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Wednesday, 16 June 2010

History's Financial Shadow

Wealth Depends on History Not Geography

Jared Diamond in his superb book Guns, Germs and Steel outlined a theory of human economic development that regards Western Europe’s original pre-eminence in this regard as being contingent on geography combined with a large slice of luck. Great book though it is more recent work casts doubt on the main findings. Increasingly it looks like success in economic terms depends less on geography and more on history.

Quite how history impacts differential economic development as seen in the world today is a booming and fascinating area of research. Teasing out the relevant factors from a jumble of data is a difficult and delicate art but one theme seems to be increasingly prevalent. It rather looks like current economic success and failure is predictable from the robustness or otherwise of institutions established hundreds of years ago. History casts a long financial shadow it seems.

Geography Is Wealth

The differential economic development of countries has long been a puzzle to economists, who have developed multiple hypotheses to explain it. One theory has it that the main determinant of success is geography, another that it’s a consequence of history which has long-term, hidden but decidedly enduring effects.

The geographic explanation was covered by Diamond, whose tour de force of a book covers vast amounts of ground. Summarising briefly, though, the peoples of the European-Asian land mass were especially favoured because the East-West directionality of the continents meant that people and animals could spread without encountering hugely unfavourable climate conditions. In Africa, for example, spreading North-South meant overcoming widely different temperature conditions, a malarial zone and the Sahara Desert.

Meanwhile Europe and Asia were especially favoured by access to the widest range of domesticatable animals and plants and furthermore then benefited from natural selection in favour of those people best fitted to survive the diseases which could jump species. The full argument, of course, is much more developed than this but it’s best to read it for yourself. It's a terrific book.

Persistent Institutions

The historical argument comes down to the establishment and long-term pervasiveness of institutions. The idea here is that the effect of robust institutions – for better or worse – has significant impacts on societies over unexpectedly long periods of time. This suggestion arose out of the observation that many of today’s economic success stories are those countries where European colonisers laid down roots and established lasting institutions, while many of the basket cases are places where expropriation of resources was the main, lasting accomplishment of the colonial powers.

Observation of the geographical distribution of the economically successful nations versus the basket cases led to a hypothesis that this was linked to climate. Those countries where colonizers were able to settle developed strong institutions and a respect for the rule of law, those where settlement wasn’t possible – mainly because of disease – didn’t and spent most of their time expropriating resources as fast as possible. When Acemoglu, Johnson and Robinson investigated this though some cunning analysis of mortality rates amongst various settler groups this is exactly what they found – where historical settler death rates were high economic development is low and vice versa. The researchers also point out that this issue was well understood by potential colonists:
“An interesting example of the awareness of the disease environment comes from the Pilgrim fathers. They decided to migrate to the United States rather than Guyana because of the high mortality rates in Guyana”
A second, rather subtle point, made in the research is that the diseases that killed the colonists didn’t have much effect on locals, who were largely immune to their effects. So the local geography, at least as typified by diseases, appears to be irrelevant to the future economic development path. It’s history what matters, you see.

The Primacy of Institutions

Although this institutional link to colonisation seems to make sense it’s fairly clear that it can’t be the whole story. A couple of issues are immediately striking. Firstly, there are serious economic inequalities between countries that have never been colonised, secondly if institutions are the transmission mechanism of wealth this implies historical persistence – somehow the value of these institutions transmits itself down the centuries.

Rodrik, Subramanian and Trebbi investigated the general question of whether institutions are important in all cases of economic development in Institutions Rule: The Primacy of Institutions over Integration and Geography in Economic Development, although they rather spoiled the ending with their title: it’s a bit like titling Sixth Sense as The Ghost who Helped the Boy who Saw Ghosts. Anyway, their research supported the idea that the permanence of settlement of colonisers made a difference through the transmission mechanism of institutions. However, their research also suggests that institutional quality also determines the economic advancement of countries that have never been colonised.

Property Rights Rule

In particular there appears to be a link between property rights and economic growth which seems to make intuitive sense. If you believe you’ll be allowed to reap the rewards of your labour you’re more likely to work harder and re-invest earnings. If you expect your profits to be expropriated then you’re more likely to bury them in the back garden or hide them in Switzerland where they won’t help local economic growth. They point out:
"Our findings indicate that when investors believe their property rights are protected, the economy ends up richer. But nothing is implied about the actual form that property rights should take. We cannot even necessarily deduce that enacting a private property-rights regime would produce superior results compared to alternative forms of property rights.

