Nobel insights into institutional determinants of prosperity

Sound institutions make countries rich, say the Nobel laureates, meaning institutions that make capitalism work

Institutions that make capitalism tick make for prosperity, find the Nobel laureates

Many readers might be familiar with the book, Why Nations Fail, by Daron Acemoglu and James A Robinson, two members of the trio who have been awarded this year’s Nobel Prize in Economics. The third, Simon Johnson, had collaborated with Acemoglu and Robinson to produce an influential paper in 2002 published in the Quarterly Journal of Economics, ‘Reversal of Fortune: Geography and Institutions in the Making of the Modern World Income Distribution’, whose thesis is elaborated in the book, and has won them the Nobel earlier this week.

This is not the first time institutional economics has been recognised by the Nobel committee. Douglass C North won the prize in 1993 for his articulation of the role of institutions in determining economic outcomes, along with Robert W Fogel, who specialised in analysing history with quantita tive rigour.

That institutions matter in how economies perform may be tritely obvious. All those who chant the mantra of ‘ease of doing business’ articulate this insight, even if many of them do not appear overly insightful. That a functional system to enforce contracts is vital for economic efficiency, and that the lethargy of the judicial process in India hurts growth, are obvious. The Nobel committee did not award the prize for such bits of common sense.

Acemoglu and his collaborators have an explanation for how growth-constraining and growth-promoting institutions come into being. Further, they posit the possibility of growth-retarding institutions being changed into growth-friendly ones through popular pressure.

No, they are not advocates of violence and revolution. Rather, while they do not rule out any role for violence in forcing institutional change, they suggest that non-violent political mobilisation is likely to agglomerate numerically larger coalitions that press for change, and is, thus, likely to be more successful.

One major contribution of the laureates is to decisively debunk the notion that geography is destiny, championed by the likes of Jeffrey Sachs — another Nobel Prize-winning economist — and popular since the beginning of the European conquest of the world.

The laureates debunk geographic determinism by looking at a town called Nogales, divided into two by the US-Mexico border. Both halves of the town have the same geographic location, the same climate, and the same cultural heritage of Spanish colonisation. Yet, the people of North Nogales in Arizona, US, are more prosperous than the people of South Nogales in Sonora, Mexico.

The residents of American Nogales have access to functional markets and arelatively level playing field, enabled by American democracy, American law enforcement, American education and the American dream. Southern Nogalans live with drug cartels, political corruption, regulatory capture and, in con sequence, prosper far less.

The authors have a Eurocentric explanation for institutional arrangements in different parts of the world. Europeans colonised much of the world. The sparsely populated bits could accommodate large numbers of settlers, and here the colonisers instituted inclusive institutions, that led to prosperity, as exemplified by North America and Australia.

Lands that were heavily populated, or were otherwise unsuitable for European settlement thanks to local diseases, were left with their institutions more or less intact. The local population provided the workforce needed for colonial enrichment, and the local elite continued to benefit, even as a share of the surplus went to the colonising power. Such areas failed to prosper.

Areas of the world that were more prosperous than Europe before colonisation lagged, as modern institutions powered the Industrial Revolution in Europe, and in the lands where Europe-like institutions were introduced. This resulted in the reversal of fortunes, with relatively backward Europe overtaking India and China, and racing far ahead.

This might seem a schematic explanation for why some nations fail. But let us note that the laureates credit cultural institutions with the power they have to fuel or retard growth. Take the caste system in India. It is culturally appropriate only for the bania to use money to make more money. Most of India’s industrialists are from groups that embrace this culture.

At the same time, most banias, even when they don the mantle of industrialists, remain traders at heart. Few, if any, invest in R&D to create something new.

Culture hampers the creation of new knowledge as well. The Vedas, goes the theory and theology, contain all knowledge. Knowledge is thus pre-existing, and the scholar’s job is to master it, not to create something new. Caste valorises cerebral work, demeans physical work. Not surprisingly, our engineers can write code, but struggle to fix real-world problems.

Karl Marx had a simple term for the swathe of institutions that promote growth: capitalism, defined, in essence, by the rendering of labour power into a commodity, setting the direct producer doubly free. He is free (read: deprived) of any means of production, and unaccountable to his employer outside his hours of work — unlike a slave, or a peasant. The capitalist mode of production is the set of institutions that sets the direct producer doubly free.

Marx thought revolutions were necessary to change from one mode of production to another. He lived in a world that had not adopted universal adult suffrage. Our latest Nobel laureates think peaceful mobilisation for the desired institutional change is viable. Let us hope they are right.