Memoire Online - Governance, Quality of Institutions and Economic Growth: Empirical Evidence from a Cross-National Analysis

Governance, Quality of Institutions and Economic Growth:
Empirical Evidence from a Cross-National Analysis

Abstract: This paper examines the relationship between the quality of institutions and economic growth. The first part will be devoted to the definition of the concept of governance and its measurements. In the second part we will briefly review the literature on the relation between governance and growth. Finally, we will carry out an empirical investigation by using an endogenous model of growth, which deals with the relation between governance and growth in 96 countries. Using a cross section analysis, the estimation results prove that there is a strongly significant relation between the institutional variables used in our work and the income per capita.

Résumé: Ce papier examine le lien entre la qualité des institutions et la croissance économique. La première partie sera consacrée à la définition du concept de gouvernance et à ses mesures. La deuxième partie fera l'objet d'une revue de la littérature sur la relation entre gouvernance et croissance. Enfin, dans la dernière partie, on va effectuer une investigation empirique en utilisant un modèle de croissance endogène, traitant de la relation entre gouvernance et croissance dans 96 pays. Les résultats d'estimation avec l'analyse en coupe transversale prouvent qu'il y a une relation fortement significative entre les variables institutionnelles utilisées dans notre travail et le revenu par tête.

Key words: Governance, Quality of Institutions, Economic Growth, Cross-Section. Classification JEL: O43, C2 1

* URED, Faculty of Economics and Management of Sfax 3029, Tunisia :abdelkarim.yahyaoui@ fsegs.rnu.tn ** CEMAFI-URED, Faculty of Right, Political Sciences, Economic and Management of Nice: ouidade_chatti@yahoo.fr *** URED, Faculty of Economics and Management of Sfax: nouri.chtourou@fsegs.rnu.tn

1. Introduction

Since the beginning of the 1990^is, the concept of governance has gained a remarkable importance. It has currently become part of the common vocabulary used by financial institutions and by in the international development institutions as well (WB, IMF, and UNDP). It is based primarily on the introduction of new reforms neither economic nor financial but institutional, aiming essentially at the improvement of the State. In the same time, we witness a renewed interest for the concept of institutions and in particular for the question of their capability of supporting the growth. These two concepts, governance and institutions, have become truly operational and have been actually introduced into the studying process of developing countries only recently, following the first evaluations of the Structural Adjustment Programs (SAP). Ever since, they have become dominant concepts in the management of public affairs. So, the role of the governance and institutional quality in the determination of long run economic performances is a subject which has preoccupied the economists of development and economic growth for many years.

On the theoretical level, a very great agreement has already been achieved toward recognizing the benefits of good governance when it comes to developing countries and the fact that good public institutions lead to a better governance. So the question of governance joins that of the institutions and analyzing the first one necessarily requires studying the question of the institutions capacity of supporting the growth.

After a decade of hard work to figure out the role of the governance in the development, several basic questions persist: what does the concept of governance consist of? How to measure it? What is the link between governance and growth?

Our principal objective in this work is to try to contribute to a more precise knowledge of this concept of governance and measurement in order to evaluate it, as well as of the links between the governance and the economic growth both on the theoretical level and on the empirical one.

Our article is organized in the following way. The first section will be devoted to the definition of the concept of governance and its measurements. In the second section we will briefly review the literature about the relation between governance and growth. Finally the last section consists of an empirical investigation through an endogenous growth model explaining the relation between governance and growth in 96 countries.

2. Governance: concepts and measurements

The term of governance appears in the French language at the beginning of the 1 3th century as equivalent to the term of government¹. Since the beginning of the 1990^is, the governance has been a fashionable word. It is a term carrying several meanings and in constant evolution. This word has more than one meaning: first it refers to companies' governance or "corporate governance", the second to the global governance, the third to the national governance and finally the fourth to the local governance. It is the national governance which specifically interests us in this work.

The concept of national governance and the expression «good governance" appear at the beginning of the 1 990^s, in the vocabulary used by the vast international institutions and more particularly the World Bank In 1992, the latter defines governance as the way in which the power is exerted to manage the economic and social resources of a country. For the World Bank good governance is a sign of a healthily managed development (World Bank, 1992).Today this concept has been adopted by development agencies and the various international or regional organizations. Each has developed its own definition of governance.

