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 power
in 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 by
the 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
Political loosers as barriers to economic development
All else equal, politically powerful groups would welcome superior
institutions 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 institutions
or 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 make
politically powerful groups fear losing power and oppose economic and political change, even when such change will benefit society as a whole
Political loosers as barriers to economic development
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 uneven
across 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
Political loosers as barriers to economic development
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)
Political loosers as barriers to economic development
In the context of nineteenth-century industrialization, the theory
suggests 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
Political loosers as barriers to economic development
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
Political loosers as barriers to economic development
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
Political loosers as barriers to economic development
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
Political loosers as barriers to economic development
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
Political loosers and istitutional reform: The data
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
Political loosers and istitutional reform: The data
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
Political loosers and istitutional reform: The data
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 data
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:
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