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Do Institutions Cause Economic Growth?

Incentives move the economy and the world, and institutions are the clearest representation of the incentive structure of an economy

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To study institutional effects on economic development, and which particular institutions promote economic growth, we should first of all think about what we understand for institutions. It is very useful to think of institutions as political constraints that structure social and economic interactions (North, 1991), which contribute to the creation of order and the reduction of uncertainty in economic and social exchange processes. 

We can categorize institutions in two main groups: formal; as is the case with constitutions or property rights, and informal; as codes of conduct or tradition. Institutions affect economic decisions in different ways. Along with alternative economic and social constraints, they affect transaction and production costs, the viability of a certain economic activity and influence decisions of economic agents. Institutions have shown to be dynamic throughout history, by continuously evolving and bridging the past with the present. Incentives move the economy and the world, and institutions are the clearest representation of the incentive structure of an economy (North, 1991), shaping the direction of economic change and, in some way, determining the route of economic development. Following this narrative, I’ll now proceed to describe in more detail how institutions affect economic decisions and show how institutions can cause growth or decline, depending on which of them we describe. 

Institutions are constraints and incentive sets with direct effects on economic decisions. Exchange institutions such as currency permit low-cost transacting, while others as education allow for specialization and efficient cooperation in the context of rational wealth-maximizing individuals. The effect of institutions on economic decisions is directly related to the effectiveness of their enforcement, especially in the case of political and legal institutions.  As described by Glaeser et al. (2004), institutions, when effective, increase the profit obtained from cooperative solutions and cause potential gains from trade to be realizable, by reducing transaction and production costs. Therefore, legal, political and economic institutions are central to the institutional matrix in determining economic development. Markets are sustained, protected and legitimized by institutions, both formal and informal, as is the case of legal codes or constitutions, for the former or codes of conduct and tradition, for the latter. But that’s not the end of the story. Long distance trade and the benefits from it were possible thanks to institutions, as negotiation and contract enforcement in alien regions of the world required the development of certain standardized codes of conduct, laws and even weights and measures, which made possible effectively transacting and engaging in international trade (Rodrik, 2011). 

In terms of legal institutions, we observe a crucial difference when studying the diverging economic effects of different legal traditions as that of Common Law vs Civil Law. While the Common Law is formed by appellate judges who establish precedents by solving legal disputes, Civil Law relies on established legal codes and statutes as primary means of ordering legal material. While the first of these traditions is common in Anglo-Saxon tradition countries, the latter tradition is the oldest and most influential, mostly related to European, African and Latin American countries. La Porta et al. (2008) have documented empirically that the laws of Common Law-countries were more protective of international investors than those of civil law countries, being legal investor protection a strong historical proxy for financial development. Institutions related to government ownership and regulation also play a decisive role through their impact on markets, being countries with Common Law tradition associated with more efficient contract enforcement, more flexible labor markets and greater protection of property rights, in contrast to Civil Law-tradition countries. The Legal Origin Theory shows that these two legal traditions have underlying differing views regarding social control of economic life, and while Common Law seeks to support private market outcomes, Civil Law looks to replace those outcomes with state-desired enforced allocations. So, we could say that while Common Law has a more “market supporting and protecting” tradition, Civil Law is more directed towards interventionist policymaking. 

Throughout history, political institutions of limited government have shown to solidly support for economic growth and development, and according to Glaeser et al. (2008): “recent growth has reached close to an intellectual consensus that the political institutions of limited government cause economic growth”. This view sees pro-investment and pro-growth policies as a consequence of political constraints on government. Glaser et al. (2008) show that traditional indices of institutional quality are strongly correlated with each other, as with per capita income levels. The evidence presented in their paper shows a significant correlation between economic growth over a determined period and the average assessment of institutional quality measured as “constraints on government”, these being: constraints on the executive, risk of expropriation or public expenditure effectiveness. As these assessments improve, the economy grows at a greater rate. However, the authors can’t confirm the direction of causality, and present an alternative hypothesis that could also be supported by these empirical findings. 

The alternative theory derives from Lipset’s hypothesis, which can be summarised in growth and economic development leading to better political institutions. Lipset (1960) supported the idea that educated people are more likely to solve problems through negotiation and cooperation rather than through violent disputes, while literacy encourages the spread of knowledge. This theory establishes that countries’ differences in their stocks of human and social capital determine the divergence of outcomes regarding institutional quality and economic development. 

It needs to be taken into account that, apart from education for building up human capital, Lipset (1960) also establishes secure property rights as a necessary condition to support investment and physical capital formation, and consequently, long term economic development. Glaeser et al. (2008) also support this point of view, showing that from 1900, predicting economic growth, human capital levels are a better proxy than institutions. However, they also insist that institutions related to government constraints are necessary for economic development and emphasize how developing countries need to promote economic policies that ensure private property rights and reliable legal systems, in search of institutional improvement. This interpretation is also coherent with the evidence presented by Alesina et al. (1996), who show that political and legal stability predict economic growth in the long term. 

On the other hand, there are some institutions that can harm economic growth and development. These have been recently referred to as “extractive institutions”, a term widely popularised by Acemoglu and Robinson after the publishing of their bestselling book Why Nations Fail (2012). According to Acemoglu and Robinson’s theory, extractive economic institutions are coupled with extractive political institutions, with North Korea, China under Mao’s regime or the Soviet Union being examples of it. In these cases, political power is tightly and narrowly held, and this power is usually employed to enrich the political and economic elites of the country, which tend to be intertwined through public conglomerates in the main industries. Furthermore, this wealth is later on used to entrench their political power. The real problem arises when countries get locked into extractive political, legal and economic institutions. Extractive institutions harm the vast majority of the population, but they benefit the elite that holds political and legal power. A clear example of this was Zimbabwe under Mugabe’s regime. If Zimbabwe had had inclusive institutions at the time, its economic development would have been much faster, and its citizens would have enjoyed a higher living standard. However, Mugabe and the ruling elite benefited from those extractive institutions as a politicized legal system or authoritarian political measures. History has shown that extractive institutions lead to economic decline while inclusive institutions ensure prosperity and development, even if in the long term. Acemoglu and Robinson (2012), through their theory of institutions have developed a compelling way of understanding how institutions affect economic development, and why political and legal institutions being inclusive or extractive matters for that purpose, supporting their theory with causal empiricism. 

To conclude, throughout this text we have seen how existing research shows that political and legal institutions related to greater government constraints and transparency are favorable to growth and development. However, there remains to be no clear causal relationship between institutions and economic development. Some research has shown that human capital rather than institutions has a causal effect on economic growth, being this growth the factor leading to further institutional development. In this framework, as supported by Lipset, Przeworski or Barro, institutions would have only a second-order effect on economic development, coming from the first-order effect of available human and social capital.

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