Bai ktpt tieu luan

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© 2007 The Author Journal compilation © 2007 Crawford School of Economics and Government, The Australian National University and Blackwell Publishing Asia Pty Ltd.

doi: 10.1111/j.1467-8411.2007.00190.x

Blackwell Publishing AsiaMelbourne, AustraliaAPELAsian-Pacific Economic Literature0818-9935© 2007 Asia Pacific School of Economics and Government, The Australian National University and Blackwell Publishing Asia Pty LtdMay 2007211

ORIGINAL ARTICLE

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A SELECTIVE REVIEW OF RECENT DEVELOPMENTS IN THE ECONOMIC GROWTH LITERATURE

ASIAN-PACIFIC ECONOMIC LITERATURE

A Selective Review of Recent Developments in

the Economic Growth Literature

Tao Kong*

The role of institutions in the process of economic growth and developmenthas generated considerable interest among researchers over the past fewdecades. In particular, incorporating institutional variables into the establishedgrowth theories and empirics involves understanding the impact andmechanisms through which institutions affect growth. In surveyingrecent developments in the economic growth literature, this review paysattention to the resurgent institutionalist research trend and its implicationsfor growth theory and empirical research on growth. Policy issues primarilyfocused on Asian Pacific developing countries are highlighted.

Understanding the process of economicgrowth and explaining the vast differences ineconomic performance across countries havebeen fundamental challenges for economicsand the socio-political sciences. In the post-World War II era, growth economists haveestablished a body of theory and empiricalanalysis that gives substantial insights into theprocess of economic growth. This analysis canbe broadly categorised into three waves ofinterest.

The first wave, which was stimulated byHarrod (1939) and Domar (1946), had a strongKeynesian flavour. They raised the issue of thestability of the growth path by contrastingtwo growth rates. The second wave focusedon steady state growth rates exogenouslydetermined by technological progress. Initiatedby Solow (1956) and Swan (1956), the enrichedneoclassical economic growth model inspiredsubstantial theoretical and empirical research.Three decades later, Romer (1986) and Lucas(1988) began the third wave of interest in

growth theory, developing endogenouseconomic growth models that explicitlyrecognise the roles of knowledge, innovationand human capital. Despite significantimprovements in the understanding of thesubject, growth theories have yet to provide asatisfactory explanation or prediction fora particular phenomenon of recent decades:the great divergence in economic performanceamong lower-income countries. While somegrow at a very rapid pace—indeed, muchfaster than many developed countries, forexample, Singapore and South Korea in the1960s and China since the 1980s—the incomesof the underdeveloped economies as a wholeare failing to catch up to the incomes of thedeveloped countries (Durlauf and Quah1998). In recognition of this inadequacy,interest in economic growth studies has beencharacterised by a shift of focus from capitaland other productive factors towards thequality of institutions and policies (Olson1996).

* Tao Kong is a research fellow at the Economics Division, Research School of Pacific and Asian Studies, The AustralianNational University. The author would like to thank seminar participants at Economics Division, RSPAS, ANU forhelpful comments and suggestions.


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© 2007 The AuthorJournal compilation © 2007 Crawford School of Economics and Government, The Australian National University

and Blackwell Publishing Asia Pty Ltd.

Extensive surveys of recent developmentsin the economic growth literature can providea backdrop for this review, including Solow(2000), Aghion and Howitt (1998), Kenny andWilliams (2001), Temple (1999), Bosworth andCollins (2003) and Rogers (2003). The reviewhas two objectives. First, it provides a partialoverview of some of the main contributionsto the recent growth literature, particularlythose reflecting the focus on institutions.Second, it evaluates the relevance to thegrowth performance of developing countriesin the Asian Pacific area. To achieve the firstobjective, the paper draws on the work ofa large number of researchers to highlightsome of the regularities in the data and recentdevelopments in theoretical models. To reachthe second objective, the survey draws on thefindings that are seen to be of most importanceto the developing countries in the Asia Pacific.These two objectives are connected by thequestion of how recent developments in thegrowth literature can contribute to the bigeconomic development questions faced byAsian Pacific countries.

The organisation of the paper is as follows.The following two sections aim to tie togetherthe accomplishments of the theoretical andempirical economic growth literature into anoverarching picture of the causes of economicgrowth. They begin with a brief summary ofthe growth theories, and go on to look atrecent theoretical developments on a numberof fronts, including human capital, trade,institutions, and political economy. Thenthey cover the central debate on the drivingforces of growth, the role of government,and the political economy aspects of thegrowth empirics. In particular, studies of thegrowth effects of political institutions areused to illustrate econometric issues inempirical research. The survey then goes onto analyse the advancements in the growthliterature in terms of their implications forthe Asia Pacific.

Recent developments in growth

models

Theoretical models in perspective: from neoclassical models to endogenous growth models, and the role of institutions

The neoclassical approach to economic growthmodelling is succinctly described by Prescott(1988) as having a constant returns to scaleaggregate production function with substitutionbetween two inputs—capital and labour—andassuming a constant fraction of output isinvested. The original Solow–Swan model(Solow 1956; Swan 1956; Barro and Sala-i-Martin 1995) is characterised by diminishingreturns to capital in a closed economy, wheretechnological progress is assumed to be exoge-nous. The central hypothesis is that diminish-ing returns to investment cause the growthrate of a country to decline as it approaches,from below, its steady state level of capital perunit of effective labour. This implies that, outof steady state,

ceteris paribus

, rich economieswill grow more slowly than poor economies,where capital deepening is still under way.While the savings rate and population growthhave level effects

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—the higher the rate ofsavings or the lower the rate of populationgrowth, the richer the country in the steadystate—the speed of technological progress deter-mines the steady state growth rate.

The renewed interest in economic growththeory since the 1980s has led to its advance-ments on various fronts. Several variablesformerly treated as exogenous are endogenised.Among others, the Ramsey-Cass-Koopmansmodel (see Romer 2001) replaces the exogenoussavings rate with a solution of the explicit util-ity maximisation problem. Under differentassumptions, Galor and Weil (1996), Cignoand Rosati (1996), and Barro and Becker (1989)contributed significantly to the endogenousfertility literature. In particular, the absence

1 Qualitatively, the Solow–Swan model emphasises a distinction between ‘growth effects’—changes in parameters thatalter growth rates along balanced paths—and ‘level effects’—changes that raise or lower balanced growth paths withoutaffecting their slope (Lucas 1988).

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of explicit consideration of human capital inthe Solow–Swan model stimulated work on endo-genous growth theory (for example, Lucas 1988;Romer 1986, 1990) and a series of idea-basedmodels (Grossman and Helpman 1991; Aghionand Howitt 1998; Howitt 2000).

A principal feature of both the Romer (1990)and Grossman and Helpman (1991) models

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is the presence of positive externalities of humancapital accumulation. Given the existence ofimperfect competition, the mark-up of priceover marginal cost forces a wedge betweenthe marginal social product of an input usedin this sector and its market compensation.In equilibrium, the marginal value of anadditional unit of human capital is higherthan the market wage. The difference conse-quently opens a wedge between the privateand social optimal rates of accumulation inknowledge and human capital. Furthermore,as suggested both in the early AK-style growthmodels

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(Romer 1986, 1989; Lucas 1988; Rebelo1991), and subsequent models focusing moreexplicitly on endogenous technological change(Romer 1990; Grossman and Helpman 1991;Aghion and Howitt 1992), permanent changesin variables potentially affected by governmentpolicies lead to permanent changes in growthrates. For instance, the organisation of institu-tions and markets where human capital accu-mulation and research and development (R&D)take place are shown to be crucial for the rateof technological progress, and hence theprocess of economic development.

One of the biggest challenges facing growtheconomists is to identify the fundamentaldriving forces of growth and explain the greatvariation in cross-country economic performanceover time. Neither the neoclassical growthmodels nor the endogenous growth models havethe ability to address adequately the phenomenaof uneven development and persistentinternational inequality. Over recent decades,

poor countries on average have failed to growfaster than any high-income country, while thefastest growing economies have been a sub-setof the lower-income countries (Olson 1996).This observation cannot be explained by theSolow–Swan type of growth model, whichpredicts a general tendency of convergence.The ‘new growth theory’, or endogenous growthmodels, provides an explanation for whycountries with higher income per capita cangrow as fast or faster than low-income coun-tries, and why large countries may growfaster due to scale effects. However it doesnot predict the great differences in economicperformance among under-developed economies.

In addition to the development of theendogenous growth model, theoretical contri-butions that challenge the underlying assump-tions of the neoclassical approach have revealedimportant directions for further inquiry. Thisis reflected in the proliferation of literature onimperfect information, the existence of trans-action costs, incomplete market functions, andthe roles of government and institutions. Morerecently, the focal point of the growth litera-ture has been the role of institutions and insti-tutional change in economic growth, or moregenerally in economic performance (see, forexample, Hodgson 1988, 1994, 1998; Eggertsson1990; North 1989, 1999; Olson 1982, 1996, 2000;Olson et al. 2000). The central argument is thatthe great differences in the wealth of nations aredue mainly to differences in the quality of theirinstitutions and economic policies. This renewedinterest in institutions can be recognised, in part,as a growing realisation by many economiststhat economic performance cannot be under-stood through the neoclassical theories alone.However, compared to the burgeoning empir-ical literature, comprehensive theoretical modelsthat explain the role of these various factors,and the mechanisms through which they affecteconomic performance, are limited.

2 Romer’s (1990) model assumed that research produces an input purchased by a production sector engaging in monopolypricing. Alternatively, Grossman and Helpman (1991) treated commercial research as an ordinary economic activity thatrequires the input of resources and responds to profit opportunities.

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Y = AK

(

A

> 0), where

A

is a positive constant that reflects the level of technology,

K

is capital that can be considered ina broad sense including human capital. An economy described by the

AK

technology can display positive long-run percapita growth without any technological progress.


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Developments in theoretical frameworks

Human capital accumulation, productivitygrowth and technological progress

Introduc-ing human capital into an economic growthmodel involves spelling out both the way inwhich human capital levels affect currentproduction as well as the way in which currenttime allocation affects the accumulation ofhuman capital. Mankiw et al. (1992) extend the‘textbook Solow–Swan model’ by includinghuman capital as a productive factor. How-ever, under the assumption of a diminishingrate of return, human capital cannot serve asan alternative engine of growth to the technol-ogy term in the model.

In contrast, the roles of human capital andtechnology, as formulated in endogenousgrowth models, depart substantially from thoseassumed in the neoclassical growth model. Asthe outcome of profit-seeking activity, purpose-ful creation of new knowledge and technologybecomes the source of long-run growth. Tech-nological change also provides the incentive forcapital accumulation and, together, capital accu-mulation and technological change account formuch of the increase in productivity (Romer 1990).Endogenous growth models thereby extend thenotion of the contribution of capital accumulationto encompass intangible capital—human skillsand the stock of knowledge.

