Nobel Economics Prize: Prosperity Needs Strong Institutions

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Rich countries typically have strong institutions. But several (wannabe) leaders are perfectly comfortable with weakening the rule of law. They do not seem to see institutions as the cause of their prosperity, just as something that happens to be correlated.

In their view, why does the quality of institutions vary across countries?

Their work starts with something that has clearly not had a direct effect on today's economic prosperity: living conditions at the start of European colonialism in the 14th century. Their hypothesis is that, the richer and the more inhospitable to outsiders a place was, the more colonial powers were interested in brutally stealing the country's riches.

In that case, they built institutions without any regard for the people living there. This led to low-quality institutions, during the colonial period, that continued through independence and led to bad economic conditions today.

All of this is because – and this is another domain to which this year's laureates contributed – institutions create the conditions of their own persistence.

In contrast, in more hospitable and less developed places, colonialists did not take resources. They instead settled and tried to create wealth. So, it was in their (selfish) interest to build democratic institutions that benefited people living there.

The researchers then tested their hypothesis by looking at historical data. First, they found a“great reversal” of fortune. Places that were the most urbanized and densely populated in 1500 became the poorest by 1995. Second, they found that places where settlers died quickly from disease and could therefore not stay – while local populations were mostly immune – are also poorer today .

Looking at the colonial roots of institutions is an attempt to disentangle causes and consequences. It is also perhaps the main reason why the committee would say that even if this year's laureates did not invent the idea that institutions matter, their contribution is worthy of the highest distinction.

Some have suggested the work simply argues 'democracy means economic growth'. Is this true?

Not in a vacuum. For instance, their work does not tell us that imposing democracy from scratch on a country with otherwise malfunctioning institutions will work. There is no reason for a democratic leader not to become corrupt.

Institutions are a package. And this is why it is so important to preserve their different aspects today. Weakening even a little bit of the protections the state offers to citizens, workers, entrepreneurs and investors may then lead to a vicious circle where people do not feel safe that they will be defended against corruption or expropriation. And this leads to lower prosperity and more calls for authoritarian rules.

There may also be outliers. China is clearly trying to push the idea that capitalism without a liberal democracy can be compatible with economic success.

The growth of China since Deng Xiaoping's reforms in the 1980s coincides with the introduction of stronger property rights for entrepreneurs and businesses. And, in that sense, it is a textbook version of the power of institutions.

But it is also true that Deng Xiaoping ordered the crushing by the military of the Tiananmen Square protests for democracy in 1989. China today also has a clearly more authoritarian system than western democracies.