The Role of Institutions in Economic Growth

WHY DO SOME COUNTRIES PROSPER while others do not? This question has animated the research and inquiry of economists at least since Scottish philosopher and founder of modern economics Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations in 1776. Beginning with Smith’s emphasis on the critical role the division of labor plays in economic growth, a long tradition of Anglo-American economics has explained the wealth of nations by emphasizing the importance of political and legal institutions in protecting economic activity. Indeed, nearly every major school of economic thought has focused on the institutions that sustain civil society and economic growth.

For this year’s edition of the Index, three well-known economists – Professor Robert Barro of Harvard University, Dr. Alejandro Chafuen, President of the Atlas Economic Research Foundation in Virginia, and Professor Eugenio Guzmán, Director of Political Programs at the Libertad y Desarrollo Institute in Santiago, Chile – address important aspects of economic freedom. The debate about how to improve economic freedom can only be enhanced by sharing the analysis of independent experts who have examined the factors of society that contribute to or detract from economic growth and prosperity. It was not expected that these eminent peers would necessarily agree with our approach. In some cases, in fact, we knew they would not. Nor did we ask them to contribute because they contributed frequently to our co-publisher, The Wall Street Journal, although Professor Barro does that as well. Rather, we sought to promote an honest and scholarly debate on policies that would best promote economic freedom.

Robert Barro was invited because of his contributions to the modern theory of economic growth. His writing demonstrates the importance of strong institutions. “Differences in institutions have proven empirically to be among the most important determinants of cross-country differences in rates of economic growth and investment. Consequently, basic reforms that improve institutions provide one of the best routes for transforming a country over the long run from poverty to prosperity.” As he also observes, this view is “the central theme” of the Index of Economic Freedom.

This point about the important role of institutions is reinforced by both Dr. Chafuen and Professor Guzmán, who adapt their work on the correlation between corruption and economic growth, first published in 1997.

From the inception of the Index, critics have urged that a wide variety of additional factors be included, most notably measures of political freedom. Readers have long been perplexed by that conspicuous omission, which we hasten to add has always been deliberate. Many have been disturbed because a number of countries that rank highly in the Index are not known either for their democratic institutions or for extensive political liberty.

The simple response to these concerns is that the Index measures economic, not political, freedom. Although many readers may assume that freedom means political democracy, experience shows that this is not the case. Russians, who now live under what appears to be a political democracy, do not yet have economic freedom. But many analysts do believe that democracy is an important underpinning for a market economy and prospects for economic growth. One notable economist, Nobel Laureate Milton Friedman, proposed in Capitalism and Freedom that economic and political freedoms are strongly linked.

The debate surely is about the nature of that linkage. Professor Barro creatively and provocatively addresses a set of issues surrounding the linkage. His findings about democracy as a measure of electoral rights and civil liberties challenge all economists and policy analysts.

Professor Barro utilizes an index for the rule of law that measures the protection of private property – an alternative measure of the Property Rights factor in the Index. He also employs as a measure of democracy of the index used by Freedom House. Barro relates both the rule of law and democracy to economic growth. He finds that “the estimated effect of improved rule of law on growth is quantitatively large,” while “the overall relation between economic growth and democracy is statistically weak.”

These findings do not imply that democracy is unimportant, but merely that, in and of itself, it is neither necessary nor sufficient for economic growth. His analysis is extremely important for emerging economies, particularly the economies of the newly independent states of the former Soviet Union. The strategy of the United States government and other developed countries has been to recommend democratization and to promise economic assistance (bilateral and multi-lateral) to promote the process. What has been lacking has been an emphasis within the developing countries on the rule of law.

Nowhere else is the policy implication of this analysis clearer than in Russia (ranked 122nd in this year’s Index). Russia has a democracy but no rule of law; and corruption is prevalent. It should be no surprise to readers of the Index that Russia’s economy has imploded. This does not trivialize its democratization efforts, but rather emphasizes that without the rule of law, democracy by itself cannot bring automatic prosperity. It is economic freedom that fosters economic growth. Moreover, as Professor Barro suggests, political freedom can be a happy byproduct of economic growth.

Although Barro examined an index of corruption and found that it contributes little to explaining growth if the rule of law measure is held constant, the findings of studies of corruption by Chafuen and Guzmán offer a different perspective. These economists have analyzed various published indexes of economic freedom and corruption since 1997 and find not only that economic freedom is the biggest deterrent to corruption, but also that “the higher the index of economic freedom, the lower the level of corruption.” Moreover, Chafuen and Guzmán find that “corruption is pervasive in areas that lack economic freedom.”

Their analysis may be news to critics of market reforms in Latin America and elsewhere – including Russia – who charge that market reforms promote greed and lead to corruption. As these experts point out, corruption today is concentrated in fewer hands, and thanks in great part to globalization, fewer victims are “looking the other way.” The Internet and other avenues of sharing information make it easier to bring corrupt activities to light and corrupt officials to justice, and the political dynamics of democracies make it even more likely that evidence of corruption by one party will be exposed by another.

Although there is tension between Professor Barro’s findings and those of Dr. Chafuen and Professor Guzmán, there is no direct conflict. Barro examines whether a measure of corruption independently explains different economic growth rates across countries and finds that it does not. Chafuen and Guzmán ask whether greater economic freedom leads to more corruption and find that it does not.

A rich theory of economic freedom should align these results and explain the process by which greater economic freedom both enhances growth and diminishes corruption. Indeed, as Heritage Foundation President Edwin J. Feulner wrote in the 1999 Index:

Only when countries have an institutional framework based on the rule of law and free and competitive markets will their citizens have the freedom to work productively and enjoy the fruits of their labor. For with work comes the creation of wealth. And with freedom comes prosperity.

Mr. Beach is the John M. Olin Senior Fellow in Economics and Director of the Center for Data Analysis at The Heritage Foundation. Mr. O’Driscoll is Senior Fellow in Economic Policy and Director of the Center for International Trade and Economics at The Heritage Foundation. This article is excerpted from the 2000 Index of Economic Freedom.