World Economic Outlook (WEO), brought out by the IMF
in April 2003, contains detailed chapters on several
issues-on 'Why Bubbles Burst', 'Unemployment
and Labor Market Institutions: Why Reforms Pay Off',
'Growth and Institutions'. This review
intends to focus on the last of these-first,
because it is a crucial and potent issue that has
severe repercussions for the future of developing
economies, and second, because it questions issues
more interesting and perplexing than the IMF would
have us believe.
The overall conclusion of the chapter on 'Growth
and Institutions' is that institutions play
a major role in determining per capita income, economic
growth and growth volatility across countries. And
all the variables used by the report to measure institutions
support this contention. In addition, the report finds
that across different regions of the developing countries,
per capita income and institutional quality rise in
tandem. The pattern is not so consistent in the case
of differences in growth rates and growth volatility.
However, the question of causality is much more tricky,
as is admitted by the report. The analysis is definitely
very detailed and is set within the context of the
literature although there are some interesting omissions.
The report introduces the concept of 'perceptions
and assessments' of public institutions as explanatory
variables. It uses three measures of institutions.
To quote, 'these indicate, first, the quality
of governance, including the degree of corruption,
political rights, public sector efficiency, and regulatory
burdens; second, the extent of legal protection of
private property and how well such laws are enforced;
and third, the level of institutional and other limits
placed on political leaders' (WEO, p. 3).
The perceptions approach is used on the grounds that
'perceptions of the political, economic, and
policy climate embodied in the institutional measures
are likely to be of key importance in shaping overall
conditions for investment and growth. Given the mobility
of international capital, for example, such assessments
may play a major role in determining a country's
ability to attract and retain investment inflows'
(WEO, p. 3). The role of governance is treated as
a key institutional variable. Its definition, boasts
the report, is much wider and covers not just the
extent of corruption as is sometimes seen in the literature.
Recent literature has however, included many of these
factors. The exact indicators have actually been used
from other studies.
The line of enquiry is not new, nor are the conclusions
reached. For quite some time now, the role of institutions
in determining economic growth and incomes has been
a hot topic for debate. Finding its roots in the writing
of Douglas North, a historical account of the issue
is to be found in David (1994). Many empirical analyses
are to be found in the literature e.g. Easterly and
Levine (1997), Barro (1991), Knack (1996), Knack and
Keefer (1995). The recent debate has concentrated
on a few major views. The first, forwarded among others
by Jeffrey Sachs, John Gallup, Andrew Mellinger and
Jared Diamond, is that geographical and historical
factors like climate, soil fertility, location, climatic
environment and natural resource endowments play the
determining role in deciding the level of economic
development. This view underplays the role of institutions
in such determination.
A second view, proposed among others in the works
of Acemoglu, Johnson, and Robinson (2001, 2002), Engerman
and Sokoloff (1997, 2002) and Rodrik, Subramanian,
and Trebbi (2002), is that institutions subsume the
effects of historical and geographical factors and
thereby play the decisive role in determining the
path of economic development and growth. For example,
for all ex-colonies, the institutional framework will
be shaped, at least in part, by the history of its
colonization – its nature and extent. That is
why, this line of argument suggests, European established
settler-colonies like the US, New Zealand or Australia
have well-established institutions that support property
rights, enforce the rule of law, and hence support
investment and growth. This line of opinion holds
institutions as the key determinant of economic well-being.
A major branch of empirical research in this area
concentrates on the effectiveness of the particular
forms of institutions in determining the path of development
(see for example, Dani Rodrik, 2000). While some have
found financial institutions to be the driving factor,
many others point towards political institutions like
the role and the stability of the government, democratic
elements within the political system and the effect
of corruption. The role of the state comes in for
a major critical analysis here. Accusations of 'crony
capitalism' or corrupt governmental and other
machinery (like banking institutions) fostered by
the state have been regularly hurled by the Washington
Consensus to explain the Asian collapse. This opens
up questions as to which forms of institutions should
be taken to be the pivotal ones, and whether the role
of one form comes into conflict with that of another.
While it is undeniable that institutions have a major
role to play in the development of a country, a crucial
problem remains with specifics. The first is the choice
of institutional variables, from which the study is
obviously suffering. Secondly, choosing the exact
quantitative or qualitative measure poses another
problem. The need to distinguish between descriptive
measures such as absence or presence of a particular
type of institution, and the quality or performance
of that institution is very important. The third problem
is of data and methodology. This has also affected
the study but to this we would come later. The fourth
is the technical problem of using reduced form growth
equations as opposed to structural growth equations,
which much of the cross sectional studies have actually
done. Fifth, institutional variables may be endogenous
and not exogenous which would cause serious problems
for an econometric analysis. This has been pointed
out in the report but not taken care of. (for a reading
of the type of problems that may arise with such studies,
see Aron, 2000)
Right at the beginning, the WEO's use of the
concept of 'perceptions and assessments'
introduce some arbitrariness into the measures of
institutional quality used by the study and raises
some doubts regarding the results. Though it claims
to have used aggregates of over 300 indicators including
ratings by country experts and survey results, the
arbitrariness remains as is admitted by the report
in the next line itself (Footnote no: 32, page 26,
chapter 3, WEO, April, 2003). Surveys are very often
biased and unfortunately, so can be experts'
The fact is that no measure can quantify institutional
qualities easily. Measures of the quality of institutions
that affect economic exchange are suspect themselves.
