Do institutions matter

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Do institutions matter?
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Institutions defined (again)

• Douglas North Institutions are the humanly
  devised constraints that structure human
  interaction. They are made up of formal
  constraints1, informal constraints2 and their
  enforcement characteristics. Together they define
  the incentive structure of societies and
  specificially economies.
• 1) rules, laws, constitutions
• 2) norms, behavior, conventions
• or simply the rules of the game

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Institutions defined (again) cont.

• Can also be useful to distinguish between
• Economic institutions (individual property
  rights, contracts that can be written and
  enforced, patent laws etc.)
• Political institutions (democracy vs
  non-democracy, electoral rules, extent of checks
  and balances etc.)

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Correlations

• Large literature documenting positive
  correlations between certain institutions and
  economic performance.

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The identification problem

• But this hardly demonstrates a causal effect of
  institutions on economic performance.
• The kind of question we are interested in
  answering is
• if the UK were to switch its electoral rule
  from majoritarian to proportional, how would this
  affect the size of its welfare state or its
  budget deficitis? (PT)
• If Argentina were to abondon its presidential
  regime in favor of a parliamentary form of
  government, would this facilitate the adoption of
  sound policy towards economic development? (PT).
• How would changing institutions in Nigeria to
  those of Chile affect economic performance? (AJR)
• How would incresing the social infrastructure
  of Zaire to that of Switzerland affect
  productivity? (HJ)
• How did the introduction of universal suffrage
  affect redistribution levels in western Europe?
  (AR)
• Does inequality cause underdevelopment?
  (Easterly)
• Hard questions to answer empirically
• Institutions are endogenous to economic
  performance.
• Causality runs both ways
• Omitted variable bias
• Fundamental problem cannot observe the
  counterfactual

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The identification problem cont.

• Figure from Przeworski04 (institutions matter?)

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The identification problem cont.

• What we can learn from correlations and OLS
  regressions is limited.
• Acemoglu (2005) makes this argument forcefully in
  a review of Persson and Tabellini (2003).

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Endogeneity

• Agents understand that different policies will
  map into different outcomes
• Policy endogeneity
• If state policy making is purposeful action,
  responsive to economic and political conditions
  within the state, then it may be necessary to
  identify and control for the forces that lead
  policies to change if one wishes to obtain
  unbiased estimates of a policys incidence
  (Besley and Case 2000,EJ)
• Agents understand that different institutions
  will map into different policies and outcomes.
• Endogeneity of institutions

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Endogeneity cont.

• Large literature treat institutions as exogenous
  (e.g. institutions are predetermined or given
  by history)
• However, the political economy approach suggests
  that the same factors that make policies
  unappealing to treat as exogenous is relevant for
  institutions.
• E.g. The introduction of democracy was not
  random
• Papers that try to deal with this problem
  includes Mauro (1995), Hall and Jones (1999),
  Acemoglu, Johnson and Robinson (2001) and Persson
  and Tabellini (2003)

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Proximate vs fundamental causes

• Vast differences in prosperity across countries
• Output per worker 32 times higher in top five
  countries relative to to bottom five countries
  (HJ).
• What can explain this difference?
• 1) Physical capital differences
• Poor countries dont save enough
• 2) Human capital differences
• Poor countries dont invest enough in education
• 3) Technology differences
• Poor countries dont invest enough in RD and
  technology adaption, and fail to organize
  production efficiently
• 1 3 are however proximate causes of differences
  in prosperity.
• What are the fundamental causes?
• How do we distinguish between the effects of
  institution from the conditions that give rise to
  them?

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Geography

• Jared Diamond
• Proximate causes guns, germs and steel
• Fundamental causes geography
• Availability of crops and animals
• Axes of communication across continents
• Geographical differences have determined the
  timing and nature of settled agriculture. This
  have shaped societies ability to develop complex
  societies.

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Geography cont.
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Institutions

• Hall and Jones argue
• By social infrastrcture we mean the institutions
  and government policies that provide the
  incentives for individuals and firms in an
  economy.
• The incentives can encourage productive or
  predatory behavior
• Institutions are not exogenous but there are
  potential sources of exogenous variation in
  history.
• European colonization as a natural experiment.
• Use history to estimate the causal effect of
  institutions on growth.
• HJ use Western European influence to solve the
  endogeneity problem
• Distance from equator (latitude), which is
  correlated with western influence (good)
• The extent of euriopean languages spoken today in
  these countries.
• These instruments are not entirely convincing
  (see the disc. In Acemoglu 05JEL).
• We focus on the work of Acemoglu, Johnson and
  Robinson.

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AJR approach rests on three premises

• Different types of colonization policies created
  different sets of institutions.
• Extractive states e.g. Congo, Nigeria, Tunisia
• No protection of private property
• No checks and balances against government.
• Confiscatory taxation
• Neo-Europes, i.e. US, NZ, AUS.
• Protection of private property
• Law and order
• Feasibility of settlements affected the
  probability of different sets of institutions.
• Do not argue that Eur. Influence in itself was
  positive or negative
• Early institutions affect current institutions

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AJR approach rests on three premises
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Settler mortality

• In the tropics, 80 percent of European deaths
  were caused by malaria and yellow fever.
• Europeans in Africa, India and Caribbean faced
  very high death rates.
• But death rates for the adult local population
  were much lower (developed immunity).
• Yellow fever in W. Africa was a strangers
  disease.
• and had little effect on the health and economy
  of indigenous people.
• Many of the areas that were colonized in the
  tropical zone were richer and more densely
  populated in 1500 than the temperate areas later
  settled by Europeans.

