What is the Relationship between Institutions and Economic Development - Literature review Example

What is the relationship between s and economic development? Exploring the causal relation between and economic growth is a very challenging task. The study of economic theories of growth shows that economic progress is a complex phenomenon. Neoclassical growth theory limits to identify the prerequisites of economic performance, such as capital accumulation and technical progress. To explain why people save, invest, learn and seek knowledge, different institutional systems and values ​​that success or failures are based on must be paid special attention. The relationship between institutions and economic growth has been a central debate of the economic arena for a long time. A century ago, the free society realized that the institutional system plays a fundamental role in economic development-no longer seen as an inevitable gradual transition from local autarky to specialization and division of labor. The establishment and the functioning of institutions reflect the transition from chaos to order by the creation and enforcement of rules or procedures guiding economic and social life. Thus, the institutional system ensures the normal course of real and nominal economy. However, only efficient institutions are growth-promoting (Milo, 2007, p.23). There is a vast empirical literature that studies the impact of institutions on economic performance, particularly on growth (Easterly and Levine (2003), Acemoglu et al. (2001), Fukuyama (2006)). From the reverse connection perspective, the first hypothesis stating that economic growth enhances the good functioning of institutions is associated with the name of Martin Lipset, who argued that increased income and human capital accumulation are the best ways to have effective institutions. The second hypothesis states that limited central authorities and therefore, good institutions, lead to superior economic performance. This point of view is also included in the works of Montesquieu and Adam Smith and, later, in those of the ambassadors of neo-institutionalism (Buchanan, Coase, North, and Williamson). In short, the basic idea of institutionalism is that institutions create the rules of economic game; the latter provide economic incentives and thus influence the behavior of economic agents. Competition, productivity, innovation and private firms develop in an institutional environment that fosters efficient behaviors and penalizes inefficiency. If economic performance is unsatisfactory, ultimately, institutions will be changed. Reformulated, economic and social changes are institutional changes. One of the most important issues that influence the analyses of linkages between institutions and economic development is that there is no general consensus on the definition of institutions. Chang (2005) highlights three key functions of institution in fostering economic performance: Coordination and administration; Learning and innovation; Income redistribution and social cohesion. In some Asian economies in transition from socialism to capitalism, the rapid progress of free market institutions has reduced the transaction costs. In other situations, they have remained high as a result of insufficient knowledge of market mechanisms, of ambiguous rules and bureaucracy, weak legal system and corruption. Stable political structures, well-defined and recognized property rights and legal enforcement of contracts have reduced transaction costs, explaining the success of the world’s most powerful economies. Transaction cost theory was used in the analysis of general interest issues such as the role and governance practices, definition of market institutions or in explaining the differences between economic performances of nations. Related to the last element mentioned, the theory developed in close connection with the role of institutions in fostering economic efficiency by reducing trading costs. North concluded that capitalist and democratic institutions (free market, state, justice) are the result of efforts to minimize transaction costs (North 1991, p.111). Thus, the economic and social development of the Western states was due to the performance of these institutions. A way to diagnose the economic structure of a nation is to look at its institutions (Girbu, 2011, p.34). According to North (1990) vision, correlations between political and economic institutions are bidirectional, although in the end political rules lead to the creation of economic rules. Acemoglu, Jonhson and Robinson (2005) offered a more nuanced description of this framework based on several arguments: Economic institutions determine the level of economic development and the distribution of resources; Economic institutions have an endogenous nature and are created by the political power; Sometimes, political power is used to serve private interests, therefore, institutions result of a political configuration are not always proper to ensure maximum aggregate growth; Distribution policy is endogenous. There are two types of political forces: de jure and de facto political power. De facto political power is more important than de jure political power; The institutions hierarchy presents as follows: political institutions → economic institutions→ economic results. The Aghion-Howitt model of endogenous growth with quality-improving innovations (quality-ladder model) provides a more detailed description of “good” institutions. The model examines the inter-linkages between growth and institutional change (Aghion and Durlauf 2005, pp. 69) and studies the connection between productivity growth (long-term growth rate) and total amount