Institutions and Economic Growth
While poor countries have enormous potential for catch-up and convergence,
these advantages will fail to generate positive results on growth in countries
with an inadequate political, legal and regulatory framework. The notion that
institutions profoundly influence the wealth of nations is of course an old idea
first eloquently expressed by Adam Smith. Ever since the publication of Adam
Smith’s Wealth of Nations in 1776 economists have been aware that security of
property rights against expropriation by fellow citizens or the state is an important
condition for encouraging individuals to invest and accumulate capital.
Given this pedigree, economists have tended to centre their analysis of the
deeper determinants of growth on the role of institutions. Emphasis here is
placed on factors such as the role of property rights, the effectiveness of the
legal system, corruption, regulatory structures and the quality of governance
(North, 1990; World Bank, 1997; Olson, 2000; Acemoglu et al., 2001, 2002a;
Glaeser and Shleifer, 2002). From an institutionalist perspective the search for
the deeper determinants of growth has led to what Hibbs (2001) has called ‘the
politicisation of growth theory’. By ‘politicisation’ Hibbs is referring to the
increasing emphasis given by many growth researchers, in particular the seminal
contributions of Douglass North, to the importance of ‘politics, policy and
institutional arrangements’. These factors ultimately determine the structure of
incentives, the ability and willingness of people to save and invest productively,
the security of property rights and the incentive to innovate and participate in
entrepreneurial activity. Political–institutional factors also appear to be robust
determinants of growth in many cross-country regression studies (Knack and
Keefer, 1995, 1997a, 1997b; Sala-i-Martin, 1997; Dawson, 1998; Durlauf and
Quah, 1999; Easterly and Levine, 2003; Rodrik, 2003; Rodrik et al., 2004).
While the presence of technological backwardness and income per capita
gaps creates the potential for catch-up and convergence, Abramovitz (1986)
has highlighted the importance of ‘social capability’ without which countries
will not be able to realize their potential. Social capability refers to the
various institutional arrangements which set the framework for the conduct
of productive economic activities and without which market economies cannot
function efficiently. Temple and Johnson (1998) suggest that indexes of
social development developed in the 1960s by Adelman and Morris (1967)
have ‘considerable predictive power’ (see also Temple, 1998). Temple and
Johnson (1998) show that these measures, after allowing for initial income,
are ‘very useful in predicting subsequent growth’ and ‘if observers in the
early 1960s had given more emphasis to these indexes of social capability,
they might have been rather more successful in predicting the fast growth of
East Asia, and underperformance of sub-Saharan Africa’.
Developing effective institutions
Clearly the major income differentials that we observe around the world have
a lot to do with differences in the quality of countries’ institutions and
economic policies as well as the quality of political leadership. This explains
the rapid growth witnessed in a subset of East Asian developing countries
since around 1960 and the relative stagnation of most of sub-Saharan Africa
over that same period. Many economists believe that the main reasons why
some countries progress and grow rapidly while others stagnate cannot be
found in the area of geography and factor endowments. Countries with poor
natural resources such as Japan, Taiwan and South Korea have experienced
‘miracle’ growth while many natural resource-abundant economies in sub-
Saharan Africa, such as Zaire (from 1997 the Democratic Republic of Congo),
have been growth ‘disasters’. Reynolds (1985) concludes that the single most
important explanatory variable of economic progress is the political organization
and the administrative competence of government (see Herbst, 2000).
Gray and McPherson (2001), in their analysis of the leadership factor in
African policy reform, conclude that ‘a large number of African countries,
perhaps the majority, have been ruled by individuals who had sufficient
power to implement reforms had they been so motivated. However, their
motivation led them in different directions.’ It is also the case that the political
and economic losers from the changes that economic development requires
will often act as barriers to progress (Acemoglu and Robinson, 2000a; Parente
and Prescott, 2000).
Given the importance of these issues, the recent political economy of
growth literature has focused on such factors as the relationship between
economic freedom, democracy and growth (for example Barro, 1996, 1999;
Clague et al., 1996; Minier, 1998; Benson Durham, 1999; Landman, 1999;
Olson, 2000); property rights and growth (for example North and Weingast,
1989; North, 1990; DeLong and Shleifer, 1993; Acemoglu and Johnson,
2003); ethnic heterogeneity, political conflict and growth (for example East
erly and Levine, 1997; Acemoglu and Robinson, 2000a, 2000b, 2000c, 2001,
2003; Collier, 2001; Easterly, 2001b); the impact of inequality and political
instability on growth (for example Alesina and Rodrik, 1994; Alesina et al.,
1996; Lee and Roemer, 1998; Barro, 2000; Glaeser et al., 2003; see also
Chapter 10); and various measures of social capability/social infrastructure/
social capital and growth, including trust (for example Knack and Keefer,
1995, 1997a, 1997b; Abramovitz and David, 1996; Landau et al., 1996; Hall
and Jones, 1997, 1999; Temple, 1998; Temple and Johnson, 1998; Paldam,
2000; Rose-Ackerman, 2001; Zak and Knack, 2001).
According to the World Bank (2002), there is a growing body of evidence
linking the quality of institutional development to economic growth and
efficiency across both time and space and there is now widespread acceptance
of the idea that ‘good’ institutions and incentive structures are an important
precondition for successful growth and development. Because economic history
is essentially about the performance of economies over long periods of
time, it has a significant contribution to make in helping growth theorists
improve their ability to develop a better analytical framework for understanding
long-run economic change (North and Thomas, 1973; North, 1981, 1989,
1990, 1994; Myles, 2000).
The story that emerges from economic history is one which shows that the
unsuccessful economies, in terms of achieving sustained growth of living
standards, are those that fail to produce a set of enforceable economic rules
of the game that promote economic progress. As North (1991) argues, the
‘central issue of economic history and of economic development is to account
for the evolution of political and economic institutions that create an
economic environment that induces increasing productivity’.
North (1991) defines institutions as ‘the humanly devised constraints that
structure political, economic and social interaction’. The constraining institutions
may be informal (customs, traditions, taboos, conventions, self-imposed
codes of conduct involving guilt and shame) and/or formal (laws, contract
enforcement, rules, constitutions, property rights). In an ideal world the informal
and formal institutions will complement each other. These institutions
provide a structure within which repeated human interaction can take place,
they support market transactions, they help to transmit information between
economic agents and they give people the incentives necessary to engage in
productive activities. History is ‘largely a story of institutional evolution’ and
effective institutions ‘raise the benefit of co-operative solutions or the costs
of defection’ (North, 1991).
