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XPLAINING the huge difference in average see how these theories would fare when tested simultane-
incomes between the world’s richest and poorest ously against each other. Using regression analysis, we came
nations is one of the most fundamental issues in up with some sharp and striking results that have broad
development economics. How did this vast gulf implications for development conditionality, discussed
emerge, and can anything be done to reduce it? below. Our results indicate that the quality of institutions
To answer these questions, we can seek guidance from overrides everything else. Controlling for institutions, geog-
three strands of thought. First, there is a long and distin- raphy has, at best, weak direct effects on incomes, although it
guished line of theorizing that assigns a preeminent role to has a strong indirect effect through institutions by influenc-
geography. Geography is the key determinant of climate and ing their quality. Similarly, trade has a significant effect on
of natural resource endowments, and it can also play a fun- institutional quality, but it has no direct positive effect on
damental role in the disease burden, transport costs, and income. How did we arrive at these findings?
extent of diffusion of technology from more advanced areas
that societies experience. It therefore exerts a strong influ- Complex causality
ence on agricultural productivity and the quality of human Devising a reasonable empirical strategy for ascertaining how
resources. Recent writings by Jared Diamond and Jeffrey much of the variation in income levels between countries
Sachs (see page 38 in this issue) are among the more notable these three deep determinants can explain and whether they
works in this tradition. are all equally important is not straightforward. The difficulty
A second view emphasizes the role of international trade lies in disentangling the complex web of causality involving
as a driver of productivity change and income growth. We these factors and income levels, as Chart 1 illustrates.
call this the integration view because it gives participation in Geography is the only one of these deep determinants that
the larger global economy—and impediments to participa- can be treated as exogenous or not influenced by income. As
tion—a starring role in fostering economic convergence Chart 1 shows, geography can affect income directly (by
between rich and poor regions of the world. The globaliza- determining, say, agricultural productivity) as well as indi-
tion debate, of course, is to a large extent about the merits of rectly, through its impact on the extent of market integration
this integration view. or on the quality of institutions. With trade integration and
Finally, a third view centers on institutions—in particular, institutions, however, causality can run both ways. Integration
the role of property rights and the rule of law. In this view, can raise incomes, but it is equally possible for trade to be the
what matters are the rules of the game in a society, as defined result of increased productivity in an economy. And, while
by prevailing explicit and implicit behavioral norms and better institutions and better protection of property rights
their ability to create appropriate incentives for desirable increase investment and foster technological progress, thereby
economic behavior. This view, associated perhaps most raising income levels, better institutions can also be the out-
strongly with Nobel Prize winner Douglass North, has come of economic development, not least because the
recently been the subject of a number of econometric stud- demand for better institutions rises as countries and their citi-
ies, in particular by Daron Acemoglu (see page 27 in this zens become wealthier.
issue), Simon Johnson, and James Robinson. In our research, we adopted a simple yet general research
The idea that one, or even all, of the above deep determi- strategy that allowed us to estimate the elements shown in
nants can adequately explain the large variations in income Chart 1 simultaneously while taking account of the complex
levels between countries may seem, on the face of it, prepos- structure of causality. In econometric terms, using an
terous. But economists like parsimony, and we were keen to instrumental variables approach, we estimated a series of
Functions of institutions
ivit
of technology of
law
al p
Openness and
agr
Integration Institutions
are enforced. We might call them market-creating
on
Capacity to trade
lati
ets
rk ns
ma titutio long-run economic development requires more
lth
rom in s
nd
Hea
f
ce es a
istan resourc than just a boost to investment and entrepre-
D ral
Natu neurship. It also requires effort to build three
Geography
other types of institutions to sustain the growth
momentum, build resilience to shocks, and facil-
itate socially acceptable burden sharing in
regressions relating income levels to measures of geography, response to such shocks. These institutions might be called
integration, and institutions. In particular, we employed • market regulating—namely, those that deal with exter-
instruments for the two endogenous determinants—institu- nalities, economies of scale, and imperfect information.
tions and integration—drawing upon the 2001 work of Examples include regulatory agencies in telecommunica-
Acemoglu, Johnson, and Robinson and the 1999 study by tions, transport, and financial services.
