Therewith the summary representation \* *I* can now be defined as an institution. Aoki's (2001) five characteristics of institutions, depicted with his sharedbeliefs cum equilibrium-summary-representation view of institutions, are observed in the model: \* *I* , the institution, is endogenous; it is a summary representation of the decisive information; it is robust; it is universally relevant to all individuals (shared cognition); and multiple institutional equilibrium paths are conceivable, based on equal technological and ecological environments.

The institution, however, includes all relevant information the agent needs to optimally choose his strategy. With the institution in place, the agent does not consciously choose a strategy; the only possible strategy adapted from the institution is the optimal strategy. The strategy, however, is decisive for the agent's action. Hence, an individual's behavior is based on the prevalent institution.

That is to say, without the institution in place, the agent has to consciously maximize his utility as depicted in this section to achieve his equilibrium strategy. With an institution in place, the derivation is not necessary. The institution includes all relevant information and lets the individual know – without further consideration – how others will behave and how they expect the individual to behave. This is a Nash equilibrium since an incentive for an unilateral deviation does not exist. The state will continue until it is disturbed by an exogenous shock.

This applies as long as the environment varies within a certain range. An environmental change exceeding the particular range is similar to an exogenous shock and thereby causes institutional adjustment. Hence, the equilibrium state is disturbed and a new equilibrium must emerge. As long as the equilibrium does not exist, an institution cannot be observed. In this case, the specific universal rule regulating social interaction does not exist within the examined domain. An institution becomes obvious when it is already implemented in human behavior. Hence, it becomes obvious when an equilibrium is realized. Therefore, an institution is unobservable until an equilibrium state is present. Hence, the institution is associated with the equilibrium. However, other institutions, depicted by the exogenous environment , do exist. Applying the equilibrium view of institutions \* *I* refers to the one institution under consideration, but of course other institutions are prevalent.

The model is unsatisfying in the sense that it does not describe the emergence of an institution. The institution is suddenly there. However, institutional emergence can have several origins. It depends on the definition of an institution and its borderlines. Institutions can obviously emerge from other institutions or historical accidents. In any case, often institutional emergence cannot be traced back to a certain starting point. Invisible random events might, influenced by other exogenous events or shocks, generate a new institution without anybody recognizing it. Institutional emergence can be a conscious process, that is consciously initiated by individuals to regulate their interactions. However, institutions can also emerge unconsciously (and probably most institutions do); nevertheless, their intentions are to regulate social interaction.

So far, we cannot explain the emergence of an institution. At least when it comes to the origin of informal institutions, other disciplines such as neurology, genomics, evolutionary theory or in general biology and anthropology must be consulted. However, if we want to explain certain codes of conduct within a society, we can resort on a particular social value system or worldview. These are often based on a certain religion, although this might not be the case. Behavioral patterns originate in a society's tradition and culture but the roots of the culture are difficult to assess.

Therefore, the model and the equilibrium view of institutions in general have their drawbacks. However, the theory should be used to demonstrate the persistence of institutions and the issue of equilibrium strategies and inertial behavior; no more and no less.

The case study in chapter five demonstrates the emergence of a new worldview in the Arab region during the early Middle Ages because of societal, historical, religious, and accidental reasons. Starting with subtle changes, institutional modifications were put into motion that, together with external random events, altered the existing institutional environment and created a new starting point for technological development, modern sciences, and economic growth.

According to the equilibrium view, it could be argued that external shocks and a cognitive disequilibrium originating in a new worldview disrupted the institutional equilibrium and ended up, after hundreds of years, in a new stable equilibrium that seems to be less growth supportive, at least from a Western economist's point of view. Now, institutional persistence makes it difficult to change institutions in a growth-favoring way.

However, the institutional equilibrium that might become disrupted does not have to relate to the general institutional system of a state or a society. Institutional systems emerge within institutional systems. This is what makes the topic so complex. An institutional equilibrium might exist on a low level; hence, a certain institution might regulate the interactions of a certain group of individuals in a particular case. That is to say, talking about institutions does not necessarily mean talking about the 'big' institutions, such as the constitution, the jurisdiction, property rights, or the general social value system. A certain institution can be relevant for only a few individuals. Therefore, it is important to define the observed population. Institutions might exist within a circle of friends, the family, colleagues, a firm, a nation, and so on. Other institutions might be relevant not only for a country but for a whole cultural area, which might cross national borderlines. That is to say, the term 'institutional persistence' does not intend to suggest that all institutions within a state are in equilibrium and cannot be changed. Instead, an institutional system consists of a myriad institutions, formal and informal, relevant to a certain group or to all individuals in the system. All institutions interact with each other, are influenced by exogenous factors, and, of course, change. One institution in the system might be disrupted and modified. This can be without result for the other institutions, it can have consequences for a few institutions, it can have a sudden impact on the whole institutional system, or it can have a slow but strong influence on the other institutions. In the model, for example, we demonstrated institutional persistence for a certain domain, and thereby for the observed set of agents and their physically possible actions. The model can be applied to a large state-level institution or an informal institution affecting only a few individuals, but it cannot be applied to the whole institutional system.

For example in the Arab case, we cannot say that the institutional system per se experienced an exogenous shock and, therefore, deviated from the equilibrium path. Some institutions changed, others did not, and some were modified subtly, others consciously. However, some of the changes had long-lasting effects on societal and economic development. An institutional system is a dynamic entity with some constraints never changing and others being modified constantly. Thus, the equilibrium view of institutions should not be misunderstood. The model deals with only one institution for a given population. It emanates from partly unrealistic assumptions. Therefore, it cannot be applied oneon-one on the institutional environment of a state. The objective is merely to demonstrate the issue of equilibrium strategies in the case of institutional analysis. Hence, when individual and collectivist behavior is in equilibrium, codes of conduct cannot be changed. Thus, we cannot just change institutions because they are economically inefficient. Even if they result in low economic growth rates, the individuals' strategies are optimal regarding the prevalent conditions.

# **2.8 The form of societal organization**

Institutions, however, are the reason for a certain form of societal organization. Societal organization describes the collective behavior of the members of a society. Hence, with societal organization we can examine the impacts of different institutions on collective behavior. When different institutions lead to different individual and, since institutions are universal, to different collective behavior, different forms of societal organization are the consequences. Thus, choosing societies that vary in their form of organization means we can demonstrate the impact of different institutions on, for example, the equilibrium wage.

However, how does the issue of institutional persistence adhere to societal organization? Well, if optimal strategies are realized, then the value system and, therefore, norms and codes of conduct will not change until an exogenous shock causes a deviation from the equilibrium path. In any case, this means the form of societal organization is persistent. Hence, limited or generalized morality will survive, no matter which outcomes they produce. Outcomes, however, can vary widely depending on societal organization.

The next model demonstrates the impacts of different forms of societal organization. Again it is important to note that the objective of the analysis is not to identify the 'better' form of societal organization. Both societies cannot be normatively compared. In both societies, optimal strategies are implemented contingent on the corresponding prerequisites. Individuals maximize their utility by choosing the optimal strategy contingent on the others' behaviors and at least indirectly contingent on the institutional environment. Hence, it is demonstrated that different forms of societal organization cause different results. No statement is made regarding which result and which organizational form is 'better', since every form and every result is optimal per se.

### **2.8.1 Model II**

This section partly depicts the model by Greif (1994). Greif, however, examines the development paths of a collectivist and of an individualist society, where the former corresponds to the concept of limited morality and the latter is similar to a society practicing generalized morality.

The original paper from 1994 combines the game-theoretic analysis with a historical case study of Genose and Maghribi merchants of the 11th and 12th centuries.18 Here, however, only the theoretical part will be presented.

The model depicts the agency relationships between entrepreneurs and agents. The one-side prisoner's dilemma game demonstrates that different forms of societal organization lead to different patterns of agency relations that are separately in equilibrium. Agents can decide whether to cheat and earn a oneperiod gain from cheating, or whether to play honest and earn the regular wage. Entrepreneurs, by contrast, can hire an agent or decide to work on their own and not hire an agent. Whether to hire an agent or not depends on the possibilities of avoiding cheating. Thus, the entrepreneur, who pays the agent's wage if he hires the agent, can provide an incentive to play honest by correspondingly choosing the wage. The wage must be higher than the gain through cheating. Then again the entrepreneur must decide whether it is worthwhile paying the wage. Thus, the incentive structure works via a wage, which must be high enough to provide an incentive for the agent not to cheat. The wage must also be low enough to provide an incentive for the entrepreneur to hire an agent, since he can also do the work himself.

The equilibrium wage that ensures that an agent is hired, and that the agent plays honest, is calculated using the players' corresponding utility functions. When the wage is fixed, however, the differences between societies practicing

18 See also Greif (1993).

limited rather generalized morality become obvious. It is demonstrated that, depending on the form of societal organization, the equilibrium wage and societal structures differ.

Notation:

Players live indefinitely. An entrepreneur hires one agent and an agent can work for only one entrepreneur per period. Entrepreneurs and agents meet randomly; however, the entrepreneur can exclude certain groups of agents from the possible pool according to the information available to the entrepreneur. When the agent is employed he can decide whether it is worthwhile playing honest or to cheat. The reservation utility η is the utility the agent receives from being unemployed. Furthermore, the agent runs the risk that, even when he plays honest, the agency relationship is terminated. This could be the case because the entrepreneur becomes ill or retires. ξ depicts the probability that the entrepreneur terminates the relationship even though the agent plays honest. All players are aware of the history of the game.

Agent playing honest:

When the entrepreneur hires an agent and the agent plays honest, the entrepreneur receives γ −*W* ; that is the gross gain from cooperation minus the wage. The agent receives the wage *W* .

Cooperation is assumed to be efficient, that is γ - κ +η . The left-hand side of the inequality depicts the gross gain from cooperation, thereby the entrepreneur's and the agent's payoffs. γ includes the entrepreneur's net gain plus the agent's wage. The right-hand side describes the gain from noncooperation, thereby the entrepreneur's payoff κ plus the agent's reservation utility η.

Agent playing cheat:

0 entrepreneur's payoff α ηagent's payoff

If the agent cheats the entrepreneur receives zero payoff. Hence, the entrepreneur prefers noncooperation over being cheated or having to pay *W* = α since noncooperation provides him with κ -0 .

Derivation of the equilibrium wage:

Up next the players' utility functions are described, which are then used to derive the equilibrium wage.

est agent *u Vc* present value of the lifetime expected utility of an unemployed

cheater (who will be honest in the future if hired)

One period of cheating must be less attractive than the utility an agent receives from playing honest in every period. Hence:

$$V\_h \ge \alpha + V\_c^\* \tag{2.20}$$

must hold for the agent to play honest.

Utility functions:

$$W\_h = W \, \text{\*} + \mathcal{S} (1 - \xi \, \text{'} \, V\_h + \xi V\_h \, \text{''} \, \tag{2.21}$$

$$V\_{\iota}^{\iota} = \partial h\_{\iota} V\_{h} + \mathcal{S}(1 - h\_{\iota})(\eta + V\_{\iota}^{\iota}) \qquad \qquad \qquad i = h, c \tag{2.22}$$

To gain the equilibrium wage \* *W* we have to dissolve equations (2.21) and (2.22) for *Vh* and *u Vc* , which we then have to insert in the above inequality (2.20). The full derivation is demonstrated in appendix A.

