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Why Nations Fail?

21 mins read

Many theories attempt to explain why some countries are rich and others poor – but they all only get so far:

According to the geography hypothesis, the differences between rich and poor stem from geographic circumstances. This theory is based on the observation that many of the poorest countries are in tropical regions while wealthy countries tend to be in cooler climate zones.

Although temperate climatic conditions do seem to be an advantage in many cases, there are several examples that prove the opposite. Singapore, for instance, is wealthy despite its location in the tropics. Similarly, the geography hypothesis is unable to explain the stark differences between neighboring countries North and South Korea.

The culture hypothesis views a country’s culture (i.e., its religion, values and cultural attitudes) as the decisive factor. For a long time people believed that the Protestant work ethic, which is based on the idea that work is a duty, was the key to economic success, whereas Confucian values, such as humanity, loyalty and honesty, impeded it.

But this theory doesn’t hold water either. It too cannot explain the difference between North and South Korea, which, despite a similar culture, developed extremely differently.

The ignorance hypothesis assumes that economic differences are determined by the ignorance or incompetence of the ruling class. In other words, incompetent politicians are to blame for market failures and plunging their countries into poverty. This theory could explain, for example, that the economic decline of Ghana was caused by a catastrophic economic policy.

However, politicians are often aware of their problems. It is not their incompetence that leads them to take the wrong actions; more often than not it is due to external incentives and obstacles (e.g., they want to satisfy interest groups that are important for them).

All of the above-mentioned theories highlight parts of the problem at hand and are valid to a certain extent but they do not deliver a general explanation of the underlying issues.

Integrative institutions are the key to a nation’s lasting economic success

From the Mayas to sixteenth-century England to Botswana, history is chock-full of examples that prove that the most important factor for a nation’s prosperity is its institutional structure.

Integrative institutions (i.e., political and economic institutions that involve the entire society) are what enable wide democratic participation in politics and the economy. They prevent resources from being overexploited and individual people from enriching themselves without benefitting the rest of society in any way.

Integrative institutions are characterized by a variety of individual rights, such as the freedom to choose a profession, access to education, and competitive, less-controlled markets for labor, capital, goods and services.

Nearly all nations that have achieved a high standard of living have integrative institutions. They set incentives for education, performance and innovation, and create a wider income distribution, preventing small elite groups from abusing their power and any potential profit from unfair competition.

The stories of two of the richest men in the world make a clear case for understanding the difference between nations with and without integrative institutions:

While Carlos Slim got rich in Mexico – a country without integrative institutions – by exploiting his monopoly in landline telephony, Bill Gates amassed his fortune in the United States by inventing products that created value for the entire society – a value that far surpassed his own income. This type of value is only possible in countries with integrative institutions where there is the incentive structure necessary for creating a viable market economy.

Integrative institutions are the key to a nation’s lasting economic success.

Integrative institutions emerge from historical coincidences, and bring about lasting prosperity

Integrative institutions emerge from historical coincidences: one small incident sets off a chain reaction that, with time, ends up causing extensive reforms.

The plague, for instance, was the catalyst of the Glorious Revolution in England, which ultimately brought about pluralism and free enterprise. The plague had taken such a heavy toll on people of working age that it caused a labor shortage. As a result, workers had more power and began demanding higher wages and social rights. This phenomenon ran parallel to the birth of a class of prosperous merchants who opposed royal control and demanded the liberalization of trade.
Economic institutions began emerging, guaranteeing free trade, a constitutional state and the protection of private property. This revolution would eventually lead to the Industrial Revolution 50 years later.

Integrative institutions in the United States also arose out of a coincidence. Colonists in one of the first British colonies attempted to exercise authoritarian control over the English workers. When this proved ineffective, the colonists decided to give the workers incentives, ultimately granting them a kind of elected parliament that wielded the settlement’s political power – and would later become the model for American institutions.

Most countries that have achieved lasting prosperity have one thing in common: at certain points in their history, people seized the opportunity to create solid integrative institutions.

Integrative institutions emerge from historical coincidences, and bring about lasting prosperity.

