What makes some countries rich and others poor?

What makes some countries rich and others poor? Why are most European countries so developed and most African can’t get out of poverty? Is it all decided by geography? If that was the case why are some countries with good climate and abundant natural resources still so poor? What stops countries making the jump to a better future?

Those who studied economics know that the growth of any country is built of labour, capital and productivity. So, the nation can become richer by having an increasing (or longer working) population (ie. more hands to produce goods and services), attracting capital and investments (so we have for example more equipment) or by producing things much more efficiently (eg. by advancement in technology). That theory works well in explaining the growth over the medium and short term. Yet, it doesn’t answer the fundamental question — why throughout history some countries become successful and rich and others are always struggling and failing.

Institutions, stupid!

There are many research studies looking at the growth of nations over very longer term, and conclusions are usually very similar. The most important thing deciding about the long-term prospects of a country depends on the strength and quality of its institutions. There are also other important factors that intersect with the institutional framework like ideologies, culture, individuals, geography and luck. All of them play a part, but none of them can be solely attributable to success in the long term.

The stronger the rule of law, the higher the level of income.

It is institutions that decide what kind of activities are promoted in any country: Those that support long-term growth for many, or rent-seeking activities that benefit only a few individuals or groups.

Strong and stable Institutions promote growth by creating the right “environment.” They enforce the property rights so individuals and businesses are not afraid to work and invest. They create equal rules of the game for all (encourage competition). Make sure everyone adheres to the rules (predictable and stable legal system). They reduce the costs of transactions in the market (open economy). They also build the right framework by providing education and social support so most people in society have more or less equal chances of succeeding. It also depends on the institutions on how technological change and innovation is promoted and adopted. And technology and innovation directly impact productivity growth.

If that is so clear, why have not all countries adopted policies that build good institutions?

It is not by chance that reforms are so difficult — Fernando Cardoso (former Brazilian president)

There are usually two problems countries face when deciding about institutional set-up:

1. Good institutions are very often against the interests of groups who hold the power (think of authoritarian systems and their resistance to democratic elections and freedom of speech) or have preferable access to the resources (why would oligarchs in any country seek open markets and strong competition?).

The best example of the latter is the comparison of Poland and Ukraine after the fall of communism. In 1989, both countries started from a similar position. The program of reforms was slightly different. Yet, the main contrast was the extent to which the privatized wealth led to the creation of oligarchs. In the Ukrainian case, narrow elites captured so much wealth and power that they managed to block further reforms for another two decades.

2. Even if the good institutions are created, there is a challenge to maintain them. Every institution is only as good as the people who manage them. Social norms and culture play a big part here. That is why foreign-induced institutions very often do not survive the test of time if they are not tailored to local circumstances. We find that example in former colonies where institutions did not survive when the authorities who created them left.

So, what makes some countries successful in building strong institutions and others fail?

There are 40 countries that can be classified as high-income by the World Bank’s standards. There were two distinguishing features between them and the rest of the world (captured by M. Piatkowski in “Europe’s Growth Champion”):

1. They are all democracies (with a question mark around Singapore), and;
2. They have low or moderate inequality levels (as measured by the Gini coefficient). The only outlier in that group is Chile. Given what’s happening in this country right now it might only serve as a confirmation.

What is so special about those two features?

The first shows the distribution of political power, whereas the second shows the distribution of income and wealth. Democracy encourages people to take part in political life, engage and express. It makes people feel they have control over their own lives. But above all, it gives everyone similar rights and powers. It makes society inclusive.

It’s no coincidence that when the political institutions are democratic and power is widely distributed, the benefits of the economic developments are very likely to be shared among many.

From exclusive to inclusive

What is very interesting is how societies can switch from exclusive to inclusive — the prerequisite for building good-quality institutions. Marcin Piatkowski in the “Europe’s Growth Champion” argues that the transition has never been natural or internally driven. It has always been triggered by either external shock or external pressure. For Western Europe, such transition was initiated by the Black Death in the 14th century. The death of a third of society increased the role of peasants and merchants in society. Later, it was the French occupation under Napoleon that finally got rid of the remaining feudal institutions. In the case of Poland, which is the subject of the book, the adoption of social cohesion came with communism after World War II. In Germany after 1945, it was the U.S. occupation that finally made the society inclusive and democratic.

Similar conclusions can be found in Asia. In his book “How Asia Works,” Joe Studwell argues that one of the major features that distinguish rich Asian countries (eg. Japan, Taiwan, South Korea) from the poor (eg. the Philippines, Indonesia, Malaysia) was the adoption of the comprehensive land reform. The distribution of land to the vast majority of farmers allowed them to increase the efficiency of crops and share the benefits of accompanying growth. A large number of wealthier peasants could then spend more on other goods and support developing manufacturing in urban areas.

There is also another interesting aspect. Good institutions create growth, but it also growth that encourages building better institutions. It is well documented that people with higher incomes demand more from politicians and government, further strengthening economic development. It is, thus, no surprise that the growing middle class is very often a danger for authoritarian regimes.

Now, let's look now at the other circumstances that affect how the countries prosper:

• Geography. The first thing that comes to mind is natural resources. Yet, having lots of resources doesn't secure prosperity. Very often it is a curse (Venezuela or some African countries are great examples). Favorable geography is about having a safe environment (without natural disasters), productive lands and access to resources. But none of those factors is decisive on its own.
• Culture. Institutions can only work well if the broader culture is favorable and people support it. Just think of Italy, which has the same institutions, but there is a huge gap in prosperity between the south and the north. Another way to imagine the culture in this context is to think what would happen if the whole nation — say the Dutch — were moved one day to a less favorable natural environment. I guess they would again do pretty well.
• Luck and Individuals. Sometimes events or decisions by individuals decide about future generations. In the 16th century, Queen Elizabeth I allowed British merchants to trade freely in the open seas and keep the profits for themselves. That decision allowed them to thrive and build overseas power of the British Kingdom. At the same time, the Spanish monarch went the opposite decision and took away a large chunk of profits of their merchants. As a result, Spain lost supremacy over the oceans to the British.
• Ideologies. They matter less in the short term, but over the long term we can observe the impact. Liberalism gave rise to the industrial revolution. It also brought concepts of free markets, ownership or entrepreneurship. All were perfect examples of inclusive institutions. Communism, on the other hand, had also inclusive social institutions. Yet, the political and economic institutions were totally exclusive. And it failed over the longer term.

So what makes some countries rich and others poor? It turns out the answer is relatively simple. Successful countries have built institutions that promote long-term growth. Yet, it is a much more complex problem of how to build a stable and reliant institutional framework that can survive over time. In rich countries, people are taking an active part in political institutions. Economic prosperity is shared among many. They have inclusive societies where people decide about themselves and share the benefits of the development.

The widespread distribution of wealth is also essential if the country wants to preserve its system and institutions. Too much concentration of wealth and power can be a short way to destabilize democracy and threaten its existence. Economic inequalities very often spur populism. It risks moving toward authoritarian rules and creating even more economic imbalances. That is why there are growing concerns nowadays. More and more voices urge to tackle huge income and wealth gaps around the world. It is worth keeping in mind that huge inequalities have rarely been reversed in a peaceful way.

The article was originally published on www.fintaste.com where you can find more on financial markets and economic development.