Monday, June 25, 2012

Why Nations Fail: Extractive Institutions


Time to look at another very interesting book on economic history that recently came out: Why Nations Fail: The Origins of Power, Prosperity, and Poverty by Damon Acemoglu and James Robinson. It is a huge achievement, but I have mixed feelings about it.

On the one hand, it is dazzling in scope, with historical references and interesting detail ranging from the Roman Empire to contemporary Egypt and Colombia and China. To their credit, they deal with tangible reality, not simply mathematical models. There is a myriad of actual names and actual evidence in the book, not just another irrelevant econometric torturing of national income accounts data. You will encounter everything from the disappointments of inventors in Elizabethan England to the reasons for the decline of Venice to the career of Deng Xiaoping to the structure of the telecoms market in Mexico. Some of their examples and stories are riveting.

On the other hand, they try to explain too much with one parsimonious theory. There is a lack of consideration of counter-evidence in most of the book, and one is left with a feeling that it is just a little too neat. I was left intrigued but without much sense of just how far it was legitimate to push their approach.

They do argue against other explanations, such as Jared Diamond's natural endowments, in a persuasive way. They can shape a wide array of different case studies to suit their argument. But it isn't always clear how much they may be cherry-picking or leaving out or ignoring countervailing evidence. They don't engage with other views in the detail that Dierdre McCloskey does in the book we recently looked at starting here.

Just like in markets, you can often backfit any number of explanations to past data.

That said, their willingness to try to explain actual realized situations is very interesting, all the more so because Acemoglu is a winner of the hugely respected John Bates Clark medal in economics and teaches at MIT. So he comes from a very conventional economics background, and has more than paid his dues. Yet with his co-author, a Professor of Government at Harvard, he has written a book which is very much political economy in nature. It is a welcome small evolution of open-mindedness in economics.

They stress that political institutions tend to shape the economic institutions and performance of a society. It is as if an economic Pope has suddenly become much less catholic.

A larger slice versus growing the pie

The core of their case is a distinction between "extractive" and "inclusive" political and economic institutions. I'm not always sure the definitions are clear, however. At first they seem straightforward, but they can become blurry in the context of individual cases or examples.

In essence, extracttive institutions try to seize a larger share of the pie for some groups in society, at the expense of making the pie larger. Inclusive institutions prefer to see the size of the pie grow, in the interests of the majority, even if it means disruptive change for the privileged few with a valuable stake in the status quo.

So, the authors argue, the Glorious Revolution of 1688 laid the grounds for inclusive institutions in the UK, and that, together with other contingent factors like the enrichment of a broader coalition of interests from Atlantic trade, led to the industrial revolution. The king could not simply grant monopolies or restrain trade any longer.

It makes sense, but in that case it isn't clear - as McCloskey argues - why the industrial revoluton did not tke off much earlier, in Athens, say, or Republican Rome or Tyre or Alexandria. Yes, all these socieites had inequality and slavery. England had already benefitted over centures from the end of feudalism. But this is where the notion of inclusivity becomes blurry. How inclusive is enough? How and at what point do you reach escape velocity? Why couldn't you have an aristocracy that was massively competitive and open to change within its own ranks, but limited the benefits to outsiders? Indeed, that was what the Roman Republic was like in practice.

They tell a consistent story, but it still comes across largely as a plausible story rather than as a proven case.

Institutions matter, not culture

Development isn't a matter of geographical endowment or even culture, they argue. Indeed, they start off with one town that lies on both sides of the US-Mexican border.

The reason that Nogales, Arizona, is much richer than Nogales, Sonora, is simple; it is because of the very different institutions on the two sides of the border, which create very different incentives for the inhabitants of Nogales, Arizona, versus Nogales, Sonora. The United States is also far richer today than either Mexico or Peru because of the way its institutions, both economic and political, shape the incentives of businesses, individuals, and politicians.

This was not inevitable. If you go back five hundred years North America was sparsely populated and lagged economically far behind the great civilizations of Mexico and Peru. Incentives matter, they say.

Economic institutions shape economic incentives: the incentives 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.

As for political institutions,

Political institutions include but are not limited to written constitutions and to whether the society is a democracy. They include the power and capacity of the state to regulate and govern society. It is also necessary to consider more broadly the factors that determine how political power is distributed in society, particularly the ability of different groups to act collectively to pursue their objectives or to stop other people from pursuing theirs.


Extractive elites


One of the most conspicuous features of their theory is they are very willing to divide the world into good guys and bad guys. Elites most often prefer to maintain their power and wealth and influence, at the expense of "creative destruction" which would undermine their power - even if society as a whole became much richer. There is always someone to blame.

And they do marshall many fascinating examples of when elites did just that, such as the refusal of the Austrian Empire to build railways, the refusal of Roman emperors to adopt new transportation techniques, or the refusal of Gautemalan elites to build roads. Traffic jams near the port in Lagos, Nigeria, are caused by truckers parking on the highway and bribing the police to avoid moving them , leaving the rest of society in traffic jams that can last six or ten hours.


