Institutions as a Fundamental Cause of Long-Run Essay

Department of Economics, MIT, 50 Memorial Drive E52-3806, Cambridge, MA 02142 e-mail: [email protected] edu SIMON JOHNSON Sloan School o f h f a ~ g e m e n t , MIT, 50 Memorial Drive, Cambridge, MA 02142 e-mail: [email protected] edu JAMES A. ROBINSON Deparhnent of Government, WCFIA, Harvard University, 1033 Massachusetts Avenue, Cambridge, MA 02138 e-mail: [email protected] harvard. edu Contents Abstract Keywords 1. Introduction 1. 1. The question 1. 2. The argument 1. 3. Outline 2. Fundamental causes of income differences 2. . Three fundamental causes 2. 1. 1. Economic institutions 2. 1. 2. Geography 2. 1. 3. Culture 3. Institutions matter 3. 1. The Korean experiment 3. 2. The colonial experiment 4. The Reversal of Fortune i I 4. 1. 4. 2. 4. 3. 4. 4. The reversal among the former colonies Timing of the reversal Interpreting the reversal Economic institutions and the reversal Handbook ofEconomic Gmwth, Volume IA. Edited by Philippe Aghion and Steven N. Durlauf O 2005 Elsevier B. V All rights reserved 0 0 1 : lO. l016/Sl574-W84(05)OloW-3 D. Acemoglu er al. 4. 5. Understanding the colonial experience 4. 6.

Settlements, mortality and development 5. Why do institutions differ? 5. 1. 5. 2. 5. 3. 5. 4. 6. 1. 6. 2. 6. 3. 6. 4. 6. 5. 6. 6. 6. 7. 7. 1. 7. 2. 7. 3. 7. 4. The efficient institutions view – the Political Coase Theorem The ideology view The incidental institutions view The social conflict view Hold-up Political losers Economic losers The inseparability of efficiency and distribution Comparative statics The colonial experiencein light of the comparative statics Reassessment of the social conflict view Labor markets Financial markets Regulation of prices Political power and economic institutions 6.

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Sources of inefficiencies 7. The social conflict view in action ‘ 8. A theory of institutions 8. 1. Sources of political power 8. 2. Political power and political institutions 8. 3. A theo~y political institutions of 9. The theory in action 9. 1. 9. 2. 9. 3. 9. 4. Rise of constitutionalmonarchy and economic growth in early modem Europe Summary Rise of electoral democracy in Britain Summary 10. Future avenues Acknowledgements References Abstract This paper develops the empirical and theoretical case that differences in economic institutions are the fundamental cause of differences in economic development.

We first document the empirical importance of institutions by focusing on two “quasi-natural experiments” in history, the division of Korea into two parts with very different economic institutions and the colonization of much of the world by European powers starting in the fifteenth century. We then develop the basic outline of a framework for thinking about why economic institutions differ across countries. Economic institutions determine the incentives of and the constraints on economic actors, and shape economic . Ch. 6: Institutions us u Fundamental Cause of Long-Run Growth 387 outcomes. As such, they are social decisions, chosen for their consequences. Because different groups and individuals typically benefit from different economic institutions, there is generally a conflict over these social choices, ultimately resolved in favor of groups with greater political power. The distribution of political power in society is in turn determined by political institutions and the distribution of resources.

Political institutions allocate de jure political power, while groups with greater economic might typically possess greater de facto political power. We therefore view the appropriate theoretical framework as a dynamic one with political institutions and the distribution of resources as the state variables. These variables themselves change over time because prevailing economic institutions affect the distribution of resources, and because groups with de facto political power today strive to change political institutions in order to increase their de jure political power in the future.

Economic institutions encouraging economic growth emerge when political institutions allocate power to groups with interests in broad-based property rights enforcement, when they create effective constraints on power-holders, and when there are relatively few rents to be captured by power-holders. We illustrate the assumptions, the workings and the implications of this framework using a number of historical examples. Keywords institutions, growth, development, political power, rents, conflict, property rights, efficiency, distributions JEL classification:D7, H 1, 010,040 D. Acemoglu et aL . Introduction 1. 1. The question The most trite yet crucial question in the field of economic growth and development is: Why are some countries much poorer than others? Traditional neoclassical growth models, following Solow (1956), Cass (1965) and Koopmans (1965), explain differences in income per capita in terms of different paths of factor accumulation. In these models, cross-country differences in factor accumulation are due either to differences in saving rates (Solow), preferences (Cass-Koopmans), or other exogenous parameters, such as total factor productivity growth.

In these models there are institutions, for example agents have well defined property rights and exchange goods and services in markets, but differences in income and growth are not explained by variation in institutions. The first wave of the more recent incarnations of growth theory, following Romer (1986) and Lucas (1988) differed in the sense that they emphasized that externalities from physical and human capital accumulation could induce sustained steady-state growth. However, they also stayed squarely within the neoclassical tradition of explaining differences in growth rates in terms of preferences and endowments.

The second wave of models, particularly Romer (1990), Grossman and Helpman (1991) and Aghion and Howitt (1992), endogenized steady-state growth and technical progress, but their explanation for income differences is similar to that of the older theories. For instance, in the model of Romer (1990), a country may be more prosperous than another if it allocates more resources to innovation, but what determines this is essentially preferences and properties of the technology for creating ‘ideas’ Though this theoretical radition is still vibrant in economics and has provided many insights about the mechanics of economic growth, it has for a long time seemed unable to provide afundamental explanation for economic growth. As North and Thomas (1973, p. 2) put it: “the factors we have listed (innovation, economies of scale, education, capital accumulation, etc. ) are not causes of growth; they are growth (italics in original). Factor accumulation and innovation are only proximate causes of growth.

In North and Thomas’s view, the fundamental explanation of comparative growth is differences in institutions. What are institutions exactly? North (1990, p. 3) offers the following definition: “Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction”. He goes on to emphasize the key implications of institutions since, “In consequence they structure incentives in human exchange, whether political, social, or economic”. . . .’ ,,

I Although, as we discuss later, some recent contributions to growth theory emphasize the importance of economic policies, such as taxes, subsidies to research, barriers to technology adoption and human capital policy, they typically do not present an explanation for why there are differences in these policies across countries. Ch. 6: Institutions as a Fundamental Cause of Long-Run Gmwth 389 Of primary importance to economic outcomes are the economic institutions in society such as the structure of property rights and the presence and perfection of markets.

Economic institutions are important because they influence the structure of economic incentives in society. Without property rights, individuals will not have the incentive to invest in physical or human capital or adopt more efficient technologies. Economic institutions are also important because they help to allocate resources to their most efficient uses, they determine who gets profits, revenues and residual rights of control.

When markets are missing or ignored (as they were in the Soviet Union, for example), gains from trade go unexploited and resources are misallocated. Societies with economic institutions that facilitate and encourage factor accumulation, innovation and the efficient allocation of resources will prosper. Central to this chapter and to much of political economy research on institutions is that economic institutions, and institutions more broadly, are endogenous; they are, at least in part, determined by society, or a segment of it.

Consequently, the question of why some societies are much poorer than others is closely related to the question of why some societies have much “worse economic institutions” than others. Even though many scholars including John Locke, Adam Smith, John Stuart Mill, Arthur Lewis, Douglass North and Robert Thomas, and recently many papers in the literature on economic growth and development, have emphasized the importance of economic institutions, we are far from a useful framework for thinking about how economic institutions are determined and why they vary across countries.

In other words, while we have good reason to believe that economic institutions matter for economic growth, we lack the crucial comparative static results which will allow us to explain why equilibrium economic institutions differ (and perhaps this is part of the reason why much of the economics literature has focused on the proximate causes of economic growth, largely neglecting fundamental institutional causes). This chapter has three aims. First, we selectively review the evidence that differences in economic institutions are a fundamental cause of cross-country differences in prosperity.

Second, we outline a framework for thinking about why economic institutions vary across countries. We emphasize the potential comparative static results of this framework and also illustrate the key mechanisms through a series of historical examples and case studies. Finally, we highlight a large number of areas where we believe future theoretical and empirical work would be very fruitful. 1. 2. The argument The basic argument of this chapter can be summarized as follows: 1.

