By Daren Acemoglu and James A. Robinson –
“Acemoglu and Robinson…show how institutional developments…have had enormous consequences. The openness of a society, its willingness to permit creative destruction, and the rule of law appear to be decisive for economic development.” – Kenneth Arrow, Nobel laureate in economics, 1972
In reviewing the dramatic differences between American cities and Mexican cities it is important to understand why they are different. Americans have political institutions that allow them a role in the democratic process. They can elect their representatives and replace them when necessary, so politicians provide the basic services they need. Mexican towns and cities are shaped by different institutions which create very different incentives for both the politicians and the citizens. Understanding why these differences exist and what causes them is the focus of this book.
The motivation behind the Mexican Declaration of Independence from Spain was to protect the set of economic institutions developed during the colonial period. These institutions, by basing the society on the exploitation of indigenous people and the creation of monopolies, blocked the economic incentives of the great mass of the population.
The United States is far richer than Mexico or Peru because of the way its institutions, both economic and political, shaped the incentives of businesses, individuals, and politicians. Each society functions with a set of economic and political rules created and enforced by the state and citizens collectively. Economic institutions shape economic incentives: the incentive to become educated, to save and invest, to innovate and adopt new technologies, and so on. It is the political process that determines what economic institutions people live under, and it is the political institutions that determine how this process works. It is the political institutions of a nation that determine the ability of citizens to control politicians and influence how they behave. This in turn determines whether politicians are agents of the citizens, or are able to abuse the power they have to amass their own fortunes and pursue their own agendas, ones detrimental to those of the citizens. Political institutions include the power and capacity of the state to regulate and govern society. It is important to consider the factors that determine how political power is distributed in a society, particularly the ability of different groups acting collectively to pursue their objectives and to stop others from pursuing theirs.
Institutions influence the behavior and incentives that forge the success or failure of Nations. Individual talent needs an institutional framework to transform it into a positive force. The American economy works because political power is both limited and distributed sufficiently broadly that a set of economic institutions that create the incentives for prosperity could develop. It is politics and political institutions that determine what economic institutions the country has and political and economic institutions interact in causing poverty or prosperity.
The authors’ theory of world inequality shows how political interests and economic institutions interact in causing poverty or prosperity, and how different parts of the world ended up with such different sets of institutions.
Once society gets organized in a particular way it tends to persist. This persistence and the forces that created it also explain why it is so difficult to remove world inequality and to make poor countries prosperous. Societies that do not develop institutions that are best for the economic growth and welfare of their citizens do not because other institutions are better for those who control politics and political institutions.
What rules society ends up with is determined by politics: who has the power and how this power can be exercised. The authors’ theory examines the effects of institutions on the success and failure of nations’ prosperity – thus the politics of poverty and prosperity.
Chapter 2 – Theories That Do Not Work
What explains the persistent ranking of inequality within the Americas? Why have sub-Saharan African and Middle Eastern nations failed to achieve the type of economic growth seen in Western Europe, while much of East Asia has experienced a breakneck rate of economic growth?
Most hypotheses that social scientists have proposed for the origins of poverty and prosperity do not work.
The prime determinant of why agricultural productivity is so low in many poor countries is ownership structure of the land and the incentives that are created for farmers by the governments and institutions they live under.
The great inequality of the modern world that emerged in the 19th century was caused by the uneven dissemination of industrial technologies and manufacturing production.
Deng Xiaoping had different interests and political objectives then his opponents in the Communist Party and masterminded a political revolution of sorts, radically changing the leadership and direction of the party. The economic reforms, which created market incentives in agriculture and then subsequently in industry, followed from this political revolution. It was politics that determined the switch from communism and toward market incentives in China, not just a better understanding of how the economy worked.
To understand world inequality we have to understand why some societies are organized in very inefficient and socially undesirable ways. Most economists and policymakers have focused on getting it right while what is really needed is an explanation for why poor nations get it wrong. Poor countries are poor because those who have power make choices that create poverty. They do it on purpose. To understand this you need to study how decisions actually get made, who gets to make them, and why they decide to do what they do. This is the study of politics and political processes. Traditionally, economics has ignored politics, but understanding politics is crucial for explaining world inequality. Achieving prosperity depends on solving basic political problems. Economics has not been able to come up with a convincing explanation for world inequality because it assumes political problems are solved.
Chapter 3 – The Making Of Prosperity And Poverty
To be inclusive, economic institutions must feature secure private property, an unbiased system of law that provides a level playing field, and the provision of public services; it also must permit the entry of new businesses and allow people to choose their careers.
As a general principle, inclusive economic institutions foster economic activity, productivity growth, and economic prosperity. Secure private property rights are central, since only those with such rights will be willing to invest in increased productivity, and those rights must exist for the majority of people in the society. Inclusive economic institutions require secure property rights and economic opportunities, not just for the elite, but for a broad cross-section of society.
Secure property rights, the law, public services, and the freedom to contract and exchange all rely on the state, the institution with the coercive capacity to impose order, prevent theft and fraud, and enforce contracts between private parties. The degree of coordination to provide the infrastructure for prosperity requires a central authority. The state is thus inexorably intertwined with economic institutions, as the enforcer of law, and private property protections and contracts, and is a key provider of public services. Institutions that have the opposite properties from inclusive institutions are extractive economic institutions – extractive because such institutions are designed to extract incomes and wealth from one subset of society to benefit a different subset.
Inclusive economic institutions pave the way for other engines of prosperity: technology and education. Sustained economic growth is always accompanied by technological improvements that enable people to become more productive.
The climate most favorable for innovation is when economic institutions encourage private property, enforce contracts, create a level playing field, and favor the entry of new businesses that can bring new technologies to life.
The ability of economic institutions to harness the potential of inclusive markets, encourage technological innovation, invest in people, and mobilize the talents and skills of large number of individuals is critical for economic growth. Explaining why so many economic institutions fail to meet these objectives is the theme of the book
Politics is the process by which a society chooses the rulers. Politics determines the types of institutions because some people or groups will be much better off by setting up institutions that are extractive. When there is conflict over institutions, what happens depends on what people or group wins out in the game of politics – in short, who wins depends on the distribution of political power in society.
The political institutions of the society are a key determinant of the outcome of this game. They are the rules that govern incentives. They determine how the government is chosen and which part of the government has the right to do what. Political institutions determine who has power in society and to what end that power can be used.
Political institutions that distribute power broadly in society and subject it to constraints are pluralistic. There is a close connection between pluralism and inclusive economic institutions. But successful pluralistic and inclusive economic institutions have to be supported by sufficiently centralized and powerful states.
