“Institutions such as religion, democracy and government anti-diversion policies all significantly enhance a country's long-run economic performance,” Brat wrote in 2004.
“Institutions such as religion, democracy and government anti-diversion policies all significantly enhance a country's long-run economic performance,” Brat wrote in 2004.
“Institutions such as religion, democracy and government anti-diversion policies all significantly enhance a country's long-run economic performance,” Brat wrote in 2004.
Professor David A. Brat Department of Economics & Business Randolph-Macon College Ashland, VA 23005 dbrat@rmc.edu 804-752-7353
ABSTRACT
Is long-run economic growth exogenous? To address this question, Bernanke and Gurkaynak (B&G) show that the empirical framework of Mankiw, Romer, and Weil (1992) can be extended to test any growth model that admits a balanced growth path. Their broad conclusion is that long-run growth is significantly correlated with behavioral variables such as the savings rate. Hence, future empirical studies should focus on models that exhibit endogenous growth. Fair Enough. But have B&G read the growth literature lately? Douglass North won a Nobel Prize for his work on Institutions. Hall and Jones have codified these institutions and shown that they should be considered the ultimate source and cause of growth. The World Bank has institutionalized much of this project. And yet no mention of institutions exists in the Bernanke paper. Are we all describing the same world? Even if growth is endogenous, why do we have to go back to variables which economists used to favor? If savings causes growth and growth causes savings, we are still left with the ultimate question: What is the ultimate cause of savings? Why is Africa poor? Why dont they save? Is it because of endogeneity issues? I dont think so. Institutions are the new story. I will show how institutions can be placed squarely within the B&G growth framework. As there does not appear to be a clear way to adjudicate between competing right hand side variables at this time in the literature, I will follow the herd. I will simply argue that my story is one step more complete than B&Gs 2001 story.
I. Introduction
This paper takes Robert Solow seriously. Thus begins one of the most influential and widely cited pieces in the empirical growth literature, a 1992 article by N. Gregory Mankiw, David Romer, and David Weil. It also begins the paper by Bernanke and Gurkaynak (B&G) which will be examined here. In brief, Mankiw, Romer, and Weil (1992), henceforth MRW, performed an empirical evaluation of a textbook Solow (1956) growth model using the Penn World Tables, a multi-country data set constructed by Summers and Heston (1988) for the years 1960-1985. MRW found support for the Solow models predictions that, in the long-run steady state, the level of real output per worker by country should be positively correlated with the saving rate and negatively correlated with the rate of labor-force growth. However, their estimates of the textbook Solow model also implied a capital share of factor income of about 0.60, high compared to the conventional value (based on U.S. data) of about one-third.
To address this possible inconsistency, MRW considered an augmented version of the Solow model, in which human capital enters as a factor of production in symmetrical fashion with physical capital and raw labor. They found that the augmented Solow model fits the data relatively better and yields an estimated capital share more in line with conventional wisdom.
MRW concluded that an augmented Solow model that includes accumulation of human as well as physical capital provides an excellent description of the cross-country data. 1 As B&G note, the fact that MRWs augmented Solow model fits the cross-country data well is an interesting finding (and, as they point out, the results could have been otherwise). However, as B&G will discuss in some detail below, it is not entirely clear to what degree the good fit of the MRW specification may be attributed to elements that are common to many models of economic growth (such as the Cobb-Douglas production structure), and how much of
1 MRW abstract, pg. 407 the fit is due to elements that are specific to the Solow formulation (such as the exogeneity of steady-state growth rates). Indeed, as B&G have shown, MRWs basic estimation framework is broadly consistent with any growth model that admits a balanced growth path a category that includes virtually all the growth models in the literature. Hence, B&G conclude, one might argue that MRW do not actually test the Solow model, in the sense of distinguishing it from possible alternative models of economic growth. 2
In their paper, B&G modestly extend the empirical framework introduced by MRW and use it to reevaluate both the Solow model and some alternatives. In particular, they re-examine the crucial prediction of the Solow model, that long-run economic growth is determined solely by exogenous technical change and is independent of variables such as the aggregate saving rate, schooling rates, and the growth rate of the labor force.
