This post is a summary I wrote while reading Why Nations Fail by Daron Acemoglu and James Robinson and The Captured Economy by Brink Lindsey and and Steve Teles to help me collect my thoughts. Expect some tangents. I hope you find it useful!
Why Nations Fail (WNF) is a grand-narrative-of-history book that has become very famous and many people way more qualified than me have written reviews. This book has been so widely discussed that discussions of WNF have taken on a life of their own, almost separate from the book. As of the writing of this post, Wikipedia lists nine reviews of the book including one by Francis Fukuyama.
The central thesis of the book is that nations fail or stagnate because of extractive institutions, and thrive because of inclusive institutions. As extreme examples, feudalism and slavery are extractive and liberal democracy is inclusive.
As the reviews by twitter micro-celebrity Maia Mindel and Fukuyama rightly say however, Acemoglu describes various historical events through the lens of extractive institutions, but never defines them in a useful way. Saying that extractive institutions cause stagnation is not actionable when there is no framework for what makes institution extractive apart from looking at outcomes. This makes WNF bad as a predictive tool, which in turn makes it less good for designing policy (since all policy is just prediction). WNF does, however, rightly rule out many dubious theories for why some nations / states are seemingly successful while other fail / stagnate, including ignorance of leadership and the much dreaded “geography”. Furthermore, it highlights the importance of good institutions, whatever it is that makes them good. Despite some of the limitations mentioned I still enjoyed WNF. It covers a lot of interesting bits of history from various parts in the world and does so in an entertaining way. I especially enjoyed the various stories around technological suppression and secrecy.
The other book that inspired this post is The Captured Economy, a somewhat less well known book, that, on the surface, seems way more specialized and specific compared to Why Nations Fail. This post started as a review of TCE, but writing this while reading WNF I realized that these two books complement each other well in various ways. Where WNF goes hard on big history, TCE spends more time with particular institutions and companies. Where WNF focuses on the historical context and contingent events, TCE has an eye towards political economy and policy.
As any good mathematician will know sometimes a specific example can illuminate more than a general definition. This is one of those examples where the specificity of TCE really helps enlighten the term extractive institution from WNF, especially in our modern world.
TCE looks at rent-seeking: the process of extracting profits without creating (or facilitating the creation of) additional wealth. Interested parties sometimes ‘capture’ institutions to rig the economic game in their favor. This happens by stopping competition or messing with supply-and-demand in some other way. In short, if you can write the rules and play the game you always win. Although this book focuses on America, these same principles apply everywhere. These more detailed ideas are exactly what WNF is missing.
The authors, Brink Lindsey (previously at the Cato Institute and is now Vice President at the Niskanen Center) and Steve Teles (associate professor of political science at Johns Hopkins University) team up as a libertarian-liberal duo to fight the ills of sluggish economic growth and inequality. They claim in the opening that only their combined view can soberly spot these problems, as the left is too reliant on seeing government as the solution and the right is too suspicious of government to consider its use in making freer markets.
The book considers four main problem areas: financial regulation, intellectual property, occupational licensing and land use regulation. Many other such areas exist, e.g. AccuWeather lobbying to stop the Weather Bureau from publishing its own results as I mentioned at the end on my post about the weather. Once you understand how a sector of the economy is captured, you will notice this process everywhere. These kinds of processes can infect government bodies, institutions or even small organizations.
In short: monopolies are bad. Both books consider how monopolies, especially government enforced ones, come about. WNF tries to turn this into a grand theory for explaining all of history, whereas TCE has the much more humble goal of only explaining the causes of everything that is wrong in the modern US economy.
Financial Services
Financial services can be very concrete, like processing the payment of your coffee, but can get very abstract very quickly, such as managing retirement savings or high frequency trading. What makes finance even harder to understand than just the actual complexity itself, is the unhelpful naming conventions from endless acronyms to made up greek letters.
The first thing that should make us suspicious when it comes to rent-seeking is if an industry grows without getting better in some measurable way. For financial services one of the measures of “better” is cheaper transactions. However, despite the growth of the industry, the cost of transferring money (at least within the US) has not changed since the 1880s.