Dissolve (2.21) for *u Vh* :

$$V\_h'' = \frac{V\_h \sum -W \cdot \mathbf{\tilde{}}}{\xi} \qquad\qquad\qquad\text{with:}\quad \Sigma = 1 - \mathcal{S}(1 - \xi)\tag{2.23}$$

From (2.22); setting i=h:

( )( ) *u h h h h u Vh* = δ*h V* + δ 1− *h* η+*V* (2.24)

Dissolve (2.22) with i=h for *u Vh* :

$$V\_h^u = \delta H\_h V\_h + \delta \mathbb{P}\_h \eta \tag{2.25}$$

$$\text{with} \quad H\_i = \frac{h\_i}{\left[1 - \mathcal{S}(1 - h\_i)\right]}$$

$$P\_i = \frac{1 - h\_i}{1 - \mathcal{S}(1 - h\_i)} \tag{2.26}$$

Similarly; setting i=c in (2.22):

$$V\_c'' = \delta \mathcal{H}\_c V\_h + \delta \mathcal{P}\_c \eta \tag{2.26}$$

Equalizing (2.23) and (2.25):

$$\mathcal{V}\_{h} = \frac{\delta \mathcal{P}\_{h} \eta \xi \xi + W \ast}{\sum - \delta \mathcal{H}\_{h} \xi} \tag{2.27}$$

Remember:

*u Vh* ≥ α+*Vc* (2.20)

Insert (2.26) in (2.20):

*c c h H P V* δ α δ η − + ≥ 1 (2.28)

Insert (2.27) in (2.28):

Dissolve (2.29) for W\*:

$$W^\* \ge \frac{\alpha(\Sigma - \delta H\_h \xi)}{1 - \delta H\_c} + \delta \eta\_\* \left( \frac{P\_c(\Sigma - \delta H\_h \xi)}{1 - \delta H\_c} - P\_h \xi \right) \tag{2.30}$$

$$W^\* = \bowtie (\delta, h\_h, h\_c, \xi, \eta, \alpha) \rhd \eta \,. \tag{2.31}$$

*w* decreases in the agent's time discount rate δ and in the probability of hiring an honest agent *hh* . *w* increases in *hc* , the probability of hiring a cheater; in ξ , the termination probability; in η , the reservation utility; and in α , the payoff from one period of cheating.

Hence, the optimal wage is *W*\* = *w*( ) δ ,*hh* , *hc* ,ξ,η,α η with δ ∈(0,1) and 1 *hc* .

Until now no difference has been made between limited and generalized morality. The optimal wage depends on the agent's discount factor, on the probability of hiring an honest agent or a cheater, on the termination probability, the reservation utility, and the agent's payoff from one period of cheating. Altogether the wage has to be greater than the reservation utility since it must provide an incentive to an unemployed agent.

The two observed forms of societal organization differ regarding the probabilities of hiring an honest agent *hh* or a cheater *hc* . A society that practices limited morality is characterized by informal networks of social interaction. Within these networks or groups, information is transposed at no charge. That is to say, an entrepreneur is told which of the agents have cheated in the past. Hence, the entrepreneur has information on which of the agents have cheated and, therefore, is able to employ only from the group of previously honest agents. With limited morality, *hh* = *1* and = 0 *hc* . An entrepreneur will not employ an agent who cheated in the past since he knows the agents' histories. He will hire an agent from the pool of honest agents.

In a society practicing generalized morality, no such informal information networks exist. Hence, an entrepreneur does not know whether the considered agent is a cheater or not. Therefore, - 0 *hh* = *hc* . The probability of hiring a cheater is equal to the probability of hiring an honest agent. The entrepreneur does not know the agents' histories. Entrepreneur and agent are randomly matched and agents are chosen from among the pool of all agents. Hence, the

entrepreneur must pay a wage high enough to prevent agents who previously cheated from cheating in the current period.

In the case of limited morality, the entrepreneur knows that the hired agent will play honest. Hence, an incentive to keep the agent honest is not necessary. The wage must merely be higher than the agent's reservation utility, since only then it is worthwhile for the agent to get a job.

Hence, under limited morality the optimum wage is lower than under generalized morality. Societies practicing generalized morality possess no informal information network to provide the entrepreneurs with the agents' histories. Thus, the probability of employing a cheater equals the probability of employing an honest agent. Therefore, agents must be provided with an incentive to play honest.

As long as γ −*W*\* ≥ κ holds, both strategies constitute a subgame perfect equilibrium. That is to say, the net gain from cooperation has to be greater than or equal to the equilibrium wage. If this condition holds, it is worthwhile for both the entrepreneur and the agent to cooperate. Hence, both have no incentive to unilaterally deviate. The wage is low enough to make cooperation efficient for the entrepreneur and the wage is high enough to provide an incentive for the agent to play honest. Under limited morality, an incentive to play honest is not necessary. Thus, the wage has merely to be higher than the agent's reservation utility. In this case, work is more efficient to the agent than unemployment. The probability of employing a cheater is zero. Under generalized morality, history is irrelevant. The wage provides an incentive for the agents not to cheat, but cooperation is still worthwhile for the entrepreneurs. Since agents play honest under the equilibrium wage, cheating never occurs in equilibrium, neither under limited nor under generalized morality. Both the entrepreneur and the agent know how the other player will act, thereby expectations correspond to real actions; the players behave as they are expected to since this strategy is the best response. Thus, entrepreneur E knows how agent A will behave and agent A knows how entrepreneur E will behave. Behavior that violates the expectations will not occur since entrepreneur and agent would put themselves in a worse position.

This first result demonstrates that different equilibrium states can exist. Each state implicates another outcome \* *W* . However, both states are optimal even though wages differ. Hence, strategies can be in equilibrium even though economic outcomes differ. However, even the society with the lower equilibrium wage realizes its optimal wage. The generalized strategy is to hire from the pool of all agents, whereas the limited strategy is to hire only from the pool of honest agents.19

 19 Strategies off-the-path-of-play are not depicted here, however, corresponding evidence can be found in Greif, 1994, p. 920 and p. 945.

#### <IP_ADDRESS> Horizontal and vertical societal structures

The informal information network plays a major role in the model since it exists only in the case of limited morality. A further important assumption refers to the collective punishment strategies. Limited morality needs informal collective punishment strategies, since otherwise the information network would be futile. A third-party enforcer does not exist; however, official formal rules would be necessary for such an enforcement mechanism to exist. Since the rules regulating social interactions consist of norms, traditions, habits, and so on they are informal and no legitimate third-party enforcement exists. Thus, regulation and enforcement have to be provided informally.

Regulation is guaranteed by informal institutions, whereas the enforcement of the institutions is ensured by unofficial collective punishment strategies. Hence, society itself and not a third party such as the state punishes the violators. Of course, informal enforcement results in subjective punishment strategies. These are governed by subjective sentiments and might seem rude and unjustified to observers that are used to the rule of law and an independent judiciary. Nevertheless, these informal enforcement mechanisms are optimal strategies for the particular society.

In the case of our model, informal enforcement has nothing to do with crude punishment but with the fact that society punishes cheaters because entrepreneurs do not employ agents who cheated in the past. Hence, unemployment is the punishment strategy applied for dishonest agents.

Now it is assumed that entrepreneurs can work as agents for other entrepreneurs. In the original model by Greif (1994), entrepreneurs are restricted to merchants, since the historical case study deals with two groups of merchants. Regarding the historical example of Maghribi and Genose traders, it was in fact the case that merchants installed agency relations with other merchants. This made sense since merchants were situated at different locations and thereby a merchant in one place could act as an agent for a merchant situated in another location. Or, a merchant who was travelling between places could act as an agent for locally bound merchants. Merchants who were members of a society practicing limited morality (the Maghribi) actually preferred to hire other merchants from the particular society as agents. For reasons considered below, merchants were more trustworthy than pure agents.

However, in the present model we now add the possibility that entrepreneurs can be hired as agents by other entrepreneurs. In addition, pure agents exist (who can only work as agents and not as entrepreneurs). Hence, an entrepreneur can choose between employing an agent or employing an entrepreneur who provides agency services. An entrepreneur who provides agency services can either cheat or play honest.

If the entrepreneur is *honest* while providing agency services we obtain:

*A Vh* entrepreneur's expected utility from being an agent

$$\frac{\gamma - W \cdot \mathbf{\*}}{1 - \delta}$$

δγ − − + 1 *W* \* *V A h* entrepreneur's lifetime expected utility if he is always honest

If the entrepreneur *cheats* while providing agency services we obtain:

An entrepreneur should not gain from one period of cheating while providing agency services, That is:

$$V\_{\boldsymbol{\lambda}}{}^{A} + \frac{\boldsymbol{\gamma} - \boldsymbol{W}^{\star}}{1 - \boldsymbol{\delta}} \ge \boldsymbol{\alpha} + \boldsymbol{\gamma} - \boldsymbol{W}^{\star} + V\_{\boldsymbol{\varepsilon}}^{\boldsymbol{E}} + V\_{\boldsymbol{\varepsilon}}^{\boldsymbol{A}}.\tag{2.32}$$

Constanze Dobler - 978-3-653-00883-8 Downloaded from PubFactory at 01/11/2019 11:35:29AM via free access

If this inequality holds, the entrepreneur will play honest while providing agency services.

For a pure agent to play honest

$$V\_h^A \cong \alpha + V\_c^A \tag{2.33}$$

must hold.

The difference between generalized and limited morality becomes visible via the punishment strategy. By assumption, under limited morality an entrepreneur who cheated while providing agency services gets punished by withholding information from him. Thus, the entrepreneur does not learn which of the agents cheated in the past. Hence, he has to pay a higher wage, since he has to choose his agent from the pool of all agents, which includes honest agents and cheaters. Therefore, the entrepreneur has to provide an incentive for the agent to play honest. If the entrepreneur himself plays honest while providing agency services, he will not get punished and thereby gets to know the agents' histories and can choose from the pool of honest agents. Then, he does not have to provide an incentive to play honest and can pay a wage that is higher or equal to the agent's reservation utility.

The argumentation, however, might seem far-fetched. But Greif (1994) demonstrates that exactly the punishment strategy described above was applied by the Maghribi traders in the 11th century.

Under limited morality, an entrepreneur who cheated while providing agency services has to pay a higher wage to his agent, since he does not know his history. Therefore, the lifetime expected utility of the entrepreneur decreases. That is to say, *E Vc* on the right-hand side of equation (2.32) decreases and thereby it becomes less attractive for an entrepreneur to cheat while providing agency services, since cheating decreases his future utility because of higher labor costs. Thus, cheating while providing agency services influences the entrepreneur's utility of being an entrepreneur.

$$\frac{\left(\mathcal{Y} - W^\*\right)}{\left(1 - \mathcal{S}\right)} \rhd \mathcal{Y} - W^\* \dashv V\_c^E \tag{2.34}$$

Equation (2.34) includes the gains from being an entrepreneur. The left-hand side depicts an entrepreneur's gains from entrepreneurship when he plays honest while providing agency services; the right-hand side represents the gains from entrepreneurship when the entrepreneur cheats while providing agency services. Again, *E Vc* decreases and thereby it becomes more attractive to play honest.

However, because under limited morality cheating as an agent impacts on an entrepreneur's utility from entrepreneurship, the entrepreneur has more to lose from cheating than under generalized morality. Therefore, the probability that the entrepreneur cheats while providing agency services is lower under limited morality. Hence, under limited morality entrepreneurs prefer to employ other entrepreneurs as agents, since for them cheating is less attractive because it has a negative influence on their utility from entrepreneurship.

A society practicing generalized morality misses the informal information network and the collective punishment strategy – that is to say, history is irrelevant. Therefore, an entrepreneur who cheats while providing agency services does not get punished and might not pay a higher wage. However, as has been proved before, the equilibrium wage under generalized morality is higher since the probability of employing a cheater equals the probability of employing an honest agent.

In any case, under generalized morality, we observe:

( ) ( ) *E W Vc W* = − + − − \* 1 \* γ δ γ. (2.35)

That is to say, the lifetime expected utility from entrepreneurship of an entrepreneur who plays honest when providing agency services equals the lifetime expected utility from entrepreneurship of an entrepreneur who cheats when providing agency services. Hence, under generalized morality entrepreneurs do not prefer to hire other entrepreneurs for agency services. Since an entrepreneur who provides agency services realizes an income from entrepreneurship, his reservation utility might be higher than that of a pure agent. Therefore, under generalized morality, entrepreneurs might prefer to employ pure agents instead of entrepreneurs providing agency services, since the latter might demand a higher wage for playing honest because of their higher reservation utility.

It can be concluded that under limited morality, entrepreneurs prefer to hire other entrepreneurs providing agency services instead of pure agents. The collective punishment strategy deprives an entrepreneur who cheated as an agent of the information regarding the honesty of other agents and entrepreneurs. Hence,

the cheating entrepreneur has to pay a higher wage since he does not know whether the hired agent is honest or not. Therefore, entrepreneurs providing agency services have more to lose when working as an agent. Thus, they need a lower incentive to play honest and thereby a lower wage.

