The Role of the State in Economic Develo

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The Role of the State in Economic Development
Guido Tabellini
‘ya wise and frugal Government which shall restrain men fr om injuring one another, which shall
leave them otherwise free to regulate their own pursuits of industry and improvement, and shall not
take fr om the mouth of labor the bread it has earned. This is the sum of good government, and this is
necessary to close the circle of our own felicities’ (T. Jefferson, 1st Inaugural, 1801, Memorial
Edition; 3:320).
I. INTRODUCTION
This is how Thomas Jefferson viewed the role of government in 1801. Is this
minimalist view still relevant today? Or have we become wiser? This paper
addresses this question, reviewing the recent literature oneconomic growth and
on the role of the public sector in fostering economic development.
The central conclusion of this recent literature is that Jefferson was largely
right. Not because a minimalist government is necessarily better than a big
government. But because the key challenge for most developing countries is to
create the basic legal and institutional infrastructures that protect property
rights, enforce private contracts and allow individuals to freely take advantage
of market opportunities. In principle there are many more things that governments
could and should do: provide public goods, correct market failures,
reduce inequalities in income and opportunities, stabilize excessive economic
fluctuations. But these other government activities are not what make the
difference between success and failure in economic development. The real
difference ismade by the basic institutional and legal infrastructures that protect
property rights, enforce the rule of law and prevent abuse by governments.
This conclusion raises another, more difficult, question.What can developing
countries do to facilitate the emergence of these basic institutional
KYKLOS, Vol. 58 – 2005 – No. 2, 283–303
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and 350Main Street, Malden, MA 02148, USA
I am grateful to Francesco Giavazzi for several helpful discussions, to Andrew Feltenstein and
participants in the IMF conference on theMiddle East andNorthern Africa(MENA) region onApril
7, 8, 2004,Washington DC, for helpful comments, to Torsten Persson for sharing with me his data set
on democratic institutions and economic development (Persson 2004), to Gaia Narciso for excellent
research assistance, and to Bocconi University and the Canadian Institute forAdvancedResearch for
financial support.
Affiliation: IGIER, Bocconi University; CEPR; CES-Ifo. Address: Via Salasco 5, I-20136 Milan.
E-mail: Guido.Tabellini@uni-bocconi.it
infrastructures and more generally to create appropriate government incentives?
The paper concludeswith a general discussion of this question, reviewing
some recent results on the effects of economic and political liberalizations.
The outline of the paper is as follows. Section II discusses how history and
institutions influence the current level of economic development. Section III
reviews the recent empirical literature on how public policy affects economic
growth. Section IV discusses the effects of economic and political liberalizations
on economic performance and policy outcomes. SectionVsummarizes
and concludes.
II. INSTITUTIONS AND ECONOMIC DEVELOPMENT
The idea that institutions protecting property rights are key to economic
development is not new.North (1981) has built his analysis of economic history
on this premise.More recently,Hall and Jones (1999) have shown the relevance
of this idea in explaining contemporary differences in the level of economic
development across countries.
At the core of the influential paper by Hall and Jones (1999) lies a startling
correlation, depicted in Figure 1: countries with a better institutional environment
have amuch higher level of labor productivity. The vertical axis of Figure
1 measures output per worker (LOGYL) in 1988 – a similar correlation exists
with regard to total factor productivity. The horizontal axis measures the
quality of the institutional environment (GADP), at about the same point in
time. The variable GADP summarizes perceptions of structural policies and
institutional environments encouraging the production of output rather than
its diversion (through theft, corruption, litigation or expropriation)1. Of
course, reverse causation is a serious issue in interpreting Figure 1. Do better
institutions and structural policies lead tomore productivity, or does economic
development lead to better policies and institutions? Hall and Jones (1999)
argue that there is enough exogenous variation in structural policies and
institutions to identify a causal link from institutional quality to productivity.
