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Institutional quality in Europe: diverging trends in challenging economic times

Economic Report

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  • Institutional quality in Europe is high from a global perspective, but varies considerably across the continent and over time
  • While Nordic countries’ institutions rank among the best worldwide, institutional quality in the wider Balkan region including Greece and Turkey centres around the global average
  • The institutional deterioration in euro area crisis countries is particularly driven by worsening corruption, weakening of the rule of law and in some cases markedly weaker regulatory quality. Meanwhile, reflecting increasing authoritarian trends in Hungary and Turkey, voice and accountability is under pressure in both countries, but only in the former has this so far coincided with a deteriorating rule of law
  • As institutional quality is an important catalyst for economic growth, its deterioration may undermine medium to long-term economic growth

Why does institutional quality matter?

Economic theory and broad empirical evidence corroborate the importance of institutional quality in explaining economic development. Trends in institutional quality provide important indications of individual countries’ potential to make the most of their available physical and human resources. As Djankov et al. (2006) conclude, “countries with better regulations grow faster.” Acemoglu and Robinson (2012) put institutions at the very centre of their explanation of economic success and failure over the past centuries. There seems to be a causal connection between institutional and economic development, and there is an important contribution therein for institutions that in a broad sense provide ‘legal protection.’

Moreover, close examination of countries’ institutional frameworks can reveal particular country risks related to e.g. a country’s legal environment or the prevalence of corruption.

How do Europe and its regions compare in terms of institutional quality?

Europe has been at the global forefront in terms of having well-developed institutional frameworks for many decades. Consistent with economic theory and evidence on the connection between institutions and economic development, GDP per capita levels in much of the continent also rank among the highest in the world. Yet, following recent years of economic crisis and the imposition of painful fiscal austerity measures and economic reforms accompanied by increasing voter disenchantment with ruling parties, there are indications that institutional quality may have been weakened in the process. Notwithstanding Europe’s recent deep economic crisis and its excruciatingly gradual recovery, large parts of the continent still rank among the world’s most-developed regions in terms of institutional quality.

The level of institutional quality nevertheless varies considerably across the continent, whereby EU and euro-area membership do not automatically correspond with higher levels of institutional strength (see Table 1 in the appendix). Meanwhile, once poor former communist economies in Central Europe have seen concurrent improvements in both institutional quality and income levels[1]

Measuring institutional strength

There is no generally accepted objective measure of countries’ institutional quality. Still, internationally comparable indicators gauging individual countries’ relative performance on aspects of institutional development can be used to construct comprehensive indicators.  Such indicators allow us to assess relative levels of and changes in institutional quality over time. Using academic literature as a compass, we focus on three different indicators: i) an overall Institutional Strength Indicator (ISI), ii) a Legal Protection Indicator (LPI), and iii) an Absence of Corruption Indicator (ACI). All indicators are based on z-scores of several sub-indicators, which indicate a country’s performance normalised vis-à-vis the global average.

The ISI is based on the unweighted average of the six sub-indicators of the World Bank’s World Governance Indicators and the Ease of Doing Business Index. It provides an overall impression of a country’s institutional quality. The LPI measures a country’s protection of property rights and thereby gauges its attractiveness for investment. It is constructed as the unweighted average of the Enforcing Contracts sub-indicator of the World Bank’s Ease of Doing Business Index, the Rule of Law sub-indicator of the World Bank Governance Indicators, and the Property Rights indicator of the World Economic Forum’s annual Global Competitiveness Index. The ACI affects a country’s business climate in general and the adherence to rules, laws and regulations (including Investor Protection measured by the LPI) in particular. The ACI is based on an unweighted average of the Control of Corruption sub-indicator of the World Governance Indicators and the Ethics & Corruption sub-indicator of the Global Competitiveness Index.  

