“To Julius, I hope this can inspire something much better”
(referencing the fact that I should abandon Macroeconomics in favor of something “better”, i.e. Development/Institutional economics, thus explaining the genesis of this post)
Anyways, based on many years of research, these two authors have presented in their book in my view the only coherent and factually accurate theory that can explain why some nations are rich and others are poor. It is a fascinating read! It provides a number of very interesting examples, both historical and contemporary, and I would strongly advise anyone who is interested in these issues to buy the book!
Just as the authors did, I will start by introducing some theories about why some countries are and remain poor that are very popular both inside and outside of academia. The authors’ extensive research, however, shows that under thorough investigation all of these theories cannot really stand up to the facts. Subsequently, I will present Acemoglu and Robinson’s (henceforth A&R) theory of economic development discussed in their book.
The cultural hypothesis:
The cultural hypothesis asserts that some countries are richer than others because of their cultural attributes. This idea goes back to the German sociologist Max Weber who wrote that Protestants have a superior work ethic than Catholics, thus seemingly explaining why 19th century Great Britain and Germany were richer than Spain or Italy, for example. The modern proponents of the cultural hypothesis often take Asian countries as an example. They claim that the recent astonishing growth performance of some countries in East Asia is related to their cultural attributes. A&R, however, explain that the cultural hypothesis is not supported by the data and they provide a number of examples that directly violate this hypothesis.
- Countries in North America (Canada, USA), Western Europe, and East Asia (Korea, Japan, Taiwan) clearly have very diverse and differentiated cultural backgrounds. Nonetheless, all these countries are today among the industrialized high-income nations.
- Korea was characterized by a very homogeneous culture before the 1950s. The Korean War, however, split up the country into two different parts. North Korea became one of the poorest countries in the world whereas South Korea is now among the high-income industrialized nations. This difference cannot be explained by cultural attributes since the two countries clearly have the same cultural background.
- The city of Nogales is a border town between the USA and Mexico. In the past, the entire region belonged to Mexico (until the mid-1850s). The people to both sides of the border share the same ancestors and cultural background. Nowadays the city is cut in half by a fence separating Mexico from the U.S. Inhabitants of the American part of the city have on average fairly high levels of income. Furthermore, they also enjoy relatively high quality infrastructures (electricity, sewage system, public schools, health care system) provided by the U.S. state. South of the border in the Mexican part people have a very different life style. They are significantly poorer and do not enjoy most of the infrastructures just mentioned that the U.S. government provides to its citizens. Again, this difference cannot be explained by cultural differences.
The geographical hypothesis:
The geographical hypothesis claims that some countries are richer than others because they have a favorable geographical location. Again, A&R explain that this hypothesis is not confirmed by the data and they provide a number of examples. The geographical hypothesis cannot explain why North Korea is so much poorer than South Korea, why West Germany did so much better than East Germany, and why there is such a big difference in economic development between the Mexican and the American part of the city of Nogales.
The map below shows that most industrialized countries are located in the more moderate climatic zones located further away from the equator, thus seemingly supporting the climate hypothesis. Over large periods in human history, however, states in the North were actually much poorer than regions in the South. Take the Americas, for example. Before colonization, the Maya and the Incas had relatively developed societies. The Inca state, for example, was centralized and basic infrastructures existed (roads, cities, even some kind of postal service!). This is in stark contrast to North America where many indigenous people resided in very primitive habitations. They lived mostly in small groups and no centralization of any form was achieved. Nowadays North America is obviously much more prosperous than the South. The climate hypothesis, however, cannot explain why this so-called ‘reversal of fortune’ (A&R) took place: The climate is the one factor that stayed constant whereas other factors – institutions – changed significantly over time.
The ignorance hypothesis:
The proponents of this theory claim that leaders in developing countries somehow just do not know what kind of policies would lead to economic growth and prosperity. However, the fact is that, given the institutional setup in many countries, local elites simply do not have any incentive to change the status quo. A&R explain that extracting resources from the local population is often simply preferred to policies that lead to economic growth because such policies could ultimately undermine the power of the elites.
So what factors can predict the success and failure of nations over time?
A&R provide a relatively simple and straightforward answer: it’s all about institutions.
Economic growth in the long-run is mostly determined by productivity growth. Productivity growth depends crucially on the capitalist system to provide the right incentives for individuals and firms. Inventions and ideas are rewarded, creative destruction ensures that uncompetitive firms and unsound business models do not survive for long, and authorities hopefully ensure that welfare destroying monopolies do not get entrenched in the economy. It is this system that has led to unprecedented economic growth for some nations since the beginning of the Industrial Revolution in Great Britain.
