Econ4921: Institutions and Economic Systems Jon Fiva, 2009

1. Econ4921:Institutions and Economic Systems Jon Fiva, 2009

2. Institutionsdefined • Douglas North: • ”Institutionsarethehumanlydevisedconstraintsthatstructure human interaction. Theyaremade up offormal constraints1, informal constraints2 and theirenforcementcharacteristics. Togethertheydefinetheincentivestructureofsocieties and specificiallyeconomies”. • 1) rules, laws, constitutions • 2) norms ofbehavior, conventions • … or simply ’therulesofthe game’

3. Institutionsdefinedcont. • Examples • Economicinstitutions • Contractsthatcan be written and enforced • Presence and perfectionof market • Politicalinstitutions • Form ofgovernment • Extentofchecks and balances • Bureaucracy • Federalism

4. Institutionsdefinedcont. • Examples • Economicinstitutions • Contractsthatcan be written and enforced • Presence and perfectionof market • Politicalinstitutions • Form ofgovernment • Extentofchecks and balances • Bureaucracy • Federalism • Economicinstitutionsshapetheincentivesofeconomicactors • Politicalinstitutionsshapetheincentivesofpoliticalactors • Key difference from policies: durability

5. Institutionsdefinedcont. • Ifinstitutionsaretherulesofthe game, thenorganizations and theirentrepreneursaretheplayers. • Organizations aremade up ofgroupsofindividuals, boundtogether by somecommon purpose to achievecertainobjectives. • E.g. politicalparties, firms, unions…

6. Economic System • The organizationsthatcomeintoexistencewilldependonopportunitiesprovided by theinstitutions. • Butchoiceofinstitutionswillalsodependonthepoliticalpowerofexistingorganizations. • Interactionbetweeninstitutions and organizationsshapetheeconomic system. • E.g. Capitalism is an economic system wherethe predominant form ofeconomicorganization is a firmwiththeintentionof making profits.

7. Course content • The lectures will be built around the question: How do different institutions and organizations work? • Topics: • Institutions and Economic Performance • The Firm • Organized Interest and Ownership • Complementarity of Institutions • Institutions and Commitment • Bureaucracy • Fiscal Federalism • System Competition

8. Course content cont. • The course introduces students to theories for how various institutional arrangements work, with an emphasis on economic and political institutions. • The course also deals with questions like: • Why do particular institutions come into existence? • How may certain institutions complement each other? • How are economic systems affected by competitive forces?

9. Do institutions matter?

10. Natural Experiments: Korea • Korea gainedindependence from Japan in August 1945 • SovietenteredN.Korea: Socialism, abolishing private propertyof land and capital. • US supportedS.Korea: Markets and private incentives. • Completelydifferentsetsofinstitutions, but same geography/history/culture. • Divergent pathsofeconomicdevelopment.

11. From AJR05. HandbookofEcon.Growth

12. Natural Experiments: Germany • Anotherexample is West vs East Germany • One part stagnated under central planning and collectiveownership • The otherprosperedwith private property and market economy. • Illustratethatinstitutions, not for thebenefitofsociety as a whole, may be kept in placeiftheruling elite benefit from them.

13. Cross countrycorrelations • Strong positive associationbetweencertaininstitutions and economicperformance. (FROM AJR) (FROM HJ)

14. The identification problem • Butthishardlydemonstrates a causaleffectofinstitutionsoneconomicperformance. • The kindofquestionweareinterested in answering is: • ”… ifthe UK were to switchitselectoralrulefrom majoritarian to proportional, howwouldthisaffectthesizeofitswelfarestate or itsbudgetdeficitis?” (PT) • ”If Argentina were to abondonitspresidential regime in favorof a parliamentary form ofgovernment, wouldthisfacilitatetheadoptionof sound policy towardseconomicdevelopment?” (PT). • Howwouldchanginginstitutions in Nigeria to thoseof Chile affecteconomicperformance? (AJR) • Howwouldincresingthe ’socialinfrastructure’ ofZaire to thatofSwitzerlandaffectproductivity? (HJ) • Howdidtheintroductionof universal suffrageaffectredistributionlevels in western Europe? (AR) • Hard questions to answerempirically. Why?

