Institutions, Innovation, and Economic Performance

A very influential and still-developing literature, whose detailed analysis goes well beyond the scope of this article, argues that institutions are the strongest single determinant of long-term economic growth. ^{Footnote 19} However, various authors subscribing to this approach have different ideas of what institutions actually are and how exactly they affect economic performance. In this article, we borrow the view that the main role of institutions in the process of growth is to foster innovation, as the long-term macroeconomic success of a country depends mainly on its ability to remain congruent with the world’s technological frontier. ^{Footnote 20} In this sense, institutions would foster the Schumpeterian process of creative destruction by shaping an environment able to support the emergence of new ideas coming from innovative entrepreneurs. Thus, institutions have a fundamental role in this dynamic because congruence is not automatically given but is limited by a country’s resource endowment and factor supply. Institutions, however, might help to construct a proper set of social capabilities, embodied in firms and other organizations, necessary to compensate for the lack of natural congruence, to assimilate successfully foreign technologies and to create new products or processes. Our view is that social capabilities develop especially thanks to the role played by the most dynamic and innovative manufacturing sectors whose success, in turn, depends on three factors: the attitude of the general environment toward innovation; the style of owners and managers; and firms’ dimensions. The nature of the rules of the game in a given economy influences all these aspects. For example, institutional arrangements such as the enforcement of compulsory education, the support to develop technical schools, and the incentives to scientific research are pivotal in forging an innovation-supportive environment. At the same time, entrepreneurial activity can turn toward innovation and risk-taking or rent-seeking depending on the incentives provided by formal and informal rules. ^{Footnote 21} Finally, commercial codes, regulation of corporate governance, and bankruptcy laws can either limit firms’ growth or allow them to reach a dimension compatible with the process of innovation in advanced technologies. ^{Footnote 22}

In the next section, we show how problems of “extractive” entrepreneurial behavior and tiny firms’ size have always characterized the functioning of the Italian productive system, and how specific institutions influenced these problems. As far as the relationship between institutions and the attitude toward science and technology is concerned, ample evidence is provided by a dedicated article in this issue; thus, we will not inquire into this perspective here. ^{Footnote 23}

Institutional Failure in Italy: Some Evidence

In the light of several studies, doubt no longer exists that Italy has a productive system historically characterized by firms that are particularly small in comparative terms. ^{Footnote 24} For example, the share of workers employed in manufacturing firms with fewer than 10 employees was 40 percent in 1911 and still about 30 percent in the early 1960s. ^{Footnote 25} By that time, in advanced countries this share was remarkably smaller—for example, 6.4 percent in France, less than 3 percent in Germany, and 2.5 percent in the United States; even in Japan, the percentage was about half (16.4 percent) of the share in Italy. ^{Footnote 26} However, the degree of difference between Italy and the rest of the Western core economies was not constant. Interestingly, the most significant reductions of this difference also coincided with the phases of most rapid economic growth, such as the Giolittian age (1900–1914) and the post-1945 “economic miracle.” ^{Footnote 27} This correlation is not just a coincidence; in fact, there is also ample evidence that in other phases, the dwarfism of Italian firms affected considerably their ability to innovate and to stay close to the world’s technological frontier. ^{Footnote 28} On the other hand, various authors noticed how during the “economic miracle” Italy’s innovative capacity reached its historical peak, both in terms of patenting activity and as a number of success stories of breakthrough innovations. ^{Footnote 29}

Firms’ dwarfism and consequent inability to innovate have thus characterized the economic history of Italy since unification. To what extent did specific institutions have an impact on these problems? To answer these questions, we have to consider four elements unique to the Italian institutional environment: (1) the functioning of bankruptcy law; (2) the use and misuse of specific forms of governance; (3) the ample role given to business consultants; and (4) the lack of attention toward the problem of tunneling.

Firstly, as far as bankruptcy is concerned, since the 1880s Italian law gave no useful device for firms to restart. The recourse to solutions that allow firms to avoid liquidation and to continue their activity was indeed extremely complicated. Italian law established, as a condition to approve a non-bankruptcy deal, the ex ante guarantee of being able to pay a very high share (40 percent) of unsecured liabilities. Although conceived as a device to protect creditors, in fact this solution failed in its aim and only left businesses with no protection against the effects of the economic cycle, with the result that concerns were liquidated to an extent unknown in other countries. ^{Footnote 30} This can be seen as one of the main causes of the difficulties of Italian firms to survive and to grow. ^{Footnote 31}

