11/03/2012 12:18 pm ET Updated Jan 23, 2014

Why Do Nations Fail?

By Michele Boldrin, Salvatore Modica and David K. Levine -- a more detailed version of this post can be found here.

Daron Acemoglu and James Robinson's Why Nations Fail is grand history in the style of Jared Diamond. It is provocative and fun. The theme is that the reason nations fail or succeed is not -- as earlier authors argue -- economic policies, geography, culture, or value systems -- but rather political institutions. Acemoglu and Robinson theorize that there are two kinds -- "extractive" institutions in which a "small" group of individuals do their best to exploit the rest of the population, and "inclusive" institutions in which "many" people are included in the process of governing.

Acemoglu and Robinson argue that for any sort of success political institutions must be sufficiently centralized to provide basic public services. Given that, inclusive institutions enable innovation and lead to continuing growth. Extractive institutions can only deliver growth when the economy is "catching up" to the technological frontier: when innovation is needed to push the frontier they will fail.

One of the strengths of the book is its emphasis on the intrinsic randomness of history. Many small unpredictable incidents or small differences in initial circumstances can lead to either inclusive or exclusive institutions -- or more broadly success or failure. This puts the book squarely in the camp of modern economic theory, especially evolutionary theory, which emphasizes the importance of unpredictable events.

The "extractive" and "inclusive" categories are intuitive but explaining the entire history of humankind by this dichotomy is a daunting task. While many examples fit well, others are more difficult. In what sense were the institutional arrangements of the Roman Republic "inclusive" relative to those of the Communist USSR? Or in what sense did the Spanish Kingdom turn from "inclusive" to "extractive" between the XV and the XVII century? Rome and Venice grew because of inclusive institutions then collapsed because good inclusive institutions were replaced in a coup d'état by bad extractive institutions. The example of Rome is particularly difficult since Rome grew and prospered for centuries under the extractive institutions of the empire.

Other important examples are those of South Korea, Taiwan, Chile, and China all of which had good economic results under non-inclusive political institutions. With the exception of China, all of these dictatorships evolved into inclusive institutions -- leading many to wonder if pluralism is the consequence of rather than the cause of economic success.

The dramatic contrast between North and South Korea is indeed due to the extractive institutions in the North. But Northern and Southern Italy both have the same formal institutions yet the North is a thriving dynamic economy and the South a basket case. Similarly the transition from extractive colonial institutions has not led to dramatic increases in welfare -- in Zimbabwe it led to catastrophic economic collapse, and India languished economically for decades even as democracy thrived.

Acemoglu and Robinson focus on what happens within nations not between nations. Yet the single most important reason why nations fail is because they are destroyed by their neighbors. Carthage fell not because of a failure of "creative destruction" but rather because of the not so creative destruction of the Roman armies. Indeed, Acemoglu and Robinson document the many civilizations -- from the East Indies, to the West Indies, to all of North and South America, to Africa -- wiped out by the military superiority of Western Europe.

The case most troubling for Acemoglu and Robinson (and perhaps overlooked in their book) is that of Germany. Starting from the middle of the nineteenth century until the end of the second world war, Germany prospered under extractive institutions -- and the brief period of inclusiveness, the Weimar Republic, was an economic catastrophe. Yet Germany did not merely play catch-up. Germany was the leader of the second -- and many argue most important -- phase of the industrial revolution -- the systematic application of science to industry. Nazi Germany was one of the most extractive institutions in history yet it was highly innovative and came within a hair's breadth of world domination.

Nowhere is the importance of the competition between states more clearly demonstrated than during the Second World War. The extractive institutions of Nazi Germany created the first jet aircraft and guided missiles. The West never produced a tank comparable to the German Panther. It may be argued that tanks do not contribute a great deal to social welfare -- although if the native inhabitants of North America had had tanks when the Europeans arrived their welfare would have been substantially higher. However, many other technologies have had an enormous economic impact. With pre-war aviation technology we could have our mail delivered by biplane. Without German rocketry we wouldn't have the GPS. And on and on.

Germany has done well under all sorts of institutions -- which leads one to wonder -- maybe it isn't the institutions that matter? Maybe it's being German that counts?

We agree with Acemoglu and Robinson about what we must fear: the dead hand of vested interests acting to stop innovation. Call it competition or call it "creative destruction" nobody likes competitors and nobody likes to be on the receiving end of destruction. Acemoglu and Robinson's view is that inclusive political institutions can be vaccine against the dead hand of dying monopolists, while extractive political institutions spread the infection. Their book is optimistic: we in the West can look forward to a future of innovation and prosperity because of our good inclusive institutions while -- for example -- the Chinese are doomed.

We wish we as optimistic as Acemoglu and Robinson: "good inclusive institutions" are susceptible to hijacking by vested interests. We see the vines of ever increasing patents spreading their poison and strangling innovation. We see the dead hand of a dying entertainment industry holding the computer industry hostage. We see the banking industry sucking the tax revenues of entire countries into its maws to feed its bad investments. We see the overhang of debt as current generations extract from future generations. We wonder: how can these things be stopped?

It is easy to make prescriptions impossible of fulfillment. Benevolent dictatorship is no doubt the best form of government -- but how do we arrange for benevolent dictators? Democracy is best provided if it isn't hijacked by elites or overrun by populism. How do we prevent that? These are crucial questions and while classifying the world into "inclusive" and "extractive" institutions is helpful it does not provide a definitive answer.

So: this is a great read -- go and get it. It is provocative, so don't forget to bring a healthy dose of skepticism. And while learning why nations fail may put us on the path to preventing their failure -- we are not there yet.

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