Clubbing various measures are also problematic. The
literature on economic growth typically has classified
and treated the proxies collectively as "sociopolitical
measures." This practice has tended to obscure
the different channels through which institutions
operate and has impoverished the interpretation of
the role of institutions in growth. This is a serious
flaw in analysing developing countries, especially
since where 'weak' institutions are implicated
in low growth. The IMF report suffers specially from
In addition, the IMF is completely preoccupied with
variables with respect to government inefficiency
and corruption, as well as political freedom. In fact
the 'quality of governance' variable,
includes as a major factor 'regulatory burden'
which is a measure of the 'absence of government
control on goods market, banking system and international
trade'. The measure therefore places undue emphasis
on the so-called freedom of the country from government
This emphasis on political powers of the government
is deliberate. Positive association with growth and
income levels then enables the IMF to grossly interfere
with domestic political systems and workings of the
government, and force the state to withdraw in the
political as well as the economic sphere. And this
is a necessity for the IMF, not for improving the
lot of the developing countries, but to establish
the dominance of private finance capital and multinational
giants that it protects. This is the same task that
is being undertaken by US military control of 'rogue
forces' like the Taliban and Saddam Hussain
in Afghanistan and Iraq.
At the same time, there seems to be an absence of
most other types of indicators considered in the literature.
To name just a few of those mentioned in the literature,
indicators of business risk, social capital, local
government performance, ethnic and racial tensions,
social development and capability (including literacy,
social mobility, size of urban classes and crude fertility
rate), are all absent from the analysis (for a detailed
discussion, see Aron (2000)).
In particular, 'economic institutions'
in the form of banking and financial institutions
are glaringly from the analysis. While these are not
taken to be typical parts of the Anglo-Saxon system
of capitalism, these are very much a part of 'Continental
capitalism' which is based on the prominent
role of banks in corporate finance and control. Many
developing countries in fact fit this model of capitalism
better than the Anglo-Saxon one which has obviously
been the basis and the limitation of the WEO. In fact,
there is a pretty large literature that discusses
the role of banking institutions in determining the
path of economic growth and development, especially
in transition economies (for a comprehensive discussion,
See Cernat, 2002). But perhaps this is more than an
oversight or an inability to recognize forms of capitalism
other than the dominant one. It is more likely a denial
of the powers of domestic banking and financial institutions
that have been systematically weakened by the financial
liberalization policies pushed by the IMF itself.
That would conveniently fall into place with the rise
to dominance of the US Central bank as the single
powerful financial institution in the world.
The 'role of governance' factor is very
strongly related to growth, income levels and growth
volatility, finds the report. Judging by its definition,
the value of this variable should be high for a democratic
country, but cases of South Korea and China prove
to be strong examples to the contrary. In fact, China
does not even possess well-defined property rights,
which is in fact the second institutional variable
that the report considers. Nor does it possess the
third, namely, institutional freedom of its political
leaders. There are many other examples that defy this
result. Even countries like Saudi Arabia, which has
had a history of a government ruling with American
military support, has a high income just because of
its oil. Here, the factor of geographical or historical
endowments would turn out to be more important.
A very important question arises when we come to the
discussion on the role of policies viz.a.viz institutions.
The policy variables include indicators involving
inflation, trade openness, exchange rate over-valuation,
government size, financial development and capital
account openness. The report finds that the effect
of policies (mainly involving trade openness, stronger
competition and higher transparency) on per capita
incomes across countries becomes insignificant when
institutions are accounted for. The latter turns out
to be the determining and significant variable. Only
in two cases are the policy variables significant.
One is where the financial development variable is
found to have a significant impact on growth. The
other is where exchange rate overvaluation is found
to increase volatility. Similar results have also
been found by many other studies, notably by Rodrik
Now, this turns out to be rather an embarrassment
for the IMF-World Bank since they have relentlessly
advocated policies of macro economic management and
openness to trade as key forces for economic development
and higher incomes. World Bank economists like David
Dollar and Art Kraay have churned out paper after
paper to prove that this is so. Works of J. Barro
(1997), X. Sala-i-Martin (2002), have also publicized
on a mass scale, similar findings. Of course, these
did not take into account institutional factors as
such but much of the later IMF justification of its
policies viz.a.viz growth, poverty and income inequality
have depended heavily on these results.
