The Skeptics Guide to Institutions – Part 4

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The final installment of my series on the empirical institutions literature. Quick summary of the prior posts:

  1. Part 1: cross-country studies of institutions are inherently flawed by lack of identification and ordinal institutional indexes treated as cardinal
  2. Part 2: instrumental variable approaches – settler mortality included – are flawed due to bad data and questions and more identification problems.
  3. Part 3: historical studies show that there is path dependence or a poverty trap, but not that institutions themselves are central to underdevelopment

You have to be very careful with what you conclude from the institutions literature or from my three posts. We are dealing with empirics here, so we are not able to make any definitive statements. There is a null hypothesis, and we either reject or fail to reject that null.

So what is that null hypothesis? For the institutions theory, as with any theory, the correct null hypothesis is that it is wrong. Specifically, the null hypothesis is “institutions do not matter”. What does the empirical institutions literature tell me? I cannot reject that null. We do not have sufficient evidence to reject the idea that institutions do not matter.

But failure to reject the null is not the same as accepting the null. Having failed to reject the null, I cannot conclude that institutions do *not* matter. They may matter. All the other reading and thinking I’ve done on this subject suggests to me that they *do* matter. But the existing empirical evidence is not sufficient to strongly reject the null that they do *not*. As I said in the last post, there may be a working paper out there right now that offers a real definitive rejection of the null.

Given the empirical evidence, then, I’m uncomfortable making broad pronouncements that we have to get institutions “right” or “improve institutions” to generate economic development. We do not have evidence that this would work.

Further, I’m not sure that even if that mythical working paper did appear to solidly reject the null that the right advice would be to “improve institutions”. I say this because even the institutions literature tells you that it is impossible to make an exogenous change to institutions. Acemoglu and Robinson did not lay out a theory of what constitutes good institutions, they laid out a theory of why institutions are persistent. Their work shows that being stuck in the bad equilibrium is the result of a skewed distribution of economic power that grants some elite a skewed amount of political power. The elite can’t credibly commit to maintaining reforms, and the masses can’t credibly commit to preserving the elite’s position, so they can’t come to an agreement on creating better institutions (whatever those might be).

The implication of the institutions literature is that redistributing wealth towards the masses will lead to economic development (and vice versa, that redistributing it towards the elites will slow economic development). Only then will the elite and masses endogenously negotiate a better arrangement. You don’t even have to know precisely what “good institutions” means, as they will figure it out for themselves. The redistribution need not be explicit, but may arise through changes in technology, trade, or population.

Douglass North has the same underlying logic in his work. It was only with changes in the land/labor ratio favoring workers in Europe that old institutions disintegrated (serfdom) and new institutions arose (secure property rights).

A good example is South Korea. In 1950, Korea was one of the poorest places on earth, falling well below many African nations in terms of development. It had also been subject to colonization by Japan from 1910 to 1945. Korea had the same history of exploitive institutions as most African nations.

So why didn’t South Korea get stuck in the same trap of bad institutions and under-development as Africa? One answer is that is had a massive redistribution of wealth. In 1945, the richest 3 percent of rural households owned 2/3 of all land, and about 60 percent of rural households had no land. This should have led to bad institutions and persistent underdevelopment. (See Ban, Moon, and Perkins, 1980, if you can find a copy).

But starting in 1948 South Korea enacted wholesale land reform. By 1956, only 7 percent of farming households were tenants, and the rest owned their land. According to the FAO Agricultural Census of 1962, South Korea had *zero* farms larger than 5 hectares. Not a small number, not just a few, but *zero*. Agricultural land in South Korea, probably the primary source of wealth at that point, was distributed with incredible equity across households.

According to North or Acemoglu and Robinson, this redistribution changed the relative power of elites and masses. It would have allowed them to reach a deal on “good institutions”, or at least would have made the elite powerless to stop the masses from enacting reforms. South Korea got good institutions in part because it changed the distribution of wealth. [Good institutions for economic growth don’t appear to overlap with good institutions for personal freedom, though – South Korea was a dictatorship until 1988.]

The point is that even if we acknowledge that “institutions matter”, that does not imply that we can or should propose institutional reforms to generate economic development. It’s a mistake to think of ceteris paribus changes to institutions. They are not a thing that we can easily or independently alter. If they were, then they wouldn’t be *institutions* in the way that Douglass North uses the term.