Under generalized morality, entrepreneurs prefer to hire pure agents. Since a collective punishment strategy does not exist, and since the agents' histories are irrelevant, the entrepreneurs anyway pay a higher equilibrium wage. However, because of the high reservation utility of entrepreneurs providing agency services, entrepreneurs prefer to employ pure agents.

Thus, limited morality advances a horizontal social structure, whereas generalized morality results in a vertical social structure. This is what we would expect according to our previous definition of generalized and limited morality. Hence, limited morality is characterized by group affiliation. Within these groups, informal networks and punishment strategies exist. Wages are lower compared with individualistic societies. Limited morality results in a horizontal social structure. Hence, income differences are less notable. Social mobility is constrained since there is not much space for up- or downward movement. This matches the significance of the collective. Less social mobility hampers incentives to invest. Hence, incentives and preferences differ compared with a vertical social structure. This might result in less productivity, economic growth, and consequently lower living standards.

Generalized morality describes an individualistic society. Group affiliation is not important. Transactions are conducted independent of certain memberships and are regulated via formal rules.  Since informal networks do not exist, wages are higher and a vertical social structure is realized. Hence, social mobility is possible and income differences are bigger compared with limited morality. Therefore, incentives and preferences differ. Incentives to invest are higher and productivity and living standards might be higher compared with a collectivist society.

Greif (1994) indeed proves that the Maghribi traders of the 11th century realized a horizontal structure. A clear dividing line between a class of merchants and a class of agents could not be drawn. On the contrary, the society of the Genoese merchants of the 12th century was structured vertically. Merchants rarely functioned as agents and instead a relatively rich class of merchants and a relatively poor class of agents emerged (Greif, 1994, p. 928).

The current chapter shows that different institutions – and thereby the rules that regulate human interactions – lead to different behavioral patterns and that these cannot be easily changed once implemented. This can be demonstrated with the equilibrium view of institutions and a model that presents the issue of institutional persistence via equilibrium strategies. These strategies can only be changed by an exogenous shock; otherwise they persist indefinitely. However, multiple equilibria are assumed to be possible and different equilibrium strategies can occur. Since institutions determine an individual's behavior, they also determine the societal patterns of behavior since they are universal to all members of the observed population. Hence, different institutions imply different individual and collective behaviors. Although behavior differs, it might correspond to an optimal strategy regarding the particular population. Varying behavior can result in different economic outcomes, as Greif's (1994) model shows. However, although one society might realize lower economic growth rates and living standards compared with another one, it might still realize equilibrium strategies. Hence, the outcome might be optimal regarding the particular society and the prevalent basic conditions. Hence, a bad economic performance does not imply that the societal structure per se is inefficient and has to be changed. If change is still to be promoted this might be a difficult task. Since institutions are the main drivers for behavior, institutions must then be modified. However, according to the equilibrium view, institutions are associated with an equilibrium and thereby the implemented strategies are equilibrium strategies. Therefore, a modification of collective and individual behavior is only possible by a preceding institutional modification, which can only occur via an exogenous shock.

Hence, two points should be stressed: first, if a society's institutions do not promote high economic growth this does not mean that the society itself is in disequilibrium and, therefore, inefficient. Second, institutional change is not easily conducted.

Until now the institutional analysis in this thesis has been conducted theoretically. The next chapter, however, depicts an empirical analysis of institutions. It will be demonstrated how formal and informal institutions can be measured. Furthermore, issues of the empirical examination of institutions are presented. Then, a regression analysis is run that examines whether informal and formal institutions influence per capita income. Hence, it will be examined whether the theoretical consideration can be empirically verified.

# **3. Institutions – an empirical approach**

# **3.1 Informal institutions**

Informal institutions are defined as morals, values, conventions, norms, traditions, codes of conduct, habits, attitudes, and beliefs. They incorporate culture in general and, therefore, the societal value system. Hence, the term 'informal institutions' is used as a substitute for culture or cultural factors. The corresponding transmission channel is the individual himself as informal institutions affect economic development on an aggregated level through their influence on people's behaviors.

However, even Adam Smith (1759) discussed the impact of cultural traits on economic development in his *The Theory of Moral Sentiments*. Later, Banfield (1958) and Putnam (1993), inter alia, composed popular writings connecting culture and specific developments.

After cultural and institutional impacts on economic growth had been forgotten for a while, North (1990) surged ahead with his popular publication *Institutions, Institutional Change and Economic Performance*. His approach was to help growth theory out of the stagnation concerning the explication of persistent growth differences between countries. However, the often mathematically sophisticated models of endogenous growth theory, which tried to improve the inconsistencies of neoclassical theory, turned out to be too abstract to explain the real world. As good as these models were, they were not able to explain why the proximate determinants of growth varied that much between countries and why differences in productivity between countries could not be solved by applying the sophisticated economic knowledge that the models offered.

North and Thomas (1973) and North (1990) brought institutions as the decisive missing link back into play. Furthermore, North's theory of institutions incorporated cultural factors since he faced the fact that informal institutions are constraints implemented by individuals to regulate social interaction. However, North (1990) constitutes the chronological and content-related starting point of the recent study.

The effect of culture on economic development was then emphasized by Landes (1998), who traces the Western European economic success back to its supportive culture. whereas in other regions of the world, such as the Middle East or China, the existing cultural conditions were not favorable for an Western-style Industrial Revolution.

However, starting with these works cultural economics experienced a gentle revival from the beginning of the 1990s, as observable in de Jong and Eelke (2009), Platteau (2000), North (2005), Inglehart and Welzel (2005), and Harrison and Huntington (2000). Furthermore, several journal articles dealing with

culture, informal institutions, and economic development appeared.20 Since informal institutions are a subjective matter, cannot always be explained rationally, and cannot be measured in generally accepted units, the formal incorporation in economic models is a difficult task. Because direct observations are not possible, proxy variables must be used instead. That is to say, data that permit inference on a society's organization, beliefs, and values are used instead of the cultural variables themselves, which are not directly observable. However, we will revert to the issue of the measurement of informal institutions later.

For now we will concentrate on the theoretical argumentation of informal institutions and their impacts on economic growth. An early example regarding informal institutions and their influences on economic development is Max Weber's popular thesis concerning the Protestant work ethic (Weber, 2002). Weber argues that the emergence of capitalism was closely related to the belief and thereby the resulting behavior of the Protestant population. Following his argument, work was not just a means to an end but the purpose of life and God's will. People believed that God's chosen ones were blessed with a materially good and safe life. Hence, everybody tried to achieve a high living standard in order to believe that they were a chosen one. In other societies, where material standards play no role regarding God's goodwill, people lack the accordant incentives to work hard and invest. Therefore, according to Weber, countries with a high proportion of Protestant citizens were economically more successful than those without. Consequently, the beliefs, attitudes, and codes of conduct resulting from such a religious affiliation affect the development of economies. Weber's thesis comes close to this work, because religious origins result in the norms and values that people implement in their everyday lives. For now we will skip the religious dimension but will refer to this point later.

The hypothesis states that particular attitudes, norms, values, and codes of conduct support factor accumulation and technological progress whereas others do not. The challenge is to measure informal institutions and point out concrete features with which the impact on economic growth can be analyzed. Hence, we must consider which human properties can be depicted and demonstrate a clear relationship to culture. That is, the accordant characteristics must depend on values, norms, convictions and so forth, and must differ according to those criteria.

20 See, for example, Barro & McCleary (2003); Dolfsma & Verburg (2008); Fernández (2008); Fernández & Fogli (2007); Gorodnichenko & Roland (2010); Greif (1994); Guiso, Sapienza & Zingales (2003); Guiso, Sapienza & Zingales (2006); Knowles & Weatherston (2006); Porta & Scazzieri (1997); Tabellini (2005); Williamson (2009).

### **3.1.1 Trust**

An often used indicator for culture and societal organization is the level of trust. The role of trust in an economy has been studied for some time, especially in game-theoretic approaches. "In prisoner's dilemma type of situation, interactions between trusting individuals are more likely to lead to efficient outcomes, whereas lack of trust make it more difficult to overcome the inefficient equilibrium" (Tabellini, 2005, p. 9). An individual's level of trust depends on their cultural and societal background, as well as on experiences, which again are shaped by society, culture, and history (Putnam, 1993). If children are taught to trust other people, they will apply what they have learned without critical request, eventually for all their lives, and will pass their attitudes onto their own children. The same is true if we are taught not to trust others or not to trust a certain group or certain people. Knack and Keefer (1997), for example, find that the level of trust is higher in countries with less ethnical and class discrepancy. Hence, it might be true that in hierarchical societies, among which the affiliation to the family or tribe is very distinct, the level of trust within the group is high, but beyond it people might not trust others. In how far individuals of a society trust each other and trust the members of other societies depends on upbringing, (religious) beliefs, historical accidents and experiences, and traditions. Since trust is an informal institution, it is slow moving and can be characterized as an IEN institution. That is to say, the attitudes and beliefs that shape the level of trust change slowly and an external alteration is difficult. Nevertheless, change is possible, since experiences and historical accidents never stop shaping an institution. Furthermore, individuals might alter their attitudes and beliefs after logical reasoning or because they become persuaded by something else, although this way of change might be rare and take a long time.

However, because of the characteristics of slow-moving institutions, trust represents a stable determinant that does not change in an obvious way for a long time. Hence, once established the influence of trust on economic outcome is durable and must be taken for granted. Nevertheless, we will not define trust as an exogenous parameter since it can be influenced by per capita income. Because of its slow convertibility the assumption of trust being an exogenous variable might be justifiable in empirical work in some cases.

However, trust has several impacts on economic performance. Trust regulates social interactions and lowers transaction costs. In high-trust societies, information is replaced by trust. Hence, the corresponding monitoring expenses are lower. Furthermore, people in high-trust societies might not record every detail of an act of sale and spend less time and money on lawyers and the monitoring process. The business environment and, in general, economic transactions can be less regulated than in low-trust societies. People in high-trust societies might also place more confidence in the government and other official agencies,

which might result in higher credibility. However, incentives to innovate and invest are higher in high-trust societies. Since transaction costs are low, more capital and time is available for innovation and investment. This also means that the expected returns are higher since fewer costs and a lower risk premium can be discounted. Hence, the innovator and the investor retain their full returns. Furthermore, investors in a high-trust society will realize the optimal investment strategy over the long run rather than the short run.

Trust enhances anonymous market exchange and decreases the need for formal institutions and, therefore, external enforcement. That is to say, trust also increases the gains from labor division and trade (Knack & Keefer, 1997, p. 1252). La Porta et al. (1997) find that trust increases judicial efficiency, bureaucratic quality, tax compliance, and decreases corruption (p. 335).

However, these examples already indicate the ambiguous character of institutional relations since an adequate regulatory structure and legal system might also increase the level of trust. At least higher per capita incomes might lead to a general change in perspectives and priorities and thereby modify a society's level of trust in the long-term. Thus, a clear causality between trust and the respective formal institutions rather than per capita income does not exist. In any case, it is obvious that a high level of trust decreases transaction costs, whereas increasing the quantity of transactions. Therefore, trust is associated with higher economic growth (Knack & Keefer, 1997; La Porta et al., 1997; Putnam, 1993).

