Growth and Institutions
Institutions are often viewed as a key determinant of economic growth. Much research inquires whether the institutions that influence economic outcomes are themselves determined by other factors. European colonization of the world provides a laboratory in which to investigate these issues since it exogenously imposed different institutions on otherwise identical societies. Colonies where Europeans settled had institutions that protected property rights, and have since prospered, while other colonies were given centralized repressive states that extracted resources from the population and have largely remained relatively poor. Choice of institutions reflects the distribution of political power in a society.
KeywordsColonization Commitment Growth and governance Growth and institutions Mortality North, D. Political institutions, economic approaches to Property rights
A central question of economics is to understand why some countries are much poorer than others. Economists have long recognized that this relates to the fact that some countries have much less human capital, physical capital and technology than others, and use their existing factors and technologies much less efficiently. Nevertheless, these differences are only proximate causes in the sense that they pose the next question of why some countries have less human capital, physical capital and technology and make worse use of their factors and opportunities. This has motivated economists and social scientists more broadly to look for potential fundamental causes, which may be underlying these proximate differences across countries.
Institutions have emerged as a potential fundamental cause, contrasting, for example, with geographical differences or cultural factors. While geographic characteristics of countries and regions may lead to differences in the technology available to individuals or make their investments in physical and human capital more difficult, institutional differences, associated with differences in the organization of society, shape economic and political incentives and affect the nature of equilibria via these channels. There is vibrant research, both empirical and theoretical, attempting to understand the importance of institutions for economic outcomes. Since it is impossible to do justice to this burgeoning field in such a short article, my purpose here is not to survey the literature but to present some of the main conceptual issues that are useful for future work.
What Are Institutions?
Douglass North (1990, p. 3) offers the following definition: ‘Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction.’ Three important features of institutions are apparent in this definition: (a) they are ‘humanly devised’, which contrasts with other potential fundamental causes like geographic factors, which are outside human control; (b) they are ‘the rules of the game’ setting ‘constraints’ on human behavior; and (c) their major effect will be through incentives (see also North 1981).
The notion that incentives matter is second nature to economists, and institutions, if they are a key determinant of incentives, should have a major effect on economic outcomes, including economic development, growth, inequality and poverty. But do they? Are institutions key determinants of economic outcomes or secondary arrangements that respond to other, perhaps geographic or cultural, determinants of human and economic interactions?
Much empirical research attempts to answer this question. Before we discuss some of this research, it is useful to emphasize an important point: ultimately, the aim of the research on institutions is to pinpoint specific institutional characteristics that are responsible for economic outcomes in specific situations (for example, the effect of legal institutions on the types of business contracts). However, the starting point is often the impact of a broader notion of institutions on a variety of economic outcomes. This broader notion, in line with Douglass North’s conception, incorporates many aspects of the economic, political and social organization of society. Institutions can differ between societies because of their formal methods of collective decision-making (democracy versus dictatorship) or because of their economic institutions (security of property rights, entry barriers, the set of contracts available to businessmen). They may also differ because a given set of formal institutions is expected to, and does, function differently; for example, they may differ between two societies that are democratic because the distribution of political power lies with different groups or social classes, or because in one society democracy is expected to collapse while in the other it is consolidated. This broad definition of institutions is both an advantage and a curse. It is an advantage, since it enables us to get started with theoretical and empirical investigations of the role of institutions without getting bogged down by taxonomies. It is a curse, since, unless we can follow it up with a better understanding of the role of specific institutions, we have learned little.
The Impact of Institutions
There are tremendous cross-country differences in the way that economic and political life is organized. A voluminous literature documents large cross-country differences in economic institutions, and a strong correlation between these institutions and economic performance. Knack and Keefer (1995), for instance, look at measures of property rights enforcement compiled by international business organizations, Mauro (1995) looks at measures of corruption, Djankov et al. (2002) compile measures of entry barriers across countries, while many studies look at variation in educational institutions and the corresponding differences in human capital. All of these authors find substantial differences in these measures of economic institutions, and significant correlation between these measures and various indicators of economic performance. For example, Djankov et al. find that, while the total cost of opening a medium-size business in the United States is less than 0.02% of GDP per capita in 1999, the same cost is 2.7% of GDP per capita in Nigeria, 1.16% in Kenya, 0.91% in Ecuador and 4.95% in the Dominican Republic. These entry barriers are highly correlated with various economic outcomes, including the rate of economic growth and the level of development.
