Chapter 2.

INSTITUTIONALIZATION

Institutionalization

The Industrial Revolution in Britain is not only rapid output growth (Engerman and Sokoloff 2003)Property Rights, patent system, public schools, “Limited liability” of partners in a

company:

Limited Liability

“Limited liability is a concept whereby a person's financial liability is limited to a fixed sum, most commonly the value of a person's investment in a company or partnership with limited liability. In other words, if a company with limited liability is sued, then the plaintiffs are suing the company, not its owners or investors.... The development of limited liability facilitated the move to large-scale industrial enterprise, by removing the threat that an individual's total wealth would be confiscated if invested in an unsuccessful company. Large sums of personal financial capital became available, and the transferability of shares permitted a degree of business continuity not possible in other forms of enterprise”

from http://en.wikipedia.org/wiki/Limited_liability

Institutionalization

Rules and institutions that Work Need to find low-cost methods that can easily detect and

punish violators. Such systems that work must be built (North 2002)

Penalties of violation should be sufficiently deterrent: from the perspective of economic agents, the benefit of following the rule must be greater than the benefit of violating it. Does justice work? Consider traffic:

expected cost of a ticket = probability of getting caught * amount of fine

Institutionalization

Development economists of 1950s, 60s, 70s Solow, Harrod, Domar, Lewis connected lack of development to lack of savings and accumulation of physical capital. But why do some countries accumulate capital while others cannot?

Romer and Lucas in 1980s and 90s emphasized human capital and technology. But why some countries can develop human capital and technology but others just cannot?

Today, most economists explain technological development and capital accumulation by establishing successful institutions.

Institutionalization

Question: Do rich countries have good institutions (governance) because they are rich or the causation runs the other way? That is, are they rich because they have good institutions?

According to Kaufmann and Kraay (2002) good institutions cause development, not the other way around. There are countries that are rich but could not establish good governance and institutions. Why? Usually because elites do not allow any change in status quo. Being rich is not necessary for good governance.

Institutionalization and Macroeconomics Poor economic performance (high inflation, high public debt,

low growth, high unemployment) is not a cause, it is a consequence. (Acemoğlu et al. 2002)

A major cause is weak institutional framework. 4 major elements are observed in such an economy:

1. Administrators’ authority is not limited or checked. Administrators with unlimited authority distributes resources to their own group against public interest. Unlimited authority creates a destructive fight among groups to capture political positions and rent. Those who win political control have excessive gains and those who cannot win control have excessive losses.

2. Fragility increases in economies with weak institutions

Institutionalization and Macroeconomics

3. Parties to any contract are not confident about whether the terms of the contract are going to be honored or not (why?). Therefore business volume does not grow. (uncertainty, inconfidence)

4. Finally, entrepreneurs usually prefer short-term investments that they can easily liquidate: such areas are trade, real estate speculation, commodity (foodstuffs) and financial speculation. Investors are reluctant to engage in long-term, increasing returns to scale industries such as research and development, capital goods production, energy, telecommunication, etc.

Institutionalization and Microeconomics If the firms find themselves in an environment where:

property rights are not protected laws are not enforced, they are applied arbitrarily, there is

discrimination, nepotism, favoritism there is no free entry into and exit from the markets (monopoly

powers) then most profitable industries are short-term buy & sell

speculation of commodities, real estate and securities Most crucial industries for welfare such as infrastructure: roads,

energy system, telecom systems do not develop. Bureaucracy and the rents around it grow. Individuals spend their

valuable time and money in unproductive activities such as waiting for a business permit or signature for months, paying bribes and excessive taxes and fees to government institutions. (ex: noterizing documents, certifying adress, obtaining criminal record etc.)

Institutionalization and Western Europe Why did Institutionalization flourish in Western

Europe? Theories: “De Facto political power theory (Acemoğlu et al.

2004): In middle ages, the king and the church confiscated

production factors such as land, levied arbitrary taxes, etc. İn 16th and 17th centuries with the development of the

Atlantic trade, real political power was transferred from the king and church to tradesman-businessman in Britain and other parts of Europe. Then, property rights were protected, arbitrariness of laws diminished, economic prosperity and industrial revolution followed.

Institutionalization and Western Europe Atlantic trade increased urbanization (Acemoğlu

et al.) In 1300 Urbanization on the Atlantic coast was 8%, in

Eastern Europe and Asia it was 10%. In 1850 urbanization in Western Europe was 24.5%,

Eastern Europe and Asia 17%. Urbanization facilitated and accelerated capital

accumulation. Helped develop better institutions. U. together with printing press (1450) and books allowed

dissemination and accumulation of knowledge in European cities. (Newton’s “standing on the shoulders of Giants” effect)

Institutionalization and Western Europe De Soto’s 1989 Bureaucracy theory

In the third world, it is perfectly rational to go underground because:

Table 2.1: To acquire property and to start a business (firm): Egypt: 77 stages and 31 govt. agencies which take 6-14 years. Philippines: 13-25 years. In US, 2 hours.

Bureaucracy and high costs such as taxes and lost time pushes individuals to underground: Govt. loses tax revenue as a result. Borrowers cannot borrow using their wealth as collateral b/c

wealth is not officially reported. Limited credit growth --> limited economic growth. Contracts not honored there is inconfidence.

