The Institutions and Development Debate: Part II

1. The Institutions and Development Debate: Part II Institutions, Inequality and Growth Paul Dower NES

2. Inequality in transition countries Income GINI, transition countries Before transition, it used to be from 20-28 (depending on a country)

3. Outline of talk • A theory of institutional persistence. • Structural inequality and underdevelopment. • Simply inequality or institutional inequality?

4. Why do Institutions Persist? • Institutions and poverty traps: • Too poor to afford good institutions; bad institutions make poor. • Self-reinforcing institutions: • Ex. Factor endowments favor land inequality; initial land inequality leads to elite capture of political institutions; elites set up institutions that suppress majority; suppression of the majority stabilizes land distribution. North America (family farms) vs. South America (plantations). (Engerman and Sokoloff 1997) • Ex. Resource Curse.

5. Easterly (2007) • Institutional persistence and structural inequality • Structural vs. Market Inequality • Structural inequality should correspond to average inequality over longer periods. • Test Engerman and Sokoloff hypothesis: • Factor endowments affect initial inequality; • Initial inequality persists because of poor institutions; • Poor institutions leads to underdevelopment.

7. Another Geographical IV • Suitability of land for growing wheat or sugar: • Sugar farms lead to higher inequality through plantations. • Wheat farms lead to more equal land distribution through smaller farms. • Use wheat to sugar ratio as instrument for inequality.

10. What should we expect to see? • Structural inequality as predicted by initial factor endowments should positively correlate with underdevelopment. • Higher structural inequality should also predict lower investments in institutions that empower the majority such as private property and education.

13. Overidentification Test • Test whether no direct effect on development is present. • Idea: • Both are exogenous and both should be excluded from the main regression. • Adding one as a control should have no explanatory power once we properly instrument for endogeneity.

16. Summing up • Findings robust to alternative measures and samples and a variety of controls • Ethnic fractionalization • Legal origin • Commodity exporter • Share of tropical land • Evidence supports initial hypothesis that inequality affects development through education and institutions. • Over-identification test fails to reject exclusion restriction (in all but one specification)

17. Income inequality or institutional inequality? • Easterly (2007) can not distinguish between income inequality creating bad institutions and institutions that are bad because there is inequality in access. • Both interpretations are plausible since institutions index does not vary within countries.

18. Observations from Banerjee-Duflo (2005) • Within country differences are comparable to across country differences in returns to capital and technology adoption. • Fafchamps (2000): Trade credit at 2.5%/month for dominant trading group. Double that for the minority trading group. • Investment rates in developing countries do not differ substantially lower than they should be. • Duflo et al. (2003): only 15% of farmers take up fertilizer despite over 100% return. • Human capital externalities do not appear to be high. • Rauch (1993): modest positive externalities in US cities (3%-5%). Would have to be 25% to explain cross-country differences • Average rates of return are too high given the TFP ratio implied by the productivity gap.

19. Understanding growth by understanding inequality within countries • If the returns to investment in physical and human capital are different within poor countries, using aggregate models and cross-country studies may miss the main issue. • Hypothesis: the different rates of return are driven by poor institutions and understanding how these differences affect the growth process is key to understanding the great divergence. • Alternative: excessively different rates of return are driven by market failure.

20. Land Inequality and IndustrializationGalor, Moav and Vollrath (2009) • As in ES, high land inequality leads to low levels of public investment in human capital. • Tsarist Russia: Provincial councils dominated by wealthy landowners; in 1896, rural literacy rate was 21%. After Stolypin reforms, share of education in provincial council budget increased by 50%. • Without a sufficient level of human capital, industrialization in a particular region could not occur. • In contrast to ES, this effect only delays industrialization due to increasing pressure from industrial elite to invest in human capital.

21. Empirical Strategy • US States vary by land inequality and public investment in human capital, especially before 1950. • Resistance to Industrialization: • In 1900, Alabama spent $2.58 (1929 dollars) per child on education. Massachusetts spent $36.45 per child! • In 1950, Alabama spent $63.50 (1929 dollars) per child on education. Massachusetts spent $107.55 per child.

22. Location of poverty areas in the US

24. Property Rights and Finance Johnson et al. (2002) Question: Are property rights sufficient for investment? • Survey of firms in transition countries: • Firms give subjective perception of security of property. • Detailed information on investments and assets. • Possible to test between wealth inequality and institutional inequality.

25. Observations • Entrepreneurs invest less of own funds if perceive property rights are insecure. • Absence of bank finance does not preclude investment.

27. Caveats • Barriers to entry • Firms that have survived • Small-scale

28. Conclusions • Structural inequality reflects institutional persistence. • Primacy of property institutions in contributing to structural inequality.