Malaysia – a simple institutional analysis

Malaysia is classified as a non – democratic state by all international index measuring quality of democracies. This is also affirmed in academic circles.

By New Mandala  (Greg Lopez)

The works of Angus Maddison on world economic history identifies that economic growth only took off after the British Industrial Revolution. Maddison notes that from the year 1000 – 1820, advance in per capita income was a slow crawl with per capita income rising by about 50 per cent but population increased fourfold. Since 1820 however, per capita income exceeded population growth with per capita income rising by more than eightfold and population more than fivefold. Maddison also notes that these growth rates were concentrated in Western Europe.

Michael Spence, in a lecture based on his latest book, “The Next Convergence: The Future of Economic Growth in a Multi-Speed World” quotes the works of Maddison and points out that the higher growth rates since the British Industrial Revolution benefited approximately only 15 per cent of world population, namely the elites in Western Europe and its European offshoots. However, since World War II (WWII), far more people in far more geographical regions have benefited from this open international economic order created after WWII.

Why is this so?

Elhanan Helpman captures the above the phenomenon brilliantly with this quote in his book “The Mystery of Economic Growth.”

“…What makes some countries rich and others poor? Economists have asked this question since the days of Adam Smith. Yet after more than two hundred years the mystery of economic growth has not been solved…”

The growth mystery has yet to be solved but economists have after two hundred years, isolated what are the determinants of long term sustainable economic growth. Economists divide these determinants into two categories: deep and proximate determinants. In general the deep determinants are institutions, geography and trade while the proximate determinants are capital in all its forms (resources, finance, knowledge, ideas, and technology). The combination of the deep determinants when done correctly facilitates the proximate determinants which lead to productivity rising faster than wages. This leads to welfare gains to all stakeholders in the economy. However, more often than not, countries get this wrong, hence the disparity in economic performance.

The role of institutions in explaining the difference in economic performance was not always explicit. It was Douglass North who first forcefully and successfully advocated the primacy of institutions in explaining the difference in cross – country performance. In summary, the ability to combine the various determinants of growth and the factors of production optimally relies on the proper institutional set-up. Institutions function as the meta-structure within which other determinants are able to function properly. Challenges and opportunities related to trade, geography, human capital accumulation (entrepreneurship, ideas, knowledge and innovation) and investment in factors of production — physical and technological — can be mitigated, overcome, synergised and optimised through the correct institutional structures and arrangements.

In post WWII, East Asian economies, including Malaysia, appears to have got this right, notwithstanding the dissenting views.  In 1993, the World Bank in its publication, “The East Asian Miracle: Economic Growth and Public Policy”, identified eight miracle East Asian economies – including Malaysia – that had real GDP growth of around or above four per cent from 1960 to 1990, which was far better than the rates achieved since the Industrial Revolution. More importantly, these economic growth benefited the poorest in society.

Malaysia was also one of thirteen countries identified by the Growth Report to have recorded average growth rates of more than 7 per cent per year for twenty five years or more. Malaysia achieved this spectacular performance from 1967 to 1997.

Since the East Asian Financial Crisis (EAFC) of 1997/1998, Malaysia’s economic performances when compared to previous decades are lacklustre and most macroeconomic indicators are trending downwards (declining rates of growth). This was confirmed by Prime Minister Najib Razak himself in the publication of the New Economic Model – Part 1 (NEM – 1). This was a very brave move but a necessary one by the Prime Minister as he acknowledged publicly the failures of Malaysia’s current economic model in order to demonstrate urgency for reforms.

There are other studies that have come to the same conclusion. Among the more prominent ones are “Tiger Economies Under Threat” by Yusuf and Nabeshima (2009) and “Malaysia’s Development Challenges – From Middle Income to Advance Economy” by Hill, Mat Zin and Tham (2011). The World Bank through its Malaysia Economic Monitor has also produced a series of reports identifying the same key problems that are effecting Malaysia’s growth.