of resources used for innovation, thus for quality improvement. Their research has underlined some important ideas: Countries that invest more in higher education will achieve a higher productivity of research activities and reduce the opportunity cost of research and development (R & D); Growth accelerates with the number of innovations but decreases with increased competition in the goods markets and / or with the appearance of imitation (Aghion and Durlauf 2005, p.75). The last conclusion is contrary to the generally accepted perception of a directly proportional relationship between growth and competition. The authors argue that the distinctive factor is the distance from the technological frontier. In this respect, a high level of competition is good only for the markets where firms are placed on the technological frontier. Aghion and Howitt have noted that in the period 1945-1990 Japan, Korea and other Asian countries were able to impose high rates growth based on institutional arrangements that favored: Long-term cooperation between companies and banks; Predominance of large conglomerates in the economy; The governments massive intervention in the economy operationalized through promoting exports and subsidized lending to business sector. Distance to technological frontier determines a specific architecture of institutional framework. Thus, countries located under the border are recommended both policies that encourage investments to ensure access to long-term loans allocated on preferential terms, subsidized interest rates, and policies that equally promote primary, secondary, and higher education. Instruments used for this purpose include inter alia, private funding, monitoring speculative activities, trade liberalization, market flexibility and the use of highly qualified workforce. Post-socialist trends in China underlined the existence of hybrid forms of property rights-for example, the TVEs (township and village enterprises) the jure owned by local authorities sometimes operate under de facto private property rights held by prominent local individuals. Practical experience has shown the limits of a simplistic approach of the superiority of private property rights. The Chinese case, with a large plethora of private, public and mixed ownership patterns and pretty unclear property rights, it is a strong counter-example. Ex post World War II, Asian countries like Taiwan (but also Austria, France, Finland, Norway) have supported their strong economic growth with the help of state-owned companies (SOC). To illustrate, the powerful Korean steel producer, POSCO, was established in the early 1970s as a SOC in a country without any tradition in producing raw materials, embodying a decision considered a clear defiance of comparative advantages. Despite all that, after a decade it became the most cost-efficient global steel producer. Although in the same period (after the Second World War) land reforms in Korea, Japan and Taiwan violated the property rights of the landlords, they had a major contribution to the subsequent economic performance of these states. According to mainstream theories, once institutions are established they are believed to support certain patterns of human behavior. As they are influenced by very difficult to change factors such as climate, cultural elements, traditions or available resources, these patterns are almost impossible to modify. For example, many believe that Japan’ rice-growing culture in a very populated and natural disaster-prone environment encouraged the emergence institutions that fostered cooperation and Japanese capitalism. Considering the institutional imitation as a way to enhance economic development, some degree of adaptation to local condition is needed. As good institutions heavily depend, inter alia, on local parameters, culture, habits, political culture required adjustments end up in the creation of “unique institutions” (Chang, 2005). The case of early Meiji Japan institutional reform is an edifying example in this sense. The Japanese people recognized the importance of Western institutional model for the industrialization process. After analyzing the Western patterns, Japan imported several institution adjusted to country-specific factors- the Navy and the Post Office from Britain, Prussia served as model for the Army and the criminal law, France provided the civil law and Belgium gave the central bank model. They also applied the American educational system, but it proved ill-suited and was replaced with a combination of German and French systems. The successful experience of China, the Republic of Korea or Taipei-China, which have almost always applied a mix of unorthodox elements with orthodox policies illustrate proper institutional reforms in the shape of institutional innovation (Rodrik, Subramanian and Trebbi, 2004). The Korea splitting into two halves substantially different organized, with geography, cultural habits and traditions held fixed also means differences in the institutional system that can plausibly explain the variations of economic performance. Consistent with the idea that institutional differences are closely linked to comparative development, since the breakup, the two Korean regions have experienced significant diverging patterns of economic growth. In the late 1960’s South Korea was one of the Asian “miracle” countries (Acemoglu, Jonhson and Robinson 2005, p.22), while North Korea stagnated. The gap between income levels was huge, as South Korea had entered the rich nations club, the Organization of Economic Cooperation and Development, while the North displayed figures of per-capita income similar to sub-Saharan African countries. The