Political Regimes, Institutions and Growth

1. Political Regimes, Institutions and Growth Daron Acemoglu Charles P. Kindleberger Professor of Economics Massachusetts Institute of Technology June 2005 TÜSİAD-KOÇ UNIVERSITY ECONOMIC RESEARCH FORUM

2. The Wealth of Nations • Tremendous growth in income per capita in many parts of the world over the past 200 years. • E.g.: income per capita in the U.S. rose from $1200 in 1990 dollars in 1820 almost $30,000 today. • Average income in Western Europe during the same time arose from $1200 to over $18,000. • But changes not uniform; large disparities across countries. • Average income per capita in Africa is around $1300. • And much less in some countries; around $550 in Tanzania, Sierra Leone, Niger, and less in Zaire. • Smaller, but still substantial gap between the U.S. and “middle-income” countries like Portugal.

3. Why? • “Proximate” answers (channels and mechanics): • Physical capital • Human capital • “Efficiency”---Solow Residual • Growth accompanied with more physical and human capital, and greater efficiency. • Poor countries have less physical capital, human capital and lower efficiency. • Physical capital, the mere quantity of machines, only explains a relatively small part of the variation. • Most important factor seems “efficiency” (e.g., TFP).

4. Output and Efficiency

5. Understanding Efficiency • Why do some countries produce much more and generate more wealth out of their machines and labor force? • Two facets of efficiency • Different quality and types of machines available to different countries. • Different use of available resources, including technology. • While lacking access to new machines and techniques of production potentially important for some poor countries, for middle-income countries like Turkey, the key is making good use of existing technology.

6. Improving Efficiency • How can use of resources and technology be improved? • Three important levers: • Human capital. • Incentives. • Selection.

7. Fundamental Causes • Human capital, physical capital and technology are proximate causes of economic growth. • Why do some countries have better technologies and more human capital? • Most likely answer: • because they provide better incentives to those who can invest in new technologies and human capabilities. • because they select the rights type of individuals and firms to become the key investors and players.

8. Incentives and Institutions • Sources of incentives? • Incentives determined by institutions (rules of the game of society). • For businesses, most important “security of property rights”. • No investment will be forthcoming if businesses expect expropriation, high taxes or inefficient regulation. • Institutions have to make a credible commitment to reward investments. • Two major threats: • Theft by others • Inefficient intervention or taxation by government.

9. Institutional Variation • Big differences in institutions across countries. • Democracy vs. dictatorship. • Enforcement of property rights. • Legal systems and contracting institutions (e.g., how easy it is to enforce contracts---in Turkey, about 10 times as expensive to enforce a simple contracts as in the U.S., but on the bright side, relatively fast). • Entry barriers (e.g., cost of opening a new business over 70 times in Turkey compared to the U.S.).

10. LUX USA SGP CHE HKG JPN NOR DNK BEL CAN AUT 10 FRA ISL AUS ITA NLD GBR SWE FIN ARE KWT ISR IRL NZL QAT BHR ESP PRT MLT KOR GRC CHL BHS SAU OMN CZE ARG VEN URY 9 MEX GAB MYS ZAF BWA PAN COL HUN CRI THA TTO BRA POL TUR IRN TUN ECU BGR RUS PER DZA ROM DOM GTM PRY JAM JOR PHL IDN MAR SYR SUR 8 EGY SLV BOL GUY log GDP per capita in 1995 CHN AGO LKA ZWE HND NIC CMR GIN CIV COG SEN GHA PAK IND SDN MNG VNM GMB TGO HTI KEN 7 UGA BGD ZAR BFA MDG NGA ZMB NER YEM MLI MOZ MWI SLE TZA ETH 6 3 4 5 6 7 8 9 10 Average Protection Against Expropriation Risk, 1985-1995 Institutions and GDP

11. Causal Effect? • Of course, correlation does not may causation. • Institutions are endogenous, partially caused by income, and determined by only did factors simultaneously influencing income. • Do we know that institutions are important for long-run economic development? • Answer is yes, but we have to use different econometric techniques, in particular, instrumental variables. • One strategy: exploit sources of variation in institutions that are not directly related to income, e.g., features of history. • Example: exploiting the “natural experiment” of colonization. • These strategies typically show very important effects of institutional features on long-run growth, investment and efficiency.

12. Providing Incentives to Investors • Private sector impetus is only possible if potential investors have the right incentives. • Government policy have to take these into account. • Potential pitfalls for well-meaning policies: ignoring the importance of incentives in devising redistributive programs or regulation. • Even more so today because capital is footloose, and can easily move internationally. • Even more important, pure rent seeking policies. • Corruption by political and economic elites. • On these scores, Turkey potentially deficient. • According to the Heritage Foundation, Turkey 106th in the world in terms of economic freedoms (underneath Mali, Azerbaijan and Algeria!)

13. Why Not Efficient Institutions? • If institutions, and the incentives they provide, so important, why do countries choose “wrong” institutions? • Answer related to distributional conflict and commitment problems. • Brings us to political regimes (political institutions) and political power.

