648 Class Note for ECON 570 at PSU
648 Class Note for ECON 570 at PSU
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Date Created: 02/06/15
Notes on Institutions Econ 570 Spring 2005 1 Introduction We want to distinguish the role of geography institutions and policy integration but this is hard due to endogeneity This is evident in the Rodrik diagram gure 1 Geography has effects via several channels 0 direct effect via agricultural productivity and morbidity o indirect via integration with world economy eg greater costs of trade 0 indirect effect via institutions via settlers and then institutions via factor endowments and then political systems via the resource curse Of course the existence of the resource curse is itself open to question The resource curse literature assumes that resource abundance bad institutions But it could be that the impact of resource abundance on performance depends on institutional type In that case the impact of resources themselves would not be independent of the institutions choice 2 Rodrik et a1 Basic Speci cation The basic idea is to test 10gy MaINS 51NT f YGEOiJFEi 1 where y is income per capita in country i INS INT and GEO are respectively measures for institutions integration and geography and E is the random error term Throughout the paper we will be interested in the size sign and signi cance of the three coef cients 04 6 and 39y Institutions Thoughts Spring 2005 inc olne level m m 2 lt9 I 39 lt33 endogenous lutegl M1011 institutions s7 lt2 1 ge ogmphy exogenous Figure 1 The Rodrik Diagram How to measure these things For now we note that institutions are measured by rule of law index Kaufman et a11 and geography is measured as distance from the equator2 Integration is openness measured as the sum of imports plus exports to GDPa The problem with estimating 1 is of course endogeneity So they use twoestage least squares with instruments from other successful papers the AJ R paper for institutions and the FR paper for trade Hence they estimate INS A 58M OONST wGEO em 2 INT 6 aOONST TSM wGEO em 3 1Am use protection against expropriation but this choice yields a larger sample 2There are problems with thls choice AccordJng to Sachs this s an exceedJngly poor choice for a senous test of geographical yanables 1 It ls at best a proxy and a poor one at that for chmate or possibly for dJstance from major markets and shoulol not be useol as the basis of the bulk of the tests In the RST paper when much better alternatwes are available In any event most geographical analyses stress several factors dJmate geographical isolation dJsease environment so that testing these Variables one at a time ls subject to extreme nsk of leftroutrvarlable errorH 2000 4 Notme that distance from the equator could also be a proxy for settlement aThlS ls also problernatlc First lapan ls not that open by thls measure nor ls the US Second there could be problems olue to use of normnal gdp rather than PPP Suppose that traole raises prooluctmty 1D tradables Nonrtradables pnces nse relatwe to traolables ms biases down the ratio of traole to gdp Institutions Thoughts Spring 2005 where SM refers to settler mortality and CONST to the FR instrument for tradeGDP4 The exclusion restrictions are that SM and CONST do not appear in equation They use quotAER approvedquot instruments Suppose you estimated 1 with OLS ignoring endogeneity Then in the 80 country sample they obtain 036 070 A 015 W 6 4 237 686 161 geography is statistically signi cant and important What about ZSLS Now the power of GEO and TNT go away Institutions have a larger coe icient three times 32 2007 355 and it is very signi cant The others are not signi cant and have the wrong sign In the rst stage SM DISTEQ and the FR measure CONST all explain institutions Only settler mortality seems to explain openness surprisingly Greater openness also improves institutions so though no direct impact on income there is an indirect effect But this is about a tenth of the direct effect of institutions on income Why so much bigger RST then estimate how these fundamental variables impact growth determinants y k h and productivity A They simply regress these variables on DISTEQ INST and LCOPENI They nd that institutions are signi cant in all the regressions the other variables are usually not and that institutions have a larger impact on physical than six times greater than hu man capital accumulation or on 32 times greater than A This could be because institutions play their biggest role in preventing expropriation If institutions are bad best to invest in human than physical capital This is not surprising but it is intuitive 4This is the constructed trade share from Frankel and Rose They suggest that we can instrument for actual tradeGDP ratios by using tradeGDP shares constructed on the basis of a gravity equation for bilateral trade ows The FR approach consists of rst regressing bilateral trade ows as a share of a country s GDP on measures of country mass distance between the trade partners and a few other geographical variables and then constructing a predicted aggregate trade share for each country on the basis of the coef cients estimated This constructed trade share is then used as an instrument for actual trade shares in estimating the impact of trade on levels of income Institutions Thoughts Spring 2005 2 Robustness Robustness checks are needed because the instruments may not be appropriate Alternative geographical variables can be used 3 Institutions and policies Should we think of these as alternatives as in EL This is problematic Policies and institutions are related Good policies such as Meiji Restoration or what happened in South Korea in the 60 s or China after 1978 have big effects Policy innovations become institutions Or bad institutional quality could be the result of bad policies It is useful to think of policy as a ow variable and institutions as a stock Institutional quality is the cumulative outcome of past policies Let p be policy on dimension i scal trade etc let I be institutional quality and let 6 be the rate at which it depreciates Then we can express the evolution of institutional quality as where 04 is the impact of a policy on institutional quality The idea here is that good policies improve institutional quality and without this they can decay If this is correct then it is not proper