Heterogeneity in institutional effects on economic growth: theory and empirical evidence.

• Author: Tamilina, Larysa
• Position: Report

1. Introduction

   The collapse of socialism led to multifaceted and profound changes in the political, economic, and social systems of post-socialist countries. Formal institutions were expected to mold these changes into a legal framework and define new rules according to which the economy and society were supposed to operate. However, introducing free market formal institutions did not lead to the expected outcomes in many of the former socialist economies. The well-functioning institutions of capitalism, which are the foundation of economic development according to growth theory, proved rather dysfunctional in post-communist conditions (Polterovich 2005, 2008; Radygin and Entov 2008). The relationship between the quality of formal institutions and rates of economic growth appeared to be peculiar, differing from the pattern usually found in developed and/or developing countries.

   This study seeks to demonstrate that the revolutionary approach, through which key economic institutions were formed, can explain the relative dysfunctionality and inefficiency of these institutions in fostering growth in post-communist countries. We argue that the revolutionary mode of institution building occurred independently from both the culture economic agents were accustomed to and trends in economic structural transformations, resulting in institutions that were incompatible with informal norms and features of local economic systems.

2. Literature overview

   Growth theory asserts that good formal institutions are conducive to rapid economic development. Empirical evidence from economically developed and/or developing countries (Eicher and Leukert 2009) largely supports this claim (see Acemoglu and Robinson (2012) for an overview) with regard to both political (Chen and Feng 1996; Klomp and de Haan 2009; Narayan et al. 2011) and economic institutions (Rodrik et al. 2002). Post-communist countries are rarely included in such analyses, because they represent a unique group (Bosworth and Collins 2003).

   Research has been conducted independently on these countries. Studies found mixed evidence depending on the type of formal institutions analyzed, statistical methods used or the range of countries included. They either substantiate conventional findings that institutions positively impact growth rates (see Aslund (2007) for a detailed overview). Or, they recognize peculiarities concerning the effect that formal institutional frameworks have on economic growth, with the sign and strength of this impact varying depending on the phase of transition or the maturity of formal institutions (Fidrmuc and Tichit 2009; De Melo et al. 1997; Falcetti et al. 2000). Studies stemming from former Soviet Union countries go even further and entirely negate the claim that free-market formal institutions per se may lead to economic prosperity in the post-socialist world (Mau 2007; Petrunya and Ivashina 2010; Polischuk 2008; Polterovich 2008). These formal institutions lack compatibility with post-communist informal norms due to transition countries' insignificant historical experience with democracy and free markets (Yasin 2003) or due to unique features of their economic systems (the military sector's prevalence in their production capacities, dominant large companies, and a deep recession that started at the outset of transition) (Polterovich 2005; Polterovich and Popov 2006).

   In addition, the lack of strong political contexts, which assumes an independent political sector from the economic sector, is believed to hinder these countries from improving formal institutions. Their political elite often become economic elite (Aslund 2007), as a result of which institutional reforms simply promote the redistribution of economic or political power without generating substantial economic growth (Dementiev and Vishnevskiy 2011). As a consequence, many transition economies appear to be locked in an institutional trap (Polterovich 2005), with any institutional improvement being associated with considerable economic and social losses (Polterovich 2008). The introduction of private property in Russia and the Ukraine exemplifies this process: Local managers with close connections to the regional government accumulated hundreds of thousands of hectares while most of the local population was deprived of their land. This practice led to a considerable output drop and increases in poverty levels.

   Irrespective of the sign found in the relationship between formal institutions and economic growth, studies on transition economies possess one common feature: The impact of their formal institutions on growth is rarely tested in conjunction with developed and/or developing countries. An indirect comparison of results is hardly possible, since analyses do not use a standard set of conditioning variables and standard periods that would enable comparing findings.

   One should note that, in general, growth theory recognizes the existence of heterogeneity in the effects of formal institutions. It is well-established that the direction and strength of institutional effects on growth varies depending on the maturity level of formal institutions (Barro 1997; Fidrmuc and Tichit 2009; Przeworski and Limongi 1993) or a country's level of economic prosperity (Eicher and Leukert 2009; Lee and Kim 2009). However, we doubt that these two explanations are exhaustive for all post-communist countries. Transition economies started their institutional reforms from a relatively similar platform in terms of their level of economic development (see appendix 1) and the type and degree of institutional maturity but ended up at very different success levels. We argue that the cross-country variation of institutional effects on economic growth can also be attributed to the way in which such institutions were formed. The peculiar relationship of economic institutions to growth rates in transition economies can also be explained by the revolutionary nature of their institution building and socio-economic forces resulting from this process.

   The latter proposition requires that a theoretical model be constructed to juxtapose the post-communist pattern of institution building with the pattern prevalent in other countries to identify implications that this mode of institution formation may have for a country's growth dynamics. This study adopts the conventional definition of formal institutions as the basic formal rules, such as laws and regulations, that govern interactions among economic agents. We further narrow the concept of formal institutions to legal economic institutions, such as property rights and contract enforcement legislation, since they are viewed as the key to economic growth (North 1990) and have been the least successfully reformed in post-communist countries (Aslund 2007).

3. Analytical model

   We assume that economic processes have certain characteristics and operate within a system of rules. Some of these rules require legislative action and others do not. Rules that do not necessitate legislative action constitute informal institutions. Rules needing such action are formal institutions. We further assume that any legislative action is ascribed to formal rules and enforced by the central government, which operates within a set of political rules. We argue that an economy grows smoothly when formal rules are compatible with informal rules and features of political and economic systems. We also assert that the odds of ensuring this compatibility vary depending on the mode of institutional grafting.

   Economics offers two primary views on how formal institutions emerge: top-down and bottom-up (Boudreaux and Alicia 2007; Easterly 2008). The bottom-up perspective assumes that institutions develop spontaneously from cultural values and norms of individuals within a society, with the written law only formalizing what is already mainly shaped by people's attitudes (Easterly 2008). In this case, institutional change is seen as gradual in nature and constrained by previous institutions while institutional reforms are expected to be additive and cannot attempt too much (Platteau 1996). Drastic changes in the existing institutions are believed to harm the economy, even if there is no obvious reason for such institutions to exist (Easterly 2008). Institutions are deemed unique to a society and closely linked to its history. As such, societies are expected to diverge in their formal institutions both in the short and long run (Boudreaux and Alicia 2007).

   In the top-down approach, by contrast, political leaders declare laws to create institutions (Easterly 2008). Since the notion of institutions is limited to laws, the government can easily adopt new institutions at any time. Derived from this premise, this approach advocates determining an optimal set of formal institutions that can be designed from scratch and introduced in any country (Boudreaux and Alicia 2007). Some go even further and suggest that there might be 'one globally unique best set of institutions, towards which all societies are thought to be developing' (Easterly 2008). Hence, copying institutions from more advanced societies to less advanced ones is deemed possible and efficient.

   We use this distinction as a point of departure and integrate it into evolutionary and revolutionary modes of institutional grafting (Matthews 1995; North 1990; Poznanski 1995). We consider the two latter terms to be of higher order, since they assume that a certain method of institution building is applied not only to one or a few selective formal institutions but to the vast majority of such institutions, resulting in a profound transformation of the entire institutional framework. For the purpose of our research, we adopt the conventional concept 'evolutionary,' which is often used in institutional economics, and limit it to a gradual and cumulative change in institutions that usually results from a bottom-up emergence of rules (Easterly 2008). We...