Empirics and Institutions

I just completed a section in class on institutions and growth. This had led me to re-read several papers, including Acemoglu, Johnson, and Robinson (2005) on "The Rise of Europe: Atlantic Trade, Institutional Change, and Economic Growth." The idea in the paper is that the places that grew most quickly in Europe were those that could (1) take advantage of Atlantic trade and (2) had good initial institutions around 1500 AD.

The point of the paper is section II, called "Our Hypothesis". It is this:

In countries with easy access to the Atlantic and without a strong absolutist monarchy, Atlantic trade provided substantial profits and political power for commercial interests outside the royal circle. This group could then demand and obtain significant institutional reforms protecting their property rights. With their newly gained power and property rights, they took advantage of the growth opportunities offered by Atlantic trade invested more, traded more, and fueled the First Great Divergence.

This is a fine hypothesis. It seems plausible, and my guess is that one could make a solid historical case for it. In essence, Spain and France were not able to take advantage of Atlantic trade because their monarchies were too rigid/absolutist/powerful, and England and the Netherlands did take advantage because their monarchies were already relatively weak.

AJR undertake an empirical study in this paper meant to bolster their hypothesis. But the more I read through it, the less convinced I am that this empirical exercise really tells us anything useful. In particular, it doesn't do anything to convince me that their hypothesis is right.

To do this empirical exercise, they construct an index of initial institutions around the year 1500, coded from 1 to 3, that is supposed to measure the constraints on executives. 1 is few constraints (bad) and 3 is some constraint (good). They assign a value of 1--3 to each European country. To be clear, I'm not making an Albouy-like claim about the assignment itself. I'm willing to stipulate that "institutions" in the Netherlands at the time were a 3, while those in Spain were a 1, and France somewhere in between with a 2. That's not the issue.

Their empirical work is based on comparing the effect of initial institutions on subsequent economic outcomes among Atlantic traders. In practical terms, this means that they are looking at variation across five countries (England, France, Netherlands, Spain, and Portugal) with meaningful Atlantic trade. This is a small enough group to immediately see how things are going to come out. The Netherlands has a 3 for institutions in 1500, England a 2, France a 2, Spain a 1.5, and Portugal a 1. Already, this index is closely correlated to income per capita in these countries in subsequent years they analyze (1600, 1700, 1820). The index is almost exactly colinear with income per capita around 1700. The real issue is that later on (by 1820), England takes a lead over France in income per capita, so that doesn't correlate with their institutional measure. However, if you weight the institutional index by the amount of Atlantic trade a country does (i.e. number of voyages), then England looks better than France.

One issue is that it doesn't seem necessary at all to run their regressions. Their table 7 presents a series of 30(!) regressions showing that having a big value of the initial institutional index (once you weight it by the volume of trade) is correlated with urbanization, GDP per capita, and future values of the institutional index. But a (not even careful) reading of history would lead you to same correlations. Their section II, in fact, is just such a reading of history. What does it matter that the coefficient they estimate is 0.21? What does that mean?

Further, the statistical significance and coefficient estimates are arbitrary. As there are no natural units for the index, there is no meaning to going from a 2 to a 3. Are institutions in the Netherlands 33% better than in France? While the ranking is informative, the numbers themselves are not. Imagine that I re-indexed the institutions in the AJR paper as Netherlands = 5, France and England = 4, Spain = 1.5, and Portugal = 1. I haven't rescaled the entire index, I've just added 2 to the Dutch, French, and English scores. This preserves the rank ordering, but changes the spread. This will affect both the slope estimate and the standard error. If I fiddle just right with the index (e.g. adding 3 rather than 2, or giving Portugal a 0) then I can make the slope and standard error come out however I want.

Last, the regressions do not even necessarily confirm their historical intuition. They may have coded the index based on institutions, but that index picks up anything that varies widely between the Netherlands and Portugal, with England and France as some sort of intermediate case. The propensity for enjoying tulips? The prevalence of dairy farming? The inverse of average February temperatures? Just because you call it an index of institutions doesn't mean that it will only pick up variation in institutions (And no, country fixed effects do not necessarily wash out my silly examples, for the same reason that FE don't wash out the institutions index - they're continuous measures).

The really frustrating part is that this veneer of empiricial support is completely unnecessary. AJR have a perfectly plausible explanation for the general historical facts. It's a pretty compelling story, from my perspective. But there is not ever going to be a rock-solid empirical identification strategy for this kind of work. It's worth remembering that lacking identification is not the same thing as rejecting a theory. For this kind of historical hypothesis, we have to get comfortable with ambiguity.

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