Sources of inefficiencies

Having motivated our first two assertions in Section 1.2, we are now in a position to discuss the third, related to the importance of commitment problems. The inability to commit to how political power will be used in the future means that the impact of eco­nomic institutions on efficiency cannot be separated from their effects on distribution.^[265]

In any market situation where economic exchange takes place, and the quid is sepa­rated from the pro quo, issues of commitment will arise.

In contrast, if, for example, a manager believed that the state would be aligned with the interests of the owner and refuse to punish the owner if and when he failed to make a payment stipulated by the contract, then the contract would have little value. Therefore, the presence of an impartial enforcer is important for contracting. The problem when it comes to institutional choices is that there is no such impartial third party that can be trusted to enforce contracts. This is the origin of the commitment problem in politics.^[266]

To elaborate on this point, let us consider a situation where society can be governed as a dictatorship or as a democracy.

A similar problem plagues the reverse solution, whereby the dictator agrees to a vol­untary transition to democracy in return for some transfers in the future to compensate him for the lost income and privileges. Those who will benefit from a transition to democracy would be willing to make such promises, but once the dictator relinquishes his political power, there is no guarantee that citizens would agree to tax themselves in order to make payments to this former dictator. Promises of compensation to a former dictator are typically not credible.

The essence of the problem is commitment. Neither party can commit to compensate the other nor can they commit to take actions that would not be in their interests ex post. The reason why commitment problems are severe in these examples is because we are dealing with political power. Different institutions are associated with different distrib­utions of political power, and there is no outside impartial party with the will and the power to enforce agreements. In some cases, there may be self-enforcing promises that maintain an agreement. Acemoglu (2003a) discusses such possibilities, but in general, there are limits to such self-enforcing agreements, because they require the participants to be sufficiently patient, and when it comes to matters of political power, the future is uncertain enough that no party would behave in a highly patient manner.

Based on this reasoning, we can now discuss three different channels via which the presence of commitment problems will lead to the choice and persistence of inefficient institutions.

6.1. Hold-up

Imagine a situation in which an individual or a group holds unconstrained political power. Also suppose that productive investments can be undertaken by a group of cit­izens or producers that are distinct from the “political elites”, i.e., the current power holders. The producers will only undertake the productive investments if they expect to receive the benefits from their investments. Therefore, a set of economic institutions protecting their property rights are necessary for investment. Can the society opt for a set of economic institutions ensuring such secure property rights? The answer is often no (even assuming that “society” wants to do so).

The problem is that the political elites - those in control of political power - cannot commit to respect the property rights of the producers once the investment are under­taken. Naturally, ex ante, before investments are undertaken, they would like to promise secure property rights. But the fact that the monopoly of political power in their hands implies that they cannot commit to not hold-up producers once the investments are sunk.

This is an obvious parallel to the hold-up problem in the theory of the firm, where once one of the parties in a relationship has undertaken investments specific to the relationship, other parties can hold her up, and capture some of the returns from her investments. As in the theory of the firm, the prospect of hold-up discourages invest­ment. But now the problem is much more severe, since it is not only investments that are specific to a relationship that are subject to hold-up, but all investments.

This is therefore an example of how inefficient economic institutions arise because of a monopoly of political power. Those with political power cannot commit not to use their political power ex post, and this translates directly into a set of economic institu­tions that do not provide secure property rights to groups without political power.

The reason why these inefficient economic institutions persist (or may be the equi­librium institutions of the society) is related to commitment problems. Parallel to our above example of inducing the dictator to relinquish power, there are two ways to intro­duce secure property rights. First, in principle, political elites could promise to respect property rights. However, mere promises would not be credible, unless backed up by the political elites relinquishing power, and this would mean relinquishing their rents and privileges. Second, political elites can be bought off by the beneficiaries of a sys­tem of more secure property rights. This would typically be achieved by a promise of future payments. For example, after investments are undertaken and output is produced, a share can be given to the political elites. But, as pointed out above, there is another, reverse commitment problem here; the beneficiaries of the new regime cannot commit to make the promised payments to the previous political elites.

