Do institutions matter?

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

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 nondemocracy, electoral rules, extent of
checks and balances etc.)

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

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

The identification problem

cont.

Figure from Przeworski04 (institutions matter?)

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).

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

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)

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 R&D 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?

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.

Geography cont.

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.

AJR approach rests on three

premises
1. 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

2. Feasibility of settlements affected the

probability of different sets of institutions.

Do not argue that Eur. Influence in itself was positive or

negative

3. Early institutions affect current institutions

AJR approach rests on three

premises

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.

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.

The equation of interest

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?
1. Rich economies may prefer (or afford) better
institutions (the causality runs the other way)
2. Omitted variables
3. Measure of institutions created ex post
4. Attenuation bias (due to poor institution measure)

Does this suggest an upward or downward

bias in OLS?

IV
Solution, treat R as an endogenous
variable.
The first stage:

What is the identifying assumption?

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).

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)

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.

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)

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.

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)

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?

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?

Links

Acemoglu's review essay of PT: http://www.atypon-link.com/doi/abs/10.1257/002205105775362069

P&T's book: http://mitpress.mit.edu/catalog/item/default.asp?ttype=2&tid=9930

Besley and Case00: http://www.blackwell-synergy.com/doi/pdf/10.1111/1468-0297.00578
Przeworski04: http://as.nyu.edu/docs/IO/2800/go_2004.pdf
Easterly07: http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6VBV-4MNYK141&_user=674998&_coverDate=11%2F30%2F2007&_rdoc=1&_fmt=&_orig=search&_sort=d&view=
c&_acct=C000036598&_version=1&_urlVersion=0&_userid=674998&md5=e1a5dabc9db3b764417
f8e77069338d8
Jared Diamonds book 'Guns, germs and steel: http://www.amazon.com/Guns-Germs-Steel-FatesSocieties/dp/0393317552
Engerman and Sokoloff 2000: http://www.jstor.org/view/08953309/di014723/01p02397/0
Links to Hall and Jones, Acemoglu, Johnson and Robinson, Mauro, Engerman and Sokoloff97 are on
the reading list