Figure 1: Overall Institutional Strength Indicator 2013
Figure 1: Overall Institutional Strength Indicator 2013Source: World Bank, Rabobank
Figure 2: Change in Institutional Strength 2010-2013
Figure 2: Change in Institutional Strength 2010-2013Source: World Bank, Rabobank
Figure 3: Legal Protection indicator
Figure 3: Legal Protection indicatorSource: World Bank, World Economic Forum, Rabobank
Figure 4: Change in Legal Protection 2008-2014
Figure 4: Change in Legal Protection 2008-2014Source: World Bank, World Economic Forum, Rabobank
Figure 5: Absence of Corruption indicator
Figure 5: Absence of Corruption indicatorSource: World Bank, Transparency International, World Economic Forum, Rabobank
Figure 6: Change in Absence of Corruption 2008-2014
Figure 6: Change in Absence of Corruption 2008-2014Source: World Bank, Transparency International, World Economic Forum, Rabobank

Nordics maintain  their leading position

On average, the Nordic countries display the highest level of overall institutional quality, both in Europe and globally (figure 1). They perform strongly across all sub-indicators. While there have been some changes over time, the most notable trend is the deterioration of the Absence of Corruption indicator in Denmark, Sweden and particularly crisis-hit Iceland. Notwithstanding these changes, the Nordics institutional quality remains very strong, which augurs well for the region’s economic growth in the years to come 

Western Europe maintains high levels of institutional quality, as corruption worsens slightly

Among Europe’s regions, Western Europe features the second-highest level of institutional quality, which, on average, is only slightly below Nordic levels. Within the region, Switzerland and the Netherlands are the strongest performers, whilst institutional quality is weakest in France (comparable to Estonia, the best-performing Central European country). Western European countries generally perform well across most sub-indicators of overall institutional strength. Ease of doing business constitutes a relative weakness in France and Luxembourg.

Compared to 2010, overall institutional quality weakened in Austria, France, and Ireland. Meanwhile, legal protection and absence of corruption remained relatively constant since 2008, even as the latter deteriorated markedly in Austria. As Western Europe maintains its relatively high level of institutional quality, its growth potential does not seem to have suffered in that respect in recent years, which should help the region to recover going forward. Note though, that France’s already relatively weak institutional position has continued to deteriorate.

Central Europe and the Baltics on average occupy the middle ground 

Thanks to significant structural reforms since the end of communism in 1989, the Central European and Baltic countries occupy the middle ground in terms of institutional quality in Europe today. Institutional quality in most countries is comparable to levels observed in Southern European countries like Portugal, Cyprus or Spain. Compared to its European peers, the region performs relatively favourably in terms of political stability, ease of doing business, and voice and accountability (with the notable exceptions of Hungary and Latvia). Government effectiveness and regulatory quality are mediocre, however, while low levels of control of corruption continue to constitute a key weakness in the region.

Following a series of controversial economic and social policy initiatives by the incumbent Fidesz-government, Hungary features the poorest quality of institutions, as voice and accountability and the rule of law deteriorated markedly since 2010. Meanwhile, with the notable exceptions of Hungary, Slovakia and Slovenia, the region’s institutional quality has improved since 2008, as major gains were made in various countries in terms of absence of corruption. Legal protection and absence of corruption improved markedly in Poland, though the former deteriorated sharply in Hungary as the local government targeted foreign-dominated sectors with various crisis taxes.

Southern Europe

In terms of institutional quality, Southern Europe is a mixed bag. Spain, Portugal, and Cyprus feature institutions that compare well with the tail-end of the Western European group, while Italy and particularly Greece more closely resemble South-Eastern European standards. The former three countries perform relatively strongly in terms of government effectiveness, but regulatory quality, political stability and absence of violence/terrorism constitute weaknesses, particularly in Spain (Basque separatism) and Cyprus (tensions with Turkey and Northern Cyprus). Since 2010, overall institutional quality remained relatively stable in the three countries, as a slight deterioration in  regulatory quality and the rule of law in Spain and Cyprus was compensated by improving government effectiveness in Portugal and Spain. Notwithstanding, with the exception of Portugal, legal protection has deteriorated in both Spain and Cyprus and the absence of corruption weakened markedly. Still, overall institutional quality in the three countries has held up well in recent years, which augurs well for their economic prospects.