In the continuation of our work, we mean by governance « the traditions and institutions by which authority in a country is exercised. This includes (1) the process by which governments are selected, monitored and replaced, (2) the capability of the government to effectively formulate and implement sound policies, and (3) the respect of citizens and the state for the institutions that govern economic and social interactions among them" (Kaufmann, Kraay & Zoido-Lobaton 1999; p. 1). They then construct six

¹ The Robert, Historic Dictionary of the French Language, Paris 1992, opt quoted Campbell.

aggregate indicators corresponding to six basic governance concepts: voice and accountability, political instability and violence, government effectiveness, regulatory burden, rule of law, and graft. We preferred this definition to the one provided by the World Bank because it takes into account the nature of the political régimes.

In spite of its importance, the governance remains an evasive concept without any clear consensus regarding the subject of what it consists of. The question of the governance takes us then to that of the institutions and the study of the first one must necessarily pass by the study of the question of the ability of institutions to support the growth. Indeed, no clear distinction can be made between the concept of governance and institutional factor. Institutions generally correspond to a broader concept which includes the formal and informal constraints, rules and laws which are associated not only with the state's functioning but also with that of the private entities.²

The recent interest for governance and its economic consequences accompanied the need to evaluate its various dimensions. Today measuring the governance is as important well from the point of view of the national policy, as it is from of the international economic relations point of view or from the point of view of research in economic and political sciences.

There are different types of indicators: data resulting from investigations, those from experts' surveys and aggregate indicators. Data resulting from investigations are indicators related to the national averages of the answers to the questions raised in connection with the governance. An example of these investigations is World Business Environment Survey 2000 (WBES). We also point out to the data resulting from experts' surveys which consist of classifications generally produced by rating agencies, nongovernmental organizations (NGO) or international organizations. They are made in a consensual way starting from the judgments of individuals who know relatively well the reality of the country which they evaluate. A private agency of risk notation, The Political Risk Service Group (PRSG), produces database entitled research data set. It contains

0² World Economic Survey, chapter V: « Diverging Growth and Development », Development Policy and Analysis Division.

annual evaluations on the quality of governance over the period 1984-2006.Those are built starting from monthly data of the International Country Risk Guide (ICRG), one of the products of the PRSG.

This database offers measurements of the various aspects of governance like political stability, ethnic tensions or internal conflicts. In this article, we are going to use five indicators of this database: corruption (COR), Law and Order (LO), democratic accountability (DA), bureaucratic quality (BQ) and Government Stability (GS). The first three indicators go from 0 to 6, the fourth from 0 to 4 and the last one goes from 0 to 12. In all the cases, the highest values reflect better notes, i.e. less corruption, a more effective legal system, a better democratic accountability, a better bureaucracy, and low government instability.

The corruption indicator measures the abuse of the public power when it is exercised for private gain. Low scores indicate that senior officials are very corruptible and that corruption is generalized in the whole administration. The quality indicator of the legal system reflects the power and the impartiality of the legal system as well as the observance of the law. The indicator of the democratic accountability reflects the capacity of the government to install a democratic society. The indicator of the bureaucracy quality measures at the same time the independence and the autonomy of the administration with respect to the political power and the changesb of the executive power, as well as the incentives which the civil servants have to work through mechanisms of recruitment and promotion. Lastly, the indicator of political stability reflects political violence and instability in the country.

Composite indicators are generally those of the World Bank and Transparency International. Since 1995, Transparency International has annually produced a Corruption Perceptions Index (CPI). The World Bank provides a database named World Wide Governance Research Indicators, also called by the name of its authors Kauffman, Kraay and Mastruzzi (2006). This database consists of six indicators of governance, obtained for 213 autonomous countries and territories, at six different dates: 1996, 1998, 2000, 2002, 2004 and 2005. The Indicators diversity is explained by the complexity and

multidimensional character of the governance. These six indicators which will be used in our work are the following:

These indicators are qualified as composites or aggregate ones because they are elaborate starting from the results of investigations and rating of experts relating to corruption and other aspects of governance.

