Institutions and Long-Run Growth

The models we have presented in this book explain long-run economic growth as a result of the accumulation of physical and human capital and technological change. Then why don’t all countries adopt policies that are friendly to such processes? If they did, then the large differences in per capita income between the developed and less-developed world would gradually disappear.

One of the reasons that has been put forward, along with geography and cultural differences, is the role of institutions. The role of institutions has been emphasized by economic historians for a long time, as they have treated the accumulation of physical and human capital and technological progress as only the proximate and not the fundamental determinants of long-run economic growth. As North and Thomas [1973, p. 2] put it: “the factors we have listed (innovation, economies of scale, education, capital accumulation, etc.) are not causes of growth; they are growth” (italics in original). Factor accumulation and innovation are only proximate causes of growth. In North and Thomas’s view, and in the view of many other economic historians, the fundamental explanation of comparative growth is differences in institutions. Of primary importance to economic outcomes are economic and political institutions, such as civil and property rights, the existence and the imperfections of markets, the nature of the political system, and so forth.

Economic and political institutions are important, because they influence the structure of economic incentives. Without the protection of property rights, individuals will not have the incentive to invest in physical or human capital or to adopt more efficient technologies. Economic institutions are also important because they help allocate resources to their most efficient uses, and they determine who gets the profits, revenues, and residual rights of control.

Economists have also turned their attention to the role of institutions, as exemplified by the pioneering empirical study of Acemoglu et al. [2001] and the literature that it sparked. In recent years, some authors have formalized these ideas investigating the effects of institutions on the process of long-run growth. Three basic premises of this approach are as follows.

First, economic institutions matter for economic growth, because they shape the incentives to invest in physical and human capital and technology and to improve the organization of production. Although cultural and geographical factors may also matter for economic performance, differences in economic institutions are the major source of cross-country differences in economic growth and prosperity. Economic institutions not only determine the aggregate economic growth potential of the economy but also an array of economic outcomes, including the distribution of resources in the present and the future.

Second, economic institutions are treated as endogenous. They are determined collectively, in large part for their economic consequences. Not all individuals and groups will prefer the same set of economic institutions, because different economic institutions lead to different distributions of resources. Consequently, there will typically be conflicts of interest among various groups and individuals over the choice of economic institutions. These conflicts of interest are resolved through the political process.

Third, the distribution of political power in society is also treated as endogenous. Similarly to economic institutions, political institutions determine the constraints on and the incentives of the key actors in the political sphere.

There are two sources of persistence in the behavior of such a system. First, political institutions are durable, and typically, a sufficiently large change in the distribution of political power is necessary to cause a change in political institutions (such as, a transition from dictatorship to democracy). Second, when a particular group is rich relative to others, this will increase its de facto political power and enable it to push for economic and political institutions favorable to its interests. This will tend to entrench the initial disparity in relative wealth. Despite these tendencies for persistence, the framework also emphasizes the potential for change. In particular, “shocks,” including changes in technologies and the international environment, can modify the balance of (de facto) political power in society. Such shocks can lead to major changes in political institutions and therefore in economic institutions and economic growth.¹²

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