Wither institutions in economics?

1. Wither institutions in economics? Jan Fałkowski MADE lecture, 13.11.2009

2. Outline • Some historical background on institutions in economics • What do we really measure? • Hot issues in the debate

3. Insitutions in economics American institutionalism New Institutional Economics

4. Historical background • Traditional institutionalism • First 3 decades of XXth century • Veblen, Commons, Mitchell • After the 2nd WW • Galbraith, • Myrdal • Contesting standard assumptions of neoclassical economics • Extending the analysis to include political, moral, etc. factors • Insitutions – materialised customs and habits

5. Historical Background • New Institutional Economics • Incorporating insitutions into neoclassical framework • Insitutions as rules of the game • Minimising transaction costs • Competition among instiutions • Williamson, North • Formal vs informal institutions

6. Embeddedness: informal insitutions, customs, tradition, norms, religion Often noncalculative spontaneous 102 -103 L1 Get the insitutional environment right 1st order economizing Institutional environment Formal rules of the game esp. property (judiciary, bureaucracy) 10-102 L2 Get the governance structure right 2nd order economizing Governance: Play of the game – esp. Contract (aligning governance structures with transactions) 1-10 L3 Get the marginal conditions right 3rd order economizing Resource allocation and employment (prices & quantities; incentive alignment continuous L4 Williamson’s perception of insitutions Frequency (years) Level Purpose

7. Washington consensus failure • The only consensus we have is that there is no consensus • Recommended policies failed to provide universal remedy for backwardness • Disequilibrium caused by conflict between formal & informal institutions • „Insitutions matter” no longer sufficient • What insitutions matter is of importance

8. Institutionalproblemsineconomics? • Big bang vs. gradualism (Roland & Verdier, 2003) • What should the pace of reforms? • What should be the sequence of reforms? • Examples of China & Latin America

9. EBRD index of transformation Source: EBRD

10. Initial elections & reforms Source: Fish (1998)

11. How did economists respond? – theoretical approach • Three separate pillars • theory of macroeconomic policy • rationality, micro-foundations, but naive politics • public choice • agency, constitutions, interest groups, but naive methods • rational choice (political science) • collective choice procedures, but naive approach to policy • Gradual improvements on theoretical front: combining best of three approaches

12. How did economists respond? – empirical approach • Early work suffered from two problems • tests of theory not very precise • lack of institutional detail • Gradual improvements on empirical front • more solid theoretical foundations • better data • concern with identifying causal effects: micro-econometrics • appreciation of findings in empirical political science

13. Hot issue in the debate: democracy • Does democracy promote growth? • In more general terms, the dispute between: • Modernisation hypothesis (Lipset, 1954) • Critical junctures hypothesis (Moore, 1966) • Is it a necessary condition for growth? • Autocratic govt is not always a disaster! • Modern China • British industrial revolution before free & fair elections

14. Hot issue in the debate: democracy • Theory • Downs (1957) and median voter theorem • Acemoglu & Robinson predict redistribution from the elite to the citizens after an extension of voting rights • Olson & McGuirre argue that autocracies tend to tax more and spend less for general public goods than democracies • Chicago school (Stigler, Becker, Peltzman) • key determinants of the policy-making are economic and demographic factors, such as interest group structure, urban location and the technology of tax collection

15. Hot issue in the debate: democracy • Empirical findings • Income & democracy highly correlated • De Hann & Sturm (2003) greater political freedom furthers economic freedom • Giavazzi & Tabellini (2005) economic liberalisation precedes political liberalisation • Persson (2005) it is not democracy per se that matters but its specific form

16. Acemoglu, Robinson, Johnson, Yared (2009) • Existing studiessupport themodernisation hypothesis because they fail to control for thepresence of omitted variables • fxed effects in a linear model or parameterized random effects in non-linear double hazard model removes the correlation btw income & democracy • POLITY IV database, Freedom House Political Rights Index

17. Gundlach & Paldam (2009) - EJPE • Resarch Question • Does income promote demoracy? • UGT: present income differences have roots in prehistoric past • Prehistoric measures of biogeography as instruments for modern income level • Find long run casual effect of income on democracy

18. G&P (2009) • Biological variables measure the conditions that prevailed in various regions of theworld at the time of the Neolithic Revolution about 10,000 years ago • number ofdomesticable big mammals that are believed to have existed in prehistory • number of annualperennial wild grasses (plants) known to have existed in prehistory • Geographic variables measure the specific conditions that have constrained orenabled the spread of the Neolithic innovations to neighboring regions • a ranking of climates according to how favorable they are to agriculture

19. G&P (2009) • Two approaches • An OLS estimate explaining the pattern by present income. • A two stageIV estimate, where • stage one instruments the income pattern with the biogeographyvariables, and • stage two explains the democracy pattern by the generated institution freeincomes

20. Main conclusion • Does income favour democracy? • We do not know • What we know is that: • Economists should be creative!

21. Thank you for you attention!

22. Democracy • Democracy is conceived as three essential, interdependent elements: • the presence of institutions and procedures through which citizens can express effectivepreferences about alternative policies and leaders. • the existence of institutionalizedconstraints on the exercise of power by the executive. • the guarantee of civil liberties to allcitizens in their daily lives and in acts of political participation. • Other aspects of plural democracy,such as the rule of law, systems of checks and balances, freedom of the press, and so on aremeans to, or specific manifestations of, these general principles.