Good political institutions spawn good economic results

Why are some countries rich and some poor? This is an old question and the answers have varied over time.

In our modern context, we ask a slightly more inflected question. Why do some countries grow over the long run while others don't.

In itself, material growth is tied to capital investment. But, that is not enough.

Afghanistan doesn't seem to be growing in any discernible fashion, despite substantive capital deployment. In contrast, Botswana has from 1966 to 1999 grown around 9 per cent per annum often with little external help.

The deeper question is — why do some countries have capital and are able to retain it, while some others fritter away their resources.

In early 1900s, Argentina and the United States were countries with roughly the same level of income. Only seven countries were richer than Argentina. Towards the end of this decade, the Argentine income is less than half of Japan, which was destroyed by 1945.

What could the reasons be for this decline? In contrast to the success stories we hear, perhaps more can be learnt by asking: can countries undergo similar transformation as Argentina?

Prominent explanations

Various reasons for economic growth and decline have been proffered over the centuries. Some prominent explanations and their famous proponents are religion (Max Weber), geography (Jeffrey Sachs), rule of law (Andrei Shleifer), investment in education (Edward Glaesar), innovation (Joseph Schumpeter), technology (Robert Solow), research and development (Paul Romer), natural endowments (Jared Diamond) and so on.

Understandably, this greatest of economic questions has a certain lure that most economists have a go at it, at some point in their careers and it pretty much occupies them.

So, when economist Robert E. Lucas Jr, said: "Once you start thinking about economic growth, it is hard to think about anything else" — he was simply stating an empirical reality.

A new generation of economists has begun to address these questions.

An exciting new book Why Nations Fail by Daron Acemoglu and James Robinson, professors at MIT and Harvard, tries to turn the arguments, made historically, on its head.

So far, economists had generally paid lip service to politics and theorised extensively about economic phenomena and relationships.

Acemoglu and Robinson said good economic outcomes emerge from good political institutions.

Since the days of Douglas North in the 1980s, ‘institutions' have slowly made it into the centre of the economic profession.

North defines institutions as "humanly devised constraints that structure political, economic and social interactions".

Returning to this theme, over the past 15 years, Acemoglu and Robinson (along with their co-writer of academic papers, Simon Johnson) have worked with unique data sets, used better econometric methods and creatively reinterpreted the influence of geography and natural resources on institutions that emerged.

By "good institutions" what they mean are institutions that allow innovation without fear of consequences and the appropriate kind of incentives for investments.

They argue that economic prosperity is really not a mystery, but simply a matter of getting the nature of institutions in a society right. These institutions tend to be democracy, rule of law, free press, private property laws, social programmes that help reduce inequality and deep financial markets.

All of these tend to increase competition in society and allow the possibility of individual innovation to emerge.

Societies without such competitive structures tend to create "extractive institutions" where a small elite controls the resources of the larger society. They extract value for their own advantage and to this end they tend to structure laws and economic rewards schemes.

The large majority is an afterthought. Under such institutional arrangements, economic activity stumbles and the elite simply lives off the extractable income.

The columnist works for a major European investment bank in New York City. All opinions are personal and don't reflect any institutional perspectives.