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Macroeconomic Topics in Development & Transition EC938. Sharun W. Mukand. Four meta-theories of institutions. Efficiency: institutions that are efficient for society (e.g., for aggregate growth or welfare) will be adopted.

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four meta theories of institutions
Four meta-theories of institutions
  • Efficiency: institutions that are efficient for society (e.g., for aggregate growth or welfare) will be adopted.
  • Ideology: differences in beliefs determine institutions (societies choose radically different institutions because citizens or elites have different beliefs about what’s good for economic growth).
    • Perhaps North Korea chose planned economy because its leaders believed it was “better”.
  • History: institutions determined by historical accidents or unusual events, and are unchanging except for random events and further accidents.
    • Legal system today determined by past historical accidents.
  • Social conflict: institutions chosen for their distributional consequences by groups with political power.
which approach efficient institutions
Which approach? (Efficient Institutions)
  • Although, everything else equal, there would be a tendency to adopt efficient institutions, everything else far from equal in practice.
  • Every set of institutions creates different losers and beneficiaries. Efficient institutions require either the losers to be compensated or the beneficiaries to impose their choice.
  • But in practice, losers generally not compensated ex post, and often can be powerful enough to block institutional change that is beneficial in the aggregate.
  • Empirically, efficient institutions view cannot help us understand why some societies adopt institutions that were disastrous for economic growth.

(approach not very useful)

institutional persistence some things we know
Institutional persistence: some things we know
  • Institutions are by their nature durable:
      • e.g., democracy more likely tomorrow if today there is democracy than if dictatorship today.
  • Bad institutions create bad incentives and self-sustain
      • e.g., an extractive state apparatus will give incentives to political elites to use it for extraction.
  • Bad institutions create instability and self-replicate
      • e.g., if controlling the state is a major source of rents, there will be infighting to control the state as in Ghana.
  • Bad institutions affect the composition of assets and distribution of income, contributing the persistence:
      • e.g., bad institutions  greater inequality  political power of the rich to sustain bad institutions.
institutional change 1
Institutional change (1)
  • Towards a theory of institutional change:
    • Recall:

political institutions  economic institutions

    • Thus important to understand change in political institutions
    • Political institutions a way of regulating the allocation of future political power
  • Two axes:
  • Elite-driven versus conflict-driven
  • Internal versus external
institutional change 2
Institutional change (2)
  • Elite-driven: when the politically powerful elite wish to change institutions in order to increase its rents/utility.
    • E.g., the U.S. Constitution or the imposition of different systems of land relations in the Dutch East Indies.
  • Conflict-driven: when institutional change forced from the non-elites. E.g.:
      • Rise of democracy because of the threat of revolution.
      • Rise of constitutional monarchy resulting from the fight between the crown and groups of merchants in Britain and the Netherlands.
institutional change 3
Institutional change (3)
  • Internal: because of internal shocks or dynamics.
    • E.g., rise of democracy.
  • External: because of external imposition, shocks, or external incentives.
    • E.g., colonial imposition of institutions, Korean response to threat of communism.
    • E.g., EU incentives for East European reform.
  • Even with external imposition, internal dynamics are very important  the pitfall of ignoring internal dynamics.
conclusions 1
Conclusions (1)
  • Institutions matter.
  • Although ideology and history influence institutions, in many many cases institutions emerge because of their distributional consequences.
  • Although everything else equal more efficient institutions more likely to arise, there will typically be major social conflict over institutions.
  • Then the choices benefiting politically powerful groups, not the society as a whole, more likely to emerge.
conclusions 2
Conclusions (2)
  • Summary: towards a dynamic theory

Economic institutionst

Economic policiest

Political institutionst+1

De jure power

(Political institutions)t

De facto powert




Some Considerations:

  • Some countries are rich and others are poor.
  • Economic development/Institutional change is difficult:
  • Need for coordination  Role for Government.
  • Political factors further impede government’s ability to carry out change.
the washington consensus

Good governance in developing countries REQUIRES …

  • 1. Fiscal discipline
  • 2. Reorientation of public expenditures
  • 3. Tax reform
  • 4. Financial liberalization
  • 5. Unified and competitive exchange rates
  • 6. Trade liberalization
  • 7. Openness to DFI
  • 8. Privatization
  • 9. Deregulation
  • 10.Secure Property Rights

The international capital market/IMF/World Bank – insisted in its policy recommendations that there is a unique path to development…policy reforms required…

