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Influence Of The Colonial Legacy On Institutions Economics Essay

The topic I have chosen for the project of “Development and Transition” is Institutions and History. I struggled for quite a long time in deciding this topic, and indeed, if it were not for time constraints, I would have preferred to choose a topic from later lectures, which seemed to present a deep and focused exploration into some particularities of the functioning of markets and institutions in developing countries. I am more familiar with, and interested in, topics relating to finance and microfinance, and in the last term, we studied the module of macroeconomic analysis which placed a great deal of emphasis on growth models, including that of Solow and Ramsey. Having been filled with plenty of algebra and equations about the growth model, it is really a good experience to jump off and start to think about economic development from a different standpoint. This was why I decided to choose “Institutions and History” as the home project topic.

Among the six papers relating to this topic, the one which attracts my interest most is “The Colonial Origins of Comparative Development: An Empirical Investigation” by Daron Acemoglu, Simon Johnson, and James A. Robinson (2001, henceforth referred to as AJR). The young, prolific and talented MIT Economist, Acemoglu, published one of his seminal researches in the authoritative “American Economic Review” (AER) together with his regular partners, Johnson and Robinson. ‘Institution matters’ is the main idea the authors are seeking to convey to the reader. Here I would like to present my project in five sections, the first of which is a review of the literature about institutions and development. The second describes the tools used by AJR, and the third discusses the conclusions reached and the contributions made by AJR. The fourth outlines the major criticisms, and the fifth is a reflection.

Literature Review

AJR’s argument is closely related to work about the influence of the colonial legacy on institutions, and Frederich A. von Hayek (1960) finds that countries with legal systems based on common law usually provide better investor protection and have more developed financial markets than civil law countries. Similarly, Rafael La Porta et al (1998, 1999) also emphasise the importance of colonial origin and legal origin on current institutions, and demonstrate that common-law countries and former British colonies have better property rights protection and more developed financial markets. Mahoney (1999) supports Hayek’s claims by providing evidence that common law countries experienced more favourable economic growth than civil law countries during 1960-1992, and suggests that this difference reflects common law’s greater orientation toward private economic activity and civil law’s greater orientation toward government intervention.

In addition to the selected literature in the syllabus, plenty of papers provide empirical evidence which suggests that institutional differences are a major source of the differences in economic performance across countries. For example, cross-country work by a number of economists and political scientists (Knack and Keefer, 1995; Hall and Jones, 1999) found a first-order effect of institutions on growth or the level of income. Among these, Hall and Jones (1999) use distance from the equator as an instrument for measuring social infrastructure. Their rationale for this is that Western Europeans have historically had high quality institutions, and since Western Europeans settled in those areas with climates similar to their homeland, latitude is correlated with Western influence. Kaufmann et al. (1999b) also adopt a similar concept by using the percentage of English speaking and the percentage of speaking a European language as an instrument for their institutional measures, obtaining a strong effect on per capita income.

Instead of emphasising the determination of the identity of the colonisers, AJR (2001) focus on the importance of the quality of institutions for development. Specifically, what matters is not the colonial origins or legal origins; it is the colonisation policies with different associated institutions that really matters. The AJR model contains three premises, as follows:

The Europeans adopted different types of colonisation strategies. At one end of the spectrum, they migrated, settled, and built institutions to support private property protection and a check against the power of the government. In other words, life was modelled on the home country. Examples of these ‘‘settler colonies’’ include the United States, Canada, Australia, New Zealand, Hong Kong and Singapore. At the other end of the spectrum, Europeans did not intend to settle, and instead sought to exploit the natural and human resources. In such ‘‘extractive states,’’ the Europeans did not set up European-like institutions to support private property rights; rather, they established authoritarian institutions in order to solidify their control and facilitate the extraction of gold and other valuable commodities. These institutions were not beneficial for economic progress in the colonies. Primary examples include Congo, Nigeria, Ivory Coast, Ghana, Dahomey, and Tunisia.

