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Economics

Research byPeter Blaire Henry

Konosuke Matsushita Professor of

International Economics

Stanford Graduate School of

Business

Conrad Miller

Student

Stanford University

Institutions Versus Policies: A Tale

of Two Islands, Peter Blair Henry

and Conrad Miller,American

Economic Review(forthcoming May

2009).

FOR FURTHER INFORMATION: Helen K.

Chang , 650-723-3358 , Fax:

650-725-6750

Center for Global Business and the

Economy

Other economics research from the

Stanford Graduate School of

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Small Islands, Big Economic Lessons

April, 2009

STANFORD GRADUATE SCHOOL OF BUSINESSTwo Caribbean islands, alike in nearly every way, provide what

Stanford Graduate School of Business economist Peter Henry calls "as close to a laboratory experiment as you

could hope to find in social sciences" for testing what factors lead to a countrys economic success or failure.

In a new study forthcoming in the American Economic Review, Henry and Conrad Miller, a Stanfordundergraduate, show that, contrary to conventional theories of economic growth, it's not necessarily thedifferences in the laws and institutions under which countries operate that drive differences in their economic

development. Rather, it's the set of economic policies and decisions a government makes that are critical.In the 1960s, Barbados and Jamaica both received their independence from Great Britain. As former British

colonies, the two islands were strikingly similar in many ways. Culturally, both were inhabited by thedescendants of Africans who were brought to the Caribbean to cultivate sugar. Institutionally, Barbados and

Jamaica both adopted English common law, Westminster Parliamentary Democracy, and strong constitutional

protection of private property.

In spite of their legal and institutional similarities, Barbados and Jamaica experienced starkly different growthtrajectories in the aftermath of independence. From 1960 to 2002, Barbados' gross domestic product, per

capita, grew roughly three times as fast as Jamaica's. Consequently, the income gap between Barbados and

Jamaica is now almost five times larger than at the time of independence.

Much of this income gap came about because of the sharp decline in Jamaicas standard of living after 1972.

In 1973 the first world oil price shock triggered a global economic slowdown. Like most other countries,Barbados and Jamaica began to experience higher inflation and lower growth (also known as stagflation). But

growth slowed much more rapidly in Jamaica than it did in Barbados. While Jamaica's economy contracted at a

rate of 2.3 percent per year from 1972 to 1987, Barbados, whose economy has a similar structure and was

subject to the same shocks, grew by 1.2 percent per year. In other words, for a 15-year period standards ofliving in Barbados grew by 3.5 percentage points faster than in Jamaica.

As a result, the income gap between the two countries moved. In 1960 the real per capita GDP in Barbados wasUS$3,395, compared to US$2,208 in Jamaicaan income gap of US$1,187. By 2002 Barbados real GDP per

capita stood at US$8,434 versus US$3,165 in Jamaicaan income gap of US$5,269.

What specifically led to such starkly different trajectories?

The difference, Henry and Miller observe, is that in the 1970s the Jamaican government chose to respond to the

nations economic woes by running large and persistent fiscal deficits (which it financed by printing money),nationalizing companies, erecting import barriers in the form of higher tariffs and outright bans, and intervening

extensively in the economy. Barbados, on the other hand, avoided nationalization, kept state ownership to a

minimum, and adopted an outward looking growth strategy while keeping government spending under control.

Eventually, Jamaica felt it had no other choice but to devalue its currency. When faced with a similar decision in1993, Barbados was able to avoid devaluation by making other hard choices. The government negotiated with

firms, unions, and workers to institute a one-time wage cut. Firms promised to moderate price increases, and

all parties agreed to the creation of a national productivity board to provide better data on which to base future

negotiations.

Although the new wage protocol caused court battles and forced sacrifices on all sides, it prevailedenabling

the government of Barbados to maintain its fixed exchange rate without undermining the competitiveness ofthe economys export sector.

The experience of these two Caribbean nations holds lessons for governments, both large and small, grappling

with the current global crisis, says Henry, the Konosuke Matsushita Professor of International Economics at theStanford Graduate School of Business. "While there is a legitimate and helpful interim role for governments toplay in restoring the financial sector back to health," he says, "extensive and ongoing government intervention

in marketsalong with the protectionist sentiment that it is likely to arousehas the potential to cause many

more problems than it solves."

"I worry about the rise of protectionism, be it raising tariffs to protect domestic industries against foreign goods

or providing ill-advised subsidies to companies to give them a leg up against foreign competition. In comparingthe case of Jamaica and Barbados, its pretty clear that protectionist policies really hurt a countrys economy in

the long run," Henry observes. "What we dont need now is for countries to simply look out for their own

interests. We need a coordinated response in which we realize that were all in this together."

Marguerite Rigoglioso

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