HOME GROWN OR IMPORTED? INITIAL CONDITIONS, EXTERNAL ANCHORS AND THE DETERMINANTS OF INSTITUTIONAL REFORM IN THE TRANSITION ECONOMIES* Maria L. Di Tommaso, Martin Raiser and Melvyn Weeks In this article we examine the determinants of institutional change using a panel dataset comprising 25 transition economies. A defining characteristic of our approach is that we treat institutional change as a multidimensional unobserved variable, accounting for the fact that each of our indi- cators represents a noisy signal. Our results suggest that institutional change is significantly path dependent. However, policy can to some extent break this dependence through economic and political liberalisation at the start of the transition and with the help of an external anchor such as EU accession. Most social scientists agree that institutions play a fundamental role in economic development; see, for example, (Keefer and Knack, 1995, Stone et al., 1996); and for the transition economies (Havrylyshyn and Van Rooden, 1999). There has been a commensurate growth in the literature on measuring economic and political insti- tutions and relating these measures to economic performance. Acemoglu et al. (2001) is an influential recent piece; see also Rodrik (2004) for references to this literature. However, empirical research on how institutions change and thus how better institutions might be created remains underdeveloped beyond country-speci- fic historical narratives; for a case study of reform in Russia see Shleifer and Treisman (2000). Moreover, the concept of institutions used in the literature is often broad, encompassing elements of governance and corruption, the quality of the judiciary, the constitutional order and the legal system, as well as more narrow aspects of economic policy, such as rules and regulations governing competition, trade, factor markets and the Ôbusiness climateÕ. 1 This article focuses on the deter- minants of institutional change using a relatively narrowly circumscribed concept of economic institutions developed for the transition economies by the European Bank for Reconstruction and Development (EBRD). Methodologically, we propose a multiple indicator model (MIMIC) to analyse the determinants of institutional change, whereby we conceptualise institutional change as a latent variable, imperfectly captured * The authors thank for helpful comments and suggestions: Anders Aslund, Steven Fries, Manuel Arrellano, Andrew Harvey, Simon Johnson, Dariusz Rosati, participants at the Ninth International Confer- ence on Panel Data, June 2000, Geneva and seminar participants at the EBRD, the World Bank, University College London, University of Maryland, Erasmus University Rotterdam, and University of Cambridge. Fur- ther comments by two anonymous referees are also gratefully acknowledged. Financial support from the UK Know-How Fund under EBRD’s Policy Studies Programme on the Challenges of the Second Decade of Transition is gratefully acknowledged. 1 Thus, the World Bank’s annual Country Institutional Performance Assessment measures performance on no less than 16 dimensions, ranging from macroeconomic policies and the rules governing monetary and fiscal policy, trade policies, the protection of property right, social protection policies, labour market insti- tutions, and institutions governing gender issues to issues of corruption, transparency, and the quality of public administration. The Economic Journal, 117 (April), 858–881. Ó The Author(s). Journal compilation Ó Royal Economic Society 2007. Published by Blackwell Publishing, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA. [ 858 ]