Institutions and Well-Being

1. Introduction

The goal of this special issue, which we dedicate to the late Nobel Laureate Douglas North, one of the most prolific and influential economists of the twentieth century, is to encourage new socio-economic research on the relationship between institutions and well-being. North passed away on November 15, 2015, days after his 95th birthday, but his legacy in the field of economics will long be remembered. He popularized an innovative way of thinking about the big questions in economics—e.g., what makes some countries rich and others poor—by emphasizing the essential role of institutions in shaping economic and political incentives and human interactions. For him, the ultimate explanation for many economic and social phenomena is found precisely in the type of factors that many economists before him took for granted. In the spirit of Douglas North, this special issue is dedicated to the study of institutions, or as he defined them “the humanly devised constraints that structure political, economic and social interactions.” We believe that having a special issue on the topic of “Institutions & Well-being” is timely and relevant for at least three reasons.

First, institutions matter. While it is by now clear that achieving economic growth and prosperity depends on the complex interaction of many factors—policy, culture, geography, legal origins—perhaps even a fair amount of luck, development economists increasingly refer to institutions as one of the most important and “deep” determinants for sustained economic prosperity (Acemoglu et al., 2005a, 2005b; Economides and Egger, 2009). Some economists even suggest that institutions are now at the forefront of mainstream economic theory (Jones and Romer, 2009). Institutions, as North (1990, p. 111) suggests “shape the subjective mental constructs that individuals use to interpret the world around them and make choices. Moreover, by structuring the interaction of human beings in certain ways, formal institutions affect the price we pay for our actions.” In that sense, institutions play a vital role in reducing transaction costs and shaping the appropriate incentives that drive long-run economic growth and development. The ideologies that people have can also influence how they interact with each other and ultimately determine their subjective experiences and satisfaction with various aspects of their lives.

Second, most of the previous research in the field has focused on establishing the relevance of institutions to economic outcomes such as growth in GDP per capita and individual income. Well-being, however, is a multidimensional concept that requires looking not merely at the health of the economic system, but also at a variety of other human experiences and conditions such as civic engagement, community values, health, education, social networks, safety, freedom, or psychological well-being and its many sub-domains; including life satisfaction, positive and negative emotions, meaning, self-esteem, optimism, or positive engagement. Many of these well-being dimensions are strongly correlated with economic development. But there are also striking discrepancies, especially when it comes to how people perceive their lives are going (Stiglitz et al., 2009). Oil-rich countries in the Middle East, for instance, have some of the highest levels of GDP per capita in the world, yet they lack some basic human freedoms and significantly lag behind with regard to human rights, education, and other important well-being dimensions. While good institutions are an end in themselves, studying the relationship between different types of institutions and these well-being dimensions can significantly enrich our understanding of the consequences of institutions and help instruct public policy.

This is particularly important today because in recent years the measurement of socio-economic progress has started undergoing a fundamental change. Starting with the seminal work of the Commission on the Measurement of Economic and Social Progress in 2009 (Stiglitz et al., 2009), a variety of initiatives around the world have been launched that aim to provide a more complete picture of socio-economic progress. The OECD, for example, is now tracking individual well-being in eleven distinct quality of life categories using both objective and subjective indicators—from material standards of living and work-life balance to subjective indicators of health and life satisfaction. Gallup is now collecting data on human thriving and happiness in more than 140 countries. A World Happiness Report that tracks not only the level of happiness, but also its distribution, has been published annually since 2012. The New Economic Foundation (NEF) is collecting data on national well-being for 22 European countries on multiple aspects of subjective well-being such as life evaluation, emotions, vitality, autonomy, meaning, trust, supportive relationships, resilience, self-esteem, optimism, and positive functioning. An increasing number of countries, including leading economies such as the UK, now have distinct national well-being accounts.¹ The World Bank now reports, as part of the World Development Indicators, estimates of genuine investment which captures the evaluation of intertemporal social welfare (Dasgupta, 2009; Fleurbaey, 2009). This shift is now quickly gaining momentum.²

Finally, improving well-being is not only an important social-economic objective and something that most people strive for, it is also an individual and collective resource that can lead to many objective benefits and drive social progress. Healthier, wealthier, happier and more educated people can transform the social fabric of society, which can lead to higher levels of political participation, and in the long-run increase the likelihood of the development and persistence of good institutions (Lipset, 1959). More educated nations, for instance, are more likely to have higher levels of tolerance and trust, lower transaction costs and crime, and be more politically engaged (Lochner, 2011). Subjective well-being has also been linked to many objective benefits—from health and pro-social behavior to higher income and productivity (De Neve et al., 2013). In other words, pursuing well-being is both intrinsically and extrinsically valuable. We believe that a better understanding of the relationship between institutions and well-being can offer many unique insights into some of the vexing barriers to achieving sustained well-being and of the consequent conditions most conductive to improving quality of life.

