Institutions, capital, and growth.

• Author: Hall, Joshua C.

1. Introduction

   The causes of economic development have been studied before Adam Smith made his inquiry into the causes of the wealth of nations. As a field of study, however, economic development did not really exist until after World War II (Arndt 1997). The first development economists focused primarily on the accumulation of physical capital as the driving force in economic growth. (1) For example, Paul Rosenstein-Rodan, Sir Arthur Lewis, and Walt Rostow all argued that developing countries suffered from a "poverty trap," where they could not afford to save enough to accumulate the necessary amounts of physical capital to grow (Easterly 2006a). This focus on the accumulation of physical capital provided the intellectual impetus for the large sums of foreign aid provided to developing countries by international aid agencies post-World War II because aid was seen as being crucial to giving poor nations the physical capital they needed to break out of the "poverty trap." The notion that developing countries are in a poverty trap that prevents them from accumulating physical capital is still alive today, both in the actions of the World Bank and International Monetary Fund (IMF) as well as in the research of economists such as Jeffrey Sachs. (2)

   In the 1960s and 1970s, the pioneering work of Schultz (1961) and Becket (1964) on human capital caused development economists to augment their standard economic growth models to allow for human capital investment to play a role. Early research into the effects of formal education on economic growth found that education seemed to explain a significant portion of economic growth (Hall 2000). These findings led development economists to focus on human capital as a primary factor of production throughout the 1980s and 1990s (Coyne and Boettke 2006). International development organizations such as the World Bank encouraged high levels of government investment in schooling in an attempt to increase human capital levels. (3) As a result of these efforts, there was a tremendous expansion of schooling in nearly all developing countries (Easterly 2001). According to Pritchett (2001), since 1960 primary enrollments in developing countries increased from 66 to 100% and secondary enrollments rose from 14 to 40%.

   There is little evidence to suggest that efforts to increase either physical or human capital levels in developing countries, especially in Africa, have been successful in generating growth. Good historical data on public investment in capital is available for 22 African countries since 1970. From 1970-1994, those countries received $187 billion in aid and spent $342 billion on public investment, only to achieve zero per capita growth (Easterly 2006b). The same can be said of the increases in formal schooling stimulated, in part, by foreign aid. Easterly (2001) details how sub-Saharan African countries had larger increases in schooling than any other region since 1960. Yet these countries remained mired in poverty while Asian "tigers" like South Korea and Taiwan had smaller increases in education levels but flourished economically. In cross-country growth regressions, Pritchett (2001) finds no relationship between increases in education and increases in output per worker. Similarly, Gwartney, Holcombe, and Lawson (2004) find that the growth of human capital per worker is not related to per capita gross domestic product growth. (4)

   The macroeconomic evidence is somewhat paradoxical because it is contrary to the microeconomic evidence that increases in physical and human capital increase individual productivity and remuneration. After all, it would seem that summing all individual positives within a country should aggregate to a social positive. Yet in many countries this is clearly not the case. In an important paper trying to figure out "where all the education has gone," Pritchett (2001) provides a possible solution to this paradox. He argues that in some countries the institutional environment could be so perverse that increasing education actually leads to lower growth. (5)

   More generally, societal payoffs to improvements in the levels of both physical and human capital are likely dependent on the institutional context in which those investments occur. In countries with good institutions--where the social, political, and legal rules provide for secure property rights, unbiased contract enforcement, and reliance on market prices and profits and losses to guide economic activity--investments in capital are both privately beneficial to individuals and also create a positive return for society as a whole. In countries with poor institutions, however, the higher returns to investments in rent-seeking activities that plunder the wealth of others, through lobbying and lawsuit abuse, for example--draw significant resources into these privately beneficial, but socially unproductive activities. Investments in education produce more lobbyists, politicians, and lawyers, rather than engineers and scientists. (6)

   Building on Pritchett's (2001) insight, this article examines the relationship between institutional quality and the impact of human capital accumulation on economic growth, (7) We also extend this analysis to physical capital. We begin by integrating this hypothesis into the augmented Solow (1956) growth model of Mankiw, Romer, and Weil (1992). In this respect, our theoretical approach is a clear extension of the work of Dawson (1998) who was the first to incorporate institutions into the standard growth models. We then empirically test this hypothesis by interacting institutional quality with both physical and human capital in cross-country growth regressions. In this respect, our article is closely connected to the valuable work of Stroup (2007, 2008) who uses a similar approach to separate out the influence of political and economic institutions on different human welfare indicators.

   We use data on "risk of expropriation" from the International Country Risk Guide (PRS 2007) as our primary measure of institutional quality. The PRS Group annually grades each country using a 0-to-10 scale with a score of 0 being consistent with a high risk of confiscation or forced nationalization of property and a score of 10 indicating an extremely low risk of expropriation. We find that the relationship between increases in human capital and economic growth is indeed negative for countries with perverse institutional environments. We calculate that for countries with risk of expropriation scores below 7.33 (e.g., South Africa, Costa Rica), additions to the stock of human capital have a negative effect on growth of output per worker. The relationship between growth of physical capital per worker and output per worker also is negative in countries with poor institutions, albeit at a much lower level. We find that the relationship between increases in physical capital per worker and output per worker turns positive at around a risk of expropriation score of 4.90 (roughly equivalent to Uganda).

   [FIGURE 1 OMITTED]

2. Institutions, Capital, and Growth of Output per Worker

   The conventional perspective on the marginal effect of increases in physical and human capital on economic growth is that they have the same marginal effect regardless of the level of institutional quality. Figure 1 illustrates this view. The figure shows the marginal effect of a change in capital per worker on the change in output per worker conditional on the level of institutional quality. From this perspective, an additional unit of capital has the same impact on economic growth whether the country is in a good institutional environment or a poor one. To put it in the context of human capital, an additional year of education in the Democratic Republic of the Congo would have the same effect on the growth of output per worker as a year in Australia.

   This view is incorrect because it ignores the impact of institutional quality on the productivity and allocation of labor. An additional year of education in the Democratic Republic of the Congo is not the same as an additional year of education in Australia because of the opportunities provided by the overall institutional environment. (8) The best opportunities for more educated individuals in countries with low-quality institutions are more likely to be zero-or-negative sum, such as working in the government bureaucracy. When the institutional environment is "bad," increases in education levels will be less socially productive than in countries with a "good" institutional environment. While individuals will always choose the occupation that gives them the highest personal return, good institutions create a correspondence between positive personal and positive social returns.

   [FIGURE 2 OMITTED]

   In the long run, the higher payoffs to public sector activity distort the choices individuals make in the types of education to acquire. Thus in a society where the payoffs to the private sector are low because of poor institutions but payoffs to the public sector are high (also because of poor institutions), individuals will tend to invest in human capital more valued by the public sector. For example, Nobel Laureate Sir Arthur Lewis discusses in his Nobel Prize lecture how he wanted to be an engineer but could not find employment in St. Lucie as an engineer because of discrimination, thus he went into business studies with the goal of working in the civil service or private sector (Lewis 1992). While both the public and private sector employ engineers, the issue is that in countries with poor institutional environments, the payoffs to being a private sector engineer will be lower; thus we will get fewer engineers, and the ones we do have will be less alert to positive-sum entrepreneurial opportunities.

   Countries with bad institutions have more zero- or negative-sum opportunities, and thus the marginal effect of more education could be negative if enough of the...