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Introduction to Modern Economic Growth
these measures are purchased by businessmen contemplating investment in these
countries, thus they reflect the “market assessment” of security of property rights.
Figure 4.1 shows that countries with more secure property rights–thus better
economic institutions–have higher average incomes. One should not interpret the
correlation in this figure as depicting a causal relationship–that is, as establishing
that secure property rights cause prosperity. First, the correlation might reflect
reverse causation; it may be that only countries that are sufficiently wealthy can
afford to enforce property rights. Second and more importantly, there might be a
problem of omitted variable bias. It could be something else, for example, geography
or culture, that explains both why countries are poor and why they have insecure
property rights. Thus if omitted factors determine institutions and incomes, we
would spuriously infer the existence of a causal relationship between economic institutions and incomes when in fact no such relationship exists. This is the standard
identification problem in economics resulting from simultaneity or omitted variable
biases. Finally, security of property rights–or other proxy measures of economic
institutions–are themselves equilibrium outcomes, presumably resulting from the
underlying political institutions and political conflict. While this last point is important, a satisfactory discussion requires us to develop models of political economy
of institutions, which will have to wait until Part 8 of the book.
To further illustrate these potential identification problems, suppose that climate or geography matter for economic performance. In fact, a simple scatterplot
shows a positive association between latitude (the absolute value of distance from
the equator) and income per capita consistent with the views of Montesquieu and
other proponents of the geography hypothesis. Interestingly, Montesquieu not only
claimed that warm climate makes people lazy and thus unproductive, but also unfit
to be governed by democracy. He argued that despotism would be the political
system in warm climates. Therefore, a potential explanation for the patterns we see
in Figure 4.1 is that there is an omitted factor, geography, which explains both economic institutions and economic performance. Ignoring this potential third factor
would lead to mistaken conclusions.
Even if Montesquieu’s story appears both unrealistic and condescending to our
modern sensibilities, the general point should be taken seriously: the correlations
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