The Political Economy of Growth and Development: What do We Know? What do We

Need to Know?

Kunal SenIDPM and Joint Research Director, Effective States and Inclusive Development Research Centre (ESID), University of Manchester

www.effective-states.orgwww.ippg.org.uk

www.kunalsen.orgMy presentation draws from ESID WP no. 5 (also published in World Development,

May 2013).

Background“Is there some action a government of India could take that would lead the

Indian economy to grow like Indonesia’s or Egypt’s? If so, what, exactly? If not, what is it about the “nature of India” that makes it so? The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else”.

Robert E. Lucas 1988,Nobel Laureate in Economics.

• Why are there such significant and persistent differences in living standards across countries?

• Why have so few developing countries ‘caught up’ with the living standards of Western European countries?

• One of the most important and challenging areas of the social sciences. • In spite of a voluminous literature on the causes of economic growth: it is

still “hard to think about anything else”

Outline of My Lecture

• Where are we now in understanding the causes of the persistent differences in living standards across the world?

• How much have we progressed and what remains to be explained?

• What have been the main theoretical developments in the social sciences that has taken us closer to an understanding of the causes of growth and development?

• What are the unanswered questions?

Development Thinking, 1960s to 1980s

• Among economists, early interest in determinants of growth such as capital accumulation and technological advance.

• Such proximate determinants or correlates of economic growth “are not causes of growth; they are growth” (Douglas North).

• Rise of the Washington Consensus: liberalisation of markets + good governance reforms (promotion of democracy, and civil service reforms)

Critiques of the Washington Consensus

• Structural adjustment programmes implemented by the IMF-WB not successful in Africa and Latin America.

• Developmental states in East Asia – strong and effective states that were interventionists and disciplined capitalists. Not free market economies.

• International efforts to fix governance problems through good governance reforms and new modalities of aid have largely failed, both in terms of outcomes and in terms of addressing the root causes of the problem.

• But if not policies, what exactly?

Institutions as the Cause of Growth and Development

• The formal and informal ‘rules of the game’ that shape human behaviour in economic, social and political life.

• The idea that institutions are crucial determinants of growth and development has been there for a long time in the social sciences.

• The great French sociologist Émile Durkheim famously described institutions as the ‘scaffolding of society’.

The Resurgence of Interest in Institutions

• It has been only with the seminal work of Douglass North, Oliver Williamson, Elinor Ostrom and others that there was real progress in our understanding of why institutions matter.

• At the same time, there was steady accumulation of empirical knowledge on how and in what conditions institutions play a causal role in economic development.

What are economic institutions?Security of Property Rights:- Without this, individuals will lack the incentive to save and

invest as they will fear others will deprive them of the fruits of their activities.

Enforcement of Contracts:- Economic transactions promise gains to all voluntary

participants. But each may lose if the other fails to play its promised role in the transaction and acts opportunistically.

Collective Action: • - Provision of public goods and control of public ‘bads’. Can be

provided by state or community.

What are political and social institutions?

• Political institutions: rules that steer political behaviour in different directions – federal/unitary systems, proportional representation vs first past the post, presidential/parliamentary systems.

• Social/cultural institutions: language –rules governing the use of sounds for meaning and communication, systems of marriage and burial, caste/kinship.

Formal and Informal Institutions• Formal institutions are understood as being expressed in laws,

regulations, decrees or ‘parchment’ institutions which can be officially sanctioned and enforced by third parties.

• Informal institutions are best understood as socially shared customs, conventions, norms and practices which are usually unwritten and not officially enforceable though there may be non-official modes of enforcement

• Individual titles to land that can be enforced by a court is a formal institution.

• Customary land tenure: embodying rules established by custom and convention, and may not allow private ownership, purchase or sale.

Why do institutions matter?

• Stable property rights provide a conducive environment for investment and growth.

• These stable property rights can be provided by both formal and informal institutions.

• Formal institutions: written contracts, well functioning of courts.

• Informal institutions: customary land tenure in many developing countries.

Some cross-country evidence

Formal or Informal Institutions?

• In the early policy thinking on institutions, the view was that formal ‘best practice’ institutions as in Western societies should be transplanted to developing countries for development to occur.