A good example demonstrating the importance of institutions for sustained
economic growth is provided by the post-Second World War reconstruction of
Europe. As DeLong and Eichengreen (1993) argue, ‘the Marshall Plan
significantly sped western European growth by altering the environment in
which economic policy was made’ and by providing support to a recovery
strategy based on the restoration of a market-based economic system, together
with the necessary supporting institutions. In retrospect we now know that the
period 1950–73 turned out to be a ‘Golden Age’ of economic growth in the
‘mixed’ economies of Western Europe, and DeLong and Eichengreen conclude
that the Marshall plan was ‘history’s most successful structural adjustment
programme’. Eichengreen (1996) also extends the institutional based explanation
of why Europe was able to enjoy a ‘Golden Age’ of economic growth in
the 25-year period following the implementation of the Marshall Plan. European
economic growth during this quarter-century was faster than any period
either before or since (Maddison, 2001). According to Eichengreen, the foundation
for this ‘Golden Age’ was a set of domestic (the social market economy)
and international institutions (GATT, the development of free intra-European
trade, the Bretton Woods institutions) that ‘solved problems of commitment
and co-operation that would have otherwise hindered the resumption of growth’.
For individuals living in a typical rich OECD economy in the twenty-first
century it is easy to take most of these market-based institutions for granted
because they have evolved over such a long historical period. But the ‘trials
of transition’ witnessed in the former communist economies remind us just
how difficult it is to make market economies operate effectively without
having the necessary institutional infrastructure in place.
Evidence from ‘natural experiments’
One very important source of divergence in per capita incomes emphasized
by Fukuyama (1989, 1992), Olson (1996, 2000) and DeLong (2001) has
arisen because of political developments which have influenced the choice of
economic system and policies. Those countries which attempted to ‘develop’
behind the ‘Iron Curtain’ now have much lower income per capita than
countries which had a comparable income per capita in 1950 and followed
the capitalist path.
The fact that a large part of the globe was under communist rule in the twentieth
century is one major reason for the world’s divergence … depending on how you
count and how unlucky you are, 40 to 94 per cent of the potential material
prosperity of a country was annihilated if it happened to fall under communist rule
in the twentieth century. (DeLong, 2001)
The most obvious examples involve the comparative development experiences
of East and West Germany, North and South Korea, and China with
Taiwan/Singapore/Hong Kong. But comparisons between other neighbouring
countries seems reasonable, for example, comparisons between Russia and
Finland, Hungary and Austria, Greece and Bulgaria, Slovenia and Italy, and
Cambodia and Thailand reveal significant differences in living standards.
The renaissance of economic growth research 639
Of the examples mentioned above, the most dramatic ‘natural experiment’
has occurred in the Korean peninsula during the second half of the twentieth
century. Following the surrender of Japan in August 1945, Korea was divided
at the 38th parallel into two zones of occupation, with armed forces from the
Soviet Union occupying the ‘North’ and American armed forces occupying
the ‘South’. In the summer of 1948, following the May elections, the American
zone of occupation became the Republic of Korea, and in September
1948 the northern zone became formally known as the Democratic People’s
Republic of North Korea. Both ‘Koreas’ claimed full political jurisdiction
over the entire Korean peninsula and this disagreement led to the Korean
War, which lasted from June 1950 until the armistice of July 1953. Since then
the 38th parallel has remained the dividing line between the two Koreas, with
the ‘communist North’ adopting a centrally planned economic strategy and
the ‘capitalist South’ putting its faith in a capitalist mixed economy. As the
data in Tables 11.4 and 11.5 make clear, the impact of these choices on living
standards in the two Koreas, made some 50 years ago, could not have been
more dramatic. As Acemoglu (2003b) notes, ‘a distinguishing feature of
Korea before separation was its ethnic, linguistic and economic homogeneity.
The north and south are inhabited by essentially the same people with the
same culture, and there were only minor differences between the two areas.’
Therefore, this natural experiment, of dividing the Korean peninsula into two
countries, each distinguished by very different policies and institutions, ‘gives
a clear example of how, despite the very similar economic conditions, political
leaders often chose very different policies with very different outcomes’.
As Maddison’s (2001) data indicate, per capita GDP in North Korea in
1950 was $770 (at 1990 international prices). By 1998 this had only risen to
$1183. In sharp contrast, although per capita income in South Korea in 1950
was also $770, by 1998 it had risen to $12 152! This again demonstrates the
powerful effect that differential growth rates can have on the relative living
standards of two countries. While North Korean per capita economic growth
during the 1950–73 period was initially impressive (5.84 per cent per annum),
during the 1973–98 period the rate of growth collapsed to minus 3.44
per cent. During the 1950–73 period South Korea’s growth rate was also 5.84
per cent. However, during the years 1973–98 South Korea’s per capita growth
rate increased to 5.99 per cent. By 1999, World Bank (2002) data indicate
that the 47 million people living in the South had a life expectancy of 73
whereas for the 23.6 million people living in the North, life expectancy was
60 and in recent years North Korea has been experiencing a famine (Noland
et al., 2001).
These ‘natural experiments’ show that where national borders also mark
the boundaries of public policies and institutions, easily observable differentials
in economic performance emerge (Fukuyama, 1992; Olson, 1996). In
DeLong’s (1992) view, ‘over the course of the twentieth century communism
has been a major factor making for divergence: making nations that were
relatively poor poorer even as rich industrial economies have grown richer’.
Democracy, the quality of governance and growth
Does growth promote democracy or does democracy promote growth? Recent
research into the link between democracy, dictatorship and growth has
produced support for both of the above linkages. Barro (1996, 1997, 1999)
provides evidence in support of the Lipset (1959) hypothesis which suggests
that prosperity promotes democracy. Barro’s research confirms this hypotH
esis as a ‘strong empirical regularity’. Since the empirical evidence also
supports the hypothesis that economic freedom promotes prosperity, Barro
concludes that policies that promote economic freedom will also promote
greater democracy through the Lipset prosperity effect. It is certainly indisputable
that there has never been a liberal democracy (free and regular
competitive elections) where there is an absence of economic freedom (see
Friedman, 1962; Kornai, 2000; Snowdon 2003b).
Bhagwati’s (1995) essay on democracy rejects an earlier popular view
highlighted in his 1966 book on The Economics of Underdeveloped Countries
that developing countries may face a ‘cruel dilemma’ in that they must
somehow choose between economic development or democracy. During the
1960s democracy was often portrayed as a luxury that poor countries could
not afford. It was often argued that to achieve rapid growth requires tough
decisions and that in turn necessitates firm political leadership free from
democratic constraints. The balance of opinion has now moved away from
accepting as inevitable this ‘Cruel Dilemma Thesis’.
