What makes the United States so powerful and so rich? Why did the Ottoman Empire collapse? These are some questions we seek to find a satisfying answer to. Many theories are attempting to explain why some countries are rich and why others are poor.
According to the geography hypothesis, a country’s economic situation is based on its geographic circumstances. This theory is based on the observation that many of the poorest countries are in tropical regions, while wealthy countries tend to be in cooler climate zones.
Well, this theory is, in some cases, true. But there are similar cases that prove the opposite. Let’s talk about Singapore. Despite its location in the tropics, Singapore is a wealthy country. Similarly, the geography hypothesis is unable to explain the stark differences between neighboring countries, North and South Korea.
The culture hypothesis views a country’s culture, religion, values, and cultural attitudes as the decisive factor. For a long time, people’s belief in work ethic, which is based on the idea that work is a duty, was the key to economic success. Various Confucian values such as humanity, loyalty, and honesty, impeded it. But this theory does not hold water either. It, too, cannot explain the difference between North and South Korea, which, despite a similar culture, developed extremely differently.
The ignorance hypothesis assumes that economic differences are determined by the ignorance or incompetence of the ruling class. In other words, incompetent politicians are to blame for market failures and plunging their countries into poverty. However, politicians are often aware of their problems. It is not their incompetence that leads them to take the wrong actions. More often than not, it is due to external incentives and obstacles because they want to satisfy interest groups that are important for them.
All the theories I’ve mentioned, highlight parts of the problem at hand, and they’re valid to a certain extent, but they do not deliver a general explanation of the underlying issues.
Integrative institutions are the key to a nation’s lasting economist success. From the Mayas to 16th century England to Botswana, history is chock full of examples that prove that the most important factor for a nation’s prosperity is its institutional structure.
Integrative institutions are what’s enabled wide democratic participation in politics and the economy. They prevent the resources from being overexploited, and individual people from enriching themselves without benefiting the rest of the society in any way.
Integrative institutions are characterized by a variety of individual rights, such as the freedom to choose a profession, access education, and competitive, less controlled markets for labor, capital, goods, and services. Nearly all nations that have achieved a high standard of living have integrative institutions. They set incentives for education, performance, and innovation, and create a wider income distribution, preventing small elite groups from abusing power and any potential profit from unfair competition.
The stories of two of the richest men in the world make a clear case for understanding the difference between nations with and without integrative institutions. While Carlos Slim got rich in Mexico, a country without integrated institutions, by exploiting his monopoly in landline telephony, Bill Gates amassed his fortune in the US, but invented products that created value for the entire society, a value that far surpassed his own income. This type of value is only possible in countries with integrative institutions, where there is the incentive structure necessary for creating a viable market economy.
Integrative institutions emerged from historical coincidences, and bring about lasting prosperity. Integrative institutions emerged from historical coincidences, once small incidents set off a chain of reaction that, with time ends up causing extensive reforms. The plague, for instance, was the catalyst of the glorious revolution in England, which ultimately brought about pluralism and free enterprise.
The plague had taken such a heavy toll on people of working age, that it caused a labor shortage. As a result, Veracruz had more power and began demanding higher wages and social rights. This phenomenon ran parallel to the birth of a class of prosperous merchants who opposed rural control and demanded the liberalization of trades. Economic institutions began emerging, creating free trades, and constitutional states, and the protection of private property. This revolution would eventually lead to the Industrial Revolution 50 years later.
Integrative institutions in the United States also rise out of coincidence. Colonists, in one of the first British colonies, attempted to exercise authoritarian control over the English workers. When this proved ineffective, the colonists decided to give the workers incentives, ultimate to granting them a kind of elected parliaments that wielded the settlement’s political power and would later become the model for American institutions.
Most countries that have achieved lasting prosperity have one thing in common: at certain points in their history, people seize the opportunity to create solid integrative institutions. Centralized political power is crucial for lasting prosperity. A country can only achieve a high level of prosperity when it meets the following two conditions.
First, it has to have integrative political and economic institutions. Second, political power must be centralized to a certain degree as prosperity can only exist where the money goes into making investments and creating innovations. Both of these conditions required that the state is trustworthy. That kind of trust can only exist in a state that has a clear political course, indisputable authority, and a viable popularly accepted government.
Investors and innovators only spring into action when they assume they will reap the fruits of their labor. If they have doubts, they will leave for a different country. When political power is spread out too broadly, it can lead to chaos. This is what happened in Somalia, where there are no public elects with a seat in institutions to ensure security or structures that are fundamental for a stable constitutional state.
Authoritarian institutions prevail in poor countries through a vicious cycle. Historically speaking, integrative institutions are an exception to the role. Extractive institutions are far more common extractive. Extractive institutions are designed to benefit only small elites, who, above all, want to retain control over politics and the economy. Despite this common fundamental traits, the individual character of extractive institutions varies from country to country. In North Korea, for instance, citizens are not granted the right to own property.
