The Ronald Coase Institute Institutions and Development Mary M. Shirley Presentation to ESNIE, May 2004

The Ronald Coase Institute

Institutions and Development

Mary M. Shirley

Presentation to ESNIE, May 2004


Overview of talk

• What causes underdevelopment?

• Why have so few countries been able to create institutions to foster development?

• Which institutions are needed for development?

• How can countries get these institutions?

• How can we fill the gaps in knowledge?


What causes underdevelopment?

• Institution-free explanations

• It’s the institutions.


Institution-free explanations for underdevelopment

1. Under-investment

2. Lack of technological innovation

3. Lack of education

4. Geography; resource curse

5. Poor macroeconomic policies



William Easterly, The Elusive Quest for Growth, Cambridge: The MIT Press, 2001



1. Under-investment because of lack of financing.

Harrod-Domar: this year’s growth will be proportional to last year’s share of investment in GDP.

Arthur Lewis: underdeveloped countries have surplus labor but too few machines because of a financing gap


Investment did not lead to growthGDP Growth and Lagged

Investment/GDP, 4-year averages

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

0 10 20 30 40 50

Investment/GDP at world prices

GD

P g

row

th



2. Lack of technological innovation

Technological progress causes growth (Solow).

Countries are underdeveloped because of initial small capital base.

Capital should flow to countries where capital is scarce and increase their technological progress. Poorer countries should grow faster than richer ones.


Poor did not grow faster

• Poorest three fifths of countries have had zero growth of income per person since 1981

• 70% of poor countries grew more slowly than median growth per capita of richer countries


Increase in capital stock did not necessarily eliminate underdevelopment

• Nigeria & Hong Kong increased physical capital stock per worker by 250% from 1960-1985




• Gambia & Japan increased physical capital stock per worker by 500% from 1960-1985




• Increase in output per worker:– Nigeria: 12%

– Hong Kong: 328%

• Gambia & Japan increased physical capital stock per worker by 500% from 1960-1985

• Increase in output per worker:– Gambia: 2%

– Japan: 260%


Rich got richer, poor stagnated(Maximum & minimum per capita income in richest and poorest 20% of 58 countries)

0

5000

10000

15000

20000

25000

1950 1960 1970 1980 1990 1998

maxmin


Institution free explanations for underdevelopment

3. Lack of education.

Inadequate schooling leads to less skilled labor force, low productivity and low growth.


Increased schooling of labor force did not lead to growth in developing countries

-1.0%

0.0%

1.0%

2.0%

3.0%

1960s 1970s 1980s 1990s

2

2.5

3

3.5

4

4.5

GrowthInititial Schooling



4. Geography: • Resource curse: Countries with abundant

natural resources may invest too little in more promising sectors or have more corruption, weaker governance.

• Geography raises costs of transport & communication, lowers agricultural productivity, increases population density, raises risks of dangerous diseases, etc. (Sachs)


Geography explanation doesn’t hold up

• Resource curse ignores US, Australia, or Norway; e.g 60 years of fast growth in Australia.

• Geography used to be an explanation for wealth.

• Factor endowments cannot explain changes over time: many developing countries were rich in earlier ages.


Crude Oil Production, 1857-1997 (Gavin Wright & Jesse Czelusta, Mineral Resources and Economic Development, SCID working paper, November, 2003)



5. Countries chose macro-economic policies that retard growth, such as high fiscal deficits, price controls, public ownership, high barriers to trade, etc.

• Begs the question: where do bad policies come from?


It’s the institutions

• Shortage of capital because of failure to protect property rights.

• Misdirection of investment because of high transaction costs, distorted incentives, corruption, lack of trust.

• Where governance is weak, highest returns to skills may be in less productive activities, e.g. lobbying government for favors.

• Rodrik finds that institutions trump geography and trade in growth regressions.