While prosperity undoubtedly sows the seeds of democracy, the idea that a
stable democracy is good for sustained growth has also been receiving increasing
support in the literature. If property rights are the key to reducing
transaction costs and the promotion of specialization and trade, then it should
be no surprise to observe that ‘almost all of the countries that have enjoyed
good economic performance across generations are countries that have stable
democratic governments’ (Olson, 2000; Rodrik, 2000). Whereas good governance
and economic prosperity are good bedfellows, autocrats, who are
also invariably kleptomaniacs, are a high-risk form of investment. As Easterly
(2001a) notes, ‘governments can kill growth’.
For most of human history the vast majority of the peoples of the world
have been governed by what Mancur Olson (1993, 2000) calls ‘roving bandits’
and ‘stationary bandits’. History provides incontrovertible evidence that
benevolent despots are a rare breed. Roving bandits (warlords) have little
interest in promoting the well-being of the people living within their domain.
A territory dominated by competing roving bandits represents a situation of
pure anarchy and any form of sustainable economic development is impossible.
With no secure property rights there is little incentive for people to
produce any more than is necessary for their survival since any surplus will
be expropriated by force. Stationary bandits, however, can extract more tax
revenue from the territory they dominate if a stable and productive economy
can be encouraged and maintained. In this situation despots have an incentive
to provide key public goods such as law and order. But property rights can
never be fully secure under autocratic forms of governance because the
discretionary powers of the autocrat create a time-inconsistency problem.
That is, the autocrat will always have a credibility problem. History shows
that absolutist princes always find it difficult to establish stable dynasties, and
this uncertainty relating to succession prevents autocrats from taking a longerterm
view of the economy. For example, the monarchy in England between
the rule of William the Conqueror (1066) and the ‘Glorious Revolution’
(1688) was plagued by repeated crises of succession (for example the ‘Wars
of the Roses’). Only in a secure democracy, where representative government
is accountable and respectful of individual rights, can we expect to observe
an environment created that is conducive to lasting property rights (Fukuyama,
1989, 1992).
Acemoglu’s recent research highlights the importance of ‘political barriers
to development’. This work focuses on attitudes to change in hierarchical
societies. Economists recognize that economic growth is a necessary condition
for the elimination of poverty and sustainable increases in living standards.
Furthermore, technological change and innovation are key factors in promoting
growth. So why do political élites deliberately block the adoption of
institutions and policies that would help to eliminate economic backwardness?
Acemoglu and Robinson (2000a, 2000b, 2000c, 2001, 2003, 2005)
argue that superior institutions and technologies are resisted because they
may reduce the political power of the elite. Moreover, the absence of a
‘strong institution’ allows autocratic rulers to ‘adopt political strategies which
are highly effective at diffusing any opposition to their regime … the
kleptocratic ruler intensifies the collective action problem and destroys the
coalition against him by bribing the pivotal groups’ (Acemoglu et al., 2003b).
Often financed by natural resource abundance and foreign aid, kleptocrats
follow an effective power sustaining strategy of ‘divide and rule’. In the case
of Zaire, with over 200 ethnic groups, Mobutu was able to follow such a
strategy from 1965 until he was overthrown in 1997. Acemoglu’s research
reinforces the conclusions of Easterly and Levine (1997), who find that
ethnic diversity in Africa reduces the rate of economic growth (see next
section).
The general thesis advocated by North and Olson is also confirmed by
DeLong and Shleifer (1993), who show that those cities in medieval Europe
that were under more democratic forms of government were much more
productive than those under the autocratic rule of ‘princes’. The incompatibility
of despotism with sustainable economic development arises because of
the insecurity of property rights in environments where there are no constitutional
restrictions on an autocratic ruler. DeLong and Shleifer assume that the
size of urban populations is a useful proxy for commercial prosperity and
‘use the number and sizes of large pre-industrial cities as an index of economic
activity, and changes in the number of cities and the sizes of urban
population as indicators of economic growth’. Their city data show how
between the years 1000 and 1500, the centre of economic gravity in Europe
moved steadily northward. Although in the year 1000 Western Europe was a
‘backwater’ in terms of urban development, by 1800 it was established as the
most prosperous and economically advanced region of the world. While
London is ranked as the 25th largest European city at the beginning of the
thirteenth century, by 1650 it had risen to second place (after Paris), and by
1800 London was first. DeLong and Shleifer argue that security of property
can be thought of as a form of lower taxation, with the difference between
absolutist and non-absolutist governments showing up as different tax rates
on private property. It has also been argued by Douglass North that the
establishment of a credible and sustainable commitment to the security of
property rights in England required the establishment of parliamentary supremacy
over the crown. This was achieved following the ‘Glorious Revolution’
of 1688 which facilitated the gradual establishment of economic institutions
conducive to increasing security in property rights (North and Weingast,
1989; North, 1990). The contrasting economic fortunes of the North and
South American continents also bear testimony to the consequences of divergent
institutional paths for political and economic performance (Sokoloff and
Engerman, 2000; Acemoglu et al., 2001, 2002a; Khan and Sokoloff, 2001).
The failure in many countries to develop good governance has had serious,
often drastic, economic and political consequences. The case for democracy
rests very much on how regular elections and a free press and media act as
important mechanisms that increase the accountability of politicians. In a
principal–agent model, the scope for rent-seeking activities by politicians,
who have potential access to huge resources, is greatly increased if the
citizens of a country lack information and are denied the opportunity to hold
politicians accountable via regular and guaranteed competitive elections (see
Adsera et al., 2003).
In sum, we think that Winston Churchill had it right when he made his
famous statement defending democracy in the House of Commons (11 November
1947):
No one pretends that democracy is perfect or all wise. Indeed it has been said that
democracy is the worst form of government except for all those other forms that
have been tried from time to time.
Rent seeking, trust, corruption and growth
In order to foster high levels of output per worker, social institutions must be
developed which protect the output of individual productive units from diversion.
Countries with perverse infrastructure, such as a corrupt bureaucracy,
generate rent-seeking activities devoted to the diversion of resources rather
than productive activities such as capital accumulation, skills acquisition, and
the development of new goods and production techniques (Murphy et al.,
644 Modern macroeconomics
1993; Mauro, 1995). In an environment of weak law and contract enforcement,
poor protection of property rights, confiscatory taxation and widespread
corruption, unproductive profit- (rent-) seeking activities will become endemic
and cause immense damage to innovation and other growth-enhancing
activities (Tanzi, 1998).
