GEOGRAPHY AND INSTITUTIONAL QUALITY. Matthew Brown a and Lisa Verdon b. First Draft: May 2012

Transcription

1 GEOGRAPHY AND INSTITUTIONAL QUALITY Matthew Brown a and Lisa Verdon b First Draft: May 2012 a Corresponding author. West Virginia Wesleyan College, 59 College Avenue, School of Business; Buckhannon, WV, USA mattfsubrown@gmail.com. Phone: b College of Business, Wooster College; Wooster, OH, USA

2 Abstract The relationship between several broad geographic and population characteristics and the quality of economic institutions in a country is explored. This paper contributes to our understanding of these issues by introducing new variables to measure ease of exit and models their relationship with economic institutions as a form of Tiebout sorting. Countries that are more easily exited are likely to have more market-oriented economic institution. A significant relationship is demonstrated between economic institutions and geographic characteristics in numerous specifications with various control variables; these findings advance our understanding of the determinants of economic institutions which is currently a weak point in the empirical growth literature. Keywords: Institutions; Geography; Policy; Economic Freedom. JEL Codes: H11; F59; O17; P16 2

3 1. INTRODUCTION Following several seminal empirical papers on the role of institutions, Acemoglu and Johnson (2005) point out, there is a growing consensus among economists that institutions play an important role in long-run economic performance. What is less clear is why some countries adopt institutions that are consistent with long-run economic growth while many others remain constrained by institutions that are harmful to economic growth and prosperity. These questions are emerging in the literature on empirical macroeconomics and comparative political economy. Geography has often entered into discussions of economic performance. A significant division has emerged in the literature between those that view geographic characteristics as primary determinants of economics performance and those that view institutions as the significant driving force in long-term growth. The use of latitude as an instrument for economic institutions is a common example of how geography, institutional quality and economic growth of are often linked, although with somewhat less than satisfying theoretical underpinnings, given the ambiguous understanding of how latitude impacts institutional quality or growth. Thus economists have often included geography in discussions of institutions and growth, but the primary focus has been on institutions and growth and not how geography and other variables influence the formation of the institutions that drive growth. This paper introduces new variables based on geographic shape and size and develops a model of how such geographic characteristics may influence the formation of institutions by self-interested rulers and thus impact long-term economic growth. Responding to emigration pressures that result from Teibout competition, rulers will adjust institutional quality to maximize long-term utility by liberalizing institutions and policies in countries that are more easily exited in an attempt to maintain a revenue base and maximize rent extraction. These findings support the hypothesis that geography is an important determinant of institutional quality (thus influencing long-run growth) and is based on a more economically sound rationale than the commonly used latitude variable 3

4 and provides a step toward developing a more robust understanding of the determinants of economic institutions more generally. A more accurate understanding of the factors that influence institutional quality may help improve efforts to address poor economic performance around the world. Over a half-century after the creation of the World Bank and widespread international efforts to alleviate poverty in poor countries, most of the world s population continues to live in conditions that are well below the poverty lines of Western nations. As Easterly (2002) points out, development programs have undergone periodic fads, each claiming to be the solution to global poverty and each failing to provide meaningful improvement. But recognition that institutions are important may not lead to adoption of better institutions. Many obstacles prevent institutional reforms from taking root. Thus, understanding the process of institutional reform will enhance our understanding of the critical process of economic growth and development. The rest of this paper is organized as follows: first, a literature review covering the major works on the relationship between economic performance and institutional quality and the relationship between natural factors, geography and both institutional quality and economic performance; second, a theoretical explanation of the relationship between geography and institutional quality; third, a description of major data sources; fourth, a presentation of the empirical analysis including several robustness checks; and finally a concluding discussion. 2. LITERATURE REVIEW 2.1 Institutions and Economic Performance Contemporary research on the importance of economic institutions as determinants of long-run economic performance is largely associated with the work of Douglass North and a small number of other economists in the post-war period. Although the importance of institutions has been recognized by many authors since at least Adam Smith (1776) much of post-war economics research ignored the importance of institutions for economic growth and development. The seminal textbook of the era, Samuelson s 4

