Measuring the quality of institutions

By its very nature, the quality of an institution is very difficult, if not totally impossible, to quantify, in contrast to many ‘policy’ variables, such as the tariff rate or the rate of inflation. Therefore, institutional qualities are often measured by some indexes based on qualitative judgments.

These indexes are often constructed by organizations that have biases towards free-market policies and Anglo-American institutions (e.g., the World Bank, commercial information providers, the Heritage Foundation, the World Economic Forum). Given their inclinations, they do not try to identify and measure institutions that may help growth but do not fit into the liberalization narrative – for example, the welfare state.7

 7 From the liberal point of view, a bigger welfare state reduces growth by taxing wealth creators and

reducing the compulsion of the workers to work hard. However, a bigger welfare state may promote

growth, if it uses unemployment benefits and retraining programmes to increase the willingness and the

ability of the workers to change jobs, as it has been the case in Scandinavia.

And insofar as these regulatory institutions that promote growth are important at least in some countries, leaving them out of the institutional universe leads to a biased picture of how institutions may or may not promote growth and development.

Moreover, many of these indexes are based on surveys among (especially foreign) businessmen and experts (e.g., academics or financial analysts), many of whom were trained in the USA. As a result, they have biases towards free-market policies and Anglo-American institutions. Given their biases, they are likely to judge a country’s institution to be more liberalized and give them higher-quality scores than what they really deserve, if the country in question is doing well economically – for many of them, a country that is doing well must have, by definition, liberalized institutions.

Even disregarding these political biases, the survey results are strongly influenced by the general state of business, rather than the inherent quality of the institutions whose qualities they purport to measure (Rodrik, 2009: 188).

For example, many people who had thought the institutions in the East and the

Southeast Asian countries were quite good and improving before the 1997 crisis

suddenly started criticizing the institutional deficiencies of these countries after the crisis broke out (Chang, 2000).

So, for all these reasons, the data are biased from the source – a good (poor) performer is likely to score higher (lower) on the institutional score board than what it really should. When the quality measures themselves are thus structurally

biased, we need to be careful in accepting the results of the econometric studies

using those measures.

The measurement of institutional quality becomes even more difficult when the objects of measurement are conceptual composites, made up of different concrete institutions. Examples include ‘institutions’ (e.g., Glaeser et al., 2004), ‘governance’ (e.g., Kaufmann et al., 1999, 2002, 2003, 2005, 2006, 2007, 2008,

2009) or ‘the property rights system’ (e.g., Acemoglu et al., 2001).

To begin with, it is questionable whether we can add up all kinds of different

institutions into a composite concept and measure its quality. The challenge is even greater for concepts such as ‘institutions’ and ‘governance’, but even ‘property rights system’, which is a less encompassing concept, is composed of an impossibly wide range of component institutions – land law, urban planning law,

zoning law, tax law, inheritance law, contract law, company law, bankruptcy law, intellectual property laws, and customs regarding common property, to name only the most important ones. Does it really make theoretical sense to add them up?

Moreover, in practice, these indexes usually mix up incompatible variables – they mix up variables that capture the differences in the forms of institutions (such as democracy, independent judiciary, absence of state ownership) and the functions that they perform (such as rule of law, respect for private property, government effectiveness, enforceability of contracts, maintenance of price stability, the restraint on corruption). However desirable it may be to have a comprehensive measure of institutional quality, it makes no sense to mix up the form variables and the function variables.8

8 In response to this confusion, some have argued that the function variables should therefore be preferred over the form variables (Aron, 2000). However, we cannot totally ignore the forms. If we did that, we will be like a dietitian who talks about eating a ‘healthy, balanced diet’ without telling people how much of what they should have.

As a result, the variables that measure overall institutional quality are even less reliable than those that measure the quality of more concrete institutions, such as democracy or the independence of a central bank.