THE ROLE OF INSTITUTIONS IN ECONOMIC DEVELOPMENT

Introduction

Growth and development cannot take place in an institutional vacuum. Economic maturity and
the growth of markets require an institutional framework that allows transactions to take place
in an orderly manner and in which agents know that the decisions they take and the contracts
they make will be protected by law, and enforced. Savers, investors, consumers, entrepreneurs,
workers and risk-takers of all kinds need a framework of rules if rational, optimizing decisions are
to be made. They also need some guarantee of economic stability and certainty, which can be
provided only by good governance and sound economic policy-making. The alternative to a lack
of property rights, law and order and political stability is economic anarchy – and failed states (see
Chapter 10).

This chapter deals with the role of formal institutions in general in providing an economic,
political and social environment in which economies can flourish and prosper, and it considers
some of the empirical evidence on the relationship between institutional development and
economic development.

The role of institutions

The Nobel Prize-winning economist Douglass North first brought to the fore the role of institutions
in economic development. The modern exponents of the ‘primacy of institutions’ are Dani
Rodrik of Harvard University and Daron Acemoglu, Simon Johnson and James Robinson of the
Massachusetts Institute of Technology. North says in his famous book Institutions, Institutional
Change and Economic Performance (1990): I wish to assert a fundamental role for institutions in societies: they are the underlying determinants
of the long-run performance of economies – ThirdWorld countries are poor because
the institutional constraints define a set of pay-offs to political/economic activity that do not
encourage productive activity.
North also said that ‘the inability of societies to develop effective low-cost enforcement
of contracts is the most important source of both historical stagnation and contemporary
underdevelopment in the Third World’, because the absence of secure property and contractual
rights discourages investment and specialization. Mancur Olson (1982) makes the same point in
his classic book The Rise and Decline of Nations (1992).

It is possible to give both general and narrower, more formal, definitions of institutions. North
himself describes institutions very broadly as the ‘formal and informal rules [or norms] governing
human behaviour’. A similar broad definition is given by Lin and Nugent (1995) as ‘a set of
humanly devised behavioural rules that govern and shape the interaction of human beings, in
part by helping them to form expectations of what other people do’. At a more formal, precise
level, institutions can be defined in terms of the extent of property rights’ protection; the degree
to which laws and regulations are fairly enforced; the ability of the government to protect the
individual against economic shocks and to provide social protection, and the extent of political
corruption.

When economists undertake empirical work on the relation between institutional structure and economic performance, it is of course necessary to have quantitative measures of the important
institutions being discussed and evaluated. Lumping all institutions together in a single index of ‘institutional quality’ would obscure the different channels through which institutions work.

The reason why institutional structures and rules of behaviour are a necessary condition for economic activity to flourish is that incentives and price signals, so vital to amarket economy, cannot function properly without them. As Rodrik (2008) says: ‘markets require institutions because they are not self-creating; self-regulating; self-stabilising, or self-legitimising’. Which institutions are important and which are not will differ across space and time according to the history of a country, its geography, stage of development and its political aspirations, that is, what sort of society its people want. In small rural communities where everyone knows each other, the scope for cheating, fraud and not honouring contracts is limited. Transaction costs associated with the costs of information, negotiation, monitoring, coordination and enforcement of contracts are low, and communities survive by adhering to norms of behaviour; but economic development is limited through a lack of specialization. In contrast, in large, modern, industrial societies, where transactions are impersonal, there is widespread scope for opportunistic behaviour (Bardhan and Udry, 1999). Transactions (and therefore production) costs may be very high without institutional structures that curtail such behaviour, such as the enforcement of property rights and the rule of law, the provision of limited liability, the guarantee of contracts, patent protection and so on.With low transaction costs, firms and markets can concentrate on the job of investment in the knowledge that property rights are secure.

