Institutions as a Fundamental Cause of Long-Run Growth

 

The unprecedented economic crisis that Sri Lankans experienced two years ago has prompted many in the country to explore the principles underlying the science of economics. During the recovery period, interest was mainly focused on topics related to economic stability. Having witnessed how sound economic policies can steer a nation away from crisis and toward stability, many are now curious about how the country can accelerate its growth trajectory.

Three days ago, the Royal Swedish Academy of Sciences announced its decision to award the 2024 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel to Daron Acemoglu, Simon Johnson, and James A. Robinson. These three laureates have provided a scientific answer to the complex question of how a country can achieve faster growth toward prosperity.

In their influential work, Institutions as a Fundamental Cause of Long-Run Growth, economists Daron Acemoglu, Simon Johnson, and James A. Robinson argue that differences in economic institutions are a primary driver of long-term economic growth and development. The paper is part of a broader body of literature that seeks to explain why some countries are wealthy and developed, while others remain poor and underdeveloped. Their central argument is that economic institutions, which shape incentives for economic actors, are fundamental determinants of economic performance.

1. Background and Motivation

The authors begin by exploring why economic performance varies so drastically across countries. For instance, they highlight the vast differences between wealthy countries like the United States and poor countries like Haiti. Despite similar access to technology and resources, these disparities persist, suggesting that something beyond geography or culture plays a significant role in explaining these differences. They argue that institutions—rules and norms governing economic activity—shape the incentives for production, investment, innovation, and ultimately, long-term growth.

2. The Role of Institutions

Acemoglu, Johnson, and Robinson define economic institutions as the rules and constraints that structure economic interactions, including property rights, legal systems, contract enforcement mechanisms, and government policies. These institutions influence how resources are allocated and whether economic actors (firms, individuals, and the government) have the incentives to engage in productive activities like innovation and investment.

Good institutions, the authors argue, protect property rights, ensure that contracts are enforced, and provide a stable environment where individuals and firms feel secure in their investments. Poor institutions, on the other hand, may lead to expropriation, corruption, and inefficient use of resources, which stifles economic growth.

3. Why Institutions Matter for Economic Growth

The authors argue that differences in institutions explain why some countries experience sustained economic growth, while others stagnate. Their argument is grounded in historical evidence that shows how institutions influence economic outcomes.

For example, the authors point to the experience of colonization as a natural experiment in institutional differences. European colonial powers implemented vastly different institutions in different colonies. In regions where they could settle (such as North America), they established institutions that protected private property and promoted investment. However, in regions with unfavorable conditions for settlement (like much of Africa), they established extractive institutions that concentrated power and wealth in the hands of a few, while failing to provide incentives for broader economic participation.

4. Inclusive vs. Extractive Institutions

A key distinction made in the paper is between inclusive and extractive institutions:

• Inclusive institutions are those that provide broad access to economic opportunities, protect property rights, and create incentives for innovation and investment. These institutions allow a large part of the population to participate in economic activities, which promotes growth.
• Extractive institutions, on the other hand, concentrate power and wealth in the hands of a small elite, stifling innovation, reducing investment, and limiting economic growth.

The authors argue that the countries that developed inclusive institutions have been able to sustain long-term economic growth. In contrast, countries with extractive institutions have seen limited growth, as elites use their power to extract resources from the rest of the population without creating incentives for broader economic participation.

5. Historical Evidence and Empirical Support

To support their argument, Acemoglu, Johnson, and Robinson present historical and empirical evidence linking institutions to long-term economic performance. A significant part of their argument is based on what they call the "colonial origins" of current institutions. They present evidence showing that European colonialism had long-lasting effects on the economic institutions of many countries.

For example, in places like North America and Australia, where European settlers were able to establish inclusive institutions, these countries went on to experience sustained economic growth. However, in regions where colonizers established extractive institutions (such as much of Africa and Latin America), growth has been limited, and these countries continue to suffer from the legacy of poor institutional frameworks.

In addition, the authors argue that geography and culture are less important determinants of long-term growth compared to institutions. While geography might affect short-term economic performance, it does not explain the sustained differences in economic growth over long periods.

6. The Role of Political Institutions

The paper also emphasizes the role of political institutions in shaping economic institutions. Political institutions determine who holds power in society and how that power is used. Inclusive political institutions, where power is distributed broadly and checked by different groups in society, tend to lead to the development of inclusive economic institutions. In contrast, extractive political institutions, where power is concentrated in the hands of a small elite, tend to result in extractive economic institutions.

The interaction between political and economic institutions is critical for understanding long-term economic growth. Countries with inclusive political institutions are more likely to develop inclusive economic institutions, which promote growth. Conversely, countries with extractive political institutions are likely to develop extractive economic institutions, which stifle growth.

7. Path Dependence and Institutional Persistence

Another important concept discussed in the paper is path dependence. Once institutions are established, they tend to persist over time, even if they are inefficient. This is because institutions create vested interests that benefit from maintaining the status quo. For example, elites in countries with extractive institutions have little incentive to change the system, even if it leads to poor economic outcomes for the majority of the population.

This persistence of institutions helps explain why some countries remain trapped in a cycle of poverty and underdevelopment. Even if these countries have the potential for growth, the existing institutional framework prevents them from realizing that potential.

8. Policy Implications

The authors conclude by discussing the implications of their findings for policy. If institutions are the key determinant of long-term economic growth, then policies aimed at reforming institutions are crucial for promoting development. However, institutional reform is difficult, particularly in countries with extractive institutions, where elites may resist changes that threaten their power.

Successful institutional reform requires both political will and a broad coalition of support. The authors suggest that international efforts to promote good governance and institutional reform can play a role in fostering economic development, but they caution that such efforts must be tailored to the specific context of each country.

9. Criticism and Alternatives

While the paper has been highly influential, it has also faced criticism. Some scholars argue that the authors place too much emphasis on institutions and downplay other factors, such as geography, culture, or external economic shocks, that can also influence long-term growth. Others argue that while institutions are important, the process of institutional change is complex and cannot always be easily influenced by policy interventions.

Conclusion

Acemoglu, Johnson, and Robinson make a compelling case that institutions are a fundamental cause of long-term economic growth. By shaping the incentives for investment, innovation, and economic participation, institutions play a crucial role in determining whether countries experience sustained growth or remain trapped in poverty. Their work has had a profound impact on the field of development economics, highlighting the importance of institutional reform for promoting economic development.