SECRETS OF ECONOMIC SUCCESS
What role do institutions play in the economic success of nations?
By Suchitra
It will be interesting to note that this year’s Nobel Prize for Economics has been awarded for the pioneering work linking institutions to prosperity. According to the press release from the Royal Swedish Academy of Sciences for the 2024 Nobel Prize in Economics, “This year’s laureates in the economic sciences—Daron Acemoglu, Simon Johnson, and James Robinson—have demonstrated the critical role that societal institutions play in a nation's prosperity. Societies with weak rule of law and institutions that exploit their populations fail to generate growth or meaningful change. The laureates' research helps us understand why.”
The route to prosperity has remained central to economic discourse. Why are some nations prosperous while others remain impoverished? Historically, economic growth models have focused on the accumulation of production factors, such as labour, capital, and, more recently, technology or ideas. The greater the capital available per worker and the more productive its utilisation, the wealthier a nation becomes.Yet, this still leaves an unanswered question: why do some countries manage to accumulate more of these factors than others?
The recipients of this year's Nobel Prize in Economics propose that the answer lies in the quality of governance. In 2001, Daron Acemoglu and Simon Johnson, both from the Massachusetts Institute of Technology and James Robinson of the University of Chicago, published a landmark paper, "The Colonial Origins of Comparative Development: An Empirical Investigation." This widely-cited work introduced a framework for understanding institutions, classifying them as either "inclusive"—those that distribute prosperity broadly—or "extractive"—those in which a small elite exploits the majority. Inclusive institutions encourage investments in human and physical capital, while extractive institutions stifle such investments.
Robust Institutional Framework
The idea that institutions play a central role in economic growth is not new; it was proposed earlier by Douglass North, a 1993 Nobel laureate, alongside historian Robert Fogel. However, the key question explored by this year's laureates was whether economic development fosters liberal institutions or if the reverse is true. Could wealthier societies lead to democratic reforms rather than the other way around?
Acemoglu, Johnson, and Robinson use variations in settler mortality rates to distinguish between European colonies that developed inclusive institutions and those that developed extractive ones. In colonies with high mortality rates—often due to tropical diseases—colonial powers exploited indigenous labour through systems like the encomienda in South America or the rubber plantations of the Belgian Congo. Conversely, European settlers were incentivised to settle and share in the wealth they created through private property and free markets in English-speaking colonies with lower death rates- such as the United States, Australia, and Canada.
This analysis led to what the authors termed a "reversal of fortune" among colonies. Those that were wealthiest in 1500, as measured by urbanisation, became the poorest in modern times. Acemoglu, Johnson, and Robinson theorised that the greater wealth of these once-rich colonies facilitated the development of extractive institutions, while their larger populations provided a workforce for coercive labour systems in mines and plantations. A subsequent study expanded upon this research with a "quasi-experiment" in North and South Korea, where one-half of the peninsula became a prosperous, liberal democracy while the other remained authoritarian and impoverished.
The authors suggest that countries could become entrenched in poor institutional frameworks. In highly unequal societies, the threat of revolution from the lower classes could force elites to make promises to redistribute wealth. Yet, such promises were often not credible because the elites could easily reverse course once the threat subsided. This lack of trust led to instability. The authors argued that the introduction of checks and balances served as a mechanism to ensure the credibility of elite commitments to redistribution, thus averting revolutionary pressures. This dynamic, they suggested, explained the expansion of the democratic franchise in European states during the early 19th century.
Gaps in the Theory
Few economists dispute the influence of this year’s Nobel laureates. Acemoglu, in particular, has long been considered a leading candidate for the Nobel Prize due to his contributions to technological growth, labour economics, and development. However, like much empirical work, the methods employed by the prize winners have faced scrutiny. For example, David Albouy of the University of Illinois has questioned the accuracy and selective use of their settler mortality estimates. Meanwhile, Edward Glaeser of Harvard University argued that settler mortality may have influenced economic growth through channels other than institutions, such as the introduction of education and trade networks.
Historians have also critiqued the clear-cut division between extractive and inclusive institutions. For instance, South Korea experienced significant economic development under a military dictatorship. England's Glorious Revolution in 1688—identified by Acemoglu and Robinson as a turning point—enabled Parliament to displace peasants while also curbing the monarchy's powers. Similarly, the development of the United States combined individual rights and democracy for white men with slavery and the later disenfranchisement of Black citizens.
According to the laureates, inclusive institutions—those that uphold property rights, protect democratic processes, and limit corruption—are conducive to economic development. In contrast, extractive institutions, which concentrate power and restrict political freedoms, prioritise the interests of a small elite, thereby hindering economic progress. The laureates argue that the establishment of inclusive institutions has had a lasting positive impact on economic prosperity, which is why such institutions are primarily found in high-income Western countries today.
