Legalize drugs?

An upcoming policy forum sponsored by the Cato Institute discusses "Mexico and the War on Drugs." The main speaker is actually now singing a different tune: if you can't beat them, join them:

Mexico is paying a high price for fighting a war on drugs that are consumed in the United States. More than 40,000 people have died in drug-related violence since the end of 2006 when Mexico began an aggressive campaign against narco-trafficking. The drug war has led to a rise in corruption and gruesome criminality that is weakening democratic institutions, the press, law enforcement, and other elements of a free society. Former Mexican president Vicente Fox will explain that prohibition is not working and that the legalization of the sale, use, and production of drugs in Mexico and beyond offers a superior way of dealing with the problem of drug abuse.

I hope Mr. Fox is not considering completely legalizing drugs because that would mean we're abandoning the central reason why we're banning it in the first place--the negative externalities associated with drug use abuse. Studies are everywhere pointing to how drug abuse can lead to problems in society such as increases in murders, rapes, and vehicular accidents, among others.

On the other hand, if Mr. Fox is really suggesting legalizing but with some sort of regulation still in place, I would not think the same problems would go away. Think, for example, such regulation would place a limit to how much drugs one should consume. That would be very difficult to monitor. In addition, there would be some sort of opportunism that will definitely take place. Some individuals would take advantage of such regulations. Those individuals set up another black market.

And the song would continue to keep playing...

Institutions and Development

There is already a rich literature on the relationship between institutions and economic growth which Pande and Udry (hereafter referred to as PU) enumerate in their 2006 paper. Shirley (2005) and Straub (2008) also provide some excellent surveys. Majority of the papers strongly conclude that good quality institutions lead to better economic performance for a given country.

Most of the literature use cross-country data in their analysis. PU, however, points to the three limitations of doing so in the identification of channels through which institutions affect economic growth.

First, PU argues that the measurement used for institutional quality is “necessarily coarse”:

"The cross-country literature has largely relied on broad indices of institutional quality. The use of coarse institutional measures implies that cross-country regressions are typically unable to isolate the causal effect of any single institution."

PU also point to the possibility of generating omitted variable bias in the econometric methods used:

"[T]he inability to include the entire array of institutions which impinge on, say, growth as independent variables (often due to the small set of available instruments) raises the possibility of omitted variable bias. For example, some indices of institutions used in the cross-country literature are very strongly biased towards measuring the institutional environment facing urban and/or formal sector agents."

PU’s final concern deals with the nature of heterogeneity of institutions and of the actors being affected by such institutions, even within a given country. One of the many examples they gave is the fact that mechanisms of contract enforcement in the urban sectors may differ significantly to the mechanisms of contract enforcement in the rural sectors.

All in all, the authors conclude that:

"[T]he extraordinary diversity of institutional practices across and within countries places natural constraints on the usefulness of cross-country analyses for understanding the specific channels through which institutions affect economic outcomes, and how these institutions, in turn, respond to economic, demographic, political and social forces."

Given the limitations to current macro-centric efforts in the literature, PU suggest that future research in the relationship between institutions and growth is “best furthered by the analysis of much more micro-data than has typically been the norm in the literature.” Specifically, PU suggest two research programs that have significant potential:

1. Using “policy-induced variation in specific institutions within a country to examine how specific institutions influence economic outcomes.”
2. Exploiting the fact that “incentives provided by a given institutional context often vary with individuals’ economic and political status, and so close examinations can be done of the economic choices of individuals in a specific institutional context.” Identifying the specific channels on how institutions affect economic behavior and hence economic outcome can be achieved by analyzing how individuals’ respond to the same institution. Likewise, doing so would also help understand “how institutional change arises in response to changing economic and demographic pressures.”

Pande and Udry's paper goes into the heart of the new institutional economics (NIE) school. NIE has always been about institutions, and how institutions affect the behavior of agents in an economy. North (1991) states that “institutions provide the incentive structure of an economy; as that structure evolves, it shapes the direction of economic change towards growth, stagnation, or decline.”

This paper even presents another push to what I would consider an ongoing paradigm shift in how economists study the relationship between institutions and economic growth. The paradigm shift that I’m referring to is the current efforts in the literature of moving away from looking at the macroeconomic view of how institutions affect economic outcomes and into looking at the microeconomic view. PU may not have been pioneers in this research (for example, Gibson and Rozell, 2003, looked at how improved road access leads to lower poverty in Papua New Guinea), but where this paper is revolutionary is in laying down a firm conceptual framework in undertaking further research in analyzing the relationship at the micro level.

