This is a book about an economic/development theory “effects of institutions on the success or failure of the nations”. This book features an argument from an economic difference between very close areas/places, Nogales Sonora (Mexico) and Nogales Arizona (America). The authors argue that past forces and patterns influence political institutions (constitution, rule of law, democracy, and distribution of political power in the society) and politics which also affects economic institutions which determines the failure or the success of the country. The authors give a brief description of the two countries whereby Latin America was ruled by the Spanish who through excessive extractive institutions treated their colonies as their property to enrich themselves, the aftermath of the prior institutions were visible even after the independence of most Latin American counties through political instability and absence of rule of law. In the US there was a different set of rules which observed a more democratic political institution. In the US the government provided economic incentives such as patents, provision of loans and better schooling.
The authors generally claim that one thing that separates poor and rich countries is the INSTITUTION which provides different incentives.
Economic institutions shape economic incentives, incentives to become educated, save, invest and innovative technology. It is the political process that determines the economic institutions of the country, and it is the political institutions that determine how the process works. Institutions influence the behaviour of the society and they forge the success or failure of the nations. Individual talents and efforts matter at every level of society, but it is the institution system that transforms the individual forces. While economic institutions determine whether a country is poor or rich, is the politics and political institutions that determine what economic institution a country has.
A kernel argument of the book is that “if we need to change and be prosperous based on the aforementioned theory, we need to revisit forces and patterns that shaped our political processes and political institutions to positively affect our economic institutions”. This means that to fully understand and change a country institution that will stimulate economic growth, a country needs to comprehend how past critical junctures (for instance in the case of Africa is slave trade, colonialism and independence) affected current institutions.
The authors debunk the hypotheses that are widely used by economists to explain world inequality. Three hypotheses are normally associated with world inequality. These are the geography, culture, and ignorance hypotheses.
The geography hypothesis takes its shape from a French political philosopher Montesquieu who noted that geography contributes to the poverty or prosperity of the nations. Philosophers who ascribe to this hypothesis puts that, societies that live in the tropical climate tend to be lazy and lack inquisitiveness hence they don’t work hard and are not innovative. However, this hypothesis contradicts the current economic growth trend of countries such as Singapore, Malaysia and Botswana. It seems that the geography hypothesis is not sufficient to make us fully understand world inequality. The authors give examples of countries that are in the same climate but with different economic growth, these are North and South Korea, East and West Germany before the fall of the Berlin Wall. They also put that the tropical countries are not poor because of diseases, the diseases are the large consequences of poverty and of government not being able to unwilling to establish sustainable public health systems.
The culture hypothesis holds that nations are poor because of their culture. This hypothesis traces back to the works of the German socialist Max Weber who reason that protestant reformation and its ethic played an important role in the development of western Europe. This hypothesis takes on board other cultural aspects such as beliefs, nation values and ethics. For instance, people believe that African countries are poor because they believe in magic and they lack a good work ethic or that Latin America is poor because the people are intrinsically profligate and impecunious or they suffer from manana culture. The culture hypothesis to some extent makes sense only because the culture of the society might be very strong and contain social norms which can affect, the way institutions are formulated and governed. But mostly there is no connection between and world inequality. There are countries or societies which share the same culture yet are so different in terms of economic prosperity example, Nogales, South and North Korea and China which its current growth has nothing to do with Chinese values or changes in the Chinese culture but is the result of the economic transformation unleashed by the reforms implemented by Deng Xiaoping who gradually abandoned socialist economic policies and institutions compared to the times of Mao Zedong who made Chinese poor and starve due to his unfavourable policies such as the Great Leap Forward (1950s – 1960s).
The ignorance hypothesis asserts that some nations are poor because the leaders do not know how to transform their countries. Failing countries are poor because they have a lot of market failures and because economists and policymakers do not know to get rid of them and they have heeded wrong advice in the past. Rich countries are rich because they have better policies and have eliminated market failures. However, this hypothesis is not sufficient to make us understand world inequality. If ignorance was the problem the well-meaning leaders would have learned and established policies that would increase the income and welfare of the people. They give an example of the way African leaders start and implement policies not because they do not know rather is to keep themselves in power by buying support and crucial groups. The policies are chosen and implemented because they are good politics. Contrary to geographic and ignorance hypotheses, the ignorance hypothesis comes with a ready-made solution; because the leaders are ignorant then we must provide capacity building sessions to enlighten them and change the policies. The authors point that the problem of failing nations is not the ignorance of the leaders rather is the lack of incentives and constraint. The argument here is that even if we change the policies if the political processes and political institutions remain the same we will never have an inclusive and yet sustainable development. Most policymakers/economists have focused on getting it right while what is needed is why poor countries get it wrong? Getting it wrong is not about the culture, ignorance of geographic reasons, rather is because people who have power make choices that create poverty. They get it wrong not by mistake or ignorance but on purpose.
The authors explain two different types of economics which determine the prosperity of nations. These are inclusive and extractive economic institutions.
Inclusive economic institutions such as those in South Korea and the US encourage the participation of the population in economic activities that make the best use of the prowess and talents of people to make the choices they wish. To be inclusive, economic institutions must feature secure private property, an unbiased system of law and a provision of public services that provides a level playing field.
Extractive economic institutions have opposite properties to those we call inclusive economic institutions because such institutions are designed to extract incomes and wealth from one subset of society to benefit a different subset.