There is no one set of institutions that will suit all countries, but there is a consensus among
development economists that at least five main types of market-supporting institutions are necessary, if not sufficient, conditions for rapid economic progress (see Rodrik, 2000, 2008; Rodrik and Subramanian, 2008).
• property rights and legally binding contracts: market-creating institutions
• regulatory institutions: market-regulating institutions
• institutions for macroeconomic stability: market-stabilizing institutions
• social insurance institutions: market-legitimizing institutions
• institutions of conflict management: market-legitimizing institutions

Rodrik (2000) highlights the following institutional arrangements that are conspicuously absent
in poor countries:
• a clearly defined system of property rights
• a regulatory apparatus curbing the worst forms of fraud, anti-competitive behaviour and moral
hazard
• a moderately cohesive society exhibiting trust and social cooperation
• social and political institutions that mitigate risk and manage social conflict
• the rule of law and clean government
These five main prerequisites of a sound institutional structure for economic development are
described briefly below.

Property rights and legally binding contracts. These are important because agents lack the
incentive to invest and innovate if they do not have control over the return on the assets they
accumulate. Intellectual property rights are particularly important to encourage invention. Control
is more important than ownership. Formal property rights do not mean very much if there are not control rights; but control rights can spur entrepreneurial activity without clearly defined property rights (witness China).

Regulatory institutions.Markets fail if there is fraud or anti-competitive behaviour. Regulatory
institutions are needed if markets are to function properly. When markets are liberalized, a regulatory framework is also required to avoid the consequences of risky behaviour, such as financial crises if the banking system is not properly regulated (as the world economy witnessed in 2008).

Institutions to compensate for capital market imperfections and coordination failures must also
be an integral part of a ‘regulatory’ framework for promoting innovation and growth. A good
example of this is the way the state intervened to promote industrial development in Korea and
Taiwan in the 1960s and 1970s. All successful economies have an array of regulatory institutions
that oversee different markets such as the product market, financial markets and the labour market.
Developing countries may need more regulatory institutions because market failures are more
pervasive than in developed countries.

Institutions for macroeconomic stability. Monetary and fiscal policy institutions are necessary
to provide an enabling environment in which private investment can flourish. Market economies are not self-regulating, and macroeconomic instability creates risk and uncertainty. The minimization of risk is vital if entrepreneurs are to take informed, long-term investment decisions.

Financial markets are inherently unstable, which can have damaging real effects, and they
need careful supervision. A central bank, a responsible banking system and fiscal prudence are all
important ingredients of macroeconomic stability.

Social insurance institutions. These are necessary if individuals are to accept change. In rural,
peasant societies on the margins of subsistence, change may spell disaster, but progress (particularlyin agriculture) requires willingness to take risks. Insurance against unemployment, crop
failures and price fluctuations for agricultural commodities are all important if traditional agriculture
is to be transformed. Economic reforms of any type, particularly in the process of liberalizing
markets, will meet resistance if not enough attention is paid to creating social security institutions
to protect the vulnerable. Social stability and cohesion within a market economy in the process
of structural change requires social insurance and safety nets.

Institutions of conflictmanagement.Many developing countries have deep ethnic, tribal and
religious divisions. Social conflict damages economies because it diverts resources from directly
productive activities, and creates uncertainty, which deters investment. To minimize conflict
requires a full range of institutions – the rule of law, a fair legal system, a political voice for minority
groups – which make it clear that the potential winners of social conflict will not benefit and
potential losers will be properly safeguarded.

The question is, how are good institutions acquired? Because of history and the diversity ofcountries, there is no one unique set of institutions that can be prescribed for every country:
‘there is no single mapping between the market and the set of non-market institutions required
to sustain it’ (Rodrik, 2000). Rodrik likens institutions to technical progress that allows countries to
transform inputs into higher levels of output, shifting outwards a country’s production possibility
frontier. But technological blueprints that operate well in one context may not be appropriate in another – and so it is with institutions. A ‘market economy’ cannot simply be transposed from one country to another, at least without some adaptation. As Rodrik and Subramanian (2008) put it: ‘there is growing evidence that desirable institutional arrangements have a large element of context specificity arising from differences in historical trajectories, geography, political economy and other initial conditions; . institutional innovations do not necessarily travel well’. Nor is it easy to bring about institutional change. There is a collective action problem that limits potential gainers from bringing about change in opposition to vested interests (Bardhan and Udry, 1999).

One is the free-rider problem about sharing the cost of change; the other isthe bargaining problem relating to sharing the potential benefits of change. It can be difficult for potential gainers to compensate potential losers, as in the case of land reform for example. In these circumstances, the state has a role to play in fostering institutional change and development without destroying markets, or allowing itself to be influenced by special interest groups or corrupted by rent-seeking behaviour on the part of politicians and bureaucrats.

