Political Economy of Growth

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1 1 Political Economy of Growth Daron Acemoglu Department of Economics, MIT Milan, DEFAP June 11, 2007

2 The Wealth of Nations Vast differences in prosperity across countries today. Income per capita in sub-saharan Africa on average 1/20 th of U.S. income per capita In Mali, Democratic Republic of the Congo (Zaire), and Ethiopia, 1/35 th of U.S. income per capita. Adam Smith s legacy: we have to understand the functioning of markets and organizations to understand the wealth of nations. The invisible hand and markets The division of labor Skills Policies 2

3 Rethinking the Wealth of Nations Standard economic answers (à la Smith): Physical capital differences (poor countries don t save enough) Human capital differences (poor countries don t invest enough in education and skills) Technology differences (poor countries don t invest enough in R&D and technology adoption, and don t organize their production efficiently) Markets (markets don t function in poor countries). are proximate causes. We need to understand why poor countries don t save enough, don t invest enough, don t develop and use technologies and don t have functioning markets. Potential answer: differences in incentives 3

4 Towards Political Economy of Growth Where do incentives come from? Adam Smith: ``little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things.''. Potential answer: institutional differences Institutions: organization of society, rules of the game. To understand the wealth of nations, we need to understand institutional differences. Institutional differences related to social conflict. To understand social conflict, we need to understand the political economy of growth. 4

5 Sources of prosperity What lies beneath the proximate causes? Potential fundamental causes of differences in prosperity: Institutions (humanly-devised rules shaping incentives) Geography (exogenous differences of environment) Culture (differences in beliefs, attitudes and preferences) 5

6 What are institutions? Institutions: the rules of the game in economic, political and social interactions. Institutions determine social organization North: "Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction. Key point: institutions are humanly devised set constraints shape incentives 6

7 Economic institutions and economic performance. Log GDP per capita, PPP, in ZAR HTI SDN MLI KWT ARE BHR MLT GRC BHS CHL OMN SAU ARG URY VEN MEX BWA GAB PAN ZAF MYS CRI COL TTOTHA BRA IRN TUR POL TUN ECU PER DOM DZA ROM GTM JORPRYJAM PHL SUR SYR MAR IDN SLV BOL GUY EGY CHN AGO HND ZWE LKA NIC CMR GIN COG SEN CIV PAK GHA VNM MNG TGO KEN UGA MDG BFA BGD NGA ZMB NER YEM MOZ MWI QAT HKG GMB IND ISR RUS KOR CZE HUN BGR LUX USA SGP CHE BEL DNK CAN AUT JPN FRA NOR AUSITA ISL SWE FIN GBR NLD NZL IRL ESP PRT 6 SLE ETH TZA Avg. Protection Against Risk of Expropriation,

8 Political institutions and economic performance. Log GDP per capita, PPP, in SWZ SYR GIN SDN TGO NGA TCD ZAR SGP MEX GAB THA TUN DZA PER GTM JOR PRY IDN MAR EGY CHN GUY AGO ZWE HNDLKA CIV CMR NIC GHA MRT SEN COG COM LSO PAK CAF HTI KEN UGA BFA ZMB MDG YEM BDI RWA MWI MOZ FRA SLV GMB ARG VEN POL DOM BGD NPL NER MLI BEN LUX USA CHE NOR DNK DEU CAN AUT JPN BEL SWE GBR AUS NLD ITA FIN ISL NZL ISR IRL ESP PRT GRC KOR CHL MUS URY COL BWA MYS HUN PAN ZAF CRI BRA TTO TUR ECU FJI JAM PHL BOL IND 6 SLE ETH TZA Constraint on Executive in 1990s

9 But institutions are endogenous Institutions could vary because underlying factors differ across countries. Geography, ecology, climate Culture Perhaps other factors? Montesquieu s story: Geography determines human attitudes Human attitudes determine both economic performance and political system. Institutions potentially influenced by the determinants of income. Identification problem: We can learn only a limited amount from correlations. 9

10 Geography hypothesis: Montesquieu 10 Montesquieu: 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, "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". Moreover, Montesquieu argues that lazy people tend to be governed by despots, while vigorous people could be governed in democracies; thus hot climates are conducive to authoritarianism and despotism.

