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ECON 4921: Lecture 2 Jon Fiva, 2009

ECON 4921: Lecture 2 Jon Fiva, 2009. Institutions and economic performance. We are interested in establishing the causal effect of institutions on long run economic performance . However , this is not straight forward: Correlation is not causation .

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ECON 4921: Lecture 2 Jon Fiva, 2009

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  1. ECON 4921: Lecture 2Jon Fiva, 2009

  2. Institutions and economicperformance • Weareinterested in establishingthecausaleffectofinstitutionsonlong run economicperformance. • However, this is not straight forward: Correlation is not causation. • Institutionsareendogenous to economicperformance. • Causality runs bothways • E.g. poorcountrieslacktheresources to buildeffectiveinstitutions • Omitted variable bias • Underlyingconditions (e.g. geography, religion, history, culture) that lead to bothinstitutions and economicperformance.

  3. PossibleSolution • Detour: The experimental ideal • In theabsenceofexperimental data a possiblesolution is instrumental variable (IV) techniques. • Need a variable (z) thatfulfilltwocriteria: • Relevance • Excludability Observables Unobservables Institutions Economic Performance Z

  4. The colonialexperiment • In a similar fashion to HJ, AJR useEuropean colonialism to isolatepotentialexogenousvariation in currentinstitutions. • Key differencebetween HJ and AJR identifyingassumption: • Colonizercharacteristics vs. conditions in colonies • Proposed Z : Settler mortality Unobservables Observables Institutions Economic Performance Settler Mortality (M)

  5. Settler mortality In thetropics, 80 percentof European deathswerecaused by malaria and yellowfever. Europeans in Africa, India and Caribbeanfacedveryhighdeath rates. Butdeath rates for the adult localpopulationweremuchlower (developedimmunity). Yellowfever in W. Africawas ’a strangers disease’. … and hadlittleeffectonthehealth and economyofindigenouspeople. Settler mortality = Mortalityofsoldiers, bishops and sailorsbetween 17th and 19th century.

  6. AJR approach rests on three premises Different types ofcolonizationpoliciescreateddifferentsetsofinstitutions. ’Extractivestates’ e.g. Congo, Nigeria, Tunisia No protectionof private property No checks and balancesagainstgovernment. Confiscatorytaxation Neo-Europes, i.e. US, NZ, AUS. Protectionof private property Law and order Feasibilityof settlements affectedtheprobabilityofdifferentsetsofinstitutions. Do not arguethat Eur. Influence in itselfwas positive or negative Exploitvariationgenerated by localdiseaseenvironment, proxied by Europeans’ mortality rates Earlyinstitutionsaffectcurrentinstitutions

  7. Reduced form show strong negative relationshipbetween settler mortality and currenteconomicperformance. • AJR interpretation: Reflectsimpactof settler mortalityoncurrentinstitutions

  8. Current institutions Focus: property rights and checksagainstgovernmentpower (’property rights institutions’) Proxy for institutions: Protection from expropriation risks. Vary from 0 to 10, for eachcountry for eachyear. AJR useaverage over 1985-1995 Extractivestate lowvalueonthisindex. Broadmeasureofproperty rights. Data from Political Risk Services Private companywhichassessthe risk that foreign investmentwill be expropriated in differentcountiries.

  9. The equation of interest

  10. OLS • Plain OLS estimatesofeq (1) find a strongassocationbetween R and Y. Alsowhencontrolling for latitude and continentdummies. • Butthisdoes not necessarily show a causaleffect • Richeconomiesmayprefer (or afford) betterinstitutions • Omitted variables • Measureofinstitutionscreated ex post • Attenuation bias (due to poorinstitutionmeasure) • Doesthis suggest an upward or downward bias in OLS?

  11. IV • Solution, treat R as an endogenous variable. • The first stage: • Isolateexogenousvariation by usingpredictedvaluesof R from first stage regression in thesecond stage.

  12. IV cont. • IV estimates suggest a large and statisticallysignificanteffectofinstitutionsonnationalincome. • Differences in institutionsaccount for over 75% ofthevariation in income per capitatoday • Improvingtheinstitutionsof Nigeria to thelevelof Chile would lead to a 7-fold increase in Nigeria’sincome. • (in practicethedifference is 11-fold) • No impactofgeography, wheninstitutionsaretreated as an endogenous variable • ”Theseresults suggest thatAfrica is poorerthanthe rest ofthe world not becauseof pure geographic or culturalfactors, butbecauseofworseinstitutions” (p. 1372 AJR).