The same cannot be said about Italy and Greece, however, both of which are in need of stronger economic growth to address lingering debt sustainability issues. Both countries suffer from a combination of widespread corruption, weak rule of law, and low government effectiveness, which is exacerbated by poor political stability, particularly in Greece. Probably reflecting years of stalled reforms, institutional quality remained relatively stable in Italy, but the country’s already sizeable corruption problem has worsened. Meanwhile, in Greece, recently implemented reforms in line with the country’s EU/IMF bail-out packages have so far failed to bring about an improvement of institutional quality. While rules and procedures for doing business have improved, the rule of law and legal protection has deteriorated markedly, with the latter partly reflecting reform-driven legal changes. Greece’s already considerable corruption problem has also worsened, as has the quality of democratic institutions.

South-Eastern Europe lags seriously behind

Compared to its European peers, South-Eastern Europe features a very low level of Institutional quality. A detrimental combination of weak legal protection and rule of law, poor control of corruption, low government effectiveness, and lingering political instability constitute major institutional deficiencies, all of which are worse than the global average. Though still trailing the rest of Europe by large margins, the region outperforms the global average in terms of regulatory quality and ease of doing business. Within the region, with the exception of Croatia and Montenegro, the relatively young Western Balkan countries are performing particularly poorly, while Turkey, the region’s biggest economy, takes a middle position. While benefiting from relatively strong government effectiveness, regulatory quality and ease of doing business, Turkey suffers from very low levels of political stability and voice and accountability, both of which have deteriorated since 2010. The two indicators bear witness to the increasing polarisation of Turkey’s society and a concurrent deterioration of press freedom amid fears of increasing authoritarianism, as President Erdoğan strives to introduce an executive presidency.

Notwithstanding their EU membership, institutional quality in Bulgaria, Croatia and Romania remains low, as only few improvements can be observed. Meanwhile, voice and accountability and political stability have deteriorated, with the latter reflecting lingering government instability in Bulgaria and Romania. The region’s various institutional weaknesses are likely to weigh on its growth prospects going forward. In combination with its poor physical infrastructure, the current level of institutional strength is seriously damaging the region’s appeal for foreign investors, which may be attracted by its generally very low wage levels. Turkey however, thanks to its comparatively young and growing population, as well as its relatively strong regulatory environment, may still outperform the rest of the region, provided its political and social situation does not deteriorate and weakening institutional quality does not give way to populist economic policymaking. 

Did the Great Recession and fiscal austerity affect institutional quality?

The Great Recession and ensuing slow recovery have had an enormous impact on economies and societies and have also affected institutional quality. The economic pain of adjustment within a currency union is clearly visible from the change in European PPP-adjusted GDP per capita development (figure 7). The programme countries have clearly suffered the most, whilst the right tail of the figure (increases in economic wellbeing since the Great Recession) is almost invariably made up of non-EMU counties.

On the one hand, the Troika interventions in the EMU program countries included economic reforms and may have bolstered institutional quality. On the other, the loss of economic wellbeing caused by the recession and ensuing austerity and reform measures (particularly in the EMU programme countries) may have induced slippage in institutional strength. The worry here is how long-term economic progress relates to the way in which political institutions change during ‘historical turning points’ (Acemoglu and Robinson, 2012), one of which in retrospect the Great Recession may turn out to have been.

Figure 7: Change in PPP-adjusted GDP per capita
Figure 7: Change in PPP-adjusted GDP per capitaSource: IMF, Rabobank
Figure 8: Fiscal austerity and changes in institutional quality
Figure 8: Fiscal austerity and changes in institutional qualitySource: IMF, World Bank, Rabobank
Figure 9: Fiscal austerity and changes in legal protection
Figure 9: Fiscal austerity and changes in legal protectionSource: IMF, World Bank, World Economic Forum, Rabobank
Figure 10: Fiscal austerity and control of corruption
Figure 10: Fiscal austerity and control of corruptionSource: IMF, World Bank, Transparency International, World Economic Forum, Rabobank

A better understanding of how institutional quality may change during episodes of severe austerity and reform is obtained by plotting them against each other (figure 8). The figure suggests that during the relatively short time period of 2010-2013, there is no clear relationship between fiscal consolidation and slippage in overall institutional quality. This observation does not however hold true for legal protection (figure 9) and control of corruption (figure 10), for which a negative correlation is observed. While falling short of hard evidence, the findings nevertheless suggest that short-term gains in terms of strong improvements in public finances and implementation of significant economic reforms may come at the cost of deteriorating institutional quality. Consequently, hysteresis effects (whereby contemporary economic weakness may become structural) may occur through institutional slippage. Against the background of at times high public debt levels and concurrent low and deteriorating institutional quality (e.g. Italy), this observation supports the case for the decisive implementation of structural institutional reforms that should go hand in hand with fiscal consolidation. 

