Institutions and History: An analytical essay.

Ayesha Chopra (0958985)

Introduction:
Growth models over the years have revealed that one of the main reasons there exists a large difference in Per Capita Income (PCI) across countries is due to the differences in efficiency. A principal reason for the differences in efficiency is due to differences in institutions. Hence, economists explore institutions, their origins and development through history to understand these distinctions. One of the most convincing arguments to study institutions and their history is given by Douglas C North in his paper, Economic performance through time, he says Institutions form the incentive structure of a society, and the political and economic institutions, in consequence, are the underlying determinants of economic performance. Time as it relates to economic and societal change is the dimension in which the learning process of human beings shapes the way institutions evolve. That is, the beliefs that individuals, groups, and societies hold which determine choices are a consequence of learning through time-not just the span of an individual's life or of a generation of a society, but the learning embodied in individuals, groups, and societies that is cumulative through time and passed on intergenerationally by the culture of a society.(North, D. 1994) We will look at both formal and informal institutions and address and analyse questions posed and answered by economists.

SECTION I:
In section 1 we will look at two papers that study institutions and their origins. Both the papers have similar historical roots as their analysis is set in the colonial times. In their paper The Colonial Origins of Comparative Development: An Empirical Investigation, Acemoglu, Johnson and Robinson (AJR), look at all the colonies of the European powers, whereas in, History Lessons: Institutions, Factor Endowments and Paths of Development in the New World by Engerman and Sokoloff (ES), they look only at the Americas. Both the papers discuss institutional persistence and how the quality of institutions in 1900 affects the quality of institutions today. AJR pose the question, what are the fundamental causes of the large differences in PCI across countries? The view they support is that wealthier countries with better institutions and more secure property rights will invest more in physical and human capital. (Acemoglu et al. 2001) Hence, they consider expropriation risk in relation to income. They use the instrumental variable approach, where they take into consideration settler mortality which must be correlated with institutional quality, but uncorrelated with current income. They propose a theory of institutional differences among countries colonized by European powers. There were different types of colonization policies which created different set of institutions. At one extreme, European powers set up "extractive states," exemplified by the Belgian colonization of the Congo. These institutions did not introduce much protection for private

property, nor did they provide checks and balances against government expropriation. In fact, the main purpose of the extractive state was to transfer as much of the resources of the colony to the colonizer. At the other extreme, many Europeans migrated and settled in a number of colonies; creating what the historian Alfred Crosby (1986) calls "Neo-Europe." The settlers tried to replicate European institutions, with strong emphasis on private property and checks against government power. Primary examples of this include Australia, New Zealand, Canada, and the United States. The colonization strategy was influenced by the feasibility of settlements. In places where the disease environment was not favourable to European settlement, the cards were stacked against the creation of Neo-Europes, and the formation of the extractive state was more likely. Hence, settler mortality rates had an effect on institutional quality. (Acemoglu et al. 2001) Hence, persistence of institutions, i.e. the initial quality of institutions affects institutional quality today. AJR discuss three economic mechanisms that lead to institutional persistence: Setting up institutions are a costly process, hence, the elite who inherit these institutions would prefer to continue to exploit for their own benefits. If the size of the elite is smaller, then the gains they receive out of extractive policies are more lucrative and hence they have an incentive to extort. If irreversible investments are made in a set of institutions then agents will be more than willing to support them and make the institutions persist. (Acemoglu et al. 2001) The IV regression results show that past institutions account for 20% of the variance in current institutions. The settlements in 1900 explain 50% of variance in institutional quality and settler mortality explains 30% of variance in settlement rates. The measured effect of institutions is almost twice as large in the OLS regressions. (Acemoglu et al. 2001) The AJR paper has been criticised on various counts. Albouy criticised the estimates of mortality rate as in 36 out of the 63 countries they often assigned a different mortality rate. Some of their sample sizes are too small, in one case results are based only on 19 deaths. They have limited data on settler mortality and took liberty in assigning rates to different countries, for example, they applied one observation for all the countries in South America. (Albouy, D 2008) One of the main critiques of the AJR paper is that they did not identify the mechanism through which institutions are persistent. Various measures besides settler mortality have been used such as Paul Mauros ethno linguistic fractionalization (ELF), as the richer a country the more people identify themselves with the nation, rather than a narrower regional or religious group. However, the income divide causes ELF, hence they might be correlated and it might not be an appropriate measure. Another measure, the countrys distance from the equator has also been regarded i.e. countries nearer to the equator have less developed financial markets, inefficient bureaucracy and corruption. Although various studies show that this measure is statistically significant, it is very relative and has been discredited. The ES paper explains in more detail the idea and reasons behind institutional persistence. Data in the ES paper advocates that in 1700 Mexico and the United states were equally wealthy. The PCI of Mexico was 89% of the US level. Both the Caribbean and Brazil had a much higher PCI than the United States. However, today their PCI is a quarter of that of the United States. Hence, they address the question of how and why the areas that were favoured by the forecasters of that era, and the destinations of the vast majority of migrants to the Americas through 1800, fell behind economically. (Engeman et al 2000)