11 Geography hypothesis: modern versions Jared Diamond: Importance of geographic and ecological differences in agricultural technology and availability of crops and animals. Jeff Sachs: "Economies in tropical ecozones are nearly everywhere poor, while those in temperate ecozones are generally rich" because "Certain parts of the world are geographically favored Tropical agriculture faces several problems that lead to reduced productivity of perennial crops in general and of staple food crops in particular" "The burden of infectious disease is similarly higher in the tropics than in the temperate zones" 11

12 Culture hypothesis Institutions and prosperity may be joint be determined by culture (beliefs, preferences, social norms). Max Weber: "Montesquieu says of the English that they "had progressed the farthest of all peoples of the world in three important things: in piety, in commerce, and in freedom". Is it not possible that their commercial superiority and their adaptation to free political institutions are connected in some way with that record of piety which Montesquieu ascribes to them?" Culture closely related to institutions, but different. Not directly chosen by the society for its consequences Not clear how it changes. 12

13 13 Montesquieu s story?. Log GDP per capita, PPP, in 1995 Latitude AFG DZA AGO ARG ARM AUS AUT AZE BHSBHR BGD BRB BLR BEL BLZ BEN BTN BOL BIH BWA BRA BGR BFA BDI CMR CAN CPV CAF TCD CHL CHN COL COM ZAR COG CRI CIV HRV CZE DNK DJI DMA DOM ECU EGY SLV EST ETH FJI FIN FRA GAB GMB GEO DEU GHA GRC GRD GTM GIN GNB GUY HTI HND HKG HUN ISL IND IDN IRN IRQ IRL ISR ITA JAM JPN JOR KAZ KEN KOR KWT LVA LSO LBR LBY LTU LUX MDG MWI MYS MLI MLT MRT MUS MEX MDA MAR MOZ MMR NAM NPL NLD NZL NIC NER NGA NOR OMN PAK PAN PNG PRY PER PHL POL PRT QAT ROM RUS RWA STP SAU SEN SLE SGP SVK SVN SOM ZAF ESP LKA KNA LCA VCT SDN SWZ SWE CHE SYR TJK TZA THA TGO TTO TUN TUR TKM UGA GBR UKR ARE URY USA UZB VEN VNM YEM YUG ZMB ZWE

14 Empirical pitfalls of correlations Montesquieu s story example of omitted variables bias and identification problem. Other omitted factors---human nature, culture, geography--- vary across countries and affect economic performance. They also are correlated with or have a causal effect on institutions. Similar problem affects inferences about geography on income; potentially correlated with omitted variables. Reverse causality: Income affects institutions. 14

15 Need for exogenous variation Exploit natural experiments of history, where some societies that are otherwise similar were affected by historical processes leading to institutional divergence. Building towards an instrument for institutions; a source of variation that affects institutions, but has no other effect, independent or working through omitted variables, on income. Examples of potential natural experiments of history: 1. South versus North Korea 2. European colonization 15

16 The Korean experiment 16 Korea: economically, culturally and ethnically homogeneous at the end of WWII. If anything, the North more industrialized. Exogenous separation of North and South, with radically different political and economic institutions. Exogenous in the sense that institutional outcomes not related to the economic, cultural or geographic conditions in North and South. Approximating an experiment where similar subjects are treated differently. Big differences in economic and political institutions. Communism (planned economy) in the North. Capitalism, albeit with government intervention and early on without democracy, in the South. Huge differences.

17 North and South Korea GDP per capita South Korea North Kore a

18 European colonization as a natural experiment After the discovery of the New World and the rounding of the Cape of Good Hope, Europeans dominated many previously diverse societies, and fundamentally affected their social organizations (institutions). Approximating a natural experiment because Many factors, including geographic, ecological and climatic ones, constant, while big changes in institutions. Changes in institutions not a direct function of these factors. Analogy to a real experiment where similar subjects have different treatments. Consequences? Look at changes in prosperity from before colonization (circa 1500) to today in the former colonies sample. Measure of prosperity before the modern era: urbanization rates Supported with information on population density. 18

19 Urbanization and income today. 10 USA CAN AUS NZL HKG SGP GDP per capita, PPP, in BRB MUS KNA ZAF GABMYS CRI PAN BWA NAM LCA BLZ DZA ECU TUN GRD DOM GTMFJI VCT PRY JAM SWZ IDN MAR PHL EGY CPV GUY SLV SUR BOL LKA AGO ZWE HND GIN COM CIV CMR NIC GHA MRT COG LSOIND PAK SEN VNM GMB SDN TGO HTI CAF LAO KEN BEN NPL UGA BFA BGD TCD MDGZAR NGAZMB NER BDI ERI MLI RWA MWI MOZ MEX TTO COL PER DMA BRA CHL BHS ARG VEN URY TZA SLE Urbanization in 1995