Rodrik (2000) argues forcefully that ‘institutions need to be developed locally, relying on hands-on experience, local knowledge and experimentation’. Some institutional blueprints for some specific purposes may be borrowed (e.g. forms of financial regulation) because they are straightforward to implement and save costs, but others need to be built from scratch. Building from the ‘bottom up’ requires participatory political institutions that can use and assess local knowledge, so that the institutions created have consent and legitimacy. Institutions imposed from the ‘top down’ usually fail. Rodrik finds an association across countries between democratic political structures and economic success; but other studies are more agnostic.

Measuring institutions and the debate on institutions versus geography

To do serious empirical work on the impact of institutions on growth and development requires
a measure of institutional development. But some care needs to be taken because if measures of
institutional quality are used, a correlation with economic performance is almost certain to be
found because the measures themselves are partly a function of the stage of development and
economic success. Institutional measures are required which are devoid of ‘quality’. The statistical
way of putting the same point is that the institutional variables used should be strictly exogenous;
but we know in practice that institutional development is partly a function of growth and development
itself, making many institutional variables endogenous. To cope with this difficulty one can either find instruments to proxy for present-day institutions (see below), or take the initial (or base) level of institutions as the independent variable, rather than the contemporaneous level.

There are also other econometric difficulties in determining the impact of institutions.Many institutional variables are highly correlated with one another, so it is difficult to measure the separate
influence of each, and many institutionalmeasures are ordinal (they simply rank countries) rather
than cardinal, which means that they do not measure the magnitude of the difference in the institutional variables between one country and another.

Several different measures of institutions have been used in empirical work:

• An aggregate governance index, which is an average of six measures of institutions developed by Kaufman et al. (1999). These measures include (1) voice and accountability – the extent to which citizens can choose their government and enjoy political rights, civil liberties and an independent 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, independent and effective judges, and contract enforcement; and (6) freedom from graft – public power is not abused for private gain or corruption. Each of these measures can be taken individually.

• A measure of property rights and risk of expropriation using the International Country Risk Guide (ICRG) and Business Environmental Risk Intelligence (BERI). These indices are used by Keefer and Knack (1995). The ICRG index includes a measure of expropriation risk, rule of law, repudiation of contracts by governments, corruption in government and quality of bureaucracy. The BERI index includes contract enforceability, nationalization potential and bureaucratic delays.

• An index of democracy, political rights and civil liberties, e.g. the Freedom House Index of
Political Rights and Civil Liberties (Gastil, 1983, 1986).

• Political instability as measured by the number of revolutions and coups, and by the number
of assassinations (Barro, 1991).

• An index of corruption (Transparency International)

• Economic freedom (Heritage Foundation)

• An index of social division, e.g. ethnic diversity
Apart from Rodrik, the other foremost modern exponents of the view that institutions are of
primary importance in understanding the development process, and why some countries are rich
today and others poor, are Acemoglu et al. (2001, 2002). Acemoglu (2008) himself identifies three
important characteristics of good institutions:
• The enforcement of property rights and the rule of law, so that individuals have the incentive
to save, invest and take risks (as argued above)
• Constraints on those in positions of power so that they cannot expropriate the resources of a
country for their own benefit
• Equal opportunities for all, so that everyone has the incentive to better themselves and to
participate productively in society.

Acemoglu and his colleagues believe that the fundamental cause of differences in the levels of
development across countries of the world lies in differences in the evolution of institutions (in
particular, property rights), which has historical roots, and that it is possible to find an exogenous
cause of variations in institutions today that is unrelated to the level of development itself (or
geography); namely the way in which colonizers settled in countries in the seventeenth and eighteenth centuries. This is determined by the mortality rates of soldiers, sailors and missionaries in
various parts of the world.

The model of institutional development proposed by Acemoglu et al. (2001) is that (potential)
settler mortality determined the degree of settlement, the degree of settlement determined the
type of early institutions, and that early institutions have determined current institutions and can
explain current economic performance. In other words, mortality rates in countries during early
colonial times can be used for predicting institutions and the level of per capita income across
countries today.