B&G find strong statistical evidence against the basic Solow prediction. In particular, they find that a countrys rate of investment in physical capital is strongly correlated with its long-run growth rate of output per worker, and that rates of human capital accumulation and population growth are also correlated, though somewhat less strongly, with the rate of economic growth. They, thus, find that growth is endogenous. Growth is correlated with savings rates. 3 This is their new story. It is true but it is not complete.
II. Bernankes Replication and Extension of the MRW Results
The original MRW article used cross-national data for the period 1960-1985. In their paper, B&G replicate the MRW results for 1960-1985 and extend them through 1995. They find that the MRW conclusions about the fit of the textbook Solow model and the augmented Solow model seem slightly weaker when they use revised and/or extended data, though their main results survive. B&G also propose a new test of the Solow model based on joint estimation of equations in the form of their equations (2.17) and (2.18). 4 We will use this new specification proposed by B&G and test whether institutions belong in their model. If their model is not specified properly, then of course, their findings are not statistically valid.
Following MRW and B&G, we draw our basic data from the Summers-Heston Penn World Tables (PWT), which contain information on real output, investment, and population (among many other variables) for a large number of countries. The data set used in the original MRW study was PWT version 4.0. The PWT data have been revised twice since publication of the MRW article; as of this writing, PWT version 5.6 (which extends coverage of most variables through 1992) is the latest publicly available version.
MRW measure n as the average growth of the working-age population (ages 15 to 64). They obtained these data from the World Banks World Tables and the 1988 World Development Report. B&G use the original MRW data on working-age population in conjunction with the PWT 4.0 data set. For analyses using PWT 5.6 and PWT 6.0, they use analogous data taken from the World Banks World Development Indicators 2000 CD-ROM. The saving rate relevant to physical capital, K s , is measured as the average share of gross investment in GDP, as in MRW.
MRWs estimates of the augmented Solow model (with human capital accumulation) include a variable they call SCHOOL, analogous to our H s , which is the average percentage of a countrys workingage population in secondary school. More specifically, MRW define SCHOOL as the percentage of schoolage population (12-17) attending secondary school times the percentage of the working-age population that is of secondary school age (15-19). The age ranges in the two components of SCHOOL are incommensurate but we are inclined to agree with MRW that the imperfect match up is not likely to create major biases and we use the same construct. Data on enrollment rates, and working-age population and its components are from the sources noted two paragraphs above and from the UN World Population Prospects.
2 B&G pgs. 1-2 3 B&G, pg. 2 4 B&G, pg. 8 As in MRW, the three country samples we examine are 1) the non-oil sample, the set of all countries for which complete data are available, excluding oil producers (98 countries); 2) the intermediate sample, which is the non-oil sample excluding countries whose data receive a grade of D from Summers and Heston or whose population is less than one million (75 countries); and 3) the OECD sample, OECD countries with populations greater than one million (22 countries). Note that, because of missing data, the sample sizes are in some cases slightly smaller when PWT 5.6 and PWT 6.0 are used for the replication.