If you want to generate economic development, the implication of the institutions literature is that you have to reform the underlying distribution of economic power first. Once you do that institutions will endogenously evolve towards the “good” equilibrium, whatever that may be.

[But the distribution of economic power *is* an institution, you might say. Okay, sure. Define institutions broadly enough and it will become trivially true that institutions matter. Defined broadly enough, institutions are the reason my Diet Coke spilled this morning, because gravity is an “institution governing the interaction of two masses in space”.]

18 thoughts on “The Skeptics Guide to Institutions – Part 4

    • I have. And theirs is a fine conclusion, in the sense that it takes as a default that you should act. But it isn’t clear that you are really having any real impact.

  1. DIetz, I have to intervene in your narrative once more 🙂

    “So what is that null hypothesis?”

    I disagree with the either-or dichotomy or the existence of a big null hypothesis. I think, evidences say (not necessarily the authors who found them) that institutions matter in a particular way, not always and not everywhere. It’s not like tomorrow you can find out that they _finally_ matter (or don’t). We just should keep digging.

    “You don’t even have to know precisely what “good institutions” means, as they will figure it out for themselves.”

    I’m not sure what literature you mean, but authors from the institutional camp actually name optimal institution: rule of law, protection of private property rights, unbiased judiciary, free labor, free (and formal) contracting.

    As a general reference, “figure it out for themselves” sounds like the political Coase theorem, which leads to Acemoglu’s 2003 paper and North’s earlier ideas about the problem of commitment.

    “The implication of the institutions literature is that redistributing wealth towards the masses will lead to economic development”

    “The institutions literature” tells us about more nuanced relations. Redistribution under weak political institutions may lead to no development at all. Take Venezuela, which shows weak performance despite high oil prices and increasing redistribution. May it be that in the future, as masses get richer, this redistribution will help? I doubt it. Venezuela, Russia, and other resource rich countries with weak political institutions buy their population’s support while empowering narrow elites. The Soviet Union’s privatization is another story of failed redistribution under extractive political institutions.

    Critique is useful. And there’re forward-looking critique, which enriches our understanding by fixing weak spots, and backward-looking critique, which looks for weak spots to reject what we know. (Let me be clear. Backward-looking critique is great and important.) The literature on institutions have many flaws, but I think it really needs more forward-looking critique.

    • Anton – the posts are absolutely in the spirit of “make the worst case against institutions I can” and see what we are left with. So your notion that I’m being a little unfair is probably right. I was being unfair, deliberately. But I will disagree slightly with the comment on the null. Institutions-ists very much claim that institutions matter, as a broad statement about the underlying source of development. So that is a fair null. That being said, we can certainly reject certain narrow nulls – “the slave trade had no impact on African development”, for example.

      We have notions of what constitute good institutions, but no good practical ideas. What is “rule of law”? The UK has no written constitution, but scores high on rule of law. Meaning what? There is no law to be ruled by, just customs. What does protecting property rights mean? Does it mean fee simple ownership of land? Does it mean incorporation laws that allow limited liability? Does it mean freedom from arbitrary search and seizure? Does it mean banking secrecy?

      I think the “figure it out themselves” is the right way to think about this. We don’t quite know the practical details, so letting good institutions evolve endogenously is likely to make things work better than imposing them from above. And yes, the inst. lit. does say that they’ll figure out good institutions all by themselves so long as we don’t have an elite group powerful enough to stop things. Or, perhaps more accurately, we’ll get closer to “ideal” institutions the less power the elite has to block reform.

      But in the end, the critiques are meant as a means to interact with this lit., not dismiss it entirely. Like I said, by revealed preference I read this stuff carefully and teach it to my students. But it is worth noting the holes in the lit., if only to give my grads ideas about research topics.

      • The definitions of institutions depend on the variables (by Polity, Freedom House et al) used in the regressions. These variables have serious problems, but are quite specific.

        Actually, the alternative definitions of the rule of law (not expert scores, but things like violent deaths per 1,000) give interesting results. Given these definitions, China, for example, becomes a state with the rule of law, so its high growth ceases to be a puzzle.