They show that institutional quality is explained by historical and geographic
features of countries (such as distance from the equator and percentage of the
population speaking English or another European language).Moreover, these
historical and geographic variables are valid instruments for institutional
1. This variable has been compiled byKnack andKeefer (1995) usingICRGdata. It ismeasured over the
period 1986–95 and consists of a simple average of five indicators; two ofwhich relate to the role of the
government in protecting property rights against private diversion (law and order, and bureaucratic
quality); the other three to the role of the government itself as a source of diversion (corruption, risk of
expropriation and government repudiation of contracts). The variableGADP varies from0 to 1, with
higher values indicating better policies (more protection of property rights).Wereturn to this variable
in Sections IV and V below.
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quality, in the sense that they influence economic development exclusively
through their impact on institutions.
Although the instruments used by Hall and Jones (1999) are somewhat
dubious, subsequent researchhas confirmedthe validity androbustness of their
basic insight. In particular, Acemoglu, Johnson and Robinson (2001) have
shown that the quality of institutions and structural policies as measured by
GADP is explained by the colonial history of countries. European colonizers
pursued different objectives. Some colonieswere exploited to extract resources;
others were settled by European inhabitants who transplanted their economic
and political institutions. This choice was strongly influenced by local conditions
at the time of colonization, such as the hospitality of the local environment
for European settlers and the density of the indigenous population.
Acemoglu, Johnson and Robinson (2001) argue that this pattern of colonization
had long lasting and relevant implications. The colonies that were
exploited for extractive purposes never developed adequate institutional
infrastructures,while those thatwere settled byEuropean colonizers developed
much better institutions that persisted after independence. To test this idea,
Acemglu, Johnson and Robinson (2001) collected data on the mortality rate
6.91856
10.4756
Labor productivity
.225 1
GADP
Figure 1
Labor Productivity and Institutional Quality (GADP)
Source: Hall and Jones (1999)
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of European settlers in the colonies between the 17th and 19th centuries and on
the density of the indigenous population at that time. The data are strongly
supportive: as shown in Figure 2, the index of institutional quality and
structural policies, GADP, is negatively correlated with settler’s mortality
measured in logs, lmort: wh ere settler’s mortality was higher, current institutions
are worse. Similar results are obtained with the density of the indigenous
population at the start of colonization. Moreover, these variables are valid
instruments for institutional quality in the regressionswhere labor productivity
is the dependent variable. Finally, the original instruments used by Hall
and Jones (1999) lose explanatory power once local conditions at the time
of colonization are controlled for, suggesting that their instruments, and
in particular distance from the equator, really proxy for colonial history.
More recent research by Easterly and Levine (2002) and by Rodrik, Subramanian
and Trebbi (2002) further confirms the robustness of this link from
colonial history to institutional infrastructures to current economic development.
See also the discussion in Acemoglu, Johnson, and Robinson (2004).
Having established the relevance of a causal link from basic institutional
infrastructures to economic development is only a first step.The next challenge
is to gain a better understanding of what these good institutional features
.225
.986
GADP
2.14593 7.98617
log_mortality
Figure 2
Institutional Quality (GADP) and Log of Settler’s Mortality
Source: Hall and Jones (1999) and Acemoglu, Johnson and Robinson (2001)
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are, and how can countries deliberately acquire them. This means addressing
several problems.
Afirst issue concerns the precise nature of formal institutions.The indexes of
institutional quality used in the literature are averages of individual perceptions
about the protection of property rights, the absence of corruption in the
public sector, the respect of the rule of law. These perceptions in turn reflect
a variety of formal features of institutions and structural policies, ranging
froman independent and effective judiciary, to the quality of the bureaucracy,
to the deeper constitutional features that guarantee basic political and civic
rights, checks and balances on the executive, and generally well functioning
democratic institutions.Which of these several features of formal institutions
is responsible for the causal effects on economic development? Answering
this question is particularly difficult, also because these institutional features
are likely to be strongly correlated across countries. A recent paper by
Acemoglu and Johnson (2003) suggests the primacy of political institutions.