### **3.1.2 Limited and generalized morality**

The concept of generalized and limited morality corresponds to the organization of society per se. The societal organization can be seen as the general framework that depends on the prevalent morals, norms, beliefs, and values. Institutions are implemented through behavior, and thereby societal organization allows inferences regarding the institutional environment. Hence, knowing the societal order, we might be able to deduce the value system and vice versa. However, limited morality (collectivist societies) characterizes hierarchical societies, in which high levels of trust and cooperation are prevalent inside groups such as the family, the clan, the tribe, and religious or ethnic groups. That is to say, within the respective group transaction costs are low and business is done. However, beyond the group mistrust is dominant. Cooperation between members of different groups depends on high monitoring and information costs and thereby transactions between the groups are rare. Hence, a hierarchical society with distinct familial or tribal structures suffers from restricted economic relations because of high transaction costs. Contracts between affiliates of the same group are closed according to informal rules. Hence, traditions, morals, and codes of conduct play a decisive role in business relationships. The same holds for enforcement mechanisms, which are conducted informally regarding morals and traditions.  Hence, an official enforcement mechanism implemented by a third party does not exist. Instead, informal rules and enforcement mechanisms (collective punishment) regulate social interaction. The macroeconomic outcome and thereby per capita income, could be increased by optimizing business relations, trade, and production in general. However, this is not possible because of certain morals and norms, which stand in the way of the corresponding economic activity. Hence, in societies where limited morality is prevalent, innovation, investment, factor accumulation, trade, and thereby economic development per se is restricted through the limited possibilities of cooperation. Nevertheless, the members of the society optimize their strategies and achieve an equilibrium state. Hence, the societal organization of limited morality and its economic outcome cannot be described as inefficient per se (Platteau, 2000; Greif, 1994; Greif, 2006; Zweynert & Goldschmidt, 2006).

By contrast, societies in which social interactions are conducted independent of familial or tribal affiliation practice what is called generalized morality. Transaction costs are reduced via formal rules that regulate, for example, the formation of contracts and enforcement mechanisms. Hence, societies that realize a form of generalized morality need to develop a formal institutional framework to regulate their interactions and decrease transaction costs. That is to say, a third-party enforcement mechanism and authorized punishment strategies are necessary. Thus, economic transactions are conducted independent of group affiliation and unfamiliar informal rules. Therefore, high efficiency gains can be realized. Furthermore, in a society where generalized morality is prevalent, the free-rider issue on public goods might be less dominant. Since people trust each other and legitimized punishment strategies are conducted by a third party, public goods might not be misused. Hence, transaction costs are low and the scope of cooperation increases. Innovation and investment are stimulated and so the concept of generalized morality supports economic development.21 Generalized morality is a form of societal organization that emerges from a strategy optimization and depicts a different equilibrium state than does limited morality. Therefore, because we are talking about two completely different entities, a comparison that rates the societies according to their economic performances is pointless. Both societies realize their individual optimal outcomes.

However, the transition from limited to generalized morality is fluent. We can imagine that norms of good conduct and trust decrease with distance. Hence, a society that practices generalized morality concerning its own members might mistrust geographically or culturally distant societies. That is to say, even if

21 See also Greif (1993); Greif (1994); Platteau (2000); Tabellini (2005); and Tabellini (2008a,b).

generalized morality is prevalent within the society, limited morality might be practiced if we extend the geographical scope.

However, Tabellini (2008b) argues that limited and generalized morality not only shape economic development, but also are a matter of the development progress itself. Accordingly, "at early stages of development, transactions are mainly local, and both values and cooperation remain more limited in scope. As development progresses, and impersonal transactions gain relevance, this is accompanied by a generalization of the scope of values and cooperation" (p. 932).

Hence, Tabellini hints at the issue of reverse causality, since societal organization influences economic development, whereas economic development impacts values and beliefs and, therefore, societal organization. In another article, he demonstrates that democratic political institutions support the realization of generalized morality, whereas countries that practice generalized morality possess better government indicators and legal institutions (Tabellini, 2008a). However, we should not rely on the fact that economic development shapes values and beliefs in a way that supports generalized morality and, therefore, further progress. The interdependencies between economic development and generalized versus limited morality can also lead an economy to be stuck in a state of backwardness. Societies that practice limited morality can have less respect for the law and be more tolerant of lax law enforcement, since informal institutions govern their interrelationships. By contrast, the quality of law enforcement strengthens sound values, beliefs, and morals (Tabellini, 2008b). Accordingly, "in Western Europe impersonal exchange took place in anonymous markets supported by specialized institutions obeying formal procedures. In East Asia markets were organized through a web of kin-based social structures linked by personal relations (Greif, 2005). […] these different arrangements are likely to encourage the diffusion of different values: in the West a generalized respect for the individual and their rights, in the East a culture of loyalty to the local community or to a network of relatives and friends. […] these different values facilitated the evolution of different political and economic arrangements, with feedback effects in both directions" (Tabellini, 2008b, p. 930f.). Hence, this might explain why "… distant historical circumstances have such long lasting effects, and why some societies might remain trapped in cultural, institutional and economic backwardness" (Tabellini, 2008b, p. 938).

The form of societal organization allows us to draw conclusions regarding the institutional environment. Hence, a society practicing limited morality will be characterized by a conservative value system and corresponding attitudes. A society realizing generalized morality is assumed to be indicated by modern values and morals. However, the equilibrium view demonstrates that whether conservative or modern every society acts optimally given the prevalent conditions.

## **3.1.3 Beliefs that encourage the accumulation of physical and human capital**

However, to examine the impact of informal institutions on economic development theoretically and empirically, it is not enough to speculate on beliefs, values, norms, and attitudes in general. To make meaningful statements research must become more concrete. Therefore, particular informal institutional features will be singled out, which are also used in the empirical analysis, and their influence on economic development will be described. Since beliefs and attitudes influencing economic activity are manifold, we concentrate on the particular variables that can be measured empirically and have been used in econometric analysis before. This allows us to demonstrate the empirical results later on and to use the particular variables for the following analysis. However, many other beliefs, attitudes, and so forth exist, which influence an individual's economic behavior and aggregated economic outcome. Hence, the following enumeration is not complete and is thought to demonstrate a few examples.

### <IP_ADDRESS> Destiny

An informal institutional feature that depends on the cultural environment and influences economic activity is an individual's conviction concerning their control over their own life. However, destiny as a relevant determinant of economic development might first appear to be somewhat abstract. Nevertheless, the belief concerning one's destiny is an informal institution that perfectly demonstrates the interrelationship with economic growth. If people are persuaded of being able to influence destiny they will try to improve their situation and be proactive. If, by contrast, people believe in predestination, they are not in the position to better their situation through their own initiative. Hence, investment in physical and human capital will in general be lower than in a society in which everybody works hard and invests to improve her or his life. That is to say, the individual has no incentive to innovate and invest. The attitude concerning control over one's own life originates from religious beliefs since in some religions God determines everything in life rather than the individual itself. However, even the belief concerning one's destiny is subject to reverse causality and influenced by the institutional environment. A higher per capita income might change one's worldview and purpose in life and people might rather feel that they are in control of their fate. Furthermore, an authoritarian political system that domineers over its citizens combined with bad economic performance, and thereby low per capita income, probably does not entail self-confidence but resignation. In any case, believing in predestination rather inhibits growth on an aggregated level.22 Several approaches use World Values Survey (WVS) data to measure the impact of culture or informal institutions on economic development using *control* as a single variable or as part of an indicator (Knack & Keefer, 1997; Knowles & Weatherston, 2006; Tabellini, 2005; Tabellini, 2008a).

### <IP_ADDRESS> Life after death

However, as already indicated, institutions do their jobs through incentives. Hence, if people believe in life after death or reincarnation, these beliefs influence people's behaviors since they offer an incentive to live life in a certain way. Thus, abiding by the religious rules might guarantee a good life after death or a reincarnation on a higher level. However, not only life after death but also the belief in heaven and hell offers incentives to abide by certain rules. Living life according to a certain morality might guarantee a place in heaven, whereas breaking the rules might lead to hell. The rules that must be followed to arrive in heaven might inhibit economic growth. If, for example, a population is required to live an abstinent, traditional life without any luxury, this does not boost factor accumulation. Hence, if materialism and luxury are regarded as a sin, this does not foster growth. The same is true concerning the accumulation of human capital. Certain beliefs and attitudes concerning the natural world might prevent individuals from becoming educated. Furthermore, a belief in God or being religious per se makes believers live their lives following religious doctrines.  Anyway, every restriction provides an incentive to act in a certain manner. Of course, the beliefs might not promote behavior that supports growth. On the contrary, if, for example, materialism and modernism are banned by religious doctrines, if women are not allowed to work, if naturalism is regarded as blasphemy, then the believers have no incentive to accumulate physical capital and to use their human capital in a productive way. According to Weber (2002), the contrary is true concerning the Protestant work ethic. Calvinism propagated that all humans belonged either to the group of chosen ones or to the group of notchosen ones. Who is a chosen one and who is not is predestined and cannot be influenced by the human being. However, since work effort and economic success are signs of being a chosen one and dawdling and accumulating luxuries are a sin, people worked hard to prove to others and to themselves that they belonged to the chosen ones. Hence, the fear of not being a chosen one drove people to work hard and be economically successful. That is to say, the religious

 22 Data on the attitude concerning control over one's own life (*control*) is taken from the WVS. The relevant question text can be found in the data description at the end of the chapter.

doctrine stimulated growth since it indirectly forced people to accumulate capital and invest. However, the argument is not without controversy. It has also been stated that the economic success of the Protestant work ethic depended on the fact that people became better educated since they had to be literate to read the bible (Becker & Wößmann, 2009).

Nevertheless, we can imagine that widespread beliefs that directly or indirectly influence factor accumulation, investment, innovation, technological knowledge, and so forth can inhibit or support growth on an aggregated level. Religious doctrines or other convictions regarding destiny, life after death, reincarnation, or God's goodwill offer incentives for people to act in a certain way. We can also imagine non-religious incentives that are rooted in tradition and other cultural traits other than religion. However, the incentives can be either growth supporting or growth inhibiting.

This section already hinted at the role of religion regarding economic development and institutions. Several of the mentioned informal institutions are influenced by religious doctrines. This leads us to the question of what determines informal institutions. We will leave it at that for now but will return to the question later.

# **3.2 Formal institutions**

Since institutions can be classified from general to specific categories – that is, for example, from the categorization of political, legal, and social institutions to regime type, electoral rule, business regulations, and so forth – formal institutions are manifold and cannot be enumerated completely. However, some formal institutions turn out to be growth supporting in general. Hence, guaranteeing these formal institutions basically stimulates growth unless they do not match the prevalent informal institutions. If this is the case, economic progress will be difficult to prevail. However, the most basic formal institutions thought to support growth if matched by the informal environment are depicted in this section.

### **3.2.1 Property rights**

Regarding formal institutions, the protection of property rights is usually described as the decisive institutional feature concerning growth (De Soto, 2000; Kerekes & Williamson, 2008; North, 1990; Platteau, 2000; Rodrik, 2000; Williamson & Kerekes, 2009). Property rights afford the individual the right to decide on their labor supply, physical and human capital, and the goods and services they possess (North, 1990, p. 33). That is to say, the individual has the exclusive rights to decide on their assets. Hence, the owner benefits from the complete returns on the usage of the property. The exclusiveness and irreproachable allocation of ownership offer the crucial incentive to invest. Furthermore, property rights highlight the economic potential of an asset, since the owner will use his property in a way that maximizes his utility. Therefore, it is assured that the asset is used optimally. However, since we do not emanate from a pure homo economicus, individual utility maximization might not be equated with profit maximization. It is assumed that individuals are selfish and want to maximize their own utility. Anyway, individual utility is not equal to material utility. People might want to maximize their immaterial utility – that is, they might be altruistic because it makes them feel better or they might abstain from something because they are persuaded of doing the right thing. Hence, abstaining from something, abiding divine rules, or being altruistic makes people feel good and, therefore, maximizes their individual, eventually immaterial, utility. Nevertheless, the owner is most suitable to value his asset.

However, since property rights reveal an asset's economic potential, property can be used as collateral and can generate new capital and receive credit. De Soto (2000) explains that one of the foremost problems of underdevelopment is that in many underdeveloped countries property is not clearly assigned to a particular owner and cannot be used as collateral and to generate new capital. However, property rights, coupled with an appropriate law to protect them are, according to De Soto (2000), the lifeline of economic success in Western economies.

Despite the direct channel on income, the dominance of secure property rights also makes a statement concerning the political and legal environment of a state. Property rights are usually not afforded in dictatorships or authoritarian states, where expropriation by the political power or even by private interest groups is possible since no appropriate law and no independent judiciary exist. Hence, unsecure property rights are accompanied by less political and economic freedom, fewer civil rights, and a manipulable judiciary. To maximize economic outcome the opposite situation is necessary.

