THE MAKING OF PROSPERITY AND POVERTY THE ECONOMICS OF THE 38TH PARALLEL IN THE SUMMER OF 1945, as the Second World War was drawing to a close, the Japanese colony in Korea began to collapse. Within a month of Japan’s August 15 unconditional surrender, Korea was divided at the 38th parallel into two spheres of influence. The South was administered by the United States. The North, by Russia. The uneasy peace of the cold war was shattered in June 1950 when the North Korean army invaded the South. Though initially the North Koreans made large inroads, capturing the capital city, Seoul, by the autumn, they were in full retreat. It was then that Hwang Pyŏng-Wŏn and his brother were separated. Hwang Pyŏng-Wŏn managed to hide and avoid being drafted into the North Korean army. He stayed in the South and worked as a pharmacist. His brother, a doctor working in Seoul treating wounded soldiers from the South Korean army, was taken north as the North Korean army retreated. Dragged apart in 1950, they met again in 2000 in Seoul for the first time in fifty years, after the two governments finally agreed to initiate a limited program of family reunification.
As a doctor, Hwang Pyŏng-Wŏn’s brother had ended up working for the air force, a good job in a military dictatorship. But even those with privileges in North Korea don’t do that well. When the brothers met, Hwang Pyŏng-Wŏn asked about how life was north of the 38th parallel. He had a car, but his brother didn’t. “Do you have a telephone?” he asked his brother. “No,” said his brother. “My daughter, who works at the Foreign Ministry, has a phone, but if you don’t know the code you can’t call.” Hwang Pyŏng-Wŏn recalled how all the people from the North at the reunion were asking for money, so he offered some to his brother. But his brother said, “If I go back with money the government will say, ‘Give that money to us,’ so keep it.” Hwang Pyŏng-Wŏn noticed his brother’s coat was threadbare: “Take off that coat and leave it, and when you go back wear this one,” he suggested. “I can’t do that,” his brother replied. “This is just borrowed from the government to come here.” Hwang Pyŏng-Wŏn recalled how when they parted, his brother was ill at ease and always nervous as though someone were listening. He was poorer than Hwang Pyŏng-Wŏn imagined. His brother said he lived well, but Hwang Pyŏng-Wŏn thought he looked awful and was thin as a rake.
The people of South Korea have living standards similar to those of Portugal and Spain. To the north, in the so-called Democratic People’s Republic of Korea, or North Korea, living standards are akin to those of a sub-Saharan African country, about one-tenth of average living standards in South Korea. The health of North Koreans is in an even worse state; the average North Korean can expect to live ten years less than his cousins south of the 38th parallel. Map 7 illustrates in a dramatic way the economic gap between the Koreas. It plots data on the intensity of light at night from satellite images. North Korea is almost completely dark due to lack of electricity; South Korea is blazing with light.
These striking differences are not ancient. In fact, they did not exist prior to the end of the Second World War. But after 1945, the different governments in the North and the South adopted very different ways of organizing their economies. South Korea was led, and its early economic and political institutions were shaped, by the Harvard- and Princeton-educated, staunchly anticommunist Syngman Rhee, with significant support from the United States. Rhee was elected president in 1948. Forged in the midst of the Korean War and against the threat of communism spreading to the south of the 38th parallel, South Korea was no democracy. Both Rhee and his equally famous successor, General Park Chung-Hee, secured their places in history as authoritarian presidents. But both governed a market economy where private property was recognized, and after 1961, Park effectively threw the weight of the state behind rapid economic growth, channeling credit and subsidies to firms that were successful.
The situation north of the 38th parallel was different. Kim Il-Sung, a leader of anti-Japanese communist partisans during the Second World War, established himself as dictator by 1947 and, with the help of the Soviet Union, introduced a rigid form of centrally planned economy as part of the so-called Juche system. Private property was outlawed, and markets were banned. Freedoms were curtailed not only in the marketplace, but in every sphere of North Koreans’ lives—except for those who happened to be part of the very small ruling elite around Kim Il-Sung and, later, his son and successor Kim Jong-Il.