to include both p and I in regressions Not just because of frequency 7 EL average policies over four decades The problem is that information about the former is already contained in the latter Of course we really need a theory to develop 5 and this should be one of our goals but the implications for testing seem evident The idea here is that levels of income depend on I The impact of p should then be on changes in the level of income This is very different from Sachs s argument quot Economic theory suggests that the determi nation of per capita income should be speci ed as a dynamic process in which the growth of income during a time interval 0 T is a function of the income level at the start of the period Institutions Thoughts Spring 2005 and some kind of average of the values of the forcing variables during the time interval 3le 1 Vi f1nYTgt 50 511mm gznom 53111360 6 6 Here Z represent other factors Sachs s point is that the quality of institutions in a given time period will affect the growth rate of the economy during that period controlling for initial income as opposed to the contemporaneous level of national income Is this true however Growth rate differences may be explained by high frequency phenomena 7 policies 7 and the degree of backwardness Institutional quality may impact growth rates if the correct other factors are there I suppose But the question we are after is what explains the large differences in income levels 5 1 Transition Issues It is likely that causation goes in both directions but that these operate on different horizons Comparing countries with very different income levels 7 differences that took a very long time to occur 7 differences in institutions are likely to play a key role In the shorter run however improvements in income are likely to make it less costly to improve institutions and to make such improvements stick5 The problem for transition economics is to nd instruments to separate out these two different channels The reason for this confusion is partly due to the way most of these tests are speci ed They typically estimate a cross country regression of the form In 6061I Q52Zi5i 7 where Y is income I is a measure of institutional quality and Z is a vector of other variables that could affect income Ignoring the problems of endogeneity involved in estimating this regression the important point for our purposes is that static nature of the hypothesis being tested that the current level of institutional quality determines the current level of income6 5Crises are also periods when institutional change is rapid but what is clearly crucial for performance is the stability and durability of institutional change 6This point is emphasized by Sachs 7 Institutions Thoughts Spring 2005 But the mechanisms through which the quality of institutions are supposed to impact on performance are more likely to affect the growth rate of the economy than its level7 It is much more likely that institutional quality impacts on the growth rate of the economy given some initial level of income The process is a dynamic one The reason why regressions like expression 7 quotworkquot is that cross country differences in income are very large and so re ect years of different growth rates while the indicator of institutional quality is really the accumulation of increments in performance What transition economists would really want to explain is something like yi0T 50 f 51l om f 62Zi0T 53111330 8139 8 where yMO T is the growth rate of income over the period QT and we know measure the other forcing variables over the time period of question There are two serious problems for transition economists in this framework One relates to difference in this institution variable and what it means The second relates to the initial income variable In the context of a global cross country regression a variable like I 30m has a straightfor ward interpretation It is the institutional setup that characterizes an economy during the period that we are explaining Cross country we expect that differences in these institutional setups will be larger than any time series changes in them during the period of observation But we certainly cannot make this assumption for transition economies Time series variation in I Q is really the whole point The question is then how to measure institutional quality and how to specify the dynamic relationship between this and performance Now a serious problem for transition economists is how to measure the initial level of income when estimating an expression like 1n development economics this is not really an issue because there is no belief that initial income is measures signi cantly worse than subsequent levels unless the time period is very long But for transition economies this is precisely the problem The initial income level at the start of transition is an item of great uncertainty in transition economics because of continuing controversies about the size of the 7Notice that while this is clearly true for development it may not be so for transition Think of replacing planning institutions with the market this could improve the static allocation of resources independent of any impact on the growth rate Institutions Thoughts Spring 2005 output fall Transition is the process of prices gaining meaning So over time the dependent variable is measured with increased precision But the starting level is a big problem Of course if the size of the output fall is equally mismeasured in all transition economies then estimating 8 will not be seriously compromised But this is hypothesis is very dif cult to maintain 32 Hard Work RST argue that all of this is just a prelude to the hard work Knowing that institutions matter does not tell policy makers much What these models do is estimate 6 the impact of I on 31 but what they need to know about is 04 This is especially dif cult as the identi cation strategies for I rely on exogenous sources of information They are good instruments but they are not quotinstrumentalquot To see this sharply consider the fact that the measures of I are related to observer ratings of likelihood to invest And property rights is clearly an important factor in this Yet if we compare China and Russia we observe that in the latter there is clear formal legal protection of property rights while in the former there is a socialist