Institutions and Economic Development

1. Institutions and Economic Development Sources: Economics Network & other

2. Guest Lecture • Raji Rajan, Coffey International • A development consultancy • Will talk about Markets for the poor (I think!) • Time: Monday, 24 Feb, 2-4 p.m. • G11, HBS

3. Definition • ‘Institutions are a set of rules, compliance procedures and moral and ethical behavioural norms designed to constrain the behaviour of individuals in the interests of maximising the wealth or utility of the principals’ (North, 1981, p.201-2). • “Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction.” (North, 1990) • “In consequence they structure incentives in human exchange, whether political, social, or economic.” (North, 1990) • Lin and Nugent (1995) "a set of humanly devised behavioral rules that govern and shape the interactions of human beings, in part by helping them to form expectations of what other people will do.

4. Pande and Udry (2005) contest the notion of ‘agency’ embodied in the North definition by arguing that institutions are often not ‘designed’ and even when they are, their operation may be different to what was originally intended. They therefore argue that we should concentrate on de facto institutions rather than de jure ones. North’s ‘moral and ethical behavioural norms’ are often embodied in informal institutions like religion and caste that determine the quality and sustainability of formal institutions like schools, labour markets and the rules and regulations governing economic activity.

5. Standard Neo-Classical economic framework assumes a well-defined set of property rights with a full set of complete and contingent markets. It also assumes that contracts are signed with no fear that they will be revoked when it suits one of the parties. • In the background of this model, there exist institutions that establish and protect property rights and enforce contracts - a system of laws and courts. • Laws imply a legislator and a police force. The legislator's authority may derive from religion, family lineage, or access to superior violence or alternatively, may be provided by popular support (in a democracy). • This implies the beginnings of a governmental structure that goes well beyond the narrow needs of the market. • One implication of all this is that the market economy is necessarily "embedded" in a set of non-market institutions. • Another is that not all of these institutions are there to serve the needs of the market economy first and foremost, even if their presence is required by the internal logic of private property and contract enforcement. (Rodrik, 2000)

6. Institutions • Contractarian perspective: historically institutions emerged through a social contract between citizens and the state which delegated the use of violence to the latter in exchange for protection and social order. • defence, political institutions esp those relating to governance. • Over time, these institutions were supplemented by economic institutions like private property rights and markets, all of which stimulate economic growth (see Rodrik (2000, 2005) and Savoia et al (2010)). • For development, we need growth igniting institutions but also growth sustaining institutions which will reinforce long term economic development (as opposed to growth alone) and conflict management institutions, which will relieve social conflict. • How are formal institutions formed? • informal institutions (gender, class, caste and social capital) shape formal ones (e.g. the law). • informal institutions (customs) gradually change the actions and interactions of agents in all sorts of social organisations (households, groups, villages, as well as firms and governments).

7. Formation of Institutions • North’s theory of institutional change explains that formal institutions are a crystallisation of informal ones (North, 1990), and that both co-evolve through the operation of organisations (informal and formal social groups, from households and villages to networks, firms, parties and governments). • Institutions affect economic outcomes but will society choose those institutions that maximise social surplus (North and Thomas, Demsetz)? • Institutions are not always chosen by all of society but instead by the few, hence not efficient. Coase Theorem does not apply, i.e. the winners do not fully compensate the losers. • North (1981) argues that institutions act to constrain the individual in order to enhance the welfare of the ‘principals’. • Informal institutions in developing countries play a very significant role in shaping formal institutions and the operation of markets, and can emerge as the preponderant rules of interaction when formal institutions and markets fail. • Eg. caste, religion or tribe can influence access to schools, credit etc. • They can influence the outcomes of elections and therefore the benefits derived from them.

