Why are some countries much poorer than others? According to several economists, the

fundamental explanation of comparative growth is differences in institutions. Critically

examine this view, using the recent studies on ‘reversal of fortunes’ and ‘colonial origins’.

Introduction

What has caused income levels in the world’s richest and poorest nations to differ by a factor of

over 100? Despite this being one of the most potent questions within modern day economics

there is no definitive answer, nevertheless many factors have been found significant in

explaining the trend. The proximate causes of growth are widely regarded to be initial per

capita income, investment and quality of human capital; however these are largely foundations

of economic growth and do not identify the origin of the current income disparity. In order to

examine the root causes of comparative growth disparities, I will examine the four factors

identified by Rodrik et al (2003) (shown in Figure 1) as well as analysing culture and factor

endowments. A key problem with examining these determinants is highlighted in Figure 1 with

these factors being largely interrelated; this makes it hard to isolate the endemic cause of a

countries relative success or failure. Despite this, all of these factors can be said to go some way

in explaining why some countries are poorer than others.

Institutions

Institutions are broadly defined as rules of structured social interaction and are a vital

mechanism for organising human exchange. A country’s institutional quality is often stated to be

the most important factor in determining a nation’s income levels, with the prominent

development economist Dani Rodrik (2003, pg. 4) stating “the quality of institutions trumps

everything else” with regards to comparative growth. This is due to their function of allocating,

encouraging and enabling investment in human and physical capital, which in turn should lead

to future economic growth and prosperity.

However there are differing views with regards to the efficiency of institutions which in turn

alters the possible impact institutions have on comparative growth. North and Thomas (1973)

Figure 1: The deep determinants of income, (Rodrik et al, p.24, 2002)

support the ‘efficiency view of institutions’ stating that the institutions present within a nation

are chosen by society in order to maximise the social surplus. Under this view a government will

only enforce property rights where it is efficient to do so and therefore differences in

institutions result from either accidents or variances in a nation’s characteristics. With this

assumption institutional quality will have no effect on the wealth of a nation, unless nations are

trying to achieve economic and social goals due to disparities in culture.

Yet there are a number of historical examples of how differences in institutions have affected

comparative growth, suggesting that the conflict view of institutions (whereby institutions are

not chosen by the whole society) is indeed correct. The countless examples of embezzlement

and corruption carried out by governments support the existence of predatory institutions

whereby the institutions are chosen by the few most powerful members of society. This is the

most widely held belief regarding institutions in a nation, and it is largely assumed that not all

institutions maximise a nation’s social surplus.

The study on “Colonial Origins”, conducted by Acemoglu et al. (2001) finds institutional quality

to be the major determinant of comparative growth, through the deployment of a 2SLS

regression using the mortality rates of colonial settlers as a proxy for institutional quality. The

logic behind this is that settler mortality had an important effect on the type of institutions that

were created in lands that were colonised by the main European powers. Where the colonisers

faced relatively few health risks in nations such as the US, they formed solid institutions that

protected property rights and wrote the rules of law. In other colonies such as Congo where

health risks were much higher, they were most concerned with extracting a large amount of

resources as quickly as possible and did not erect such institutions. Using settler mortality as a

determinant of average protection against expropriation risk, (used as a proxy for institutional

quality), we find in table 4 that expropriation risk is both statistically and quantitatively

significant. However the R2 values are still relatively low for all samples suggesting that there

are other important determinants in Log GDP.

Table 1: 2SLS regression of institutional quality (protection against expropraition risk) on Log GDP, standard error in parenthesis (Acemoglu et al., p. 1386,2001

However economists such as Gleaser (2004) think that protection against expropriation risk is a

weak proxy for institutional quality as it does not code dictators who choose to respect property

rights any differently than democratic leaders who are obliged to accept them. Protection

against expropriation risk is also largely caused by growth, causing more doubts that causality

runs from growth to expropriation risk rather that the other way round.

The study on the “Reversal of Fortunes” also written by Acemoglu et al. (2003) expands on this

view coining the “Institutions Hypothesis” which focuses on how European overseas empires

from the sixteenth century onwards caused major institutional changes. The paper also

mentions an “Institutional Reversal” which describes the development of new institutions in

previously poor areas, whilst maintaining existing extractive institutions in previously

prosperous places. Acemoglu et al. (2003) use urbanisation as a proxy for relative income and

again finds that there was indeed a ‘reversal of urbanisation’ from 1900 to the present day. This

was largely due to European colonisers finding it easier and more lucrative to settle in

previously sparsely populated areas.

