Stuff I Say at School – Part VII: The Importance of Institutions

This is part of the Stuff I Say at School series.

Summary & Commentary on Week’s Readings

Acemoglu et al argue that inefficient institutions persist for a number of major reasons. First, the lack of third-party enforcement of commitments prevents elites from relinquishing their monopoly on political power. Furthermore, the beneficiaries of the economic status quo are usually unwilling to risk their economic welfare through competition. This leads them to promote protectionism and further engage in rent-seeking activities. Institutions that encourage these kinds of activities fail to grow. We see this kind of conflict manifest in various areas of the economy, from labor and financial markets to regulations in pricing. The more institutions concentrate political power in the hands of the few, the more incentives are warped and distort paths to economic growth.

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In their book Why Nations Fail: The Origins of Power, Prosperity, and Poverty, Daron Acemoglu and James Robinson distinguish between inclusive and extractive institutions, with the former creating the conditions for prosperity. “Inclusive economic institutions,” they write,

…are those that allow and encourage participants by the great mass of people in economic activities that make best use of their talents and skills and that enable individuals to make the choices they wish. To be inclusive, economic institutions must feature secure private property, an unbiased system of law, and a provision of public services that provides a level playing field in which people can exchange and contract; it also must permit the entry of new business and allow people to choose their careers…Inclusive economic institutions foster economic activity, productivity growth, and economic prosperity (pg. 74-75).

On the other hand, extractive economic institutions lack these properties and instead “extract incomes and wealth from one subset of society to benefit a different subset,” empowering the few at the expense of the many (pg. 76).

The importance of getting institutions right is highlighted by Rodrik and Subramanian’s study. Three theoretical culprits have been blamed for the vast income inequality between countries: (1) geography, (2) integration (globalization, international trade), and (3) institutions. Regression analyses indicate that institutions trump all other explanations. This is also shown from the outset of Acemoglu and Robinson’s Why Nations Fail, in their story of Nogales, Arizona (United States of America) and Nogales, Sonora, (Mexico). Acemoglu and Robinson lay out their archetype story of two towns with the same essential culture, geography, and relative free trade (NAFTA), in most ways they are the same place. The only reason they are two towns is an institutional barrier between two separate countries. Yet one is rich and one is poor because of institutions. The direct effects of geography are weak at best, while there were no direct effects from integration. However, there were indirect effects of integration: institutions have significant, positive effects on integration, while integration has a positive impact on institutions. This, in some sense, creates a virtuous, growth-enhancing cycle. Rodrik and Subramanian point out that the institutional factors emphasized the most have largely been market-oriented (e.g., property rights, enforceable contracts). Yet, factors such as regulation, financial stabilization, and social insurance also matter in getting institutions right.

The interaction between political and economic institutions is an important insight. For example, even though most research finds that seemingly liberal political institutions like democracy have no direct impact on economic growth, more recent evidence from Acemoglu and colleagues suggests that they may in fact contribute to growth. What’s more, the evidence strongly suggests that economic openness—particularly international trade—contributes to growth.1 A 2010 study used data from 131 developed and developing countries and found that reductions in trade protections led to higher levels of income per capita. A World Bank study found that between 1950 and 1998, “countries that liberalized their trade regimes experienced average annual growth rates that were about 1.5 percentage points higher than before liberalization. Postliberalization investment rates rose 1.5-2.0 percentage points, confirming past findings that liberalization fosters growth in part through its effect on physical capital accumulation…Trade-centered reforms thus have significant effects on economic growth within countries” (pg. 212). A 2016 IMF paper found that trade liberalization boosts productivity through increased competition and greater variety and quality of inputs. All this suggests that Sachs and Warner were correct when they found “that open policies together with other correlated policies were sufficient for growth in excess of 2 percent during 1970-89” (pg. 45; fn. 61). Their findings also suggest “that property rights, freedom, and safety from violence are additional determinants of growth” (pg. 50). Acemoglu and Robinson in a 2005 paper found “robust evidence that property rights institutions have a major influence on long-run economic growth, investment, and financial development, while contracting institutions appear to affect the form of financial intermediation but have a more limited impact on growth, investment, and the total amount of credit in the economy” (pg. 988).

In short, inclusive institutions are necessary to fully reap the benefits of an open economy.

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