Therefore, economic success depends on secure property rights. But who decides on the protection of ownership, and, thus, the structure of the legal and economic system? Acemoglu, Johnson and Robinson (2005) developed a theoretical approach that ascribes the emergence of the political, legal, and economic institutional environment to resource endowment and, therefore, to property rights. In their model, political power is crucial regarding the formal institutional environment of a state — that is, the elites in power will arrange formal institutions in a way that best fits their interests. The essential theoretical feature is the differentiation between de jure and de facto political power. The former depicts the legitimate or official political power, whereas de facto political power is not legitimized, but able to enforce its interests. Hence, legitimate governance can, but might not necessarily, possess de facto political power. Instead, de facto political power depends on resource endowment. Thus, an interest group with an adequate endowment of capital and other resources might be able to determine formal institutional properties. The exercise of de facto political power can vary. One possibility is a military coup in which individuals equipped with arms and money, and eventually supported by further interest groups, use their resources to overthrow the current government. Then, the de facto political power will implement formal institutions that fit its interests, that is, the retention of political power. Therefore, civil property rights and political participation will not be afforded, since this would endow individuals with resources that could be used to overthrow the rebels.

A less martial example is lobbying. Even in democratic states, particular industries or other interest groups use the power resulting from their resource endowment to determine the institutional form in a way that best fits their interests, that is, the further accumulation of resources.

Hedlund (2001, p. 217–227; 2005) describes the historical dimension of the implementation of property rights in Russia. His article and book demonstrate that property rights necessitate a culture and tradition of private property. Hence, in a country's history historical accidents and path-dependent developments must have led to the convention of property rights implemented by the citizens and the executive. If a tradition of property rights is missing and if a society never experiences being entitled to private property, the positive effects of private ownership cannot be implemented. Hence, property rights might not be understood as a natural right, they might also occur through convention (Hedlund, 2001, p. 217). Since conventions differ between states and regions, not every country could develop a tradition and culture of private property.

### **3.2.2 Legal system – the rule of law**

Property rights are useless if they are not secured by an appropriate law. Hence, to utilize the full potential of property rights the legal system must guarantee the owner complete freedom of choice and exclusiveness with respect to the relevant asset. Hence, neither state-run nor private expropriation can be tolerated.

However, complete secure property rights can only exist under the rule of law and thereby with an independent judiciary. Any other legal system offers a possibility for private or state-run interest groups to intervene. Even if a nondemocratic government provides secure property rights, the form of government permits minorities to enforce their interests via a coup d'etat or bribery, for example. Hence, de facto political power is able to determine the legal environment to the detriment of property rights. Therefore, the rule of law and an independent judiciary are essential for secure property rights. The rule of law and an independent judiciary are guaranteed in democratic states.23 Hence, the allocation of secure property rights is usually accompanied by a democratic system and postulates an independent judiciary. This is the case since the legal system must be able to enforce property rights against governmental and private offences. Democracy ensures that formal institutions cannot be changed on behalf of a certain interest group that possesses the appropriate resources. Property rights in conjunction with civil liberties guarantee the efficient use of every asset in a society, and thereby the optimization of per capita income. Nevertheless, property rights can also exist and be protected in other political systems, but since their application will probably be constrained in a non-democratic state, total economic efficiency will be adversely affected (Besley & Kudamatsu, 2008; Rodrik, 2007). Furthermore, to develop their full potential ownership rights must be accompanied by a free-market system that allows any individual to use their assets in a way that maximizes their utility. Then, the economy can realize its maximal growth potential on an aggregated level.

La Porta et al. (2004) examined a sample of 71 countries and found that judicial independence is a strong predictor of economic freedom. However, as in the case of property rights, the rule of law corresponds to an institutional entity that depends on random historical developments, too. Hence, the rule of law necessitates a tradition of private property and of generally accepted rights that hold for every member of society. Therefore, the rule of law also necessitates a certain understanding of the state. The state must be constrained and subordinated to the rule of law; however, it must also enforce the rule. Hedlund (2001, 2005) describes the difference between a state that subordinates itself to the law and a one that overrides the law with the terms 'rule of law' rather 'rule by law'. Rule by law, as in the Russian case, does not support a tradition of property rights, civil liberties, and equality before the law. On the contrary, a tradition of rule by law inhibits confidence in the state. Instead, it conveys the impression of a state that officially adheres to the law but can override it whenever in the mood. Hence, the relationship between the members of the society and the state per se differs compared with a society with a tradition of the rule of law. This has impacts on all further developments. When a country accidentally strokes the way of rule by law, the emergence of a constitutional state and secure property rights is impossible. Even if foreign or indigenous forces try to implement the rule of law at a later point in time, a tradition and culture of property rights and the rule of law will be missing. Hence, FEX or IEX institutions will not match IEN institutions and will, therefore, remain ineffective.

23 La Porta et al. (2004) examined the effect of judicial independence and constitutional review empirically and affirmed the hypothesis that indicial independence guarantees economic and political freedom by the protection of property rights inter alia.

### **3.2.3 Form of government – democracy**

Democracy is a broad concept with which we usually associate power being directly or indirectly exercised by citizens through a system of representation. Furthermore, universal suffrage, civil rights, the rule of law, and the separation of powers are components of democracy. Since definitions are broad and different concepts of democracy exist, we borrow the Polity IV definition, which states that democracy is conceived as three elements (Jaggers & Marshall, 2005):

1) "The presence of institutions and procedures through which citizens can express effective preferences about alternative policies and leaders" (p. 13).

2) "The existence of institutionalized constraints on the exercise of power by the executive" (p. 13).

3) "The guarantee of civil liberties to all citizens in their daily lives and in acts of political participation" (p. 13).

"Other aspects of plural democracy, such as the rule of law, systems of checks and balances, freedom of the press and so on are means to, or specific manifestations of, these principles" (p. 13).

Since different political regimes determine different economic and legal institutions their impact on economic growth varies. The question is whether democracy yields institutions that support growth rather than autocracy.

Democracy inhibits resource-rich minorities from implementing institutions that best fit their interests. Hence, the possibility that a minority overthrows the government by using its resources, for example money or weapons, is lower than in an autocracy where no separation of power and thereby no independent judiciary gives shelter to the head of state. In a non-democracy, the elites in power will enforce the institutions that best fit their own interests. In the majority of cases, these interests will increase their profits and power, but will be detrimental to aggregated economic growth. Hence, improvements in the general living standard are not optimized. Institutions in a democracy might not be growth maximizing, and political participation and universal suffrage will inhibit the establishment of institutions that benefit a small elite. Hence, democratic institutions might not maximize growth, but, compared with other institutional environments, democracy guarantees the most efficient economic outcome.

What mostly affects the efficiency of democracies is the freedom it guarantees its citizens. Civil liberties are constrained by institutions such as constitution and the rule of law, which optimize social coexistence in decreasing transaction costs and guarantee individual utility maximization. Property rights, freedom of opinion and speech, and the right to physical integrity offer incentives to accumulate physical and human capital and to invest. Democratic institutions allow the largest possible individual freedom. The constraints, thereby the insti-

tutions, that characterize democracy are there to afford maximal individual freedom since less restrictions would mean that the individuals themselves would reduce their freedom through uncertainty. Hence, transaction costs would be high and capital accumulation and investment would be lower.

However, the growth effect of democratic institutions again depends on the complex system of institutions and other relevant determinants. Just to say that democracy is the most efficient institutional system is too simple in reality. A country's political system is determined by the prevalent deep determinants that is, geography, institutions, and history. Therefore, the implementation of democracy might not be efficient if a country has a non-democratic history, is embedded in a non-democratic institutional environment concerning its neighboring countries, or if its formal and informal institutions do not support democracy. Hence, democratic institutions might not have positive growth effects if they are implemented in a non-democratic environment. This is the case because the implementation will fail. That is to say, the relationships and dependencies with the prevalent institutions will not come about. Hence, the democratic institutions will exist in isolation and will have no effect at all. In this case, they will be abolished as soon as possible. However, the implemented democratic institutions can even have detrimental effects if they demolish parts of the existing institutional system. By contrast, it might also happen that the prevalent institutional system adjusts to democracy and supports it. However, this process will take time and come at some cost.

Empirical evidence on democracy and its influence on growth is mixed. Rodrik (2007) finds that a participatory political system guarantees less volatile growth rates, better adjustment regarding external shocks, and less distributive inequality.

Persson and Tabellini (2009) examined the economic effects of political regimes. Via a panel estimation they analyzed data from up to 155 countries for up to 180 years. Accordingly, democracy supports economic growth via physical capital accumulation, which in turn fosters democracy. However, high per capita income does not encourage a transformation from autocracy to democracy. Democratic capital, which is defined as a society's civic values that support democracy, plays a decisive role. Therefore, a virtuous circle can emerge, because democratic experience supports capital accumulation (also democratic capital) and thereby fosters democracy.

Persson and Tabellini (2006) demonstrate that economic liberalization must precede political liberalization. That is to say, economic liberalization followed by democracy has a positive and significant effect on economic growth, whereas democracy followed by economic liberalization has a negative and significant impact on the growth rate.24

# **3.3 Measuring institutions – a literature review**

It is not enough just to form a theory about the influence of institutions on economic growth nowadays. In the past 20 years, the revival of growth theory has been based on a mixture of theoretical and empirical reasoning. The term 'informal institutions' has been known since North's work in 1990. Despite that, empirical measures of institutions were predicted from factors describing formal institutions, because determinants such as values, norms, morals, attitudes, habits, and codes of conduct cannot be easily measured. However, since the incorporation of societal and cultural factors into economic theory has gained more acceptance research projects dealing with the issue have emerged. The WVS, for example, is an oft-used data source for indicating and measuring informal institutions (Inglehart & Welzel, 2005; Inglehart et al., 2004). It is based on surveys and is separated into different parts dealing with topics such as "perceptions of life", "politics and society", and "religion and morals", inter alia. This section provides a short overview regarding influential empirical work on informal and formal institutions.

An influential work concerning culture and its impact on GDP per capita, which is based on the WVS data, is Tabellini (2005). The author examines data on European regions and identifies history as the decisive determinant of economic growth. He argues that culture depicts the connection between history and current economic development. That is to say, historical accidents shape a society's values, attitudes, and morality. Values, attitudes, and morality determine peoples' behaviors and, therefore, economic development on an aggregated level. Since culture is slow moving and only marginal change occurs from one generation to the next, values, attitudes, and morality are persistent determinants, which indirectly connect history with current economic performance. Hence, Tabellini has had to identify a variable that reflects culture, is shaped by history, and influences current economic growth. Therefore, he created a cultural indicator using the WVS data set. The indicator is meant to measure individual values and beliefs and thereby comprises data on the level of trust and respect for other people as well as on the confidence and self-determination of the individuals taken from the WVS. Accordingly, trust, respect for other people, and individual self-determination encourage economic development, whereas obedience, seen as a measure of the hierarchical structure of a society,

24 Further references on democracy and the economy include Acemoglu & Robinson (2005) and Acemoglu et al. (2008).

is detrimental to economic growth. Tabellini uses the percentage of the population being Protestant (La Porta et al., 1999) and, in another regression, literacy rates in 1880 and political institutions between the 17th and 19th centuries as instrumental variables for culture. All variables are explained in detail in the appendix of his paper. His argument is that the instrumental variables do not influence current economic outcome directly, but only through their effects on culture. Hence, European regions that were poorly educated at the end of the 19th century differ from better educated regions regarding their cultural characteristics even today. The same is true for early political institutions, which affected cultural patterns and thereby current income. However, Tabellini detects that early political institutions have had a significant influence on economic performance today. Culture, as explained by historical variables, is a decisive determinant of regional economic development and performance in Tabellini's work. Particular cultural traits – that is, trust and respect on the one hand and individual confidence and self-determination on the other hand – are found to be favorable to economic development. Furthermore, no primacy of formal institutions over culture or informal institutions can be observed. On the contrary, both interact with each other and thereby shape the economic environment. Tabellini's accurate article became a guideline for further research since he explains his theoretical, empirical, and methodical proceedings in detail and is correct in his analysis. Furthermore, the cultural indicator created by Tabellini has been used in several studies on the impact of culture or informal institutions on economic performance since then.