8. Acemoglu, Johnson and Robinson (AJR, 2004) provide the following framework for understanding the formation of institutions. • Economic institutions influence growth because they shape incentives and affect investment in physical and human capital • Institutions  incentives investment  growth • Economic institutions are endogenous – determined as collective choices of society – mostly for their economic consequences. • Some conflict of interests amongst individuals and groups. • Equilibrium institutions determined by groups with political power • Distribution of power in society is also endogenous. It is determined by political institutions. Two types of institutions – de jure and de facto political institutions. • Political institutions determine de jure political power.

9. 4. De facto political power arises from the ability to co-ordinate and ‘band’ together to solve problems (e.g. Arab Spring) or military strength or economic strength. • Distribution of resources leads to de facto political power 5. Two state (exogenous) variables – political institutions and distribution of resources. • Both change very slowly and knowledge of these variables sufficient to determine all other variables [de jure and de facto political power, economic institutions, future political institutions, economic performance and distribution of resources in future].

10. Acemoglu, Johnson and Robinson, 2004

11. the way that humans themselves decide to organize their societies determines whether or not they prosper. Some ways of organizing societies encourage people to innovate, to take risks, to save for the future, to find better ways of doing things, to learn and educate themselves, solve problems of collective action and provide public goods. Others do not. (AJR, 2004) Jean Phillipe Platteau argues that economic specialization requires well-defined property rights, which must evolve over time. Practices and rules as well as the public agencies and moral environment which sustain trust are determined at least in part, if not largely, by the cultural endowment of societies as they have developed over their particular histories (Platteau, 1994). an individual’s position vis a vis others and therefore their ability to access resources depends on historically and culturally determined power relations, which are continuously changed by people pushing the boundaries of what is feasible (empowerment processes, but also social and economic entrepreneurship). Adam Smith and J.S. Mill argued that good institutions include: Enforcement of property rights so that individuals have incentives to invest. Equality of opportunity so that those with opportunities can take advantage of them.

12. Why do institutions differ across countries? • Efficient Institutions View • Societies will choose the economic institutions that are socially efficient. It does not matter how the surplus is distributed across the groups because as surplus is produced, all externalities will be internalised and new distributions will emerge (Coase Theorem). • Ideology View • Societies choose different institutions because they or their leaders disagree about what would be good for society. • Incidental Institutions View • Popular amongst political scientists and sociologists • Downplays the role of choice in institution building and thinks of institutions as by products of other societal interactions or historical accidents. • Social Conflict View • Economic and social institutions are chosen not by whole society but by groups who control power • These groups choose institutions to maximise their rents and this may not be the same as maximising social benefits.

13. Institutions and Growth • Relationship between institutions and economic growth widely studied (AJR, 2001, 2004; Hall and Jones, 1999; Knack and Keefer, 1995;). • Findings of this literature are ‘of fundamental importance for development economists and policy practitioners in that they suggest that institutional quality may cause poor countries and people to stay poor,’ (Pande and Udry, 2005, p.2) • Glaeser et al (2004) argue that measures of institutional quality such as risk of expropriation (used in Acemoglu et al 2001), government effectiveness and constraints on the executive are ‘outcomes’ and do not represent ‘deep’ institutions. They estimate the following equation:

14. Institutions and Growth

15. Institutions and Growth Interpretation of Glaeser’s results Coefficient on Initial level of schooling is always +ve and significant. So also the coefficients on Initial GDP per capita (-ve and significant) and Share of Population living in Temperate Zone (+ve and significant). The beta coefficients are only significant when the institutional proxies stand for outcomes (expropriation risk (82-90) or government effectiveness (98-2000). Other proxies for institutions such as judicial independence or constitutional review are insignificant.

16. Institutions and Growth – Empirical Estimation 2 Problems: • Endogeneity: Institutions affect growth but the latter in turn influences the kind of institutions that exist. • The solution is for us to try and find a variable or a factor that meaningfully can affect institutions but does not directly affect economic growth. • Acemoglu, Johnson and Robinson (American Economic Review, 2001) addressed this point by including baseline settler mortality in colonial period. • Most institutional variables that are available in datasets tend to be outcome variables rather than deep institutional variables. • For instance, these measures do not code dictators who choose to respect property rights any differently than democratically elected leaders who have no choice but to respect them. Since these measures confound constraints on government with dictatorial choices, they do not proxy for institutions, which in their essence are constraints (North 1981). • To use the latter, we need to concentrate on a single country within which changes in institutions can be traced, rather than study institutions across countries. Measuring institutions is difficultbecause popular measures are (i) ‘outcomes’ rather than anything ‘deep’ (ii) they are mostly subjective (iii) when non-outcome proxies for institutions are used they are insignificant.