Brazil and the Caribbean had high economies of scale as they produced crops such as sugarcane. Where the soils and climate were conducive to crops such as sugar and coffee, along with a large native population, there existed a high inequality. The indigenous population who worked as labourers would be exploited by land owners which lead to inequality and concentration of power. In countries like the US and Canada, where the climate was conducive only for grains, there existed low economies of scale and inequality. In societies that begun with extreme inequality, elites were better able to establish a legal framework that insured them disproportionate shares of political power, and to use that greater influence to establish rules, laws and other government policies that advantaged members of the elite relative to non-members- contributing to persistence over time of a high degree of inequality (Kousser, 1974; Acemoglu and Robinson, 2000) This inequality is reflected in the institutional setup of the countries and the pace at which the institutions developed. For example, in the mid 1800, in the United States there existed secret ballots and no wealth or literacy requirements were to be fulfilled in order to vote. Hence, in 1880, 18% of the voting population voted in the US. In Chile however, only 1.6% voted, due to wealth and literacy requirements. In 1850 in the United States 96% of the white population was literate. In 1939, almost 90 years later, in Brazil 57% of the population was literate. (Engeman et al 2000). High scale economy crops thus, caused an inequality which undervalued investment in education and caused restrictions in the right to vote which propagated inequality and hence lower quality institutions. ES infer that the suffrage differences across societies in the distribution of political power may have contributed to persistence in the relative degrees of inequality through the effects on institutional development. Unlike the United States and Canada who achieved sustained economic growth in the late eighteenth and early nineteenth century, the others did not manage to attain this goal until late in the nineteenth or in the twentieth century. The causes that seem most relevant for the substantial difference are inequality in wealth, human capital, and political power which were rooted in the factor endowments of respective colonies but persisted over time. (Engeman et al 2000) Both these papers develop the persistence hypothesis and support it by providing data and information. However, they do not have any policy implications. There are no answers or suggestions provided as to what policies should be framed in order to get rid of the inequality which has lead to low quality institutions.

SECTION II
In order to make progress on the policy front, Acemoglu and Johnson, in Unbudling Institutions, state that there is a need to look at institutions in a detailed manner. Unbundling is a strategy which identifies diverse instruments for institutions such as courts and contract enforcement and property rights. They correlate legal origin with contacting, settler mortality, and population in 1500 with property rights. They conclude that property rights are important for the development of good quality institutions, whereas contract enforcement does not. Unbundling was an attempt to realise policy implications, however, there are various problems with its theory. One being, that all the measures of institutions are highly correlated