5 Economics: An Introductory Analysis (1946), does not even include the word institutions in its index. Much of economics followed Samuelson s example in the post-war decades leading to many important conceptual gains, but also thus ignoring institutions. Alternatively, North's less mainstream research over several decades provides the primary arguments for why institutions matter. "The evolution of institutions that create an hospitable environment for cooperative solutions to complex exchange provides for economic growth" (North 1990, vii). According to North, institutions are the "rules of the game" in an economy or "the humanly devised constraints that shape human interaction" (North 1990, 3). The broad, yet vague, nature of this definition simultaneously reveals the importance of institutions and the difficulty of developing reliable and meaningful measures of them. North and Thomas (1973) argued that institutions, by shaping the incentives faced by individuals, were the driving force in long-run economic growth, and that changes in relative prices, such as their much cited example of feudalism and population change, were the reason that institutions evolved. Institutions responded efficiently in this explanation. North (1981) moved away from this efficiency explanation for institutional change and instead argued that institutions were adopted by self-interested rulers to satisfy their own interests and that there was no reason to believe that such institutions would be efficient or lead to maximum economic growth, but only to the increased wellbeing of the ruler and his supporters. North (1990) builds on this theory and argues that inefficient institutions that were adopted in the interest of the ruler or ruling elite may result in a path dependence in economic and institutional development that long outlasts the rulers who put the institutions in place. Other research in the 1980s and 1990s complemented North's emphasis on the importance of studying institutions. De Soto (1989) argued that economic development in poor countries was hindered by excessive regulation and bureaucracy that raised transactions costs so high that it prevented simple entrepreneurial activities from occurring. De Soto (2000) argued that poor countries lack the foundations of market economies, like a clear system of property rights, that rich countries developed in the nineteenth century and that the absence of such clear institutional underpinnings prevents individuals in poor countries from leveraging their informal, or extra-legal, property 5

6 holdings into more productive economic activity. Rosenberg and Birdzell (1986) support this view with the argument that economic development in the West was a slow and gradual process that succeeded through experimentation. "The key elements of the system were the wide diffusion of the authority and resources necessary to experiment; an absence of more than rudimentary political and religious restrictions on experiment; and incentives which combined ample rewards for success" (33). Research on the importance of firms and contracting (Coase 1937, 1960 and Williamson 1985) and the price system (Hayek 1945) among many others have led to a large body of work explaining why institutions are an important, perhaps the most important, explanation for economic growth. More recently economists have begun efforts to examine empirically the importance of institutions in macroeconomic performance. Two important articles in this line of research were produced by Acemoglu, Johnson, and Robinson in 2001 and Their articles are among the most highly cited in the field of empirical macroeconomics and have made large contributions to the emergence, in its own right, of the field of comparative political economy as a mainstream area of research. In these companion pieces Acemoglu et al. investigate how pre-existing conditions impacted the establishment of institutions in European colonies and how institutions have impacted long-run growth in those former colonies. Both papers take exception with the argument of Jeffrey Sachs and others who claim that geographic factors like disease environment and climate directly impact economic performance today (see for example Sachs 2003). Instead Acemoglu et al. argue that economic institutions, such as property rights, which may have originally been influenced by natural conditions, are in fact the primary determinants of economic performance today. In their 2001 Colonial Origins paper, Acemolgu et al. use the mortality of colonial settlers as an instrument for economic institutions. They argue that colonial powers were more likely to set up extractive institutions in colonies where it was difficult to survive, thus allowing them to extract as much wealth as possible from the colony with little regard for long-run performance. In colonies where it was easier to survive they developed productive institutions, institutions that respected property rights and rule of law and encouraged long-run growth. In their 2002 paper, Reversal of Fortunes, they 6

7 used population density as an instrument for institutions. Here they argued that colonies with dense existing populations where more likely to receive extractive institutions, and colonies with sparse population densities were more likely to receive productive institutions. In both papers they found that their colonial instruments, mortality and population density, were good predictors of current day institutions and they used this to show that there is a strong causal relationship between the strength of property rights and current economic performance. These papers suggest that once institutional factors are taken properly into account current geographic factors, like disease environment, have no direct impact on economic performance. Further their papers suggest that economic institutions often have deep historical roots that may be difficult to easily alter. Other recent research using various instruments to get around the causality problem has bolstered the argument that institutions are a primary determinant of economic growth. Easterly and Levine (2003) reject natural conditions as a cause of long-run growth beyond the impact those conditions have on institutions and argue that institutions are the fundamental cause of long-run performance. Rodrick et al. (2004) argue in the title of their paper that "institutions rule" and conclude "the quality of institutions trumps everything else" (2004, 135). But while institutions may rule, exactly which institutions rule and why is still an open question. Acemoglu and Johnson (2005) identify two types of institutions that reasonably could be thought to be important for economic growth: property rights institutions and contracting institutions. They identify property rights institutions as those that determine how secure property is from expropriation by the state or governmental entities. Contracting institutions are identified as those that govern the security of contracts signed by individual economic agents and how well those contracts are enforced. So the first group of institutions govern how the individual and his property interact with the state, and the second group of institutions govern how individuals interact with each other given the existing state. The goal of Acemoglu and Johnson is to determine the importance of these two different groups for long-run economic growth. There is much economic theory to support the importance of both groups. To address problems with endogeneity they use 7