legal system and very informal protection Yet investors are more secure in China than in Russia So you could not interpret the correct policy to be establish formal property rights But then it is not clear exactly how to improve I Presumably this is a problem of formal versus informal institutions We need more theory of that It is also related to the politics of rejecting institutions Institutional antibodies 7 ala Khrushchev and the Sovnakhozy 4 Unbundling Institutions AJ point out that we need to unbundle institutions We know that good institutions promote performance but why Is it support for private contracting or protection against ex propriation They use legal origins 7 who settled 7 to determine the degree of legal formalism and settler mortality for the protection type institutions Multiple IV s Institutions Thoughts Spring 2005 They nd that legal origins explains degree of legal formalism But once you control for 1 property rights protection legal formalism has little impact on y or Suggests that legal institutions have more impact on form of nancial intermediation than on growth etc Their intuition is that private contracting and reputation mechanisms can alleviate inef ciencies that are the result of insuf cient legal formalism But when property rights protection is weak there is often no easy ways to circumvent the problem Better for capital just to ea 5 Imposition versus Adoption 0 Is mortality a good instrument or does it proxy for something else Note that it is settler mortality before there was growth in per capita consumption so it is not a proxy for poverty Indeed it is positively correlated with their measure of wealth because it is European settler mortality 0 The implicit assumption here is that institutions are more easily adopted via settlement transplantation Even though institutions are non rivalrous they are not adopted easily Imitation is dif cult Japans are very few and hard to explain 0 Two problems with imitation of institutions rather than transplantation Resistance of locals to foreign institutions this could be due to threats to political power see below Dif culty in getting new institutions to work in foreign cultures 0 Where Europeans could leave their stamp they solve both problems but where the societies were already developed it is harder Of course all this begs why these institutions developed in Europe If these insti tutions are superior why must they be imposed rather than imitated Institutions Thoughts Spring 2005 5 Invasion versus imitation o This seems very much related to notions of technology transfer Sometimes it works and other times it does not Why AJR seems to imply that invasion is necessary Relate to Mokyr s examples of technology eg Da Vinci s inventions Relate it to informal institutions versus formal institutions 0 Mokyr s thesis for macroinventions to survive three conditions are essential The new idea must be technically feasible That is within the ability of contemporaries to reproduce it8 The new idea must be economically feasible The new invention has to be borne into a socially sympathetic environment in biological evolution it is sometimes necessary for an environmental shock eg earthquake to cut off a region so that speciation can occur What about political shocks to allow institutional development cutoff of cheap Soviet energy might have forced institutional change in Central Europe 0 Mokyr discusses the complementary microinventions that are necessary for a macroin vention to succeed Is there anything similar for institutional development Is this what informal institutions is all about 0 Why do powerful interest groups block the introduction of new technologies Acemoglu Robinson If they have such power why not allow the innovation that raises output and tax the proceeds 8This is where many of Da Vinci s ideas failed the workmen of the time were not skilled enough to carry them out Institutions Thoughts Spring 2005 could be limits to scal instruments more likely it is the fact that the innovation could threaten political power it is precisely when the innovation threatens the continuation of political power that innovations will be blocked blocking thus depends on the prob of remaining in power if they block 1 versus the prob of remaining in power if they do not block 8 Notice if s gt q they would never block so it is the opposite case that is interesting notice also that if the new technology is su iciently better then the monopolist would never block if s q l Taxing would always be better Blocking arises because 8 lt 1 they argue that in Britain and Germany the aristocracy was not threatened so they allowed innovation In Russia and Austria political power was more fragile So they were more concerned to block new technologies The latter had more closed political systems so they were more fragile q 7 8 may have been higher 0 The role of informal institutions is important North contrasts this with formal rules That the informal constraints are important in themselves and not simply as appendages to formal rules can be observed from the evidence that the same formal rules and or constitutions imposed on different societies produce different outcomes And discontinuous institutional change such as revolution or military conquest and subjugation certainly produce new outcomes But what is most striking although seldom observed particularly by advocates of revolution is the persistence of so many aspects of a society in spite of a total change in the rules p 36 o the key point here is that these informal constraints preexist the formal constraints They are the iceberg below the sea 7 they impact how far the formal rules can sink roots into the system 10 Institutions Thoughts Spring 2005 o What determines the power and persistence of informal rules When will they be able to bloc reform and when not Perhaps most important of all the formal rules change but the informal con straints do not In consequence there develops an ongoing tension between infor mal constraints and the new formal rules An immediate tendency is to have new formal rules supplant the persisting informal constraints Such change is sometimes possible in particular in a partial equilibrium context but it ignores the deep seated cultural inheritance that underlies many informal constraints Al though a wholesale change in the formal rules may