PhD Course: Development Economics – Macro Aspects Chapter 1.

Governance: Introduction

What drives growth and development?

BA and MA courses: factor accumulation and productivity
This course: “Deep Determinants”.

A Natural Experiment: Korea

Until end of WW II under Japanese occupation. Independence 1945.
Then Soviet forces entered North Korea and took over control of these provinces
under leadership of Kim Il Sung. It became the Democratic Peoples Republic of
Korea
The U.S. supported the South. Election 1948: a new constitution, establishment of
the Republic of Korea.

Note: both countries shared the same

history and cultural roots
same ethnic homogeneity
approx. same geography and disease environment
approx. same natural resources
same initial level of development (e.g. degree industrialization, education)
but adopted a completely different set of political and economic institutions.
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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Well, and you know that

South Korea was transformed into one of the Asian ”miracle” economies.
Became OECD member.
GDP per capita in year 2000: $16.000.

We know relatively little about the North:

It stagnated on the level of an SSA country.
Famines from time to time.
GDP probably below $1000.

A similar experiment with qualitatively similar (yet less drastic) results: East and West
Germany.

Or compare China
under Mao
under Deng Xiaoping
(1000 years ago)

Obviously, governance can be good or bad for growth.

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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Yet why do we need governance at all?

market failure
income redistribution.

Correction of market failures:

public good provision: infrastructure, defense, rule of law,...
internalization of externalities
I positive ones: education, R&D (recall Part II), ...
I negative ones: pollution, ...
monopolies: natural monopolies, regulation.

But then how can it be bad for growth?

regulation inhibits competition and efficiency ( → privatization, de-regulation)
government finance: taxes drive down incentives
the government (the ”state”) is not a benevolent welfare maximizer.

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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Recall the undergraduate macro-textbook view of the state: The state as a non-actor:
a state without agency
without its own objective function
the state does not represent the interests of some groups in the society
→ any call for the state to intervene resulted from market failures.

Alternative views of the state:

The state as a nexus of cooperation.
The state, by virtue of its coercive power, encourages cooperation among social
groups.
This does not necessarily imply a benevolent state or democracy.
Hobbes’ Leviathan
Rousseau’s social contract.

The state as the agent of a social group/ruling class, e.g.

landed aristocracy
capitalists
dictatorship of the proletariat.
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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

The state as autonomous bureaucracy:

Politicians and bureaucrats acting on behalf of society or special social groups
Optimal bureaucracy (Weber)
Principal agents problem (Buchanan, Tullock)
Evil bureaucracy: the state as grabbing hand
( → the IPE course)

The Rule of Law.

probably the most essential task of a state (Nachtwächterstaat)
the state as a monopoly of violence.
Top 1 for economists: provision and enforcement of property rights: legal code,
independent jurisdiction, (non-corruptible) police, courts, military,...

Why are secure property rights so important?

long-term commitments, safe returns → incentives for capital accumulation
intellectual property → incentives for innovations, R&D-driven growth.

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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Nowadays
consensus among researchers:property rights are the most powerful predictor of
economic well-being.
debate about what else matters independently (e.g. geography).

Freeman and Lindauer (Why not Africa?):

There is no simple nor single recipe for achieving economic growth, but there is one way
to prevent growth: through instability and absence of property rights.

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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Rule of law is a composite index: enforceability of contracts, predictability of judiciary,

incidence of crime.

Keefer and Knack, 1997, Why don’t poor countries catch up?, Economic Inquiry 35,
590-602.
Measures of institutional quality are strongly correlated.
Any measure is strongly correlated with growth even after controlling for other
potential determinants of growth.
Poor countries with excessively deficient institutions fail to catch up.
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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Professor Dr. Holger Strulik 8 / 18

 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Taxation and Growth of the Government Sector.

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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Growth of the government sector (Wagner’s law)

Baumol’s cost disease: government is a sector of low productivity growth →
recall the two-sector growth model from Part II.
socio-economic position of the decisive voter → more later.

Why can government growth affect economic growth?

rising income share of taxes → disincentives for the private sector.
rising incentive to avoid taxes → inefficiency.
government debt is no way out (recall Ricardian equivalence).
Note: different taxes are differently harmful for growth.

Recall from Public Finance: taxation implies inevitably a welfare loss.

Insert Figure: Excess burden of taxation

Note the tax could be on a consumption good, oil, labor income, capital income, money
holdings (seignorage), ...
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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Observe:
consumers lose consumer surplus
producers lose producer surplus
for given taxes the losses depend on the slopes of supply and demand
for given market structure the losses are the higher the higher the tax rate.

The Ramsey problem: how should we design taxes in order to minimize inefficiency (and
to finance a given budget). → Optimal taxation.

A point estimate: 1 Dollar of government spending costs 2 Dollars of taxation (Feldstein,

1997). Yet note that costs of taxation are convex.

Optimal taxation is an interesting problem of normative theory. Positively, we have to

explain why actually observable government policy is frequently inefficient....

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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

We will tackle the following issues

Distribution conflicts arising through
I class conflict (income inequality)
I ethnic conflict.
Evil rulers (dictators, kleptocrats vs. democracy)
Evil bureaucracy: rent seeking, corruption

On average, poor countries have worse governance than rich ones. Yet what is cause and
what consequence? (Note the importance of the answer for aid policies).

1. High income causes good governance:

Today’s rich countries also started out with relatively poor governance.
Good governance is a luxury good.
Rich countries can afford to pay reasonable wages for their bureaucrats.
Mass education → public spiritedness → honest citizens and government.

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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

2. Good governance causes high income

The argument is mainly based on historical observation/empirics
the reversal fortune
colonial origins

Reversal of Fortune: countries that were intially rich (in natural resources, talent, ...)
were overtaken by countries with the better institutions (governance):
Latin America
China
More on that later.

Colonial Origins of Comparative Development (Daron Acemoglu et al., 2001:, American

Economic Review 91, 1369-1401):
Idea: depending on their survival prob. the colonialists founded:
Neo-Europes: large settlements, good institutions: U.S., Canada, Australia, New
Zealand (South Africa ?)
Extractive States: small settlements, bad institutions: Sub-Saharan Africa, South
East Asia.
Since institutions change slowly, Acemoglu et. al used settler mortality as instrument:

mortality at colonial times → settlements → early institutions → current institutions →

current performance.
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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Note:
Focus on income levels (not growth)
Focus on former colonies
Settler mortality 150 - 200 years ago.
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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Note: a high index number for Expropriation Risk means low risk of expropriation.
Observe: a strong relationship between settler mortality and current exprop. risk

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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Results
The effect of institutions is large.
The 7-fold difference in income between Chile and Nigeria is almost completely
explained by the 2.24 point difference in their expropriation risk (2 countries on the
regression line).
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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Latitude turns then out to be insignificant as direct regressor → “Institutions Rule”

literature.
Ethnolinguistic fractionalization turns out to be significantly negative → later.
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 PhD Course: Development Economics – Macro Aspects Chapter 1. Governance: Introduction

Critique:
Settler mortality correlated with mortality today → health and fertility lectures.
The indices don’t measure institutions but outcomes of institutions.
e.g. France and Singapur have very different institutions but approx. the same
property rights indices.
(Strategic?) Flaws in data collection for settler mortality (Albuouy, AER 2012).
More on property rights → later.

Anyway, Acemoglu et al. (2001) is already one of the most cited, re-assessed, and
debated articles of growth theory.
It instigated the ongoing debate about the Deep Determinants of economic growth.

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