Political institutions

Question 1

2.1 Evolution of institutions over time (8) (State + voluntary organisations)

Answer 1

• North (1991) - in barter economies and tribal societies, small local networks aid exchange because there is a personal enforcement of contracts with repeat-exchange and intensive bargaining (e.g. bazaars in the Middle East)
• As trade developed in early modern Europe between 11-16th centuries and became more long-distanced, size of the market grows and transaction costs become substantial. Hence, enforcement becomes a bigger concern than in a small village-based economy
• When impersonal contract enforcement becomes important, we need effective political institutions to establish property rights to develop effective product and factor markets such as capital markets
• COMPLEXITY of institutions increased as trade became international; development of bills of exchange, printing of prices and exchange rates, marine insurance, accounting methods and notarial records
• Institutional evolution - voluntary organizations expanded trade and made exchange more productive.
• State developed to take over protection and enforcement of property rights as impersonal exchange made contract enforcement increasingly costly for voluntary organisations
• In the absence of a state that enforces contracts, personal things like religion do so
• Economic theory holds that institutions are created when it is efficient to create them, that is, when the social benefits of building institutions exceed the transaction costs of doing so (Demsetz, 1967; North, 1981).

Question 2

Institution definition (North?) - why?
Political institution definition

Answer 2

North - “a humanly devised constraint that structures political, economic and social interaction” - covers most important function of an institution, which is to govern interactions within society
Political institution - pertains to the distribution of political power within a country, determined by factors such as the form of government and the implementation of the separation of powers

Question 3

2.2 Role of state in economic development (5)

Answer 3

• What is a good government? (La Porta et al. 1999) - Lack of intervention by the government, benign regulation, low taxation, high quality of the bureaucracy, successful provision of essential public goods, effective spending, and democracy
• Phase 1: optimistic phase – (Rodrik et al. 2003) the state’s role as an ‘omniscient social welfare maximiser’
• Phase 2: pessimistic phase – the state’s role as a major obstacle to development due to corruption
• Phase 3: enabling phase – the state’s ability to formulate policy independent of corrupting influences and to implement policy effectively
• 2008 financial crisis has highlighted again the role of the state – pre-2008 there was a movement towards anti-state intervention

Question 4

2.2 Role of state in economic development - arguments FOR state intervention (5)

Answer 4

• Pessimism about the ability of markets to deliver economic change (reflected in high inequality estimates)
• State intervention should be minimal on production e.g. health, education, infrastructure, basic administration, law and order, and defence
• Economic coordination and encouragement of new ideas
• Vulnerable populations rely primarily on state action in the event of natural disasters e.g. floods, earthquakes
• In poor countries:
  o Market failure – externalities, missing markets, increasing returns on savings, public goods, imperfect information etc.
  o Reduce poverty and increase economic distribution
  o Rights to certain facilities such as education, health, and housing
  o Paternalism
  o The state is the only entity looking at the needs and rights of future generations also like climate change

Question 5

2.2 Role of state in economic development - arguments AGAINST state intervention (6)

Answer 5

• Government failure; popularised under Thatcher, rolled back the state
• Individuals know more about their individual preferences than the state – asymmetric information
• Government controls may prevent private-sector initiatives
• Different parts of government are poorly coordinated
• Controls create incentives for rent-seeking or ‘directly unproductive profit-seeking’ activities (DUPs) – e.g. lobbying/’wining and dining’ officials for import licenses for example, a waste of resources
• Public choice theory

Question 6

2.3 Extractive vs inclusive institutions (Acemoglu & Robinson)

Answer 6

• Acemoglu & Robinson characterise political institutions into being either:
  o Extractive - power concentrated in hands of a few
  o Inclusive - broad political participation encouraged & constraints placed on politicians to limit their influence over economic decision-making

