Why Nations Fail: The Origins of Power, Prosperity and Poverty
Daron Acemoglu and James Robinson
New York: Crown Publishers, 2012
Institutions, Institutional Change and Economic Performance
Douglass C. North
London: Cambridge University Press, 1990
Several theories of economic development have received attention in the popular press in recent years, even though many of these are based on non-economic foundations. For example, in Guns, Germs and Steel (1997) and Collapse (2005) Diamond presents a largely economic history of the world as determined by geographic and ecological factors. According to Diamond, Western Europe’s dominant role in global affairs, from the 17th century on, can largely be attributed to East-West trade routes, the domestication of certain species, resistances to certain diseases and balkanization. Diamond believes that the latter encouraged greater competition and, eventually, served as the catalyst of European Imperialism.
Another theory was advocated by Landes in The Wealth and Poverty of Nations (1998). Close followers of American politics are probably most familiar with (an incredibly simplified version of) this theory thanks to comments from Republican Presidential candidate Mitt Romney. He tried to explain the differences in wealth between Israel and the occupied Palestinian territories as the result of Israel’s “superior culture.” The ideas that largely cultural factors – like punctuality, industriousness and the willingness to embrace entrepreneurial risk – determine national success is quite old. Weber, for example, wrote about them in The Protestant Work Ethic and the Spirit of Capitalism (2009).
These two theories, along with several others, are decisively dispelled in Acemoglu and Robinson’s new book, Why Nations Fail (2012). By analyzing a series of natural experiments, the authors show the extreme limitations of theories about geography and culture. One of their most famous cases involves the city of Nogales, which lies on the US/Mexico border, between the states of Arizona (US) and Sonora (Mexico). The two sides of the border share similar heritage, culture, geography and climate. Many people living on one side frequently visit friends and relatives on the other. The only substantial difference between the two sides is national affiliation.
Despite these deep similarities, the two halves of Nogales exhibit remarkably different levels of development. The northern half of Nogales has an average household income of $30,000 a year. South of the border, per capita income is about one third of that amount. Average life spans are longer in the north. Children, on average, spend more years in school. Infant mortality is lower. Public infrastructure is much more developed. Political corruption is much lower. In most meaningful ways, the level of development north of the border is substantially higher than that to the south.
You cannot explain these differences with the theories of Landes and Diamond. The majority of citizens of both Nogaleses shares a common ancestry, traditions, even language. The river dividing the two cities does not create one climate north of the border and one to the south. So what’s going on? As the authors write,
Of course, there is a very simple and obvious explanation for the differences between the two halves of Nogales that you’ve probably long since guessed: the very border that defines the two halves. Nogales, Arizona, is in the United States. Its inhabitants have access to the economic institutions of the United States, which enable them to choose their occupations freely, acquire schooling and skills, and encourage their employers to invest in the best technology, which leads to higher wages for them. They also have access to political institutions that allow them to take part in the democratic process, to elect their representatives, and replace them if they misbehave. In consequence, politicians provide the basic services (ranging from public health to roads to law and order) that the citizens demand. Those of Nogales, Sonora, are not so lucky. They live in a different world shaped by different institutions. These different institutions create very disparate incentives for the inhabitants of the two Nogaleses and for the entrepreneurs and businesses willing to invest there. These incentives created by the different institutions of the Nogaleses and the countries in which they are situated are the main reason for the differences in economic prosperity on the two sides of the border.
The existence of different political and economic institutions does more than explain the differences between the two halves of Nogales, a similar framework can be applied to explain the differences between North and South Korea, where the former is one of the poorest nations on earth and the latter is one of the richest. Institutions are key to Botswana’s explosive economic growth, despite the extreme poverty of most its neighbors and the huge development challenges it faces as a landlocked country in Sub-Sahara Africa. In fact, the lasting effects of certain political and economic institutions are visible throughout the world, explaining the vast majority of differences between rich and poor nations.
Rich nations are universally characterized by inclusive political institutions, which allow for a diversity of political actors that hold elites accountable for their actions. These political institutions are reflected in economic institutions, where property rights and the rule of law are respected. Inclusive economic institutions reward risk, encourage investment, promote the development of human capital and provide strong public goods for individual actors to share and enjoy.
Countries with weak, non-inclusive political institutions predominantly feature extractive economic institutions. The elite use their political power to extract wealth from the rest of the populace. This process stifles economic innovation, since entrepreneurs are not rewarded for taking their own risks. It encourages sclerosis and decline, as favored industries are protected and creative destruction is snuffed out. Most importantly, extractive institutions are highly unstable. Warring groups of elites can become locked into cycles of strife over the control of key national resources, like diamonds, oil or the drug trade.
