Formal and Informal Institutions

Types of Institutions

• Institutions shape the interactions of individuals, businesses, and governments and the stability of markets
• Institutions evolve in response to economic needs and societal changes
• Institutions are either formal or informal
• Formal institutions are codified in legal and political frameworks
• Informal institutions exist within societal traditions, customs, and unwritten rules that shape economic behaviour

Formal Institutions

• Formal institutions are written rules, laws, and organizational structures that govern society
• Formal institutions provide predictability, accountability, and a structured framework for resolving disputes, conducting business, and ensuring public welfare
• Formal institutions are enforced through state mechanisms like courts, regulatory agencies, and law enforcement bodies
• India has formal institutions like the Indian Constitution, financial regulatory bodies (Reserve Bank of India and SEBI), corporate laws, and property rights frameworks
• India's judicial system serves as the ultimate arbitrator in economic and civil disputes
• India's legal framework is based on a common law system, where courts interpret laws and set precedents

Key Legislation in India

• The Companies Act, 2013 governs corporate governance and business regulations
• The Insolvency and Bankruptcy Code (IBC), 2016, provides a structured process for resolving financial distress and liquidating businesses
• The Real Estate (Regulation and Development) Act (RERA), 2016, aims to protect homebuyers and regulate the real estate market

Challenges and Reforms in India

• Implementation challenges and judicial delays often reduce the effectiveness of formal institutions
• India struggles with millions of pending land dispute cases due to bureaucratic inefficiencies, slow judicial processes, and gaps in land records
• The Unique Identification Authority of India (UIDAI) implemented Aadhaar, improving financial inclusion, direct benefit transfers, and social welfare distribution
• When formal institutions are slow or inefficient, informal institutions fill gaps in governance, business operations, and dispute resolution mechanisms

Informal Institutions

• Informal institutions are not codified in law but are deeply embedded in cultural traditions, social norms, and historical practices
• Informal institutions govern economic interactions, business relationships, and personal conduct, sometimes complementing or conflicting with formal institutions
• The caste system in India is an influential informal institution that shapes business networks, social mobility, and political affiliations
• The Banias, Marwaris, and Chettiars have historically dominated trade and finance, while agricultural labor has been concentrated among lower castes.
• Kinship-based economic networks rely more on trust and social reputation than on formal legal contracts
• The Hawala system operates as an informal money transfer network based on trust rather than legal documentation
• It is illegal under Indian law but widely used in informal trade, remittances, and money laundering activities

Microfinance in India: A Case Study of Informal Institutions

• Women's self-help groups (SHGs) operate through informal lending systems, pooling resources and providing loans based on trust
• SHGs function outside formal banking institutions but improve women's financial inclusion
• The Indian government and banks have integrated SHGs into formal credit mechanisms through programs like the National Rural Livelihoods Mission (NRLM)
• Over 12 million women-led SHGs are linked to formal banking institutions, receiving structured loans and financial support

Interplay Between Formal and Informal Institutions in India

• Formal legal frameworks coexist with deeply entrenched informal traditions
• The duality creates synergies and conflicts, influencing economic policies, governance, and social structures
• This relationship has significance in property rights, business regulations, taxation, and financial systems
• India's economic history reflects a transformation from an informal, agrarian economy to a modern, formalized market
• Informal institutions like caste networks, customary land ownership, and family-based business practices play a role alongside formal institutions

Property Rights: Conflict Between Formal and Informal Land Laws

• Land ownership in India is shaped by customary land ownership, caste-based inheritance practices, and local panchayat dispute resolution mechanisms
• India has a complex land ownership system with overlapping legal frameworks inherited from British colonial rule, post-independence reforms, and traditional landholding customs
• The Transfer of Property Act (1882) and the Right to Fair Compensation and Transparency in Land Acquisition Act (2013) aim to formalize property transactions
• Formal institutions often face resistance from informal institutions at the local level

Land Ownership Conflicts: Rural India Case Study

• Tribal areas govern land rights by customary laws rather than national legal frameworks, leading to collective ownership of land by the village
• The modern formal legal system recognizes individual land ownership and requires formal land titles, leading to disputes over land acquisition
• The POSCO steel plant controversy in Odisha (2005-2017) exemplifies the clash between formal institutions (government land acquisition policies) and informal institutions (tribal land rights)
• The Forest Rights Act (2006) recognizes traditional forest dwellers' rights, attempting to bridge the gap between customary land ownership and formal property rights

Business and Economic Networks and Informal Institutions

• The Indian economy blends formal corporate enterprises and informal business networks
• Caste, kinship, and community shape economic activities
• Corporate laws, tax regulations, and banking systems provide the framework for business operations
• Trust-based business relationships, community lending, and caste-based occupations hold significant influence