There is abundant evidence that economic incentives can influence the
productivity and interests of talented individuals who potentially can make a
huge contribution to the accumulation of wealth. For individuals or groups of
individuals to have an incentive to adopt more advanced technology or engage
in the creation of new ideas requires an institutional framework which
allows for an adequate rate of return. In an interesting development of
Schumpeter’s theory of entrepreneurship Baumol (1990) has shown that by
extending the model, so that it encompasses the ‘allocation’ of entrepreneurial
skills, the power of the model to yield policy insights is greatly
enhanced. In Schumpeter’s (1934) analysis he identifies five forms of entrepreneurial
activity in addition to those related to fostering improvements in
technology, namely:
1. the introduction of new goods and/or new quality of an existing good;
2. the introduction of a new production method;
3. the opening of a new market;
4. the ‘conquest’ of a new source of supply of raw materials;
5. the new organization of any industry.
Baumol (1990) argues that Schumpeter’s list is deficient and in need of
extension to include:
6. ‘innovative acts of technology transfer that take advantage of opportunities
to introduce already available technology to geographical locales
whose suitability for the purpose had previously gone unrecognised or at
least unused’;
7. ‘innovations in rent seeking procedures’.
This last category is of crucial importance because it includes what Baumol
calls ‘acts of unproductive entrepreneurship’. Given that Baumol defines
entrepreneurs as ‘persons who are ingenious and creative in finding ways that
add to their own wealth, power, and prestige’, it follows that one of the main
determinants of the allocation of entrepreneurial talent at a particular time
and place will be the ‘prevailing rules of the game that govern the payoff of
one entrepreneurial activity relative to another’. Talented individuals are naturally
attracted to activities with the highest private returns. There is no guarantee
that such activities will always have the highest social rate of return. There
fore entrepreneurs can be ‘unproductive’, even ‘destructive’, as well as productive
from society’s point of view. While in some economies talented
people become conventional business entrepreneurs, in others talent is attracted
to the government bureaucracy, the armed forces, religion, crime and
other rent-seeking activities. Since the ‘rules of the game’ can and do change,
we can expect to see a reallocation of entrepreneurial talent appropriate to
any new environment. The forms of entrepreneurial behaviour that we observe
will obviously change over historical time and across geographical
space. Therefore the allocation of entrepreneurship between productive, unproductive
and destructive activities cannot but have a ‘profound effect’ on
the innovativeness, and hence growth, of any economy. For example, Landes
(1969) suggests that the reason why the Industrial Revolution began in England
rather than in France is linked to the allocation of talent. Any country
interested in growth must ensure that its most able people are allocated to the
productive sectors of the economy. Murphy et al. (1991) argue that a possible
reason for the productivity growth slowdown in the US economy during the
1970s could be the misallocation of human capital because talented individuals
have increasingly become rent seekers (for example lawyers) rather than
producers (for example engineers). They conclude that the ‘allocation of
talented people to entrepreneurship is good for growth and their allocation to
rent seeking is bad for growth’. In Baumol’s view the predominant form of
unproductive entrepreneurship in economies today is rent seeking, and the
prevailing laws, regulations and structure of financial incentives will inevitably
have a major effect on the ‘allocation of talent’.
These insights suggest that a fruitful line of research is to focus on crosscountry
differences in incentive structures facing entrepreneurs with respect
to encouragement to create new enterprises, adopt new technologies and
thereby increase growth. If barriers to productive entrepreneurship are deliberately
created by specific groups who have a clear vested interest in the
status quo, then the task of economists is to offer policy advice about how to
design and establish institutions that minimize this ‘unproductive’ behaviour.
When an environment is created that is conducive to the adoption of new
ideas by entrepreneurs, a type of capital is generated which economists have
referred to as ‘organizational’ or ‘business’ capital, which exists independently
of the entrepreneur. Countries that lack organizational capital will remain
unattractive to foreign direct investment.
Trust between economic agents is a crucial determinant of the cost of
transactions. This idea has a long pedigree (Fukuyama, 1995). For example,
John Stuart Mill (1848) noted that there are counties in Europe
where the most serious impediment to conducting business concerns on a large
and expenditure of large sums of money … The advantage to mankind of being
able to trust one another, penetrates into every crevice and cranny of human life:
the economical is perhaps the smallest part of it, yet even this is incalculable.
In a recent paper, Zak and Knack (2001) have taken up this insight and show
that the extent of trust in an economy ‘significantly’ influences growth rates,
and that ‘high trust societies produce more output than low trust societies’. In
economies where there is a high level of trust between transactors, the rate of
investment and economic growth is likely to be higher than in low-trust
environments. This finding supports the earlier empirical research of Knack
and Keefer (1995, 1997a, 1997b), who find a positive relationship between
trust and growth for a sample of 29 market economies. Zak and Knack argue
that trust is lower in countries where: (i) there is an absence of formal (laws,
contract enforcement) and informal (ostracism, guilt, loss of reputation) mechanisms
and institutions which deter and punish cheaters and constrain
opportunistic behaviour; (ii) population heterogeneity (ethnic diversity) is
greater; and (iii) inequalities are more pervasive. Easterly and Levine (1997)
find that ethnic diversity in Africa reduces the rate of economic growth since
diverse groups find it more difficult to reach cooperative solutions and scarce
resources are wasted because of continuous distributional struggles, of which
civil war, ‘ethnic cleansing’ and genocide are the most extreme manifestations
(Bosnia, Rwanda, Kosovo, Afghanistan). Collier’s (2001) research
suggests that ethnically diverse societies are ‘peculiarly ill suited to dictatorship’
and that providing there is not ‘ethnic dominance’ in the political
system, then democratic institutions can greatly reduce the potential adverse
economic impact of ethnic diversity and the wars of attrition that can take
place between competing groups. Easterly (2001b) argues that formal institutions
that protect minorities and guarantee freedom from expropriation and
contract repudiation can ‘constrain the amount of damage that one ethnic
group could do to another’. In Easterly’s framework of analysis the following
relationship holds:
Ethnic conflict = f (ethnic diversity, institutional quality)
Easterly’s research findings show that ethnic diversity does not lower growth
or result in worse economic policies providing that good institutions are in
place (Snowdon, 2003a). Good institutions also ‘lower the risk of wars and
genocides that might otherwise result from ethnic fractionalisation’. Rodrik
(1999a, 1999b, 2000) has also shown how societies with deep social divisions
and a lack of democratic institutions of conflict management are highly
vulnerable to exogenous economic shocks (see also Alesina and Rodrik,
1994). The adverse effect of an external shock (S) on economic growth is the
The renaissance of economic growth research 647
bigger the greater the latent social conflict (LSC) and the weaker are a
society’s institutions of conflict management (ICM). Rodrik’s hypothesis can
be captured by the following relationship:
Δ growth = – S(LSC/ICM)
Rodrik (1999a) uses this framework to explain the numerous ‘growth collapses’
that occurred across the world economy after the economic shocks of
the 1970s. In his empirical analysis countries with democratic and high-quality
government institutions demonstrated better macroeconomic management and
as a result experienced less volatility in their growth rates than countries with
weak institutions of conflict management.