Let us consider the theory in more detail, and then some of the evidence. The model is based
on three basic premises. First, there were different colonization policies which created different
types of institutions. At one extreme, in some countries (mainly in Africa) ‘extractive states’ were
created with the main purpose of transferring as many resources as possible from the colony.
Private property rights were not established and colonizers did not settle in large numbers. At the
other extreme, in countries such as the USA and Australia, Europeans settled in large numbers and
tried to replicate European institutions with a strong emphasis on private property, and checking
the power of elites – political and vested interests. The second premise is that the colonization
strategy depended to a large extent on the feasibility of settlement, and particularly the incidence
of disease and mortality. Thirdly, the institutions created during the colonial period persisted after
the colonies became independent.

The authors present a mass of evidence of how mortality rates affected the willingness to
settle in the various colonies, and how the presence or absence of European settlers was a key
determinant of the form colonization took. A great deal of historical evidence is also presented
that the control structures set up during the colonial period in the ‘extractive states’ that were
not settled, such as in Africa and parts of Latin America, have persisted to this day, while the
institutions of protecting private property rights, and law and order that were established in settler
countries such as Australia, Canada, the USA, Hong Kong and Singapore, have also persisted.
The measure of institutions today, used by Acemoglu et al., is a ‘risk expropriation’ index first
used by Keefer and Knack (1995).1 The index goes from 0 (lowest protection of property rights)
to 10 (highest), measured for each country for each year. They test their model using 64 former
colonies for which there are data on settler mortality in the nineteenth century, current protection against expropriation risk, and living standards for the period 1985–95. Using simple two-variable regressions shows: (1) a strong negative correlation between per capita income (PCY) today and settler mortality rates per 1,000 of population; (2) a strong positive relation between PCY and protection against expropriation risk today (the correlation coefficient exceeds 50 per cent), and (3) that the settler mortality rate explains 25 per cent of the variation in the expropriation risk index.When the endogeneity of the expropriation risk index (as the measure of institutional quality) is instrumented by the settler–mortality variable, a significant negative effect on the current level of per capita income of countries is found, even controlling for other variables that might be correlated with settler mortality such as the identity of the colonial power, natural resource endowments, soil quality, religion, temperature and humidity. In fact, the authors dismiss the effect of geography altogether (see below).

Moreover, the strong results are not dependent on the heavily settled countries with good institutions, such as the USA, Canada, Australia and New Zealand, nor if African countries are excluded from the sample.When a dummy variable for Africa is used in the equation, it is not statistically significant, which leads the authors to conclude that Africa is poor not because of geography but because of poor institutions, inherited from the past because the colonial powers established ‘extractive states’. In a separate analysis, Acemoglu et al. (2002) try to support their theory by showing how the fortunes of countries between the sixteenth century and the present have changed because of ‘institutional reversal’. It is a fact that those countries that were relatively rich in 1500 are now relatively poor, and vice versa, and this is attributed to the two different types of institutional structures discussed above that were imposed on countries during colonial times. Economic prosperity in 1500 is measured by the rate of urbanization and population density. With either measure there is a negative relation between prosperity in 1500 and the level of PCY today. The explanation given is that in previously poor areas European colonialism led to the development of institutions of private property because the regions were sparsely populated, which enabled Europeans to settle in large numbers and develop new institutions to the benefit of all. By contrast, in previously prosperous areas, already more densely populated with powerful ruling elites, colonizers found it easier andmore profitable to maintain or introduce extractive institutions. There was a ready workforce available and taxation was relatively easy. Besides, in the more densely populated regions there was more disease, and mortality rates were higher. The reversal of relative incomes took place in the eighteenth and nineteenth centuries, with societies with good institutions taking advantage of the opportunity to industrialize: ‘the interaction between institutions and the opportunity to industrialise during the 19th century played a central role in the long-run development of the former colonies’ (Acemoglu et al., 2002). The authors find a negative relation between measures
of prosperity in 1500 and the risk of expropriation (insecure property rights) today. Some basic
econometric results are: (i) a 10 percentage point lower rate of urbanization in 1500 is associated
with double the level of PCY today, and (ii) a 10 per cent higher population density in 1500 is
associated with a 4 per cent lower PCY today.