Furthermore, while the production of newknowledge is through a technology that exhibitsdiminishing returns, ‘the creation of newknowledge by one firm is assumed to have apositive external effect on the production pos-sibilities of other firms . . . [so that] productionof consumption goods as a function of stock ofknowledge exhibits increasing returns’ (Romer1986:1003). The nature of non-diminishingreturns of human capital accumulation in thesemodels (for example, Uzawa 1965; Romer 1990,1986; Lucas 1988; Rebelo 1991; Becker et al. 1990)implies that changes in the stock of human

capital can ultimately affect the growth rate.Thus, an important feature of the endogenouseconomic growth literature is that the positiveexternalities of knowledge and human capitalformation are at the centre of the economicgrowth process.

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Endogenous growth models regard R&Dand innovation by profit-seeking firms asthe source of technological advancement. Thissuggests that the regulatory and policy envir-onments shaping the incentives of firms arecrucial. For example, enforced patent laws canensure innovators capture some of the returnsfrom R&D. In the absence of policies thatremove the divergence between social andprivate returns to research, a second-best choicewould be to subsidise the accumulation ofhuman capital. Technology is a non-rival andpartially excludable good. Therefore, if thepositive externalities of technology are largeenough, a sustained increase in expenditurewill induce more research and developmentactivities and raise the long-run growth rate.

Once new technology is available, the paceof technological progress largely depends onthe process of adoption, which is not determinedby market forces alone. Even in the case ofunambiguous superiority, new technologiesare not necessarily adopted. Mokyr (1990a,1990b, 1994, 2001) points out that, historically,technological inertia and economic stagnationhave been commonplace because regulatoryor political processes have been used to deter-mine whether an innovation is to be adopted.However, these decisions are the outcomeof rational behaviour by utility-maximisingindividuals responding to the existing incentives.Therefore, the underlying causes of variationsin technological progress and productivitygrowth lie in the incentive structure of eacheconomy.

Trade and international financial integration

The impact that openness to trade and financialflows has on economic growth has long been

4 In contrast, Mankiw et al. (1992) suggested that the elasticity of income, with respect to the stock of physical capital, isnot substantially different from capital’s share in income. This conclusion implies that capital receives approximately itssocial return. In other words, there are not substantial externalities to the accumulation of physical capital. On the otherhand, they admit that despite the absence of externalities, the accumulation of physical capital has a larger impact onincome per capita than the standard Solow–Swan model implies. This difference between the standard model and theaugmented model is quantitatively important.

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an important and dynamic area of economicthought, extending as far back as the worksof Adam Smith and David Ricardo. Forunderstanding the persistence of cross-countryincome disparity, three separate branches oftheory on growth and international trade arerelevant: classical political economy, the North–South trade models, and the ‘new’ growth andtrade theories incorporating increasing returnsand/or product differentiation (Darity andDavis 2005). More recently, theoretical debatehas taken place on the interaction betweengrowth models (neoclassical and endogenous)and trade models (assuming constant returnsto scale and perfect competition, or, as in thenew theory, with both assumptions relaxed).

While the Solow–Swan model is for closedeconomies, the extension of neoclassicalgrowth models shows that opening aneconomy can have a level effect and give atemporary increase in the growth rate(Srinivasan and Bhagwati 1980). In the contextof endogenous growth models, openness tointernational trade can affect economicperformance through various channels, includinglearning-by-doing, specialisation and spillovers(Lucas 1988; Young 1991), transfer of knowledgeand R&D activities (Grossman and Helpman1991; Coe and Helpman 1995), and a scale effect(Rivera-Batis and Romer 1991). However,depending on the models and the characteristicsof the trading countries (level of development,human capital endowment, and so on), theoverall impact of trade on growth can eitherbe positive or unclear. Rodriguez and Rodrik(2000) provide a summary, with taxonomy, ofthe literature on the relationship between tradeand growth.

Another aspect of international opennessconcerns financial flows. Rogers (2003) catego-rises international investment into two broadtypes: long-term foreign direct investment (FDI)and short-term foreign bank loans or portfolioinvestment. Although theoretical models onthe relationship between FDI and growth arescarce, it is commonly argued that, similar totrade, FDI induces knowledge and technologytransfer and hence positively affects the hosteconomy (Romer 1993; Moran 1998; Moranet al. 2005). In particular, FDI can generate

positive externalities through demonstrationeffects, vertical linkages and labour mobility,in addition to other resources that interna-tional investment brings to the host country.Furthermore, the impact of FDI needs to beconsidered in the context of the host econ-omy’s policy environment, such as the traderegime (Brecher and Diaz-Alejandro 1977;Bhagwati 1973, 1985) and the conditions of thelocal firms, for example, their level of humancapital (Lucas 1990; Keller 1996). As to thegrowth effects of financial integration, thedebate is ongoing. While the development offinancial markets is generally thought to beconducive to growth (for a literature survey,see Levine 2005), the instability associatedwith short-term financial flows can obscurethe overall effect.

The growth effects of international openness,in both trade and financial terms, have beenconnected increasingly with the discussion onthe role of institutions. For example, it isargued that the growth-enhancing effects ofinternational investment depend on the ‘socialcapability’ or ‘absorptive capacity’ of the hosteconomies, and that institutional quality is oneof the main factors underlying such capacity(Abramovitz 1986:387). However, a majorcritique of the studies highlighting therelationship between trade and growth claimsthat trade is merely a proxy for a myriad ofother important variables (Rodriguez andRodrik 2000). More fundamentally, Rodrik,Subramanian and Trebbi (2002) assert theprimacy of institutions in explaining the vastincome differences across countries. Theyshow that once institutions are controlled for,integration has no direct effect on income.

Institutions and other socio-political factors

The differences in economic performance acrosscountries are, to a large extent, explicable interms of their economic characteristics.However, in many cases, countries’ economicperformance is significantly less satisfactorythan warranted by these characteristics. Thisrealisation has motivated economists to enrich,or get away from, the austere assumptionsabout human behaviour of the standardversion of neoclassical theory (Nelson andSampat 2001). Subsequently, there has been


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a substantial and burgeoning literature oninstitutions and other socio-political factors inthe field of economics, including the NewInstitutional Economics (NIE),

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public (social)choice theory, law and economics, cliometrics,rational choice sociology, and economicstudies of demography, family and crime(Olson 1996).

It is worth noting that in the growing litera-ture, the meaning and implications of the term‘institutions’ can differ considerably amongauthors. These differences can be so significantas to suggest that ‘institutions’ have becomea label for everything that is missing or takenfor granted in earlier analysis, particularly inneoclassical theory. Given the diversity ofinstitutional theorising in economics as well asin other social sciences, there is probably nocorrect answer to the question: what is thedefinition of institutions? There have beendifferent typologies of the idea of institutions.Some of these classifications are based onvarious levels of social analysis (Williamson1987, 1996), while others accord with the ana-lytical approaches of the function and evolutionof institutions.

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Here, it is useful to present ageneral overview of the various notions of‘institutions’.

The strands of the various conceptionscan be summarised into two encompassingdefinitions. The first equates institutions to therules of the game, whereas the second seesinstitutions primarily as governing structures.The former emphasises that, as rules, institutionsestablish the baseline conditions for humaninteraction and give predictability to whatother parties will do in particular contexts.The body of writing following this definitionis vast and covers a variety of topics fromproperty rights (Demsetz 1967; Alchian andDemsetz 1973; Morris 1989; Svensson 1998), tothe role of formal law (Cooter 1996; Laffont

and Tirole 1990; McCubbins et al. 1987) andthe impact of culture, norms and religion onhuman behaviour and individual decisionmaking (North 1990, 1991).

The second definition of institutions focuseson the organisation and structure of thegovernance of economic activities. Coase (1937)

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and others are concerned with questions suchas what determines the boundaries of firmsand what explains the ownership pattern of afirm and corporate culture (see, for example,Williamson 1987; Kreps 1990). In line withthis definition, firms, organisations anddesignations of other kinds are commonlyreferred to as institutions, for example, financialinstitutions and labour market institutions.

The recent resurgence in studies on the roleof institutions is largely empirical in natureand the main contributions will be reviewed inthe next section. But the growing interest ininstitutions as a factor shaping economicperformance is, in a way, reminiscent of AdamSmith’s arguments over two hundred yearsago. He explained that the productivity of theeconomic system depends on the division oflabour and specialisation, but that specialisationis only possible if there is exchange (Smith1937). According to the theory of institutionaleconomics, the ‘exchange’ of money, materialsor services is not, as assumed by the classicaland hedonistic economists, an exchange ofphysical products or material services, but isinstead the transfer of two ownerships(Commons 1936). Ownership and its alienationare created solely by the institutions ofsovereignty (Commons 1936). Therefore,institutions—notably property rights—arecrucial determinants of market efficiency. Itis institutions that form the rules that inducecustomary behaviour patterns and reduceuncertainty (North 1990, 1991). Countries withbetter institutions, more secure property rights,

5 NIE places political, economic and/or social institutions at the centre of analysis and examines how these shape actorpreferences and behaviour (Casey 1998). It also differs from the older institutional economics in having a distinctlytheoretical orientation (or a thorough comparison of the ‘old’ and the ‘new’ institutional economics, see Rutherford 1994).

6 For example, Acemoglu (2002) categorises the conceptions of institutions into four views: efficient view, incidental view,rent-seeking view and costly view.

7 It is commonly said that NIE started with ‘the nature of the firm’ (Coase 1937) with its explicit introduction of transactioncosts into economic analysis (Coase 1998).

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and less distortionary policies will invest morein physical and human capital and use thesefactors more efficiently to achieve a higherlevel of income.

In elucidating this point from a somewhatdifferent perspective, North (1989) arguesthat the most fundamental source of changein the long run is learning by individuals andentrepreneurs of organisations. Specifically,the speed of economic change is a functionof the dynamics of learning, but the rate of thatchange is a function of the expected payoffsfor acquiring different kinds of knowledge.Similarly, as argued by economic growththeorists, technological change is assumedto arise in large part because of intentional actiontaken by people who respond to market incen-tives (Romer 1990). The comparative experi-ence in economic growth over the recent decadeshas also highlighted the importance of privateinitiative and incentives. Rodrik (2000) claimsthat all instances of successful developmentare, ultimately, the collective result of individualdecisions by entrepreneurs to invest in riskynew ventures and try out new ideas.