If it’s institutions, then

1. Why have so few countries been able to create and sustain the institutions that foster growth and social progress?

2. Which institutions must function effectively if countries are to develop?

3. How can poorer countries attain well functioning institutions?


If it’s institutions, then:



Two Kinds of Institutions Needed for Development

Encourage trade by promoting trust & lowering transaction costs

• For example, contract laws & enforcement, norms favoring trust


Two Kinds of Institutions Needed for Development

Encourage trade by promoting trust & lowering transaction costs

• For example, contract laws & enforcement, norms favoring trust

Direct the power of the state toward protecting property, not exploiting it

• For example, separation of powers, federalism, norms against corruption


Colonial heritage

Colonial heritage plus

Political conflict

Beliefs & norms

Why do countries have underdeveloped institutions?


Colonial heritage

North (1990) La Porta, Lopez-de-Silanes, Shleifer, & Vishny (1997, 1998, 1999)


Acemoglu, Johnson, & Robinson (2001a&b) Engermann & Sokoloff (1998, 2000, 2002)

Political conflict North & Wiengast (1989) Bates(2001), Herbst (2000) Nugent & Robinson (2002)

Beliefs & norms North (1994, 2002) Greif (1994) Knack & Keefer(1997)



Colonial heritage

Countries inherited poor institutions from colonial masters. Legal origins important.



Colonial heritage



• Spain brought centralized, despotic state, large bureaucracy, & tradition of elite privileges to colonies; Britain brought decentralized, limited government.

• Common law heritage countries have better protection for investors and property rights, more flexibility in face of change, greater independence of judiciary, limited state power,than countries with civil law heritage.


Colonial heritage



Countries had valuable resources/people and colonizers designed institutions to exploit


• Large population that could be enslaved & climate suited to plantation agriculture led to low settlement from mother countryand exploitative institutions

• Factor endowments interacted with colonizers’ institutions that created persistent inequality in wealth, human capital & politicalpower in some places





• Large population that could be enslaved & climate suited to plantation agriculture led to low settlement from mother countryand exploitative institutions

• Factor endowments interacted with colonizers’ institutions and created persistent inequality in wealth, human capital & politicalpower in some places. Slavery, plantation agriculture.


Colonial heritage




Political conflict Countries had too little political competition over borders or between elites; allowed rulers to build institutions to serve selfish interests





•Geography & Cold War prevented border conflicts in Africa. Elites did not have to grant concessions to citizens.

• Competition among merchant elites led them to grant property rights & franchise to smallholder farmers in Colombia & Costa Rica. Versus cooperation among landowning elites in El Salvador & Guatemala.


Colonial heritage





Beliefs & norms Countries had beliefs & norms inhospitable to markets or trust; prevented them from building institutions to encourage trade & investment



Beliefs & norms Countries had beliefs & norms inhospitable to markets or trust; prevented them from building institutions to encourage trade & investment


• Collectivist enforcement among Maghribi traders led them to rely on partnerships, community ties, ostracism to enforce bargains. Versus Genoa which relied on formal contracts, courts – and traded outside network ties.

• Norms that support cooperation even when people have no family or business or other ties reduces the cost of securing agreements. Trust correlates with growth & development.


Colonial heritage

Countries with same colonial master but different outcomes. Common law has no growth effect. Large differences in enforcement.


Ignores differences among colonial powers. No test of casual effects of institutions. Africa?

Political conflict Ignore other factors in Glorious Revolution. Case specific arguments hard to generalize.

Beliefs & norms Hard to falsify. Advice?

These explanations are not sufficient


Common themes

Institutions are critical to development

Some institutions endure for centuries

Greater equality and some political

competition led to institutions to secure

bargains and limit government






Which institutions matter for development?

Significant Variables in Growth Regressions:

Number of Studies

Protection of property rights & enforcement of contracts

7

Civil liberties 10

Political rights & democracy 10

Political instability 15

Institutions supporting cooperation (trust, religion, social clubs, etc.

4

Adapted from Aron, 2000


Which institutions matter?

Many variables are not institutions, they are:

• Outcomes (secure property rights, instability)

• Socio-economic conditions (ethnic fragmentation)

• Policies (trade barriers, black market premium)



• Large number of institutional variables are significant (nine winners in Roll & Talbott (2001) horse race)

• Institutional variables are broad aggregates or indices (rule of law)

• Rodrik: econometrically successful, but little progress in identifying underlying causal variables with precision


Common Themes

• Strong statistical evidence that institutions are significantly correlated with growth.