While poor countries have enormous potential for catch-up and convergence,
these advantages will fail to generate positive results on growth in countries
with an inadequate political, legal and regulatory framework. The notion that
institutions profoundly influence the wealth of nations is of course an old idea
first eloquently expressed by Adam Smith. Ever since the publication of Adam
Smith’s Wealth of Nations in 1776 economists have been aware that security of
property rights against expropriation by fellow citizens or the state is an important
condition for encouraging individuals to invest and accumulate capital.
Given this pedigree, economists have tended to centre their analysis of the
deeper determinants of growth on the role of institutions. Emphasis here is
placed on factors such as the role of property rights, the effectiveness of the
legal system, corruption, regulatory structures and the quality of governance
(North, 1990; World Bank, 1997; Olson, 2000; Acemoglu et al., 2001, 2002a;
Glaeser and Shleifer, 2002). From an institutionalist perspective the search for
the deeper determinants of growth has led to what Hibbs (2001) has called ‘the
politicisation of growth theory’. By ‘politicisation’ Hibbs is referring to the
increasing emphasis given by many growth researchers, in particular the seminal
contributions of Douglass North, to the importance of ‘politics, policy and
institutional arrangements’. These factors ultimately determine the structure of
incentives, the ability and willingness of people to save and invest productively,
the security of property rights and the incentive to innovate and participate in
entrepreneurial activity. Political–institutional factors also appear to be robust
determinants of growth in many cross-country regression studies (Knack and
Keefer, 1995, 1997a, 1997b; Sala-i-Martin, 1997; Dawson, 1998; Durlauf and
Quah, 1999; Easterly and Levine, 2003; Rodrik, 2003; Rodrik et al., 2004).
While the presence of technological backwardness and income per capita
gaps creates the potential for catch-up and convergence, Abramovitz (1986)
has highlighted the importance of ‘social capability’ without which countries
will not be able to realize their potential. Social capability refers to the
various institutional arrangements which set the framework for the conduct
of productive economic activities and without which market economies cannot
function efficiently. Temple and Johnson (1998) suggest that indexes of
social development developed in the 1960s by Adelman and Morris (1967)
have ‘considerable predictive power’ (see also Temple, 1998). Temple and
Johnson (1998) show that these measures, after allowing for initial income,
are ‘very useful in predicting subsequent growth’ and ‘if observers in the
early 1960s had given more emphasis to these indexes of social capability,
they might have been rather more successful in predicting the fast growth of
East Asia, and underperformance of sub-Saharan Africa’.
Developing effective institutions
Clearly the major income differentials that we observe around the world have
a lot to do with differences in the quality of countries’ institutions and
economic policies as well as the quality of political leadership. This explains
the rapid growth witnessed in a subset of East Asian developing countries
since around 1960 and the relative stagnation of most of sub-Saharan Africa
over that same period. Many economists believe that the main reasons why
some countries progress and grow rapidly while others stagnate cannot be
found in the area of geography and factor endowments. Countries with poor
natural resources such as Japan, Taiwan and South Korea have experienced
‘miracle’ growth while many natural resource-abundant economies in sub-
Saharan Africa, such as Zaire (from 1997 the Democratic Republic of Congo),
have been growth ‘disasters’. Reynolds (1985) concludes that the single most
important explanatory variable of economic progress is the political organization
and the administrative competence of government (see Herbst, 2000).
Gray and McPherson (2001), in their analysis of the leadership factor in
African policy reform, conclude that ‘a large number of African countries,
perhaps the majority, have been ruled by individuals who had sufficient
power to implement reforms had they been so motivated. However, their
motivation led them in different directions.’ It is also the case that the political
and economic losers from the changes that economic development requires
will often act as barriers to progress (Acemoglu and Robinson, 2000a; Parente
and Prescott, 2000).
Given the importance of these issues, the recent political economy of
growth literature has focused on such factors as the relationship between
economic freedom, democracy and growth (for example Barro, 1996, 1999;
Clague et al., 1996; Minier, 1998; Benson Durham, 1999; Landman, 1999;
Olson, 2000); property rights and growth (for example North and Weingast,
1989; North, 1990; DeLong and Shleifer, 1993; Acemoglu and Johnson,
2003); ethnic heterogeneity, political conflict and growth (for example East
erly and Levine, 1997; Acemoglu and Robinson, 2000a, 2000b, 2000c, 2001,
2003; Collier, 2001; Easterly, 2001b); the impact of inequality and political
instability on growth (for example Alesina and Rodrik, 1994; Alesina et al.,
1996; Lee and Roemer, 1998; Barro, 2000; Glaeser et al., 2003; see also
Chapter 10); and various measures of social capability/social infrastructure/
social capital and growth, including trust (for example Knack and Keefer,
1995, 1997a, 1997b; Abramovitz and David, 1996; Landau et al., 1996; Hall
and Jones, 1997, 1999; Temple, 1998; Temple and Johnson, 1998; Paldam,
2000; Rose-Ackerman, 2001; Zak and Knack, 2001).
According to the World Bank (2002), there is a growing body of evidence
linking the quality of institutional development to economic growth and
efficiency across both time and space and there is now widespread acceptance
of the idea that ‘good’ institutions and incentive structures are an important
precondition for successful growth and development. Because economic history
is essentially about the performance of economies over long periods of
time, it has a significant contribution to make in helping growth theorists
improve their ability to develop a better analytical framework for understanding
long-run economic change (North and Thomas, 1973; North, 1981, 1989,
1990, 1994; Myles, 2000).
The story that emerges from economic history is one which shows that the
unsuccessful economies, in terms of achieving sustained growth of living
standards, are those that fail to produce a set of enforceable economic rules
of the game that promote economic progress. As North (1991) argues, the
‘central issue of economic history and of economic development is to account
for the evolution of political and economic institutions that create an
economic environment that induces increasing productivity’.
North (1991) defines institutions as ‘the humanly devised constraints that
structure political, economic and social interaction’. The constraining institutions
may be informal (customs, traditions, taboos, conventions, self-imposed
codes of conduct involving guilt and shame) and/or formal (laws, contract
enforcement, rules, constitutions, property rights). In an ideal world the informal
and formal institutions will complement each other. These institutions
provide a structure within which repeated human interaction can take place,
they support market transactions, they help to transmit information between
economic agents and they give people the incentives necessary to engage in
productive activities. History is ‘largely a story of institutional evolution’ and
effective institutions ‘raise the benefit of co-operative solutions or the costs
of defection’ (North, 1991).
