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Institutions and Economic Growth: Theoretical and Methodological Issues
By
Kilishi, A.A. (Ph.D)*, Yakubu, A.T., Mobolaji, H.I. (Ph.D) and A. M. Yaru,
*corresponding author: Kilishi A. Abdulhakeem
Department of Economics
University of Ilorin,
Ilorin Nigeria.
e-mail: [email protected]
phone: 08050221980
Abstract
Issues surrounding the study of institutions and economic growth are discussed in this paper. It is
shown that despite the voluminous literature on institutions, issues such as conceptualization of
institutions, absence of unified theoretical framework, handling endogeneity problem, and
unbundling the impact of specific institutions still remain unresolved. Thus, questions such as
which of the institutions matter most, why are institutional quality differ across countries, and is
the relationship observed between institutions and growth depict causality will remain relevant
research issues for the next few years.
Keywords: institutions, growth, empirical challenges
JEL Classification: B52, O43
1. Introduction
There is abundant evidence in the literature that institutions that shape the incentives of people
are the fundamental cause of differences in economic performance across countries (see for
example: Mauro (1995), Knack and Keefer (1995), Hall and Jones (1999), Acemoglu, Johnson
and Robinson (2001, 2002) and Rodrik, Subramanain and Trebbi (2004)). However, there are
number of challenges in the study of institutions – growth nexus. First is the issue of
conceptualization which borders definition and measurement of institutional variables. The
second issues is the explicit absence of institutions in the orthodox neoclassical economics
framework. Hence, the argument that institutions matter mostly come from empirical analyses
based on extended or augmented neoclassical growth models. This is because there is not yet any
well articulated theory on institutional economics that can replace existing neoclassical
framework. Eirik and Rudolf (2003), and Varian, (1993) argue that the difficulties surrounding
the construction of new framework which is comparable in scope and detail with the general
equilibrium models of neoclassical theory are very great and may not be overcome now. Thus,
one of the criticisms of institutional economists is that their arguments are based only on
empirical evidence and without theoretical back up. However, there are attempts by a number of
institutional economists to expand the neoclassical models so as to integrate institutions into the
neoclassical framework. The third challenge in the literature of institutions is the reliability of the
empirical evidences. This doubt is due to three main problems: (i) problem of measuring bias;
(ii) problem of endogeneity and (iii) problem of specificity.
This paper intends to discuss issues/challenges and efforts made in the study of institutions.
Thus, the paper answers questions such as: (i) what are challenges in the study of institutions?
(ii) how have researchers tried to work around these challenges? (iv) what are the limitations in
the current efforts to circumvent these challenges? and (v) what is the research agenda in
institutional economics for next few years? Therefore, the paper is divided into six sections,
following this introduction is the conceptual issues. Section three presents theoretical issues,
while empirical and policy issues are discussed in sections four and five respectively. Finally,
section six concludes the paper.
2. Conceptual Issues
Conceptual issues in the study of institutions surround correctly defining what institutions are
and accurately measuring them. In this paper, we discuss the challenges of definition and
measurement of institutions as well as the efforts in the literature to over come these challenges.
2.1 What are institutions?
One of the major difficulties in the study of institutions is the absence of widely acceptable
definition of the concept. This is made more difficult because institutions are studied by people
from different disciplines such as economics, philosophy, sociology, politics, law and geography.
Therefore, the concept means different things to different people. Chang (2005) identifies some
of the reasons why it is difficult to come up with a consensus definition of institutions. First, an
institution may perform more than one function. For example, political institutions perform a
number of functions such as distillation of different opinions into a decision, conflict resolution,
provision of social cohesion, designing economic policies and nation building. Second, a number
of institutions may serve the same function, for example, macroeconomic stability is achieved
not simply by an independent central bank but also by a host of other institutions, such as
budgeting, financial regulation, wage and price setting institutions. Third, the same function
could be served by different institutions in different societies or in the same society at different
times. Another difficulty in the definition of the concept is the problem of clearly distinguishing
between forms of institutions (e.g. democracy, judiciary and market system) and the functions
they perform (e.g. rule of law, respect for private property right, enforceability of contracts,
maintenance of price stability, restraint on corruption).
