Mehmet BABACAN

The Role of Institutions and Governance in International Trade

2011

(Supervisor: Fatma Doğruel)

ABSTRACT

Institutions are counted among the most important factors of determining long-run economic performance. For centuries, they played a very crucial role in fostering growth, increasing welfare and sustaining social structures both in the Western and traditional societies. Whether conventional or modern, institutions and their reflections on governance elements are vital to understand the underlying mechanism of economic prosperity and development. Today, a vast body of literature on the role of institutions do exist both in the fields of economics and political science, primarily. The two are conceivably inter-related and there are mechanisms that provide the tools of mutual understanding. Public choice, for instance has emerged from such a logical foundation that intersects the realms of politics and economy.

The basic approach taken on the nature of institutions in the dissertation is that institutions are structures with general forms that evolve in a long period of time while governance elements which are conceived as perceptions or reflections on the underlying institutions may change in a shorter time span. Governance indicators could be said to provide specific and observable aspects of the quality of institutions in an economy.

International trade on the other hand, is one of the fewest areas under the macroeconomic theory that has attracted many researchers who have sought to understand economic growth and welfare differentials across the globe. In its traditional sense (i.e. Ricardian framework), trade is assessed as a positive factor that fosters aggregate growth for the engaging parties. The channels through which it affects income level and its distribution among and within the countries however are subject to a prolonged debate. The factor returns and prices, the change in relative wages depending on the relative abundance of the production factors in tradable goods and net welfare impact of international trade have long been discussed in several theoretical and empirical works. The impact of geography, climate, culture and demography is quite well examined in the literature initiated by the so-called “new trade theory” in early 1990s with a technical contribution which came from the “gravity equation” models since 1980s.

The dissertation has therefore adapted a perspective that merges the two bodies of literature in order to shed light on the dynamics of cross-border and bilateral trade volumes among countries, in specific. Given the relevance of gravity type equations in the current literature, the study has benefited very much of the model. As it incorporates both national accounts (i.e. shares in Gross Domestic Product [GDP]) and other factors such as geography (i.e., distance and land structure), demography (i.e., population); the gravity model has already become a useful tool to reveal the dynamics of trade. Our argument in the dissertation is that the institutional variables, specifically the administrative quality signaling ones, are at least equally important as the geographical components of bilateral trade are. A critical attempt made by the dissertation is to provide empirical and intuitional rationales that assess the comparative roles of institutions which are proxied by governance indicators and geographical measures that presumably instrument trade patterns in some ways.

The outline of the dissertation is as follows: after this first chapter that provides an introduction; the first of the remaining three chapters is dedicated to the inter-links between the literature on institutions, trade and growth. Beginning with an overview of institutional paradigm that has evolved over the years, a comparative analysis of the neoclassical, new institutional and the more recent lines of institutional research follows this chapter. Last, the intersections of governance and trade literatures are emphasized. The importance of this dissertation manifests itself immediately after a brief overview of the existing literature since the effect of governance indicators on international trade is relatively less exhausted while a single indicator (corruption) is usually studied in occasional papers. The third chapter provides a general brief on the structure of the problem with special emphasis on the reasoning behind the analysis, along with an overview of technical details that stem from econometric methodology and discusses the results while the fourth and last chapter concludes.

Overall, this dissertation underlines the importance of governance indicators in explaining the “border puzzle” in a way that it asserts the relevance of institutional similarities to gain the upper hand against geographical explanations of trade resistance between countries. Technological developments have also contributed this recently rising apprehension of the diminishing role of geographical elements in explaining trade creation or divergence. Relating to the governance on the other hand, this dissertation claims that the governance should be taken as an overall phenomenon that reflects itself in explaining trade differences among countries, rather than being individualist patterns. Therefore, corruption, administrative effectiveness, law enforcement and such indicators gain importance when assessed altogether while they could posit controversial results when taken individually. With the help of statistical and econometric tools, this dissertation concludes that aggregated governance indicator –including 9 individual indicators- and administrative quality as a sub-category among other governance indicators which is measured specifically by the bureaucratic quality, the extent of law and order and the level of corruption in a given country, is significantly associated with the rise in trade share. A number of governance indicators are also persistently found to be more effective on the level of bilateral trade between countries where they enter into the gravity equation one by one, compared to the geographical and other components. The overall results however pose mixed conclusions for the estimations while. On the policy-making side; our results open the door into a wide range of speculation and interpretations with the most general conclusion that the effect of governance on international trade should be assessed as a general phenomenon that incorporates a set of inter-related components rather than to be explained by individual indicators.