Governments are endowed with the powerto change incentive structures, for example,through the provision of public goods andservices or the imposition of distortions. Theformer has the potential to remedy the situationwhere individuals cannot deal efficiently throughvoluntary actions in the market place. Thelatter may adversely affect the incentives forindividuals to produce (Barro 1991). Therefore,the power of governments is a double-edgedsword that is decisive in economic performance.The underlying institutional framework of well-performed economies consistently reinforcesincentives for individuals and organisations toengage in productive activity. In contrast, inpoorly performed economies, governments haveoverwhelmingly favoured redistributive ratherthan productive activity, created monopoliesrather than competitive conditions, or restrictedopportunities rather than expanding them(Rodrik 2000). These paths to stagnation canpersist because the transaction costs in thepolitical and economic markets of the econo-mies, together with the subjective beliefs of theactors, do not lead them to move incrementally

toward more efficient outcomes (North 1989).Similar arguments emphasising the institutionaland socio-political foundations of economicdevelopment have been made by at least theWorld Bank (1997), Borner et al. (1995), Scully(1992), Weingast (1993) and Platteau (2000).

Despite the growing body of literature,institutions are yet to be fully incorporatedinto coherent modelling frameworks of thedeterminants of economic performance. Neve-rtheless, efforts have been made to integrateinstitutional variables into growth models. Forexample, Torsten Persson and Guido Tabellinihave developed theoretical models linkingeconomic performance with various politicaland institutional characteristics, includingpolitical accountability (Persson et al. 1997),electoral systems (Persson and Tabellini 2000;Persson et al. 2003), size and scope of thegovernment (Persson and Tabellini 1999),constitutions (Persson and Tabellini 2003, 2004)and corruption (Persson and Tabellini 2003).Feng (2003) examines general patterns ofpolitical regimes and economic growth in across-national setting. He focuses on threemain features of political institutions: thetype of political system (for example, the degreeof political freedom), political stability (forexample, the likelihood of unconstitutionalgovernment change), and policy certainty (forexample, the intensity of political opposition).On the basis of theoretical modelling andempirical tests, he argues that no single politicaldimension can determine growth. Moreover,in addition to their direct impact on growth,these political factors also affect economicgrowth through their influence on othervariables that are themselves either detrimentalor conducive to growth.

The political economy of growth

Until recently,the role of government in the process ofeconomic growth was seen to lie outside theboundary of economics. However, economistshave been quick to point out that while marketfailure exists, government failure is often thecause of economic backwardness. There hasbeen limited examination of why this is thecase and what can be done to address theproblem. Most of the studies of this topic fallin the realm of political economy.


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A selective review of this literature followsthe taxonomy in Persson and Tabellini (2000),where political economy research is categorisedinto three broad fields. The first originatesfrom the relatively recent literature on thedevelopment and consequences of economicpolicies. Persson and Tabellini (1990) surveythe early contributions in the theory ofmacroeconomic policymaking, and Persson andTabellini (1999) review recent developmentsin this field. This body of literature datesback to the work on rational expectations byLucas in the mid-1970s. It mainly analysesthe effects of various constraints on the policy-making process. The basic idea is a study ofthe consequences of economic policy basedon individuals’ perceptions of the incentivesfacing policymakers. Due to the link betweenthis strand of literature and macroeconomics,the study emphasises the underlying economictheory and maintains the assumption of indi-vidual rationality. Moreover, it pays particularattention to inter-temporal policy choicesand economic dynamics (Persson and Tabellini2000). This strand of research has often reliedon rather superficial assumptions about politicalinstitutions and political conflict, and has tendedto shy away from empirical analysis (Perssonand Tabellini 2000).

A second body of literature is that of publicchoice, which explores the implications ofrational self-interest for political interactions.The seminal contributors were Buchanan andTullock (1969). Their book,

The Calculus ofConsent

, analyses the problems of democraticgovernance for taxation and public expenditure.Mueller (1997, 2003) offers a comprehensivesurvey of the contributions in this field. Themain questions of the public choice literatureconcern voting rules, party electoral systems,rent-seeking, agency problems, interest groups,and constitutional economics. For example,Olson (1965) and Becker (1983) study lobbyingand influence activities by interest groups.A key idea developed by the public choiceschool is its approach to the study of politicalbehaviour—building on models in whichrational individuals seek to advance their owninterests. The public choice analysis identifiesinstitutions as a choice of rules, as opposed to

the choice within rules, and thus stresses theimportance of constitutions as constraints onself-interest. Buchanan (1989:18) argues that‘to improve politics, it is necessary to improveor reform rules, the framework within whichthe game of politics is played’.

The third strand of the political economyliterature stems primarily from politicalscience. This research often focuses on theinstitutional details, for example, how agenda-setting powers are allocated and how thelegislative process is structured. Osborne (1995)provides a survey of the theoretical literatureon electoral competition. Moser (1999) surveysthe literature on the impact of legislativeinstitutions on public policy, particularly thatrelated to the question of how the structureof decision-making processes contributes tostable and consistent policy choices. Over time,the insights from political science have gainedmuch influence among economists. For example,an idea that emerged from political science inDowns’ path-breaking book,

An Economic Theoryof Democracy

, is that if parties cared only aboutwinning they would have an incentive toconverge to the centre (Downs 1957). This ideaprovides a justification for the argument widelyused in economics that politics would convergeto the preferences of the median voter. Berg-strom and Goodman (1973) first explored theempirical implications of the median-votermodel to explain the supply of public goods.Romer (1975) developed a theoretical median-voter model of redistributive taxation. However,researchers in this vein have mainly focusedon political institutions as such, paying littleattention to specific economic policy issues(Persson and Tabellini 2000).

Drawing predominantly on the establishedliterature in political economy and politicalscience, there are broadly two strands of thoughtin modelling the role of government. Referringto whether a government makes crediblepromises, in other words, whether a govern-ment does what it promises to do, one strandemphasises credibility and commitment (Kyd-land and Prescott 1977; Cox and McCubbins2000). The other focuses on flexibility anddecisiveness, while looking at whether agovernment has the ability to make decisions

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and implement policies promptly and decisivelyin response to changing situations (Weaverand Rockman 1993; Cox and McCubbins 2000).Using a spatial model of political interaction,Moe and Caldwell (1994), Palmer (1995),Baron (1998) and Henisz (2000) analyse policyoutcomes as a function of political institutions.

Among the theoretical linkages exploredby political scientists, the

Veto Player

theory(Tsebelis 2002) provides an innovative andpowerful framework for tackling the complic-ated issue of the economic role of politicalinstitutional configurations. Previous economicresearch on political institutions had mainlyinvestigated the relationships between politicalinstitutions and economic growth using aggre-gate variables. Within the

Veto Player

frame-work, each configuration of these variables ismapped on a specific constellation of vetoplayers and hence further empirical studiesincorporating veto players would be feasible.

One of the central ways in which to theoriseabout the impact of the degree of politicalpower concentration is to see politicalinstitutions as an important but incompletesocial contract.

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Within this framework,political institutions define the responsibilityand shape the incentives of the parties includedin the contract. For example, members ofsociety delegate monopolistic governing powerto the government. The incompleteness of thiscontract lies at the heart of the inquiry into theimpact of power concentration. The contract isincomplete because when the members ofsociety (the principal) entrust the government(the agent) with the tasks of governing, thecontract cannot include all the contingenciesthat will present in the future, and thereforewill always involve uncertainties.

Such incompleteness can stem from theexistence of asymmetric information, with theagent having information that is not directlyavailable to the principal. Laffont and Marti-mort (2002) suggest that this private informa-tion can be of two types: either the agent cantake an action that is not observed by theprincipal (the case of moral hazard or hidden

action); or the agent has private knowledgeabout cost or valuation (the case of adverseselection or hidden knowledge). The incom-pleteness of information may also be due tothe fact that the principal cannot observe theactions of the agent without cost; or the agentmight have to act in situations too complexto be amenable to a clear-cut evaluation. Insituations of incomplete information, theprincipal wants the agent to be able to respondto changing information about the environmentand economy. This means the principal has toallow the agent a certain amount of discretion.However, it is not desirable if the agent’sresponses are guided by their own goals,which may conflict with that of the principal.Therefore, the main focus of the principal–agent theory is on the design of the optimalcontract, given the assumption of asymmetri-cally distributed information.

Recent empirical findings of the

economic growth literature

The sources of growth

Identifying the driving forces of economicgrowth has always been a central concern ofthe growth literature. Since the 1980s, manyeconomists have contributed to identifying thesources of growth empirically, with insightsfrom neoclassical and endogenous growththeories. The present consensus is that economicgrowth is largely determined by a numberof proximate sources—the accumulation ofphysical capital, human capital, and knowledgethat can be used in production

.

Moreover,efficient allocation of resources and effectivemarket functions are essential to successfuleconomic performance. In addition, other‘deep’ determinants may work through theproximate sources and cause variations ineconomic performance.

Results from cross-country economic growthregressions are thought to be very informativeabout systematic differences across nations in

8 The notion that individuals create a government by way of a contract is not meant to be a historically precise descriptionbut simply an heuristic tool (Buchanan 1975).


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per capita output and the proximate orultimate drivers of total factor productivity(TFP) growth (Barro 1997). With much confi-dence, growth economists have demonstratedthat natural endowments matter for economicgrowth, as do institutions, international trade,incentives and policies. However, while thelist of factors, believed to be of high import-ance, has grown ever longer, the empirical evi-dence does not support a particular view ofthe growth process (Kenny and Williams 2001).The answer to Landes’ (1990) question—whyare we so rich and they so poor?—remainselusive. The following discussion exploresthe recent empirical analysis, with specialattention given to the debate on the growtheffects of institutions. Surveys on the empiricsof growth by Kenny and Williams (2001),Temple (1999) and Bosworth and Collins (2003)provide a good starting point.

The controversial findings by Young (1992,1995) on the determinants of growth in thefast-growing East Asian economies sparkeda rich body of literature on productivity analysis.Trefler (1993, 1995) and Hall and Jones (1999)show that cross-country productivity differencesare substantial, even among industrialised coun-tries. Carlaw and Lipsey (2003) provide a criti-cal review of the definition and measurementof TFP. There are primarily three approachesto measuring TFP: the growth accountingapproach, the index number approach, andthe distance function approach. The growthaccounting approach is problematic due to itsstrong assumption on the aggregation ofproduction functions for individual productsand the stability of such aggregation. The indexnumber approach extends the growth account-ing approach but suffers from the same prob-lem in terms of the assumptions adopted.

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The distance function approach decomposesthe change in TFP into two components: thedistance of the economy or sector from theefficiency frontier, and shifts in that frontier. Inpractice, the frontier is often determined bythe most efficient sector at the time, and allother sectors are evaluated in terms of their

distance from that frontier. Similarly, cross-country comparisons are carried out by lettingthose countries that produce the most output,at given levels of inputs, determine the frontier.

