Saturday, July 26, 2008

Economic Growth: Institutions rule but endowments do matter more than expected

What are the reasons for highly rich and poor country clubs? The  reasons  vary based on researchers-- institutions,  geography,   genetically capitalist  and bourgeois virtues (mainly Gregory Clark), and also see Diamond on guns, germs, and steel determining the fate of human societies. However, two school of thoughts have garnered more attention in this debate. One believes in geography/endowments (led by Sachs) and the other in institutions (led by ???...but Rodrik, AJR and AJR are some of the ones I studied).

The debate is never ending. Some also argue that these school of thoughts might be getting different interpretations by running very similar correlations. Dixit seems unsatisfied with econometric evidence so far because the instrumental variables used by the school of thought that emphasizes the role of institutions are either geographic variables themselves or are highly correlated with geography, hence making it difficult to distinguish the partial effect of geography and institutions on income.

Now, a recent study (The Colonial and Geographic Origins of Comparative Development) by Raphael Auer shows how the effects of institutions and geographic endowments on income can be distinguished. He writes:

The key insight is that one can distinguish between the determinants of development by utilising the fact that geographic endowments had a differential effect on institutional development in former colonies and in the rest of the world. For example, in a former colony, high prevalence of malaria has reduced income because of both the direct effect of the disease on income and the indirect effect of the disease on settler mortality and thus colonisation policies. In contrast, in a country that has never been colonised, only the first of these two effects is present.

While the indirect impact of endowments on colonisation policies and thus institutions is present only in former colonies, the direct impact of endowments on income is present in all countries. Therefore, one can identify the relation between income and institutions by utilising the difference in how endowments have shaped institutional development in former colonies and in the rest of the world.

In contrast to the existing literature, this way of identifying the relation between institutions and income does not restrict the direct effect of endowments on income to be absent, thus allowing me to estimate the partial effects of the two channels.

He concludes that though institutions are not the only one, it is the main determinant of development. He underscores that endowments do have a statistically significant and economically relevant impact on income. Easterly and Levine also show that though geography does not affect economic development directly, it definitely affect indirectly through institutions. Similar conclusion was also reached by Rodrik, Subramanian, and Trebbi but they place very little (almost nil) emphasis on the role of geography and endowments. This is where Auer differs from Rodrik et al:

For example, in a typical specification, I find that a one standard-deviation difference in the included measures of geographic endowments is associated with a direct effect on income per capita equivalent to a seven-fold difference in GDP per capita. For a former colony, the same one standard-deviation difference is associated with an effect on colonisation policies, institutional outcomes, and thus income equivalent to an additional 18-fold difference in GDP per capita. Thus, while institutions are substantially more important than endowments, the direct effect of economic endowments can hardly be neglected.Together, both channels can explain around 40% of the variation in international income levels.

What are the policy implications for poverty reduction? Well, Auer argues that the current focus on aid and healthcare intervention would only help solve extreme poverty, not end poverty. Ending poverty requires appropriate institutional reforms that can convert development aid into sustained economic growth. Not a surprising policy prescription (despite quite and interesting study) because we all know these recommendations already! But an interesting study overall.