• Some institutions can be very long lived

• Development is associated with institutions that limit government & allow some civil liberties


Which Institutions Matter?

Past success no guarantee of future success.

Environment that allows experimentation & adaptation may be key to emergence of market supporting institutionsSome political competition and liberties, but not

necessarily democracy?







How Can Countries Change their Institutions?

• Most change is at the margin, framework stable because of:– path dependency

– norms and beliefs

• Context matters -- Imported institutions often fail:– Latin American constitutions, francophone African

educational systems, transitional economies commercial codes


How can countries change their institutions?

Experimentation & adaptation: China’s “Market Supporting Federalism” (Weingast); TVEs; goodness of fit (Levy & Spiller)

Hard for outsiders to judge success:• How supportive is institutional innovation

of movement towards an efficient market economy over long term?


Can Foreign Aid Help Countries Improve their Institutions?

Institutional economics suggests pessimism:– Fundamental institutions are long lived & path

dependent– Norms and beliefs unlikely to change because

of aid– Aid agencies support best practice, not

experimentation & adaptation – Imported institutions often fail


Aid is a poor tool for institutional reform

• Projects last for four years or less

• Measurable changes preferred

• Staff rotated every +/- every 3 years

• Staff rewarded for project approval & disbursement, not outcomes

• Counterpart is government officials


What are the effects of aid?

• Aid leads to Reforms: e.g. privatization, regulation of telecoms & electricity (Henisz, Zelner, & Guillen 2003)


What are the effects of aid?

• Aid leads to Reforms: e.g. privatization, regulation of telecoms & electricity (Henisz, Zelner, & Guillen 2003)

• Aid doesn’t lead to Growth: Aid has no impact on growth in poor policy environments & no impact on policy (Burnside & Dollar, 2000) or no effect period (Boone 1994,1996; Easterly, Levine & Roodman, 2003)


Aid & conditionality in weak institutional settings

• Laws without mechanisms for their enforcement;

• Agencies without adequate staffing, budget or mandate;

• Privatized state enterprises without competition or competent corporate governance.


Performance contracts an example of pro forma reform

• Aid disbursed in exchange for signed contract between government & SOE

• Governments failed to negotiate tough targets, demand necessary information, pay promised bonuses for good performance, impose promised punishments for bad performance, or provide promised autonomy to lay off workers or close plants


Performance Changes After the Introduction of Contracts

Return on assets

No change

Deteriorated0

4

8

12

Number of state-owned enterprises



Labor productivity

Improved

No change0

4

8

12




Total factor productivity

0

4

8

12


Improved

Deteriorated

No change


Institutions matter

• Institutions affect incentives and thus determine – how investment, technological innovation or

education are used, – which policies are chosen, – how factors are used.

• Countries have poor institutions because of historical factors.



• Depends on country’s circumstances.

• Limited government, political competition, norms that support cooperation are consistently important.

• Experimentation and innovation key.


How can countries change their institutions? - Recap

• Successful institutional changes may defy best practice or conventional wisdom

• Successful institutional changes result from experimentation by insiders

• Sustained institutional change depends on changes in beliefs

• Foreign aid seems ill suited to promote institutional innovations or change beliefs


How can we fill the gap in our knowledge?

Institutions matter, butNone of the three questions I posed can be fully

answered:1. Why have so few countries been able to create and

sustain the institutions that foster growth and social progress?





Fill the gap with a pincer movement?• Cross country studies that move from

aggregation to specificity (Keefer 2001)



Fill the gap with a pincer movement?• Analytical narratives: case studies that test

hypotheses with methodological rigor and also describe historical context, norms and beliefs and institutional adaptations (Bates, et al. 1998)

• Move from sui generis to comparative• E.g. Levy & Spiller 1995 on telecom; Ostrom

1999 on common pool resources; Shirley 2002 on urban water



Deeper analysis of institutions within developing countries (Spiller & Tomassi study of Argentina)

Critical mass of local researchers: prerequisite for understanding institutions fully, stimulating informed debate, and fostering changes in belief systems

Documents

The Ronald Coase Institute Institutions and Development Mary M. Shirley Presentation to ESNIE, May 2004