Trade and Harmonization: If your institutions are good, does it matter if they are different?

Author:Roumeen Islam. Ariell Reshef
Profession:World Bank. New York University

Good institutional quality (function) and similar institutional design (form) can promote international trade by reducing transactions costs. We evaluate the relative importance of function versus form in a gravity model, using an indicator of different legal systems as a proxy for differences in form together with indicators of overall institutional quality. We find that good institutions... (see full summary)


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In recent years1 we have been witnessing a shift of effort into changing specific institutions so that they are standardized across countries (institutional harmonization). In particular, policymakers, governments and multilateral agencies have promoted harmonization of institutions as a way to promote trade, presumably by reducing transactions costs or as a way to protect the distribution of gains from economic activity (or capture them). For instance, the WTO has been pushing forward the Trade Related Intellectual Property Rights (TRIPS) agreement (that was signed in 1994 and then amended in 2003 and 2005) which aims to standardize how intellectual property is protected across countries. The debate on regulatory standards -like pasteurization to ensure safety of traded milk products -is another example. Competition law and enforcement, which were on the negotiating table in the earlier Doha rounds of trade talks is yet another example2. A key policy question for developing countries is how important it is to standardize particular institutions versus just trying to get them to work better overall in each country3. This question has hitherto not been addressed in the literature.

We evaluate empirically the relative importance for international trade of institutional harmonization versus institutional quality, while differentiating the impact of overall institutional quality from the impact of institutional diversity on trade. Anderson and Marcouillier (2002) estimate the effect of two measures of institutional quality -"Transparency" (of government policies) and "Enforceability" (of legal contracts) -but do not control for differences in form.

We use differences in legal origins as a proxy for institutional diversity, and three different Page 2 measures of institutional quality: bureaucratic quality, control of corruption and protection of property rights. We employ two methods in order to evaluate the relative importance of institutional quality versus differences in legal systems. The first is to estimate how much more trade would be induced by a reasonable change in institutional quality versus how much is deterred by differences in legal systems. This method serves as an evaluation of possible policy outcomes4. The second method is to evaluate the relative contribution of institutional quality versus differences in legal systems in explaining the variation in trade using beta coefficients, and serves as a way to evaluate explanatory power in practice.

The results are striking. As expected, institutional quality has a positive effect on bilateral trade, while differences in legal origin have a negative effect on trade. But we estimate that the effect of institutional quality is much higher than the effect of differences in legal origin on trade -in some estimates up to ten times higher. By this we mean that, for the average trading pair, a reasonable and achievable improvement in institutional quality5 can increase bilateral trade much more than harmonization of their legal systems (in the typical case legal origins are different). We also find that institutional quality explains 5-15 times more of the variation in bilateral trade flows, relative to differences in legal origins.

Moreover, we find that the effect of differences in legal origin is estimated to be lower than some of the other factors that affect trade. For example, infrastructure quality turns out to be an important determinant of trade; the number of telephone lines per capita has an effect of up to 10 times the effect of differences in legal origin. The telephone lines per capita are also estimated to have an effect on trade that is 2-3 times the effect of institutional quality.

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These results inform policy: the first order of business should be just getting your institutions to work rather than worrying about the trade-related effects of institutional standardization.

In order to estimate the separate effects of institutional form and function on trade we had to use a measure of institutional diversity that is not perfectly correlated with institutional quality. The measure we use to proxy for institutional diversity is differences in legal origin. While some empirical work shows that different legal origins affect institutional quality (La Porta et. al. [1997, 1998, 1999]), other work (Berkowitz et al. [2003], Pistor et al. [2002, 2003] and Acemoglu, ([2001, 2004]) argue that the nature of the process by which institutions are transplanted and developed, rather than legal origin which affects institutional quality. In fact, Acemoglu and Johnson (2005) provide some evidence showing that legal family, while affecting the type of financial intermediation that occurs, does not affect economic activity overall6. Nor is legal origin a good instrument for institutions that reflect the relation between the state and citizens. 7 Moreover, there is no reason that a mere difference in legal origins signals any particular level of institutional quality. We elaborate on this below.

Background and Literature

Good institutions reduce the transactions costs associated with doing business (North [1991, 1994]), and, in particular, should promote trade because they reduce the severity of holdup problems. International trade conducted across great distances and intertemporal lags suffers from potentially large transactions costs. Importers are more likely to purchase from a seller if they can be assured that they are getting what they paid for; and in case they do not get it, what Page 4 kind of recourse is available. Exporters are more likely to sell to a partner that is constrained to honor commitments, where mutual commitments can be written into contracts which can be enforced. They are also more likely to get access to finance for trade if institutions are good (see literature below).

Differences in endowments, preferences and history have led to the development of different institutional forms to achieve broadly similar objectives. Moreover, differences in formal institutional design occur partly because of differences in norms or informal institutions (and vice versa).

Having the same set of institutions may increase trade, but this would entail identifying the best institutions and getting all those trading partners not having these institutions to bear some cost to obtain them. This is hardly a simple matter for at least 3 reasons: (a) there is not a "best" design for all institutions; (b) there is a pecuniary cost to changing laws/regulations, which might prove to be quite large and (c) changing institutions would mean changing the distribution of benefits which would create resistance by losers. Since global rules determine inter-country claims on resources or assets, it is difficult to say which rule is the most desirable8.

Moreover, in some situations, discussed below, formal harmonization may not increase trade but Page 5 instead may alter the pattern of trade or even reduce it by blocking entry into markets. So in the absence of a best solution, the emphasis on harmonization at the policy level may be misplaced9. Although the governments and multilateral organizations who support standardization of institutions claim to do so to promote trade, governments and others may be doing so with a view to restricting trade, or affecting overall trading patterns and profits for their constituencies. We cannot distinguish between harmonization of institutions that is motivated by attempts to limit market entry of competing producers, policy changes intended to promote trade and harmonization induced by changing consumer preferences (which would be associated with rising trade). However, we are really interested in the case of policy induced harmonization. Finally, as in the field of technology there is always a potential conflict between the (costlowering) benefits of standardization and the dynamic gains from potential innovations and diversity.10

We draw on three strands of the economics literature -institutional economics, international trade and fiscal decentralization -to provide a theoretical background for the work. First we draw on the extensive institutional economics literature such as the seminal works by North (1991, 1994), Grief, Milgrom and Weingast (GMW, 1994), Greif (1989, 1993a), Milgrom, North and Weingast (1990), who study the link between institutions and economic exchange within and between nations. According to North (1991, 1994) in order to gain from increasing specialization and division of labor in economic production it is necessary for society to develop institutions that support impersonal and anonymous exchange across time and space. As individuals and groups become increasingly interdependent, more complex institutional Page 6 structures are necessary to capture the potential gains from trade. GMW and Grief use game theoretic modeling to explain the development of institutions supporting information exchange, respect for property rights and contract enforcement that support the historical emergence of long-distance trading relationships. In their analyzes, the development of merchant guilds as organizational units that shared information and whose members acted in a coordinated manner, facilitated dealings with medieval rulers and merchants who in turn respected merchants? property rights. Though each guild?s precise institutional form varied they performed similar functions. Acemoglu et al (2002) examine how trading opportunities in Europe led to the development of institutions to further support trade. Pistor et al (2001)11 analyze how competition between trading states in Europe...

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