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Effect of Property Rights and Contract Enforceability on Economic Growth

Muhammad Zargham Khan

09U0532

Research Methodology

Lahore School of Economics

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Law and Economic Nexus

Economy and society have always been closely linked together. Both are interdependent on each

other, a better economy leads to a better society and it is true vice versa. An organized economy

and society are compulsory for a sustainable development. There needs to be a system for

working of large states or countries. To ensure this every country or state has devised a system of

rules, based on the norms and culture of the society, to ensure stability and equilibrium in the

society. The strength of such system will determine the level of stability and justice in the

society. For economic growth such a system provides stability as well as a regulatory framework

according to which all the economic activities should take place. So in a sense we can say that

system of rules or the law system has an evident effect on the economic growth of the country.

We see that there have been many theories regarding the economic growth of the developed

countries versus that of developing countries. There are many factors that have played an

important role in the consistent growth of developed countries, but one general factor, which is

not economic but socio-political, is the rule of law in the developed countries. Rule of law

basically indicates that the legal institutions are strong and they enforce rules without any

discrimination. Rights of the individuals are protected by the state and no one is above the law.

Thus law serves the function of distributive and corrective justice. Countries with a strong legal

system have witness a consistent growth in their economy. Although many economists believe in

free market economy where there is no intervention by any state organization but to ensure such

a free market one need a proper system with some rules which can be enforced easily. Adam

Smith in his book Wealth of Nations writes Commerce and manufactures can seldom flourish

long in any state which does not enjoy a regular administration of justice, in which the people do

not feel themselves secure in the possession of their property, in which the faith of contract is not

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supported by law [Adam Smith, Wealth of Nations (V, iii)]. This indicates that rule of law

has been considered as an important factor by early economists. A system of rules consists of

rules and the legal institutions enforcing those rules. Legal institutions consists of courts, state

enforcement agencies and law making institutions, if efficient, are not a burden on the economy,

but facilitate the economic activities by protecting the rights and enforcing contracts.

Pakistan is on the verge of development but there have been hindrances that have kept the

development and economic growth erratic. When rule of law is discussed in economic

perspective, institutions are the focal point in determining the state of law in the country.

Pakistan has suffered in this regard as the role of institutions has been very minimal and had

adverse effect on economic development. Different regime changes over the year have led to

deterioration in the quality of institutions. This has given rise to lawlessness and uncertainty, a

situation which is detrimental to the economic activities taking place in the country. Pakistan in

recent years has gone through changes in economy. It has become more market based economy,

which economists argue is helpful for economic growth but then policy makers have ignored the

fact that a market based economy cannot provide efficient results if the institutions are weak and

the rule of law is negated. The investment sector in Pakistan has failed to flourish because there

has been high degree of uncertainty. This uncertainty is due to absence of rule of law as things

dont go about according to the formal laws. This low level of investment has led to slow

economic growth rate over the years. This link between rule of law and economic growth is very

crucial for Pakistan and ignoring this aspect will lead to fruitless results of different other

economic policies which aim to trigger economic growth in the country.

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1.1 Effect of Rule of law on Economy

Many researchers have researched on this topic with different approaches. La Porta argues that

the origin of the state legal institutions affect the property rights. Two different systems are

distinguished one is common law and the other civil law. According to the paper Common law

system gives more protection to investor in the form of property rights and contract

enforceability as compared to civil law. So the countries which have legal origins from common

law have higher property rights and thus higher economic growth then the civil law countries.

Other researchers have taken personal security as a proxy of Rule of law like Narayan (2001)

which explains the concept that security of economic agents, who are involved in economic

activities, are more important than the security of their property and contracts. Such a threat to

security of an individual can be measured through crime rates. The rule of law can also be

determined through the independence of judiciary in a country. An independent judiciary ensures

that rights of anyone are not violated and there are no bias decisions that may create unrest or

perception of inequality. The structure of legal institutions has also been studied as major factor

of political and law situation of a country. But the core theories relating this topic are that of

property rights and contract enforceability (Coase 1960, Alchian 1965, Demsetz 1967, Alchian

& Demsetz 1973, Williamson 1971, 1985). These studies are backed by the empirical evidence

of cross-country analysis which shows that the property rights of developed countries are more

secured than that of less developed countries. One of the simple indicator has been corruption

which shows that how inefficient is the current system of the country. Comparing corruption

with the economic growth has yielded many useful results and also has shed light on the effects

of institutions on economy. Corruption as an indicator of governance and institutional strength

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has helped the researchers deduce empirical results in the past, but it includes too many aspects

so it is not quite specific but more generalized unit of measurement.

