DEVELOPMENT ECONOMICS

INSTITUTIONS
 Fundamental question: Why are some countries richer than others?

 We want to deal with income levels, not growth rates, to discern the reason. This is
because:

 Income levels represent the long-run economic performance of a nation.

 Changes in growth rates tend to be transitory; low correlation between changes in

growth rates across decades (Hall and Jones (1999)).

 Old and new growth theory (see Topic 2) tends to explain the reason as being due to
either:

 Physical capital accumulation (Exogenous)

 Human capital accumulation (Endogenous)

 Productivity (Both)

 But what causes different countries to have different accumulation and productivity?
We need to discern between FUNDAMENTAL and PROXIMATE causes of growth.

 Physical/Human capital accumulation and productivity are proximate causes of

growth  they directly influence income, but are in turn influenced by deeper
determinants of growth. The diagram on the next page shows the story I have in
mind.
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 This is the basic causality presented by Hall and
Jones (1999), that Fundamental  Proximate 
Income.
Geography Policies Culture
 However, there is a complex causality between
the fundamental determinants; broadly speaking,
there are four sources of fundamental growth in
the literature: Geography, Policies, Culture and
Institutions.

 Acemoglu et al (2004) considers Geo, Pol, Inst;

Institutions Easterly and Levine (2002) and Rodrick et al
(2002) consider Geo, Pol, Inst.

 All come out with similar results; when

controlling for institutions, the other
fundamental factors have NO DIRECT EFFECT on
current levels of income.
Proximate Causes  Therefore , all the fundamental factors work via
their effect on the institutions of a country.

 However, Sachs (2003) refutes the hypothesis for

geography; using Malaria transmission as a proxy
for geography, he finds that there is a significant
direct negative effect on level of income.
Level of Income
 Therefore, it is likely that Geography has some
direct effect on income as well.
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 INSTITUTIONS: GEO 2
 How does each ‘type’ of geography affect institutions?

 It depended on the level of inequality that conditions permitted.

 In regions with high levels of slave labour (imported or native), and very heterogeneous
populations, a legal framework was adopted that favoured the elites.

 In these regions, the majority of resources were controlled by a minority of the population. An
example are the Pampas (essentially farms) in Argentina; even though the climate was conducive to
small-scale agriculture, like in North America, the abundance of docile native labour allowed for
limited migration and thus very few ‘elites’ between which to share resources.

 The Elites created institutions that reaffirmed and protected their power (restricting suffrage,
restricting property rights, restricting popular education).

 In colonies with relatively homogenous populations, legal frameworks were adopted that ensured
relative equality.

 In North America, land was abundant, capital-intensity was low and agriculture was viable small
scale; therefore, individuals created small farms.

 Because resources were distributed equally, so was political power; the US led both universal
suffrage, enforced property rights and popular education, which ensured the persistence of
egalitarian institutions.

 Important to note that it was not necessarily the COLONIZING FORCE that determined the type of
institutions. ‘The Caribbean riddle’  British-Colonized Caribbean (Jamaica, Haiti) suffered the
same fate as Spanish-colonized Latin America.
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 Culture, how does it affect income?

 Weber argued that certain religions were more compatible with good institutions, like
capitalism, than others.

 Protestantism lent a ‘moral effect’ to labour which induced hard work and thriftiness.

 Catholicism was less congruous with the entrepreneurial spirit.

 Veliz characterises the European and Iberian cultures as:

 Iberian: Hedgehog. Focused on only one thing (preserving the catholic faith) and pursued an
‘empire of conquest’. It could be characterised by the Counter-reformation.

 Europe: Fox. Open-minded and eager, desire to establish an ‘empire of commerce’. It could
be characterised by the Industrialisation.

 Veliz also notes that culture follows people; thus, the colonizers imparted their culture
upon their colonies. Those that were colonized by West Europe received the ‘good’ culture’,
and vice-versa for Iberian colonies.

 However, this approach gives rise to the ‘Caribbean riddle’: if such a transfer of culture was
automatic and ubiquitous, why did West Europe establish extractive institutions in the
Caribbean colonies?

 Culture and religion did play a key part in forming the initial institutions of the new world,
but it was not the full explanation (use E+S endowment theory as a complement).
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 Policy, how does it affect income?:

 Sound macroeconomic policies, openness to trade, absence of capital

controls all contribute to higher levels of income directly.
 Via reducing uncertainty, stimulating trade and increasing investment.

 Also encourages the development of sound institutions; financial

liberalisation  financial development (but note the pre-requisites
noted in the topic 3 slides; need to prevent information asymmetries
and public good problems).
 Easterly + Levine (2002) use proxies for all three policy areas, and
conclude that, when controlling for both institutions and endowments,
macroeconomic policies have no effect on growth.

 Rodrick et al (2004) criticises this result, noting that E+L regress policies
(which are a flow variable) onto income levels (which is a stock
variable). It seems odd to suggest that policies have no effect.

 Still, there may well be reverse causality; it is likely that bad institutions
will create bad policy choices.
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 The Institutional view is also able to explain the ‘reversal of fortune’

that occurred in some colonizing countries but not others.

