Impact of uncertainty on economic growth: The role of pro‐market institutions in developing countries

Abstract

Various shocks, including the Gulf War, the US recession, the 9/11 attacks, financial credit crunch, and domestic political shocks like coups, and revolutions, have contributed to the persistence of high uncertainty. This uncertainty has direct implications for economic activity, affecting both business investment and household consumption decisions. This article explores the mediating role of the quality of pro‐market institutions in the relationship between economic performance and changes in the uncertainty. It also investigates whether reforming pro‐market institutions during a period of uncertainty can mitigate the negative effects of the uncertainty on economic performance, while analyzing the channels through which the mediating effect of reforms during uncertainty manifests. Using a sample of 61 developing countries over the period 1990–2014, our results, robust to various tests, indicate that higher quality of pro‐market institutions significantly reduces the negative effects of uncertainty on economic performance. Indeed, the reduction in GDP growth due to a change in uncertainty decreases by 93 percentage points with higher levels of pro‐market institutional quality, and this variation depends on the nature of the pro‐market institutions considered. Furthermore, implementing pro‐market institutional liberalization reforms during a period of uncertainty could not only alleviate the negative effects of uncertainty but also contribute to medium‐term economic growth. The analysis of channels suggests that this effect is mediated by the impact of reforms on household consumption and business investment. These results highlight how pro‐market institutions and reforms in these institutions can enhance the resilience of economies facing high uncertainty or unexpected and substantial economic shocks.