It’s the institutions, stupid!

Why Nations Fail

I wonder who he could mean…

This summer I’ve been reading Acemoglu and Robinson’s “Why Nations Fail.” It’s a terrific read in case you haven’t gotten your hands on it – Ángel Alayón did a great job summarizing it a few months ago.

Now, I won’t bore you with the details of the book. I will, however, outline the authors’ basic point, and go from there.

The book draws a distinction between countries that have “inclusive” economic institutions and those that have “extractive” ones. The former includes countries 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.” The latter includes countries whose institutions “are designed to extract incomes and wealth from one subset of society to benefit a different subset.”

The authors continue,

“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…

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 society. Extractive economic institutions thus naturally accompany extractive political institutions.”

Clearly Venezuela has extractive (literally, extractive) economic and political institutions. Obviously, if one agrees with the authors, one has to move toward inclusive economic institutions. But how?

You will read a lot in the coming months about what Venezuela needs to do to get out of the jam that chavenomics has left us in – scarcity, inflation, devaluation, general rise in poverty. But whenever you hear the experts, ask yourselves if what they are proposing is enough.

Ask your economists, your politicians, and your thinkers if anything they propose signifies a shift to inclusive institutions. They probably do at some level. For example, in our “roadmap” series of posts, Quico has written about the need for macroeconomic stability. I have written about the importance of embracing globalization. Both things require an institutional re-design in order to be succesful – for example, free-trade agreements or constitutional rules regarding the Central Bank. Those are shifts to “inclusive” institutions.

In other words, we need to focus on the “how” and not just on the “what.” That is what makes proposals such as those of loyal reader “extorres,” for example, so appealing: they are so radical they imply an automatic switch from extractive to inclusive institutions. It is all shockingly simple, yet horribly complicated to implement.

As we continue thinking of the long term, we need to do our best to keep in mind the institutional re-design we require. Otherwise, we’ll just be blowing smoke out of our behinds.

28 thoughts on “It’s the institutions, stupid!

  1. Juan, thanks for bringing this up.
    Now, I would like you once to handle the topic of what it means concretely to accept “free markets”.
    It’s amazing how the US-educated economists of today repeat that and don’t get into the details of how avoid the collapse of the economies that are opening up. They simply give a short comment, if at all, like “sure, some areas might be protected for a very short time” or the like, but they really hate, hate like hell to get into the specifics.

    And reality is that not a single country that has turned into an industrial nation has done so by taking the absolute path these economists claim is needed.

    You just have to look at economic history.

    You want Venezuela to take the same path Japan took before the Meiji period. That led to disaster and revolt. You do not see what the Japanese did in the Meiji period.
    And that is not “Japan ages and ages ago”.
    That’s what China is doing now – not a blind opening. And that is what South Korea did.
    And that is what actually the USA very much did. And Britain.

    The devil is in the detail. Simplified models never work.

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    • “The Quest for Prosperity” book outlines a framework of gradual change in the economy to make it more viable. It covers all the examples you used.

      I hope the future policy makers get ahold of that book or, at least, are familiar with those ideals.

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      • Thanks. I will take a look at it.
        I would love to see when other economists mechanically repeating the simple “free market+property rights” mantra address the statements I made. I mean: if at least they could show ONE, ONE single case in which that little, simple formula alone worked. Of course those elements are necessary – under special conditions and within boundaries, as history has shown over and over again. But they are nothing without the other items…items apparently these economists are not keen to ponder about.

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    • Free markets are institutions in which “supply and demand” determine what is produced, and the price at which it is consumed. It is therefore a direct reflection of the original distribution of wealth in the system. Those with zero, or few, bolivars or dollars will have zero, or little, economic power. The system excludes them.

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  2. The ironic part is that the current narrow elite came to power by ranting, raving and revolting against the “old” narrow elite. You know what they say about the more things change…

    Excellent book. It was in the queue along with Kahneman’s Thinking Fast and Slow ahead of yours when you published.

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  3. Great for Juan to post this book for discussion . Its a hefty interesting topic , and one which concerns us Venezuelans directly . Only caveat is that the division of regimes into two neat categories seems a tad oversimplistic ..

    The conflict between working classes and the bourgoise (business oriented) middle classes is maybe false for Venezuela . In Venezuela the conflict is between do nothing produce nothing govt supported clientelar classes and the generally more productive but also clientelar dependent working and middle classes . Thus the real distinction may lie along side the fault that divides marginal society from civil society .
    .
    If you look at it more carefully the poor masses in Venezuela are not working classes in the marxist sense but classless marginals who dont actually do any particularly productive work. Something more in the line of the ochlocracy of which Hannah Arendt spoke of.

