MICHAEL OPPONG (21812993)

ECM I60

QUESTION ONE.
INSTITUTIONS ARE IMPORTANT TO ECONOMIC GROWTH. DISCUSS WITH
EVIDENCE

WORD COUNT: 2949

Why are some countries richer than others? Why are there vast differences in growth across
countries? Why do some countries grow at a fast pace than the others? These and many are the
sought of questions that comes to mind when one begin to think about economic growth.
However economic growth require an institutional framework that allows transactions to take
place in an orderly and efficient manner and in which agents know that the decisions they take
and the contracts they make will be protected by law, and enforced. Thus economic growth
cannot take place in an institutional vacuum.
Economic growth
Economic growth is one of several indicators which is used to determine the health of a countrys
economy and refers to an upsurge in the production and consumption of goods and services
within a country over a specific time period. Thus it is identified by increasing gross domestic
product (GDP) of a country. Economic growth may also refer to an economy that is getting
bigger, not automatically one that is getting better, however, has signs of upturns in the stock of
capital, technological improvement, and advance in the quality and level of literacy in the
economy.
This paper seeks to examine critically the effects of institutions on economic growth. It is argued
in this paper that, better institutions are the main driving force to growth which is evident in
Rodrik, Subramanian and Trebbi (2002) when they found out that institutional determinants
supersedes all in an attempt to assess the relative importance of institutions, geography and
integration in determining the differences in incomes between the worlds most developed
countries and the poorest ones. It is also evident in the Wealth of Nations of Adam Smith when
he emphasized the importance of a justice system, property rights, and the rule of law in the
development of a country.

The paper sets out with an introduction of various definitions of institutions and then proceed
with the importance of institutions in an economy. The last section then develop the argument to
see the effects of institutions on growth. Thus, institutions and the extent of their correlation to
economic growth providing evidence from the literature and making comparison of several
countries.
What are Institutions?
In order to understand the concept well, we need to define the concept. How then do we define
institutions? Institutions according to North (1990: p.4) are the rules of the game in a society
or, more formally, are the humanly devised constraints that shape human interaction". This
means that institutions in a general sense refers to the rules of well-defined ways in which
individuals respond to one another. It also means that institutions are sets of instructions or rules,
procedures or norms that constrain the behavior of individuals to conform to society. Thus North
meant that institutions are premeditated and designed by individuals who are acting reasonably
and free of constrictions.
Pande and Udry (2005) argued that even though institutions are set of rules or procedures that
govern or constrain behavior, they are not designed, and even if they are, their actual operation
may be different to what was initially intended. Pande and Udry therefore suggested that
concentration should be based on de facto institutions which arises from the ability to co-ordinate
and band together to solve problems rather than de jure institutions and one that pays attention to
how changes in resource endowments can cause individuals to change their economic behavior
within a given institutional context and potentially cause the institution itself to change in the
longer run. Accordingly Hodgson (1988) also noted that institutions are the kinds of structures
that matter most in the social realm and they make up the stuff of social life.

Brunt (2007) also noted that, institutions may refer to somewhat much bigger and broader than
basically the set of easily identifiable legal entities, such as the federal banks, parliament or
unions, even though these are all specific examples of institutions. This implies that an institution
is any generally accepted procedure that governs the process of interaction between members of
a society. Moreover, the set of these easily identifiable institutions such as the central banks and
the parliament as noted by Brunt, are institutions that shape the behavior of individuals because
they have norms and laws enshrined in them.

Formal and Informal Institutions

Institutions therefore can be categorized into two different forms; formal and informal. Formal
Institutions refer to the constitutions, laws, and other governmental regulations that control the
political system, the economic system and the enforcement system .Informal Institutions refer to
the, customs, religious beliefs, moral values, traditions and all other rules of behavior that have
lasted for a very long time. Pejovich (2012) noted that informal institutions are the old ethos or
the carriers of history. Moreover they represent what the society perceive about the world, the
wisdom that has been accumulated over the past years, and a contemporary set of values. Thus,
informal institutions are the part of a societys custom (Pejovich 2012). Casson et al., (2010)
therefore argue that Norths moral and ethical behaviourial are often embodied in informal
institutions like religion and caste that determine the quality and sustainability of formal
institutions like schools, labor markets, and the rules and regulations governing economic
activity.
Even though no single set of institutions will suit all countries, however, consensus among most
researchers and economists suggests that at least five main types of institutions are necessary, if

not adequate conditions for speedy economic growth (Rodrick and Subramanian, 2008). These
set of institutions as noted by Rodrick and Subramanian (property rights and legally binding
contracts, regulatory institutions, institutions for macroeconomic stability, social insurance
institutions, market-legitimizing institutions) tend to fall under

either formal or informal

institutions.