They contrast two sets of institutions: ‘contractual institutions’ (technologies
for enforcing private contracts) vs ‘property right institutions’ (technologies for
avoiding expropriation of private property by the government). ‘Contractual
institutions’ are measured by the index of legal formalism compiled by
Djankov et al. (2003a, 2003b) and are instrumented by the country of legal
origin (whether French-civil-law or English-common-law). ‘Property right
institutions’ are measured by perceptions of risk of government expropriation
and by an index of constraints on the executive compiled by POLICY IV and
are instrumented by colonial history as measured by settler’s mortality or
density of indigenous population. Acemoglu and Johnson (2003) show that
‘property rights institutions’ seem to be fundamental determinants of output
and investment, while ‘contractual institutions’ are of secondary importance.
They interpret this finding as suggesting that investors cannot really escape the
threat of government expropriation, while private transactions can be structured
to overcome the deficiencies of the judiciary. But much more remains to
be done to identify the separate effects of specific institutional provisions.
Moreover, as remarked byRodrik(2003),we shouldnot take it for grantedthat
there exist institutional blueprints that work well in all economic and social
environments. If the effects of institutions are heterogeneous and depend on the
environment, the task of identifying the causal effects of specific institutions
becomes even more difficult.
A second problem concerns the distinction between formal legal or constitutional
provisions vs informal habits and social norms. Real world
institutions are shaped by both, and perceptions of institutional quality clearly
reflect both formal and informal institutions. Yet, changing habits and social
normsmay be even more difficult and lengthy than enacting new legislation or
reforming political institution. We still know very little about the relevance of
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this distinction for the effects of institutions on economic development. Note
that if informal institutionsmatter, the effects of formal institutions is bound to
be heterogeneous and dependontheoverall environment, adding another layer
of complexity.
Finally, even if we can identify the precise (formal or informal) institutional
features that aremost helpful for economic development, there is the question
of how to acquire them. Institutions are largely a legacy of history: the age of
democracy (i.e. for how long a country has been democratic) is strongly
correlated with the institutional infrastructures that promote economic development,
as shown in Figure 32. But changing political institutions is very
difficult, for obvious reasons.
We return to the question of how to acquire better institutional infrastructures
in Section IV. In the next section, we continue our review of the evidence
on the role of the public sector in fostering economic development.
GADP_residuals
AGE_residuals
.256065 .726798
.331056
.387992
Figure 3
Institutional Quality (GADP) and Age of Democracy (AGE)
Both variables are the residuals of a regression on distance from the equator and a dummy variable for
being a democracy in 1980 Source:Hall and Jones (1999), Persson and Tabellini (2003), Persson (2004),
Polity IV
2. The age of democracy (AGE) is defined as the fraction of years between 1980 and 1800 for which the
country has been a democracy in the sense of having had an uninterrupted string of positive values of
the variable POLITY2 in the POLITY IV dataset (without subsequent reversals into autocracy).
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III. POLICIES AND GROWTH
The view that the current level of economic development of a country is
determined by its institutions is important and plausible. But it has the
disturbing implication that economic development is largely a legacy of
history. What can governments do to rid themselves of that legacy, besides
engaging in deep and difficult institutional reform? What kind of economic
policies are more likely to accelerate the process of economic development?
Motivated by these questions, a large literature has studied the link between
growth (rather than the level of development) and public policy (rather than
institutions). This section briefly reviews its main insights3.
This line of research originates with the theories of endogenous growth
formulated by Lucas and Romer in the mid 1980s. These theories imply
that economic policy can easily have large effects on long run growth of income
per capita, through individual decisions to accumulate physical or human
capital. But when taking this implication to the data, several difficulties
immediately arise.
First, over theperiod1960–2000 forwhich data are available, the growth rate
of developing countries has been far fromstable.Easterly et al. (1993) point out
that the correlation of economic growth across the decades 1960–69, 1970–79,
1980–88 for a large sample of countries is almost nil (it ranges from0.1 to 0.3).
Similarly low numbers apply to economic growth across successive 5-year
periods in the sample up to 1999 (Easterly 2003)4. This suggests that shocks
have been an important determinant of economic performance.Of course, this
could include policy shocks. But most observed policies and other country
features tend to be much more stable than economic growth (Easterly et al.