Many real world examples illustrate the commitment problems involved in limiting the use of political power. In practice, although buying off dictators and persuading them to leave power is difficult, there have been many attempts to do so, usually by trying to guarantee that they will not be persecuted subsequently. One way of doing this is to give them asylum in another country. Nevertheless, such attempts rarely succeed, most likely again because of commitment problems (the new regime cannot commit to abide by its promises). An illustrative example of this is the attempts by the Reagan administration to persuade Jean-Claude (‘Baby Doc') Duvalier to relinquish power in Haiti in 1986. In the face of a popular uprising and rising social and economic chaos, the Reagan administration, via the intermediation of the Jamaican Prime Minster Edward Seaga, tried to persuade Duvalier to go into exile.

A more common, and in many ways more interesting strategy to induce dictators to relinquish power is to try to structure political institutions so as to guarantee that they will not be punished. Such institutional changes are sometimes important in transitions to democracy. For example, President Pinochet was willing to abide by the results of the 1989 plebiscite he lost in Chile because as a senator the Constitution protected him from prosecution. It was only when he left the country that he was vulnerable.

Although Pinochet’s experience illustrates an example of structuring political insti­tutions to achieve commitment, to create durable institutions constraining future use of political power is difficult in practice. These difficulties are well illustrated by the transition from white rule in Rhodesia to majority rule in Zimbabwe. Facing an un- winable guerrilla war, the white elite in Rhodesia sought to negotiate a transition of majority rule, but with enough institutional safeguards that their rents would be pro­tected. These safeguards included the electoral system they wanted, which was used for the first post-independence elections, and massive over-representation in parliament [Reynolds (1999, p. 163)]. Whites were guaranteed 20% of the seats in the legislature for seven years despite making up only 2-3% of the population and were guaranteed 10 seats of the 40 seat senate. Clauses of the 1980 Constitution were also aimed at directly guaranteeing the property rights of the whites. In particular land reform was outlawed for 10 years after which it could only take place if compensated.

The white negotiators at the Lancaster House talks in 1979 that produced these agree­ments understood that any promises made by the black majority negotiators about what would happen after independence could not be believed.

6.2. Political losers

Another related source of inefficient economic institutions arises from the desire of political elites to protect their political power. Political power is the source of the in­comes, rents, and privileges of the elite. If their political power were eroded, their rents would decline. Consequently, the political elite should evaluate every potential economic change not only according to its economic consequences, such as its effects on economic growth and income distribution, but also according to its political conse­quences. Any economic change that will erode the elite’s political power is likely to reduce their economic rents in the long run.

As an example, imagine a change in economic institutions that will increase economic growth, but in doing so, will also enrich groups that could potentially contest political power in the future. Everything else equal, greater economic growth is good for those holding political power. It will create greater returns on the assets that they possess, and also greater incomes that they can tax or expropriate. However, if their potential enemies are enriched, this also means greater threats against their power in the future. Fearing these potential threats to their political power, the elites may oppose changes in economic institutions that would stimulate economic growth.

That the threat of becoming a political loser impedes the adoption of better insti­tutions is again due to a commitment problem. If those who gained political power from institutional change could promise to compensate those who lost power then there would be no incentive to block better institutions.

There are many historical examples illustrating how the fear of losing political power has led various groups of political and economic elites to oppose institutional change and also the introduction of new technologies. Perhaps the best documented examples come from the attitude of the elites to industrialization during the nineteenth century [see Acemoglu and Robinson (2000b, 2002)]. There were large differences between the rates at which countries caught up with British industrialization with many countries completely failing to take advantage of the new technologies and opportunities. In most of these cases, the attitudes of political elites towards industrialization, new technology and institutional change appear to have been the decisive factor, and these attitudes were driven by their fears of becoming political losers. These issues are best illustrated by the experiences of Russia and Austria-Hungary.