Question 7

2.3 Evaluating the success of state intervention through empirical analysis - India (1:1, 1:3)

Answer 7

• In the 1960s and 1970s, the failures of development planning were widely recognized (soviet planning for example)
  o 5 year plans based on Russian system, ended up constraining growth rates
• Causes for poor plan performance:
  o Ambitious targets, inadequate resources, irregular flows of development aid, and institutional weakness
  o The political system is dominated by rich farmers, big businesses and unionised workers of the organised sector
  o Local bureaucracy who belong to rural elite undermine the effects of national policy

Question 8

2.3 Extractive political institutions - Sierra Leone (5)

Answer 8

• Extractive political institutions in Sierra Leone have inhibited development - political structure has meant that economic agents in rural areas have virtually no political power
• Power imbalance allows members of elite to extract from rural farmers through marketing boards established in 1949, which serve as an avenue for heavy taxation
• Disincentivises farmers to investing in technologies, using fertilisers to preserve soil - limits productivity improvement in the economy
• Institutions clearly harmful to development - preventing growth in GNP per capita whilst worsening rural-urban inequality
• Moreover, extractive political institutions likely to have cyclical impacts on economic decisions
  o Ruler who inherit extractive political institutions incentivised to perpetuate structure for their benefit, in turn harming future generations

Question 9

2.3 Evaluating the success of state intervention through empirical analysis - South Korea (3)

Answer 9

• ‘Governing the market to get the prices right’ (Wade, 1990)
• Picking winners, protecting infant industries (e.g. semiconductors), and promoting exports
• Policy instruments used promotionally rather than restrictively – the government shut down any industries not performing and reaching target export volumes

Question 10

2.4 Key areas the state in poor countries must target (4)

Answer 10

• Essential areas: education, health, infrastructure
• Important, but more controversial areas: land reform, industrial development
• The state should guide the market, ensuring that the objectives of policy do not conflict with the instruments of policy
• ‘The task is to dismantle the disabling state, and to establish the enabling state’ (Colclough & Manor 1991)

Question 11

2.5 Relationship between governance and growth (7)

Answer 11

• Democratisation has been sweeping across the developed world as reflected in governance indices.
• ‘LIPSET HYPOTHESIS’ (1959) – prosperity / increases in living standards generate a rise in democracy
  o Educated people are more likely to resolve their differences through negotiation and voting than through violent disputes. Education is needed for courts to operate and to empower citizens to engage with government institutions.
• Barro (1996) - Favourable effects on growth of democracy include:
  o maintenance of the rule of law
  o free markets
  o small government consumption
  o high human capital
  However, this effect is weakly negative - more democracy enhances growth at low levels of political freedom but depresses growth when moderate level of freedom has already been achieved.
• Politicians have an incentive to reflect the will of the people
• Corrupt politicians who know they can be voted out may steal as much as possible
• In autocracy, there are fewer constraints, and can pursue long-term development strategies (Singapore, South Korea, Taiwan, China)
• Relationship between democracy and growth is not robust but democracy is good for broader development objectives such as equity, education, health, famine prevention

Question 12

2.5 Relationship between governance and growth (Barro, 1996) (7)

Answer 12

• Growth and democracy are analysed for a panel of about 100 countries from 1960-1990
• Favourable effects on growth include the maintenance of the rule of law, free markets, small govt. consumption, and high human capital.
• Barro attempts to examine the relationship between democracy and growth - STRONGLY REJECTS the linearity assumption.
• The results indicate that the middle level of democracy is most favourable to growth, the lowest level comes second and the highest level comes third. The strongest part of this finding is the superiority of the middle level over the other 2, the highest and lowest groups do not have statistically different growth rates.
• Similar conclusions emerge if democracy indicator is entered directly in a quadratic form. The growth rate reaches a peak in the middle level of democracy, the point estimate is 0.47, and then diminishes if democracy continues to rise.
• From the regression that tries to test the hypothesis that prosperity stimulates the development of democratic institutions, there are significantly positive coefficients on log(GDP) of 0.054 (0.024) and on log(life expectancy) of 0.37 (0.12), with the dependent variables being the averages of the democracy indexes over three periods; 1965-75, 1975-84, 1985-93 - indicate that the target level of democracy is increasing in these indicators of the standard of living.
• The more general conclusion is that the advanced western nations would contribute more to the welfare of poor nations by exporting their economic systems, notably property rights and free markets, rather than their political systems, which typically developed after reasonable standards of living had been attained. So, in the long run, the propagation of Western economic systems would seem to be the effective way to expand democracy in the world.