Centralized political power is crucial for lasting prosperity

A country can only achieve a high level of prosperity when it meets the following two conditions:
First, it has to have integrative political and economic institutions. Second, political power must be centralized to a certain degree, as prosperity can only exist where money goes into making investments and creating innovations.

Both of these conditions necessitate a reliable and trustworthy state. That kind of trust can only exist in a state that has a clear political course, indisputable authority, and a viable, popularly accepted government. Investors and innovators only spring into action when they assume they’ll reap the fruits of their labor. If they have doubts, they’ll leave for a different country.

When political power is spread out too broadly, it can lead to chaos. This is what happened in Somalia, where there are no popularly accepted state institutions to ensure security or structures that are fundamental for a stable, constitutional state.

Centralized political power is crucial for lasting prosperity.

Authoritarian institutions prevail in poorer countries through a vicious circle

Historically speaking, integrative institutions are an exception to the rule. Extractive institutions (i.e., authoritarian and exploitative) are far more common.

Extractive institutions are designed to benefit only a small elite who, above all, want to retain control over politics and the economy.

Despite this common fundamental trait, the individual character of extractive institutions varies from country to country. In North Korea, for instance, citizens are not granted the right to own property. In the Congo, institutions are still set up the way they were in the days of colonialism, even though the “white man” is not in control: a small elite cashes in on the country’s resources, and raw materials are sent out of the country as quickly and cheaply as possible.

Countries with extractive institutions often end up falling into a vicious circle: the elite exploit their political power to benefit themselves economically. If they have gained political and economic control, they do everything they can to strengthen and keep that power, whether by means of intimidation or arbitrary distribution of privileges. A free market, which could potentially destabilize this power, is thus thwarted.

History has shown that even after revolution and upheaval, extractive institutions tend to end up back in place, like in the Congo. Only in very few countries, such as Botswana, were the people able to carry out a political and economic transformation.

Authoritarian institutions prevail in poorer countries through a vicious circle.

There can be no lasting growth in authoritarian systems

Authoritarian elites try to spur economic growth – their profits would not increase otherwise. In authoritarian systems, growth only occurs when already available methods and technologies are exploited. In order to achieve lasting growth, innovations and technological change are both essential. And this type of change is impossible in authoritarian systems where there are no incentives for inventions because the elite fear change and prevent free markets from emerging.

During the Cold War in the 1970s, it looked for a while like the Soviet Union would surpass the United States economically. But the reason for the Soviet economy’s rapid growth had to do with the relocation of labor from agriculture to manufacturing. This shift resulted in a temporary economic growth, but ended soon thereafter.

Even China – the growth miracle of our time – is bound to reach its limit. China may exhibit several characteristics of integrative institutions, like ownership laws and fairly viable financial markets, but its political institutions are still authoritarian.

China’s current economic growth –like the Soviet Union’s in the 1970s – hinges on the relocation of labor and capital from an inefficient agricultural sector to the manufacturing industry, the latter of which mainly profits from existing technologies without creating new ones. That’s why China will not be in a position to achieve the same growth of other developed countries. Without far-reaching reforms, China’s growth will drop steeply over the next decade.

There can be no lasting growth in authoritarian systems.

Authoritarian systems fail because they do not create the right kind of incentives

In a free market, incentive systems make it possible for innovations to be made and efficiency to be increased. In authoritarian systems, on the other hand, sustainable technological change and increased productivity usually do not take place.

In these systems, incentives for innovation and efficiency boosts are usually determined centrally, which rarely leads to satisfactory results. Also, authoritarian institutions often fall prey to the complexity of their own plans.

Under Stalin’s rule, for instance, Soviet laborers often received a good third of their wages as a bonus when certain production quotas were reached. However, this prevented innovation. Why? Because innovation causes short-term productivity loss – albeit loss that ends up creating long-term productivity increases. As a result of the regime’s bonus rule, laborers merely focused on working for their bonus money rather than working on new innovations.

In conclusion, we can safely say that a centralized planning force cannot replace the market’s invisible hand as a driver of innovation. The underlying mechanisms are simply too complicated to be artificially imitated.

