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Tuesday, September 24, 2013

A Reversal of Fortune

What is the fundamental cause, rather than just the proximate cause, of economic development? A debate centers around whether it is geography or institutions that are paramount. On the one camp are those that say geographic features are what is essential in the long run: the disease environment, climate, whether the country is landlocked or not, whether it is has ample amount of natural resources, etc. The simple version of the view holds that time invariant characteristics of an area impose contemporaneous long term effects on economic development, a view held by Jeffrey Sachs and convincingly argued by Jared Diamond in his book Guns, Germs and Steel. On the other camp are those who highlight institutions, humanly devised constraints that shape human interaction and behavior, as the main driver of development. Geography only plays a part in its interaction with historical events.

One of my favorite big picture papers in development, written by Acemoglu, Johnson and Robinson is on the Reversal of Fortunes. It is one of those papers I wish I had written because the analysis is so simple: they document a massive change in fortunes over the course of 500 years. The civilizations that were rich in the 1500s (as proxied by urban and population density then) are now the countries that are relatively poor while those who were poor are now the countries that are relatively rich. This negative correlation over time is robust, even when controlling for a host of geographic factors normally thought of as important for development. Compare for instance, what had happened to the Mughals in India or the Aztects or Incas in the Americas versus the fate of the US, Canada, or Australia now. This disputes the geography hypothesis since those factors which had made countries relatively rich before should also make them relatively rich now while those geographic variables which had constrained development before should continue to impose its long shadow now. But this does not appear to be the case.

On the contrary, the evidence appears to side with an institutions story. The reversal seems to occur around the time of the industrial revolution. European colonialists established rent-seeking institutions in previously rich and high-density areas (e.g. high taxes, slave labor) while they had the incentive to promote growth-inducing institutions in sparser areas, because it was there that they settled and had to live themselves by these rules. The reversal seems to occur because areas with superior institutions were better able to take advantage of the technology that suddenly became available during the industrial revolution. It is a compelling argument for why institutions are the main driver of economic prosperity rather than geography.

I take this to be both humbling and empowering. Humbling because it highlights how human beings are culpable for the poor outcomes that many in society still face. Institutions after all are humanly devised rules of the game. Underdevelopment is not just caused by some exogenous factor. On the other hand, empowering because institutions can be changed, however difficult a process that may be. Poor countries are not permanently at a disadvantage. And in order to develop, society should look to reforming the rules of the game that structure incentives of human beings.