Fundamental causes of income differences

We begin by taking a step back. The presumption in the introduction was that economic institutions matter, and should in fact be thought of as one of the key fundamental causes of economic growth and cross-country differences in economic performance.

2.1. Three fundamental causes

If standard economic models of factor accumulation and endogenous technical change only provide proximate explanations of comparative growth, what types of explanations would constitute fundamental ones? Though there is no conventional wisdom on this, we can distinguish three such theories: the first set of theories, our main focus in this chapter, emphasize the importance of economic institutions, which influence economic outcomes by shaping economic incentives; the second emphasize geography, and the third emphasize the importance of culture (a fourth possibility is that differences are due to “luck”, some societies were just lucky; however we do not believe that differences in luck by themselves constitute a sufficient fundamental causes of cross-country income differences).

2.1.1. Economic institutions

At its core, the hypothesis that differences in economic institutions are the fundamental cause of different patterns of economic growth is based on the notion that it is the way that humans themselves decide to organize their societies that determines whether or not they prosper. Some ways of organizing societies encourage people to innovate, to take risks, to save for the future, to find better ways of doing things, to learn and educate themselves, solve problems of collective action and provide public goods. Others do not.

The idea that the prosperity of a society depends on its economic institutions goes back at least to Adam Smith, for example in his discussions of mercantilism and the role of markets, and was prominent in the work of many nineteenth century scholars such as John Stuart Mill [see the discussion in Jones (1981)]: societies are economi­cally successful when they have ‘good’ economic institutions and it is these institutions that are the cause of prosperity.

One could think of other types of economic institutions and many explanations for growth and development have moved beyond models based on preferences, technol­ogy and factor endowments to focus on what might loosely be called institutions. One set of ideas, important for our work, has emphasized that conflict over resources and predation, as well as production, are fundamental forces in society. Scholars such as Skaperdas (1992), Grossman and Kim (1995,1996), Hirshleifer (2001) and Dixit (2004) have examined how stable property rights can emerge in such circumstances. These scholars have studied almost institution free models and asked how the type of social order that underlies standard economic models might emerge endogenously. Closely related to this work is the research that shows how rent-seeking and redistributional conflict more generally has important implications for growth [e.g., Tornell and Velasco (1992), Murphy, Shleifer and Vishny (1991) Acemoglu (1995), Alesina and Perotti (1996), Benhabib and Rustichini (1996)].

Another literature, following in the footsteps of traditional accounts of economic growth by historians, following the lead of Adam Smith, has emphasized the perfec­tion and spread of markets, clearly a key economic institution [Pirenne (1937), Hicks (1969)]. Problems of the imperfection or absence of markets can clearly have impor­tant ramifications for resource allocation, incentives and growth. A central role here has been played by capital markets.

The idea that market imperfections and economic institutions play a central role in development has also been important in the academic literature on development economics since its initiation. Both Adam Smith and Alfred Marshall argued that share­cropping was an inefficient way of organizing agriculture because it gave incorrect incentives to tenants. This argument has been formalized, and at the heart of a large literature on development are imperfections in tenancy, labor, land and credit markets [see Ray (1998), Bardhan and Udry (1999), Banerjee and Duflo (2005)].

Finally, the literature that one might broadly class as institutional has extensively discussed political economy models. Most influential is the early work of Perotti (1993), Saint-Paul and Verdier (1993), Alesina and Rodrik (1994) and Persson and Tabellini (1994) who developed dynamic models to examine the effect of redistributive taxation on growth.

