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Monday, May 7, 2018

Understanding why nations fail

How a book celebrated by the world’s leading economists is actually an intellectual absurdity 

Last Saturday, my intellectual friends and I held a thrilling debate on a book by James Robinson and Daron Acemoglu titled `Why Nations Fail’. The book became an instant bestseller when it was published. Five Nobel laureates in economics endorsed it. Four other economists I hold in high esteem did that same. Jarred Diamond, whose work on the role of geography in the economic prosperity got me thinking in 1998, said good things about it.

At our debate, Ramathan Goobi, an economist and lecturer at the Makerere Business School who has internalised the book made a good presentation of its core argument. It is hard to argue against so many Nobel laureates in economics and say they are mistaken or deluded. Yet this is what I am setting out to do.

The core argument of the book is that prosperity is entirely determined by institutions. Countries with “inclusive institutions” i.e. those what allow every citizen political rights which translate into economic freedom incentivise their citizens to be more productive. Countries with “extractive institutions” enrich a small clique of elites at the expense of the many.

The authors argue that it does not matter where a country is located geographically or its culture and initial endowments. As long as a country has inclusive institutions, it will prosper. To illustrate this point, they look at the differences in economic outcomes between North and South Korea. The two nations have same culture and geography. Yet their economic fortunes are entirely different. North Korea has per capital income (nominal) of $665 while South Korea has $27,800 i.e. 42 times richer.
On this basis, the authors conclude that geography and culture are irrelevant to prosperity. Chapter 13 is titled “Why nations fail today: institutions, institutions, institutions” to underline their core argument that seek ye first inclusive institutions and the rest will be added unto you.

There is no doubt that institutions are critical to economic prosperity. However, it is absurd to argue that they are all that matters. Institutions interact with many other factors like geography, culture, history, initial endowments (like human capita), timing etc. to produce prosperity. In other words (and to use a cliché) institutions are necessary but not a sufficient for prosperity.

The book is a study of income inequality. What led the authors to an absurd conclusion was that they made nations their unit of analysis. Had they looked at inequality generally – among regions, or ethnic groups or even individuals within the same country they would have realised the centrality of other factors.

Take the different states in the USA that are subject to the same inclusive institutions. The richest state in America in 2018 is Massachusetts with a per capita income of $65,545 while the poorest is Mississippi with a per capita income of $31,881. Why this difference?

First, let us assume that somehow, the institutions of Connecticut are more inclusive than those of Mississippi. Even within Connecticut itself, the different ethnic groups living there and facing the same institutions have Jews, whites and Asians richer than blacks and Hispanics.

One can argue that blacks and Hispanics are discriminated against hence their low-income levels. But even within black and Hispanic communities some individuals are richer than their co-ethnics. Among whites there are wealthy people like Bill Gates with a net worth of nearly $91 billion, and many other white people who sleep on the streets without any income at all.

Income inequality exits between nations but also within nations. And within nations it exits between certain regions of the same country and certain ethnicities within the same country or even between individuals in the same ethnic group. There are factors of history, culture, geography etc. that shape these inequalities between nations, regions, social groups and individuals. Institutions are only one such factor.

Let us return to the example of North and South Korea. The GDP of South Korea is 82 times larger than that of North Korea ($1.4 trillion versus $17 billion). But when one looks keenly at North Korea, one notices that they are able – in spite of sanctions, low levels of both GDP and GDP per capita – to achieve exceptionally high levels of technological sophistication.

For instance, North Korea is able to place satellites in space, manufacture highly sophisticated tanks, armored personnel careers, fighter jets, intercontinental ballistic missiles, advanced artillery, etc. Indeed, if the two nations went to war, North Korea could easily destroy her rich southern neighbour. North Korea is able to achieve technological feats that African countries with 200 times her GDP cannot even attempt.

Even a casual observer would immediately notice that what is holding North Korea from prosperity is the choice of institutions – and I guess this is the reason why Robinson and Acemoglu arrived at their absurd conclusion. But it is wrong to move from North and South Korea and conclude that if Uganda or Malawi were given inclusive institutions, these nations would produce products that would rival Sam Sung.

Robinson and Acemoglu ignored human capital in their analysis of prosperity, an argument I have been making for many years now. While it is true that Ghana and South Korea had roughly the same per capita income in 1960, there are other endowments that South Korea possessed that allowed it to transform from a backward peasant society into a modern industrial economy. One such critical endowment is human capital.

Beyond a shared language and culture, a long history of nationhood and a state built on meritocratic recruitment, South Korea had high levels of human skills. In 1960, it had well over 58,000 engineers and technicians. As early as 1933, over 40% of total industrial output in Korea was produced by home-based factories; Koreans owned 26 banks, not to mention the large number of managers and marketing executives.

There were also 1.5 million Koreans working in Japan and another 1.5 million working in Manchuria, China, who returned after 1946. Many worked in manual jobs but many others in factories where they had manufacturing experience. These initial endowments were fundamental to South Korea’s rapid transformation.

It is not true that if inclusive institutions were hurled on Democratic Republic of Congo with only nine university graduates, no engineers, managers, architects or experienced civil servants – not to mention absence of a shared language, history of nationhood and statehood, it would in a few years achieve what South Korea did. Therefore institutions matter and matter a lot. But they need many other factors including culture, geography, and initial endowments like human capital to bring prosperity to nations.


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