Footnote

[1] The regions are defined as follows: Nordics (Denmark, Finland, Iceland, Norway, Sweden), Western Europe (Austria, Belgium, France, Germany, Ireland, Luxembourg, Netherlands, UK, Switzerland), Southern Europe (Cyprus, Greece, Italy, Malta, Portugal, Slovenia, Spain), Baltics (Estonia, Latvia, Lithuania), CEE (Czech Republic, Hungary, Poland, Slovakia), SEE (Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Kosovo, FYR Macedonia, Moldova, Montenegro, Romania, Serbia), and Turkey.

Literature

Acemoglu, D. & Robinson, J. (2012). Why Nations Fail: The Origins of Power, Prosperity, and Poverty, Crown Business.

Djankov, S., McLiesh, C., & Ramalho, R. (2006). Regulation and Growth. Economics Letters, 92, 395 - 401.

Appendix

Table 1: Overall institutional strength 2013
Table 1: Overall institutional strength 2013Source: Rabobank
Table 2: Change 2010-2013
Table 2: Change 2010-2013 Source: Rabobank

Colophon

This study is a publication of Economic Research (KEO) of Rabobank.

The views presented in this publication are based on data from sources we consider to be reliable. Among others, these include Macrobond. The economic growth forecasts are generated from the NiGEM global econometric structure models.

This data has been carefully incorporated into our analyses. Rabobank accepts, however, no liability whatsoever should the data or prognoses presented in this publication contain any errors. The information concerned is of a general nature and is subject to change.

No rights may be derived from the information provided. Past results provide no guarantee for the future. Rabobank and all other providers of information contained in this study and on the websites to which it makes reference accept no liability whatsoever for the content or for information provided on or via the websites.

The use of this publication in whole or in part is permitted only if accompanied by an acknowledgement of the source. The user of the information is responsible for any use of the information. The user is obliged to adhere to changes made by the Rabobank regarding the information’s use. Dutch law applies.

Abbreviations for sources: AMECO: Annual Macro-Economic Database, BIS: Bank for International Settlements, DOTS: Directions of Trade Statistics, EC: European Commission, ECB: European Central Bank, OECD: Organisation for Economic Co-operation and Development, EIU: Economist Intelligence Unit, IMF: International Monetary Fund, WEO: World Economic Outlook, UN: United Nations

Abbreviations used for countries: AL: Albania, AT: Austria, BE: Belgium, BG: Bulgaria, BA: Bosnia and Herzegovina, CH: Switzerland, CY: Cyprus, CZ: Czech Republic, DE: Germany, DK: Denmark, EE: Estonia, ES: Spain, FI: Finland, GB: Great Britain (UK), GR/EL: Greece IE: HR: Croatia, Ireland, IS: Iceland, HU: Hungary, IT: Italy, LU: LV: Latvia, Luxembourg, LT: Lithuania, MD: Moldova, ME: Montenegro, MK: Macedonia, FYR, MT: Malta, NL: The Netherlands, NO: Norway, PL: Poland, PT: Portugal, RO: Romania, RS: Serbia, SI: Slovenia, SK: Slovakia, TR/TK: Turkey, XK: Kosovo, SE: Sweden, EA17: Euro Area-17, EU27: European Union.

Economic Research is also on the internet: www.rabobank.com/economics

For more information, please call the KEO secretariat on tel. +31 (0)30 – 216 2666 or send an email to economics@rn.rabobank.nl

Editors-in-chief: 
Allard Bruinshoofd, head of International Research, Economic Research

Graphics: Selma Heijnekamp and Reinier Meijer

Production coordinator: Maartje Wijffelaars and Christel Frentz

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Author(s)
Fabian Briegel
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 64053
Allard Bruinshoofd
Rabobank KEO
+31 30 21 62666

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