Identifying the Effect of Institutions on Economic Growth

Abstract

This chapter describes how institutional quality can be measured, quantifies the correlation between institutional and economic developments, and reviews and discusses the literature on the causal impact of institutions on growth. Identifying a causal effect of institutions on development, and understanding the technology of the transmission of institutional quality to growth are challenging issues. This is due to the difficulty (1) of disentangling the causal and reverse causal effects, (2) of accounting for unobserved shocks affecting both institutions and growth, and (3) of capturing the lag structure of the relationship. To address these problems, existing cross-country studies have instrumented institutional quality using variables reflecting the settlement decisions of colonizers and imperial powers between the sixteenth and the nineteenth century. While fully recognizing the merits and the methodological rigor of this literature, I show that the type of institution implemented by imperial powers was statistically linked to unobserved factors affecting long-term economic performance. Hence, the quantitative predictions of these studies must be used with caution. Alternatively, collecting long-run data on institutional and economic changes, and searching for quasi-natural experiments (comparing the dynamics of countries which were initially similar and experienced different, unexpected institutional shocks) are promising research avenues.