3. Governance and economic growth: literature review

Many authors recognize the benefits of good governance when it comes to the developing countries. According to these authors, good public institutions allow good governance. So the question of the governance is linked to that of the institutions and the

analysis of the first one necessarily passes by the study of the question of the capacity of institutions to support the growth.³

In this direction, a wide literature has already been built to show the importance of institutions in the determination of long run economic performances on the theoretical level and on the empirical level as well. On the one hand, we find the theoretical work of the New Institutional Economics (NIE) and of the new endogenous theory of growth, and on the other hand, we find the empirical work in the forms of cross-section study of the growth through the countries which seek to establish a relation between governance or quality of institutions and economic growth.

On the theoretical level, the NIE having North as file leader, shows that effective institutions can make the difference in the success of the market reforms and even affirms that institutions constitute one of the determining factors of the economic growth in the long run. North (1990) defines the institutions as "the rules of the game" which shape the human behaviors in a company. The institutions have a very significant role in the company because they determine the fundamental structure of the human interactions, whether they are political, social or economic.

A State equipped with a legal system and effective property right is a State which creates a favorable environment to capital accumulation and growth. While defective institutions create a market for nonproductive activities such as rent seeking, corruption, and also generate high transaction costs and of course handicapping economic inefficiencies. So the institutions act in a direct way on the intensity of the investment and thereby on the growth. The impacts of the quality of institutions on long run economic performances are spread by the means of the cost-cutting of transactions, limitation of the risks and disappearance of rigidities which deteriorate the markets (Chtourou 2004).

We also point out to the work of the theory of endogenous growth. Following the insufficiencies of exogenous growth models to explain a stable growth in the situation of equilibrium, new models of growth emerged specifying the necessary conditions that

³ Throughout this work, the concepts of gouvernance and institutions will be employed to say the same thing.

guarantee a long run growth, known as endogenous growth. The new theory of endogenous growth was developed by several economists such as Lucas (1988), Romer (1986), McKinnon and Shaw (1973), Barro (1989), Roubini and Salt-I-Martin (1995)... etc. these works took a better advantage of the data resulting from the economic sphere to try to justify the variations of growth between countries.

However, the limits of the estimates that have been carried out, and in particular the need for adding regional dummies within the models to manage to explain the variance of observations, suggested the incompleteness of models which are being limited to the economic indicators to explain the behavior of the growth.

This reflexion encouraged the economists to turn out to the institutional variables to try to find a justification for the production gap that exists between countries and unexplained by the only economic data. Several political and institutional factors were then presented: the democracy according to Barro (1996), the respect of the property rights according to Clague, Keefer and Olson (1996), political instability according to Alesina and Perotti (1994). Rodrik (1999) supports the idea that good governance would be a necessary condition for market economies success. Hall and Jones (1999) show that the differences observed in the intensity of physical capital and in the education level realized, explain only a small fraction in the differences noted in the levels of output per worker through countries. So they show that the differences in the social infrastructure (institutions and governmental policy) through nations account for the differences noted in capital accumulation, the level of education carried out and the productivity, which explain the disparity in the level of income and development of countries.

On the empirical level, one finds a wide empirical literature enhancing the importance of the governance and the institutions as a determining factor of growth and development. This literature appears in the form of cross section studies of the growth across countries which seek to establish a positive correlation between the quality of governance and the growth.

The income per capita or the growth rate is regressed on several governance indicators: narrow indicators such as civil freedoms, rules of laws, property rights, political stability, and global indicators of governance. Other variables are used in these regressions however they are not related to the governance like geographical and historical variables.

Kormendi and Meguire (1985), Scully (1988), Grier and Tullock (1989), Barro (1996) and Helliwell (1994) and Isham, Kaufman and Pritchett (1997) all confirm the existence of a positive correlation between the civil freedoms indicator as an institutional framework measures, and the economic growth for the majority of countries taken in their sample.

Acemoglu, Johnson and Robinson (2004) showed that the variation of growth between rich and poor countries is mainly due to the difference in the guarantee of the property rights in these countries. Rodrik, Subramanian and Trebbi (2002), in their study, confirm the idea according to which the guarantee of property rights accelerates the growth.

