Saturday, March 15, 2008

Rule of Law, Institutions, and Economic Growth

The Economist has an interesting and insightful article about how the "rule of law" argument evolved and made its way into the mainstream economics, especially development economics. Also see what Rodrik feels about The Economist magazine and this recent article!

...Economists became fascinated by the rule of law after the crumbling of the “Washington consensus”. This consensus, which was economic orthodoxy in the 1980s, held that the best way for countries to grow was to “get the policies right”—on, for example, budgets and exchange rates. But the Asian crisis of 1997-98 shook economists' confidence that they knew which policies were, in fact, right. This drove them to re-examine what had gone wrong. The answer, they concluded, was the institutional setting of policymaking, especially the rule of law. If the rules of the game were a mess, they reasoned, no amount of tinkering with macroeconomic policy would produce the desired results.

..."300% dividend"...a country's income per head rises by roughly 300% if it improves its governance by one standard deviation (Daniel Kaufmann and Aart Kraay)...

Economists have repeatedly found that the better the rule of law, the richer the nation...Every rich country with the arguable exceptions of Italy and Greece scores well on rule-of-law measures; most poor countries do not.

The World Bank is now running such projects (narrowly defined) worth almost $450m; on a wider definition, almost half the bank's total lending of $24 billion in 2006 had some rule-of-law component (for example, advice on conflict resolution in village-development projects, or on bankruptcy law in privatisation programmes). In roughly a decade the rule of law has gone from a specialist political and legal topic into a staple of economic thinking and the subject of a vast aid-giving effort.

...Among other proponents of a thick definition (of rule of law) are Friedrich Hayek, an Austrian economist, and Cass Sunstein of the University of Chicago. In their view, the rule of law includes elements of political morality.

...Thin definitions (of rule of law) are more formal. The important things, on this account, are not democracy and morality but property rights and the efficient administration of justice. Laws must provide stability. They do not necessarily have to be moral or promote human rights.

...One account of growth—associated with Douglass North of Washington University in St Louis, Missouri—is “institutional”. It focuses on the importance of property rights, transaction costs and economic organisation. On this view, stable, predictable laws encourage investment and growth. Thin definitions of the rule of law fit this well.The other—associated with Amartya Sen of Harvard—says that if you expand people's “capabilities” (Mr Sen's term), they will do things that help countries grow rich. Freeing people to take advantage of their capabilities usually means lifting the oppressive burden of the state and guaranteeing certain basic rights—a much thicker concept.

...But as a generalisation, the efforts of the past few years have thrown up mixed messages. They suggest the rule of law can be improved sharply; that rule-of-law reform is at root a political not a technical undertaking; and that it is linked to growth, if weakly in the short term. But they do not really bear out the assertion that the rule of law is an underlying prerequisite for growth. Rather, the more economists find out about the rule of law, the more desirable it seems—and the more problematic as a universal economic guide.