In both Russia and Austria-Hungary, absolutist monarchies feared that promoting industrialization would undermine their political power. In Russia, during the reign of Nikolai I between 1825 and 1855 only one railway line was built in Russia, and this was simply to allow the court to travel between Moscow and St. Petersburg. Economic growth and the set of institutions that would have facilitated it were opposed since, as Mosse (1992, p. 19) puts it “it was understood that industrial development might lead to social and political change”. In a similar vein, Gregory (1991, p. 74) argues: “Prior to the about face in the 1850s, the Russian state feared that industrialization and modernization would concentrate revolution minded workers in cities, railways would give them mobility, and education would create opposition to the monarchy”.

It was only after the defeat in the Crimean War that Nikolai’s successor, Alexandr II, initiated a large scale project of railway building and an attempt to modernize the economy by introducing a western legal system, decentralizing government, and ending feudalism by freeing the serfs. This period of industrialization witnessed heightened political tensions, consistent with the fears of the elites that times of rapid change would destabilize the political status quo and strengthen their opposition [McDaniel (1991) gives a detailed account of these events, see also Mosse (1958)].

The consensus view amongst historians also appears to be that the main explanation for the slow growth of Austria-Hungary in the nineteenth century was lack of technol­ogy adoption and institutional change, again driven by the opposition of the state to economic change. This view was proposed by Gerschenkron who argued that the state not only failed to promote industrialization, but rather, “economic progress began to be viewed with great suspicion and the railroads came to be regarded, not as welcome carriers of goods and persons, but as carriers of the dreaded revolution. Then the state clearly became an obstacle to the economic development of the country” (1970, p. 89). See also Gross (1973).

The analysis of Freudenberger (1967, pp. 498-499) is similar. As with the Tsar, the Hapsburg emperors opposed the building of railways and infrastructure and there was no attempt to develop an effective educational system. Blum (1943) pointed to the pre-modern institutional inheritance as the major blockage to industrialization arguing (p. 26) that

“these living forces of the traditional economic system were the greatest barrier to development. Their chief supporter was... Emperor Francis. He knew that the advances in the techniques of production threatened the life of the old order of which he was so determined a protector. Because of his unique position as final arbiter of all proposals for change he could stem the flood for a time. Thus when plans for the construction of a steam railroad were put before him, he refused to give consent to their execution ‘lest revolution might come into the country’.”

6.3. Economiclosers

A distinct but related source of inefficiency stems from the basic supposition of the social conflict view that different economic institutions imply different distributions of incomes. This implies that a move from a bad to a better set of economic institutions will make some people or groups worse off (and will not be Pareto improving). This in turn implies that such groups will have an incentive to block or impede such institutional changes even if they benefit the whole of society in some aggregate sense.

The idea that economic losers impede the choice of efficient economic institutions and economic policies is widespread in economics and was seen earliest in the litera­ture on international trade. Even though free trade may be socially desirable, individuals invested in sectors in which an economy does not enjoy comparative advantage will lose economically from free trade. Since at least the work of Schattschneider (1935) the role of economic losers has been central in understanding why free trade is not adopted. In the context of development economics, this idea was first discussed by Kuznets (1968), developed at length by Olson (1982, 2000) and Mokyr (1990), and for­malized by Krusell and Rios-Rull (1996) and Parente and Prescott (1999, 2005). Most of the examples discussed in the development literature on economic losers are about technological change - people with specific investments in obsolete technology try to block the introduction of better technology. The most celebrated example is the case of the Luddites, skilled weavers in early nineteenth century England who smashed new mechanized looms which threatened to lead to massive cuts in their wages [see Thomis (1970), Randall (1991)]. Scott (2000, p. 200) relates a similar example from modern Malaysia, “When, in 1976, combine harvesters began to make serious inroads into the wages of poor villagers, the entire region experienced a rash of machine-breaking and sabotage reminiscent of the 1830s in England”.

