Institutions

 Definitions: Judicial systems, competition, disclosure requirements on companies, land

inheritance norms.
 Institutions to minimise risk: accounting practice; judicial systems
 Policy implications: property rights, land reform, communications infrastructure,
privatisation, policing, monopolies commissions.......
 Institutional weakness refers to inability of institutions to support economic transactions,
weak protection property rights, excess bureaucracy, centralized decision making, low
regard of rule of law, inefficient/ineffective judiciary system, and high levels of corruption.
 Hall and Jones: measure social infrastructure in terms of: law and order, quality of the civil
service (indicator of good governance), government corruption, risk of expropriation,
openness to trade.

 Theory: Transactions costs in business are excessive. In modern MEDCs we have elaborate
systems of monitoring and enforcing contracts that are embodied in law as property rights.
 Coase (1960) theorem: of let markets operate: only holds under assumption of no
transactions costs. With private transactions costs, institutions matter.
 Information asymmetry and lack of ability to enforce contracts = high transactions cost,
developing world.
 Law and order is the first institution necessary to protect investment in future growth. Mafia
racketeering is an example of private action that promotes wealth destruction rather than
creation.
 Need for norms of behaviour to constrain those in interactions.
 For institutions to develop, need benefits of institutional development> cost of monitoring
and enforcing market transactions. Brazil: favelas, people go untaxed because cost of
enforcing> benefits of taxation.
 Need for institutional reform to get away from financial crises.
 Rewards to formal/informal business activity determine whether individuals invest in
productive human capital (education and training) or invest in perverse social capital (=build
up contacts for protection or rent seeking). Cumulative effects of such decisions build up
institutions and social organisations to promote productive enterprise or alternatively
criminal activity. A society is created that pushes individuals talent in one direction or the
other = a virtuous cycle or a viscous cycle
 Difficult to change set institutions because of path dependency.
 Good institutions: have two desirable economic results: 1) relatively equal access to
economic opportunity (2) those who provide labour/capital appropriately rewarded and
their property rights protected.
 Good economic institutions likely to be accompanied by good political institutions. Need for
political power to be broadly shared and subject to checks and balances.
 North: organisations that come into existence will reflect the opportunities provided by the
institutional matrix. If institutional framework rewards piracy, then piratical organisations
come into existence.
 Findings: It is the way in which institutions monitor and regulate markets that determines
the success or failure of development strategies.
 North: ‘Institutions are rules, enforced characteristics of rules and norms of behaviour that
structure repeated human interaction’
 North: argues that, without exception, countries grow slowest when property rights are
weak or absent, the rule of law is unreliable and where governments are corrupt e.g. Roman
Empire
 Hall and Jones (1999) find that main explanatory variable to explain differences in
development is the lack of institutional support. Find that differences in output per worker
only partly explained by differences in physical capital and educational attainment.
Document that the differences in capital accumulation, productivity and therefore output
per worker are driven by differences in institutions and government policies, which they call
social infrastructure. Social infrastructure seen as endogenous, determined historically by
location and other factors captured in part by language. Social infrastructure measured as
government policies and openness to international change. Results: highest SI = Switzerland
and Canada vs. Lowest SI = Haiti and Bangladesh.
 Correlation between quality of infrastructure and output per worker, positive relationship;
Canada, USA, Singapore vs. Zimbabwe, Togo, Rwanda
 Ancient Rome: had low transactions costs, even though traded over large distances. Due to
strong central authority and enforcement.
 North: argue that historical factors can contribute to development of institutions.
 North argues that divergence in development due to differences in how institutional
structure evolves.
 Holden et al.: ‘property rights are those rules and enforcement mechanisms that determine
the ownership and means of transfer of factors of production, goods and services’.
 Licht, Goldschmidt and Schwartz (2007): modern competitive market economies emphasises
autonomy, egalitarianism, transparency, accountability. This not fit well with hierarchical
cultures social norms, where loyalty and paying tribute to the local patron is prized.
 Edwards: Latin America: lack of property rights to land leaves workers with a lack of
collateral to secure loans. Therefore not result in entrepreneurship/growth.
 Wallis and North(1986): empirical study that 45% US GNP devoted to transactions sector in
1970.

