'Failure' has been a common theme of the introspective assessments made in the banking sector and of economies more generally since the onset of the global financial crisis. The authors of Why Nations Fail examine the differences between those countries that sink and those that swim.

The world economy seems to be suffering tectonic shifts of late. The European economy stagnates, trying to reconcile servicing a massive debt overhang with stimulating economic growth. The experience of rising inequality and political gridlock in the US has people predicting the oligarchisation of the country with the end of its economic leadership.

The US will be replaced, of course, by China, whose economic rise since the late 1970s has authors predicting a return to the world before the industrial revolution when China was the world’s biggest economy. Even more striking, for the first time ever, African countries are experiencing rapid economic growth. What is the world coming to?

Why countries succeed

A great deal of perspective is needed to interpret these events and trends properly. Even better, a theory would help. In Why Nations Fail, we provide such a theory that can help explain why some countries succeed economically while others do not. To grow economically a country needs to raise the productivity of its citizens. The way it does this is by investing in education and in saving to accumulate capital.

Even more important is that countries need to innovate and adopt new and better technologies. A satellite view of the Korean peninsular at night shows the south humming with light and electricity. The north is black. Technologies that have been well known for more than a century – electricity, the light bulb – and which immensely improve productivity and people’s well-being are not readily available in North Korea, while they are in South Korea. This is the nature of the differences between poor and rich countries.

Before even getting to a theory of why it is that countries have such different experiences of technology adoption or investment, even this basic fact tells us something important. Take economic growth in China since 1978. The cause of this was not better macroeconomic policy. Nor was it the case that Mao Zedong’s China was one of the poorest countries in the world because it had the wrong monetary policy or insufficient fiscal stimulus. China embarked on a breakneck growth process because Chinese people massively invested in human and physical capital and borrowed, copied and adopted better technologies than they had. They did so because the incentives and opportunities under which they lived were transformed after 1978.

This perspective shows that if there is an economic problem in Europe, it’s unlikely to be just a consequence of macroeconomic policy. Of course, hyperinflation or macroeconomic crisis or deflation will destroy investment incentives and create misallocation. But these are often not the main causes of poverty or economic failure. Europe’s economic problem likely lies elsewhere.

Reaping the rewards

But to dig deeper, we want to ask why is it that some countries innovate and invest so much more than others and accumulate so much more capital, both human and physical? In Why Nations Fail we argue that this is because of the institutions of societies, the rules – both formal and informal – that channel people’s energies and create very different patterns of incentives and opportunities. In particular we distinguish between two broad situations, one where a country has inclusive economic institutions that stimulate broad-based incentives and opportunities in society, and another, a situation where economic institutions are extractive and have the opposite effect.

A powerful way to see this distinction in action is in China's economic growth, which was precipitated precisely by a movement away from extractive economic institutions towards more inclusive ones. Starting in 1978, the country's government moved to deregulate agriculture, creating incentives and opportunities and making people the residual claimants on their actions. This generated huge increases in productivity which spread to industry, starting in the 1980s. Rapid economic growth in China was not created by the Communist Party, except to the extent that it was created by the party stopping trying to control every aspect of people’s lives.

But if inclusive economic institutions are the key to generating prosperity, why doesn’t every country have them and why was it only in 1978 that the Chinese moved towards them? Perhaps many ideas come to mind; the role of ideology or socialism. But in fact history is full of extractive economic institutions such as those that the Chinese started to dismantle in 1978, and this has nothing to do with central planning or socialism. In fact, central planning is very common historically, Greek Bronze Age societies had it, as did the Inca Empire.

An inclusive approach

This brings us to perhaps the most important aspect of Why Nations Fail. To explain why societies have the economic institutions they do, you need to understand the politics of institutional choice. The decision to start to dismantle the socialist economy in China in 1978 was a political choice. More generally, in order to create inclusive economic institutions, a society needs to have inclusive political institutions, a broad distribution of political power and an effective central state. If these conditions fail, when political institutions are extractive, economic institutions are unlikely to support economic growth.

The economic success of the US over the past 200 years illustrates these relationships. Take the US patent system, a wonderful example of an inclusive economic institution. The first patent board in 1790 was deemed so important that founding father and future US president Thomas Jefferson sat on it. Innovation creates ideas and ideas are easy to borrow or steal. Thus any innovator can only expect to reap a small amount of the wealth he or she generates. The patent system, by protecting intellectual property rights, was designed to counteract these disincentives for innovation. The key thing about the patent system was that anyone could pay the same fee, take out a patent and the state would enforce it.

This is key because ideas, skills, talent and creativity are widely spread in society. US patentees in the 19th century came from all over the social spectrum. For a society to generate innovation it needs institutions that can harness and include all this latent talent in society and the patent system helped to do exactly this. The US ended up with this inclusive economic institution precisely because its political institutions were inclusive, power was very broadly distributed in historical terms and the state was effective, for example, in enforcing patents.

Not everyone could take out a patent, of course; politically disempowered slaves could not and the US was poorer historically because of that.

The China conundrum

The argument of Why Nations Fail is that prosperityis generated by inclusive institutions while poverty is created by extractive institutions.

But does China really fit into this scheme? In 1978, China was certainly extractive and moved economic institutions in a more inclusive direction stimulating growth. But what about political institutions? In fact, China is in the top right cell of the matrix experiencing what we call “extractive growth”. China has part of what it takes to be politically inclusive, an effective state, but it lacks the broad distribution of political power.

The consequence is that our theory suggests Chinese economic growth is unsustainable. History is full of examples of transitory extractive growth, Argentina before the First World War and Tunisia until the rise of Ben Ali. These examples show that concentrated political power always ends up getting abused at the expense of the economy. The Chinese Communist Party that brought the household responsibility system is the same one that brought the Great Leap Forward and the Cultural Revolution.

In the case of Europe, despite all the pain and suffering induced by recession and austerity, the real issue is whether or not the inclusive nature of European institutions, which have made it so prosperous, are being challenged. Some blame the EU, but in fact the EU has been a huge force towards making institutions more inclusive in the past decades, particularly in eastern Europe. The biggest threat seems to come precisely from the political backlash that the recession has created, leading to the rise of nationalist parties, opposition to immigration and mounting isolationism in the UK and France.

Politicians need to look hard and long at the consequences of their policies not just for whether or not debts are paid back in the short run, but for the political and institutional consequences of such decisions that are much more important for the prosperity of Europe.

US under threat

Is the prosperity of the US threatened by a movement towards more extractive institutions? In Why Nations Fail we show that the inclusiveness of US institutions has been threatened many times in the past and yet the country has always proved resilient. For example, when Europeans moved to restrict immigration, US president Barack Obama moved to legalise illegal immigrants. A huge asset the US has is precisely the ability to embrace latent talent from all over the world. Moreover, despite rising inequality it is also always good to ask just how is it that people got rich.

Consider Bill Gates and Carlos Slim, the two richest men in the world. The former made his fortune through innovation, creating huge positive spillovers throughout the economy, the latter’s fortune, according to the Organisation for Economic Co-operation and Development, reduces the national income of Mexico by about 2% a year. This says it all about the differences between inclusive and extractive institutions and their consequences.

James A Robinson is a professor of government at Harvard University and the author of the book Why Nations Fail. The book, and this article, was co-authored by Daron Acemoglu.

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