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Current institutions

• Protection from expropriation risks.
• Vary from 0 to 10, for each country for each
  year.
• AJR use average over 1985-1995
• Extractive state ? low value on this index.
• Broad measure of property rights.
• Data from Political Risk Services
• Private company which assess the risk that
  foreign investment will be expropriated in
  different countiries.

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The equation of interest
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OLS

• Plain OLS estimates of eq (1) find a strong
  assocation between R and Y. Also when controlling
  for latitude and continent dummies.
• Why doesnt this necessarily show a causal
  effect?
• Rich economies may prefer (or afford) better
  institutions (the causality runs the other way)
• Omitted variables
• Measure of institutions created ex post
• Attenuation bias (due to poor institution
  measure)
• Does this suggest an upward or downward bias in
  OLS?

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IV

• Solution, treat R as an endogenous variable.
• The first stage
• What is the identifying assumption?

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IV cont.

• IV estimates suggest a large and statistically
  significant effect of institution on economic
  performance.
• Differences in institutions account for over 75
  of the variation in income per capita today
• Improving the institutions of Nigeria to the
  level of Chile would lead to a 7-fold increase in
  Nigerias income.
• (in practice the difference is 11-fold)
• No impact of geography, when institutions are
  treated as an endogenous variable
• These results suggest that Africa is poorer than
  the rest of the world not because of pure
  geographic or cultural factors, but because of
  worse institutions (p. 1372 AJR).

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IV cont.

• Results robust to
• Different subsamples
• Controlling for continent dummies, geography.
• Controlling for current prevalence of malaria and
  life expectancy
• Only using yellow fever as an instrument
  (eradicated today)

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Conditions in the colonies

• A key aspect of AJR is that it is not the
  identity of the colonizer that matters, but
  conditions in the colonies.
• Clearly depart from HJ where European influence
  in itself is deemed beneficial
• Related to the work of Engerman and Sokolof
  (1997).
• The Caribbean islands illustrate the adverse
  affects of Europeans, which set up repressive
  regimes based on slavery and forced labor.
• Factor endowments such as geography, climate and
  soil conditions help explain the builings up of
  good institutions in nortern am. And poor
  institutions in Lat. Am.

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From ES 2000 JEP

• North am. Of relatively marginal econ. Interest
  compared with the extraordinary opportunities
  available in the Caribbean and Lat. am (ES2000)
• Haiti probably richest country in the world (on
  per cap basis) in 1790
• Why did US/CAN experience sustained econ. Growth
  in 18th and early 19th century?
• (while others did not attain this goal until late
  19th or 20th century, if ever)

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Factor endowments

• Some econ. Historians have explained the
  divergence due to the identity of the colonizer.
• But striking differences within the identity of
  the colonizer (e.g. US, Can vs. Barbados,
  Jamaica, e.g. Argentina vs Peru) calls for other
  explanation.
• AJR explain the divergence as a result of
  institutions.
• ES Factor endowments (incl. Climate, soil,
  density of native population)
• Predisposed North am. Colonies towards relatively
  equal distributions and corresponding
  institutions favoring a broad range of the
  population in commercial activity.
• Predisposed Lat. Am, Caribbean colonies to highly
  unequeal distributions and institutions that
  protected the elite.
• The suitability for cultivating sugar and other
  highly valued commodities
• ? economics of scale ? extensive use of slaves,
  and the densely populated native population.

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Persistence

• In those societies that began with extreme
  inequality, elites were better able to establish
  a legal framework that insured them
  disproportionate shares of political power, and
  to use that greater influence to establish rules,
  laws, and other government policies that
  advantaged members of the elite relative to
  non-members contributing to persistence over
  time of the high degree of inequality.(ES2000)

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Inequality and per capita income

• A recent paper by Easterly (JDE 2007) draws on ES
  to try to answer the question does inequality
  cause underdevelopment?

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Inequality and per capita income

• Measures of factor endowments as instruments for
  structural inequality.
• Sugarcane ? labor intensive ? high historical
  ineq.
• Wheat ? capital intensive ? low historical ineq.
• What is the identifying assumption?
• Do we believe in this?

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Links

• Acemoglu's review essay of PT http//www.atypon-l
  ink.com/doi/abs/10.1257/002205105775362069  
• PT's book http//mitpress.mit.edu/catalog/item/d
  efault.asp?ttype2tid9930
• Besley and Case00 http//www.blackwell-synergy.co
  m/doi/pdf/10.1111/1468-0297.00578
• Przeworski04 http//as.nyu.edu/docs/IO/2800/go_20
  04.pdf
• Easterly07 http//www.sciencedirect.com/science?_
  obArticleURL_udiB6VBV-4MNYK14-1_user674998_c
  overDate112F302F2007_rdoc1_fmt_origsearch
  _sortdviewc_acctC000036598_version1_urlVe
  rsion0_userid674998md5e1a5dabc9db3b764417f8e7
  7069338d8
•  Jared Diamonds book 'Guns, germs and steel
  http//www.amazon.com/Guns-Germs-Steel-Fates-Socie
  ties/dp/0393317552
• Engerman and Sokoloff 2000 http//www.jstor.org/v
  iew/08953309/di014723/01p02397/0
• Links to Hall and Jones, Acemoglu, Johnson and
  Robinson, Mauro, Engerman and Sokoloff97 are on
  the reading list