IZA DP No. 5598 Risk, Institutions and Growth: Why England and Not China? Avner Greif Murat Iyigun Diego Sasson March 2011 DISCUSSION PAPER SERIES Forschungsinstitut zur Zukunft der Arbeit Institute for the Study of Labor Risk, Institutions and Growth: Why England and Not China? Avner Greif Stanford University Murat Iyigun University of Colorado and IZA Diego Sasson Goldman Sachs Discussion Paper No. 5598 March 2011 IZA P.O. Box 7240 53072 Bonn Germany Phone: +49-228-3894-0 Fax: +49-228-3894-180 E-mail: [email protected] Any opinions expressed here are those of the author(s) and not those of IZA. Research published in this series may include views on policy, but the institute itself takes no institutional policy positions. The Institute for the Study of Labor (IZA) in Bonn is a local and virtual international research center and a place of communication between science, politics and business. IZA is an independent nonprofit organization supported by Deutsche Post Foundation. The center is associated with the University of Bonn and offers a stimulating research environment through its international network, workshops and conferences, data service, project support, research visits and doctoral program. IZA engages in (i) original and internationally competitive research in all fields of labor economics, (ii) development of policy concepts, and (iii) dissemination of research results and concepts to the interested public. IZA Discussion Papers often represent preliminary work and are circulated to encourage discussion. Citation of such a paper should account for its provisional character. A revised version may be available directly from the author. IZA Discussion Paper No. 5598 March 2011 ABSTRACT Risk, Institutions and Growth: Why England and Not China? We analyze the role of risk-sharing institutions in transitions to modern economies. Transitions requires individual-level risk-taking in pursuing productivity-enhancing activities including using and developing new knowledge. Individual-level, idiosyncratic risk implies that distinct risk-sharing institutions – even those providing the same level of insurance – can lead to different growth trajectories if they differently motivate risk-taking. Historically, risk sharing institutions were selected based on their cultural and institutional compatibility and not their unforeseen growth implications. We simulate our growth model incorporating England’s and China’s distinct pre-modern risk-sharing institutions. The model predicts a transition in England and not China even with equal levels of risk sharing. Under the clan-based Chinese institution, the relatively risk-averse elders had more control over technological choices implying lower risk-taking. Focusing on non-market institutions expands on previous growth- theoretic models to highlight that transitions can transpire even in the absence of exogenous productivity shocks or time-dependent state variables. Recognizing the role of non-market institutions in the growth process bridges the view that transitions are due to luck and the view that transitions are inevitable. Transitions transpire when ‘luck’ creates the conditions under which economic agents find it beneficial to make the choices leading to positive rates of technological change. Luck came in the form of historical processes leading to risk-sharing institutions whose unintended consequences encouraged productivity-enhancing risk-taking. JEL Classification: O10, O31, O43, N10 Keywords: institutions, risk, growth, development Corresponding author: Avner Greif Department of Economics Stanford University Stanford, CA 94305 USA E-mail: [email protected] “Theories of economic growth have failed. These theories are built around a positive rate of technological change, either simply assumed or generated ... by ... assumption.” Robert E. Lucas Jr., 2002, p.110. “Variations in the economic performance across countries (e.g, earlier indus- trialization in England than in China) reflect initial differences in geographical factors and historical accidents and their manifestations in variations in insti- tutional, demographic and cultural factors...” Oded Galor, 2005, Ch. 4. 1Introduction What has led to transitions from pre-modern economies to modern economies? Growth- theoretic models identify two important causes of transition from pre-modern economies to modern ones. In multiple-equilibria growth models, a low-growth economy is a stable equilibrium because decreasing relative risk aversion implies that agents are too risk-averse to choose the modern, high-risk, high-return technology. A transition to a high-growth economy requires exogenous “accidents and good fortune” that disables the low-growth equilibrium (Becker et al., 1990, p. 14) . In ‘endogenous transition’ models, by contrast, low-growth equilibria are unstable and a “transition from stagnation to growth is largely an inevitable outcome of the process of development” (Galor, 2007, p. 472). In particular, time-dependent changes in relative prices, technology, or wealth trigger a transition.1 Both the multiple equilibria and the endogenous transition models have been criti- cized for failing to explain transitions. Multiple-equilibria models invoke accidents (Galor 2005, pp. 176-7) while endogenous transition models "are built around a positive rate of technological change, either simply assumed or generated as an equilibrium outcome by the assumption of [for example] constant or increasing returns to the accumulation of knowledge" (Lucas, 2002, p. 110). This paper theoretically analyzes and historically evaluates endogenous transitions in the absence of accidental changes in wealth or productivity, time-dependent variables, efficient markets, or knowledge of modern technologies. It focuses on how risk-sharing 1 See the review in Galor (2005). For some important contributions to both lines of research, see Kremer (1993), Jones (2001), Galor and Weil (2000), Hansen and Prescott (2002), Gollin, Parente and Rogerson (2002) and Galor (2005). 1 institutions as well as their forms and functions influence individual-level incentives to engage in risky, productivity-enhancing activities. Productivity enhancements require cultivators, producers, and traders to conduct risky experiments.2 Yet, low levels of wealth and decreasing relative risk aversion imply that individual-level risk taking, while socially beneficial, is not likely to be individually rational prior to a transition. Risk- sharing institutions that make risk-taking individually rational can increase productivity and lead to a transition.3 Whether a transition transpires directly depends only on the choice of institutions at the social level and choices about risk-taking at the individual level. We model this argument using an OLG ‘technology transition’ model in which eco- nomic agents choose how to employ their capital.4 An agent’s choice determines the probability of higher future capital productivity. This higher productivity is due to a complex process of the creation of new productivity-enhancing knowledge from which we abstract away. Choosing the ‘traditional’ technology is less likely to generate new knowl- edge but is also less risky. Experimenting is more risky but is more likely to generate new knowledge. This knowledge increases the capital productivity of the agent who discovers it and, once this knowledge spreads, it increases capital productivity more generally. A pre-modern economy is one in which most agents choose the ‘traditional’ technology and the rate of productivity growth is correspondingly low. A modern economy is one where all agents experiment and choose the ‘risky’ technology leading to a high rate of productivity growth. In a transition, the number of agents choosing the risky technology increases over time causing an increase in the rate of productivity growth. Positive externalities imply that agents will employ less capital than socially optimal in the risky technology. Decreasing relative risk aversion implies that poor agents select the traditional technology. If sufficiently many agents are poor, a transition will therefore not transpire and the economy stagnates. A risk-sharing institution can mitigate the impact of low wealth and risk aversion on some agent’s technological choices and initiate an endogenous transition. More specifically, a risk-sharing institution that sufficiently increases risk-taking causes a transition. For reasons discussed below, two institutions that provide the same risk-sharing, can nevertheless have different risk-taking implications. 2 Such risky experimentation was particularly important in the past because the epistemological basis of technology was narrow (Mokyr, 2002). The ability to predict was lower because causal relations were not well understood. Along these lines, Acemoglu and Zilibotti (1997) examine the relations between the indivisibility of risky projects, diversification, and growth. 3 There was, of course, some risk-taking in all pre-modern economies. Some risky activities such as warfare and exploration were taken by those who could pay others to bear the personal cost of failure. Necessity and various means to mitigate risk (particularly in commerce) motivated others to pursue risky ventures. Our model allows – and simulations reveal – some risk taking prior to the transition. 4 Analytically, we focus, without loss of generality, on capital productivity rather than human capital to capture choices with positive externalities (e.g., cultivation techniques). 2 Risk-sharing institutions – in particular,