Kumar and Russell (2002) use non-parametricmethods to construct the world-wide produc-tion frontier and the associated efficiency levelsof individual economies. They decomposethe growth in labour productivity into threecomponents: technological change, technologicalcatch-up, and capital accumulation. This approachis consistent with Quah’s (1997) analysis basedon the conditioning of productivity distributionon fundamental factors, specifically, geo-graphical proximity to rich countries andopenness to trade. The findings of Kumar andRussell (2002) suggest substantial evidence oftechnological catch-up, and that technologicalchange is decidedly non-neutral. Furthermore,both growth and bipolar international diver-gence are driven primarily by capital deepen-ing. However, Carlaw and Lipsey (2003) pointout that the comparisons and the impliedresource allocation efficiency argument impli-citly assume all units—economies, industries orsectors—being compared have the sameaggregate production function. Since thisassumption is unlikely to hold, such compari-sons of TFP across units are effectivelyabout average productivity and not marginalproductivity. Consequently, a major critique ofthis approach is that it provides little insightinto the efficient allocation of resources;what matters is the equalisation of marginalproductivity across units and not necessarily,or likely, at the average.

In a nutshell, Carlaw and Lipsey (2003)dispute that productivity growth measurestechnological change or longer-term prospectsfor increases in output. They argue that thecorrect interpretation of TFP is the contemporaryreturns that are in excess of the normal rate ofreturn on investing in known technology. Thisinterpretation implies combined returns ofexternalities (or ‘free lunches’) and a returnto the initial entrepreneur for undertakingthe uncertainty associated with technological

9 See Deiwert and Lawrence (1999) and Fox (2002) for discussions of the many different index numbers that can be usedin measuring TFP, and the problems with this approach.

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change. More fundamentally, they argue thatthere is no necessary relationship between therate of technological transformation of theeconomy, on the one hand, and the rate ofproductivity growth on the other.

Underlying the productivity debate arethe competing theories on the engine ofgrowth and the implications for convergence.Neoclassical growth suggests that technologicalprogress is the source of growth, and thatcapital accumulation leads to convergence. Incontrast, endogenous growth models empha-sise the role of human capital and explain whyconvergence may not take place due to differ-ences in technology across countries and overtime. In search of the ultimate sources of growth,institutions and other non-economic factorshave been the focus of recent empirical studies.

In regard to the role of human capital,microeconomic analysis often finds thatschooling has a significant impact on wageearnings. In contrast, macroeconomic empiricalstudies often find changes in human capitallead to little variation in output. Hanushekand Kimko (2000) suggest that indicators oflabour force quality influenced by traditionalschooling, or primary or secondary-schoolenrolment rate variables, are better predictorsof economic growth. In advocating the utilityof endogenous growth theory, Howitt (2000)presents an integrated analysis of capitalaccumulation and endogenous innovation. Heargues that the reason the Schumpeterianmodel can account for more than the neoclassicalmodel is that per capita income varies acrosscountries not only because of differences incapital stock per worker but also because ofdifferences in productivity. Schumpeterianmodels imply that long-run differences inproductivity are endogenous and depend onthe incentives to innovate and accumulatecapital. However, proponents of neoclassicaltheory argue that estimates by Mankiw, Romerand Weil (1992) are consistent with estimatedrates of convergence, equal to approximately 2per cent per year. In response, Howitt (2000)argues that neoclassical theory has neglectedendogenous movements in productivity, thusomitting a factor that serves to attenuate theconvergence process.

If the East Asian productivity growth debatecaptured the greatest attention in the 1990s,the theme of the present decade is clearly therole of institutions as a fundamental determi-nant of growth. Among the candidates for thefundamental driving force of growth, there areprimarily three strands of explanations for thehuge differences in average income betweenthe richest and poorest countries, for example,the USA versus Sub-Saharan Africa. Rodriket al. (2002) label these strands the geographyview, the integration view and the institutionsview. At the centre of the debate is the questionof the importance of institutions. Before individualstudies are discussed, it is worth mentioningthat, similar to the broad spectrum of institu-tional theories, the empirical literature consistsof approaches that differ not only in theresearch questions pursued and the methodol-ogies deployed, but also in their conceptionsof institutions.

There are a large number of studies investi-gating the non-economic determinants of growth.Barro (1997) extends Barro and Lee (1993) toinclude two institutional factors in his cross-country growth regressions in addition tothe political instability variable—the rule oflaw index and the index of democracy. Barro(1997) interprets the non-linear relationshipfound between democracy and growth to implythat where there are low levels of politicalrights there is little economic growth. However,once a moderate amount of democracy hasbeen attained, the further development ofdemocracy increases growth. Also with afocus on political variables, Mauro (1995) andKnack and Keefer (1995) use other measuresof political instability—subjective indexes derivedfrom information collected by private monitor-ing organisations. These indexes are typicallyused by international investors to evaluatecountry risk. Similar to Alesina et al. (1996),these studies report that political instabilityhas a negative effect on investment and growth.They also found that subjective indexes of cor-ruption and the quality of bureaucracy arenegatively associated with growth.

Being more directly related to economicoutcome, the impact of economic rights hasbeen a popular area for empirical study.


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Analysis of economic rights often usesmeasures, such as restrictions on capital mobil-ity, trade restrictions, and other indicators ofeconomic regulations. It is argued that lessregulation and fewer obstacles to individualsgaining access to markets and carrying outmarket activities should stimulate faster growthrates. Results by Barro (1991) and Ozler andRodrik (1992) suggest that civil liberties areconducive to growth and capital accumulation.Property rights are often better protected in ademocratic liberalisation process, and thereforeentrepreneurs would have the incentive toaccumulate and innovate, as they have bettercontrol over the return to the assets producedor improved (De Haan and Sturm 2000). How-ever, the effects of economic freedom ongrowth can vary across areas (Heckelman andStroup 2000; Carlsson and Lundstruöm 2002).For example, it could be argued that more civilliberties may translate into more conflict overdistribution. De Haan et al. (2006) provide acritical review of these effects.

Other empirical investigations of the ‘deep’determinants of growth found that countrieswith a tropical climate and those that arelandlocked have lower steady-state incomes,and that higher government savings, increasedglobal integration, and better institutionalquality all raise steady-state income and,therefore, bolster transitional growth (Sachsand Warner 1997). Interestingly, they alsofound that countries abundant in naturalresources have lower growth, which supportsthe ‘natural resources curse’ view. Easterlyand Levine (1997) highlighted the role ofethnic diversity or fractionalisation. Socialcapital has also emerged as an importantexplanatory factor for a wide range of socialphenomena, including political participation(DiPasquale and Glaeser 1999), child welfare(Putnam 2000) and economic outcomes (Knackand Keefer 1997).

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The resurgence of interest in the economicimpact of institutions has been partly led byforceful advocates such as Acemoglu et al.(2001, 2003), Rodrik et al. (2002) and Easterlyand Levine (2002). In their studies, institutions

are found to be the most important factorsaffecting a country’s income, even to the pointthat Rodrik et al. (2002:1) assert that ‘institutionsrule’. Drawing upon the work of Acemoglu et al.(2001) and Frankel and Romer (1999), Rodriket al. (2002) used instruments for two endogen-ous variables—institutions and integration—and found that the quality of institutions (asmeasured by a composite indicator of elementsthat capture the protection to property rightsand the strength of the rule of law) is the onlypositive and significant determinant of incomelevels. Furthermore, the role of geography inexplaining cross-country patterns of incomeper capita operates predominantly through thechoice of institutions, having little direct effecton income. Trade, on the other hand, has a sig-nificant effect on institutional quality, but nodirect positive effect on income.

Despite the evidence from the empiricalstudies being mixed, the above-mentionedconclusions stand in stark contrast to theconventional wisdom. The welfare gains fromeconomic integration are widely establishedand the role of international trade as a driverof productivity change and income growth hasbeen confirmed by many empirical studies (forexample, Dollar 1992; Sachs and Warner 1995;Edwards 1998; Greenaway et al. 1998; Frankeland Romer 1999; Vamvakidis 2002). Collierand Gunning (1999:69) and Baldwin (2003)also document the growth effects of tradeopenness. The growth effects of trade havealso been found to operate via differentchannels, such as investment (Levine andRenelt 1992), human capital accumulation andtechnology (Frankel and Romer 1999), as wellas through other mechanisms such as thequality of macroeconomic policy, governmentsize and the extent of price distortions(Wacziarg 2001). In particular, Coe and Helpman(1995) find that the estimated rates of returnon R&D are very high, both in terms ofdomestic output and international spillovers.Furthermore, the beneficial effects of foreignR&D on domestic productivity are strongerwhere an economy is more open to trade withcountries having high stocks of R&D capital.

10 Durlauf (2002) provides an in-depth review and discussion on the role of social capital in empirical studies.

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In a recent investigation on the relativeimportance of trade and institutions, Dollarand Kraay (2003) employ regressions ofchanges in decadal growth rates on properlyinstrumented changes in trade and changesin institutional quality. Their findingssuggest that trade has a strong effect ongrowth, and only a minor role in improvinginstitutions. Focusing on microeconomicevidence concerning the growth effects oftrade, López (2005) surveys recent empiricalstudies and confirms the view that opennessto trade increases productivity and growthin developing countries. An importantextension of the finding that trade opennessis important for growth is that the growtheffects of trade openness are significant insmall economies (Collier and Gunning 1999).Lewer and Van den Berg (2003) focus on thesize of the growth effect and conclude that a1 per cent increase in the growth of exports isassociated with a 0.2 per cent increase ineconomic growth. As to financial integration,Hanson (2001) surveys the empirical findingsand concludes that there is weak evidence tosuggest that FDI generates positive spilloversto host countries.

In contrast, others have argued that thepositive correlation between trade andeconomic growth is not robust, and thatthe direct impact of trade on growth issensitive to the variables measuring opennessas well as other variables included in thegrowth regression (Edwards 1993; Rodriguezand Rodrik 2000). Temple and Johnson (1998)also note that technological spillovers willonly be effective if a country has the technicaland social capability for absorption and invest-ment in new processes of production, or ifthey trade with more advanced economies.These results imply an important joint role oftrade and institutions over the long run, and arelatively larger role of trade in the short run.Using 20 years of cross-country data, Edisonet al. (2002) investigate the growth impact offinancial integration with three differentestimation methods. Surprisingly, none of themethods produces convincing evidence of arobust relationship between financial integra-tion and growth. This result holds even when

they allow the effects of financial integrationto differ by the level of development of a rangeof indicators, including income, domesticfinancial markets, institutional quality andmacroeconomic quality.

The recent critique by Rodriguez andRodrik (2000) on the importance of trade as agrowth determinant was predominantly moti-vated by empirical investigations. They claimthat trade is a proxy for myriad of otherimportant policy variables. Rodrik (1998)criticises the trade-openness measures used bySachs and Warner (1995, 1997), particularlywith respect to Africa’s participation ininternational trade. Contrary to Sachs andWarner’s claim that African economies aremuch more closed than other developingcountries, in particular their East Asiancounterparts, Rodrik found that Africa’sparticipation in international trade is normalfor its non-policy characteristics. The conclusionof Rodrik, Subramanian and Trebbi (2002)is that once institutions are controlled for,integration has no direct effect on income.