14. Distributional Conflict • Every set of (economic) institutions creates different losers and beneficiaries. • E.g.: a monopolist would be opposed to a reduction in entry barriers even if they are efficient. • Difference between potential and actual Pareto improvements. • Conflict over economic institutions. • Efficient institutions would emerge either when the losers can be compensated or when the beneficiaries to impose their choice because they have sufficient political power.

15. Commitment Problems and Limits to Efficiency • Key barrier to buying off losers: commitment. • Promise of compensation after institutional change not credible. • Monopoly of political power creates commitment problems. • Contrast contracting between two private citizens versus political contracting between two parties one of whom holds political power. • Two private citizens can write contracts enforced by a third party. • In contrast, in politics, the party with political power cannot commit to refrain from hold up; promise of a dictator not to expropriate after investments is not credible. • Also promise of payments to a dictator after he relinquishes power is not credible.

16. Importance of Political Power • If losers cannot be bought off, i.e., if potential Pareto improvements cannot be turned into actual, how are collective choices made? • Importance of political power • Political power: the power to impose or secure social choices against the wishes of other groups. • Political power  economic institutions • Key questions to be addressed later; • Where does political power come from?

17. Political Institutions (Regimes) • Where does political power come from? • Political institutions determine the distribution of political power and regulate its use  sources of political power. • Association between economic and political institutions • E.g., democratic systems emerged in European colonies which were smallholder societies with secure property rights. • Coercive states with few constraints emerged in societies with slave production, forced labor and tribute systems. • This is what theory predicts: • If political power is the monopoly of the few, the property rights of the rest cannot be entirely secure. • Conversely, if economic institutions lead to unequal distribution of resources, political institutions cannot be democratic.

18. Sources of Political Power • Two types of political power: • De jure (formal) political power • Allocated by political institutions • E.g., political power allocated to a party or Prime Minister by an election. • De facto political power • Determined by economic and military power, or access to extra-legal means • E.g., the political power of rebel groups in a Civil War, or of masses who can create social unrest or a revolution. • De facto political power typically relies on military superiority or on solving the “collective action problem”. • Distribution of political power in society determined by the distribution of de jure and de facto political power.

19. Political Institutions and Political Power • Political institutions are highly persistent; thus de jure political power is persistent. • De facto political power, which relies on military superiority and solution to the collective action problem, is by its nature transient. • If a group uses its de facto political power to change economic allocations or economic institutions for immediate gain, these changes might be reversed when the distribution of de facto political power changes. • If a group uses its de facto political power to change political institutions, then it can secure more durable gains. • It therefore makes sense to use de facto power to change political institutions and to regulate the future distribution of de jure political power.

20. Towards a Theory of Institutions • Economic institutions essential for the prosperity of nations • But also benefit different groups and individuals  social conflict • In the presence of social conflict; • political power economic and political institutions. • good institutions emerge when they benefit those with political power. • political institutions  de jure political power • Constraints on elites often conducive to better institutions. • de facto political power  political institutions  de jure political power, both today and in the future. • Toward a theory of institutional change • political power  institutions  political power • Source of persistence.

21. Dynamic linkages (summary) Economic institutionst Economic policiest Political institutionst+1 De jure power (Political institutions)t De facto powert political powert

22. Application: Rise of Constitutional Regimes in Europe • Major issue in early modern Europe: security of property rights for merchants and control of entry into overseas trade. • These economic institutions determined by the distribution of political power. • In absolutist monarchies, less security of property rights and crown monopoly of foreign trade. • Thus: political power  economic institutions

23. Rise of Constitutional Regimes (2) • Changing environment: opening of trade routes to New World and Asia via the Atlantic. • Different effects of this new economic opportunity depending on economic and political institutions • In countries with access to the Atlantic and with some degree of entry into foreign trade (i.e., Britain and the Netherlands): new groups of merchants enriched. • In countries with tight crown monopoly of trade (i.e., Spain, Portugal, France), the monarchy and its allies became the main beneficiaries • For countries without access to the Atlantic; no direct benefits and indirect costs through diversion of trade

24. Rise of Constitutional Regimes (3) • Social conflict: in Britain and the Netherlands, merchants and segments of landowners demand greater security of property rights, lower taxes and free entry into foreign trade. • New merchants’ greater economic fortunes increased their political power. • Secure victory in the English Civil War and Glorious Revolution, and the Dutch War of Independence. • In all three cases, forces against the monarchy led and largely financed by mercantile interests, especially those benefiting from overseas trade. • In Spain and Portugal, the monarchy remains strong.

25. Rise of Constitutional Regimes (4) • Thus: economic institutions  (economic outcomes) political power. political power  economic institutions • But note the role of de facto political power in determining political and economic institutions. • Merchants’ political power in the Civil War, in the Glorious Revolution or in the Dutch revolt was not granted by political institutions, but obtained because • the “Atlantic shock” improved their economic situation and their greater incomes enabled them to acquire military power and • they could coordinate and solve the collective action problem. • This was de facto political power, by its nature transient. • In fact, merchants and their allies demanded not only changes in economic institutions but changes in political institutions.

