Institutions and long-term development

Tomas Cvrcek

13th December 2012

5HP381 so far• Discussion of regulation• Discussion of economic systems• Discussion of business cycle

These are all important topics but they are mostly relatively short-term in their horizon

• Let’s go long-run!!!

Low, Middle, & High Income Nations

Why are some countries rich and others poor?

Economics for Leaders

World GDP per capitaSource: http://econ161.berkeley.edu/tceh/2000/world_gdp/estimating_world_gdp.html

178138133

6539

679

98

0

1000

2000

3000

4000

5000

6000

0 200 400 600 800 1000 1200 1400 1600 1800 2000

Year

19

90

do

lla

rs

Why are some countries rich and other countries

poor?• Economic growth raises standards of living, even in the continuing face of scarcity

• Growth does not eliminate scarcity but may attenuate it (some things become less scarce)

• Growth is Not even across times and countries Not automatic Not irreversible

BUT!It is the most powerful weapon against poverty ever discovered!

A short account of the race in engineering prowess

that occurred between Great Britain and France

in the 18th century

1730s

1760s

1780s

Source: Wikimedia Commons

What is it that turns…

…some technology into growth…

…and another into a curiosity?

The story of two canals

Source: Wikimedia Commons

How could 101 mi. of Suez canal…

…do more for economic growth…

…than 1114 mi. of the Grand canal?

INSTITUTIONS !!!

• the formal and informal “rules of the game” that shape incentives and outline expected and acceptable forms of behavior in social interaction.

Incentives• The reward or penalties that influence people’s

choices and behavior.

The peculiar story of property rights• Ownership of many things is straight-forward• Ownership of many other things is complicated– Ideas: patents– Stakes: share holding– Other people’s commitments: debt instruments– Real estate: deed of ownership– People: slavery

• Notice: some property rights are very new, others (though old) have disappeared/been abolished

Property rights…

• …are bundles of allowable action• …publicly known rules regarding our actions– That allow others to form expectations– That allow owners even to harm and benefit

others (within the scope of the rights)

• …can be traded (usually)

Property rights• Can/Do I own…–…my laptop?–…my time?–…my brother?–…my kidney?–…someone else’s kidney?–…the office of tax collector?–…the air we breath?–…marijuana?

•Yes•Yes•No•No•No•No•No•No

Yes

Yes

NoYes

NoNoNoYes

Can I sell you… OWN SELLGIVEYes

Yes

NoYes

NoNoNoNo

Can I give you…

Fishermen vs Dye-makers

Dye

Profits

πF

πD

πF + πD

Fishermen’s preferred level of dye productionDye-makers’ preferred level of dye

production

Enter property rights

Dye

Profits

If fishermen own the river…

What dye-makers keep

πF

Fee paid by dye-makers to fishermen

Enter property rights

Dye

Profits

If dye-makers own the river…

What fishermen keep

πD

Fee paid by fishermen to dye-makers

The upshot: aggregate view

Dye

Profits

If the river is owned by no-one,

There will be an externality and consequently a loss

If the river is private property of whomever

From society’s point of view: better private than

public!

Property rights and externalities• Why do property rights arise?– To internalize an externality!

• What if negative externality is not internalized?– Overconsumption/overuse of a resource– This is the tragedy of the commons

• What if positive externality is not internalized?– Underproduction of a benefit

• Let us consider the following examples:– Patenting (property right in ideas)– Limited liability (shareholding)– Separation of powers (protection of property right in govt

commitments)

Ex. 1: Problems of patenting

• Inventions usually have– High initial fixed cost– Low (or zero) marginal cost of reproduction

• The patenting trade-off:– How to reward the inventor and cover his/her high

initial fixed costs…– …while allowing for a widespread diffusion, so that

society can reap ample benefits?

Modern patent structure

• Patents are awarded on three aspects:– Firstness (i.e. don’t reinvent the wheel)– Substantial novelty (i.e. don’t just repaint it)– Utility (i.e. no works of art)

• Patents provide rewards– Monopoly of ownership for a given period of time

• Patents allow (at least) for (some) diffusion– At first, trade with the inventor– Once patent expires, it’s in public domain

21

Patent owner as a monopolist vs perfect competition

Q

P

MC = AC = c

DMR

Patents are a statically inefficient but dynamically superior alternative to having no protection of intellectual property.