Finance is not only unnecessarily large, but is starting to infect other industries. This has been termed the over financialization of everything. In effect, this encourages people to move away from the actual production of real goods and services, and towards the more abstract goal of moving money around. At its best finance allows efficiency gains and moves capital to industries that need it the most. At its worst it exacerbates the boom and bust cycles due to unnecessary speculation and uses the price of important commodities as its playground.
The main weapon to make this happen are financial derivatives, products that can be traded which derive their value from the performance of some underlying stock or bond or mortgage. These products are in themselves not bad, and can serve many stabilizing functions. Both farmers and airlines alike buy or sell futures (i.e. a contract guaranteeing the price of a certain asset in the future) to have more predictable cash flows, and offset risk. However, in the 1980s the finance industry was around 20% of all futures trading, whereas now it is the vast majority. Some companies use derivatives to make uncovering fraud profitable. These tools become a problem when they are used to take on more risk for higher potential profits. This happens in two ways: leverage and trading on margin. Leverage here refers to derivatives that move more than the underlying, for example we could have a contract for difference where the derivative pays out 5x or 10x the amount the underlying moved. On the other hand, this also means that the risk you take on multiplies by the same amount. Margin trading occurs if the money the trader uses to enter some financial agreement is borrowed. This means in particular that the trader has a risk of going into debt if their speculation does not pay out. For these types of reasons Warren Buffet has famously called derivative contract “financial weapons of mass destruction”.
This gets us to the great recession. It was famously caused not only by bad US housing policy (which we will get to), but also the trading of credit default swaps (CDS), i.e. options on top of mortgage payments. To add jet fuel to the fire, further options were even traded on the CDSs. These all multiplied the effect the popping of the housing bubble had. This would have not been a problem if the trading of risky options and lending money to new homeowners were legally separated. The reason they were not is that the Glass-Steagall act of 1933 was repealed in 1999. It separated commercial and investment banks.
This is exactly the main point of the Captured Economy. This was allowed to happen by regulators, because the financial industry managed to captured government through incessant lobbying. Banks and other institutions use their vast profits to influence policy making in such a way to rig the game in their own favor. While slightly off topic, I must mention that the bank bail-outs were good and very important for the economic recovery. The US government event managed to turn a profit on the bail-outs.
On the other hand, WNF can teach us that excessive financial and especially trade regulation can hamper growth. It tells the story of Venice and its merchant class comparing to England and its international trade. Venetian trade made Venice into one of the most prosperous regions of the Middle Ages. As the importance of the trade grew, and its rents became more and more attractive, the Venetian government “nationalized” its trade to keep its grip on the institution. In particular, they limited the number of people that could become merchantmen. In contrast, due to the circumstances of England around the Glorious Revolution, the merchant class there liberalized trade and managed to limit the authoritarian power of the monarchy. Thereafter, England became the center for the industrial revolution, but Venice became a museum.
Intellectual Property (aka Mickey Mouse)
Let us start with a brief aside to know what the difference between copyright and patents are. A copyright is the individual right you automatically get once you create an original work to the reproduction, distribution and display of your work. This includes transferring these rights through licensing or or selling. Copyright applies automatically, but can be registered with the Copyright Alliance which is required if you want to sue someone for infringement. A patent, on the other hand, exists to protect inventions such as manufacturing processes, machines or new chemicals. The copyright alliance website states that:
Unlike the copyright registration process, the patent application process is expensive, complex, and time consuming and generally should not be attempted without the assistance of an experienced patent attorney or agent.
Note that I am skipping the part on occupational licensing, where the authors of TCE argue, among other things, that the lawyer class in the US has captured political institutions and used this power to make lawyers required, where they otherwise would not be. This is one of these examples of rent-seeking behavior. I digress.
Intellectual property serves as an important protection and motivation for inventors and entrepreneurs. In an excerpt from WNF quoting a letter from James Watt to his father:
“Dear Father,
After a series of various and violent Oppositions I have at last got an Act of Parliament vesting the property of my new Fire engines in me and my Assigns, throughout Great Britain & the plantations for twenty five years to come, which I hope will be very beneficial to me, as there is already considerable demand for them.”