Economic institutions matter for economic growth because they shape the incentives of key economic actors in society, in particular, they influence investments in physical and human capital and technology, and the organization of production. Although cultural and geographical factors may also matter for economic performance, differences in economic institutions are the major source of cross-country differences in economic growth and prosperity. Economic institutions not only determine the ag- 390 D. Acemoglu et al. regate economic growth potential of the economy, but also an array of economic outcomes, including the distribution of resources in the future (i. e. , the distribution of wealth, of physical capital or human capital). In other words, they influence not only the size of the aggregate pie, but how this pie is divided among different groups and individuals in society. We summarize these ideas schematically as (where the subscript t refers to current period and t 1 to the future): + economic institutions, ===+ economic performance, distribution of resources,+l 2. Economic institutions are endogenous. They are determined as collective choices of the society, in large part for their economic consequences. However, there is no guarantee that all individuals and groups will prefer the same set of economic institutions because, as noted above, different economic institutions lead to different distributions of resources. Consequently, there will typically be a conflict of interest among various groups and individuals over the choice of economic institutions. So how are equilibrium economic institutions determined?

If there are, for example, two groups with opposing preferences over the set of economic institutions, which group’s preferences will prevail? The answer depends on the political power of the two groups. Although the efficiency of one set of economic institutions compared with another may play a role in this choice, political power will be the ultimate arbiter. Whichever group has more political power is likely to secure the set of economic institutions that it prefers. This leads to the second building block of our framework: political power, ===+ economic institutions,. . Implicit in the notion that political power determines economic institutions is the idea that there are conflicting interests over the distribution of resources and therefore indirectly over the set of economic institutions. But why do the groups with conflicting interests not agree on the set of economic institutions that maximize aggregate growth (the size of the aggregate pie) and then use their political power simply to determine the distribution of the gains? Why does the exercise of political power lead to economic inefficiencies and even poverty?

We will explain that this is because there are commitment problems inherent in the use of political power. Individuals who have political power cannot commit not to use it in their best interests, and this commitment problem creates an inseparability between efficiency and distribution because credible compensating transfers and side-payments cannot be made to offset the distributional consequences of any particular set of economic institutions. 4. The distribution of political power in society is also endogenous, however.

In our framework, it is useful to distinguish between two components of political power, which we refer to as de jure (institutional) and de facto political power. Here de jure political power refers to power that originates from the political institutions in society. Political institutions, similarly to economic institutions, determine the constraints on and the incentives of the key actors, but this time in the political sphere. Examples of political institutions include the form of government, for example, democracy vs. dictatorship or Ch. 6: Institutions as a Fundamental Cause of Long-Run Growth 91 autocracy, and the extent of constraints on politicians and political elites. For example, in a monarchy, political institutions allocate all de jure political power to the monarch, and place few constraints on its exercise. A constitutional monarchy, in contrast, corresponds to a set of political institutions that reallocates some of the political power of the monarch to a parliament, thus effectively constraining the political power of the monarch. This dscussion therefore implies that: ==+ political in~titutionst~ de jure political power,. 5.

There is more to political power than political institutions, however. A group of individuals, even if they are not allocated power by political institutions, for example as specified in the constitution, may nonetheless possess political power. Namely, they can revolt, use arms, hire mercenaries, co-opt the military, or use economically costly but largely peaceful protests in order to impose their wishes on society. We refer to this type of political power as de facto political power, which itself has two sources. First, it depends on the ability of the group in question to solve its collective action problem, i. . , to ensure that people act together, even when any individual may have an incentive to free ride. For example, peasants in the Middle Ages, who were given no political power by the constitution, could sometimes solve the collective action problem and undertake a revolt against the authorities. Second, the de facto power of a group depends on its economic resources, which determine both their ability to use (or misuse) existing political institutions and also their option to hire and use force against different groups.

Since we do not yet have a satisfactory theory of when groups are able to solve their collective action problems, our focus will be on the second source of de facto political power, hence: distribution of resources, ==+ de facto political power,. 6. This brings us to the evolution of one of the two main state variables in our framework, political institutions (the other state variable is the distribution of resources, including distribution of physical and human capital stocks, etc. ).

Political institutions and the distribution of resources are the state variables in this dynamic system because they typically change relatively slowly, and more importantly, they determine economic institutions and economic performance both directly and indirectly. Their direct effect is straightforward to understand. If political institutions place all political power in the hands of a single individual or a small group, economic institutions that provide protection of property rights and equal opportunity for the rest of the population are difficult to sustain.

The indirect effect works through the channels discussed above: political institutions determine the distribution of de jure political power, which in turn affects the choice of economic institutions. This framework therefore introduces a natural concept of a hierarchy of institutions, with political institutions influencing equilibrium economic institutions, which then determine economic outcomes. Political institutions, though slow changing, are also endogenous. Societies transition from dictatorship to democracy, and change their constitutions to modify the constraints on power holders.

Since, like economic institutions, political institutions are collective 392 D. Acemoglu et al. choices, the distribution of political power in society is the key determinant of their evolution. This creates a tendency for persistence: political institutions allocate de jure political power, and those who hold political power influence the evolution of political institutions, and they will generally opt to maintain the political institutions that give them political power. However, de facto political power occasionally creates changes in political institutions.

While these changes are sometimes discontinuous, for example when an imbalance of power leads to a revolution or the threat of revolution leads to major reforms in political institutions, often they simply influence the way existing political institutions function, for example, whether the rules laid down in a particular constitution are respected as in most functioning democracies, or ignored as in currentday Zimbabwe. Summarizing this discussion, we have: political power, Putting all these pieces together, a schematic (and simplistic) representation of our framework is as follows: political institutions, de jure political power, & 3 political in~titutions,+~ * * economic institutions, political institution^[+^ economic performance, & distribution of resources, de facto political power, distribution of resources, +1 The two state variables are political institutions and the distribution of resources, and the knowledge of these two variables at time t is sufficient to determine all the other variables in the system. While political institutions determine the distribution of de jure political power in society, the distribution of resources influences the distribution of de facto political power at time t.

These two sources of political power, in turn, affect the choice of economic institutions and influence the future evolution of political institutions. Economic institutions determine economic outcomes, including the aggregate growth rate of the economy and the distribution of resources at time t 1. Although economic institutions are the essential factor shaping economic outcomes, they are themselves endogenous and determined by political institutions and distribution of resources in society.

There are two sources of persistence in the behavior of the system: first, political institutions are durable, and typically, a sufficiently large change in the distribution of political power is necessary to cause a change in political institutions, such as a transition from dictatorship to democracy. Second, when a particular group is rich relative to others, this will increase its de facto political power and enable it to push for economic and political institutions favorable to its interests.

This will tend to reproduce the initial relative wealth disparity in the future. Despite these tendencies for persistence, the framework also emphasizes the potential for change. In particular, "shocks”, including changes in technologies and the international environment, that modify the balance of + Ch. 6: Institutions as a Fundamental Cause of Long-Run Growth 393 (de facto) political power in society and can lead to major changes in political institutions and therefore in economic institutions and economic growth.

A brief example might be useful to clarify these notions before commenting on some of the underlying assumptions and discussing comparative statics. Consider the development of property rights in Europe during the Middle Ages. There is no doubt that lack of property rights for landowners, merchants and proto-industrialists was detrimental to economic growth during this epoch. Since political institutions at the time placed political power in the hands of kings and various types of hereditary monarchies, such rights were largely decided by these monarchs.

Unfortunately for economic growth, while monarchs had every incentive to protect their own property rights, they did not generally enforce the property rights of others. On the contrary, monarchs often used their powers to expropriate producers, impose arbitrary taxation, renege on their debts, and allocate the productive resources of society to their allies in return for economic benefits or political support. Consequently, economic institutions during the Middle Ages provided little incentive to invest in land, physical or human capital, or technology, and failed to foster economic growth.