It should not surprise us that the economic fortunes of South and North Korea diverged sharply. Kim Il-Sung’s command economy and the Juche system soon proved to be a disaster. Detailed statistics are not available from North Korea, which is a secretive state, to say the least. Nonetheless, available evidence confirms what we know from the all-too-often recurring famines: not only did industrial production fail to take off, but North Korea in fact experienced a collapse in agricultural productivity. Lack of private property meant that few people had incentives to invest or to exert effort to increase or even maintain productivity. The stifling, repressive regime was inimical to innovation and the adoption of new technologies. But Kim Il-Sung, Kim Jong-Il, and their cronies had no intention of reforming the system, or introducing private property, markets, private contracts, or changing economic and political institutions. North Korea continues to stagnate economically.
Meanwhile, in the South, economic institutions encouraged investment and trade. South Korean politicians invested in education, achieving high rates of literacy and schooling. South Korean companies were quick to take advantage of the relatively educated population, the policies encouraging investment and industrialization, exports, and the transfer of technology. South Korea quickly became one of East Asia’s “Miracle Economies,” one of the most rapidly growing nations in the world.
By the late 1990s, in just about half a century, South Korean growth and North Korean stagnation led to a tenfold gap between the two halves of this once-united country—imagine what a difference a couple of centuries could make. The economic disaster of North Korea, which led to the starvation of millions, when placed against the South Korean economic success, is striking: neither culture nor geography nor ignorance can explain the divergent paths of North and South Korea. We have to look at institutions for an answer.
EXTRACTIVE AND INCLUSIVE ECONOMIC INSTITUTIONS Countries differ in their economic success because of their different institutions, the rules influencing how the economy works, and the incentives that motivate people. Imagine teenagers in North and South Korea and what they expect from life. Those in the North grow up in poverty, without entrepreneurial initiative, creativity, or adequate education to prepare them for skilled work. Much of the education they receive at school is pure propaganda, meant to shore up the legitimacy of the regime; there are few books, let alone computers. After finishing school, everyone has to go into the army for ten years. These teenagers know that they will not be able to own property, start a business, or become more prosperous even if many people engage illegally in private economic activities to make a living. They also know that they will not have legal access to markets where they can use their skills or their earnings to purchase the goods they need and desire. They are even unsure about what kind of human rights they will have.
Those in the South obtain a good education, and face incentives that encourage them to exert effort and excel in their chosen vocation. South Korea is a market economy, built on private property. South Korean teenagers know that, if successful as entrepreneurs or workers, they can one day enjoy the fruits of their investments and efforts; they can improve their standard of living and buy cars, houses, and health care.
In the South the state supports economic activity. So it is possible for entrepreneurs to borrow money from banks and financial markets, for foreign companies to enter into partnerships with South Korean firms, for individuals to take up mortgages to buy houses. In the South, by and large, you are free to open any business you like. In the North, you are not. In the South, you can hire workers, sell your products or services, and spend your money in the marketplace in whichever way you want. In the North, there are only black markets. These different rules are the institutions under which North and South Koreans live.
Inclusive economic institutions, such as those in South Korea or in the United States, are those that allow and encourage participation by the great mass of people in economic activities that make best use of their talents and skills and that enable individuals to make the choices they wish. To be inclusive, economic institutions must feature secure private property, an unbiased system of law, and a provision of public services that provides a level playing field in which people can exchange and contract; it also must permit the entry of new businesses and allow people to choose their careers.
THE CONTRAST OF South and North Korea, and of the United States and Latin America, illustrates a general principle. Inclusive economic institutions foster economic activity, productivity growth, and economic prosperity. Secure private property rights are central, since only those with such rights will be willing to invest and increase productivity. A businessman who expects his output to be stolen, expropriated, or entirely taxed away will have little incentive to work, let alone any incentive to undertake investments and innovations. But such rights must exist for the majority of people in society.