1.2 Historic Evidence of effect of Law on Growth

The economic growth of different countries has been characterized by rule of law in these

countries. The European countries have very old legal systems which have improved over the

years; these countries have shown remarkable economic growth. The evidence suggests that

these countries have very strong legal systems and the rule of law has been very strong. Whereas

on the other hand the developing or under developed countries have either no proper legal

system or the system is not efficient in enforcing the rules and regulations. The strong legal

institutions regulate the economy in a way that rights of individuals are protected and the

economy remain running in a stable and sound position. Rule of law is a social factor which has

been identified as one of the most important factor for economic growth. Furthermore the rule of

law is a vast factor; we have to be more specific when talking in terms of economic growth. Rule

of law in a country can be indicated by two sub factors which are property rights and contract

enforceability. These two are the basic and most important rules of law that effect economic

activity in a country. Rule of law is determined by strong legal institutions, which enforce rules

and punish those who violate them. The legal institutions enforce different types of laws which

concern different fields. The two important laws of property rights and contract enforceability,

concerns the economic activities in every country. Hence to see the strength of legal institutions

in regulating the economy we have to look at the property rights of individuals and whether these

individuals can enforce their contracts, which are daily part of economic activity. Thus property

rights ensure that the investment or property of the investor is protected by state from

expropriation, this reduces the risk for him. This research basically tries to link the rule of law

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and economic development through property rights and contract enforceability. This is one of the

aspects of rule of law which effects economic growth.

1.3 Managerial Concerns pertaining to research

Rule of law ensures that there is stable society and the rights of individuals are protected. Now

lets consider an investor who wants to invest in a country. If there is no rule of law and the

rights of that investor can be violated by anyone then that investor would never want to invest in

that country because there is high risk that his investment could be expropriated and he wont be

able to do anything about it. So investors and businessmen require stable and sound environment

to takeout their business activities, and we know that these activities are necessary for economic

growth. Pakistan is facing lawlessness from a very long time. The rule of law has been weakened

over the years, which in turn have shattered the confidence of investors and businessmen and

now they are moving to other countries to carry out their businesses. In this regard the research

tries to link the lawlessness present in Pakistan with the economic deterioration. The foreign

direct investment is closely linked to the law situation in the country. Moreover countries with

lawlessness have seen flight of capital to other safe havens. Thus in the current scenario of

Pakistan it is very important to look at the rules and laws governing the economy. Expropriation

risk has been very high in the rural Pakistan where the powerful landlords can take over any land

in their vicinity. Similarly intellectual property rights are not present in the country which

discourages people to innovate and invent. This shows that the legal institutions of Pakistan are

weak and cannot enforce the laws made for protection of rights. The research could explain how

property rights and contract enforceability are vital for economic development and how much

they affect the economic growth in the country. The results can then help us understand whether

there is a linkage between property rights and economic development, and would it be gainful to

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enhance such rights in Pakistan. It will also help to develop policies in the future which govern

the economy as well as social and political aspects of the country. The study will provide

empirical evidence to the Government and policy makers to develop their policies in such a way

that the economic growth could be sustained. The highlighted factors can then be taken into

consideration when formulating different policies. The lawmakers can also look upon the results

and recommendations to develop and approve laws in such a way that the cost of enforceability

is minimized and they could be enforced in the most efficient way possible. This research can be

a milestone for further researches in the field of political economy of Pakistan. There has been

no concise empirical study on this subject in the context of Pakistan. This study will help other

researches in the future and can be used as a basic literature for different political economy

researches. Further this model can be more elaborated in the future if new techniques of

measuring institutional working are developed which may increase the statistical information

about this topic.

