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Florida State University Libraries Electronic Theses, Treatises and Dissertations The Graduate School 2010 Determinants of Economic Institutions Matthew Eldyn Brown Follow this and additional works at the FSU Digital Library. For more information, please contact [email protected] THE FLORIDA STATE UNIVERSITY COLLEGE OF SOCIAL SCIENCES AND PUBLIC POLICY DETERMINANTS OF ECONOMIC INSTITUTIONS By MATTHEW ELDYN BROWN A Dissertation submitted to the Department of Economics in partial fulfillment of the requirements for the degree of Doctor of Philosophy Degree Awarded: Summer Semester, 2010 The members of the committee approve the dissertation of Matthew Eldyn Brown defended on May 20, 2010. _________________________________________ Bruce L. Benson Professor Co-Directing Dissertation _________________________________________ James D. Gwartney Professor Co-Directing Dissertation _________________________________________ Douglas Stevens University Representative _________________________________________ Randall G. Holcombe Committee Member _________________________________________ R. Mark Isaac Committee Member The Graduate School has verified and approved the above-named committee members. ii ACKNOWLEDGEMENTS The research presented here is the culmination of a long process of intellectual development and discussions with numerous gifted friends and advisors. In particular, I thank Jon Wisman of American University with whom I first discussed the work of Jared Diamond and Jane Shaw for organizing a Liberty Fund conference on the book Guns, Germs and Steel, both of which sparked my interest in geography and economic institutions many years ago. Since then my professional development as an economist has been significantly advanced by my friends Dan Klein and Rick Stroup. Jim Gwartney and Bruce Benson provided significant guidance and insight over the course of a long summer developing the questions explored here and have generously—and patiently— provided valuable feedback along the way as co-directors of my research project. Early input from Dave MacPherson and Jon Klick was also helpful. I thank Randy Holcombe, Doug Stevens and Mark Isaac for their support and feedback on the project and their service on my committee. The support of the Charles G. Koch Charitable Foundation and its staff is also greatly appreciated. Finally, I thank Lora Holcombe for first teaching me to fall in love with economics and helping to start me on this extraordinary journey. iii TABLE OF CONTENTS List of Tables vi List of Figures viii Abstract ix INTRODUCTION 1 1. INSTITUTIONS AND ECONOMIC PERFORMANCE: A REVIEW OF THE LITERATURE 5 Geography, Endowments and Institutions 8 Policy, Growth and Institutions 10 Institutional Hypotheses 11 2. DESCRIPTION OF MAJOR DATA SOURCES 17 Economic Freedom of the World 17 Index of Economic Freedom 21 World Development Indicators 21 Human Development Index 21 Freedom in the World 22 Polity IV 24 Fractionalization 25 3. CHANGES IN INSTITUTIONAL QUALITY SINCE 1980 29 Introduction 29 Case Study Selection 30 Case Studies 34 Summary of Case Studies 99 Chapter 3 Conclusion 106 4. DETERMINANTS OF INSTITUTIONAL CHANGE 109 Introduction 109 Economic Freedom and Economic Performance 110 Economic Freedom, Geography and Size 113 Why Might Small Countries Have Better Institutions? 116 Other Geographic Characteristics 117 Geography and Subcomponents of Economic Freedom 125 Non-Geographic Factors Influencing Economic Freedom 126 Conclusion 137 iv CONCLUSION 139 REFERENCES 145 BIOGRAPHICAL SKETCH 169 v LIST OF TABLES Table 2.1. EFW Ratings for 2004 20 Table 2.2. Freedom House Scoring 23 Table 2.3. Freedom House Ratings 23 Table 3.1. Improvements in Economic Freedom 31 Table 3.2. Improvements in Economic Freedom Relative to Possible Improvement 32 Table 3.3. Case Studies 33 Table 3.4. Estonia 39 Table 3.5. Latvia 39 Table 3.6. Lithuania 40 Table 3.7. Chile 43 Table 3.8. Republic of Congo 45 Table 3.9. El Salvador 48 Table 3.10. Ghana 50 Table 3.11. Hungary 54 Table 3.12. Iceland 57 Table 3.13. Ireland 59 Table 3.14. Israel 61 Table. 3.15. Jamaica 64 Table 3.16. Kuwait 66 Table 3.17. Myanmar 70 Table 3.18. New Zealand 72 vi Table 3.19. Nicaragua 75 Table 3.20. Peru 78 Table 3.21. Poland 80 Table 3.22. Tanzania 84 Table 3.23. Uganda 87 Table 3.24. United Kingdom 89 Table 3.25. Venezuela 91 Table 3.26. Zambia 95 Table 3.27. Zimbabwe 99 Table 3.28. Case Summaries 100 Table 4.1. Economic Freedom and Growth of Per Capital GDP 113 Table 4.2. Geography and Economic Freedom 122 Table 4.3. Economic Freedom and Geography with Natural Hazards and Endowments 124 Table 4.4. Geography and Subcomponents of Economic Freedom 126 Table 4.5. Economic Freedom and Openness to International Trade 129 Table 4.6. Economic Freedom and Civil and Political Freedom 132 Table 4.7. Economic Freedom and Civil and Political Freedom Reexamined 133 Table 4.8. Fractionalization and Economic Freedom 135 Table 4.9. Economic Freedom and Economic Performance 136 vii LIST OF FIGURES Figure 3.1. Global Economic Freedom Average: 1980 to 2004 106 Figure 3.2. EFW Area Scores: 1980, 1990 and 2000 107 Figure 4.1. Per Capita Income and Economic Freedom by Quartile 110 Figure 4.2. Average Growth Rates and Economic Freedom by Quartile 111 Figure 4.3. Economic Freedom in 1980 and Income in 1980 and 2004 112 Figure 4.4. Economic Freedom and Area by Quartile 115 Figure 4.5. Economic Freedom and Population by Quartile 116 Figure 4.6. Map of Europe and China: Does Shape Matter? 