These economic institutions also ensured that the monarchs controlled a large fraction of the economic resources in society, solidifying their political power and ensuring the continuation of the political regime. The seventeenth century, however, witnessed major changes in the economic and political institutions that paved the way for the development of property rights and limits on monarchs’ power, especially in England after the Civil War of 1642 and the Glorious Revolution of 1688, and in the Netherlands after the Dutch Revolt against the Hapsburgs. How did these major institutional changes take place?

In England, for example, until the sixteenth century the king also possessed a substantial amount of de facto political power, and leaving aside civil wars related to royal succession, no other social group could amass sufficient de facto political power to challenge the king. But changes in the English land market [Tawney (1941)l and the expansion of Atlantic trade in the sixteenth and seventeenth centuries [Acemoglu, Johnson and Robinson (2005)l gradually increased the economic fortunes, and consequently the de facto power of landowners and merchants.

These groups were diverse, but contained important elements that perceived themselves as having interests in conflict with those of the king: while the English kings were interested in predating against society to increase their tax incomes, the gentry and merchants were interested in strengthening their property rights. By the seventeenth century, the growing prosperity of the merchants and the gentry, based both on internal and overseas, especially Atlantic, trade, enabled them to field military forces capable of defeating the king.

This de facto power overcame the Stuart monarchs in the Civil War and Glorious Revolution, and led to a change in political institutions that stripped the king of much of his previous power over policy. These changes in the distribution of political power led to major changes in economic institutions, strengthening the property rights of both land and capital owners and spurred a process of financial and commercial expansion. The consequence was rapid economic growth, culminating in the Industrial Revolution, and a very different istribution of economic resources from that in the Middle Ages. 394 D. Acemoglu et al. It is worth returning at this point to two critical assumptions in our framework. First, why do the groups with conflicting interests not agree on the set of economic institutions that maximize aggregate growth? So in the case of the conflict between the monarchy and the merchants, why does the monarchy not set up secure property rights to encourage economic growth and tax some of the benefits? Second, why do groups with political power want to change political institutions in their favor?

For instance, in the context of the example above, why did the gentry and merchants use their de facto political power to change political institutions rather than simply implement the policies they wanted? The answers to both questions revolve around issues of commitment and go to the heart of our framework. The distribution of resources in society is an inherently conflictual, and therefore political, decision. As mentioned above, this leads to major commitment problems, since groups with political power cannot commit to not using their power to change the distribution of resources in their favor.

For example, economic institutions that increased the security of property rights for land and capital owners during the Middle Ages would not have been credible as long as the monarch monopolized political power. He could promise to respect property rights, but then at some point, renege on his promise, as exemplified by the numerous financial defaults by medieval kings [e. g. , Veitch (1986)l. Credible secure property rights necessitated a reduction in the political power of the monarch.

Although these more secure property rights would foster economic growth, they were not appealing to the monarchs who would lose their rents from predation and expropriation as well as various other privileges associated with their monopoly of political power. This is why the institutional changes in England as a result of the Glorious Revolution were not simply conceded by the Stuart kings. James II had to be deposed for the changes to take place. The reason why political power is often used to change political institutions is related. In a ynamic world, individuals care not only about economic outcomes today but also in the future. In the example above, the gentry and merchants were interested in their profits and therefore in the security of their property rights, not only in the present but also in the future. Therefore, they would have liked to use their (de facto) political power to secure benefits in the future as well as the present. However, commitment to future allocations (or economic institutions) was not possible because decisions in the future would be decided by those who had political power in the future with little reference to past promises.

If the gentry and merchants would have been sure to maintain their de facto political power, this would not have been a problem. However, de facto political power is often transient, for example because the collective action problems that are solved to amass this power are likely to resurface in the future, or other groups, especially those controlling de jure power, can become stronger in the future. Therefore, any change in policies and economic institutions that relies purely on de facto political power is likely to be reversed in the future.

In addition, many revolutions are followed by conflict within the revolutionaries. Recognizing this, the English gentry and merchants strove not just to change economic institutions in their favor following their victories against the Stuart monarchy, but also to alter political institutions and the – Ch. 6: Institutions as a Fundamental Cause of brig-Run Growth 395 future allocation of de jure power. Using political power to change political institutions then emerges as a useful strategy to make gains more durable.

The framework that we propose, therefore, emphasizes the importance of political institutions, and changes in political institutions, as a way of manipulating future political power, and thus indirectly shaping future, as well as present, economic institutions and outcomes. This framework, though abstract and highly simple, enables us to provide some preliminary answers to our main question: why do some societies choose "good economic institutions”? At this point, we need to be more specific about what good economic institutions are.

A danger we would like to avoid is that we define good economic institutions as those that generate economic growth, potentially leading to a tautology. This danger arises because a given set of economic institutions may be relatively good during some periods and bad during others. For example, a set of economic institutions that protects the property rights of a small elite might not be inimical to economic growth when all major investment opportunities are in the hands of this elite, but could be very harmful when investments and participation by other groups are important for economic growth [see Acemoglu (2003b)l.

To avoid such a tautology and to simplify and focus the discussion, throughout we think of good economic institutions as those that provide security of property rights and relatively equal access to economic resources to a broad cross-section of society. Although this definition is far from requiring equality of opportunity in society, it implies that societies where only a very small fraction of the population have well-enforced property rights do not have good economic institutions.

Consequently, as we will see in some of the historical cases discussed below, a given set of economic institutions may have very different implications for economic growth depending on the technological possibilities and opportunities. Given this definition of good economic institutions as providing secure property rights for a broad cross-section of society, our framework leads to a number of important comparative statics, and thus to an answer to our basic question.

First, political institutions that place checks on those who hold political power, for example, by creating a balance of power in society, are useful for the emergence of good economic institutions. This result is intuitive; without checks on political power, power holders are more likely to opt for a set of economic institutions that are beneficial for themselves and detrimental for the rest of society, which will typically fail to protect property rights of a broad cross-section of people.

Second, good economic institutions are more likely to arise when political power is in the hands of a relatively broad group with significant investment opportunities. The reason for this result is that, everything else equal, in this case power holders will themselves benefit from secure property rights. ‘ Third, good economic institutions are more likely to arise and persist when there are only limited rents that power holders can extract from the rest of society, since such rents would

The reason why we inserted the caveat of "a relatively broad group” is that when a small group with significant investment opportunities holds power, they may sometimes opt for an oligarchic system where their own property rights are protected, but those of others are not [see Acemoglu (2003b)l. 396 D. Acemoglu et al. encourage them to opt for a set of economic institutions that make the expropriation of others possible. These comparative statics therefore place political institutions at the center of the story, as emphasized by our term "hierarchy of institutions” above.

Political institutions are essential both because they determine the constraints on the use of (de facto and de jure) political power and also which groups hold de jure political power in society. We will see below how these comparative statics help us understand institutional differences across countries and over time in a number of important historical examples. 1. 3. Outline In the next section we discuss how economic institutions constitute the basis for a fundamental theory of growth, and we contrast this with other potential fundamental theories.

In Section 3 we consider some empirical evidence that suggests a key role for economic institutions in determining long-run growth. We also emphasize some of the key problems involved in establishing a causal relationship between economic institutions and growth. We then show in Section 4 how the experience of European colonialism can be used as a ‘natural experiment’ which can address these problems. Having established the central causal role of economic institutions and their importance relative to other factors in cross-country differences in conomic performance, the rest of the paper focuses on developing a theory of economic institutions. Section 5 discusses four types of explanation for why countries have different institutions, and argues that the most plausible is the social conJlict view. According to this theory, bad institutions arise because the groups with political power benefit from bad institutions. The emphasis on social conflict arises naturally from our observation above that economic institutions influence the distribution of resources as well as efficiency.

Different groups or individuals will therefore prefer different institutions and conflict will arise as each tries to get their own way. Section 6 delves deeper into questions of efficiency and asks why a political version of the Coase Theorem does not hold. We emphasize the idea that commitment problems are intrinsic to the exercise of political power. In Section 7 we argue that a series of historical examples of diverging economic institutions are best explained by the social conflict view.