A good example demonstrating the importance of institutions for sustained
economic growth is provided by the post-Second World War reconstruction of
Europe. As DeLong and Eichengreen (1993) argue, ‘the Marshall Plan
significantly sped western European growth by altering the environment in
which economic policy was made’ and by providing support to a recovery
strategy based on the restoration of a market-based economic system, together
with the necessary supporting institutions. In retrospect we now know that the
period 1950–73 turned out to be a ‘Golden Age’ of economic growth in the
‘mixed’ economies of Western Europe, and DeLong and Eichengreen conclude
that the Marshall plan was ‘history’s most successful structural adjustment
programme’. Eichengreen (1996) also extends the institutional based explanation
of why Europe was able to enjoy a ‘Golden Age’ of economic growth in
the 25-year period following the implementation of the Marshall Plan. European
economic growth during this quarter-century was faster than any period
either before or since (Maddison, 2001). According to Eichengreen, the foundation
for this ‘Golden Age’ was a set of domestic (the social market economy)
and international institutions (GATT, the development of free intra-European
trade, the Bretton Woods institutions) that ‘solved problems of commitment
and co-operation that would have otherwise hindered the resumption of growth’.
For individuals living in a typical rich OECD economy in the twenty-first
century it is easy to take most of these market-based institutions for granted
because they have evolved over such a long historical period. But the ‘trials
of transition’ witnessed in the former communist economies remind us just
how difficult it is to make market economies operate effectively without
having the necessary institutional infrastructure in place.
Evidence from ‘natural experiments’
One very important source of divergence in per capita incomes emphasized
by Fukuyama (1989, 1992), Olson (1996, 2000) and DeLong (2001) has
arisen because of political developments which have influenced the choice of
economic system and policies. Those countries which attempted to ‘develop’
behind the ‘Iron Curtain’ now have much lower income per capita than
countries which had a comparable income per capita in 1950 and followed
the capitalist path.
The fact that a large part of the globe was under communist rule in the twentieth
century is one major reason for the world’s divergence … depending on how you
count and how unlucky you are, 40 to 94 per cent of the potential material
prosperity of a country was annihilated if it happened to fall under communist rule
in the twentieth century. (DeLong, 2001)
The most obvious examples involve the comparative development experiences
of East and West Germany, North and South Korea, and China with
Taiwan/Singapore/Hong Kong. But comparisons between other neighbouring
countries seems reasonable, for example, comparisons between Russia and
Finland, Hungary and Austria, Greece and Bulgaria, Slovenia and Italy, and
Cambodia and Thailand reveal significant differences in living standards.
The renaissance of economic growth research 639
Of the examples mentioned above, the most dramatic ‘natural experiment’
has occurred in the Korean peninsula during the second half of the twentieth
century. Following the surrender of Japan in August 1945, Korea was divided
at the 38th parallel into two zones of occupation, with armed forces from the
Soviet Union occupying the ‘North’ and American armed forces occupying
the ‘South’. In the summer of 1948, following the May elections, the American
zone of occupation became the Republic of Korea, and in September
1948 the northern zone became formally known as the Democratic People’s
Republic of North Korea. Both ‘Koreas’ claimed full political jurisdiction
over the entire Korean peninsula and this disagreement led to the Korean
War, which lasted from June 1950 until the armistice of July 1953. Since then
the 38th parallel has remained the dividing line between the two Koreas, with
the ‘communist North’ adopting a centrally planned economic strategy and
the ‘capitalist South’ putting its faith in a capitalist mixed economy. As the
data in Tables 11.4 and 11.5 make clear, the impact of these choices on living
standards in the two Koreas, made some 50 years ago, could not have been
more dramatic. As Acemoglu (2003b) notes, ‘a distinguishing feature of
Korea before separation was its ethnic, linguistic and economic homogeneity.
The north and south are inhabited by essentially the same people with the
same culture, and there were only minor differences between the two areas.’
Therefore, this natural experiment, of dividing the Korean peninsula into two
countries, each distinguished by very different policies and institutions, ‘gives
a clear example of how, despite the very similar economic conditions, political
leaders often chose very different policies with very different outcomes’.
As Maddison’s (2001) data indicate, per capita GDP in North Korea in
1950 was $770 (at 1990 international prices). By 1998 this had only risen to
$1183. In sharp contrast, although per capita income in South Korea in 1950
was also $770, by 1998 it had risen to $12 152! This again demonstrates the
powerful effect that differential growth rates can have on the relative living
standards of two countries. While North Korean per capita economic growth
during the 1950–73 period was initially impressive (5.84 per cent per annum),
during the 1973–98 period the rate of growth collapsed to minus 3.44
per cent. During the 1950–73 period South Korea’s growth rate was also 5.84
per cent. However, during the years 1973–98 South Korea’s per capita growth
rate increased to 5.99 per cent. By 1999, World Bank (2002) data indicate
that the 47 million people living in the South had a life expectancy of 73
whereas for the 23.6 million people living in the North, life expectancy was
60 and in recent years North Korea has been experiencing a famine (Noland
et al., 2001).
These ‘natural experiments’ show that where national borders also mark
the boundaries of public policies and institutions, easily observable differentials
in economic performance emerge (Fukuyama, 1992; Olson, 1996). In
DeLong’s (1992) view, ‘over the course of the twentieth century communism
has been a major factor making for divergence: making nations that were
relatively poor poorer even as rich industrial economies have grown richer’.
Democracy, the quality of governance and growth
Does growth promote democracy or does democracy promote growth? Recent
research into the link between democracy, dictatorship and growth has
produced support for both of the above linkages. Barro (1996, 1997, 1999)
provides evidence in support of the Lipset (1959) hypothesis which suggests
that prosperity promotes democracy. Barro’s research confirms this hypotH
esis as a ‘strong empirical regularity’. Since the empirical evidence also
supports the hypothesis that economic freedom promotes prosperity, Barro
concludes that policies that promote economic freedom will also promote
greater democracy through the Lipset prosperity effect. It is certainly indisputable
that there has never been a liberal democracy (free and regular
competitive elections) where there is an absence of economic freedom (see
Friedman, 1962; Kornai, 2000; Snowdon 2003b).
Bhagwati’s (1995) essay on democracy rejects an earlier popular view
highlighted in his 1966 book on The Economics of Underdeveloped Countries
that developing countries may face a ‘cruel dilemma’ in that they must
somehow choose between economic development or democracy. During the
1960s democracy was often portrayed as a luxury that poor countries could
not afford. It was often argued that to achieve rapid growth requires tough
decisions and that in turn necessitates firm political leadership free from
democratic constraints. The balance of opinion has now moved away from
accepting as inevitable this ‘Cruel Dilemma Thesis’.
