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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. References Acemoglu, D. and Robinson J. 2008. Persistence of power, elites and institutions. American Economic Review, Vol.98, No1, PP 267-293 Acemoglu, D. and Robinson J. 2006. Persistence of power, elites and institutions. NBER Working Paper 12108 Acemoglu, D., Johnson, S. and Robinson J. 2004. Institutions as the fundamental cause of longrun growth. Prepared for the Handbook of Economic Growth Acemoglu, D., Johnson, S. and Robinson J. 2001. The colonial origins of comparative development: An empirical investigation. American Economic Review, Vol. 91, No.5 pp. 1369-1401 Acemoglu, D., Johnson, S. and Robinson J. 2002. Reversal of fortune: geography and institutions in the making of the modern world income distribution. Quarterly Journal of Economics, Vol.117, No.9 pp. 1231-1294 Alcala F. and Ciccone A. 2004. Trade and productivity. Quarterly Journal of Economics, Vol. 119, No. 2 pp613 – 646 Chang H. 2005. Understanding the relationship between institutions and economic development: some key theoretical issues. Presented at the WIDER Jubilee Conference Coase, R. H. 1937. The nature of the firm. Economica, Vol4, pp.386 – 405 Davis L. and North D. 1970. Institutional change and American economic growth: a first step towards a theory of institutional innovation. The Journal of Economic History, Vol. 30, No.1 pp 131 -149 Eirik G. F. and Rudolf R. 2003. Institutions and Economic Theory the Contribution of the New Institutional Economics. University of Michigan Press Glaeser E., Rafael L., Florencio L. and Shleifer A. 2004. Do institutions cause growth?. Journal of Economic Growth, Vol. 9, No. 3 pp. 271 – 303 Hall, R. E. and Jones C. I. 1999. Why do some countries produce so much more output per worker than others?. Quarterly Journal of Economics, Vol. 114, No. 1 pp.83-116 Knack S. and Keefer P. 1995. Institutions and economic performance: cross-country tests using alternative institutional measures. Economics and Politics, Vol.7, No.3 PP. 207-227 Mauro P. 1995. Corruption and growth. Quarterly Journal of Economics, Vol. 110, No.3, pp 681-712 North, D. and Thomas R. 1973. The rise of the Western world: a new economic history. Cambridge University Press, Cambridge North, D. 1990. Institutions, institutional change and economic performance. Cambridge University Press, Cambridge North, D. 1992. Transaction costs, institutions, and economic performance. International Centre for Economic Growth, Occasional Paper, No.30, Pande R. and Udry C. 2006. Institutions and development: a view from below. Economic Growth Centre Working Paper Rodrik D., Subramanian A. and Trebbi F. 2004. Institutions rule: the primacy of institutions over geography and integration in economic development. Journal of Economic Growth Varian H. R. 1993. What Use is Economic Theory?. Working Paper, Department of Economics, University of Michigan