Why Nations Fail: Institutions, Hayek, and Mises

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In the book Why Nations Fail: The Origins of Power, Prosperity, and Poverty, American economists Daron Acemoglu and James A. Robinson contend stable institutions and political centralization are necessary conditions for economic prosperity and long-term social stability. Differentiating between “inclusive” and “extractive” philosophies, Acemoglu and Robinson maintain encompassing institutions stem educational and technological advancements, while extractive institutions stifle and impede wealth and growth. In addition, stable and centralized political institutions not only safeguard vital elements such as intellectual property rights, but provide a reliable legal foundation from which to peacefully arbitrate and mediate disputes between citizens and firms.

While the notion that sound legal structures and institutions precede successful emerging markets is not novel, the extent to which institutions should influence societies and economies is disputable and subjective. Failing to both clarify or quantify successful institutional involvement—or centralized “planning” as it should be more transparently stated—Acemoglu and Robinson’s thesis is vulnerable to criticisms from the outset. How many institutions are too many institutions? How much structure is too much structure? If indeed there is no such thing as excessive or burdensome institutional participation, what is to prevent politicians and bureaucrats at the helms of government from incidentally and/or indirectly becoming the very oppressive economic forces those institutional structures were constructed to initially normalize?

Acemoglu and Robinson appear to imply political centralization would remedy excessive institutionalism by virtue of the democratic process and participatory nature of inclusive government. However, relying on political centralization rather than measurable or quantifiable systemic restraint not only naively operates under the assumption that institutional structures are primarily comprised of honorable personnel, it discounts the very past and present world Why Nations Fail endeavors to explain. Indeed, U.S. history alone is rife with examples of institutional configurations gone awry at the expense of economic growth and progress (the prohibition of alcohol during the 20s, the twentieth century monopolization of Pan American World Airways, to name a few.)  Similarly, it was precisely because of institutional hindrances—along with underperforming state-owned enterprises—that the U.S. re-implemented laissez-faire-leaning economic and governmental reforms during the late 70s and 80s (the philosophical consistency and purity of those implementations can be debated).

Acemoglu and Robinson rest equal emphasis on stable and secure financial institutions. Drawing stark parallels between Mexico and the United States, Acemoglu and Robinson underline the “rapid expansion of financial intermediation and banking” that occurred within the United States at the outset of the nineteenth century. Competitive banking not only lowered interest rates, it disseminated capital in the form of lending to businesses and entrepreneurs. Early nineteenth century Mexico, however, permitted limited banking and financial competition, and shouldered a constitutional foundation that significantly lacked adequate political centralization and democratic stability. That is, while government officials in the United States could be peacefully voted out of office and replaced. In Mexico, transitions of power often emanated in the form of violent overthrow, destabilizing and disrupting already volatile political and financial institutions.

But Acemoglu and Robinson again fail to clarify just how much, or how little, institutional involvement belongs in the financial system. Indeed, Joseph Schumpeter, who Acemoglu and Robinson cite as a “great economist,” was a well-known proponent of fixed-exchange rates and limited institutional meddling. That being said, it is widely accepted that the Latin American debt crisis was, at its core, a direct product of irresponsible borrowing and lending. So should institutions and governments have done more or less? Acemoglu and Robinson do not imply or specify. Likewise, financial plights stemmed by irresponsible institutions in democratized and institutionally inclusive countries—for example, the central bank’s sudden contraction of the money supply at the outset of Great Depression—are overlooked and ignored. Nonetheless, it can be argued that such incidences demonstrate politically centralized banking institutions and centrally-planned monetary policies are equally vulnerable to varying degrees of failure.

Incentives matter

Principal among inclusive institutions are economic incentives. According to Acemoglu and Robinson, sufficient productivity and economic incentives cannot sustain devoid of inclusive markets and basic property rights. Illustrating inadequate economic incentives and insufficient property rights, Acemoglu and Robinson emphasize the industrial contrast between North and South Korea. While North Korea remains extractive and impoverished, South Korea enjoys a more affluent population upon adopting more inclusive reforms during the 80s. Equally, Acemoglu and Robinson point to the rise and fall of the Soviet Union, arguing though significant economic productivity is capable of occurring under extractive regimes that practice ineffective and collectivized tax systems, sustained long-term productivity is less probable as incentives wane.