The authors again dismiss the role of geography because geography is a ‘constant’ and predicts
the persistence of economic outcomes. If geography is themost important factor in development,
the most (least) prosperous areas prior to colonization should have continued to be the most
(least) prosperous, but this is not the case. Geography cannot explain the reversal of fortunes. The
authors recognize what they call a ‘sophisticated version’ of the geography hypothesis; that certain
geographic characteristics that were inimical to successful economic performance in 1500 became
less important later on when new crops and new technologies made temperate zones more productive than the more prosperous tropical zones (where civilization started), and transport costs
fell. But they argue that there is no evidence that the reversal of economic fortunes between
sets of countries in the eighteenth and nineteenth centuries were associated with agriculture or
a more favourable transport environment. Reversal was most closely related to industrialization.
The authors conclude: ‘if you want to understand why a country is poor today, you have to look
at institutions rather than its geography’. But institutions and geography cannot be separated so easily. Geography, and its effects on disease, affects the type of colonization and therefore the character of institutions. Acemoglu (2008) effectively concedes this when he says ‘geographic factors also likely influenced the institutions that Europeans introduced’. Rodrik et al. (2004) (see also Rodrik and Subramanian, 2008) attempt to tackle this issue empirically. They estimate a series of regressions relating the income levels of countries to measures of geography, institutions (and also the degree of economic integration), taking account of the endogeneity of institutions. Institutional development ismeasured by a composite indicator of the strength of property rights and the rule of law. They reach the conclusion that: Quality of institutions is the only positive and significant determinant of income levels. Once institutions are controlled for, integration has no direct effect on income, while geography has but weak direct effects.

These results are very robust. Rodrik et al. (2004) claim that the quality of institutions overrides everything else, but also concede, like Acemoglu, that ‘geography has a strong indirect effect through institutions byinfluencing their quality’. Thus, geography may be the ultimate determinant after all!

In fact, Sachs (2008) points out that the incidence of malaria itself is enough to account for the negative relation between the mortality rates of British soldiers in various parts of the world in the nineteenth century and low levels of per capita income today. Sachs is critical of the almost exclusive emphasis on institutions in explaining differences in economic performance between
countries, as if nothing else matters: ‘the barriers to economic development in the poorest countries
today are more complex than institutional shortcomings . both institutions and resource endowments are critical, not just one or the other’.

Another critic is Bardhan (2005b), who argues that there are other institutions that matter besides property rights and the rule of law, particularly coordinating institutions to overcome coordination failures which are endemic in poor countries and require institutions to cope with them. They would remain important even if property rights were secure. In Bardhan’s view, ‘this preoccupation of the literature with the institutions of security and property rights, often to the exclusion of other important institutions, severely limits our understanding of the development process’. Bardhan doubts whether the mortality rate of colonial settlers really captures the major historical forces that determined the economic and social structure of colonies.

Think of the differences between countries today all with similar disease environments, such as Brazil, India or the Congo in Africa, let alone the countries that were never colonized, such as
Ethiopia and Thailand. Countries had a history before colonization: Bardhan calls this state antiquity, a term that refers to whether a country had a unified state structure or not. By this criterion,

Asia ranks higher than Latin America and Africa, and in the latter, as a result of colonial rule, the post-colonial state was often incongruent with the pre-colonial political structures and geographic
boundaries. This has been a major source of political turmoil and instability. In statistical analysis, Bardhan finds the state antiquity variable a significant determinant of differences in per capita income today (as well as settler mortality rates).

The role of democracy

Apart from the institutions versus geography debate, most empirical work on the role of institutions
in economic development has been conducted on political instability and on the impact of
political structures and the role of democracy. The challenge for any government, whatever its
structure, is to provide leadership in resolving collective action problems (Bardhan, 1993), which
means a commitment to formulating and implementing development policies in the interests of
all the people, to prevent groups going their own separate ways. Democracy can make this more
difficult because politicians can succumb to vested interest groups and take short-term decisions.
On the other hand, dictatorships may have no interest in maximizing total output, and may allocate
resources very inefficiently. Democracy makes life difficult for corrupt elites. In the discussion
of democracy and growth it is also important to distinguish between democracy defined as free,
multi-party elections on the one hand and civil and economic liberties on the other (Alesina and
Perotti, 1994). Some non-democratic regimes in the first sense (e.g. China) give their citizens a lot
of economic rights, and vice versa.

