Institutions Rule: The Primacy of
Institutions over Geography and
Integration in Economic Development
Dani Rodrik, Arvind Subramanian, Francesco Trebbi
CID Working Paper No. 97
October 2002
Copyright 2002 Dani Rodrik, Arvind Subramanian, Francesco
Trebbi and the President and Fellows of Harvard College
at Harvard Universit
y
Center for International Develo
p
ment
Working Papers
INSTITUTIONS RULE: THE PRIMACY OF INSTITUTIONS OVER
GEOGRAPHY AND INTEGRATION IN ECONOMIC DEVELOPMENT
Dani Rodrik Arvind Subramanian Francesco Trebbi
Harvard University IMF Harvard University
Revised
October 2002
ABSTRACT
We estimate the respective contributions of institutions, geography, and trade in determining income
levels around the world, using recently developed instruments for institutions and trade. Our results
indicate that the quality of institutions “trumps” everything else. Once institutions are controlled for,
measures of geography have at best weak direct effects on incomes, although they have a strong
indirect effect by influencing the quality of institutions. Similarly, once institutions are controlled for,
trade is almost always insignificant, and often enters the income equation with the “wrong” (i.e.,
negative) sign, although trade too has a positive effect on institutional quality. We relate our results to
recent literature, and where differences exist, trace their origins to choices on samples, specification,
and instrumentation.
The views expressed in this paper are the authors’ own and not of the institutions with which they are
affiliated. We thank Chad Jones, James Robinson, Will Masters, and participants at the Harvard-MIT
development seminar and the Harvard econometrics workshop for their comments, Daron Acemoglu
for helpful conversations, and Aart Kraay for providing us with his data. Dani Rodrik gratefully
acknowledges support from the Carnegie Corporation of New York.
Commerce and manufactures can seldom flourish long in any state which does not enjoy a regular
administration of justice, in which the people do not feel themselves secure in the possession of their property,
in which the faith of contracts is not supported by law, and in which the authority of the state is not supposed to
be regularly employed in enforcing the payment of debts from all those who are able to pay. Commerce and
manufactures, in short, can seldom flourish in any state in which there is not a certain degree of confidence in
the justice of government.
-- Adam Smith, Wealth of Nations
I. Introduction
Average income levels in the world’s richest and poorest nations differ by a factor of more
than 100. Sierra Leone, the poorest economy for which we have national income statistics,
has a per-capita GDP of $490, compared to Luxembourg’s $50,061.
1
What accounts for
these differences, and what (if anything) can we do to reduce them? It is hard to think of any
question in economics that is of greater intellectual significance, or of greater relevance to
the vast majority of the word’s population.
In the voluminous literature on this subject, three strands of thoughts stand out. First, there is
a long and distinguished line of theorizing that places geography at the center of the story.
Geography is a key determinant of climate, endowment of natural resources, disease burden,
transport costs, and diffusion of knowledge and technology from more advanced areas. It
exerts therefore a strong influence on agricultural productivity and the quality of human
resources. Recent writings by Jared Diamond and Jeffrey Sachs are among the more notable
works in this tradition (see Diamond 1997; Gallup, Sachs, and Mellinger 1998, and Sachs
2001).
A second camp emphasizes the role of international trade as a driver of productivity change.
We call this the integration
view, as it gives market integration, and impediments thereof, a
starring role in fostering economic convergence between rich and poor regions of the world.
Notable recent research in this camp includes Frankel and Romer (FR,1999) and the pre-
geography work of Sachs (Sachs and Warner 1995).
Finally, a third group of explanations centers on institutions
, and in particular the role of
property rights and the rule of law. In this view, what matters are the rules of the game in a
society and their conduciveness to desirable economic behavior. This view is associated
most strongly with Douglass North (1990). It has received careful econometric treatment
recently in Hall and Jones (1999), who focus on what they call “social infrastructure,” and in
1
These are figures for 2000, and they are expressed in current “international” dollars,
adjusted for PPP differences. The source is the World Development Indicators CD-Rom of
the World Bank.
2
Acemoglu, Johnson, and Robinson (AJR, 2001), who focus on the expropriation risk that
current and potential investors face.
Growth theory has traditionally focused on physical and human capital accumulation, and, in
its endogenous growth variant, on technological change. But accumulation and technological
change are at best proximate causes of economic growth. No sooner have we ascertained the
impact of these two on growth—and with some luck their respective roles also—that we
want to ask: But why did some societies manage to accumulate and innovate more rapidly
than others? The three-fold classification offered above—geography, integration, and
institutions—allows us to organize our thoughts on the “deeper” determinants of economic
growth. These three are the factors that determine which societies will innovate and
accumulate, and therefore develop, and which will not.