Nevertheless, this type of correlation does not establish that the countries with worse institutions are poor because of their institutions. After all, the United States differs from Nigeria, Kenya and the Dominican Republic in its social, geographic, cultural and economic fundamentals, so these may be the source of their poor economic performance. In fact, these differences may be the source of institutional differences themselves. Consequently, evidence based on correlation does not establish whether institutions are important determinants of economic outcomes.
To make further progress, one needs to isolate a source of exogenous differences in institutions, so that we approximate a situation in which a number of otherwise identical societies end up with different sets of institutions. European colonization of the rest of the world provides a potential laboratory in which to investigate these issues. From the late 15th century, Europeans dominated and colonized much of the rest of the globe. Together with European dominance came the imposition of very different institutions and social power structures in different parts of the world.
Acemoglu et al. (2001) document that in a large number of colonies, especially those in Africa, Central America, the Caribbean and South Asia, European powers set up ‘extractive states’. These institutions (again broadly construed) did not introduce much protection for private property, nor did they provide checks and balances against the government. The explicit aim of the Europeans in these colonies was extraction of resources, in one form or another. This colonization strategy and the associated institutions contrast with the institutions Europeans set up in other colonies, especially in colonies where they settled in large numbers: for example, the United States, Canada, Australia and New Zealand. In these colonies the emphasis was on the enforcement of property rights for a broad cross section of the society, especially smallholders, merchants and entrepreneurs. The term ‘broad cross section’ is emphasized here since, even in the societies with the worst institutions, the property rights of the elite are often secure, but the vast majority of the population enjoys no such rights and faces significant barriers to participation in many economic activities. Although investments by the elite can generate economic growth for limited periods, for sustained growth property rights for a broad cross section seem to be crucial (Acemoglu et al. 2002; Acemoglu 2003).
A crucial determinant of whether Europeans chose the path of extractive institutions was whether they settled in large numbers. In colonies where Europeans settled, the institutions were developed for their own future benefits. In colonies where Europeans did not settle, their objective was to set up a highly centralized state apparatus, and other associated institutions, to oppress the native population and facilitate the extraction of resources in the short run. Based on this idea, Acemoglu et al. (2001) suggest that, in places where the disease environments made it easy for Europeans to settle, the path of institutional development should have been different from areas where Europeans faced high mortality rates.
In practice, during the time of colonization, Europeans faced widely different mortality rates in colonies because of differences in the prevalence of malaria and yellow fever. These mortality rates provide a possible candidate for a source of exogenous variation in institutions. The mortality rates should not directly influence output today but, by affecting the settlement patterns of Europeans, they may have had a first-order effect on institutional development. Consequently, these potential settler mortality rates can be used as an instrument for broad institutional differences across countries in an instrumental-variables estimation strategy.
The key requirement for an instrument is that it should have no direct effect on the outcome that is the object of interest (other than its effect via the endogenous regressor). There are a number of channels through which potential settler mortality could influence current economic outcomes or may be correlated with other factors influencing these outcomes. Nevertheless, there are also good reasons why, as a first approximation, these mortality rates should not have a direct effect. Malaria and yellow fever were fatal to Europeans who had no immunity, and thus had a major effect on settlement patterns, but they had much more limited effects on natives who, over centuries, had developed various types of immunities. The exclusion restriction is also supported by the death rates of native populations, which appear to be similar between areas with very different mortality rates for Europeans (see, for example, Curtin 1964).
The data also show that there were major differences in the institutional development of the high-mortality and low-mortality colonies. Moreover, consistent with the key idea in Acemoglu et al. (2001), various measures of broad institutions – for example, measures of protection against expropriation – are highly correlated with the death rates Europeans faced more than a century ago and with early European settlement patterns. They also show that these institutional differences induced by mortality rates and European settlement patterns have a major (and robust) effect on income per capita. For example, the estimates imply that improving Nigeria’s institutions to the level of those in Chile could, in the long run, lead to as much as a sevenfold increase in Nigeria’s income. This evidence suggests that, once we focus on potentially exogenous sources of variation, the data point to a large effect of broad institutional differences on economic development.
Naturally, mortality rates faced by Europeans were not the only determinant of Europeans’ colonization strategies. Acemoglu et al. (2002) focus on another important aspect, namely, how densely different regions were settled before colonization. They document that in more densely settled areas Europeans were more likely to introduce extractive institutions because it was more profitable for them to exploit the indigenous population, either by having them work in plantations and mines or by maintaining the existing system and collecting taxes and tributes. This suggests another source of variation in institutions that may have persisted to the present, and Acemoglu et al. (2002) show similar large effects from this source of variation.
