Neoclassical growth theory explains differences in per capita income between countries with different paths of accumulation of production factors such as physical and human capital. These, in turn, are due to differences in propensity to save, preferences or other exogenous parameters, such as total factor productivity or technological progress. On closer inspection, however, factors such as innovation, education and capital accumulation are not fundamental but only indicative causes underlying growth. The question remains why innovation, education or investment are higher in some countries than in others. In the literature, three main causes are discussed.

North and Thomas (1973) argue that the fundamental causes of growth can be found in institutions. According to North’s (1990) definition, institutions represent the rules of the game in a society, they are both informal rules (such as taboos, customs, traditions) and formal rules (such as constitutions, laws, property rights). Institutions exert a decisive influence on the incentives in interpersonal exchange, be it in political, social, or economic contexts. In theory, countries that guarantee property rights and protection against expropriation for broad sections of the population invest more in physical and human capital, so the returns on productive investments remain where the risk is borne. This allows resources to be channeled more efficiently to different uses. If, in extreme cases, markets are absent, as in a planned economy, exchange advantages go unused.

Geography is discussed as another fundamental cause. In contrast to man-made institutions, the focus here lies on natural conditions such as climate and ecology. It is therefore conceivable that the climate has a significant influence on performance, work incentives and labor productivity. The different prevalence of diseases (e.g. malaria) and the associated differences in mortality rates are also seen as possible fundamental causes of income differences between countries. Since geographical conditions remain constant over time or change only very slowly, this simplified version of the geography hypothesis cannot explain significant changes in income differences that have occurred in the past. However, there are more nuanced versions of the geography hypothesis, according to which geographical conditions can be advantageous or disadvantageous depending on the state of technology (e.g. in agriculture).

Finally, another strand of literature focuses on culture. Culture (including religion) is seen as a key determinant of the values, preferences and beliefs of individuals and societies, which in turn exert a significant influence on economic activity. For example, it is argued that the origins of industrialization in Western Europe can be traced back to the Reformation, as Protestantism conveyed values that emphasized hard work and thrift.

Empirical Evidence

In recent history, two natural experiments offer insight into the profound effects that different institutions can have. The division of Korea into northern and southern parts and the division of Germany into eastern and western parts provide examples of this. While the geographical and cultural conditions remained unchanged after the division, the economic institutions underwent a fundamental transformation. One part of the country was oriented towards communism and a planned economy (North Korea, East Germany), while the other was oriented towards capitalism and a market economy (South Korea, West Germany). Starting from a similar level of prosperity, significant differences in economic performance and living standards emerged within a few decades after the division. While GDP per capita in North Korea is currently 1,700 US dollars (at purchasing power parity), it is 25 times higher in South Korea at 43,000 US dollars.

Of course, these are just two - albeit striking - observations. However, a correlation between institutions and economic performance is also evident across all countries. Figure 1 shows the correlation between GDP per capita (as a measure of economic performance) and selected subcategories of the Heritage Foundation’s Index of Economic Freedom (as a measure of the relevant economic institutions) for 2021. Specifically, these are:

  • Property rights (physical and intellectual property rights, strength of investor protection, risk of expropriation, quality of land administration)
  • Judicial effectiveness (judicial independence, quality of the judicial process)
  • Government integrity (irregular payments and bribes, transparency, corruption)
  • Business freedom (time, cost and effort for starting and closing a business, approval procedures)
The correlation with GDP per capita is positive for all four measures. Countries with more secure property rights, more effective legal protection, less corruption or lower bureaucratic costs for business start-ups and dissolutions have a higher economic output per capita. The differences in income are immense (note the logarithmic scale for GDP per capita). At 44,000 US dollars, New Zealand, a country with a high index value for the protection of property rights, has a GDP per capita that is approximately 24 times higher than Haiti, a country with a very low value (both countries are located roughly on the regression line in Figure 1, top left).

The apparent positive correlation between institutions and economic performance does not automatically imply that better institutions are the cause of higher economic performance. It is equally conceivable that a higher level of prosperity results in better institutions (reverse causality) or that a third factor, such as geography or culture, influences both institutions and economic performance in the same direction.2

To address this identification problem, empirical studies typically employ the instrumental variable approach. The most significant example is a series of studies by Daron Acemoglu and coauthors, which utilize the colonization of large parts of the globe by Europeans beginning in the 15th century as a large-scale natural experiment (Acemoglu, Johnson and Robinson 2001, 2002, 2005). The starting point is the observation that a reversal in the prosperity of the former colonies occurred ("Reversal of Fortune"). Some cultures, such as those in India and Central and South America, were among the richest in the world before colonization, whereas the countries that emerged on these territories are currently underdeveloped. Conversely, many of the countries whose territories were underdeveloped before colonization are now among the richest in the world (e.g. USA, Canada, New Zealand, Australia). There has been no such reversal in the non-colonized rest of the world. Also over the 500 years preceding colonization, there was no significant change in the global differences in economic performance.

Acemoglu et al. argue that the reversal in the prosperity of former colonies was caused by the different institutions that Europeans established in their colonies. Colonies that were relatively rich at the outset (in terms of population density or urbanization in 1500) were more likely to receive "extractive institutions" in the course of colonization, which concentrated political power in the hands of a small elite in combination with a high risk of expropriation for the majority of the population. Due to the considerable wealth of the colonies, the European colonizers were primarily interested in exploiting them. In contrast, less developed, sparsely populated regions where Europeans settled and quickly formed the majority of the population tended to be exposed to more "inclusive institutions" (Donges, Meier and Silva 2022). The interest here was not in exploitation, but in creating favorable conditions for themselves, such as a high level of protection of property rights. The various institutions that were created in the different regions have, for the most part, remained in place to this day.