118 viii ABSTRACT This dissertation explores the factors that determine the variation in institutional quality among nations. Previously, a growing body of literature has demonstrated the importance of economic institutions in determining prosperity, but significantly less work has been dedicated to understanding how those institutions are determined. A brief review of the literature on economic performance and institutions is provided as is a discussion of the various datasets used to measure institutional quality. Twenty-four case studies are presented of countries that have experienced significant changes in their economic institutions since 1980 with common experiences and themes developed that may account for changes in institutional quality. Empirical analysis demonstrates that geographic factors, particularly the ease of exit from a country, play a significant role in determining institutional quality. Openness to international trade is also shown to be a significant factor. Political factors and fractionalization are less important when these other characteristics are taken into account. ix INTRODUCTION The role and importance of institutions in economic growth is a topic that has been around as long as economics itself. But much of the work in post-World War II macroeconomics deemphasized institutions and focused instead on inputs into the production function, such as labor and capital, as the fundamental sources of aggregate economic performance. However, the institutional approach received renewed interest and legitimacy within the economics profession in the early 1990s. The collapse of the Soviet Union led to a serious reevaluation of the failures of central planning and the importance of markets in economic activity along with widespread disenchantment with socialism more generally. Then the awarding of the Nobel Prize to Ronald Coase in 1991 and Douglas North in 1993 helped refocus attention among the mainstream of the economics profession on the importance of institutions. Largely left out of the mathematical models of macroeconomics and development because of their difficulty to define and measure, institutions have since begun to receive increasing attention as a primary determinant of economic growth. Drawing on the work of North and others on why institutions matter, economists have more recently been asking how to measure institutions and test their importance empirically. The Economic Freedom of the World project of the Fraser Institute and the Doing Business report of the World Bank, which was inspired by the work of de Soto, are among a group of widely-used measures that have been developed to quantify institutional quality. A growing body of work has been produced using various indicators of this type to test the impact of institutions on economic performance with broadly consistent results. As Acemoglu and Johnson (2005) observe "there is a growing consensus among economists and political scientists that the broad outlines of North's story are correct: the social, economic, legal, and political organization of a society, that is, its 'institutions', is a primary determinant of economic performance" (2005, 949). But many questions remain to be answered. If "institutions rule" as one recent paper claimed (Rodrick et al. 2004), why don't countries with poor economic performance adopt "good" institutions? An emerging field of research is now beginning to address that question both theoretically and empirically. This dissertation will seek to advance that literature by asking: What factors determine why some countries adopt institutions that are more conducive to long-run economic growth while others fail to do so? This research project is the outcome of a long intellectual evolution that I began in the late 1990s studying institutional economics in the graduate school at American University. The AU approach to economics emphasizes heterodox thinking and included a good deal of study in institutional economics and economic history, as well as touching on feminist economics, Marxian theory and cultural studies and social history. The initial spark for the questions addressed here was discussions around the book Guns, Germs and Steel, which came out around the time I was finishing at AU. Those discussions eventually resulted in me helping to put together a Liberty Fund colloquium led by Jane Shaw at Big Sky Ranch in Montana. The other major contributor to my interest in this topic came from my work at the Florida State University with Jim Gwartney focusing on the economic freedom of the world project. That work, as well as a summer spent 1 surveying the institutional growth literature with Jim Gwartney and Bruce Benson, led to the outline of the questions that are ultimately presented here.