The Reason for Inequality – The Strongest Theory : “Inclusive Institutions” – ESSAY BLOG

Acemoglu’s institutional theory gives economists the best way of understanding why countries have developed in different ways to one another, and how we can encourage more balanced growth, even if we should not “solve” inequality.

Already, I have debunked three economic theories for the reason for wealth inequality between nations. To me, the most prominent theory is described in Acemoglu’s “Why Nations Fail”, and is known as the “institutional argument”. Put simply, the theory states that in order to increase the rate of economic growth and development within a country, it is necessary to design inclusive, pluralistic economic and political institutions, that incentivise growth and productivity. Acemoglu argues that from time to time, countries are faced with important events in the form of “critical junctures”, that allow the country to reform their political and economic institutions, and therefore allow for more inclusive institutions to develop.

Why Nations Fail

Acemoglu analyses numerous case studies to support his theory. I found the most thought provoking to be the comparison between Mexico and USA. Both countries are faced with similar geographic and cultural identities. However, South of the border, the murder rate and infant mortality rate is three times higher, whereas budget expenditure per capita and GDP per capita are respectively 12 and 4 times lower. This difference does not lie in cultural idiosyncrasies, or geographic niceties, but rather very simply, Mexico is subject to Mexican extractive institutions, whereas USA is subject to inclusive American institutions.

Inclusive institutions are institutions that allow many people to benefit from economic growth. America is inclusive. If an individual wants to set up a business in America, they can do so without facing any major barriers of entry. New technological breakthroughs are supported by government subsidies, so that productivity and enterprise can expand that country’s productive potential. This is a stark contrast to the economic and political institutional design of Mexico. Take Carlos Slim as an example of the extractive nature of the Mexican system, whereby only a few very wealthy individuals can benefit. Slim did not become the second richest man in the world through innovation (unlike the American richest man, Bill Gates), rather, in 1990, he purchased a 51% stake in Telmex, the Mexican nationalised telecommunications firm. Mexico’s telecommunications monopoly became Slim’s very own privatised monopoly. This clearly became hugely profitable. Had Slim been practising on American soil, the inclusive political institutions would not have allowed him to bid at an auction to control such a staple industry such as national telecommunications, and even had he been able to control the market share, the relaxed barriers to entry to American markets would have encouraged new firms to enter the market, and therefore prevent Slim from dominating the market share and establishing a monopoly. However, because Slim was based in Mexico, the extractive nature of institutions meant that a large proportion of Mexican GDP is focused only towards one individual, hence as the median income decreases and inequality steepens, innovation slows, and with it so does economic growth.

 

Rich vs Poor

However, countries are sometimes faced with an event known a “critical juncture” in which they can change the nature of their institutions, in the aftermath of a political event. For instance, the 14th Century Black Death swept through Europe, killing around 40% of the European population. Peasants were particularly susceptible to contracting the plague, due to the open sewers and lack of basic cleanliness etc. Previously across Europe, the Feudal system was adopted, in which the peasants worked for landowners, who worked under the dukes and barons, and then the monarch was at the top of the hierarchy. However, when faced with the black death, Western Europe and Eastern Europe reacted to the decline in labour population in two very different ways. In Western European England, the peasants realised their increased value after the Black Death, so demanded greater freedoms, as well as increased land ownership, so that they could personally benefit off of their own hard work, rather than paying their produce to the land owners. In 1381, they commenced the Peasants Revolt, and quickly captured London. Although the revolution was quickly quashed, it highlighted to the barons and dukes the importance of their labour supply, and consequently, over the next 100 years, peasants began to earn more money, as well as experiencing greater freedoms. On the other hand, in Eastern Europe, the opposite occurred. Due to the shortage of labour, landowners were even more incentivised to hold onto their workers, and hence reduced their freedoms in order to ensure that they

 would/could not leave. 90% of the population became serfs, as Eastern Europe descended into Serfdom. In Hungary, serfs would be forced to complete three days per week of unpaid labour for their landowners, which ultimately annihilated any incentive to work hard or innovate processes in order to encourage economic growth. As Eastern Europe became more extractive, Western Europe became more inclusive. Britain began to innovate politically, as a government gained more power, hence political institutions became more pluralistic, as voting rights became more accessible. This in turn created the framework for economic growth, by harbouring the climate necessary to encourage innovation and productivity.

 

Inequality CartoonUltimately, I believe that Acemoglu’s “Institutional” theory is far more reliable than the flawed ignorance, geographic and cultural theories. However, thats not to say that the theory is perfect, as I also believe that it is a “cop out”. Is it not too simple to say that “country A is more prosperous than country B, because its institutions allow for growth?” To me, that is as simple as saying that country A is more economically developed than B “just because it is”. To adopt this argument is to say that economic growth is exclusively a result of a country’s inclusive institutions, but this cannot be the case as countries such as Saudi Arabia have huge levels of wealth, but relatively low levels of access to markets and inclusive economic institutions. Conclusively, I do not believe that there is one single theory that can explain why certain countries are more prosperous than others. There are too many unique/singular countries that one can bring up, that do not abide by the theory, and hence weaken its reliability. To me, wealth inequality must always exist in order to encourage incentive. If every country and every person was of equal wealth, then there would be not drive to “keep up with the Jones’”, and we would see a USSR style of weak productivity and lack of work incentive. Certain countries are richer than others, but there is no blanket reason/formula for why every rich country is richer than its poorer equivalent. However, in my opinion, Acemoglu’s institutional theory gives economists the best way of understanding why countries have developed in different ways to one another, and how we can encourage more balanced growth ; and to me, this understanding is far more important than trying to understand why a country may be more prosperous than its neighbour.

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