Authoritarian systems fail because they do not create the right kind of incentives

Political change always means institutional change – and that takes time

If you want to understand a country and its development, you have to know its institutions. Sensible political measures can only be introduced when a nation’s institutional framework has been analyzed in detail.

Initiating political change is usually challenging and its consequences tend to be unpredictable, since many countries are stuck in a vicious circle that is extremely hard to break out of. To cite a recent example, Hosni Mubarak’s downfall may have been a step towards democracy in Egypt but it also created the risk that a military regime operating the same sort of authoritarian institutions would fill the power vacuum. That’s because many people are afraid of instability, a state of affairs that would be characteristic of a true democracy in its beginnings.

After all, the change to integrative institutions and a functioning democracy does not happen overnight. After the French Revolution ended in 1799, it took 80 years for a stable democracy to form. It is hence unrealistic to assume that this sort of development could take place in just a few years in countries like Egypt.

But still, the first step on the long way towards democracy and prosperity is a deep understanding of the institutions of any given country.

Political change always means institutional change – and that takes time.

Foreign aid should be targeted at institutional reforms, not at supporting authoritarian systems

Afghanistan is a prime example of how billions of dollars in foreign aid were misused. After the fall of the Taliban in 2001, Afghanistan had the opportunity to establish a democracy. But not much of the money it received from foreign aid was used for rebuilding – a large portion of it trickled away into administrative affairs. The country’s weak-willed bureaucratic elite were lured to work in foreign aid because of the higher pay, which ended up hurting the fragile state more than helping it.

However, Afghanistan is not exceptional. Many studies have shown that, in general, only 10–20 percent of foreign aid actually reaches its intended addressee. It is thus clear that the idea behind foreign aid is based on a false understanding of the causes of poverty.

Nations like Afghanistan are poor because their institutions are authoritarian, which accounts for the absence of ownership rights and rule of law.

For the above-mentioned reasons, foreign aid should be used to support reforms that work towards developing integrative institutions. Cooperation with developing countries should be structured so that social groups that have been previously excluded can partake in the decision-making process.
All programs developed without a comprehensive understanding of a nation’s institutional structure are wasteful and counterproductive.

Foreign aid should be targeted at institutional reforms, not at supporting authoritarian systems.

Final Summary

The key messages in the book are:
Rich and poor countries differ, above all, in their political and economic institutions. In wealthy countries there are integrative institutions (i.e., democratic institutions that involve the whole society), whereas in poor countries there are extractive institutions (i.e., authoritarian and exploitative institutions that reinforce the power of an elite class).

The questions answered:

Why are some nations wealthy, and how does lasting prosperity emerge?

  • Many theories attempt to explain why some countries are rich and others poor – but they all only get so far.
  • Integrative institutions are the key to a nation’s lasting economic success.
  • Integrative institutions emerge from historical coincidences, and bring about lasting prosperity.
  • Centralized political power is crucial for lasting prosperity.

Why are other nations poor and why do they stay that way?

  • Authoritarian institutions prevail in poorer countries through a vicious circle.
  • There can be no lasting growth in authoritarian systems.
  • Authoritarian systems fail because they do not create the right kind of incentives.

How can we confront inequality in the world?

  • Political change always means institutional change – and that takes time.
  • Foreign aid should be targeted at institutional reforms, not at supporting authoritarian systems

Authors

Daron Acemoglu

Daron Acemoglu is the Elizabeth and James Killian Professor of Economics at MIT. In 2005 he received the John Bates Clark Medal, given to economists under age forty judged to have made the most significant contribution to economic thought and knowledge, in 2012 he was awarded the Erwin Plein Nemmers Prize in economics for work of lasting significance, and in 2016 he received the BBVA Frontiers of Knowledge Award in economics, finance, and management for his lifetime contributions.

James A. Robinson

James A. Robinson, a political scientist and economist, is one of nine University Professors at the University of Chicago. Focused on Latin America and Africa, he is currently conducting research in Bolivia, the Democratic Republic of the Congo, Sierra Leone, Haiti, and Colombia, where he has taught for many years during the summer at the University of the Andes in Bogotá.

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