The Institutions and Development Debate: Part II

Institutions, Inequality and Growth

Paul Dower

NES

Inequality in transition countriesGini

Albania

ArmeniaAzerbaijan

BelarusBulgaria

Croatia

Czech Republic

EstoniaGeorgia

Hungary

Kazakhstan

Kyrgyz Republic

Latvia Lithuania

Macedonia, FYR

Moldova

PolandRomania

Russian Federation

Slovak Republic

Tajikistan

Turkmenistan

Ukraine

Uzbekistan

20

25

30

35

40

45

50

0 2000 4000 6000 8000 10000 12000 14000 16000 18000

GDP per capita, PPP, 2002

Income GINI, transition countries

Before transition, it used to be from 20-28 (depending on a country)

Outline of talk

1. A theory of institutional persistence.

2. Structural inequality and underdevelopment.

3. Simply inequality or institutional inequality?

Why do Institutions Persist?

• Institutions and poverty traps:– Too poor to afford good institutions; bad institutions

make poor.

• Self-reinforcing institutions:– Ex. Factor endowments favor land inequality; initial

land inequality leads to elite capture of political institutions; elites set up institutions that suppress majority; suppression of the majority stabilizes land distribution. North America (family farms) vs. South America (plantations). (Engerman and Sokoloff 1997)

– Ex. Resource Curse.

Easterly (2007)

• Institutional persistence and structural inequality– Structural vs. Market Inequality – Structural inequality should correspond to average

inequality over longer periods.

• Test Engerman and Sokoloff hypothesis:– Factor endowments affect initial inequality;– Initial inequality persists because of poor institutions;– Poor institutions leads to underdevelopment.

Another Geographical IV

• Suitability of land for growing wheat or sugar: – Sugar farms lead to higher inequality through

plantations.– Wheat farms lead to more equal land

distribution through smaller farms.

• Use wheat to sugar ratio as instrument for inequality.

What should we expect to see?

• Structural inequality as predicted by initial factor endowments should positively correlate with underdevelopment.

• Higher structural inequality should also predict lower investments in institutions that empower the majority such as private property and education.

Overidentification Test

• Test whether no direct effect on development is present.

• Idea: – Both are exogenous and both should be

excluded from the main regression. – Adding one as a control should have no

explanatory power once we properly instrument for endogeneity.

Summing up

• Findings robust to alternative measures and samples and a variety of controls– Ethnic fractionalization– Legal origin– Commodity exporter– Share of tropical land

• Evidence supports initial hypothesis that inequality affects development through education and institutions.

• Over-identification test fails to reject exclusion restriction (in all but one specification)

Income inequality or institutional inequality?

• Easterly (2007) can not distinguish between income inequality creating bad institutions and institutions that are bad because there is inequality in access.

• Both interpretations are plausible since institutions index does not vary within countries.

Observations from Banerjee-Duflo (2005)

• Within country differences are comparable to across country differences in returns to capital and technology adoption.– Fafchamps (2000): Trade credit at 2.5%/month for dominant

trading group. Double that for the minority trading group.• Investment rates in developing countries do not differ

substantially lower than they should be.– Duflo et al. (2003): only 15% of farmers take up fertilizer despite

over 100% return.• Human capital externalities do not appear to be high.

– Rauch (1993): modest positive externalities in US cities (3%-5%). Would have to be 25% to explain cross-country differences

• Average rates of return are too high given the TFP ratio implied by the productivity gap.

Understanding growth by understanding inequality within countries

• If the returns to investment in physical and human capital are different within poor countries, using aggregate models and cross-country studies may miss the main issue.

• Hypothesis: the different rates of return are driven by poor institutions and understanding how these differences affect the growth process is key to understanding the great divergence.

• Alternative: excessively different rates of return are driven by market failure.

Land Inequality and IndustrializationGalor, Moav and Vollrath (2009)

• As in ES, high land inequality leads to low levels of public investment in human capital.– Tsarist Russia: Provincial councils dominated by wealthy

landowners; in 1896, rural literacy rate was 21%. After Stolypin reforms, share of education in provincial council budget increased by 50%.

• Without a sufficient level of human capital, industrialization in a particular region could not occur.

• In contrast to ES, this effect only delays industrialization due to increasing pressure from industrial elite to invest in human capital.

Empirical Strategy

• US States vary by land inequality and public investment in human capital, especially before 1950.

• Resistance to Industrialization: – In 1900, Alabama spent $2.58 (1929 dollars) per child

on education. Massachusetts spent $36.45 per child! – In 1950, Alabama spent $63.50 (1929 dollars) per

child on education. Massachusetts spent $107.55 per child.

Location of poverty areas in the US

Property Rights and Finance Johnson et al. (2002)

Question: Are property rights sufficient for investment?

• Survey of firms in transition countries:– Firms give subjective perception of security of

property.– Detailed information on investments and

assets.

• Possible to test between wealth inequality and institutional inequality.

Observations

• Entrepreneurs invest less of own funds if perceive property rights are insecure.

• Absence of bank finance does not preclude investment.

Caveats

• Barriers to entry

• Firms that have survived

• Small-scale

Conclusions

• Structural inequality reflects institutional persistence.

• Primacy of property institutions in contributing to structural inequality.