8 instrumental variables to test for a causal relationship between these variables and economic growth. The instrument for property rights institutions is the colonial mortality data from the Acemoglu et al. Colonial Origins paper (2001) and the instrument for contracting institutions is the data on origins of the legal system developed by La Porta et al. (1997, 1998) and Djankov et al. (2002, 2003), which identifies the legal tradition (English, French, German etc) that underlies the legal system of each country. Their analysis suggests that a strong relationship exists between property rights institutions and economic performance, but that once these are controlled for, contracting institutions have no statistically significant impact on growth. They speculate that in an environment of secure property rights economic agents will be able to develop mechanism, such as reputation monitoring, to overcome shortcomings from a country's contracting rules. The authors concede that the mechanism by which institutions impact growth is still something of a black box. But the overwhelming evidence from this growing body of work on empirical tests of institutions has been that institutions are important foundations for long-run economic performance. Acemoglu and Johnson's paper leaves many other types of institutions unaddressed, such as monetary policy, regulations, and corruption, but it is an important step in helping to determine just what types of institutions poor countries will need to focus on if they are to encourage long-run economic growth. 2.2 Geography, Endowments and Institutions Having collected a large amount of evidence on the importance of institutions for long-run economic performance, economists have started to ask why some countries continue to have inefficient institutions. Several papers have begun to address this issue empirically. The past decade has seen an increasing emphasis on geography in the field of economic development. What has not been discussed as frequently is the degree to which geography influences the quality of institutions. Few would debate the notion that geography plays some role in influencing growth. Many discussions devolve into a quarrel over relative importance. Dani Rodrik et al. (2004) delineated three main schools 8

9 of thought in the literature geography, trade and institutions. While all three are relevant determinants of growth, debate remains regarding interaction and relative impact. Previously, many had been hesitant to revive such a deterministic conception of growth as geography. It risks bringing to mind racist development theories that go back at least as far as Montesquieu (1750) and Machiavelli (1519) (Easterly and Levine 2003, 5). Yet, empirics suggest equatorial nations are substantially poorer than their counterparts at higher latitudes (Sachs et al. 1995; 1997). The most prominent representatives of the Geography School, Jeffrey Sachs et al. (1998, 2001, 2003) and Jared Diamond (1998), argue that geography has both direct, as well as indirect effects, the direct being the most significant contributing factor for longterm growth. Sachs and Diamond approach the topic from slightly different perspectives. While Sachs illustrates how geography currently impedes economic development, Diamond tries to explain how geography influenced development over the course of history. Gallup and Sachs (1998) note that there are two unmistakable correlations with economic development. The first is that the majority of tropical countries are poor. The only tropical countries in the top thirty countries in terms of income are Hong Kong and Singapore. Secondly, coastal economies are richer than landlocked countries. There are no rich, landlocked countries in the world outside of Europe. Gallup and Sachs argue that these geographic factors continue to exert a direct impact on growth today. They estimate the following costs to per capita income for various factors: $4700 for being in the sub-tropics; $3,500 for being in the southern hemisphere; $10,000 for being socialist; $5,000 for being landlocked. In their 2003 work Institutions Don t Rule: Direct Effects of Geography on Per Capita Income, Sachs et al. flesh out the tropical thesis by focusing on the direct impact of the malarial environment on growth in equatorial nations. They cite three main ways that disease climate has a direct effect on income: (1) unhealthy people are less productive; (2) poor health conditions reduce life expectancy and shorter lives mean less human capital is accumulated over the lifetime; and (3) poor health may reduce the ability for human capital investment. 9

10 In addition to the tropical climate, Sachs et al. (1995; 1998; 2003) also discuss the relevance of coastal proximity for the growth of developing nations. They are not the first. Given lower transportation costs by sea than via land, one would expect that coastal nations would benefit more from exchange than their landlocked counterparts. Bauer devotes a few pages of his 1991 collection of essays, The Development Frontier, to addressing the relative importance of geography. He notes that while geographic factors play a significant role in shaping development in the short term, this elementary analysis reveals nothing about developments over a longer period (Baurer 1991, 28). Jared Diamond s 1997 book Guns, Germs, and Steel provides a different take on the role of geography in the history of development. Diamond suggests four main causal paths through which biological and geographical factors affected development. To illustrate his hypotheses, he describes the differences in the development of Europe, Africa and Asia. First, Diamond attributes divergence in development to biological differences across continents. Societies with wild plants and livestock capable of being domesticated (Europe) developed resistance to certain infectious diseases like measles and small pox, while those who lacked farm animals failed to develop the same immunity. This proved disastrous for the original populations of the Americas after contact with European explorers. The other obvious benefit of livestock resides in the productivity gains from agricultural use. Diamond notes that Africa missed out on these gains due to a disease climate that limited the number of cattle. Diamond s second contention is that diffusion within continents via migration allowed for greater rates of development in Europe and Asia than in Africa and the Americas. Climate is relatively uniform along latitudinal lines, and therefore many of the crops that developed in Europe or Asia were easily transplanted from one continent to another along similar latitudes. On the contrary, the number of climatic regions in continents that are oriented primarily along north to south axes did not allow for the same spread of innovation. If a productive crop is already available, incipient farmers will surely proceed to grow it rather than start all over again by gathering its not yet so useful wild relative and redomesticating it (179). These continental corridors also allowed for contact that would have inspired trade, and the diffusion of technological innovations 10

