In trying to explain this pattern, the authors dismiss some existing theories that explain RF, such as the “geography hypothesis.” The geography hypothesis “explains most of the differences in economic prosperity by geographic, climatic, or ecological differences across countries.” AJR provide evidence that weights against this simple version of the geography hypothesis. AJR also claim that there is little evidence to support even the more sophisticated versions of this hypothesis such as the “temperate drift hypothesis.”
For AJR, the more plausible explanation for RF is what they termed “institutions hypothesis.” AJR’s main hypothesis is that:
[A] cluster of institutions ensuring secure property rights for a broad cross section of society, referred to as “institutions of private property,” are essential for investment incentives and successful economic performance. In contrast, “extractive institutions,” which concentrate power in the hands of a small elite and create a high risk of expropriation for the majority of the population, are likely to discourage investment and economic development.
AJR find historical and econometric evidence suggesting that:
European colonialism led to the development of institutions of private property in previously poor areas, while introducing extractive institutions or maintaining existing extractive institutions in previously prosperous places. The expansion of European overseas empires, combined with the institutional reversal, is consistent with the reversal in relative incomes since 1500.
Finally, AJR were able to document that the reversal in relative incomes among the former colonies was related to industrialization. They surmised that societies with institutions of private property “take advantage of the opportunity to industrialize, while societies with extractive institutions fail to do so.” They concluded that this led to the industrialization that took place in the nineteenth century and played a central role in the long-run development of the former colonies.
The main finding of AJR in this paper is that the reversal of relative income among former colony countries that we observed today are primarily due to “European colonialism that led to the development of institutions of private property in previously poor areas, while introducing extractive institutions or maintaining existing extractive institutions in previously prosperous places.” This fits perfectly within the major tenets of the new institutional economics (NIE) school. Coase (1998) established that “it is the institutions that govern the performance of an economy.” North (1991) explained that “institutions are the humanly devised constraints that structure political, economic and social interaction” and that institutions “consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal rules (constitutions, laws, property rights).” Using this framework, Williamson (2000) states that the NIE “has been concerned principally with levels 2 and 3” of what he considers the four levels of social analysis. He refers to the second level as “institutional environment,” where “much of the economics of property rights is.”
The main strength of the paper is how AJR overcame one of the limitations of making comparative analysis involving a long timeframe. Data in 1500 is certainly not perfect, if not absent. The authors instead became creative and used urbanization rate and population density as proxy for the level of prosperity. Their effort is likewise not without theoretical precedence. They cited numerous papers in the literature that support their claim. Furthermore, they backed up this claim by conducting regression analysis to support the use of said proxies.
While I agree with how the paper describes “equilibrium institutions” (“when extractive institutions were more profitable, Europeans were more likely to opt for them” versus “Europeans were more likely develop institutions of private property when they settled in large numbers”), it must be that the reasons for the persistence of institutions are not only limited to these two cases. Further developments in theory must be made to come up with other reasons the two types of institutions persist. Austin (2008), for example, points to this oversimplification of European colonies into “settlers” and “non-settlers.” Each may have a different kind of “historical path” than the one described by AJR.
Huillery (2011) looking at French West Africa, for example, states that there are some colonies with extractive institutions that performed better simply because they have more European settlers than colonies with extractive institutions. In other words, colonized areas that received more European settlers have performed better than colonized areas that received less European settlers. Acemoglu et al. actually have the same idea—the more settlers the better, but according to Huillery, this also applies even among extractive colonies.
Furthermore, the time period between 1500 and 1995 is too long to disregard any other factors that might help explain the reversal. If we refer to Williamson’s (2000) four levels of social analysis, AJR’s analysis may very well be operating within second level, where “the definition and enforcement of property right and of contact laws are important features.” In the 500 years since 1500, however, things may be happening at the third level, where “governance of contractual relations become the focus of analysis.” For instance, we might find one in history where a dictator rules a country, but which enforces good property rights.
In spite of these weaknesses, this paper is another great addition to the literature of how institutions, particularly those involved in securing property rights, explain economic outcomes. The paper adds empirical support to the finding that countries with institutions that secure property rights are more developed than countries that do not have such institutions.
In addition, and more importantly, this paper provides an explanation about how these institutions came to be. In a sense, this is paper lends support to the work of La Porta et al. (1998), which looks at how institutions themselves are a product of history, i.e. colonialism. Their paper looks at the “legal rules covering protection of corporate shareholders and creditors.” They find that “common law countries generally have the strongest, and French civil-law the weakest, legal protections of investors.” Protection of investors’ rights is important because according to La Porta et al., “without these rights, investors would not be able to get paid, and therefore firms would find it harder to raise external finance.” This lack of free-flowing capital would be detrimental to the productivity, and hence welfare, of a country. Much like AJR’s paper, the laws of a country, especially one that is a former colony, are received through “colonial transplantation.” Both papers talk about how different property-securing institutions led to different outcomes. Whereas AJR looks at the current RF phenomenon, La Porta et al. looks at the current state of different legal rules covering the protection of investors.
References
Acemoglu, Daron, Simon Johnson, and James A. Robinson (2002), “Reversal of fortune: Geography and Institutions in the making of the modern world income distribution”, Quarterly Journal of Economics, 117(4):1231-94.
Austin, Gareth (2008), “The ‘reversal of fortune’ thesis and the compression of history: Perspectives from African and comparative economic history”, Journal of International Development, 20:996-1027.
Coase, Ronald (1998), “The new institutional economics”, The American Economic Review, 88(2):72-4.
La Porta, Rafael, Florencio Lopes-de-Silanes, Andrei Shleifer, and Robert W. Vishny (1998), “Law and finance”, Journal of Political Economy, 106(6):1113-55.
North, Douglass C. (1991), “Institutions”, The Journal of Economic Perspectives, 5(1):97-112.
Williamson, Oliver E. (2000), “The new institutional economics: Taking stock, looking ahead”, Journal of Economic Literature, 38(3):595-613.