While prosperity undoubtedly sows the seeds of democracy, the idea that a
stable democracy is good for sustained growth has also been receiving increasing
support in the literature. If property rights are the key to reducing
transaction costs and the promotion of specialization and trade, then it should
be no surprise to observe that ‘almost all of the countries that have enjoyed
good economic performance across generations are countries that have stable
democratic governments’ (Olson, 2000; Rodrik, 2000). Whereas good governance
and economic prosperity are good bedfellows, autocrats, who are
also invariably kleptomaniacs, are a high-risk form of investment. As Easterly
(2001a) notes, ‘governments can kill growth’.
For most of human history the vast majority of the peoples of the world
have been governed by what Mancur Olson (1993, 2000) calls ‘roving bandits’
and ‘stationary bandits’. History provides incontrovertible evidence that
benevolent despots are a rare breed. Roving bandits (warlords) have little
interest in promoting the well-being of the people living within their domain.
A territory dominated by competing roving bandits represents a situation of
pure anarchy and any form of sustainable economic development is impossible.
With no secure property rights there is little incentive for people to
produce any more than is necessary for their survival since any surplus will
be expropriated by force. Stationary bandits, however, can extract more tax
revenue from the territory they dominate if a stable and productive economy
can be encouraged and maintained. In this situation despots have an incentive
to provide key public goods such as law and order. But property rights can
never be fully secure under autocratic forms of governance because the
discretionary powers of the autocrat create a time-inconsistency problem.
That is, the autocrat will always have a credibility problem. History shows
that absolutist princes always find it difficult to establish stable dynasties, and
this uncertainty relating to succession prevents autocrats from taking a longerterm
view of the economy. For example, the monarchy in England between
the rule of William the Conqueror (1066) and the ‘Glorious Revolution’
(1688) was plagued by repeated crises of succession (for example the ‘Wars
of the Roses’). Only in a secure democracy, where representative government
is accountable and respectful of individual rights, can we expect to observe
an environment created that is conducive to lasting property rights (Fukuyama,
1989, 1992).
Acemoglu’s recent research highlights the importance of ‘political barriers
to development’. This work focuses on attitudes to change in hierarchical
societies. Economists recognize that economic growth is a necessary condition
for the elimination of poverty and sustainable increases in living standards.
Furthermore, technological change and innovation are key factors in promoting
growth. So why do political élites deliberately block the adoption of
institutions and policies that would help to eliminate economic backwardness?
Acemoglu and Robinson (2000a, 2000b, 2000c, 2001, 2003, 2005)
argue that superior institutions and technologies are resisted because they
may reduce the political power of the elite. Moreover, the absence of a
‘strong institution’ allows autocratic rulers to ‘adopt political strategies which
are highly effective at diffusing any opposition to their regime … the
kleptocratic ruler intensifies the collective action problem and destroys the
coalition against him by bribing the pivotal groups’ (Acemoglu et al., 2003b).
Often financed by natural resource abundance and foreign aid, kleptocrats
follow an effective power sustaining strategy of ‘divide and rule’. In the case
of Zaire, with over 200 ethnic groups, Mobutu was able to follow such a
strategy from 1965 until he was overthrown in 1997. Acemoglu’s research
reinforces the conclusions of Easterly and Levine (1997), who find that
ethnic diversity in Africa reduces the rate of economic growth (see next
section).
The general thesis advocated by North and Olson is also confirmed by
DeLong and Shleifer (1993), who show that those cities in medieval Europe
that were under more democratic forms of government were much more
productive than those under the autocratic rule of ‘princes’. The incompatibility
of despotism with sustainable economic development arises because of
the insecurity of property rights in environments where there are no constitutional
restrictions on an autocratic ruler. DeLong and Shleifer assume that the
size of urban populations is a useful proxy for commercial prosperity and
‘use the number and sizes of large pre-industrial cities as an index of economic
activity, and changes in the number of cities and the sizes of urban
population as indicators of economic growth’. Their city data show how
between the years 1000 and 1500, the centre of economic gravity in Europe
moved steadily northward. Although in the year 1000 Western Europe was a
‘backwater’ in terms of urban development, by 1800 it was established as the
most prosperous and economically advanced region of the world. While
London is ranked as the 25th largest European city at the beginning of the
thirteenth century, by 1650 it had risen to second place (after Paris), and by
1800 London was first. DeLong and Shleifer argue that security of property
can be thought of as a form of lower taxation, with the difference between
absolutist and non-absolutist governments showing up as different tax rates
on private property. It has also been argued by Douglass North that the
establishment of a credible and sustainable commitment to the security of
property rights in England required the establishment of parliamentary supremacy
over the crown. This was achieved following the ‘Glorious Revolution’
of 1688 which facilitated the gradual establishment of economic institutions
conducive to increasing security in property rights (North and Weingast,
1989; North, 1990). The contrasting economic fortunes of the North and
South American continents also bear testimony to the consequences of divergent
institutional paths for political and economic performance (Sokoloff and
Engerman, 2000; Acemoglu et al., 2001, 2002a; Khan and Sokoloff, 2001).
The failure in many countries to develop good governance has had serious,
often drastic, economic and political consequences. The case for democracy
rests very much on how regular elections and a free press and media act as
important mechanisms that increase the accountability of politicians. In a
principal–agent model, the scope for rent-seeking activities by politicians,
who have potential access to huge resources, is greatly increased if the
citizens of a country lack information and are denied the opportunity to hold
politicians accountable via regular and guaranteed competitive elections (see
Adsera et al., 2003).
In sum, we think that Winston Churchill had it right when he made his
famous statement defending democracy in the House of Commons (11 November
1947):
No one pretends that democracy is perfect or all wise. Indeed it has been said that
democracy is the worst form of government except for all those other forms that
have been tried from time to time.
Rent seeking, trust, corruption and growth
In order to foster high levels of output per worker, social institutions must be
developed which protect the output of individual productive units from diversion.
Countries with perverse infrastructure, such as a corrupt bureaucracy,
generate rent-seeking activities devoted to the diversion of resources rather
than productive activities such as capital accumulation, skills acquisition, and
the development of new goods and production techniques (Murphy et al.,
644 Modern macroeconomics
1993; Mauro, 1995). In an environment of weak law and contract enforcement,
poor protection of property rights, confiscatory taxation and widespread
corruption, unproductive profit- (rent-) seeking activities will become endemic
and cause immense damage to innovation and other growth-enhancing
activities (Tanzi, 1998).
There is abundant evidence that economic incentives can influence the
productivity and interests of talented individuals who potentially can make a
huge contribution to the accumulation of wealth. For individuals or groups of
individuals to have an incentive to adopt more advanced technology or engage
in the creation of new ideas requires an institutional framework which
allows for an adequate rate of return. In an interesting development of
Schumpeter’s theory of entrepreneurship Baumol (1990) has shown that by
extending the model, so that it encompasses the ‘allocation’ of entrepreneurial
skills, the power of the model to yield policy insights is greatly
enhanced. In Schumpeter’s (1934) analysis he identifies five forms of entrepreneurial
activity in addition to those related to fostering improvements in
technology, namely:
1. the introduction of new goods and/or new quality of an existing good;
2. the introduction of a new production method;
3. the opening of a new market;
4. the ‘conquest’ of a new source of supply of raw materials;
5. the new organization of any industry.
