Saturday, May 26, 2012

Nation Fail

Why are some countries rich and others poor? This is a question that has bedeviled economists for centuries. A new book that attempts to explain this discrepancy is getting a lot of attention - Why Nations Fail by Daron Acemoglu and James Robinson. This book by two prominent economists ambitiously attempts to answer that fundamental question. Their answer, in a nutshell, is that some countries develop inclusive political institutions that lead to inclusive economic institutions where anyone has a fair shot at succeeding. Poor counties, by contrast, have political structures ruled by oligarchs, often family-centered, and thus develop extractive economic institutions, where economic growth is siphoned off by the elites for their own benefit, so people see no use in trying to get ahead. That's a vast oversimplification, of course, and I have not yet read the book. Matt Yglesias has a good summary of what this is like in practice:
The basic framework of the book is to lay out the relationship between economic institutions and political institutions. Some countries (Canada, Denmark, Japan) have "inclusive" political institutions and consequently develop "inclusive" economic institutions. When your economic institutions are inclusive, everyone gets a chance to go to school and learn, everyone has a chance to switch jobs or start a new business, and everyone has the opportunity to save and invest. But where countries have "extractive" political institutions they end up with "extractive" economic institutions. The president's wife's brother's son gets an exclusive license to import exercise machines (mostly used in hotel gyms since local people are too poor to use them) and earns a nice living do so free from competition. Eventually some eager beaver comes along and says, hey if this other guy is earning monopoly rents importing exercise machines then I'll just build some here domestically. But the eager beaver is naive. The exclusive import license isn't a coincidence, it reflects the president's wife's brother's son's privileged position in the political system. Smart hoteliers will know better than to buy from a competitor since it will only buy them regulatory trouble. Smart bankers will know that the new business is doomed and won't lend him money and even if it weren't doomed, lending him money would only buy them regulatory trouble. Eventually, the eager beaver's savvier wife will explain to him why the plan is doomed. Absent opportunity, human and physical capital stagnates and ambitious people focus their attention on climbing the ladder of corruption. Even if the President realizes that on some level he's running a counterproductively dysfunctional system, he knows that if he starts threatening the economic privileges of the people he counts on to support the regime that his own base will vanish.

So that's the story. To get rich you need to either land on a bunch of oil (Qatar) or else have the kind of inclusive institutions that allow for "creative destruction" and widespread opportunity. They don't deny that countries with extractive institutions (the Soviet Union in the 1950s, China in the 2000s) can grow rapidly, but this kind of extractive growth isn't sustainable.
Two Cheers for Growth Under Extractive Institutions (Slate)

There seems to be widespread agreement on this fundamental thesis, but according to to some others it overlooks a number of other key points, points where one would expect conventional economists to have blinders. As this review points out, you can't just talk about "property rights" without pointing out that who has property and how it's distributed matter a great deal too:
The authors place enormous emphasis on property rights, for example. But property, too, is fundamentally a political matter. The aristocrats who seized common land in 18th century England did so because they controlled parliament. They violated centuries of custom and practice because they could. The settlers who created a society of independent farmers in the American colonies did so because those very same English aristocrats were too far away to stop them. The violation of property rights in North America promoted widespread prosperity because it shifted economic opportunity from the few to the many.
And the exploitation of certain nations through "free trade" matters too:
The Koreans were strong enough politically to protect their native industries from foreign competition until they were able to compete. And rather than allowing domestic producers to enjoy easy profits behind tariff barriers, Korea's political elite drove them to modernise and export. All rich industrial countries have followed a similar path. In countries where the majority are poor, on the other hand, foreign interests often work with local elites in an arrangement that suits them both - but is a disaster for everyone else. Industry is strangled at birth and vast mineral and oil wealth finds its way offshore. It is odd that the authors don't feel able to set this out in plain terms.
This review concludes, pointing out that the wealth of countries is based on political factors, and these factors can change:
But the book is correct on the key point: Economic development is determined by political factors. We should all be relieved that the economics establishment is finally willing to acknowledge the fact.

And of course the point has implications for countries that have achieved general prosperity. In Europe and North America inequality has been growing for the past generation or so. In the United States, median hourly earnings have scarcely increased in real terms since 1972. Stock markets and executive pay, on the other hand, have boomed. More widely, in the rich, industrialised world, the percentage of GDP captured by all workers in the form of wages fell from 75 per cent in the mid-1970s to 66 per cent in the first decade of this century. For a generation now, the owners and controllers of capital - the financial sector in particular - have secured the lion’s share of the new wealth.

