Some new book recommendations (1): Why Nations Fail

Daron Acemoglu and James Robinson: “Why Nations Fail

There have been many fascinating books in the last couple of decades on the big question of why some countries are rich and others poor, and the persistence of inequality over decades, even centuries. Jared Diamond’s “Guns, Germs and Steel” and David Landes’ “The Wealth and Poverty of Nations” are two excellent examples. But “Why Nations Fail” is the best I’ve read, partly because it encompasses the analysis of many of the others and shows where previous explanations were wrong or at least incomplete.

Acemoglu, at MIT, is one of the most gifted economists of his generation. He won the John Bates Clark medal for the best economist under the age of 40 and has been producing fascinating research for the last decade about the central importance of institutions in economic success.  Robinson is professor of government at Harvard who has researched widely around the world to build a remarkably broad knowledge of modern history.

A few, rather isolated economists have researched institutions in the past but mainstream economics ignored them or saw them as something of interest only to other social scientists, the equivalent in their eyes of a physicist referring a matter to the attention of bird-spotters. Economic theory as taught in early undergraduate classes and to MBAs is a tale of pure theory, no time, space or history, in which perfectly rational agents interact unproblematically through something called the market to achieve a harmonious resolution of their wants.

The glaring omission here is that markets are themselves institutions and one of the most important conditions for their success is peaceful maintenance of secure property rights. The central idea of “Why Nations Fail” is that this cannot be taken for granted. Indeed relatively few countries have the secure rule of law combined with institutions that allow enterprising people to keep most of what they create. Without these institutions there is no incentive to work hard, innovate or invest.

Countries and regions (eg. the southern USA before the civil rights movement, southern Italy) with “extractive” institutions are doomed to mass poverty. An elite rips off the rest of the people and has no incentive to allow political or economic innovation that would make the economy as a whole much better off because it might threaten the entrenched position of those in power and with wealth. Historic examples abound, particularly in Latin America and Africa, partly owing to European colonialism, but the colonists often reinforced existing exploitative institutions. Even more depressingly, the post-colonial system frequently remained extractive so that many African nations are poorer than they were fifty years ago.

The successful countries have “inclusive” institutions which encourage enterprise, work and innovation. These countries also have stable, pluralistic political institutions and the rule of law, which is not the same as having a legal system. It means that there is a disciplined system in which people are formally and actually equal before the law, and where contracts are enforced more or less fairly, at reasonable cost. Safe in the belief that their property and liberty will not arbitrarily be taken away, people are free to prosper and innovate. And they do. The richer countries, essentially those that have had an industrial revolution spontaneously (as opposed to Communist-driven industrialisation), have continued to grow and innovate.

The book recounts the familiar story that the first of these countries was the UK because of its “Glorious Revolution” in 1688 (I’ve written about this before). The French Revolution of 1789, followed by Napoleon’s conquests, destroyed the extractive feudal system of western Europe, allowing industrial capitalism to follow. Eastern Europe, stuck with autocratic, extractive institutions, only industrialised slowly and much later, because capitalism threatened the interests of the landed elite. The Russian Czar opposed the building of railways until the country’s defeat by Japan in 1905 forced a reluctant modernisation.

An implicit assumption is that the desire to work hard and build a better standard of living for yourself and your family is universal. I believe this is true. When working in Lesotho in 1985-87 some friends and I took a holiday to Victoria Falls, on the border of Zimbabwe and Zambia. Aside from an awkward encounter with some former guerrilla fighters on the train from Bulawayo, in which my friend’s frankness nearly got us killed, it was a wonderful holiday. This was before Robert Mugabe wrecked the Zimbabwe economy, a clear enough example of the power of extractive institutions, inherited in large part from the racist former colonial regime. The hotels at Victoria Falls were beautiful and the gardens exquisitely maintained. At least that was true in Zimbabwe. We crossed a small bridge into Zambia, at that time prostrate from low commodity prices (they don’t always go up) and from years of economic mismanagement. It was as if there was a sign saying “You are now entering the third world(*)”. The bored, dispirited guard on the Zambian side of the border had a shabby hut to sit in, the path was just dirt, there were no gardens. But there was enterprise. A group of men greeted us with a collection of rather unimpressive handicrafts, wooden carvings, mats and so on. Somebody, probably their wives and daughters, had made these things for sale. The men then tried to interest us in them. What struck me was their willingness to haggle – in five different currencies. The one currency they weren’t interested in was Zambian kwacha. But they offered prices in Zimbabwean dollars, South African Rand, British pounds, German marks (this was the good old days before the Euro) and American dollars. Each time they offered up to five prices. We started counter bidding and I kept switching currencies. As far as my mental arithmetic could keep up, they maintained perfect arbitrage across the five currencies. These, possibly illiterate street traders, would have easily coped in a London forex dealing room. Only the oppressive circumstances of the economy they were unlucky enough to have be born in stopped them from becoming prosperous.

To the extent that this wonderfully interesting and readable book “explains” everything, it does so by invoking historical chance. So, in other words, it doesn’t. There are historic “critical junctures”, where things may go either way. Most of the time countries seem to be prisoners of their history and it is difficult to see how anybody can do much about it. Wars, revolutions, even epidemics (the Black Death destroyed feudalism in England by making labour expensive) can be agents of positive change.

So you leave the book with the intellectual satisfaction of having an explanation of so much of the world’s economic inequality, but with a sense of frustrated resignation, that the destiny of many people is largely determined by historic luck.

A controversial argument made by the book is that China’s institutions remain essentially extractive, which will inhibit long term economic growth. Both Communist China and, before it, the USSR, achieved high rates of economic growth under a highly centralised political system. The authors argue that the long period of remarkable Soviet growth was ultimately unsustainable because it was based on forced transfer of resources (at huge human cost) and copying of best practice from the west. The system had little intrinsic dynamism or innovation, outside the military sphere. Soviet growth slowed down from the 1960s and by the 1980s the USSR was economically stagnant and dependent on high oil prices for survival. Russia today is not that much different.

China, they argue, is not that different either, and will eventually run out of economic growth too. I’m not so convinced by this, as China is pouring money into research, development and education and has a far more competitive (in the sense of open to international trade) and market-based economy than the USSR ever had. It’s true that the protected and sluggish state owned monopolies remain important but their share of the economy is shrinking and the government seems to be trying to push more finance to the dynamic SME sector. Recently we’ve heard both the government and the bank regulator criticise the state banks for high profits and high fees. This may be posturing ahead of the regime change but it seems to show a realisation by one faction of the Party that further economic growth will need more competition and the  further breaking down of state control. The other faction of course disagrees and we’ll have to see who wins.

This is one of the most interesting books that I’ve read in a long while, with a great stock of historically fascinating examples . I strongly recommend it and the authors’ excellent website.

(*) The term “third world” has fallen out of use. It was coined in the 1960s to refer to those countries that were neither part of the rich capitalist group (the first world) nor Communist (the second world). It became synonymous with poor countries. Economists later started using the term LDCs (less developed countries – how condescending) and later still emerging economies, which has a more upbeat, positive tone.

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