These examples illustrate how economic institutions are determined by the distribution of political power, and how this distribution is influenced by political institutions. Section 8 puts these ideas together to build our theory of institutions. In Section 9 we then consider two more extended examples of the theory in action, the rise of constitutional rule in early modem Europe, and the creation of mass democracy, particularly in Britain, in the nineteenth and twentieth centuries. Section 10 concludes with a discussion of where this research program can go next. ~ 2.

Fundamental causes of income differences We begin by taking a step back. The presumption in the introduction was that economic institutions matter, and should in fact be thought of as one of the key fundamental causes Ch. 6: Institutions as a Fundamental Cause ofLong-Run Growth 397 of economic growth and cross-country differences in economic performance. How do we know this? 2. 1. Threefundamental causes . If standard economic models of factor accumulation and endogenous technical change only provide proximate explanations of comparative growth, what types of explanations would constitute fundamental ones?

Though there is no conventional wisdom on this, we can distinguish three such theories: the first set of theories, our main focus in this chapter, emphasize the importance of economic institutions, which influence economic outcomes by shaping economic incentives; the second emphasize geography, and the third emphasize the importance of culture (a fourth possibility is that differences are due to "luck”, some societies were just lucky; however we do not believe that differences in luck by themselves constitute a sufficient fundamental causes of cross-country income differences). . 1. 1. Economic institutions . At its core, the hypothesis that differences in economic institutions are the fundamental cause of different patterns of economic growth is based on the notion that it is the way that humans themselves decide to organize their societies that determines whether or not they prosper. Some ways of organizing societies encourage people to innovate, to take risks, to save for the future, to find better ways of doing things, to learn and educate themselves, solve problems of collective action and provide public goods. Others do not.

The idea that the prosperity of a society depends on its economic institutions goes back at least to Adam Smith, for example in his discussions of mercantilism and the role of markets, and was prominent in the work of many nineteenth century scholars such as John Stuart Mill [see the discussion in Jones (1981)l: societies are economically successful when they have ‘good’ economic institutions and it is these institutions that are the cause of prosperity. We can think of these good economic institutions as consisting of an inter-related cluster of things.

There must be enforcement of property rights for a broad cross-section of society so that all individuals have an incentive to invest, innovate and take part in economic activity. There must also be some degree of equality of opportunity in society, including such things as equality before the law, so that those with good investment opportunities can take advantage of them. 3 One could think of other types of economic institutions and many explanations for growth and development have moved beyond models based on preferences, technology and factor endowments to focus on what might loosely be called institutions.

One In Acemoglu, Johnson and Robinson (2001), we coined the term institutions of private property for a cluster of good economic institutions, including the rule of law and the enforcement of property rights, and the term extractive institutions to designate institutions under which the rule of law and property rights are absent for large majorities of the population. 398 D. Acemoglu et al. set of ideas, important for our work, has emphasized that conflict over resources and predation, as well as production, are fundamental forces in society.

Scholars such as Skaperdas (1992), Grossman and Kim (1995,1996), Hirshleifer (2001) and Dixit (2004) have examined how stable property rights can emerge in such circumstances. These scholars have studied almost institution free models and asked how the type of social order that underlies standard economic models might emerge endogenously. Closely related to this work is the research that shows how rent-seeking and redistributional conflict more generally has important implications for growth [e. g. , Tornell and Velasco (1992), Murphy, Shleifer and Vishny (1991)

Acemoglu (1995), Alesina and Perotti (1996), Benhabib and Rustichini (1996)l. Another literature, following in the footsteps of traditional accounts of economic growth by historians, following the lead of Adam Smith, has emphasized the perfection and spread of markets, clearly a key economic institution [Pirenne (1937), Hicks (1969)l. Problems of the imperfection or absence of markets can clearly have important ramifications for resource allocation, incentives and growth. A central role here has been played by capital markets.

For example, Banerjee and Newman (1993) and Galor and Zeira (1993) propose canonical models of how imperfect financial markets can impede growth and development. Models of poverty traps in the tradition of Rosenstein-Rodan (1943), Mu~phy, Vishny and Shleifer (1989a, 1989b) and Acemoglu (1995, 1997). are based on the idea that market imperfections can lead to the existence of multiple Pareto-ranked equilibria. As a consequence a country can get stuck in a Pareto inferior equilibrium, associated with poverty, but getting out of such a trap necessitates coordinated activities that the market cannot deliver.

Other mechanisms, such as increasing returns to scale, can lead to similar situations [e. g. , Durlauf (1993), Krugman and Venables (1995), see Azariadis and Stachurski (2005), for other mechanisms and examples]. The implications of many other types of market imperfections have been considered, for example in the labor market [Aghion an[Aghion and Howitt (1994), Pissarides (2000)l and other scholars have examined the implications of industrial organization, market structure and the nature of competition [e. g. , Acemoglu and Zilibotti (1997), Aghion et al. (2001), Aghion and Howitt (2005)l.

The idea that market imperfections and economic institutions play a central role in development has also been important in the academic literature on development economics since its initiation. Both Adam Smith and Alfred Marshall argued that sharecropping was an inefficient way of organizing agriculture because it gave incorrect incentives to tenants. This argument has been formalized, and at the heart of a large literature on development are imperfections in tenancy, labor, land and credit markets [see Ray (1998), Bardhan and Udry (1999), Banerjee and Duflo (2005)l.

Finally, the literature that one might broadly class as institutional has extensively discussed political economy models. Most influential is the early work of Perotti (1993), Saint-Paul and Verdier (1993), Alesina and Rodrik (1994) and Persson and Tabellini (1994) who developed dynamic models to examine the effect of redistributive taxation on growth. There are now many models where political mechanisms and outcomes can have important influences on the growth rate [see Ades and Verdier (1996), Krusell and Ch. 6: Institutions as a Fundamental Cause of Long-Run Gmwth 399

Rios-Rull (1999), Bourguignon and Verdier (2000) and other contributions which we discuss in the body of the paper]level then there is a bewildering array of ideas connecting institutions, both economic and political, to growth and development. In this chapter however, as will already be apparent, we do not attempt to survey all of these theories. Rather, we attempt to develop a perspective on this topic which revolves around what we see as the key issues. From the empirical side this entails really establishing the causal role of institutions in development.

From the theoretical side this involves emphasizing the importance of understanding why institutions hffer across countries. From the perspective of this chapter the main problem with most of the existing research is the lack of comparative statics and the absence of a truly comparative focus. For instance, in the model of Grossman and Kim (1995) stable property rights may emerge as an equilibrium, but whether they do so or not depends on parameters in the fighting technology which are hard to interpret in reality.

Most models of imperfect markets and multiple equilibria fail to provide explanations either for why markets are incomplete or imperfect, or for how some societies manage to get into good equilibria while others do not. To the extent that imperfect market are grounded in imperfections in information or possibilities for opportunism, one would like to know how and why these vary across countries in ways which are consistent with the basic facts about relative economic outcomes. We believe that the structure of markets is endogenous, and partly determined by property rights.

Once individuals have secure property rights and there is equality of opportunity, the incentives will exist to create and improve markets (even though achieving perfect markets would be typically impossible). Thus we expect differences in markets to be an outcome of differing systems of property rights and political institutions, not unalterable characteristics responsible for cross-country differences in economic performance. This motivates our focus on economic institutions related to the enforcement of the property rights of a broad cross-section of society. There are some genuinely comparative studies in the literature.

For example, Banerjee and Newman (1993), Alesina and Rodrik (1994) and Persson and Tabellini (1994) all point to differences in wealth distribution as the key to success or failure. We will discuss other such theories, for example those connected to legal origins [e. g. , L[e. g. , La Porta et al. (1998)l later. Nevertheless, these studies are very different from the approach we propose in thls chapter. 2. 1. 2. Geography While institutional theories emphasize the importance of man-made factors shaping incentives, an alternative is to focus on the role of "nature”, that is, on the physical and geographical environment.