1993, Easterly 2003). Hence, a large component of growth over the period
1960–2000 is likely to remain unexplained. Moreover, if good economic
performance is a temporary phenomenon, the level of development reached
at the end of this period is almost exclusively explained by the initial conditions.
Indeed, Easterly (2003) points out that the correlation between per capita
incomein 1999 and in 1960 is close to 0.9.Our attempt to escape fromthe legacy
of history is unlikely to take us very far away.
A second problem is that economic performance has deteriorated in the
period 1980–2000, relative to the previous two decades. But economic policies
have generally improved in the later period. Easterly (2001) andRodrik (2003)
point out that in the 1980s and onwards several developing countries adhered
3. Helpman (2004), Easterly (2001, 2003), Easterly and Levine (2001) among others review this line of
research in much greater detail.
4. According to Easterly and Levine (2002), however, the instability is greater for total factor
productivity growth than for capital deepening.
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more closely to the so called ‘Washington consensus’ of good policies (fiscal
discipline, competitive currencies, privatization and deregulation, trade and
financial liberalization).Yet, this did not prevent a decline in their growth rate.
Finally, there is an important methodological problem. We are interested in
the growth effects of economic policies.But economic policy itself is endogenous.
When estimating regressionsof growthonpolicy variables,we assume that
variations in policy are random, as if they were due to new discoveries about
policy consequences or to random experimentation. This assumption is
generally untenable. Variation in policies (across countries or over time) is
more likely to reflect different incentives of governments, rather than different
information. But government incentives in turn are shaped by institutions
(mainly political institutions). Even rigorous policy analysis, therefore, cannot
avoid taking into account institutional determinants of government choices.
With these general caveats in mind, we now review the main conclusions of
the existing literature on the growth effects of specific government policies.
1. Macroeconomic Policy
A stable macroeconomic environment, with low and predictable inflation, a
sustainable budget balance, and a stable and competitive currency, is widely
believed to be one of the ingredients of economic success. Policy-induced
macroeconomic uncertainty interferes with price signals of relative scarcity
inducing misallocation of resources, and might discourageprivate investments.
Moreover, a distorted foreign exchange market in the form of a high black
market exchange premium acts as a tax on exporters and induces the
expectation of future depreciation, with negative effects on investment and
on the allocation of resources.
Several papershave askedwhether these priors are indeed consistentwith the
data. Fischer (1991, 1993), in particular, estimated cross sectional or panel
regressions wh ere the dependent variable is either the growth of per capita
income, or its components obtained froma growth accounting exercise (capital
deepening or total factor productivity); the macroeconomic policy environment
is measured by the rate or the variability of inflation, the government
budget surplus in percent of GDP, the black market exchange premium. His
findings support the priors summarized above: inflation, budget deficits and a
distorted exchange rate market all reduce growth; the effects operate through
both lower investment and lower total factor productivity growth.
Canwe interpret these empirical correlations as causal, and infer that a better
and more stable macroeconomic environment would bring about more rapid
growth? Unfortunately the answer is no, or at least not in all circumstances.
First, according to Easterly (2003), such empirical results are largely due to
extreme observations. Once these extreme observations are removed from the
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sample, the effect ofmacroeconomic policies becomes statistically insignificant.
This is confirmed by the simple plot of average growth of GDP per capita
against the log of average inflation (linf ) depicted in Figure 4 above. The
extreme observations reflect instances of very bad policies (such as inflation
rates or black market premia in excess of 35%, or budget deficits greater than
12%of GDP). Several observations can be classified as extreme in this sense.
Thus, Easterly (2003) is not pointing out a statistical fragility. Rather, the
interpretation is that very badmacroeconomic policies can be very harmful to
growth, but in a more moderate range the effect of the macroeconomic policy
environmentongrowth seems negligible.To put itmore bluntly, a very bad and
unsustainable macroeconomic environment almost certainly kills growth; but
....
open is treated as endogenous with the same instrument as in Frankel and
Romer (1999).