In 1680 the English government conducted a census of the population of its West Indian colony of Barbados. The census revealed that of the total population on the island of around 60,000, almost 39,000 were African slaves who were the property of the remaining one-third of the population. Indeed, they were mostly the property of the largest 175 sugar planters, who also owned most of the land. These large planters had secure and well-enforced property rights over their land and even over their slaves. If one planter wanted to sell slaves to another, he could do so and expect a court to enforce such a sale or any other contract he wrote. Why? Of the forty judges and justices of the peace on the island, twenty-nine of them were large planters. Also, the eight most senior military officials were all large planters. Despite well-defined, secure, and enforced property rights and contracts for the island’s elite, Barbados did not have inclusive economic institutions, since two-thirds of the population were slaves with no access to education or economic opportunities, and no ability or incentive to use their talents or skills. Inclusive economic institutions require secure property rights and economic opportunities not just for the elite but for a broad cross-section of society.
Secure property rights, the law, public services, and the freedom to contract and exchange all rely on the state, the institution with the coercive capacity to impose order, prevent theft and fraud, and enforce contracts between private parties. To function well, society also needs other public services: roads and a transport network so that goods can be transported; a public infrastructure so that economic activity can flourish; and some type of basic regulation to prevent fraud and malfeasance. Though many of these public services can be provided by markets and private citizens, the degree of coordination necessary to do so on a large scale often eludes all but a central authority. The state is thus inexorably intertwined with economic institutions, as the enforcer of law and order, private property, and contracts, and often as a key provider of public services. Inclusive economic institutions need and use the state.
The economic institutions of North Korea or of colonial Latin America—the mita, encomienda, or repartimiento described earlier—do not have these properties. Private property is nonexistent in North Korea. In colonial Latin America there was private property for Spaniards, but the property of the indigenous peoples was highly insecure. In neither type of society was the vast mass of people able to make the economic decisions they wanted to; they were subject to mass coercion. In neither type of society was the power of the state used to provide key public services that promoted prosperity. In North Korea, the state built an education system to inculcate propaganda, but was unable to prevent famine. In colonial Latin America, the state focused on coercing indigenous peoples. In neither type of society was there a level playing field or an unbiased legal system. In North Korea, the legal system is an arm of the ruling Communist Party, and in Latin America it was a tool of discrimination against the mass of people. We call such institutions, which have opposite properties to those we call inclusive, extractive economic institutions—extractive because such institutions are designed to extract incomes and wealth from one subset of society to benefit a different subset.
ENGINES OF PROSPERITY Inclusive economic institutions create inclusive markets, which not only give people freedom to pursue the vocations in life that best suit their talents but also provide a level playing field that gives them the opportunity to do so. Those who have good ideas will be able to start businesses, workers will tend to go to activities where their productivity is greater, and less efficient firms can be replaced by more efficient ones. Contrast how people choose their occupations under inclusive markets to colonial Peru and Bolivia, where under the mita, many were forced to work in silver and mercury mines, regardless of their skills or whether they wanted to. Inclusive markets are not just free markets. Barbados in the seventeenth century also had markets. But in the same way that it lacked property rights for all but the narrow planter elite, its markets were far from inclusive; markets in slaves were in fact one part of the economic institutions systematically coercing the majority of the population and robbing them of the ability to choose their occupations and how they should utilize their talents.
Inclusive economic institutions also pave the way for two other engines of prosperity: technology and education. Sustained economic growth is almost always accompanied by technological improvements that enable people (labor), land, and existing capital (buildings, existing machines, and so on) to become more productive. Think of our great-great-grandparents, just over a century ago, who did not have access to planes or automobiles or most of the drugs and health care we now take for granted, not to mention indoor plumbing, air-conditioning, shopping malls, radio, or motion pictures; let alone information technology, robotics, or computer-controlled machinery. And going back a few more generations, the technological know-how and living standards were even more backward, so much so that we would find it hard to imagine how most people struggled through life. These improvements follow from science and from entrepreneurs such as Thomas Edison, who applied science to create profitable businesses. This process of innovation is made possible by economic institutions that encourage private property, uphold contracts, create a level playing field, and encourage and allow the entry of new businesses that can bring new technologies to life. It should therefore be no surprise that it was U.S. society, not Mexico or Peru, that produced Thomas Edison, and that it was South Korea, not North Korea, that today produces technologically innovative companies such as Samsung and Hyundai.