“In Search of the Holy Grail: Policy Convergence, Experimentation and Economic Performance” (2005) American Economic Review
  • Developing countries have undertaken “Washington consensus” style reform during the eighties and nineties.
  • Policy convergence  Economic convergence??
  • Why the discrepancy?
  • Countries not implementing economic reform in first place (i.e. no policy convergence).
  • Universal applicability of policy?? Is it a reasonable assumption.
Appropriate reforms and policies have a large element of specificity and experimentation is required to discover what works locally…..
  • Two track reform worked well in Deng’s China but not in Gorbachev’s Soviet Union.
  • Gradualism may work in India but not in Chile
  • Import Substitution may be appropriate in Brazil but not Argentina
  • Privatization may be necessary in Latin America but not Asia…..
Are we implying that economic principles work differently in different places…?
  • No.
  • We distinguish between economic principles and their institutional embodiment. Most first-order economic principles come institution free…incentives, competition, hard budget constraints, sound money, fiscal sustainability…are central to the way economists think.
  • However, these universal economic principles do not of themselves map into specific institutional solutions…
  • Property rights can be implemented through common law, civil law or Chinese-style socialism…
Countries located on unit circle: countries differ in terms of their “location”: dictated by differences in history, geography, culture.

Country “location” given by zi.

  • Country can either “Imitate” and adopt institutions developed and refined in other countries or “Experiment” and engage in institutional innovation.
  • Both “Imitation” and “Experimentation” have both an upside and a downside.
  • Imitation  no uncertainty about the blueprint (+)

 may adopt institutions that are not appropriate for

local conditions (loss in output) (-).

  • Experimentation  uncertainty (-)

 institution may be adapted to local needs (+)

If a country’s location is zj and the institutional/policy choice is ai then the expected output is given by:

yi = -θ(ai - zj)2

  • Government preferences: Vi = yi – λK; where

λ = 1 if govt. experiments and,

λ = 0 if govt imitates policy/institutions.

K = private fixed cost paid by govt. if it experiments.

  • Uncertainty with Experimentation: Government has imperfect control: if it chooses ai’ = zi + η , where η ~N(0, σ2).

Eyi(IMIT)= -θ(a1 – z2)2

  • Experimentation:

Ey(EXPT.) =E{ -θ(a’2 – z2)2– F}

  • Experimentation versus Imitation: Govt. in country i will prefer imitation to experimentation if…

Ey(IMIT) ≥ Ey(EXPT.)

In the immediate “neighborhood” of the successful leading country, follower countries prefer to “imitate” the leader  growth pole across the successful leader.
  • Countries far from the leader – the “far-periphery” will experiment. Economic performance is on average worse than that of the leaders  but much greater “variance” than the followers.
  • The worst performing followers should be at some `intermediate’ distance from the leader country.
  • Economic Performance should show a U shaped relationship when plotted against distance.
institutional adoption the transition economies as an experiment
Institutional Adoption: The Transition Economies as an Experiment
  • Around 1990: socialism has failed! There is no ambiguity about whether countries searching for new institutions to replace socialism.
  • Set of countries searching for new institutions can be cleanly identified: all former socialist countries.
  • Plausible notion of “distance”….?...
Provides a framework to think about the “specificity” of policy implementation.

Economic Policy (universal economic principle)


Institutional Specificity

Economic Outcomes (e.g. economic growth, pcy)

In light of specificity, insistence by international K mkt., IMF, World Bank that developing countries adopt the “Washington Consensus” set of policies/institutions to be successful 


In light of specificity, insistence by international K mkt., IMF, World Bank that developing countries adopt the “Washington Consensus” set of policies/institutions to be successful 


  • Transition economies  even a decade later, had yet to catch up with pre-transition levels of pcy
  • Sub-Saharan Africa did not take off despite significant reforms…
  • Frequent and painful financial crises in LA/East Asia/Russia…
  • Latin American Recovery of the90s was short-lived…crash of Argentina (the poster boy for Washington consensus policies)…

(“Goodbye Washington Consensus, Hello Washington Confusion?” Dani Rodrik (2006), Journal of Economic Literature

IMF claim: Policy Reform did not yield sustained results in many developing countries because

(i) genuine reform was skin deep with no `follow through’,

(ii) Reforms in face of poor institutions was not sustainable. Regulatory mkts weak, Corruption endemic...

New set of `Washington consensus’ reforms  heavy emphasis on Institutional Reform.

  • Are Institutions key to growth and development?
globalization and governance
Globalization and Governance
  • Developing countries:
  • Weak political institutions  Political Selection weak  poor leaders  Bad governments.
  • Poor Economic institutions  imperfect contract enforcement, rule of law..
  • Weak Economic and Political Institutions  Economic Insecurity  low investment  low economic growth  poverty and underdevelopment.
  • How do we develop new, better quality growth promoting institutions?
  • What is the impact of globalization on a government’s incentive to adopt good quality institutions?
globalization and growth how to make poor countries grow when governance poor
Globalization and Growth:How to make poor countries grow when Governance poor?
  • Attract capital…(one way)…

(i) attract Foreign Aid;