That better economic institutions are blocked by individuals whose incomes are threatened by such change is again due to a problem of commitment. If those whose incomes rose when economic institutions changed could promise to compensate those whose incomes fell then there would be no incentive to block better economic insti­tutions. Nevertheless, it is difficult to commit to such transfers. To consider again the example of the Luddites, the factory owners could have promised to pay the weavers high wages in the future even though their skills were redundant. Once the new technol­ogy was in place however, owners would have a clear incentive to fire the weavers and hire much cheaper unskilled workers.^[267]

Although the problem of economic losers is appealing at first sight, has received some attention in the economics literature, and fits into our framework by emphasizing the importance of commitment problems, we view it both theoretically and empirically less important than the holdup and the political loser problems. First, as pointed out in Acemoglu and Robinson (2000b), in theories emphasizing issues of economic losers, there are implicit assumptions about politics, which, when spelled out, imply that po­litical concerns must be important whenever issues of economic losers are present. The idea of economic losers is that certain groups, fearing that they will lose their eco­nomic rents, prevent adoption of beneficial economic institutions or technologies. The assumption in this scenario is that these groups have the political power to block so­cially beneficial changes. But then, if they have the political power to block change, why would not they allow the change to take place and then use their political power to redistribute some of the gains to themselves? The implicit assumption must therefore be that groups losing economically also experience a reduction in their political power, making it impossible for them to redistribute the gains to themselves after to change takes place. This reasoning therefore suggests that whether certain groups will lose eco­nomically or not is not as essential to their attitudes towards change as whether their political power will be eroded. Problems of political losers therefore seem much more important than problems of economic losers.

Possibly for this reason, advocates of the economic losers view have been unable to come up with any well documented examples where the economic losers hypothesis can actually explain first-order patterns of development. For instance, while it is true that the Luddites tried to break machines, they singularly failed to halt the progress of agricultural technology in nineteenth century Britain. The same is true for Malaysia in the 1970s, one of the fastest growing economies in the world at that time. Neither set of workers had sufficient political power to stop change. Indeed, when political powerful groups became economic losers, such as landowners in nineteenth century England who saw land prices and agricultural rents fall rapidly after 1870, they did nothing to block change because their political power allowed them to benefit from efficient economic institutions [Acemoglu and Robinson (2002)].

Perhaps the most interesting failure of economic losers to halt progress in English economic history comes from the impact of the enclosure of common lands. Land has not always been privately owned as property. In much of Africa land is still owned communally, rather than individually, and this was true in Medieval Britain. Starting around 1550 however an ‘enclosure movement’ gathered pace where ‘common land’ was divided between cultivators and privatized. By 1850 this process of enclosures had made practically all of Britain private property.

Enclosure was a heterogenous process [Overton (1996, p. 147)] and it also took place at different times in different places. Nevertheless, most of it was in two waves, the so called ‘Tudor enclosures’ between 1550 and 1700 and the ‘parliamentary enclosures’ in the century after 1750.

“From the mid-eighteenth century the most usual way in which common rights were removed was through a specific act of parliament for the enclosure of a par­ticular locality. Such acts... made the process easier because enclosure could be secured provided the owners of a majority (four fifths) of the land, the lord of the manor, and the owner of the tithe agreed it should take place. Thus the law of parliament (statue law) only took account of the wishes of those owning land as opposed to the common law which took account of all those who had both owner­ship rights and use rights to land. Moreover... in some parishes the... majority could be held by a single landowner... parliamentary enclosure often resulted in a minority of owners imposing their will on the majority of farmers” [Overton (1996, p. 158), italics in original].

