The Poverty of Nations: Institutions—more than geography or culture—may explain wealth disparities around the globe.

Commentary, Housing Affordability, Frontier Centre

Why is Mexico poorer than the United States? In "Why Nations Fail," Daron Acemoglu and James Robinson blame the encomienda. After the defeat of the Aztec empire in 1521, the Spanish imposed the system as a means of extracting tribute from the local population. Each encomendero would be allocated a number of Native Americans, who would then be used essentially as slave labor.

In early Virginia and Maryland, Edward Wingfield and Lord Baltimore also tried to impose a manorial system upon the English colonists. But that system never took root because settlers had a multitude of other opportunities in the New World. The colonial institutions of North America gave most colonists—or at least the adult men—a say in how their colonies were governed.

The result, according to Messrs. Acemoglu and Robinson, is that in Mexico, colonization ultimately led to the entrenchment of economic and political institutions that aimed at making a few rich at the expense of the many. But in the United States, colonization bequeathed institutions that have, despite their imperfections, catered to the needs of the population at large.

The main claim of "Why Nations Fail" is twofold. First, differences in institutions—not geography or culture—are the key explanation for differences in wealth around the globe. Second, those differences are often a result of historical accidents, such as the different colonization strategies adopted in different regions of the Americas.

Messrs. Acemoglu and Robinson hardly need introduction. Professors of economics at the Massachusetts Institute of Technology and Harvard, respectively, they are among the world's most influential voices in the field. In 2005, Mr. Acemoglu received the John Bates Clarke Medal, an award given by the American Economic Association to outstanding economists under the age of 40. Receiving the award is highly correlated with later receiving the Nobel Prize in economics.

How compelling is their view of drivers of uneven economic development? A quick look at contemporary Mexico and the U.S. hint that it might not be off the mark. As their book notes, the wealthiest man in the U.S., Bill Gates, is a self-made entrepreneur whose products have transformed the lives of more than a billion individuals around the planet. The richest Mexican, Carlos Slim, made most of his wealth by privatizing Telmex, previously Mexico's national telecom company, and by collecting monopoly profits at a time when the demand for telecommunication services exploded.

At the heart of Messrs. Acemoglu and Robinson's theory is a distinction between "inclusive" and "extractive" institutions. Political institutions are "inclusive" when they allow broad participation through secure property rights, law and order, and relatively free entry of new businesses. In contrast, "extractive" institutions "are designed to extract incomes and wealth from one subset of society to benefit a different subset."

Both inclusive and exclusive institutions are self-reinforcing—and so produce either virtuous or vicious circles of economic development. Combinations of extractive and inclusive institutions, on the other hand, are unstable—the authors argue that "inclusive economic institutions will neither support nor be supported by extractive political ones." Likewise, under inclusive political institutions, those in power "cannot easily use it to set up extractive economic institutions for their own benefit."

Seen through that frame, it's no wonder that the elites in 19th century Russia or in the Habsburg Empire very often opposed economic changes that opened access to economic opportunity. Messrs. Acemoglu and Robinson quote Friedrich von Gentz, an adviser to Austrian statesman Klemens von Metternich, who put the matter bluntly: "We do not desire at all that the great masses shall become well off. . . . How could we otherwise rule over them?"

What emerges from "How Nations Fail" is a thorough economic theory of institutional change. Economic and political institutions become extractive or inclusive based on the payoffs perceived by those who are making political decisions. Inclusive reforms, such as the extension of suffrage or the abolition of monopoly privileges, occur when the elites perceive that the benefits outweigh the costs. The payoffs are shaped by various considerations, including the threat of social unrest and revolution, efficiency gains from moving towards more inclusive economic institutions and the possibility of compensating the losers of such reforms.

Together with Tim Besley's and Torsten Persson's recent work, "The Pillars of Prosperity," Messrs. Acemoglu and Robinson's book epitomizes the emerging consensus in the economics profession that the drivers of economic growth are the state's capacity to provide public goods and to serve the population at large, not just the economic or political elite.

But this consensus still leaves a lot to be desired.While Messrs. Acemoglu and Robinson are right to reject geography as an explanation for economic development, they are too quick to dismiss culture and mistaken policy ideas as alternative factors driving the rise and fall of nations. It is true, as the authors argue, that "poor countries are poor because those who have power make choices that create poverty." But even if choices over policies and formal rules are guided by purely economic considerations, they are informed by expectations and beliefs of the policy makers, and by the prevailing social norms.

"Why Nations Fail" is a splendid piece of scholarship and a showcase of economic rigor. But even so, it captures only part of the story. To understand economic growth at a deeper level we need to go beyond neoclassical economics and have a serious conversation about what shapes the beliefs, cultural norms and values of societies, and the effects that these, in turn, have on our economies.