The Primacy of Institutions (and what this does and does not mean)

• Author: Dani Rodrik/Arvind Subramanian
• Position: Professor of International Political Economy at Harvard University/Advisor in the IMF's Research Department
• Pages: 31-34

Page 31

Explaining the huge difference in average incomes between the world's richest and poorest nations is one of the most fundamental issues in development economics. How did this vast gulf emerge, and can anything be done to reduce it?

To answer these questions, we can seek guidance from three strands of thought. First, there is a long and distinguished line of theorizing that assigns a preeminent role to geography. Geography is the key determinant of climate and of natural resource endowments, and it can also play a fundamental role in the disease burden, transport costs, and extent of diffusion of technology from more advanced areas that societies experience. It therefore exerts a strong influence on agricultural productivity and the quality of human resources. Recent writings by Jared Diamond and Jeffrey Sachs (see page 38 in this issue) are among the more notable works in this tradition.

A second view emphasizes the role of international trade as a driver of productivity change and income growth. We call this the integration view because it gives participation in the larger global economy-and impediments to participation-a starring role in fostering economic convergence between rich and poor regions of the world. The globalization debate, of course, is to a large extent about the merits of this integration view.

Finally, a third view centers on institutions -in particular, the role of property rights and the rule of law. In this view, what matters are the rules of the game in a society, as defined by prevailing explicit and implicit behavioral norms and their ability to create appropriate incentives for desirable economic behavior. This view, associated perhaps most strongly with Nobel Prize winner Douglass North, has recently been the subject of a number of econometric studies, in particular by Daron Acemoglu (see page 27 in this issue), Simon Johnson, and James Robinson.

The idea that one, or even all, of the above deep determinants can adequately explain the large variations in income levels between countries may seem, on the face of it, preposterous. But economists like parsimony, and we were keen to see how these theories would fare when tested simultaneously against each other. Using regression analysis, we came up with some sharp and striking results that have broad implications for development conditionality, discussed below. Our results indicate that the quality of institutions overrides everything else. Controlling for institutions, geography has, at best, weak direct effects on incomes, although it has a strong indirect effect through institutions by influencing their quality. Similarly, trade has a significant effect on institutional quality, but it has no direct positive effect on income. How did we arrive at these findings?

Complex causality

Devising a reasonable empirical strategy for ascertaining how much of the variation in income levels between countries these three deep determinants can explain and whether they are all equally important is not straightforward. The difficulty lies in disentangling the complex web of causality involving these factors and income levels, as Chart 1 illustrates.

Geography is the only one of these deep determinants that can be treated as exogenous or not influenced by income. As Chart 1 shows, geography can affect income directly (by determining, say, agricultural productivity) as well as indirectly, through its impact on the extent of market integration or on the quality of institutions. With trade integration and institutions, however, causality can run both ways. Integration can raise incomes, but it is equally possible for trade to be the result of increased productivity in an economy. And, while better institutions and better protection of property rights increase investment and foster technological progress, thereby raising income levels, better institutions can also be the outcome of economic development, not least because the demand for better institutions rises as countries and their citizens become wealthier.

In our research, we adopted a simple yet general research strategy that allowed us to estimate the elements shown in Chart 1 simultaneously while taking...