The Nobel Prize in Economics for 2024 has been awarded to Daron Acemoglu, Simon Johnson and James Robinson (AJR as they are popularly called) for their work on “how institutions are formed and affect prosperity”. The choice of the award is interesting as it not just explains the role of institutions in economic development but also opens Pandora’s Box on role of colonization in economic history.

The Nobel Citation of the 2024 award states this fact “the richest 20 per cent of the world’s countries are now around 30 times richer than the poorest 20 per cent”. Though poorest countries have become richer over the years but the gap between poor and rich countries has persisted. These facts lead to the most important question of economic inquiry: Why are some countries rich and others poor?

The three economists awarded the Nobel Prize in 2024 give one line answer to the question: It is the difference in country’s quality of institutions that determines the income gap.

Long quest for the secret sauce of wealth

The search for an answer to the grandest economics question is hardly new. It drove Adam Smith to write his classic- An Inquiry into the Nature and Causes of Wealth of Nations, which laid the foundations of economics as a discipline. Post-Smith, many economists have tried to answer the question. The answers have varied from productivity, geography, climate, or disease burden as key drivers of economic differences.

Robert Lucas (Nobel Laureate 1995) in a 1988 research paper  wrote the moment one thinks about these inter-country differences in incomes, “it is hard to think about anything else”.  

Even the answer that institutions matter for economic growth is not anything new. Adam Smith and John Stuart Mill suggested institutions as one of the reasons for economic development without calling them institutions.

In the 1970s and 1980s, Douglass North first showed that institutions are the most important factor for long-term growth. North defined institutions broadly as “rules of the game in a society … , which structure incentives in human exchange, whether political, social or economic”. Accordingly, North was awarded the Nobel Prize in 1993 (along with Robert Fogel) for his work on institutions. Before North, Hayek whose Nobel Prize completed 50 years in 2024 had suggested in 1960 that British common law was superior to French Law.

AJR’s path-breaking work on causation

What is novel about AJR is their approach where they show the causation between institutions and economic development. While economists in the past understood that institutions and growth are correlated, they could not convincingly show the causation. There is a possibility that higher economic development itself leads to better institutions. So one could argue that as rich economies are more developed compared to poor economies, they have better institutions.  So, the poor should try generate higher growth which will eventually lead to better institutions. We are running in circles here.

AJR help resolve this circular paradox by using insights from colonial economic history and historical data to show the causation is indeed from institutions to growth. In a way, the 2024 is also an award for economic history. It is also the third consecutive year that Nobel Prize has been awarded for work on economic history. Last year it was given to Claudia Goldin who also used economic history to show trends in labour force participation of women and Ben Bernanke the year before that for his work on the role of banks in the 1930s Great Depression.

Role of colonialism

First, they showed that European colonisers established two types of institutions: inclusive and extractive. Inclusive institutions were those where colonizers established law and property rights system, and extractive were those where both law and property rights were absent. In some colonies, the purpose was to exploit the indigenous population and extract natural resources to benefit the colonisers. In other colonies, they built inclusive political and economic systems for the long-term benefit of European settlers. The countries which had extractive institutions continue to face poorer growth prospects compared to countries which had inclusive institutions.

Why did Europeans establish these different institutions? One major reason was density of local population. If local population was more, it would lead to more resistance but also provide cheap labour for exploitation. As costs of resistance were larger than profits from cheaper labour, most colonisers preferred colonies with lesser population density.

The authors use the diseases and mortality data as an innovation to explain the linkages. There were certain regions which had deadly diseases and higher mortality. The places which had more dangerous diseases (Africa and India) had lesser settlers and thus more extractive institutions. The places where diseases were less (Australia and New Zealand) had more settlers and thus more inclusive institutions.

Fourth, they show that there is a reversal of fortune and once richer countries are poorer today because of extractive institutions. In the richer colonies, once colonisers established more extractive institutions compared to poorer colonies, these extractive institutions continue to influence poorer economic performance today.

Finally, given these lessons, why is it that poor countries simply don’t replace the extractive institutions with inclusive democratic institutions? This is because there is this constant conflict over political power between the ruling elite and the population. Those with extractive political institutions develop this mistrust between elites and people which is difficult to overcome. So institution building is a historical process which has deep consequences for future. So even if elites promise change, people do not believe their commitment. Having said that, as their population is large they can mobilise to force a democratic and inclusive revolution as we keep seeing in different countries regularly. Their research is used to explain how democratization was achieved in Western Europe due to widespread protests as elites were not able to keep their promises.

Case for democracy and China’s future

To sum up, AJR’s research stresses on the importance of inclusive political institutions in economic development. In today’s times, inclusive political systems are associated with democracy.

In 2012, Acemoglu and Robinson published a popular book - Why Nations Fail – to explain their findings to a general audience. The book generated a lot of discussion and controversy. There were questions on how China was able to achieve growth over nearly three decades despite not being a democracy? The authors had responded saying based on their analysis the growth cannot last in China. The prophecy is coming true with Xi Jinping threatening to undermine the economic development of China.

India’s case is opposite of China. Why India did not grow despite building inclusive political institutions by fostering democracy against all odds? India did now grow due to economic policies that restricted private investment and inward orientation. Once India started reforming the economy post 1991, the inclusive political institutions abetted in the development. There is now this widespread thinking that India’s democracy has hindered India’s growth prospects. AJR analysis shows the dangers of such thinking.

Finally, the award also opens the otherwise closed Pandora’s Box on institutions and colonization. Social scientists, outside economics discipline, have often disagreed with economists’ view of institutions. They see it is a much more historical process than the model-driven view of economists. Colonization is also not the simple garden variety as explained by AJR. Even inclusive institutions were highly extractive and exploitative as shown by historical records. The award would have been more balanced if the Committee had chosen scholars who are not primarily economists who work on institutions and negative aspects of colonization. They would showed results that are the opposite of AJR findings!