Originally written for the Students For Liberty Blogging Series, posted here on 2.12.15.
Put human history on a timeline, and you’ll quickly realize that the theme of Prosperous Nations and People is an extremely rare anomaly. Since Adam Smith published The Wealth of Nations, economists have obsessed themselves with the origins and causes of economic prosperity, asking the question, “Why are some nations wealthy while others aren’t?” Over the years, multiple theories answering this question have arisen from academia. While each school of thought has its warrants, New Institutional Economics asks another important question before it gives an answer: Why is Nogales, Arizona richer than Nogales, Sonora, Mexico?
Quantitatively, the differences between the two Nogales are minimal, quips an argument introduced in Why Nations Fail, by Daron Acemoglu and James Robinson. The city is split by state boundaries alone, with both sides sharing the same geographic and cultural backgrounds. Both sides’ demographics are nearly identical in regards to age, race, ethnicity, and religion, despite the fact that some residents live in Arizona, US and some live in Sonora, Mexico. Due to the homogeneous nature of Nogales, many theories used by economists don’t hold to explain the differences in wealth between Nogales, AZ and Nogales, Sonora.
The answer to this economic mystery can be found in the differences of Institutions on both sides of the border. Nogales, AZ, has reliable travel, utility, and economic infrastructure. Law and order is dealt quickly and equitably; education is within reach of most citizens; and the ability to influence the local government is possible for any adult. Just a stone’s throw away, you’ll notice the opposite: poor to non-existent infrastructure; systemic crime; poorly defended property rights; and little government accountability.
It is clear that the two Nogales’ political and economic institutions are not the same. Acemoglu and Robinson rightly claim that the influential nature of institutions determines the wealth of nations or, more importantly, the poverty of nations.
Nogales is just one of many examples that shows how major theories revolving around geography, culture, and the intelligence of leaders cannot explain the seeming inability for some nations to be prosperous.
Acemoglu and Robinson’s argument is critical, because for economists to successfully influence prosperity in nations, they must understand why these nations are poor to start with.
At the core of society sit its institutions, which are the structures that facilitate almost all social phenomena, be it cultural, economic, or political. Institutions are rooted in history, and consequently are extremely hard to change.
The Nogales’ disparate wealth exemplifies this principle, as their citizens’ prosperity is based largely on what side of the fence they live on. On one side of the fence, there are instituted strict property rights, a (relatively) equitable legal system, and a political system that is (again, relatively) responsive to the mandates of its citizens. These institutions facilitate the activities of citizens in Nogales, AZ, allowing them to have confidence in the security of their investments, their livelihoods, and their physical safety. The institutions of Nogales, AZ, and of the entire US, were based on a strong classical liberal philosophy and were also inclusive- politically and economically- of the population.
Sadly, the same can not be said for Nogales, Sonora, which suffers from a political system that is monolithic and unresponsive; that not only perpetuates corruption, but also allows for crime and economic institutions that do not foster growth. Mexico’s history is riddled with power struggles and an endemic cronyism that has perverted the political institutions of the nation, which act in the interest of elites alone, rather than those of the people of Mexico. In the United States, if a politician is blatantly caught giving out favors and is openly violating the rights of Americans en masse, there is some form of repercussion. In Mexico, to punish a politician is unheard of; and it is an open fact that most Mexicans suspect politicians to be involved in some form of corruption. When there is an election in the United States, people know that power will transition peacefully and without question to the new Congressmen or President. For most of the 20th century, Mexico was dominated by a single political party, and prior to that, had witnessed over 50 changes in government due to elites competing for control over the nation and its institutions.
This is where the importance of Institutional Economics lies, because economists can only foster positive change in a nation by understanding the complexity of its institutions. It’s because of institutions that nations in Africa are habitually stagnant in growth and prone to political instability. It’s because of institutions that China 30 years ago was an extremely impoverished nation, but is now joining the developed world in wealth. It’s because of classical liberal values, (relatively and progressively) inclusive political systems, and responsive economic institutions that the US has been able to be prosperous for centuries. For a nation to be prosperous, it needs institutions that are inclusive of the population, allowing power to be distributed among the people, rather than among a select few. Inclusive institutions ensure that the political and economic systems of a nation will work for the people, rather than against them. In the United States, our institution are inclusive, while those in Mexico and abroad are often ‘extractive.’
Institutional Economics helps explain why nations are poor more often than they are rich, and more pressingly, it highlights why inclusive institutions must be protected and fostered. The extractive institutions that plague much of Latin America, East Asia, and Africa act as leaches on any true growth and prosperity for their people. To help these nations, bringing change to their institutions must come as a priority. Simultaneously, in the developed world, we must maintain the institutions that have created an era of wealth and security that humanity has never seen before. It goes to show once more that transparent and responsive government, equitable and fair legal systems, and open markets serve civilization best. All of history points to these institutions, or lack of, as to Why Nations Fail.