Ohio State University

February 2015

Exploring the Linkage between Political and Economic Institutions and Economic Development

“Few political scientists and economists doubt that institutions potentially affect macroeconomic performance” argues Benson Durham, “but, the challenge is to avoid tautologies and to render testable propositions.” Many scholars have examined the linkage between institutions and economic development yet nothing has been fully set in stone regarding the “causal” linkage between these two phenomena. Some experts argue that better institutions yield higher macroeconomic performance whereas others maintain that it is the economic development that opens the doors for more sound institutions. This short piece will briefly cover the divergent strands of the literature, underline the problems in the extant literature, and provide possible solutions to these problems.

The first strand of the institutions-economic development literature derives from the Grand Transition (GT) and modernization arguments. The GT scholars who favor a Kuznetsian (1968) view regarding the relationship between institutions and economic well-being argue that economic development leads to institutional development (cf. Paldam and Gundlach 2008). In a similar vein, modernization scholars (cf. Lipset 1959) underline economic wealth as an important precondition for democratic institutions (Geddes 1999; Boix and Stokes 2003; and Boix 2011).

On the other hand, some scholars reverse the direction of causal arrow in institutions-economic development nexus and maintain that enhancements in political and economic institutions must yield better economic development. These scholars espouse a Northian (1990) view of institutions and apply the “Primacy of Institutions” (PoI) argument (e.g.: Rodrik 2000; Bueno de Mesquita et al. 2001; Acemoglu, Johnson, and Robinson 2005).

The extant body of the literature suffers from some weaknesses. The first set of problems in the literature is empirical. To be more specific, most of the extant studies adopt one side of the aforementioned strands of the literature (either GT/modernization or PoI) and apply statistical analyses based on their one-sided premise with a basketful of socioeconomic and political controls. However, the intricate relationship between institutions and economic development dictates meticulous tests for robustness. To begin with, tests for multicollinearity (collinear relationship between independent variables) are vital in statistical analyses which incorporate variables on education, industrialization, urbanization etc. that are most likely interrelated to each other. Lack of vigilance regarding multicollinearity may render statistical analyses invalid for individual independent variables under examination (Green 1993). Further, tests for reverse causality should be conducted to shed light on the direction of causal arrow between institutions and economic development. It may well be the case that higher economic performance brings about better institutions and at the same time better institutions yield more economic development. A possible reverse causality between institutions and economic development calls for detailed statistical models (such as instrumental-variable econometric models), beyond the OLS analyses that most of the literature prefer. Attention for these methodological issues is a must to further the extant body of the literature.

The second set of problem in the literature is methodological. Scholars in the field mostly prefer cross-country analyses that utilize panel datasets. While these studies offer a general picture about institutions and economic well-being in the world, they fail to account for the diversity of experiences of the individual countries in their institutions-economic development trajectories (West, Durlauf, and Brock 2003). In reality, there are country- and region-specific institutions-economic output effects (cf. Doucouliagos and Ulubaşoğlu 2008), which dictates a more thorough analysis regarding each country (or a region). Moreover, as Boening et al (2012: 59) maintain, “it would be insufficient and incomplete to explain the economic development mainly with help of institutional development by confining to econometric models”.

The literature on political and economic institutions and economic development stands on divergent strands of the literature. To unearth the linkage between institutions and economic development, we should first take into consideration all of the contrasting views in the literature and pay attention to each of them. This requires empirical vigilance and econometric models that address the aforementioned problems of reverse causality and multicollinearity. However, a purely econometric approach would offer us only a part of the whole story. Qualitative, historical analyses of single-country cases should be conducted to complement our statistical analyses. Hence, a mixed-method, country-focused approach is a must to fully explore the relationship between institutions and economic development.

References

Acemoglu, Daron, Simon Johnson, and James A. Robinson. 2005. “Institutions as the Fundamental Cause of Long-Run Economic Growth.” In Handbook of Economic Growth, edited by Philippe Aghion and Stephen Durlauf, Volume 1, Part 1, pp. 385–472. North Holland: Amsterdam, Holland.

Boening, Astrid B., L. Díaz Romero, J.R.García Hernández, P. González del Miño, Niklas Helwig, Karel Lannoo, Simon Stroß, Csaba Töro, J. Antonio Yañez-Barnuevo, Bahri Yılmaz. 2012. The EU as a Global Player. Fundación University-San Pablo.

Boix, Carles. 2011. “Democracy, Development, and the International System.” American Political Science Review 105 (4): 809-828.

Boix, Carles and Susan C. Stokes. 2003. “Endogenous Democratization.” World Politics 55 (4): 517-549.

Bueno de Mesquita, Bruce, James D. Morrow, Randolph Siverson, and Alastair Smith. 2001. “Political Competition and Economic Growth” Journal of Democracy 12: 58-72.

Doucouliagos, Hristos and Mehmet Ali Ulubaşoğlu. 2008. “Democracy and Economic Growth: A Meta-Analysis” American Journal of Political Science 52 (1): 61-83.

Durham, J. Benson. 2004. “Economic Growth and Institutions: Some Sensitivity Analyses, 1961-2000” International Organization 58 (3): 485-529.

Geddes, Barbara. 1999. “What Do We Know About Democratization After Twenty Years?” Annual Review of Political Science 2: 115-144.

Greene, W. H. 1993. Econometric Analysis, 2nd edition. New York: Macmillan.

Kuznets, Simon. 1968. Towards a Theory of Economic Growth. New Haven, CT: Yale University Press.

North, Douglass C. 1990. Institutions, Institutional Change, and Economic Performance. Cambridge University Press: Cambridge, UK.

Paldam, Martin and Erich Gundlach. 2008. “Two Views on Institutions and Development: The Grand Transition vs the Primacy of Institutions” Kyklos 61: 65-100.

Rodrik, Dani. 2000. “Institutions For High-Quality Growth: What They Are And How To Acquire Them” CEPR Discussion Papers 2370.

West, Kenneth D., Steven N. Durlauf and William A. Brock. 2003. “Policy Evaluation in Uncertain Economic Environments” Brookings Papers on Economic Activity 2003, No. 1.