In the context of understanding cross-country differences in economic performance, this approach emphasizes differences in geography, climate and ecology that determine both the preferences and the opportunity set of individual economic agents in different societies. We refer to this broad approach as the "geography 400 D. Acemoglu et a1 hypothesis”. There are at least three main versions of the geography hypothesis, each emphasizing a different mechanism for how geography affects prosperity. First, climate may be an important determinant of work effort, incentives, or even productivity.

This idea dates back at least to the famous French philosopher, Montesquieu (1748), who wrote in his classic book The Spirit of the Laws: "The heat of the climate can be so excessive that the body there will be absolutely without strength. So, prostration will pass even to the spirit; no curiosity, no noble enterprise, no generous sentiment; inclinations will all be passive there; laziness there will be happiness”, and "People are . . . more vigorous in cold climates. The inhabitants of warm countries are, like old men, timorous; the people in cold countries are, like young men, brave. One of the founders of modem economics Marshall is another prominent figure who emphasized the importance of climate, arguing: "vigor depends partly on race qualities: but these, so far as they can be explained at all, seem to be chiefly due to climate” [Marshall (1890, p. 195)l. Second, geography may determine the technology available to a society, especially in agriculture. This view is developed by an early Nobel Prize winner in economics, Myrdal, who wrote "serious study of the problems of underdevelopment . . . hould take into account the climate and its impacts on soil, vegetation, animals, humans and physical assets – in short, on living conditions in economic development” [Myrdal (1968, vol. 3, p. 2121)l. More recently, Diamond espouses this view, ". . . proximate factors behind Europe’s conquest of the Americas were the differences in all aspects of technology. These differences stemmed ultimately from Eurasia’s much longer history of densely populated . .. [societies dependent on food production] was in turn determined by geographical Merences between Europe and the Americas [Diamond (1997, p. 358)l[Diamond (1997, p. 358)l.

The economist Sachs has been a recent and forceful proponent of the importance of geography in agricultural productivity, stating that "By the start of the era of modem economic growth, if not much earlier, temperate-zone technologies were more productive than tropical-zone technologies . . . ” [Sachs (2001, p. 2)]he geography hypothesis, especially popular over the past decade, links poverty in many areas of the world to their “disease burden”, emphasizing that: “The burden of infectious disease is similarly higher in the tropics than in the temperate zones” [Sachs (2000, p. 32)].

[Sachs (2000, p. 32)]: justify">Bloom and Sachs (1998) claim that the prevalence of malaria, a disease which kills millions of children every year in sub-Saharan Africa, reduces the annual growth rate of sub-Saharan African economies by more than 1. 3 percent a year (this is a large effect, implying that had malaria been eradicated in 1950, income per capita in sub-Saharan Africa would be double what it is today). 2. 1. 3. Culture The final fundamental explanation for economic growth emphasizes the idea that different societies (or perhaps different races or ethnic groups) have different cultures, because of different shared experiences or ifferent religions. Culture is viewed as a . . Ch. 6: Institutions as a Fundamental Cause of Long-Run Growth 40 1 . . key determinant of the values, preferences and beliefs of individuals and societies and, the argument goes, these differences play a key role in shaping economic performance. At some level, culture can be thought to influence equilibrium outcomes for a given set of institutions. Possibly there are multiple equilibria connected with any set of institutions and difference~ culture mean that different societies will coordinate on in different equilibria.

Alternatively, as argued by Greif (1994), different cultures generate different sets of beliefs about how people behave and this can alter the set of equilibria for a given specificationof institutions (for example, some beliefs will allow punishment strategies to be used whereas others will not). The most famous link between culture and economic development is that proposed by Weber (1930) who argued that the origins of industrialization in western Europe could be traced to the Protestant reformation and particularly the rise of Calvinism.

In his view, the set of beliefs about the world that was intrinsic to Protestantism were crucial to the development of capitalism. Protestantism emphasized the idea of predestination in the sense that some individuals were ‘chosen’ while others were not. “We know that a part of humanity is saved, the rest damned. To assume that human merit or guilt play a part in determining this destiny would be to think of God’s absolutely free decrees, which have been settled from eternity, as subject to change by human influence, an impossible contradction” [Weber (1930, p. 0)]. But [Weber (1930, p. 0)]and who not? Calvin did not explain this. Weber (1930, p. 66) notes “Quite naturally this attitude was impossible for his followers … for the broad mass of ordinary men . . . So wherever the doctrine of predestination was held, the question could not be suppressed whether there was any infallible criteria by which membership of the electi could be known”. Practical solutions to this problem were quickly developed, “. . . in order to attain that self-confidence intense worldly activity is recommended as the most suitable means.

It and it alone disperses religious doubts and gives the certainly of grace” [Weber (1930, pp. 66-67)].[Weber (1930, pp. 66-67)]good works might be as a means of attaining salvation . . . nevertheless, they are indispensable as a sign of election. They are the technical means, not of purchasing salvation, but of getting rid of the fear of damnation” (p. 69). Though economic activity was encouraged, enjoying the fruits of such activity was not. “Waste of time is . . . the first and in principle the deadliest of sins.

The span of human life is infinitely short and precious to make sure of one’s own election. Loss of time through sociability, idle talk, luxury, even more sleep than is necessary for health . .. is worthy of absolute moral condemnation .. . Unwillingness to work is symptomatic of the lack of grace” (pp. 104-105). Thus Protestantism led to a set of beliefs which emphasized hard work, thrift, saving, and where economic success was interpreted as consistent with (if not actually signaling) being chosen by God.

Weber contrasted these characteristics of Protestantism with those of other religions, such as Catholicism, which he argued did not promote capitalism. For instance on his book on Indian religion he argued that the caste system blocked capitalist development [Weber (1958, p. 112)]. 40[Weber (1958, p. 112)]ore recently, scholars, such as Landes (1998), have also argued that the origins of Western economic dominance are due to a particular set of beliefs about the world and how it could be transformed by human endeavor, which is again linked to religious differences.

Although Barro and McCleary (2003) provide evidence of a positive correlation between the prevalence of religious beliefs, notably about hell and heaven, and economic growth, this evidence does not show a causal effect of religion on economic growth, since religious beliefs are endogenous both to economic outcomes and to other fundamental causes of income differences [points made by Tawney (19[points made by Tawney (1926), and Hill (1961b), in the context of Weber’s thesis]: justify">Ideas about how culture may influence growth are not restricted to the role of religion. Within the literature trying to explain comparative development there have been arguments that there is something special about particular cultural endowments, usually linked to particular nation states. For instance, Latin America may be poor because of its Iberian heritage, while North America is prosperous because of its Anglo-Saxon heritage [VCliz (1994)l.

In addition, a large literature in anthropology argues that societies may become ‘dysfunctional’ or ‘maladapted’ in the sense that they adopt a system of beliefs or ways or operating which do not promote the success or prosperity of the society [see Edgerton (1992), for a survey of this literature]of such an argument is due to Banfield (1958) who argued that the poverty of Southern Italy was due to the fact that people had adopted a culture of “amoral familiarism” where they only trusted individuals of their own families and refused to cooperate or trust anyone else.

This argument was revived in the extensive empirical study of Putnam, Leonardi and Nanetti (1993) who characterized such societies as lacking “social capital”. Although Putnam and others, for example, Knack and Keefer (1997) and Durlauf and Fafchamps (2004), document positive co~elations between measures of social capital and various economic outcomes, there is no evidence of a causal effect, since, as with religious beliefs discussed above, measures of social capital are potentially endogenous. . 3. Institutions matter

We now argue that there is convincing empirical support for the hypothesis that differences in economic institutions, rather than geography or culture, cause differences in incomes per-capita. Consider first Figure 1. This shows the cross-country bivariate relationship between the log of GDP percapita in 1995 and a broad measure of property rights, “protection against expropriation risk, averaged over the period 1985 to 1995. The data on economic institutions come from Political Risk Services, a private company which assesses the risk that investments will be expropriated in different countries.