 Spain vs. Britain: Spain and Britain } best example of divergent institutional policy
 American colonies of Britain permitted to develop local control and representation.
 Spain in Latin America: lots of rules/bureaucracy (detailed economic and political policy)
 Edwards: earlier 1519 colonisation of Latin America compared to 1609 colonization of North
America. Political and religious changes in the 90 years (particularly the reformation). Also
English could learn form Spanish mistakes.
 Catholic rule in South America contribute to culture of centralization (e.g. non-believers
forced to convert).
 Veliz: English more tolerant, flexible, loved change, which passed on to Colonies. America
avoids heavy bureaucracy and religious intolerance and get a decentralized political system.
 Spain want “empire of conquest” (centralized, protectionist, bureaucratic) in Latin America,
England want “empire of commerce” (lean, decentralized, tolerant) in America

 Examples:

 Last 30 years: collapse of colonial empires; technological improvements = industrialisation;

globalisation; fall communism.

 Sierra Leone: natural resource (diamonds) but lack of institutions so did not develop.
Whereas: Saudi Arabia: good instructions: 45% GDP from oil.
 Peru: 1968-90: land reform and confiscation. Abrogation of privately held land and the
assets of MNCs. Collapse of agriculture.
 Afghanistan: forcing democracy on their society. Clash with their cultures/religions.
 Nature of centralized government ruled by decree e.g. Venezuela (Chavez) nationalisation:
cease property without compensation.
 Institutional transformation? Bolivian revolution: nationalisation of tin mines, but still goes
back to same income distribution.
 Russia: formal institutions changed, but informal remain the same. Spain (Franco): exhibit
democratic change.
 Eastern Europe: change demand by populist consent due to demonstration effect from the
West.
 Nicaragua: institutional weakness because of confidence in legal strength.
 Nigeria: oil as resource curse} corruption and poor governance. Need institutions to change
a resource from a curse to a benefit.
 World Economic Outlook (2003): if Africa institutions could be improved to the level of Asia,
African per capita GDP might be expected to double over the long term.
 Reform only successful if change the incentive structure in an economy. Contrast process of
ownership transformation in China and Esatern Europe. Very different reforms, but both
change incentive structure to create environment for fast growth. Eastern Europe:
privatisation. China: firms neither state or privately owned, but rather collectively owned
enterprises.
 China: agricultural reform (1978) = increased productivity. Therefore later reform was
against a backdrop of success elsewhere. Also agricultural surplus employed.
 Eastern Europe: more output/employment in industrial sector. Collapse of cenral planning =
decrease in output and an increase in unemployment. Their backdrop for transition was
different to that of China. Therefore the needed rapid privatisation. Enthusiastic support for
market economy because planned economy had failed. Therefore initial conditions do
matter and reforms need to be country specific.
 Japan is a rare example of a country being able to change “Path Dependency”.
 Bolivian Revolution (1952) and Mexican Revolution (1910): appear to have changed the
underlying institutional outcomes relatively little.

 Latin America 4: Informal sector of Latin America allegedly developed as a reaction against
weak property rights} wasted potential.
 Latin America: only 5% farmers actually own land they farm.

 Rubio (1997): two forms of social change in Colombia: (a) reforms economically have opened
up Colombia to trade, which is accompanied by institutional changes that have favoured
efficiency, competitiveness and productivity (b) also simultaneous growth in informal sector
and illegal sector (criminal organisations, guerrilla fractions, drug cartels)
 Colombia: see that norms of conduct in formal sector which lead to success, very similar to
those that bring success to the illegal drug sector. Distinction: is trust for government;
substitution of local “informal” system for property right enforcement, rather than national
laws and norms.
 How did Colombia institutions evolve? Rubio: look at Antiquia (Colombia) 19 th century and
California gold rush of 1849: both evolved originally on gold mining pursued through the
threat of violence (instead of property rights). Difference today: North America society
decentralised, Latin America still based on centralised government, and the marked distance
between centralised authority and local reality (seen in growth and persistence of informal
sector)

 “Cabildo” (local government institutions): outgoing members choose their replacements; in

Mexico City some were sold to the highest bidder.
 Mexico: Mishkin (2006) state that financial reforms are only ‘half way there’. An inefficient
legal system makes it hard to enforce financial contracts and this weakness in property
rights makes it difficult for banks to loan to the private sector.
 1993 electoral reforms: lead to NAFTA, central bank independence and membership of the
OECD.