At some level then there is a bewildering array of ideas connecting institutions, both economic and political, to growth and development. In this chapter however, as will already be apparent, we do not attempt to survey all of these theories. Rather, we at­tempt to develop a perspective on this topic which revolves around what we see as the key issues. From the empirical side this entails really establishing the causal role of institutions in development. From the theoretical side this involves emphasizing the im­portance of understanding why institutions differ across countries. From the perspective of this chapter the main problem with most of the existing research is the lack of com­parative statics and the absence of a truly comparative focus. For instance, in the model of Grossman and Kim (1995) stable property rights may emerge as an equilibrium, but whether they do so or not depends on parameters in the fighting technology which are hard to interpret in reality. Most models of imperfect markets and multiple equilibria fail to provide explanations either for why markets are incomplete or imperfect, or for how some societies manage to get into good equilibria while others do not. To the ex­tent that imperfect market are grounded in imperfections in information or possibilities for opportunism, one would like to know how and why these vary across countries in ways which are consistent with the basic facts about relative economic outcomes. We believe that the structure of markets is endogenous, and partly determined by property rights. Once individuals have secure property rights and there is equality of opportunity, the incentives will exist to create and improve markets (even though achieving perfect markets would be typically impossible).

There are some genuinely comparative studies in the literature. Forexample, Banerjee and Newman (1993), Alesina and Rodrik (1994) and Persson and Tabellini (1994) all point to differences in wealth distribution as the key to success or failure. We will dis­cuss other such theories, for example those connected to legal origins [e.g., La Porta et al. (1998)] later. Nevertheless, these studies are very different from the approach we propose in this chapter.

2.1.2. Geography

While institutional theories emphasize the importance of man-made factors shaping in­centives, an alternative is to focus on the role of “nature”, that is, on the physical and geographical environment. In the context of understanding cross-country differences in economic performance, this approach emphasizes differences in geography, climate and ecology that determine both the preferences and the opportunity set of individual eco­nomic agents in different societies. We refer to this broad approach as the “geography hypothesis”. There are at least three main versions of the geography hypothesis, each emphasizing a different mechanism for how geography affects prosperity.

First, climate may be an important determinant of work effort, incentives, or even pro­ductivity. This idea dates back at least to the famous French philosopher, Montesquieu (1748), who wrote in his classic book The Spirit of the Laws: “The heat of the climate can be so excessive that the body there will be absolutely without strength. So, prostra­tion will pass even to the spirit; no curiosity, no noble enterprise, no generous sentiment; inclinations will all be passive there; laziness there will be happiness”, and “People are...

Second, geography may determine the technology available to a society, especially in agriculture. This view is developed by an early Nobel Prize winner in economics, Myrdal, who wrote “serious study of the problems of underdevelopment... should take into account the climate and its impacts on soil, vegetation, animals, humans and phys­ical assets - in short, on living conditions in economic development” [Myrdal (1968, vol. 3, p. 2121)]. More recently, Diamond espouses this view,.. proximate factors behind Europe’s conquest of the Americas were the differences in all aspects of tech­nology. These differences stemmed ultimately from Eurasia’s much longer history of densely populated... [societies dependent on food production]”, which was in turn determined by geographical differences between Europe and the Americas [Diamond (1997, p. 358)]. The economist Sachs has been a recent and forceful proponent of the importance of geography in agricultural productivity, stating that “By the start of the era of modern economic growth, if not much earlier, temperate-zone technologies were more productive than tropical-zone technologies..C [Sachs (2001, p. 2)].

The third variant of the geography hypothesis, especially popular over the past decade, links poverty in many areas of the world to their “disease burden”, emphasiz­ing that: “The burden of infectious disease is similarly higher in the tropics than in the temperate zones” [Sachs (2000, p. 32)]. Bloom and Sachs (1998) claim that the preva­lence of malaria, a disease which kills millions of children every year in sub-Saharan Africa, reduces the annual growth rate of sub-Saharan African economies by more than 1.3 percent a year (this is a large effect, implying that had malaria been eradicated in 1950, income per capita in sub-Saharan Africa would be double what it is today).

2.1.3. Culture

The final fundamental explanation for economic growth emphasizes the idea that dif­ferent societies (or perhaps different races or ethnic groups) have different cultures, because of different shared experiences or different religions. Culture is viewed as a key determinant of the values, preferences and beliefs of individuals and societies and, the argument goes, these differences play a key role in shaping economic performance.

At some level, culture can be thought to influence equilibrium outcomes for a given set of institutions. Possibly there are multiple equilibria connected with any set of in­stitutions and differences in culture mean that different societies will coordinate on different equilibria. Alternatively, as argued by Greif (1994), different cultures generate different sets of beliefs about how people behave and this can alter the set of equilibria for a given specification of institutions (for example, some beliefs will allow punishment strategies to be used whereas others will not).