These data, first used by Knack and Keefer (1995) and subsequently by Hall and Jones (1999) and Acemoglu, Johnson and Robinson (2001,2002) are imperfect as a measure of economic institutions, but the findings are robust to using other available measures of economic institutions. The scatter plot Ch. 6: Institutions as a Fundamental Cause of Long-Run Growth HKG K W E a.. T ARG PAN IRN PER DOM ‘au NEEGD 1 / ML’ KEN NGA ZME YEM MOZ MW SLE ETH TZA 4 6 8 Avg. Protection Against Risk of Expropriation. 1985-95 10 Figure 1. Average protection against risk of expropriation 1985-95 and log GDP per capita 1995. hows that countries with more secure property rights, i. e. , better economic institutions, have higher average incomes. It is tempting to interpret Figure 1 as depicting a causal relationship (i. e. , as establishing that secure property rights cause prosperity). Nevertheless, there are well-known problems with making such an inference. First, there could be reverse causation – perhaps only countries that are sufficiently wealthy can afford to enforce property rights. More importantly, there might be a problem of omitted variable bias.

It could be something else, e. g. , geography, that explains both why countries are poor and why they have insecure property rights. Thus if omitted factors determine institutions and incomes, we would spuriously infer the existence of a causal relationship between economic institutions and incomes when in fact no such relationship exists. Trying to estimate the relationship between institutions and prosperity using Ordinary Least Squares, as was done by Knack and Keefer (1995) and Barro (1997) could therefore result in biased regression coefficients.

To further illustrate these potential identification problems, suppose that climate, or geography more generally, matters for economic performance. In fact, a simple scatterplot shows a positive association between latitude (the absolute value of distance from the equator) and income per capita. Montesquieu, however, not only claimed that warm climate makes people lazy and thus unproductive,but also unfit to be governed by democracy. He argued that despotism would be the political system in warm climates.

Therefore, a potential explanation for the patterns we see in Figure 1 is that there is an omitted factor, geography, which explains both economic institutions and economic performance. Ignoring this potential third factor would lead to mistaken conclusions. D. Acemoglu et al. USA HKG Q A i U S ARE BRB BHSHR KWTISR MLT KORpfffRL EST L I A RUS LUX CHE FWT Y . ~ ~ N K CA#O~ [email protected]~ JPN ITA BIH LBR BEN MOZ TJK AFG RWA ZAR “I TZA NGp MDG ETH SLEo~ I o .2 I -4 Latitude I .6 .€I I Figure 2.

Latitude and log GDP per capita 1995. Even if Montesquieu’s story appears both unrealistic and condescending to our modem sensibilities, the general point should be taken seriously: the relationship shown in Figure 1, and for that matter that shown in Figure 2, is not causal. As we pointed out in the context of the effect of religion or social capital on economic performance, these types of scatterplots, correlations, or their multidimensionalversion in OLS regressions, cannot establish causality. What can we do?

The solution to these problems of inference is familiar in microeconometrics: find a source of variation in economic institutions that should have no effect on economic outcomes, or depending on the context, look for a natural experiment. As an example, consider first one of the clearest natural experiments for institutions. 3. 1. The Korean experiment Until the end of World War 11, Korea was under Japanese occupation. Korean independence came shortly after the Japanese Emperor Hirohito announced the Japanese surrender on August 15, 1945.

After this date, Soviet forces entered Manchuria and North Korea and took over the control of these provinces from the Japanese. The major fear of the United States during this time period was the takeover of the entire Korean peninsular either by the Soviet Union or by communist forces under the control of the former guemlla fighter, Kim Il Sung. U. S. authorities therefore supported the influential nationalist leader Syngman Rhee, who was in favor of separation rather than a united communist Korea. Elections in the South were held in May 1948, amidst a widespread * Ch. : Institutions as a Fundamental Cause of Long-Run Gmwth 405 boycott by Koreans opposed to separation. The newly elected representatives proceeded to draft a new constitution and established the Republic of Korea to the south of the 38th parallel. The North became the Democratic People’s Republic of Korea, under the 1 control of Kim 1 Sung. These two independent countries organized themselves in very different ways and adopted completely different sets of institutions. The North followed the model of Soviet socialism and the Chinese Revolution in abolishing private property of land and capital.

Economic decisions were not mediated by the market, but by the communist state. The South instead maintained a system of private property and the government, especially after the rise to power of Park Chung Hee in 1961, attempted to use markets and private incentives in order to develop the economy. Before this “natural experiment” in institutional change, North and South Korea shared the same history and cultural roots. In fact, Korea exhibited an unparalleled degree of ethnic, linguistic, cultural, geographic and economic homogeneity.

There are few geographic distinctions between the North and South, and both share the same disease environment. For example, the CIA Factbook describes the climate of North Korea as “temperate with rainfall concentrated in summer” and that of South Korea as “temperate, with rainfall heavier in summer than winter”. In terms of terrain North Korea is characterized as consisting of “mostly hills and mountains separated by deep, narrow valleys; coastal plains wide in west, discontinuous in east”, while South Korea is “mostly hills and mountains; wide coastal plains in west and outh”. In terms of natural resources North Korea is better endowed with significant reserves of coal, lead, tungsten, zinc, graphite, magnesite, iron ore, copper, gold, pyrites, salt, fluorspar, hydropower. South Korea’s natural resources are “coal, tungsten, graphite, molybdenum, lead, hydropower potential”. Both countries share the same geographic possibilities in terms of access to markets and the cost of transportation. Other man-made initial economic conditions were also similar, and if anything, advantaged the North.

For example, there was significant industrialization during the colonial period with the expansion of both Japanese and indigenous firms. Yet this development was concentrated more in the North than the South. For instance, the large Japanese zaibatsu of Noguchi, which accounted for one third of Japanese investment in Korea, was centered in the North. It built large hydroelectric plants, including the Suiho dam on the Yalu river, second in the world only to the Boulder dam on the Colorado river. It also created Nippon Chisso, the second largest chemical complex in the world that was taken over by the North Korean state.

Finally, in Ch’ongjin North Korea also had the largest port on the Sea of Japan. All in all, despite some potential advantages for Maddison (2001) estimates that at the time of separation, North and South the ~ o r t h ? Korea had approximately the same income per capita. We can therefore think of the splitting on the Koreas 50 years ago as a natural experiment that we can use to identify the causal influence of a particular dimension of Such initial differences were probably eradicated by the intensive bombing campaign that the United States unleashed in the early 1950’s on North Korea [see Cumings (2004, Chapte[see Cumings (2004, Chapter I)]ign: justify">Acemoglu er al. GDP per capita Figure 3. GDP per capita in North and South Korea, 195CL98. institutions on prosperity. Korea was split into two, with the two halves organized in radically different ways, and with geography, culture and many other potential determinants of economic prosperity held fixed. Thus any differences in economic performance can plausibly be attributed to differences in institutions. Consistent with the hypothesis that it is institutional differences that drive comparative development, since separation, the two Koreas have experienced dramatically diverging paths of economic development (Figure 3).

By the late 1960’s South Korea was transformed into one of the Asian “miracle” economies, experiencing one of the most rapid surges of economic prosperity in history while North Korea stagnated. By 2000 the level of income in South Korea was $16,100 while in North Korea it was only $1,000. By 2000 the South had become a member of the Organization of Economic Cooperation and Development, the rich nations club, while the North had a level of per-capita income about the same as a typical sub-Saharan African country.

There is only one plausible explanation for the radically different economic experiences on the two Koreas after 1950: their very different institutions led to divergent economic outcomes. In this context, it is noteworthy that the two Koreas not only shared the same geography, but also the same culture. It is possible that Kim I1 Sung and Communist Party members in the North believed that communist policies would be better for the country and the economy in the late 1940s. However, by the 1980s it was clear that the communist economic policies in the North were not working.

The continued efforts of the leadership to cling to these policies and to power can only be explained by those leaders wishing to look after their own interests at the expense of the population at large. Bad institutions are therefore Ch. 6: Institutions us a Fundamental Cause of Long-Run Growth 407 kept in place, clearly not for the benefit of society as a whole, but for the benefit of the ruling elite, and this is a pattern we encounter in most cases of institutional failure that we discuss in detail below.