Institutionalization and Colonies

Engerman-Sokoloff (1994) theory of Geographical Conditions:Why did North America develop while South

America lagged behind? Both had European immigrants?

South A. climate and soil was more suitable for cultivating coffee and sugar which show economies of scale. Large number of natives. Large farms employing slaves or natives. Small elites of Europeans holding a disproportionate share of wealth & land & political power.

Institutionalization and Colonies

North A.: climate suitable for grains with no economies of scale. Small free farmers could sustain themselves and own land. Smaller number of natives. Majority owns land, relatively equal distribution of power.

Equal distribution brings democracy and freedoms. Only a large middle class can demand sufficient qty of

industrial goods such as steel, communications and transportation: large fixed cost industries with economies of scale. Middle class brings growth.

Institutionalization and Colonies Equal distribution --> allows democratic system,

economic freedoms, property rights. Industrial Revolution standart industrial goods

with economies of scale, if middle class demand is sufficient, industry develops

South A. very unequal distriibution, not sufficient demand for industrial goods Imports luxury goods for rich minority, exports raw materials.

North A.: industrial goods producer, consumer and exporter.

Institutionalization and ColoniesTable 2.2: Population Distribution in colonies.

Whites are a majority in North A. : 80% in 1825. Small number of blacks and natives.

Whites make only 18% in South A. The rest are blacks and natives, used as slaves.

Table 2.3: “general per capita income” vs. “free man’s per capita income”. Eastern US: $36,6 / $38,2Caribbean and Brazil: $84 / $1200.

Institutionalization and Colonies Land ownership in 1910: Mexico %2.5, USA %75. South of USA before 1860 was similar to South

America in terms of geography, slavery, elite oligarchy. Southern US states accepted North’s institutions after they

lost the civil war of 1861-64. Slavery abolished. Southern US quickly developed.

So: Independent from initial conditions, if institutions are strong, then comes growth. But it is not enough to just copy laws, enforcement matters. Enforcement mechanisms, behavioral norms, long-term persistence.

Institutionalization and ColoniesPopulation density theory (Acemoğlu et

al.): In colonies where there is a large indigenous

population, developemnt is slow. Because natives are used as slaves and unequal distribution of power: South America, Middle Africa.

If small indigenous population, settlers settle a majority. Ex: USA and Australia.

Institutionalization and ColoniesEasterly-Levine Ethno-Linguistic Theory

to explain African growth tragedyEthno-Linguistic fragmentation prevents

institutional development. Definition: the probability of two individuals belonging to a different ethno-linguistic group

Certain group-clan assumes power, prevents development of the other groups. Confidence is minimal.

Boundaries in Africa is random, different tribes, civil war and armed clashes.

Turkey and Middle East Institutions Timur Kuran (2003,2010): Practice of İslamic

Law Legal framework for a partnership: unlimited liability of

shareholders, personal wealth can be seized-confiscated for losses. Company is not a separate entity independent from its partners. Each partner has veto power in decision-making. Small-sized and short-lived. Shares not transferable and not publicly traded.

Unlike West after the Ind.Rev.: limited liability and continuity of company by separating it from its partners and employees. Majority principle in decision-making. Transferability of shares increase the firm`s life.

Turkey and Middle East Institutions

İslamic laws of inheritance is more egalitarian than Western Europe, but causes division of capital into smaller pieces. In addition, the state confiscates a major portion of inheritance as tax.

In Europe (christianity), İnheritance is patrilineal: sons or the eldest son receives most inheritance. Women do not. This is not just or equal but it prevented division of capital and promoted its accumulation and continuity of companies.

Turkey and Middle East InstitutionsT Kuran (2004) Foundation (Vakıf) theory:

Rich individuals establish foundations (fnd) in order to protect their property from government and benefit their family and descendants after they die. Founders appoint their descendants to posts in the fnd. Fnd’s provided continuity independent from founder or employees. But fnd’s could not legally engage in trade, only in public works such as health, education, water provision, etc. Not like a company, not flexible to change activities.

In Europe, “corporate” idea was similar to fnd, but they evolved into business & trade company.

Application: Institutions of Central Asian Turkic States Why did Central and Eastern Europe develop after

1990 but not Central Asia? Kazakhstan Kirghizistan, Tajikistan,Turkmenistan, Uzbekistan.

Political Rights and Civil Freedoms Table 2.4: 1 most free, 7 least free. Elections: opposition never wins an election and govt.

never changes with elections: opposition cannot campaign or appear on media, or sometimes enter the elections. Elections are rigged.

Little freedoms of expression and press: restrictions on political, academic, religious expression.

Application: Institutions of Central Asian Turkic StatesEconomic indices and ranking:

Corruption Perceptions Index: Table 2.5 . Bribery everywhere: business, education (entering university, getting a good grade), govt agencies.

Personal connections, organized crime, poverty. Dependent Justice, largely underground system. :

Table 2.6. Property is not protected, company executives spend most of the time with bureaucrats.

Presentation topics: Study institutional development of a particular country or region.