Last week the Nobel Prize for Economics (or, for the truly pedantic the Sveriges Riksbank Prize in Economics in Memory of Alfred Nobel) was awarded to Daron Acemoglu, (a member of the Clark Center US Experts Panel) Simon Johnson, and James Robinson for work on the most important topic on economics – why are some countries rich and others poor?
Even in 2024 life remains a lottery with the country in which one is born playing an often decisive role in one’s life chances. Investigating why some countries have developed thriving, prosperous economies and others have not is amongst the most important work carried out in all the social sciences.
For Acemoglu, Johnson, and Robinson, the answer is to be found in institutions – a topic to which the Clark Center US and European panels turned this week.
When economists – and other social scientists – talk of institutions, they tend to be using the term in a somewhat different sense to laypeople. The police department of a city is, economists and non-economists can definitely agree, surely an institution. It is an organization with staff, rules, procedures, and a physical location. But economic institutions refer not only to such organizations with a door one can knock on or a website one can visit, but to a wider set of well-established arrangements and structures that govern how an economy – and indeed a society – function. The police department is the organization that will respond if you steal from a supermarket, it is definitely an institution. But so too is the notion that, in general, one should not steal from a supermarket regardless of whether or not the police department will respond in time to intervene.
Institutions might be thought of as the rules of the game for how an economy is run. As Daron Acemoglu wrote in response to a question this week:
Summary of my view: constitutions, laws and institutional practices provide the framework within which other decisions are made.
The institutional framework in this case is more than just a collection of institutions with a website and a collection of laws and rules, it also brings in a set of expected and customary behaviors.
Economists have long recognized that such frameworks matter. Indeed Douglas North and Robert Fogel won the Nobel in 1993 for their own work on the role of institutions in explaining long run growth. A good place to start for seeking to understand the theories of North is with his 2006 paper, “A conceptual framework for interpreting recorded human history” – which your columnist has always thought was a wonderfully ambitious title for a paper.
One can go back further to find economists writing of the role of institutions in long term development. Adam Smith was, to a modern economist, thinking in institutional terms when he argued that “peace, easy taxes, and a tolerable administration of justice” were the ingredients needed for a sound economy.
The work for Acemoglu, Johnson, and Robinson won their Nobel goes beyond merely pointing out that institutions play a crucial long term role. That much was already recognized. Their 2001 paper The Colonial Origins of Comparative Development: An Empirical Investigation, which has gone on to become one of the most cited papers of all time, goes much further. The paper argued that European colonizers developed different kinds of institutions in their various overseas holdings. In countries where mortality rates were high they generally employed extractive institutions which sought to exploit local populations and take out economic wealth. By contrast, in colonies where the climate was more suited to Europeans, they often employed more inclusive institutional structures to attract European settlers to the colony by offering them a chance to share in the colony’s economic development. The pattern of colonial rule, and the institutions associated with it, looked rather different in Canada and Australia, say, to those found in Spanish South America or in the Belgian-run Congo.
These colonial roots can run deep, as the Nobel committee explained in their announcement of this year’s prize:
This is an important reason for why former colonies that were once rich are now poor, and vice versa.
Some countries become trapped in a situation with extractive institutions and low economic growth. The introduction of inclusive institutions would create long-term benefits for everyone, but extractive institutions provide short-term gains for the people in power. As long as the political system guarantees they will remain in control, no one will trust their promises of future economic reforms. According to the laureates, this is why no improvement occurs.
However, this inability to make credible promises of positive change can also explain why democratisation sometimes occurs. When there is a threat of revolution, the people in power face a dilemma. They would prefer to remain in power and try to placate the masses by promising economic reforms, but the population are unlikely to believe that they will not return to the old system as soon as the situation settles down. In the end, the only option may be to transfer power and establish democracy.
Both of the European and US Expert Panels of the center, strongly agreed that institutions play a crucial role in economic outcomes. Perhaps most interestingly there was also agreement – on both panels – that “countries where democracy and the rule of law are weakened are likely to experience measurable damage to their economic performance”.
Few economists nowadays would disagree, the institutions on which the rich world’s success has been built, developed slowly over decades and centuries. There is a risk that they are sometimes taken for granted. Of course, just as the benefits of any institutional structure can take years to have any real impact on economic performance, so too can the damage done take a long time to show up.