If this seems stretching things too far, consider the experiences of China and Russia. China still retains a socialist legal system, while Russia has a regime of private property rights in place. Despite the absence of formal private property rights, Chinese entrepreneurs have felt sufficiently secure to make large investments, making that country the world's fastest growing economy over the last two decades. In Russia, by contrast, investors have felt insecure, and private investment has remained low. Our institutional quality indicators bear this out.”
History Matters

For all this to make sense there needs to be historical persistence of the value of institutions over a long, long time– hundreds of years, at least. Increasingly research is suggesting just that: that decisions made centuries ago are still influencing the differences between the haves and the have nots of this world. Banerjee and Iyer, for instance, show that the way that revenue collection in British controlled India was performed, can predict multiple economic factors in different regions: direct revenue collection by British officials has led to better levels of education and health.

In research on a Spanish controlled forced labour mining system in Peru, originally instituted in 1573 Melissa Dell has shown that this has present day adverse economic effects on the regions covered. On average these districts have average household consumption a third lower and childhood stunting - a sign of malnutrition and lower living standards - 5% points higher than similar regions not impacted by the mining press gangs. Similarly Elise Huillery has shown a positive relationship between colonial investments in infrastructure and modern days levels of education and health in French West Africa. It seems that history matters.

Safety in Institutions

At the moment the transmission mechanism between institutions and economic success and failure aren’t entirely clear but really this doesn’t matter for those of us looking for investment clues. When it comes to economic leadership the presence of strong institutions, a respect for the rule of law and a state guarantee of property rights are certainly necessary conditions, even if they’re not entirely sufficient. Investment in any country without these characteristics is a risk too far.

It also implies a few lessons for would-be regime changers: it’s not the precise economic or political system that matters but the infrastructure supporting the rule of law. Corruption and a disregard for property rights is the enemy of economic advancement, not lack of freedom. Of course, all too often these go hand in hand but it ain’t necessarily so...

Related articles: The Case Against Emerging Markets, Property Rights and Wrongs, Copper at Morewellham Quay


  1. A sniff of Machiavelli in the final paragraph there.

  2. Property reghts are critical. Here is an 8 minute youtube of Hernando DeSoto, author of "Mystery of Capital", talking about capitalism and property rights.

  3. Forget the link:

  4. It is my belief that one of the things killing us today is that marketing has become too dominant. Marketing is the opposite of science; it is rooted in fantasy. When marketing becomes too dominant, rationality goes out the window.

    The problem with all explanations of historical developments is that you only see the effect after it has taken place. If the Triumph of Marketing really is a problem, we will come to see that -- but only after it has done a lot of damage.


  5. Property rights rather than geology probably explain why the bulk of gold production comes from countries with a Common law structure rather Roman or other legal codes.

    Why develop a mine over a 5 to 10 year period if you are not sure you can keep the proceeds.

    Of course the argument could be reversed. It was the presence of gold that attracted Anglo-Saxon entrepreneurs. If they didn't get there first then they achieved ownership through warfare if possible.

  6. Hi Tim, I'm not sure I know what you mean by "institutions" - can you explain? Thanks, Ilene

  7. Hi Ilene

    Good question, the best definition I can find is:

    Institutions are systemic patterns of shared expectations, taken-for-granted assumptions, accepted norms and routines of interaction that have robust effects on shaping the motivations and behavior of sets of interconnected social actors. In modern societies, they are usually embedded in authoritatively coordinated organizations with formal rules and the capacity to impose coercive sanctions, such as the government or the firms. (The Role of Institutions in Economic Change)

    I think, basically, the idea is that we should know one when we see one :)

  8. Thanks TIm, that greatly helps me understand the article. - Ilene

  9. I think an interesting tangential point to this discussion is that it is surely driven (and has potency) because of our perceived policy failures in Africa, as well as the lingering ripples of Fukoyama's 'End of History' thesis. We don't debate what we don't care (or feel guilty?) about.

    @Rob - Gold is a bit of a circular point, surely? The UK for instance had gold mines - they were depleted by whatever drive to enterprise is under debate, and to get more gold you had to look abroad.

  10. I suggest you read David Landes 1999 Book
    "The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor"

    This book precedes Jared's work.

  11. New World gold and silver caused so much inflation that it wrecked the Spanish economy and turned Europe's most powerful country into a basket case. Other countries had to make and sell things to earn a living so retained the habit of work rather than supervising native American slaves.