However convincing on its own terms, the evidence from this natural experiment is not sufficient for the purposes of establishing the importance of economic institutions as the primary factor shaping cross-country differences in economic prosperity. First, this is only one case, and in the better-controlled experiments in the natural sciences, a relatively large sample is essential. Second, here we have an example of an extreme case, the difference between a market-oriented economy and a communist one. Few social scientists today would deny that a lengthy period of totalitarian centrally planned rule has significant economic costs.

And yet, many might argue that differences in economic institutions among capitalist economies or among democracies are not the major factor leading to differences in their economic trajectories. To establish the major role of economic institutions in the prosperity and poverty of nations we need to look at a larger scale “natural experiment” in institutional divergence. 3. 2. The colonial experiment The colonization of much of the world by Europeans provides such a large scale natural experiment. Beginning in the early fifteenth century and massively intensifying after 1492, Europeans conquered many other nations.

The colonization experience transformed the institutions in many diverse lands conquered or controlled by Europeans. Most importantly, Europeans imposed very different sets of institutions in different parts of their global empire, as exemplified most sharply by the contrast to the economic institutions in the northeast of America to those in the plantation societies of the Caribbean. As a result, while geography was held constant, Europeans initiated large changes in economic institutions, in the social organization of different societies.

We will now show that this experience provides evidence which conclusively establishes the central role of economic institutions in development. Given the importance of this material and the details we need to provide, we discuss the colonial experience in the next section. 4. The Reversal of Fortune The impact of European colonialism on economic institutions is perhaps most dramatically conveyed by a single fact – historical evidence shows that there has been a remarkable Reversal of Fortune in economic prosperity within former European colonies.

Societies like the Mughals in India, and the Aztecs and the Incas in the Americas were among the richest civilizations in 1500, yet the nation states that now coincide with the boundaries of these empires are among the poorer societies of today. In contrast, countries occupying the territories of the less-developed civilizations in North America, New Zealand and Australia are now much richer than those in the lands of the Mughals, Aztecs and Incas. 408 D. Acemoglu et al, 4. 1.

The reversal among the former colonies The Reversal of Fortune is not confined to such comparisons. Using reasonable proxies for prosperity before modem times, we can show that it is a much more systematic phenomenon. Our proxies for income per capita in pre-industrial societies are urbanization rates and population density. Only societies with a certain level of productivity in agriculture and a relatively developed system of transport and commerce can sustain large urban centers and a dense population.

Figure 4 shows the relationship between income per capita and urbanization (fraction of the population living in urban centers with greater than 5000 inhabitants) today, and demonstrates that in the current era there is a significant relationship between urbanization and prosperity. Naturally, high rates of urbanization do not mean that the majority of the population lived in prosperity. In fact, before the twentieth century urban areas were centers of poverty and ill health. Nevertheless, urbanization is a good proxy for average income per capita in society, which closely corresponds to the measure we are using to look at prosperity.

Figures 5 and 6 show the relationship between income per capita today and urbanization rates and (log) population density in 1500 for the sample of European co~onies. ~ – USA CAN HKG BRB MUS KNA wMY6~~ BWA 6 -1 I TU SLE I I 1 0 50 Urbanization in 1995 100 Figure 4. Urbanization in 1995 and log GDP per capita in 1995. The sample includes the counhies colonized by the Europeans between the 15th and the 19th centuries as part of their overseas expansion after the discovery of the New World and the rounding of the Cape of Good Hope.

It therefore excludes Ireland, parts of the Russian Empire and also the Middle East and countries briefly controlled by European powers as U. N. Mondays during the 20th century. Ch. 6: Institutions as a Fundamental Cause of Long-Run Growth SGP HKG I NZL MYS COL w DZA MEX DOM JAM PHL IDN SLV BOL MAR EGY NIC VNM HTI LAO BGD I I 0 5′ 10 Urbanization in 1500 1 5 Figure 5. Urbanization in 1500 and log GDP per capita in 1995, among former European colonies. CHL 8R8 TUN Swz JAM EGY LSO 6 I 1 I TZA SCE I I -5 0 Log Population Density in 1500 5 Figure 6. Log population density in 1500 and log GDP per capita in 1995, mong former European colonies. D. Acemoglu el a1 Non-Colonies EEL NLD I I I 10 20 30 Urbanization in 1000 Figure 7. Urbanization in 1000 and 1500, among nonxolonies. We pick 1500 since it is before European colonization had an effect on any of these societies. A strong negative relationship, indicating a reversal in the rankings in terms of economic prosperity between 1500 and today, is clear in both figures. In fact, the figures show that in 1500 the temperate areas were generally less prosperous than the tropical areas, but this pattem too was reversed by the twentieth century.

The urbanization data for these figures come from Bairoch (1988), Bairoch, Batou and Chbvre (1988), Chandler (1987), and Eggimann (1999). The data on population density are from McEvedy and Jones (1978). Details and further results are in Acemoglu, Johnson and Robinson (2002). There is something extraordinary about this reversal. For example, after the initial spread of agriculture there was remarkable persistence in urbanization and population density for all countries, including those which were to be subsequently colonized by Europeans.

In Figures 7 and 8 we show the relationships for urbanization plotting separately the relationship between urbanization in 1000 and in 1500 for the samples of colonies and all other countries. Both figures show persistence, not reversal. Although Ancient Egypt, Athens, Rome, Carthage and other empires rose and fell, what these pictures show is that there was remarkable persistence in the prosperity of regions. Moreover, reversal was not the general pattem in the world after 1500. Figure 9 shows that within countries not colonized by Europeans in the early modem and modem period, there was no reversal between 1500 and 1995.

There is therefore no reason to think that what is going on in Figures 5 and 6 is some sort of natural reversion to the mean. , Ch. 6: Institutions as a Fundamental Cause of Long-Run Gmwth Former Colonies MAR DZA MMR NmS 0 I 1 5 7 10 Urbanization in 1000 Figure 8. Urbanization in 1000 and 1500, among former European colonies, Non-Colonies ROM B R V EGR I 0 UKR CHN ALB UD* 10 7 -I – 20 Urbanization in1500 jl,- Figure 9. Urbanization in 1500 and log GDP per capita in 1995, among non-colonies. 412 Urbankalion in excolonies with low and hlgh urbanlzatlon In 1600 (avenges weighted wlhln each group by population In 1600) 25

D. Acemoglu er al. 7 tlow ubmizatimn in 1503 exmlonies +high urbanization in f5CO excdonies Figure 10. Evolution of urbanization among former European colonies. 4. 2. Timing o the reversal f When did the reversal occur? One possibility is that it arose shortly after the conquest of societies by Europeans but Figures 10 and 1 1 show that the previously-poor colonies surpassed the former highly-urbanized colonies starting in the late eighteenth and early nineteenth centuries, and this went hand in hand with industrialization.

Figure 10 shows average urbanization in colonies with relatively low and high urbanization in 1500. The initially hlgh-urbanization countries have higher levels of urbanization and prosperity until around 1800. At that time the initially low-urbanization countries start to grow much more rapidly and a prolonged period of divergence begins. Figure 11 shows industrial production per capita in a number of countries. Although not easy to see in the figure, there was more industry (per capita and total) in India in 1750 than in the United States.

By 1860, the United States and British colonies with relatively good economic institutions, such as Australia and New Zealand, began to move ahead rapidly, and by 1953, a huge gap had opened up. 4. 3. Interpreting the reversal Which of the three broad hypotheses about the sources of cross-country income differences are consistent with the reversal and its timing? These patterns are clearly Ch. 6: Institutions as a Fundamental Cause of Long-Run Growth Industrial Production Per Capita, UK in 1800 = 100 (from Bairooh) 413 Figure 11. Evolution of industrial production per capita among former European colonies nconsistent with simple geography based views of relative prosperity. In 3500 it was the countries in the tropics which were relatively prosperous, in 2003 it is the reverse. This makes it implausible to base a theory of relative prosperity today, as Sachs (2000, 2001) does, on the intrinsic poverty of the tropics. This argument is inconsistent with the historical evidence. Nevertheless, following Diamond (1997), one could propose what Acemoglu, Johnson and Robinson (2002) call a “sophisticated geography hypothesis” which claims that geography matters but in a time varying way.

