Academic journal article Economic Inquiry

Politics and Productivity

Academic journal article Economic Inquiry

Politics and Productivity

Article excerpt


Economic studies of long-run performance are focusing increasingly on political, legal, financial, and social factors. Development is no longer regarded as a gradual, inevitable transformation from self-sufficiency to specialization and participation in the division of labor. Instead, progress follows the creation and evolution of institutions that support social and commercial relationships. The new institutional economics explains that growth requires that the potential hazards of trade (shirking, opportunism, risk, and so on) be controlled by institutions like secure property rights, reliable procedures for resolving disputes, and means of enforcing contracts in the absence of close social ties. These institutions reduce information costs, encourage capital formation and capital mobility, allow risks to be priced and shared, and otherwise facilitate cooperation (North and Thomas, 1973; North, 1990; Drobak and Nye, 1997; Levine, 1997). In particular, political authorities must make credible commitments not to expropriate private resources once investments have been made. (1)

Despite widespread agreement that institutions matter, there is no consensus on how they should be incorporated into the analysis. Even the best empirical studies of productivity and growth treat institutional characteristics in an eclectic way. Barro's (1991) influential article, for example, uses the numbers of assassinations and revolutions per capita as proxies for political instability, finding these measures negatively correlated with growth and investment. Scully (1988) regresses growth rates on dummy variables derived from Gastil's (1982) ordinal rankings of political and economic liberty. King and Levine (1993a; 1993b; 1993c) derive various measures of the quality of financial intermediaries and show that these measures are good predictors of growth.

This article presents a different approach to analyzing the relationship between institutions and aggregate economic performance. Following the modem productivity literature (see, for example, Fried et al., 1993), we model economic performance with a stochastic production frontier. Frontier analysis is a form of benchmarking. It analyzes a group of branches, firms, nations, or other units by identifying best practices and evaluating each member's performance relative to the best-practice frontier. The results produce not only qualitative rankings of the group members but also numerical efficiency scores that can be used to assess the effects of various policies and characteristics. For this reason, frontier analysis is well suited for studying the effects of legal and political institutions on the economic performance of nations.

To capture institutional factors, we use two comprehensive indexes of legal, regulatory, and political conditions. Working with a broad sample of countries from 1975 to 1990, we incorporate a widely used measure of economic freedom along with a new measure of policy stability to represent a country's institutional environment. The new institutional economics suggests that countries with high levels of economic freedom (protection of private property rights, respect for the rule of law, an unhampered price system, and so on) and policy stability (commitment not to change the rules of the game ex post) will be closer to the best-practice frontier.

In our model, economic freedom and policy stability affect economic performance by enhancing technical efficiency. In other words, these institutions do not alter the state of technology, but they allow producers to squeeze more out of current technology. For instance, countries with more stable policies attract more foreign investment than countries with less stable policies, ceteris paribus; this leads to increased competition among producers, which in turn brings efficiency gains. Similarly, countries with lower taxes, milder regulatory burdens, lower inflation, fewer restrictions on foreign ownership, and so on are likely to produce output more efficiently than countries with policies that restrict production, inhibit capital formation, and reduce competition. …

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