A more powerful test of the Solow model
According to B&G, based on the their replication of MRWs regression results, one might follow MRW and draw broadly positive conclusions aboutthe fit of the Solow model, especially when augmented with human capital. Notably, a simple regression using only three variates (the saving rate, the schooling rate, and the population growth rate) seems to explain a remarkable share of cross-country variation in the level of output per worker. It is true that the estimates of the production function coefficients are not always reasonable, and we have found that the over-identifying restriction implied by the Cobb-Douglas structure is often rejected, but problems with estimation of production relationships are not uncommon. Very possibly, these statistical rejections are not of great economic significance. 5
However, as the B&G exposition in Section II suggests, the results shown so far do not constitute the strongest test of the Solow model within this framework. In their view, the better test of the Solow model involves testing the restrictions on the analogue of equation (2.18), the equation explaining long-run growth. In particular, if the hypothesis that the steady state of the Solow model describes the cross sectional distribution of output per worker is true, then we should not be able to reject the hypothesis that factors such as the saving rate or the rate of human capital accumulation do not enter into the determination of the long-run growth rate. 6
According to B&G, formally, equations (2.17) and (2.18), together with the assumptions that all countries share the same production function parameters and long-run growth rate, imply that where the growth rate g is constant across countries. A straightforward statistical implication of the model, easily tested in this framework, is that the coefficients on variables such as the saving rate, the schooling rate, and the growth rate of the workforce rate should be zero, when they are entered on the right side of eq. (3.2). (More precisely, we divide both sides of eq. (3.2) by the number of periods t, so that the annual growth rate is on the right-hand side). 7
Table I reports the results of the primary B&G test. (It is table 5 in the B&G paper.) Equations (3.1) and (3.2) are estimated jointly by seemingly unrelated regression (SUR), with equation (3.2) being augmented by the variables I/GDP,SCHOOL, and the labor-force growth rate n . The prediction of the Solow model (under the auxiliary assumption of steady states) is that the estimated coefficients of the last three variables should all be zero.
Table I shows the parameter estimates and standard errors for the augmented equation (3.2). In brief, B&G show that the Solow models implication that growth is exogenous is strongly rejected for the nonoil and intermediate samples. The z-statistics for I/GDP are bolded to show its statistical significance. The implication is that growth is endogenous.
There are at least two possible reasons for the statistical rejections found in Table I: First, growth may not be truly exogenous, in the sense of the Solow model. Second, the maintained hypothesis that the countries in the sample are in the steady state may be wrong, i.e., we may be picking up transition dynamics. 8
5 B&G, pg.12 6 B&G, pg.12 7 B&G, pg.12 8 B&G, pg.13 B&G show that one simple test of the second possibility is to consider only the 22 countries in our sample that are located in the Western hemisphere. Arguably, the assumption of steady states makes more sense for Western hemisphere countries than for the rest of the world, as the Americas have not been the scene of major wartime destruction, post-colonial transitions, or (except for Cuba, which is not in our sample) sustained non-market experiments during the past century. Interestingly, as Table V shows, the restrictions of the Solow model cannot be rejected for the countries of the Western hemisphere as a group. Thus, it remains possible that the results of this section arise because of transition dynamics, not because the Solow model is fundamentally wrong about long-run growth. In the latter part of their paper, B&G address this issue directly by considering the determinants of TFP growth rather than output. 9
III. Bernankes Omission of Institutions: The Ultimate Cause of Growth!
The analysis thus far has reviewed the work of Bernanke and Gurkaynak. They present a solid case that growth is not exogenous and their modeling exercise is helpful in understanding some of the shortcomings of the Solow model and of the Mankiw paper. However, Bernankes critique applies to a 1992 paper. In the meantime, much has taken place in the literature of Growth Economics. The highlight may be the 1993 Nobel Prize in Economics awarded to Douglass North for his pioneering work on institutions. Since that time, prominent authors such as Hall and Jones and Barro, and indeed even Brat, have investigated the effects of institutions on economic growth in just the cross-country framework which Bernanke uses.
The purpose of the present paper is to show that institutional variables belong in the framework of Bernanke as presented above. Standard econometric evidence will clearly prove this case. It will also be shown that institutions of all sorts are compatible with Bernankes story. Thus it is not simply one variable which is being omitted. Much work needs to be done here. Previous work by Brat has shown that a Protestant institutional variable explains why some countries are rich and why some are poor within the Mankiw framework. Interestingly, the Protestant institutional variable is statistically significant in explaining differences in income levels but not in explaining current growth rates. The same Protestant variable produced similar results when included in the Barro framework and within the growth framework of Hall and Jones. In all of these cases, arguments have been given for why the Protestant variable is actually the best ex ante exogenous variable in the literature. Bradford Delong deserves the credit for putting this argument forward in the American Economic Review back in 1988.