The spread of diseases in the colonies that were life-threatening for Europeans played a significant role in determining whether Europeans exploited a colony or settled in large numbers. In contrast to the indigenous population, Europeans had no immunity to tropical diseases such as malaria and yellow fever. Consequently, they tended to settle in places where there was a relatively low mortality rate among the settlers. Acemoglu et al. (2001) demonstrate that property rights were (and continue to be) less protected in former colonies where settler mortality was relatively high during the colonial period compared to those with relatively low settler mortality. In their empirical analysis, the authors utilize settler mortality as an external instrument for contemporary institutions and conclude that differences in institutions can explain a significant portion of the current income disparities between countries worldwide.

The authors argue that once controlling for institutions within econometric analyses, geographical factors lose their significance. Consequently, variables such as distance from the equator, temperature, humidity, natural resources, soil quality, access to the sea or the current (as opposed to past) spread of diseases no longer make a significant contribution to explaining income differences globally. According to this interpretation, the infamous spurious correlation between GDP per capita of countries and the distance of these countries from the equator is the result of the lack of immunity of European settlers to tropical diseases during the colonial period, which is why they tended to settle in temperate latitudes and establish advantageous institutions of private property, while exploiting colonies in tropical regions with the help of extractive institutions.

This reversal in prosperity speaks against the simple geography hypothesis, as the geographical conditions either did not change at all or only very slowly in the period under consideration. The timing of the reversal also argues against some more differentiated variants of the geography hypothesis, which see technological progress in agricultural production as playing an important role. The reversal in prosperity did not take place immediately after colonization, but only at the end of the 18th century or the beginning of the 19th century during the course of industrialization. The timing of the reversal, instead, is in line with the institutions hypothesis, as inclusive institutions were supposed to take effect primarily when new technologies open up new investment opportunities and promise high prosperity gains.

Cultural factors also lose their explanatory power when controlling for institutions, according to the studies. Thus, today’s income differences between the countries of the world are not attributable to the identity of the colonial power, the proportion of Europeans in today’s population or the proportion of different religious affiliations in the population. The hypothesis that the identity or culture of the colonial power does not make an important contribution to the explanation is also supported by the fact that a reversal in prosperity also took place among the British colonies.

In addition to colonization, empirical analyses used the French occupation of some German territories after the French Revolution as a natural experiment. The French occupiers implemented a series of extensive institutional reforms in the occupied territories, including the imposition of the "code civil," the abolition of guilds and the remnants of feudalism, and the introduction of equality before the law. In their empirical analysis, Acemoglu et al. (2011) find evidence that German areas, which had been under French influence for longer, subsequently underwent a faster urbanization process (as a measure of economic performance). The evidence supports the idea that the positive effect of institutions on economic growth only came to fruition during the course of industrialization. The results of Donges, Meier and Silva (2022) complement these findings by showing that beneficial institutions had a positive effect on prosperity through increased innovation. In their analysis, the authors demonstrate that the number of patents per capita in 1900 was twice as high in the German counties with the longest period of French occupation than in unoccupied counties. The introduction of the "code civil", equality before the law and the promotion of commercial freedom through the abolition of guilds proved to be particularly effective in enhancing the prosperity of the French territories. Conversely, reforms that increased labor market mobility and agricultural reforms that reduced the power of oligarchs in the countryside were less effective in promoting prosperity. Robustness tests indicate that the finding that the French occupation increased the innovative power of a region in the long term cannot be explained by the fact that the French occupiers merely transferred their culture, knowledge, or technology to the occupied territories.

Critique

The institutions hypothesis is, of course, not entirely uncontroversial. Several research papers have cast doubt on the validity of Acemoglu et al.’s work on the colonial period. Albouy (2012) questions the quality of the data used by Acemoglu et al. (2001) and criticizes, in particular, that settler mortality is not a suitable instrument for analyzing the influence of institutions on economic performance. In a detailed response with numerous robustness tests, Acemoglu et al. (2012) reject the criticism as unfounded and, above all, inconsequential for their core finding. Glaeser et al. (2004) argue that during the colonial period, Europeans primarily brought themselves and their human capital with them, did so to varying degrees depending on the colony, and that this is the cause of today’s income differences between the former colonies. In a detailed empirical analysis, Acemoglu et al. (2014) address this criticism. Contrary to the assumption of Glaeser et al. (2004), the historical evidence shows that Europeans contributed more human capital per capita to the colonies they exploited than to the colonies in which they settled. Furthermore, the authors demonstrate that if the historical determinants of institutions and human capital are controlled for or both are considered as endogenous, the estimated effects of human capital decrease significantly and in some cases become insignificant, while the estimated effects of institutions remain qualitatively and quantitatively robust. The authors interpret their results as confirming their hypothesis that institutions are the fundamental cause of long-term economic growth and that the impact channels include not only physical capital and innovation, but also human capital.

Of particular interest is the study by Michalopoulos and Papaioannou (2014), which examines the relationship between institutions and development levels within Africa. Upon initial examination, the results appear to contradict the institutions hypothesis. The authors argue that the political borders between African countries divide the tribal areas of more than 200 ethnic groups, exposing culturally homogeneous population groups in homogeneous geographical areas to different institutions. The study initially finds no correlation between the level of development (as measured by satellite data on light density at night) and institutions. However, it demonstrates that institutions are positively correlated with the level of development in border regions near capital cities, but that this correlation gradually disappears as regions are located further away from the capital. This evidence is consistent with the hypothesis that in developing countries, laws and formal institutions are enforced and practiced in the capital cities but lose influence with distance to the capital cities.

Notes:

  1. This section draws heavily on Acemoglu, Johnson and Robinson (2005).
  2. In this case, econometric estimates would be biased ("omitted variable bias")

Figure 1: Institutions and gross domestic product per capita in the countries of the world