Wacziarg and Welch (2003) update the Sachs and Werner index of trade
liberalizations for the 1990s.The cross-sectional correlations areweaker for the
1990s. But the time series variation in the data reveals very robust effects:
episodes of trade liberalizations are followed by an increased trade volume,
faster growth and an acceleration of investment. These findings are confirmed
by Giavazzi andTabellini (2004)with a difference-in-difference estimation that
also compares countries that underwent trade liberalizations with those that
did not over the same period. Finally, BenDavid (2000) documents how trade
liberalizations and trade integration accelerate income convergence.
IV. ECONOMIC AND POLITICAL LIBERALIZATIONS
Trade liberalizations seem to play an important role in accelerating economic
development. Perhaps this is the only positive and robust finding discussed in
the previous section. But what is the channel through which this happens?
Opening up the economy changes both private and government incentives. On
the one hand, trade liberalizations remove economic distortions and create new
opportunities for the private sector.Onthe other hand, opening up the economy
acts as a discipline device on governments, because it increases the cost of
pursuing inefficient policies. Which of these two channels is more important?
Giavazzi and Tabellini (2004) address this question by comparing macroeconomic
policies and structural policies before and after episodes of trade
liberalizations, also taking into account what happened in countries that did
not liberalize. This difference-in-difference estimation reveals that the process
of trade liberalization is accompanied by overall macroeconomic improvements
(lower inflation and lower budget deficit), while the liberalization itself
may also be triggered by a bad or unsustainable macroeconomic situation.
Moreover, trade liberalizations are also associated or followed by improvements
in structural policies and institutional infrastructures (such as better
protection of property rights and lower corruption – the same institutional
indicators discussed in Section II). This contributes to explain why trade
liberalizations induce better economic performance: on average, a more open
economic environment is accompanied by a generalized improvement in
economic policies and other institutions.
Of course, this pattern of correlations cannot establish that the direction of
causality runs from trade liberalizations to better macroeconomic and structural
policies. Although the data suggest that a regime open to international
trade is an important ingredient of a successful reformpackage, it could be that
trade reforms tend to be accompanied bymore comprehensive reforms, simply
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because a reformminded government acts on several dimensions at once12. But
this remark doesnotdiminish our interest in these episodes of economic reform.
On the contrary, whether they are pure trade reforms of more generalized
economic liberalizations, we would like to know what triggers them.
A plausible conjecture is that more open and democratic political institutions
facilitate the decision of governments to liberalize their economy. The
benefits of international trade typically accrue to citizens at large: consumers,
new producers who find profit opportunities in the liberalized sectors, but also
owners of factors of production employed in export oriented sectors. The
opponents of liberalizations, instead, are typically large incumbent producers
in the import competing sectors. Political reforms that improve democratic
institutions expand the number of citizens included in the winning political
coalition: almost by definition, a democratic government has to rely on the
support of many citizens, while an autocratic government can rule against the
will of the majority. Hence, when a country becomes democratic, the political
influence of those who benefit from international trade is likely to increase,
at the expense of the large incumbent firms in the economy. But the direction
of causation could also go the other way, from international openness to
democracy. A more open economy increases the returns from engaging in
productive activities, as opposed to political rent seeking. It also exposes the
ruling class to more competition, because it facilitates comparisons with what
happens in other countries.Moreover, amore open international environment
increases the cost of inefficient policies, and this in turn makes citizens more
demanding and less tolerant of corrupt and unaccountable leaders.
Motivated by these arguments, Giavazzi and Tabellini (2004) study what
happens once a country becomes a democracy, focusing in particular on the
interactions and the feedback effects between economic and political liberalizations.
Acursory look at episodes of trade liberalizations reveals that they are
often precededbydemocratic reforms, rather than the otherway around. This is
confirmed bymore careful statistical analysis. AlthoughGiavazzi and Tabellini
(2004) cannot rule out that feedback effects go both ways, democratization
imparts a significant boost to trade reforms. They estimate that already 4 years
after having become ademocracy, the probability of being opento international
trade is about 30 percentage points higher than before democratization.