The articles in this special issue contribute to our understanding of institutions and well-being along at least one of three margins described above. Section 2 provides a brief review of the literature on institutions and well-being, followed in Section 3 by a synopsis of the papers in this issue and how they contribute to this literature. Concluding remarks are offered in Section 4.

2. A brief literature review

Since the early days of economics as a distinct discipline, often associated with the release of Adam Smith's The Wealth of Nations, economists have sought to understand the fundamental causes of social progress and human prosperity. Classical economists such as Smith, John Stuart Mill, and David Ricardo stressed the importance of institutions, public policy, and the rule of law in shaping economic performance and human well-being. As economics became increasingly formalized throughout the twentieth century, and particularly with the development of neo-classical growth models, the explanation for differences in economic development and material well-being across the world began to focus on the accumulation of physical and human capital (Solow, 1956; Koopmans, 1965; Lucas, 1988). As Easterly and Levine (2001) recognized, however, factor accumulation is unable to explain the majority of the variation in income and growth differences in cross-country growth regressions. Easterly and Levine noted that the residual, often referred to as total factor productivity (TFP), has the most explanatory power, and called for economists to focus on the determinants of TFP as a means to better understand economic growth.

Most neoclassical growth models treat the production process as a “black box” in which quantities of labor, capital, and technology are somehow combined to produce goods and services, ascribing differences in these variables as the causes of economic prosperity. But why and how societies choose to invest in new technology or human capital is often left unexplained. Along these lines, North and Thomas (1973, p. 2) suggest that factors such as innovation, economies of scale, education, and capital accumulation “are not causes of growth; they are growth.” Acemoglu (2009, p. 109) adds: “…any explanation [of growth] that simply relies on technology, physical capital, and human capital differences across countries is, at some level, incomplete. There must be other, deeper reasons that we will refer to as “fundamental causes” of economic growth. It is these reasons that are preventing many countries from investing enough in technology, physical capital, and human capital.” In other words, variables such as technology and human and physical capital are only proximate causes of economic growth and prosperity, but are insufficient as fundamental explanatory causes. The experience of the transition economies at the end of the last decade furthermore suggests that factors of production are incapable of delivering growth without the appropriate institutional environment (Eicher and Garcia-Penalosa, 2006). The work of Nikolova (this issue), for example, shows that even the glaring happiness gap between transitioning and advanced economies is now closing, largely due to improvements in institutions such as the rule of law.

Increasingly, economists are interested in understanding the fundamental, long-run causes of economic growth and development. Spolaore and Wacziarg (2013, p. 325) provide a review of the burgeoning literature examining the so-called “deep roots” of economic development, which include a host of factors that “have been transmitted across generations over the very long run” such as culture, genetic diversity, geography, and institutions. In his 1993 Nobel Prize lecture, North (1994, p. 359) stated that “Institutions form the incentive structure of a society and the political and economic institutions, in consequence, are the underlying determinant of economic performance.”

Institutions, as North (1991) defines them, “consist of both informal constraints (sanctions, taboos, customs, traditions, codes of conduct), and formal rules (constitutions, laws, property rights).” According to North (1990), formal rules are created by the state while informal rules are part of the heritage we call “culture.” The role of institutions throughout history, as North (1990) explains, has been to create order and reduce uncertainty. This is how institutions are directly related to economic outcomes by reducing transaction costs, risk, and hence the total cost of production. Bjørnskov (this issue), using post-Cold War data on 212 economic crises in 175 countries, shows that institutions consistent with the principles of economic freedom are associated with a lower risk of economic crises, as measured by smaller peak-to-through ratios and shorter recovery time.

Even more importantly, institutions determine the “rules of the game” and shape the relative rewards from different social, economic, and political activities such as innovation, investment in education, or rent seeking. In this sense, institutions can be seen as “deep” determinants of the allocation of entrepreneurial talent to different productive, unproductive and even destructive social activities that lead to a variety of well-being outcomes (Baumol, 1990).

North's theory about institutions and economic performance has exerted a lasting impact on the social sciences, undoubtedly influential at spurring interest in the measurement of economic, legal and political institutions as a means to empirically test his hypothesis. Indeed, a stream of empirical papers (e.g., De Long and Shleifer, 1993; Knack and Keefer, 1995; Mauro, 1995; Hall and Jones, 1999; de Haan and Sturm, 2000; Acemoglu et al., 2001; Dawson, 2003; Easterly and Levine, 2003; Rodrik et al., 2004; Doucouliagos and Ulubasoglu, 2006) have tested North's hypothesis using a variety of institutional measures, reaching a “close to intellectual consensus that the political institutions of limited government cause economic growth” (Glaeser et al., 2004, p. 272).