One of the strengths of the paper is the methodical way that PU presents their ideas. They start by doing a review of the rich “macro”-literature and proceeded to identifying the limitations of how the existing papers establish “a causal link between a cluster of ‘good’ institutions and more rapid long run growth.” They not only focused on some technical limitations, such as the problems of omitted variable bias when it comes to econometric specifications, but also on one obvious drawback—these studies never really specified the exact channels through which institutions do affect economic growth. They then proceeded to their main thesis which would solve the limitations—looking at the micro level in two different ways. The solutions they suggest also seemed practical, as they close their paper with an application of their suggested research framework to the land tenure system in Ghana.

PU’s suggestion of analyzing the relationship between institutions and economic growth at the micro level in two research perspectives is the biggest contribution of this paper in the literature. I mentioned earlier that this paper tries to suggest a solution to one obvious limitation in the current literature—that of the lack of specifying the exact channels through which institutions affect economic growth. Analyzing the exact channels has important implications in terms of policy. North (1993) points out that “successful development policy entails an understanding of the dynamics of economic change if the policies pursued are to have the desired consequences. And a dynamic model of economic change entails as an integral part of that model analysis of the polity since it is the polity that specifies and enforces the formal rules.” This paper provides two frameworks for researchers and policymakers on how to go about understanding the dynamics.

Even if the current empirical literature is strongly based on the theory that institutions affect growth through its effect on individual agents, it would still greatly advance the tenets of NIE if authors can provide empirical basis on what is happening down below—at the micro level. PU has definitely helped in that effort with this paper.

Referencs

Gibson, John and Scott Rozelle (2003), “Poverty and access to roads in Papua New Guinea”, Economic development and Cultural Change, 52(1):159-85.
North, Douglass C. (1991), “Institutions”, The Journal of Economic Perspectives, 5(1):97-112.
North, Douglass C. (1993), “The new institutional economics and development”, Working paper, Washington University in St. Louis.
Pande, Rohini and Christopher Udry (2006), “Institutions and Development: A View from Below” in Richard Blundell, Whitney Newey, and Torsten Persson, eds., Advances in Economics and Econometrics Theory and Applications (New York: Cambridge University Press) 981-1022.
Shirley, Mary M. (2005), “Institutions and Development”, in Claude Menard and Mary M. Shirley (eds.) Handbook of New Institutional Economics, Dordrech: Springer, 611-38.
Straub, Stephane (2008), “Infrastructure and growth in developing countries: Recent advances and research challenges”, World Bank Policy Research Working Paper 4460.

Reversal of Fortune

There has already been studies that document the phenomenon called “reversal of fortune,” (RF) or reversal of relative income: areas that were relatively prosperous in the past are relatively poor now, and areas that were relatively poor then are now relatively rich. The authors (Daron Acemoglu, Simon Johnson, and James A. Robinson, hereafter AJR) adds to this literature by documenting the reversal among former European colonies. Using urbanization rate and population density to represent prosperity in the 1500, the authors find that there is indeed “a negative association between economic prosperity in 1500 and 1995.” They show through different econometric specifications that this relationship is robust. Even after controlling for continent dummies, the identity of the colonial power, religion, distance from the equator, temperature, humidity, resources, whether the country is landlocked, and excluding the “neo-Europes” (the United States, Canada, New Zealand, and Australia) from the sample, the negative relation still holds.

In trying to explain this pattern, the authors dismiss some existing theories that explain RF, such as the “geography hypothesis.” The geography hypothesis “explains most of the differences in economic prosperity by geographic, climatic, or ecological differences across countries.” AJR provide evidence that weights against this simple version of the geography hypothesis. AJR also claim that there is little evidence to support even the more sophisticated versions of this hypothesis such as the “temperate drift hypothesis.”

For AJR, the more plausible explanation for RF is what they termed “institutions hypothesis.” AJR’s main hypothesis is that:

[A] cluster of institutions ensuring secure property rights for a broad cross section of society, referred to as “institutions of private property,” are essential for investment incentives and successful economic performance. In contrast, “extractive institutions,” which concentrate power in the hands of a small elite and create a high risk of expropriation for the majority of the population, are likely to discourage investment and economic development.

AJR find historical and econometric evidence suggesting that:

European colonialism led to the development of institutions of private property in previously poor areas, while introducing extractive institutions or maintaining existing extractive institutions in previously prosperous places. The expansion of European overseas empires, combined with the institutional reversal, is consistent with the reversal in relative incomes since 1500.

Finally, AJR were able to document that the reversal in relative incomes among the former colonies was related to industrialization. They surmised that societies with institutions of private property “take advantage of the opportunity to industrialize, while societies with extractive institutions fail to do so.” They concluded that this led to the industrialization that took place in the nineteenth century and played a central role in the long-run development of the former colonies.

