Economia e Finanza Pubblica Pietro Navarra Settimana #2: Istituzioni e sviluppo economico

Economia e Finanza Pubblica

Pietro Navarra

Settimana #2: Istituzioni e sviluppo economico

Why do institutions differ?

We saw that economic institutions matter, indeed are central in determining relative prosperity. However, finding that differences in economic institutions can account for the preponderance of differences in per-capita income between countries creates as many questions as it answers

Why do countries have different economic institutions? If poor countries are poor because they have bad economic institutions why do they not change them to better institutions?

So far we supported the view that economic institutions determine prosperity. We must now move to argue that economic institutions must be treated as endogenous and point out that what economic institutions emerge depends on the distribution of political powerin society. This is a key step towards our theory of economic institutions

Why do institutions differ? The social conflict view

Broadly speaking, there are several approaches to the question of why institutions differ across countries, one of which coincides with the approach we propose in this course: the social conflict view

Economic (and political) institutions are not always chosen bythe whole society (and not for the benefit of the whole society), but by the groups that control political power at the time (perhaps as a result of conflict with other groups)

These groups will choose the economic institutions that maximize their own rents, and the economic institutions that result may not coincide with those that maximize total surplus, wealth or income

Example: economic institutions that enforce property rights by restricting state predation may not be in the interest of a ruler who wants to appropriate assets in the future

Why do institutions differ? The social conflict view

The first systematic development of this point of view in the economics literature is North (1981), who argued in the chapter on “A Neoclassical Theory of the State” that agents who controlled the state should be modeled as self-interested

He then argued that the set of property rights that they would choose for society would be those that maximized their payoff and because of ‘transactions costs,’ these would not necessarily be the set that maximized social welfare

Political institutions play a crucial role in the social conflict view. Which economic institutions arise depends on who has political power to create or block different economic institutions

Political institutions play a central role in the allocation of such power. Thus they will be an intimate part of a social conflict theory of economic institutions

Political loosers as barriers to economic development

Why do many societies adopt policies that discourage investment and maintain institutions that cause economic backwardness?

Perhaps, politically powerful groups (elites) are not in favor of economic growth

Why should it be? It would appear that economic growth would provide more resources for these groups to take over or tax, increasing their economic returns

So why don’t powerful groups always support economic development?

We develop a theory of inefficient government policies and institutions to answer these questions

All else equal, politically powerful groups would welcome superiorinstitutions and technologies. But in practice all else is not equal, because superior institutions and technologies may reduce their political power and make it more likely that they will be replaced

At the center of this theory is the idea that changes in institutionsor the introduction of new technologies often create turbulence, eroding the political advantages and future economic rents of incumbent elites

Alternatively, new technologies may enrich competing groups, increasing their threat to incumbents. These considerations makepolitically powerful groups fear losing power and oppose economic and political change, even when such change will benefit society as a whole


Consider a concrete example: industrialization in the nineteenth century

Bairoch (1982) estimates that between 1830 and 1913, world industrialization increased by a factor of 5 (see Table 1 Panel A). Nevertheless, this process was highly unevenacross regions and countries

Over the same period the level of industrialization in developed countries (Europe and North America) increased by a factor of over 10, whereas it declined in the Third World

Among developed countries, there were also marked differences: while Britain and the U.S. adopted new technologies and industrialized rapidly, Russia, Austria-Hungary, and Spain lagged behind



Why did these countries fail to adopt new technologies that would have increased their incomes?

We argue that the desire to promote economic institutions necessary for industrialization varied considerably across countries. In the countries that lagged the most, rather than actively promoting industrialization, political elites opposed it

Why did the political elites in some societies not only fail to encourage industrialization, but also blocked the introduction of economic institutions necessary for industrialization, such as well functioning factor markets, property rights, and legal systems?

