Is there an institutional trap in middle-income countries?

By José Antonio Alonso, professor of Applied Economics at the Complutense University of Madrid. He is co-editor of the recent book: Trapped in the Middle? Developmental Challenges for Middle-Income Countries, Oxford University Press, 2020

It is assumed that, as countries progress, they require better institutions to manage the societal issues that emerge with more extensive and sophisticated markets and respond to the needs of a more demanding society. In other words, the development process requires a path of institutional change. However, economic and institutional processes do not necessarily evolve at the same pace, as institutions are subject to greater inertia. As a consequence, inertial institutions can fall behind social demands, or else changes in institutions may not be properly rooted in social behaviour.

These issues are particularly relevant to middle-income countries which tend to experience episodes of intense economic growth that put their institutional frameworks under pressure. Transforming expansive episodes into sustained economic convergence with high-income countries requires a continuous and successful process of institutional improvement. However, these two processes are difficult to synchronise.

In fact, we might identify two common ‘institutional pathologies’ in the evolution of middle-income countries.

In some cases, the institutional framework seems to resist change even when the societies are themselves in a clear process of transformation. This pathology is more frequently seen in hierarchical social orders featuring authoritarian regimes, low levels of education, and a high degree of traditionalist values. In these cases, countries tend reinforce institutional inertia, sustaining outdated institutions that scarcely suit the new social reality – which can be referred to as the ‘stiffness’ of institutions. In response, an increasing social disregard for inherited institutions manifests itself, particularly among the more dynamic members of society such as youth. The massive ‘Arab Spring’ demonstrations in favour of more open and democratic regimes across certain middle-income countries in the Middle East and North Africa, are one example.

In other cases, where political rights are recognised but stark and chronic social inequalities are strife, formal institutions tend to be built on weak foundations, poorly embedded in society and subject to recurrent (sometimes cosmetic) changes, making it difficult for new rules to take root. In this case, the level of institutional instability is high, and institutions’ capacity to effectively shape social behaviour and gain credibility is low. This can be seen as a consequence of the ‘excessive fluidity’ of institutions. The social mobilisation and political crises in certain Latin American countries (such as Ecuador, Colombia, Peru and Chile) over the past two years are examples of this pathology.

Although each national case has its specificities, there are also commonalities. Characteristically, in all cases, social movements demand changes in governance, calling for more open, credible, and inclusive institutions. Both pathologies can lead nations into a vicious circle: because people do not trust public institutions, they do not support the process of reinforcing the State (resulting in weak taxation or a large informal sector); and given the State’s limited capacity and resources, it is unable to provide the public goods that society demands, further reinforcing people’s distrust.

This circular logic could drive us to hypothesise the existence of potential ‘institutional traps’ in middle-income countries, understood as a sort of discontinuity in the process of institutional improvement connected with middle-income status. Although some evidence points in this direction, it is not enough to unequivocally confirm this interpretation. However, there is enough empirical data that does confirm that a successful transition from middle- to high-income status tends to be accompanied by a rapid improvement in institutional quality indicators. In fact, the slope of the relation between GDP per capita and institutional quality becomes especially steep in the transition phase from middle- to high-income.

Knowledge remains limited around which institutions matter most for middle-income countries to converge with the high-income group. Empirical research is scarce, but tentative results suggest that: i) demand for institutional change is heterogeneous and depends on countries’ income levels; and ii) while institutional attempts to protect property rights and create markets appear crucial to nurturing an economy at any development stage, those institutions aimed specifically at managing distributive conflicts grow increasingly relevant as countries ascend the income ladder. Chile provides a good example, where social protests that began in 2019 and that are now reappearing, are not necessarily related to the decline in people’s economic conditions, but rather to demands for more transparent and inclusive institutions.

In short, institutional reform is a crucial and challenging task for middle-income countries, making it important to discover those variables associated with institutional improvement. With all the caution that such a complex subject demands, our empirical exploration can shed some light on this challenge, pointing to five major factors significantly associated with better institutions.

First, as expected, institutional quality is positively affected by a country’s development level. Higher per capita income leads to higher institutional quality; and because the latter also promotes economic development, these two variables can interact and create a virtuous circle.

Second, institutional quality is linked to the strength of the ‘implicit fiscal covenant’ between State and citizens. Taxation should be understood as part of a broader State-building agenda and can make the State both stronger and more responsive to its own citizens.

Third, the average level of education equally affects the quality of institutions: a better educated population tends to be more demanding of quality in the institutional framework, while at the same time education is itself required to build better institutions.

Fourth, institutional quality is found to be negatively conditioned by inequality: strong inequality leads to conflicts, socio-political instability, and insecurity. Inequality reduces people’s disposition toward cooperative action and facilitates the capture of institutions by powerful groups oriented to private interests rather than the common good.  

Finally, there is a strong and positive relation between institutional quality and international openness. A more dynamic, competitive, and demanding environment fuels greater demand for good institutions, meanwhile reducing rent-seeking activities and facilitating learning processes and the imitation of international good practices.

Two interesting implications arise from these results. First, in contrast to other studies, institutional quality is linked here to variables that can potentially be modulated by public policies, rather than by immutable historical or geographical factors (latitude, colonial ties, legal origins). Secondly, as middle-income countries often present weaknesses in many of the identified determinants of institutional quality, our findings could help explain why institutions are sometimes so fragile in this group of countries, and they may further help inspire the best policies for countries seeking to improve their institutional frameworks.