Do better institutions lead to more effective economic development?

The currently dominant view is that institutions are the ultimate determinants of economic performance (e.g., for the latest statements along this line, see Acemoglu et al., 2005; North, 2005). However, the causality in the otherdirection – that is, from economic development to institutions – is usually neglected.3

3 Acemoglu et al. (2001) is a partial exception – exception in the sense that it does recognize the two-way nature of the relationship at a theoretical level but only a partial exception in that it goes on to conclude, through the use of an instrumental variable, that empirically the causality basically runs from institutions to development.

Economic development changes institutions through a number of channels.First, increased wealth due to growth may create higher demands for higher-quality institutions (e.g., demands for political institutions with greater transparency and accountability). Second, greater wealth also makes better institutions more affordable. Institutions are costly to establish and run, and the higher their quality the more ‘expensive’ they become (see below). Third, economic development creates new agents of change, demanding new institutions. In the 18th century, the rising industrial capitalists supported the development of banking against the opposition to it by landlords, while in the late 19th and the early 20th centuries, the growing power of the working class led to the rise of the welfare state and protective labour laws, against the capitalists who thought those institutions would bring about the end of civilization as they knew it.

Indeed, there is quite a lot of historical evidence to suggest that the causality may be stronger in the latter direction (economic development improving institutions) than in the former (better institutions promoting economic development).

Today’s rich countries acquired most of the institutions that today’s dominant view considers to be prerequisites of economic development after, not before, their economic development – democracy, modern bureaucracy, IPRs, limited liability, bankruptcy law, banking, the central bank, securities regulation, and so on (Chang, 2002a: chapter 3). More specifically, the Anglo-American countries, whose institutions today are considered to be GSIs, themselves did not have most of those institutions in their earlier stages of development and acquired most of them only after they became rich (Chang,2005). If the causality runs more strongly in the direction of development to institutions, rather than the other way around, the financial and human resources that developing countries are expending in order to acquire GSIs may be better used for other policies that more directly stimulate economic development – be they educational expenditure, infrastructural investments, or industrial subsidies – especially when they also indirectly promote institutional development, which can then further promote economic development.

Further complicating the picture regarding causality is what may be called the ‘late-comer’ effect (Chang, 2002a: chapter 4). In the same way in which they can import better technologies without having to pay the full cost of developing them, late-comer countries can import superior institutions without having to pay for their development. Therefore, today’s developing countries tend to have institutions that are more developed than what their standards of material development would strictly demand, making it difficult to identify the exact relationship between institutions and development.

Given all of this, by almost exclusively looking at one direction of causality, that is, from institutions to economic development, the currently dominant discourse on institutions and development gives us only a partial picture. We need to look at the causality in the other direction as well, if we are to have a full understanding of how institutions and economic development interact with each other and give the right policy advice.