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 Divergence
Ratio to "subsistence" income, log base 2 scale
Growth Rates Diverge between Rich
and Poor: 1820-1992
64
32
16
8
4
2
1
1820
Source: Pritchett (1997)
1992
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 rule
Sachs (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.
A horse named malaria
Malaria
Institutions
Effect on
Income
Effect on
Income
-1.43***
-.32*
.53***
1.43**
Sachs
Rodrik et al.
*, **, *** means statistically different than zero at the 10%, 5%, and 1% level.
Source: Sachs (2002) and Rodrik et al. (2003)
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.
Causal effect of colonial institutions
Effect on
Income
Effect on
Income
Effect on
Income
Institutions
.41***
1.0***
1.1***
Latitude
.92
-.65
-1.2
Africa
-.90***
OLS
-.44
2SLS
2SLS
*, **, *** 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.
Source: Acemoglu et. al (2001)
Checking the data -- Story of two data points (Singapore
and Mali, SGP and MLI in diagram below)
Investigating the IV
Albouy (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 institutions
Glaeser 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.