20 Results: until 1500 Persistence is the usual state of the world. There is mean reversion and rise and decline of nations, and certainly of cities. But countries that are relatively rich at a point in time tend to remain relatively rich. The data confirm this persistence. After the initial spread of agriculture, there was remarkable persistence in urbanization and population density. Largely true from 1000 BC to 1500 AD, and also for subperiods. More important, true also in the former colonies sample. 20

21 Reversal since 1500 (1). 10 USA CAN AUS SGP HKG NZL GDP per capita, PPP, in CHL ARG URY VEN BRA PRY GUY DOM JAM PHL MYS COL PAN CRI BLZ GTM IDN SLV LKA HND NIC ECU PER BOL TUN DZA MEX EGY MAR 7 HTI VNM LAO PAK IND BGD Urbanization in 1500

22 Reversal since 1500 (2). 10 CAN AUS USA SGP HKG NZL GDP per capita, PPP, in ARG URY BWA BRA NAM SUR GUY CHL BRB BHS VEN ZAF MYS KNA GAB MEX COL PAN TTO CRI LCA ECU TUN DOM GRD PER DMA BLZ DZA VCT GTM PRY JAM SWZ PHL IDN MAR CPV BOL SLV AGO ZWE HND LKA CMR NIC GIN COG MRTCOM CIV LSO GHA SEN GMB SDN PAK IND HTI CAF TGO VNM LAO KEN BEN UGA NPL TCD MDG BFA BGD ZMB ZAR NGA NER MLI ERI BDI MWI MOZ RWA EGY TZA SLE Log Population Density in 1500

23 When did the reversal happen? 25 Urbanization in excolonies with low and high urbanization in 1500 (averages weighted within each group by population in 1500) low urbanization in 1500 excolonies high urbanization in 1500 excolonies 23

24 The nature of the reversal: industrialization Industrial Production Per Capita, UK in 1900 = 100 (from Bairoch) US Australia Canada New Zealand Brazil Mexico India

25 What s happening? 25 Former colonies with high urbanization and population density in 1500 have relatively low GDP per capita today, while those with low initial urbanization and population density have generally prospered. But gains in the growing societies not always equally shared. Native Indians and aborigines in the New World have all but disappeared. (Simple) Geography hypothesis? It cannot be geographical differences; no change in geography. Sophisticated geography hypothesis? Certain geographic characteristics that were good in 1500 are now harmful? no evidence to support this view; reversal related to industrialization, and no empirical link between geography and industrialization.

26 Understanding the patterns from 1500 to Reversal related to changes in institutions/social organizations. Relatively better institutions emerged in places that were previously poor and sparsely settled. E.g., compare the United States vs. the Caribbean or Peru. Thus an institutional reversal Richer societies ended up with worse institutions. Europeans introduced relatively good institutions in sparsely-settled and poor places, and introduced or maintained previously-existing bad institutions in densely-settled and rich places. E.g.; slavery in the Caribbean, forced labor in South America, tribute systems in Asia, Africa and South America. Institutions have persisted and affected the evolution of income, especially during the era of industrialization why to be discussed more below.

27 Institutions matter 27 Reversal in prosperity resulting from the institutional reversal, combined with persistence in institutions. Countries with better institutions prosper, while those with bad institutions stagnate or decline. The reversal also emphasizes that the differences are not only between capitalist and communist systems. What matters more is the type of capitalism. But then why different institutions? And what are good and bad institutions? For now, take good institutions to be those that encourage investment in physical, human capital, and in technology, and bad institutions in the opposite Are the same institutions always good and bad?

28 Are British colonies special? Popular view going back to Adam Smith and Winston Churchill that British cultural and political influence was beneficial, certainly better than that of Spanish and French influence. Closely related to the culture view. Does the evidence support this view? The answer is no. The patterns shown above are robust to controlling for the identity of colonial power. Similar patterns when we look at only British colonies. 28

29 The Reversal among former British colonies CAN 10 AUS USA SGP HKG NZL GDP per capita, PPP, in BWA NAM GUY BRB BHS ZAF MYS KNA TTO LCA GRD DMA VCT BLZ SWZ ZWE LSO ZMB KEN JAM GHA GMB NGA UGA LKA SDN PAK IND NPL BGD EGY MWI SLE Log Population Density in 1500