11 (179). Diamond notes that diffusion occurred more slowly in Africa and the Americas, given the north-south axes and geographic barriers. In addition to diffusion within continents, some factors allowed for diffusion between different continents. Some continents (Australia, Americas) have traditionally been more isolated than others. This led to less interhemispheric diffusion than that which has been observed within the Eurasian region, given its east-west major axis and its relatively modest ecological and geographical barriers (407). Diamond s fourth hypothesis is that continents benefit from large geographic or population size. A larger area or population means more potential inventors, more competing societies, more innovations available to adopt and more pressure to adopt and retain innovations, because societies failing to do so will tend to be eliminated by competing societies (407). Essentially, the competition and diffusion created by large areas for people to interact fostered development over the course of history. While all of Diamond s arguments seem plausible he includes one final important hypothesis as almost an afterthought in his book. He presents a map of the borders of Europe and China and speculates that differences in their shape could have significantly influenced their institutional developments. China, he speculates based on the map, was easier to centralize and bring under the control of one ruling group while Europe was geographically suited for more local, decentralized control and was harder to reign in by any one power. As Diamond explains it, Europe is much more indented and includes more large peninsulas and two large islands providing natural barriers to political centralization. (414). Hall and Jones (1999) were among the first to empirically explore the effects of geography on institutions. They found latitude to be a very significant determinant of institutional quality. Countries that are farther north have significantly more productive institutions than those closer to the equator. They explored institutions as part of what they deemed social infrastructure, and found them to be productivity enhancing. About the same time Kaufmann et al. (1999) used percentages of English and European speaking populations to instrument for institutions. The reasoning, similar to that of Hall and Jones, is that Europeans have traditionally had better institutions, and generally settled in climates that were similar to those they were used to in Europe. 11

12 Engerman and Sokoloff (1997, 2000) focus on the type of natural endowments present in different geographical locations, and how this translates to institutions. Their 2000 study, Institutions, Factor Endowments, and Paths of Development in the New World, centers on the disparity between development in North and South America. The argument is that given South America s abundance of resources that lend themselves to commoditization (rice, silver, sugar cane), economies of scale led to slave labor under a few ruling elites. This stands in stark contrast to the history of North America, where the climate allowed for grains like maize and wheat which permitted relatively small farms given the technology of the times and may help explain why such a policy of smallholding was implemented and was effective (224). Ultimately, extreme inequality in the majority of the countries in the Americas allowed a few ruling elites to consolidate political power that still endures. In contrast, due to large amounts of available land and open immigration, the United States and Canada developed large middle classes that checked the power of those at the top of the wealth distribution. Because industrialization required the consent of the majority, these middle classes proved indispensable. This distinction was also apparent in the United States prior to the Civil War as southern states developed more extractive, less entrepreneurially focused institutions built around the slave-driven cotton industry, while the northern states developed more productive institutions. Following Engerman and Sokoloff, Acemoglu et al s 2001 and 2002 pieces (discussed above) on how pre-existing geographically-determined conditions impacted the establishment of institutions in European colonies, and how those institutions have impacted long-run growth in those former colonies, are two of the most influential pieces in the literature. The Acemoglu et al. papers have been criticized, but primarily for the validity of their instruments as proxies for institutions not so much for their claims that the geographic conditions would have influenced institutions (see for example Sachs and McArther 2001). That being said, Rodrik (2004) argued that a better instrument for institutions had yet to be discovered. Easterly and Levine s 2003 work Tropics, Germs, and Crops: How Endowments Influence Development examines Engerman and Sokoloff s (1997) hypothesis that endowments influence institutions. They develop dummy variables to test whether or not 12

