DO INSTITUTIONS CAUSE GROWTH?

DO INSTITUTIONS CAUSE GROWTH?

E.L. Gleaser, R. La Porta, F. Lopez-de-Silanes & A. Shleifer

Journal of Economic Growth, 9 (2004)

A SUMMARY

In a Nutshell

Broadly speaking there are two schools of thought regarding institutions. Firstly, as epitomized by Douglas North and latterly Acemoglu, Jonson and Robinson, are those that argue the political institutions of limited government cause economic growth. Putting the right institutions in place will therefore create investment, human and physical capital and hence growth. The second school argues that the institutions of limited government are themselves caused by human capital development as essentially more educated people are more likely to resolve disputes by negotiation as opposed to violence, and literacy etc. means that people are better able to engage with politics, understand political wrongs etc. According to this thesis which has received support from Prezworski and Lipset, relatively unconstrained leaders pursue policies which alter the stock of human and social capital, and then as that stock increases the institutions of democracy etc. develop. This argument is related to the Olken & Jones article summarized above. The article supports the latter of these arguments.

It does so by seeking to address flaws in the literature relating to the former hypothesis. Firstly it argues that the measures of institutions as used in various institutional studies are not capturing real institutions, but rather the outcomes of political choices. Secondly they attack the instrumental variable analyses of amongst others AJR, by showing that the instruments used are correlated with human capital stocks both past and present, and thus exogeneity conditions are violated. In other words it appears the instruments are isolating not institutions but human capital. They run a variety of correlation analyses which all indicate that political institutions properly measured have little significant effect on growth, whereas human capital does.

Measurement on Institutions

Institutions as defined by North are the rules of the game that place constraints on individuals [executive politicians etc.] which are relatively durable and unchanging. This implies that it is constitutional arrangements, not policies that fall within the definition of institutions. However, the data used in institutional papers is largely survey data based on subjective assessments of expropriation risk, government effectiveness etc. which are outcome measures of policy choices not permanent institutional arrangements. This can be seen when it is shown that the measures employed both rise with income levels, and have a high variance. If institutional measures improve with income then they are not a good basis for establishing causality due to endogeneity problems.

They go on to look at correlations between true institutional variables – plurality, proportional representation, judicial independence and constitutional review, and find that they are not generally correlated with income, and they are only weakly correlated with the outcome indices traditionally used.

The bottom line is thus that the measures usually used are not suitable for establishing causation as they do not reflect constraints on governments nor permanent features of the political system, but rather volatile outcome measures of policies pursued by those in charge.

Human Capital

In regression analysis initial levels of human capital in 1960 is a much better predictor of subsequent growth than the true institutional variables noted above which all enter insignificantly. The traditional measures all still enter positively and significantly most likely reflecting the reverse causality issues. They conclude that in OLS regressions the evidence that institutions cause growth rather than the other way around is non-existent, and true measures of institutions have no predictive power even when averaged.

Politics and Growth Since 1960

Strong association between dictatorship and low levels of education. Countries with high human capital levels in 1960 have grown twice as fast as those with low levels.

Instrumental Variables

AJR use settler mortality in their groundbreaking paper. However, it is not clear that what the Europeans brought with them was their institutions rather than their human capital. Thus if settler patterns influence growth through channels other than institutions, the approach is fundamentally flawed.

They test the correlation between settler mortality and the constitutional measures of institutions as defined above and find only very weak correlations. i.e. settler mortality is not strongly correlated with the rules and procedures that actually govern the societies in question. Additionally the instrument appears to be correlated with the disease environment today [suggested by Sachs and friends to be a prime cause of underdevelopment], so the issue of the modern disease environment is real and should not be overlooked. The killer point is that settler mortality is strongly correlated with years of schooling both in 1960 and 2000, and the correlations are even stronger than between mortality and measures of institutions. Thus the instrument is not exogenous and is most likely proxying for human capital. They run a 2SLS regression of log GDP per capita in 2000 on human capital levels in 1960 and 200, as well as executive constraints, both instrumented for settler mortality etc. (which produce strong first stages). Whilst years of schooling are significant in the second stage, executive constraints are not which indicates that human capital measures are more important than institutional measures. In conclusion, they are not saying that human capital is all that is important, only that patterns of colonization have effected growth through a variety of channels. The IV approach does not tell us what causes growth.

From Schooling to Institutions

They supply indicative evidence that schooling leads to institutions rather than the other way around, by lagging school variables, which are significantly correlated with subsequent institutions. There is no significant correlation when the institutional variables are lagged as against the subsequent schooling variable.

Conclusion

It appears that communities face a set of institutional possibilities that are defined by levels of human capital. These possibilities increase with human capital. The institutions are persistent, but they can improve also with income. But in this framework institutions have only a second order effect, as it is human capital that shapes both institutional landscape and productive possibilities of a society.

Policy implications are that a focus solely on democratic institutions is flawed when pursuing growth. The right mix of policies can equally be chosen by a dictator. For countries to emerge from poverty it may be more important to increase the human capital that will subsequently cause institutions to improve.

 

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