How do political and economic institutions affect each other?

Abstract

This paper provides evidence for the mutually reinforcing relation of political and economic institutions. To overcome problems of endogeneity I utilize lag instruments within a GMM framework for dynamic panel data. Employing recently developed tests, I show that limiting the number of lag instruments and collapsing the instru- ment matrix eliminates many and weak instrument biases. My major findings are that (i) improving economic institutions has a large positive effect on future po- litical institutions, and (ii) political institutions have a positive but quantitatively smaller effect on current economic institutions. In addition, (iii) political instability positively affects future political institutions. In line with predictions from the in- stitutional literature, the timing of effects is such that political institutions depend on lags of explanatory variables, while economic institutions are contemporaneously determined. Moreover, results are driven by countries with initially low political institutions implying that in these countries, much is to be gained from institutional reform.