The historical evidence is unanimous that the incentive to enclose was because “en­closed land was worth more than open common field land... the general consensus has been that rents doubled” [Overton (1996, p. 162)]. More controversial is the source of this increase in rent. Overton continues (pp. 162-163) “The proportion of profits taken as rents from tenants by landlords is the outcome of a power struggle between the two groups, and the increase in rent with enclosure may simply reflect an increase in landlord power”. Allen (1982, 1992) showed, in his seminal study of the enclosure movement in the South Midlands, that the main impact was a large increase in agricultural rents and a redistribution of income away from those cultivators who had previously used the commons.

The enclosure of common land thus led to a huge increase in inequality in early modern England. Many peasants and rural dwellers had their traditional property rights expropriated. In protest, groups of citizens dispossessed by enclosure attempted to op­pose it through collective action and riots - attempting to influence the exercise of political power. These groups were no match for the British state, however. Kett’s rebel­lion of 1549, the Oxfordshire rebellion of 1596, the Midland Revolt of 1607, and others up to the Swing Riots of 1830-1831 were all defeated [see Charlesworth (1983)]. The presence of economic losers did not prevent this huge change in economic institutions and income distribution.

6.4. The inseparability of efficiency and distribution

Commitment problems in the use and the allocation of political power therefore intro­duce a basic trade-off between efficiency and distribution. For example, when lack of commitment causes hold-ups, those who hold political power know that people will not have the right incentives to invest so growth will be low. In response to this, they might voluntarily give away their power or try to create political institutions that restricted their power. Such a change in political institutions would create better investment in­centives. Though this situation is hypothetically possible and has formed the basis for some theories of institutional change [e.g., Barzel (2001)] it appears to be insignifi­cant in reality. Even faced with severe underinvestment, political elites are reluctant to give away their power because of its distributional implications, i.e., because this would reduce their ability to extract rents from the rest of society. Thus poor economic institu­tions, here lack of property rights and hold-up, persist in equilibrium because to solve the problem, holders of political power have to voluntarily constrain their power or give it away. This may increase the security of property in society and increase incentives to invest, but it also undermines the ability of rulers to extract rents. They may be better off with a large slice of a small pie.

Similar phenomena are at work when there are either political or economic losers. In the first case, namely a situation where political power holders anticipate being political losers, promoting good institutions directly reduces the political power and rents of in­cumbents and a similar trade-off emerges. Adopting efficient economic institutions will stimulate growth, but when the political status quo is simultaneously eroded the amount of rent accruing to the initially powerful may fall. In the second case, the incomes of those with political power to determine economic institutions falls directly when better economic institutions are introduced. In the absence of credible commitments to side­payments, those whose incomes fall when better economic institutions are introduced have an incentive to block such institutions.

Because commitment problems seem so endemic in collective choice and politics, it seems natural to believe that institutional change has significant distributional conse­quences and as a result there will be conflict over the set of institutions in society.

6.5. Comparativestatics

Our analysis so far has made some progress towards our theory of differences in eco­nomic institutions. Although our full theory is yet to be developed in the later sections, the different mechanisms discussed in this section already point out the major compara­tive static implications of our approach regarding when economic institutions protecting the property rights of a broad cross-section of society are likely to be adopted, and when they are likely to be opposed and blocked. We now briefly discuss these comparative statics.

Hold-up, political loser and economic loser considerations lead to some interesting comparative static results which can be derived by considering the political institutions that lie behind these phenomena.

1. First, the perspective of hold-ups immediately suggests that situations in which there are constraints on the use of political power, for example, because there is a balance of political power in society or a form of separation of powers between different power-holders, are more likely to engender an environment protecting the property rights of a broad cross-section of society. When political elites cannot use their political power to expropriate the incomes and assets of others, even groups outside the elite may have relatively secure property rights. Therefore, constraints and checks on the use of political power by the elite are typically conducive to the emergence of better economic institutions

2. Second, a similar reasoning implies that economic institutions protecting the rights of a broad cross-section are more likely to arise when political power is in the hands of a relatively broad group containing those with access to the most impor­tant investment opportunities. When groups holding political power are narrower, they may protect their own property rights, and this might encourage their own investments, but the groups outside the political elites are less likely to receive adequate protection for their investments [see Acemoglu (2003b)].