  13. IV cont. • Results robust to: • Different subsamples • Controlling for continent dummies, geography. • Controlling for current prevalence of malaria and life expectancy • Only using yellow fever as an instrument (eradicated today)

  14. Reversalof fortune • Manyofthe areas thatwerecolonized in thetropicalzonewerericher and more denselypopulated in 1500 thanthetemperate areas later settled by Europeans. • e.g. Mughals in India/Aztecs and Incas in Americas vs. North America, Australia. • Proxy for pre-industrialincome per capita : urbanization Source: Acemogluet al. 2002, QJE

  15. Reversalof fortune cont. • Geography or culturecanhardlyexplainthereversal • But AJR suggest: • Relativelyrichplacesgotworseinstitutions (’extractive’). • Relativelypoorplaces, wherecolonizerssettled in large numbers, gotbetterinstitutionsprotectingproperty rights of a broadcross-sectionofsociety. • Canexplain timing ofreversal (19th century): Whenthereare more investmentopportunities, institutionsshould be more important.

  16. Main point • The workof AJR suggest thatinstitutionsarethe fundamental causeoflong run growth. • goodinstitutionspreventthegovernment or elite to extract rents from society.

  17. Unbundlinginstitutions • AJR focusonproperty rights institutions, i.e. institutionsconstraininggovernment and elite expropriation. • A closelyrelatedliteraturefocusoncontractinginstitutions, i.e. institutionssupporting private contracts. • Severalpapers by Shleifer and co-authors (e.g. La Porta et al JPE1998, La Porta et al. JEL2008) • Main division: common vs. civillaw • Colonialtransplantationofthe legal system • Acemoglu and Johnson (to be discussed at the seminar) aim to ’unbundleinstitutions’ • Main findings: • Weakcontractinginstitutions do not have a negative effectonlong-runeconomicperformance, whileproperty rights institutions do.

  18. Conditions in the colonies • A keyaspectof AJR is that it is not theidentityofthecolonizerthat matters, butconditions in thecolonies. • Clearlydepart from HJ where European influence in itself is deemedbeneficial • Relatedto theworkofEngerman and Sokolof(1997, 2000). • The Caribbeanislandsillustratetheadverseaffectsof Europeans, whichset up repressive regimes basedonslavery and forcedlabor. • Factorendowmentssuch as geography, climate and soilconditionshelpexplainthebuilings up of ’goodinstitutions’ in nortern am. And ’poorinstitutions’ in Lat. Am.

  19. North am. Of relatively ”marginal econ. Interestcomparedwiththeextraordinaryopportunitiesavailable in theCaribbean and Lat. am” (ES2000) Haiti probablyrichestcountry in the world (on per cap basis) in 1790 Puzzle: Whydid US/CAN experiencesustainedecon. Growth in 18th and early 19th century? Pathsofdevelopment

  20. Factor endowments • Someecon. Historians have explainedthedivergence due to theidentityofthecolonizer. • But striking differenceswithintheidentityofthecolonizer (e.g. US, Can vs. Barbados, Jamaica, e.g. Argentina vs Peru) calls for otherexplanation. • AJR explainthedivergence as a resultofinstitutions. • ES: Factorendowments (incl. Climate, soil, densityof native population) • Predisposed North am. Coloniestowardsrelativelyequaldistributionsand correspondinginstitutionsfavoring a broad range ofthepopulation in commercialactivity. • Suitable for grains and livestock  noeconomicsofscale  Smallfamily farms • Predisposed Lat. Am, Caribbeancolonies to highlyunequealdistributions and institutionsthatprotectedthe elite. • Suitable for cultivatingsugar and otherhighlyvaluedcommodities  economicsofscale  extensiveuseof slaves, and thedenselypopulated native population.

  21. Persistence • ”In thosesocietiesthatbeganwithextremeinequality, elites werebetterable to establish a legal frameworkthatinsuredthemdisproportionatesharesofpoliticalpower, and to usethatgreaterinfluence to establishrules, laws, and othergovernmentpoliciesthatadvantagedmembersofthe elite relative to non-members – contributing to persistence over time ofthehighdegreeofinequality”.(ES2000) • Inequality elite withstrongpoliticalpower  institutions • E.g. considertheextensionof franchise in North Am. Vs Lat. Am.

  22. Furtherreading • Acemoglu, Johnson and Robinson 2002, QJE, Reversal of fortune: http://www.jstor.org/page/termsConfirm.jsp?redirectUri=/stable/pdfplus/4132478.pdf • Engermanand Sokoloff 2000: http://www.jstor.org/view/08953309/di014723/01p02397/0 • Rafael La Porta , FlorencioLópez de Silanes, Andrei Shleifer , and Robert Vishny . "Law and Finance" Journal ofPoliticalEconomy 106 (1998): 1113-1155. http://www.journals.uchicago.edu/cgi-bin/resolve?JPEv106p1113PDF • Rafael La Porta , FlorencioLópez de Silanes, Andrei Shleifer. ”The EconomicConsequencesof Legal Origin”, Journal ofEconomicLiterature 46 (2008), 285-332 http://www.economics.harvard.edu/faculty/shleifer/files/consequences_JEL_final.pdf

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