The Politics of Growth: How Institutions Shape Our World

The world has been permanently changed ever since the inception of the Industrial Revolution in 1760, the main consequence being an era of ‘modern economic growth’. This new age has been characterised through an increase in life expectancy, population explosion, rapid urbanisation, dynamic labour markets and rising per capita income across the whole world. However, given that the diffusion of technology was concentrated in only a few areas, we have also witnessed the emergence of a rise in global inequality as economic growth has spread unevenly, leading to what some may call the ‘great divergence’. (Snowdon & Vane, 2014) There has been a large debate around the fundamental reasons for this divergence in growth with some pointing the finger to a country’s geography or their culture, but many seem to miss the effect that political and economic institutions have on economic growth.

Contrary to popular opinion, the Industrial Revolution in England did not begin with the creation of the steam engine but truly began with the institutional struggles of the sixteenth and seventeenth century. The two most notable events of this era that led to the Industrial Revolution was the rise of trade in the Atlantic Ocean after 1500 and the Glorious Revolution from 1688 to 1689. (Acemoglu, 2011) The rise of trade in the Atlantic Ocean after 1500, especially 1600 onwards, helped to enrich and strengthen business interests outside of the monarchy and gave them the power to demand changes to the current institutional framework, such as more checks and balances on the Crown and of their friends. (Acemoglu & Robinson, 2005) In turn, by changing the institutional framework of royal power, the seeds of further political change began to take root and in 1688 the Glorious Revolution (also dubbed as the “Bloodless Revolution”) took place which limited the power of the king and the executive and gave Parliament the power to determine the economic institutions of Britain. (History.com, 2018)

Source: Hulton Archive/Getty Images

This resulted in the modernisation of private property rights, removal of arbitrary taxation and sale of land, the breaking up of monopolies that benefitted the Crown and their allies, an independent judicial system and the initiation of Parliamentary supremacy. (North & Weingast, 1989) In turn, creating more inclusive political and economic institutions gave inventors the incentive to invest their own financial and human capital into new profitable ideas as the risk of the Crown appropriating this away from them became non-existent, hence fostering the conditions of technological innovation and paving the way for the Industrial Revolution to take place.

However, these institutional struggles were not limited to Britain, they also occurred here in Australia during the 19th century. The story of these institutional struggles began with the first convict settlement group that came on the 18th of January 1788 but settled in Sydney Harbour on the 26th of January 1788. This group of convicts had a diverse range of work backgrounds and were mostly made up of people convicted of non-violent property crimes. Over time, these workers were made to work within these colonies for little to no pay while being subjugated to awful working conditions and punishments that involved imprisonment for leaving their place of employment without the permission of their employer and the lash for any form of disobedience. (Maxwell-Stewart, Oxley & Digital Panopticon, n.d.) Dubbed as “the British Empire’s Guantanamo Bay” by historian Tony Moore, the convicts were not going to put up with it any longer and began to collectively protest against their colonial rulers demanding better working conditions, political rights and better pay. On average, a convict had been brought before the courts on over six occasions for work-related dissent and there was estimated to be at least 400,000 occasions on which they were tried for this crime, illustrating the fight for institutional change. (Watson & Arnold, 2019)

Source: Getty – Universal History Archive/Universal Images Group

Over time, the governments in Australia began to move away from rule by colonists and the wealthy landowning elite to a Parliamentary system that was elected and ruled by ordinary working-class citizens who pushed for greater egalitarian reform within the political and economic system of Australia. (Hirst, 2004) This fostered the development of strong labour market institutions, greater voter enfranchisement and our own intellectual property laws that protected innovators. In turn, this allowed for the Industrial Revolution to spread to Australia where we saw the introduction of many new technologies such as the invention of the locomotive brake system for our trains and the innovation of the electronic pacemaker that regulated the heart rate of medical patients.

Source: Tibor Kolley/The Globe and Mail

These stories are one of many but central to these pieces of history is the importance of political and economic institutions in shaping the incentives of political and economic actors in society. These institutions can be defined as ‘human devised constraints that structure political, economic, and social interaction’ (Douglass, 1991) and can be categorised as either inclusive or extractive. Hence, ‘inclusive’ institutions such as secure property rights, equality before the law and political pluralism foster the conditions key to long-run economic growth, namely technological innovation. On the other hand, ‘extractive’ institutions where governments have little to no checks on their power and where property rights are insecure are likely to push back against technological innovation resulting in lower rates of economic growth. (Acemoglu, 2011) Thus, inclusive political and economic institutions are a key determinant to long-run economic growth. (Acemoglu, Robinson & Johnson, 2004)

To evaluate this theory empirically, we can see from the diagram below that there is a positive correlation between per capita income with property rights and constraints on the executive, indicating that institutions are an important factor in economic growth.