Acemoglu and Robinson highlight the characteristics of inclusive and extractive institutions in a whirlwind tour of economic history. They pay particular attention to the Glorious Revolution in England, which established a process for greater political inclusion and built the foundations for the industrial revolution. They contrast this moment with the political history of Spain, Britain’s richer adversary and chief competitor during the age of Imperialism. While political institutions in Britain forced its monarchy to relinquish the control over trade, creating a merchant class that formed the backbone of the country’s political system, the Spanish monarchy monopolized all colonial trade to finance its own costly wars. Over the next three centuries, political power would become progressively more diffuse throughout English society while it became more concentrated in Spain. England flourished, bringing modern industrial capitalism to the world. Spain stagnated.
While the application of political institutions to development theory is novel, much of the authors’ understanding of institutions and the process of institutional change comes from Nobel Laureate Douglass C. North. A reference to the analytical framework the North defines in Institutions, Institutional Change and Economic Performance (1990) does much to illustrate the theory of Acemoglu and Robinson. For example, North provides a clear and explicit definition of institutions, something the authors of Why Nations Fail strangely neglect. As North writes,
Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interactions. In consequence, they structure incentives in human exchange, whether political, social or economic. Institutional change shapes the way societies evolve through time and hence is the key to understanding historical change.
To use the language of North, societies characterized by extractive institutions have higher transaction costs. Corruption, disregard for the rule of law and nepotism continually interfere with the basic elements of economic development: the accumulation of physical capital, the development of human capital and the expansion of technology. The most notable elements of failed states – plutocracy, authoritarianism and civil war – are all the result of perverse incentive structures, where resource accumulation for personal gain is much more desirable than the promotion of broad social development.
North’s framework is also at the heart of Acemoglu and Johnson’s definition of institutional change and of how some nations escape the trap of extractive institutions. For North, organizations are the key actors within societies, and their efforts to fulfill specific organizational goals drive institutional change. Acemoglu and Johnson would add that a diversity of organizations within a society both spurs greater innovation and change while preventing one organization from using its political and economic power from suppressing others.
For most economists raised in the neoclassical tradition, the study of institutions is unfamiliar terrain. How can we go about measuring the effectiveness of institutions? Where is the index of political egalitarianism? North asserts that we should return to Coase’s “The Nature of the Firm” (1937) and pay particular attention to his theory of transaction costs. While we may not be able to measure institutional effectiveness directly, an understanding of transaction costs and the sources of these costs can do much to illustrate the operation of institutions.
Most importantly, the work of Acemoglu, Johnson and North forces economists to acknowledge a sometimes inconvenient fact: politics matter. While neoclassical models are based on a frictionless world that promotes optimal solutions, the actual allocation of resources in a society has much more to do with political power than most of us are comfortable admitting. More traditional models of public choice, like those often attributed to James M. Buchanan, tend to view governments as comprised of agents set on maximizing their own utility. A broader understanding of political economy and economic institutions would assert that government is a set of tools that are exploited by specific organizations for the benefit of their members; organizations are perpetually locked in competition over control of these tools. The stakes in this organized combat are high, both in the immediate and long term. As Acemoglu and Robinson point out, they often determine whether a country experiences lasting prosperity or sustained poverty.
This article was originally published in the CSS Research Bulletin at KIMEP University.
References
Acemoglu, D., and Robinson, J. A. (2012). Why nations fail: The origins of power, prosperity and poverty. New York: Crown Publishers.
Buchanan, J. M., & Liberty Fund. (1999). The collected works of James M. Buchanan. Indianapolis, IN: Liberty Fund.
Coase, R. H. (1937). The Nature of the Firm. Economica. Volume 4, Issue 16, pages 386–405, November
Diamond, J. M. (1998). Guns, germs, and steel: The fates of human societies. New York: W.W. Norton & Co.
Diamond, J. M. (2005). Collapse: How societies choose to fail or succeed. New York: Viking.
Landes, D. S. (1998). The wealth and poverty of nations: Why some are so rich and some so poor. New York: W.W. Norton.
North, D. C. (1990). Institutions, institutional change, and economic performance. Cambridge: Cambridge University Press.
Weber, M., and Kalberg, S. (2009). The Protestant ethic and the spirit of capitalism: With other writings on the rise of the West. New York: Oxford University Press.
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