The institutionalist approach also challengesthe long-held view that geography is a funda-mental determinant of economic development.In conspicuous contrast to the advocates ofinstitutions, a large body of literature empha-sises the important role of geography in eco-nomic development experiences. Representa-tives of this view are Sachs (2003) and Sachsand Warner (1995, 1997), who warn against thetendency to use institutions as a single-factorexplanation of the complicated issue of eco-nomic development. Sachs argues that the roleof geography and resource endowments indevelopment should not be underestimated:‘institutions matter, but not for everything’(Sachs 2003:38).

Given that there is no evidence for conver-gence in the existing empirical literature, effortshave been made to evaluate all the majordeterminants of growth at one time or another.Sala-i-Martin (1997), in his paper involvingtwo million regressions, found 21 robustvariables. With regard to the specification ofgrowth regressions, Bleaney and Nishiyama(2002) conducted non-nested tests of theregression models, used by Barro (1997),


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Easterly and Levine (1997) and Sachs andWarner (1997), and found that the data stronglyprefer an encompassing model but could notreject any of them. This finding implies thatwhile each model contains some truth, none istotally satisfactory. The encompassing modelprovides a benchmark model against whichfuture innovations in empirical growth researchcan be judged, by showing either that theinclusion of untried variables improves thefit of the benchmark model or that thosevariables have an indirect impact on growth.The results of Bleaney and Nishiyama (2002)indicate that human capital, institutions,specialisation in primary products, and changesin terms of trade all seem to be importantdeterminants of growth. They also foundevidence of a significant non-linearity in therelationship, which has an inverted U-shape,between initial per capita income levels andgrowth.

The role of government and economic policy

The neoclassical and endogenous growththeories view the role of economic policy quitedifferently. In the neoclassical case, the long-run growth rate is independent of governmentpolicy. However, the endogenous growthmodel, by emphasising the dependence oflong-run growth on private incentives, arguesfor the role of policy in affecting the long-termgrowth rate to the extent that policy canchange these incentives. When it comes to therole of government, two distinct views prevail.One emphasises the detrimental effect ofgovernment failure and hence advocates aminimalist role for government. The otherhighlights the existence of market failure andthe potential growth-enhancing impact of gov-ernment in modifying the incentive structure.

The basic assumptions of the conventionalneoclassical school of thought are that rationaland utility-maximising individuals respond to

market price signals, and resources are appro-priately allocated in the absence of distortions.Consequently, government is often treated asa source of market distortion. Typically,government spending is considered unpro-ductive and as having a ‘crowding-out’ effecton private investment. Therefore, it is arguedthat part of the explanation for variations ingrowth across countries can be found in theextent to which market-distorting barriers areerected by the state. Hence, the economy isbest coordinated by the market rather than thestate, and growth is best achieved by the statethat governs least.

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Conventional neoclassical theory is veryuseful and, in certain respects, quite powerfulin analysing the operation of pure, abstractmarkets. But the real world is both morecomplicated and capable of multiple andselective interpretations (Samuels 1992). Thesuccess of high-performing Asian economies

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(HPAEs) seemed to suggest a strong anddecisive government helped to provide anenvironment in which markets can workeffectively. More than two decades ago, Thurow(1980:95) argued that ‘we no longer haveuntrammelled play of the market mechanism’.The extent to which government planning andcontrols are exercised has become fairly broadwith all kinds of legislative acts enablingadministrative agencies to guide the economyas in the manner of a rudder for a sail-boat’.This reading does not suggest a simplegovernment intervention view, which can beequally problematic due to the presence ofgovernment failure. Instead, it raises doubtsabout the validity of an unqualified neoclassi-cal model and calls for a close study of therole of government in the economic growthprocess.

Over recent decades, many studies haveincorporated government in line with thedevelopment of endogenous economic growththeory (see, for example, Aschauer 1989; Barro

11 Neoclassical economic theory does not completely reject the idea of market failure but maintains a constrained view ofthe sources of market failure and the necessity for state intervention (Casey 1998).

12 The World Bank (1993) categorises eight Asian economies that had seemingly miraculous growth from 1965 to 1990 ashigh-performing Asian economies: Japan, the ‘Four Tigers’—Hong Kong, the Republic of Korea, Singapore, and Taiwan,China—and the three newly industrialising economies of Indonesia, Malaysia, and Thailand.

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1990; Bates and Krueger 1993). Grossmanand Helpman (1991) produced a model thatinvestigates the role of trade in the economicgrowth process. An important conclusionsuggested by their model is that polices canhave a significant impact on the long-runeconomic growth. The Keynesian type ofcapital-driven growth models supports theview that achieving sustained growth will bemore difficult for capitalist economies thanfor economies in which the central planningapparatus has more direct access to the instru-ments needed to force a rise in the savingsrates and to allocate investment to its mostproductive uses (Ruttan 1998). On the otherhand, Barro (1990), Aschauer (1989) andSamuels (1992) have argued that while thesepowers may be used to promote investmentand income redistribution, and in other waysto correct market failures, they can be abusedby rent-seekers in many unproductive ways.Recently, Acemoglu et al. (2004) argues thatpolitical institutions determine the distributionof political power, which in turn formseconomic institutions. Consequently, economicinstitutions shape the incentives of keyeconomic actors in society. The incentivesthat are particularly important are those thatinfluence investments in physical and humancapital and technology, and the organisationof production. Therefore, similar to economicinstitutions, political institutions determine theconstraints and incentives facing the key actorsin the political sphere.

An effective market economy requires anincentive structure that, at least, clearly definesand effectively enforces property rights sothat individuals have incentives to save andinvest. More fundamentally, the incentivesfor productive factor accumulation rest on theability of individuals to appropriate the fruitsof their efforts. An effective market economyalso needs an environment that ensuresindividuals can best advance their interests bybeing as productive as possible and engagingin mutually beneficial trade. In addition, it isnecessary to have a legal framework that

impartially enforces contracts and encouragesinvention through patents and copyrights, orfacilitates risk-sharing through insuranceand hedging in futures markets. Rodrik andSubramanian (2003) emphasise that market-creating institutions, namely those that protectproperty rights and ensure contract enforce-ment, often rely on a functioning legal system.Moreover, the important role of secure propertyrights is, to a large extent, a necessary comple-ment to other institutions that create thefavourable incentive structure for economicgrowth to take place (Rodrik 2000; WorldBank 2002).

Consequently, how to design institutions toproduce policies that provide good incentivesfor economic agents has become a centralquestion of economics (Laffont and Martimort2002). As numerous authors have argued, tothe extent that effective intervention occurred,its foundation rested on certain fundamentaldomestic and international political conditions(see, for example, Morris and Adelman 1989;Casey 1998; Kenny and Williams 2001). Since itis through the political process that conflictinginterests are ultimately aggregated into publicpolicy decisions, political institutions have afundamental impact on economic performance.Government thus plays an important role inestablishing these pro-growth conditions.

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The fairly large informal sectors in most devel-oping countries are much less productive thanthey would otherwise be, because the rela-tively poor and powerless individuals in thesesectors have almost no legal rights (Olson2002). Government and market are synergisticrather than categorical alternatives.

However, just as government is essentialfor the establishment and enforcement ofindividual rights, it is also the greatest threatto them. For instance, only government canexpropriate property on a large scale. Therefore,an argument for an active state role in economicdevelopment is balanced by the criticism ofpervasive rent-seeking behaviour in govern-ment policies and of government failures.Clearly, the tension between the conflicting

13 For example, in the absence of government, no one has any socially enforceable rights and there will be no privateproperty, contracts, corporations or patents.


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arguments on the role of government partlyexplains why the institutions needed forsuccessful development are not more generallyunderstood or more widely used. Somegovernment intervention, through the imple-mentation of government policies, can beconducive to economic growth, while otherintervention can be inefficient and destructiveto the extent that it may become a major obstaclehindering economic growth. Olson (2002) putsforward a paradoxical hypothesis: the role ofgovernment that sustains economic develop-ment may require governments that are strongenough to last indefinitely, yet are also limitedand restrained so that they do not use theiroverwhelming power to abrogate individualrights. Jones (1988) discusses the role ofgovernment from the perspective of over athousand years of history. He points outthere was an optimality band of governmentintervention where factor and commoditymarkets are freed and the government isneither too grasping nor too weak.

From a flurry of empirical work, the con-clusion emerges that policies matter for aggre-gate performance.

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For example, Isham andKaufmann (1999) found that controlling forother characteristics, countries with undistorted(distorted) macroeconomic, exchange rate, trade,and pricing policies have highly productive(unproductive) investments. However, growthregressions generally have limited explanatorypower with respect to the importance of macro-economic policies relative to microeconomicpolicies (Collier and Gunning 1999). Usingmicroeconomic unit data, Collier and Gunning(1999) highlight the importance of economicpolicy by demonstrating how a poor policyenvironment damages the economic rate ofreturn of investment projects. Yet studies onthe impact of microeconomic policies arelimited, often due to the difficulties of findingappropriate indicators or proxies and isolatingthe effects of particular policies. Furthermore,although policies in general do matter foreconomic growth, the effects ultimately dependon the nature of the individual policies.

The determinants of economic growth nowinclude an extended list of factors rangingfrom inputs (such as physical and humancapital accumulation) to natural endowmentfactors (such as distance to the equator andaccess to the sea). A range of policy variables(such as size of the government and inter-national openness) and institutional factors(such as economic freedom—particularly in termsof protection of property rights, politicalstability and rule of law) have also been iden-tified. The policy variables identified by researchhave become increasingly complicated and morespecific to country idiosyncrasies. Easterly(2001) has listed the alleged ‘panaceas’ that inpractice did not help much in countering theever widening gap between the poor and therich.

To link the empirical studies on the causesof economic performance and appropriatepolicy suggestions, it is helpful to make thedistinction between those that are intrinsic andthose that are policy-dependent (Collier andGunning 1999). The intrinsic factors—notablynatural endowments and geographicallocation—at least include distance to the equator,being landlocked, and proportion of arid land.While these factors are undoubtedly importantto the understanding of the internationaldifferences in growth performance, they oftenleave little room for improvement. For example,in the case of Africa, the disadvantages ofgeography can, at least over the medium term,be more than offset by catch-up growth, andgood macroeconomic policy can be a potentforce behind better performance.

Moreover, in order to understand the impactof policies, the emphasis should not be con-fined to the policies themselves; attentionshould be paid to the broader social, cultural,political and economic contexts in whichthe policies are implemented. The role ofeconomic policy is also related to the timedimension of economic development.Countries at different levels of developmentrequire policies that are compatible with theirparticular characteristics. The concept of

14 An exception is Easterly and Levine (2001) who make the somewhat extreme assertion that policies have no impact onincome levels once institutions are controlled for.