Tinkering on the margin

• How much protection?• How long to protect it?• What constitutes an infringement?• How easy or difficult is it to litigate? To sell the

patent? To circumvent it?

• Remember, technology itself can upset an existing patenting legislation!

~1750

Population Growth and Important World Events

Ex 2.: Invention of limited liability• Historically, the way to run a business was as a

partnership (e.g. “Scrooge & Marley”)• There was unlimited liability: – commitments are backed by everything you have– this limits everyone to a single partnership (otherwise

there would be conflicting claims)– The extent of investment is also limited/constrained• Risk aversion• Limits on means of the few partners (2 or 3 or 4…)

Modern corporation• Offers an opportunity to undertake a large project– Resources of several investors are pooled– Everybody gets his/her share of the profit

BUT!• There is a problem:– Too many investors = not all can be managers– Agency problem => potential negative externality

• Manager makes a costly mistake• Everybody else would be liable to the last penny

• Solution: – limited liability means a backstop on losses– Tradeability of shares means easy exit from corporation

Ex. 3: Property rights to govt debt• Default and expropriation is a huge negative

externality– It passes the cost of govt spending on someone else– It ruins credibility for the future (i.e. increases interest

rates for future-generation governments)

• It is hard to fight the government when govt has all the power (legislative, executive, judicial)

• NOTICE! Even the threat of default is enough to generate negative consequences

Debt defaults by European governments since 1700

• France: 1701, 1715, 1770, 1788, 1812• Spain: 1809, 1820, 1831, 1834, 1851, 1867, 1872, 1882• Habsburg Empire: 1796, 1802, 1805, 1811, 1816, 1868, 1918• Portugal: 1828, 1837, 1841, 1845, 1890• Russia: 1839, 1885, 1918, 1991, 1998

• Britain: not once• USA: not once (except the Confederacy)

(Note: These defaults do not include hyperinflations which also expropriate creditors.)

How does separation of powers help?(the North & Weingast (1989) story)

• Before 1689, Stuart kings tried to make Britain an absolutist monarchy

• After 1689, Britain creates many checks and balances against expropriating government:– Parliamentary control of taxation and spending– Earmarking of tax revenue for debt– Establishing Bank of England (1694)– Separating judges from executive power– Independent revenue sources curtailed

The upshot• Once governments can credibly commit– Willingness to lend increases significantly– Interest rates (price of credit) falls precipitously– Trade in government securities develops– Financial markets develop– Financial innovation develops

• Note how much rarer govt debt defaults are in the 20th century

• Protection of property rights in general improves:– Govt is by far the biggest thief in history– If govt can be controlled, the rest can be dealt with (and vice

versa: once govt turns rapacious, all goes downhill, no matter how good the rest)

Long-term assessment• Property rights change in long-run, OK…• … but does this really have any appreciable

impact on economic growth?

Let’s see:• The work of Acemoglu, Johnson and Robinson

(2002 – 2012)– They look at institutions around the world and

compare them against the growth and development record of individual countries

Low, Middle, & High Income NationsThe chicken-and-egg problem• How to disentangle which way

the causal link goes?– Look at where European colonists go– What sort of institutions they

establish there• Protective inst vs extractive inst

– What impact this has on long-term growth

• It turns out that– In places with low settler mortality,

institutions are protective– In places with high settler mortality,

institutions are extractive

What does all this mean for us today?• Remember the infamous social theorists of 19th century:– Proudhon: “All property is theft.”– Marx: “Revolution will abolish private property.”

• Notice: – They were right that property rights were important– They were wrong about how they’re important:

• Stable and well-enforced property rights IMPROVE welfare• Unstable, unclear and weak property rights WORSEN the situation

• The hard part: these things take centuries to get right– On the other hand, screwing them up is quick (hello, Lenin)

• The immediate impact of undermined property rights is small• The long-term impact is devastating and hard to fix

So, what’s next? Monday, SB 411, 18:00• Link this lecture with modern times• How does this hang with the current debt crisis?• What if there is a sudden property rights upset?• What makes property rights and institutions in

general “stick”? What makes them permanent?

• See you on Monday.