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What Causes Economic Growth? Institutions or Human Capital?

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Sybren Dijkstra, Catello Alvino

Growth, Institutions and Business

  • Rijksuniversiteit Groningen

Introduction

An increasing amount of empirical research has been focused on measuring and approximating the effects of historical variables on the economies of today. There seems to be a chicken or the egg story in the literature: Do political institutions cause economic growth or does economic growth, through human capital, lead to better institutions? There seems to be a gap in the literature around the colonization period concerning human capital and institutions. We would like to add to this debate by researching the period before the colonization, using empirical research. We would like to add to this debate by researching the period beforearound the colonization period: Could it be possible that the human capital people broughtbrought by people to the colonies was gained due institutions in their native countries and that therefore institutions cause better human capital and therefore growth? In this essay we will bring across a simple message: you first need institutions to create human capital, in order to foster growth.? First we will lay the foundation of our theory by discussing empirical works that cover theperiod before the age of imperialism. Then we shall discuss the empirical proof that institutions do cause growth, after which we will analyze refute the human capital side argument. Finally, we will sum up our findings and provide suggestions for further research.

Reversal of fortune and the importance of institutions

Acemoglu et al. (2003) deliver a detailed analysis on different outcomes of today’s post-colonial countries. It was found that the divergence in economic development that is observable among former colonies is caused by the way the settlers established institutions in the area. Indeed, it is easily seen that regions like North America have shown to perform much better than countries located in Central and Southern America and in other parts of Africa colonized by roughly the same populations. Essentially, in the areas where resources were relatively scarce and population density was low, the pioneers established institutions pretty similar to the ones they had in their homeland, implementing systems of property rights protection that stimulated investments. In areas where resources and indigenous inhabitants were abundant, the settlers created “extracting institutions”, where their goal was not a long lasting development, but just a depletion of resources. These institutions were based on property rights restricted to an enclosed elite that consisted of the European settlers, in which the indigenous population was not included. not of indigenous people but that excluded the indigenous people., who The indigenous peopley were forced to work, mostly in conditions of slavery, in order to yield the highest profit possible. This explains why countries which were prosperous before the colonization, are today performing much significantly worse than countries where institutions were accessible to by all the inhabitants. Therefore, what these findings really show is that human capital is not the ultimate deep cause of eof better institutionsconomic development, but that instead it is the proximate cause., Indeed the true cause of why some colonies thrived and others haven’t ofare institutions and these institutions which supplied the legal foundations, including property rights being the ultimate cause.

More evidence on thisin favor of our thesis is given by Acemoglu et al. (2014), who gathered data about the literacy of the different settlers. They showed that the conquistadores that who colonized South and Central America where much moresubstantially better educated (at least speaking about literacyusing literacy as a proxy for the level of education) than the English settlers colonizing North America. Nevertheless, the latter turned out to be better developed in the future. Acemoglu et al. (2014) finds again that the primethe reason forof this difference is into the kind of institutions that were in place. Besides this explanation, there is another key variable missing; the education these settlers received in their homeland. Institutions and human capital did not come out of the blue, but most of the papers written supporting the human capital argument assume everyone starts off from square one, so to say, when they arrive in the colony. For example, a person educated as an engineer does not lose his engineering knowledge, once s/he arrives in the colony, like the human capital argument suggest. Furthermore, Acemoglu et al. (2014) show that there is no significant support for the human capital argument that differences in the human capital endowments of colonists have been a crucial factor in the institutional development of these institutions. The way institutions were established by the colonists was deeply influenced by the institutions in their home countries. Especially before those colonies became independent they were legally dependent on their homeland, with roughly the same institutions, the difference being that these institutions were reshaped in order to comply with territorial needs. The new communities established would base their institutions on the ones they were used to in their native country. Of course with time some switched to different systems, but the so-called seed that let the tree grow was coming from somewhere else. And this “somewhere else” is indeed their country of origin and its institutions.

Considerations on the human capital theory

In this section we are going to better explain why we consider the claim that human capital is the prime cause of economic development is wrongeconomic growth causes better institutions is inconsistent. In a prominent human capital argument article by Glaeser et al. (2004) the relation between human capital and growth is the point of discussion. The authors claim that countries possessing more human capital in the past performed better than others, independently by which institutions they were established before the introduction of human capital. They affirm that human capital is not caused by institutions, but that instead it causes themhuman capital causes growth and therefore better institutions. Granted, Glaeser et al. (2004) has the same requirement as we propose for growth; property rights. However,We strongly disagree with that view. A population can have as much human capital as they can accumulate, but if it is not pushed to its real potential, it fails to improve a society’s economic situation. we then wonder how a society can gain human capital, without well-functioning institutions that provide property rights. If that society does not protect property rights or does not give to all its components roughly equal rights, growth will be slower, if not completely absent. people will not invest in human or physical capital, since the payoff of the investment is uncertain. Think about a generic example: if a society does not protect anyone’s property but just the property of a closed elite, outsiders who might have groundbreaking ideas, will probably not get to develop their ideas, given that in this way they might not have the means to do so or they might just not be given the incentive to fulfill their potential. This is exactly what we think has happened in the extracting societies: even if the conquistadores were better (according to the literacy measurements made by Acemoglu et al.) were pretty educated on average, the indigenous population wereas not allowed to participate in the society improvement process or to hold property; instead they were forced to work in conditions of slavery. The opposite happened in North America and we can see how ithistory tells how it turned out: most of the population was composed by emigrants from the Old Continent, whom wereto whom were given the same rights, and even if there were some minorities like the African American who were granted less rights, there were still more people enjoying the benefits of the institutions than in the countriesthe countries where extracting institutions persisted.

Further evidence in support of our argumenton this topic is given by Weil (2013): when comparing a country’s wealth with its amount of human capital seen as education, he shows that there is no direct correlation. The difference in wealth is not entirely explained by education. If this was the case, for example, Mozambique would have had 43% of the U.S. GDP (Gross Domestic Product) per worker, but in reality it produces only 1.9% of it. Weil explains this discrepancy using the quality of education, which changes the effect of education on wealth drastically. These differences in quality of schooling are directly related to the institutions present; the students of richer countries learn faster and more effectively, because they are provided better educational facilities and means of learning.

Conclusion

As we have shown in this brief essay, in order to foster growth potential in the first place, one needs institutions that create and protect property rights. Indeed, we have shown, using empirical research, that human capital is caused by institutions in the first place, which then indirectly causes growth. However, we do not say that human capital cannot feed into the quality of institutions at a later stage, the relation is far more elegant and complex than that, we simply wanted to show that the institutions are the beginning of the story. Furthermore, we think that institutions placed in colonial countries did not directly originate there, but that they were derived from the institutions that were present in the native countries. As a final remark, we strongly urge that more research should be done on the development of institutions and human capital and how they compare to their native country around the colonization period, which has only been treated superficially in the literature.

References

Acemoglu, D., Johnson, S. and Robinson, J. (2002). ‘Reversal of Fortune: Geography and Institutions in the Making of the Modern World Income Distribution’. The Quarterly Journal of Economics, 117(4), pp.1231-1294. Acemoglu, D., Gallego, F., and Robinson, J. A. (2014). ‘Institutions, human capital and development’. Unpublished working paper. University of Harvard, Cambridge.

Glaeser, E., La Porta, R., Lopez-de-Silanes, F. and Shleifer, A. (2004). ‘Do Institutions Cause Growth?’. Journal of Economic Growth, 9(3), pp.271-303. Weil, D. (2013). Economic growth. Boston: Pearson, pp.170-197.


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