We study how endogeneity between welfare and institutions recommends the efficacy of subtle institutional reforms that must be exogenous. We use evidence from a field study conducted in five Indonesian districts, and build a model that illustrates how the initial socioeconomic conditions and quality of institutions generate certain institutional attributes, such as a particular level of local capture (that is, gaining of influence over institutions, and hence over policy, by local elites), local leadership and participation. By endogenising the degree of local capture, we show how cooperation between local leaders and local elites could affect welfare positively or negatively, depending on initial socio-economic conditions. These institutional attributes, which evolve with changing welfare, create self-reinforcing processes in the long run that could be vicious, virtuous or neutral. The policy question we investigate is how to break a vicious cycle between low welfare and low institutional quality.
We argue that institutional reform must be welfare based and context based to allow adjustments to different institutional complexes, including cultural beliefs, social norms and capacities for reform. Reform must be exogenous and multidimensional, requiring welfare and institutions to be mutually reinforcing. In the context of post-decentralisation Indonesia, any multi-dimensional institutional reform must include not only policies to strengthen local institutions, but also policies to increase welfare.