Institutions

Dr. Fernando Aragon

October 2010

Institutions

• The idea that institutions are an important determinants

of economic development is far from new.

• Douglas North won his Noble prize mostly because of

his work on institutions.

• Institutions: “humanly devised constraints that shape • Institutions: “humanly devised constraints that shape

social interaction”

• Or simply “the rules of the game”

Institutions

• What do we mean by institutions?– Key words: Humanly devised constraints

– Can be formal or informal

– They shape scope for opportunistic behaviour and shape incentives for savings, investment, production and trade.

• For example: – Property rights

– Legal systems– Legal systems

– Democracy

– Customs and norms of behaviour

• Do not confuse institutions with organisations such as a particular university, a court or a parliament.

• Institutions do not necessarily have to be laws or formal procedures

Main functions

• By their function, we can distinguish two (very) broad

types of institutions:

1. Contracting institutions

– Enable private contracts to facilitate economic transactions and facilitate cooperation (Reduce transaction costs)

– Shape gains from trade and cooperation– Shape gains from trade and cooperation

2. Property rights institutions

– Constrain expropriation by government or elite, specially predatory governments.

– Shape incentives to invest and produce

Where do institutions fit?

• Consider the aggregate production function

• Institutions may in principle affect all parts of this.

• They may shape returns to investment or production (expropriation risks) and affect accumulation of physical and human capital, as well labour supply.

αα −= 1)()()()( tLtKtAtY

labour supply.

• They may also enter as part of the Solow residual by affecting the transaction costs in an economy or the incentives to adopt technology

• This explains the importance of institutions in current economic and policy debates.

• We could study the effect of institutions both on income levels and economic growth.

Some methodological issues

• Measurement

• Identification (the egg and chicken problem)

Measuring institutions

• Not general agreement about how to measure institutions, but issue has attracted lot of interest recently

• Two existing approaches:

– (Soft) Collect subjective opinion from experts about particular institutional dimensions

• Country Risk assessment by International Country Risk Guide.

• Political institutions: Polity IV

• Business environment: Doing Business project (World Bank)

– (Hard) Analysis of laws and constitutions to obtain objective measures of constitutional features: judicial review, terms of appointments of supreme court justices, etc.

• See La Porta et al (2004)

• Each approach has its merits, and disadvantages:

– In many cases indicators measure outcomes rather than institutions, specially with subjective opinions.

– Systematic measurement error

– Hard measures may fail to measure important informal institutions or the actual implementation of rules

• La Porta et al (2004) rank Peru’s judicial independence in 1995 with the highest score. Though reality seemed to have been somehow different.

Identifying the effect of institutions

• Observing a correlation between a measure of institutions and economic performance is not very informative

• Rich countries tend to have “better” institutions, but– Are they rich BECAUSE of the institutions?

– Or do they have better institutions because they are richer?

– This is the typical reverse causality problem

• Measurement error: • Measurement error: – We saw before the main difficulties to measure institutions

– Measurement error would produce attenuation bias.

– More worryingly, the measurement error may be systematic: we have better institutional information from richer countries.

• Omitted variables:

– There may several confounding factors affecting both institutions and economic outcomes

– Maybe there is link between institutions and economic performance.

• What can we do?

• Institutions are relatively stable over time, so we can only exploit cross sectional variation. Experiments?

• The identification strategy most common in the literature is the use of instrumental variables (IV).

• Key idea is to find a variable z that is correlated to x but uncorrelated to the error term.uncorrelated to the error term.

• Structural model :

• Strategy valid as long as z does not belong in the second stage. We can estimate it using 2SLS

• We can also estimate the reduced form:

(2)

(1)

iii

iii

xy

zx

εβ

ηγ

+=

+=

Hall and Jones (1999)

• A seminal paper studying relation between institutions and

economic performance (output per worker) using cross

country variation.

• As a measure of institutions they use what they called “social

infrastructure”. This is basically the average of two indices: infrastructure”. This is basically the average of two indices:

– Government anti-diversion policies (itself an aggregation of

indicators from the ICRG)

– Openness to international trades (Sachs and Warner

1995)

• They try to measure the extent of protection against a

predatory government

• Of course the previous relation cannot be interpret as the

effect of social infrastructure on output per worker. Why?