Doug North as Motivation
The motivation for this study is to provide an alternative perspective to the new macroeconomic growth theory. While Mankiw, Romer and Weil, (MRW) have claimed that "the (human capital) augmented Solow model provides an almost complete explanation of why some countries are rich and others are poor" 10 , Douglass North has taken another tack.
In his 1993 Nobel lecture, North stated that "Neoclassical theory is simply an inappropriate tool to analyze and prescribe policies that will induce development. It is concerned with the operation of markets, not with how markets develop. In fact, most societies throughout history got stuck in an institutional matrix that did not evolve into the impersonal exchange essential to capturing the productivity gains that came from the specialization and division of labor that have produced the Wealth of Nations. 11
Such a theory sounds plausible, but how does one test such a theory empirically? One paper in particular set the stage for such an empirical analysis. Bradford DeLong discovered that "there is one striking ex ante association between economic growth in the period 1870-1979 and a predetermined variable: this variable is a nation's dominant religious establishment." 12
9 B&G, pg. 13 10 MRW, pg. 408 11 North, pgs. 359, 364 12 DeLong, pg. 1146 DeLong further notes that while difficult to interpret, his regression results "do serve as an example of how culture may be associated with substantial divergence in growth performance.....a country's religious establishment has been a surprisingly good proxy for the social capability to assimilate modern technology." 13
Is there a systematic relationship between a country's dominant religious establishment and the standard of living across countries? How do we examine this question? The heart of the argument in this paper is that while MRW claim an almost complete explanation of economic development based on their three right hand side variables, they have not really explained development at all. It is true that rich countries have relatively more capital, both physical and human. It is also true that these variables are correlated with high incomes. However, the more interesting development question is why these countries acquired these types of capital inputs in the first place.
To conclude that rational actors choose to acquire less capital and remain in the midst of high levels of absolute poverty commits the rational actor theory to a strange position indeed. Douglass North concludes that it is necessary to dismantle the rationality assumption underlying economic theory in order to approach constructively the nature of human learning. History demonstrates that ideas, ideologies, myths, dogmas and prejudices matter. 14 DeLongs regressions presented above reveals that religion does matter in history.
The Protestant Institution
The positive coefficient on the Protestant institutional variable indicates that countries with a Protestant religious establishment have on average higher income levels. As DeLong noted above, it is this variable and not capital or education or democracy or OECD status which has been associated with economic growth over the long run. It is therefore logical that these countries should now have higher incomes on average. They do.
Equally significant is that this variable is the only ex ante variable of interest. It is the variable which comes first historically and explains future economic behavior. A dummy variable representing OECD countries would be trivial as it is a collection of those countries which have become rich and therefore begs the whole question of what caused this richness. It is quite another thing to claim that a countrys religious establishment in 1600 would predict future income levels.
Why might Protestant countries have grown more quickly over the long run as suggested by DeLong? Should we still expect a positive connection between Protestantism and economic performance? Douglass North has given the broad theoretical answer to this question. To the extent that Protestantism provides an efficient set of property rights and encourages a modern set of economic incentives, one might anticipate positive economic performance. If one looks to the Reformation period itself, it is clear that at a minimum, the Protestant countries provided a relatively more decentralized economic environment for economic actors. Swanson gives an extensive analysis of this claim.
Swanson shows that a remarkable pattern emerges in Western Europe that remains constant for over three centuries. Countries with Catholic regimes tend to be more centralized. Countries with Lutheran or Anglican (Protestant) regimes tend to be intermediate and Calvinist (Protestant) regimes tend to be the most decentralized. No normative claims are being made here. But a clear linkage is being established between religion, regime and decentralization in order to add content to Norths claim that institutions matter in history. Could this decentralization encourage the institutional matrix of impersonal exchange essential to modern economic life? 15 I will put this forward as my best tentative hypothesis thus far. I will also show that many other tentative hypotheses are not as strong.