Tabellini (2008a) also uses survey data from the WVS, which measure the level of trust and the level of respect for other people as proxy variables for the character of morality – that is, generalized vs. limited morality. Via a probit model he estimates the effect of the ancestors' countries of origin on the current level of trust. Furthermore, Tabellini uses certain language properties (rules on the use of pronouns) as instrumental variables for values. He finds that there exists a correlation between grammatical rules and his proxies of morality. Then, Tabellini regresses the first-stage results on the measures of the quality of government and trade. However, he detects that generalized morality is correlated with better government indicators and vice versa. In addition, a connection between the prevalent character of morality and the specialization in certain sectors can be found.

Knowles and Weatherston (2006) rely on the WVS data set to measure the effect of informal institutions on economic growth. The authors refer to the deep determinants of growth literature and incorporate proxies for institutions, geography, and openness as independent variables in their regression analysis on per capita income.25 They differentiate between formal and informal institutions,

25 See also Rodrik (2000); and Rodrik, Subramanian & Trebbi (2004).

which are defined as conventions, norms, and codes of behavior. Informal institutions are measured using an indicator similar to Tabellini's cultural index (Tabellini, 2005). The authors add together Tabellini's variables regarding the levels of trust and respect (*TRUST*, *RESPECT*) and control over one's own life (*CONTROL*) and call their indicator *INFORM*. Formal institutions are measured by the 'average protection of risk against expropriation' taken from the International Country Risk Guide and 'constraints on the executive' from the Polity IV data set. Since formal and informal institutions are endogenous, Knowles and Weatherston run two and three stage least squares (2SLS and 3SLS) regressions using the proportion of the population speaking English, the proportion of the population speaking a major European language (Hall & Jones, 1999), state history (Bockstette, Chanda & Putternam, 2002), population density in 1500 (Glaeser et al., 2004; McEvedy & Jones, 1978), and the proportion of the population being Protestant (La Porta et al., 1999) as instrumental variables. Of course, they also use instruments for geography and openness; nevertheless, this is not our current topic. However, the authors find significant effects of formal and informal institutions and geography on per capita income. Accordingly, informal institutions are no less decisive for economic performance than formal institutions are.

Williamson (2009) examines the relationship between different formal and informal institutional arrangements. Her aim is to detect whether institutions are transferrable and, therefore, whether the institutional structure of economically successful countries can be imposed on underdeveloped economies. She uses a modified indicator of Tabellini's cultural index on a country level to measure informal institutions (Williamson & Kerekes, 2009; Williamson, 2009).

Guiso, Sapienza and Zingales (2006) use the WVS data to measure the effect of culture on expectations and preferences and their impacts on economic outcomes. They estimate, for example, how far trust influences the probability of becoming an entrepreneur (data source: WVS and General Social Survey) and how cultural traits affect saving decisions and political preferences such as redistribution. They use religion (proportion of people of the different religious denominations in each country) and ethnicity (ancestors' countries of origin) as instrumental variables for culture, since both measures are nearly time-invariant and thereby the causality issue can be faded out. Cultural traits are measured using questions on redistribution and the importance of thriftiness from the WVS. However, cultural traits are highly correlated with countries' saving rates and governmental redistributive policies, whereas the endogenous cultural variables are highly correlated with data on religious denomination and ancestors' origins.

In an earlier work, Guiso, Sapienza and Zingales (2003) analyzed the influence of religion on particular cultural traits measured via the WVS data. By using the answers to questions that ask for the frequency of attending religious services and whether the particular person was raised religiously, they studied the degree and the type of a person's religiosity. The religious variables are then regressed on the societal attitudes that are shown to be supportive of growth, such as attitudes towards trust, thriftiness, cooperation, the market economy, and so forth.

Knack and Keefer (1997) estimate the effect of interpersonal trust and norms of civic cooperation on economic performance. Trust (TRUST) is measured via the corresponding answers to the question from the WVS (see appendix). Norms of civic cooperation (CIVIC) are measured via a questions asking if certain statements can be justified, with the possible answers ranging from 1 (never justifiable) to 10 (always justifiable). The statements are: "Claiming government benefits to which you are not entitled"; "Avoiding a fare on public transport"; "Cheating on taxes if you have a chance"; "Failing to report damage you've done accidentally to a parked vehicle"; and "Keeping money that you have found". They find that TRUST and CIVIC are correlated with economic outcome, secure property rights, and contract rights.

Fernández and Fogli (2007) study the effect of culture on economic performance, using work and fertility rates of second-generation American women. Accordingly, culture influences peoples' beliefs and preferences and thereby peoples' attitudes concerning, for example, the role of women in society. Therefore, conservative societies exhibit low female labor supply and high fertility rates, since the predominant opinion is that women should stay at home and raise children. On the contrary, modern societies feature high female labor supply and lower fertility rates. However, when individuals emigrate they take their culture with them, but live in a new institutional environment. If culture is partly responsible for the large variation in incomes per capita, it should be persistent. Hence, ancestors' beliefs and preferences should equal the beliefs and preferences of their descendants. If culture adjusts immediately to the new environment, it is not a deep determinant of growth and cannot help explain per capita income differences. Therefore, Fernández and Fogli use data on labor and fertility of second-generation American women, who were born and raised in the United States. Hence, these women grew up within the same institutional environment, but their cultural heritage differs according to their parents' countries of origin. The authors use 1970 values of female labor force participation and total fertility rates as proxy variables for culture. They use female labor force participation and total fertility rates from the woman's country of ancestry in 1950 as instrumental variables for culture. They then run several regressions using different techniques and variables and find that past female labor participation of the ancestors' countries of origin and past fertility rates of the ancestors' countries of origin have a significant effect on female labor participation and fertility today. The results are robust to the inclusion of women's education data, husbands' education data, husbands' incomes, data on institutions and markets, and so on. Thus, culture decisively influences the proximate determinants of growth and thereby a country's economic performance.

Since empirical analyses on formal institutions are manifold, the following summary is incomplete. However, the most influential approaches concerning the dissertation thesis are depicted. Several approaches explain the economic success of Western industrialized countries with certain institutional prerequisites that were prevalent in these countries.

Hall and Jones (1999), for example, estimate the impact of *social infrastructure* on per capita income levels. They define *social infrastructure* as the institutions and government policies that determine the economic environment within which individuals act (Hall and Jones, 1999, p. 84). To measure *social infrastructure*, the authors create an indicator called "government antidiversion policies" (p. 97) from Political Risk Services data. Hence, they use data on law and order, bureaucratic quality, corruption, risk of expropriation, and government repudiation of contracts (p. 97f.). They further include a measure for a country's openness to international trade. Since causality between *social infrastructure* and output per worker (the dependent variable) can run both ways, Hall and Jones (1999) conduct an instrumental variable estimation. The fraction of the population speaking English or a major European language and distance from the equator are used as instrumental variables for *social infrastructure*. The choice of instruments is justified by the fact that these variables are said to measure the extent of Western European influence and are positively correlated with *social infrastructure*. Hence, countries that were influenced by Western Europe developed a growth promoting *social infrastructure*, whereas others did not. According to the authors, early Western European influence can be measured through the extent to which English, French, German, Portuguese, and Spanish are spoken as first languages today (Hall and Jones, 1999, p. 100). Concerning distance from the equator, Hall and Jones argue that "Western Europeans were more likely to migrate to and settle regions of the world that were sparsely populated at the start of the 15th century … such as the United States, Canada, Australia, New Zealand, and Argentina … [and] it appears that Western Europeans were more likely to settle in areas that were broadly similar in climate to Western Europe" (Hall and Jones, 1999, p. 101). They discover that *social infrastructure*, and thereby political and economical institutions, have a significant effect on economic development. Accordingly, differences in capital accumulation, education, and productivity can be partly explained by differences in *social infrastructure*.

Another approach that emphasizes Western European influence comes from Acemoglu, Johnson and Robinson (2001). The authors trace current economic performance back to particular colonization strategies. That is to say, current economic performance depends on current formal institutions. The quality of current formal institutions, in turn, depends on the quality of early institutions.

Hence, a country that possessed growth-inhibiting formal institutions in the past is still characterized by growth-hindering formal institutions today. However, the quality of early institutions depended on the colonization strategy. Where Western Europeans settled, they replicated European institutions, emphasized property rights, and restricted governmental power. In areas where Europeans could not settle they set up extractive institutions that helped exploit resources but did not protect property or constrain the particular government. Whether Europeans were able to settle was dependent on their probability to survive. Acemoglu, Johnson and Robinson (2001) use records of the 18th and 19th centuries concerning the mortality rates of soldiers, bishops, and sailors in former European colonies to create a measure of 'settler mortality', which is then used as an instrument for current institutions. They do so because settler mortality in the 17th and 19th centuries should have no effect on current economic performance other than through institutions. Data on the risk of expropriation (Political Risk Services) and on constraints on the executive (Polity IV) are used as proxies for current institutions. However, the authors obtain high correlations between mortality rates and European settlements, between European settlements and early institutions,26 and between early and current institutions.

Moreover, Acemoglu, Johnson and Robinson (2002) demonstrates a 'reversal of fortune'.27 It shows that former European colonies, which were relatively rich before colonization, are relatively poor today and vice versa. Data on urbanization and population density in 1500 is used as a proxy for economic prosperity before colonization. However, the authors find a negative relationship between economic prosperity in 1500 and economic prosperity today. Again, they trace the development back to colonization strategies and institutional quality. Accordingly, the colonizers preferred to settle in places that were sparsely populated and did not settle in regions that were densely populated. In regions where Europeans settled, they established secure property rights and restricted governmental powers, whereas extractive institutions were introduced, or could remain, in populated places. Again, average protection against expropriation risk (Political Risk Services) and constraints on the executive (Polity III) are used as proxies for current formal institutions. In both papers, Acemoglu, Johnson and Robinson (2001, 2002) control for many additional variables on geography, policy, history, and ethnicity, and conduct several tests of robustness.

Acemoglu and Johnson (2005) examine the importance of property rights institutions and contracting institutions. Although contracting institutions correspond to transactions between private individuals or parties, property rights in-

26 Early institutions are measured with data on constraints on the executive in 1900, an index of democracy in 1900, and constraints on the executive in the first year of independence (Polity III).

27 See also Przeworski (2004).

stitutions regulate the relationships between private citizens and the political power. The authors detect that countries with secure property rights (measured with 'constraints on the executive' taken from the Polity IV data set) have significantly higher per capita incomes. However, contracting institutions seem to affect financial intermediation, but have no impact on per capita income once property rights are controlled for.

Further important empirical work on formal institutions comes from La Porta et al. (1999), who examine the influence of political and cultural institutions on government performance (thereby on another institution). Governance performance is measured with several indices measuring government intervention (property rights index, business regulation index, top marginal tax rate) and government efficiency (corruption, bureaucratic delays, tax compliance, average government wages). The independent variables are: ethnolinguistic fractionalization, which is used as a proxy for political institutions; legal origin, also used as a proxy for political institution; and the religious affiliation of the population, used as a proxy for cultural institutions.28 The authors discover a positive relationship between government performance and per capita income. However, their results "present clear evidence of systematic influence of historical circumstances, as captured by ethnolinguistic heterogeneity, legal origins, and religion, on government performance" (La Porta et al., 1999, p. 265).

La Porta et al. (2004) focus on legal institutions. They regress measures of political and economic freedom (for example, a property rights index, a democracy index, a political rights index) on proxies for judicial independence and constitutional review. They find that especially judicial independence is correlated with economic and political freedom.

Rodrik, Subramanian and Trebbi (2004) deal with the so-called deep determinants of growth such as institutions, geography, and integration and with the question of which of these determinants is most important for the level of per capita income. They measure the quality of (formal) institutions with an indicator from Kaufmann, Kraay and Zoido-Lobatón (2002). The indicator is composed of data "that capture the protection afforded to property rights as well as the strength of the rule of law" (Rodrik, Subramanian & Trebbi, 2004, p. 138). Integration is measured with the ratio of trade to GDP, and several measures of geography are used, for example, distance from the equator and an index of malaria risk. Furthermore, the authors use several instrumental variables depending on the particular country sample. For example, they use the Frankel and Romer (1999) instrumental variable for integration and the settler mortality variable from Acemoglu, Johnson and Robinson (2001) as an instrument for institutions. Further instruments are the proportion of the population speaking English or a

28 La Porta et al. (1999) focus on Catholic and Muslim religions "which have been recently singled out by Landes (1998) as hostile to institutional development" (p. 224).