Since long-term economic development is a complex phenomenon, the idea that any one (or
even all) of the above deep determinants can provide an adequate accounting of centuries of
economic history is, on the face of it, preposterous. Historians and many social scientists
prefer nuanced, layered explanations where these factors interact with human choices and
many other not-so-simple twists and turns of fate. But economists like parsimony. We want
to know how well these simple stories do, not only on their own or collectively, but more
importantly, vis-à-vis each other. How much of the astounding variation in cross-national
incomes around the world can geography, integration, and institutions explain? Do these
factors operate additively, or do they interact? Are they all equally important? Does one of
the explanations “trump” the other two?
The questions may be simple, but devising a reasonable empirical strategy for answering
them is far from straightforward. This is not because we do not have good empirical proxies
for each of these deep determinants. There are many reasonable measures of “geography,”
such as distance from the equator (our preferred measure), percentage land mass located in
the tropics, or average temperature. The intensity of an economy’s integration with the rest
of the world can be measured by flows of trade or the height of trade barriers. The quality of
institutions can be measured with a range of perceptions-based indicators of property rights
and the rule of law. The difficulty lies instead in sorting out the complex web of causality
that entangles these factors.
The extent to which an economy is integrated with the rest of the world and the quality of its
institutions are both endogenous
, shaped potentially not just by each other and by geography,
but also by income levels. Problems of endogeneity and reverse causality plague any
empirical researcher trying to make sense of the relationships among these causal factors.
We illustrate this with the help of Figure 1, adapted from Rodrik (2003, forthcoming). The
plethora of arrows in the figure, going in both directions at once in many cases, exemplifies
the difficulty.
The task of demonstrating causality is perhaps easiest for the geographical determinists.
Geography is as exogenous a determinant as an economist can ever hope to get, and the main
burden here is to identify the main channel(s) through which geography influences economic
3
performance. Geography may have a direct effect on incomes, through its effect on
agricultural productivity and morbidity. This is shown with arrow (1) in Figure 1. It can also
have an indirect effect through its impact on distance from markets and the extent of
integration (arrow [2]) or its impact on the quality of domestic institutions (arrow [3]). With
regard to the latter, economic historians have emphasized the disadvantageous consequences
for institutional development of certain patterns of factor endowments, which engender
extreme inequalities and enable the entrenchment of a small group of elites (e.g., Engerman
and Sokoloff, 1994). A similar explanation, linking ample endowment of natural resources
with stunted institutional development, also goes under the name of “resource curse.”
Trade fundamentalists and institutionalists have a considerably more difficult job to do, since
they have to demonstrate causality for their preferred determinant, as well as identify the
effective channel(s) through which it works. For the former, the task consists of showing
that arrows (4) and (5)—capturing the direct impact of integration on income and the indirect
impact through institutions, respectively—are the relevant ones, while arrows (6) and (7)—
reverse feedbacks from incomes and institutions, respectively—are relatively insignificant.
Reverse causality cannot be ruled out easily, since expanded trade and integration can be
mainly the result of increased productivity in the economy and/or improved domestic
institutions, rather than a cause thereof.
Institutionalists, meanwhile, have to worry about different kinds of reverse causality. They
need to show that improvements in property rights, the rule of law and other aspects of the
institutional environment are an independent determinant of incomes (arrow [8]), and are not
simply the consequence of higher incomes (arrow [9]) or of greater integration (arrow [5]).
In econometric terms, what we need to sort all this out are good instruments for integration
and institutions—sources of exogenous variation for the extent of integration and
institutional quality, respectively, that are uncorrelated with other plausible (and excluded)
determinants of income levels. Two recent papers help us make progress by providing
plausible instruments. FR (1999) suggests that we can instrument for actual trade/GDP ratios
by using trade/GDP shares constructed on the basis of a gravity equation for bilateral trade
flows. The FR approach consists of first regressing bilateral trade flows (as a share of a
country’s GDP) on measures of country mass, distance between the trade partners, and a few
other geographical variables, and then constructing a predicted aggregate trade share for each
country on the basis of the coefficients estimated. This constructed trade share is then used
as an instrument for actual trade shares in estimating the impact of trade on levels of income.
Acemoglu, Johnson, and Robinson (AJR, 2001) use mortality rates of colonial settlers as an
instrument for institutional quality. They argue that settler mortality had an important effect
on the type of institutions that were built in lands that were colonized by the main European
powers. Where the colonizers encountered relatively few health hazards to European
settlement, they erected solid institutions that protected property rights and established the
rule of law. In other areas, their interests were limited to extracting as much resources as
quickly as possible, and they showed little interest in building high-quality institutions.
Under the added assumption that institutions change only gradually over time, AJR argue