There is a strong synergy between economic and political institutions. Extractive political institutions concentrate power in the hands of a narrow elite. Extractive economic institutions that naturally accompany extractive political institutions depend on those political institutions for that form of society’s survival. Inclusive political institutions, vesting power broadly, would tend to uproot economic institutions that expropriate the resources of the many, wreck entry barriers, and suppress the functioning of markets so that only a few benefit.
The resources these extractive economic institutions generate enable their elites to build armies and security forces to defend their monopoly of political power, so these political and economic institutions support each other and tend to persist. The insidious nature of such extractive institutions and the synergy between extractive political and economic institutions is such that when newcomers break through and overthrow such a regime they have strong incentives to maintain the same political and economic arrangements.
Nations fail when they have extractive economic institutions supported by extractive political institutions that impede and even block economic growth. Understanding the politics of institutions is central to understanding the reasons for the success and failure of nations.
Economic growth is a transformative and destabilizing process associated with widespread creative destruction. Growth is resisted both by its economic losers and by elites who fear their political power will be eroded.
Conflict over scarce resources, income, and power, causes conflict over the rules of the game, the economic institutions which will determine the types of economic activities and who will benefit from them. Who the winners of this conflict are has fundamental implications for a nation’s economic trajectory.
There are two distinct but complementary ways for growth under extractive political institutions: first, when elites can directly allocate resources to high productivity activities that they control; second, when the development of somewhat more inclusive economic institutions is allowed. By their very nature, extractive institutions do not foster creative destruction and generate only a limited amount of technological progress.
Extractive political and economic institutions create a tendency for infighting because they lead to the concentration of wealth and power in the hands of a narrow elite. If another group can seize control of the state, they will be the ones enjoying this wealth and power. Fighting to control the all-powerful state is always latent, and it will periodically intensify and bring down these regimes, as it turns into civil war and sometimes into a collapse of the state.
Chapter 4 – Small Differences In Critical Junctures: The Weight Of History
England was unique among nations when it made the breakthrough to sustained economic growth in the 17th century. Major economic changes were preceded by a political revolution that brought a distinct set of economic and political institutions much more inclusive than those of any previous society. These institutions would have profound implications, not only for economic incentives and prosperity, but also for who would reap the benefits of prosperity. They were based not on consensus but were the result of intense conflict as different groups competed for power and attempted to structure institutions in their own favor. The culmination of the institutional struggles was two landmark events: the English Civil War between 1642 and 1651, and particularly the Glorious Revolution of 1688. The Glorious Revolution limited the power of the king and the executive, and relocated to Parliament the power to determine economic institutions. At the same time it opened up the political system to a broad cross-section of society who were able to exert considerable influence over the way the state functions. The Glorious Revolution was the foundation for creating a pluralistic society, and it built on and accelerated a process of political centralization. It created the world’s first set of inclusive political institutions.
Formerly the English government engaged in arbitrary taxation and manipulated the legal system. There were many restrictions on the economic activities people could engage in. This changed after the Glorious Revolution. The government adopted a set of economic institutions that provided incentives for investment, trade, and innovation. It steadfastly enforced property rights, including patents granting property rights for ideas, thus providing a major stimulus to innovation. It protected law and order. Historically unprecedented was the application of English law to all citizens. These foundations decisively changed incentives for people and invigorated the engines of prosperity. The Industrial Revolution depended on major technological advances exploiting the knowledge base that had accumulated in Europe during past centuries. It was a radical break from the past, made possible by scientific inquiry and the talents of unique individuals. The full force of this revolution came from the market that created profitable opportunities for technologies to be developed and applied. It was the inclusive nature of markets that allowed people to allocate their talents to the right lines of business. It also relied on high levels of education.
During critical junctures, a major event or confluence of factors disrupts the existing balance of political or economic power in the nation. Such critical junctures are important because there are formidable barriers against gradual improvements, resulting from the synergy between extractive political and economic institutions and the support they give each other. The persistence of this feedback loop creates a vicious circle. Those who benefit from the status quo are wealthy and well organized, and can effectively fight major changes that will take away their economic privileges and political power.
In thinking about the effects of the Glorious Revolution in England consider: how these institutions persisted and became strengthened to lay the foundations for the Industrial Revolution, thanks in part to the virtuous circle and in part to fortunate turns of contingency; and how the vicious circle and iron law of oligarchy have created a powerful tendency for extractive institutions to persist, so the lands where the Industrial Revolution originally did not spread remain relatively poor.
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Numerous experiments were tried by the Communist Party in Russia to make the economy more efficient, but as long as political authority and power rested with the Communist Party it was impossible to fundamentally change the basic incentives that people faced. Between 1940 and 1955, 36 million people, were found guilty of economic offenses. Of these, 15 million were sent to prison and 250,000 were shot. This was a desperate and diabolical attempt to offset the barriers to productivity created by the system’s blocking of rationally designed incentives.
The fact that truly effective incentives could not be introduced in the centrally planned economy of the Soviet Union was intrinsic to the whole method by which extractive growth had been achieved – by government command, which could solve some basic economic problems but sustained economic growth required that individuals use their talent and ideas, and this could never be done with the Soviet style economic system.
Throughout history most societies have been ruled by extractive institutions. They are so common because they have a powerful logic: they can generate limited prosperity whose benefits can be allocated to a small elite. The potential for creating extractive growth gives an impetus to political centralization.
Chapter 6 – Drifting Apart
At one point Venice was possibly the richest place in the world, with the most advanced set of inclusive economic institutions. The economic expansion of Venice was initiated by a series of contractual innovations making economic institutions much more inclusive. The economic expansion of Venice created more pressure for political change. The first important innovation was the creation of the Great Council, the ultimate source of political power in Venice. Political reforms led to a series of institutional innovations in law, the creation of independent magistrates, courts, Court of Appeals, the new private contract and bankruptcy laws etc. These new Venetian economic institutions allowed the creation of new legal business forms and new types of contracts. There was rapid financial innovation, and the beginnings of modern banking. The dynamic moving Venice toward fully inclusive institutions looked unstoppable. But as each new wave of enterprising young men became rich, which tended to reduce the profit and economic status of established elites, there was a temptation for the existing elites on the Great Council to close down the system to these new people. Once they did so Venetian prosperity began its decline because the switch to extractive political institutions led to extractive economic institutions.
The Roman Republic cleverly designed political institutions with many inclusive elements. The Republic’s institutions contained a system of checks and balances that distributed power fairly widely and the political institutions had pluralistic elements. The Plebeians had their own Assembly which could elect the Plebeian Tribunes, who had the power to veto actions by the Magistrate and propose legislation.