The second area of negative impact of institutions on firms’ size is the artificial protection of specific forms of governance—for instance, artisan firms. After 1945, this was achieved mainly via lower tax rates, privileged interest rates, and a softer bankruptcy law, ^{Footnote 32} and was conducted on a scale incomparable to all other European countries. These policies resulted in an extremely large number of this type of business—for instance, in 1961 there were more than 700,000 firms registered as artisans, with about one million employees. ^{Footnote 33} In some traditional sectors, artisan firms were the majority of the total. This attitude, to an extent even justifiable in economic terms, had negative implications for the growth of businesses. Artisan firms, for instance, remained artificially small and based on archaic technologies, because to maintain their legal privileges they had to show that in their productive activity, the input of labor prevailed over the input of capital. More in general, however, the lack of controls and enforcement also created perverse incentives for standard industrial concerns to formally register as artisan firms to enjoy the artificial protection reserved to this type of business. ^{Footnote 34} This is a clear anomaly of the Italian productive system vis-à-vis other types of capitalism. In Anglo-Saxon countries, for example, artisans are a negligible component of the productive system, and the very concept does not even have a proper translation. ^{Footnote 35} On the other side of the spectrum, artisans have an enormous relevance in the German economy, but they operate in a completely different way than in Italy. Rather than being small, backward in technology, and concentrated in traditional industries, as in Italy, thanks to dedicated institutions and regulations German Handwerk has evolved into modern and often relatively big firms (up to 200 employees). They operate in traditional as well as advanced sectors, thanks to knowledge of “theory, management, accounting, and marketing” ^{Footnote 36} and the recourse to skilled workers, trained in technical schools or even in dedicated R&D centers financed by the artisans’ guilds and associations.

The third institutional failure affecting firm size is the unique wide role played by accountants in Italy. ^{Footnote 37} For reasons linked to the extreme complexity of the fiscal legislations, every Italian firm had to hire a accountants (commercialista) that tended to expand its influence in all other aspects of management. ^{Footnote 38} The position of the accountant, however, depended critically on the firm’s small dimension—on the one hand, because as soon as businesses increased in size they became inclined to internalize these functions, and on the other hand, because accountancy firms themselves tended to be small, thus unable to serve big clients. The small size of accountancy firms was also due to the law, which forbade their incorporation. ^{Footnote 39} As a consequence, once in place as managers of small firms, accountants had no incentives to promote their growth. The same can be said about governance: accountants were hired directly by the owner(s), not by the firm, and had no advantage in promoting the entry of other investors, as this would have weakened their position. ^{Footnote 40}

Finally, the fourth way in which Italian institutions affected firms’ growth (and size) is by facilitating the tunneling of resources from firms to their owners. This could be done, for example, by promoting fake investment in assets formally belonging to the firm but used only by the owner, or by moving undeclared profits into accounts in foreign banks. ^{Footnote 41} Although the quantification of such phenomena is impossible to obtain, evidence of its existence is provided in the secondary literature. Mainstream economists have showed how in Italy the legal protection of minority creditors is ineffective, paving the way to very large benefits deriving from private control of firms, including the possibility of tunneling. ^{Footnote 42} At the same time, economic historians have argued that this is far from a recent phenomenon. ^{Footnote 43} Tunneling is not at all separated from the problem of the wide role left to accountants; given that their power depended on firms’ remaining small, and their remuneration and volume of activity on the satisfaction of the customers (that is, the owners of firms), accountants had a double incentive to channel resources from companies to their owners.

Whereas small size made Italian firms unable to fully embrace the technological race, entrepreneurial attitudes might have made Italian businesses unwilling to innovate. In fact, recent work by Toninelli and Vasta ^{Footnote 44} revealed how in Italy the number of genuine Schumpeterian entrepreneurs has always been small, and these few innovative entrepreneurs played a marginal role in the process of growth. Peculiar aspects of the Italian institutional environment went in the direction of supporting conservative, if not openly “predatory,” attitudes from Italian business owners. Specifically, the weakness of the enforcement in two key areas of business regulation de facto created opportunity for high profits even in the absence of substantial investment in technology and innovation.