Political elites block beneficial economic and institutional change when they are afraid that these changes will destabilize the existing system and make it more likely that they will lose political power (i.e., political replacement effect)


In the context of nineteenth-century industrialization, the theorysuggests that the elites, the monarchy and landowning interests, opposed industrialization and the necessary institutional changes, because these changes were likely to erode their political power

In fact, in most cases, the rise of markets and industrialization have been associated with a shift of political power away from traditional rulers and landowners toward industrial and commercial interests, and ultimately to popular interests and the masses

For example, in Russia, the Tzar were initially strongly opposed to industrialization. When after the Crimean War industrialization in Russia finally got underway, the fears of the elites were confirmed:industrialization brought social turbulence in urban centers, and political and social change, culminating in the 1905 Revolution. This is the idea underlying our political replacement effect


The impact of political competition on blocking is nonmonotonic. Both political elites that are subject to competition and those that are highly entrenched are likely to adopt new technologies

With intense political competition, elites prefer to innovate. Otherwise they are likely to be replaced. With a high degree of entrenchment, incumbents innovate, because they are not afraid of losing political power. Instead, it is elites that are somewhat entrenched but still fear replacement that will block innovation

New technologies were rapidly adopted in Britain and subsequently in Germany where the political elites –the landed aristocracy–were sufficiently entrenched. Differently, in Russia and Austria-Hungary, where the monarchy & aristocracy controlled the political system, but feared replacement, they were against industrialization. They continued to rely on the existing system of production


The analysis that economic change is more likely to be blocked when exist greater rents to political elites from staying in power

Another factor contributing to stagnation in Russia and Austria-Hungary may have been the substantial rents obtained by the landed aristocracy from the more feudal labor relations in the agricultural sector of these countries

Rents were influenced by political institutions. Both Russia and Austria-Hungary were ruled by absolute monarchies who were unconstrained by representative political institutions. In Britain, the absolute monarchy had been to a large extent emasculated by the Glorious Revolution of 1688 and had lost many prerogatives

Therefore, an important determinant of attitudes toward change will be the preexisting political institutions: when these institutions limit political rents, elites will be more favorable toward change


Differences in the level of human capital may be important in shaping the elites’ attitudes toward industrialization

Since human capital is complementary to industrial activity, a high level of human capital makes future gains from industrialization larger relative to the rents from preserving the existing system, thus discouraging blocking by the elites

Finally, external threats often make incumbents more pro-innovation, because falling behind technologically makes counties vulnerable to foreign invasion

This insight may explain why the Russian defeat in the Crimean war or the American blockade of Japan changed political elites’ attitudes toward industrialization and modernization


Three main empirically testable propositions can be derived from A&R theory

Proposition 1 Incumbent political elites decide to implement economic reforms critical to production if political competition is either very high or very low. For intermediate levels of political competition incumbent political elites opt for blocking economic reforms

Proposition 2 Incumbent political elites are more likely to block institutional reform when political rents are high and human capital of the workforce is low

Proposition 3 Incumbent political elites are more likely to implement institutional reform in the presence of a severe external threat and when the perpetrator is more developed

Political loosers and istitutional reform: The data

In order to verify empirically the above propositions we need to select appropriate data

We proxy the extent of economic reforms by using the Economic Freedom index annually compiled by the Fraser Institute (available online at www.freetheworld.org). The index ranks more than 140 countries in terms of their degree of economic freedom as measured by a composite of almost 45 indicators grouped into five major categories: size of government, legal structure, monetary and banking policy, international trade and regulation. The index ranges between 0 and 10, indicating low and high levels of economic freedom respectively


The degree of political competition in a country is measured by the political competition index included in the Polity IV dataset, which is annually compiled (available online at http://www.systemicpeace.org/polity/polity4.htm)

It is constructed in terms of competitiveness of participation and the existence of binding rules on when, whether and how political preferences may be expressed. It ranges between 1 and 10 with low and high values indicating low and high levels of political freedom, respectively


In order to test Proposition 2 and 3, we need data for the level of political rents accruing to the governing elites, the development of human capital and the extent of external threat

We proxy the level of political rents by using the index for corruption in the political system annually compiled by the Political Service Risk Group. That index ranges from 0 (no corruption) and 6 (high corruption)

We proxy the development of human capital by using data from the UNESCO database and the Barro and Lee (2000) human capital dataset


The third factor, affecting the decision of implementing market reforms is the risk of an external threat

We measure the extent of external threat by using an index drawn from Political Service Risk Group database which contains information about the risk for a country to face episodes of international violence. The index ranges from 0 to 12 with low and high values indicating respectively low and high risk

A simple inspection of data seems to confirm the existence of a non-linear relationship between the extent of economic reforms and the degree of political competition. The following figure clarifies this point, although it is simply a correlation


Political loosers and istitutional reform: The methodology

A formal test of the above theory requires an empirical methodology, which assesses several econometric issues. Since those issues are beyond our scope, we do not stress them.