    Maybe after reading the posts offering more carefully there will be room for a reinterpretation of the two systems . In Venezuela the profession of political loyalties is economically more profitable than actually engaging in economically productive activity .!!

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  4. In order to implement a more inclusive system, people have to be in agreement otherwise the society will just revert back to its old ways.If you implement socialism, people will find a way to capitalize and speculate on everything because Venezuelans are by nature capitalists.If you try to create a working and fair system of jurisprudence it will be abused, unless the people have seen the light and sincerely want a change.My 40 year observation of living in all manner of sub groups there is that the elitism in Venezuelan is tied to authoritarianism, rather than to inclusive tendencies.This has always been a big beef in my book.

    Perhaps now that we have had this horrendous experience, people will be more open to changes… changes like sharing power,or creating justice for all in the future, but it would not be easy. Habits are hard to break.

    I could recount hundreds of stories that might interest folks- stories that illustrate this theme quite well , but I think it is pretty easy to understand with just a quick, and honest look.

    I think if we are realistic , it has to be baby steps, and starting with Justice Reform.

    The need for safety and security is the foundation of a secure platform on which to later build institutions that could actually work out.Depending on the level of corruption in the Justice system( and there is always some everywhere) we will be able to proceed to other areas of reform, or not.

    A good solid house is built on a strong foundation.

    Bill Blass

    Saying that the poor in Venezuela do not actually do any work is quite a simplification.There are many who work the tails off.There are some that leech off relatives, and are rather indigent, but you cannot oversimplify like that.

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    • Firepiggette : Sorry for oversimplifying , Of course there are poor people who work a hell of a lot , my point is that most of marginalized venezuelans ( not all those who are poor) even if they work are not very PRODUCTIVE or hold jobs which are not very PRODUCTIVE but rather of the ‘Soft’ or ‘Make Believe Work ‘ variety like most which the Misiones offer. !! Stats show that about half Venezuelans or more engage in ‘Underemployed work’ like small time buhoneros . Work is not just raw muscular effort or occupying time in some activity , its getting things done or produced which are worth something , its helping to create wealth . And work as i see it is work done with dedication and thoroughenss not just whiling away the hours in a half hearted effort to convinve your employer that you are doing what you are hired to do while actually thinking of how to goof of when he is not looking.

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  5. I’m a firm believer that if we want people to care about property rights, we have to put property in their hands. Only then will property rights cease to be an alien concept and become an integral part of their worldview.

    That means a post chavista government should regularize the situation of the thousands of families living in houses with no clear legal owner.

    Get rid of all the Giordanomics barriers to export. Right now exporting from Venezuela is heavily criminalized, due to its tenet of the more you sell the bigger your losses: export gas and empty the public treasury, export food and generate scarcity (since prices don’t cover costs + reinversion), re-export things (Panama’s main economic activity) and it’s a currency crime, etc.

    It also means it should drastically bring down the difficulty of registering a new business in terms of costs, time, paperwork, and batshit-crazy regulation (price control, currency control, import permits, export permits, maximum profit rate, etc). It should discourage informal economic activity, AFTER easing the registration of formal business in order to increase the tax base, formal jobs and to improve the oversight over health code violations, tampering with weight scales, counterfeit and upholding other consumer protection measures.

    Putting property in people’s hands would also mean making it easier for small investors to purchase bonds, stock in private companies, stock in mixed oil ventures, index funds or mutual funds so investing in one’s retirement becomes a possibility for every Venezuelan.

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    • J. Navarro,

      Completely agree. I definitely think that the key to building respect for property rights is to give people the rights to their current property. In addition, I completely agree with your assessment of the necessary next steps.

      The one piece that I feel is missing is how to increase the productivity of Venezuelan industry. Reducing the burdens of doing business would help and the collapse in the currency would also make Venezuelan exports more competitive. However, it’s difficult to imagine how to ramp productivity up in the short term while preserving the petro-state.

      I could imagine leveraging the oil and gas to enhance productivity in energy-intensive industries. However, I’m not sure we have any of those left in any condition to take advantage of a more intelligent and flexible energy strategy.

      Would love to hear your thoughts on this.

      Paul

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      • Right now Venezuelan labor is dirt-cheap. Minimum wage is USD 60 a month, and there’s plenty of engineers, doctors, nurses an other college professionals willing to work for USD 200 a month, USD 300 a month is a great salary.

        Also, we are already exporting to Colombia, albeit “illegally”.