This steepening inequality is not inevitable; it is a political achievement. Like their ancestors in 18th century England, successive governments have crafted legislation and distributed state patronage in the interests of the wealthy and the well connected. The unions have been stripped of bargaining power and large companies have shifted both production and profits offshore. The state has paid for technology and then given it to private corporations. This new technology has reduced the need for unemployment and boosted profits. Meanwhile, the tax levied on large companies and rich individuals has fallen, and the rest of us have had to make up the shortfall through increases in sales taxes and cuts in public services.
Why nations fail (Al Jazeera)

One of the best reviews was by the noted scientist Jared Diamond, author of Guns, Germs and Steel, and Collapse. He sums up the authors' thesis in this way:
In particular, [the authors] stress what they term inclusive economic and political institutions: “Inclusive economic institutions…are those that allow and encourage participation by the great mass of people in economic activities that make best use of their talents and skills and that enable individuals to make the choices they wish.” ...Such inclusive economic institutions in turn arise from “political institutions that distribute power broadly in society and subject it to constraints…. Instead of being vested in a single individual or a narrow group, [inclusive] political power rests with a broad coalition or a plurality of groups.”...Inclusive economic and political institutions provide individuals with incentives to increase their economic productivity as they think best. Such inclusive institutions are to be contrasted with absolutist political institutions that narrowly concentrate political power, and with extractive economic institutions that force people to work largely for the benefit of dictators....While absolutist regimes with extractive economic institutions can sometimes achieve economic growth, that growth is based on existing technology, and is nonsustainable and prone to collapse; whereas inclusive institutions are required for sustained growth based on technological change. One might naively expect dictators to promote long-term economic growth, because such growth would generate more wealth for them to extract. But their efforts are warped, because what’s economically good for individual citizens may be bad for the political elite, and because economic growth may be best promoted by political institutions that would shake the elite’s hegemony.
He cites historical examples:
For example, in South Korea but not in North Korea people can get a good education, own property, start a business, sell products and services, accumulate and invest capital, spend money in open markets, take out a mortgage to buy a house, and thereby expect that by working harder they may enjoy a good life....South Korea recently, and Britain and the US beginning much earlier, do have broad participation of citizens in political decisions; North Korea does not. ..The ultimate development of inclusive political institutions to date is in modern Scandinavian democracies with universal suffrage and relatively egalitarian societies. However, compared to modern dictatorships (like North Korea) and the absolute monarchies widespread in the past, societies (such as eighteenth-century Britain) in which only a minority of citizens could vote or participate in political decisions still represented a big advance toward inclusiveness.

In their narrow focus on inclusive institutions, however, the authors ignore or dismiss other factors.
Diamond goes on to list those factors:

1. Some regions are richer because they literally had a head start. Large-scale agriculture - and the institutions that are created from it including civilization itself - happened much earlier in certain parts of the world with various natural advantages.
The various durations of government around the world are linked to the various durations and productivities of farming that was the prerequisite for the rise of governments. For example, Europe began to acquire highly productive agriculture 9,000 years ago and state government by at least 4,000 years ago, but subequatorial Africa acquired less productive agriculture only between 2,000 and 1,800 years ago and state government even more recently. Those historical differences prove to have huge effects on the modern distribution of wealth.
2. In areas colonized by European powers where native populations remained to exploit, the conquerors developed extractive institutions. In placed where Europeans had to do their own work, they created ones that rewarded hard work. Countries that are rich in mineral, agricultural or fossil fuel wealth are often paradoxically poor. This is because they are more likely to have extractive institutions put in place by societal elites. Countries without such resources realize that the only path to riches is to develop their human capital, and so create institutions to allow this to flourish (good schools, honest legal system, skilled bureaucrats, meritocracy etc.): formerly rich countries with dense native populations, such as Peru, Indonesia, and India, Europeans introduced corrupt “extractive” economic institutions, such as forced labor and confiscation of produce, to drain wealth and labor from the natives. But in formerly poor countries with sparse native populations, such as Costa Rica and Australia, European settlers had to work themselves and developed institutional incentives rewarding work...The extractive institutions retarded economic development, but incentivizing institutions promoted it.
3. Tropical countries tend to be poorer because there are more tropical diseases like malaria and parasites that affect the population.
Tropical diseases differ on average from temperate diseases, in several respects. First, there are far more parasitic diseases (such as elephantiasis and schistosomiasis) in tropical areas, because cold temperate winters kill parasite stages outside our bodies, but tropical parasites can thrive outside our bodies all year long. Second, disease vectors, such as mosquitoes and ticks, are far more diverse in tropical than in temperate areas. Finally, biological characteristics of the responsible microbes have made it easier to develop vaccines against major infectious diseases of temperate areas than against tropical diseases; we still aren’t close to a vaccine against malaria, despite billions of dollars invested. Hence tropical diseases impose a huge burden on economies of tropical countries.
4. Tropical countries tend to be poorer because their agriculture is less productive overall:
First, temperate plants store more energy in parts edible to us humans (such as seeds and tubers) than do tropical plants. Second, diseases borne by insects and other pests reduce crop yields more in the tropics than in the temperate zones, because the pests are more diverse and survive better year-round in tropical than in temperate areas. Third, glaciers repeatedly advanced and retreated over temperate areas, creating young nutrient-rich soils. Tropical lowland areas haven’t been glaciated and hence tend to have older soils, leached of their nutrients by rain for thousands of years. Fourth, the higher average rainfall of tropical than of temperate areas results in more nutrients being leached out of the soil by rain. Finally, higher tropical temperatures cause dead leaves and other organic matter falling to the ground to be broken down quickly by microbes and other organisms, releasing their nutrients to be leached away. Hence in temperate areas soil fertility is on average higher, crop losses to pests lower, and agricultural productivity higher than in tropical areas.
5. Some countries have easy access to water to participate in global trade while others lack access:
It costs roughly seven times more to ship a ton of cargo by land than by sea. That puts landlocked countries at an economic disadvantage, and helps explain why landlocked Bolivia and semilandlocked Paraguay are the poorest countries of South America. It also helps explain why Africa, with no river navigable to the sea for hundreds of miles except the Nile, and with fifteen landlocked nations, is the poorest continent.
6. Some counties irreparably damage their natural resource base, leading to cycles of poverty:
Countries that excessively deplete their resources—whether inadvertently or intentionally—tend to impoverish themselves, although the difficulty of estimating accurately the costs of resource destruction causes economists to ignore it. It helps explain why notoriously deforested countries—such as Haiti, Rwanda, Burundi, Madagascar, and Nepal—tend to be notoriously poor and politically unstable.
He takes the authors to task for neglecting historical factors and the natural environment in their analysis:
Some countries, such as Britain and Japan, have such institutions, while other countries, such as Ethiopia and the Congo, don’t. To explain why, the authors give a just-so story of each country’s history, which ends by concluding that that story explains why that country either did or didn’t develop good institutions...But it’s obvious that good institutions, and the wealth and power that they spawned, did not crop up randomly. For instance, all Western European countries ended up richer and with better institutions than any tropical African country. Big underlying differences led to this divergence of outcomes. Europe has had a long history (of up to nine thousand years) of agriculture based on the world’s most productive crops and domestic animals, both of which were domesticated in and introduced to Europe from the Fertile Crescent. Agriculture in tropical Africa is only between 1,800 and 5,000 years old and based on less productive domesticated crops and imported animals. As a result, Europe has had up to four thousand years’ experience of government, complex institutions, and growing national identities, compared to a few centuries or less for all of sub-Saharan Africa. Europe has glaciated fertile soils, reliable summer rainfall, and few tropical diseases; tropical Africa has unglaciated and extensively infertile soils, less reliable rainfall, and many tropical diseases.
Although not the conclusion, this is a good summary:
These, then, are the main factors invoked to understand why nations differ in wealth. The factors are multiple and diverse. We all know, from our personal experience, that there isn’t one simple answer to the question why each of us becomes richer or poorer: it depends on inheritance, education, ambition, talent, health, personal connections, opportunities, and luck, just to mention some factors. Hence we shouldn’t be surprised that the question of why whole societies become richer or poorer also cannot be given one simple answer.
What Makes Countries Rich or Poor? Jared Diamond, The New York Review of Books.

That said, there are a few omissions in Jared Diamond's review that I find surprising. I'm surprised Diamond didn't mention overpopulation and Malthusian constraints. Countries like Nigeria and Bangladesh with their enormous populations are certainly at a disadvantage.  Countries like Iceland and Norway have high per capita incomes because of their low populations, and the small distance between representatives and the general populace helps prevent political and economic corruption (look at Iceland's response to the banking crisis).

Another omission by Diamond that surprises me is an exploration of the use of fossil fuel enabled technology. This allows wealth to be extracted from local communities and concentrated in relatively few hands, with the byzantine workings of the money system serving as a sleight-of hand. Without fossil fuels and technology, it's harder to concentrate wealth and transport it out of a community. Before fossil fuels, transporting goods from afar was a slow and difficult process, so economies, and political institutions, were semi-local and size-constrained. Now with the global economy and the Internet, the elites are able to command the resources and skilled labor of the entire world, and concentrate the resulting wealth in financial centers like Manhattan, The City (London), Shanghai, Dubai, and various offshore tax havens. Much national wealth centers around these areas.