17. Variables used Common proxies for institutions are: • Voice and accountability • Political Stability/No violence • Government Effectiveness • Regulatory Quality • Rule of Law • Control of Corruption • Corporate Ethics • Corporate Corruption • Judicial Effectiveness • Corporate Governance etc. • Problem is that all of these variables are related to the level of development. So, more developed economies are likely to have better institutions. How then can we identify whether these institutions influence the level of growth or development? • Also, these variables are not ‘deep’ institutions. Instead, they denote ‘outcome’ institutions (or quality of secondary institutions) and the question is what determined these institutions.

18. Institutions & Development • So far, have concentrated on institutions relating to growth. • However, almost all aspects of development are influenced by institutions e.g. levels of equality (income as well as social equity), urbanisation, education, health, sustainability etc. • As mentioned earlier, a lot of literature on growth and institutions. Less so on development and institutions though fast growing literature on it. • Paper by Crost & Kambhampati (2010) one example of this literature.

19. The existing literature on institutions and development is limited in three ways: It does not precisely define the respective roles of formal and informal institutions in development processes. Institutions are seen in very broad terms as relating to certain political or economic rules of behaviour (eg. protection against expropriation risk or government anti-diversion policies or country’s openness or bureaucratic efficiency. Very few authors consider informal institutions like caste, ethnicity or trust. It concentrates on the impact that institutions have on growth, rather than on development in broader terms. Thus, most of the existing papers are concerned with the impact on log GDP per capita or output per worker. They concentrate on growth igniting institutions rather than growth sustaining or conflict management institutions. reverse causality i.e. from development to the quality of institutions within a country makes it hard to identify the impact of institutions on development or growth.

20. Institutions and Economic Development Institutions can be (i) developmental or (ii) predatory Developmental Institutions – encourage investment, growth and productivity. Predatory – extractive institutions that favour the few. Problem: institutional quality itself is determined by lack of equity in a society: inequitable economies develop exploitative and inefficient institutions. Unfair wealth distributions can block the emergence of effective democracy because it makes redistribution too costly for the elites in power. Inequality shapes, and is shaped by, political institutions. Initial conditions matter and change is very slow and difficult to initiate.

21. Institutions influencing SchoolingCrost & Kambhampati, 2010 • Analyse the factors that influence the availability of schools in India. • Include a range of formal (political) and informal (caste, religion, ethnicity) institutions. • The political variables include: • extent of political competition in the district (as reflected in the margin of victory of the incumbent party, • the extent of party fractionalization, • the probability that an incumbent party loses an election; • political awareness of inhabitants of the village (as reflected in turnout at elections) • empowerment of minority communities (as reflected in reservation of seats for such communities in assembly elections). • ethnic diversity: caste fractionalization index constructed using upper caste, middle caste, SC, backward agricultural & other castes, Muslims.

22. Crost and Kambhampati, 2010

23. When seats are reserved for certain minority groups (political reservation), then the number of primary schools decreases. • Implying that minority politicians are less bothered about getting schools built? • When there are a large number of small parties (party fractionalisation) and when parties are often overthrown at elections (party turnover), then more primary schools built. • Number of middle schools is not affected by any political variable except the margin of victory – higher this is, smaller the number of middle schools. • If schools are to be used as election winners, then primary schools easier to set up……also see that they are very tangible. Less likely to see quality of schools being improved. • Informal institutions eg. caste, religion etc. • Upper caste villages have more primary schools and also more teachers per school. • SC districts have fewer primary schools.