Worrying Signs About Domestic Economic Institutions in Europe

Domestic institutions are an important factor explaining past economic performance (Acemoglu, Johnson and Robinson, 2001) as well as comparative advantage (Levchenko, 2005; Nunn, 2007). Simply put, domestic institutions are essential for economic activity in the sense that they can enforce contracts between seller and buyer. Economists usually take a variable called “rule of law” to proxy for the quality of these domestic economic institutions or, in other words, contract enforcing mechanisms.

The role of the rule of law becomes important for countries that specialize in non-standard and non-homogeneous sectors in which products, services and other inputs need to be tailored toward the needs of the buyer. The more specific these needs, the harder they can be defined in a contract and the more important it becomes that a strong rule of law backs up the transaction. Without a strong rule of law, parties may easily default and so under-investment takes place. More than often, developed countries such as the EU and the US are specializing in non-standard products and services.

How do these domestic institutions, and in particular the rule of law, look like in Europe? Overall good, but there are worrying signs. Figure 1 shows that on the whole the rule of law in the EU is pretty high and stable, ranging from 0 (bad institutions) to 4 (high institutions). However, the EU’s level of rule of law is still lower than the rule of law in the US. One part of the explanation is Eastern Europe which, although catching-up rapidly, started from a lower level. When taking out such countries and focusing only on the North, this part of the EU even outperforms the US.

This pattern becomes problematic if we concentrate on other parts of Europe. Figure 2 shows the trend of the rule of law for each of the four parts of the EU (some countries overlap of course) and re-computes the index for each region so that their developments starts from a common base, namely 1. Three clear messages stand out in this picture. One, both Northern and Western Europe show a stable pattern, which, as previously noted, has a high level anyways. Second, the East is catching up steadily with the rest of Europe. Third, and this is the worrying part, the South is regressing. Figure 2 illustrates that the average level of rule of law in countries such as Spain, Portugal, Italy, Greece and even France are performing worse over time. In fact, in 2014 (latest year available) Eastern Europe was not that far anymore from the South in terms of nominal levels, although recent developments in Eastern Europe may have altered the figures somewhat.

In short, this institutional gap is worrying. European economies are increasingly specializing in advanced and sophisticated sectors that generate greater value-added from which greater welfare gains can be reached and for which strong domestic institutions are a pre-condition. Losing out on this factor won’t speed up any economic convergence, something the EU is strongly aiming for.