Jeffrey Frankel and David Romer, respectively. These instru- • market stabilizing—namely, those that ensure low infla-
ments allow us to capture the variation in the determinant tion, minimize macroeconomic volatility, and avert financial
that is exogenous. crises. Examples include central banks, exchange rate
Our results, illustrated in Chart 2, show that the quality of regimes, and budgetary and fiscal rules.
institutions (as measured by a composite indicator of a num- • market legitimizing—namely, those that provide social
ber of elements that capture the protection afforded to prop- protection and insurance, involve redistribution, and man-
erty rights as well as the strength of the rule of law) is the age conflict. Examples include pension systems, unemploy-
only positive and significant determinant of income levels. ment insurance schemes, and other social funds.
Once institutions are controlled for, integration has no direct Evidence of some of the stabilizing and legitimizing func-
effect on incomes, while geography has at best weak direct tions of institutions comes from a study, published by Rodrik
effects. These results are very robust. They remain in 1999, of the experiences of a number of sub-Saharan
unchanged within a large range of reasonable alterations in African countries. No fewer than 15 such countries grew at
our core econometric specification (different samples, alter- rates exceeding 2.5 percent a year before 1973. But, because
native measures of geography and integration, different of weak domestic institutions, few of them, if any, were able
instruments, and additional covariates, among other things). to withstand the effects of the oil price increases and other
On the relationship between the determinants, we found macroeconomic shocks in the 1970s, so growth declined
that institutional quality always has a positive and significant sharply in the subsequent period. Macroeconomic responses
effect on integration, while integration also has a (positive) to such shocks entail serious distributional implications. For
impact on institutional quality—suggesting that trade can example, in response to a balance of payments crisis, coun-
have an indirect effect on incomes by improving institutional tries need to reduce aggregate demand by tightening fiscal
quality. Our results also tend to confirm the 2002 findings of policies. But which ones, and how? Should fiscal tightening
William Easterly and Ross Levine, who found geography to take the form of tax increases or expenditure reductions? If
be an important determinant of the quality of institutions. the latter, should spending cuts fall on defense, capital,
By how much can good institutions boost incomes? Our health, or education? Robust domestic institutions, especially
estimates indicate that an increase in institutional quality can those that provide for wide participation, allow these con-
produce large increases in income per capita. For example, in flicts to be handled at the least possible cost and prevent
Chart 2
Institutional quality scores high
Institutional quality can boost income significantly, while global integration and geography, on their own, do not.
As institutional quality rises, so does income ... but increases in integration may not help ... nor does a more benign geographic location.
2.65 –0.57 1.65
per capita1
per capita1
per capita1
Log GDP
Log GDP
Log GDP
This article draws upon “Institutions Rule: The Primacy of Institutions International Economics).
over Geography and Integration in Economic Development,” by Dani Frankel, Jeffrey, and David Romer, 1999, “Does Trade Cause
Rodrik, Arvind Subramanian, and Francesco Trebbi, NBER Working Growth?” American Economic Review, Vol. 89 (June), pp. 379–99.
Paper 9305, October 2002 (Cambridge, Massachusetts: National Bureau North, Douglass C., 1990, Institutions, Institutional Change and
of Economic Research). Economic Performance (New York: Cambridge University Press).
References: Rodrik, Dani, 1999, “Where Did All the Growth Go? External Shocks,
Acemoglu, Daron, Simon Johnson, and James A. Robinson, 2001, Social Conflict, and Growth Collapses,” Journal of Economic Growth,
“The Colonial Origins of Comparative Development: An Empirical Vol. 4, No. 4, pp. 385–412.
Investigation,” American Economic Review, Vol. 91 (December), ———, 2003, “Institutions, Integration, and Geography: In Search of
pp. 1369–1401. the Deep Determinants of Economic Growth,” in In Search of Prosperity:
Diamond, Jared, 1997, Guns, Germs, and Steel (New York: W.W. Analytic Country Studies on Growth, ed. by Dani Rodrik, forthcoming
Norton & Co). (Princeton, New Jersey: Princeton University Press).
Easterly, William, and Ross Levine, 2002, “Tropics, Germs, and Sachs, Jeffrey D., 2001, “Tropical Underdevelopment,” NBER
Crops: How Endowments Influence Economic Development” (unpub- Working Paper 8119 (Cambridge, Massachusetts: National Bureau of
lished; Washington: Center for Global Development and Institute for Economic Research).