Testing the theory This view, which suggests that economic development is determined in part by

the ways in which institutions are organized, has led to a body of work examining the relationship between economic growth and institutions in the form of particular rules and laws. This contrasts with previous views that saw geographical location, natural resource endowments or cultural factors as key determinants of economic development. Analysis can indeed quickly show that there is a strong correlation between economic performance and the existence of ‘good’ institutions, such as effective property rights. But this does not always tell us whether the causes of better performance lie in the institutions themselves or in other underlying economic, social, geographical or cultural factors.

It is difficult to investigate this causality by using the techniques of regression analysis – a favourite among economists – because it is not easy to

INSTITUTIONS, MARKETS AND ECONOMIC DEVELOPMENT

find variables that can capture the quality of institutions independently of these other underlying factors. As is apparent from the discussion on North’s work above, the quality of institutions is the outcome of a long historical process. If economic growth is thought to be both dependent on those institutions and a cause of their continuation, then it is not very easy to isolate variables that can capture each of these factors independently. This has therefore led to a methodological endeavour to find ways of separating causes and effects. The main approach considers colonization as a process in which institutions were imposed upon many different countries, but in some of these they were set up primarily to extract resources, while in others effective systems for property rights protection were established, which benefited a ‘broad cross-section’ of the society, including the European settlers. This availability of rights to a significant proportion of the population appears to have made a big difference to subsequent patterns of development. A factor determining whether or not Europeans settled in greater numbers was mortality rates due to diseases, such as yellow fever and malaria. Acemoglu et al (2007) have therefore used this variable (settler mortality rates) in their analysis because it is related to the type of institutions established at the outset, but is independent of their subsequent effects on growth. As a result, they have been able to conclude that these broad institutional differences – European settlements and the wide availability of property rights – are important in explaining differences in economic growth.

Rodrik et al (2004) have also used this methodological approach to assess whether differences in income are due to either: (1) geography determining climate, natural resource endowments, diseases, transport costs and so on; (2) integration, that is, the extent to which economies are integrated into the world economy through openness to trade; or (3) institutions, such as the protection of property rights and the rule of law. They find that institutions are by far the most significant and positive determinants of income levels. Once this is taken into account, integration is seen as having no direct effect and geography only a weak direct effect.

While this research leads to broad conclusions about the importance of institutions, it does not help to identify which specific institutions are the most important for specific contexts. The focus in the empirical analysis has primarily been on property rights and their enforcement. It is evident that there are many other types of institutions that enable economic growth to take place. Rodrik and Subramanian (2003) highlight three categories of institutions: those that are (1) market stabilizing: institutions that manage the economy to produce stable conditions for growth by minimizing volatility, producing low inflation and averting crises (this is done through fiscal rules, budgets and exchange rate regimes); (2) market legitimizing: institutions that promote redistribution through social protection, insurance and welfare systems; (3) market regulating: institutions that deal with externalities, economies of scale and imperfect information, e.g. regulatory agencies for specific sectors, such as utilities, telecommunications or financial services.

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This institutional literature has therefore tended to focus on property rights and institutions for regulation, macroeconomic stabilization and social insurance. However, this has been criticized because it is not clear why these particular institutions are the ones that are most focused on or, in other words, it is not clear how this focus is theoretically informed (Chang 2005). Moreover, the function that institutions deliver within the economy may be similar, but the institutions themselves can take on many forms. Hence, legal systems can

be organized in very different ways to secure property rights, as can competition or regulatory agencies dealing with externalities or other market failures. More work therefore needs to be done to properly conceptualize the contribution of institutions to economic development.

Level

Frequency of change

Purpose

(years)

10 2 to 10 3 Often non-calculative; Embeddedness: informal spontaneous

institutions, customs, traditions, norms, religion

10 to 10 2 Get the institutional Institutional environment:

formal rules of the game, environment right. First

esp. property, judiciary, order economizing bureaucracy

Get the governance Governance: play of the structures right. Second

1 to 10

L3 game, esp. contract

order economizing (aligning governance

structures with transactions)

Resource allocation and

continuous

Get the marginal conditions right. Third

L4 employment (prices and

order economizing quantities; incentives

alignment)

L1: social theory L2: economics of property rights/positive political theory

Figure 7.1 Categorization of institutions in the economy by level

Source: Williamson (2000, p597)

INSTITUTIONS, MARKETS AND ECONOMIC DEVELOPMENT

Williamson (2000) has described a categorization of institutions consisting of four levels (Figure 7.1): the first level is those institutions that relate to the underlying social structures. This is not a level that other theorists have considered greatly, while the other three levels relate more clearly to the institutional aspects suggested above. The second level relates to the rules of the game, such as property rights and the judiciary, which define the overall (formal) institutional environment or what can be exchanged (in the context of markets). The third level is about rules that relate to the playing of the game, such as contracts; and the fourth about rules that relate to resource-allocation mechanisms, such as social security systems. This certainly helps us to consider the nature of institutions, and in particular which underlying social institutions underpin which different levels. We further explore the idea that institutions are embedded in informal institutions, customs and norms below.

All the institutional levels described in Figure 7.1 determine the way the economy operates and the way economic development therefore occurs. This implies that ‘getting institutions right’ is not as straightforward as transplanting formal rules and regulations seen to operate well in some contexts to other countries. Indeed, it becomes apparent that the functions of institutions may arise from a range of forms. Moreover, this situation becomes even more complex when we appreciate how formal rules are underpinned by informal rules and norms.

Testing the theory This view, which suggests that economic development is determined in part by