 Argentina: short term ism: tenant farmers have short term contracts to plant alfalfa (for
fattening cattle). Maximised short term development rewards but led to the view that the
land was something to be exploited. Immigrants had no long term objective to stay in
Argentina. Whereas in Canada, 19th-20th Centuries, consistently investing in building
community and widening access to property rights. Canada institutions thus more
innovative, entrepreneurial and pro-long-term growth than Argentina.
 Argentina: highly centralized in 1980s: rigid rules on hiring/firing.
 Argentina: Menem (1999) tried to fix an illegal re-election to the presidency
 It is the institutional structure of the Argentine economy (the nature of land holdings; access
to liquid and human capital; the distribution of rents; the means to resolve conflicts etc.)
that has determined the nature of economic policies implemented.
 From 19th century primary export promotion to 20 th century ISI and excessive government
patronage.
 Argentina: major long term problems institutionalised: a better division of industry against
agriculture government as patron and provider rather than market policeman; increasing
fiscal deficits and external trade imbalances.
 Political transition (1983) with democratic government. Economic transition early 1990s
because of hyperinflation.
  Chile: 1973 military government initiated changes in economic institutions.

Geography vs. Institutions vs. Policy:

 Easterly and Levine (2002): Burundi poor, despite lush agricultural endowment: three
growing seasons, abundant rainfall, fertile volcanic soils, suitability for cash crops e.g. coffee,
tea cotton, bananas. BUT: on equator, landlocked, disease environment = life expectancy of
47. Belgian colonist exploits land through forced labour on coffee.
 Canada: far from the tropics, long border with a rich trading partner, access to the sea, life
expectancy 79 ( disease environment good). One of the world’s premier grain producers
(even though this not a good cash crop, it still basis for development). One of the world’s
best ratings on freedom from corruption.
 Canada Income is 107 times greater than Burundi.
 Compared to temperate climates, tropical environments tend to have poor crop yields, more
disease.
 Landlocked = not open to trade.
 Resource endowments e.g. cash crops.
 Environment shape development by influence inputs into the production function and the
production function itself.
 Bloom and Sachs (1998): Africa’s tropical location as large hindrance to development: low
fertility of tropical soils; crop pests; low net rate of photosynthesis; unstable supply of water;
high evaporation; lack of cold or dry season.
 Acemoglu, Johnsom, Robinson (2001): Europeans adopted different types of colonization
strategies. At one of the spectrum, Europeans settled and created institutions that
supported private property and checked the power of the state e.g. US, Australia, New
Zealand. Other end of the spectrum, Europeans not aim to settle, instead extract as much as
possible from the colony as possible. Not create institutions to support private property
rights, rather they establish institutions that empowered the elite to extract gold, silver, cash
crops e.g. Ivory Cost, Mexico, Peru.
 “Settler Colonies” produce post colonial governments that were more democratic and more
devoted to defending private property rights than extractive colonies. “Extractive Colonies”:
post colonial elite assumed power and exploited the pre-existing extractive institutions.
 Engerman and Sokollof (1997) argue that land endowments of Latin America lent themselves
to commodities featuring economies of scale (Rice, silver) thus historically associated with
power concentrated in the hands of the plantation and the mining elite. Endowments of
North America lent themselves to commodities growth on family farms (wheat, maize).
Leads to growth of a big middle class in which power was widely distributed.
 Mexico: 1910: 2.4% households owned land
 US: 1910: 75% farmers owned land.
 Patents fees in late 19th century in Argentina, Brazil, and Mexico etc: $400 (equivalent to
approximately 2.5-9.5 the average annual inflation). North America = $35.
 1940s: US and Canada had proportions of population voting that were 5-10 times higher
than Brazil, Bolivia, and Chile.
 Policy: sound macroeconomic polices; openness to international trade; absence of capital
account controls (and low inflation)} foster long run economic success.
 Results of regression: endowments statistically explain both economic and institutional
development. Macroeconomic policies not help account for economic development after
accounting for impact of endowments on level of economic development.
 Rodrik (2004): if the roots of underdevelopment lie in contrasting encounters with
colonisers, how can we explain the fact that countries that have never been colonies by
Europeans are among both the poorest and richest of today’s economies? Ethiopia,
Afghanistan (poor); turkey, Thailand (middle); Japan (rich).
 Geography as most pure exogenous variable of income.
 Sachs (2003) argues geography exerts a strong independent effect through it simpact on
public health environment and on transport costs.
 ‘Centrality of institution does not preclude an important indirect role for geography’.
 Attitudinal change on part of top political leadership towards a more market orientated,
private sector friendly policy framework often plays as large a role as the scope of policy
reform itself (seen in India since 1980s).
 Acemoglu, Johnson and Robinson (2002): “institutional reversal” among societies, meaning
that Europeans were more likely to introduce institutions encouraging investment in regions
that were previously poor.
 Use urbanization as a measure of economic prosperity. Also use population density as a
proxy.
 Countries income reversal since 1950s because geography useful then not useful now, and
visa versa.
 “Extractive institutions”: where power in hands of few elite = not invest.
 Idea developed in 1500s: climate has an affect on income because effect on work effort.
 Lack of resource endowments (e.g. coal) for industrialisation hinders growth? In reality, over
100 countries have coal reserves and over 50 produce coal. Therefore this theory does not
hold in reality.
 Rodrik (2004): quality of institutions “trumps” geography and trade.
 Once institutions are controlled for, integration has no direct effects on incomes, while
geography has at best weak direct effects. Trade often enters the income regression with the
wrong (i.e. negative) sign.
 Also find geography exerts a significant effect on the quality of institutions, and via this
channel on incomes.
 These results do not give explicit policy implications e.g. rule of law important, but not know
how to use this in an individual country.
 China still remains a socialist legal system, despite absence of private property rights,
Chinese entrepreneurs have felt sufficiently secure to make large investments.
 Russia: private property rights, but investors feel insecure = lack of investment.
 Past Exam Questions

