More than $50 billion in World Bank sponsored projects had some focus on institutional reform as part of the project design between 2006 and 2011. Many other major development institutions such as the Asian, African and Inter-American Development Banks now have institutional reform as a major part of their projects. With a new leader being considered for the top job at the World Bank, the Bank has a unique opportunity to consider a development strategy that focuses more on the inextricable link between innovation and institutions.
There is now growing evidence that developing institutions isn’t having the desired effects on creating and sustaining well-functioning systems in many economies. By some estimates, up to 70% of reforms have “muted results.” It turns out that building strong institutions—ones that will shape and hold a country’s values for generations—is not as simple as “export what works elsewhere, add water, and stir.”
In low- and middle-income countries, world leaders and business executives bemoan the lack of good institutions necessary to support robust economic development. In wealthy countries, leaders complain about the eroding institutions that helped their nations prosper. Most will agree on one thing: for progress to be made, we will need to foster better and more inclusive institutions. The question then becomes, what is a better way to build and strengthen the institutions that are critical to economic growth?
The answer lies in understanding the critical relationship between innovation and institutions.
We have learned that innovation, and more specifically what we call “market-creating innovation,” is often a precursor to the development of strong institutions. Market-creating innovations transform complicated and expensive products into simple and affordable ones, making them accessible to many more people in society. A new market generates many jobs since it requires people to make, market, distribute, sell and service the products. In addition, the market creates the necessary profits to provide tax revenues that go on to fund better infrastructures and institutions. And finally, when the new market begins to thrive, the culture of a region starts to change and many more people begin to value the market and want to see it succeed.
Successful market-creation has the result of “pulling in” the necessary institutions such as, legal systems, more contextual regulations, and even more relevant schools, when they become essential to sustaining and growing that market. To illustrate our point, consider how IguanaFix created a new market for tens of thousands of contractors in Argentina, Brazil, Mexico and Uruguay.
After years of studying and working in the United States, Matias Recchia returned to Argentina. The relatively simple task of finding, furnishing, and fixing up his apartment caused him so much grief that he had to do something about it. Recchia explained that, “the experience of finding a plumber, an electrician and a painter was awful. Not only was there no price transparency, but most contractors also didn’t stick to whatever rough agreement we’d made initially, and they would never show up on time.” Recchia couldn’t find reliable contractors as most were part of the informal economy in Argentina. As such, not only were they not paying taxes, but they also provided subpar service because most of their work was one-off and transactional.
On the one hand, these contractors were not adhering to the “good laws” of the land. They were not registering their businesses, not paying taxes, and not following through on contracts and agreements. On the other hand, however, they were simply doing the rational thing. After all, what incentive does a hand-to-mouth contractor have for registering his business or reporting his income? So the government might take some of it away in taxes?
However, a shift in the contractors’ culture came about when an innovation created a new market that made it simple and affordable for them to register their businesses and benefit from transparency.
Recchia understood the struggle of both customers and contractors. Four years after his own frustrating experience, he built IguanaFix, an online service connecting consumers with reliable, transparent contractors. By joining the formal market, service providers can access corporate customers, get access to health and work insurance, open their first bank account, and access financing. This enables contractors to have more control over their work schedules, lives, and wallets. IguanaFix emphasized these benefits.
In its first three years alone, IguanaFix generated some $25 million and directly employed 140 people. But perhaps more significantly, it pulled more than 25,000 contractors in four countries into the formal economy, with thousands more on a waiting list. Not only are these contractors now reporting earnings and paying taxes (both of which are part of the service that IguanaFix both requires and provides), but some of them are also beginning to expand and build their own businesses in ways they couldn’t have imagined before. This leap into the formal, tax-paying, rule-abiding economy has not been one born of a sudden sense of civic responsibility or crushing penalties for not abiding by the established rules of business.
It turns out that we cannot fix problems with the law, systems, and institutions by simply adding another law, system, or institution. Before IguanaFix, there were laws, systems, and institutions in these countries that contractors were supposed to abide by. But it was when Reccia’s IguanaFix created the new market with its online service that the incentives for the people were altered– and the institutions were able to function the way they were meant to.
We have learned that effective institutions are not just about rules and regulations. Ultimately, institutions are intertwined with the creation of new markets that pull them into society. At their core, institutions reflect what people value. So, if the fundamental dynamics of a society—what people value and how they choose to make progress—have not changed, no amount of pushing good institutions onto that society will change its underlying values. This helps explain why a society’s transformation begins with new markets—new markets help people make progress.
In matters of economic development, institutions are important, but it turns out that innovation is the engine that powers our institutions. Without it, strong institutions are incredibly difficult to create, and almost impossible to sustain. As the World Bank looks to create prosperity in low- and middle-income countries, it would be well served to focus more on supporting market-creating innovations. If that happens, our research suggests that more people in these countries would pull the already existing institutions into their lives, a process which will trigger a virtuous cycle that creates more economic prosperity.
As it turns out, good laws alone are not enough.