Source: Acemoglu (2004)
Source: Acemoglu (2004)

However, there are two problems with these graphs that involve ‘reverse causality’ and ‘omitted variable bias’. An argument could be made that as countries become richer, they are able to better secure property and afford to become democratic, hence it is difficult to determine if inclusive economic institutions have a causal effect on economic growth or if it’s the other way around. In addition, there is also a positive correlation between the distance from the equator and per capita income, making it difficult to come up with a proper identification strategy to determine if economic institutions are the main factor contributing to long-run economic growth. (Acemoglu, 2004)

Source: Acemoglu (2004)

However, luckily for us there is a natural experiment in history that is free from bias, South and North Korea, both places with similar geography and who started off with very similar cultures. Once the brutal Japanese colonial rule ended after World War Two, Korea was divided into two zones of influence, with the United States backing the Republic of Korea (or South Korea) with its capital at Seoul and the Soviet Union backing the Democratic People’s Republic of Korea (or North Korea) with its capital at Pyongyang. After the Korean war broke out in 1950 and ended as a stalemate in 1953, the two Korea’s were divided into Northern and Southern regions across the 38th parallel. (History.com, 2018) This led to two paths of divergence as North Korea went down the path of communism with South Korea becoming a relatively capitalist liberal-democratic nation. So, what became of these two countries?

Source: Murray, Housden, Byrson, Fletcher & Shah (2017)

The results are staggering and clearly show that institutions do matter. After the stalemate and the drawing up of the 38th parallel, South Korea has become one of the richest countries in the world and has seen one of the most rapid surges of economic growth in history while it’s counterpart North Korea has seen little to no growth with further stagnation as of late. This difference can be further seen at night, where one country shines bright and one resides in darkness.

Source: Economist.com (2019)

There can be no denying that political and economic institutions do matter but how much do they matter? While the example of South and North Korea paints a picture of institutional divergence, it is hard to explain all cross-country differences, especially marginal ones, using an example of two extremes. On the other hand, there are readers who will bring up China, a nation that can only be described as politically authoritarian in nature but has seen large amounts of economic growth that has lifted billions of people out of poverty due to state centralisation and market-based reforms.

However, we have seen growth under extractive institutions before, this is nothing new. An example of this is the USSR, where we saw rapid industrialisation and mobilisation of capital and labour to productive areas of the economy, leading to high rates of economic growth. But the reader would be mistaken to believe this is sustainable, after all, we saw that the growth rate in the USSR collapsed alongside its own living standards while capitalist liberal democratic countries boomed. It’s important to remember that technological innovation is the foundation of long-term economic growth, and without inclusive economic and political institutions, growth under extractive institutions is not sustainable in the long run as creative destruction will be unable to take place on a large scale.

• References

[1] Acemoglu, D. (2011, April 27). “Why Nations Fail” – Lecture Slides. Retrieved from https://economics.mit.edu/files/6699

[2] Snowdon, B., & Vane, H. (2014). Modern Macroeconomics: Its Origins, Development and Current state. In Modern Macroeconomics: Its Origins, Development and Current State (pp. 579-643). Cheltenham: Edward Elgar.

[3] Acemoglu, D., & Robinson, J. (2013). Why Nations Fail: The Origins of Power, Prosperity, and Poverty. London: Profile Books.

[4] Acemoglu, D., Robinson, J., & Johnson, S. (2005). The Rise of Europe: Atlantic Trade, Institutional Change, and Economic Growth. MIT. Retrieved from https://economics.mit.edu/files/4466

[5] Acemoglu, D., Johnson, S., & Robinson, J. (2004). Institutions as a Fundamental Cause of Long-Run Growth. Retrieved from https://economics.mit.edu/files/4469

[6] North, Douglass C. 1991. “Institutions.” Journal of Economic Perspectives, 5 (1): 97-112.

[7] History.com Editors. (2018, February 20). Glorious revolution. Retrieved from https://www.history.com/topics/british-history/glorious-revolution

[8] Acemoglu, Daron. (2004, Feb. 23 – 25) “Understanding Institutions” – Lecture Slides. Retrieved from: https://economics.mit.edu/files/1353.

[9] History.com Editors. (2018, February 02). South Korea. Retrieved from https://www.history.com/topics/korea/south-korea

[10] Murray, A., Housden, T., Byrson, M., Fletcher, G., & Shah, P. (2017, September 26). Nine charts which tell you all you need to know about North Korea. Retrieved from https://www.bbc.com/news/world-asia-41228181

[11] Economist.com Editors. (2019, May 4). Satellite data shed new light on North Korea’s opaque economy. Retrieved from https://www.economist.com/graphic-detail/2019/05/04/satellite-data-shed-new-light-on-north-koreas-opaque-economy

[12] North, D. C., & Weingast, B. R. (1989). Constitutions and Commitment: The Evolution of Institutions Governing Public choice in Seventeenth-Century England. The Journal of Economic History, 49(4), 803-832.

[13] Hirst, J. (2004, December). The Distinctiveness of Australian Democracy. Retrieved from https://www.aph.gov.au/sitecore/content/Home/About_Parliament/Senate/Powers_practice_n_procedures/pops/pop42/hirst

[14] Watson, J., & Arnold, A. (2019, September 29). How convicts helped turn one of the most unfree places on Earth into a democracy. Retrieved from https://www.abc.net.au/news/2019-09-29/political-convicts-chartists-made-australian-democracy/11520622

[15] Maxwell-Stewart, H., & Oxley, D. (n.d.). Convicts and the colonisation of Australia, 1788-1868. Retrieved from https://www.digitalpanopticon.org/Convicts_and_the_Colonisation_of_Australia,_1788-1868