Measuring Institutions

1. Measuring Institutions Veneta Andonova Universidad de los Andes Colombia

2. Outline A. Economics and comparative institutional analysis • Definition and proxies • Empirical strategy • Interpretation B. International business and sociology (GLOBE) • Proxies • Interpretation C. Conclusions

3. A. Definition “A set of rules, compliance procedures, and moral and ethical behavioral norms designed to constrain the behavior of individuals in the interests of maximizing the wealth or utility of principals” (p. 201) North, Douglass C. 1981, Structure and Change in Economic History. New York: Norton & Co. “the constraints need to be reasonably permanent or durable” (p. 7) Glaeser, E., Rafael La Porta, Florencio Lopez-de-Silanes and Andrei Shleifer. 2004, “Do institutions cause growth?” SSRN Working Paper (GLLS)

4. A. Databases • Survey indicators of institutional quality from the International Country Risk Guide (the 1980s and 1990s) • Knack and Keefer (1995), Hall and Jones (1999), Acemoglu, Johnson and Robinson (2001) • Aggregated index of survey assessments of government effectiveness collected by Kaufman, Kraay and Mastruzzi (2003) • Rodrik, Subramanian and Trebbi (2002) • Polity IV data set (Jaggers and Marshall, 2000) • POLCON data set and index (Henisz, 2000) • Doing Business Project (outcome measures)

5. A. Institutional proxies • International Country Risk Guide: subjective assessment of risk for international investors Proxies: law and order; bureaucratic quality; corruption; risk of expropriation by the government; risk of government contract repudiation. These variables are highly volatile and whatever they measure, it is not permanent rules, norms and procedures constraining the sovereign (GLLS, 2004).

6. A. Institutional proxies • Aggregated index of survey assessments of government effectiveness collected by Kaufman, Kraay and Mastruzzi (2003) A large number of subjective assessments of institutional quality (quality of public service provision, quality of bureaucracy, competence of civil servants, independence of the civil service from political pressures, credibility of government’s commitment to policies) is aggregated into an index of “government effectiveness”. These are outcomes, not institutional constraints and they are highly correlated with the level of economic development (GLLS, 2004).

7. A. Institutional proxies • Polity IV data set (Jaggers and Marshall, 2000) Democracy: “the presence of institutions and procedures through which citizens can express effective preference about alternative policies and leaders, the existence of institutional constraints of the exercise of power by the executive, and the guarantee of civil liberties to all citizens in their daily lives and in acts of political participation.” • POLCON index (Henisz, 2000) Considers “the number of independent veto point over policy outcomes and the distribution of preferences of political actors that inhabit them.” By construction these variables reflects most recent electoral experiences not institutions.

8. A. Institutional proxies • The most popular institutional proxies does not have the “depth” (permanent and durable features of the environment) they are expected to have and they rarely measure constrains on government. By construction these proxies do not measure institutions, as we defined them. • These measures cannot be used to establish causality. • These measures are not correlated with ‘objective measures’ of constitutional constraints on government ([de jure] judicial independence, constitutional review, plurality, and proportional representation) (GLLS, 2004).

9. A. Empirical strategy • Acemoglu, Johnson and Robinson (2001) Mortality of European settlers influenced their decision to settle or not in certain places. When Europeans settled, they transplanted their effective institutions with multiple checks and balances, whereas when they did not settle they established a system of exploitation of local populations and arbitrary rule. • Acemoglu, Johnson and Robinson (2002) The density of local populations shaped the European settlement pattern. Both settler mortality and indigenous population density can be used as instruments for modern day political institutions constraining the executive.

10. A. Empirical strategy • Instrumental variables estimation can avoid biases the OLS estimation suffers when explanatory variables are correlated with the error term. • Finding appropriate instruments is a challenge.

