Journal of Institutional Economics (2011), 7: 4, 473-498 C The JOIE Foundation 2010doi:10.1017/S1744137410000378 First published online 15 October 2010 Institutions and economic development: theory, policy and history HA-JOON CHANG∗ Faculty of Economics, University of Cambridge, Sidgwick Avenue, Cambridge CB3 9DD, UK Abstract:The article tries to advance our understanding of institutional economics by critically examining the currently dominant discourse on institutions and economic development. First, I argue that the discourse suffers from a number of theoretical problems - its neglect of the causality running from development to institutions, its inability to see the impossibility of a free market, and its belief that the freest market and the strongest protection of private property rights are best for economic development. Second, I point out that the supposed evidence showing the superiority of 'liberalized' institutions relies too much on cross-section econometric studies, which suffer from defective concepts, flawed measurements and heterogeneous samples. Finally, I argue that the currently dominant discourse on institutions and development has a poor understanding of changes in institutions themselves, which often makes it take unduly optimistic or pessimistic positions about the feasibility of institutional reform. 1. Introduction Once a marginal topic, the role of institutions has become one of the most popular research areas in development economics over the last 10-15 years. Influenced by the broader revival of interest in institutions in economics, represented by the rise of New Institutional Economics in the 1980s, institutions started gaining popularity by the early 1990s as an explanation of international differences in economic development, even in places such as the World Bank and the International Monetary Fund (IMF), which had been rather hostile to the notion (Stein, 2008: 38-42). However, it is from the late 1990s that institutions have moved to the centre stage in the debate on economic development. Since the late 1990s, the view that poor-quality institutions are the root cause of economic problems in developing countries has become widespread. In accordance, the IMF and the World Bank started to impose many 'governance- related conditionalities', which required that the borrowing country adopts 'better' institutions that improve 'governance' (see Kapur and Webber, 2000). Around the same time, many rich country governments also started to attach governance conditionalities to their bilateral aids. There is no agreed definition ∗ Email: [email protected]473
474 HA-JOON CHANG of what these 'better' institutions, often called the Global Standard Institutions (GSIs), are. However, they are institutions that are typically found in Anglo- Americancountries,whichareseenasmaximizingmarketfreedomand protecting private property rights most strongly. 1 The pressure for the adoption of GSIs by developing countries also came from various bilateral, regional, and multilateral trade and investment agreements, which started mushrooming from the mid-1990s. For example, the WTO (World Trade Organization) has forced developing countries to adopt American-style intellectual property rights (IPRs) laws through the trade-related intellectual property rights (TRIPS) agreement. For another example, the notorious chapter 11 of the NAFTA (North American Free Trade Agreement) has completely changed the institution through which the member-country governments regulate corporations. Unprecedentedly, it allows foreign investors to sue host-country governments directly in case they think that they have been expropriated by the government, not just directly through confiscation but also indirectly through profit-reducing regulations. In addition to loan/aid conditionalities and international rules, developing countries have been increasingly subject to more informal pressures to adopt GSIs. Not only the World Bank and the IMF, but also the OECD (Organization for Economic Cooperation and Development), the G7, the World Economic Forum, and many other think-tanks and policy forums that are dominated by the rich countries have promoted the view that developing countries should adopt GSIs. The international financial press routinely paints countries with non- Anglo-American institutions, including many developed countries, as lacking in institutional quality.2 These negative comments by the press have come to be taken more seriously by developing countries in the recent period because the 1 The most frequently mentioned are: (i) a common law legal system, which, by allowing all transactions unless explicitly prohibited, promotes free contracts; (ii) an industrial system based on private ownership, which requires significant privatization in many countries; (iii) a financial system based on a developed stock market with easy M&A (mergers and acquisitions), which will ensure that the best management team available runs each enterprise; (iv) a regime of financial regulation that encourages 'prudence' and 'stability', including a politically independent central bank and the strict observance of the BIS (Bank for International Settlements) capital adequacy ratio; (v) a shareholder-oriented corporate governance system, which will ensure that the corporations are run for their owners; (vi) a flexible labour market that allows quick re-allocation of labour in response to price changes; (vii) a political system that restricts arbitrary actions of political rulers and their agents (i.e., bureaucrats) through decentralization of power and the minimization of discretion for public sector agents (for theoretical and empirical criticisms of the GSI discourse, see Chang, 2005). 2 Despite these pressures, the institutions in non-Anglo-American developed countries have proved quite durable, partly because those who were putting such pressures on these countries did not have enough financial leverage over them, while the forces defending the existing institutions were quite strong. So, the institutional differences between rich countries still remain very large, even though they may have been somewhat reduced, compared to the period between the end of the Second World War and the rise of neo-liberalism in the 1980s. On the institutional diversity of capitalism, see Albert (1991), Streeck (1992), Chang (1997), and Hall and Soskice (2001).
Institutions and economic development475 increasing opening of their capital markets has significantly increased the power of foreign investors, who are strongly influenced by the international financial press. Of course, the above discussion of external forces is not to say that there were no internal pressures for the adoption of GSIs in developing countries. GSIs are institutions that inherently favour the rich over the poor, capital over labour, and finance capital over industrial capital. Therefore, many rich people, especially financial capitalists, in developing countries have been very much in favour of GSIs. Also, some of the free-market ideologues in developing countries were even more dogmatic than the ones from the rich countries in a manner that the Latin Americans describe as being 'more Catholic than the Pope'. Being encouraged by and stimulating the increasing demands for institutional reform in developing countries was the explosive growth in the academic research on the role of institutions in economic development. Sometimes such research was provided from within the organizations making such demands - the best examples being the 'Governance Matters' paper series (Mark I published in 1999 and Mark VIII published in 2009 by the research group led by Daniel Kaufmann; see Kaufmannet al., 1999, 2002, 2003, 2005, 2006, 2007, 2008, 2009) and the annualDoing Businessreports, both published by the World Bank. However, a lot of this was supplied by academic economists, sometimes in direct response to real-world demands but also influenced by the academic fashion and the high publishability of a relatively new research topic. In this article, I try to critically evaluate the currently dominant discourse on the relationship between institutions and economic development, which argues that institutions that maximize market freedom and most strongly protect private property rights are the best for economic development. While firmly believing that markets and private property are essential institutions for economic prosperity, I first point out in the article that the understanding of the relationship between the institutions of private property and markets, on the one hand, and economic development, on the other hand, found in the dominant discourse is rather simplistic. I then go on to argue that the empirical evidence behind the dominant discourse may look rather impressive on a first look but that it does not survive a more careful scrutiny very well. This is followed by a discussion on how the currently dominant discourse on institutions and development suffers from a rather deficient theory of how institutions themselves change. 2. Theoretical problems with the dominant discourse on institutions and economic development The currently dominant discourse on institutions and development suffers fromtwocategoriesoftheoreticalproblems.Thefirstisthatitalmost