Marwari Business Community Case Study

• The Marwari business community operates at the intersection of formal corporate laws and informal trust-based networks
• Marwari traders relied on personalized credit systems, word-of-mouth agreements, and community arbitration mechanisms, rather than on formal legal contracts
• Many Marwari businesses prefer informal lending arrangements (hundis) over bank loans
• Business families emphasize trust and honor rather than rigid legal contracts, allowing for fast decision-making and flexible trade relationships
• These businesses operate within the formal legal framework, complying with tax laws, corporate governance rules, and financial regulations
• Informal institutions often coexist and complement formal institutions, providing efficiency and adaptability in economic activities
• Conflicts arise when informal practices clash with formal regulations, like unreported income, tax evasion, and unregulated financial transactions
• The Indian government has attempted to address this through measures like GST (Goods and Services Tax) to bring informal businesses into the formal taxation system

Informal Labor Market and Formalization

• India’s labor market has formal and informal interactions
• Despite labor laws like the Factories Act (1948), the Minimum Wages Act (1948), and the Industrial Disputes Act (1947), the informal sector employs 80-90% of the workforce
• Many workers in construction, textiles, agriculture, and small-scale industries operate outside the formal labor protection framework
• Workers often lack legal contracts, social security, or healthcare benefits
• Reliance on informal labor markets has been a challenge for economic policy

Migrant Labor and Institutional Challenges

• The COVID-19 pandemic in 2020 exposed vulnerabilities in India's informal labor force
• The nationwide lockdown left millions of migrant workers stranded without legal employment contracts, social security, or financial support
• Formal institutions were insufficient to address this crisis because most workers were unregistered under formal employment systems
• The government launched the E-Shram Portal in 2021 to register informal workers and integrate them into formal social security schemes
• This represents an attempt to bridge the gap between informal labor practices and formal institutional protections

The Caste System: India's Deepest Informal Institution

• The caste system continues to influence economic mobility, employment, and social interactions, despite formal laws banning caste-based discrimination
• The Indian Constitution prohibits caste discrimination and abolishes untouchability through Article 15 and Article 17
• Caste-based informal institutions remain prevalent, especially in rural India, shaping occupational choices, social status, and business networks

Affirmative Action and Institutional Conflicts

• The Indian government has implemented reservation policies in education, public sector jobs, and political representation to counteract the historical disadvantages of lower castes
• The Mandal Commission Report (1980) recommended 27% reservations for Other Backward Classes (OBCs) in government institutions
• Affirmative action has improved educational access and job opportunities for disadvantaged groups
• Caste-based networks continue to play a role in private-sector hiring, business relationships, and marriage alliances
• Many companies and industries still unofficially favor caste-based hiring

Aligning Formal and Informal Institutions for Sustainable Growth

• India's economic development is shaped by the interaction between formal and informal institutions
• Strengthening formal legal frameworks for business, labor, and governance have made significant strides
• Informal institutions continue to influence daily economic transactions and social interactions
• Formal and informal institutions create stability and efficiency when they work in harmony
• Clashes between formal and informal institutions lead to inefficiencies, economic exclusion, and governance challenges
• India’s economic success depends on how well it can integrate informal institutions into formal governance structures
• Policies like GST for informal businesses, E-Shram for unregistered workers, and land titling reforms are steps in the right direction
• Institutional evolution requires legal changes and shifts in social norms, business practices, and local governance models
• Institutions evolve together, shaping and reshaping economic destiny

Institutions as an Endogenous Factor in Economic Growth

• Contemporary economic thought recognizes institutions are endogenous and evolve in response to economic, political, and social dynamics
• Institutions is referring to formal and informal rules, laws, and enforcement mechanisms that govern economic interactions
• Formal institutions include constitutions, property laws, regulatory frameworks, financial institutions, and judicial systems
• Informal institutions comprise cultural norms, business practices, and social contracts
• The World Bank’s Worldwide Governance Indicators (WGI) show that countries with strong institutions have higher GDP per capita
• High-income economies rank among the top in governance indicators, while nations with weak institutions struggle with economic growth
• Economist Douglas North argued that institutions reduce uncertainty in economic transactions, and that nations with secure property rights have faster economic growth
• Institutions adapt and change endogenously as societies develop

Property Rights in the Industrial Revolution as an Evolutionary Case Study:

• The Industrial Revolution (1760–1840) involved institutional changes, like property rights and contract enforcement
• Before the Industrial Revolution, Britain’s economy was largely agrarian, and land was controlled by feudal elites
• The Glorious Revolution of 1688 meant Parliament asserted control over economic policy and strengthened property rights
• Between 1700 and 1870, Britain’s GDP per capita grew significantly to an annual rate of 1.2%
• Secure property rights enabled commercial and industrial expansion, and helped grow population of Manchester
• Stronger institutions protecting intellectual property led to increased patent registrations, fostering an innovation-friendly environment
• The argument is reinforced that institutions evolve endogenously rather than existing as static frameworks

Financial Regulations and the US Banking System

• In the 19th century, the U.S. banking was decentralized, with individual states issuing their own currencies and granting bank charters
• This led to frequent financial crises, including the Panic of 1907, saw the New York Stock Exchange lose nearly 50% of its value in three weeks, leading to bank failures and economic distress.
• Financial institutions were established in response, like the Federal Reserve System in 1913
• The Great Depression (1929–1939), wiped out banks and saw major unemployment, leading to major regulatory reforms:
• The Glass-Steagall Act (1933) separated commercial banking from investment banking, limiting risky speculation.
• The Federal Deposit Insurance Corporation (FDIC) was established to protect bank deposits, restoring confidence in the banking sector.
• The Securities and Exchange Commission (SEC) was created in 1934 to regulate financial markets and prevent corporate fraud.
• Financial institutions evolve as economic actors to meets the demands of security, transparency, and stability.

Economic Reforms and Institutional Change in China

• China’s economic rise over the last four decades showcases how institutions adapt to economic transformation
• China’s economy was centrally planned prior to 1978, with state ownership of all enterprises and strict government control over production, pricing, and trade
• Deng Xiaoping introduced market-oriented policies that led to the gradual opening of the economy
• Shenzhen was desinated as a Special Economic Zone in 1980
• By 2023 Shenzhen's GDP exceeded $400 billion
• China allowed private businesses to operate alongside state enterprises, leading to explosion in entrepreneurship
• Millions private firms were registered, compared to virtually non in 1978
• Foreign Direct Investment (FDI) Growth helped growth and legal protections
• China’s institutional reforms reinforce the idea that institutions evolve endogenously as economies grow
• Institutions are adaptive systems that change in response to economic forces

The relationship between property rights and the ease of doing business

• Countries with stronger property rights have higher GDP per capita
• The World Bank's Ease of Doing Business Index shows nations with efficient contract enforcement and regulatory stability higher foreign investment and long-term growth
• Legal frameworks must adapt to economic changes to ensure laws and regulations evolve with advancements

Singapore vs. Venezuela in Institutional Evolution

• Singapore and Venezuela are both locations with great economic potential based on resource scarcity vs resource aundance
• Singapore and Venezuela teach the role of institutions as an endogenous factor, with Singapore ascending to become a global economic powerhouse and Venezuela collapsing.
• Economic growth shaped by adaptable institutions

The rise of Singapore

• Singapore in 1965 was a fragile, newly independent nation and an economy largely dependent on entrepôt trade
• Singapore was recognizing the need to create a stable and predictable environment
• Singapore's Prime Minister, Lee Kuan Yew, spearheaded institutional reforms that focused on strengthening contract, securities, business protocols.
• Singapore adopted a pragmatic, market-driven approach creating a business-friendly legal system for foreign investment.
• An anti-corruption approach sent a strong message to investors, Singapore would be a place where the rule of law prevailed.
• Bureaucratic barriers were eliminated and processes streamlined, corporation tax rates were kept low and a focus on efficiency and dispute resolution.

Institutional Decay and Economic Collapse Of Venezuela

• Singapore built institutions that encouraged economic expansion
• In the 1950s & 60s, Venezuela was rich with abundant oil resources and extensive middle class populations
• Fragile, economic evolution stalled
• Venezuela’s oil wealth was ample but lacking in encouragement towards business like Singapore
• Venezuela focused on an increasing state control over the economy.
• Nationalization over key industries and the state expropriated private enterprises, reducing incentives for domestic and foreign investors.
• Large corporations and the judiciary were increasingly politicized, making contract enforcement unreliable.
• This drove investors away and flight accelerated
• Oil price crashes and and the absence of evolution over scale caused a financial collapse over oil revenues so they printed money excessively leading to hyperinflation
• Venezuela's GDP per capita dropped significantly - The country sought refuge from economic hardships and political instability.

In Summary: Institutional Evolution vs. Institutional Decay

• The states show that institutions act as endogenous factors in economic growth based on stability and efficiency
• Legal systems must adapt to meet demands
• Nations must recognize economic conditions and respond with changes, and those that are more dynamic adapt.
• Economic growth shows resilience, and a nation's prosperity is determined by the strength of its institutions.