radically heterogeneous economic dynamics of the two regions ex post 1950 are explained by their very different institutions which led to divergent economic outcomes. By the 1980’s it became obvious that communist economic policy programs in the North were just not working; however, desperate efforts of the political figures to continue with this measures and to cling to power for their own interests affected the population at large. Thus, the ruling elite maintained the bad institutions in place with a negative impact on the society as a whole. This “natural experiment” highlights the importance of institutions as a major factor shaping cross-country differences in economic performance. According to Glaeser, La Porta, de Silanes and Shleifer (2004), the economic performance of East Asia ex post World War II and especially of China has been the result of good-for-growth dictators, not of institutions constraining them. Indeed, the Chinese experience is relevant: there was nothing pre-destined about Deng, one of the most supportive dictators of growth, succeeding Mao, one of the worst. Not always the onset of economic growth requires an extensive ambitious agenda of complementary institutional reforms, as the case of China and India shows us. For the world’s largest two developing economies, modest changes in institutional arrangements and in authorities’ attitudes towards the economic environment have generated huge growth payoffs (Milo, 2007, p.26). The case of Philippines is a little bit different, as it continues to stagnate despite the strong improvement in its fundamentals since the 1980’s. The paradox is that although the Philippines applies sound policies and has best-fitted institutions in terms of conventional wisdom, is in a poor state; by contrast Vietnam has divergent institutions and yet is doing well. Several studies explain the week position of the Philippines pointing out its relative autonomy from the interest of powerful social figures, influential political groups and families, landed elite and wealthy Filipino capitalists (Banloi, (2004), Hutchcroft (1997, 1998), Mango (1992)). Thus, a weak Philippine state has created poor governing institutions, which in turn have generated low levels of economic performance, placing the country far behind its Southeast Asian neighbors. Moreover, the national political system hasn’t followed the patterns and requirements of economic development. To summarize, there is a rich empirical literature that has demonstrated the existence of a positive link between institutional quality and economic growth, but there were also studies concluding that countries must have a minimum level of economic development to appropriately capitalize the institutional matrix. However, it is generally accepted that between institutions and economic performance it is a two-way relationship, of mutually potentiation: developed states become stronger due to the fact that development supports institutional efficiency while the poor remain in a poverty trap because of the fragility of formal institutions. References 1. Acemoglu, D., Johnson, S., Robinson, J., 2001. The Colonial Origins of Comparative Development: An Empirical Investigation. American Economic Review 91 (December): 1369–401. 2. Acemoglu, D., Johnson, S., Robinson. S., 2005. Institutions as a Fundamental Cause of Long-Run Growth. In Aghion, P. and Durlaf, N. eds. 2005. Handbook of Economic Growth, Vol. 1, Elsevier, pp. 386-464. 3. Aghion, P., Durlauf, S., 2005. Handbook of Economic Growth. North-Holland: Elsevier. 4. Banloi, R., 2004. Globalization and Nation-Building in the Philippines: State Predicaments in Managing Society in the Midst of Diversity. In: Sato, Y. Hawaii ed. 2004 Growth and Governance in Asia, Asia-Pacific Center for Security Studies. 5. Chang, H.J., 2005. Understanding the Relationship between Institutions and Economic Development-Some Key Theoretical Issues. WIDER Jubilee Conference. Helsinki, Finland 17-18 June 2005. 6. Easterly, W., Levine, R., 2003. Tropics, Germs, and Crops: How Endowments Influence Economic Development. Journal of Monetary Economics 50(1), pp. 3–39. 7. Fukuyama, F., 2006. Development and the Limits of Institutional Design. In the Seventh Annual Global Development Network Conference. St. Petersburg, Russia 19–21 January 2006. 8. Girbu, V., 2011. Influence of Institutions on the Economic Development. Akademos, No. 3 (22), pp. 34-48. 9. Glaeser, E., La Porta, R., de Silanes, L. Shleifer, A., 2004. Do Institutions Cause Growth?. Journal of Economic Growth 9, pp. 271-303. Kluver Academic Publishers 10. Hutchcroft, P., 1997. The Politics of Privilege: Assessing the Impact of Rents, Corruption, and Clientelism on Philippine Development. Institute for Popular Democracy Occasional Paper No. 1. 11. Hutchcroft, P., 1998. Booty Capitalism: The Politics of Banking in the Philippines. Quezon City: Ateneo de Manila Press. 12. Mango, F., 1992. Weak State, Ravage Forests: Political Constraints to Sustainable Upland Management in the Philippines. Philippine Political Science Journal Numbers 33-36 (June 1991–December 1992), pp. 81–82. 13. Milo, M., 2007. Integrated Financial Supervision: An Institutional Perspective for the Philippines. ADBI Institute Discussion Paper No. 81 North, D.C., 1990. Institutions, Institutional Change and Economic Performance. New York: Cambridge University Press. 14. Rodrik, D., Subramanian, A, Trebbi. F., 2004. Institutions Rule: The primacy of Institutions over Geography and Integration in Economic Development. Journal of Economic Growth 9, pp. 131-165. 15. Williamson, O., 1998. Transaction Cost Economics: How it Works, where it is Headed. De Economist 146, No.1, pp.23-58. Read More