The impact of institutions on economic growth: the case of transition economies.

Author:Redek, Tjasa

Economic transition, a phenomenon that has marked the development of the bigger part of Europe in the past decade, is above all a problem of coordination. Economic transition is a process of institutional change, a process of building new institutions required by a capitalist economy. Transition brought about the overnight destruction of the socialist coordination mechanism, while the market coordination took time to be established and agents had to become cognizant of it.

The aim of this paper is to analyze the importance of institutional quality for economic performance in transition economies in the past decade. The structure of the paper is as follows. First, we present the results of analyses by other authors which deal with the importance of institutional quality for economic performance in general or for transition economies. Then, some institutional and economic characteristics of socialist economies are briefly presented, and these initial conditions are contrasted with the present situation to provide an illustration of how institutions might have contributed to transitional success or failure. This is followed by a more in-depth econometric analysis intended to isolate the influence of institutional quality on economic performance. Finally, the results are tested with a sensitivity analysis to confirm the importance of the speed and quality of institution building in the transition process.

Institutions and Economic Performance

Definition of Institutions

In recent years scholars and policy makers alike have paid increasing attention to the complex relationship between institutions and economic performance. There are numerous reasons why it is important to understand the role of institutions: economic stagnation in many developing countries; structural problems in the old industrial economies; the collapse of the economies in the former Soviet Union, Central Asia, and Eastern and Central Europe. Institutional analysis is of paramount importance for guiding the transition to markets in formerly centrally managed economies. Many scholars now recognize that mainstream economic analysis, neoclassical economics, is of little help in restructuring economies that lack secure markets; the same criticism holds for other disciplines in the social sciences (Alston et al. 1996, 1).

Institutional critiques of mainstream economics are not new. Todd Buchholz (1999, 176) very illustratively states that old institutionalists a century ago attacked the marginalists for assuming a smooth, gradual path to a point of equilibrium. Equilibria do not exist; the economy always changes: equilibrium is a daydream of economists who do not live in the real world. Today, new institutional economics is gaining a lot of interest. Malcolm Rutherford (1995, 443) has claimed that the central tenet of both old and new institutional economics is that institutions matter in shaping economic behavior and economic performance. But the two differ in their approach: the old institutional economics rejects the hypothesis of a rational economic player in favor of one that places economic behavior in its cultural context. (1) For new institutionalists mankind is still a rational chooser, but more focus is given to the role of institutions. The new institutional economics works with a set of more neoclassical scissors, which has been pointed out by William Dugger (1990). Regardless of the methodology used, what is important is that institutions are coming to the forefront of economic analysis. New or old, all institutionalists recognize what Thorstein Veblen (1898, 376) said: "Economics is a theory of a process, of an unfolding sequence." And institutions do shape this process. They impact the behavior of economic agents and thus affect economic performance. This can be seen, using the words of Paul Bush and Marc Tool (2003, 10), as the main "point of convergence" in the analytical interests of the original and the new institutional economics. It might be sensible even for hardcore neoclassicists to consider the conclusions of institutional economics at least as a complement to their theory. Figure 1 shows how institutional economics complements modern growth theory in explaining the process of economic growth. (2)


What are institutions? Institutions are the rules of the game in a society--more formally, they are the limitations to free behavior imposed on the individual by the society, shaping the relationships among individuals (North 1990, 3). In the words of J. R. Commons, they represent "collective action in control of individual action." (3) Consequently they have a lot of impact on political, social, and economic relationships in a society. Institutional changes shape and contribute to the evolution of a society in time and affect history. (4) According to Veblen (cited in Bush and Tool 2003, 17), "institutions are products of the past process, are adapted to past circumstances, and are therefore never in full accord with the requirements of the present." Postsocialist economies, with their huge burden of "past processes," have during the last fifteen years been one of the most comprehensive proofs in support of Veblen's definition. The fact that neither economic theory nor cliometric history shows much interest in the role of institutions in economic processes is above all due to the lack of suitable analytical tools by means of which institutions could be efficiently integrated into economics.

Which institutions are important for economic performance? Dani Rodrik (2000, 4) has emphasized the importance of the following institutions: property rights, regulatory institutions, institutions for macroeconomic stabilization, institutions for social insurance, and institutions of conflict management. The classification of institutions into five relatively broad categories includes the majority of institutions important for growth, although others could be added. The importance of private property and the legal system for stimulation need no comment. A stable macroeconomic environment is a necessary although not sufficient condition for growth, but nonetheless the central bank and the state are crucial. Social insurance and institutions of conflict management increase cohesion in the society, which contributes to better economic performance. See also figure 1.

There are several other classifications of institutions into categories. We will at this point mention only briefly the classification used by the Freedom House and the Heritage Foundation, since the data from these two independent organizations will be used in our analysis.

According to the Freedom House, (5) the quality of institutions is measured by grading three areas which all affect economic performance: (1) the democratization process--taking into account the average political process, the role of civil society, the independence of media, and the efficiency of governance and public administration, (2) the rule of law--summarizing the constitutional, legislative, and judicial framework and the level of corruption, and (3) economic liberalization--summarizing the successfulness of privatization, macroeconomic policy, and microeconomic policy.

The Heritage Foundation evaluates ten areas which affect economic performance directly or indirectly: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and foreign investment, banking and finance, wages and prices, property rights, regulation, and informal market activity. All ten areas are important for economic development. Above all in the long run, the property rights, regulation, and stability of the economy (provided by a suitable policy mix) have been shown to be crucial. As we continue, we shall mention another classification of institutions--the Fraser Institute definition. All three are additionally explained and data provided in appendix A. The data from these organizations will serve as a basis to attempt to confirm the importance of institutional quality for economic growth.

An Overview of Previous Analyses

The comparative experience with economic growth over the past few decades after World War II has posed a number of intriguing questions. It has become evident that the growth process itself cannot be explained merely by the simple neoclassical equation stating that per capita product is a simple function of effective (6) labor. As classical political economists have already emphasized, economic growth can be presented only by a much more general equation, assuming that the gross domestic product is a function of the employed production factors, namely capital and labor, their productivity, and institutions. (7) Special emphasis was put on natural conditions, government, and international relations. Many of the theories developed later, especially in the neoclassical tradition, neglected the importance of institutions in the process of economic growth. Nevertheless, many articles published in the last two decades emphasize the importance of institutions as supporting factors in the growth process.

Rodrik (2000) presented one of the most thorough analyses of the role of institutions in the process of economic growth. The analysis takes into consideration the roles of property rights, regulatory institutions, institutions for macroeconomic stabilization, institutions for social insurance, and institutions of conflict management. Although there is some diversity among countries regarding economic growth and the structure and efficiency of the institutions mentioned above, countries with higher quality institutions recorded higher rates of economic growth. Especially important are the roles of property rights, regulatory institutions, and institutions in macroeconomic stabilization. Rodrik emphasized that every well-functioning market economy is a mix of state and market, intervention and laissez-faire. It is the efficiency of the mix...

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