Early work by Barro (1991) measured institutional quality by the number of revolutions and
coups in countries and by the number of political assassinations. A negative relation was found
between these measures and economic growth across a sample of 98 countries, controlling for
other variables (see Chapter 5).

But political instability is not the same as the nature of the political system. Here we shall
highlight two major studies on the role of democracy by Rodrik (2000) and Barro (1996a, 2008).
Rodrik examines data for 90 countries over the period 1970–89, using the Freedom House Index
of Political Rights and Civil Liberties (the Gastil index) as a measure of democracy which ranks
countries on a scale zero to one. He draws four important conclusions:
• democracies deliver more predictable long-run growth rates
• democracies produce greater short-term stability
• democracies handle adverse shocks much better
• democracies promote a fairer distribution of income

Democracies produce better outcomes in these ways because they produce superior institutions
better suited to local conditions. There is little evidence that the average growth rate is higher in
democracies than in more autocratic regimes, but the variance around the average is significantly
lower in democracies. One reason for this is because adjustment to shocks requires managing
social conflict, and democratic institutions are more efficient institutions for conflict management.
Democracies deliver better institutional outcomes because they tend to create more equal
opportunities for people, especially in the fields of health, education and employment opportunity,
which manifests itself in a higher share of wages in national income. In general, therefore,
democracy helps to build better institutions based on local knowledge: ‘participatory and decentralized political systems are the most effective ones we have for processing and aggregating local knowledge. We can think of democracy as a meta-institution for building other good institutions’
(Rodrik, 2000). Barro (2008), on the other hand, is more circumspect about the impact of democracy.

Most agree that democracy tends to follow economic development, rather than precede
it; what is debated is the role of democracy in sustaining development once it has started. Barro
argues that democracy can hamper growth in the early stages of development by the tendency of
majority voting to support programmes that redistribute income from rich to the poor, involving
tax increases and other distortions that reduce incentives. Also, democracies may give in to pressure groups that redistribute resources to themselves; for example agricultural lobbies, defence
contractors and trade unions. On the other hand, and very important, democracy is a check on
corrupt autocracies (dictators). In statistical work that examines the link between democracy and
growth, Barro measures the degree of democracy by the Gastil index of political rights in Gastil’s
publication Freedom in the World (1983, 1986). The definition of political rights is: ‘rights to participate meaningfully in the political process. In a democracy this means the right of all adults to vote and compete for public office, and for elected representatives to have a decisive vote on public
policies.’ Barro’s results suggest that the relationship between democracy and growth across countries is weakly negative, but not statistically significant. The most interesting finding is that there
is evidence of non-linearity; that is, more democracy increases growth when political freedoms
are weak, but depresses growth when a moderate degree of freedom has been achieved (perhaps
because, as said above, democracies give in to pressure groups and engage in more redistribution).
Barro concludes that ‘democracy is not the key to economic growth; advanced Western
countries would contribute more to the welfare of poor nations by exporting their economic
systems, notably property rights and free markets, rather than their political systems, which typically
developed after reasonable standards of living had been attained’. Barro’s conclusion concurs
with that of Alesina and Perotti (1994) in their early survey of the political economy of growth
when they say: ‘growth is influenced not so much by the nature of the political regime (democracy
or dictatorship) as by the stability of the political regime . . . transitions from dictatorship to
democracy, being associated with socio-economic instability, should be typically periods of low
growth’.

The historical evidence for the now-developed countries, as documented by Chang (2003),
would seem to support this broad conclusion. He considers six categories of institutions as they
were in the developed countries in the nineteenth century – democracy; bureaucracy (including
the judiciary); property rights; corporate governance institutions; financial institutions; and
welfare and labour institutions – and reaches the following conclusion: First, the now-developed
countries did not develop on the basis of democracy. Universal suffrage only came in the twentieth
century. Poor developing countries today are adopting suffrage at much lower levels of
income than in now-developed countries. Second, public offices and the judiciary were historically
corrupt. Appointments were made not on merit, but through class or political connections,
and the judiciary often lacked independence, dispensing justice according to class and race.
Third, property rights, such as contract law, company law, bankruptcy law, tax law and land law
were all lax historically. So, too, were intellectual property rights. Chang remarks with respect
to patents, copyrights and trademarks: ‘the protection fell well short of what is demanded in
developing countries today’. Fourth, in most now-developed countries, modern corporate governance structures emerged after, rather than before, industrial development. There was no proper auditing of companies and no bankruptcy law, and competition laws did not properly exist until the twentieth century. Fifth, banking regulation in the nineteenth century was very perfunctory,
and banks only became professional lending institutions, serving all the people, in the early
twentieth century. Finally, social security institutions to protect against change were virtually
non-existent.

