Economies cannot function in an institutional vacuum; otherwise there is economic (and political) chaos. At the very minimum there has to be the rule or law; the protection of property rights and constraints on power and corruption if private individuals are to be entrepreneurial, to take risks and invest.
In many developing countries, the rule of law and the protection of property rights is still rudimentary, and politicians (and bureaucrats abuse their powers. Many economists have recently argued that it is weak institutional structures that are the fundamental causes of underdevelopment because the character of institutions is the determinant of all the proximate causes of progress such as investment, education, trade and so on.
Three main ones are highlighted: the extent of legal protection of private property; the quality if governance (including the strength of the rule of law) and the limit placed on political leaders. Attempts have been made to distinguish economically the relative importance of institutions compared with other factors (including geography) in explaining different levels of per capita income across the world, with interesting, but controversial results.
Rodrick et al (2002) take a large sample of developed and developing countries, measuring the quality of institutions mainly by a composite indicator or a number of elements that, capture protection afforded by property rights, and conclude ‘our results indicate that the quality of institutions overrides everything else.
Controlling for institutions, geography has, at least weak direct effects on income …similarly trade has no direct positive effect on income,” Easterly and Lavine (2002) also test the influence of institutions compared with geography and policy variables across 75 rich and poor countries and find that institutions seem to matter most as the determinant of per capita income. Even countries with ‘bad policies’ do well with good institutions.
Defining and Measuring Institutions
What do we mean by institutions?
The term institution has been defined in different ways. Douglass North (1990) describes institutions very broadly, as the formal and informal rules governing human interactions. There are also narrow (and easier to grasp) definitions of institutions that focus on specific organizational entities, procedural devices and regulatory framework.
At a more intermediate level, institutions are defined in terms of the degree of property rights protection, the degree to which laws and regulations are fairly applied, and the extent of corruption. It is narrower than North’s definition, which includes all of the norms governing human interactions. Much of the recent research into determinants of economic development has adopted the intermediate definition.
How is institutional quality measured?
Recent empirical analyses have typically considered three relatively broad measures of institutions, the quality of governance, including the degree of corruption, political rights, public sector efficiency, and regulatory burdens; the extent of legal protection of private property and how well such laws are enforced; and the limits placed on political leaders.
The measures themselves are not objective but, rather, the subjective perceptions and assessment of country experts or the assessment; made by residents responding to surveys carried out by international organizations and non-governmental organizations.
The first of these measures, i.e, the aggregate governance index, is the average of the six measures of institutions developed in a 1999 study by Daniel Kaufman, Art Kraay and Pablo Zoido-Lobaton. These measures include
(1) voice and accountability the extent to which citizens can choose their government and have political rights, civil liberties and an independence press;
(2) political stability and absence of violence – the likelihood that the government will not be overthrown by unconstitutional or violent means
(3) government effectiveness – the quality of public service delivery and competence and political independence of the civil service
(4) regulatory burden – the relative absence of government controls on goods markets, banking systems, and international trade;
(5) rule of law – the protection of persons and’ property against violence and theft, independence and effective judges, and contract enforcement; and
(6) freedom from graft – public power is not abused for private gain or corruption.
A second measure focuses on property rights. This measure indicates the protection that private property receives. Yet another measure, constraints on the executive, reflects institutional and other limits placed on presidents and other political leaders. In a society with appropriate constraints on elites and politicians, there is less fighting between various groups for control of the state, and policies are more sustainable.
It is recognized, however, that the correlation found between institutions and economic development could reflect reverse causality, or omitted factors. We need to find a source of exogenous variation in institutions where institutions differ or change independently of other factors.
Acemoglu et el (2001) argue that the different experience of colonization is one exogenous source where at one extreme colonizers set up exclusively extractive institutions (to exploit minerals and other primary products) such as slavery and forced labour, which neither gave property rights to inhabitants nor constraints the power of elites.
This was the experience in Africa and Latin America, At the other extreme, colonizers created settler societies, replicating the European form of institutions protecting private property and controlling elites and politicians in countries such as Australia, New Zealand and North America.
Weak institutional Structures
What determines why some countries were settled and others not? Acemoglu et al argued that the major determinant was the mortality rate faced by the early settlers, and that there is both a negative correlation between past mortality rates and current institutional quality (because institutions persisted) and between past mortality and the current levels of per capita income.
In fact, over 50 per cent of the variations In per capita income across the 75 countries is associated with variation in one particular index of institutional quality whichmeasures ‘protection against expropriation.’ The authors conclude ‘There is 3 high correlation between mortality rates faced by soldiers, bishops and sailors in the colonies and European settlements; between European settlements and early measures of institutions, and between early institutions and institutions today.
We estimate large effects of institutions on income per capita using this source of variation.’ They say that this relationship is not driven by outliers, and is robust controlling for latitude, climate, current disease environment, religion, natural resources, soil quality, ethyl linguistic fragmentation, and current racial composition’. But this is where the controversy starts because presumably his mortality rates of the early settlers, which affected the nature of institutions, was strongly influenced by geography as it affects disease. in the same vein Sachs (2003) argues that the findings of Acemoglu et al.
Concerning the negative relation between mortality rates 200 years ago and per capita income today is simply licking up the pernicious effects of malaria (which stir persists), not institutions. Development is not simply about good government and institutions. institutions might make anti-poverty policies more effective, but that is all.
Poor countries need resources to fight disease; to provide education and infrastructure, and all the other resource prerequisites of development. Sachs classified three types of countries combining institutions and geography, which is a sensible approach:
- Countries where institutions, policies and geography are all reasonably favourable, e.g. the coastal regions of East Asia
- Countries with favourable geography, but weak institutions, e.g. many of the transition economies of Eastern Europe.
Countries impoverished by a combination of unfavourable geography, such as landlocked countries and those plagued with disease and poor governance, e.g. many of the countries of sub-Saharan Africa.