• ‘Institutional mono-cropping’ (Peter Evans).• But this was a naïve view of how institutions matter. • When formal institutions were not there or not

functioning well, informal institutions could be equally effective.

The Mafia in Sicily• After the feudal system collapsed in Sicily and before the

emergence of the modern state, banditry was rife.• Landlords started hiring the toughest of the bandits as guards.• These protectors got together to form the mafia. • “When the butcher comes to me to buy an animal, he knows

that I want to cheat him (by supplying a low quality animal). But I know that he wants to cheat me (by reneging on the payment). Thus we need Pepe, the mafioso, to make both of us agree. And we both pay Pepe a commission”.

The Colonial Origins of Comparative Development (Acemoglu, Johnson and

Robinson)• There were different types of colonization policies which

created different sets of institutions. In some of the colonies, Europeans set up “extractive institutions” (Belgian conquest of Congo).

• These institutions did not introduce much protection for private property; nor did they provide much in the way of checks and balances against government expropriation.

• The main purpose of these extractive institutions was to transfer as much of the resources from the colony to the coloniser. These institutions were detrimental to investment and development.

Colonial Origins of Development

• At the other extreme, many Europeans migrated and settled in a number of colonies, where they tried to replicate European institutions, with strong emphasis on private property and checks against government power.

• These institutions enforced the rule of law and encouraged investment.

• Primary examples include Australia, Canada, New Zealand and the United States. In other colonies, Europeans migrated and settled, and set up “European-like” institutions (Australia, Canada, New Zealand, USA).

Economic development now can be related to Institutions introduced by Colonial Powers

• The colonization strategy was influenced by the feasibility of settlements. In places where the disease environment was not favourable to settlement, extractive institutions were more likely to be set up.

• The colonial state and institutions persisted even after independence.• This is because the political elite that came to power at independence in

the previously colonised countries had a strong self-interest in maintaining the extractive institutions established during colonial times and the access to revenues obtained from the control of these institutions.

• Past Institutions -> Present Institutions -> Present Economic Development

Limitations of the Institutions Literature

• If weak or poor institutions were the cause of growth and development, surely we could change these institutions?

• Why do we then observe the survival of apparently inefficient or extractive institutions?

• How and why do institutions persist once established? • Not enough to purely focus on institutions as the cause of

development.• We need to understand the political conditions under which

growth-impeding institutions persist, and why we very rarely see such institutions being replaced by growth-enhancing institutions.

• Power and politics are central in understanding institutional change and persistence.

Acemoglu-Robinson (AR)

North, Wallis, Weingast (NWW)

New Concepts in Political Economy: The Political Settlement/ Political Equilibrum

• “A political settlement emerges when institutions generate a distribution of benefits that is compatible with and sustains the distribution of power, subject to economic viability” (Mushtaq Khan)

• Political equilibrium: the set of political and economic institutions compatible with de facto political power, which depend on the ability of groups to solve their collective action problems and the distribution of economic resources, source: Acemoglu-Robinson (AR).

Power and Elites• Elites make bargains between themselves and

establish institutions that align the distribution of benefits with the underlying distribution of power.

• Elite bargains give rise to institutions that shape social, political and economic change.

• Rent-seeking & -sharing/patronage becomes the norm– Between elites: incentivises powerful groups to

remain onside; build credibility with economic elites (e.g. property rights, expropriation)

– With middle/lower groups: public sector jobs; club goods to particular localities/groups; petty benefits through vote-buying etc.

Who are the elites and how do they behave?

• Elites are people with partial or total control on policy and economy.

• E.g. Large landowners, business owners, bureaucrats, politicians in authoritarian regimes, unions, religious leaders, ruling castes, etc..

• Elites tend to choose institutions that maximise their payoff.• Guided by both self-interest and ideology.• Elites are not necessarily monolithic and may comprise of

different groups with partly divergent interests.

A Summary of AR’s Main Arguments• Economic institutions and political institutions are

determined by the political equilibrium, as the prevalent power relations will determine which set of economic and political institutions are more likely to emerge.