1.4 Academic concerns pertaining to research

The economic growth has been the main concern of the Government in all years. It has

experimented with every option. Sometimes the economy showed immense growth but then due

to lack of proper system and set of institutions the growth could not be sustained. Rule of law is

important for a country as it ensures that all institutions and organization are kept at same level

and they are under check and balance from other institutions. We can see that the democratic

countries all over the world have better legal systems then monarchy or Dictatorships. Countries

that are more developed have a better legal system where the property rights are secure. These

countries enjoy high investment and high amount of business activities which are necessary for

the growth of a country. The model developed in this research could be applied to other countries

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Rule of law: The rule of law refers to a principle of governance in which all persons, institutions

and entities, public and private, including the State itself, are accountable to laws that are

publicly promulgated, equally enforced and independently adjudicated, and which are consistent

with international human rights norms and standards. (Report of the Secretary-General World

bank)

Economic Growth: Economic development is a process whereby an economy's real national

Income as well as per capita income increases over a long period of time. (Prof Meier and

Baldwin, Economic Development and Growth)

Property Rights: The right to hold a property and have authority to determine how to use it.

(Armen, Property rights paradigms)

Contract Enforceability: To compel observance of or obedience to a contract. (Avner Greif,

Contract Enforceability and Economic Institutions in Early Trade)

Literature Review

2.1 Multiple channels of Rule of law effect on economic Growth

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When discussing the effects of rule of law on economic growth it is very important to look at

different channels through which it effects economic growth. Rule of law has a wide spread

effect on society and economy; we have to look at what are the main things which translate the

effect of rule of law on the economic growth. After distinguishing these channels, we will decide

upon one of them and will try to quantify those effects. If we try to see how rule of law can

improve the society, the first thing that comes into our mind is quick and impartial dispensation

of justice. Obviously independent judiciary will lead to swift justice and conflicts between

different parties could be resolved objectively bringing stability in the society. Then rule of law

ensures personal safety of people which means investors and entrepreneurs will have trust in the

system and feel safe to invest. If people dont feel safe in a country or region, they wont invest

in that country and so they flight of capital will take place to places with better security of

persons. Countries where we observe lawlessness, there is also a high level of corruption in

Government institutions. Bureaucrats will not work according to law but will use their power

subjectively which will give rise to biasness. This corruption clearly indicates that Government

institutions are not governed by rule but rather persons whom decisions lead to loss of waste of

resources, just to benefit few people. Collier (1998) looks at the effects of civil war on countys

GDP. Certainly in civil war security of personal is at a very low. There is no law and order,

country is in a state of war except that the war is not with some other country but within itself.

To look at how security situation of individuals, which deteriorates in civil war, can affect the

economic growth of the country, we review the study of collier (1998) who looks at the different

effects of civil war like infrastructure destruction, flight of capital from the country, diversion

effect of expenditure which shifts from public goods to military expansion. Higher costs will be

incurred by individuals to keep their safety; also transportation cost will also increase as

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travelling at night or through some routes may become risky. The main effect which we are

concerned is portfolio substitution, in which private investors shifts his capital out of the country

due to the security reasons. The main variables that the study introduces are the total war months

and post war months. The results show that longer the total war months the more GDP will

deteriorate. On average it will decrease by 2.1% a year. Similarly if the war ends after a long

period of time then the post war growth will be rapid as compared to a post war period after a

short war, which can be described by war overhang effect. The study also looks at the changes in

GDP composition by considering that civil war will lead to flight of capital, so the capital

intensive segments will contract more than other segments of the economy. Although the

empirical evidence is not so strong and we can take a general perspective from this study that

law and order situation should be stable for an economy to prosper. We cannot exactly confer

the effects of security of individuals on economic growth but generally it has been proved that in

the study.

Whenever we think of rule of law, we think of freedom, which is political as well as

economic. The liberalist have argued that rule of law in a society can be distinguished by

independence of judiciary. La Porta et.al (2004) look at the relation of judicial independence and

constitutional review on economic and political freedom. Judicial independence has been

quantified by making an index from the data of judges tenure, tenure in higher ordinary courts

and administrative courts and lastly judicial decisions as a source of law. The constitutional

review has been measured by two factors; rigidness of the constitution and judicial review power

of the judiciary. The score for these two variables lie between zero and ten. The data has been

based on a sample of 71 countries. The regression results show that countries with high judicial

independence show high economic freedom and political freedom. Adding control variables

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reduce the effect but it still remains significant. Economic freedom includes property right index,

number of procedures to start a new business, employment regulation and number of banks

owned by Government. Constitutional review has a significant effect on the political freedom but

not on economic freedom. Thus the results show that countries with high judicial independence

enjoy greater economic freedom. La Porta et.al (2004) conclude with indicating a reverse

biasness in the equation, which can result in the case of constitutional review equation. The

measures of economic and political freedom are subjective which are prone to changes and

depend upon the source.