Indeed incentives matter. Acemoglu and Robinson, however, fall short of addressing or analyzing the motives and incentives of those drawn to governments and institutions in the first place. Are these incentives not vital to understanding or sustaining peace and prosperity? This phenomenon, pessimistic though it may seem, is probably best confronted, if not explained through the lens of public choice theory. Public choice theory not only contends consumers and buyers primarily operate out of self-interest, but political actors operate out of self-interest as well (this is evident in pork barrel spending and crony capitalism). Moreover, can an apathetic voter that lacks a comprehensive understanding of governmental policy and process, genuinely be incentivized to restrain or chastise a folly institution? Acemoglu and Robinson offer no insight.

Prior theories and knowledge

Acemoglu and Robinson challenge preceding theories attempting to explain wealth discrepancy between nations. Beginning with the “geography hypothesis”—a theory that argues rich and poor countries are the unintended byproduct of geographic location—Acemoglu and Robinson cite stark institutional differences between areas in close proximity. Areas notably include the Korean Peninsula and Cold War Germany. Economic development in Malaysia and Singapore further seem to challenge any correlation between poverty and climate.

Similarly challenging the “culture hypothesis”—a theory that speculates unorthodox beliefs, ethics, and general cultural idiosyncrasies inadvertently produce underdevelopment in some countries— Acemoglu and Robinson again point to the Korean Peninsula. North and South Korea not only once shared “unprecedented homogeneity in terms of language,” but continue to share an assortment of beliefs, attitudes, and values.

Lastly, Acemoglu and Robinson confront the popularly held “ignorance hypothesis”—a theory that affirms countries remain underdeveloped because their leaders simply do not understand how to generate economic growth and development. Taking issue with the notion that ignorance is the catalyst behind poor institutional and governmental performance, Acemoglu and Robinson point to early twentieth century differences between Mexico and the United States, contending:

“…Leaders of African nations that have languished over the last half century under insecure property rights and economic institutions, impoverishing much of their populations, did not allow this to happen because they thought it was good economics; they did so because they could get away with it and enrich themselves at the expense of the rest, or because they thought it was good politics, a way of keeping themselves in power by buying the support of crucial groups or elites.”

In many ways, this was one the most declarative and telling statements in Why Nations Fail, for it touches on a broader ongoing theme: institutional design. Acemoglu and Robinson not only believe rulers of impoverished nations have the knowledge and capability to institutionally abet economic success, but often deliberately choose to forgo prosperity in place of unrestricted institutional and extractive power. Indeed, while this certainly might be true for some countries and rulers, it is likewise a very bold and prejudiced assumption. Acemoglu and Robinson themselves argue extractive nations languish behind inclusive nations in technology and education, so why assume their rulers are educated enough to understand “good economics?” Does power equate to knowledge? If power does equate to knowledge, how much knowledge serves as a precondition to satisfy “good economics”? Indeed, there is a fundamental flaw and danger associated with the notion that rulers and institutions—well intentioned or not—are somehow omniscient.

Contrary to this position might be what the late Austrian economist Friedrich Hayek adeptly referred to as the “the knowledge problem.” To clarify, no single institution or ruler—no matter how democratic, centralized, or well-intentioned—is capable of knowing everything. Reversely, information is highly localized, fragmented, and imperfect. Fellow Austrian economist Ludwig Von Mises proposed an equally important preceding concept called the “economic calculation problem.” Not only are economies incapable of being algorithmically calculated or planned, they can only be interpreted through price mechanisms.