• Political power can be both de jure and de facto. • De jure political institutions determine the constraints

on and the incentives of key actors in the political sphere and could be both formal (that is, whether the political system is democratic or autocratic) or informal (that is, the set of informal constraints on politicians and political elites).

De facto Political Institutions

• De facto political institutions originate from the possibility that important social and political groups which hold political power may not find the distributions of benefits allocated by de jure political institutions and by economic institutions acceptable to them.

• They may use both legal and extra-legal means to impose their wishes on society and try to change these institutions (for example, they may revolt, use arms, co-opt the military or undertake protests).

The Evolution of Political and Economic Institutions in AR

Inclusive Institutions• Broadbased economic growth due to inclusive economic

and political institutions. • Inclusive economic institutions: Secure property rights for

the majority of the population, law and order, markets and state support (public services and regulation) for markets; open to relatively free entry of new businesses; uphold contracts; access to education and opportunity for the great majority of citizens.

• Inclusive political institutions: Political institutions allowing broad participation, pluralism, and placing constraints and checks on politicians.

• But also some degree of political centralization for the states to be able to effectively enforce law and order.

Path Dependence• Bad political equilibria that lead to poor economic performance may persist

over time, and economic growth may stagnate in a country for many years as a consequence.

• Since the distribution of political power determines the evolution of economic and political institutions, political elites who hold power will always have an incentive to maintain the political institutions that give them political power, and the economic institutions that distribute resources to them.

• The initial distribution of resources allow elites who have access to these resources to increase their de facto political power, allowing them to push for economic and political institutions favourable to their interests, reproducing the initial disparity in political power.

• There will be a persistence of extractive economic and political institutions in societies with such institutions, since the elites who benefit from these institutions would not be an incentive to change them.

Will Institutional or Policy Reforms Work?

• Making or imposing specific institutional or policy reforms may have little impact on the general structure of economic institutions or performance if they leave untouched the underlying political equilibrium.

• E.g economic reforms that try to bring in competition will not succeed if elites have no interest in reducing the market power or the control of rents they derive from extractive institutions (e.g India now).

• Elections in themselves will not lead to democratisation (e.g. Egypt now).

An Example: Civil War in Sub-Saharan Africa

• Attempts by the IFIs to induce downsizing of the public sector, for example by closing down loss-making parastatals may have played an important role in creating civil war in Sierra Leone and Liberia.

• Political elites used public sector employment as a means to redistribute rents to opponents or potential opponents as a way of obtaining political support.

• With the decline in the possibility of using public sector employment as a means to redistribute rents following structural adjustment, opposition to the political regime in power emerged, leading to civil war in some contexts.

• While the underlying political equilibrium that was built in part around patronage relations and rent distribution via public sector employment in many African countries in the 1980s may have been inefficient, changes in this equilibrium brought through institutional change by exogenous actors such as the World Bank and the IMF may have led a more inefficient (and socially undesirable) outcome.

The dynamics of institutional change in AR

Limitations of AR (and also of NWW)

• Autocracies or semi-authoritarian regimes seem to have the highest rates of economic growth. E.g Korea and Singapore in the 1960s to 1980s, China and Vietnam now.

• Conversely, democracies do not seem to do well in growth – India historically.

• Crucial limitation: why we move from bad political equilibria to good political equilibria (and sometimes back again) is exogenous to AR.

• But this is the most important question that any theory of growth and development needs to address!

What Do We Need to Know?• Do we really need inclusive institutions at the start of the growth process?• How long can growth last with extractive institutions? Is there a limit to

growth in countries with extractive institutions?• Is the growth in an extractive institutions regime likely to be biased towards

the rich and not inclusive?• What are the drivers of institutional change and the move from extractive

to inclusive institutions? And why do so many developing countries shift back from inclusive to extractive institutions?

• Are these exogenous as argued by AR or endogenous? If endogenous, what are its drivers?

• Is it related to the structure of the economy (e.g elites in resource rich countries with high rent extraction will be less likely to press for institutional change)?

• Or is it related to elite commitment to long term development goals? And what determines this commitment?

• We have come a long way in addressing the ultimate cause of the wealth and poverty of nations, but there is some distance to go.