(ii) IMF help

(iii) Foreign Investment (FDI, Portfolio equity investment…)

bad governance and the globalization of capital
Bad Governance and the Globalization of Capital
  • LDCs typically have a high marginal product of capital. So investment should flow to developing countries.
  • However, typically developing countries lack financial markets that allow transfer of funds from savers to borrowers
  • Weak enforcement of economic laws and regulations
    • Weak enforcement of property rights makes investors less willing to engage in investment activities and makes savers less willing to lend to investors/borrowers.
    • Weak enforcement of bankruptcy laws and loan contracts makes savers less willing to lend to borrowers/investors.
Over the past decade, emerging market bond markets have deepened markedly.
  • Volume of international securities by emerging market sovereigns and corporates has increased from a level of $325 million in 1995 to roughly $700 million in 2003.
don t mess with moodys new york times 1995
“Don’t Mess With Moodys” New York Times 1995.
  • “In the 1960\'s the most important visitor a developing country could have was from the head of AID, the U.S. agency that doled out foreign aid. In the 1970\'s and 80\'s the most important visitor a developing country could have was from the I.M.F., to help restructure its economy. In the 1990\'s the most important visitor a developing country can have is from Moody\'s Investors Service Inc.
  • Because we now live in an age when governments are basically broke, the only way for most countries to raise cash for development is either to enforce savings at home or attract investors from the world\'s major bond markets. Moody\'s is the credit rating agency that signals the electronic herd of global investors where to plunk down their money, by telling them which countries\' bonds are blue-chip and which are junk.
That makes Moody\'s one powerful agency. In fact, you could almost say that we live again in a two-superpower world. There is the U.S. and there is Moody\'s. The U.S. can destroy a country by leveling it with bombs; Moody\'s can destroy a country by downgrading its bonds.
  • Moody\'s rates the investment quality of countries today just as it rates companies. Those that get their economic house in order will be rated AAA and be able to sell bonds at low interest. Those that don\'t will be rated C and have to pay pawnbroker interest rates
  • ….. Moody\'s and the bond market are now imposing on democracies economic and political decisions that the democracies, left to their own devices, simply cannot take.”
  • (Thomas Friedman in the New York Times, 1995)
disciplining and the international capital market
Disciplining and the International Capital Market
  • Disciplining effect of the international capital market?
  • Can the international capital market improve global governance through punishing poor governance and rewarding good governance?
foreign direct investment stocks
Foreign Direct Investment Stocks
  • International integration of product markets may be fostered by FDI stocks (FDI is long term and flows are volatile)
  • World FDI Stock as a % of World Output


1913 1960 1975 1980 1997


9.0 4.4 4.5 4.8 11.8


  • FDI/GDP ratio highest for France/UK in 1914

and UK/Germany in 1997.

  • Traditionally FDI/Foreign Aid main form of capital flows to developing countries. In recent decades things have changed….
net capital flows to developing countries 1996 2004
Net capital flows to developing countries, 1996-2004

Net inflows ($ billions)

  • Unofficial flows to developing countries far outstrip official flows
  • FDI and remittances dominate unofficial flows
  • FDI is becoming increasingly concentrated
  • FDI outflows have surged dramatically to $40 billion (South-North and South-South investment)
  • Corporate bonds and portfolio equity will also become increasingly important in middle-income countries

Foreign direct investment

Worker remittances



Portfolio equity

Bank loans

Source: World Bank Global Development Finance 2005

the confidence game
The Confidence Game
  • “Washington\'s preoccupation has been not economic fundamentals but market confidence. And what does it take to restore confidence? Policies that may not make sense in and of themselves but that policymakers believe will appeal to the prejudices of investors--or, in some cases, that they believe will appeal to what investors believe are the prejudices of their colleagues”Paul Krugman
  • “Governing the Global Economy: Does One Architecture Style Fit All” Dani Rodrik (1999) available at
  • “Globalization and the Confidence Game” Mukand in Journal of International Economics (2006)
The Confidence Game: will the government always choose a policy in accordance with its private signal?
  • Unknown State of the World: {SL, SR}. Prior is that SR is more likely.
  • Different policies appropriate for different states of the world:

SL ------------ aL - GL

SR ------------ aR  GR

However, a mismatch results in low productivity, e.g. G = 0.

  • Y = G f(k) = G. (k)α
  • Government receives a private signal sj that is more reliable than the prior.
  • Govt. then chooses to implement either policy aL or aR. (Socially optimal for government to use all available information in making making its policy choice.)
Foreign investors observe government’s policy choice and decide on how much to invest.
  • Realization of Public good productivity (or quality of economic environment). Output realized.
  • Payoffs realized: Foreign investors (earn α.y) and national income is (1-α)y.


Case I: Prior versus the private information:

Prior = ω = P(SR)>1/2

Private Signal= sL of reliability Φ>ω

bayesian updating
Bayesian updating
  • Reliability of signal: Φ = P(sR|SR) = P(sL|SL).
  • Government should always choose a signal that accords with its private signal if it wants to maximize overall output P(sR|SR) > P(sL|SL) >1/2.
Government may ignore private signal and go along with priors of the international capital market, in order to attract foreign capital and (in expected terms) maximize output.