The Wealth of Nations and the Poverty of Economics

Matías Vernengo

The new book (and the accompanying blog) by Daron Acemoglu and James Robinson Why Nations Fails is a popular version of their academic papers (several with Simon Johnson, the ex IMF chief economist) on the topic [read a brief summary here]. The main idea is that institutions and not geography or culture are the key to economic development. That is for the most part true.

They use South and North Korea (and Nogales, México and Arizona) as an example of countries that share the same culture and geography, but have very different institutions, and, as a result, a huge disparity in income per capita. Jared Diamond is correct to point out that, in part, technology is geographically determined. No plants and animals to domesticate, and provide for a large surplus (Diamond uses the old classical notion of surplus), and higher population density (with the diseases and immunities associated to those Germs) and no advantages associated to a more developed division of labor (Diamond is also Smithian in that sense), with the consequent development of technology (Guns and Steel). But the problem is that this won’t help you understand why England and not China industrialized (the opposite extremes of the Eurasian continent).

Culture has fewer defenders; most prominently among modern economists is probably David Landes (in The Wealth and Poverty of Nations), but the obstacles to that argument are even more difficult to overcome. Not the least because in modern times countries with diverse cultures have become developed. [It’s important to note that culture does matter, even if it’s not determinant, since different cultures produce different types of capitalism, and the diverse varieties of capitalism produce a few more benign than others].

In that sense, given the limitations of the geographic and cultural interpretations, the argument for institutions is strong indeed. The problem with Acemoglu and Robinson’s New Institutionalist argument (which builds on the work of Douglas North) is that the institutions (fundamentally property rights) that they emphasize are uniquely concentrated on the supply side, and the generation of incentives for productive investment. And the historical evidence for patents, copyright and other forms of property protection for explaining growth is limited at best. As Abhijit Banerjee said: “it is … hard to be sanguine about growth automatically picking up if we were to suddenly institute U.S.-style property rights in Sierra Leone.”

Robert Allen, who has been critical of property rights as the main determinant of investment, has suggested still that supply constraints are central to determine the path of technological development. For him inexpensive energy (as the result of the existence of cheap coal as pointed out by Ken Pomeranz) and high wages were central to explain why the Industrial Revolution was a British phenomenon. For him, high wages and cheap energy forced British producers to innovate to save labor, leading to technological innovation and growth. Forget for a while the problems of his use of aggregate production functions [for a detailed critique go here], still the idea that firms would produce more, and use more and better machines as a result of a change in their relative cost, and without concern with demand goes against common sense.

Adam Smith, in the Wealth of Nations, argued that the division of labor (the basis of technological progress) was limited by the extent of the market (demand). Without more demand why produce more? Landes, in his classic account of the Industrial Revolution in England (The Unbound Prometheus) said: “it was in large measure the pressure of demand on the mode of production that called forth new techniques in Britain, and the abundant, responsive supply of factors that made possible their rapid exploitation and diffusion. The point will bear stressing, the more so as economists, particularly theorists, are inclined to concentrate almost exclusively on the supply side.” Sadly that is still true.

The importance of demand is always downplayed. Poor countries that arrive late to the process of capitalist development cannot expand demand without limits since the imports of intermediary and capital goods cause balance of payments crises. The institutions that allow for the expansion of demand, including those that allow for higher wages to expand consumption, and to avoid the external constraints, are and have been central to growth and development.

The dominance and persistence of Say’s Law and the associated notion of a natural rate of unemployment, which says that demand adjusts to supply is what is behind the irrelevance of the economist’s account of the wealth of nations. It’s also the reason why economists tend to side with those social groups that benefit from austerity (i.e. with not pushing demand), and in a period of crisis like this one are not just irrelevant, but decidedly dangerous.

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