The Institutions and Development Debate: Part I

Cause or effect?

Paul Dower

NES

Modern economic growth

• Economic growth is a relatively recent phenomenon.

• Maddison (2003):– World income per capita same in 500 and

1500 AD– In 1500-1820 cumulative growth of 15%

(0.04% p.a.)– Since then growth at 1.2% a year (doubles

every 58 years)

The Great DivergenceGrowth Rates Diverge between Rich

and Poor: 1820-1992

1820 1992

Ratio to "subsistence" income, log base 2 scale

2

4

8

16

32

64

1

Source: Pritchett (1997)

Growth Theory in brief

• Factor accumulation (conditional convergence)

• Differences in technology

Question: How is it that these differences come about?

Adam Smith’s answer

Differences in institutions can possibly explain income differences across countries because of differences in how they affect the growth process.

Source: Easterly and Levine (2003)

What is an Institution?

An integrated system of beliefs, norms, organizations and rules that generate a regularity of behavior

Man-made, non-technological features that influence economic outcomes by constraining behavior.

Grief (2006), North (1990)

Coordinating Institutions

Rule: Drive on the right side of the road

Organization: Highway Patrol

Belief or Norm: Drivers will follow the rule.

Regularity of behavior: Drivers drive on the right side of the road.

Extractive Institutions

Rule: Police require at least $100 to dismiss minor offense charges.

Organization: Police, Courts Belief or Norm: Police find bribes profitable

and bribes are cheaper than facing the charges.

Regularity of behavior: Corruption

Productive Institutions

Rule: Secure property rights assure investors get return to investment.

Organization: Courts

Belief or Norm: Financial contract will be enforced.

Regularity of behavior: Investment in enterprise.

Institutions affect efficiency and productivity by influencing and coordinating:

consumption,savings, exchange, investment, production and innovation.

Adam Smith’s answer

Geography can explain differences in the growth process through endowments that are more or less conducive to trade, technology and survival.

What do we mean by geography?

• Disease, germs

• Crop suitability

• Temperature

• Distance to major bodies of water

Source: Sachs et al. (1998)

How can geography affect the growth process?

• Transportation costs

• Mortality

• Subsistence

• Agricultural productivity

The Institutions and Development Debate

Weak view: Geography has an indirect effect through institutions.

(Easterly and Levine 2003), (Acemoglu et. al. 2001, 2002)

Alternative: The direct effect of geography dominates any indirect effects.

(Sachs 2002), (Sachs et al. 1998)

Strong view: Variation is due to differences in legal tradition.

(Djankov et. al) (Kuran 2003)

Alternative: Human capital is needed to establish good institutions.

(Glaeser et. al. 2004)

Major Data Sources

• Historical income: Maddison

• Income inequality: UN WIDER

• Institutional indices:– Polity IV– ICRG– Kauffman, Kraay and Zoido-Labaton (2002)– Freedom Index, Doing Business, Lex Mundi

Institutions Rule Indirectly

Acemoglu et al. (2002) argue that the level of development before colonization led to different incentives to set up productive or extractive institutions, which eventually led to a reversal in income for these ex-colonies.

Acemoglu et al. (2001) argue that extractive institutions were set up during the colonial period in places where colonists did not want to stay using settler mortality rates as a proxy for this desire.

Easterly and Levine (2003) show that tropics, germs, and crops matter for economic growth but primarily through the effect of good institutions on economic growth.

Easterly and Levine (2003)

• Replacing Mexico’s institutional index score with the US score removes the income gap.

• “if Burundi’s endowments had been like those of Canada, it would have increased Burundi’s income per capita through institutions by a factor of 38.”

Actual difference is 107 times so only variation by a factor of 2.8 (107/38) is unexplained. (In log terms, 78 percent of the log income difference between Canada and Burundi is explained.)

Reversal of Fortune?

Direct effects of geography can not explain the reversal of fortune (Acemoglu et. al. 2002)

Idea: Do urbanization rates in 1500 predict current differences in income?

For non-colonies, positive effect.

For ex-colonies, negative effect but not once we control for institutions.

Source: Acemoglu et al. (2002)

“Temperate Drift” Hypothesis

• Tropics had an early advantage which shifted to more temperate zones with subsequent agricultural technological developments.

• Empirical Evidence:– Divergence in income did not occur when these

technologies were introduced.– Divergence was mainly due to industrialization.– The reversal in income does not appear to depend on

geographical variables. Nor does industrialization depend on geographical variables.

Institutions don’t ruleSachs (2003), Sachs et al. (1998)

• Strong correlations between geographical variables and income per capita.– Disease environment– Distance to international trade– High population density (especially when it is due to a

rapid increase)• Malaria risk has a direct effect after controlling for

institutions and indirect effects of geography on institutions.

• Population increase is likely to take place in geographically disadvantaged regions.

Source: Sachs (2002) and Rodrik et al. (2003)

Effect on Income

Effect on Income

Malaria -1.43*** -.32*

Institutions .53*** 1.43**

Sachs Rodrik et al.

A horse named malaria

*, **, *** means statistically different than zero at the 10%, 5%, and 1% level.

A closer look at the evidence

1) Reverse causality (Albouy 2006)

2) Measurement (Woodruff 2006), (Glaeser et. al. 2004)

3) Persistence of institutions

Causality

• Potential reverse causality from development to institutions.