Question 13

2.5 Criticisms of Barro (1996) - why might democracy be better? (3)

Answer 13

• Democracy may stimulate growth by affecting some of the explanatory variables held constant in Barro’s regression
  o e.g. widespread political rights promote females entering education - in turn, reduces birth rates which may promote growth
• Conversely, in an autocracy, high possibility for corruption, incentive to extract as much as possible e.g. Marcos administration in the Philippines - World Bank (1989) estimates $5-10 billion in ill-gotten wealth
• Thus, democracy may be desirable for other reasons - may exist an equity-efficiency trade-off

Question 14

2.6 Do political institutions cause growth or does human capital matter more? - How to measure political institutions? 6)

Answer 14

• (1) Survey indicators of institutional quality, e.g. law and order, bureaucratic quality, corruption
• (2) Survey assessments of government effectiveness e.g. competency of civil servants, credibility of government policy
• (3) political scientists’ constitutional measures on the limits of executive power e.g. Polity IV dataset - includes variables such as executive constraints, competitiveness of Executive Recruitment, political participation and rule of law
• All measures rise with per capita income and are highly volatile hence difficult to contend that they are good measures to establish causality
• First 2 measures: dictators who choose good policies receive as high valuations as governments constrained to choose them
  o Singapore and USSR who respected property rights receive high scores for example
• Constitutional measures (3rd) are ‘noisy’
  o Out of a score of 7, India, Botswana and South Africa get perfect scores of 7
   Very different countries and contexts
  o China scores 3, Cuba and North Korea score 1
   Yet China has grown tremendously

Question 15

2.6 Do political institutions cause growth or does human capital matter more? Do institutions cause growth? - the debate (6)

Answer 15

• Debate about whether political institutions cause growth or whether growth and human capital accumulation lead to institutional improvement and democracy
• One view: democracy and other checks to constrain government secure property rights (Smith 1776; North 1991; Rodrik et al. 2004; Acemoglu, Johnson, Robinson 2001).
• Alternative view: Human capital is more basic source of growth than institutions (Lipset 1959, Glaeser et al. 2004).
• Human capital empowers citizens, spreads knowledge, affects institutions through stocks of human and social capital
• Poor countries get out of poverty through good policies often pursued by dictators and subsequently improve their political institutions
• Accords well with South Korea, Taiwan, China, which all grew under one party dictatorships

Question 16

2.6 Do political institutions cause growth or does human capital matter more? View 1 - Institutions Matter (Acemoglu, Johnson, Robinson 2001 & 2002) (13)

Answer 16

• A negative association between economic prosperity in 1500 and today (Acemoglu, Johnson and Robinson, 2001 and 2002) – so countries doing well in 1500 doing comparatively worse today relative to everyone else – institutional reversal
• In understanding a nation’s political institutions, it is whether they themselves settled in particular colonies, and not what laws the Europeans brought
• The mortality of European settlers in the countries they colonized shaped their decision to settle or not
• When the Europeans settled, they brought with them effective European institutions constraining the executive, whereas when they did not settle, they instituted systems of arbitrary rule and expropriation of local populations
• In the case of the US, New Zealand and Australia, they settled and set up institutions that enforced the rule of law and encouraged investment, but in the Congo, they set up extractive states with the intention of resource extraction
• The density of non-European populations in the prospective colonies shaped the European settlement patterns (e.g. US not dense so settled there)
• When a region was densely settled by the locals, the Europeans did not settle themselves, but rather introduced exploitative institutions
• In low-density areas however, they settled and brought with them their institutions of limited government, thereby causing long run growth (e.g. USA)
• Using this logic, both settler mortality and indigenous population density in 1500 can be used as instruments (exogenous proxies for institutions) for modern day political institutions constraining the executive
• AJR – Countries with better ‘institutions’, more secure property rights and less distortionary policies will invest more in physical and human capital – will use these factors more efficiently to achieve a greater level of income
• Institutions matter to the development of economies – explore the divergent paths of North and South Korea, or East and West Germany –> one part of the country stagnated under central planning and collective ownership; other prospered with private property and a market economy
• Acemoglu, Johnson and Robinson – (potential) settler mortality –> Settlements –> Early institutions –> Current Institutions –> Current Performance
• Curtin’s work on mortality rates is used in order to explain the mechanism described above —> settlers were well informed about the mortality rates despite not knowing how to control the diseases that caused these mortality rates