13 a country produces any wheat or mining commodities to test the theory. Contrary to the endowment and policy theorists, Easterly and Levine find no evidence that endowments affect country incomes directly other than through institutions, nor any effect of policies on development once we control for institutions. (39). But interestingly, as with much of this literature, the emphasis of the findings is placed on explaining the role of institutions in determining growth, and scant discussion is given to the reappearing assertion that geography is a major factor determining those institutions. Economists, for the most part, seem content to skip that step in the logic. Rodrik et al. s 2004 piece Institutions Rule: The Primacy of Institutions Over Geography and Integration in Economic Development serves as a summary of prior works in that debate. Rodrik et al. compile the various instruments to argue that Acemoglu et al s proxy for institutions is a more significant determinant than any of Sachs geographic instruments, Frankel s trade variables, or a number of other potential institutional measures. 2.3 Informal Institutions, Fractionalization and Trust Williamson (2009) distinguishes between formal institutions, which represent government enforced constraints, and informal institutions, which represent privately enforced practices. The contention based on empirical analysis is that informal institutions have an important role in determining economic outcomes and that formal institutions matter primarily if they are imbedded within or related to informal institutions. Her work points to an important role for informal institutions, culture, etc. in determining formal institutions and thus growth. These conclusions are supportive of the work of Easterly (2006), which focuses on the likelihood of failure if outside influences (as development lenders) impose formal institutions rather than building on organic, bottom-up informal means. Easterly s contention is that institutions are important, maybe the most important thing in determining long-run economic growth, but that so little attention has been paid to understanding how developing countries work that almost all attempts to improve institutions have done very little good. As he expresses it the free market is a universally useful system. Economic freedom is one of mankind s most underrated inventions (72). 13

14 However, while free-markets work well, he points out that free-market reforms are quite often failures because the designers of reform fail to understand the local underpinnings of how institutions evolve. The emphasis, he argues, must be placed on understanding how institutions evolve locally and how assistance can be contributed within that process rather than aid being used to try to force imported practices to replace local practices. He clearly contends that productive institutions are not likely to be successfully imposed though outside pressure such as advocated by the Washington Consensus. The argument that informal institutions matter a lot in determining formal institutions and performance is supported by the small line of research on trust. Fukuyama (1996) was one of the first major efforts to discuss the role of trust in determining economic performance. Trust, he argues, can lower transactions costs by making it easier for parties to a transaction to agree to terms and feel comfortable about business dealings. Also trust may contribute to the adoption of more consistently fair formal institutions by creating a lower sense of unease about how the rest of society might take advantage of those institutions. Knack and Keefer (1997) have investigated Fukuyama s hypothesis empirically using survey data and found that economic performance is positively correlated with reported levels of trust in a society. Fractionalization within the population whether on religious, ethnic or linguistic grounds is thought to be a potential hindrance to greater social cohesion and trust. Recent empirical work has attempted to develop measures of this type of fractionalization and test its impact on institutions and growth. Alesina et al (2003) developed the current standard measures of these three forms of fractionalization for 190 countries. Their study suggests some importance for fractionalization in determining institutional quality and economic performance, but is not conclusive. It s greatest contribution has been spurring greater interest in the measurement and application of the concept of fractionalization to empirical growth literature. A theoretical foundation for the importance of fractionalization in determining institutional quality was provided by Olson (1982). In The Rise and Decline of Nations Olson applies the lessons from his 1965 work, The Logic of Collective Action, to the question of economic growth and performance and economic institutions. He argues that most development research in economics misses the primary drivers of institutions and 14

15 growth. They trace the water in the river to the streams and lakes from which it comes but they do not explain the rain (1982, 4). Olson (1965) argues that group coordination is hindered by the free-rider problems; that is, if benefits of group action are dispersed each individual does not have an incentive to work very hard to achieve that action and instead has an incentive to free ride on the efforts of others. The larger a group is, and the more diverse are its members, the less likely it is to pursue actions in its members interests. Olson 1982 applies this logic to social evolution and institutions. Societies with more heterogeneity fractionalization in the current literature are likely to have less social interactions and organization and are less likely to make decisions in the interest of the whole society for example, adopting sound economic institutions. Political entrepreneurs, he argues, are more successful if they deal with homogeneous groups whose interests can be clearly identified and rewarded. Given the free-rider problem smaller groups have an advantage in organizing their members to capture the interests of these political entrepreneurs. As heterogeneity increases, so too does the likelihood that policies will be adopted to support the interest of only one or a small number of groups and not society as a whole. The number of distinct interest groups increases the likelihood of bad outcomes in this reasoning. Thus, in Olson s model and much of the political economy literature, fractionalization is expected to play a critical role in determining if a country will experience positive or negative economic institutions and performance. Taken as a whole the institutions and growth literature has advanced rapidly in the last decade. Significant progress has been made in empirically understanding the role of institutions in long-term economic performance. Many other issues have been identified as important factors in the evolution of institutions (such as informal institutions and fractionalization) which are only beginning to be well understood in relation to the growth process. A better understanding of the role of factors such as geography, fractionalization and other variables in the process of institutional development is critical to continuing to develop a more complete understanding of the process of economic growth. 15