The first area is the already mentioned problem of tunneling; the other is tax evasion, a phenomenon as old as the history of the country and largely acknowledged by the literature. ^{Footnote 45} An estimate provided by the well-known statistician Gini for 1909 suggested that a total level of fiscal evasion was about 32 percent. By using the same methodology, the editors of the second edition of Gini’s book calculated a level to 50 to 70 percent for the 1920s and 1930s. ^{Footnote 46} After 1945, matters did not improve; possibly the best impressionistic piece of evidence is the phenomenon, occurring at least since the late 1980s, of employers (particularly shopkeepers and artisans) declaring annual incomes lower than the salaries of their employees. ^{Footnote 47} This segment of the middle class systematically cheated the state’s finances. Through tax evasion and by reinvesting part of these resources in Italian government bonds, they received high returns while increasing the size of the Italian public debt. Although more research is needed in this area, it is reasonable to argue that the possibility of evading taxation and the prompt availability of a safe and high-return investment might have pushed firms’ owners away from engagement with advanced technologies, new products, and so on.

In Italy, issues of tunneling and tax evasion have always been linked to the wider institutional problem of balance-sheet regulation. Before the introduction of the new commercial code in 1942, de facto there was no regulation of the information to be included in companies’ balance sheets; after 1942, things did not change substantially. In fact, manipulation of the books has always been the norm, ^{Footnote 48} often with the excuse of too a high level of taxation; at the 1911 National Congress of Joint-Stock Companies, for example, an anonymous, yet recorded, voice suggested that it would have been unreasonable to expect true balance sheets given the existing high level of taxation. ^{Footnote 49}

The Roots of Institutional Failure

From the analysis conducted in the previous section, it appears that the institutional failure in key areas of the Italian economy has been evident since unification. If this were the case, the obvious question is why inefficient institutions have not changed and been replaced with sounder ones. In fact, the idea of institutional inefficiency as the main problem of the Italian economy is not new; some of the authors who developed this view also provided reasons for the stickiness of inefficient rules. For example, one interpretation, provided by a growing body of literature in mainstream economics, argues that, at least since the end of World War II, the Italian economy showed remarkable weaknesses in the regulation of corporate governance, specifically in the protection of the rights of minority shareholders. This led to the underdevelopment of the financial market, fewer companies implementing a sound separation between ownership and control, and structural problems of tunneling. ^{Footnote 50} In line with the “political economy” view suggested by Pagano and Volpin, ^{Footnote 51} the lack of efficient regulation in the field of corporate governance can be seen as the result of the action of an oligopoly of few powerful industrialists allied with a lobby of long-serving politicians refusing to open up the country to the virtue of competition. Defense of insiders, lack of proper competition, and the collusive attitude of the state also underpin the recent view that the post-1990s Italian decline has been mainly the effect of a long-term institutional capture from conservative trade unions à la Olson, with the consequent decline of the efficiency of the labor market. ^{Footnote 52}

Our interpretation of the Italian institutional failure is not necessarily fully incompatible with some aspects of these views, but it differs on many crucial points. In particular, contrary to the views described earlier, we believe that institutional problems were (and are) not confined to specific aspects of the economy, rather extended to the basic, day-to-day interactions among economic agents. Furthermore, we argue that institutional failure did not necessarily serve only the interests of specific and easy-identifiable lobbies, but rather the ones of a large minority, whose composition changed over time and in which advantages were not equally distributed among its members. Following North, ^{Footnote 53} our view is that what he defines as “political entrepreneurs” provide rules in line with their personal interests. Inefficient rules thus emerge (and survive) when vested interests are not consistent with the public good, but also if benevolent rulemakers suffer from a form of cognitive deficit: They fail to understand what institutions the economy really needs, or cannot foresee that the actual effects of the rules they provide might end up being very different from the expected ones. What we claim is that in Italy ineffective rules of the game were the result of a mix of these two aspects. Specifically, up to World War II problems were mainly, although far from exclusively, linked to issues of cognitive deficit, whereas since 1945 the defense of vested interests became the dominant force in the process of institutional failure.