Intimately linked to technology are the education, skills, competencies, and know-how of the workforce, acquired in schools, at home, and on the job. We are so much more productive than a century ago not just because of better technology embodied in machines but also because of the greater know-how that workers possess. All the technology in the world would be of little use without workers who knew how to operate it. But there is more to skills and competencies than just the ability to run machines. It is the education and skills of the workforce that generate the scientific knowledge upon which our progress is built and that enable the adaptation and adoption of these technologies in diverse lines of business. Though we saw in chapter 1 that many of the innovators of the Industrial Revolution and afterward, like Thomas Edison, were not highly educated, these innovations were much simpler than modern technology. Today technological change requires education both for the innovator and the worker. And here we see the importance of economic institutions that create a level playing field. The United States could produce, or attract from foreign lands, the likes of Bill Gates, Steve Jobs, Sergey Brin, Larry Page, and Jeff Bezos, and the hundreds of scientists who made fundamental discoveries in information technology, nuclear power, biotech, and other fields upon which these entrepreneurs built their businesses. The supply of talent was there to be harnessed because most teenagers in the United States have access to as much schooling as they wish or are capable of attaining. Now imagine a different society, for example the Congo or Haiti, where a large fraction of the population has no means of attending school, or where, if they manage to go to school, the quality of teaching is lamentable, where teachers do not show up for work, and even if they do, there may not be any books.
The low education level of poor countries is caused by economic institutions that fail to create incentives for parents to educate their children and by political institutions that fail to induce the government to build, finance, and support schools and the wishes of parents and children. The price these nations pay for low education of their population and lack of inclusive markets is high. They fail to mobilize their nascent talent. They have many potential Bill Gateses and perhaps one or two Albert Einsteins who are now working as poor, uneducated farmers, being coerced to do what they don’t want to do or being drafted into the army, because they never had the opportunity to realize their vocation in life.
The ability of economic institutions to harness the potential of inclusive markets, encourage technological innovation, invest in people, and mobilize the talents and skills of a large number of individuals is critical for economic growth. Explaining why so many economic institutions fail to meet these simple objectives is the central theme of this book.
EXTRACTIVE AND INCLUSIVE POLITICAL INSTITUTIONS All economic institutions are created by society. Those of North Korea, for example, were forced on its citizens by the communists who took over the country in the 1940s, while those of colonial Latin America were imposed by Spanish conquistadors. South Korea ended up with very different economic institutions than the North because different people with different interests and objectives made the decisions about how to structure society. In other words, South Korea had different politics.
Politics is the process by which a society chooses the rules that will govern it. Politics surrounds institutions for the simple reason that while inclusive institutions may be good for the economic prosperity of a nation, some people or groups, such as the elite of the Communist Party of North Korea or the sugar planters of colonial Barbados, will be much better off by setting up institutions that are extractive. When there is conflict over institutions, what happens depends on which people or group wins out in the game of politics—who can get more support, obtain additional resources, and form more effective alliances. In short, who wins depends on the distribution of political power in society.
The political institutions of a society are a key determinant of the outcome of this game. They are the rules that govern incentives in politics. They determine how the government is chosen and which part of the government has the right to do what. Political institutions determine who has power in society and to what ends that power can be used. If the distribution of power is narrow and unconstrained, then the political institutions are absolutist, as exemplified by the absolutist monarchies reigning throughout the world during much of history. Under absolutist political institutions such as those in North Korea and colonial Latin America, those who can wield this power will be able to set up economic institutions to enrich themselves and augment their power at the expense of society. In contrast, political institutions that distribute power broadly in society and subject it to constraints are pluralistic. Instead of being vested in a single individual or a narrow group, political power rests with a broad coalition or a plurality of groups.
There is obviously a close connection between pluralism and inclusive economic institutions. But the key to understanding why South Korea and the United States have inclusive economic institutions is not just their pluralistic political institutions but also their sufficiently centralized and powerful states. A telling contrast is with the East African nation of Somalia. As we will see later in the book, political power in Somalia has long been widely distributed—almost pluralistic. Indeed there is no real authority that can control or sanction what anyone does. Society is divided into deeply antagonistic clans that cannot dominate one another. The power of one clan is constrained only by the guns of another. This distribution of power leads not to inclusive institutions but to chaos, and at the root of it is the Somali state’s lack of any kind of political centralization, or state centralization, and its inability to enforce even the minimal amount of law and order to support economic activity, trade, or even the basic security of its citizens.