Mauro (1995) looks at the effect of corruption on economic growth. The paper tries to

measure the inefficiency of institutions by variables like corruption, bureaucratic efficiency,

political stability and red tape indices. The data used for these variables is subjective taken from

Business International indices of corruption and institutional efficiency. The theory of the paper

suggests that corruption and institutional inefficiency effects investment, which further effects

economic growth. The empirical results suggest the same. The OLS model shows that corruption

and bureaucratic efficiency effects investment sizably. To reduce reverse causality Mauro

introduced an exogenous instrument of ethno linguistic fractionalization. Corruption effects

growth directly but its direct effect is very minute as compared to indirect effect through

investment. The paper although provides solid evidence of its theory but fails to explain the

outliers. For example countries like Thailand, Saudi Arabia and South Korea, which have weak

institutions or higher corruption but still their growth is sufficiently high. The subjective data on

the corruption indices can have problems because analyst might rank institutions strong if growth

rates are high, giving rise to a two way effect. Although an endogenous instrument was used but

it is not clear that to which extent this instrument is exogenous to growth rates and investment.

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There is another dimension to the rule of law effect on economic growth and that is property

rights and contract enforceability. There is a vast literature on this topic and it is now considered

as an important socio economic factor for private investment. How can property rights and

contract enforceability effect economic growth and how are they related to rule of law. Property

rights and contract enforceability measures the strength of institutions in enforcing the rights and

agreements of individuals according to the law. In a way they are also reflecting the strength of

institutions in a country or a region. So better the rule of law in a society the more strong will be

the property rights and stronger contract enforceability. The second part of the question arises

how can it effect economic growth? North (1990) asserts that the inability of societies to

develop effective, low-cost enforcement of contracts is the most important source of both

historical stagnation and contemporary underdevelopment in the Third World... This is because

weak property rights and contract enforceability discourages investment. How can an investor

invest in a country where he has a high expropriation risk and where there is no hope that his

contracts will be enforced? Alchian, Demsetz (1973) argue that private property rights are really

important in capitalist society as it resolves the conflict over the use of scarce resources. This

topic is discussed in detail in the next part of literature review.

2.2 Justification of Effect of Property rights and contract enforceability on Economic growth

The literature on property rights and contract enforceability is quite sufficient to state that it is an

important factor in determining private investment in a country. The theory behind it is very

simple and discussed above. Many scholarly articles have discussed property rights alone while

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some have discussed both property rights and contract enforceability. Both are important

concerns of an investor and mold his/her decision about a certain investment or business

opportunity. The literature on this topic goes back to 1960s when Coase (1960) came up with

theory of social benefits and costs. The theory discusses how externalities arising from a private

process can have social costs or benefits. These social costs can be minimized if there are well

defined property rights. In the absence of property rights there will be inefficient distribution of

resources and inefficient level of production in some cases. Similarly Alchian, Demsetz (1973)

links the structure of property rights in a society to total economic efficiency. Different property

rights regimes have different effect on how the resources are used. Communal and private

property rights evolve with new demands, change in technology and worth of the property.

Private property rights lead to better allocation of resources as individuals are more concern of

social costs being imposed on them and they will use a resource where they achieve maximum

utility. Barzel (1997) look at the economic analysis of property rights. Economic rights and legal

rights are differentiated in a ways that economic right is the right to enjoy a property, whereas

legal rights are the rights which state recognizes and enforces. In the absence of legal rights of

property, one can have the economic rights but then it have to be self-enforced. In a contest

between powerful and weak, the powerful will always get the economic rights to a property

because there are no legal rules of adjudication and enforcement. All of these articles propose

theoretical justification of economic effect of property rights. Coase(1960) was more concerned

with the efficiency at the micro level due to property rights enforcement whereas Alchian,

Demsetz (1973) discussed different regimes of property rights and their effect of the economy as

a whole. Although the implication of coase theorem certainly indicates that with proper property

rights transaction cost are minimum and resource allocation is efficient which will lead to

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economy wise efficiency. Barzel (1997) discuss the full implications in a whole book about

property rights. The theories have many thing in common and all point towards the importance

of property rights in an economy. In early years there was no method developed to quantify

property rights and contract enforceability, so there wasnt much empirical studies to support

these theories. In the later years as more and more literature surfaced on this topic, empirical

studies were also carried out to provide some solid evidence for these theories. These theories

helped to understand the basic concept of property rights and lead to further studies on this topic.