Inclusive economic institutions also pave the way for two other engines of prosperity; Education and Technology. Innovation is made possible by economic institutions that encourage private property, hold contracts and create a level playing field. The low education level of poor countries is caused by economic institutions that fail to provide incentives to the parents or create incentives to the parents to educate their children and by political institutions that fail to induce the government to build, finance and support schools and wishes of the parents and children.
All the economic institutions are made by society. The political institutions of a society are a key determinant of the outcome of the game. They are the rules that govern incentives in politics. They determine how the government is chosen and run. If the distribution of the power is narrow and unconstrained then the political institutions are absolutist. The elites in the absolutist political institutions set up the economic institutions to enrich themselves. In contrast, the political institutions that distribute their power broadly to the public and subject it to constraints are pluralistic. The authors refer to political institutions that are sufficiently centralized and pluralistic as inclusive political institutions. When either of these conditions fails, they refer to the institutions as extractive political institutions.
There are reasons why nations do not always choose prosperity. For instance, Mobutu created a highly extractive set of economic institutions. The citizens were impoverished, but Mobutu and the elite surrounding him known as Les Grosses Legumes (The Big Vegetables) became wealthy. Economic growth and technological change are accompanied by what the great economist Joseph Schumpeter called “creative destruction” (simply the replacement of old by new). Fear of creative destruction is often at the root of the opposition to inclusive economic and political institutions. The only way to change the extractive political institutions is to force the elite to create more pluralistic institutions.
The central thesis of the book is that economic growth and prosperity are associated with inclusive economic and political institutions, while extractive institutions typically lead to stagnation and poverty. However, that does not imply that economic growth can never happen under the extractive economy and political institutions. There are two alternatives where economic growth might happen under extractive institutions.
1. When the elites allocate high productive activities that they control for instance during the 16th -18th centuries, the Caribbean Islands were wealthy but most of its people were slaves (Cuba, Haiti, Jamaica) and another example is during the Soviet Union (19
28-1970s)
2. When the institutions permit the development of somewhat. This will be the growth of the economy which is not complete (partial) and not threatening the elites. For instance, China is growing rapidly under the extractive institutions, controlled by the state with little sign of transition to inclusive political institutions. But for this to happen the political power should be centralized.
The growth under extractive institutions by nature they are fragile and can collapse or be easily destroyed by the infights that the extractive institutions themselves generate (case of Soviet Union in the 1970s).
The authors go on to give examples of how some countries developed inclusive institutions, for instance, they give account to how England through the Glorious Revolution (1688) limited the power of the King and the executive and relocated to Parliament the power to determine economic institutions. After the revolution, England adopted a set of economic institutions that provided incentives for investment, trade and innovation. The revolution enforced property rights including patents, grating property rights for ideas, thereby providing a major stimulus to innovation. It is not a coincidence that the Industrial Revolution started in England a few decades after the revolution. The great inventors were able to take up the economic opportunities generated by their ideas, confident that their property rights would be respected and access to markets where their innovations could be profitably sold and used.
The technological advances, the drive of business to expand and invest, and the efficient use of skills and talent were all made possible by the inclusive economic institutions developed. The Glorious Revolution forged a broad and powerful coalition able to place durable constraints on the power of the monarchy and the executive.
Generally, the authors argue that the most common reason why nations fail today is that they have extractive institutions. Countries become failed states not because of their geography or their culture, but because of the legacy of extractive institutions, which concentrate power and wealth in the hands of those controlling the state, opening the way for unrest, strife, and civil war. Extractive institutions also directly contribute to the gradual failing of the state by neglecting investment in the most basic public services. However, the solution to economic and political failure for nations today is to transform their extractive institutions toward inclusive ones. The vicious cycle (negative feedback) means that this is not easy. But is not impossible, and the iron law of oligarchy (one extractive regime replacing the other) is not inevitable. Either some preexisting inclusive elements in institutions, or the presence of broad coalitions leading the fight against the existing regime, or just the contingent nature of history, can break the vicious cycle.
The theory links inclusive economic and political institutions and prosperity. Inclusive economic institutions that enforce property rights, create a level playing field and encourage investments in the new technologies and skills are more conducive to economic growth than extractive economic institutions that are structured to extract resources from the many by the few and that fail to protect property rights or provide incentives for economic activity. Inclusive economic institutions are in turn supported by, and support, inclusive political institutions, that is, those that distribute political power widely in a pluralistic manner and can achieve some amount of political centralization to establish law and order, the foundations of secure property rights, and an inclusive market economy. Similarly, extractive economic institutions are synergically linked to extractive political institutions, which concentrate power in the hands of a few, who will then have incentives to maintain and develop extractive economic institutions for their benefit and use the resources they obtain to cement their hold on political power.
The theory of this book suggests that growth under extractive political institutions, as in China, will not bring sustained growth even if the economic institutions are incomparably more inclusive today than three decades ago. Despite the recent emphasis in China on innovation and technology, Chinese growth is based on the adoption of existing technologies and rapid investment, not creative destruction. Property rights are not entirely secure in China. Now and then some entrepreneurs are expropriated, and many elements of the economy are still under the party’s command and protection. The party has the power to direct private companies in China what should do, where it should invest and what its target will be.
In the case of foreign aid, the authors argue that foreign aid is not a very effective means of dealing with the failures of the nations unless the foreign aid is used to at least facilitate the development of inclusive economic and political institutions.
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