26. Rise of Constitutional Regimes (5) • Why fight to change political institutions? • Because they care about the future as well as the present and their de facto political power is transient. • Political institutions, by regulating the future allocation of de jure political power, influence future economic institutions, outcomes • Thus: de facto political power  political institutions political institutions  political power • These changes consolidate because now merchants and groups in favor of a constrained monarchy are richer and more powerful, thus command both greater de facto and de jure political power • In Spain and Portugal, economic institutions implied a different distribution of gains, and therefore the distribution of de facto political power was very different, hence no regime change.

27. Limits to Pro-Business Policies • So far the emphasis on providing the right incentives to businesses (e.g., secure property rights, good contracting institutions and environment). • But incentives alone are not sufficient. • We also need “selection”. • The right firms and people to undertake the investments. • In other words : level playing field.

28. Selection and the Incumbents • Existing firms have to be given the right incentives to undertake investments, adopt new technologies, expand their operations, etc.. • But almost always will also demand protection against competitors, especially more efficient competitors. • The process of economic growth requires “Schumpeterian creative destruction”, in other words the selection of new and more efficient firms and individuals to replace incumbents. • Without this, the process of growth will slowdown or even stop.

29. Problems of Oligarchy • Oligarchic structures, where the rich dominate politics, may generate investment, because the rich will have incentives to protect their own property rights. • But slows down creative destruction because it creates a non-level playing field and a potential hold-up problem because power is monopolized by the rich. • More efficient producers do not enter and invest enough. • Problem of institutional reform: how to transition from oligarchy to a democracy?

30. Implicit Barriers • In addition to explicit barriers protecting incumbents, implicit barriers are important; e.g., barriers created in the credit market. • If only existing large companies can raise loans, this creates a very effective entry barrier. • Lower competition will slow down of the process of creative destruction and prevent the introduction of new technologies. • Turkish banking sector until recently not playing the role of providing loans to new businesses. • Because of bad regulation, highly monopolistic structure and corruption.

31. The Balance • The balance therefore has to be found between providing incentives to existing businesses, but also limiting their power to create a non-level playing field. • An important area both for academic research and actual policy. • Need for the rights type of regulation and especially opening up of the economy to both foreign and domestic competition.

32. The Current Context • Two major economic trends of the past 30 and next 30 years: • Skill-biased technical change • New technologies replacing tasks previously performed by unskilled labor, and complementary to indicated, skilled and specialized workers • Globalization; international trade, outsourcing, foreign direct investment and financial integration • A more integrated world, through trade, within-company outsourcing, increasing foreign direct investment and capital market liberalization.

33. Skill-Biased Technical Change • Technical change, such as introduction of computers, robotics, new information processing systems, require a more skilled workforce. • More educated workers and countries with sufficient supply of educated unskilled workers are the economic winners. • Increased demand for skills and wage premium to skilled workers in both high and middle-income countries. • Slower transfer of technology to countries without a sufficient supply of skilled managers and engineers.

34. Globalization • Greater competition in the world economy. • Although standard international trade theory predicts that globalization may reduce demand for skills in middle and low-income countries, the current wave associated with transfer of technologies and outsourcing, typically increasing the demand for skills. • Skill-upgrading as a result of international trade, especially associated with outsourcing • A process similar to skill-biased technical change, favoring countries with skilled managers and engineers.

35. Globalization Challenges • Globalization an opportunity for most countries, but also a challenge. • Incorporation of China, India, Pakistan and Indonesia into the world economy means competition for low-cost producers for middle-income countries like Turkey. • No longer possible to be competitive with low wages alone. • Need to move up the quality ladder towards more skill-intensive products • Again, pitfalls of shortage of skills.

36. Institutions Now More Important • These two developments necessitate • greater creative destruction • greater investment in human capital by non-elites • more technology transfer from abroad, thus greater investments by groups outside the traditional elites • greater political stability • Becomes even more important to reform the political regime and institutions in Turkey.

37. Incentives and FDI • In a globalized world, foreign direct investment is an increasingly an important lever for transfer of technology to middle-income countries. • But incentives are even more important for FDI than for domestic investment. • Foreign companies have many options and have to incur costs to undertake investments in new countries. • Because of the general economic environment, military and political risk and regulations, Turkey has been very slow in attracting FDI.

38. Natural Synergies in Reform • Various reforms towards this new environment are potentially synergistic. • Political reform will make a level playing field easier. • Level playing field not only for businesses, but also for individuals. • Tremendous talent often lost for the society because the best education and jobs limited to the elite. • Also a natural synergy between more and better quality investment in human capital and creating a level-playing field for individuals.

39. Conclusions(1) • Proximate causes of economic growth: • human capital, physical capital and technology. • human capital’s special role in enabling technological progress. • potential pitfalls for middle-income countries • Fundamental causes: • incentives • selection

40. Conclusions (2) • Globalization and new technologies: both opportunities and pitfalls. • For a country like Turkey, institutional reform to create economic freedoms but also limit the power of incumbents (both and economic and political arena) very important. • Opportunities presented by European Union: • Most important, an engine of institutional reform • Paving the way to FDI and import of new technologies.