16 3. THEORETICAL MODEL When looking for factors to help explain economic institutions geography is a natural option (as revealed by the preceding discussion). The relationship between latitude and institutions has long been discussed in the history literature as an important relationship that may explain economic performance over time. Possible explanations for latitude s importance have ranged from the impact of heat on working conditions and human energy, climate s impact on agricultural productivity, and the idea that variation in temperatures at higher latitudes requires greater ingenuity and adaptability. Since Hall and Jones (1999) it has become common to use latitude as an instrument for institutional quality in the empirical growth literature. The strong correlation between economic performance and latitude makes it impossible to ignore this factor as a potential determinant of economic performance (Table 7 in the Appendix provides a correlation of.38 between a measure of economic institutions and latitude). Nevertheless, a clear explanation of the impact of latitude on economic performance is lacking. The two most common explanations for the importance of latitude discussed in the economics literature are: 1) that latitude is a good measure of whether a country is tropical this is the view closely associated with Jeffrey Sachs that the tropical disease environment directly impedes economic development; and 2) that latitude is closely linked with how desirable a location was for colonial powers to develop long-term settlements this is the idea closely associated with the work of Acemoglu and his colleagues. Regardless of the ultimate explanation of why latitude is so closely related to economic performance and economic institutions, its strong correlation makes it imperative that latitude be included in the empirical analysis of the determinants of institutional quality. So for the analyses conducted here latitude will consistently be included as a control variable to ensure that the importance of other measures is not unintentionally exaggerated. Casual empiricism suggests some interesting relationships between geography and economic institutions. Figure 1 shows the relationship between a common measure of economic institutions and geographic size. The countries were 16

17 broken down into four quartiles going from smallest geographic area to the largest. As Figure 1 indicates the simple relationship between area and institutional quality is negative (higher scores in this measure of institutional quality represent greater reliance on market allocation). The average economic freedom score (see the next section for data discussion) for the smallest-by-area quartile is roughly 6.8 while the average economic freedom score for the largest-by-area quartile is just roughly 5.9. The middle quartiles fall in between, but do not suggest a clear monotonic pattern. Figure 1: Economic Institutions and Area by Quartile The suggestive relationship between geographic size and economic institutions raises the question: are other measures of country size are correlated with institutional quality? Figure 2 explores the relationship between population size and economic institutions with a quartile graph. Here the relationship is much less clear. The largest-by-population quartile has a higher average economic freedom score (about 6.7) than the other quartiles (6.05 to 6.26), yet the simple correlation is not statistically significant at any meaningful level. Population proves to be not significant in regression analysis in multiple specifications as well and is 17

18 left out of further analysis as it does not appear to be a meaningful measure of size at least in terms of trying to explain institutional quality. Figure 2: Economic Institutions and Population by Quartile 3.1 Why Might Small Countries Have Better Institutions? Competitive processes may influence the quality of a nation s institutions and policies. A smaller country may seem like the ideal place for a rent seeking political elite to exact maximum control over a populace with limited resources and technology it is likely easier to exert control over a small area than a large one. However, as often happens in economic reasoning, this static view is not likely accurate. Decision-makers in small countries may have a stronger incentive than those in larger ones to adopt institutions and policies more consistent with economic liberalism and long-term economic progress. There are several reasons why this might be the case. First, exchange with foreigners will be more important for the residents of small nations. If the residents of small countries are restricted from trading with foreigners, it will be more difficult for domestic businesses to realize fully the potential gains from 18

19 scale economies. Similarly, domestic entrepreneurs in small countries will often find it cheaper to obtain financing from investors in other countries. Opportunities for business expansion and other entrepreneurial activities will be limited by the domestic capital market if funds cannot also be attracted from abroad. However, foreign investors must have confidence that they will be treated fairly. This means that the country s legal, regulatory, and tax systems must protect property rights, enforce contracts, and apply to both citizens and foreigners in an even-handed manner. Because the potential gains from trade with foreigners will be more important for the residents of a small country than for one with a larger domestic market, decision makers in small countries may have a stronger incentive to adopt and sustain sound institutions and policies both because the population has a strong incentive to demand it and because the economic base upon which the political class can predate will be larger. Second, compared to large countries, the residents of small nations can generally exercise the exit option at a lower cost. For the typical person, the distance to the border will be shorter, thus increasing the number of potential institutional substitutes. Thus, harmful policies will generally cause a larger share of the population to exit in small countries than in large ones. This puts still more pressure on the political decision-makers of small countries to adopt and maintain sound policies. If they do not residents are more likely to leave and the tax-base will erode. It will also potentially be easier for citizens in small countries to monitor political agents and to find private solutions to common problems lessoning the need for intervention (Coase 1960; Olson 1982). However, the cost and incentive structure relative to economic institutions does not always favor small countries relative to their larger counterparts. If there are substantial economies of scale in the provision of institutions or policies generally provided by governments, small countries may be at a disadvantage. For example, the cost of operating a central bank may be approximately the same in a small country as for a large one. Thus, the per-person cost of this service is likely to be greater in small countries. Furthermore, like language, currency is a network good. The service provided to each user will be of greater value when the currency is readily accepted by a large number of people. Therefore, both the per-person cost and the value of the service provided are likely to work to the disadvantage of small countries attempting to provide 19