Formal economic institutions such as competitive markets, the banking system, or the structure of property rights are especially important for economic progress because they fundamentally influence how society invests in human capital, physical capital, and technology, as well as how production is organized. Using genetic diversity as a plausible source of exogenous variation, Faria et al. (this issue) provide strong evidence for a potentially causal link between institutions, measured by the Economic Freedom of the World index, and long-run economic growth. The results in their study also highlight the importance of human capital, approximated by cognitive skills, as an important determinant of economic institutions. Their analysis suggests a more dynamic view of development in which institutions lead to economic development, but higher levels of physical and human capital can improve the quality of economic and political institutions, creating a virtuous cycle.

Institutional economists have thus tried to identify the consequences of “imperfect institutions” (Eggertsson, 2005, p.1), essentially expanding neoclassical growth models to include institutions as the underlying mechanism that drives development. The relationship between corruption and genuine wealth creation, for instance, is strong and negative: simply put, the most corrupt countries are also the poorest ones (Aidt, 2009, 2011). While some economists believe that institutional economics does not fundamentally challenge the tools of neoclassical growth models (Brousseau and Glanchant, 2008; Joskow, 2008), many others consider institutions as the main determinant of economic growth (Economides and Egger, 2009; Acemoglu et al., 2005a, 2005b).

Recent studies have also emphasized the importance of cultural institutions (for a review see Alesina and Giuliano, 2015). There is strong evidence, for instance, that the value dimension individualism-collectivism is one of the strongest cultural determinants of economic growth and prosperity (Gorodnichenko and Roland, 2011). Individualistic cultures that place value on personal freedom, self-reliance, creative expression, affective autonomy, and reward individuals for their accomplishments with higher social status tend to experience faster rates of innovation and economic growth compared to more collectivist societies. Using subjective well-being data from eleven Central and Eastern European countries, Ferrer-i-Carbonell and Gërxhani (this issue), furthermore, find that evading taxes is negatively associated with individuals’ life satisfaction. This relationship is largely shaped by people's perception of formal and informal tax-related institutions and social capital.

Despite the growing body of theoretical and empirical research that shows that institutions are strongly correlated with better economic outcomes, it is by now also clear that institutions are endogenous. As Rodrik (2004, p.1) notes: “rich countries are [also] those where investors feel secure about their property rights, the rule of law prevails, private incentives are aligned with social objectives, monetary and fiscal policies are grounded in solid macroeconomic institutions, idiosyncratic risks are appropriately mediated through social insurance, and citizens have recourse to civil liberties and political representation” to demand better political institutions and influence the formation of economic institutions. Acemoglu et al. (2005a, 2005b), for example, build a dynamic model in which economic institutions determine economic performance, but economic institutions are determined by the distribution of political power, which then determines political institutions and the distribution of resources. Much of this literature assumes that institutions are the consequences of choices made by domestic actors constrained by domestic factors. In reality, many international factors also play a role: international trade, international factor mobility, foreign investment, development aid, or open or covert foreign intervention by foreign powers (e.g., Antràs, and Padró i Miquel, 2011; Aidt and Albornoz, 2011). Dutta and Williamson (this issue) provide some support for the hypothesis that foreign aid can help poor countries improve their economic institutions, but only when good political institutions are already present. Nejad and Young (this issue), using evidence from bilateral migration flows, furthermore show that economic institutions, particularly property rights and the rule of law, are a significant pull factor for potential migrants.

In which direction the causality between institutions and economics outcomes goes and what are the exact mechanisms through which institutions work is still highly debated in the economic development literature. Glaser et al. (2004), for instance, suggest that most measures of formal institutions are simply inadequate for the task to establish the “deep” determinants of economic growth, although their view is challenged by Acemoglu et al. (2015). It is accepted, however, that institutions are causal to economic prosperity in the sense that if a poor country improves the quality of its institutions in the direction of stronger protection of property rights, it is likely to experience higher levels of economic prosperity (Rodrik, 2004). Developing a new measure of democratic institutions, the Support Vector Machine Democracy index, Gründler and Krieger (this issue) contributes to this literature. They report a robust positive relationship between the new democracy index and economic growth, and suggest that democracy exerts influence on growth through better education, higher investment shares, and lower fertility rates, but not necessarily higher levels of redistribution.