However, a major issue with this analysis is the assertion that certain institutions must be in place as a precondition for economic development. Mushtaq Khan, a professor of economics at SOAS, University of London, contends that their findings mainly show that today's wealthy countries perform better on Western-based institutional indices but do not necessarily prove that economic development occurred because these states first established inclusive institutions.
Historical evidence provides numerous examples of countries that achieved rapid economic growth without initially having inclusive institutions. East Asian nations such as Singapore, South Korea, and Taiwan exemplify this phenomenon. More recently, China has demonstrated similar growth patterns.
In her award-winning books on China's development, Yuen Yuen Ang has detailed how corruption was pervasive throughout China's growth process. Following the announcement of this year's Nobel Prize, Ang remarked that the laureates' theory fails to explain China's development and struggles to account for growth in Western nations. She notes that during its own development process, the United States was rife with corruption, yet it still managed to grow economically.
Legitimising Colonialism?
While nations are not misguided in seeking to adopt the inclusive institutions outlined in the work of Acemoglu, Johnson, and Robinson, a concerning aspect of their analysis is its potential to legitimise the supremacy of Western institutions—and, at worst, to endorse the processes of imperialism and colonialism indirectly. Their work has been criticised for failing to address the brutal realities of colonialism adequately.
Acemoglu, Johnson, and Robinson argue that settler colonies have, over time, performed better economically, thereby suggesting that European institutions are superior for development. However, given that colonisation plays a central role in their analysis, it is perplexing that the laureates do not address the broader costs of colonialism. Even in settler colonies where inclusive institutions eventually emerged, they were often preceded by years of violence, sometimes approaching the level of genocide against native populations. Should this not be considered an integral part of the development process?
The laureates claim that Europeans settled in the poorest, most sparsely populated regions and introduced institutions that contributed to long-term prosperity. After receiving the award, Acemoglu stated that the normative questions surrounding colonialism were not their focus: “Rather than asking whether colonialism is good or bad, we note that different colonial strategies have led to different institutional patterns that have persisted over time.”
This statement is not unexpected. Unfortunately, it has become a point of pride within mainstream economics to analyse the world without a normative lens or value judgments. This broader issue partly explains why economics as a discipline has become increasingly isolated and detached from other social sciences.
The Nobel Prize in Economics, which was not one of the original five Nobel Prizes, illustrates this problem. The list of past winners is geographically and institutionally narrow, predominantly composed of economists from elite U.S. universities. A recent study also found that the institutional and geographical concentration of awards in economics is much higher than in other academic fields. Almost all major award winners have passed through fewer than ten top U.S. universities at some point in their careers.
The Need for Inclusivity
The 2024 Economics Nobel Prize is important as it highlights what matters at the end of the day for the long-term economic success of any country.
The "institutions" that the laureates talk about as crucial to long-term economic prosperity are nothing but the various rules, which could be either explicit laws or implicit social norms that govern human interaction in society. Such institutions may also include laws that protect citizens from government expropriation. The rapid economic growth of China and India since their economic liberalisation in the late 1970s and the early 1990s, respectively, are good examples of countries prospering soon after a significant change in the nature of the institutions or the "rules of the game" that governed their economies. Structural reforms that further improve the quality of institutions are thus crucial if these economies are to achieve living standards similar to those of high-income developed countries in the West.
Notably, this Nobel Prize also comes at a time when existing institutions around the world are under the significant threat of being destabilised by personality-driven populist movements. It is worth noting that in their work, the Nobel laureates have classified democracy as an important "inclusive" institution that is good for long-term economic growth. However, the rise of illiberal democracies with protectionist economic policies in recent years shows that liberal institutions that work for the upliftment of the many and development, not just for a few, are now under severe threat. A democracy driven by short-term populist policies can be as "extractive" as an autocracy that serves the interests of a narrow elite that is close to the people in power.
Key Takeaways
Despite the debates surrounding their methods, the Nobel laureates’ work has undoubtedly underscored the importance of historical context in understanding economic development. While Acemoglu, Johnson, and Robinson may not have provided a definitive answer to why some nations are wealthy, and others are not, their research has laid a strong foundation for future economists to build upon.
Clearly, the nature of institutions that emerge has a linkage to the political system prevalent in that country and the degree of inclusivity that it permits. This has been true for the advanced nations of the West. But can it equally apply to the Global South in the same measure? China, in particular may have proved this theory a bit shaky on this account.