To achieve a desirable economic outcome, the economic, social, political and health institutions
in the country must be well structured. This section provides reasons why institutions are
fundamental to growth. Thus property right, economic institutions, culture and conflict
management and the extent of their correlation to economic growth.
Acemoglu et al., (2005) argue that the assumption that differences in economic institutions are
the fundamental cause of different patterns of economic growth is based on the notion that, it is
the way that individuals themselves decide to organize their societies that determines whether or
not they grow. Hence some ways of organizing societies encourage people to innovate, to take
risks, to save for the future (which gingers growth), to find better ways of doing things, to learn
and educate themselves, solve problems of collective action and provide public goods. This
means that countries that do not organize themselves well will not prosper or grow.

Property Right and Economic growth

Economic institutions like property right are essential to growth since they influence the
structure of economic incentives in society. Thus without property rights, individuals will not
have the incentive to invest in physical or human capital or adopt more efficient technologies
which will incentivize growth (Acemoglu et al., 2005). If property is protected individuals are

more willing to invest and to incur sunk costs. An example is where Pande and Udry (2005)
recounting on the ownership of land system in Ghana, are able to show that where individual
awareness of security of land tenure is low, investment in the land is significantly reduced, and
output consequently drops which leads to low growth. However, in the few cases in which land
is obtained through commercial transactions, there ceases to be any difference in levels of
investment because security of land tenure is assured. Thus property rights create an atmosphere
that influences and increases output, hence conducive to economic growth. Another example
where Claessens and Laevan (2003) consider the role of property rights on firm financing, asset
allocation, and ultimately economic growth and found out that, there is a significant effect on
growth from the interaction of property rights and asset mix.
The other side of the argument is that, the protection of property rights requires an expanded role
for state authority. Individuals and groups sacrifice a degree of freedom in order to ensure state
protection; they accept levies and taxes to cover policing expenses, and state monopoly over the
use of force for common security (Bates, 2001). However, there is a risk that states which have
the power to enforce property rights may use that power to expropriate property too. Instead of
reducing risk of economic transactions, this rather tend to increase it. Thus property rights are by
no means sufficient to spur economic growth, and must be balanced by institutions which limit
the extractive capacity of state power. These typically involve independent parliaments and
judiciaries. Democratic institutions of political representation strongly contribute to this process
(Rodrik, 2000). This shows that even though property rights may not be sufficient factor for
growth, if it is well balanced with other institutions, then it spurs growth. Thus institutions are
important to growth.

Economic institutions are also essential because they help in distributing resources to their most
efficient uses. Thus they determine who gets the returns or profits and residual rights of control.
In the absence of markets, improvements from trade go unexploited and resources are misused.
Societies with economic institutions that facilitate and encourage factor accumulation,
innovation and the efficient allocation of resources will grow (Acemoglu et al., 2005). In other
words, institutions tend to influence not only the size of the aggregate pie, but how this pie is
distributed among different groups and individuals in society.

Culture and Economic Growth

Another important institution to economic growth is the culture of the society. Different
societies or ethnic groups have different cultures, because of different shared experiences or
different religions. Culture is viewed as a key determinant of the values, preferences and beliefs
of individuals and societies. The argument is that, these differences play a crucial role in shaping
economic performance. At some level, culture can be thought to influence equilibrium outcomes
for a given set of institutions. Possibly there are multiple equilibria connected with any set of
institutions and differences in culture mean that different societies will coordinate on different
equilibria. Alternatively, as argued by Greif (1993), different cultures generate different sets of
beliefs about how people behave and this can alter the set of equilibria for a given specification
of institutions. The commonly cited link between culture and economic growth is that, the
origins of industrialization in Western Europe could be traced to the Protestant reformation and
particularly the rise of Calvinism (Weber, 1930 cited in Ferrini, 2012).In Webers view, the set of
beliefs about the world that was intrinsic to Protestantism were crucial to the development of

capitalism. Protestantism emphasized the idea of predestination in the sense that some
individuals were chosen while others were not.
Another example is, Bagella, Becchetti, and Caiazza (2002) when they investigated the role of
culture and religious backgrounds on institutional and financial development as well as the
finance-growth link and find that a positive finance-growth link arises only in countries where
the societys cultural background has allowed sufficient financial development.

Conflict Management and Economic Growth

Another important institution for growth is the conflict management institution. Many
developing countries like Ghana and Nigeria have deep ethnic, tribal and religious divisions
which most at times leads to conflict (Example is Boko Haram in Nigeria). Thus social conflict
damages economies by diverting resources from directly productive activities, and creates
uncertainty, which in turn deters investment and eventually a decline in growth. To minimize
conflict requires a full range of institutions the rule of law, a fair legal system, and a political
voice for minority groups which make it clear that the potential winners of social conflict will
not benefit and potential losers will be properly safeguarded. This means that when institutions
are well structured and used to the advantage of the whole society, then growth will proceed.
Another reason why institutional structures and rules of behaviour are a necessary condition for
economic growth is that, incentives and price signals, so vital to a market economy, cannot
function properly without them. As Rodrik (2008) suggests, markets require institutions because
they are not self-creating; self-regulating; self-stabilising, or self-legitimising.