As in Venice, Rome’s initial economic success was based on inclusive institutions. These institutions became decidedly more extractive over time as a consequence of the change from the Republic (510 BC – 49 BC) to the Empire (49 BC – A.D. 476) and even during the Republic much of the Roman economy was based on extraction. The transition from Republic to Empire increased extraction and ultimately led to the kind of infighting, instability and collapse that are seen in the history of so many other societies.
Western Europe’s subsequent institutional development was a consequence of critical junctures that were common across the region in the wake of the collapse of the Western Roman Empire. These critical junctures had little parallel in other parts of the world. Roman decline led to feudalism, which caused slavery to wither away, brought into existence cities that were outside the sphere of influence of monarchs and aristocrats, and in the process created a set of institutions where the political powers of rulers were weakened. It was on this feudal foundation that the Black Death would create havoc and further strengthen independent cities and peasants at the expense of monarchs, aristocrats, and large landowners. Most other parts of the world did not undergo these changes, and in consequence drifted apart.
Though not much richer than the most spectacular Asian civilizations in India or China, Europe differed from these polities in some key ways. It had developed representative institutions of the sort unseen there. These would play a critical role in the development of inclusive institutions. Small institutional differences would really matter within Europe, and these favored England, because it was there that the feudal order had made way most comprehensively for commercially minded farmers and independent urban centers where merchants and industrialists could flourish. These groups were already demanding more secure property rights, different economic institutions, and political voice from the monarchs. The whole process would come to a head in the 17th century.
Chapter 7- The Turning Point
The fear of creative destruction is the main reason why there was no sustained increase in living standards between the Neolithic and The Industrial Revolutions. Technological innovation makes human society prosperous, but also involves the replacement of the old with the new, and the destruction of the economic privileges and political power of certain people. For sustained economic growth we need new technologies, new ways of doing things, and they usually come from newcomers. It may make society prosperous, but the process of creative destruction that it initiates threatens the livelihood of those who work with old technology.
More important, major innovations also threaten to reshape political power. The elite, especially when their political power is threatened, form a formidable barrier to innovation. The fact that they have much to lose from creative destruction means that they will often resist and try to stop such innovations. Society needs newcomers (those formerly outside the elite group) to introduce the most radical innovations, and these newcomers and the creative destruction they wreak must often overcome several sources of resistance, including that from powerful rulers and elites.
Conflict over institutions and the distribution of resources have been pervasive throughout history.
Centralization of state institutions means that inclusive political institutions become possible because they can increase the demand for broader based political representation. But the process of political centralization can actually lead to absolutism because it allows the rulers to crush other powerful groups in society. In opposition to this force, the centralization of a state’s institutions can also mobilize demand for a nascent form of pluralism, as it did in England when the barons and local elites recognized political power would become increasingly more centralized, so demanded a say in how the centralized power was used. They made a great effort to have Parliament as a counterweight against the Crown and to partially control the way the state functions. The Tudor project, not only initiated political centralization, one pillar of the inclusive institutions, but also contributed to pluralism, the other pillar of inclusive institutions. In England political power was being redistributed not simply from the king to the Lords, but also from the elite to the people, which made the emergence of a broad coalition opposed to absolute rule possible and thus laid the foundations for pluralistic political institutions.
In 1688 after the victory in the Glorious Revolution, Parliament and William negotiated a new constitution. This was followed by the Declaration Of Rights produced by Parliament in 1689. After England and Scotland were united by the Act Of Union in 1707 Parliament was firmly in control of state policy which made a huge difference. Many of those in Parliament had important investments in trade and industry and had a strong stake in enforcing property rights.
The level of state infrastructure developed shortly after the Glorious Revolution exceeded what governments of most poor countries can achieve even today and this was in 1710.
The Industrial Revolution affected every aspect of the English economy. The most significant area of innovation was the mechanization of textile production and the development of factories to produce it. This dynamic process was unleashed by the institutional changes that flowed from the Glorious Revolution. There was a fundamental reorganization of economic institutions in favor of innovators and entrepreneurs, based on the emergence of more secure and efficient property rights.
By 1760 the combination of improved and new property rights, improved infrastructure, a changed fiscal regime, greater access to finance, and aggressive protection of traders and manufacturers was beginning to have an effect. After this date, there was a jump in the number of patented inventions, and the great flowering of technological change that was to be at the heart of the Industrial Revolution. Innovations took place on many fronts, reflecting the improved institutional environment.
The English textile industry not only was the driving force behind the Industrial Revolution but also revolutionized the world economy. Factories were a completely new way of organizing production.
It was the growth in this sector that pulled forward the whole economy. The combination of technological and organizational innovation provided a model for economic progress that transformed the economies of the world, and those nations that implemented these transformative institutional changes became rich. New people with new ideas were crucial to this transformation.
Creative destruction redistributes not only income and wealth, but also political power. In 1932 England passed the First Reform Act which enfranchised the major manufacturing cities and broadened the base of voting so manufacturers could be represented in Parliament. This shift in political power moved policy in the direction favored by these newly represented interests. This success in changing laws that handicapped them demonstrated again that creative destruction meant a redistribution, not just of income, but also of political power, which would lead to further redistributions of income.
The Industrial Revolution started in England because of uniquely inclusive economic institutions. These were built on foundations laid by inclusive political institutions brought about by the Glorious Revolution that strengthened and rationalized property rights, improved financial markets, undermined state sanctioned monarchical monopolies, and removed the barriers to the expansion of industry. It made the political system open and responsive to the economic needs and aspirations of society. These inclusive economic institutions gave men of talent and vision the opportunity and incentive to develop their skills and ideas and influence the system in ways that benefited both them and the nation.
Why did this process start in England and why in the 17th century? Why did England develop pluralistic political institutions and break away from extractive institutions? The Glorious Revolution was shaped by several interlinked processes. Central was the political conflict between absolutism and its opponents. The outcome of the conflict put a stop to attempts to create a renewed absolutism in England and also empowered those seeking to fundamentally change the institutions of society. The opponents of absolutism did not simply attempt to build a different type of absolutism. The Glorious Revolution established a new regime based on constitutional rule and pluralism. This outcome was a consequence of the evolution in English institutions and the way they interacted with critical junctures.
The Glorious Revolution was a momentous event because it was led by a broad coalition, which forged a constitutional regime with constraints on the power of both the executive and, equally crucially, its own members. It meant that there were checks within Parliament against any single group becoming too powerful and abusing its power. This was the critical factor in the emergence of pluralistic political institutions.
