Institution Building and Growth in Transition Economies

1. Institution Building and Growth in Transition Economies Thorsten Beck Luc Laeven

2. Large and widening disparity in GDP per capita over the first decade of transition

3. Large variation in institution building across transition economies

4. Motivation • Large and widening disparity in economic and institutional development over the first decade of transition • Explanations of growth performance in transition economies have focused on macroeconomic policies and initial conditions • Large cross-country literature on impact of institutions on growth • Experience of transition economies offers a unique historic experiment in institution building (similar to colonization in Acemoglu et al. (2001, 2002)

5. Our explanation • Political economy theory of institution building • “institutions are not usually created to be socially efficient, [but] are created to serve the interests of those with bargaining power to create new rules” (North) • Socialist entrenchment • Incumbent socialist elite had fewer incentives to create institutions that fostered competition, as this would reduce their economic power • Reliance on natural resource • Economies that rely more on natural resources offer larger opportunities for the elite to extract rents • Countries that spent longer time under socialism and are more reliant on natural resources had less open political system at start of transition and a larger presence of former communist in parliament after first election, with negative repercussions for subsequent institution building and economic growth

6. Overview • Motivation • Institution Building in Transition Economies • Conceptual Framework • Data and Results • Institutions and Growth in Transition Economies

7. What are institutions? • Underlying rules that govern transactions between agents in an economy, both transactions between private parties, as well as between private parties and the government • Property right protection: gives incentives for investment in tangible and intangible assets and risk-taking • Contract enforcement: encourages market-based commercial and financial transaction • Socialist institutions did not allow for effective private property and for market-based exchange Transition economies had to build new market-compatible institutions

8. Framework of Institution Building Natural resource curse • Reliance on natural resources • Easier to realize short-term gains from natural resources than manufacturing • Elites were most interested in securing property rights over natural resources rather than building up market-compatible institutions • Hypothesis: Countries with higher natural resource reliance had less open political systems at start of transition and slower institution building • Examples: • Armenia vs. Azerbaijan • Albania • Measures: Initial Raw Exports/GDP, Gas reserves/population

9. Framework of Institution BuildingSocialist entrenchment • Socialist entrenchment: • Absence of civil society institutions, more centralization, thus more entrenched elites • Outside opportunities for bureaucrats lower • Hypothesis: Countries longer under socialism had less open political systems at start of transition and larger role for former communists, with negative repercussions for institution building • Examples: Belarus and Ukraine • Measure: Years under Socialism

10. Initial Raw exports/GDP Time under socialism Natural Resource Endowment Communist Entrenchment Initial Political Structure 1. Communist share 2. Executive constraints Institutional Development (Δ) KKM 1. Per capita GDP growth 2. Household consumption 3. Electricity consumption Economic Growth Macroeconomic Policies and Reforms

11. Sample

12. Determinants of Initial Political Structure - OLS regressions

13. Initial raw exports/GDP Time under socialism Natural Resource Endowment Communist Entrenchment Initial Political Structure 1. Communist share 2. Executive constraints Institutional Development (Δ) KKM 1. Per capita GDP growth 2. Household consumption 3. Electricity consumption Economic Growth Macroeconomic Policies and Reforms

14. Determinants of Institutional Development - IV regressions 1st stage: Political Structure = aZ + bX + e 2nd stage: Institutions = gPolitical Structure + dX + e Z = {Initial raw exports/GDP, Years under Socialism}

15. Determinants of Institutional Development - Robustness Tests Relationship between initial political structure and institution building robust to controlling for • Other country characteristics: Ethnic fractionalization, landlocked • Other transition characteristics: EU Accession, civil war • Initial conditions: FSU, CMEA Trade share, repressed inflation • Education: tertiary enrolment rate • Policies: Initial liberalization and speed of liberalization, Voucher privatization

16. Overview • Motivation • Institution Building in Transition Economies • Conceptual Framework • Data and Results • Institutions and Growth in Transition Economies

17. Initial raw exports/GDP Time under socialism Natural Resource Endowment Communist Entrenchment Initial Political Structure 1. Communist share 2. Executive constraints Institutional Development (Δ) KKM 1. Per capita GDP growth 2. Household consumption 3. Electricity consumption Economic Growth Macroeconomic Policies and Reforms

18. Indicators of economic development • Average annual GDP per capita growth, 1992 –2002 • Robustness checks: • Average annual GDP per capita growth, T-2002 • T = start of transition • Annual growth in electricity consumption per capita, 1992– 2002 • Annual growth in real household consumption, 1992 –2002 • Two-Stage Least Square • 1st stage: Institutions = aZ + bX + e • 2nd stage: Growth = gInstitutions + dX + e • Z = {Initial raw exports/GDP, Years under Socialism} • X = {Initial dependent variable, other controls}

19. Institution building and economic development – IV regressions

20. Institution building and economic development - Robustness Tests Relationship between institution building and GDP per capita growth is robust to controlling for • Other country characteristics: Ethnic fractionalization*, landlocked • Other transition characteristics: EU Accession, civil war* • Initial conditions: FSU, CMEA Trade share, repressed inflation • Education: tertiary enrolment rate • Policies: Initial liberalization and speed of liberalization, voucher privatization*, government consumption, monetary growth

21. Conclusions • Institutions are more important than policies in explaining growth variation across countries • Easterly and Levine (2003), Rodrik et al. (2004) • Institutional development has to be interpreted in the context of political economy