Fiscal and Monetary Policy Institutions and Economic growth

Another major important institution is the institutions for macroeconomic stability. Monetary and
fiscal policy institutions are necessary to provide an enabling environment in which private
investment can flourish. Market economies are not self-regulating, and macroeconomic
instability creates risk and uncertainty. The minimization of risk is vital if entrepreneurs are to
take informed, long-term investment decisions. An example is where Demetriades and Law
(2006) consider 72 countries over roughly twenty years using cross-sectional analysis as well as
panel approaches based on mean group and pooled mean group estimators to examine the
interaction of finance and institutions on real GDP per capita. The findings was that finance has a
greater effect on GDP per capita (growth) when rooted in a strong institutional environment.

Power of Expropriation and Growth

Furthermore is the power of expropriation. Thus institutions also determine the extent to which
those in power are able to expropriate the economys resources to their private advantage.
Unequal institutions strongly limit growth and development by reducing the capacity of
individuals to access resources, expand production and increase their incomes. For example, the
unequal landownership system in Latin America has been indicated as a fundamental cause of its
underdevelopment. There is evidence that it limits the development of greater rural employment
and higher rural incomes (World Bank, 2008, cited in Ferrini, 2012).Another example is where
the Economic Commission for Latin America (ECLA), has repeatedly flagged the importance of
land reform in the process of poverty-reducing agriculture and rural development. This also
shows that better land reform in Latin America will cause a decline in poverty and ensure growth
in the long run.

Empirically, greater equality and functional economic institutions are also seen as the cause for
the successful development of Vietnam compared to a similar country as Nicaragua, where high
inequality has concentrated power in the hands of a restricted elite, and governments have failed
to adequately invest in infrastructure and public welfare. Similarly, institutional capacity to
exploit domestic primary resources is indicated as the key to the success of Botswana and
Mauritius in comparison to other developing countries for which primary resources have turned
into a curse, like Sierra Leone who has diamonds, Angola, Equatorial Guinea and Nigeria and
more recently Ghana where they are blessed with oil ((Birdsall et al., 2005). The outcomes of
institutions have effects which lie deep in the socio-economic fabric of societies.
Institutions which are conducive to growth and development ensure greater self-expression,
allow the free flow of information and encourage the formation of associations and clubs. These
form wealthy and well-to-do social relationships, which are favorable to greater economic
interaction by increasing levels of trust and wider availability of information (Putnam, 1993,
cited in Ferrini 2012).

Thus they allow greater sharing of resources through democratic

institutions and the use of the state to reduce the risk attached to economic activity (Bardhan,
2006). The welfare state is an example of an institution which pools resources to limit the
negative effects of business cycles on incomes and unemployment. Institutions conducive to
growth and development pool resources to provide the investments in education, health and
infrastructure which lie at the basis of economic interaction and are necessary and
complementary to private investment. Informal institutions lie at the basis of an economy. They
include public agencies, trade unions, community structures and professional associations. They
make up the fabric which determines the response to laws and government decisions. Most often
they shape these outcomes themselves.

In conclusion, there is wide range of evidence that institutions are important in determining the
level of economic growth of a country. Cross-country analyses use indicators such as degree of
protection of property rights, the rule of law, and civic liberties and find that they are strongly
correlated to economic performance.
This paper has described why institutions are so important for economic growth and
development and has also provided evidence for the claims made. The paper has also identified
several channels through which the relationship between institutions and growth can be
explained. First of all, institutions determine the degree of appropriability of return to
investment. Thus protection of property rights and the rule of law spur investment and thus
increase incomes and causes growth. Moreover, Institutions also determine the scope for
oppression and expropriation of resources by elite. Hence unequal institutions which allow the
dominance of powerful elites over economic exchange strongly limit development, as can be
seen in the case of many ex-colonial countries.
Finally, institutions determine the degree to which the environment is conducive to cooperation
and increased social capital, inclusive and participatory institutions increase the flow of
information and the extent to which resources can be pooled to reduce risk and ensure sustained
levels of wealth. This fits nicely with the finding of historical studies that high quality
institutions today are rooted in greater equality, political competition and cooperative norms in
the past. Institutions strongly affect the economic growth and development of countries and act
in society at all levels by determining the frameworks in which economic exchange occurs. They
determine the volume of interactions available, the benefits from economic exchange and the
form which they can take.

Also, base on the conclusion of Rodrik, everything we know about economic growth indicates
that large-scale institutional transformation is not so necessary for getting growth started, but that
it is very important for sustaining it. Thus institutions are important to growth and development.

References
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