ECONOMICS OF LESS DEVELOPED COUNTRIESmichaelking.ie/wp-content/uploads/2017/01/EC3040-L3-Institutions.pdf · Growth and Changing Institutions • Douglas North –inevitable trade

EC3040b Economics of Less Developed Countries 1

ECONOMICS OF LESS DEVELOPED COUNTRIES

EC3040b Spring 2017

Lecture Notes 3

Michael King

EC3040b Economics of Less Developed Countries

Final Tutorial Schedule

Choice of two tutorials: 1. Thursday 11 am (Aras an Phiarsaigh 2.04) 2. Thursday 12 Noon (Aras an Phiarsaigh 2.03)

Ø Take place in week 3, 5, 9 and 11.

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Course Outline 1.  Contemporary Theories of Economic

Development 2.  Policymaking: What Role for the State in

Development? 3.  The Role of Institutions in Development 4.  Aid: Does it Work? 5.  Trade: Engine of Growth or Obstacle to

Development? 6.  Domestic and International Finance:

Opportunities and Instability 7.  Economic Growth and Environmental

Sustainability


Readings 1 Suggested Readings 1.  Douglas, North. The Role of Institutions in Economic Development United

Nations Economic Commission For Europe. Discussion Paper 2003 http://www.unece.org/oes/disc_papers/ECE_DP_2003-2.pdf

2.  Evans, Peter. Development as Institutional Change: The Pitfalls of Monocropping and the Potentials of Deliberation. Studies in Comparative International Development, Winter 2004, Vol. 38, No. 4, pp. 30-52 http://sociology.berkeley.edu/profiles/evans/pdf/Developement_as_Institutional_Change.pdf

3.  Rodrik, Subramanian and Trebbi. Institutions Rule: The Primacy of Institutions over Geography and Integration in Economic Development (2002) http://www.nber.org/papers/w9305.pdf

4.  Rodrik, Dani. Institutions for high quality growth: What they are and how we acquire them (2000) http://www.nber.org/papers/w7540.pdf

5.  Rodrik, Dani. Where Did All the Growth Go? External Shocks, Social Conflict, and Growth Collapses Journal of economic growth, 1999 http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.7.6006&rep=rep1&type=pdf

6.  Collier, Paul. The Bottom Billion (2007)


Readings 2

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Lecture Structure

1.  Understanding ‘Institutions’ 2.  Impact of Institutions on Growth 3.  Agenda for Improving Institutions 4.  Role of Conflict in Development


Homework

•  Watch “Law and Disorder in Lagos, Nigeria” - Louis Theroux

Ø  http://archive.org/details/LawAndDisorderInLagosNigeria-LouisTheroux

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1.  Understanding ‘Institutions’ •  Institutions define the rules of the game for individuals,

firms and government actors. At a general level they seek to: –  Reduce uncertainty by providing structure to everyday life –  Define and limit the set of choices of individuals –  Affect economic performance by their effect on costs of

exchange and production –  Can be both formal and informal, both of which are important –  Differ from organisations in that organisations are the agents of

change whereas institutions are the “rules of the game” –  Ideas and ideologies matter in behaviour, but the role of

institutions in structuring interactions affect the price we pay for our individual actions

–  Polity makes and puts in place the economic rules of the game


‘Institutions’: All in the Mind

1.  Many of the building blocks of the world around us are a product of the human mind.

2.  Aggregation of beliefs and institutions evolved over time 3.  Cultural heritage is a mixture of beliefs inherited from

the past filtered by new experiences 4.  Institutions crucial when we move from the personal to

impersonal exchanges (don’t know the other player, large no. of players) –  It pays to cooperate in personal exchanges, the reverse when

we move to the impersonal 5.  Humans initially evolved institutions to ‘manage’ the

physical environment


Low Cost Enforcement

•  Never pays for enforcement to be perfect because at the margin an incremental resource devoted to enforcement at some point is not worthwhile in terms of the increased enforcement obtained.

•  Importance of oversight – Example: Envelope of $200 and Car park

security camera


Multiple Equilibria in Institutions

•  What is the return to a top chemist in Bangladesh or the US? –  Skills only valuable to the degree that it is

possible to integrate your knowledge with 500 other skilled people.