A&R observe that this system crucially depends on inclusive political and inclusive economic institutions (definition given below), and basically any rich country today finds itself in the top left corner in the following diagram.
Inclusive political institutions:
Inclusive political institutions are those that distribute power broadly in society and ensure that individuals are on equal footing. These institutions rely on the existence of a powerful and centralized state that can enforce the rule of law in society. Obviously, democratic states fit the description just given above. Needless to say, extractive political institutions share the opposite characteristics. Political power is in the hand of a few individuals instead of society as a whole.
Not every so-called democracy, however, has inclusive political institutions or even a powerful state. In countries like Mexico, a democracy, some people definitely seem to have a “more equal footing” than others, especially those with a lot of money. They can bribe officials and authorities and consequently tilt political power in their favor. Also, the Mexican state seems to be very powerless in enforcing the law as drug cartels have killed thousands of people over the last couple of years.
Inclusive economic institutions:
An economy with inclusive economic institutions has a functioning legal system, secure property rights, and competitive markets. The economic system rewards innovation and ideas and provides individuals with incentives to work. Entrepreneurial activities and creative destruction are key. Individuals are supposed to interact on a level playing field. All industrialized countries exhibit an economic system that fulfills these requirements. Other countries, like Mexico, do not. Carlos Slim, one of the three richest men in the world, made his money largely with monopolies, in particular telecommunications. He bought the Mexican phone company when it was privatized and obtained it even though he even wasn’t the largest bidder! As a result of no competition, phone prices in Mexico are extremely high (compared to incomes). Countries like the USA on the other hand have relatively successful antitrust laws that prevent firms from engaging in excessive and illegal rent-seeking activities.
So how do countries end up in the upper left corner of the diagram where both economic and political inclusiveness is fulfilled?
It turns out that the answer to this question is not that straightforward. It took many countries hundred of years to democratize and set up inclusive economic institutions. There are many events in history, which had enormous consequences for the future. A&R call them critical junctures. They explain that these critical junctures can affect nations in such way that small institutional differences can add up over time. A&R call this cumulative divergence institutional drift.
The best example of such a critical juncture, a historical event with huge consequences for the rest of the world and leading to institutional drift, is the discoveries of the Americas. A&R highlight that the institutional difference between the colonial powers was not that big in the beginning.
Let’s take Spain, France and England as an example. All these countries were monarchies in the beginning of the 15th century. These countries were ruled by a monarch and a very select aristocratic elite. The rights of normal citizens on the other hand were very limited.
After the discovery of the New World it seemed relatively clear that Spain would be the unchallenged winner in the ‘game’ of colonization. Indeed, the Spanish crown managed to quickly grab the most ‘valuable’ pieces of land in the Americas. Precious metals such as silver and gold were found in enormous quantities in countries like Mexico, Bolivia, Peru, all of them Spanish territories. The English on the other hand, to some extent latecomers to the ‘game’ of colonization, were stuck with the ‘invaluable’ and sparsely settled territories in North America. In the next 200-300 years, however, it would become clear that not Spain or France but the latecomer England benefited the most from the discovery of the New World.
So why is that?
It turns out that both the French and even more so the Spanish monarchy monopolized all trade coming from the new colonies. The Spanish exploited the indigenous people in the colonies and only used these territories for extracting resources, which would end up in the treasuries of the Spanish crown. The accumulation of gold and silver, however, does not lead to economic growth. Economic growth, as mentioned above, relies on productivity growth, technological progress and creative destruction. The monopolization of trade and the hording of precious metals by both the French and the Spanish monarchs did in no way benefit their respective citizens.
The English story, however, is somewhat different. In England, trade with the new world was not entirely monopolized by the state. Merchants started to play a crucial role. The emergence of a prosperous class of merchants led to more inclusive political institutions as these people demanded more and more civil liberties from the crown. Indeed, there was what A&R call a positive feedback loop. In England, the development of more inclusive political institutions also led to more inclusive economic institutions and these, in turn, positively influenced the development of even more inclusive political institutions, and so on.
It thus should not be a surprise that the Industrial Revolution 3 centuries later started in Great Britain, which was at that time the country with the most inclusive political and economic institutions in the world. The economies of France and especially Spain, on the other hand, did not grow as quickly as the English economy after colonization of the Americas because institutions were highly extractive in these two countries.
Great Britain is the example that shows how countries can successfully end up in the top left corner of the diagram. A&R explain that for many nations the change towards more political inclusive institutions came first. This can (but does not necessarily have to) be followed by the development of more inclusive economic institutions. Indeed, many countries followed the route illustrated by the blue arrows below. My next post will discuss how the alternative (red arrows) as a path towards success is more unlikely.
Acemoglu and Robinson: Why Nations Fail
Their blog: http://whynationsfail.com/