 RED=West European Colonizers, BLUE=Iberian. (S+E, 2000)

GDP P.C relative to the US in GDP P.C relative to the US in

1800 1997
Argentina (102%) Barbados (51%)
Barbados (100%) [Guestimate] Chile (42%)
Brazil (50%) Argentina (35%)
Mexico (50%) Mexico (28%)
Chile (46%) Brazil (22%)
Peru (41%) Peru (15%)
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Economic
Political De Jure Economic Performance t
Institutions t Political Power t Institutions t
Distribution of
Resources t+1

Distribution of De Facto Political

Resources t Political Power t Institutions t+1
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 Binswanger and Deininger (1997) Emphasise, with particular reference to agricultural policy,
that reforms are more likely to happen under a fiscal crisis.

 This fits in with the Acemoglu framework; a fiscal crisis changes the distribution of resources,
altering the relative political power between de jure and de facto.

 Can use the Chile example; Allende’s nationalist policies drove the country to a fiscal crisis.

 North (1994/1989) has a different view on how institutions evolve, however.

 Institutional change is driven by changes in relative prices (due to a change in population or

technology) which mean that all parties can achieve a Pareto improvement by renegotiating
the institutional mix.

 However, institutional change is everywhere an incremental process:

 Even if the formal constraints (rules, laws) can be changed overnight due to a revolution or
serious reforms, the informal constraints (norms) that lend legitimacy to the formal
constraints take a long time to evolve.

 Norms change due to entrepreneurs/individuals learning and reacting to a new environment.

The speed of this change is driven by competition intensity.

 It is possible to get stuck in a low level equilibrium trap if the ‘learning’ has been in the
‘wrong’ direction historically. Learning can only take place in the institutional context of the
time, so bad institutions set off a Path dependency.
CHILE: INSTITUTIONS + NRC
CHILE: INSTITUTIONS
CHILE: INSTITUTIONS
CHILE INSTITUTIONS
MEXICO: INSTITUTIONS
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 Acemoglu et al. (2004) provide a rather convenient example of the social

conflict view:

 The US and Mexican banking systems are markedly different:

 In 1910, the US had around 25,000 banks, all in competition with one
another.

 In 1910 (before the revolution), Mexico had only 42 banks, with 2 owning
60% of total assets.

 This was because of the concentration of political power:

 In the US, there was universal suffrage amongst white males, and hence de
jure power was allocated to those who wanted access to credit and loans.

 In Mexico, political power was highly concentrated under the Diaz regime,
and so de jure power was with those who wanted to maximise monopoly
rents and distribute those to political supporters.

 These policies lead to beneficial and harmful growth, respectively, and in

Mexico’s case, the harmful policies were sustained through the political
institutions by those with de jure power.
ARGENTINA: INSTITUTIONS +
NRC
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 ISI and chaos:

 Auty (2001) notes that there was wide scale redistribution from agricultural elites to
industrial workers via:

 Holding domestic and export prices of primary produce below World levels (hurting
exporters)

 Taxing imports to raise the price of manufactured goods (hurting consumers).

 The generous Government support to industry under the infant industry banner
retarded incentives for industry to develop efficiently.

 Instead, a culture of rent-seeking was engendered.

 Meanwhile, the previously dynamic agricultural sector had over 40% of potential
revenues extracted by the Government from 1960 – 85.

 Tradables shrank and failed to diversify as industry was effectively untradeable such
was the lack of competitiveness.

 The distorted economic structure lead to POOR INVESTMENT, POOR GROWTH, POOR
HUMAN CAPITAL ACCUMULATION, BLOATED PUBLIC SECTOR and POOR
EMPLOYMENT (manufactures tended to be capital, not labour, intensive).
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 The McKinsey Quarterly (2002) noted that whilst the 2001 crisis was
broadly due to macroeconomic factors, there were institutional
weaknesses that allowed TFP to suffer:
 In the meat processing industry (a key industry for Argentina’s ‘super-
staple’ of beef), a large scale slaughterhouse is twice as productive as a
small scale one, yet small scale slaughterhouses are able to undercut
large scale:
 This is because of a lack of fiscal control (tax system) and an excessive
level of regulation which makes informality (operating outside of the
law) an attractive route.
 In the meat processing industry, tax evasion explains up to 60% of the
TFP gap with the US, and red-tape accounts for up to 30% of the TFP
gap.
 Even in public sector jobs (teaching, social security), tax evasion is near
50%.
 Tax evasion is especially harmful as a diminished tax base means the
Government has to increase taxes on those who are paying in order to
compensate.
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MEXICO: INSTITUTIONS
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 The World Bank (2008) noted that recent Mexican TFP growth
had been poor due to poor institutions and co-ordination failures,
namely:
 High cost of infrastructure services.
 High competition from informal sector firms.
 Low investment and productive innovation (need better
education – Mexico has one of the worst track records of
education in Latin America – and R+D).
 Poor access to financial firms (suggests adverse selection and
moral hazard problems).
 A lack of accountable and transparent Government.
 Palma-Rangel (2006) note the relatively poor performance of
Mexico with respect to PROPERTY RIGHTS and RULE OF LAW,
which creates perverse incentives for entrepreneurial activities.
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