Question 17

2.6 Do political institutions cause growth or does human capital matter more? View 1 - Institutions matter (Acemoglu, Johnson, Robinson 2001 & 2002) - REGRESSION (13)

Answer 17

• The regression done by AJR shows that mortality rates faced by settlers more than 100 years ago explains over 25% percent of the variation in current institutions.
• They also find a strong negative relationship between the logarithm of GDP per capita today and the logarithm of settler mortality rates per thousand for a sample of 75 countries. To try and see if this is effect is working through the institutions brought by the Europeans, they then perform a two stage least squares regression by regressing current performance on current institutions and instrument the latter by settler mortality rates.
• They document that this relationship works through these channels: (potential) settler mortality rates were a major determinant of settlements; settlements were a major determinant of early institutions (in practice, institutions in 1900); and there is a strong correlation between early institutions and institutions today.
• They do this using the ‘protection against risk of expropriation’ from Political Risk Services as a proxy for institutions
  o Ordinary Least-Squares Regression – log per capita income on the protection against expropriation variable

log yi = μ+ αRi + Xi ‘γ+ i

yi=income per capita in country i
Ri =protection against expropriation measure
Xi ‘=Vector of other covariates
α=0.54 (World Sample-110 Observations→R2=0.62)

• The 2SLS estimate of the impact of institutions on income per capita is 0.94 – this estimate is highly significant with a standard error of 0.16 – measurement error in the institutions variable that creates attenuation bias is likely to be more important than reverse causality and omitted variables biases.
  o The coefficient mentioned earlier (0.54) is for income per capita against the protection against expropriation measure – the value of 0.94 is for the 2SLS which allows the comparison between settler mortality and income per capita (done with 2 stages of regression – initially settler mortality vs. protection against expropriation risk and then income per capita and expropriation risk)
• Validity of 2SLS depends on the assumption that settler mortality in the past has no direct effect on current economic performance (results change remarkably little with the inclusion of these variables)
• In the paper ‘reversal of fortune’ by Acemoglu et al., written in 2002 after the 2001 paper ‘The Colonial Origins of Comparative Development’, they run a regression to see if, as they hypothesise, it is through the channel of institutions that explains why among countries colonized by European powers during the past 500 years, those that were relatively rich in 1500 are relatively poorer now. Their reasons for this are that:
  o European colonisers were more likely to introduce institutions encouraging investment in regions that were previously poor
  o Relatively poor regions were sparsely populated, and this enabled or induced Europeans to settle in large numbers and develop institutions encouraging investment.
  o Large population and relative prosperity made extractive institutions more profitable for the colonizers; for example, the native population could be forced to work in mines and plantations, or taxed by taking over existing tax and tribute systems
• Interested in hypothesis that i.e. population density or urbanization in 1500 affects income today only via institutions.
• Measure of institutions is mortality rates faced by settlers; in areas with high mortality Europeans did not settle and were more likely to develop extractive institutions (CRIT: IS THIS A FAIR MEASURE OF INSTITUTIONS?)
• Regression includes time effects, country effects, measurement of institutions, industrial output in the UK, error
• Summary: institutions played an important role in the process of economic growth and in the surge of industrialization among the formerly poor colonies, and via this channel, account for a significant fraction of current income differences
• While societies with extractive institutions or those with highly hierarchical structures could exploit available agricultural technologies relatively effectively, the spread of industrial technology required the participation of a broad cross section of the society-the smallholders, the middle class, and the entrepreneurs. The age of industry, therefore, created a considerable advantage for societies with institutions of private property.