Another example that illustrates the consequences of difference in institutions is the contrast between North Korea and South Korea. The geopolitical balance between the Soviet Union and the United States following the Second World War led to separation along the 38th parallel. The North, under the dictatorship of Kim II Sung, adopted a very centralized command economy with little role for private property. In the meantime, South Korea, though far from a free-market economy, relied on a capitalist organization of the economy, with private ownership of the means of production and legal protection for a range of producers, especially those under the umbrella of the chaebols, the large family conglomerates that dominated the South Korean economy. Although not democratic during its early phases, the South Korean state was generally supportive of rapid development and is often credited with facilitating, or even encouraging, investment and rapid growth in Korea.
Under these two highly contrasting regimes, the economies of North and South Korea diverged. While South Korea grew rapidly under capitalist institutions and policies, North Korea has experienced minimal growth since 1950 under communist institutions and policies.
Overall, a variety of evidence paints a picture in which broad institutional differences across countries have had a major influence on their economic development. This evidence suggests that to understand why some countries are poor we should understand why their institutions are dysfunctional. But this is only part of a first step in the journey towards an answer. The next question is even harder: if institutions have such a large effect on economic riches, why do some societies choose, end up with and maintain these dysfunctional institutions?
Modelling Institutional Differences
As a first step in modelling institutions, let us consider the relationship between three institutional characteristics: (a) economic institutions, (b) political power, and (c) political institutions.
As already mentioned, economic institutions matter for economic growth because they shape the incentives of key economic actors in society; in particular, they influence investments in physical and human capital and technology, and the organization of production. Economic institutions determine not only the aggregate economic growth potential of the economy but also the distribution of resources in the society, and herein lies part of the problem: different institutions will be associated not only with different degrees of efficiency and potential for economic growth, but also with different distributions of the gains across different individuals and social groups.
How are economic institutions determined? Although various factors play a role here, including history and chance, ultimately economic institutions are produced by collective choices of the society. And because of their influence on the distribution of economic gains, not all individuals and groups typically prefer the same set of economic institutions. This leads to a conflict of interest among various groups and individuals over the choice of economic institutions; and the political power of the different groups will be the deciding factor.
The distribution of political power in society is also endogenous. To make more progress here, let us distinguish between two components of political power; de jure (formal) and de facto political power (see Acemoglu and Robinson 2006). De jure political power refers to power that originates from the political institutions in society. Political institutions, similar to economic institutions, determine the constraints on and the incentives of the key actors, but this time in the political sphere. Examples of political institutions include the form of government – for example, democracy versus dictatorship or autocracy – and the extent of constraints on politicians and political elites.
A group of individuals, even if they are not allocated power by political institutions, may possess political power; for example, they can revolt, use arms, hire mercenaries, co-opt the military, or undertake protests in order to impose their wishes on society. This type of de facto political power originates from both the ability of the group in question to solve its collective action problem and from the economic resources available to the group (which determine their capacity to use force against other groups).
This discussion highlights the fact that we can think of political institutions and the distribution of economic resources in society as two state variables, affecting how political power will be distributed and how economic institutions will be chosen. An important notion is that of persistence; the distribution of resources and political institutions are relatively slow-changing and persistent. Since, like economic institutions, political institutions are collective choices, the distribution of political power in society is the key determinant of their evolution. This creates a central mechanism of persistence: political institutions allocate de jure political power, and those who hold political power influence the evolution of political institutions, and they will generally opt to maintain the political institutions that give them political power. A second mechanism of persistence comes from the distribution of resources: when a particular group is rich relative to others, this will increase its de facto political power and enable it to push for economic and political institutions favorable to its interests, reproducing the initial disparity. Despite these tendencies for persistence, the framework also emphasizes the potential for change. In particular, ‘shocks’ to the balance of de facto political power, including changes in technologies and the international environment, have the potential to generate major changes in political institutions, and consequently in economic institutions and economic growth.
Institutions in Action
As a brief example, consider the development of property rights in Europe during the Middle Ages. Lack of property rights for landowners, merchants and protoindustrialists was detrimental to economic growth during this epoch. Since political institutions at the time placed political power in the hands of kings and various types of hereditary monarchies, such rights were largely decided by these monarchs. The monarchs often used their powers to expropriate producers, impose arbitrary taxation, renege on their debts, and allocate the productive resources of society to their allies in return for economic benefits or political support. Consequently, economic institutions during the Middle Ages provided little incentive to invest in land, physical or human capital, or technology, and failed to foster economic growth. These economic institutions also ensured that the monarchs controlled a large fraction of the economic resources in society, solidifying their political power and ensuring the continuation of the political regime.