2009: Q 6. Is it geography, institutions or policy that best explain economic progress? Critically assess
the relative importance of these factors with respect to EITHER Colombia OR Mexico.

ANSWER: All three are important and the best answers will show clearly how each of these issues
links together to explain the economic realities of the chosen country. I would expect that most will
conclude that institutions are the dominant influence. Geography is not destiny: even the most
difficult geographic terrain can be overcome and, equally, ‘bad’ economic policies can be reversed,
given the right combination of incentives, enterprise and protection from predation, corruption or
government dictat. Can students identify which specific institutions are important and why, rather
than just vaguely praise them?

2008: Q5. Much recent research emphasises the importance of institutions in promoting economic
growth and development. Explain and assess this claim and identify which institutions – for good or
ill – have affected the economic performance of a Latin American country of your choice.

ANSWER: Countries develop most successfully where people have incentives to invest in physical and
human capital, to trade and to build efficient markets. (World Development Report, 2002). North, de
Soto, Rodrik and others emphasise the institutions of secure property rights and low transactions
costs – facilitated in turn by impartial law enforcement, business competition, a transparent and
incorruptible civil service, prudent fiscal and monetary institutions and political institutions that
resolve conflicts (arguably, a democracy subject to checks and balances). Students should be well
capable of explaining the rationale here, the key issue is whether or not they can go on to apply this
knowledge in a Latin American context.

Identification of specific institutions in a chosen country is required. Students should be able to use
examples from Chile, Mexico, Colombia and Argentina, in various stages in their histories, to
illustrate the economic costs of not having such institutions but Chile today perhaps provides the best
Latin American example of sustained economic growth - though the political regime that initiated
the economic turnaround and ‘resolved’ political conflict at first was Pinochet’s military dictatorship.
Trade opening, fiscal and monetary regulation, was first institutionalised under military rule but an
inflation-targeting, independent central bank, tighter fiscal rules and a copper stabilisation fund
were all consolidated under subsequent democracy. Managing the ongoing conflict between those
who have, and those who have not, remains a challenge

2006: Q 2. Institutions rule: much research now emphasizes the primacy of institutions over
geography, trade and government policies in influencing economic development. Evaluate this claim
with respect to the development record of Argentina.