More recent studies have started examining the relationship between formal and cultural institutions, and variety of other objective and subjective social outcomes such as trust, tolerance, crime, poverty, or subjective well-being. Berggren and Nilsson (this issue), for example, find suggestive evidence that the institutions of economic freedom increase tolerance, measured by the willingness to let atheists, homosexuals and communists speak, keep books in libraries and be a college level teacher. They suggest that this relationship may work through reducing feelings of tension and conflict. In this sense, institutions may play a vital role in creating a non-discriminatory and inclusive environment that fulfills the basic psychological need for relatedness.

An important insight from this literature, for instance, is that institutions may have a positive impact on psychological well-being beyond their direct impact on variety of socio-economic outcomes: a concept known as procedural utility (Frey et al., 2004). The idea here is that people care not merely about outcomes, but also about the processes that lead to these outcomes. In this respect, institutions may provide an independent source of utility by influencing how individuals perceive their own sense of self. Individuals, for instance, may experience a higher level of subjective well-being if they believe that they are treated in a way they consider just or fair regardless of the material outcomes (Frey and Stutzer, 2002). For instance, the right to participate in the political process, measured by the extent of direct democratic rights across regions, is strongly correlated with subjective well-being (Frey and Stutzer, 2002). Nikolaev and Bennett (this issue) show that people who live in countries with institutions consistent with the principles of economic freedom experience a greater perception of freedom of choice and control over their life. They furthermore find suggestive evidence that a potential mechanism that explains this relationship is the perception of procedural fairness and social mobility.

An emerging literature on the relationship between formal institutions and subjective well-being also finds a positive correlation between the institutions of economic freedom and subjective well-being, most often proxied by survey measures of life satisfaction (for a review of this literature see Spruk and Keseljevic, 2015). Cheng et al. (this issue) build a theoretical model and find that even housing property rights matter for subjective well-being. Specifically, using subjective well-being data from China, the authors find that home ownership is associated with higher levels of life satisfaction, although this happiness premium is larger for people who have full ownership compared to those who have only a minor ownership stake in their home.

3. The contributions to the special issue

The special issue contains ten contributions to the literature on institutions and well-being. We discuss them in the following subsections: Economic freedom studies; Institutions and long-run growth; and Well-being and institutions in transition economies.

4. Conclusion

For a long time, neo-classical economists have built models, conducted research, and prescribed policies based on theories that ignore one of the most fundamental aspects of economic life: institutions, or the formal and informal rules in society that “structure incentives in exchange, whether political, social, or economic” (North, 1992, p.5). According to North (1992), all economies have transaction costs—the multitude of costs associated with doing business every day. For North (1992), how successful a country is in achieving economic growth and prosperity in the long-run depends to a great extent on how successful it is in creating the type of political and economic institutions that minimize these transaction costs. As Acemoglu and Johnson (2005, p.950) note: “There is a growing consensus among economists and political scientists that the broad outlines of North's story are correct: The social, economic, legal, and political organization of a society, i.e., its ‘institutions,’ is a primary determinant of economic performance.”

Despite many theoretical and empirical advances that have allowed economists to study economic and political institutions in a more systematic way, there are still many important questions that remain to be answered and continue to be intensely debated in the literature. North (1991, 1992) himself pointed out many of these questions: What are the deep origins of formal institutions and what is their interplay with culture; how to best measure and model institutional dynamics; what is the direction of causality; and what are the underlying mechanisms through which institutions work.

The failure of the introduction of Western style political institutions in Russia and Eastern Europe to ignite economic growth after the transition process began in the early 1990s, for instance, points out that such institutions alone are not a sufficient condition for economic growth. Prosperity requires open markets, but also respect for the rule of law, generalized level of trust, and a variety of other formal and informal institutions to align well with each other. Spelling out precisely how to move from bad to good institutions remains an unresolved puzzle in the literature.

The astounding levels of economic development in China over the past two decades despite little political reform, and the success of countries such as Singapore where the state is still heavily involved in economic life⁸ (Coffman et al., 2013), have furthermore raised important questions about the mix of economic and political institutions that is optimal for long run prosperity. The success of economies such as Vietnam that rank poorly on indices that measure formal institutions, also begs the question whether and when informal institutions can serve as substitutes for formal institutions. As Rodrik (2004)suggests, for many developing countries “second-best” institutions remain the best option during the transitional process.

Finally, a majority of the papers so far examine the average effect across countries and citizens. Yet, some of the most interesting questions are usually at the margin. Do institutions of capitalism, for instance, favor only certain groups in society more than others? Is the relationship between formal institutions, culture, and well-being heterogeneous with respect to the level of economic development? What are underlying mechanisms that can explain this relationship? Many of these questions will, we hope, shape the research agenda in the field in the coming decades.