Barro (1991) and Londregan & Poole (1992) state that political instability and violence generate a weak growth. Alesina and Perotti (1996) and Svensson (1998) note a negative effect of political instability on the investment.

we also find the studies of Kaufmann, Kraay and Mastruzzi (2004) who use an indicator of the rules and laws to show that good governance exerts a positive effect on growth. They find a strong and positive correlation between this indicator and the income level.

Mauro (1995) tests three indices made by the International Business (IB): index of corruption, index of bureaucratic quality and the index of political stability. He finds that these three indicators are related positively and significantly to the growth and the investment. Knack and Keefer (1995) use two indicators collected in the ICRG and the BERI. They create two indices, the first for measuring the security of contracts and the second for the property rights, and they find an expected positive effect of these

indicators on the growth. Easterly and Levine (2002) use the global index of governance of Kaufmann, Kray, Zoido-Lobation (2002) to show that the governance affects the growth positively and significantly.

We notice that the empirical literature, throughout narrow indicators of the governance as well as through the global indicators, actually shows that the governance has a strong influence on the levels of incomes. These studies confirm a strong, positive and significant correlation between good governance and economic performances.

This is why we are going to try, in the following paragraphs, to validate this report by an empirical analysis using the cross-sections method.

4. Empirical analysis of the relation between governance and economic growth

On this level of analysis we seek to study the impact of various measurements of the governance on the long run global economic performances in 96 countries. Basing our study on the model of growth of Mankiw & al. (1992), Knight & al. (1993) and Ghra

& Hadjmichael (1996) [quoted by Demetriades and Law, 2006, p. 5)]. Our starting point is the following Cobb-Douglas production function:

Where Y is real output, K is the stock of physical capital, H is the stock of human capital, L is the raw labour, A is a labour-augmenting factor reflecting the level of technology and efficiency in the economy and the subscript t indicates time.

It is assumed that á + â < 1, i.e. decreasing returns to all capital (physical capital and human capital). Raw labour and labour-augmenting technology are assumed to grow according to the following functions:

where n is the exogenous rate of growth of the labour force, g is the exogenous rate of technological progress, P is a vector of financial development, institutions and other factors that can affect the level of technology and efficiency in the economy, and è is a vector of coefficients related to these variables.

In this model, the variable A depends on the exogenous technological improvements, the degree of commercial opening and the level of other variables. It is obvious that A in our study differs from that employed by Mankiw and al. (1992). This modification is particularly appropriate to the empirical validation of the relations between Institutions quality and economic growth. The technological improvements are encouraged by effective institutions (North 1990) and by healthy institutional environment (World Bank).

In equilibrium condition, the output per capita increases at a constant rate G (the exogenous component of the growth rate of the variable reflecting the level of technology and efficiency of an economy). These results can be obtained directly from the definition of output per effective worker (Average Labour Productivity):

As we apply the logarithm on the two sides for the equation (4) and to simplify calculation we eliminate the time index, we have then:

The equation (5) determines the output per capita in the equilibrium state; also in this equation the vector p gather the institutional variables which will be defined in the fallowing paragraph.

Because of a data limitation, one can suppose in this study that s^h and g.t do not change through time (Demetriades and Law (2006)), whereas s^k and n vary Indeed, Ln (A 0), g.t and s^h can be gathered in a constant á0 in the equation (6). Therefore, output per capita (also called Average Labour Productivity) is given by:

After simplification of the equation (6), we obtain an equation of evaluation for the relation between the quality of institutions and output per capita:

With, y Gross domestic product per capita (GDP/capita); INS a vector gathering the institutional variables, k is the stock of capital investment or physical capital accumulation; n is the rate of labour force; g is the rate of technology growth or technological progress and ä is the rate of depreciation. g and ä are assumed to be constant across countries and over time and their sum equals 0.05, following Mankiw and al. (1992, p.413). á0, á1, á2 and á3 are the parameters to be estimated.

4.1. Econometric approach

The equation (7) is considered as the base for the empirical models which will be estimated by the cross-section method:

With, y is real GDP per capita in logarithm, á₀ constant, á^' = (á₁,á₂,á₃) a vector of dimension (3;1), X i = (X1 _,i ;X2 ,i ;X3 ,i ) vector of explanatory variables, and îi innovations supposed to be independently identical of null mean and variance ó î 2.

