1. Political economy Lecture 3 Economic growth & institutions Jan Fałkowski Faculty of Economic Sciences, University of Warsaw February-June 2010

2. 2 Outline We have made ourselves familiar with economists’ perception of „institutions” Now the question is: How do they work in practice? Can we establish the relationship between insitutions and economic growth? What does it look like? Lecture based on: – Acemoglu (2008) – chapter 1 – Acemoglu & Robinson (2001) – Gleaser et al. (2004)

3. 3 Why economic growth? Understanding it often presented as a core of economics Income differences have major welfare implications May highlight (mis)functioning of the state

4. Economic growth – some data Large differences in income per capita across countries In 2000: US 34 000, Mexico 8 000, India 2 500, Nigeria 1 000 (all in PPP US $) Without PPP adjustments, gaps even larger Over time: slight increase in inequality across nations not necessarily across individuals in the world economy – due to growth in China and India High incomes = high standards of living how does economic growth affect consumer choices? (rising aspirations) – given bundles may no longer satisfy consumer Income positively correlated with life expectancy at birth and consumption levels Economic growth may affect pollution issues, etc. => It is worth investigating differences in incomes

5. Why are there differences in incomes? Some argue that: technological differences are at the heart – Poor countries do not use best available technologies – Poor countries do not use their technologies efficiently The question though remains: why is that so? Others argue that: market failures (credit, land) are responsible The question still remains: why do we observe these markets to fail?

6. Why are there differences in incomes? Differences in growth rates in the postwar era, do not provide the whole explanation for differences in incomes – Gaps we observe today have already been before – See the different growth patterns in XIX th century (Maddison) – … and earlier data Existing views: – Luck – History – path dependence – Geography – exogenous factors – Institutions: humanly devised rules providing incentives

7. Institutions & growth What kind of institutions we are interested in? – Enforcement of property rights – Contract enforcement (judiciary system, codified rules) – Constraints on executive (politicians) Distribution of political power – Market structure Entry barriers – But also institutions for managing social conflict Growth creating both winners and losers – Creative destruction – Structural transformation

8. Institutions & growth Correlates vs. casual effects – Correlation may simply reflect omitted vars affecting both investigated phenomena – Difficult task to establish casual relationship (endogenous variables being equilibrium outcomes themselves; omitted variables effect) How can we measure the impact of insitutions? Acemoglu et al. (2001) provide an interesting example – Methodological issue: settler mortality as an instrument

9. Acemoglu et al. 2001 Natural experiment: European colonization – Why natural? Randomized experiments are rare, therefore we rely on actual policy changes and take advantage of changes that were not made explicitly to measure the effects of policies – Other example: separating Korea between North & South Geography is held constant European settlers establish new institutions – Importantly there is a variation among institutions chosen by European settlers

10. Acemoglu et al. 2001 Departure point: – Different colonization policies (compare Latin America or Belgian Congo and English speaking colonies) – „Extractive policies” vs. replicating European institutions Colonization policy was determined by feasibility of settlement – Greater mortality increased the likeliness of „extractive policies” Insitutions and performance persisted after colonies become independent states

11. Acemoglu et al. 2001

12. Current institutions (protection against risk of expropriation) instrumented with settlers’ mortality positively affect current income levels Established institutions provided checks on politicians implementing (bad) policies

13. Are institutions always good? When can we expect institutions harmful for long- run growth? – in the face of social conflict – Those in power will not benefit from growth, institutions changing the distribution of political power – There are huge resources to be (potentially) extracted – Weak constraints on executive – Manipulating factor prices

14. Bad institutions – example of Iceland Eggertsson (2005): „The central paradox in Iceland’s economic history is Icelanders’ failure to develop a specialized fishing industry and exploit on a large scale the country’s famous fisheries” Political elites – agric. landlords – opposed it being affraid of losing workers moving to fishing industry and facing high labour costs => Elites pressure on tightening regulations in labour market and their enforcement

15. Glaeser et al. (2004) Casual relationship between growth and institutions may run the other way around: – Growth promotes good isntitutions Note also human & social capital impact on insitutions – Determine institutional opportunities Much evidence points to the primacy of human capital for growth & institutions – Institutions having only second order effect – not to say that they do not matter

16. Glaeser et al. (2004) Do settlers bring with them insitutions, human capital, or something else? Econometrics: If settlers’ mortality affects growth thorough other channels than institutions (e.g. human capital) than using it as an instrument may be wrong (correlation with error term)

17. Next lecture We will talk about property rights Read: Besley (1995) & Acemoglu & Johnson (2005)

18. Thank you for your attention & see you next week