The NEM – 1 identifies domestic factors such as weak investor confidence, capability constraints (weak human capital, entrepreneurial base and innovative capacity) , productivity ceilings and institutional degradation and external factors such as a sluggish global economy caused by the global financial crisis (GFC) and the rise of neighbours in the region in contributing to the declining growth trajectory.

Now IF we revisit the determinants of growth and agree with the view that proper institutions are the meta-structure that determines long term sustainable growth, then the logical response is to reform Malaysia’s institutional set-up as it must be the deepest determinant of what is hindering economic growth.

This view is further strengthened as the other deep determinants, geography and trade, are favourable in the case of Malaysia. Malaysia has abundant natural resources, is shielded from natural hazards and is located strategically both geopolitically and economically. Malaysia has also benefitted tremendously from being an open economy especially in the merchandise sector.

The NEM – 1 also reports that regional challenges (e.g. China, India and Vietnam) are a cause for Malaysia’s declining economic performance. What has changed about these countries? They have all undertaken institutional reforms: China since 1978, India since 1992 and Vietnam since 1986 and are reaping the benefits while Malaysia has stagnated since the 1990s and is suffering from it.

The above points stress the importance of institutional reforms in Malaysia, something that Mr. Najib Razak has ironically neglected in his signature policies – 1Malaysia, Government Transformation Programme and Economic Transformation Programme.

What are institutions and how do we go about analysing them?

There is no consensus of what is meant by institutions or institutional analysis. I use the most widely quoted definition on institutions. North defines institutions and its impact on economic performance as:

“…Institutions are the humanly devised constraints that structure human interaction. They are made up of formal constraints (rules, laws, constitutions), informal constraints (norms of behaviour, conventions, and self imposed codes of conduct), and their enforcement characteristics. Together they define the incentive structure of societies and specifically economies. Institutions and the technology employed determine the transaction and transformation costs that add up to the costs of production…”

Geoffrey Hodgson simplifies this to:

“…systems of established and prevalent social rules that structure social interactions. Language, money, law, systems of weight and measures, table manners, and firms (and other organisations) are thus all institutions…”

The key terminology here are norms and incentives. I add ideology to these key terminologies. Incentives (and disincentives) I define to include psychological and material benefits and penalties. Therefore, institutions provide the incentives that structure human behaviour in a society.

Thus far, we’ve established that institutions play an important role in driving growth. We’ve also established what constitutes institutions broadly. Analysing institutions and the role it plays in economic growth is a challenge when there is no consensus on what are institutions and its definition is very broad. However, Hollingsworth provides an approach which is meaningful for our purpose. Hollingsworth suggests that institutions are best compartmentalised by the strength of their resistance to change and by extension, the ability to exert influence. Once compartmentalised, they can each be analysed.

Hollingsworth notes that:

The five components (levels) in the schema are arranged in descending order of permanence and stability with Level 1 being the most enduring and persistent compared to all other components. Each component is interrelated with every other component, and changes in one are highly likely to have some effect in bringing about change in each of the other components.

According to the Growth Commission:

“…fast sustained growth is not a miracle; it is attainable for developing countries with the “right mix of ingredients.” Countries need leaders who are committed to achieving growth and who can take advantage of opportunities from the global economy. They also need to know about the levels of incentives and public investments that are necessary for private investment to take off and ensure the long-term diversification of the economy and its integration in the global economy…”

Michael Spence, the Chair of the Growth Commission, reflected and elaborated further on his extensive experience working with developing countries on growth issues in his latest book by affirming the findings of the Growth Report and further identifying two important characteristics for developing countries to ensure long term sustainable growth – the role of political leadership and democratic norms. He suggests four characteristics for governments that are necessary requirements to underpin long term growth:

1. The government takes economic performance and growth seriously.

2. The governing group has values that cause it to try to act in the interest of the vast majority of the people (as opposed to themselves or some subgroup, however defined)

3. The government is competent and effective and selects a viable sustained-growth strategy that includes openness to the global economy, high levels of investment, and a strong future orientation.