Political entrepreneurs’ cognitive deficit finds its origin in the features of the process of state formation. As recently argued by Cassese, this process was very fast, and ultimately failed “to integrate people in the institutions,” ^{Footnote 54} meaning that it was unable to customize standard institutional settings to the specific needs of the Italian economy. The speed of the process also meant a very strong degree of centralization of power that made whatever decision taken by political entrepreneurs less subject to the check of democratic counterbalances, hence more prone to the problems described previously. Political and administrative unification was accomplished through an extension of the boundaries of the Kingdom of Sardinia, led by politicians such as Cavour, who believed that liberal institutions, designed for Piedmont, would automatically generate economic progress in the entire country. Unfortunately, this political class did not appropriately understand the situation of the country; for instance, Cavour never visited a place south of Florence in his life. ^{Footnote 55} As a result, many rules they introduced were not suitable for the whole nation. One of the most revealing examples of this problem is the organization of primary education, which seems to be a typical case of institutional failure. In 1861 the Casati law, originally approved in Piedmont in 1859, was extended to the entire Kingdom of Italy. The act made municipalities bear the burden of primary education; this type of organization—suitable for a relatively developed area, such as Piedmont—was completely inadequate for the poor regions of southern Italy. Two reciprocally reinforcing mechanisms played negatively in this sense: first, the southern regions did not have sufficient financial resources to invest in education; second, as suggested by a recent contribution, lower investment in education could be also a product of the lack of willingness. ^{Footnote 56} Following the Engerman and Sokoloff hypothesis, ^{Footnote 57} we can explain exhaustively the institutional mechanisms driving investments in education in Italy. Local landowners, who usually ruled municipalities, taxed themselves much less in the south than in the north and, as a consequence, in the former areas there were fewer resources to invest in education. This led to a significant delay in the process of literacy of the south; still, in 1911 the literacy rate of the southern regions was 40.3 percent, whereas the northern and central regions had passed the threshold of 80 percent. It was only with the development of centralized state-financed education in 1911 that the trend changed. ^{Footnote 58} The Casati law described previously is a clear example of this problem, but the impact of the “cognitive deficit” is visible in other areas too. For instance, whereas long debates took place to decide which commercial code would have best suited the economic needs of the nation, much less attention, if any, was turned to the fact that poor enforcement of basic property rights in the south was creating a monopoly for organized crime in supporting the fast-developing sulfur industry in Sicily. ^{Footnote 59} Italian policymakers also remained prisoners of an archaic view of the functioning of modern economies and misunderstood the needs of a developing country. For example, they struggled to recognize the key role of education, scientific research, and innovation in the process of economic growth. Still, at the end of the nineteenth century, the Italian minister of education maintained that universities should provide basic knowledge and nothing more, ^{Footnote 60} because “vexatio dat intellectum” (vexation sharpens the intellect). Similarly, the hostile attitude toward debts and bankruptcy was inspired by moral rather than technical views of financial intermediation. This led to the provision of a bankruptcy law whose strong bias toward the protection of creditors only made it hard to apply and enforce. ^{Footnote 61}

Similar problems occurred also in public administration. Contrary to countries such as France and the United Kingdom, which had a firmly established tradition in the training of civil servants—such as the grands corps or the Oxbridge system—the Italian public administration had to form and recruit its own bureaucracy in the absence of an external and dedicated training system. As a consequence, since the beginning of the nineteenth century, public administration progressively became the natural destination for law graduates, something that fostered the idealistic traits of the Italian cultural tradition. Thus, the attention toward the formal coherence of the legislative order became prominent vis-à-vis the issue of technical and economic efficiency, which led to a progressive distance from the needs of the world of production, a natural monopoly of graduates in technical disciplines. ^{Footnote 62}

Until 1945, cognitive deficit also went hand in hand with the defense of specific interests, resulting, for example, in little attention to rules about firms’ governance and banking regulation. ^{Footnote 63} More in general, Felice showed that, to a large extent, the lack of attention toward the conditions of the Mezzogiorno was also motivated by the protection of the advantages for given southern constituencies, even via turning a blind eye to the expansion of the power of organized crime. The power of these constituencies, in turn, helped preserve the stability of the entire political system. ^{Footnote 64}

From this perspective, however, World War II represents a clear watershed, as the already existing process of distortion of the rules of the game for the direct gain of political entrepreneurs picked up momentum. This was due, among other reasons, to the fact that at least until the 1980s the Italian political system was de facto dominated by the two major parties (the Democrazia Cristiana and the Partito Comunista) that could pursue the interests of their constituencies without fearing any real political competition. A revealing effect of this attitude was the defense, for electoral purposes, of small dimension in all economic sectors: manufacturing, ^{Footnote 65} banking, ^{Footnote 66} distribution, ^{Footnote 67} and probably agriculture as well. To an extent, this responded to the logical aim of protecting the country’s competitive advantages but, as Conti and Ferri argued, some of the reasons behind this policy were “less noble” than others. ^{Footnote 68} In particular, this approach was part of a political and institutional setup promoted by the Democrazia Cristiana—partly shared also by the Partito Comunista—and supported by the central bank with the aim of creating a block of consensus to counterbalance the growing influence of big businesses. ^{Footnote 69} As we saw in the previous section, this contributed to the problem of dwarfism of Italian firms, but also led to constant lack of sanctions for the abuse of or noncompliance with some basic rules—in particular, in areas such as balance sheet regulation, tunneling of firms’ resources, and fiscal evasion. In fact, historians such as Crainz and Ginsborg ^{Footnote 70} have argued that the protection of small dimension and tolerance to tax evasion were two sides of the same coin of supporting, for political convenience, the segment of the middle class operating in small concerns in manufacturing, distribution, and services.