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‘path dependence’ has been increasinglyapplied to economic analysis since the mid-1980s. It refers to a property of contingent,non-reversible, dynamic processes, including awide array of biological and social processesthat can be described as ‘evolutionary’ (David1988, 2000). Path dependence implies thatevery decision-making act—whether carriedout by an individual or an organisation or inthe development of an institution—is dependenton the previously covered path, endogenousexperience and feedback (Rizzello 2004).

Empirically, many institutional studieshave reflected recognition of the problems inthe policy-orientated literature. The trend overthe past two decades has been to examinesuccess stories and encourage emulation ofthese policies. Pritchett and Summers (1993)discuss the types of policies that matter mostfor development. With the recognition of thecritical role of government, the priorities indevelopment policies came to be known asthe ‘Washington Consensus’ (Williamson 1990).

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This consensus includes a combination ofdesirable economic policies for economicgrowth, such as fiscal discipline, trade liberali-sation, privatisation, and property rights. Toimprove economic performance, the policiesrequired by different countries may be similarbut are not identical. However, by implicitlytreating all economies as interchangeable, thepolicy-orientated perspective—in either its‘simple-minded’ free market view or the inter-ventionist variant—fails to account for thesignificant influence of a state’s political andeconomic structures on the efficacy of policyoptions. By presuming all economic actors tobe interchangeable rational utility maximisers,the free market model underplays the role thatspecific institutional and cultural structurescan have in shaping economic development.North (1994:359) clearly pointed out:

when applied to economic history anddevelopment, it [neoclassical theory] focused on

technological development and more recentlyhuman-capital investment but ignored theincentive structure embodied in institutions thatdetermined the extent of societal investment inthose factors.

The empirics of the political economy of growth

The role of institutions in the process ofeconomic growth has recently attracted muchdiscussion. The large, burgeoning body ofliterature on institutions mainly seeks to explainthree questions. (1) Do institutions matter and,if so, how? The literature addressing thisquestion primarily examines the impact ofinstitutions on economic growth. (2) Whatkinds of institutions matter? This literature focuseson identifying the institutions that enhancegrowth. (3) Why, after acquiring a reasonableunderstanding of the first two questions, havepro-growth institutions not been built? The lit-erature in response to this question exploresthe evolution of institutions and policy issues.The preceding discussion has focused on thefirst and second of these questions. Followingis a discussion looking at the question of ‘why’.

In recent decades there has been a notableintellectual movement away from supportingand towards challenging this view of efficientinstitutions. Among others, Douglass Northhas moved from his early position—that theprimary function of institutions is to reducethe transaction costs of reaching voluntaryagreements (North 1981)—to his present beliefthat societies are very lucky when they possessrelatively efficient institutions (North 1989).Moreover, he argues that existing institutionsare not necessarily the choice of the wholesociety, but rather chosen by those groupsthat hold political power. Consequently, theinstitutions chosen may not maximise thewelfare of the society as a whole. North (1989)contends that there is a persistent tensionbetween the ownership structure that maximisesrents to the ruler (and his group) and an

15 Williamson (1990) argues that the set of policy reforms, which most Washington-based institutions thought would begood for Latin American countries, could be summarised as follows: fiscal discipline; redirection of public expenditure;tax reform; interest rate liberalisation; a competitive exchange rate; trade liberalisation; elimination of barriers to foreigndirect investment; privatisation; deregulation to abolish barriers to market entry and competition, and secure propertyrights. Williamson believed this ‘consensus’ reflected the intellectual convergence underlying the liberalising reformsadvocated at the time (Williamson 2000).


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efficient system that reduces transactioncosts and encourages economic growth.

Rodrik (1993) calls for the positive economicsof policy reform. This is one of the earlierattempts to explain why ‘inefficient’ outcomescan be compatible with rational and non-myopic behaviour at the individual level. Thekey feature of policy reforms, as Fernandezand Rodrik (1991) emphasise, is the uncertaintyabout the identity of those who gain and thosewho lose, and the uncertainty can block theadoption of an efficiency-enhancing reform.This argument is in line with Alesina andDrazen (1991), who show that the distribu-tional struggle over the benefits of reformmay lead to delay. Both studies develop theirargument with reference to asymmetricinformation. From a somewhat differentperspective, Samuels (1992) argues that thereare several connections between rights andallocation, including ones far more importantfor both analytical and policy purposesthan those posed by the Coase theorem. Bystressing the structure of legal rights and thelink between the power structure and allocation,he argues that the Coase theorem is incompleteand imprecise, and that its thrust might evenbe reversed if these weaknesses were corrected.Acemoglu (2002) also argues that there arestrong empirical and theoretical grounds forbelieving that inefficient policies and institutionsare relatively prevalent. In particular, there arecommitment problems that prevent Coasianbargains from being efficient.

Whether a government is able to makecredible commitments has much to do withthe political institutional structure, or howpower is shared in the government. One lineof research suggests that divided governmentsencourage political budget deficits and delayreactions to crises (see, for example, Alesina,Perotti and Tavares 1998). Tsebelis (2002) arguesthat the number of veto players is positivelycorrelated with higher deficits, because differentveto players require significant portions of thebudget. Moreover, more veto players lead to ahigher probability of inertia, and thereforecountries with high levels of debt will continueto have high deficits. In contrast, another lineof work stresses the importance of institutional

arrangements that disperse power, therebyincreasing stability and predictability, as wellas reducing the risk of arbitrary or capriciousgovernment action (Fiorina 1992; Hammondand Miller 1987; Keefer 2001). This strand ofliterature focuses on the ability of a governmentto make credible commitments. Elster (1994:215)asserts that ‘to be effective, power must bedivided’. Witold Henisz (2000a, 2000b) usedlong times series data and found that growthrates and investment are higher when thepolitical system is unable to change the rulesof the economic game. Acemoglu (2002) alsoclaims that inefficient policies and institutionsare chosen as the consequences of commitmentproblems; parties holding political powercannot make commitments to bind theirfuture actions because there is no outsideagency with the coercive capacity to enforcesuch arrangements.

Presented with the dilemma between thenecessity of governments comprising enoughpower to protect property rights on the onehand and the possibility of using this power toconfiscate the wealth of citizens on the other,Weingast (1995:1) considers ‘market preservingfederalism’ as the instrument that couldprovide a resolution. Ackerman (2000) alsoadopts an intermediate position in suggestingthat the optimal institutional configuration isnot one with many veto players, like theAmerican system, or one with few, as in theUK. Instead, he advocates the intermediatecase of a parliamentary system with a senatethat cannot veto all the time, and with thepossibility of referendums that are called byone government and performed by another, inorder to diffuse the power of government toset the agenda.

Econometric issues

As mentioned at the beginning of this review,despite the vast empirical literature on economicgrowth, little consensus has been establishedand much of the explanation of the greatvariation in economic outcomes remainselusive. For example, even on the very firstquestion for any empirical study on economic

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growth—calculating growth rates—differentopinions have emerged. Penn World Tables(PWT) is probably the most widely used dataset, but the difficulties in measuring growthacross countries and over time are highlightedby Summers and Heston (1991). Subsequently,Canjels and Watson (1997) and Kakwani (1997)have furthered the discussion on growth ratemeasurement. Temple (1999) points out thepotential problems of using only initial andfinal output. Instead, he suggests using theleast squares of the growth rate, which isobtained by regressing the whole of the logoutput series on a constant and time trend. Atan overall level, Bosworth and Collins (2003)show that much of the apparent variability inconclusions from earlier studies can be tracedto measurement problems, differences in dataor definition, and, in the regression analyses,failure to include other conditioning variables.Using the empirical studies on the economicimpact of political institutions as an example,this section highlights a number of econometricproblems that often plague the empiricalstudies of economic growth.

Proxies and measurement

In general, the empirical results on the economicimpact of political institutions are controversialand evidence a lack of consensus. Typically,indicators or proxies of political institutionsare used in carrying out quantitative studies.Different researchers often have different choicesof indicators or proxies for the same theoreticalconcept. A wide range of variables and measureshave been employed to capture various aspectsof political institutions including democracy,political instability, and quality of governance.Among these variables, democracy has beenone of the most popular indicators for politicalinstitutions.

The concept of democracy is hardly definedwith great precision. There are at least twodistinctive but related definitions. The firstidentifies democracy as a national politicalregime with regular, free, competitive (multi-party) elections; while the second focuses onthe extent of civil and economic libertiesavailable to the population. Although thesetwo definitions clearly have different implica-

tions, the classification of whether a country ora regime is democratic or not is not alwaysconsistent. In fact, some obvious non-democraticregimes, according to the first criterion, can beconsidered democratic by the second criterion,as they grant a fair amount of individual, andespecially economic rights to their citizens(Alesina and Perotti 1994). Some newly indus-trialised economies in Asia, such as Singaporeand South Korea, are good examples of this.

The second definition of democracy focusesmore on civil and economic rights. The mostwidely used index of civil liberties is the Gastil/Freedom House index, which ranks countrieson seven levels (Freedom House 2003). Theconjecture that individual rights and economicgrowth are correlated is hardly a new one butremains controversial among economists (Voigt1997). Hayek (1944) and Friedman (1962) sug-gest individual liberty increases the prospects ofeconomic growth. In line with the neoclassicalpoint of view, economic liberty seems to fosterentrepreneurship and market activities, andhence growth. However, diverse conclusionshave been drawn to support either a positiveor a negative correlation between civil libertiesand growth. La Porta et al. (2002) examinedthe constitutional rules of 71 countries andfound that English institutions, which guaran-tee the independence of judges from politicalinterference in the administration of justice,are strong predictors of economic freedom butweaker predictors of political freedom. Incontrast, American institutions of checks andbalances are strong predictors of political butnot of economic freedom. De Haan et al. (2006)look critically at the economic freedom indicatorand its impact on economic growth. An obviousproblem associated with these measurementsis that these indicators tend to be highly sub-jective, or driven by the forces of economicdevelopment and well-being that the indicesthemselves purport to explain.

Another frequently used indicator of politicalinstitutions is political instability. It is definedand measured primarily in two ways. The firstlooks at social violence, often using an index ofsocio-political unrest that summarises severalindicators of more or less violent forms ofpolitical protest and social violence. The second


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focuses on executive turnover, usually measuringit by the frequency of government collapse.