–  To get advantage of specialisation and division of labour need to develop a variety of organisations and institutions that will integrate your knowledge at low cost (structure of networks)


Institutions in LDCs

•  Norms and institutions are required to act as a substitute for missing markets in an environment of pervasive risks and severe transaction and information costs

•  Important institutions: –  Security of property rights against the predatory state or

marauding individuals or groups –  Voice or participation rights may be just as important as security

of property rights in explaining cross-country variations (Bardhan, 2004)

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Growth and Changing Institutions

•  Douglas North –inevitable trade off in the historical growth process between economies of scale and specialisation and transaction costs.

•  In a small, closed, face to face peasant community transaction costs are low but production costs are high (specialisation and division of labour limited)

•  Li (2003) argued that relation based systems of governance may have low fixed costs but high and rising marginal costs as business expands.

•  Model developed by Li (2003)

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Source: Li (2003)


Growth and Changing Institutions

•  In a large scale complex economy, as the network of interdependence widens the impersonal exchange process gives considerable scope for all kinds of opportunistic behaviour and the costs of exchange can be high.

•  Relation based traditional institutions of exchange in developing countries often did not evolve into more complex (impersonal, open, legal, rational) rules or intuitions of enforcement as in early modern Europe.

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(1) Market supporting institutions

•  Which institutions matter for growth? (1) Market supporting institutions –  Property rights (more than legislation → enforcement) –  Regulatory institutions (anti-trust, financial

supervision, security regulation) –  Institutions for macroeconomic stabilization (e.g.

lender of last resort vs. currency board; pro-cyclical policies harmful)

–  Institutions for social insurance (varieties ranging from forms of transfer program aid out of fiscal resources to lifetime employment and enterprise-provided benefits)

–  Institutions of conflict management


(2) Informal Norms

•  Which institutions matter for growth? (2) Informal Norms –  Laws rarely govern all aspects of transactions and

contracts. –  Informal arrangements are useful as the cost of using

the formal legal system can be high: evaluation and enforcement of a judgment is a lengthy process

–  Norms are even more important in developing countries as a large proportion of the economy is informal in both urban and rural areas


2.  Impact of Institutions on Development

•  Institutions key to economic growth •  What matters are the rules of the game in

a society and their conduciveness to desirable economic behaviour

•  Reverse causality cannot be ruled out easily


Impact of Institutions on Development

•  Rodrik, Subramanian and Trebbi (2002) estimate the respective contributions of institutions, geography, and trade in determining income levels around the world –  The results indicate that the quality of institutions

“trumps” everything else. –  Integration has no direct effect on incomes, while

geography has at best weak direct effects once institutions are controlled for.

–  Integration also has a (positive) impact on institutional quality, suggesting that trade can have an indirect effect on incomes by improving institutional quality.


The determinants of income - Rodrik, Subramanian and Trebbi (2002)

Institutions

Geography Exogenous

Endogenous Integration

Income levels


Lessons from Economic History -Acemoglu, Johnson and Robinson

(2002) 1.  Among countries colonized by European powers over past 500

years, those that were relatively rich in 1500 are now relatively poor. 2.  Authors analysis this reversal using urbanization patterns and

population density(proxy for economic prosperity). 3.  Reversal reflects changes in the institutions resulting from European

colonialism. 1.  Europeans were more likely to introduce institutions encouraging investment in

regions that were previously poor.

4.  Reversal took place during the late eighteenth and early nineteenth centuries whereby societies with good institutions took advantage of the opportunity to industrialise.

5.  This reversal weighs against a view that links economic development to geographic factors

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Source: Acemoglu, Johnson, and. Robinson (2002)







•  Acemoglu, Johnson, and. Robinson (2001) exploit the differences in the mortality rates faced by European colonialists to estimate the effect of institutions on economic performance.

•  Argument: 1.  Europeans adopted different colonization policies in

different colonies, with different associated institutions.

2.  Choice of colonization strategy was in part determined by whether the Europeans could settle in the colony.



3.  Where Europeans faced high mortality rates, they could not settle and they were more likely to set up worse (extractive) institutions.

4.  If they could settle, superior growth supporting institutions were established

5.  The early institutions persisted to the present.

Ø  Estimates imply that differences in institutions explain approximately ¾ of the income per capita differences across former colonies.



•  Easterly and Levine (2002) find evidence that tropics, germs, and crops affect development through institutions and find no evidence that tropics, germs, and crops affect country incomes directly.