One of the most widely accepted definition of institutions was given by North (1990). According
to him “institutions are the rules of the game in a society or, more formally, are the humanly
devised constraints that shape human interaction. In consequence they structure incentives in
human exchange, whether political, social, or economic” (North, 1990, p. 3). They consist of
formal rules (for example, constitutions, laws, property rights), and informal constraints (for
example, sanctions, taboos, traditions, customs, norms of behaviour, conventions and codes of
behaviour) as well as their enforcement characteristics. In other words, they consist of the
structure that humans impose on their dealings with each other and the extent to rules are
enforced. Institutions often establish the constraints, determine the costs and benefits under
which individuals take decisions. The extent of constraints and the choices individuals make in
different institutional settings depend on the effectiveness of their enforcement. Good rules that
are poorly enforced would result to inefficient institutional framework. On the other hand, bad
rules that are effectively enforced would also end up in sub-optimal equilibrium. Institutions are
constitutive rules and practices prescribing appropriate behaviour for actors. They empower and
constrain actors differently and make them more or less capable of acting according to prescribed
rules of appropriateness. The core perspective is that institutions create elements of order and
predictability. Hence, institutions reduce uncertainty in society by establishing a stable structure
to human interaction.
2.2 How are Institutions Measured?
Like the definition of institutions, there is no universal agreement on the measurement of
institutions. Glaeser et al (2004) pointed out that must of the measures of institutions used in the
literature are measures of outcome rather than institutions. However, much efforts have been
made and some progress are recorded. In this section therefore, we discuss some of the popular
measures of institutions.
The prominent measures of institutions used in the literature include: protection against
expropriation risk; index of social infrastructure; International country risk guide (ICRG);
business environmental risk intelligence dataset; Index of institutional efficiency; Index of
bureaucratic efficiency; property rights; governance; political institutions; contracting
institutions; index of business environment; legal system and labour market institutions among
others. Difference data sources provide different indicators for these measures.
Institutions quality are either measure via ‘hard’ or ‘soft’ evaluations. Hard evaluations are based
on records from written document which are verifiable and not subject value judgment. On the
other hand, soft evaluations are based on perceptions of experts, managers of big companies and
other key participants in an economy. Hard evaluations are usually free of subjective biases but
the problem of this measure is that such evaluation do not completely capture the institutional
environment targeted. Meaning that the measure of institutional quality evaluated through the
hard approach do leave something out in the institutional environment. For example,
enforcement or implementation of rules and regulation are not usually capture in hard evaluation.
For instance does the presence of corruption fighting agents like EFCC, ICPC in Nigeria implies
there will less corruption compare to countries where similar agency are absence? The
alternative method of approach, soft evaluation has the advantage of capturing many things in
the institutional environment that could not be captured in hard evaluation. However, soft
evaluations are subject to subjective biases, for example, many people are likely to judge a
country to be highly corrupt during or after economic crisis.
The other concern is that institutions supposed to be reasonably permanent or durable. Glaeser et
al (2004) argued that some of the measures of institutions used in the literature rise with per
capita income and are highly volatile. This implies that these measures do not measure
permanent or durable features of institutional environment. Pande and Udry (2006) observed that
measures of institutions are coarse and urban-based. That is, most measures of institutional
quality are aggregate measures and relate to institutional environment faced by businesses and
individuals in the more formal urban sector. Thus, the question is, to what extent do measures of
institutions really measure the indicators they are supposed to measure?
3. Theoretical Issues
Adam Smith, the father of modern economics, made some allowance for rules and principles,
however, the development of the profession of economics focuses on invisible hand and almost
unconsciously neglected other methods of coordinating human interaction. The analytical
framework of the neoclassical economics is based on the fundamental assumption of a
‘spontaneous order’, mechanisms through which a good result would be achieved without an
authority giving central command. In this framework information and other transaction costs are
assumed to be free. Thus, with the construction of general equilibrium model by Leon Walras,
price mechanism moves to centre stage in economic analysis and became ever more refined
through the analysis of Hicks, Samuelson and Arrow–Debreu. Other forms of human relations
than the price system, such as rules and principles, political decisions and collective group
actions, were crowded out of the profession.
The first economic scientist to discover the lacunae was Coase (1937), he explained that
transaction costs had been omitted from economic analysis. North (1990) argued that “the
costliness of information is the key to the costs of transacting, which consist of the costs of
measuring the valuable attributes of what is being exchanged and the costs of protecting rights
and policing and enforcing agreements. These measurement and enforcement costs are the
sources of social, political, and economic institutions”. Having identified the limitation of
neoclassical framework and the importance of institutions in explaining human behavior, the
next biggest challenge is how to whether integrate institutions into the neoclassical framework or
to construct new theoretical framework that will replace the neoclassical framework. Meanwhile,
Eirik and Rudolf (2003) noted that the difficulties surrounding the construction of new analytical
framework which will be comparable in scope and detail with the general equilibrium models of
neoclassical theory are very great and may not be overcome now. The other alternative is to
modify the existing orthodox framework to accommodate institutions. In what follows, we
discuss some the efforts made to integrate institutions into the main stream economic analysis.