Chapter 8 – Not On Our Turf: Barriers To Development
After the invention of the printing press and its spread the Ottoman Empire heavily restricted its use. This opposition to printing had the obvious consequences for literacy, education, and economic success. In 1800 probably only 3% of the citizens of the Ottoman Empire were literate compared with 60% of adult males and 40% of adult females in England.
Given the highly absolutist institutions, the sultans’ hostility to the printing press is easy to understand. Books spread ideas and make the population much harder to control. Some of these new ideas may be valuable new ways to increase economic growth, but others may be subversive and challenge the existing political and social status quo.
The Industrial Revolution created a critical juncture that affected almost every country. Some nations actively encouraged commerce and industrialization, and grew rapidly. Many, such as the Ottoman Empire, China, and other absolutist regimes, lagged behind as they either blocked or failed to encourage the spread of industry. Political and economic institutions shape the response to technological innovation, creating the familiar pattern of interaction between existing institutions and critical junctures leading to the divergence in institutions and economic outcomes.
The reason the economic changes that took place in England did not happen in the Ottoman Empire is the natural connection between extractive, absolutist political institutions and extractive economic institutions. Absolutism is rule unconstrained by law. These narrow power groups in the Ottoman Empire, China, and the like, organized political institutions whose primary focus was to perpetuate their power.
Absolutism was not the only type of political institution preventing industrialization, without a centralized state to provide order and enforce rules of property rights, inclusive institutions could not emerge.
Absolutism and a lack of, or weak, political centralization are two different barriers to the spread of industry. But both are kept in place by fear of creative destruction.
Resistance to political centralization is motivated by reasons similar to resistance to inclusive political institutions: fear of losing political power, this time to the newly centralizing state and those who control it. The process of political centralization under the Tudor monarchy in England increased demands for representation in national political institutions by different local elites as a way offsetting their loss of local political power. A stronger Parliament was thus created, enabling the development of inclusive political institutions.
But in many other cases, just the opposite takes place, where the process of political centralization ushers in an era of greater absolutism, as in Russia under Peter the Great.
Without the changes in political institutions and political power similar to those of England after 1688, there was little chance for absolutist countries to benefit from the innovations and new technologies of the Industrial Revolution.
In Russia and Austria-Hungary the rulers actively blocked any attempt to introduce new technologies and basic investments in infrastructure such as railroads.
Just at the time when international trade and the discovery of the Americas were fundamentally transforming the institutions of England, China was cutting itself off from this critical juncture by turning inward. The consequence of absolutist control of the economy was predictable: the Chinese economy was stagnant throughout the 19th and early 20th centuries while other economies were industrializing. By the time Mao set up his communist regime in 1949, China had become one of the poorest countries in the world.
Even today, many nations, such as Afghanistan, Haiti, Nepal, and Somalia, are unable to maintain the most rudimentary order and laws to allow economic progress.
Chapter 9 – Reversing Development
Chapter 10 – The Diffusion Of Prosperity
The French Revolution abolished the feudal system and all obligations and dues that it entailed, and it entirely removed the tax exemption of the nobility and the clergy. The most radical measure made all citizens eligible for any office or profession. So there was now equality before the law for all, not only in daily life and business, but also in politics. Together with the removal of the rigid political and social roles, critical barriers against economic activities were stamped out. The guilds and all occupational restrictions were abolished, creating a more level playing field in the cities.
The Third Republic in 1870 would bring to France the type of parliamentary system that the Glorious Revolution put in motion in England. The French Revolution created much violence, suffering, instability, and war. Nevertheless, thanks to it, the French did not get trapped with extractive institutions blocking economic growth and prosperity, as did absolutist regimes in Eastern Europe such as Austria-Hungary and Russia.
A confluence of factors opened the way to the French Revolution, and these were intimately related to the fact that Britain was industrializing rapidly.
The French Revolution and, subsequently Napoleon, exported the revolution to the lands they conquered, destroying absolutism, ending feudal land relations, abolishing guilds, and imposing equality before the law – the all-important notion of rule of law. The French Revolution thus prepared, not only France, but much of the rest of Europe for inclusive institutions and the economic growth that these would birth. Napoleon codified the Roman law and the ideas of equality before the law into a legal system that became known as Code Napoleon. Before long industrialization was rapidly underway in almost all the places that the French controlled.
The French Revolution brought much suffering in Europe but it also radically changed the lay of the land. In much of Europe, gone were the feudal relations; the power of the guilds; the absolutist control of monarchs and princes; the grip of the clergy on economic, social, and political power: the foundation of the ancien regime which treated different people unequally based on birth status. These changes created the type of inclusive economic institutions that would then allow industrialization to progress.
In 1868 Japan was an economically underdeveloped country with a society that was similar to that of medieval Europe, with strict occupational categories, restrictions on trade, and high rates of taxation on farmers. At that point a powerful group developed a plan to change the political and economic institutions completely and overthrow the shogunate which had ruled Japan since 1600. In 1868 the Meiji restoration was declared resulting in a civil war in which the armies of the shogun were vanquished. Following the Meiji restoration a process of transformative institutional reforms began. In 1869 feudalism was abolished, taxation was centralized, and a modern bureaucratic state replaced the old feudal one. In 1869 the equality of all social classes before the law was introduced, and restrictions on internal migration and trade were abolished. The samurai class was abolished. Individual property rights on land were introduced and people were allowed the freedom to enter and practice any trade. The state became heavily involved in the construction of infrastructure. It also began to develop a manufacturing industry with a concerted effort to industrialize. By 1890 Japan was the first Asian country to adopt a written Constitution, which created a constitutional monarchy with an elected parliament, the diet, and an independent judiciary. These changes were decisive factors in enabling Japan to be the primary beneficiary from the Industrial Revolution in Asia.
In the mid-19th century both China and Japan were poor nations languishing under absolutist regimes, but there were notable political differences. China had a centralized bureaucratic empire ruled by an absolutist Emperor. The Emperor faced some constraints on his power, mainly the threat of rebellion. From 1850 to 1864 the Taiping Rebellion ravaged the whole of southern China in which millions died, either in conflict or from starvation, but opposition to the Emperor was not institutionalized.
The recognition that economic backwardness created military backwardness was part of the impetus behind the plan to overthrow the shogunate and put in motion the changes that led to the Meiji restoration in Japan. The leaders realized that economic growth – perhaps even Japanese survival – could be achieved only by institutional reforms, but the shogun opposed them because his power was tied to the existing set of institutions.
As a consequence of their initial differences, each country responded differently to the challenges of the 19th century, and Japan and China diverged dramatically in the face of the critical juncture created by the Industrial Revolution. While Japanese institutions were being transformed and the economy was beginning to grow rapidly, in China, forces pushing for institutional change were not strong enough, and extractive institutions persisted largely unabated until they would take a turn for the worse with Mao’s communist revolution in 1949.
