Why are some societies poorer than others? Why do some have worse economic institutions than others? This paper for the National Bureau of Economic Research (NBER) uses historical examples of European colonialism and Korea to develop a framework for analysing differences in economic institutions across countries. Economic outcomes are determined by the quality of economic institutions, which are rooted in political institutions and the distribution of resources. Good economic institutions emerge when there are constraints on power-holders, broad based property rights enforcement, and relatively few rents to be captured by elites.
Neoclassical economic growth theories help us understand the mechanics of growth, but do not analyse its fundamental determinants. Three sets of theories attempt more fundamental analysis, respectively emphasising the importance of geography, culture and economic institutions. Evidence from the history of European colonialism and the division of Korea supports the latter approach. Economic institutions shape the incentives of key economic actors in society, determining both growth potential and the distribution of resources. Good economic institutions are defined as those which provide secure property rights and relatively equal access to resources to a broad cross-section of society. The authors propose a framework where individuals have preferences over economic institutions because of the allocation of resources that these institutions produce, and following from this:
- People’s preferences do not agree because efficiency and distribution cannot be separated. Different economic institutions will benefit different groups, leading to social conflicts
- The problem of commitment explains why efficiency and distribution are inseparable. Political elites are loath to give away their power because this reduces their ability to extract rents from the rest of society
- The distribution of political power determines the structure of economic institutions, the allocation of resources, and the rate of economic growth
- Political power has two forms: de jure power determined by political institutions and de facto power stemming from the ability to act collectively and mobilise resources
- The distribution of de facto power is influenced by the distribution of resources in society
- Political institutions are endogenous. The existing balance of political power determines future political institutions.
Donors need to go beyond the neoclassical growth model and its derivatives to understand why different countries have different economic institutions. The evidence is that economic growth depends on how society is organised. To build good economic institutions and sustainable growth it is necessary to fully understand and address issues of de jure and de facto political power. More understanding is needed of the mechanisms through which institutions persist, and what causes them to change. Other stated or implied policy relevant factors are:
- Whether or not increases in de facto power are translated into democracy depends on how costly and difficult it is for elites to use repression
- Social conflict can lead to institutional choices which cause under-development, even when all agents have common knowledge that this is so
- Historical context is important to understanding economic and political institutions.