The type of colonisation strategy was mainly dependent on the feasibility of settlement. In areas where mortality rates were high among the early settlers, Europeans tended to adopt an extractive strategy. In areas where conditions were favourable for settlement, Europeans tended to form settler colonies. For example, AJR note that the Pilgrims decided to settle in the American colonies instead of Guyana partially because of the high mortality rates in Guyana. Similarly, Engerman and Sokoloff (2000) note that a Puritan colony on Providence Island off the coast of Nicaragua did not last long. Moreover, Curtin (1964, 1989, 1998) notes that the European press published colonial mortality rates widely, so that potential settlers had reliable information about colonial living conditions. Thus, according to the endowment theory, the disease environment shaped the colonisation strategy and the types of institutions established by European colonisers.

AJR argue that the institutions created by European colonisers persisted after independence. Settler colonies tended to produce post-colonial governments which were more democratic and more devoted to securing property rights than extractive colonies. On the contrary, since extractive colonies had already constructed institutions for effectively extracting resources, the post-colonial elite frequently assumed power and readily exploited pre-existing extractive institutions, sometimes making the situation even worse. An example of this is the large number of monopolies and regulations in Latin America which were created by Spain. These institutions remained unchanged for most of the nineteenth century.

In a subsequent paper, AJR (2001) provide further evidence that it is institutions, rather than tropics per se, which matter. They find that, among the colonised countries of the world, societies with higher urbanisation or population density in the fifteenth century have worse institutions and lower income today. Because urbanisation and population density are a good proxy for income, this suggests that there has been a reversal in income ranking between the fifteenth century and today. Since latitude does not change, the tropics hypothesis would claim persistence in income ranking. AJR (2002) then argue that it was the introduction of extractive institutions in highly urbanised places, in contrast with the introduction of ‘‘settler institutions’’ in places of low urbanisation, which explains the reversal in income ranking.

More recently, Easterly and Levine (2002) provide evidence that tropics, germs, and crops affect development through institutions. They find no evidence that tropics, germs, and crops affect country incomes directly other than through institutions, nor do they find any effect of policies on development if institutional variables are controlled. In their model, they use the average of six measures as a proxy of institutional development, including voice and accountability, political stability and absence of violence, government effectiveness, a light regulatory burden, rule of law, and freedom from graft.

Tools used

Economic theory and basic common sense suggest that differences in institutions should have an effect on economic outcomes. However, due to possible causal relationships between the variables, we must be cautious in undertaking econometric works. In econometrics, methods of Instrumental Variables (IVs) are also commonly used to estimate causal effects in contexts in which controlled experiments are not available. The credibility of the estimates hinges on the selection of suitable instruments. AJR use the mortality rates expected by early European settlers in the colonies as an instrument for measuring the current institutions in these countries. Specifically, they regress current economic outcomes on current institutions, and instrument the latter by settler mortality rates. Their logic can be summarised as follows:

(potential)

settler

mortality

settlements

early institutions

current institutions

current performance

Institutions, defined broadly as the political and economic organisation of societies, differ significantly across countries and over time. What is critical is whether the organisation of the society ensures that the society has effective property rights, so that people with productive opportunities expect to gain returns from their investments. Therefore, AJR focus institutional development on property rights and checks against government power. They use the protection against “risk of expropriation” index from Political Risk Services as a proxy for institutions. Since government expropriation is definitely not the only institutional feature that matters, they also use a variety of variables to capture institutional differences among the 64 countries which were ex-colonies, and where the settler mortality rates, protection against expropriation risk and GDP data is available.

To distinguish between the mortality and institutional hypotheses, AJR run two-stage least squares regressions (2SLS), the results of which demonstrate that there is a strong first-stage relationship between settler mortality rates and current institutions, with the settler mortality alone explaining 27 percent of the differences in institutions today. The corresponding 2SLS estimation of the institutions on income per capita is 0.94, which is highly significant.