take place at the same time there will be many informal constraints that have great survival tenacity because they still resolve basic exchange problems among the participants be they social political or economic The result over time tends to be a restructuring of the overall constraints 7 in both directions 7 to produce a new equilibrium that is far less revolutionary p 91 o the point here is that the informal rules are solving problems that are embedded in the society If the underlying structure is unchanged they will still have great value institutions typically change incrementally rather than in discontinuous fash ion How and why they change incrementally and why even discontinuous changes such as revolution and conquest are never completely discontinuous are a result of the imbeddedness of informal constraints in societies Although formal rules may change overnight as the result of political or judicial decisions informal con straints embodied in customs traditions and codes of conduct are much more impervious to deliberate policies These cultural constraints not only connect the past with the present and future but provide us with a key to explaining the path of historical change p 6 11 Institutions Thoughts Spring 2005 0 we can think of informal institutions as a reason why it is hard to import institutions Almost like antibodies rejecting foreign organisms o O ring theory gives another way to think about why technologies may not work as well in different countries 0 what this all suggests is that adopting what appear to be ef cient institutions that are successful in one society may be problematic in different societies if institutions are organizations plus expectations it is critical that the expectations beliefs be appropriate in the adopter society This of course depends on history because of the importance of cultural beliefs Hence to answer this question it is critical that we understand the conditions that make the institutions successful in particular we need to understand what collateral institutions are necessary to support them 0 Adoption takes time in a gametheoretic setting a change in the extensive form should change the equilibrium of the game instantly but in practice these changes often take a long time this may be because expectations are historically dependent this would be especially important in settings with multiple equilibria coordination games it is also due to bounded rationality which limits the ability to fully comprehend the strategic possibilities inherent in a speci c situation the work on the emergence of norms is important here it is important to recognize that a whole range of factors 7 social political cultural 7 may affect equilibrium selection not just economic ef ciency think about the cross country work on the ultimatum game 12 Institutions Thoughts Spring 2005 this would not be important if equilibria are unique but with multiple equilibria this is important the literature on the emergence of conventions is relevant here 52 Privatization of relational capital 0 1n the STE supply relations involved Gossnab obkom of cials and enterprise relations 1n transition the privatization of relational capital means essentially that Gossnab and the obkom of cials are out But the enterprise relations remain You are get ting rid of the formal rules of the old system which had already eroded under Gorbachev But during the Gorbachev period the informal relations had our ished o The reformers get rid of the formal system 7 all their attention is focused on that But what really mattered by then was the informal relations In particular Communist party had mediated relational capital Now relational capital is more direct 7 it is not mediated by other institutions Getting rid of the mediation made it easier more economical to invest in relational capital The director has more power Less people to please Returns to investment in relational capital are now all appropriated by me 7 before the State took it You could say that the tax service still takes it but liberalization makes it easier for me to evade the state So 1 have more incentive to invest in 7 Had the relational capital not previously existed privatization etc would have been correct The only action would have been to invest in reducing d But because the relational capital was there you choose to invest in r 13 Institutions Thoughts Spring 2005 55 Transition and Institutions 0 Note that institutions arise to meet the challenges posed to agents If you change the rules it had better be the case that new institutions will solve this better than the old There is competition between the structures 0 There are two critical factors in this story First there is the inherited structure of the games agents are involved with This structure determines the suitability of institutions to help agents solve the problems they face The second factor is that informal rules exist that developed when the old rules and the inherited structure were predominant When the formal rules are changed the informal rules provide an alternative lifeboat for those agents that cannot play by the new rules So in our game if the market system is suf ciently advantageous it can invade and take over the Soviet environment That means that the new formal rules are not too out of sync with the problems agents face If the legacy from the old regime is so severe that the new rules are not consistent with the problems agents face then a change in the formal rules may not be suf cient to make the new rules dominate In these circumstances the informal rules may end up dominating if the perturbation is not large enough then the virtual economy becomes the equilibrium Conquest recognizes the dif culty but the metaphor is incorrect It is not as if a country can as it were be put in dry dock and equipped with new institutions in a careful and considered way The whole venture is more like trying to reequip a ship at sea in stormy waters with a new engine This metaphor misses the point because it has the institutions replaced still in one fell swoop but it is appealing because it explains that time does not sit still for reformers and 14 Institutions Thoughts Spring 2005 that the key problem they face is the di icult environment in Which the neW institutions must take root 15
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