22.11.2024Nobel Prize: How institutions decide over poor and rich

This year's Nobel Prize winners in economics show the influence of institutions on a country's prosperity. The three prizewinners have close ties to the University of Zurich.

Adjusted for purchasing power, per capita income in Switzerland is 75 times higher than in the Democratic Republic of Congo, one of the poorest countries in the world. How can such extreme differences in prosperity levels be explained? And why is the economy of some countries growing while elsewhere it is stagnating or even shrinking? This question also occupied this year's winners of the “Alfred Nobel Memorial Prize in Economic Sciences”. In October 2024, the prize was awarded to Daron Acemoglu, Simon Johnson and James Robinson (see box). These central questions have been occupying economics since the times of Adam Smith. As early as 1776, he was driven by these questions, to which he sought an answer in his magnum opus “The Wealth of Nations” [1]. “Once you start thinking about it, it's hard to think about anything else,” said Robert Lucas, winner of the Nobel Prize in Economics in 1995. Traditionally, economics explains the different growth rates of countries by the fact that they invest different amounts in capital, education or technological innovation. This is because these investments boost the productivity of an economy and thus lead to higher income. However, this then raises another question: “Why” do some countries invest more than others? Or, in other words, what are the “fundamental” causes of economic growth?

Institutions or wealth: Which came first?

Douglas North, who won the Nobel Prize in Economic Sciences in 1993, had already argued that the answer lies in institutional differences between countries. Such institutions include, in particular, rules and laws that significantly influence the economic incentives of companies and households – for example, the guarantee of property rights, the independence of the judiciary, functioning markets, political stability, an efficient tax system and opportunities for social advancement. But this view was controversial at the time for two reasons. Firstly, because causality could actually work in the opposite direction, namely that economic development leads to the introduction of better institutions. And secondly, it was popularly believed that geographical factors were crucial for economic development. In 1998, for example, the scientist Jared Diamond put forward this view in his Pulitzer Prize-winning bestseller “Guns, Germs and Steel”. His theory emphasizes natural and geographical conditions such as soil quality, natural resources, topography, climatic conditions and diseases such as malaria. These in turn have an impact on agricultural productivity, transport costs and the accumulation of human capital, according to his thesis.

Nobel Prize winners solve the chicken-and-egg question

This is the starting point for the research of this year's Nobel Prize winners in economics. Starting with a sensational article in the American Economic Review in 2001, economists Daron Acemoglu, Simon Johnson and James Robinson presented causal evidence on the role of institutions in economic development. In addition, they have developed new theories in a series of research papers and books that can explain why inefficient institutions persist. They also defined conditions under which institutional reforms can take place. To break down the cause-and-effect relationship between institutions and economic development, the researchers delved into the archives of economic history. Specifically, they looked at the age of colonization between the 15th and 20th centuries, when European powers began to establish settlements on other continents. The researchers argued that where the mortality rate of the first settlers was high due to disease, the Europeans set up purely “extractive” institutions. These had the sole purpose of exploiting the available resources. In contrast, “integrative” institutions based on the European model were set up in places that offered better chances of survival. The aim was to establish a European population there. The United States is one example of this. From the beginning of colonization, the settlers there established relatively inclusive institutions for the time: the 13 colonies were fairly independent from London and had an elected representative assembly. However, there was one major difference: slavery was widespread in the South. While it allowed a small elite to amass considerable wealth in the plantation economy, it was at the expense of a large portion of the population. And because the established elite benefited from the status quo, slavery slowed down innovation and industrialization. By the mid-19th century, the South was considerably poorer than the North.

From poor to rich

Due to the longevity of such institutional differences, countries like Congo or Haiti, where there was initially a high mortality rate among settlers, are still poorer today (see figure). Empirical evidence also shows that this is the case even when the countries are geographically similar. In addition, there is what is known as the resource curse: natural resources often lead to extractive institutions, so that resource-rich countries like the American South or Haiti, which were relatively rich originally, ultimately developed less than initially poorer countries like the northern United States or Australia. Like the southern United States, Haiti was dependent on plantation agriculture and slavery, but unlike the southern United States, it had no inclusive institutions for a significant portion of its population. Although the country's GDP was comparatively very high at the end of the 18th century, it never developed further. By contrast, Switzerland is an example of a country that has benefited from inclusive institutions. It did not experience absolutism and gradually became more democratic, including through the introduction of direct democracy. Although Switzerland was not among the first countries in Western Europe to industrialize, it eventually became one of the richest. The work of this year's Nobel Prize winners has had a significant impact on research into fundamental questions of economic growth. In particular, they have promoted the linking of economic-historical analyses with models of political economy and growth theory. The conviction that institutions are crucial for economic development is now widespread and has also found its way into development policy.

Acemoglu's connections to Zurich

In particular, the Turkish-American economics professor Daron Acemoglu, who teaches at the Massachusetts Institute of Technology (MIT) in the United States, had long been considered a candidate for the Nobel Prize in Economics. In addition to his Nobel Prize-winning work, he has published influential research in other areas of economics that could also have earned a Nobel Prize. For example, in his work on “directed technical change,” he explains under which circumstances the direction of technological progress tends to increase income inequality or favor dirty energy over clean energy. [2] Daron Acemoglu also has close ties to the Department of Economics at the University of Zurich. He has visited the department regularly, for example in 2012 for the opening of the UBS Center for Economics in Society. And he will be at the Department of Economics at the University of Zurich on January 29 to present his latest book, “Power and Progress,” in a lecture. Last but not least, we also have a personal connection to Daron Acemoglu as authors. David Hémous, for example, has conducted research with him several times [3], and Florian Scheuer completed his doctoral thesis at MIT under his supervision in 2010. We can both testify that Daron is an excellent mentor who generously shares his time and whose advice has always been very helpful.

Original article in German and French by Florian Scheuer and David Hémous, published first in "Die Volkswirtschaft". See the full publication.

Automatic Translation via DeepL, edited by Chris Shenton and refined by David Hémous

Reference: 1: See Smith (1776);  2 : See Acemoglu, Aghion, Bursztyn, and Hémous (2012); 3 : See Acemoglu, Aghion, Bursztyn, und Hémous (2012)