In the Congo, institutions are still set up the way they were in the days of colonialism. Even though the white man is not in control, small elites cash in on the country’s resources. And the raw materials are sent out of the country as quickly and cheaply as possible. Countries with extractive institutions often end up falling into a vicious cycle.
The elite split their political power to benefit themselves economically. If they have gained political and economic control, they do everything they can to strengthen and keep that power. Whether by means of intimidation or arbitrary distribution of privileges. A free market, which could potentially destabilize this power, is thus thwarted. History has shown that even after revolution and upheaval, extractive institutions tend to end up back in place, like in the Congo. Only in very few countries, such as Botswana, the people were able to carry out a political and economic transformation.
There can be no lasting growth in authoritarian systems. Authoritarian leaders try to split the economy graph; their profits will not increase otherwise. In authoritarian systems, growth only occurs on already available methods and technologies are exploited. In order to achieve lasting growth, innovations and technological change are both essential. And this type of change is impossible in authoritative systems where there are no incentives for inventions because the elites fear change, and prevent free markets from emerging.
During the Cold War in the 1970s, it looked for a while like the Soviet Union would surpass the United States economy. But the reason for the Soviet economy’s rapid growth had to do with the relocation of labor from agriculture to manufacturing. This shift resulted in temporary economic growth but ended soon thereafter. Even China, the growth miracle of our time, is bound to reach its limits. China might exhibit several characteristics of integrative institutions like ownership laws, and fill viable financial markets, but its political institutions are still authoritarian.
China’s current economic growth, like the Soviet Union in the 1970s, hinges on the relocation of labor and capital from an inefficient agriculture sector to the manufacturing industry, the latter of which made the profits from existing technologies instead of creating new ones. That’s why China will not be in a position to achieve the same growth in under-developed countries.
With fast, far-reaching reforms, China’s growth will just tip over in the next decades. Authoritarian systems fail because they do not create the right kind of incentives. In the free markets, incentive systems make it possible for innovations to be made and efficiency to be increased. In authoritarian systems, on the other hand, sustainable technological change and increased productivity usually do not take place.
In these systems, incentives for innovation and efficiency boosts are usually determined centrally, which really leads to satisfactory results. Also, authoritarian institutions often fall prey to the complexity of their own plants. And the same is true. For instance, Soviet laborers often received a good third of their wages as a bonus when certain production quotas are reached.
However, this prevented innovation. Why? Because innovation causes short temporal activity loss, albeit laws that end up creating long temporal activity increases as a result of the regions’ bonus rule. Laborers mainly focused on working for their bonus money, rather than working on new innovations. In conclusion, we can safely say that a centralized planning force cannot replace the market’s invisible hands as a driver of innovation. The underlying mechanisms are simply too complicated to be artificially imitated.
If you want to understand a country and its development, you have to know its institutions. Sensible political measures can only be introduced when a nation’s institutional framework has been analyzed in detail. Initiating political change is usually challenging, and its consequences tend to be unpredictable. Since many countries are stuck in a vicious circle that is extremely hard to break out of.
To cite a recent example, Hosni Mubarak’s downfall may have been a step towards democracy in Egypt, but it also created the risk that a military regime operating the same sort of authoritarian institutions will fill the power vacuum. That’s because many people are afraid of instability, a state of affairs that will be characteristic of true democracy in its beginnings.
After all, the change to integrative institutions and a functioning democracy does not happen overnight. After the French Revolution ended in 1799, it took 80 years for a stable democracy to form. It is hence unrealistic to assume that this sort of development could take place in just a few years in countries like Egypt. But still, the first step on the long way towards democracy and prosperity is a deep understanding of the institutions of any given country.
Foreign aid should be targeted at institutional reforms, not at supporting authoritarian systems. Afghanistan is a prime example of how billions of dollars in foreign aid were misused. After the fall of the Taliban in 2001, Afghanistan had the opportunity to establish a democracy, but not much of the money it received from foreign aid was used for rebuilding. A large portion of it trickled their way into administrative affairs. The country’s talent was lured into administering foreign aids because of the higher pay, which ended up hurting the fragile states more than helping it.
However, Afghanistan is not exceptional. Ministers have shown that in general, only 10 to 20% foreign aids actually reaches its intended addressee. It is thus clear that the idea behind foreign aids is based on a false understanding of the cause of poverty. Nations like Afghanistan are poor because their institutions are authoritarians, which accounts for the sense of ownership rights and the rule of law.
For the above-mentioned reasons, foreign aid should be used to support reforms that work towards developing integrative institutions. Cooperation with developing countries should be structured, so that social groups that have been previously excluded can partake in the decision-making process.
All programs developed without a comprehensive understanding of a nation’s institutional structure are wasteful and counter-productive.
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