3. Third, good economic institutions are more likely to arise and persist when there are only limited rents that power holders can extract from the rest of society, since such rents would encourage them to opt for a set of economic institutions that make the expropriation of others possible.

4. Finally, considerations related to issues of political losers suggest that institutional reforms that do not threaten the power of incumbents are more likely to succeed. Therefore, institutional changes that do not strengthen strong opposition groups or destabilize the political situation are more likely to be adopted.

6.6. The colonial experience in light of the comparative statics

We now briefly return to the colonial experience, and discuss how the comparative sta­tics discussed here shed light on the differences in economic institutions across the former colonies and the institutional reversal.

The second comparative static result above suggests a reason why better economic institutions developed in places where Europeans settled. In these societies, a relatively broad-based group of Europeans came to dominate political power, and they opted for a set of economic institutions protecting their own property rights. In contrast, in places where Europeans did not settle, especially where they were a small minority relative to a large indigenous population, they did not have the incentives to develop good economic institutions because such institutions would have made it considerably more difficult for them to extract resources from the rest of society.

The third comparative static suggests an important reason why in places with more wealth, resources and also a high density of indigenous population to be exploited, Europeans were more likely to opt for worse institutions, without any protection for the majority of the population, again because such institutions facilitated the extraction of resources by the Europeans.

The first comparative static result, in turn, is related to the persistence of the differ­ent types of economic institutions that Europeans established, or maintained, in different colonies. In colonies where Europeans settled in large numbers, they also developed po­litical institutions placing effective checks on economic and political elites. In contrast, the political institutions in colonies with high population density, extractive systems of production, and few Europeans, concentrated power in the hands of the elite, and built a state apparatus designed to use coercion against the majority of the population. These different political institutions naturally implied different constraints on political and economic elites. In the former set of colonies, there were constraints on the devel­opment of economic institutions that would favor a few at the expense of the majority. Such constraints were entirely absent in the latter set of colonies.

Finally, the fourth comparative static is useful in thinking about why many colonies did not attempt to change their economic institutions during the nineteenth century when new economic opportunities made their previous system based on forced labor, slavery, or tribute-taking much less beneficial relative to one encouraging investment in industry and commerce. Part of the answer appears to lie in the fact that the political power of the elites, for example of the plantation owners in the Caribbean, was intimately linked to the existing economic system. A change in the economic system would turn them into political losers, an outcome they very much wanted to avoid.

6.7. Reassessment of the social conflict view

So far we have shown that the econometric evidence is convincing that differences in economic institutions are the root cause of differences in prosperity. We then argued that although there are different approaches which can account for variation in economic in­stitutions, the most plausible approach is the social conflict view. Though we believe that there certainly are instances where history and ideology matter for the institutional structure of society, and clearly institutions are highly persistent, the most promising approach to understanding why different countries have different institutions is to fo­cus on choices and their subsequent consequences. The social conflict view emphasizes the distributional implication of economic institutions and how commitment problems imply that efficiency and distribution cannot be separated. Hence the fundamental con­flict within society over the nature of economic institutions has important implications for economic performance. Some economic institutions will promote growth, but they will not necessarily benefit all groups in society. Alternative economic institutions may induce economic stagnation, but may nevertheless enrich some groups. Which set of institutions results and whether or not a society prospers will be determined by which of these groups has the political power to get the institutions that differentially benefit them. At this point we have therefore substantiated the first three points we made in the introduction. To develop our theory of economic institutions further we need to be more specific about political power - where it comes from and why some people have it and not others. We undertake this task in Section 8. Before doing this however the next section discusses three important historical examples of the evolution of economic institutions. We use these examples to show the explanatory power of the social conflict view and to begin to illustrate in concrete settings how political power works.

7.