This book attempts to explain why certain countries benefited from the Industrial Revolution and embarked on the path to growth, while others did not, steadfastly refusing to allow even the beginnings of industrialization. Whether a country embarked on industrialization was largely a function of its institutions.
The French Revolution exported its institutions by invading and forcibly reforming the extractive institutions of several neighboring countries. This opened the way to industrialization not only in France, but in Belgium, the Netherlands, Switzerland, and parts of Germany and Italy. In the countries of Eastern Europe instead of crumbling, feudalism intensified. Austria-Hungary, Russia, and the Ottoman Empire fell even further behind economically, but the absolutist monarchies managed to stay in place until the First World War.
If China reacted to the Industrial Revolution as Eastern Europe, Japan reacted in the same ways as Western Europe. Just as in France, it took a revolution to change the system.
The institutional dynamics ultimately determined which countries took advantage of the major opportunities presented in the 19th century onward and which ones failed to do so. The roots of world inequality we observe today can be found in this divergence.
Chapter 11 – The Virtuous Circle
The Glorious Revolution created the rule of law, by which the elites were more constrained than they had anticipated.
The rule of law – that the law applies to everyone equally – is not imaginable under absolutist political institutions. It is a creation of pluralist political institutions and of the broad coalitions that support them. It is only when many individuals and groups have a say in decisions that the idea they should all be treated fairly makes sense. It is important to understand the link between pluralism and the rule of law and the dynamics of virtuous circles. The Glorious Revolution was not the overthrow of one elite by another, but a revolution against absolutism by a broad coalition. The emergence of pluralist political institutions was a consequence of this revolution, and the rule of law was a natural byproduct. With many parties at the table sharing power, it was essential to have laws and constraints apply to all of them, lest one-party start amassing too much power and ultimately undermine the very foundations of pluralism. The notion that there were limits and restraints on rulers, the essence of the rule of law, was part of the logic of the principle of the rule of law and was a key argument against Stuart absolutism.
It was in the very nature of the rule of law that the measures selected for their own defense (by those fighting the Crown) could not be reserved for their exclusive use only. The law applied to the principles of equity and universality which had to be extended to all sorts and degrees of men. Once in place, the notion of the rule of law not only kept absolutism at bay but also created a type of virtuous circle: if the laws apply equally to everybody, no individual or group could rise above the law and everyone had the right to a fair trial.
The virtuous circle is a powerful process, positive feedback that preserves its institutions in the face of attempts to undermine them and sets in motion forces that lead to greater inclusiveness. The logic of virtuous circles stems partly from the fact that inclusive institutions are based on constraints on the exercise of power and on a pluralistic distribution of political power in society, enshrined in the rule of law. The ability of a subset to impose its will on others without any constraints threatens this very balance. Widespread recognition of this threat became a persistent feature of British political institutions and was responsible for their continuous evolution in a more pluralistic direction.
The virtuous circle arises not only from the inherent logic of pluralism and the rule of law, but also because inclusive political institutions tend to support inclusive economic institutions. This then leads to a more equal distribution of income, empowering a broad segment of society, making the political playing field even more level. This limits what one can achieve by usurping political power and reduces the incentives to re-create extractive political institutions. These factors were important in the development of truly democratic political institutions.
Pluralism also creates a more open system and allows independent media to flourish, making it easier for groups that have an interest in the continuation of inclusive institutions to become aware of, and organize against, the threats to these institutions.
British democracy was not given by the elite. Beginning in the 1830s it was largely taken by the masses, who were empowered by the political processes that had been ongoing in England for the previous several centuries. They were encouraged by the changes in the nature of political institutions unleashed by the Glorious Revolution and wanted the vote to defend their interests. The economic and political changes that had taken place in Britain made using force to repress their demands both unattractive for the elite and increasingly unfeasible. The rulers of England were faced with alarming alternatives. They could either dispense with the rule of law, dismantle their elaborate constitutional structures, and rule by force; or they could submit to their own rules. Had they not done so they would have risked the stability of the entire system.
Inclusive economic institutions led to the development of inclusive markets, inducing a more efficient allocation of resources, greater encouragement to acquire education and skills, and further innovations in technology. All these forces were employed in Britain by 1831. Clamping down on popular demands and undermining inclusive political institutions would reverse these gains and the elites opposing greater democratization might lose their fortunes from the economic destruction.
Under inclusive economic and political institutions controlling power becomes less central, so clinging to power was thus much less valuable for the British elite. The logic of the virtuous circle also meant that repressive steps would be increasingly unfeasible because of the positive feedback between inclusive economic and political institutions. Inclusive economic institutions lead to a more equitable distribution of resources than extractive institutions, and empower the citizens at large, and create a more level playing field, especially when it comes to the fight for power. This makes it more difficult for a small elite to crush the masses rather than accommodate their demands. The British political changes were always toward more inclusive political institutions because of the relentless pressure from the masses for more political representation. But they were also gradual. There was conflict over each step, and the outcome of each was contingent. But the virtuous circle created forces that reduced the stakes involved in clinging to power. It also spurred the rule of law, making it harder to use force against those who were demanding more rights. There is great virtue in this sort of gradual change and less threatening to the elite. Each step is small and it makes sense to give into small demands rather than create a major showdown. The virtuous circle led to the First Reform Act of Britain in 1832 but this was just the beginning.
Gradual change also prevents ventures into uncharted territories. The violent overthrow of the system means that something entirely new has to be built in its place. This was the case with the French Revolution, where the first experiment led to the Terror, and then back to monarchy twice, before finally leading to the French Third Republic in 1870. It was the case in the Russian revolution, where the desires of many for a more equal system led to a one-party dictatorship that was much more violent, bloody, and vicious than what it had replaced. Gradual reform was difficult in these societies because they lacked pluralism and were highly extractive. It was the pluralism emerging from the Glorious Revolution, and the rule of law that it introduced, that made gradual change feasible in Britain. The gradualist political reform would be more effective because its gradual nature made it more powerful, harder to resist, and ultimately more durable
Concentrating power in the hands of an individual or a narrow group would undermine the foundations of pluralistic political institutions, and the true measure of pluralism is its ability to resist such attempts. The principle of the rule of law opens the door for greater participation in the political process, as it introduces the idea that people should be equal not only before the law but also in the political system.
Inclusive political institutions allow a free media to flourish, and a free media often provides information about, and mobilizes opposition to, threats against inclusive institutions.
Chapter 12 – The Vicious Circle
The vicious circle is based on extractive political institutions creating extractive economic institutions which support them because economic wealth and power buy political power.
