Growth and Institutions
Author: M MacFarlan and H Edison
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There has recently been a resurgence of interest in the importance of institutions for economic development and growth, motivated in part by renewed attention to enormous cross-country differences in incomes. What is the relative significance of institutional quality compared with other influences on development? How can policymakers contribute to overall institutional development? Compiled for the International Monetary Fund, this paper examines recent work on the impact of institutions on economic performance.
Institutions have been defined across a wide spectrum. At one end is the view that institutions range from the formal and informal constraints on political, economic and social interaction, or the rules of the game. At the other end, institutions are more specifically defined as particular entities, procedural devices and regulatory frameworks. An approach that lies between these two perspectives focuses on perceptions and assessments of institutions – how they function and their impact on behaviour.
Renewed interest in the links between institutions and development stems from the continuing uneven global dispersion of incomes. While improvements in macroeconomic policies may have helped reverse the overall stagnation of per capita incomes among developing economies that set in early in the 1980s, these countries continue to face large and persistent income gaps relative to advanced economies. There are a number of simple correlations and differences that can be outlined:
- On the whole, high income countries tend to have relatively strong institutions and institutions tend to be weaker in low-income countries.
- Across the developing country regions, per capita income levels and institutional quality rise more or less in tandem.
- As countries grow and prosper, they may find that they need, and can afford, to strengthen the institutions underpinning real and financial market activity.
- While not denying the role of geography, including location, climatic conditions and resource endowments, institutions are emphasised as the key intermediary between geographical influences and economic development.
- Historical patterns of colonisation and settlement are also important as institutional emphasis tends to favour the maintenance of power and wealth of the local elite where Europeans did not settle in large numbers.
Countries are not predestined to have weak or strong institutions, hence there are likely to be important interactions between institutions and economic policies. There are a number of considerations for policymakers working on institutional reform:
- While countries at all levels of development would benefit from stronger institutions, the impact of institutional improvement on growth is strongest for countries starting from a lower level of economic and institutional development.
- A country's institutions are deeply rooted in its history and culture and effecting change may be difficult and slow, with radical institutional reform taking place in only exceptional circumstances, including post-conflict states.
- Institutional arrangements and reform strategies that appear to have worked well in one country are unlikely to perform as effectively if transplanted to another without appropriate adaptation and innovation to suit local circumstances.
- An overriding need is for domestic ownership of and commitment to reforms, flexibility in programme design and ensuring that key participants in the reform process are fully empowered.
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International Monetary Fund, 2003, ‘Growth and Institutions’, Chapter 3 in World Economic Outlook: Growth and Institutions, IMF, Washington D.C.