Another omission is the timetable for the development of fossil fuel-based technology. Some countries, notably Western Europe, particularly Great Britain, and North America, had a huge advantage in the harvesting of fossil fuels and the adaptation of mechanized agriculture. Diamond mentions the age of various civilizations, but most modern wealth is also determined by the use of modern technology. This head start has obviously had a major role in which nations are rich and others poor. For most of history, China was the world's wealthiest and most technologically advanced nation. That diverged with the development in Western Europe of the joint-stock corporation, the scientific method, and the steam engine. In addition to institutions, this must also be considered. England's coal sources were relatively accessible in comparison to a country like Japan, which was a country very similar in institutional and political advancement. The European discovery of the Americas plays a role here too (the distance from Western Europe to North America is half that from Asia)

Genetic factors play a role too. Some societies have a greater portion of society with facilities in technical subjects like math and science. Africa, one of the poorest continents, has less genetic diversity than many other areas of the world, since it is the origin point of humanity before migration to other continents. This genetic diversity may play a role in making modern economies work. According to Gregory Clark, the recurrent plagues and famines through European history caused the upper class to have more surviving children, dispersing them through "downward mobility" into all walks of life - blacksmiths, butchers, colliers, etc. According to Clark, this played a role in England's escape from the Malthusian trap of greater populations gobbling up any accumulated surplus.

The other factor, and it's politically explosive, is religion. Countries where large amounts of people claim belief in a deity, pray, and attend religious services regularly tend to be poorer than those who have populations who say religion is not that important. This even holds true within countries - in the United States, the poorest and most backward states are those of the "Bible Belt" where religious fundamentalism is widespread. This goes hand-in-hand with political corruption, cultural backwardness, repression by elites, and poverty. Go into the poorest areas of any city and you're sure to see churches everywhere, as you will in poor rural areas. Why this is so is not understood.

Elites have always used religion to justify their rule, from the very first civilizations in ancient Egypt, Mesopotamia, China, and the Americas. Only the gods changed. Usually the leader spoke for the deity, or was himself a deity. Belief in the majority organized religion seems to be tightly correlated to authoritarian behavior throughout history for whatever reason. Religious beliefs seems to be correlated with acceptance of one's fate, submission to authorities and deference to elites. Religious populations tend to be very credulous of the leaders claims on their wealth, even if those claims are outrageous. They tend to be more susceptible to propaganda and the control methods used by elites. And they tend to be less likely to act up - they accept their lot in life even when elites run roughshod all over them. Thus, in religious countries, extreme concentrations of wealth and political corruption tend to be rationalized away. This might be because religious populations are not only more susceptible to strong, charismatic leaders and more credulous of the national leadership mythology. Another reason might be because they view the afterlife as more of a goal, and hence do not try and upset the order down here, which they believe is ordained by God. Latin America, the Middle East and Africa are all prime examples of this. Economists who have looked at this have found one major outlier - The United States. Thus it makes sense that the United States is rapidly devolving to the level of government and development it "should" be at considering the widespread fundamentalist religious beliefs of its population. See this.

Francis Fukuyama, in The Origins of Political Order, argues that societies that develop institutions based upon loyalty to the state, rather than kinship, tend to be more successful than ones where institutions are designed to benefit the genetic kinsmen of elites. On page 210, he says:
A number of political scientists have compared the early modern European state to organized crime. they mean that rulers of states seek to use their expertise in the organization of violence to extract resources from the rest of society, what economists call rents. Other writers use the term "predatory state" to describe a range of more recent developing world regimes like Zaire under Mobutu Sese Seko or Liberia under Charles Taylor. In a predatory state, the elites in charge seek to extract the highest level of resources they can from the underlying society and divert them to their own private uses. The reason these elites seek power in the first place is the access that power gives them to economic rents.
By contrast, bureaucratic institutions where merit rather than kinship is an important factor tend to have better outcomes and wealth creation.

It's no secret that wealthy oligarchs in the  United States have been working double-time to dismantle it's inclusive institutions built in the past and replace them with predatory ones. This is why the US is looking less and less like Denmark, and more and more like a banana republic - a tiny group of plutocrats living like oriental pashas amongst widespread desperation and squalor. My own feeling is that as the global economy slows down due to the limits to growth and the imbalance between our archaic medieval money system and the real world of scarce resources, we will see inclusive institutions dismantled in every country all around the world in favor of extractive ones. Social mobility will no longer be achievable, and the institutions that made capitalism work will be dismantled in favor of ones beholden to elites. The elites will maintain a veneer of democracy, while taking ever more extreme measures to control the unruly population that they are looting, as described here many times. Inclusive institutions will increasingly be seen as a threat to their power, and will be crushed or rendered impotent. All of this will become more intense as fossil-fuels become more expensive, jobs whither away and economic growth stalls.

How this plays out depends on a number of factors. I think it will depend on a nation's own cultural background and social fabric. Suffice it to say, places like Denmark and Japan will fare far better than places like Russia or the United States. But I think we'll be seeing a lot more nations fail in the years ahead.

For a look at how America's institutions have changed, see this: The Oligarchy’s Rule of Law: From Boris Yeltsin’s Russia to Aubrey McClendon’s Oklahoma (The Exiled)

Why Nations Fail - the blog of the authors about these topics.

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