Western European language. The dependent variable is GDP per capita. However, the results suggest that institutions matter the most for the level of per capita income. In any case, the authors stress the policy implications that could be deduced from the regression results and emphasize that they do not provide a general pattern to increase income in individual countries.

Glaeser et al. (2004) critically regard current empirical approaches on institutions and growth. They emphasize the causality issue in institutional economics and bring human capital into play as a decisive determinant of growth. They demonstrate that democracies exhibit higher educational levels than autocracies, whereas causality cannot be determined. Hence, it is not clear whether democracy supports education or whether education supports democracy. However, both factors probably influence each other and neither can be exposed as the starting point. Glaeser et al. (2004) argue that constraints on political power might be overrated as a growth-relevant determinant. Accordingly, this is the case since human capital accumulation is decisive. Economic growth, it is argued, can also be obtained in autocratic regimes where the political power is unconstrained. Furthermore, the measures for institutions are criticized, since many of them measure choices rather than constraints. Hence, no clear causality from institutions to growth can be determined. However, Glaeser et al. (2004) describe Polity IV's 'constraints on the executive' as being the best available proxy for formal institutions. The authors emphasize instrumental variable estimation as a valid method to solve the causality issue. They challenge the usage of 'settler mortality' by Acemoglu, Johnson and Robinson (2001) as instrument for institutions, stating that the fact that European settlers brought their human capital along is more decisive than the institutions they established. In addition, the exogeneity of the instrument is questioned. The authors run several regressions including educational variables and demonstrate a significant relationship between education and income.

Glaeser et al. (2004) are right in their critical reflection of empirical institutional analysis. However, every economist engaged in the field should be aware of these issues otherwise reliable research is impossible. Nevertheless, research should be performed using the available data. It is in the hands of the particular researcher to conduct serious work and be aware of the respective methodical issues and data problems.

Glaeser et al. (2004) also use a disputatious variable, namely the initial years of schooling, to measure human capital. First, reverse causality and correlation with the error term might also be an issue regarding years of schooling. Second, years of schooling might not be a valid measure for human capital. It excludes many important properties, such as the subjects taught, the quality of education, the human capital acquired outside schools or universities, and so on. Hence, it might be incomplete and not comparable across countries. Nevertheless, it is often used as a proxy for human capital since it probably is the best available measure.

However, Glaeser et al. (2004) are right that human capital should be studied in relation to institutions. Informal institutions such as beliefs, attitudes, worldviews, and so on are definitely correlated with educational standards and the subjects taught. For example, morality and beliefs might hinder the teaching of certain subjects such as evolutionary theory. Furthermore, traditional societies might despise the role of education and hinder parts of the population from becoming educated. For example, in many underdeveloped countries girls are not allowed to go to school or they go to school only to learn the essential basics such as how to read and write. Comparable attitudes still exist in some developed societies or in parts of nearly every society.

Furthermore, the level of education influences an individual's general understanding of the state and society. Hence, highly educated societies tend to be democratic as shown by Glaeser et al. (2004).

# **3.4 Endogeneity**

The empirical analysis of institutions is particularly hampered by the fact that "institutional quality is as endogenous to income levels as anything can possibly be" (Rodrik, 2007, p. 185). Institutions influence each other and are influenced by further factors. That is to say, institutions impact per capita income and vice versa.

However, the transmission channels between informal institutions and economic development have already been described using several examples. Particular norms and values lead to behavioral patterns that do not necessarily support growth. Take, for example, the exclusion of women, and thereby a large part of the potential workforce, from education and economic life in several societies. By contrast, it is conceivable that income levels also influence cultural features. In general, institutions are characterized by their stickiness. In any case, institutions can be changed, although this might take time, especially if informal institutions are involved. As usually only marginal progress is made from one generation to the next, a change in norms, values, and conventions can take decades or centuries (Boettke, Coyne & Leeson, 2008; Roland, 2005).

Institutions emerge to reduce transaction costs, uncertainty, and instability. Informal institutions guarantee a kind of non-material or social stability, whereas formal institutions secure material stability. As the standard of living increases, perspectives, priorities, and preferences are modified. That is to say, under the premise of material stability, the significance of non-material stability changes. People living at the margin of subsistence have other preferences and purposes in life than people receiving a regular salary and social security. Furthermore, higher material security alters the incentives for social affiliation. Social patterns that exist for security reasons are no longer necessary when income increases. Modern societies, for example, are usually linked with the breakup of the traditional family structure. That is to say, family, clan, or tribal affiliation becomes less important. More emphasis is on the individual. The birth rate decreases since couples have fewer children. In traditional societies, several generations often live under one umbrella, whereas the spatial distance between family members widens with modernity. Other social relationships, such as friends or colleagues, become more important. Therefore, the societal structure of generalized morality can rather be observed in modern societies.29

An increase in the living standard is accompanied by a change in values, norms, beliefs, attitudes, and convictions, as well as morality, habits, and codes of conduct. Since material stability is warranted from a certain level of income, the role of beliefs that are responsible for immaterial stability changes. Hence, attitudes concerning the individual, the family, women's work participation, minorities, materialism, and so forth change. With the collapse of familial and tribal boundaries, trust and respect concerning other people widens. Furthermore, even if an individual loses a part of their property, they still might not fear for their existence. Consequently, priorities in life change. Furthermore, increasing income levels are often accompanied by higher educational standards. Hence, people might be able to question traditional belief and value systems. They will realign informal institutions corresponding to their new preferences and needs.

However, trust depends on common norms and values, and if these are altered because of higher per capita incomes the level of trust will also adjust. We are trusting when we do not expect other people to cheat us, and thereby our expectations regarding other peoples' behaviors are decisive. Peoples' actions depend on their beliefs, attitudes, values, experiences, and so forth. Hence, if the common norms and values that are responsible for the level of trust change because of higher per capita income, trust will also adjust. An increase in the general level of trust alters the societal structure and generalized morality is thereby observable in modern societies.

The belief concerning control over one's life also becomes modified. A higher living standard contributes to an attitude of self-determination and selfconfidence. People endued with property would rather that their wealth be traced back to their own decisions and activities. These individuals will also believe that they can shape their futures according to their own wishes. Of course, wealth can also be traced back to destiny such as, for example, in Weber's thesis on the Protestant work ethic. In this thesis, people thought God's chosen ones could be recognized by their material standards, and thereby people worked hard

29 See, for example, Tabellini (2005, 2008a).

and accumulated capital to show to themselves and others that they belonged to the chosen ones. A high living standard will be preferred to be traced back to one's own efforts, and thereby will encourage further endeavor. Even in Weber's argument, people worked hard and invested to show that they are the chosen ones, and thereby their wealth could be traced back to their own efforts, even though they believed it was because of God's will.

Since the modernization that accompanies an increase in per capita income is associated with higher educational standards, a more rational and logical view of life and the world in general emerges. As a consequence, even religious doctrines and cultural traditions might need to adjust. Religious doctrines and traditions as well as conservative attitudes, values, and beliefs might be reconsidered and reinterpreted using this new knowledge (Mokyr, 2002).

Nevertheless, since humans are social beings, the non-material stability warranted through informal institutions cannot be completely replaced or altered. Several beliefs, values, and norms maintain since individuals need certain informal institutions for self-identification and self-orientation. Therefore, some informal institutions might not be changeable, independent of variations in living standards. Since informal institutions are sticky, an alteration takes time and only marginal change might be observable from one generation to the next. Informal institutions do not only impact per capita income, they also are influenced by higher living standards.

However, an increase in per capita income not only alters informal institutions but also formal institutions. We have already discussed this matter with reference to the model of Acemoglu, Johnson and Robinson (2005). Higher per capita incomes can shift the power allocation within a state. A group or person endued with appropriate resources is able to takeover de facto political power and, therefore, arrange institutions in a way that best fits their respective interests. If parts of the population gain de facto political power through economic growth and thereby higher per capita incomes, they will try to enforce their interests. However, radical changes in political and economic institutions are difficult to explain without the introduction of informal institutions. An increase in per capita income alters informal institutions, which then impact formal institutions. Hence, all three factors – per capita income and formal and informal institutions – influence each other. Thus, the basic settings of a society can jointly be responsible for the general concept of the state, the political system, and the structure of power. An autocratic government and a hierarchic system might enhance explicit cultural features such as disrespect, mistrust, resignation, a collective social structure and, hence, limited morality. In turn, these cultural characteristics again support the preservation of an authoritarian government and, in general, of the prevalent formal institutional structure. An increasing per capita income improves the level of informal institutions in the sense that people become more trustful and respectful, self-reliant, and confident. Apart from that, it

could be correlated to higher educational standards, which are associated with more open-minded and educated individuals. These people might have the ability to question and criticize the predominant institutions, both formal and informal, and alter them. Therefore, in general, some level of physical and human capital is necessary to be able to understand the importance of a growthpromoting institutional framework.

Owing to their higher per capita incomes, individuals are able to enforce the institutions that fit their interests. Hence, they will question the current system and further enforce property rights and political participation. A democratic state might support growth-supporting informal institutions. Independent citizens who can freely participate in political, economic, and social processes might realize a higher level of trust, self-determination, and self-confidence.

The interplay between informal and formal institutions and the effect on economic growth is also mentioned by Persson and Tabellini (2008). They name the cultural and societal features that support democracy 'democratic capital'. Accordingly, democracy must be supported by the democratic attitudes and convictions of the citizens. Societies with no democratic tradition possess no accordant attitudes and are not persuaded by the ideas of democracy. Hence, democratic capital emerges through democratic experience. The longer democracy exists in a country, the stronger its democratic capital will be. That is to say, with the experience of democracy, people become more and more persuaded of its ideas and are prepared to plead and even fight for the preservation of democracy. Hence, certain attitudes and values might be more supportive of a political system than others, but a political system can also influence attitudes and values.

# **3.5 Deep determinants of growth**

The aim of this study is to examine the effect of institutions on economic development. However, institutions are added to the explanatory variables because the variables that have been obtained in growth models so far have not helped explain the divergent processes of income levels and growth rates around the globe. That is to say, mainstream growth theory does not explain why the conventional factors of production – factor accumulation and technology – differ between countries. Or, more precisely, why countries are not able to use these conventional factors of production in a way that optimizes their growth performances. Factor accumulation and technology are called the proximate determinants of growth or the proximate causes of growth (Rodrik, 2003; Rodrik, Subramanian & Trebbi, 2004; Acemoglu, 2009, pp. 109–143). Hence, it must be examined which factors determine the proximate determinants of growth. If we know which variables determine factor accumulation and technology, we know

why the proximate determinants differ and, eventually, we can seize the problem by the roots and help countries find a way out of the underdevelopment trap.

The theory of the deep determinants of growth states that the proximate determinants are endogenous and are determined by the deep determinants of growth. The deep determinants depict the pre-existing environment within which a country develops. Hence, the deep determinants are the basic conditions, which, at least for a certain period of time, must be taken as given. They are the underlying factors that shape a country's social, political, and economic development.

The deep determinants of growth are institutions, geography, and openness (Knowles & Weatherston 2006; Rodrik, 2003; Rodrik, Subramanian & Trebbi, 2004). Acemoglu (2009, pp. 109–143) speaks about the "fundamental causes of growth" instead of deep determinants. He defines these fundamental causes as luck or multiple equilibria, geography, culture, and institutions.

Since institutions are differentiated into informal and formal institutions, our analysis incorporates the fundamental causes of growth, which Acemoglu calls 'institutions' and 'culture'.

Of course, *geography* is a further determinant that affects factor accumulation and productivity. It makes a difference whether a country has access to the seaside and is located in a temperate climate zone, or whether it is embedded in inaccessible terrain and has to cope with climatic extremes such as droughts and heat or severe rainfall and cold. Moreover, its geographical position determines a country's resource endowment and is responsible for the disease environment.

