Economics Essay, Research Paper

The aim of this essay is not to agree with or refute the statement made by Douglass

North. The purpose of this essay is to identify the key points of the statement and discuss

with relation to the institutional evolution in the Australian financial and labour Markets.

With this, it will attempt to conclude whether the statement has a relevance to the

evolution of the financial and labour markets.

The passage, taken from North?s paper Institutions has a relevance to Australia?s

Financial and Labour Markets. Its relevance can be shown by analysing the key points of

the statement. These being, institutions are humanly devised, institutions provide

constraints to the market, institutions provide economic incentives and institutional

change leads an economy towards its success or failure.

North?s statement regards Institutions as being ? humanly devised ?. Institutions are

devised for the purpose of protecting the various groups effected by the market. This is

done by imposing corrections on a market ( subject to failure). A market failure occurs

?when the market is unable to determine the use and allocation of resources in a way

society most desires?. ( Kirkwood, Cronk, Swiericzuk & Searle 1999). Institutional

intervention in a market occurs due to imperfections in the market and is an attempt at

ammending such imperfections. The key institution within the financial system is the

Reserve Bank of Australia (RBA). In January 1960, legislation was passed to create the

RBA, hiving off the central banking functions of the Commonwealth Bank of Australia

(CBA). The induction of the RBA in1960 was due to growing concern from the private

banking sector of a commercial bank maintaining the functions of a central bank (Lewis

& Wallace 1997). The RBA was devised to ? ensure that monetary and banking policy of

the bank is directed to the greatest advantage of the people of Australia….. and will best

contribute to the stability of the currency of Australia, the maintenance of full

employment in Australia and the economic prosperity of Australia?1. (Reserve Bank Act

1959). Before 1960, the role of the RBA was performed by the CBA. The CBA was

established in 1911 to regulate the banking sector that saw widespread failures in the

1890?s which caused the closure of fifty-four of sixty-four banks across Australia (Lewis

& Wallace). As North?s statement suggests, institutions are devised by human

admission, shown by the introduction of the CBA in 1911 and RBA in 1960. Institutional

intervention in the financial market has been for the protection and prosperity of those

organisations and community groups involved.

As with the financial market, institutional organisations in the labour market were

formed by people looking to protect the interests of those involved in the market.

Institutions have traditionally played a key role in the Australian labour market in

determining wage rates and employment levels. The key institutions within the labour

market are employer association and trade unions. Employer associations were created

by individual businesses concerned with protecting themselves against overseas

competitors and more importantly against the might of unions. Trade unions are

concerned with the ?defence of employee interests and administration of awards and

enterprise agreements?.( K.Bruce Lecture 4).

In relation to the labour and financial markets, North?s point that Institutions are

?humanly devised? is valid as it is evident that institutions do not occur for the market

but as a result of the markets inability to ?work? in a way suitable to the entire society.

Another important concept put forward by North is that ? Institutions are humanly

devised constraints ?. What is a constraint? A constraint is an intervention in a market

that hinders the free interplay of market forces. Elementary forms of constraints are rules

and regulations that form the basis for what organisations within the market can and

cannot do. Constraints are necessary because if the market was left primarily to market

forces, the end result would not always be desirable for society. Such institutional

constraints in the labour market are set by government regulation including reasonable

wages and conditions and laws against child labour, long hours and wrongful dismissals.

Within the Financial Market, the CBA and then the RBA had highly constrictive

regulatory measures over the financial sector up until the late 1960s. This confined the

banking sector to limited trading activities allowing limited success in the market

(Edey&Grey 1997).

One of the most important issues in the Australian financial and labour markets is the

ability for institutions to provide economic incentives. Institutional structure needs to

provide incentives to industry for greater productivity and an incentive to consumers to

increase quantity demanded otherwise growth within the economy will be limited. North

mentions the concept of institutions providing constraints on a market. This is provided

by a basis of rules and regulations to protect industry and consumers. Such constraints

provide limited incentives to consumers or business. An example of this is evident in the

tightly regulated financial system present in Australia during the 1950?s and 1960?s. At

this time, banks went through a period of declining market share when corresponding

gains were made by non-banking financial intermediaries (NBFI). This trend is shown in

appendix one ( Total assets of financial institutions as per cent of GDP) where during this

time period, NBFI increased their share in total assets where the banking sector

remained at a constant level. ?This trend reflects the competitive disadvantage that

financial regulations placed on banks? (Edey&Grey 1997). In particular, interest rate

controls which tended to keep the entire structure of bank rates below market-clearing

levels causing the emergence of a market for high rates on term deposits through NBFI.

