Testing the Links

• Author: Hali Edison
• Position: Senior Economist in the IMF's Research Department
• Pages: 35-37

How strong are the links between institutional quality and economic performance?

Page 35

Agreat deal of economic research in recent years suggests that institutions are vital for economic development and growth. Typically, economists have looked at the level of economic development, as measured by per capita GDP, and have found that differences in per capita incomes around the globe-ranging from only about $100 a year in parts of sub-Saharan Africa to over $40,000 in some of the advanced economies-are closely related to differences in the quality of institutions. The aim of an IMF research study has been to take stock of recent work relating to the impact of institutions on three dimensions of economic performance-level of economic development, growth, and volatility of growth-and advance the debate through new empirical analysis. In particular, the study tries to estimate the empirical strength of these relationships; the impact that improvements in institutions could have on incomes and growth in different regions; and the role that economic policies play, both in contributing to stronger institutions and in supporting better economic outcomes more generally.

To determine to what extent institutions affect economic performance, we developed a simple econometric framework relating the macroeconomic outcomes for each country to (1) a measure of its institutions (see Box 1); (2) a measure (or set of measures) of macroeconomic policy; and (3) a set of exogenous variables. This framework allows one to consider competing explanations that have been put forward in the literature- notably, the roles of institutions, policies, and geography-and to assess their quantitative impact. The study finds that institutional quality does have a significant effect, not only on the level of income but also on growth and the volatility of growth. The findings are also consistent for all measures of institutions, but we rely on the aggregate governance index for the illustrations. Given the dominance of institutional factors in explaining economic performance, is there a role for policies? The results show that there is.

Institutions and income level

We began by looking at the impact of institutions on incomes. The research found that institutions have a statistically significant influence on economic performance, substantially increasing the level of per capita GDP. These findings hold whether institutional quality is measured by broad-based indicators (such as an aggregate of various perceptions of public sector governance) or by more specific measures (for example, the extent of property rights protection or application of the rule of law). Furthermore, the empirical results take into account the possibility of reverse causation (see Box 2).

These results suggest that economic outcomes could be substantially improved if developing countries strengthened the quality of their institutions. As...