The most famous link between culture and economic development is that proposed by Weber (1930) who argued that the origins of industrialization in western Europe could be traced to the Protestant reformation and particularly the rise of Calvinism. In his view, the set of beliefs about the world that was intrinsic to Protestantism were crucial to the development of capitalism. Protestantism emphasized the idea of predestination in the sense that some individuals were ‘chosen’ while others were not. “We know that a part of humanity is saved, the rest damned. To assume that human merit or guilt play a part in determining this destiny would be to think of God’s absolutely free decrees, which have been settled from eternity, as subject to change by human influence, an impossible contradiction” [Weber (1930, p. 60)].

But who had been chosen and who not? Calvin did not explain this. Weber (1930, p. 66) notes “Quite naturally this attitude was impossible for his followers... for the broad mass of ordinary men... So wherever the doctrine of predestination was held, the question could not be suppressed whether there was any infallible criteria by which membership of the electi could be known”. Practical solutions to this problem were quickly developed,.. in order to attain that self-confidence intense worldly activity is recommended as the most suitable means. It and it alone disperses religious doubts and gives the certainly of grace” [Weber (1930, pp. 66-67)].

Thus “however useless good works might be as a means of attaining salvation... nevertheless, they are indispensable as a sign of election. They are the technical means, not of purchasing salvation, but of getting rid of the fear of damnation” (p. 69). Though economic activity was encouraged, enjoying the fruits of such activity was not. “Waste of time is... the first and in principle the deadliest of sins. The span of human life is infinitely short and precious to make sure of one’s own election. Loss of time through sociability, idle talk, luxury, even more sleep than is necessary for health... is worthy of absolute moral condemnation... Unwillingness to work is symptomatic of the lack of grace” (pp. 104-105).

Thus Protestantism led to a set of beliefs which emphasized hard work, thrift, saving, and where economic success was interpreted as consistent with (if not actually signal­ing) being chosen by God. Weber contrasted these characteristics of Protestantism with those of other religions, such as Catholicism, which he argued did not promote capital­ism. For instance on his book on Indian religion he argued that the caste system blocked capitalist development [Weber (1958, p. 112)].

More recently, scholars, such as Landes (1998), have also argued that the origins of Western economic dominance are due to a particular set of beliefs about the world and how it could be transformed by human endeavor, which is again linked to religious differences. Although Barro and McCleary (2003) provide evidence of a positive cor­relation between the prevalence of religious beliefs, notably about hell and heaven, and economic growth, this evidence does not show a causal effect of religion on economic growth, since religious beliefs are endogenous both to economic outcomes and to other fundamental causes of income differences [points made by Tawney (1926), and Hill (1961b), in the context of Weber’s thesis].

Ideas about how culture may influence growth are not restricted to the role of reli­gion. Within the literature trying to explain comparative development there have been arguments that there is something special about particular cultural endowments, usually linked to particular nation states. For instance, Latin America may be poor because of its Iberian heritage, while North America is prosperous because of its Anglo-Saxon her­itage [Veliz (1994)]. In addition, a large literature in anthropology argues that societies may become ‘dysfunctional’ or ‘maladapted’ in the sense that they adopt a system of be­liefs or ways or operating which do not promote the success or prosperity of the society [see Edgerton (1992), for a survey of this literature]. The most famous version of such an argument is due to Banfield (1958) who argued that the poverty of Southern Italy was due to the fact that people had adopted a culture of “amoral familiarism” where they only trusted individuals of their own families and refused to cooperate or trust anyone else. This argument was revived in the extensive empirical study of Putnam, Leonardi and Nanetti (1993) who characterized such societies as lacking “social capi­tal”. Although Putnam and others, for example, Knack and Keefer (1997) and Durlauf and Fafchamps (2004), document positive correlations between measures of social capi­tal and various economic outcomes, there is no evidence of a causal effect, since, as with religious beliefs discussed above, measures of social capital are potentially endogenous.

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