Institutions versus policies
Recent research has examined the relative role of historical institutions and more recent government policy behavior. The institutions view holds that geographic and historical conditions produce long-lasting differences in institutions.
For example, environments where crops are most effectively produced using large plantations will quickly develop political and legal institutions that protect the few landholders from the many peasants [Engerman and Sokoloff (1997)]. Even when agriculture recedes from the economic spotlight, enduring institutions will continue to thwart competition and hence economic development. Similarly, many countries’ institutions were shaped during colonization, so that examining colonies is a natural experiment. European colonialists found different disease environments around the globe. In colonies with inhospitable germs and climates, the colonial powers established extractive institutions, so that a few colonialists could exploit natural resources. In colonies with hospitable climates and germs, colonial powers established settler institutions. According to this view, the institutional structures created by the colonialists in response to the environment endure even with the end of colonialism [Acemoglu, Johnson and Robinson (2001, 2002)]. A history of ethnolinguistic divisions may both prevent the development of good institutions and be more damaging when those institutions are absent [Mauro (1995), Easterly and Levine (1997), and Easterly (2001)]. Thus, the institution view argues that economic development mainly depends on institutions that reflect deep-seated historical factors [North (1990)].In contrast, the policy view - which is really a collection of many different approaches - questions the importance of history or geography in shaping economic development today. This view is embedded in the approach of multilateral development institutions.
The policy view holds that economic policies and institutions reflect current knowledge and political forces. Thus, changes in either knowledge about which policies and institutions are best for development or changes in political incentives will produce rapid changes in institutions and economic policies. According to the policy view, while history and geography may have influenced production and institutions, understanding them is not crucial to understanding economic development today.Easterly and Levine (2003) examine whether major macroeconomic policies - inflation, trade policies, and impediments to international transactions as reflected in real exchange rate overvaluation - help explain current levels of economic development, after controlling for institutions. They do this in two steps. First, they treat the macroeconomic policy indicators, which are averaged over the last four decades as exogenous. Simultaneity bias may bias these results toward finding a significant statistical relationship between policies and economic development if economic success tends to produce better policies. Second, they treat the macroeconomic policy indicators as endogenous; they use instrumental variables (geographic variables and ethnolinguistic fractionaliza- tion) to control for potential simultaneity bias. Using these two methods, they assess whether macroeconomic policies explain cross-country differences in economic development. In both methods they instrument for institutions with the set of variables discussed above.
The evidence suggests that macroeconomic policies do not have a significant impact on economic development after accounting for the impact of institutions on the level of economic development. When the policy variables are treated as included exogenous variables, the Institutions Index enters all of the regression significantly. Furthermore, the coefficient size on the Institutions Index is essentially unchanged from regressions that did not include policy indicators.
Thus, even after controlling for macroeconomic policies, institutions explain cross-country differences in economic development. Furthermore, the data never reject the OIR-test. The policy indicators never enter the regressions significantly. Inflation, Openness, and Real Exchange Rate Overvaluation never enter with a P -value below 0.10. Moreover, even when they are included together, the data do not reject the null hypothesis that the three policies all enter with coefficients equal to zero, which is shown using the F-test on the three policy variables.When using instrumental variables for the policy indicators, they again find that macroeconomic policies do not explain economic development. Specifically, they fail to reject that hypothesis that macroeconomic policies have zero impact on economic development after accounting for the impact of institutions.
As noted earlier, the instrumental variables explain a significant amount of the crosscountry variation in the Institutions Index. In the first-stage regressions for policy, Easterly and Levine (2003) find that the instruments explain a significant amount of the cross-country variation in Openness and Real Exchange Rate Overvaluation at the 0.01 significance level. However, the instruments do not do a very good job of explaining cross-country variation in inflation, i.e., they fail to find evidence that the instruments explain average inflation rates over the last four decades at the 0.01 significance level. The policy variables never enter significantly in either method. While the exogenous component of the Institutions Index (i.e., the component defined by endowments) continues to significantly account for international differences in the level of GDP per capita, the macroeconomic policy indicators do not add any additional explanatory power.
This raises the suspicion that adverse macroeconomic policies (and macroeconomic volatility in general) may have been proxying for poor institutions in growth regressions. Acemoglu et al. (2003) provide some evidence supporting this suspicion.
In sum, the long run effect of policies on development is difficult to discern once you also control for institutions.
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