Development Economics

10 October 2023
Lecture 8
SAU
 Role of Institutions and Economic
Development
• Institutions gained importance since 1990s as an explanation for
inter-country differences in economic development
• Beginning in the early 1980s, the World Bank sought to minimize the
role of the state, reform and downsize the civil service, and
decentralize government (Stein, 2008)
• Since the late 1990s, the view that poor-quality institutions are the
root cause of economic problems in developing countries was
propagated
How?
• the IMF and the World Bank started to impose many ‘governance
related conditionalities’, which required that the borrowing country
adopts ‘better’ institutions that improve ‘governance’
• When the Thai Government established a Pharmaceutical Patent
Review Board to assess the effects of patents on drug accessibility, the
US Trade Representative’s office threatened sanctions on certain Thai
exports. The board was quickly disbanded and Thailand, which sends
a quarter of its exports to the United States, set limits on the right to
issue compulsory licences for pharmaceuticals
What are better institutions?
There is no agreed definition of what are ‘better’ institutions, often called the Global Standard
Institutions
• The most frequently mentioned are:
1. A common law legal system, which, by allowing all transactions unless explicitly prohibited,
promotes free contracts;
2. An industrial system based on private ownership, which requires significant privatization in
many countries;
3. Financial system based on a developed stock market with easy M&A (mergers and
acquisitions), which will ensure that the best management team available runs each enterprise;
4. A regime of financial regulation that encourages ‘prudence’ and ‘stability’, including a politically
independent central bank and the strict observance of the BIS (Bank for International
Settlements) capital adequacy ratio;
5. A shareholder-oriented corporate governance system, which will ensure that the corporations
are run for their owners;
6. A flexible labour market that allows quick re-allocation of labour in response to price changes;
7. A political system that restricts arbitrary actions of political rulers and their agents (i.e.,
bureaucrats) through decentralization of power and the minimization of discretion for public
sector agents
 Role of Academia
• Being encouraged by and stimulating the increasing demands for
institutional reform in developing countries was the explosive growth in
the academic research on the role of institutions in economic
development.
• Example:
• ‘Governance Matters’ paper series Kaufmann et al., 1999, 2002, 2003, 2005,
2006, 2007, 2008, 2009
• annual Doing Business reports, both published by the World Bank
 Theoretical problems

1. causality runs from institutions to economic

development, ignoring the important possibility
that economic development changes institutions.
2. Second, even when we focus on the ‘institutions
to development’ part of the causality, the
relationship is theorized in a rather simplistic,
linear, and static way.
Which Way?
Causality runs from economic
development to institutions--- HOW?

Better Economic
Institutions Development
 Economic development changes institutions through a
number of channels

• increased wealth due to growth may create higher demands for higher-quality
institutions
• e.g., demands for political institutions with greater transparency and accountability.

• greater wealth also makes better institutions more affordable. Institutions are
costly to establish and run, and the higher their quality the more ‘expensive’ they
become

• economic development creates new agents of change, demanding new institutions.

 Did Institutions Exist in Early Economic
Development Experience?
• democracy, modern bureaucracy, IPRs, limited liability,
bankruptcy law, banking, the central bank, securities
regulation, and so on---- All came after, not before, the
economic development of the present developed countries
• Eg., the Anglo-American countries (US, Canada, the UK, Australia and New
Zealand), whose institutions today are considered to be GSIs,
themselves did not have most of those institutions in their
earlier stages of development and acquired most of them only
after they became rich
What should developing countries do?
• the financial and human resources that developing countries
are expending in order to acquire GSIs may be better used
for other policies that more directly stimulate economic
development –
• educational expenditure, infrastructural investments, or industrial
subsidies –
• These measures indirectly promote institutional
development, which can then further promote economic
development.
• Are liberalized institutions better for economic development?
• Do institutions that provide greater economic freedom lead to faster
growth?
• Is a stronger protection of private property rights better for growth?
• Is the relationship between institutions and economic development
always the same?