15. The identification problem • Butthishardlydemonstrates a causaleffectofinstitutionsoneconomicperformance. • The kindofquestionweareinterested in answering is: • ”… ifthe UK were to switchitselectoralrulefrom majoritarian to proportional, howwouldthisaffectthesizeofitswelfarestate or itsbudgetdeficitis?” (PT) • ”If Argentina were to abondonitspresidential regime in favorof a parliamentary form ofgovernment, wouldthisfacilitatetheadoptionof sound policy towardseconomicdevelopment?” (PT). • Howwouldchanginginstitutions in Nigeria to thoseof Chile affecteconomicperformance? (AJR) • Howwouldincresingthe ’socialinfrastructure’ ofZaire to thatofSwitzerlandaffectproductivity? (HJ) • Howdidtheintroductionof universal suffrageaffectredistributionlevels in western Europe? (AR) • Hard questions to answerempirically. Why? • Institutionsareendogenous to economicperformance. • Causality runs bothways • E.g. poorcountrieslacktheresources to buildeffectiveinstitutions • Omitted variable bias • Underlyingconditions (e.g. geography) that lead to institutions and economicperformance. • Fundamental problem: cannotobservethecounterfactual

16. The identification problem cont. • Whatwecanlearn from correlations and OLS regressions is limited. • Acemoglu (2005, JEL) makes this argument forcefully in a reviewof Persson and Tabellini (2003).

17. Endogeneity • Agents understand thatdifferentpolicieswillmapintodifferentoutcomes • Policy endogeneity • ”Ifstate policy making is purposeful action, responsive to economic and politicalconditionswithinthestate, then it may be necessary to identify and control for theforcesthat lead policies to changeifonewishes to obtainunbiasedestimatesof a policy’sincidence” (Besley and Case 2000,EJ) • Agents understand thatdifferentinstitutionswillmapintodifferentpolicies and outcomes. • Endogeneity ofinstitutions

18. Endogeneity cont. • Large literaturetreatinstitutions as exogenous (e.g. institutionsare ’predetermined’ or ’given by history’) • However, the same factorsthat make policiesunappealing to treat as exogenous is relevant for institutions. • E.g. The introductionofdemocracywas not ’random’ • Importantcontributionsthattry to dealwiththis problem includes Hall and Jones (1999), La Porta et al. (1998), Acemoglu, Johnson and Robinson (2001), Persson and Tabellini (2003), Acemoglu and Johnson (2005).

19. Proximate vs fundamental causes • Vast differences in prosperityacrosscountries • Output per worker 32 times higher in topfivecountries relative to tobottomfivecountries (HJ). • Whatcanexplainthisdifference? • 1) Physicalcapitaldifferences • Poorcountriesdon’t save enough • 2) Human capitaldifferences • Poorcountriesdon’tinvestenough in education • 3) ’Technology’ differences • Poorcountriesdon’tinvestenough in R&D and technologyadaption, and fail to organizeproductionefficiently • HJ findthatconventionaleconomicexplanations (1-2) explainlittleofdifferences in output per worker (about 1/8 ofactualdifferences) • 1 – 3 arehoweverproximatecausesofdifferences in prosperity. • Whatarethefundamental causes?

20. Geography • JaredDiamond • Proximatecauses: guns, germs and steel • Fundamental causes: geography • Availabilityofcrops and animals • Axesofcommunicationacrosscontinents • Geographicaldifferences have determinedthe timing and nature ofsettledagriculture. This have shapedsocietiesability to developcomplexsocieties. • Similar arguments offered by e.g. • Myrdal (1968): “serious study of the problems of underdevelopment . . . should take into account the climate and its impacts on soil, vegetation, animals, humans and physical assets – in short, on living conditions in economic development.” • For furtherdiscussionsee AJR05 (HandbookofEcon. Growth).

21. Institutions • Hall and Jones (HJ) argue: • ”By socialinfrastrcturewemeantheinstitutions and governmentpoliciesthatprovidetheincentives for individuals and firms in an economy”. • The incentivescanencourageproductive or predatorybehavior… • HJ suggested thatoriginsofgoodinstitutionsare (partly) driven by western European influence. • “Western Europe discovered the ideas of Adam Smith, the importance of property rights, and the system of checks and balances in government, and the countries that were strongly influenced by Western Europe were, other things equal, more likely to adopt favourable infrastructure”

22. Institutions • HJ useproximity to Europe as instruments for qualityofinstitutions. • Distance from equator (latitude) • The extentofeuropeanlanguagesspokentoday in thesecountries. • These instruments are not entirelyconvincing. Why not? • WefocusontheworkofAcemoglu, Johnson and Robinson (nextweek).

23. Furtherreading • Acemoglu's review essay of PT: http://www.atypon-link.com/doi/abs/10.1257/002205105775362069 • P&T's book: http://mitpress.mit.edu/catalog/item/default.asp?ttype=2&tid=9930 • Besley and Case00: http://www.blackwell-synergy.com/doi/pdf/10.1111/1468-0297.00578 • Jared Diamonds book 'Guns, germs and steel‘: http://www.amazon.com/Guns-Germs-Steel-Fates-Societies/dp/0393317552 • AJR “Institutions as the fundamental cause of long run growth” Handbook of Economic Growth. http://dx.doi.org/10.1016/S1574-0684(05)01006-3 • Links to Hall and Jones, Acemoglu, Johnson and Robinson, Acemoglu and Johnson are on the reading list