Therefore both of these studies wholeheartedly support the view that differences in institutions

is the paramount explanation for comparative growth.

Culture

Culture is measured by indicators of individual values and beliefs and is often included as a

subsection of institutions. Despite being hard to isolate economists such as Tabellini (2005)

have found that cultural traits due to history are strongly correlated with current economic

development when controlling for a number of factors. Culture can be used to describe the

differing economic and social objectives of an economy which in turn have an effect on the

institutions of a nation. The culture of a nation is not mentioned in either paper however in the

“colonial origins” study culture could have been determined by the number of colonial

settlements, with the European settlers imparting their attitudes and beliefs to the regions.

Factor Endowments/Initial Income

Many of the success stories of economic development over the last hundred years can be

attributed to countries initial Factor endowments. Countries such as the UAE, Botswana and

Malaysia have all benefited from their reserves of highly sought after natural resources, whilst

nations in East Asia have grown in recent years due to their relative labour abundance.

Engerman and Sokoloff (1994) suggest that the root of Canada and the US’s growth can be

attributed to their relative factor endowments, whilst also highlighting the importance of their

institutions. Historic GDP can also be said to be a significant determinant of a nation’s wealth

today, with the richest nations in 1900 still remaining at the top of the leader board.

A major explanation for this trend is that a nation can use its initial wealth, or the revenues it

generates from the sales of natural resources to invest in human capital and infrastructure in

order to boost economic growth. For example the UAE state of Dubai (Kleibert 2012) has

invested the revenues they have received from oil and natural gas in order to successfully

diversify their economy through becoming an International Financial sector and high class

tourism destination. However there have been many nations such as Nigeria that defy this

trend, which has led to the phrase “natural resource curse” (Auty 1993) furthering the case for

the importance of institutions. The “Colonial Origins” paper (Acemoglu et al 2001) finds that

natural resources have been historically inconsequential in determining growth, with the p-

values for natural resources and soil quality proving insignificant when included as factors in

determining GDP.

The “Reversal of Fortunes” paper disputes the view of Engerman and Sokoloff (1994),

mentioning that if economic growth was caused directly by the extraction of resources the

reversal would have occurred immediately after colonisation, which in the United States case

was around 1600. However as can be seen in Figure 2 the growth of urbanisation in the US

occurred mostly in the eighteenth and nineteenth centuries implying that the growth in

urbanisation was caused by industrialisation (Figure 3). Nevertheless resource endowments

could have had a major effect on the extent of industrialisation. Pomeranz (2000) mentions the

importance of the accessibility of coal during industrialisation, suggesting that coal had a great

effect on the divergence of growth between the east and west during the industrialisation

period. This connotes that natural endowments instead of institutions could have been the key

determinant of growth during industrialisation, which has led to some of the wealth disparities

today.

Figure 2: Urbanization Rate in India, the United States, and New World Countries, (Acemoglu et al. 2002, p.1257)

Geography

Geography is a key determinant of climate, endowment of natural resources, disease burden,

transport costs and diffusion of knowledge and technology from more developed areas. The

‘Geography hypothesis’ supported by well-regarded economists such as Sachs (2001) and

Diamond (1997) concludes that geography is the main factor in determining a nation’s growth;

this is supported by the undeniable trend between a country’s location and its current GDP

(Figure 5). We have already seen the importance of geography with regards to factor

endowments however the climate and disease burden of a nation can be argued to be more

salient factors in a nation’s long term success.