with one another. The definitions of the variable used are very relative and differ from one institution to another. For example, for courts, they take the formalism of the legal system i.e. the number of steps it takes for one case to be sorted out by the court. For property rights, however, they survey investors. Hence, it is not a very promising approach. Hence, we study a notion that is more promising, which is to analyse specific institutions in more detail. Avner Greifs work, Cultural Beliefs and the Organisation of Society: A Historical and Theoretical Reflection on Collectivist and Individualist Societies looks at the working of very specific institutions and the consequences of those institutions for the efficiency with which the economy operates. The paper gives insight into cultural variations that account for intersociety differences in social organisation. (Grief, A. 1994) He does this by comparing the Magribi traders from North Africa with the Genoese traders from Genoa in the twelfth century. The relationships in the economy are viewed as repeated games, this game if repeated often enough, help sustain cooperation. The paper addresses a key issue of how trade over long distances should be conducted. It can be conducted either by the merchant taking his goods himself or employing an agent to do so. However, there is always a fear of the agent cheating the merchant. The manner in which this problem is resolved can be collectivist, where contract enforcement is achieved through informal economic and social institutions or individualist where contract enforcement is achieved through specialized organisations such as the court. The paper discusses a coalition where a game of trust is played between merchants and their agents. There exists a one sided prisoners dilemma where agents can cheat on their merchants, however, merchants cannot cheat on agents. Cooperation is sustained only if the game is repeatedly. If the agent cheats the merchant and the game is repeated, then the agent weighs the gain from cheating now against the discounted loss from punishment by the merchants in the future. In the collectivist model, there will be some wages paid by the merchant to the agent to keep the agent honest. If the game will end in one period, the agent is more likely to cheat. However, if the game is repeated the cheating agent will never be rehired, but wages paid to agents can be lower when honest agents are rehired. There needs to be active and ongoing communication amongst the merchants and it is a better idea to hire other merchants as agents because if they cheat they are excluded from the coalition. In the individualist model i.e. the Genoese, there existed no similar coalition. It was a rapidly growing centre of trade and it was impossible to form a closed network. Hence, there was an incentive to establish a formal mechanism to enforce contracts. Without a closed coalition, merchants were expected to pay more to agents. However, as trade expanded rapidly to new and more distant areas, the Maghribis, unlike the Genoese were not able to easily incorporate new agents who had previously been outside the coalition into the coalition. Hence, they were not able to expand rapidly as a group and there was market friction.

CONCLUSION
Institutions today are affected by their origins and their development is tied up with the understanding of their historical roots and the reasons behind their success or hampered progress. Historical differences help identify the effect of institutions in a statistical sense. The papers discussed in section I provide econometric evidence to show that institutions matter and project a mechanism for persistence of institutions. However, they are very unsatisfying from the policy perspective. They do not provide solutions to change what happened in the past. In section II, the unbundling approach seems unlikely to identify critical institutions and is a very superficial method of understanding institutions. Hence, a detailed approach is what is required. Institutions, formal or informal, matter as society relies on them to form a code of conduct and prescribe rules to individuals. They inform individuals of the code to be followed in situations and give them a collective feeling of security and oneness. Hence, it is very necessary to understand the development of institutions and to remove any obstacles that mat hamper their progress.

BIBLIOGRAPHY
JOURNALS:
Avner Greif. 1994. Cultural Beliefs and the Organization of Society: A Historical and Theoretical Reflection on Collectivist and Individualist Societies. Journal of Political Economy, 102 (October 1994): 91250. Botticini and Ekstein, From Farmers to Merchants, Conversions and Diaspora: Human Capital and Jewish History, Journal of the European Economic Association, 5(5) pp. 885-926, September 2007. Acemoglu, Daron, Simon Johnson, and James Robinson (2001), "The Colonial Origins of Comparative Development: An Empirical Investigation", American Economic Review, 91, 13691401 Engerman and Sokoloff, 2000, History Lessons: Institutions, Factor Endowments and Paths of Development in the New World, Journal of Economic Perspectives, 14(3), pp. 217-232 Acemoglu, Daron and Simon Johnson, 2005, Unbundling Institutions, Journal of Political Economy, 113(5), pp. 949-995. Albouy, David, 2008, The Colonial Origins of Comparative Development: An Investigation of the Settler Mortality Data, NBER Working paper 14130. Doughlas C. North, 1994, Economic Performance through Time, American Economic Review pp. 359-368