The first measure, which is conventionallylabelled the socio-political instability (SPI)approach, begins with a list of variablesthat identify events such as riots, politicaldemonstrations against the government, andassassinations. The classic reference for thisapproach is Hibbs (1973). In his large multi-equation study, Hibbs found that politicalinstability has no effect on growth. Venierisand Gupta (1986) construct an SPI index andshow that SPI has a negative effect on the savingsrate. Using measures similar to Venieris andGupta’s (1986), Benhabib and Spiegel (1994)argue that socio-political instability reducesinvestment. The concept of SPI has alsoproven quite powerful in explaining otherphenomena, especially in developing coun-tries. For example, Ozler and Rodrik (1992)show that instability leads to an increase inexternal debt in developing countries. Overthe past two decades, much empirical researchhas investigated the relationship betweenpolitical instability and economic develop-ment. For example, Barro (1991) added twopolitical variables—the frequency of

coups d’état

and the number of political assassinations—tothe cross-sectional growth regressions andfound that they negatively influence growth.Easterly and Rebelo (1993) found similar results,which are valuable in drawing attention to theimportant role of political institutions in theprocess of development. However, becausethere is little explanation in the models aboutthe underlying mechanisms of how politicalinstitutions affect growth, the analysis is a kindof add-all-in-and-stir recipe. Thus, theseresults cannot provide a complete answer toan inquiry about the economic role of politicalinstitutions.

The second approach to modelling politicalinstability focuses on executive turnover. Theexecutive instability approach begins by usingprobit regressions to estimate the propensityof a government to collapse. A key problemthat many of these contributions do not formallyaddress is the joint endogeneity of politicalinstability and growth or inflation (exceptionsare Hibbs 1973; Gupta 1990). Economic variables,

such as growth and inflation, can explain thepropensity of government changes, which inturn is used as an explanatory variable foreconomic outcomes. However, problems ofsimultaneity and reverse causality clearlyabound. Alesina et al. (1996) adopt Londreganand Poole’s (1990) two-equation model anduse different specifications to explore furtherthe impact of political instability on economicperformance. The two-equation model consistsof a probit regression where the dependentvariable captures the occurrence of

coups d’état

and the other uses growth in per capitaincome as the dependent variable. Alesinaet al. (1996) control for many more economicdeterminants of growth, focusing not onlyon coups but also on a broader definition ofgovernment changes, including constitutionalchanges of the executive. Their results confirmLondregan and Poole’s (1990) findings on theeffects of poverty on coups—poverty and, tosome extent, low growth increase the likeli-hood of coups. However, confirming the resultsof Mauro (1995) and Knack and Keefer (1995),Alesina et al. (1996) also found that a high pro-pensity for executive instability reduces growth,which is contrary to Londregan and Poole’sfinding that the propensity to have coups doesnot reduce growth. Londregan and Poole(1992) confirm their own results using a differ-ent sample and estimation techniques. Yet,Alesina et al. claim their result is robust andholds under several different specifications ofthe system.

A more general observation on the use ofproxies and measurement is that, whileeconomists have been using some highlycontroversial indices, for example as instru-ments to control for endogeneity, they have shiedaway from more direct measures of policieswith a low correlation with growth. The morefundamental measurement issues that underliegrowth empirics have been neglected.

Model uncertainty: heterogeneity, omitted variables and structural breaks

After controlling for the economic determinantsof growth, the first definition of democracyappears to have no effect, or a statisticallyinsignificant impact, on growth. For instance,

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Przeworski and Limongi (1993) summarise theempirical findings of the time and remainagnostic, whereas Helliwell (1994) reportsinconclusive results. Alesina et al. (1996) andAlesina and Rodrik (1994) also conclude withsimilar findings. It seems that the empiricalliterature aiming to find a causal relationshipbetween democracy and development is, ingeneral, rather unhelpful and unpersuasive.

One of the potential contributors to thisinclusive picture is heterogeneity, whichcan be categorised into at least two types—heterogeneity across countries and hetero-geneity over time within countries. The formeris often referred to as parameter heterogeneity,where countries of distinctive idiosyncrasiesare not expected to share common parameters(Solow 1994; Temple 1999). The latter reflectsthe episodic nature of economic growth, whichis often obscured by averaging growth ratesover a long period of time. Durlauf andJohnson (1995), Durlauf and Quah (1998) andDurlauf (2001) establish strong evidence forheterogeneity.

A possible explanation for these inconclusiveresults about the impact of democracy ongrowth could be that the (large) group of‘dictatorships’ is not at all homogenous. Somedictatorships (particularly those in SoutheastAsia) have done rather well over a long periodof time, while many others (particularly in Africaand Latin America) have not. In contrast,the group of democracies is more homoge-nous. The democracies have in general donemuch better than the worst dictatorships, butnot as well as some of the most successful dic-tatorships. Sah (1991) argues that authoritarianregimes exhibit a larger variance in economicperformance than democracies. Another possi-ble explanation is that developed countries arerelatively homogenous in terms of both politi-cal regime and growth rates, whereas there isa much greater variance in economic growthrates among developing countries (Sachs andWarner 1995). In addition, as far as politicalregimes are concerned, developing countriesare also more heterogeneous than developedcountries in terms of power arrangements.These complexities are likely to contribute toinconclusive empirical outcomes.

Meanwhile, the problem with this type ofexercise is that it carries the risk of ending upin a tautology—growth is high in dictatorshipsthat enhance growth and low in dictatorshipsthat follow sub-optimal policies. What shouldbe kept in mind is that state domination doesnot necessarily translate into national power.The latter is, above all, a function of activecooperation among capable groups, ratherthan domination. Development requires theconsent and active participation of diverseeconomic actors. Good institutions must reflectand promote such cooperation; it is not at allclear that the dichotomy of political institu-tions of authoritarian or democratic regimes canprovide a framework with sufficient sensitivityto analyse the role of political institutions.

In addition, economic performance canbe strongly episodic. Some countries arecharacterised by persistent low or highgrowth, while others have had episodes of riseand decline. In a cross-country exercise, theepisodic features of growth performance areoften inadequately analysed by the practiceof averaging variables over long periods. Ifthese episodes were separately defined, non-linearities and hysteresis might be found(Collier and Gunning 1999). For example, inthe 1997–98 East Asian financial crisis, theaffected countries suffered various levels ofeconomic setback, with some even to the pointof political breakdown.

Omitted variable bias and simultaneousrelationships undoubtedly still plague eventhe most sophisticated statistical models. Giventhat there have been various models specifiedto investigate the role of political institutions,it is useful to juxtapose the results derivedfrom various methods (data), ideally using thesame set of data (models), and compare themin order to establish to what extent the differ-ences in results are due to differences in modelspecification (data).

Endogeneity and causality

The existing empirical research does not seemto reach any agreement on the role of politicalinstitutions. One of the main challenges is howto deal with joint endogeneity. Does politicalstability foster growth? Does growth foster


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political stability? Or do political stability andgrowth reinforce each other (Alesina andPerotti 1994)? Exceptions are Hibbs (1973)and Gupta (1990). Economic variables, such asgrowth and inflation, can explain the propen-sity for government changes, which in turn areused as an explanatory variable for economicoutcomes. However, problems of simultaneityand reverse causality clearly abound.

An important reason for the difficultiesinvolved in handling endogeneity issues is thecomplex nature of the subject matter. In fact,the search for the fundamental determinantsof growth has long been plagued by difficultiesin dealing with the intertwined relationshipsamong the dependent variable and thecandidates for growth determinants. Amongthe three major candidates for the underlyingdrivers of growth—trade, institutions andgeography—only geographical endowments(such as location, ecological conditions andnatural environment) are exogenous to economicperformance. International openness or tradeintegration, and institutions have highly com-plex causality in the context of economicdevelopment. Conceptually, trade integrationand institutions not only affect income, butthey can also be affected by changes inincome. As Rodrik and Subramanian (2003)summarise, integration can raise incomelevels, but it is equally possible that it isthe result of increased productivity. Simi-larly, while better institutions increase invest-ment and foster technological progress,thereby raising income levels, they can alsobe the outcome of economic development.Moreover, the interaction among these threefactors further complicates the causal relation-ship. In particular, the causal relationshipbetween trade and institutions can run bothways, while geography can affect the othertwo determinants, and in turn have an indirecteffect on growth.

Taking account of the endogeneity problemarising from the use of the trade share in thegrowth regression, Frankel and Romer (1999)

use a gravity model of trade to demonstratethat geography is a powerful determinant of acountry’s overall trade. Their results suggestthat trade has a quantitatively large andpositive, though only moderately statisticallysignificant, effect on income. However, studiesexamining the economic impact of institutionshave long been troubled by the lack of a validinstrumental variable. It is an extremelydifficult job to find an appropriate variablethat is correlated with institutions, but notwith economic performance.

As the most popular instrumental variablesfor institutions, geographical factors andethnic fractions are not completely satisfactorydue to the possible linkage with economicdevelopment. Hall and Jones (1999) show thatdifferences in capital accumulation andproductivity, and therefore output per worker,are driven by differences in institutions andgovernment policies—what they call socialinfrastructure. They treat infrastructure asendogenous, determined historically bylocation and other factors that are partiallyfeatured by language. They argue that geo-graphical latitude is correlated with ‘Westerninfluence’, which leads to good institutions.As a result, the distance from the equator canserve as an instrumental variable.

More recently, Acemoglu et al. (2001) identifya new instrumental variable for institutions—the settler mortality of former colonies.Despite various criticisms,

16

this instrumentalvariable has quickly become an ‘industrystandard’ used widely in institution-relatedempirical studies. Not only is their identificationof an innovative instrumental variable highlyinfluential, but the conclusion of Acemoglu etal. (2001) that institutions do matter has alsobeen one of the most significant findings in therecent development of the empirical economicgrowth literature. Acemoglu et al. (2001) alsoconfirm that distance from the equator doesnot have an independent effect on economicperformance, and therefore the use of latitudeas an instrumental variable is valid despite the

16 For example, Sachs (2003) argues that the Acemoglu et al. (2001) finding—the high mortality rates of British soldiersaround 1820 in various parts of the world correlates well with the low levels of GNP per capita in the 1990s—is actuallya discovery of the pernicious effects of malaria in blocking long-term economic development.

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theoretical reasoning not being entirelyconvincing.

Overall, the empirical literature does notconfirm a clear causal process. Tavares andWacziarg (2000) introduce a full system ofequations to examine the empirical relationshipbetween democracy and economic growth.They tackle the question by looking at thechannels through which democratic institu-tions affect growth, including the accumula-tion of physical and human capital, incomeinequality, and government consumption.Their results suggest that the overall effect ofdemocracy on economic growth is moderatelynegative.

Implications for development in the

Asian Pacific region

Over recent decades, several Asian economieshave achieved rapid growth for extendedperiods. However, the big question facing thedeveloping countries in the region remainshow to close the gap with the developed world.Among the three candidates for the ‘deep’causes of growth discussed above, inter-national openness and institutions (or govern-ance quality) appear to be of most relevance.