        The one drawback is the stringent job security since it doesn’t allow companies to fire employees even if they fail to go to work repeatedly, are violent, disrespectful, lazy, incompetent, etc. The good news, is that it’s a decree and not a law, which makes it easier to change.

        Initially shifting away from Job Security to Job Stability, understood as allowing companies to fire employees provided they hire someone to replace them at equal or higher pay, would allow many industrial companies (think EFE) to put back some discipline among workers, and replace dead weight with fresh blood. We could see many companies raising productivity just by decreasing absenteeism, while keeping social unrest somewhat in check. Under the assumption that we’re also getting rid of Giordanomics, these companies would have both access to import raw materials, labor and exporting products.

        Then we could begin to export to Colombia legally, at roughly the same price but altering the profit distribution in favor of the producer and in detriment of the middlemen, since there wouldn’t be as much risk as bachaqueo faces, and we could use economies of scale to send trucks full of goods.

        If we raise salaries, gradually, taking into account the decrease in subsisides and the rise in productivity, we can end up in a USD 300 minimum wage and USD 1000 minimum wage, thus improving the quality of life workers can enjoy, without losing that initial export edge. Once the economy starts to grow, we can ease Job Stability (as defined above) to protect lower salary thresholds, until it is scrapped.

        If you add into the mix, reforming Corpoelect by breaking it up along the lines of energy production and energy distribution, and/or splitting it up in regional corporations, and/or opening to private capital in a mixed venture, and/or splitting it up and privatizing some assets, and/or bringing some competition into the energy sector, we can recover our historic advantage of plentiful cheap and clean electricity from Guri to power Guayana, Carabobo, La Victoria, Zulia and other industrial regions.

        If you add into the mix either privatizing CANTV, making it a mixed company, or having it form joint partnerships. We can lay more fiber to increase Venezuela’s average internet speed. It would allow us to follow India into the outsourcing market, by having Venezuelan spanish phone operators, Venezuelan programmers, Venezuelan designers service remotely other companies in Spain, Latin america and the Latino market in the US.

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        • Thanks for the detailed thoughts, J. Navarro.

          I love the idea of Job Stability, and think that would go a long way towards setting the right incentives and spurring more private enterprise. I think that privatizing CANTV and reforming Corpoelec would also help drastically.

          However, you make the point that we should raise salaries “taking into account the decrease in subsidies and the rise in productivity”. That’s the part that I have trouble with right now. Liberalizing the labor market (big plus), ensuring the supply of electricity is stable (tough to do in the short term but certainly something that can be achieved), leveraging our cheap energy reserves, and removing trade barriers would all help make Venezuelan products more competitive. Relaxing exchange rates would also make the Venezuelan workforce cheap.

          However, none of this would lead to increases in production if there is no productive apparatus to take advantage of it. Given the dire situation of Venezuelan industry and services, I think it would take some additional reform to spur a significant growth in domestic production. One possibility would be (significant) tax incentives for the private sector to rebuild, another one would be to piggyback on oil investments ala Brazil (wouldn’t be my preference as it would create additional market distortions, but given how messed up our economy is, it may help).

          What do you think?

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          • The initial increases in production would come from idle capacity. There’s plenty of unrealized industrial potential because of absenteeism, lack of raw materials, lack of spare parts, profit restriction, price controls, etc.

            There’s companies like EFE, that just need to be able to fire conflictive employees, who don’t even represent the majority of workers. There’s also the labor impunity, that promotes absenteeism and laziness for lack the of punishment enforced by labor inspectors.

            There’s companies like GM, Ford or Toyota heavily affected by barriers to import the necessary parts, reluctance to put in more money if they can’t get their dividends back, price control, labor related violence, price controls, etc.

            There are entire sectors like milk, cheese, chicken and meat paralyzed because government control rendered them unprofitable. Other sectors like coffee, cornmeal and sugar have been severely hit, but still exist, and could become exporters like before Chavez.

            There’s companies like SIDOR and old CEMEX, that can be privatized or made mixed companies, so they can resume exporting like they did until the early 2000s.

            Privatization of public companies HAVE to include little investors, if we want people to join the defense of property rights. Some shares could go to workers, maybe like in private CANTV and Ternium-SIDOR; others could go to mutual funds, small investors, etc. We shouldn’t waste that opportunity by just selling those companies to a huge foreign consortium, thus reinforcing the “I’m not one of those filthy Capitalists” mindset.

            I’m not too fond of targeted tax incentives (per sector, for doing something, investing in something), as I think they benefit the haves way more than the have-nots, because the haves can afford more lawyers and accountants to find a loophole for them. On the other hand, I strongly support simplifying the tax code for everyone and setting a moderate tax rate, so people and companies consider Venezuela a good place to do business.