Max Weber, who we met in the previous chapter, provided the most famous and widely accepted definition of the state, identifying it with the “monopoly of legitimate violence” in society. Without such a monopoly and the degree of centralization that it entails, the state cannot play its role as enforcer of law and order, let alone provide public services and encourage and regulate economic activity. When the state fails to achieve almost any political centralization, society sooner or later descends into chaos, as did Somalia.
We will refer to political institutions that are sufficiently centralized and pluralistic as inclusive political institutions. When either of these conditions fails, we will refer to the institutions as extractive political institutions.
There is strong synergy between economic and political institutions. Extractive political institutions concentrate power in the hands of a narrow elite and place few constraints on the exercise of this power. Economic institutions are then often structured by this elite to extract resources from the rest of the society. Extractive economic institutions thus naturally accompany extractive political institutions. In fact, they must inherently depend on extractive political institutions for their survival. Inclusive political institutions, vesting power broadly, would tend to uproot economic institutions that expropriate the resources of the many, erect entry barriers, and suppress the functioning of markets so that only a few benefit.
In Barbados, for example, the plantation system based on the exploitation of slaves could not have survived without political institutions that suppressed and completely excluded the slaves from the political process. The economic system impoverishing millions for the benefit of a narrow communist elite in North Korea would also be unthinkable without the total political domination of the Communist Party.
This synergistic relationship between extractive economic and political institutions introduces a strong feedback loop: political institutions enable the elites controlling political power to choose economic institutions with few constraints or opposing forces. They also enable the elites to structure future political institutions and their evolution. Extractive economic institutions, in turn, enrich the same elites, and their economic wealth and power help consolidate their political dominance. In Barbados or in Latin America, for example, the colonists were able to use their political power to impose a set of economic institutions that made them huge fortunes at the expense of the rest of the population. The resources these economic institutions generated enabled these elites to build armies and security forces to defend their absolutist monopoly of political power. The implication of course is that extractive political and economic institutions support each other and tend to persist.
There is in fact more to the synergy between extractive economic and political institutions. When existing elites are challenged under extractive political institutions and the newcomers break through, the newcomers are likewise subject to only a few constraints. They thus have incentives to maintain these political institutions and create a similar set of economic institutions, as Porfirio Díaz and the elite surrounding him did at the end of the nineteenth century in Mexico.
Inclusive economic institutions, in turn, are forged on foundations laid by inclusive political institutions, which make power broadly distributed in society and constrain its arbitrary exercise. Such political institutions also make it harder for others to usurp power and undermine the foundations of inclusive institutions. Those controlling political power cannot easily use it to set up extractive economic institutions for their own benefit. Inclusive economic institutions, in turn, create a more equitable distribution of resources, facilitating the persistence of inclusive political institutions.
It was not a coincidence that when, in 1618, the Virginia Company gave land, and freedom from their draconian contracts, to the colonists it had previously tried to coerce, the General Assembly in the following year allowed the colonists to begin governing themselves. Economic rights without political rights would not have been trusted by the colonists, who had seen the persistent efforts of the Virginia Company to coerce them. Neither would these economies have been stable and durable. In fact, combinations of extractive and inclusive institutions are generally unstable. Extractive economic institutions under inclusive political institutions are unlikely to survive for long, as our discussion of Barbados suggests.
Similarly, inclusive economic institutions will neither support nor be supported by extractive political ones. Either they will be transformed into extractive economic institutions to the benefit of the narrow interests that hold power, or the economic dynamism they create will destabilize the extractive political institutions, opening the way for the emergence of inclusive political institutions. Inclusive economic institutions also tend to reduce the benefits the elites can enjoy by ruling over extractive political institutions, since those institutions face competition in the marketplace and are constrained by the contracts and property rights of the rest of society.