• They estimate the following regression

where S is the measure of institutions

• As instruments for S, they use:

– Distance to the equator

– Frank-Romel predicted trade share of an economy

– Fraction of population speaking English at birth

– Fraction of population speaking a Western European language at birth

Main findings:

• Positive relation between social infrastructure and output per

worker

• Differences in social infrastructure also explain differences in

capital accumulation and productivity (Solow residual)

• But...

Main empirical issues

• How convincing are these results?

• Issues about:

– Measure of institutions: do they capture what we mean by

property institutions?

– Probably more worryingly: how valid are the instruments?– Probably more worryingly: how valid are the instruments?

• We may have reasons to take these results with a pinch of

salt.

• Can we do better?

The importance of history

• Increased interest on role of history in economic development in the last 10 years.

• Important realization that history is actually replete with interesting sources of exogenous variation, that may have created a long lasting effect on institutions.

• Most of the empirical work exploits, in one form or another, shocks • Most of the empirical work exploits, in one form or another, shocks associated to the European colonization that started in the 16th

century. We will review a seminal paper later in this lecture.

• Others use geographical features (like availability of natural ports or access to oceans) that shaped historical trading routes (ACJ 2005), patterns of slave trade (Nunn 2008) and even technology levels in 1000 BC! (Comin, Easterly and Gong, 2006)

• It is a real challenge to know how to think about this

• Behind the use of these instruments is the assumption that a

big shock in the past shaped modern institutions. But, while

the change on initial institutions might have been exogenous,

the persistence of them might not.

• Moreover, historical events (like the European colonization) • Moreover, historical events (like the European colonization)

not only changed institutions but also other factors e.g settlers

brought human capital as well as European institutions. Does

this invalidate the exclusion restriction?

• We will discuss three seminal lines of research that exploit

European colonial expansion as a source of exogenous

variation.

• Their main difference is on their views of which aspects of

colonial rule were crucial for shaping institutions and in the

specifics of the proposed causal mechanisms

1. Engerman and Sokoloff (2000)

– Type of colonial rule driven by factor endowments (plantations and slave labour vs small landholdings)

2. Acemoglu, Johnson and Robinson (2001)

– type of colonization and initial institutions (settlements vsextractive colonies) driven by disease environment

3. La Porta et al (1997, 2008)

– What matters is the identity of the colonizer: transplanting of legal institutions

Engerman and Sokoloff

• Starting point is that European colonization in 16th century

was driven by desire to exploit economic opportunities

overseas.

• This colonization took two basic forms

– Extractive colonies– Extractive colonies

– Permanent settlements

• They argue that the endowment of resources drove the type

of colonization

• In resource rich colonies, European power established extractive posts

– Soils suitable for sugar and coffee in the Caribbean

– Gold and silver in Peru and Mexico

– Tobacco in Southern US.

– Very profitable activities that required massive use of labour.

– In some cases the colony already had a supply of semi-– In some cases the colony already had a supply of semi-slave native populations (like Peru and Mexico).

– In others, it required the import of labour, most of them slaves from Africa

– Economies of scale led to the use of large plantations, estates or mines.

– These factors combined, led to a initial very unequal distribution of land (and wealth) in these colonies and the creation of powerful elites.

• In contrast in other regions (like North East US and Canada)

– Soils less suitable to sugar and coffee, but instead

comparative advantage to produce grain.

– Grain technology with required small landholdings

– Settlements mostly using European labour, less inflow of

slaves

– This led to a more homogeneous distribution of land and – This led to a more homogeneous distribution of land and

wealth, and political power

• In unequal societies, elites were most able to establish

institutions than ensure their disproportionate share of political

power and granted selective access to economic and political

opportunities.

• These type of institutions are less conducive to the protection

of individual property rights, may reduce incentives to invest

and produce and encourage persistence of inequalityand produce and encourage persistence of inequality

• Basic argument:

Factor endowments ���� inequality ���� institutions

• Has this argument been tested empirically?

Easterly (2007)

• Easterly tests empirically Engerman and Sokoloff’s

hypothesis.

• Explore relation between inequality and development

outcomes: income per capita, index of institutions, aggregate

schooling.

• Use measure of suitability of land for wheat and sugar as an

instrument for inequality.

