UNBUNDLING INSTITUTIONS

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UNBUNDLING INSTITUTIONS

• Daron Acemoglu and Simon Johnson
• Oct. 2005

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Background AND INFLUENCES
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Douglass North Structure and Change in Economic
History (1981)

• Distinguishes between (1) contract theory of
  the state and (2) predatory theory of the
  state.
• Contract Theory the state and associated
  institutions provide the legal framework that
  enables private contracts to facilitate economic
  transactions (i.e. reduce transaction costs).
  (950)
• Predatory Theory the state is an instrument
  for transferring resources from one group to
  another. (950)
• Combines the two theories and argues that good
  institutions will simultaneously support private
  contracts and provide checks against
  expropriation by the government or other
  politically powerful groups. (950)

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Contract Theory Literature Coase (1937, 1960),
Williamson (1975, 1985), Grossman and Hart
(1986), Hart and Moore (1990), and Hart (1995)

• The efficiency of organizations and societies is
  linked to what type of contracts can be written
  and enforced. (950)
• Underscores the importance of contracting
  institutions. (950)

Property Rights Literature Jones (1981), De Long
and Shleifer (1993), and Olson (2000)

• Emphasizes importance of private property rights,
  especially against government expropriation.
  (950)

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summary

• All agree a societys institutions (its social,
  economic, legal, and political organization) are
  a primary determinant of economic performance.
  (950)
• However, the contemporary literature has not
  attempted to determine the relative roles of
  institutions supporting private contracts
  (contracting institutions) and institutions
  constraining government and elite expropriation
  (property rights institutions). (950)
• Instead, it has documented the importance of a
  cluster of institutions that include both
  contracting and private property protections
  elements, despite the existence of
  well-established theoretical arguments
  emphasizing each set of institutions. (950)

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objective
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• This paper is an attempt to unbundle the broad
  cluster of institutions and learn more about the
  relative importance of contracting institutions
  versus property rights institutions at the
  macro level. It is the first step to
  investigating which types of institutions matter
  more and for which economic outcomes. (950/988)
• In effect, Acemoglu and Johnson attempt to
• Separate the effects of contracting
  institutions from property rights institutions
• Determine which types of institutions affect
  certain economic outcomes
• Determine which types of institutions possesses
  the greater effect on those economic outcomes

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The variables
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Defining the economic outcomes

• The economic outcomes focused on in this paper
  are (956-957)
• Long-Run Growth measured by the level of GDP per
  capita
• A societys ability to channel money into
  investments measured by the ratio of investment
  to GDP
• Finance provided through the banking sector and
  trade credit measured by the amount of private
  credit as a percentage of GDP
• Equity finance measured by the stock market
  capitalization as a percentage of GDP

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Defining the institutions

• Contracting Institutions-The rules and
  regulations governing contracting between
  ordinary citizens. (955)
• -Example Between a creditor and debtor or
• a supplier and its customers.
• -Most important component legal
• system.
• Property Rights Institutions-The rules and
  regulations protecting citizens against the power
  of the government and elites. (955)
• -Example Laws protecting against
• government expropriation.
• -Related to political and state-society
• interactions.

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Compare/Contrastthe institutions

• Contracting institutions regulate transactions
  between private parties whereas property rights
  institutions regulate the relationship between
  ordinary private citizens and the politicians or
  elites with access to political power (950-951).
• This results in a difference of options open to
  individuals affected by weak contracting and
  property rights institutions. (955)

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The Strategy
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The equation
Yc a Fc ßIc Zc?0 ec where (956) Yc
The outcome of interest for country c Fc A
measure of contracting institutions a A
parameter of interest Ic A measure of property
rights institutions ß A parameter of
interest ZcA vector of other controls ?0A
vector capturing effects of the control
variables ecError term NOTE This equation
ignores nonlinearities
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The challenge with no obvious form of
measurement, how does one measure Contracting and
property rights institutions?Answer By Proxies
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The proxies contracting institutions

• Index of legal formalism measures the number of
  formal legal procedures necessary to resolve a
  case of collecting on a bounced check worth 5 of
  the countrys annual income per capita. (951,
  957)
• Index of procedural complexity measures the
  difficulties in resolving the case of an unpaid
  commercial debt contract worth 50 of the
  countrys annual income per capita. (951, 957)
• The number of procedures necessary to resolve a
  court case involving this same commercial debt
  from above. (951, 957)

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The proxies property rights institutions

• Polity IVs constraint on the executive
  measures (scale from 1 to 7) the degree of
  constraints on politicians and politically
  powerful elites. A higher score indicates greater
  constraints. (951, 958)
• Risk Services protection against expropriation
  by government measures (scale 0 to 10) the
  degree of protection against expropriation. Zero
  indicates the lowest protection against
  expropriation. (951, 958)
• (3) Heritage Foundations private property index
  measures the extent to which private property is
  protected against both government and other
  sources of expropriation. (952, 958)

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The challenge how does one ensure a clean
regression analysis?