Institutions required for Trade

•  “The theoretical analyses indicate that although some trade is possible even without supporting organizations, sustaining the efficient level of trade is more demanding. Without administrative bodies capable of coordinating and sometimes compelling merchants’ responses to a ruler’s transgressions, trade could not expand to its efficient level.” Greif et al. (1994)


3.  Agenda for Improving ‘Institutions’

•  Easier to change formal rules •  Strategies for institution building: No blueprints! •  Accepting institutional diversity → one

implication could be that institutions we have today form only a subset of possibilities we can explore

•  Importance of local knowledge perspective / experimentalism

•  Participatory policies as important


Institutional Monocropping

•  Why is institutional monocropping attractive? –  Institutions that rich countries can understand

should help poor countries join the global economy

– Re-inventing the wheel is generally a bad idea.

– Basic institutions of rich countries are associated with development in those countries.



•  Nonetheless, why is institutional monocropping unlikely to be successful? –  Imposing new sets of rules without reshaping the

distribution of power can be problematic –  Institutions being imposed on the South are not those

that characterized the North during the period of their development.

–  Anglo-American models neglect the delivery of collective goods and emphasize the provision of individual incentives over distributional outcomes.



•  Monocropping has not worked very well in practice.

•  Last twenty years have witnessed a decline in growth rates among the supposed beneficiaries of this process in the South. –  Argentina is the most recent and dramatic example of

failure, while post-1989 institutional restructuring in Russia is perhaps the grandest.

–  China, Vietnam and Malaysia – the star performers in terms of sheer economic growth during the last 10 years –exhibit institutional patterns that are embarrassingly hybrid and non-conforming relative to the monocropping ideal.


Alternative approach: Deliberative Reform

•  We must evolve political, economic, social and cultural institutions to new challenges and to produce superior outcomes

•  Evolving institutions through public discussion and exchange

•  A valued end in itself •  Leads to acceptance of new institutions •  Adaptive efficiency: Flexible institutions that

provide maximal choice at any moment in time


Case Study: Post Arab-spring Egypt

•  http://www.economist.com/blogs/pomegranate/2013/08/egypts-politics

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Challenges Remain

•  Institutions are hard to change because of self-reinforcement mechanisms such as –  Large setup/fixed costs –  learning effects –  coordination effects –  adaptive expectations.

•  A common set of price changes or rules changes will yield different results in settings in which institutional arrangements are different


Role of Aid in Institutional Reform

•  Development aid has been used to change institutions both macro and micro and informal institutions both – Directly: Aid conditionality –  Indirectly: New rules of the game imbedded in

aid projects


Persistence of dysfunctional institutions?

•  Acemoglu and Robinson (2002) –  Reform has gainers and losers, but in most cases the winners

could compensate the losers. Politically difficult for gainers to credibly commit to compensating losers.

–  Theory where incumbent elites may want to block the introduction of the new and efficient technologies because this will reduce their future political power

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4.  Introduction: Conflict •  Conflict and instability prevent progress towards the

MDGs by undermining social and economic gains and destroying civil and political institutions

•  Over 50 per cent of the countries in Africa and 20 percent of the African population were affected by either regional or domestic conflict in 2000

•  Peace and security regularly cited as the biggest priority for ordinary Africans across the continent

•  Longer peace and security is maintained, the higher a region’s probability of escaping the conflict trap and enjoying sustained economic growth


Costs of Conflict •  The economic and social costs of these conflicts

are immense. –  Since 1960, the cost of war in Africa has included the

loss of over 8 million people (69 per cent of whom were civilian causalities)

–  Destruction of economic and administrative infrastructure

–  Displacement of millions of people –  Unethical debts –  Severe damage to the continent’s image as a

destination of foreign direct investment


Causes of Conflict •  The causes of conflict in Africa are complex and

interrelated. They include: 1.  Weak initial state institutions (post-colonial) 2.  Poor and volatile economic growth performances have served

to undermine the credibility of these institutions 3.  Natural resources abundance 4.  Availability of arms, 5.  Abuse of ethnicity 6.  Absence of an independent, well-informed civil society sector 7.  Unemployment 8.  Lack of education 9.  Population pressure 10. Misplaced humanitarian and development assistance


Rodrik (1998) Where did all the growth go?

Questions Asked •  What accounts for instability in economic performance

in most developing countries in 1970s – 1990s? •  Why were some countries hardly affected by the

volatility in their external environment during the second half of the 1970s while others suffered extensively for a decade or more before starting to recover?

•  Why do external shocks often cripple economic performance vastly disproportionately to the direct economic consequences of these shocks?