4.2. Presentation of the variables and their sources

As endogenous variable, one takes GDP/capita in logarithm Ln(y).The basic and control variables are respectively, labour force (n), the accumulation of physical capital in logarithm Ln(k) obtained by the variable ``Gross fixed capital formation" in logarithm. The institutional variables are obtained from two sources: Kaufmann, Kraay, and Mastruzzi (2006) and the ICRG (2007). The indicators of governance of Kaufmann selected are defined in the first part of this work and are respectively; voice and accountability, political stability, government effectiveness, regulatory quality, rule of law, and control of corruption. We then held from ICRG, five institutional variables which are: government stability (GS), corruption (COR), laws and orders (LO), bureaucratic quality (BQ) and the Democratic Accountability (DA).

5. Results of estimates

By using the cross-section method on 96 countries⁶ and by making the average for each variable over the period 1996-2003, we obtain the results presented in the tables below.

⁶ The choice of the 96 countries was made according to the availability of the data.

For the first table, there is a regression in function with the variables of bases only (Model 1 :M1). For the remainder of the regressions, we integrate each time one of the six indicators of governance from the data base of KAUFMANN⁷.

	M1	M2	M3	M4	M5	M6	M7
Cste	-4.280 (-3.400)	2.790 (2.023)	1.648 (1.237)	3.473 (2.788)	2.617 (2.253)	3.498 (2.902)	2.905 (2.491)
Ln(n+g+ä)	-2.047 (-4.088)	0.065 (0.134)	-0.142 (-0.289)	-0.400 (-0.986)	-0.373 (-0.93 1)	-0.305 (-0.76)	-0.340 (-0.855)
Lnk	0.324 (8.165)	0.260 (7.961)	0.291 (8.912)	0.171 (5.124)	0.208 (6.717)	0.184 (5.793)	0.205 (6.659)
KAUFMANN
VA		0.689 (7.444)
PS			0.633 (6.957)
GE				0.711 (9.171)
RQ					0.893 (9.429)
RL						0.725 (9.617)
CC							0.648 (9.603)
N. Obs	96	96	96	96	96	96	96
R2	0.597	0.748	0.736	0.789	0.795	0.799	0.799

⁷ For each indicator of gouvernance one makes the average of the data available: 1/5 * (Value 96+ Value 98+ Value 2000+ Value 2002+ Value 2003).

For the second table and for each regression, we integrate each time one of the five institutional variables⁸ selected by the ICRG⁹.

	M8	M9	M 10	M 11	M 12
Cste Ln(n+g+ä) Lnk GS COR LO BQ DA	-5.338 (-3.557)	-1.521 (-1.334)	-2.110 (-1.660)	1.726 (1.476)	-1.873 (-1.42)
	-2.085 (-4.172)	-0.850 (-1.850)	-1.285 (-2.591)	-0.844 (-2.116)	-1.052 (-2.00)
	0.313 (7.743)	0.287 (8.492)	0.269 (6.943)	0.135 (3.674)	0.292 (7.761)
		ICRG
	0.130 (1.285)
		-0.42 1 (-6.366)
			0.276 (4.183)
				0.656 (8.641)
					0.243 (4.031)
N. Obs R2	96	96	96	96	96
	0.604	0.720	0.661	0.777	0.658

The results above are significant since they come to confirm the existence of a close connection between the quality of governance and economic growth. It is noted that when one adds the governance variables of Kaufmann, the R² passes from 0,597 to 0,748 % with the introduction of the Voice and Accountability indicator (VA), to 0,736% with the indicator of Political Stability (PS), to 0,789% with the Government Effectiveness indicator (GE), to 0,795% with the Regulatory Quality indicator (RQ), to 0,799% with the Rule of Law indicator (RL) and finally to 0,799 % with the Corruption Control indicator (CC). The corresponding estimated coefficients are positive and statistically significant. The most significant are respectively the Regulatory Quality (RQ), the Rule of Law (RL), the Government Effectiveness (GE), the Voice and Accountability (VA), the Control of Corruption (CC) and finally Political Stability (PS).

⁸ The choice of these variables has been made to remain in the same context that the variables of KAUFMANN.

⁹ For each institutional variable, one makes the average over the period 1996-2003.

