Institutions, Governance, and Growth: Empirical Linkages

Various studies have demonstrated that institutional quality is crucial for economic and social development. For example, Adam Smith (1776) noted that private contracting (institutional quality) is an important prerequisite for the mutually beneficial exchanges that promote specialization, innovation and growth—the main factors leading to gains from trade. More recent empirical studies have revealed that institutional quality is associated with (i) higher economic growth and income levels (Campos and Nugent 1998; Barro 1999; Acemoglu, Johnson, and Robinson 2002; Lee and Kim 2009); (ii) higher public and private investment (Knack and Keefer 1995; Rodrik 2003; Alfaro, Kalemli-Ozcan, and Volosovych 2005); (iii) improvements in the stock of human capital (Arimah 2004); (iv) better management of ethnic conflicts (Easterly 2001); (v) less income inequality (Chong and Gradstein 2004); (vi) better financial development (Beck et al. 2001); (vii) more efficient allocation of aid (Epstein and Gang 2009), and (viii) greater sustainability of “common resource pools” through human cooperation (Ostrom 2005), among others.

2.1 Governance, Growth, and Income: Direct Links

Figure 1 [ PDF 13.4KB | 1 page ] traces how institutions and governance can be an important determinant of economic growth and income levels. Governance can have a direct influence on growth and income; for example, it can help reduce transactions costs (Aron 2000; Rodrik, Subramanian, and Trebbi 2002), wh ich are far higher if economic actors and agents cannot fully trust property rights or the rule of law. As a consequence, economic agents typically operate on a smaller scale, using inexpensive but less efficient technologies which render them less competitive. They may even retreat to the black market economy and rely on bribery and corruption to facilitate their operations (Busse et al. 2007). Ultimately, this leads to the rise of a rent-seeking, informal economy.

Overall, as explained by Rodrik, Subrama nian, and Trebbi (2002), institutional quality can directly affect income levels through three channels: (i) reduced information asymmetries, as institutions channel information about market conditions, goods, and participants; (ii) reduced risk, as institutions define and enforce property rights; and (iii) greater restrictions on the actions of politicians and interest groups, as institutions make them (more) accountable to citizens (World Trade Organization [WTO] 2004). Conversely, income levels can also have an impact on institutions and governance: more developed countries are likely to have a stronger preference for high quality institutions and good governance. They would also have the requisite knowledge and resources to promote the latter.

2.2 Governance, Growth, and Income: Indirect Links

Governance can also affect growth and income indirectly, through its impact on other determining factors such as trade, investments, infrastructure, and geography.

Trade has a positive effect on income levels (Figure 1). The extent to which a country is integrated with the rest of the world is endogenous: that is, trade influences economic growth rates, and vice versa. For example, trade might not only boost growth in the medium and long run terms, it might also be the outcome of increased productivity; this, in turn, improves the country's competitiveness.

By exploiting comparative advantage and economies of scale in production, and taking advantage of technology spillovers and knowledge information, institutions and governance can boost trade and, thus, economic growth and income levels. High quality institutions also help reduce the risk premium required for international trade.

Institutional quality can be proxied by governance (Busse et al. 2007). Bolaky and Freund (2004) demonstrated that regulatory quality influences the interaction between trade and economic growth, and that countries with excessive regulations do not benefit from trade. Excessive regulations may encourage a country to produce goods for which it has no comparative advantage, or for which the terms of trade have been unfavorable over recent decades (Rodrik, Subramanian, and Trebbi, 2002).¹

Lowering trade barriers will allow nations to benefit from exchange and specialization. However, these trade benefits would be suboptimal or unattainable in the absence of adequate infrastructure and proper institutions that practice good governance (Kohsaka 2007). Smaller economies in Asia are less likely to achieve welfare gains from trade liberalization in the presence of perennial economic asymmetries, where increased market access may produce little positive results in the short- to medium-term. The quality of institutions has been identified as a major factor for the disappointing export performance and economic underdevelopment of smaller and vulnerable economies.² As such, more recent free trade agreements (FTAs) tend to go beyond the standard features of an FTA by enhancing the political dimension, explicitly addressing corruption, promoting participatory approaches, and refocusing development policies on poverty reduction.³

Anderson and Marcouiller (2002) argued that weak institutions act as significant barriers to trade. Increasing the transparency of the trading environment through greater predictability and simplification can be an important way of reducing trade costs (Helble, Shepherd, and Wilson 2009). De Groot et al. (2004) found that both institutional quality and existence of similar institutions in trading partners are positively associated with b ilateral trade.

Trade might also influence the quality of institutions and governance through two main channels (Busse et al. 2007): (i) economic agents in open economies may learn from the experiences of their trading partners, and adapt successful institutions and regulations; and (ii) international competition may force countries to improve their institutional and regulatory setting, as a lack of reforms would otherwise force domestic producers out of business.

In addition to facilitating trade, better regional institutions improve the regional investment climate and increase FDI inflows into each member country (Busse et al. 2007). Rent seeking and corruption might be harder in more open economies, as foreign firms increase the number of economic agents involved (Rajan and Zingales 2003).

One highly relevant variable that directly affects income, trade, institutions, and governance is geography. Not many indicators are as exogenous as a country's geographical location (Rodrik, Subramanian, and Trebbi 2004). Geography can have a direct impact on income through climate, natural resource endowments, and agricultural productivity. At the same time, an abundance of resources can have an impact on institutional quality in developing countries, since this enriches (and may even corrupt) the ruling class (Bulte and Damania 2005).

Geography can also have an indirect impact on income through its influence on trade, where the distance from major markets and the degree of integration play a vital role. Strong institutional coordination, coupled with improved infrastructure, helps minimize international trade costs (Francois and Manchin 2007).

Quite clearly, good governance and growth are positively correlated, and the quality of institutions and policies affect long-run economic growth. It is the interaction between institutions and organizations that shapes the institutional evolution of an economy (or a region).

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