• Empirical strategy exploits between country variation.

Main findings:

• Inequality negatively correlated to land suitability for wheat

and proportion of small landholdings in the past

– Areas more suitable for wheat production are currently

less unequal and had a larger shares of family farms in

19th century and early 20th century.

• Inequality linked to reductions in income per capita,

institutional quality and human capital.

• These results seem to support the Engerman-Sokoloff

argument .

AJR 2001: Settlers’ mortality

• Take a different view about what drove the type of colony (and

institutions): settlers’ mortality

• In their view, in areas with high mortality rates (due to disease

environment), Europeans could not settle and were more

likely to set up extractive colonies.

– “Neo-Europes” (New England, Australia and Canada) vs. Congo

• This argument is not new for historians. To quote one

example, Niall Ferguson (Empire, How Britain made the

Modern World) provides vivid accounts of how high mortality

rates discouraged white settlement in rich Caribbean sugar

plantations, and instead drove migrants to more temperate

climates.

• They argue that the different colonization policies led to

different initial institutions, which have persisted over time.

– Extractive states vs rule of law

• Their identification strategy uses settler mortality as

instruments for currents institutions. They are interested on

studying the effect of institutions on economic performance

• This diagram illustrates the idea:

• They obtain measures of (potential) settler mortality from

historical records of morality of soldiers, bishops and sailors

collated by Curtin

• As measure of institutions, they use an index of expropriation

risk from the ICRG (soft measure)

• The baseline specification is

• The identification assumption is that, conditional on the

observables X, settler’s mortality M only affects economic

performance today through their effect on institutions R.

• Main finding: countries with “better” property right

institutions have a higher incomer per capita.

• This paper has been very influential in the literature and has

started a quest, among empirical economics, for instruments

in history books.

• Though is not exempt from criticisms

– Settlers not only brought institutions with them but also

human capital and technology (change interpretation of

results!)

– Challenges to the reliability of the measure of settler

mortality (David Albouy 2008)

La Porta et al (1997,1998)

• La Porta et al. adopt the view that the identity of the colonizer matters. In their view, legal institutions were transplanted during the colonial period. In turn those legal traditions have determinant the current quality of institutions (e.g. Degree of protection of investors)

• They show that common-law countries have stronger legal protection of investors, while Roman civil law ones, the weakest. Germanic and Scandinavian traditions fall somewhere in between.Germanic and Scandinavian traditions fall somewhere in between.

• More interestingly, colonial legal origin is related to financial development. In particular, countries with weaker legal protection of investor (Roman civil law) have smaller, narrower equity and debt markets.

• This has led to a widespread us of “legal origins” as instruments for contracting and financial institutions

Unbundling institutions

• Another issue is that institutions overlap a lot. So, even in the

best case scenario, we identify the effect of a cluster of

institutions on economic performance.

• This tell us little about which institutions are fundamental for

economic development

• There has been some work trying to unbundle institutions.

• Acemoglu and Robinson (2005) use measures of broad

property rights (Polity IV, soft) and narrow contracting

institutions (mostly hard, procedural measures).

• Instruments: legal origin (instruments for contracting

institutions) and settlers’ mortality and pop. density in 1500

Acemoglu and Robinson (2005)

institutions) and settlers’ mortality and pop. density in 1500

(for property rights).

• They find that broad property rights are more important to

explain income level across countries than contracting

institutions.

• Some people interpret this result as evidence that informal

institutions matter more (because their measure of contracting

institutions is biased toward formal procedures)

• There is an increasing interest on measuring, and

disentangling the effect of, informal institutions relative to formal institutions.

Assessment

• Institutions seem to be an importance piece of the puzzle and have attracted lot of attention. Most of the recent emphasis on governance echoes this interest.

• There are, however, important challenges to test empirically the role of institutions.

• Recent efforts to measure institutions and use historical events have expanded significantly our knowledge and there is afresh evidence using cross country and within country variation. But there are still using cross country and within country variation. But there are still many thing we do not know.

• The most conservative reading of the evidence is that initial conditions (like colonization) matter for current performance. But it is less clear whether this is driven by long lasting effect on institution, inequality or other factors.

• Recent micro evidence favours a political channel instead of inequality.