            We ought to look ant the Ease of Doing Business index, the Index of Economic Freedom, and similar benchmarks to detect where’s a good place to start and which bottlenecks, once removed, would yield the most improvement.

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  6. Sorry, but this doesn’t cut:

    “True, these are largely members of Venezuela’s upper middle class, only a subsector of Venezuela’s demographics. But they are also the best and brightest of the country’s under-30s.”
    Are you going to tell us you are not co-relating brightest with upper middle class?

    These are the by far better skilled, but the brightest? These are the luckiest in that sense.
    You get an intact family where parents have some for Venezuelan standard good education and where there is money to buy books or at least there was and where teachers’ absenteeism – you won’ believe it-
    is just a fraction of a fraction of a fraction of what the average Venezuelan pupil has to see and there is absolutely no surprise you are among the better educated.

    And that is DEFINITELY not bright.

    Once we start tackling that we will have some chance of developing.

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  7. My two cents:

    The main point in Why Nations Fail isn’t that a simple “free market + property rights” formula is the recipe for success. It’s actually very far from that.

    The main point is that societies with inclusive political and economic institutions tend to display both high levels of economic development AND broad economic freedoms, property rights, etc; in contrast, underdeveolped societies are usually characterized by extractive political and economic institutions, on which property rights are violated by the state and there’s a high degree of direct government intervention in economic life (ie. high taxes, regulations, expropiations, etc.).

    Based on this premise, the authors then recount several examples of world history which illustrate the features of both cases.

    And when they get to the question of HOW to foster development, they conclude that:

    1. Evolution in political institutions precedes change in economic institutions.
    2. Evolution in political institutions is ‘path-contingent’ (ie. non-linear, unstable, almost unpredictable).
    3. A government can (but only temporarily) mix extractive politics with ‘inclusive’ economics (modern examples include Russia, China, Thailand, Vietnam, etc.); but this institutional mix often breaks down due to its internal contradictions.
    4. History shows that the path for development necessarily starts with a broad-based political movement commited (ideollogically, but most important, economically) to share political power throughout society, and also to establish checks and balances to itself.
    5. Evolution in economic institutions to more inclusion / less extraction will follow naturally, since is in the own interests of the broad society.
    6. The ‘Natural Resource Curse’ is conditonal on the quality of political institutions preceding the discovery of natural resources. And it is reinforcing, because a government awash in natural resource wealth entrenches itself in power via patronage networks, or plain old dictatorship.

    Some links for reference (from the ‘Why Nations Fail’ blog):

    http://whynationsfail.com/blog/2013/5/21/the-economic-nature-of-the-resource-curse-evidence.html

    http://whynationsfail.com/blog/2013/6/27/resource-curse-and-institutions-getting-more-specific.html

    http://whynationsfail.com/blog/2013/5/29/natural-resources-and-political-institutions-democracy.html

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  8. I haven’t had time to read all the comments above yet, but I have a simple comment. Over the last four years, private enterprise has been obstructed, investment has been is discouraged, and now there is a huge accumulation of needs for repair, reconstruction, new investment, growth, jobs, and everything that government can do to level the playing field by making sure that corporations and entrepreneurs follow rules that protect their incentives while serving the common good. That’s all!
    Venezuela has opportunities everywhere! Build a new government as described above and they will come, but make sure there is no abuse, and make sure the democracy is safe.

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  9. Although not disagreeing with the notion that economic inclusion is a good thing, the idea that the opposite of that is an ‘extractive’ system where an evil elite controls all things so as to monopolize all economic benefits for itself, and to that end purposefully excludes the goody goody masses from sharing in those benefits , has too much of a ´cowboys and indian’ ring to it for my taste . The reality is usually far more complex and ambivalent .than is represented by such models .
    Also there is nor role in such interpretations for the effect of sheer human collective stupidity at the top or botton side of the social ladder . As Adolfo Bioy Casares once wrote : “”El mundo atribuye sus infortunios a las conspiraciones y maquinaciones de grandes malvados. Entiendo que se subestima la estupidez.”

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  10. I received this book as a christmas gift and startes reading it last week. Very interesting read. As usual I agree 100% with you Juan

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  11. On this particular point, I have always been a fan of Hernando de Soto, a Peruvian economist. He has researched how the big countries like the US made the shift (spoiler: the Wild West was wild for a reason), with an emphasis on property rights, because without them, we can’t build an economy that includes everyone.

    The Mystery of Capital covers his thesis on the subject. Includes a plan of action that countries can take for it. Of course, it’s easier to say it than to do it, but is there.

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