Why Nations Fail

March 02, 2020

I just finished the book Why Nations Fail and really enjoyed it, and I highly recommend it to everyone. Its theory is that institutions are the most important factor in whether a country is prosperous or whether it’s poor and struggling. I think it makes a strong case for capitalism based on inclusive institutions. It uses some really interesting history to argue its case, and while most theories aren’t as strong as their creators make them out to be I do think it seems like a likely explanation for a big part of the difference between rich and poor countries.

Why Nations Fail is written by two economists, and before publishing the book they wrote a really interesting related paper that I think is worth discussing and learning about. They don’t talk about this paper at all in the book, but it’s directly related to the subject.

The paper is called “The Colonial Origins of Comparative Development” and it uses an interesting approach to show that colonialism (which directly affected the vast majority of countries on this planet) and the institutions established by it are responsible for why some countries are rich and some are poor today. Their hypothesis is that settler mortality determined whether an area was set up with extractive or inclusive institutions, and that those institutions persist to modern times in most places and determine whether a country is rich or poor. They use an instrumental variables approach to determine if their hypothesis is correct, which is a useful approach for determining causality when you can’t run an experiment.

A common example of the instrumental variables approach is cigarette taxes and health. Though it seems obvious, it’s hard to prove with evidence that smoking causes bad health because you can’t force a random group of people to start smoking in order to compare their health outcomes to a control group. Since you can’t do that, it leaves open the possibility that maybe people with bad health choose to smoke as a comfort. In other words it’s difficult to determine which way the causality goes. So instead you can choose an instrumental variable, like cigarette taxes, and see if places with high cigarette taxes have better health. An important factor with instrumental variables is the variable can’t be a direct cause of the final result. The tax itself is going to have no direct effect on health outcomes. It’s only through the tax’s effect on the price of cigarettes that the health outcomes change. Another important component is that your causal chain has to be accurate. If places with higher cigarette taxes don’t actually have less smoking then even if their health is better your theory is busted. The causal chain is broken because smoking isn’t less than in other places. So using that instrumental variables approach you can indeed find that places with higher cigarette taxes have less smoking and better health. This is strong evidence of the link between smoking and bad health outcomes, and my understanding is instrumental variable approaches like this are kind of the gold standard in studying things where you can’t run a randomized controlled trial.

The paper uses settler mortality as their instrumental variable. They theorize that settler mortality determined whether institutions became inclusive or extractive. In South America and Africa settler mortality was high due to disease. So the theory is that instead of settling there and establishing colonies where settlers would come to live, they set up extractive institutions to get slaves and gold. They established institutions based on forced labor, few or no rights, and the colonists using power and violence to rule with an iron fist and extract the wealth for themselves. In contrast, places like North America, New Zealand, and Australia had lower settler mortality. The colonists moved there to live, eventually setting up institutions where they would have political power and rights. The quote below is from the paper, discussing places where extractive institutions were developed.

This is in sharp contrast to the colonial experience in Latin America during the seventeenth and eighteenth centuries, and in Asia and Africa during the nineteenth and early twentieth centuries. The main objective of the Spanish and the Portuguese colonization was to obtain gold and other valuables from America. Soon after the conquest, the Spanish crown granted rights to land and labor (the encomienda) and set up a complex mercantilist system of monopolies and trade regulations to extract resources from the colonies.

Europeans developed the slave trade in Africa for similar reasons. Before the mid-nineteenth century, colonial powers were mostly restricted to the African coast and concentrated on monopolizing trade in slaves, gold, and other valuable commodities–witness the names used to describe West African countries: the Gold Coast, the Ivory Coast.

But wait, couldn’t it be that places with high mortality are poorer just because they have more people dying making it harder to succeed? The paper addresses this point by noting that the mortality of native people was a lot lower than that of settlers. Many Africans develop a resistance to malaria so that while it’s still dangerous in childhood, adults are often not affected by it. Settler mortality often differed drastically from native mortality, and therefore using settler mortality is still valid.

Something interesting the paper notes about settler awareness of mortality rates is that the early pilgrims who arrived to settle the United States had originally planned to go to Guyana until they learned of the high mortality rates in Guyana. People had enough information to have a good idea which places were deadly and which were safer to settle in.

They also present evidence to prove their theory that early institutions are hard to change and often still persist to this day, which is why those early institutions are so important for modern day wealth.

So the causal chain the paper uses is this:

(Potential) settler mortality –> settlements –> early institutions –> current institutions –> current performance

They find that their hypothesis is strong and accounts for a good portion of the difference in modern day wealth and performance. Places with high settler mortality are much poorer on average than those with low settler mortality, and they show that the causal chain holds up and that the type of institutions (extractive or inclusive) matters a lot.

They check their work by controlling for or including a number of other factors like geography, colony origin (British, French, Dutch, etc.), prevalence of malaria, and so on. They find these other factors have little effect on the results and conclude that settler mortality and its effect on institutions is the most important factor.

Like all theories it’s not perfect, and I know there has been some back and forth between the authors and another economist who criticized the quality of the settler mortality data. Getting accurate data from a few hundred years ago can be difficult. But it does seem to be a pretty convincing theory that seems to me to be respected by the authors’ peers. Even if it doesn’t explain all of the difference between rich and poor countries I think it makes a pretty strong case that the type of institutions a country has are important for its development and that those institutions depend on historical factors and can be difficult to change.

Link to paper: https://economics.mit.edu/files/4123