The 17th century, however, witnessed major changes in the economic and political institutions that paved the way for the development of property rights and limits on monarchs’ power, especially in England after the civil war of 1642–6 and the Glorious Revolution of 1688, and in the Netherlands after the Dutch revolt against the Hapsburgs. How did these major institutional changes take place? In England until the 16th century the king also possessed a substantial amount of de facto political power, and, if we leave aside civil wars related to royal succession, no other social group could amass sufficient de facto political power to challenge the king. But changes in the English land market (Tawney 1941) and the expansion of Atlantic trade in the 16th and 17th centuries (Acemoglu et al. 2005a) gradually increased the economic fortunes, and consequently the de facto power, of landowners and merchants opposed to the absolutist tendencies of the Kings.
By the 17th century, the growing prosperity of the merchants and the gentry, based on both internal and overseas (especially Atlantic) trade, enabled them to field military forces capable of defeating the king. This de facto power overcame the Stuart monarchs in the English civil war and Glorious Revolution, and led to a change in political institutions that stripped the king of much of his previous power over policy. These changes in the distribution of political power led to major changes in economic institutions, strengthening the property rights of both landowners and capital owners and spurring a process of financial and commercial expansion. The consequence was rapid economic growth, culminating in the industrial revolution,and a very different distribution of economic resources from that in the Middle Ages.
This discussion poses, and also gives clues about the answers to, two crucial questions. First, why do the groups with conflicting interests not agree on the set of economic institutions that maximize aggregate growth? Second, why do groups with political power want to change political institutions in their favour? In the context of the example above, why did the gentry and merchants use their de facto political power to change political institutions rather than simply implement the policies they wanted? The issue of commitment is at the root of the answers to both questions.
An agreement on the efficient set of institutions is often not forthcoming because of the complementarity between economic and political institutions and because groups with political power cannot commit to not using their power to change the distribution of resources in their favour. For example, economic institutions that increased the security of property rights for landowners and capital owners during the Middle Ages would not have been credible as long as the monarch monopolized political power. He could promise to respect property rights, but then at some point renege on his promise, as exemplified by the numerous financial defaults by medieval kings. Credible secure property rights necessitated a reduction in the political power of the monarch. Although these more secure property rights would foster economic growth, they were not appealing to the monarchs, who would thereby lose their rents from predation and expropriation as well as various other privileges associated with their monopoly of political power. This is why the institutional changes in England as a result of the Glorious Revolution were not simply conceded by the Stuart kings. James II had to be deposed for the changes to take place.
The reason why political power is often used to change political institutions is related. In a dynamic world, individuals care about not only economic outcomes today but also those in the future. In the example above, the gentry and merchants were interested in their profits and therefore in the security of their property rights, not only in the present but also in the future. Therefore, they would have liked to use their (de facto) political power to secure benefits in the future as well as the present. However, commitment to future allocations (or economic institutions) is in general not possible because decisions in the future are made by those who hold political power at the time. If the gentry and merchants had been certain to maintain their de facto political power, this would not have been a problem. However, de facto political power is often transient, for example because the collective action problems that are solved to amass this power are likely to resurface in the future, or other groups, especially those controlling de jure power, can become stronger in the future. Therefore, any change in policies and economic institutions that relies purely on de facto political power is likely to be reversed in the future. In addition, many revolutions are followed by conflict among the revolutionaries. Recognizing this, the English gentry and merchants strove not just to change economic institutions in their favour following their victories against the Stuart monarchy, but also to alter political institutions and the future allocation of de jure power. Using political power to change political institutions then emerges as a useful strategy to make gains more durable. Consequently, political institutions and changes in political institutions are important as ways of manipulating future political power, and thus indirectly shaping future, as well as present, economic institutions and outcomes. Acemoglu and Robinson (2000, 2006) and Acemoglu et al. (2005b) provide more detailed models and discuss further applications, including the creation and consolidation of electoral democracies in the West and in Latin America.
- Acemoglu, D., S. Johnson, and J. Robinson. 2005b. Institutions as the fundamental cause of long-run growth. In Handbook of economic growth, ed. P. Aghion and S. Durlauf. Amsterdam: North-Holland.Google Scholar
- Acemoglu, D., and J. Robinson. 2006. Economic origins of dictatorship and democracy. Cambridge: Cambridge University Press.Google Scholar
- North, D. 1981. Structure and change in economic history. New York: W.W. Norton and Co.Google Scholar