Conclusions reached and contributions

North (1981) defines an institution as “a set of rules, compliance procedures, and moral and ethical behavioural norms designed to constrain the behaviour of individuals in the interests of maximising the wealth or utility of principals”. Since the two outstanding institutional economists, Coase and North, were awarded the Nobel Prize in the early 1990, it seems that the significance of institutions is not in doubt. However, are institutions the key determinant factor for economic growth? Some scholars are still arguing the causal relationship between institutions and economic growth, namely whether institutions bring about economic performance or if rich countries have more ability to establish higher quality institutions. Debates like “which came first, the chicken or the egg?” are always a popular topic among economists and social scientists.

Although many institutional economists argue that differences in institutions are at the root of large discrepancies in income per capita across countries, as AJR note, “there is little agreement about what determines institutions, making it difficult to isolate exogenous sources of variation in institutions to estimate their effect on performance.” Now the story of AJR is undoubtedly fascinating. The current institutions of the colonies depend on past institutions, and past institutions were mainly influenced by the settlers’ different colonial strategies, which in turn, depended on the feasibility of the settlements. In areas where early European settlers faced potentially high mortality rates, they lacked the incentive to establish long-run institutions to secure property rights and tended to exploit, which caused “bad” institutions. In contrast, “good” institutions were built for areas more suited to migration. Therefore, the differences in institutions caused the discrepancies in economic performance.

As can be seen from previous contexts, AJR used very common econometric tools of Ordinary Least Squares (OLS), without the requirement of complex techniques and mathematics, to develop a powerful link between mortality, settlements and institutions. They found that as much as three-quarters of the income gap between the top and bottom of the world’s income distribution may be due to differences in institutions. The robustness of AJR is quite comprehensive. In addition, a couple of interesting results are also found in their model, one of which is that the identity of the colonisers, the legal origin and religion, previously argued by many institutional economists, are not key determinants of institutional development once the effect of institutions is controlled. The work of AJR greatly influenced subsequent researchers by reinvigorating the debate over the relationship between property rights and economic growth. According to the statistics of Google’s scholar search engine, their work has been cited 3,497 times until now, which means that, on average per year, it is cited by almost 350 articles or papers!

Criticism and Defence

Interesting stuff always attracts criticism, and in his paper “Do Institutions Cause Growth?” (2004), Shleifer, another talented economist from Harvard University and a neighbour of MIT, raises indirect, but sharp, doubts. He revisits the measurement of institutions used by AJR, namely the “risk of expropriation” by the government, and argues that it is an outcome measure which reflects the government’s past restraint from expropriation, not the permanent characteristics referred to by North. For example, although dictatorial countries, such as Singapore, respect property rights and receive high scores in the “risk of expropriation” index, dictatorship cannot be said to be a good institution. More interestingly, Shleifer uses the instruments previously used by AJR for institutions, and demonstrates that they are even more highly correlated with human capital, both today and in the nineteenth century, and that, in terms of instrumental variable specifications predicting economic growth, human capital performs better than institutions.

The most severe criticism comes from Professor Albouy (2004a, 2004b, 2006, 2008), from the University of Michigan. In his latest paper, he argues that there are a number of reasons to doubt the reliability and consistency of AJR’s European settler mortality rates and the conclusions which depend on them. Firstly, only 28 of the 64 countries in their sample have mortality rates which originate from within their own borders. The other 36 countries in the sample are assigned rates based on AJR’s conjectures as to which countries have similar disease environments. These assignments are based on weak, and sometimes mistaken, foundations. Among these, AJR misunderstand 6 former names of countries in Africa. Another 16 assignments are based upon the questionable use of bishop mortality data in Latin America from Gutierrez (1986),whereby AJR use the bishop rates multiplied by a factor of 4.25. Secondly, the mortality rates do not come from actual European settlers. Instead, they come primarily from European and American soldiers in the nineteenth century. In some countries, AJR use rates from soldiers in peaceful periods, while in others, they use rates from soldiers at war. Soldiers at wars typically have higher mortality rates from disease, and AJR use rates from wars more often in countries with greater expropriation risk and lower GDP, thereby artificially favouring their hypothesis. Finally, Albouy concludes that, if these 36 questionable mortality rates are dropped from the sample and the control of the source of the mortality rates, the empirical relationship between expropriation risk and mortality rates virtually disappears!