      • On figure it out themselves, you may enjoy Brian Levy’s book Working with the grain. I think he was former head of governance at the World Bank

  2. These 4 articles have been very, very interesting. One tid bit of extremely interesting inforamtion is the part about the massive redistribution in Korea. How is that possible in such a short time frame?
    I would imagine the Korean war was an important contributor.

    Seeing this in the context of Pickettys thesis that the redistribution in the West during the 20th century is mostly down to wars as well is very interesting.

    • I don’t know enough about the politics of the land reform to say for sure. I know that in 1948 the origins of the reform were laid by the American occupation government – so it may have only been possible because the American military effectively eliminated the elite as a political force.

  3. Institutions are the formal and informal rules and expectations of conduct.

    Your null hypothesis basically amounts to a statement that how people interact makes no difference in outcome.

    • Sorry, I submitted before finishing… Here is the rest of the comment.

      Consider the following rules of conduct and their implications.

      Example one:
      When encountering a person on a narrow road you should:
      1). Pass on the left
      2). Pass on the right
      3). Step aside for the person of higher caste or class to have right of way
      4). Fight to the death over priority

      To determine who decides how property is used you should:
      1). Give control to the person creating it or voluntarily exchanging for it
      2). Give control to the master planner (which is decided by Royal combat)
      3). Give control to the person immediately south of the person creating it, unless they are a Druid.
      4). Appeal to God as revealed by the sacramental tea leaves on the third Sunday after the full moon

      To create and decide on better explanations to natural phenomena you should:
      1). Encourage secrecy, and decide upon competing alternatives by consulting Aristotle
      2). Consult the bible
      3). Encourage empirical experimentation, parsimonious explanations, and reward publishing priority via status
      4). Leave well enough alone, and kill natural philosophers as a threat to the natural order

      To say institutions don’t matter, or even just to say institutions don’t matter for growth (which is really a subset of the former) is pretty extreme. You are effectively saying it doesn’t matter which choices we make above.

      I would hypothesize most economists can point to better institutional solutions above and back it up with both theory and empirical examples. They can’t do it perfectly. They may contest some answers. It may not make a difference on others (pass left or right). Other answers may be contextual or historically contingent. But clearly institutions matter.

      I will agree that institutions are hard to change, pretty much by definition. But they are not impossible to change or influence. Solutions include persuasion, education, institutional experimentation, institutional competition, entrance and exit rights (voting with our feet or choices), charter cities, and so forth.

      • I made the point in the last of the 4 posts that “failing to reject the null” is not the same thing as “accepting the null”. The current state of the empirical institutions literature does not offer any definitive evidence that they matter. That does not mean that institutions do *not* matter. But any sense that they matter is drive by theory and/or intuition – as in your perfectly reasonable examples – not empirical evidence.

        Now let me make one devil’s advocate argument. Take your decisions posed in your comment. The choice we make clearly matters in each case. But why is choice made necessarily driven by “institutions”, and not by something else? Luck, geography, fate, culture, prices, anything?

  4. In my opinion the Acemoglu and Robinson theories in particular are often misinterpreted and simplified, and unfortunately this blog post is no exception.

    For example, let’s examine your statement “If you want to generate economic development, the implication of the institutions literature is that you have to reform the underlying distribution of economic power first.”

    While redistribution of wealth could certainly lead to improvements in political institutions, this is not the main implication of institutions literature, and is certainly not the only way a country can generate economic development. A&R have a theory that the quality of economic and political institutions are mutually self-reinforcing. This means that improving economic institutions could lead to improved political institutions as you identify, but the reverse can also happen, such as in the example of the UK.

    Also, if you accept that there are few aspects of a country that are truly exogenous, then it’s misleading to assume a simple cause-and-effect phenomenon, such as having to reform the distribution of economic power prior to anything else. In practice, different areas of policy and institutions are likely to change in concert; in particular, economic policy is endogenously determined, and countries that have achieved development have taken different routes. Your statement implies that the institutions literature has ignored these points.

    • Michael – without question there is no such thing as a mono-causal reason for development (unless we define “institutions” so vaguely that it has to be universally true). My point was not that redistribution *is* the only way to elicit development, but that the AR work only allows for redistribution to drive development. Their work is about how institutions get stuck in bad equilibria – to get out, you have to change the initial conditions, which in their work is invariably some distribution of wealth/power. So *in their theory*, redistribution is necessary.

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