However, the following analysis also includes *openness* as a deep determinant, since we follow the approach of Knowles and Weatherston (2006) and Rodrik, Subramanian & Trebbi (2004). The degree of a country's openness to international trade mainly depends on its geographical position, its institutions, and its history. Nevertheless, *openness* is defined as a deep determinant since we want to examine the level of current per capita income. Hence, we wish to find the underlying factors that determine the current proximate determinants. The level of *openness* influences factor accumulation and technology. Therefore, it will be included as a deep determinant of growth. However, *openness* is completely endogenous. It entirely depends on the remaining deep determinants, the proximate determinants, and per capita income (Dollar & Kraay, 2004).

Not only *openness* but also *institutions* and *geography* are at least partly endogenous.30 Therefore, *Figure 3.1* demonstrates the connections between the

30 Rodrik, Subramanian and Trebbi (2004) assume geography to be the only clear exogenous deep determinant of growth. From a theoretical point of view, this assumption is right since a country's geographical position, and thereby its environment, cannot be influenced by other factors. However, concerning the empirical analysis, geography is often pooled with ecology. Hence, ecological factors are described as geographical factors. This might not be wrong, since a country's ecological conditions depend on its geographical position. This, for exam-

proximate and the deep determinants of growth and per capita income. The proximate determinants are endogenous, that is to say, an analysis that only incorporates the proximate determinants of growth cannot express development processes since it does not consider the effects of the deep determinants and the reverse causality matters. A theoretical analysis that does not include the deep determinants of growth will not reproduce a real picture and thereby cannot examine real operations, since the assumed prerequisites are wrong. An empirical analysis that excludes the deep determinants will eventually suffer from an omitted variable bias. However, the empirical work knows methods to deals with this issue.31

*Figure 3.1: deep determinants of growth. Source: own illustration.*

# **3.6 Methodical issues**

The endogeneity and causality issues in institutional analysis depict a particular challenge for empirical work. Typically, an ordinary least squares (OLS) regression cannot be run because of a possible omitted variable bias and reverse causality. Institutions, as they are defined in this work, can be influenced by several factors, but we are not able to detect every determinant that might affect institu-

ple, is true regarding a country's disease burden. Growth regressions often use the risk of contracting malaria in a country as a proxy variable for geography. However, malaria risk is clearly endogenous. A higher per capita income decreases the risk of a malaria infection, since it is accompanied with improved health care and widespread vaccination. Therefore, geography is defined as partly endogenous. However, other geographical proxy variables are clearly exogenous.

31 See, for example, Dollar & Kraay (2004); Easterly & Levine (2003); Sachs & Warner (1995).

tional quality. Hence, it is unavoidable that certain variables correlated with institutions are incorporated into the error term. That is, the coefficients are biased because of omitted variables.

The aim of the work is to estimate the effect of institutions on per capita income. As stated above, this effect is not unidirectional. Formal and informal institutions influence each other and income, which again has an impact on both kinds of institutions. Hence, the institutional coefficient of an OLS regression would not only estimate the unidirectional effect of, for example, informal institutions on income but also the feedback reaction from income to informal institutions.

However, the problem of endogeneity in growth empirics is commonly solved through instrumental variable estimation, that is, an instrumental variable must be found for each of the endogenous regressors. The detection of an adequate instrument can become tricky. An instrumental variable must possess two features: it has to be correlated with the appropriate endogenous variable and it must be uncorrelated with the disturbance. While the former can be tested, the fulfillment of the second feature, and thereby the relevance and accuracy of the regression result, relies on the researcher's intuition. Because causality is the main issue in the deep determinants analysis, a channel that transmits the effect of the particular endogenous variable in the right direction – and thereby from institutions to income and not vice versa – must be determined. It must be ensured that the instrumental variable does not influence the dependent variable directly, but only through its effect on the endogenous variable. If this requirement is fulfilled, the causality issue is solved and the estimated coefficient measures the effect of institutions on income.

### **3.6.1 Two stage least squares**

The problems of omitted variable bias and reverse causality can be solved via an instrumental variable estimation.

*Figure 3.2: endogeneity and reverse causality. Source: own illustration.*

As can be seen in *Figure 3.2,* endogeneity exists if an independent variable x1 is correlated with an omitted variable included in the error term. Furthermore, the issue of reverse causality occurs if x1 not only influences y, but if y also has

89

a reverse impact on x1. In the case of a single endogenous regressor we want to estimate the following equation:

$$\mathbf{y} = \boldsymbol{\beta}\_0 + \boldsymbol{\beta}\_0 \boldsymbol{\mu} + \boldsymbol{\beta}\_2 \mathbf{x}\_2 + \boldsymbol{\beta}\_3 \mathbf{x}\_3 + \dots + \boldsymbol{\beta}\_n \mathbf{x}\_n + \varepsilon \tag{3.1}$$

Hence, is assumed to be endogenous and influenced by y. If an OLS regression is run, β1 and eventually the other coefficients would be biased. In addition, β1 would measure the bilateral effect between and y instead of the unidirectional effect going from to y. Hence, to solve the problem of omitted variable bias and reverse causality, an instrumental variable for must be found. However, the instrument must satisfy two premises:

1) to avoid omitted variable bias, it must not be correlated with the error term:

$$\operatorname{Cov}(\rho\_i, \varepsilon) = 0 \dots$$

However, this precondition deters from being an omitted variable included in the error term of the first-stage regression . Furthermore, the assumption declares that no direct correlation between y and is allowed, thereby

$$\operatorname{Cov}(\underline{\boldsymbol{y}}, \boldsymbol{\rho}\_{\iota}) = \mathbf{0} \quad \underline{\boldsymbol{\rho}}$$

Therefore, the causality issue is solved since the direction of the effect goes from to to y and not vice versa.

2) The instrumental variable must be correlated with the relevant endogenous variable:

$$Cov(\rho\_\circ, \mu) \neq 0 \ .$$

Applying the 2SLS method, two equations are estimated:

$$\text{Second-stage regression:} \qquad y = \beta\_0 + \beta\_1 \boldsymbol{\Omega} + \beta\_2 \mathbf{x}\_2 + \beta\_3 \mathbf{x}\_3 + \dots + \beta\_n \mathbf{x}\_n + \boldsymbol{\varepsilon}, \tag{3.2}$$

$$\begin{array}{ll}\text{First-stage regression:}\\\end{array}\text{\textbullet}\qquad\qquad\qquad\mu=\theta\_0+\theta\_1\rho\_1+\theta\_2\mathbf{x}\_2+\theta\_3\mathbf{x}\_3+...+\theta\_n\mathbf{x}\_n+\upsilon,\tag{3.3}$$

$$
\rangle \implies \hat{\boldsymbol{\mu}} = \hat{\boldsymbol{\theta}}\_0 + \hat{\boldsymbol{\theta}}\_i \boldsymbol{\rho}\_i + \hat{\boldsymbol{\theta}}\_2 \mathbf{x}\_2 + \hat{\boldsymbol{\theta}}\_3 \mathbf{x}\_3 + ... + \hat{\boldsymbol{\theta}}\_n \mathbf{x}\_n. \tag{3.4}
$$

Hence, first a regression on is run, including the instrumental variable 1 and all exogenous independent variables xi. This regression results in the fitted value μˆ . Then, μˆ is used to estimate the coefficient of interest -1. Since 1 is not correlated with  the problem of omitted variable bias is solved. However, 1 is not correlated with y either – that is, there is no direct effect between the instrument and the dependent variable. Only an indirect effect between 1 and y exists because 1 influences μˆ , which is correlated with y. Hence, the transmission channel is unidirectional from 1 to μˆ to y. Therefore, -1 measures the effect of μˆ on y and not vice versa.

In the case of multiple endogenous regressors, at least one instrumental variable for each endogenous variable is needed. If fewer instruments than endogenous variables are available, the equation is underidentified and the regression cannot be run. However, if the number of instruments equates the number of endogenous variables, the equation is said to be exactly identified and the regression can be run. The same holds if the number of instruments exceeds the quantity of endogenous regressors – that is, if the equation is overidentified.

With multiple endogenous regressors i, one first-stage regression for each endogenous variable must be run:

Second-stage regression:

$$\mathbf{y} = \boldsymbol{\beta}\_{o} + \boldsymbol{\beta}\_{1}\hat{\boldsymbol{\mu}}\_{1} + \boldsymbol{\beta}\_{2}\hat{\boldsymbol{\mu}}\_{2} + \dots + \boldsymbol{\beta}\_{n}\hat{\boldsymbol{\mu}}\_{n} + \boldsymbol{\beta}\_{n+1}\mathbf{x}\_{1} + \boldsymbol{\beta}\_{n+2}\mathbf{x}\_{2} + \dots + \boldsymbol{\beta}\_{n+n}\mathbf{x}\_{n} + \varepsilon\tag{3.5}$$

First-stage regressions and fitted values:

$$\mu\_1 = \theta\_0 + \theta\_1 \rho\_1 + \theta\_2 \rho\_2 + \dots + \theta\_n \rho\_n + \theta\_{n+1} \mathbf{x}\_1 + \theta\_{n+2} \mathbf{x}\_2 + \dots + \theta\_{n+m} \mathbf{x}\_n + \mathcal{U}\_l \tag{3.6}$$

$$\begin{aligned} \xleftarrow{\sum} \quad \hat{\mu}\_{\text{i}} &= \hat{\theta}\_{0} + \hat{\theta}\_{\text{i}}\rho\_{1} + \hat{\theta}\_{2}\rho\_{2} + ... + \hat{\theta}\_{n}\rho\_{n} + \hat{\theta}\_{n+1}\mathbf{x}\_{\text{i}} + \hat{\theta}\_{n+2}\mathbf{x}\_{2} + ... + \hat{\theta}\_{n+m}\mathbf{x}\_{m} \end{aligned} \tag{3.7}$$

$$\mu\_2 = \theta\_0 + \theta\_1 \rho\_1 + \theta\_2 \rho\_2 + \dots + \theta\_n \rho\_n + \theta\_{n+1} \mathbf{x}\_1 + \theta\_{n+2} \mathbf{x}\_2 + \dots + \theta\_{n+m} \mathbf{x}\_n + \mathcal{U}\_2 \tag{5.8}$$

$$\sum \quad \hat{\mu}\_2 = \hat{\theta}\_0 + \hat{\theta}\_1 \rho\_1 + \hat{\theta}\_2 \rho\_2 + \dots + \hat{\theta}\_n \rho\_n + \hat{\theta}\_{n+1} \mathbf{x}\_1 + \hat{\theta}\_{n+2} \mathbf{x}\_2 + \dots + \hat{\theta}\_{n+w} \mathbf{x}\_n \tag{3.9}$$

$$
\mu\_n = \theta\_0 + \theta\_1 \rho\_1 + \theta\_2 \rho\_2 + \dots + \theta\_n \rho\_n + \theta\_{n+l} \mathbf{x}\_l + \theta\_{n+2} \mathbf{x}\_2 + \dots + \theta\_{n+n} \mathbf{x}\_n + \vartheta\_n \tag{3.10}
$$

*n n n n n n m m x x x* μ = θ +θ ρ +θ ρ + +θ ρ +θ + +θ + + +θ+ ˆ ... ˆ ˆ ˆ ... ˆ ˆ ˆ ˆ 0 1 1 2 2 1 1 2 2 (3.11)

However, instrumental variable estimation has its disadvantages, especially regarding the issues of instrument validity and instrument weakness. The validity of an instrumental variable depends on its correlation with the error term of the first-stage regression  and, therefore, the compliance with assumption one. If the instrument is correlated with , it is not valid and an instrumental variable estimation cannot be conducted. The weakness of an instrumental variable is determined by its correlation with the endogenous variable i. If and are only sparsely correlated, the instrument is said to be weak.

An instrumental variable estimator (j) is consistent if assumptions one and two hold. If either condition fails, the instrumental variable estimator is inconsistent. However, even if the independent variable i is endogenous so that instrumental variable estimation is necessary, the estimator j is never unbiased. Thus, especially in small samples, the bias in the instrumental variable estimator can be substantial.