However, when responding to the severe comments from Albouy, the members of AJR do not step aside, but keep defending themselves. AJR (2005) argue that their original coding of the data was not inconsistent, questionable, or erroneous. Instead, they claim that Albouy’s results are entirely driven by inconsistent, incorrect, selective, and unreasonable revisions to their original data, particularly where Africa is concerned. In their second response, AJR (2006) demonstrate that their results regarding the positive effect of institutions on income per capita are just as strong and robust, even if all of the African data is excluded from the sample.

Indeed, not all of the available primary data sources can have been investigated by every researcher, and there must be numerous potential sources which could contain new material about the mortality rates faced by potential European settlers. It seems to me that what Albouy should have done is to carefully incorporate this data instead of merely offering such devastating criticism. Perhaps, ultimately, no one issue can be proved to be absolutely correct. Sometimes, the pursuit of truth per se is simply a kind of faith, which has nothing to do with science, and the fact that economists never agree on one thing fills the world of economics with challenges and makes it fun to explore.

Reflections

While AJR’s work is broadly recognised and supported by many economists (e.g. Auer, 2007) and the claims made are of tremendous importance for scientific motivation, what can be done about them remains in significant doubt. For example, is more research needed into the role of health policies?

Recently, Henry and Miller (2008, hereafter referred to as HM), Professors from Stanford University, published a case study on Barbados and Jamaica, which seems to provide a striking counter example to AJR’s view of development determination. As former British colonies, both countries inherited almost identical political, economic, and legal institutions, and yet they experienced markedly different growth after their independence. From 1960 to 2002, Barbados' GDP per capita grew roughly three times as fast as that of Jamaica, and the income gap between Barbados and Jamaica is now almost five times larger than at the time of independence. The evidence implies that difference in the choice of macroeconomic policies, rather than the difference in institutions, is the major determinant of the divergent growth experiences of these two Caribbean nations. If such a case prevails, the logical link of AJR is broken.

Thus, HM argue that the macroeconomic decisions of governments can have just as much influence on the trajectory of the economy as the institutions within which those decisions take place. Countries may have no control over their colonial heritage, legal origin, or geographic location, but they do have governance over the policies they implement. For example, of particular importance for most small open economies in the world is the policy response of a fall in terms of trade when they face macroeconomic shocks.

In conclusion, I would like to make a brief self-examination on the development experiences of my home country, Taiwan. New York Times columnist, Thomas L. Friedman, a three-time Pulitzer Prize winner, paid a visit to Taiwan months ago and indicated that, with a population of 23 million, despite the nation’s lack of natural resources and the high frequency of natural disasters, Taiwan has accumulated the world’s fourth-largest foreign exchange reserves. He attributed this achievement to the wealth of human capital found on the island, and proposed that innovation was the most crucial renewable resource possessed by the nation.

It is widely recognised that state capitalism is the major force behind tiny Taiwan's economic status, its indispensable role in the global supply chain, and its evolution into a high-tech bastion. The government harnessed its power to steer the economy, and converted limited land and resources into development technology, transforming Taiwan from an agricultural society into an industrial economy, and moving the country toward economic modernisation. The importance of the strong will of government officials to develop the country at that time cannot be ignored. No matter how plausible the work of AJR, the policy-makers and the people on the island prefer to accept the claims of Shleifer, Henry and Miller, and ignore their history of once being the first colony of Japan. During its 50 years of colonisation, Japan rapidly developed its commercial relations with the island and transplanted its own economic institutions without delay, which has had a profound impact on Taiwan right up until today.

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