• Possible Solution: find instruments for institutions.

Requirement of instrument: (1) good predictor of institutions, but (2) doesn’t directly affect development, i.e. other than through its effect on institutions

Causal Structure of Development

Geography Development

Institutions

Causal + Econometric Structure of Development

Geography Development

Institutions(not necessarily causal)

Instrumental Variable

Colonial Origins and Settler Mortality (Acemoglu et. al. 2001)

• Settler mortality as an IV (and theory of differences in institutions)

• High rates encourage the use of extractive institutions by the colonial settlers whereas low rates encourage the use of productive institutions.

• If institutions persist through time, then settler mortality could predict an exogenous source of variation in current institutions.

Source: Acemoglu et. al (2001)

Effect on Income

Effect on Income

Effect on Income

Institutions .41*** 1.0*** 1.1***

Latitude .92 -.65 -1.2

Africa -.90*** -.44

OLS 2SLS 2SLS

Causal effect of colonial institutions

*, **, *** means statistically different than zero at the 10%, 5%, and 1% level.

Model predicts Chile has seven times the income per capita of Nigeria given their differences in institutions.

Actual amount is 11 times.

Checking the data -- Story of two data points (Singapore and Mali, SGP and MLI in diagram below)

Investigating the IVAlbouy (2006)

1. Acemoglu et al. (2001) distribute 34 distinct mortality rates among 64 countries. Some mistakes on assigning mortality rates to countries.

2. They also mix high wartime deaths from disease of soldiers with low peacetime soldier death rates.

3. Data sometimes based on very small samples; larger samples available for the same country give different estimates.

Singapore and Hong Kong

• Singapore is an influential observation with mortality of only 17.7. • Curtin (1989) says “the mean strength of this

{military} force was too low to be significant.” He gives example of 83 men in Straits Settlement in 1863, with one death (from a heart attack).

• Data are actually from Penang in Malaysia, more than 500 km from Singapore.

• Historical literature on Singapore points to normal tropical mortality rates.

• Alternative numbers on Hong Kong from a report by the Colonial Surgeon and from statistics on soldier mortality give much higher mortality in Hong Kong than Acemoglu et al. (2001). Source: Easterly Lecture notes (2007)

Further considerations on data

• “the remarkable nineteenth century success of European medicine in keeping soldiers alive in tropical conditions” (p. ix)

• Is this mortality measure endogenous? – Disease rates throughout tropics dropped sharply

during second half of 19th century – One speculation is that causation is from “desire for

tropical empire”, which “may have been the principal incentive for research and discoveries in tropical hygiene” (p. x)

Source: Easterly Lecture Notes, 2007.

Institutions Rule

La Porta et al. (1999): French civil law does less to ensure the security of private property than the British common law, and consequently, citizens governed by French civil law will have weaker protection of their property.

Kuran (2003): Commercial crisis in the Islamic states in the Middle East mainly driven by a comparative disadvantage in legal rules.

Measurement

• Main measures of institutions:

1. Risk of expropriation

2. Cost of doing business

3. Constraints on executive

4. Constitutional checks and balances such as judicial independence

5. Rules on representation such as electoral rules • The first three measures:

– change over time – represent outcomes not rules – highly correlated with each other.

• Ex. North Korea vs. South Korea

Measurement continued

• Hard (objective) vs. soft (subjective) measures:The drawback is soft often measure de facto institutions

which matter for economic outcomes, whereas hard measures only capture de jure differences.

Ex. Under 4, Peru is the ideal state.

• Broad vs. narrow measures

In general, the empirical evidence suggests soft and broad measures matter more for economic outcomes. But these measures are vague and hard to target with policies.

Human capital vs. formal institutionsGlaeser et al. (2004)

• Authors restrict notion of institutions to objectively measurable characteristics.– Implication 1: informal institutions are lumped into

human capital.– Implication 2: indirect effect of geography on

institutions becomes statistically weak.– Implication 3: effect of institutions disappears.– Implication 4: lagged values of education predict

current institutions and not the other way around.

Measurement matters!

Concluding Remarks:What about institutional change?

• Problem: Evidence requires institutional persistence AND no direct effect of settler mortality on development. – Malaria (Carstensen and Gundlach, 2005)

• Why didn’t institutions change? Or did they?

Concluding Remarks:Unobserved institutional change makes the

estimates difficult to interpret.• Historical accidents trigger change:

Ensminger (1992) studies the emergence of commercialism among Orma cattle herders in Kenya. She argues the conversion to Islam led to the adoption of social practices such as credit lending system and counting of cattle for alms that made market practices less costly. Greater market activity and the standardization of measures led to increased use of credit and individualization of herd ownership.

• Colonial origins may be irrelevant:Colonial traditions of commercial law in Benin, Madagascar and Malawi. Fafchamps (2004) shows that traders took preventative measures which they would not have to take if courts were effective.

Concluding Remarks:Directed Institutional Change

Given the apparent importance of institutions for explaining income differences, policies that initiate institutional change as a development tool are an intriguing possibility.

The open question is which institutions matter most and how to achieve desired effects if institutions primarily affect economic outcomes through informal means.