11. A. Empirical strategy • OLS is problematic when one or more explanators in a regression are contemporaneously correlated with the regression’s disturbances • This correlation may exist because of an omitted explanator, a miss-measured explanator, an endogenous explanator, or a lagged dependent variable among the explanators (Murray, 2005)

12. A. Empirical strategy • Frequently, regressions requiring IV estimation have a single troublesome explanator (Y2i) and several non-troublesome explanators (Xi) (Murray, 2005): Y1i =b0 + b1Y2i + Xi b2 + ei (1) • IV estimation is made possible by a vector Z containing r variables that are (i) uncorrelated with the ei, (ii) correlated with Y2i, and (iii) are not explanators in equation (1). • For 2SLS with one troublesome estimator: Y2i = a0 + Zi a1 +Xi a2 + mi (2)

13. A. Empirical strategy • AJR 2001 • Does the risk of expropriation (institutions) partially account for differences in incomes of countries that were colonized by Europeans? • The question is interesting because it is argued that these countries had similar GDPpc 400 years ago, but their wealth widely varying today. • OLS regression cannot help answer the question, because even if a positive correlation between GDPpc and institutional proxies were found the causality cannot be established .

14. A. Empirical strategy • AJR 2001 log GDPpci = b0 + b1Ri + b2 Xi + ei (1) Ri is the protection against expropriation measure taken from International Country Risk Guide. Xiis a vector of covariates (latitude, continent dummies, legal origin dummies, temperature, humidity, soil quality, natural resources, landlocked dummy). Ri = a0 + a1 log Mi + a2 Xi + si (2) Miis settler mortality

15. A. Empirical strategy • Omitted explanators and weak instruments: • Omitting current health conditions from the income regression is problematic, as current and past health conditions are not supposed to differ much. • When malaria index for 1994 is added to the model, 2SLS yields statistically significant coefficient on the risk of expropriation. • When continent dummies are added, 2SLS does not find a statistically significant coefficient on the risk of expropriation, indicating that the instrument is weak. (instruments are weakly correlated with the troublesome variable) (Murray, 2005).

16. A. Empirical strategy • 2SLS is a poor estimation strategy when instruments are weak. The point estimates might suffer considerable bias and the estimated confidence intervals are likely to be too narrow (Murray, 2005). • A stronger instrument can be found: the 1900 proportion of the population of European descent (Murray, 2005).

17. A. Empirical strategy • Can we conclude from the pattern of European settlement that the asset being transplanted is institutions? • If settlement patterns influence growth through channels other than institutions (human capital), the validity of the instrument is compromised (GLLS, 2004). • Measurement issue: Settlers mortality is uncorrelated with constitutional measures of checks and balances and the log of 1500 population density is very weakly correlated with plurality and proportional representation (GLLS, 2004).

18. A. Empirical strategy • Acemoglu and Johnson, 2005 Yc =a1Fc + a2Ic + a3Zc + ec (1) Yc: GDPpc; the ratio of investment to GDP; the amount of private credit as a percentage of GDP; stock market capitalization as a percentage of GDP. Fc: Contracting institutions: index of legal formalism from Djankov et al. (2003); overall procedural complexity for resolving a court case involving nonpayment of commercial debt; the number of distinct procedures involved in this process (both from Doing Business, 2004). Ic: Property rights institutions: constraint on executive (Polity IV); protection against expropriation (ICRG); Heritage Foundation PRs index.

19. A. Empirical strategy • Instrumenting Institutions: Fc = b1Lc + d1Mc +Zc f1 +u1c Ic = b2Lc + d2Mc +Zc f2 +u2c (2) Mc: Instrument for PRs institutions: log mortality rate of European settlers or log indigenous population density in 1500 Lc: Instrument for contracting institutions: Dummy for English legal origin or British colony

20. A. Interpretation “Strong “first-stage” relationships between property rights institutions and the determinants of European colonization strategy (settler mortality and population density before colonization) and between contracting institutions and the identity of the colonizing power. Using this instrumental variables approach, we find that property rights institutions have a first-order effect on long-run economic growth, investment, and financial development. Contracting institutions appear to matter only for the form of financial intermediation.” (AJ, 2005)