Baumol (1990) argues that Schumpeter’s list is deficient and in need of
extension to include:
6. ‘innovative acts of technology transfer that take advantage of opportunities
to introduce already available technology to geographical locales
whose suitability for the purpose had previously gone unrecognised or at
least unused’;
7. ‘innovations in rent seeking procedures’.
This last category is of crucial importance because it includes what Baumol
calls ‘acts of unproductive entrepreneurship’. Given that Baumol defines
entrepreneurs as ‘persons who are ingenious and creative in finding ways that
add to their own wealth, power, and prestige’, it follows that one of the main
determinants of the allocation of entrepreneurial talent at a particular time
and place will be the ‘prevailing rules of the game that govern the payoff of
one entrepreneurial activity relative to another’. Talented individuals are naturally
attracted to activities with the highest private returns. There is no guarantee
that such activities will always have the highest social rate of return. There
fore entrepreneurs can be ‘unproductive’, even ‘destructive’, as well as productive
from society’s point of view. While in some economies talented
people become conventional business entrepreneurs, in others talent is attracted
to the government bureaucracy, the armed forces, religion, crime and
other rent-seeking activities. Since the ‘rules of the game’ can and do change,
we can expect to see a reallocation of entrepreneurial talent appropriate to
any new environment. The forms of entrepreneurial behaviour that we observe
will obviously change over historical time and across geographical
space. Therefore the allocation of entrepreneurship between productive, unproductive
and destructive activities cannot but have a ‘profound effect’ on
the innovativeness, and hence growth, of any economy. For example, Landes
(1969) suggests that the reason why the Industrial Revolution began in England
rather than in France is linked to the allocation of talent. Any country
interested in growth must ensure that its most able people are allocated to the
productive sectors of the economy. Murphy et al. (1991) argue that a possible
reason for the productivity growth slowdown in the US economy during the
1970s could be the misallocation of human capital because talented individuals
have increasingly become rent seekers (for example lawyers) rather than
producers (for example engineers). They conclude that the ‘allocation of
talented people to entrepreneurship is good for growth and their allocation to
rent seeking is bad for growth’. In Baumol’s view the predominant form of
unproductive entrepreneurship in economies today is rent seeking, and the
prevailing laws, regulations and structure of financial incentives will inevitably
have a major effect on the ‘allocation of talent’.
These insights suggest that a fruitful line of research is to focus on crosscountry
differences in incentive structures facing entrepreneurs with respect
to encouragement to create new enterprises, adopt new technologies and
thereby increase growth. If barriers to productive entrepreneurship are deliberately
created by specific groups who have a clear vested interest in the
status quo, then the task of economists is to offer policy advice about how to
design and establish institutions that minimize this ‘unproductive’ behaviour.
When an environment is created that is conducive to the adoption of new
ideas by entrepreneurs, a type of capital is generated which economists have
referred to as ‘organizational’ or ‘business’ capital, which exists independently
of the entrepreneur. Countries that lack organizational capital will remain
unattractive to foreign direct investment.
Trust between economic agents is a crucial determinant of the cost of
transactions. This idea has a long pedigree (Fukuyama, 1995). For example,
John Stuart Mill (1848) noted that there are counties in Europe
where the most serious impediment to conducting business concerns on a large
and expenditure of large sums of money … The advantage to mankind of being
able to trust one another, penetrates into every crevice and cranny of human life:
the economical is perhaps the smallest part of it, yet even this is incalculable.
In a recent paper, Zak and Knack (2001) have taken up this insight and show
that the extent of trust in an economy ‘significantly’ influences growth rates,
and that ‘high trust societies produce more output than low trust societies’. In
economies where there is a high level of trust between transactors, the rate of
investment and economic growth is likely to be higher than in low-trust
environments. This finding supports the earlier empirical research of Knack
and Keefer (1995, 1997a, 1997b), who find a positive relationship between
trust and growth for a sample of 29 market economies. Zak and Knack argue
that trust is lower in countries where: (i) there is an absence of formal (laws,
contract enforcement) and informal (ostracism, guilt, loss of reputation) mechanisms
and institutions which deter and punish cheaters and constrain
opportunistic behaviour; (ii) population heterogeneity (ethnic diversity) is
greater; and (iii) inequalities are more pervasive. Easterly and Levine (1997)
find that ethnic diversity in Africa reduces the rate of economic growth since
diverse groups find it more difficult to reach cooperative solutions and scarce
resources are wasted because of continuous distributional struggles, of which
civil war, ‘ethnic cleansing’ and genocide are the most extreme manifestations
(Bosnia, Rwanda, Kosovo, Afghanistan). Collier’s (2001) research
suggests that ethnically diverse societies are ‘peculiarly ill suited to dictatorship’
and that providing there is not ‘ethnic dominance’ in the political
system, then democratic institutions can greatly reduce the potential adverse
economic impact of ethnic diversity and the wars of attrition that can take
place between competing groups. Easterly (2001b) argues that formal institutions
that protect minorities and guarantee freedom from expropriation and
contract repudiation can ‘constrain the amount of damage that one ethnic
group could do to another’. In Easterly’s framework of analysis the following
relationship holds:
Ethnic conflict = f (ethnic diversity, institutional quality)
Easterly’s research findings show that ethnic diversity does not lower growth
or result in worse economic policies providing that good institutions are in
place (Snowdon, 2003a). Good institutions also ‘lower the risk of wars and
genocides that might otherwise result from ethnic fractionalisation’. Rodrik
(1999a, 1999b, 2000) has also shown how societies with deep social divisions
and a lack of democratic institutions of conflict management are highly
vulnerable to exogenous economic shocks (see also Alesina and Rodrik,
1994). The adverse effect of an external shock (S) on economic growth is the
The renaissance of economic growth research 647
bigger the greater the latent social conflict (LSC) and the weaker are a
society’s institutions of conflict management (ICM). Rodrik’s hypothesis can
be captured by the following relationship:
Δ growth = – S(LSC/ICM)
Rodrik (1999a) uses this framework to explain the numerous ‘growth collapses’
that occurred across the world economy after the economic shocks of
the 1970s. In his empirical analysis countries with democratic and high-quality
government institutions demonstrated better macroeconomic management and
as a result experienced less volatility in their growth rates than countries with
weak institutions of conflict management.
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