Caught in this predicament, the Report has desperately
tried to save the situation by pointing out, how this
can be explained (page 10,16, Chapter 3, WEO, April
2003). Many explanations are offered. First, last
forty years of policies (captured in the measure used)
cannot properly reflect the impact on present incomes,
which may be a result of a period of policies much
longer than that. Second, policies cannot be implemented
properly and their effects on growth are weak unless
proper institutions are in place (page 10, Chapter
3, WEO, April, 1993). Third, the directions of causality
between institutions and policies are not clearly
known and works, in most cases, in both directions
(page 7, Chapter 3, WEO, April, 1993). Fourth, policies
are part of the institutions themselves and may be
correlated heavily with the institutional variables
which would render them insignificant in a regression
exercise. Fifth, Statistical and econometric analysis
based only on cross sectional data (used by the study)
that catches long term effects is unable to effectively
capture the impact of policies which can change very
rapidly. The fourth and the fifth explanations in
particular, however show that there are major problems
with this kind of an analysis. In this case, we cannot
take any co-efficient at its face value.
The result viz.a.viz policies certainly raise another
question. Policies of increased financial liberalization,
or capital account openness (as the specific variable
used by the report), have led to disastrous results
in many economies, notably those in many countries
in Latin America, Asia, and in Turkey and Russia.
The main reason has been the volatility in short-term
capital flows. It has been admitted as much by IMF
and World Bank officials - for example, by the Economic
Counselor and Director of Research of the IMF, Michael
Mussa (2000)(see also Global Development Finance,
2001, World Bank, Chapter 3). Shouldn't the
results found by the WEO, if tested correctly, have
shown a negative effect of financial openness on growth
and, or at least a positive one on growth volatility?
In the concluding section to the discussion on institutions
and policies, the Report ironically points to the
weaknesses of its own methodology. To quote, 'the
"bottom line" from these findings is not
that policies are unimportant, but that our econometric
framework (which is constrained, in particular, by
the limited time series data on institutions) is not
well suited to uncovering a relationship between policies
and growth that may well be revealed through time'
(page 17, Chapter 3, WEO, April, 2003).
If we are to believe them, we cannot take any of the
- Acemoglu, Daron, Simon Johnson,
and James A.Robinson, (2001): 'The Colonial
Origins of Comparative Development: An Empirical
Investigation,' American Economic Review,
Vol. 91 (December), pp. 1369-401.
- Aron, J. (2000): 'Growth
and Institutions: A Review of the Evidence',
World Bank Research Observer 15(1): 99-135.
- Barro, R. J. (1991): 'Economic
Growth in a Cross Section of Countries', Quarterly
Journal of Economics 106(2): 407-43.
- Barro, R. J. (1997): 'Determinants
of Economic Growth: A Cross-Country Empirical Study',
Cambridge, MIT Press.
- Cernat L. (2002): 'Institutions
and Economic Growth: Which Model of Capitalism for
Central and Eastern Europe?', Journal for
Institutional Innovation, Development and Transition,
- David, P. (1994): 'Why Are
Institutions the 'Carriers of History'?
Path Dependence and the Evolution of Conventions,
Organizations, and Institutions', Structural
Change and Economic Dynamics, 5(2): 205-20
- Diamond, Jared. (1997): 'Guns,
Germs, and Steel: The Fates of Human Societies'
(New York: W.W. Norton).
- Easterly, William, and Ross Levine.
(1997): 'Africa's Growth Tragedy: Policies
and Ethnic Divisions.' Quarterly Journal of
Economics 112(4, November): 1203-50.
- Engerman, Stanley L. and Kenneth
L. Sokoloff (1997): 'Factor Endowments, Institutions,
and Differential Paths of Growth Among New World
Economies: A View from Economic Historians of the
United States,' in How Latin America Fell
Behind, (ed.) by Stephen Haber (Stanford, California:
Stanford University Press), pp. 260-304.
- (2002): 'Factor Endowments,
Inequality, and Paths of Development among New World
Economies,' NBER Working Paper No. 9259
- Gallup, John L., Jeffrey Sachs,
and Andrew D. Mellinger (1998): 'Geography
and Economic Development,' NBER Working Paper
No. 6849 (Cambridge, Massachusetts: National Bureau
of Economic Research).
- Knack, S. (1996): 'Institutions
and the Convergence Hypothesis: The Cross-Country
Evidence', Public Choice 87(3-4):207-28.
- Knack, S and P. Keefer (1995):
'Institutions and Economic Performance: Cross-Country
Tests Using Alternative Institutional Measures'
Economics and Politics 7(3):207-27.
- Mussa Michael (2000): 'Factors
Driving Global Economic Integration', paper
presented in Jackson Hole, Wyoming, at a symposium
sponsored by the Federal Reserve Bank of Kansas
City on 'Global Opportunities and Challenges',
- North, Douglass. (1990): 'Institutions,
Institutional Change, and Economic Performance',
New York: Cambridge University Press
- Rodrik Dani, Arvind Subramanian
and Francesco Trebbi (2002): Institutions Rule:
The Primacy of Institutions over Geography and Integration
in Economic Development, NBER Paper no. W9305
- Rodrik Dani (2000): Institutions
for High-Quality Growth: What They are and How to
Acquire Them, NBER paper no. W7540
- Sala-i-Martin, X. (2002): The Disturbing
"Rise" of Global Income Inequality,
Discussion Paper, Department of Economics, Columbia