2.3 Empirical Evidence On property Rights and Contract Enforceability

In the late 80s and 90s many paper were published which provide empirical evidence on the

property rights and contract enforceability theory. Most of them were cross country analysis

which compared the rule of law with economic growth in those countries. Some of the pioneer

work was done by Knack, Keefer (1995), Scully (1988), La Porta et.al (1997) and Clague et.al

(1999). The basic difference between these papers was how they measured property rights and

contract enforceability. Most of them used subjective measures to quantify in the form indices.

Then Dependent variables were also different but the main underlying theory which they all try

to prove is the same with slightly different results. La Porta et.al (1997) and Knack, Keefer

(1995) both used subjective data from International Country Risk Guide, which provide data on

different risks of countries on yearly basis. Knack and Keefer (1995) used expropriation risk

index, Rule of law index and Repudiation of contracts by Government as the main variables for

property rights and contract enforceability. BERI indices were also used to compare the results.

Where La Porta et.al (1997) used the aggregate index rule of law as a proxy for property rights.

Both the paper differ in the sense that Knack, Keefer (1995) analyzed the effect of independent

variables on the economic growth rate measured by real GDP change and Private investment

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mid of 1995 and 1996. For debt financing the paper used aggregate data on total bank debt of

private sector and total face value of corporate bonds in each country. The aggregate data relative

to GNP gives a plausible measure of the overall debt financing of private sector. The measure of

contract enforceability and property rights as discussed above is rule of law aggregate index. The

results of regression equations give very useful insight into the theory. Secure property rights and

contract enforceability in a country leads to increase in the size of countrys capital market. Thus

good legal environment is needed for private investments. The paper also indicated that countries

with legal origin of common law had better capital markets than civil law origin countries. This

can be implied that common law countries provide more protection to investors and owners of

property. Although both of the papers came up with solid evidence in the favor of property rights

and contract enforceability but the measure used are subjective measures which can have

different results and can also lead to reverse biasness. Biasness can arise on the part of analysts

who construct these indices can rate countries with high economic growth as high in property

rights and contract enforceability. Moreover the sample size in La Porta et.al (1997) study is not

large enough, which can cause misleading results.

The papers of Scully (1988) and Clague (1999) gives further evidence on property rights theory.

Scully (1988) is different as it uses Gastill (1982) Indices to measure the property rights and

contract enforceability across the country. The size of the sample is 115 countries which is quite

large. Gastill (1982) has annually published since (1973) country rankings of political liberty and

civil liberty, type of economic system, and other measures of freedom. These institutional

variables are subjective just like ICRG and BERI. On the other hand Clague (1999) uses an

objective measure, which is contract intensive measure to be used as a proxy for contract

enforceability and property rights. The sample size is 110 which is nearly equal to that of Scully

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(1988). The subjective indices of Gastill (1982) are based on the ranking from 0 to 10, but Scully

(1988) converted them into dummy variables and regressed it on economic growth which is

measured in annual real GDP growth rate. For each measure of liberty three dummy variables

were constructed. The empirical results were that all the variables have significant effect on the

economic growth rate per capita. The results indicated that economy with political liberty, with

rule of law and which give preference to individual rights over scarce resources grew more in

economic terms than other countries with more state rights and less political liberty. The results

can be misleading as the data used in the paper is based on the subjective valuation of countrys

institution. The same problem of reverse biasness can occur here as with the other studies that

used ICRG and BERI indices. Clague (1999) used an objective measure, to check whether it is

an appropriate proxy for property rights and contract enforceability, the contract intensive money

was correlated with ICRG and BERI indices. The correlation turned out to be positive. There

were two main dependent variables used in the study, one was the annual GDP growth per capita

and second was Investment relative to GDP. The results in both regression equations were

controlled by variables like inflation, mean years of education and population size. The results

showed that contract intensive money has a positive co-efficient in both equations which

signifies that contract enforceability and property rights do lead to economic growth. The paper

discusses that the main channel for property rights effect is the change in investment due to

strong property rights and contract enforceability. Property rights and contract enforceability

effect economic growth through change in investment. That is why effect of contract intensive

money is more on investment than directly on GDP. By adding investment in the GDP regression

the effect of contract intensive money decreases which clearly indicates that contract intensive

money effects GDP mainly through investment channel. Although the paper gave reasonable