Even self-declared good guys often become bad guys. There is an 'iron law of oligarchy'. Extractive institutions mean that even if new rulers do take over, they will most often maintain the same ruthless policies. Lawrence Kabila if anything was worse than Mobutu in Zaire, for example. The sheer wealth that can be accummulated by such extractive elites also makes civil war and political instability much more likely, because the stakes are so high.

This means the problem of development is tougher than several generations of development economists believed.

This persistence and the forces that create it also explain why it is so difficult to remove world inequality and to make poor countries prosperous. Though institutions are the key to the differences between the two Nogaleses and between Mexico and the United States, that doesn’t mean there will be a consensus in Mexico to change institutions. There is no necessity for a society to develop or adopt the institutions that are best for economic growth or the welfare of its citizens, because other institutions may be even better for those who control politics and political institutions. The powerful and the rest of society will often disagree about which set of institutions should remain in place and which ones should be changed.

Importantly, this explains why "ignorance of policy" is seldom the reason policymakers do not follow sensible economic policies, a point which is surely correct. Nkrumah's Ghana was not badly run because they did not listen to development economists.

This endless stream of economically irrational developments was not caused by the fact that Nkrumah or his advisers were badly informed or ignorant of the right economic policies. They had people like Killick and had even been advised by Nobel laureate Sir Arthur Lewis, who knew the policies were not good. What drove the form the economic policies took was the fact that Nkrumah needed to use them to buy political support and sustain his undemocratic regime.

So you have to look at how decisions are made in practice. Standard economics presupposes much politics.

To understand this, you have to go beyond economics and expert advice on the best thing to do and, instead, study how decisions actually get made, who gets to make them, and why those people 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. As the economist Abba Lerner noted in the 1970s, “Economics has gained the title Queen of the Social Sciences by choosing solved political problems as its domain.”

We will argue that achieving prosperity depends on solving some basic political problems. It is precisely because economics has assumed that political problems are solved that it has not been able to come up with a convincing explanation for world inequality.


Importantly, inclusive institutions must extend across society for there to be a chance of sustainable growth. Extractive societies can grow for a while - such as the USSR before 1970, or indeed China today. But because such elites cannot stomach creative destruction, growth is bound to run out.

Their argument also usefully sidesteps the government versus market debate. Some degree of state centralization is essential:

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. To function well, society also needs other public services: roads and a transport network so that goods can be transported; a public infrastructure so that economic activity can flourish; and some type of basic regulation to prevent fraud and malfeasance.

Occupy the Academy

In some ways - although they do not develop this view- it's a charter for thinking in terms of the 1% versus the 99%. You could run the argument in terms of greedy Wall St bankers and private equity titans versus ordinary citizens.

But I'm not sure things are so clear cut. Are the elderly in the US an extractive elite in some respects? They certainly grasp a hugely disproportionate share of government resources at the expense of other groups.

Acemoglu and Robinson are also notably willing to believe something which sails close to "revolutionary ends justify the means": they believe the French Revolution was a great success because it swept away many older restrictions, even if there was much regrettable violence and war.

In fact, Mancur Olson's notion of distributive coalitions and ossification of institutions in The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities may be more widely applicable than the "extractive institution" in this book. It may not always be a narrow elite which serves to defend its interests at the expense of the common good. It can also be labor unions. richer provinces, specific professions like the AMA or the Bar, or even older generations versus the young. Societies tend to pick up social rigidities like barnacles.

Acemoglu and Robinson very much endorse disruptive creative destruction as the way to wealth and prosperity - and I agree with that. But there may be times when people actually value some features of their current situation for more than purely selfish reasons - pride in a culture, for example, or attachment to a way of life. There can be more trade-offs in change than the authors are willing to acknowledge.

Speaking to the converted

And they do not really acknowledge that development economics in general, and the IMF and World Bank and major development ministries in particular, have been moving in the direction of emphasizing governance for almost twenty years now. The discipline of economics simply lagged behind what was happening in the field and in the committee rooms. The major international donors have tried to put more emphasis on NGOs rather than state aid, or imposed conditionality related to opening up monopolies and other extractive mechansims favored by local elites.

So on that metric, the book is not really arguing for anything new in practice. It is simply giving a more generalized public-choice explanation of why that ought to work, without a lot of attention to the history of those public choice ideas. There is too much attention, in the end, to illustrative examples than the story of how we think about these issues - the intellectual development of these ideas.

There is a limit to what a parsimonious social theory can ever hope to do. And I'm not convinced that the notion of theoretical "explanation" using these theories is that valuable. The only way theory really helps in the social sciences is to educate the "prepared mind", but in practice it just as often leads to professional blindness.

But the book is certainly along the right lines, albeit lines which have already been trodden by many international organizations in practice.

It is a magnificent hedgehog of a work. But I remain a fox. I enjoyed the fabulous diversity of examples. But I remain unconvinced that the hedgehog theory at the heart of the book is really that new or transformative, beyond warning us not to make the mistakes of previous all-encompassing hedgehog theories.



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