Thursday, November 19, 2009

Institutions, Incentives, Poverty and Inequality

Daron Acemoglu explains why and how there is persistent inequality and what can be done about it (fix incentives and governments):

The question social scientists have unsuccessfully wrestled with for centuries is, Why? But the question they should have been asking is, How? Because inequality is not predetermined. Nations are not like children — they are not born rich or poor. Their governments make them that way.

Economist Jeffrey Sachs, director of Columbia University's Earth Institute, attributes the relative success of nations to geography and weather: In the poorest parts of the world, he argues, nutrient-starved tropical soil makes agriculture a challenge, and tropical climates foment disease, particularly malaria. Perhaps if we were to fix these problems, teach the citizens of these nations better farming techniques, eliminate malaria, or at the very least equip them with artemisinin to fight this deadly disease, we could eliminate poverty. Or better yet, perhaps we just move these people and abandon their inhospitable land altogether.

Jared Diamond, the famous ecologist and best-selling author, has a different theory: The origin of world inequality stems from the historical endowment of plant and animal species and the advancement of technology. In Diamond's telling, the cultures that first learned to plant crops were the first to learn how to use a plow, and thus were first to adopt other technologies, the engine of every successful economy. Perhaps then the solution to world inequality rests in technology — wiring the developing world with Internet and cell phones.

And yet while Sachs and Diamond offer good insight into certain aspects of poverty, they share something in common with Montesquieu and others who followed: They ignore incentives. People need incentives to invest and prosper; they need to know that if they work hard, they can make money and actually keep that money. And the key to ensuring those incentives is sound institutions — the rule of law and security and a governing system that offers opportunities to achieve and innovate. That's what determines the haves from the have-nots — not geography or weather or technology or disease or ethnicity.

Put simply: Fix incentives and you will fix poverty. And if you wish to fix institutions, you have to fix governments.