North was the first to attempt to formally build theory of institutions. Many of his early
contributions centered on American economic history. His most important first attempt that
shows the limits of neoclassical economics and the role of institutions was “Institutional change
and American Economic Growth (1970, co-authored with Lance Davis). As mentioned earlier,
most application of neoclassical economics take property rights, institutions and rule of the game
as given. Davis and North (1970) demonstrated that capturing gains from exchange often
required changes in property rights and the invention of new institutional arrangements and
forms of economic organisation. In doing so, they provided a new interpretation of American
economic growth from the perspective of how economic agents pursued profit opportunities by
changing the rules. Seen in this way, much of American economic growth occurred not simply
because of neoclassical considerations such as factor accumulation but also because of
complementary process of institutional evolution. They therefore, develop a theoretical model of
institutional innovation. They use the model to explain how institutional arrangement influence
main sources of income growth such as economies of scale, risk management, dealing with
externalities and correcting market failure.
In another study North and Thomas (1973) attempt to identify the elements that allowed the
Western European economy to rise to affluence. They argued that traditional of growth such as
capital accumulation, technology and economies of scale are not the causes of economic growth
but inherent parts of the growth process. They argued further that the fundamental cause of
economic growth was and is an efficient economic system. Efficient in the sense that the system
of property rights give individuals incentives to innovate and produce, and conversely inhibits
those activities (rent-seeking, theft, arbitrary confiscation and/or excessive taxation) that reduce
individual incentives.
North (1990) leads to a deeper understanding of the role of institutions. He argues that
institutions exist due to the uncertainties involved in human interaction; they are constraints
devised to structure that interaction. Yet, institutions vary widely in their consequences for
economic performance; some economies develop institutions that produce growth and
development while others develop institutions that produce stagnation. This is because the choice
of formal institutions is made within the political system where transaction costs are very high.
The situation is also complicated by the fact that the political system is the arena for clashes
between different interest groups.
North (1992) summarises his ideas of how institutions evolve and the way they shape economic
performance. Institutions, together with the technology employed, determine the cost of
transacting and producing. He concludes his analytical framework by summing up the key
features of institutional change as: (i) The continuous interaction between institutions and
organisations in the economic setting of society and hence competition is the key to institutional
change; (ii) Competition forces organisations to continually invest in skills and knowledge to
survive. (iii) The institutional framework dictates the kind of skills and knowledge perceived to
have the maximum payoff; (iv) The mental constructs of players, given complexity of the
environment, limited information feedback on consequences of actions, and the inherited cultural
conditioning of players, determine perceptions; and (v) The economies of scope,
complementarities and network externalities of an institutional matrix make institutional change
overwhelming incremental and path dependent.
Another landmark contribution to the development of theory of institutions and institutional
changes is the work of Acemoglu, Johnson and Robinson (2001, 2002). They propose a theory of
institutional differences among countries colonised by Europeans and exploit the theory to derive
a possible sources of exogenous variation. Their theory rests on three premises:
i. There were different types of colonisation policies which created different sets of
institutions. At one extreme, European powers set up ‘extractive states’, exemplified by
the Belgian colonisation of the Congo. These institutions did not introduce much
protection for private property nor did they provide checks and balances against
government expropriation. The main purpose of the extractive state was to transfer as
much of the resources of the colony to the coloniser. At the other extreme, many
Europeans migrated and settled in a number of colonies, creating what the historian
Crosby (1986) calls ‘Neo-Europes’. The settlers tried to replicate European institutions,
with strong emphasis on private property and checks against government power. Primary
examples of this include Australia, New Zealand, Canada and the United States.
ii. The colonisation strategy was influenced by the feasibility of settlements. In places where
the disease environment was not favourable to the European settlements, the cards were
stacked against the creation of Neo-Europes and the formation of the extractive state was
more likely.
iii. The colonial state and institutions persisted even after independence.
Their theory can be schematically summarised as:
Potential settler mortality
Settlements
Early Institutions
Current Institutions
Current Performance
The argument is that current institutional differences across countries are highly influenced by
the early institutions setting established by the European colonisers. The early institutions were
influenced by the settlement of the Europeans, determined by the mortality rates they faced.
Acemoglu, Johnson and Robinson (2004) consider political economy dimension of how
institutions emerge and their impact on economic growth. They started the theory on the basic
assumption that economic institutions determine the incentives of and constraints on economic
actors and shape economic outcomes. As such, institutions are social decisions, chosen for their
consequences. Because different groups and individuals typically benefit from different
economic institutions, there is generally a conflict over these social choices, ultimately resolved
in favour of groups with greater political power. The distribution of political power in a society
is in turn determined by political institutions and the distribution of resources. Political
institutions allocate de jure political power while groups with greater resources typically possess
greater de facto political power. The analytical framework is schematically presented as:
Political
institutio𝑛𝑠𝑡
De jure
political
powe𝑟𝑡
Economic
institutio𝑛𝑠𝑡
Economic
performanc𝑒𝑡
&
Distribution
of resource𝑠𝑡
De facto
political
powe𝑟𝑡
Political
institutio𝑛𝑠𝑡+1
Distribution
of resource𝑠𝑡+1
While political institutions determine the distribution of de jure political power in a society, the
distribution of resources influences the distribution of de facto political power at time 𝑡. These
two sources of political power, in turn, affect the choice of economic institutions and influence
the future evolution of political institutions. Economic institutions determine economic
outcomes, including the aggregate growth rate of the economy and distribution of resources at
time 𝑡 + 1. Thus, though economic institutions are the essential factor shaping economic
outcomes, they are themselves endogenous and determined by political institutions and
distribution of resources in the society.