The lessons of history are that many institutions deemed to be important for poor developing
countries today emerged after, not before, economic development was taking place, and it took a
long time for themto emerge in fully fledged form from the time of their perceived need. Chang is
right to conclude, however, that this does not mean ‘the clock should be turned back’; rather, that
institutional development is not the sine qua non of economic development, and institutional
reforms in developing countries should not be imposed from outside, but should be allowed to
evolve naturally, internally.

This would accord with the central conclusion of Rodrik, namely everything we know about
economic growth indicates that large-scale institutional transformation is not so necessary for
getting growth started, but that it is very important for sustaining it. This conclusion is based
on the pioneering research by Hausmann et al. (2005) on ‘growth accelerations’. The secret of
economic success in the early stages of development is to find the ‘binding constraints’ on growth
using ‘growth diagnostics’ (see Chapter 5). This does not require wholesale institutional reform.

Summary
• Institutional structures and rules of behaviour are a necessary condition for economic activity
to flourish because incentives and price signals in a market economy cannot function properly
without them.

• There are at least five main types of market-supporting institutions that are necessary, if not
sufficient, conditions for rapid economic progress: property rights and legally binding contracts;
regulatory institutions; social insurance institutions; institutions for conflict management, and
institutions to secure macroeconomic stability.

• Poor countries are often characterized by a lack of trust and the rule of law; weak institutions
to mitigate risk and to manage social conflict; no clearly defined system of property rights; an
inadequate regulatory apparatus to curb fraud and anti-competitive behaviour; and a lack of
clean government.

• Without property rights and the rule of law, the incentive to invest, on which economic growth
ultimately depends, is very weak.

• It is not easy to bring about institutional change. There is a collective action problem which
limits potential gainers from bringing about change in opposition to vested interests, including
the free-rider problem and the bargaining problem of distributing the gains.

• It is not easy to measure institutional development and its impact on economic performance
because institutional development itself is endogenous to economic development. An
exogenous measure of institutions is required.
• Several different measures of institutions have been used in empirical work, such as a measure
of property rights and risk of expropriation; an aggregate governance index; an index
of democracy, political rights and civil liberties; an index of political instability; an index of
corruption; an index of economic freedom, and an index of social division.

• The economists Acemoglu, Johnson and Robinson believe that the fundamental cause of differences in the level of development across countries in the world today is the historical evolution
of institutions, and that in those parts of the world where conditions were harsh, in Africa for example, colonizers created ‘extractive states’ with no firm property rights, while in other
parts (e.g. the USA and Australia) colonizers settled in large numbers and built institutions conducive
to development. Disease and mortality rates in the nineteenth century are taken as an exogenous institutional variable. The role of geography (a constant) is dismissed.

• If geography was the most important factor in development, the most (least) prosperous areas
prior to colonization should have continued to be the most (least) prosperous, but this is not
the case. On the other hand, geography, and its effects on disease and mortality, affected
the type of colonization and therefore the character of institutions. The role of geography is
therefore controversial.

• Apart from the debate on institutions versus geography, most of the empirical work on the role
of institutions in economic development has been conducted on the influence of democracy
and political stability on economic performance.

• Rodrik finds that democracies deliver more predictable long-run growth rates, produce greater
short-term stability, handle adverse shocks better and promote a fairer distribution of income
than non-democratic states.

• Chang shows, however, that the lessons of history are that many of the institutions that are
argued to be important for developing countries today emerged after, not before, economic
development was taking place – for example, democracy and property rights, contract law,
company law, bankruptcy law and tax law. Hismessage is that institutions should be allowed to
evolve naturally, internally, and not be imposed from outside.

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