Colonialism, disease and globalization

According to Acemoglu and Robinson, globalization and disease have had a similar, albeit more random, influence on global wealth disparity. Citing the Black Death as a pivotal turning point in world history, Acemoglu and Robinson maintain such critical junctures “can cause a sharp turn in the trajectory of a nation.” Indeed, England not only benefited from preparing for the Black Death, but the deaths and labor shortages that resulted inadvertently transformed the feudal order, culminating in more inclusive market institutions. As England accumulated wealth and expanded, so too did its influence.

Pointing to Africa, Acemoglu and Robinson contend European Expansion incidentally “sowed the seeds of underdevelopment in many diverse corners of the world by imposing, or further strengthening existing, extractive institutions.” Acemoglu and Robinson continue by underscoring a variety of cyclical philosophies and policies that have exacerbated and intensified destitution in countries still lingering below the poverty line. Such counterproductive governmental and economic traits include the existence of monopolies, disproportionate power distribution, convoluted and inconsistent rule-of-law, and failure to provide basic services.

Though the root of some, not all, inefficient institutions and philosophies can be linked to prior colonial endeavors, the same institutions and attitudes are often indirectly sustained in new shapes and forms by elites who wish to retain power. Likewise, rulers tend to fear the unpredictable social transformations that accompany replacing old economic orders (i.e., creative destruction), as evident in France’s early opposition to steam railways.

According to Acemoglu and Robinson, the nineteenth century contrast between England and the Ottoman Empire directly reflect institutional proclivities and decisions that arose four centuries earlier. Rather than embrace and incorporate technological advancements such as the printing press during the fifteenth century, the Ottoman Empire rejected modernization out of fear that an educated populous could threaten or undermine the absolutist status quo. Reversely, England adopted and integrated technological advancements and, as a consequence, became advantageous recipients of relatively sophisticated literacy rates. Benefiting from an educated population and relatively centralized government, England not only found itself equipped to intellectually embrace and institutionally encourage the coming Industrial Revolution, but generate prosperity as a consequence.

The pathway to prosperity

Acemoglu and Robinson ultimately maintain there is more than one pathway to inclusive institutions and prosperity. Though England, for example, necessitated a revolution to abolish absolutist rule, and the United States required a similar revolution to abolish British colonial rule, other areas of Western Europe forged a pathway to prosperity over longer durations and smaller conflicts. Acemoglu and Robinson likewise contend inclusive institutions are reliable but still vulnerable, therefore, are contingent on continued political centralization in order to properly function and persist, for political centralization culminates in what can only be described as a kind of “virtuous circle.”

On one hand, a number of very basic liberal economic concepts are introduced and espoused in Why Nations Fail, from creative destruction to profit-motives. On the other, Acemoglu and Robinson seem to place a significant amount of faith and virtue in institutional structures and processes, while similarly overlooking and ignoring a variety of important political distinctions and questions. What about the driving forces behind, and prevalence of, black markets under both inclusive and extractive institutions? How do incentives affect those drawn to institutions and power? How do private institutional structures and traditions compare to public institutional structures and traditions? Is one more effective or preferable to the other? How does the institutional existence and practice of imminent domain in advanced democratic countries promote and defend property rights? The list goes on.

That being said, Acemoglu and Robinson still formulate a very comprehensive and adequate historical case for the need of at least some level of institutional structure and arbitration in order to procure growth and prosperity in developing countries. The difficulty lies in determining how much structure.

Written By Brandon Loran Maxwell

Works cited

Acemoglu, Daron, and Robinson, James. “Why Nations Fail: The Origins of Power, Prosperity and Poverty.” 1st ed. New York: Crown. 2012

Hayek, Friedrich. “The Use of Knowledge in Society.” American Economic Review. XXXV, no 4. pp 519-30. American Economic Association. Sept 1945.

Mises, Ludwig. “Die Wirtschaftsrechnung im sozialistischen Gemeinwesen,” Archiv für Sozialwissenschaft und Sozialpolitik 47, no. 1. Translated as “Economic Calculation in the Socialist Commonwealth.” Apr 1920.