Such constraints provided limited incentive for new banks to enter the financial market

and even for current banks to continue operations.

How were the financial institutions going to provide economic incentives to industry

and the consumer? Answering this question was key to the structural evolution of

financial institutions in Australia. An important question that North?s statement does not

answer is, how do institutions provides incentives whilst placing constraints upon the

market? The answer within the financial market was to remove some of those

constraints2. Deregulation of institutional ?shackles? on the financial market allowed a

more competitive and productive industry to grow. In the early to mid decades of this

century, a highly regulated financial system was set. The majority of goods and services

produced by the market were locally owned and a tightly regulated system was required

to protect the banking sector from overseas competitors( University of Adelaide 1986). In

todays society, deregulatory measures are necessary as the world economies are gradually

become united, inturn creating greater competitiveness and productivity. Deregulation in

the financial market from a relatively closed structure in the 1950?s to a more open

competitive system offered a wide range of services from an array of different providers

(Kirkwood, Cronk, Swiericzuk & Searle 1999 ). This gave new financial providers, the

ability to specialise with an increased use of resources.

Over the past 15 years, there have been a number of inquiries into the Australian

financial system: the Cambell Inquiry in the early 1980s, the Martin Inquiry in 1991 and

the Wallis Report in 1997. The focus of these reports was on enhancing competition and

contestability in the financial market whilst maintaining stability. The aim of which was

to encourage Australian financial institutions to adopt more efficient strategies to

compete with international competitors. (I.Harper 1997)

As is stated by North, institutions provide the structure of economic incentives however

within Australia?s? financial market, this does not occur though the provision of

constraints but rather through the reductions of restrictive regulations.

The final point evident in North?s statement is that ?institutional change leads

economies towards success or failure?. It is important to realise that in such a global

market, the institutional change from a highly regulated, collectivist bargaining system to

a decentralised deregulated environment within the labour market has been an important

step in Australia?s? success towards a highly prosperous and competitive economy.

Although the traditional roles of the unions and employer organisations have been lost, it

has been crucial that the ?us against them? mentality has been removed. Replaced with a

more rational mediation process in determining wages and conditions. Mediation at

business level rather than collectively is required to create success in a highly

competitive global economy (Whitfield & Ross 1995).

North stated that institutional change ?shapes the direction of economic change

towards growth, stagnation or decline?. Within the labour market, such direction is

seemingly towards growth with the economic incentives of a decentral wage

determination such as profit sharing for employees and greater production therefore

profits for business.

It is also evident within the financial market that growth has been a direct product of it

structural change. The aim of which was to increase the markets competitiveness and

efficiency through opening up the financial sector to foreign ownership, deregulating

interest rates and introducing a floating exchange rate. These changes have given rise to

new markets and increased the productivity of others. In the foreign exchange market

daily turnovers increased from one billion dollars with a fixed rate to 54 billion dollar

turnovers after the float. The four large Australian banks have been able to increase

market shares overseas and have foreign assets comprising about 40 per cent of balance

sheet totals. (Lewis and Wallace 1997).

In conclusion, it is evident through analysing the ideas of Douglass North through the

above statement, institutions are humanly devised constraints that govern the

interactions of a market place. However in a economy that is becoming more global

every day, those markets tightly regulated by their institutions have required a loosening

of such constraints to compete in such a world economy. There is no doubt that North?s

views on Institutions are relevant to Australia?s economy but what is lacking from the

statement analysed is a distinction between how institutions provide economic

constraints and the provision of economic incentives. As shown through the evolution of

the Australian financial and labour markets, constraints on a market limit economic

incentives and economic incentives require limited constraints.