These results come to corroborate those obtained by Kaufmann and al. (1999) and Knack and Keefer (1995) who show that the indicators of governance constitute relevant elements of the long run economic growth.

For the ICRG indicators, we also note that when the institutional variables are added, the R² passes from 0,597 to 0,604% with the introduction of the government stability indicator (GS), to 0,720 % with the corruption indicator (COR), to 0,66 1% with the laws and orders indicator (LO), to 0,777% with the bureaucratic quality indicator (BQ) and finally to 0,65 8 with the democratic accountability indicator (DA). All these indicators present expected significant signs except the indicator of government stability which is not significant.

One can note that these empirical results for all the 96 countries come to confirm those obtained by several authors like Barro (1991) and Londregan and Poole (1992) for political stability, Mauro (1995) for corruption and Kaufmann, Kraay and Mastruzzi (2004) for the indicator of rules and laws.

That makes it possible to conclude that the determinants of good governance, the capacity of the State to manage the resources effectively and to formulate and implement policies and quality regulations, all of them explain for the most part the long run economic performances of nations.

6. Conclusion

In this work on the relation between the governance and the economic growth, we initially showed that the governance is a concept which does not have a clear consensus of what it consists of and which it is a concept difficult to define and to measure. In the second time, we showed through the existing literature that good governance is presented, during these last years, like a very significant element in the determination of the longrun economic performances. We also showed through the existing literature that the elements of good governance offer an environment favourable for capital accumulation and later on for economic growth. That was confirmed in our empirical study which enabled us to show the existence of a close link between the quality of governance and

economic growth for 96 countries between 1996 and 2003. Our principal empirical results suggest that the quality of governance, under its various aspects, is presented in the form of a relevant factor for the economic growth.

A limit which we can attribute to our work is the use of the indicators of governance without taking their limits into account. Indeed, the indicators of governance are based on perceptions and are determined by subjective opinions. Moreover, the absence of a subjacent conceptual framework or governance theory to identify the causes of the results of the governance reflected in the indicators, lacks clearness about the reasons for which such country obtains such result for such indicator. It is thus paradoxical that the financial backers and the investors judge and sometimes punish the developing countries for an absence perceived of transparent governance on the basis of so complex indicators.

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Appendix 1:

Albania Algeria Argentina

Australia Austria Bangladesh

Belgium Botswana

Brazil

Bulgaria Burkina Faso

Cameroon

Canada Chile

China

Colombia

Costa Rica

Czech Republic Denmark

Dominican Republic Ecuador

Egypt. Arab Rep.

El Salvador

Ethiopia Finland France Gabon Gambia. The

Germany

Ghana Greece Guatemala

Guinea Guinea-Bis sau

Haiti

Honduras Hungary Iceland India

Indonesia

Iran, Islamic Rep. Ireland

Israel

Italy

J amaica Japan

Jordan

Kenya

Lebanon Luxembourg Madagascar

Malawi

Malaysia Mali

Mexico Morocco Mozambique Namibia Netherlands Nicaragua Norway Pakistan Panama Paraguay

Peru

Philippines Poland

Portugal

Romania

Rus sian Federation

Saudi Arabia Senegal

Sierra Leone Singapore

Slovak Republic

South Africa Spain

Sri Lanka

Sudan

Sweden

Switzerland

Syrian Arab Republic Tanzania

Thailand

Togo

Trinidad and Tobago Tunisia

Turkey

Uganda

United Kingdom

United States Uruguay

Venezuela, RB Vietnam

Yemen, Rep. Zambia

Appendix 2:

Variables Notations Sources
*Dependent variable*
GDP/capita Lny WDI, IFS
*Basic variables*
Labour force	LnLF	WDI (2005)
Physical accumulation of capital	LnK	WDI (2005)
Institutional Variables
Kaufmann
* Voice and Accountability * Political Stability * Government Effectiveness * Regulatory Quality * Rule of Law * Control of Corruption	VA PS GE RQ RL CC	Kaufmann D., A. Kraay, and Mr. Mastruzzi 2006.
ICRG
* Government Stability * Corruption * Laws and Orders * Bureaucratic Quality * Democratic Accountability	GS COR LO BQ DA	www.prsgroup.com/icrg/