2. Defending the ‘institutions matter’ hypothesis

Adam Smith (Reference Smith and Cannan1776) has offered, if not the first, arguably the clearest articulation of the ‘institutions matter’ hypothesis. ‘Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism,’ Smith (ibid., xliii) argued convincingly, ‘but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things.’ When the scope of the market and, so, the division of labor expands, nations become wealthier. When governments fail to clearly define and protect property rights or fail to enforce contracts, when they overtax their citizens, when they engage in internal and external predation, nations do not develop. Since Smith, there has been a raft of theoretical and empirical studies that have confirmed his formula (see, for instance, Hall and Lawson, Reference Hall and Lawson2011). Rather than engaging Smith's formula directly, however, Chang instead engages the weakest form of the ‘institutions matter’ hypothesis. Consequently, his arguments against the ‘dominant discourse on institutions and growth’ are not as convincing as he might have hoped.

The chief shortcoming of Chang's paper is that it does not provide a discussion about which institutions matter most for economic growth. Rather than focusing on private property, contract enforcement and the rule of law exclusively, Chang points to a variety of institutions that even proponents of the ‘institutions matter’ hypothesis would not describe as being essential for growth and concludes that these non-essential institutions are in fact non-essential. The institutions that Chang discusses, for instance, include a financial regulatory system with a central bank and securities regulation, a corporate governance system that is shareholder-oriented, a ‘flexible’ labor market, and even NAFTA (North American Free Trade Agreement). According to Chang (Reference Chang2011), these institutions are particularly ‘Anglo-American’ (ibid.: 2). He then concludes that:

In concluding that bankruptcy law or intellectual property rights or any of the other ‘Anglo-American’ institutions he points to represent products but not prerequisites of economic growth, however, he is not challenging the ‘institutions matter’ hypothesis, as he supposes. Instead, he is challenging the form of that hypothesis that is mistakenly embraced by some of the development and foreign aid organizations. His quarrel is, thus, fundamentally against the practice of economic development, not the scholarship regarding economic development.

A related concern with Chang's focusing on non-essential institutions and his argument that ‘higher-quality institutions’ are more likely to follow than precede economic development is that he privileges foreign aid without institutional strings attached over foreign aid that demands institutional reform. Chang writes:

Putting aside the feasibility of these programs for now, Chang seems to neglect that such programs require institutions (at some level) to work effectively. Indeed, it is unclear if we should really expect educational expenditure, infrastructural investments, or industrial subsidies to lead to wealth outside of a context where private property is respected and the rule of law preserved. Moreover, if wealth is paramount for the adoption of ‘superior’ institutions, then it follows that massive aid transfers to developing countries will put them on the path to good institutions. Without effective institutions, we cannot successfully interact to coordinate our activities, as we must in order to achieve our goals; this is certainly true if our goal is to create and improve an educational system, or to develop a nation's infrastructure or to subsidize industries. Thus, assuming economic development has an impact on institutions does not answer the truly important puzzle – how to achieve economic development in the first place. Western countries have poured over two trillion dollars into many African, Latin American, and Asian countries, however, with very few success stories in terms of growth-enhancing institutions, liberal or otherwise (Easterly, Reference Easterly2001). The progress made by these countries does not match the funds they received, and economists are becoming hyper-aware of the failures of foreign aid (Burnside and Dollar, Reference Burnside and Dollar2000; Svensson, Reference Svensson2000; Knack, Reference Knack2001; Alesina and Weder, Reference Alesina and Weder2002; Leeson, Reference Leeson2008; Carden, Reference Carden2009; John and Storr, Reference John and Storr2009).

While Chang is of course correct that economic development affects the quality of institutions, he does not demonstrate that certain fundamental institutions (namely, property, contract and the rule of law) are not essential for economic growth. Additionally, his critiques of the empirical efforts to tease out the connection between institutions and growth cut against the very evidence that he marshals in favor of his position. Chang (Reference Chang2011), for instance, claims that the evidence in support of the primacy of institutions is ‘a lot shakier than what the supporters of the dominant view want us to believe’ (ibid.: 11). Cross-sectional econometric studies, he suggests, are insufficient and, thus, time-series analysis will better determine how changes in institutions cause changes in economic outcomes. Furthermore, he claims that samples are treated homogeneously, even though the relationship between the dependent (economic growth) and independent variable (institution) in one country may not hold in another. Chang, however, uses poor empirics to make his case. He, for instance, points to Singapore as a prime example of how a strong state and supposedly illiberal institutions can result in an economic success story, while ignoring the pro-market institutions that allow Singapore to succeed, and never conceding that Singapore is but one observation and by no means a typical case. Similarly, his examples of African and Latin American countries (who he claims ‘faithfully reformed their institutions in the neo-liberal direction’; ibid.: 11), at best, demonstrate that official rules imposed from outside a society that do not match unofficial rules are not likely to have much success. These cases might indict the practice of top-down reform but do not overturn the notion that certain liberal institutions are necessary for economic growth.

Despite his efforts, Chang's assertion that good institutions follow growth rather than preceding growth is not convincing. And the assertion, to be plausible, requires that we conflate the academic literature on institutions and growth with the unfortunate structural adjustment programs that are often advocated by development agencies. These programs, however, have been convincingly criticized by supporters of the ‘institutions matter’ hypothesis and have been shown to matter less for appreciating growth than the institutional nexus in the country prior to ‘structural adjustment’ (see, for instance, Dollar and Svensson, Reference Dollar and Svensson2000). Chang's critique of Global Standard Institutions is, thus, most convincing when he laments (Chang, Reference Chang2011: 3) that the conditionalities placed on aid-recipient countries by the Washington Consensus organizations ‘are institutions that inherently favour the rich over the poor, capital over labour, and finance capital over industrial capital’ (ibid. 3). As he concludes, however, ‘the same institution in the same dose may be good for one country but bad for another’ (ibid.: 9) and, moreover, since institutions do not change easily, imposing institutions in certain countries may come at a very high cost (ibid.: 16–18).