a minimum level of unemployment insurance, for example. In the US in recent years, federal and state legislatures prolonged unemployment benefits as joblessness persisted.

Similarly, debtors and creditors can rely on credible bankruptcy proceedings to determine their relative shares. With an explicit institutional mechanism in place to dictate the division of pain, there is no need to take to the streets.

By contrast, when institutions are too weak to offer predictable and acceptable settlements, or to protect existing shares, everyone has an incentive to jockey for a larger slice of the pie. Outcomes will be mediated more by actors’ relative bargaining power than by pre-existing implicit or explicit contracts. Often, bargaining will break down. Everyone is made worse off by strikes, lockouts, and even violent conflict.

Can countries without a reliable and effective legislature or legal system do better to protect against downturns?

One answer may be to use arrangements that depend in a limited way on the legal system for enforcement. For example, labour contracts in many developing countries effectively prohibit employers from firing workers. This is regarded as inefficient because firms cannot adjust quickly to changing business conditions.

Often, such prohibitions are attributed to overly strong unions that hold the economy hostage. But, if slow or corrupt courts mean that a worker who is wrongfully dismissed has no legal recourse, perhaps the prohibition on firing—enforced by mass protests against violations, which are easily and publicly observable—is the only way to protect workers from arbitrary decisions by employers.

Job tenure may also serve as a form of social security, because the government performs miserably on providing a safety net and private insurance markets do not exist. Thus, an inflexible contract can protect workers when the preponderance of bargaining power is with firms.

Such inflexible arrangements are not without cost. In a downturn, too many firms will fail, because they cannot shed labour. Alternatively, knowing that they cannot fire permanent workers, firms may remain tiny in order to remain below the authorities’ radar. Or they may hire informal workers who have no rights, or pay inspectors to look the other way (a related point could be made about workplace safety in Bangladesh’s garment factories).

Thus, the attempt to protect workers with rigid labour laws may have the unintended consequence of generating too few protected jobs. This may be the situation in India, where most workers have few rights, and the few large firms that are established in the formal sector tend to use a lot of labour-saving capital in order to avoid hiring protected workers.

Change is not easy. Protected workers have no reason to give up their benefits. Moreover, removing rigid protections without offering alternative, contingent safety nets and judicial redress is a recipe for conflict. At the same time, some protection is better than none, and if most workers are unprotected, change becomes necessary to avoid even worse conflict.

Sustainable change in developing countries requires reforming not only specific arrangements, such as rigid labour laws, but also more basic institutions, such as the legislature and the judiciary, to make them more responsive to people’s needs. If developed countries’ citizens want to feel slightly better about their economies’ slow growth and high unemployment, they should contemplate how much worse matters could be without the institutions that they have.

The view expressed here are the author’s own.

Raghuram Rajan, professor of finance at the University of Chicago Booth School of Business and the chief economic adviser in India’s finance ministry, is the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.