20 and manage their own currency regime or other network goods. Thus absolute size seems theoretically to be an ambiguous explanation for institutional quality. 3.2 Other Geographic Characteristics Absolute size is not the only way to measure geographic characteristics. Indeed it may not even be the most accurate method to capture the impact size-like characteristics have on institutional quality. Diamond (1997) hypothesized that one of the reasons Europe may have had an early advantage over China in economic development was because China was easily controlled by one authority due to its relatively smooth shape and uninterrupted geography as compared to Europe with its abundance of peninsulas, islands etc. Diamond s observation was almost an afterthought placed at the end of his lengthy book, however, the empirical analysis that follows suggests it is of major importance in explaining institutional quality. Figure 3 represents the outline of Europe and China and begs the question Diamond posed about shape and institutions. Length and shape of borders could help integrate Diamond s insight into an empirical analysis of institutional quality. Countries with the shortest borders (smallest length of total border) have an average economic freedom score over a half a point higher than countries with the longest borders. However, total border will be very closely related to total geographic size and so distinguishing the two characteristics is difficult when analyzing impact on economic institutions. An alternative approach that would capture the impact of both size and shape would be to create a new calculated variable called here exitability described in equation 1. (1) EX = ( B+ C) A 20

21 Exitability, EX, is defined as the sum of land borders, B, and coastline, C, divided by total geographic area, A. This variable more closely captures the idea Diamond was discussing. A country with an irregularly shaped border would have a higher ratio of exit options per land area than a country with smooth borders like Europe relative to China in Figure 3. From a theoretical perspective, institutional competition requires available substitutes. Ideally, for competition to be maximized, the location of any individual within a given country ought to be as close as possible to a different system of governance. Exitability, gives us an approximation of how easy a country is to leave (an estimate the cost of mobility). Figure 3: Map of Europe and China: Does Shape Matter? The exitability score is higher if the length of borders and coast line per total area is higher and lower when there are shorter borders and coastline relative to total area. So countries with rather irregular borders have higher exitability while countries with smoother more regular border have lower scores. China, which Diamond used as an example, has a relatively low exitability ratio of Another example of a low ratio is Chad with an exitability ratio of Both countries have relatively large landmasses away from any borders and have relatively smooth borders the sweeping half-moon shape of China and the more rectangular shape of Chad. In contrast Denmark has an exitability ratio of 0.17 and Panama is 0.039, both relatively high exitability numbers. These countries are shaped in such a way that more of their area is close to a border or coast the peninsula and many islands of Denmark and the long narrow isthmus of Panama. 21

22 One way to consider the importance of ease of exit lies in the ability it provides citizens to give feedback to the governing party. Individuals will, if possible, vote with their feet if that is their only option of impacting the institutional status quo. In this sense we can think of exitability as providing a measure of Tiebout sorting among countries. Tiebout (1956) developed a novel model for describing the provision of local public goods. In his model residents would choose among competing localities for the bundle of publicly provided goods that best fit their preferences. According to the Tiebout model large governments are inefficient because they cannot design a bundle of publicly provided goods that satisfies the variety of preferences among a large populace. Smaller localities in this model are more efficient as they can tailor their provisions to a more homogeneous population. Individuals can express their preferences by moving amongst the segmented localities to find the best match for themselves. This Tiebout sorting process can result in competition (Tiebout competition) among the various jurisdictions to provide the bundle of services that will attract population and thus a revenue base for the government. Given that consumers have heterogeneous preferences and that localities vary in the goods provided (government programs) and costs (taxes, fees etc.), optimal allocation of citizens, government programs and taxes are only likely to arise over an extended period of Tiebout sorting. Optimal allocation arises in Tiebout s model if information is widely available (perfect information) and it is easy to move between localities (perfect mobility). As either of these assumptions is relaxed the optimality of the Tiebout allocation will diminish. Applying the logic of Tiebout sorting to the international level we can assume individual agents have a preference to sort themselves into national jurisdictions that most closely satisfy their preferences for publicly provided goods and taxes. Here we can think of the institutional environment as one of the publicly provided goods, or more accurately a bundle of publicly provided goods. The ability to engage in Tiebout sorting is clearly impacted by national policies regarding migration; a prohibition against outward migration would be a clear obstacle to Tiebout sorting as was often noted during the era of the Iron Curtain. 22