4. Economic freedom is present and is supported by the legal system and regulatory policy

Manifestations of Malay/Muslim Supremacy 

Malaysia is classified as a non – democratic state by all international index measuring quality of democracies. This is also affirmed in academic circles. During the boom years, Malaysians accepted this trade-off – restricted  freedom for economic growth. Since 1997/98, this has changed as expected. The government has not delivered on growth, therefore the natural demand for reforms and by extension freedom.

There is consensus that Malaysia needs extensive economic, political and social reforms. This is all the more evident IF we agree that institutions are key to long term growth. Also, IF we agree with Spence, these reforms must come from a government with the four characteristics identified above.

Astute observers of Malaysia know the reasons why the present administration and the ones before were unable to make fundamental reforms in Malaysia. This has much to do with the ideology of Malay/Muslim Supremacy as defined by United Malays National Organisation’s (UMNO) and accepted by large swaths of Malaysians, Muslims and non-Muslims alike.

From the literature we can infer that the ideology of Malay/Muslim supremacy has provided the perverse incentives that has manifested itself in many ways. The more critical ones are:

– Institutional degradation: The deterioration in the quality of Malaysia’s institutions, particularly during Mahathir’s years such as  the lack of independence between the branches of government; the politicisation of the civil service, producing a culture of risk aversion and a lack of creativity; and the expansion of the non-transparent Government Linked Corporations (GLCs);

– Crony capitalism: Affirmative action in the name of Malays have become a smokescreen  for crony capitalism. Affirmative action is the instrument for rampant elite-based (elites from all races, not only Malays) cronyism. High levels of income inequality in Malaysia in general but more so within the Malay community proves this.

– Race based affirmative action: Race-based affirmative action in itself is recognised as one of the important reasons for Malaysia’s declining economic performance. Malaysia’s focus on the ex-post equalisation of outcomes across ethnicities rather than ensuring effective ex-ante equalisation of access to opportunities has had important direct efficiency implications, affecting growth by distorting incentives and thereby the competitive process.

– Excessive centralisation: An interesting institutional feature is the lack of decentralisation in the country which is nominally a Federation and the top-down approach in public policymaking. This is a key disconnect in the reform rethoric in the ETP and GTP. To strengthen public service delivery, local communities need to be empowered. Fiscal relationships between federal-state-local also demonstrates institutional failure.

– Feedback mechanisms:  Related to Malaysia’s top-down approaches is an almost complete disregard of the monitoring and evaluation function. As a result there is little feedback from outcomes into policy design. The obsession with centralising policy making is also evident in lack of information sharing both within government and with the public.

The need to remove UMNO to create a new “people based ideology”

First let me put forward what I think are the two most critical issue affecting Malaysia: competency and competition.

In relation to competition, the quality of the human capital base in Malaysia is suspect. This is due to the quality of education from pre-school through tertiary and on-the-job. It is linked with ethnicity issues and is exacerbated by the outflow of high-skilled individuals and affected by the inflow of low-skilled labor. There are not only problems on the supply side of the market for skills, but also on the demand side, where firms may not be competitive enough to offer higher wages. The market for skills itself is also problematic in that the price mechanism does not work adequately and this is were wage setting issues play a role.

A bigger and more important challenge than competency is internal competition. This is quite distinct from external competitiveness, on which front Malaysia has scored relatively well in the merchandise sector given its stage of development and the nature of its manufacturing processes which is still dominated by competitiveness identified by low cost rather than high value.

Read more at: http://asiapacific.anu.edu.au/newmandala/2011/08/22/malaysia-%E2%80%93-a-simple-institutional-analysis/

Greg Lopez is a PhD scholar at the Crawford School of Economics and Government at the Australian National University.