The Rules of the Game and the Rules of the “Beautiful Game”

From the analysis conducted so far, it appears that the Italian economy has been the victim of long-term institutional failure, and one can wonder why Italians did not try to correct this anomaly. Our interpretation is that such institutional failure was probably often able to favor a large minority of people, whose composition changed over time and space, and whose members got different levels of benefits. We think that one of the best examples comes from one of the things Italians love most: football.

Firstly, it is worth noting that Italian football is not only a divertissement, as it represents an important industrial sector—the production value of professional football clubs equaled 0.15 percent of Italian GDP in 2011. ^{Footnote 71} Moreover, it has been estimated that about 70 percent of Italian people are interested in football, and it is one of the most important businesses for all television networks, considering the amount of advertising revenues it produces. ^{Footnote 72} However, much to the surprise of Anglo-Saxon observers, for which football is mainly a game, in Italy it has extremely controversial social and cultural ramifications, and its meaning and importance extend well beyond its economic value. ^{Footnote 73} For example, it has been argued that the advent of Berlusconi in the mid-1990s as a politician can be understood only considering his successful career as owner and president of AC Milan, one of the most famous Italian football clubs. ^{Footnote 74} In fact, references to football constituted the backbone of Berlusconi’s language and messages, from the continuous use of football metaphors in his speeches, to the very name of his party (Forza Italia), cloned from the traditional motto of the supporters of the Italian national team. ^{Footnote 75} On the other hand, one must not forget that one of the biggest Italian private companies, Fiat, also controls the most powerful Italian football club, Juventus.

The “beautiful game,” one can think, is thus in Italy too an important economic, political, social, and cultural phenomenon, constantly under the scrutiny of the press and the public, to be managed with distorted or just inefficient rules. In fact, the story of football scandals in Italy is rich and long. ^{Footnote 76} The most devastating one for the credibility of the industry emerged in 2006, when it became clear that a criminal organization rotating around the general manager of the Juventus football club, Luciano Moggi, had the power to fix matches by bribing and blackmailing a network of referees, journalists, and directors of other clubs. ^{Footnote 77} Disturbingly, it also appeared that Moggi’s relationship network was so wide as to include the Italian minister of home affairs. ^{Footnote 78} Econometric analysis run by two economists had showed that, in fact, these phenomena (in particular, the corruption of referees to the advantage of Juventus) were widespread and structural well before 2006. ^{Footnote 79}

For the sake of our argument, it is revealing that such scandals were not the result of idiosyncratic criminal behavior of few individuals, rather the direct consequences of ill-conceived rules of the game. Two examples are particularly revealing. The first one concerns the way referees were selected for given matches; this happened (and still happens) on the basis of a discretional assessment of their abilities and with a very biased system of allocation, which gives enormous power to the people in charge of the procedure . As noticed, the result was “that Juve[ntus] and Milan can often rig the system to assign themselves the most mediocre, provincially minded referees, who are (subconsciously) more deferential toward their prestige clubs.” ^{Footnote 80} The second peculiarity is that the main Italian clubs also have a direct interest in the media industry, which represents the main source of income. ^{Footnote 81} However, media are also used to put pressure on referees, thereby affecting their reputation and their careers. Again, “referees who have issued critical penalties against Juve have found themselves working games in the lowly Serie B.” ^{Footnote 82} In this sense, it can be argued that referees’ deference to powerful clubs was not just a matter of subconscious pressure, as often argued, but also of direct and explicit interest.

In light of the argument proposed by this article, the analysis of Italian football teaches us two significant lessons that can be extended to the rest of the economy. First, institutional shortage, in terms of poor basic rules, appears in all aspects of the Italian economic life, including the “beautiful game.” Second, when the general interest is affected by the ineffectiveness of rules, no reaction takes place as long as a big enough minority benefits from it. This is the case of fans of AC Milan and Juventus, who represented around 40 percent of Italian football supporters and thus could enjoy easy and numerous successes. This contributes to explaining why many more voices have been raised to complain about the alleged unfairness of the trials that followed the discovery of match fixing than to ask for more transparent and efficient rules.