30 More on the role of culture Culture not useful in understanding the Korean divergence North and South were culturally homogeneous. Possible that the reversal related to culture. But the growth trajectories of British colonies similarly to Spanish, Portuguese and French colonies once we control for differences in local conditions. Moreover, no econometric evidence that religion matters for understanding the reversal or for long-run growth. Reversal also not related to the presence of Europeans. Examples of prosperity in Singapore and Hong Kong, where population is now almost entirely non-european, but institutions protect investment. No evidence that European values or culture played a special role. 30

31 The Reversal for colonies with less than 1% of European descent in SGP HKG GDP per capita, PPP, in BWA MYSGAB AGO CMR COG HTI ZMB MDGZAR NER MLI MWI KEN IDN GIN CIV GHA SEN GMB TGO NGA BFA DZA VNM UGA TUN LKA SDN PAK IND BGD EGY TZA SLE Log Population Density in 1500

32 But why do institutions differ? Towards political economy If institutions so important for growth, why do they differ across societies? Answer: social conflict. Economic growth, like everything else, creates winners and losers. E.g.: a monopolist would be opposed to a reduction in entry barriers even if these increase aggregate income. Whether growth-promoting institutions will be adopted or not depends on who has political power and on checks and balances. Political economy of growth 32

33 Institutions and social conflict 33 Institutions chosen for their economic consequences. In particular, economic institutions which shape incentives and determine distribution of resources. But also taking account of their distributional implications How does society make decisions in conflictual situations (i.e., when there is no agreement on what should be done?) Importance of political power Political power: the power to impose or secure social choices against the wishes of other groups. Political power social choices; Political power economic institutions Key questions to be addressed later; Where does political power come from? What about political institutions?

34 Towards the political economy of growth 34 When do we expect a society to adopt good institutions? 1. When those holding political power benefit from property rights (and financial development, free entry, etc.) Importance of creative destruction 2. When there are relatively few resources to be extracted Importance of factor endowments and resources 3. When constraints on political power create real checks Importance of political institutions Social conflict and political power are key. Europeans monopolized political power and set up institutions for their own benefit, even if not beneficial for the society at large.

35 Understanding the timing of the reversal 35 Why did the reversal take place in the 19 th century? Coercive institutions imposed by Europeans not extremely costly when they dominated the major productive opportunities. E.g., the plantation complex generated investment in sugar production; Barbados, Cuba, Haiti, Jamaica among the richest places in the world at some point between 16 th and 19 th centuries. The major cost of these institutions arises when new opportunities, in this instance in industry and commerce, require investment by new groups, broad-based participation and creative destruction. 19 th century was a period of industrialization, and societies with relatively democratic institutions were the ones allowing free-entry by new entrepreneurs. Highlights that the same set of institutions can have very different effects under different circumstances.

36 Sources of political power 36 Two types of political power: De jure (formal) political power Allocated by political institutions E.g., political power allocated to a party or Prime Minister by an election. De facto political power Determined by economic and military power, or access to extralegal means E.g., the political power of rebel groups in a Civil War, or of masses who can create social unrest or a revolution. De facto political power typically relies on military superiority or on solving the collective action problem. Distribution of political power in society determined by the distribution of de jure and de facto political power.

37 Economics and political power 37 The interplay between economic institutions and political power adds to institutional persistence. Political power economic institutions Economic institutions distribution of resources Distribution of resources de facto political power A non-level playing field in the economy favors those with political power, which in turn increases their political power further Example: colonialism in the Caribbean; planters monopolized political power, which enabled them to capture the majority of the gains from sugar and other products. The planters incomes enabled them to dominate military power and control the state persistence of the system

38 A theory of institutions 38 Economic institutions essential for the prosperity of nations But also benefit different groups and individuals social conflict In the presence of social conflict; political power economic and political institutions good institutions emerge when they benefit those with political power. political institutions de jure political power Constraints on elites often conducive to better institutions. de facto political power political institutions de jure political power, both today and in the future Toward a theory of institutional change political power institutions political power Source of persistence.

39 Schematic representation De jure power (Political institutions) t De facto power t political power t Economic institutions t Economic policies t Political institutions t+1 39

40 Conclusions Growth intimately linked to institutions. Central to understand the political economy of growth. Progress towards a useful framework for thinking about institutions and political economy of growth. Emerging framework: formal theory + careful econometric research Much research left to be done Future areas: 1. Unbundling institutions 2. Institutional persistence 3. Institutional change 4. Policy to influence institutions? (further further in the future!) 40

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