Not all radical changes are doomed to failure. The glorious Revolution was a radical change, and it led to what turned out to be possibly the most important political revolution of the past two millennia. The French Revolution was even more radical, with its chaos and excessive violence and the ascent of Napoleon, but it did not re-create the ancien regime.
Three factors greatly facilitated the emergence of more inclusive political institutions following both the Glorious Revolution and the French Revolution. The first was the merchants and businessmen seeking to unleash the power of creative destruction from which they themselves would benefit; these new men were among the key members of the revolutionary coalitions and did not want to see the development of yet another set of extractive institutions that might prey on them.
The second factor was the nature of the broad coalition that had formed in both cases. The glorious Revolution was not a narrow group or a specific narrow interest, but a movement backed by merchants, industrialists, the gentry, and diverse political groupings. The same was largely true for the French Revolution.
The third factor relates to the history of English and French political institutions. They created a background against which new, more inclusive regimes could develop. In both countries there was a tradition of parliaments and power-sharing going back to the Magna Carta in England and to the Assembly Of Notables in France. Moreover, both revolutions happened in the midst of the process that had already weakened the grasp of the absolutist, or expiring absolutist, regimes.
The pattern of vicious circles depicted by the transition from the European colonial powers to independence for the sub-Saharan African nations illustrates the iron law of oligarchy. The internal logic of oligarchies, and of all hierarchical organizations, is that they will reproduce themselves even when an entirely new group takes control.
The international community thought that postcolonial Africa independence would lead to economic growth, but there was no private sector, because the European colonizing countries, while themselves operating under inclusive institutions, had established highly extractive political and economic institutions in their Sub-Saharan African colonies, and so there were enormous benefits from holding the power that control of these institutions gave. These benefits both attracted the most unscrupulous men who wished to monopolize this power, and brought the worst out in them once they were in power. There was nothing to break the vicious circle.
Rich nations are rich largely because they managed to develop inclusive institutions at some point during the past 300 years. These institutions have persisted through a process of virtuous circles. These institutions generated dynamics that would create a process of positive feedback, gradually increasing their inclusiveness.
Under inclusive economic institutions, wealth is not concentrated in the hands of a small group that continues to hold on to its economic might to increase its political power disproportionately. Under inclusive economic institutions there are more limited gains from holding political power, that is, weaker incentives for every group and every ambitious individual to try to take control of the state. The confluence of factors that a critical juncture, including interplay between existing institutions and the opportunities and challenges brought by the critical juncture, is generally responsible for the onset of inclusive institutions. Virtuous circles enable the institutions continuity and often unleash dynamics taking society to a greater inclusiveness.
As virtuous circles make inclusive institutions persist, vicious circles create powerful forces toward the persistence of extractive institutions. Vicious circles are not unbreakable, but they are resilient. They create a powerful process of negative feedback, with the extractive political institutions forging extractive economic institutions, which in turn create the basis for the persistence of extractive political institutions.
The iron law of oligarchy dictates that the overthrow of the regime presiding over extractive institutions heralds the arrival of a new set of masters to exploit the same set of pernicious extractive institutions.
The logic of this type of vicious circle is simple: extractive political institutions create few constraints on the exercise of power, so there are essentially no institutions to restrain the use and abuse of power by those overthrowing previous dictators and assuming control of the state; and extractive economic institutions underpin the great profits and wealth to may be made merely by controlling power, expropriating the assets of others, and setting up monopolies.
A revolution by a broad coalition makes the emergence of pluralistic political institutions much more likely.
Another even more destructive facet of the vicious circle is that when extractive institutions create huge inequalities in society and great wealth and unchecked power for those in control, there will be many wishing to fight to take control of the state and its institutions. Extractive institutions not only pave the way for the next regime, which will be even more extractive, but they also engender continuous infighting and civil wars. The civil wars cause more human suffering and also destroy even what state centralization the societies have achieved. This starts the process of descent into lawlessness, state failure and political chaos, crushing all hopes of economic prosperity.
Chapter 13 – Why Nations Fail Today
Nations fail today because their economic institutions do not create the incentives needed for people to save, invest, and become educated. Extractive political institutions support these economic institutions by cementing the power of those who benefit from the extraction. Extractive economic and political institutions are always at the root of this phase. Extractive institutions can pave the way for complete state failure, destroying not only law and order but also even the most basic economic incentives.
It is impossible to understand many of the poorest regions of the world at the end of the 20th century without understanding the new absolutism of the 20th century: communism.
Stalin’s collectivization and purges may have killed as many as 40 million people. Russian communism was brutal, repressive, and bloody, but not unique. The economic consequences and the human suffering were quite typical of what happened elsewhere – in Cambodia in the 1970s, in China, and in North Korea. In all cases communism brought vicious dictatorships and widespread human rights abuses. Beyond the human suffering and carnage, the communist regimes all set up various types of extractive institutions. The economic institutions were designed to extract resources from people, and by abolishing property rights, they all created poverty instead of prosperity. In the Soviet case the communist system at first generated rapid growth, but then faltered and led to stagnation. The consequences were much more devastating in China under Mao, in Cambodia under the Khmer Rouge, and in North Korea, for the communist economic institutions led to economic collapse and famine.
The communist economic institutions were supported by extractive political institutions, concentrating all power in the hands of communist parties with no constraints on the exercise of this power.
* * *
Economic reforms of the 1990s promoted by international financial institutions and economists for so-called developing countries were aimed at freeing up markets and reducing the role of the state in the economy. The key pillar of such reforms everywhere was the privatization of state-owned assets. The typical result was the Mexican privatization which, instead of increasing competition, simply turned state monopolies into privately owned monopolies, in the process enriching politically connected businessmen. Exactly the same thing took place in Egypt and numerous other places.
Nations fail economically because of extractive institutions. They all have very different histories, languages, customs, but what all have exstractive institutions. In all these cases the basis of these institutions is an elite who design economic institutions to enrich themselves and perpetuate their political power at the expense of the rest of the country. The reasons these extractive institutions persist is always related to the vicious circle.
Chapter 14 – BREAKING THE MOLD
When Mao gained control of China he immediately nationalized all land and abolished property rights. He had landlords, and other segments he saw as threats to the regime, executed. The market economy was abolished. People in rural areas were organized into communal farms. Money and wages were replaced by work points which could be traded for goods.
After 1958 the attempts at industrialization turned into the infamous Great Leap Forward with the rollout of the second five-year plan. Mao’s insane plan to increase steel production with mandatory backyard blast furnaces fed by iron farm implements and cooking utensils resulted in a calamitous famine in the Chinese countryside resulting in the death of between 20 and 40 million people. The Cultural Revolution like The Great Leap Forward would wreck both the economy and human lives.