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evidence on contract intensive money as a proxy for property rights and contract enforceability

but the main emphasis is how it will perform in time series data for a single country.

There have been a lot of researches carried out with the results providing evidence for property

rights theory but there are also few studies which show that strong legal environment is not

necessary for economic growth. One of such paper is of F. Allen et.al (2005) which discusses the

case of China. All cross country analysis give equal to weight to all countries irrespective to their

size and diversity that is why they conclude same results for all but China is an exception, it does

not have strong legal system and enforceability system. Institutions are underdeveloped but still

China is the fastest growing country in the world. The State and listed sectors of the economy

show poor growth due to poor legal system but the growth in private sector offsets this loss. The

system of alternative mechanisms and institutions plays an important role in supporting the

growth in the Private Sector, and they are good substitutes for standard corporate governance

mechanisms and financing channels. The paper examines statistics of different sectors rather

than going for a regression equations. The statistical surveys show that private sector has been

able to enhance its financing through reputation and trust. This poses a very complex questions

that whether a country really need a strong legal environment to boost up its economy or it can

follow in the footsteps of China and increase its private sector by alternative mechanisms. This

indicates that in the absence of legal environment, there develops an alternate system of property

rights and contract enforceability. Clearly further research is needed in this area to fully

understand the implications of alternative mechanisms.

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2.4 Rule of law in case of Pakistan

Law and Economics is a developing field of study in Pakistan. There have been not much studies

conducted on this topic with focus on Pakistan. There are many theoretical articles which stress

the need of rule of law in the country and its effect on economy. There has been no proper study

which can give us a quantitative view of the topic; most of the studies are descriptive in nature.

One such study by Hasan et al (2010) discusses the effect of rule of law on economic growth in

Pakistan by highlighting the key issues in the institutional setup and also the market setup. The

article explains the whole situation in great detail using World Banks rule of law index, which

show that Pakistan ranks lower than majority of countries in its region. This can be explained by

the suspension of constitution over and over again by different military regimes. The institutional

setup in Pakistan is very weak which leads to inefficient markets. The market of credit faces

problem as land is one of the basic asset collateral used in Pakistan for credit, but the land record

and transfer system is very weak, this give rise to land disputes. The court system has been

unable to resolve these land disputes and the cases usually last years without any decision. This

has hampered the credit market to flourish in Pakistan and has greatly undermined the property

rights regarding land. The stock and capital market faces issues regarding market manipulation

and corporate aggregation of capital in few hands. There are few regulations that govern the

corporate world which has led to very less market capitalization and emergence of informal

sector. The judicial system of Pakistan is very slow, which makes the dispute resolution a great

challenge in day to day business activities. The article although very brief in highlighting the link

between law and economics, fails to give any quantitative analysis.

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Methodology and Analytical Choices

3.1 Framework Analysis

+ve

Investment Share in total GDP(Clague , Knack & Olson,

Contract Intensive Money

(Clague , Knack & Olson, 1999)

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-ve +ve -ve

+ve +ve

-ve +ve

Growth in Real GDP per capita

(Clague , Knack & Olson,

1999)Literacy rate

(Knack & Keefer,

Currency Depreciation


Size of the Government


Corruption

(Knack & Keefer,

1995)

Unemployment

(Scully, 1988)

Trade Balance

(Clague , Knack &

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References

Growth in Real GDP

Clague , C., Knack , S., & Olson, M. (1999). Contract-intensive money: Contract enforcement,

property rights, and economic performance.Journal of Economic Growth, 4, 185-211. Retrieved

from

www. ideas.repec.org/p/pra/mprapa/25717.