Trade and regional integration have beenimportant factors for growth in the region,particularly in East Asia, enabling progressin narrowing the gap with the high-incomecountries. Estimates by the World Bank (2003)indicate that the share of world exports ofemerging East Asian economies

17

has morethan tripled during the past quarter-century,from 5.4 per cent in 1975 to 18.7 per cent in2001. Because of the potential shown by itsdynamic exporters, East Asia is estimated tobenefit more than any other region fromglobal liberalisation. Further, because of thewide scope for intra-regional trade amongwhat are very diverse economies, it couldachieve much of the benefits of liberalisationthrough regional integration (World Bank2003).

However, the pursuit of a ‘trade for devel-opment’ strategy is not straightforward. Itdemands more than trade policies

per se

. Thesize of the gains from trade largely depends oncomplementary measures designated to tackleconstraints on efficient production and exports.Many of the mechanisms enabling maximisa-tion of the developmental benefits of trade andinvestment liberalisation require an institu-tional and regulatory environment of reason-able quality. This implies that policymakersneed to consider trade and investment policieswithin a broader framework.

The policies adopted by the HPAEs havebeen widely discussed. The role of the statehas often been highlighted, particularly thecapacity of governments to design and imple-ment a development-orientated interventionistagenda. However, the difficulty of implement-ing ‘good policies’ based on the successfulexperience of other economies has motivatedeconomists to consider factors beyond theconventional realm of economics. Summers(2004) notes that an overwhelming lesson ofthe 1990s is the transcendent importance ofthe quality of institutions and the efficacy ofpolitical administration. The HPAEs havealso demonstrated that the challenge ofeconomic growth often lies in coordinatingthe expectations of different segments of thepopulation.

The reason for the importance of politicalinstitutions is that they are most concernedwith providing incentives to select good poli-cies and ensuring that they are implementedwell. Therefore, the power base of a govern-ment is important. Economic policies are oftenmanifestations of a government’s objectivesand ideologies. The political equilibrium hasto allow pro-growth policymaking and policyimplementation to take place. Governmentsthat are controlled by narrow interest groupstend to create policies that benefit these groupsat the expense of the rest of the economy.Collier and Gunning (1999) argue that Africangovernments have behaved in ways damagingto the long-term interests of the majority of

17 Emerging East Asian economies include ASEAN countries, other newly industrialised economies, China and Mongolia(World Bank 2003).


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their populations because they serve narrowconstituencies. The damage caused has beenpartly through ‘sins of commission’ such asagricultural taxation, and partly through ‘sinsof omission’, such as failure to provideadequate infrastructure. Therefore, governmentsneed to be representationally broad-based andaccountable for economic outcomes.

The remarkable performance of the fast-developing economies in the Asian Pacificregion has offered new perspectives on thekinds of political institutions that fostereconomic growth. In the development ofWestern democracies, the key to successwas typically representative institutions thatlegitimised the rule and restrained the discre-tion of monarchs claiming absolute power.However, in the HPAEs a different set ofpolitical institutions emerged to establish regimelegitimacy and limit government discretionover economic policies. Despite substantial vari-ations, these countries share enough commonelements to suggest a developmental modelthat differs from that established by Westerneconomies. One of the key characteristics ofthis model is the institutional arrangementsthat allow governments to make crediblecommitments. Institutions that make thereversibility of policies costly, and those thatspread the benefits of growth-enhancingpolicies widely, work together and provideindividuals and firms with the confidence thatthey will share the growth dividend.

The challenges for Asian and Pacificeconomies also lie beyond the realm ofeconomics. In relation to the low-incomecountries in the region, the policies andinstitutions that will contribute to fullerintegration will, to a large extent, hinge on theoutcome of political arrangements. For fast-growing economies, the growth consensusmay sooner or later have to give way to amore affluent, complex and diverse bodypolitic. Increasingly, governments in thesecountries have to take into account the diver-gent ambitions of their people. In particular,long-run structural transformations—mainlyeconomic and demographic—have created anenvironment conducive to a more dispersedpower-sharing structure.

A fundamental transformation in thestructure of government has been takingplace across East Asia. Before 1990, most EastAsian countries were highly centralised; today,sub-national governments have emerged asthe fulcrum for much of the region’s develop-ment (World Bank 2005). This process is char-acterised by unevenness in the way it is plannedand implemented across countries. The overalltrend, however, has been toward greater localautonomy. The implications of such a profoundchange in political institutional arrangementsare foremost in terms of governance. It iscommonly accepted that decentralisation alignsgovernment decision-making more closely withlocal preferences, largely because of the infor-mational advantages associated with smallerjurisdictions. It also encourages competitionamong regions, thereby making local officialsmore accountable to constituents for theirperformance. However, limited empiricalfindings have disputed the expected govern-ance gains from decentralisation. Bardhan andMookherjee (2000) suggest that this is partlydue to the higher susceptibility of localgovernments to state capture. In addition,clientelism and limitations in the capacity oflocal governments are likely to adverselyaffect the quality of governance.

The process of economic development iscomplex. The growth regressions have demon-strated that cross-country productivity differ-ences explain, to a large extent, internationalincome differentials (for example, Hall andJones 1999). This suggests that there exists aprescription which, if followed, will lead toeconomic growth in developing countries.This prescription is likely to include strategiessuch as technology adoption, promotion oflabour mobility from the agricultural sector toindustry and services, capital deepening, andleaving costly and uncertain R&D to richcountries. Hill and Hill (2005) studied fiveSoutheast Asian countries and found that, usingpredicted values derived from cross-countrygrowth regressions, their growth rates camevery close to the actual growth rates of Singa-pore and Thailand. In contrast, predictions forIndonesia and Malaysia understate theireconomic performance, while the Philippines

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consistently under-performs compared to whatmight be expected. These results reinforce thepoint that attempts to understand country-specific stories through cross-country growthregressions can enjoy only limited success.

Asian Pacific countries are diverse and eachhas a different set of priorities, such that thetransition to modernisation is necessarily acase-by-case process (Landes 1990). For example,adopting cutting-edge technology in developingcountries may not be optimal. Simply dismiss-ing the existing structure of less developedcountries as inherently inefficient or as reflec-tive of rent-seeking behaviour is not veryhelpful. Instead, it is important to first under-stand what gave rise to the present system,and the incentives and constraints establishedby existing institutions and markets. Questionsthen arise as to the extent (bad) incentives canbe changed and (distorting) constraints can berelaxed. These questions can only be answeredwith an understanding of the political context.

Summary and conclusions

The economic growth literature, both theoreticaland empirical, has been investigating thefollowing major issues: 1) international incomedistribution and comparative economic per-formance; 2) catching-up growth and converg-ence of incomes; 3) extent of diminishing returns;4) proximate and deeper causes of cross-countrydifferences in growth rates; and 5) the natureof long-run economic growth.

This review has highlighted importantrecent developments in the economic growthliterature and their implications for develop-ing countries in the Asian Pacific region; how-ever, the survey is by no means exhaustive.Furthermore, it is almost certain that many ofthe factors that influence the rate and directionof technological and institutional innovationlie outside the usual purview of economicgrowth theory. Some of these factors, and theirtreatment by other social science disciplines,have been touched on but cannot be addressedfully.

The conventional neoclassical wisdom isthat economic growth is largely determined by

the accumulation of physical and humancapital, and knowledge usable in production.These factors are considered as proximatedeterminants of economic growth. Today, formany economists, economics is, to a largeextent, a matter of incentives. The changes inproductive factors are primarily driven bythe decisions of economic agents, and thesedecisions are, in turn, shaped by incentives—to work hard, to produce good quality products,to study, to invest, to save, and so on (Laffontand Martimort 2002). Therefore, in many ways,incentives are deeper determinants behind theaccumulation of productive factors. Theseideas are not new. Adam Smith argued that ifinternal institutions of civil law and propertyrights failed to ensure an adequate degreeof security for economic actors, incentivesfor productive activity and capital accumu-lation, including human capital, would notexist.

Much of the current debate in the growthliterature is taking place in the empirical arena.The recent resurgence of institutional researchhas focused on institutional structures andthe processes through which they shape thedecisions made by economic actors. This focusadds institutions and the time dimension tothe neoclassical framework. The extendedframework is more useful for explaining vari-ations in performance, and offers more valuableguidance in formulating economic policy. It isnow widely accepted that studies of eco-nomic development need to be consideredin a broad political and institutional context.

Many recent studies attempt to place marketsin an institutional context within which variousagents, such as consumers, firms, politiciansand voters, interact. In contrast, traditionalissues, such as technology transfer and adop-tion, agricultural policy and urbanisation,have drawn less attention. However, there isnot unanimous agreement on the fundamentaldriving forces of economic growth, and theimportance of institutions is the subject ofongoing debate.

As regards policy implications, a consensushas been established by a large number ofstudies that there is no one-size-fits-all setof policies. Economies at different stages of


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development have different endowments andface different challenges. Given the diversehistoric and socio-political circumstances of eachcountry, the outcomes of policies are highlydependent on the interaction of all of thesefactors. The merit of cross-country growthregressions probably lies in the revelation ofsome common factors that help explain whygrowth experiences have been so widelydivergent internationally.

Increasingly, the development agenda in theAsian Pacific region has become intertwinedwith its focus on growth, the trade policyagenda, including regional integration, andsocial stability. Policymakers need to developa coherent set of economic policies thatcan deliver stability, growth, and regionalintegration. In doing so, it is imperative notto overlook the complementarities betweencountry-specific policies, institutions andeconomic development. Consideration alsohas to be given to the limits on the efficacyof economic policies due to the fragility of therule of law in many countries. The key ques-tion is how best to modify institutionalarrangements and improve governance qual-ity. Among other things, policies need to bedeveloped to foster competitive markets, andpublic action is needed to provide information,reduce transaction costs, guarantee public

service delivery, and address market andcollective action failure.

However, knowing what needs to be doneis hardly sufficient. North (1990) explains thatfrom a conceptual point of view, ‘pathdependence’ curtails the set of choices availa-ble. This leads to the possibility of explainingthe existence of multiple equilibrium states,including sub-optimality in development,with each situation supported by a specific setof beliefs and expectations. While economicgrowth has increasingly become a story abouteconomically ‘exogenous’ factors—such asculture, religion, national economic policies, orbroadly defined social institutions (Azariadisand Drazen 1990:503)—history and luck mayalso be critical determinants of a country’sgrowth experience (Becker et al. 1990:S14).Furthermore, it has been demonstrated thatsmall events or initial perturbations arerelevant in determining a system’s end state(Arthur 1989). At an overall level, proliferationof statistical evidence has outweighedtheoretical understanding of the economicgrowth drivers, particularly the relativeimportance of each and the mechanismsthrough which the various factors operate.However, to an extent, the empirical findingspoint to where the theoretical effort should bedirected.

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