The main finding of AJR in this paper is that the reversal of relative income among former colony countries that we observed today are primarily due to “European colonialism that led to the development of institutions of private property in previously poor areas, while introducing extractive institutions or maintaining existing extractive institutions in previously prosperous places.” This fits perfectly within the major tenets of the new institutional economics (NIE) school. Coase (1998) established that “it is the institutions that govern the performance of an economy.” North (1991) explained that “institutions are the humanly devised constraints that structure political, economic and social interaction” and that institutions “consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal rules (constitutions, laws, property rights).” Using this framework, Williamson (2000) states that the NIE “has been concerned principally with levels 2 and 3” of what he considers the four levels of social analysis. He refers to the second level as “institutional environment,” where “much of the economics of property rights is.”

The main strength of the paper is how AJR overcame one of the limitations of making comparative analysis involving a long timeframe. Data in 1500 is certainly not perfect, if not absent. The authors instead became creative and used urbanization rate and population density as proxy for the level of prosperity. Their effort is likewise not without theoretical precedence. They cited numerous papers in the literature that support their claim. Furthermore, they backed up this claim by conducting regression analysis to support the use of said proxies.

While I agree with how the paper describes “equilibrium institutions” (“when extractive institutions were more profitable, Europeans were more likely to opt for them” versus “Europeans were more likely develop institutions of private property when they settled in large numbers”), it must be that the reasons for the persistence of institutions are not only limited to these two cases. Further developments in theory must be made to come up with other reasons the two types of institutions persist. Austin (2008), for example, points to this oversimplification of European colonies into “settlers” and “non-settlers.” Each may have a different kind of “historical path” than the one described by AJR.

Huillery (2011) looking at French West Africa, for example, states that there are some colonies with extractive institutions that performed better simply because they have more European settlers than colonies with extractive institutions. In other words, colonized areas that received more European settlers have performed better than colonized areas that received less European settlers. Acemoglu et al. actually have the same idea—the more settlers the better, but according to Huillery, this also applies even among extractive colonies.

Furthermore, the time period between 1500 and 1995 is too long to disregard any other factors that might help explain the reversal. If we refer to Williamson’s (2000) four levels of social analysis, AJR’s analysis may very well be operating within second level, where “the definition and enforcement of property right and of contact laws are important features.” In the 500 years since 1500, however, things may be happening at the third level, where “governance of contractual relations become the focus of analysis.” For instance, we might find one in history where a dictator rules a country, but which enforces good property rights.

In spite of these weaknesses, this paper is another great addition to the literature of how institutions, particularly those involved in securing property rights, explain economic outcomes. The paper adds empirical support to the finding that countries with institutions that secure property rights are more developed than countries that do not have such institutions.

In addition, and more importantly, this paper provides an explanation about how these institutions came to be. In a sense, this is paper lends support to the work of La Porta et al. (1998), which looks at how institutions themselves are a product of history, i.e. colonialism. Their paper looks at the “legal rules covering protection of corporate shareholders and creditors.” They find that “common law countries generally have the strongest, and French civil-law the weakest, legal protections of investors.” Protection of investors’ rights is important because according to La Porta et al., “without these rights, investors would not be able to get paid, and therefore firms would find it harder to raise external finance.” This lack of free-flowing capital would be detrimental to the productivity, and hence welfare, of a country. Much like AJR’s paper, the laws of a country, especially one that is a former colony, are received through “colonial transplantation.” Both papers talk about how different property-securing institutions led to different outcomes. Whereas AJR looks at the current RF phenomenon, La Porta et al. looks at the current state of different legal rules covering the protection of investors.

References

Acemoglu, Daron, Simon Johnson, and James A. Robinson (2002), “Reversal of fortune: Geography and Institutions in the making of the modern world income distribution”, Quarterly Journal of Economics, 117(4):1231-94.
Austin, Gareth (2008), “The ‘reversal of fortune’ thesis and the compression of history: Perspectives from African and comparative economic history”, Journal of International Development, 20:996-1027.
Coase, Ronald (1998), “The new institutional economics”, The American Economic Review, 88(2):72-4.
La Porta, Rafael, Florencio Lopes-de-Silanes, Andrei Shleifer, and Robert W. Vishny (1998), “Law and finance”, Journal of Political Economy, 106(6):1113-55.
North, Douglass C. (1991), “Institutions”, The Journal of Economic Perspectives, 5(1):97-112.
Williamson, Oliver E. (2000), “The new institutional economics: Taking stock, looking ahead”, Journal of Economic Literature, 38(3):595-613.