If this was the end of the story, it would be a very happy ending. We would
have a simple and appealing lesson to preach to countries around the world:
become a democracy! Once democratic institutions were in place, citizens
12. Wacziarg and Welch (2003) focus on a subset of 21 countries; they point out that of these, 7 are
exclusively trade reformers (Bolivia, El Salvador, Ghana, Kenya, Morocco, Trinidad & Tobago,
Uruguay), while 14 are comprehensive reformers (Argentina, Brazil, Chile, Colombia, Costa Rica,
Ecuador, Guatemala, Hungary, Mexico, New Zealand, Paraguay, Poland, Spain, Sri Lanka).
would have the carrot and the stick with which to induce their governments to
enact better policies and to build appropriate institutional infrastructures. But
unfortunately, the world is not so simple. Despite the positive association with
subsequent economic liberalizations, Giavazzi and Tabellini (2004) also find
that onaverage transitions to democracy are not followedby significant growth
accelerations nor by large improvements in economic policies. Why is that so
and how can it be consistent with the positive association between democratization
and economic liberalization?
Giavazzi and Tabellini (2004) suggest that the answer has to do with the
sequence of reforms. They find that opening up the economy first and then
becoming a democracy gives better results than the opposite sequence.
Countries that first liberalize the economy, and then make the transition to a
democracy, do better, in terms of growth, investment, trade volume and macro
policies, than those that adopt the two reforms in the reverse order. There are
two possible interpretations of this finding. One possibility is that economic
liberalizations enacted first aremore effective. ‘Dictators’ are less likely to open
upthe economy.Butwhen they doit, likePinochet inChile, they crushwhoever
opposes the reforms and hence economic liberalization is more pervasive and
complete. A liberalizing democracy, instead, is bogged down by veto players
and it is forced to compromise or to compensate the losers. The other
possibility is that the ‘good’ sequence (open the economy first and become a
democracy second) produces better democracies. An open and competitive
economy constrains democratic populism and makes it less likely that redistributive
conflicts end up with inefficient policies. Moreover, the sequence
economic liberalization followed by political liberalization might indicate the
presence of a controlled and pre-planned liberalization enacted by a far sighted
leader. When democratization comes first, instead, it is more likely to be
unexpected and result fromviolent struggles or collapses of state authority.As
such, it is more likely to be associated with economic disruptions and
redistributive struggles.
V. CONCLUDING REMARKS
This paper reviewed a large body of empirical research that asked what kind of
economic policies are more conducive to economic growth. In the end, we are left
with the conviction that this is not the right question. At a general level, it is quite
clear what kind of economic policies are good for growth: a stable macroeconomic
environment, generalised access to the world economy, protection of
individual property rights, spending in public goods that provide benefits to all.
Thereally crucialquestion iswhy don’t governments pursue these sound policies?
Lack of knowledgemay be part of the answer. Sound economic principles do not
translate precisely into unique policy packages, but need to be adapted to the
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specific economic and social realities, as argued for instance by Rodrik (2003).
But lack of incentives is bound to be much more important. This is suggested by
the finding in the literature that bad economic policies are generally associated
with institutional failures, particularly failure of political institutions.
But what can be done to give the right incentives to the governments
of developing countries, short of waiting until they become mature democracies?
A practical conclusion of this analysis is that there are beneficial
complementarities frompolitical and economic liberalization. Political liberalization
facilitates opening up the economy to international competition,
probably because democracy increases the political influence of those that
are more likely to benefit from international integration. But economic
liberalization seems a necessary step towards economic success: without it,
new democracies do not prosper.
The detailed interactions and feedbacks between economic and political
liberalizations are still not well understood, however. Moreover, while economic
liberalizations have been extensively studied, less is known about
political liberalizations and episodes of transition towards democracy. Which
specific features of democratic institutions are more likely to promote sound
economic policies? And how do they interact with local conditions and with
specific features of the economic and social environment, such as inequality,
media diffusion, and structure of property rights?Making progress in answering
these questions is essential, if we want to offer valuable advice to many
countries that are not developing.