Deng Xiaoping, a very successful general during the revolution, led an anti-rightist campaign early on but had a change of heart. He realized China needed policies that would encourage production so it could feed its people.
In 1967 Deng found himself labeled number-two capitalist roader and was jailed. He was rehabilitated in 1975, and Mao was persuaded by Premier Zhou Enlai to make Deng First Vice Premier. Already in 1975 Deng had proposed revitalization of higher education, a return to material incentives in industry and agriculture, and the removal of leftists from the party.
In 1976 there was a critical juncture: Mao died. With Mao gone, there was a power vacuum, which resulted in a struggle between those with different visions and different beliefs about the consequences of change. The Gang Of Four intended to continue the policies of the Cultural Revolution.
Deng did not want to abolish the communist regime. He and his supporters thought that significant economic growth could be achieved with partially inclusive economic institutions and extractive political institutions in a way that would not threaten their power, especially since the Chinese people were in dire need of improved living standards and because all meaningful opposition to the Communist Party had been obliterated during the Cultural Revolution. To achieve this, they planned to repudiate not just the Cultural Revolution but also much of the Maoist institutional legacy. They realized economic growth would be possible only with significant moves toward inclusive economic institutions, so sought to reform the economy by bolstering the role of market forces and incentives. They also wanted to expand the scope of private ownership and reduce the role of the Communist Party in society and the administration, getting rid of such concepts as class struggle. They were open to foreign investment and international trade and wanted to pursue a much more aggressive policy of integrating with the international economy, but with limits. Building truly inclusive economic institutions and significantly lessening the grip of the Communist Party on the economy were not even options.
The turning point for China was Hua Guofeng taking power and his willingness to use it against the Gang Of Four. Within a month of Mao’s death, Hua outmaneuvered the Gang Of Four, had them all arrested and reinstated Deng in March 1977. Then Hua himself was politically outmaneuvered by Deng, who encouraged public criticism of the Cultural Revolution and began to fill key positions in the Communist Party at all levels with people aligned with him. Hua lacked the web of connections and informal relations that Deng had built up over many years. Deng’s supporters presented basic principles of economic reform – firms should be given greater initiative and authority to make their own production decisions, prices should be allowed to bring supply and demand together, rather than being set by government, and state regulation of the economy more reduced.
At The Third Plenum in 1978 it was decided that the focus of the party would change from class struggle to economic modernization.
The Central Committee acknowledged the centrality of “truth from facts” and declared the Cultural Revolution to have been a great calamity for the Chinese people. Throughout this period Deng was securing the appointment of his own supporters to important positions in the party, army, and government. Because he had to move slowly against Hua’s supporters in the Central Committee, Deng created parallel bases of power.
Once Deng and the reformers had consummated their political revolution and were in control of the state, they launched a series of further changes in economic institutions. They began with agriculture: by 1983 the household responsibility system, authored by Hu Qiaomu, would provide economic incentives to farm and administrative control of agricultural prices was greatly relaxed. It was the rural economy that took off first. The introduction of incentives led to a dramatic increase in agricultural productivity.
The current extractive institutions in China are crucially dependent on the Party’s control of the media which has become frighteningly sophisticated. Three pillars of Communist Party control in China are control of the Armed Forces, the cadres, and the news.
China broke the mold even if it did not transform its political institutions. The crucial changes came during the critical juncture following Mao’s death. Extractive institutions can be replaced by inclusive ones, but it is neither automatic nor easy. A critical juncture coupled with a broad coalition of those pushing for reform is often necessary for a nation to make strides toward more inclusive institutions. Some luck is key because history always unfolds in a contingent way.
Chapter 15 – Understanding Prosperity And Poverty
To answer the question of why Western Europe, the United States, and Japan become so much richer than sub-Saharan Africa, Latin America, and China over the last 200 years we need a theory of why some nations are prosperous while others fail. This theory needs to delineate both the factors that create and retard prosperity and their historical origins. This book has proposed such a theory. Many complex social phenomena have a multitude of causes, making most social scientists shun monocausal, simple, and broadly applicable theories, and instead seek different explanations for seemingly similar outcomes. Instead, the authors have offered a simple theory and used it to explain the main contours of economic and political development around the world since the Neolithic Revolution. The choice of theory was motivated by the belief that a theory should enable us to focus on the parallels. A successful theory provides a useful and empirically well-rounded explanation for a range of processes while also clarifying the main forces at work.
The authors’ theory has attempted to achieve this by operating on two levels. The first is the distinction between extractive and inclusive economic and political institutions. The second is their explanation for why inclusive institutions emerged in some parts of the world and not in others. While the first level of the theory is about institutional interpretation of history, the second level is about how history has shaped institutional trajectories of nations.
Central to the theory is the link between inclusive economic and political institutions and prosperity. Inclusive economic institutions that enforce property rights, create a level playing field, and encourage investment in new technologies and skills are more conducive to economic growth than extractive institutions that are structured to extract resources from the many by the few and that fail to protect property rights or provide incentives for economic activity. Inclusive economic institutions are in turn supported by, and support, inclusive political institutions, i.e. those that distribute political power widely in a pluralistic manner, are able to achieve some amount of political centralization so as to establish law and order, the foundations of secure property rights, and an inclusive market economy. Similarly, extractive economic institutions are synergistically linked to extractive political institutions, which concentrate power in the hands of a few, who will then have incentive to maintain and develop extractive institutions for their benefit and use the resources they obtain to cement their hold on political power.
Because elites dominating extractive institutions fear creative destruction, they will resist it, and any growth that germinates under extractive institutions will ultimately be short-lived. Second, the ability of those who dominate extractive institutions to benefit greatly at the expense of the rest of society ensures that political power under extractive institutions is highly coveted, making many groups and individuals fight to obtain it. So there will be powerful forces pushing societies under extractive institutions toward political instability.
The synergies between extractive economic and political institutions create a vicious circle, where extractive institutions, once in place, tend to persist. Major institutional change, the requisite for major economic change, takes place as a result of the interaction between existing institutions and critical junctures. Critical junctures are major events that disrupt the existing political and economic balance.
Conflict over income and power, and indirectly over institutions, is a constant in all societies.
The authors’ theory is useful for policy analysis, as it enables us to recognize bad policy advice, based either on incorrect hypotheses or inadequate understanding of how institutions can change. Avoiding the worst mistakes is as important as, and more realistic than, attempting to develop simple solutions.