21. A. Interpretation Przeworski (2004) • Baseline difference: the units observed as democracies (British colonies) may have had different performance as dictatorships (Spanish colonies) to those that were in fact dictatorships (Spanish colonies) or vice versa. • Effect of the treated on the treated: the units observed as controls may have performed differently under treatment than those that were actually observed as treated. This will be true if the choice of treatment is in part driven by its consequences

22. A. Interpretation • Post-treatment effect: Changing just the performance and nothing else that affects performance may be impossible (GLLS, 2004). • Distance effect: The distance under which the actual cases were observed and their closest observed matches under alternative institutions (‘treatments’) is a source of bias. • Aggregate effect: a violation of the principle that observations are independent, which implies their realizations of counterfactuals do not alter the values actually observed.

23. A. Doing Business/ World Bank institutional measures • Surveys (4 law firms per country on average) • Detailed account on procedures and time • Variables monitored: starting and closing a business, getting credit, employing workers, registering property, dealing with licensing, protecting investors, paying taxes, trading across borders, enforcing contracts) • These all are outcome variables. • They are used to condition loans (Menard and Marais, 2006) • These measures are accessible and easy to use.

24. A. Doing Business/ World Bank institutional measures • These measures are heavily biased in favor of cost minimization and reduction of legal formalism. They say nothing about the value creation capacity of institutions (Arruñada, 2007).

25. A. Doing Business/ World Bank institutional measures • Arruñada (2007) • Shell we believe that all countries must optimally have the same degree of legal formalization? Only if we believe the answer is yes we can rank countries on this dimension. • Is it possible that the demand for more or less formalization is driven by factors such as the frequency and volume of transaction and the value of the assets transacted? (the case of Peru) • We need a measure of the value added by different institutions (including formalization). It is hard to estimate it because most of the time we should be aware of the opportunity costs of institutions.

26. B. GLOBE • Global Leadership and Organizational Behavior Effectiveness research program • A study of 62 societies for the period 1993-2004 • 170 researchers • 17.300 middle managers in 951 organizations • 735 questionnaire items

27. B. GLOBE Societal culture: commonly experienced language, ideological belief system, ethnic heritage, and history. • Cultural practices (“what is”) • Cultural values (“what should be”) Cultural dimensions: multi–item constructs that capture the complexity of the phenomenon (Uncertainty avoidance, future orientation, power distance, institutional collectivism, humane orientation, performance orientation, in-group collectivism, gender egalitarianism, assertiveness)

28. B. GLOBE The measures are not flawless. However, they allow cross-country comparisons because concepts were validated across cultures. They capture the multiple facets of the phenomenon as they are multi-item constructs.

29. B. GLOBE-alizing institutional analysis • Lijphart, Arend,1999. Patterns of Democracy Lijphart uses 10 institutional outcomes to characterize the 36 democratic institutions under investigation for the period 1947-1977 Institutional outcomes: number of parties in Parliament; one-party governments; index of executive discretion; index of electoral disproportionality; index for interest groups; index of federalism; bicameral Parliament; index of constitutional rigidity; index of judicial revision; index of central bank independence.

30. B. GLOBE-alizing institutional analysis • Lijphart extracts 2 underling dimension of the data: • Executive-party dimension = consensual vs. majoritarian democracy (number of parties in Parliament; one-party governments; index of executive discretion; index of electoral disproportionality; pluralism index for interest groups) • Federal-unitary state dimension (index of federalism; bicameral Parliament; index of constitutional rigidity; index of judicial revision; index of central bank independence) These are cultural and historically determined and pass the test of institutional “depth”.

31. C. Conclusions • Need for internationally comparable large-scale studies on institutional outcomes (or more optimistically, institutions). • Search for valid multi-item constructs as proxies for institutions. • Apply advanced econometric techniques to check for biases.