PUBLIC GOVERNANCE AND ECONOMIC GROWTH IN THE TRANSITIONAL ECONOMIES OF THE EUROPEAN UNION.

• Author: Bayar, Yilmaz

1. Introduction

   Public governance is an essential determinant of long-run economic growth. Although consensus is lacking on the definition of governance, Kaufmann, Kraay and Mastruzzi (2010), considering various definitions, view governance as 'the traditions and institutions by which authority in a country is exercised'. Therefore, governance is defined as (i) the process of the selection, monitoring and replacement of governments; (ii) the power of the government to effectively establish and perform sound policies; and (iii) the respect of citizens and the state for the institutions that govern economic and social interactions among them (Kaufmann, Kraay and Mastruzzi, 2010, p. 3).

   The impact of governance on economic growth was disregarded by neoclassical growth theory, but public governance became an important component of economic growth with the emergence of endogenous growth theories in the late 1980s. Countries' institutional structure has the potential to affect economic growth within the context of new growth theories because it is a determinant of both transaction costs and production costs (Aron, 2000, p. 104). Alternatively, the countries with higher levels of public governance will likely stimulate domestic private investments and foreign direct investments by reducing uncertainty, creating an investment environment for both domestic and foreign firms and positively contributing to economic growth.

   We focus on the transitional economies of the European Union (EU), including Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia, because these countries experienced significant changes in public governance during the economic transformation, transiting from centrally planned economies to market economies as a result of the Communist Bloc's collapse in the late 1980s and the early 1990s, and pursued integration within the EU. The Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia became EU members in 2004, Romania and Bulgaria in 2007 and, finally, Croatia in 2012. These countries made the required reforms to meet the membership criteria during the EU integration process. The key criteria for accession to the EU, also called the Copenhagen criteria, consisted of stable institutions guaranteeing democracy, rule of law, human rights and respect for and protection of minorities, a functioning market economy, the capacity to cope with competition and market forces in the EU and the ability to take on and effectively implement the obligations of membership, including adherence to the aims of a political, economic and monetary union (European Commission, undated). Consequently, the transitional economies of the EU have come a long way in terms of good governance.

   In this context, this study investigates the impact of improvements in the governance of EU transition economies on economic growth during the 2002-2013 period and is a pioneering study on the relationship between governance and economic growth for this group of countries. The rest of the study is structured as follows: the next section outlines the empirical literature on the nexus between public governance and economic growth, section 3 introduces the data, econometric methodology and empirical analysis, and section 4 gives a conclusion and policy implications.

2. The relationship between governance and economic growth: literature review

   The emergence of new endogenous growth theories has directed scholars to determine alternative sources of economic growth and differences among the countries' economic development levels. In this regard, the impact of public governance, in other words, the quality of public administration, on the economic growth has been investigated theoretically and empirically. Public governance has the potential to affect economic growth via many direct and indirect channels because it is the main determinant of the economic environment and institutions that have a significant impact on the decision-making process of key economic actors (Acemoglu, Johnson and Robinson, 2005) and that affect investments in both physical and human capital and technology, which are major drivers of economic growth. Furthermore, public governance may positively affect economic growth by contributing to the development of the financial sector, increasing foreign direct investment inflows and improving corporate governance, which positively impact economic growth.

   Empirical studies have generally focused on the relationship between corporate governance, economic growth and firm performance (Morck, Wolfenzon and Yeung, 2005; Tiwari, 2010; Todorovic, 2013). However, relatively few studies have been conducted on the relationship between public governance and economic growth, or on the transition economies of the EU, and existing studies employ mostly panel regression analysis for econometric analysis. The majority of studies have benefited from the Worldwide Governance Indicators (WGI) of the World Bank in investigating the impact of public governance on economic growth and have generally concluded that public governance components positively impact economic growth (Kaufmann and Kraay, 2002; Badun, 2005; Beck and Laeven, 2006; Mendez-Picazo, Galindo-Martin and Ribeiro-Soriano, 2012; Bouoiyour and Naimbayel, 2012; Fayissa and Nsiah, 2013).

   Badun (2005) investigated the impact of rule of law and public administration quality on economic growth in EU countries and candidate countries including Croatia, Bulgaria and Romania using panel regression, finding that both factors positively impact economic growth in transition economies. In contrast, Tridico (2006) examined the impact of governance on firm productivity in Poland and found that the firms located in a more healthily governed region experienced better performance. Beck and Laeven (2006) investigated the relationship between economic growth and institutional quality (proxied by WGI) in 24 transition economies during the 1992-2004 period by employing panel regression and found a strong positive relationship between economic growth and institutional development.

   Cooray (2009) investigated the relationship between economic growth and the size and institutional quality of governments based on World Bank governance indicators in the context of a neoclassical model in 71 countries, including several EU transition economies during the 1996-2003 period and found that governance positively affected economic growth. In contrast, Peev and Mueller (2012) investigated the relationship between economic growth, democracy and economic freedom by including indicators of public governance in a panel regression for 24 transition economies during the 1994-2007 period and found a positive relationship between economic growth and the quality of economic institutions. Finally, Petreski (2014) examined the impact of institutional quality on economic growth in 30 transition economies during the 2005-2011 period and found that regulatory environments with good governance had a positive impact on economic growth.

   Beside these findings, many empirical studies have been conducted on the relationship between public governance and economic growth for countries in different income groups, excluding our sample countries. In a pioneering study, Kaufmann and Kraay (2002) investigated the impact of governance indicators on economic growth in 175 countries during the 2000-2001 period and found strong positive causality from governance to economic growth. On the other hand, Emara and Jhonsa (2014) investigated the impact of governance (proxied by Worldwide Governance Indicators) on economic growth in 197 countries for the year 2009 by using a two-stage least square regression and found bidirectional causality between governance and economic growth. These authors also examined the same relationship in 22 Middle Eastern and North African...