China was first able to grow because under Deng Xiaoping there were radical reforms away from the most extractive economic institutions and toward more inclusive ones. China also greatly benefited from its large supply of cheap labor and its access to foreign markets, capital, and technologies. Chinese growth is based on the adoption of the existing technologies and rapid investment, not creative destruction. Since this book was published, in 1912, China’s extraordinary growth has been aided by a turn toward even more open markets and considerable creative destruction. Now it seems that Xi is beginning to reverse this process in attempting to strengthen his control.
The Soviet Union achieved growth under extractive economic institutions and extractive political institutions because it forcibly allocated resources toward industry under a centralized command structure, particularly to armaments and heavy industry. Such growth was feasible partly because there was a lot of catching up to do.
The Communist Party is all-powerful in China and controls the entire state bureaucracy, the armed forces, the media and large parts of the economy. Its control over the media including the Internet is unprecedented.
The authors predict the Chinese growth will run out of steam unless extractive political institutions make way for inclusive institutions. As long as political institutions remain extractive, growth will be inherently limited, as it has been in all of the similar cases.
Modernization theory maintains that all societies, as they grow, are headed toward a more modern, developed, and civilized existence, and especially toward democracy, and that inclusive institutions will emerge as a byproduct of the growth process. Different versions of modernization theory also claim that an educated workforce will naturally lead to democracy and better institutions.
But many relatively prosperous nations have succumbed to and supported repressive dictatorships and extractive institutions. Both Germany and Japan were among the richest and most industrialized nations in the world in the first half of the 20th century, and had comparatively well-educated citizens. This did not prevent the rise of the National Socialist Party in Germany or a militaristic regime intent on territorial expansion via war in Japan – making both political and economic institutions take a sharp turn toward extractive institutions.
Modernization theory has a wide following. Recent US attitudes toward China have been shaped by this theory. Yet the rapid increase in US China trade since the mid-1980s has done little for Chinese democracy. Modernization theory is both incorrect and unhelpful for thinking about how to confront the major policies of extractive institutions and failing nations.
It is the societies with inclusive institutions that have grown over the past 300 years and have become relatively rich today. While nations that have built inclusive economic and political institutions over the last several centuries have achieved sustained economic growth, authoritarian regimes that have grown more rapidly over the past 60 or 100 years, contrary to what modernization theory would claim, have not become more democratic. Growth under extractive institutions is possible when it does not threaten these institutions. It is often generated because those in control of the extractive institutions view economic growth as not a threat, but a support, to the regime, as the Chinese Communist Party has done since the 1980s.
Growth generated by increases in the value of the natural resources of a nation is also unlikely to lead to a fundamental transformation of an authoritarian regime toward inclusive institutions.
All of this highlights several important ideas: first, growth under authoritarian, extractive political institutions in China will not translate into sustained growth supported by truly inclusive economic institutions and creative destruction. Second, contrary to the claims of the modernization hypothesis, we should not count on authoritarian growth leading to democracy or inclusive political institutions. Third, authoritarian growth is neither desirable nor viable in the long run.
The development agencies and institutions of the first world tend to believe in the ignorance theory and believe that we can engineer prosperity around the world by presenting the right advice and convincing politicians of what is good economics. The fact is that the main obstacle to the adoption of policies that would reduce market failures and encourage economic growth is not the ignorance of politicians, but the incentives and constraints they face from the political and economic institutions in that society. Nevertheless, the ignorance hypothesis still rules supreme in Western policy thinking which, almost to the exclusion of anything else, focuses on how to engineer prosperity as an engine to encourage more inclusive institutions.
These engineering attempts come in two flavors, the first, often advocated by international organizations such as the International Monetary Fund, recognizes that poor development is caused by bad economic policies and institutions and proposes improvements for poor countries to adopt these improvements. They focus on sensible things but the approach used by international organizations in Washington, London and elsewhere, is still handicapped by an incorrect perspective that fails to recognize the role of political institutions and the constraints they place on policymaking. Attempts by international institutions to engineer growth by hectoring poor countries into adopting better policies and institutions are usually unsuccessful because they do not deal with why bad policies and institutions are there in the first place. The consequence is that the policies are not adopted or are implemented in name only. The countries’ policymakers and bureaucrats who are supposed to act on the well-intentioned advice of the international agencies are not grappling with the institutional causes of the poverty.
Many of the micro market failures that are apparently easy to fix may be illusory: the institutional structure that creates market failures will also prevent implementation of interventions to improve incentives at the micro level. Attempting to engineer prosperity without confronting the root cause of the problems – extractive institutions and the politics that keeps them in place – is usually ineffectual.
Only about 10, or at most 20%, of foreign aid will reach its target because of incompetence, waste and corruption, and a lot goes to dictators who depend on foreign aid to buy support to shore up their regimes and enrich themselves.
The cycle of failure of foreign aid repeats itself over and over again. The desire of rich countries to provide foreign aid to poor countries is based on an incorrect understanding of what causes poverty. Countless countries are poor because of their extractive institutions which result in the lack of property rights, law and order, or well-functioning legal systems, and the stifling dominance of national and local leaders over political and economic life. The same institutional problems mean that foreign aid will be ineffective, as it will be plundered and is unlikely to be delivered where it is supposed to go. In the worst cases it will prop up the regimes that are at the very root of the problems of the societies. Giving aid to regimes presiding over extractive institutions cannot be the solution. Efforts to improve education (especially for girls) and birth control have been two of the most successful focuses of foreign aid.
One sensible solution, making aid conditional on improvements, has not been successful because countries failing to meet the conditions typically receive as much aid as those that do not. The reason is they have greater need for the aid, so conditional aid seems to have little effect on nations’ institutions.
Even so, ineffective foreign aid will continue, as Western nations feel guilt over the economic and humanitarian disasters around the world and foreign aid makes some feel something is being done to help. The enormous complex of international organizations and NGOs will also ceaseless demand and mobilize resources to ensure the continuation of the status quo.
Two important lessons – first, foreign aid is not a very effective means of dealing with the failure of nations. Countries need inclusive economic and political institutions to break out of the cycle of poverty. Foreign aid can typically can do little in this respect, and certainly not in the way it is currently organized. As the roots of poverty lie in institutions, foreign aid, within the framework of given institutions in the recipient nations, will do little to spur sustained growth. Second, since the development of inclusive economic and political institutions is key, using the existing flows of foreign aid to facilitate such development would be useful. Conditionality is not the answer as it requires existing rulers to make concessions. Instead, structuring foreign aid so that its use and administration brings groups and leaders otherwise excluded from power into the decision-making process and empowering a broad segment of population might be a better prospect.
Copyright @ 2012 by Daren Acemoglu and James A. Robinson
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