Contract Intensive Money



from www. ideas.repec.org/p/pra/mprapa/25717

Literacy rate

Knack , S., & Keefer, P. (1995). Institutions and economic performance: Institutional measures

cross-country tests using alternative.ECONOMICS AND POLITICS, 7(3), Retrieved from

homepage.ntu.edu.tw/~kslin/macro2009/Knack&Keefer_1995.pdf

Trade Balance

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Size of the Government




Corruption

Knack , S., & Keefer, P. (1995). Institutions and economic performance: Institutional measures

cross-country tests using alternative.ECONOMICS AND POLITICS, 7(3), Retrieved from

homepage.ntu.edu.tw/~kslin/macro2009/Knack&Keefer_1995.pdf

Unemployment

Scully, G. (1988). The institutional framework and economic development.Journal of Political

Economy, 96(3), 652-662. Retrieved from http://www.jstor.org/stable/1830363

Investment Share of Gdp




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low morale of investor and creditors because they are not sure about their rights and security of

their property. In case a borrower defaults, the lender or financial institution will have great

difficulty in recovering its own assets back. Thus low property rights and contract enforceability

leads to high risk in financial markets due to which the banking services become costly and

limited. This all leads to crippling of financial markets which are back bone of investment in an

economy. We define contract-intensive money as portion of non-currency money to total money

(M2-currency/M2). In society where property rights and contract enforceability is ensured, there

would be larger use of contract-intensive money, which will lead to higher investment. This

indicates that property rights and contract enforceability effects economic growth through

investment channel. This was used by Scully (Scully, 1988) in cross-country comparison of

property rights and contract enforceability and its effects on economic growth. Much of the

variables are taken from his study.

We have to keep the effects of other variables constant, so other variables like literacy rate, trade

balance, size of government and unemployment were used. These factors have to be included if

we want to see the effect of contract-intensive money alone. Also currency depreciation is

included to account for changes in contract-intensive money due to depreciation in real currency.

All these independent variables are shown in the flow chart. The effect of literacy rate, trade

balance and size of government is positive on the economic growth because these are few of the

fundamental determinants of growth. Unemployment rate leads to slowing economy and hence

negative effect of the GDP. Corruption is another indicator of institutional strength and it shows

how much resources are wasted in the economy. This has a negative impact of the economy.

Secure property rights and contract enforceability leads to people holding more contract-

intensive money, which means the investment environment is secure and financial markets are

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growing. This in turn effects the growth of economy positively. So contract intensive money has

a positive effect on the growth but through the intervening variable of investment. There can be

reverse causation between economic growth and property rights. This could be happen if the

measure of property right is subjective, because an analyst might regard high property rights in

high growth period and in low growth period he might rank the country lower because the

Government is not performing well. On the other hand contract intensive money is objective

measure of individuals and firms preferences of their money holding. These preferences reflect

the contract enforcement and property rights at the moment.

3.2 Statement of Research Hypothesis:

The objective of this study is to look at the relation of property rights and economic growth. We

are now able to list down the hypothesis that we might like to test statistically to reach

conclusion. The most major hypothesis of the paper is that property rights and contract

enforceability effects economic growth positively.

Hypothesis 1

H: There is no relation between property rights and economic growth, contract enforcement and

economic growth.

H: =0

H: There is a positive relation between contract enforcement property rights and economic

growth.

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H: >0

Hypothesis 2

H: There is no relation between currency depreciation and economic growth.

H: =0

H: There is a negative relation between currency depreciation and economic growth.

H: 0

Hypothesis 4

H: There is no relation between trade balance and economic growth.

H: =0

H: There is a positive relation between trade balance and economic growth.

H: >0

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Hypothesis 5

H: There is no relation between unemployment rate and economic growth.

H: =0

H: There is a negative relation between unemployment rate and economic growth.

H: 0

Hypothesis 7

H: There is no relation between corruption and economic growth.

H: =0

H: There is a negative relation between corruption and economic growth.

H:

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The research is a study into causal relationship between property rights and economic growth in

Pakistan. It has the characteristics of a pure causal research. The cause side consists of property

rights and contract enforceability whereas the effect side looks at the economic growth. The type

of research is applied which means it looks at the real life problem of property rights and

contract enforceability in Pakistan and its effect on the economic growth. The results of this

research do not necessary give the true life of picture of the problem. It uses certain assumptions

to explain the problem of property rights in the real world case.