23 Thus we can identify at least three major obstacles to Tiebout sorting at the national level: information, travel costs (the original two constraints) and government prohibition. Exitability, as described above, will impact how binding each of these constraints are at the national level. A country with greater exitability will have a population with more information about other jurisdictions, cheaper access to them by being located more closely to borders, and an increased difficulty of enforcing border controls due to the relative abundance of locations from which to exit. Exitability thus increases the possibility that citizens of a country can engage in Tiebout sorting and seek out national jurisdictions that more closely align with their preferences. As North (1981 and 1990) among others explained, rulers will adopt institutions that allow them to maximize their own welfare given their particular national set of constraints. If the ruler (or ruling group) wishes to extract rents from the population this will become more difficult if exit is easier. Thus, with exit options abundant, a more viable solution for rent extraction may be to adopt institutions that encourage growth allowing for smaller-percentage wealth transfer from a larger economy rather than largepercentage wealth transfer from a smaller economy. Greater exit options should increase competition among national governments to improve institutional quality in order to retain citizens (revenue). As was widely recognized during the Cold War, population loss is one of the best indicators of poor governance that exists. Thus, one might expect that countries with border to area ratios that reduce the cost of exit will generally have more liberal growth encouraging institutions over the long term as the sorting process occurs. The ruler s problem can be captured in a simple utility maximization framework. Rulers will wish to maximize utility which will be a function of GDP and rent extraction, among other things: (2) max U = f( GDP, rent, Z) r The rulers ability to extract utility, U r, will be a function of both the size of the economic base and the level at which rents are extracted from the economic base. Acemoglu et al (2001; 2002; 2004) among others (as discussed above) have provided significant 23

24 empirical evidence that GDP is a function of economic institutions, EI (and certainly many other factors): (3) GDP = f ( EI, Z) Rent extraction as a percentage of economic output and other forms of utility enhancing regulation (such as providing benefits and advantages to favored political groups) will tend to be related to the quality of liberal economic institutions. Thus EI will also influence the variable rents in equation (2) as well the ruler will face a tradeoff between greater percentage rent extraction from a smaller economic base resulting from poor institutions or a lower percentage level of rent extraction from a larger economic base resulting from higher quality institutions. Both GDP and possible rents will be influenced by the exit options of the population. Thus a main constraint on the ability of rulers to maximize utility is the ability of the population to exit, which will be a function of the variable exitability, EX, among other factors: (4) gex (, X ) Taking this into account and combining equations (2) and (3) provides a simplified version of the ruler s problem as: (5) max U = f( EI, Z) EI r st..: g( EX, X) Combining and simplifying the first order conditions from this constrained optimization problem yields the ruler s optimal decision rule: (6) f '( EI, Z) = g( EX, X) 24

25 Thus changes in economic institutions will be impacted by the rulers attempt to maximize rents based on a given level of exitability. This relationship will be tested empirically to determine the impact of exitability on institutional quality. 4. DATA In addition to the variable EX described in equation (1), two other variables were constructed to test the impact of ease-of-exit on institutional quality. An analogy to the idea of exitability is the idea that will be called coastalness. Several authors have pointed to the seeming importance of coasts in a country s economic development (Bauer; Gallop and Sachs). Coastalness, here, is a calculated variable defined as the length of coastline divided by total area. As shown in the Appendix there is a positive correlation between coastalness and economic freedom. With island countries the measure of exitability is equal to the measure of coastalness. Whereas countries that are landlocked will have a zero coastalness score yet they still have the possibility of a relatively high exitability score, like, for example, Austria. Particularly before the advent of air travel, sea travel often represented the most economical means of accessing foreign cultures and goods. Thus coastal communities would not only be more likely to have more contact with people from other societies, they would also be more likely to become trading hubs among numerous societies that did not have direct access to sea routes. The potential wealth generation of these processes should encourage coastal societies to develop institutions conducive to trade. Smith (1776) summarized the importance of coastalness as follows: As by means of water-carriage a more extensive market is opened to every sort of industry than what land-carriage alone can afford it, so it is upon the sea-coast, and along the banks of navigable rivers, that industry of every kind naturally begins to subdivide and improve itself, and it is frequently not till a long time after that those improvements extend themselves to the inland parts of the country. Finally another variable has been created to capture the possible impact of shape on economic institutions. Mathematically, a circle is the shape where most of the area is 25