Why do some countries see high economic growth, while others remain poor?
There are several economic growth theories to try to explain this. These emphasise the importance of saving rates (Harrod Domar model), education and technological progress (endogenous and exogenous growth theory)
In this article, I’ll investigate how “institutions” can explain why some countries are rich and others poor.
What are institutions?
One definition of institutions is “humanly devised constraints structuring political, economic and social interaction”.
When economists talk about institutions in the context of development, they are referring to things like:
- Property rights. If you own a piece of land, a factory or a house, you do not have to worry about the government taking it away from you (“expropriation”).
- Spread of markets, including whether there are well-developed financial markets.
- Other examples include an independent judiciary and democracy.
In theory, having secure property rights encourages investment by removing the risk of the government seizing assets.
Similarly, well-developed financial markets allow firms and individuals to borrow to fund investments.
The endogeneity problem in measuring the effects of institutions
So institutions can influence the rate of economic development and growth.
But it could be the reverse. Perhaps if there’s poor economic growth, a government might seize assets to redistribute to poorer residents. We could be confusing correlation and causation.
To solve this reverse causation problem, we need to resort to quasi-experimental evidence.
Real world evidence
Following World War II, Korea separated into two independent countries, North Korea and South Korea. The conditions of each country were similar before the separation and both had approximately the same GDP per capita when they separated.
One key difference between the countries was their property rights. South Korea had private property and a market-based economy. Meanwhile, North Korea did away with private property.
The result was that by the year 2000, South Korea’s income per person was 16 times that of North Korea. In that time, South Korea had become a member of the OECD, a group of the world’s richest economies.
While the evidence here is striking, it is very specific to the North Korea – South Korea scenario. The differences between the two are very extreme.
There is similar evidence for the West Germany – East Germany divide, before the fall of the Berlin wall. Again this is a very specific example.
If we compare more generally and consider countries whose differences are less extreme, are institutions still important?
More evidence on institutions
Acemoglu, Johnson and Robinson (AJR, 2001) came up with a fascinating, yet complicated, method to test the effects of institutions.
Their statistical strategy relied on countries colonised by Europeans.
Some locations saw higher death rates for European colonisers than others. This could be because of different disease prevalence in different areas.
In these areas with higher death rates for settlers, colonisers were more likely to set up “extractive states” rather than fully settle. In other words, extracting all resources from the country, which in turn likely means weak property rights.
Often the settlers faced disease death from malaria, whereas the immunity of indigenous communities left them much less affected. An example of this is the Belgian colonisation of Congo.
The opposite, when death rates were lower, was that colonisers tended to replicate European institutions. This included the rule of law and in theory would encourage investment. Think of Australia, New Zealand, Canada and the United States as historical examples of this.
So in short, death rates affect the nature of institutions, which may or may not affect the nature of economic growth.
In a sense, the variation in death rates provided the randomisation required to explore the effect of institutions. Of course other factors will influence the existence of institutions.
This is pushing the idea of the real world experiment to its limit (and some would say pushing it too far to be plausible).
What did AJR find?
What did AJR find? Large effects of institutions on income per capita. So much so that, when controlling for the effect of institutions, there was very little variation in incomes left to explain.
This paper was significant, both in terms of the results and the new methodology.
With that in mind, this study faced a lot of criticism too.
Is their method justified or does it rely on too many assumptions? If you’re interested, I’d recommend looking into the critiques of this paper and the original authors’ responses.
A related implication from this study is that colonial settlers could be harmful to indigenous populations. This occurs by setting up “extractive institutions”.
The impact of empires on colony countries has been the subject of economic research and I will devote a separate article in the future to this issue.
Questions to consider
- What other institutions, apart from property rights and the spread of markets, could influence the economic growth rates of different countries?
- What other effects might institutions have on economic growth, apart from through business investment?
- How could one challenge the methodology of AJR? See a reply to AJR by Albouy (2012) and AJR’s response.
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