13 DeLong, pg.1148 14 North, pg. 362 15 See Swanson.
IV. The Institutional Results Protestant, Democracy and Government Corruption Variables
With our hypothesis in mind, lets take a look at the regression results. Table 1 is the exact replication of the B&G paper. Table I shows the parameter estimates and standard errors for B&Gs augmented equation (3.2). In brief, B&G show that the Solow models implication that growth is exogenous is strongly rejected for the nonoil and intermediate samples. The z-statistics are bolded to show statistical significance. The implication is that growth is endogenous. But this story is not complete as Tables 2 4 will make clear.
Looking primarily at the intermediate sample of 72 countris, the B&G regression shows that all of the Mankiw right hand side variables are statistically significant in explaining the level of income per capita in 1995, but only investment is significant in explaining growth rates from 1960 1995.
In Table 2, the DeLong Protestant variable is added to the B&G framework. Again, looking primarily at the intermediate sample of 70 countries, the Protestant variable is statistically significant in explaining both income level and growth rates. However, the sign is different and this result appears to be robust across the other samples as well. How can Protestant be positive on income but negative on growth? If you are familiar with the growth literature, it becomes clear that the Protestant variable in the growth equation is probably just stealing the explanatory power from another variable which is usually present, specifically, the initial income of the country at 1960. This is the case. When initial income is added to the right hand side of the growth equation, Protestant is no longer negatively signed and it is not statistically significant in any equation. So the net result is that Protestant explains the level of income in the cross-country regressions but does not explain current growth. Is this true for other institutional variables as well?
In Table 3, Barros Democracy variable is added to the B&G equation instead of the Protestant variable. The results are similar, but the democracy variable is not quite as robust. It also suffers from endogeneity problems which will be discussed below. It is clear that there is two-way correlation between income and democracy over time. In the largest non-oil sample, democracy is statistically significant in explaining the level of income. In the intermediate sample, it is not. In the OECD sample, it is statistically significant.
In Table 4, I have included perhaps the strongest institutional variable in the literature. Hall and Jones have constructed a variable called GADP. GADP is their measure of Government Anti-Diversion Policy. It is their primary institutional variable. They follow Knack and Keefer (1995) using an equally weighted average of 5 categories for the years 1986 1995. Two of the five categories relate to the governments (positive) role in protecting against private diversion: (i) law and order, and (ii) bureaucratic quality. Three categories relate to the governments possible (negative) role as diverter: (iii) corruption, (iv) risk of expropriation, and (v) government repudiation of contracts.
As Table 4 makes clear, this variable is highly significant in all of the level regressions. This variable therefore demands serious attention. However, a potential problem with their specification is that their most important variable for explaining long run growth is constructed using very recent data for a variable which they acknowledge to be endogenous. They address this problem in their 1999 paper. Even with this correction, however, they are still using 1990s institutional data to explain economic growth from 1800- 2000. This is a problem.
A thorough discussion of several problems with their model including identification, endogeneity, measurement error and simultaneity is given in Hall and Jones (1999). One of these problems, however, feeds directly into the discussion which follows.
Hall and Jones claim that the other important characteristic of an instrument is lack of correlation with the disturbance term. To satisfy this criterion, they ask whether European influence was somehow more intensively targeted toward regions of the world that are more likely to have high output per worker today. They note that in fact, this does not seem to be the case. Europeans did seek to conquer and exploit areas of the world that were rich in natural resources such as gold and silver or that could provide valuable trade in commodities. There is no tendency today for these areas to have high output per worker. 16 They need this assumption for their results to hold. By focusing on these areas, Hall and Jones, commit themselves backward in economic theory and look only at the basic economic variables (resources) for explanatory power. However, their current thesis is about institutions. When one looks at these areas with institutional glasses on, one might reach a very different conclusion.