3.3.2 Data collection and Preferences

The data type employed in this study is secondary data. The reason to use secondary data is that

it is easily available and can be collected from previous studies and other data sources. The

secondary data on the variables help us to quantify the effects. Secondly the scope of this study is

quite large; we look at the Country level effects of certain variables on economic growth. At

such level primary data is not suitable and it is very costly also. So due to certain limitations

secondary data suits this type of research. The reference period for this study is 1980 to 2010

which give rise to 31 observations for each variable. Data before 1980 is not available for many

variables, that is a reason why the reference period starts from 1980.

3.3.3 Data collection and Related Procedures

The main sources for the secondary data are World Data Bank and Ministry of Finance report of

Monetary Sector. At the World Bank, the Development Data Group coordinates statistical and

data work and maintains a number of macro, financial and sector databases. Working closely

with the Banks regions and sectors, the group is guided by professional standards in the

collection, compilation and dissemination of data to ensure that all data users can have

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confidence in the quality and integrity of the data produced. Much of the data comes from the

statistical systems of member countries, and the quality of global data depends on how well these

national systems perform. Current reports gathered by the Bank's country management units and

data obtained from official sources are some of the other sources of data. Ministry of Finance is a

part of Government of Pakistan which keeps track of financial data related to financial sector of

Pakistan. It develops the financial policies for the country. It is the prime institution which

collects data on monetary and fiscal policies. The data collected by State Bank of Pakistan and

Ministry of Finance is very much similar. Data on all the variables was readily available at the

above mentioned sources but data on literacy rate is missing for some years. Interpolation

techniques were used to complete the missing data.

3.4 Statement of Analytical approach and Methodology

The methodology of this research contains an econometric model which quantifies the effect of

independent variables on the dependent variable. In this approach we will use a regression model

of ordinary least square. It is a simple linear regression model in which the co-efficient of

different variables give the effect of that variable on the independent variable keeping all other

variables constant. OLS is used when we predict the relation between variables to be linear. First

we form a regression equation which consists of dependent variable on the left side and all the

other independent variables on the right side. The function form of the regression can be written

as

Economic Growth = + Contract Intensive money + Currency depreciation + Literacy

Rate + Trade balance + Unemployment rate + Size of Government + Corruption

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The equation shows the variables which effect the economic growth, is the intercept of the

equation. It means that if all variables became zero will be the value of dependent variable.

The notational form of this equation can be written as follow:

GDP = + CIM + CD + LR + TB + UR + GOVT + COR

There is a probability of reverse causation between economic growth and contract-intensive

money. To counter this SLS regression equation will also be used. The econometric model will

be a time series model which will look at the data of these variables over the years for Pakistan.

The research is secondary that means the data used for these variables has been taken from

secondary sources. The main variable on which our focus lies is the contract intensive money.

Other variables like currency depreciation, literacy rate, trade balance, unemployment rate and

size of government are controlling variables which control the effect of these factors on growth

so that we can determine the idiosyncratic effect of property rights and contract enforcement on

the economic growth. The regression equation which is OLS will be tested by looking at certain

measures. R-square known as coefficient of determination is used to describe how well a

regression line fits a set of data. A R-square near 1 gives a strong regression equation which can

be used to predict future values. To look at the significance of coefficients of different variables

we will use t scores and p-values. A high p-value indicates that the coefficient is not significant

at lower confidence interval. A high t-score indicates that the coefficient is significant, that

means higher the t-score the higher will be the significance of the coefficient. F-value is used to

check the significance of all coefficients of the equation collectively. Higher F value indicates

higher collective significance of regression equation.

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Most of the studies done in the past on this topic have been cross-sectional analysis of different

countries. Studies of la porta (La porta 1999), Djankov (2003), Acemoglu (2005) and knack and

keefer (1995) look at the effects of property rights and contract enforcement on economic growth

in different countries. The data set contained above 100 countries and the different variables

were used to look at the law and economic nexus. There have not been many time series studies

in property rights research. This is because most of the studies use data on property rights and

contract enforcement which is not suitable for time series studies. Most of the indexes used in

studies come from subjective measures whereas contract intensive money is objective measure

which can be used in a time series model.

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