• Issues
• Possible overlap between contracting and property
  rights institutions
• Both types of institutions are endogenous
• Answer By Instruments

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The instrument contracting institutions

• The legal origin of a country (either British
  common law or French civil-law) (961)
• Acemoglu and Johnson use this instrument based
  upon the previous work of
• La Porta et al. (1997, 1998) Countries have
  distinct legal origins
• Djankov et al. (2003) Determined a strong
  correlation between the legal origin of a country
  and its legal formalism (contracting
  institutions)

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The instruments Property rights institutions

• Settler Mortality and Population Density in 1500
  (959-961)
• Acemoglu and Johnson use these instruments based
  upon the previous work of
• Acemoglu et al. (2001, 2002) European
  colonization strategies affected the
  establishment of property rights institutions.
  The two key factors in the colonization
  strategies were the disease environment (if
  favorable, then stronger property rights
  institutions were established) and the indigenous
  population density (if low density, then stronger
  property rights institutions established)

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The instruments covariance and independence

• Partial correlation constraints establish that
  the property rights instruments are independent
  from the contracting instrument, thus proving the
  covariance between the institutions instruments
  to be approximately zero. (see figures 1 and 2,
  968-969)
• In effect, the instruments
• Are exogenous representations of the
  institutions.
• Are independent of each other.
• Focus on countries that were formally European
  colonies.

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The regression

• Acemoglu and Johnson used a two stage least
  squares regression in order to evaluate their
  data (959).
• First Stage Regression Objective
• Get a prediction of either Fc or Ic based on the
  corresponding measurements and instrument for the
  given type of institution.
• Second Stage Regression Objective
• Run the regression using the prediction to
  obtain the desired parameters, a and ß.

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The data, Analysis, and results
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The Data
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conclusion
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Conclusion contracting institutions

• Limited or no effect on long-run growth (GDP per
  capita) (984)
• Limited or no effect on a societys ability to
  channel money into investments (investment to GDP
  ratio) (984)
• Limited or no effect on the overall amount of
  financial intermediation in the economy/ finance
  provided through the banking sector and trade
  credit (amount of private credit as a percentage
  of GDP) (984)

• Some effect on equity finance (stock market
  capitalization) (983-984)

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Conclusion contracting institutions

• In effect, contracting institutions
• Affect the form of financial intermediation (debt
  vs. equity), but have less impact on economic
  growth, investment, and the overall level of
  financial development. (953)
• Affect the stock market there is some evidence
  that countries with worse contracting
  institutions have less developed stock markets.
  (953)

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Conclusion property Rights institutions

• Significant effect on long-run growth (GDP per
  capita) (984)
• Significant effect on a societys ability to
  channel money into investments (investment to GDP
  ratio) (984)
• Significant effect on the overall amount of
  financial intermediation in the economy/ finance
  provided through the banking sector and trade
  credit (amount of private credit as a percentage
  of GDP) (984)
• Significant effect on equity finance (stock
  market capitalization) (984)

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Conclusion Property Rights institutions

• In effect, countries with stronger property
  rights institutions (greater constraints on
  politicians and elites and more protection
  against expropriation by these powerful groups)
  have
• Substantially higher income per capita (953)
• Greater investment rates (953)
• More credit to the private sector relative to the
  gross domestic product (953)
• More developed stock markets (953)

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Why can economies function in the face of weak
contracting institutions without disastrous
consequences, but not in the presence of a
significant risk of expropriation from the
government or other powerful groups (953)?
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Conclusion Possible Explanation
Private contracts or other reputation based
mechanisms can, at least in part, alleviate the
problems originating from weak contracting
institutions. For example, when it is more
difficult for lenders to collect on their loans,
interest rates increase, banks that can monitor
effectively play a more important role, or
reputation-based credit relationships may emerge.
In contrast, when property rights institutions
fail to constrain those who control the state, it
is not possible to circumvent the ensuing
problems by writing alternative contracts to
prevent future expropriation, because the state
is the ultimate arbiter of contracts. (951, 953)
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Discussionquestions
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• Do you agree with the proxies/instruments
  Acemoglu and Johnson chose to utilize to measure
  contracting institutions and property rights
  institutions?
• What about consistent breadth of measures? (broad
  vs. narrow/ formal vs. informal)
• Do you buy their explanation of the results?
• What about a minimum level of contracting
  institutions needed for the economic outcomes to
  be favorable?
• What could be other possible explanations?
• What are the implications of this paper on policy?

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• Daron Acemoglu and Simon Johnson. Unbundling
  Institutions. Journal of Political Economy, Oct.
  2005 949-995