The climate of a nation is shown to have had a large effect on the prosperity of a nation’s

agricultural industry and has also been attributed to influencing the productivity of labour. The

Figure 4: GDP per capita by latitude (World Bank, 1997c, Tobler, Esri)

Figure 3: Industrial Production per Capita, 1750-1953 (Acemoglu et al. 2002, p.1258)

Koeppen-Geiger climate zones map (Figure 6) clearly shows that there is a relationship between

climate and wealth with the majority of the world’s developed regions lying within the

temperate-snow zone. The “Reversal of Fortunes” paper looks at climate by analysing the

‘temperate drift hypothesis’ which highlights that particular climatic characteristics that were

not useful in 1500, for ex-colonies have turned out to be beneficial today. This hypothesis

focusses on how the introduction of more advanced agricultural techniques such as the heavy

plough benefitted the temperate-snow regions, with Myrdal (1968, Ch. 14) mentioning that

technologies could diffuse within ecological zones but not across, allowing the temperate

colonies to grow at the expense of tropical colonies. However the wealth of colonies reversed

much later than the introduction of modern European farming techniques to colonial regions in

the sixteenth to eighteenth centuries connoting that this was not a significant factor.

Sachs (2000, 2001) draws on the importance of a country’s disease burden in determining

comparative growth. Countries in tropical regions have been historically hampered by diseases

such as malaria, which has caused a reduction in the quality of human capital and forces

resources to be invested into areas which do not directly cause growth. However the “Colonial

Origins” paper finds these factors trivial with the coefficients for geography and climate related

diseases insignificant or very small in value when a proxy for institutions is included. Despite

this a nation’s disease burden would have had a large impact on the relevant settler’s mortality

rate which the paper concludes to have had a prime effect on the comparative growth of a

country, meaning that this factor could therefore be seen as a causal factor for the quality of a

country’s institutions.

Trade and Integration

Basic Ricardian theory (1815) highlights the positive effect trade can have on economic growth,

with free trade allowing nations to specialise in goods in which it they hold a comparative

advantage and as a result obtain a consumption bundle outside its PPF.

The benefits of trade have also been seen empirically in recent years with previously closed

economies such as China and ex-Soviet states opening up their economies to trade and

subsequently benefitting from increased trade and integration. However the effects of trade and

integration are hard to isolate because they are highly correlated to a nation’s institutional

framework. Despite this including a proxy for trade in regression analysis, allows us to gage

Figure 5: Koeppen-Geiger climate zones, (Augero, 2001)

whether an institutions attitude to trade or the institution itself is the key determinant of

growth. Rodrik et al (2003) also found that trade can, have a large indirect effect on institutional

quality furthering its relative importance, and suggesting that institutional quality can be a

causal effect of trade.

As both the “Reversal of Fortunes” and the “Colonial Origins” papers focus on the growth of

historical colonies (all of which were open to trade), they do not extensively analyse the effects

of trade on growth and do not examine the effect of integration at all. However the relative

insignificance of geographic characteristics which are natural determinants of how actively a

nation is able to specialise and engage in free trade, suggests that historical trade levels are not

a notable factor in determining current GDP.

Table 1 shows that a proxy for integration is found to be a statistically and quantitatively

insignificant factor in determining GDP when both geography and institutions are accounted for,

further strengthening institutions case as the most important factor. This can be argued to have

been the case in China, with the opening up its economy in 1978 coinciding with a number of

institutional reforms in the nation and trade can therefore only be said to be one of a number of

factors causing economic growth (Tung, 2005).

Conclusion

My analysis has consistently supported the view that institutional quality is the most salient

factor in explaining the differences in comparative growth. When institutions are controlled for,

it has been shown in multiple OLS and 2SLS regressions, that all other factors are largely

insignificant in determining a nation’s wealth. However we have also seen that the quality of a

nation’s institutions can be highly affected by culture, trade, geography and factor endowments

making these factors still relevant in answering the question of why some countries are poorer

than others. Geographic trends have been found to be particularly influential and connote that

the climate and disease burden of a nation have been notable factors in determining a nation’s

wealth and also its institutions.

The finding of institutional quality as the key determinant of growth can be seen empirically in

the extreme cases of North and South Korea showing the cataclysmic effect institutions can have

on its relative wealth. However the view that a change in institutions will cause economic

growth has to be viewed with caution because one of the major assumptions of the “colonial

Table 2: Determinants of development- geography and institutions , t statistics in parenthesis, (Rodrik 2003 p.31)

origins model” by Acemoglu et al. (2001) is that the relative quality of the institutions in place

has not changed greatly since the colonising era, suggesting that there may be an endemic

cultural problem with regard to institutional change that stems back to the sixteenth century.

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