Explanations with no Evidence

•  Fail to explain variations in growth rates – Shocks in investment – More open trade regimes – Smaller public sectors – Large foreign debt prior to the shocks – Severity of the external shocks


Evidence Found

•  Countries that experienced the sharpest drops in growth after 1975 were – Divided societies (as measured by indicators

of inequality, ethnic fragmentation) – Had weak institutions of conflict management

(proxied by indicators of the quality of governmental institutions, rule of law, democratic rights, and social safety nets).


Key Conclusions •  Rodrik (1998) argued that social conflicts are key to

understanding growth instability •  When social conflicts run deep and institutions of conflict

management are weak, the economic costs of exogenous shocks are magnified by conflicts over distribution of resources and wealth that are triggered by the shocks

•  If the policy changes required to deal with an exogenous shock can be undertaken without upsetting existing social bargains and causing an outbreak of conflict over distribution of resources, the shock can be managed with no long-term damage to the economy.


Collier (2007): The Four Traps

1.  Conflict Trap –  Wars and coups or conflicts keep poor nations from

growing and therefore keep them dependent upon the exports of primary products.

–  In turn, because these nations stay poor, stagnant, and dependent on primary products, they are susceptible to wars and coups.

–  Wars ‘and coups feed on themselves in...ways that make history repeat itself’.


Collier (2007): The Four Traps 2.  Natural Resources Trap

–  A country with abundant natural resources will tend to export these resources. These resource exports cause the exporting country’s currency to appreciate against other currencies.

–  This appreciation makes the resource exporting country’s other (non-resource) exports uncompetitive (Dutch Disease).

–  These now uncompetitive exports would have been the best vehicles for technological progress in this resource abundant country. This is the natural resources trap.


Collier (2007): The Four Traps 3.  Trap of Being Landlocked with Bad Neighbours

–  Transport costs for a landlocked country depend greatly on how much its coastal neighbour spends on transport infrastructure. Put differently, ‘‘landlocked countries are hostages to their neighbours”

4.  Trap of Bad Governance in a Small Country –  In some small nations, bad governance persists for

extended periods of time as not everybody loses from bad governance.

–  ‘Leaders of many of the poorest countries in the world are themselves among the global superrich. They like things the way they are, and so it pays to keep their citizens uneducated and ill-informed’.


Collier on Trade

•  International trade has done great things for Asia

•  For Africa international trade is more ‘likely to lock yet more of the bottom-billion countries into the natural resource trap than to save them through export diversification’.


Collier on FDI

•  African countries not likely to get much FDI as economies are very small and because investors tend to know very little about them.

•  ‘Fifty-eight countries in the bottom billion, and investors do not track them individually but think of them collectively as ‘‘Africa’’ and dismiss them’.


Collier on Aid

•  Aid ‘alone is really unlikely...to be able to address the problems of the bottom billion, and it has become so highly politicized that its design is often pretty dysfunctional’.


Collier on External Military Intervention

•  The post-conflict situation is fraught with risks. Very well run country would take 10 years to turn the situation around.

•  In such a situation, some military force must be present to keep the peace.

•  ‘But, if the force is domestic, it exacerbates the problem. In the typical post conflict situation external military force is needed for a long time’.

•  Agenda for international military presence with peaceful and rebuilding objectives


Collier’s Agenda for Africa

•  Collier proposes a four-pronged approach consisting of –  International aid, – Military intervention, – Creation of international laws and charters – Selective use of trade policy


Questions?


Law and Disorder in Lagos •  National Union of Transport Workers (NUTW): MC – Union Treasurer.

–  Ran a system of permits for taxis, busses based on ‘Area boys’ system. –  Also provide protection for small businesses. Demand a fee for this. –  Services provided: prevention of new businesses opening up, protection from the state. –  “No Known Corruption”, culturally acceptable for strong, leaders to demand fees.

•  Repeatedly elected as Union Treasurer. –  Could organise unopposed elections either directly or by default. –  Could organise a support rally by area boys (beneficiaries from system). –  Resonance of traditional chieftain system. (Queen comparison). –  When explaining how his aide got job: Court of a King. –  Weak rules to govern rival factions, lead to abuse.

•  Conflict between local government and NUTW system. –  KIA: Clean streets of illegal traders.

•  Property rights and informal settlements. –  Too late to enforce property rights? Role of uncertainty.

•  Underlying cause: Poverty youth – rational calculation. •  Environment for Small Business

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ECONOMICS OF LESS DEVELOPED COUNTRIESmichaelking.ie/wp-content/uploads/2017/01/EC3040-L3-Institutions.pdf · Growth and Changing Institutions • Douglas North –inevitable trade

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