For example, Europeans created “latitude specific” technology, such as heavy metal ploughs, that only worked in temperate latitudes and not with tropical soils. Thus when Europe conquered most of the world after 1492, they introduced specific technologies that functioned in some places (the United States, Argentina, Australia) but not others (Peru, Mexico, West Africa). However, the timing of the reversal, coming as it does in the nineteenth century, is inconsistent with the most natural types of sophisticated geography hypotheses.

Europeans may have had latitude specific technologies, but the timing implies that these technologies must have been industrial, not agricultural, and it is difficult to see why industrial technologies do not function in the tropics (and in fact, they have functioned quite successfully in tropical Singapore and Hong on^). ^ A possible link is that proposed by Lewis (1978) who argued that tropical agriculture is less productive than temperate agriculture, and that an ‘agricultural revolution’ is a prerequisite to an industrial revolutionbecause 14 D. Acemoglu et al. Similar considerations weigh against the culture hypothesis. Although culture is slow-changing the colonial experiment was sufficiently radical to have caused major changes in the cultures of many countries that fell under European rule. In addition, the destruction of many indigenous populations and immigration from Europe are likely to have created new cultures or at least modified existing cultures in major ways [see Vargas Llosa (1989), [see Vargas Llosa (1989), for a fictionalized account of just such a cultural change]: justify">Nevertheless, the culture hypothesis does not provide a natural explanation for the reversal, and has nothing to say on the timing of the reversal. Moreover, we discuss below how econometric models that control for the effect of institutions on income do not find any evidence of an effect of religion or culture on prosperity. The most natural explanation for the reversal comes from the institutions hypothesis, which we discuss next. 4. 4. Economic institutions and the reversal Is the Reversal of Fortune consistent with a dominant role for economic institutions in comparative development?

The answer is yes. In fact, once we recognize the variation in economic institutions created by colonization, we see that the Reversal of Fortune is exactly what the institutions hypothesis predicts. In Acemoglu, Johnson and Robinson (2002) we tested the connection between initial population density, urbanization, and the creation of good economic institutions. We showed that, others things equal, the higher the initial population density or the greater initial urbanization, the worse were subsequent institutions, including both institutions right after independence and today.

Figures 12 and 13 show these relationships using the same measure of current economic institutions used in Figure 1, protection against expropriation risk today. They document that the relatively densely settled and highly urbanized colonies ended up with worse (or ‘extractive’) institutions, while sparselysettled and non-urbanized areas received an influx of European migrants and developed institutions protecting the property rights of a broad cross-section of society.

European colonialism therefore led to an institutional reversal, in the sense that the previouslyricher and more-densely settled places ended up with worse institutions? To be fair, it is possible that the Europeans did not actively introduce institutions discouraging economic progress in many of these places, but inherited them from previous civilizations there. The structure of the Mughal, Aztec and Inca empires were already very hierarchical with power concentrated in the hands of narrowly based ruling elites and structured to extract resources from the majority for the benefit of a minority.

Often high agricultural productivity is needed to stimulate the demand for industrial goods. Though obviously such an explanation is not relevant for explaining industrialization in Singapore or Hong Kong, it may be relevant in other places. The institutional reversal does not mean that institutions were necessarily better in the previously more densely-settled areas (see next paragraph). It only implies a tendency for the relatively poorer and less denselysettled areas to end up with better institutions than previously-rich and more densely-settled areas. . Ch. 6: Institutions as a Fundamental Cause of Lnng-Run Gmwth LD NZL SGP B W B HKG IND 8-W( MYS IDN MEX MAR EGY a Figure 12. Urbanization in 1500 and average protection against risk of expropriation 1985-95. USA CAN AUS NZl SGP URY -.. :r HTI R , EGY 0 Log Population Density in 1500 , 5 Figure 13. Log population density in 1500 and average protection against risk of expropriation 1985-95. 416 D. Acemoglu et al. Europeans simply took over these existing institutions.

Whether this is so is secondary for our focus, however. What matters is that in densely-settled and relatively-developed places it was in the interests of Europeans to have institutions facilitating the extraction of resources thus not respecting the property rights of the majority, while in the sparsely-settled areas it was in their interests to develop institutions protecting property rights. These incentives led to an institutional reversal.

The institutional reversal, combined with the institutions hypothesis, predicts the Reversal of Fortune: relatively rich places got relatively worse economic institutions, and if these institutions are important, we should see them become relatively poor over time. This is exactly what we find with the Reversal of Fortune. Moreover, the institutions hypothesis is consistent with the timing of the reversal. Recall that the institutions hypothesis links incentives to invest in physical and human capital and in technology to economic institutions, and argues that economic prosperity results from these investments.

Therefore, economic institutions should become more important when there are major new investment opportunities. The opportunity to industrialize was the major investment opportunity of the nineteenth century. Countries that are rich today, both among the former European colonies and other countries, are those that industrialized successfully during this critical period. 4. 5. Understanding the colonial experience The explanation for the reversal that emerges from our discussion so far is one in which the economic institutions in various colonies were shaped by

Europeans to benefit themselves. Moreover, because conditions and endowments differed between colonies, Europeans consciously created different economic institutions, which persisted and continue to shape economic performance. Why did Europeans introduce better institutions in previously-poor and unsettled areas than in previously-rich and densely-settled areas? The answer to this question relates to the comparative statics of our theoretical framework. Leaving a full discussion to later, we can note a couple of obvious ideas.

Europeans were more likely to introduce or maintain economic institutions facilitating the extraction of resources in areas where they would benefit from the extraction of resources. This typically meant areas controlled by a small group of Europeans, and areas offering resources to be extracted. These resources included gold and silver, valuable agricultural commodities such as sugar, but most importantly people. In places with a large indigenous population, Europeans could exploit the population, be it in the form of taxes, tributes or employment as forced labor in mines or plantations.

This type of colonization was incompatible with institutions providing economic or civil rights to the majority of the population. Consequently, a more developed civilization and a denser population structure made it more profitable for the Europeans to introduce worse econornic institutions. In contrast, in places with little to extract, and in sparsely-settled places where the Europeans themselves became the majority of the population, it was in their interests to introduce economic institutions protecting their own property rights. . Ch. 6: Institutions as a Fundamental Cause o Long-Run Growth f 417 4. 6. Settlements, mortality and development – . The initial conditions we have emphasized so far refer to indigenous population density and urbanization. In addition, the disease environments differed markedly among the colonies, with obvious consequences on the attractiveness of European settlement. As we noted above, when Europeans settled, they established institutions that they themselves had to live under.

Therefore, whether Europeans could settle or not had an exogenous effect on the subsequent path of institutional development. In other words, if the disease environment 200 or more years ago affects outcomes today only through its effect on institutions today, then we can use this historical disease environment as an exogenous source of variation in current institutions. From an econometric point of view we have a valid instrument which will enable us to pin down the casual effect of economic institutions on prosperity. We developed this argument in Acemoglu, Johnson and Robinson (2001) and investigated it empirically. We used initial conditions in the European colonies, particularly data from Curtin (1989, 1998) and Gutierrez (1986) on the mortality rates faced by Europeans (primarily soldiers, sailors, and bishops), as instruments for current economic institutions. The justification for this is that, outside of its effect on economic institutions during the colonial period, historical European mortality has no impact on current income levels.

Figures 14 and 15 give scatter plots of this data against contemporaneous economic institutions and GDP per-capita. The sample is countries which were colonized by Europeans in the early modem and modem periods and thus excludes, among others, China, Japan, Korea, Thailand. Figure 14 shows the very strong relationship between the historical mortality risk faced by Europeans and the current extent to which property rights are enforced. A bivariate regression has an R~ of 0. 6. It also shows that there were very large differences in European mortality. Countries such as Australia, New Zealand and the United States were very healthy with life expectancy typically greater than in Britain. On the other hand mortality was extremely high in Africa, India and South-East Asia. Differential mortality was largely due to tropical diseases such as malaria and yellow fever and at the time it was not understood how these diseases