Using their own language, we again ask whether European influence was somehow more intensively targeted toward regions of the world that are more likely to have high output per worker today? The answer is yes and the channel by which it traveled may be the institution called Protestant religious establishment. This is precisely the result which DeLong reports. Our data include a list of the 13 Protestant countries used in the Bradford DeLong paper. One sees not only a striking European influence in several now rich countries but also a striking correlation between Protestant and about every explanatory variable used by Hall and Jones. Remember, all variables are scaled [0,1] in the Hall paper. Thus, when one sees mean values for the Protestant country institutional variables in the 0.7 (0-1) range and mean values for the non-Protestant countries in the 0.4 (0-1) range, it seems that Hall and Jones have some explaining to do. They are aware of the DeLong variable and so the omission of its impact is a mystery.
V. Conclusion B&G have re-visited Mankiw, Romer, and Weils classic empirical study of the Solow model of economic growth. They showed that the MRW framework applies broadly to almost any economic growth model that admits a balanced growth path, and that the restrictions specifically imposed by the Solow model tend to be rejected. In particular, they find that variables such as the saving rate seem to be strongly correlated with long-run growth rates. The correlation of variables like the saving rate with long-run output growth rates is inconsistent with the joint hypothesis that the Solow model is true and the economies being studied are in their respective steady states. The finding that the saving rate and the growth rate of the labor force are correlated with estimated TFP growth is inconsistent with the standard Solow model, even if we do not assume steady states. 17 This paper agrees with all of B&G thus far. However, as the research above makes clear, B&G left out institutions. And institutions may well be the ultimate cause of long-run economic growth. This is therefore no small omission. The regressions above show that institutions such as religion, democracy and government anti-diversion policies all significantly enhance a countrys long-run economic performance. The theory above suggests that the religion variable may be the strongest ex ante, exogenous institutional variable in the literature. If all of this is true, then the B&G model is not specified properly and the results which flow from it are not the final word on economic growth. Institutions may not be the final word either, but this research indicates that their inclusion in the economic growth literature is one step in the right direction.
16 Hall & Jones, 1999, pg. 101. 17 B&G, pg. 28 References Barro, Robert J. and Jong-Wha Lee, International Data on Educational Attainment: Update and Implications, NBER working paper 7911, September 2000.
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Bernanke Table 5 Replicated: Test of exogeneity of growth in the Augmented Solow Model (I/GDP is statistically significant in Non Oil and Inter. Solow Mod Rejected - Growth is not Exogenous)
Dependent Variables: Top of Each Table - Log GDP per working-age person, 1995 (Level) Bottom of Each Table - Change in log GDP per working-age person, 1960-1995 (Growth)
R 2 Level: 0.84 R 2 Level: 0.45 R 2 Growth: 0.43 R 2 Growth: 0.12
TABLE 2
Bernanke Table 5 with DeLong Protestant Variable Added
Dependent Variables: Top of Each Table - Log GDP per working-age person, 1995 (Level) Bottom of Each Table - Change in log GDP per working-age person, 1960-1995 (Growth)
R 2 Level: 0.86 R 2 Level: 0.70 R 2 Growth: 0.45 R 2 Growth: 0.15
TABLE 3
Bernanke Table 5 with Barro Democracy Variable Added
Dependent Variables: Top of Each Table - Log GDP per working-age person, 1995 (Level) Bottom of Each Table - Change in log GDP per working-age person, 1960-1995 (Growth)
R 2 Level: 0.83 R 2 Level: 0.47 R 2 Growth: 0.38 R 2 Growth: 0.12 TABLE 4
Bernanke Table 5 with Hall & Jones GADP Institution Variable Added
Dependent Variables: Top of Each Table - Log GDP per working-age person, 1995 (Level) Bottom of Each Table - Change in log GDP per working-age person, 1960-1995 (Growth)