Question 18

2.6 Do political institutions cause growth or does human capital matter more? View 2 - Alternative View - Human Capital matters more (Glaeser et al., 2004) (15)

Answer 18

• Human capital matters more (Glaeser et al. 2004)
• Initial level of human capital and average level of institutional quality predict level of economic growth
• Institutional quality rises as country grows richer
• If control in regression for an average level of human capital and average level of institutional quality, this is what causes growth
• The initial level of constraints on the executive do NOT predict subsequent economic growth (this is what those with view 1 concluded), unlike the initial levels of human capital, which do
• Even if institutions play a role, it is human capital working through institutions
• Glaeser et al. suggest that commonly used measures of institutions cannot be used to establish causality. These measures are not constructed to reflect either constraints on government or permanent features of the political landscape, instead they are highly volatile and mean-reverting. They are barely correlated with the available objective measures of constitutional constraints on government. Yet these are the variables used by Acemoglu, Johnson and Robinson to show that institutions cause growth.
• The poorest countries in the world in 1960 all had uneducated populations and dictators, and a variety of growth rates
• The evidence they produce does show a strong correlation between economic growth over a period and the average assessments of institutional quality over that period, including constraints on the executive, risk of expropriation, government effectiveness and autocracy.
• Glaeser et al. also refute the Acemoglu, Johnson and Robinson argument that settler mortality and population density in 1500 predict institutional quality and economic development today
• Europeans who came to the new world brought their institutions but more significantly themselves and their human capital (Glaeser et al. 2004), which is correlated with their institutions
• To put it econometrically, valid instruments must be uncorrelated with the error term, and if settlement patterns influence growth through channels other than institutions, they are not valid instruments. The instrumental variable approach does not tell us what causes the growth.
• Hence human capital is more important for growth than constraints on the executive.
• Glaeser at al conclude by saying that while they agree that institutions do matter, but suggest the current measurement strategies have conceptual flaws
• For policy, they state that democratization and putting constraints on government may not be the best policy option for growth for developing countries, instead they should focus on developing human and physical capital accumulation. After this, as East Asia countries have done, they can go successfully form dictatorships to more democratic. In accordance with the Lipset hypothesis, the paper says that countries emerging from poverty accumulate human and physical capital under dictatorships, and then, once they become richer, are increasingly likely to improve their institutions.

Question 19

2.6 Do political institutions cause growth or does human capital matter more? View 2 - Alternative View - Human Capital matters more (Glaeser et al., 2004) - other effects of colonial settlement 6)

Answer 19

• Effects work through many channels other than human capital or political institutions
• Timing: it could be that both institutions and human capital are more important, but which comes first?
• Glaeser et al. (2004) data shows that from 1960-2000 across 89 countries:
  o Initial levels of schooling are a strong predictor of improving institutional outcomes
  o Initial per capita income has no predictive power on institutions
  o Mean reversion exists in these measures of institutions (unstable in short run but very stable in the long run)
• These findings are consistent with the Lipset (1959) view that high human capital lead to institutional improvement
• But good political institutions do not predict subsequent improvement in years of schooling
• Conclusion:C

Question 20

2.7 Conclusion on institutions (9)

Answer 20

• Countries that emerge from poverty accumulate human and physical capital under dictatorships, and then, once they become richer, are increasingly likely to improve their institutions
• Political institutions evolved historically as the complexity of transactions increased
• Some relationship between increasing prosperity and democracy
• Role of the state is clearly important – Smith’s ‘prudence, justice, and beneficence’
• But in what and how should the state invest? Institutions or human capital?
• Economists’ debate about whether political institutions cause growth
• Human capital is the alternative, but other channels also important
• Sriya Iyer’s view: Human capital investments and institutions may reinforce each other
• Moral of the story – institutions rule, but only if accompanied by education