We simply present the following equation, labelled eq. 1, to be tested:

Political loosers and istitutional reform: The results

Table 2


In Column (d) of Table 1 we note that the extent of political competition affects non-monotonically the level of economic market-oriented reform (i.e., the level of economic freedom)

The U-shaped relationship between political competition and economic reform is given by the signs and the statistical significance of PC and PC². This result allows us to confirm the results in Proposition 1

As far as Proposition 2 is concerned, we find enough evidence about the fact that the higher the level of political rents, the less likely economic reforms are implemented. We do not find empirical evidence about the role of human capital


As far as Proposition 3 is concerned, we note that the proxy for the external threat, Threat, is positive and statistically significant. This result confirms the validity of Proposition 3: the higher the external threats for a given country, the more likely the enactment of market-oriented reform

In the Column (e) of the previous table, we test the robustness of our previous finding by using a linear piecewise regression.

The results are identical to the previous ones

Political loosers, institutions and growth

Previous results are extremely interesting, since they draw a strong link between the political calculus and the decision of implementing economic reforms

As A&R argue, the implementation of economic reforms is crucial for the economic development of a country

In Table 1 we noted that countries, which do not implemented economic reforms in the developed less than the others

The next is to link the implementation of economic reforms, due to the extent of political competition, to the economic growth


Let us consider a following simple economic growth model a la Solow. The first equation defines the level of the output, while the second characterizes the accumulation of physical capital:


In the previous equation the role of the economic reforms is embodied in At which indicates the level of technology available in an economic system

We do not go through the entire development of the model, but we simply underline the facts that it may have more than one equilibrium depending on the extent of political competition and, consequently, on the decision of implementing economic reforms

More specifically the economic growth rate depends on the following four different situations


1 – The governing elites maintain the power, but do not innovate

2 – The governing elites do not innovate and are replaced

3 – The governing elites decide to innovate and maintain the power

4 – The governing elites innovate, but do not maintain the power

Clearly the cases 3 and 4 bring a larger economic growth


In order to assess how the decision of whether to implement market-oriented reforms affects economic growth, we derive from the steady state solution of the previous Solow model the following equation, labelled eq. 2:

The parameter At indicates the extent of market-oriented economic reforms

Political loosers, institutions and growth: The methodology

Our empirical strategy consists of implementing a two-step estimator

We estimate equation 1, which we analyzed before, and we include the fitted values of the dependent variable of that equation as regressor in equation 2 instead of lnAt

If the theory is fully predictive, we should note that the level of economic reforms displays a larger impact on the economic growth when it is determined by the degree of political competition

Political loosers, institutions and growth: The results


In Table 3, we report the baseline results obtained with only exogenous regressors

It should be noted that we used several proxies for the implementation of market-oriented economic reforms. More specifically, we used the general index of economic freedom and some of its components (legal system, freedom to trade, regulation and government size)

Besides Legal System and Regulation all the variables are extremely signficant and show the expected sign: the greater the estent of market-oriented reform, the higher the level of economic growth


Table 4a


Table 4b


In table 4a we report the results of the first stage of the estimation. We note that the non-monotonic relationship between political competition (democratization) and economic reform is confirmed by the data, regardless the measure of market-oriented reform we use

In Table 4b we repeat the empirical exercise already carried out in Table 3, but the variables proxing the implementation of economic reforms are now determined by the degree of political competition and other variables as indicated by A&R’s theory

All the variables, but freedom to trade, are now significant and show the expected sign. The magnitudes of coefficients are now larger than before

Political loosers, institutions and growth: Conclusions

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Economia e Finanza Pubblica Pietro Navarra Settimana #2: Istituzioni e sviluppo economico