A TALE OF TWO ISLANDS

May 15, 2009

Economists have long believed that there is a correlation between institutions and economic performance.  Rich countries, they argue, have laws that provide incentives to engage in productive economic activity.  Investors rely on secure property rights, facilitating investment in human and physical capital.  Government power is balanced and restricted by an independent judiciary.  Contracts are enforced effectively, supporting private economic transactions.  Yet these institutional factors are not the only determinants of economic growth, even over horizons of several decades, says the National Bureau of Economic Research (NBER).

Barbados and Jamaica provide a striking counter-example to the institution-focused long-run view of income determination, says the NBER.  Both countries inherited property rights and legal institutions from their English colonial masters, yet experienced starkly different growth trajectories in the aftermath of independence:

  • From 1960 to 2002, Barbados' gross domestic product (GDP) per capita grew roughly three times as fast as Jamaica's.
  • Consequently, the income gap between Barbados and Jamaica is now almost five times larger than at the time of independence.

The authors argue that the explanation for the divergence lies in differences in macroeconomic policy.  For example, in Jamaica, the People's National Party (PNP) rose to power in 1972 with the promise of democratic socialism, which translated as extensive state-intervention in the economy.  The PNP nationalized companies, erected import barriers in the form of higher tariffs and outright bans, and imposed strict exchange controls.  Social justice meant income redistribution through job-creation programs, housing development plans, and subsidies on basic food items:

  • Government spending subsequently rose in Jamaica from 23 percent of GDP in 1972 to 45 percent of GDP in 1978.
  • Revenue did not keep pace with the rise in expenditure; from 1962 through 1972 Jamaica's average fiscal deficit was 2.3 percent of GDP, but from 1973 to 1980 the average fiscal deficit was 15.5 percent of GDP.
  • Much of the deficit was financed through direct borrowing from the Bank of Jamaica.
  • Predictably, inflation also rose; from 1962 to 1972 the average rate of inflation was 4.4 percent per year and by 1980 inflation was 27 percent per year and investment had collapsed to 14 percent of GDP, down from 26 percent in 1972.

Source: Lester Picker, "A Tale of Two Islands," NBER Digest, May 2009; based upon: Peter Blair Henry and Conrad Miller, "Instituions vs. Policies: A Tale of Two Islands," National Bureau of Economic Research, Working Paper No. 14604, December 2008.

For text:

http://www.nber.org/digest/may09/w14604.html

For Working Paper:

http://papers.nber.org/papers/w14604

 

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