Recently, many developing countries particularly in African have experienced transition from
non-democratic to democratic political system, yet there is no significant improvement in
economic performance of majority of them. Acemoglu and Robinson (2008) extend their
political economy model to explain why changes in political institutions may not lead to changes
in economic institutions and performance. They argue that the transition only alters the
distribution of de jure political power but creates incentive for investment in de facto political
power which offset the gains from changes in de jure power.
In all of these efforts game theory is the key tool of analysis and close marriage between
economics with other social sciences is also evident. Though there is no controversy today that
institutions matter, the full integration of institutions into main stream microeconomics as well as
macroeconomics is yet to be achieved.
4. Empirical Issues
Introduction of institutional variable in the augmented growth model creates two critical
empirical problems. First, specification bias resulting from measurement error pose some
estimation challenges. Institutional variables are measured with error, or as mentioned earlier
measures of institutions, correspond only poorly to what is desired. Second and most important is
endogeneity problem due to possible reversed causality between growth and institutions.
Countries that have effective and efficient institutions are rich and it is rich countries that good
institutions. On the other hand poor countries have weak and inefficient institutions. It could be
that relationship between institutions and income reflect reverse causality. That is, rich countries
have good institutions because they can afford them. These two issues make OLS estimation to
biased and not reflecting real causality.
Researchers have tried to used different techniques so as to circumvent some these problems.
Most people resulted to Instrumental Variable (IV) estimation. However, the major challenge of
using IV is getting good instrument that fulfills the autogonality condition. Some of the
prominent instruments used in the literature include settler mortality (see Acemoglu, Johnson
and Robinson 2001, 2002; Acemoglu and Johnson 2005; Alcala and Ciccone, 2004; Rodrik,
Subramanian and Trebbi 2004); legal origin (used in Acemoglu and Johnson 2005; Aghion,
Howitt and Mayer-Foulkes 2005; Glaeser, La Porta, Lopez-de-Silanes and Shleifer 2004);
ethnolinguistic fractionalization was used in Mauro 1995, while Clague, Keefer, Knack and
Olson 1999 and Knack and Keefer 1997 used ethnolinguistic homogeneity. Other instruments
commonly used are distance from equator, proportion of people who speak English or European
language, colonial origin, oil exporter and predicted trade shares. The first challenge for using all
these instruments is that it is rear to find an instrument that is important determinant of current
institutional quality and affect growth only through institutions. Secondly, it is not clear in the
literature which measure of institutions do each of these instrument plausible serve as good
instrument. For example, settler mortality has been used as instrument for protection against
expropriation, executive constraints, index of rule of law and other measures of institutions in
different studies by different authors.
5. Policy Issues
Most studies on the relationship between institutions and economic performance are either cross
country or panel data studies. This is due to non-availability of long time series data for most
measures of institutions. However, institutions vary from country to country or even from region
to region of the same country. It therefore becomes difficult to draw specific policy
recommendations from either cross country/panel studies (which is the case for most institutions
– growth papers) or macro study. The second issue that makes specific policy not easy is the fact
that most measures of institutions are aggregated. Hence if institutions cause growth it is not
clear of them is doing the job.
The key conclusion from literature on institutions is that differences in economic performance
across countries is largely explain by differences in the quality of institutions. This implies that
poor countries can become rich by acquiring good and effective institutions. However, till now it
not clear in the literature how good institutions can be acquired.
6. Concluding Remarks
The roles of institutions in economic performance of any society is not controversial. However, a
number of issues still make the study of institutions difficult. The first is conceptualization of
institutions, even if conceptualized it is difficult to accurately measure them. Second, the study
on the impact of institutions on growth is equally made difficult by absence of substantial
theoretical framework and econometrics problems such endogeneity and specification biases.
Another limitation of the studies on institutions is that it is difficult to draw specific policy
relevance due to aggregation.
It is therefore obvious that despite the voluminous literature on institutions and economic
performance, there are still a number of unclear issues. Questions such as: if institutions matter
which of matters most? Since institutions matter why is it difficult for some countries to acquire
good institutions and then grow? will remain relevant research areas for the next few years.
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