This letter reveals two things. First, Watt was motivated by the market opportunities he anticipated, by the “considerable demand” in Great Britain and its plantations, the English overseas colonies. Second, it shows how he was able to influence Parliament to get what he wanted since it was responsive to the appeals of individuals and innovators.
Other positive examples are pharmaceutical companies that have huge research and development costs, which they can recoup via patented medicine, or artists that require copyright for their work to have any value.
While strong copyright law is one of the drivers that leads many people to start companies, these same laws have since morphed into a monster that achieves the opposite of what it was set out to do: spur innovation. Innovation is not only the process of inventing fully new things, but also the process of taking old ideas and improving them. Excessive copyright stops this from happening.
Similarly, in the world of pharmaceuticals the excessive patent laws lead companies to make profits way beyond the development costs of the relevant drugs, which is a part of the reason for inflated healthcare costs. Completing the above list, artists and labels use copyright law for dodgy profit motivated lawsuits and the fear of such lawsuits limits creative output.
This is not just a book about patent law, but also about how these laws came about, and there is no one who loves their copyrights more than Disney. Disney essentially managed to lobby the government to extend copyright law every time the copyright on Mickey Mouse was about to run out, so much so that the Sonny Bono Act is derisively called the Mickey Mouse Law.
These laws slow creativity and stop new and upcoming artists from freely creating new art. It also wastes countless hours on spurious lawsuits clogging courts from more important matters. By the nature of copyright the label companies must pursue these lawsuits in order to protect their right. All this just to protect one mouse.
Housing
I saved my favorite (or least favorite?) and possibly most important part for last. Housing effects everything. It impacts the jobs you are eligible for. The schools your kids can go to. How much tax you pay. Whether you need a car. On top of this, the average (renter) household is spending about 30% of their income on rent. Given how important housing is, how come we constantly have housing problems? And how can it be that the largest recent financial crash was caused by housing?
One of the first people to notice this problem was Henry George. In 1879 he released his treatise on the topic called Progress and Poverty, where he relates various ills of society back to the private ownership and inefficient use of land. He rejects socialism and communism as adequate solutions, and instead proposes a tax on the unimproved value of land (i.e. what the land would cost without having anything built on it).
The list of supporters for George’s ideas, commonly called Georgism, spans an impressive list from Milton Friedman and Joseph Stiglitz to Bertrand Russell and Leo Tolstoy. Despite this broad support the Land Value Taxes (LVTs) has only been implemented in a few countries and where it has been implemented the rate is not high enough to have a significant effect. One reason for the low adoption rate is the valuation of land. The only price that can be directly observed is the value of the property as a whole. Deducing the former from the latter is a challenge, especially because the housing market is relatively illiquid.
So what does Mr. George actually say beyond “landlordism = bad”? His central observation is that despite all of the progress we seem to have in our society, in terms of the amount and quality of stuff we produce, we still seem to have poverty. This poverty is, paradoxically, particularly bad in cities, which also tend to be richer. Mr. George set out to find the core of this problem, and what he found is (to massively oversimplify) that all excess productivity is being captured by land rents, i.e rent. Land owners are able to do this because people need land. It is an essential resource. It is required not just for housing, but also for offices, hospitals and farms. So any wage increases that stem from increased productivity can be captured by land rents. This is especially bad when land is unevenly divided among the population! Furthermore, the value of land increases in response to increased economic activity around the land. Therefore, not only does a landowners assets appreciate due to the work of other people, but owning unused land actively hinders the productivity increases that are increasing the value of the land! This is a classic case of the free rider problem.
I won’t be able to give Henry George the justice he deserves, but I recommend checking out this (very long four part) book review by Lars Doucet on AstralStarCodex’s blog, or his book Land is a Big Deal.
This brings us back to WNF and TCE. WNF doesn’t talk too much about land beyond the old systems of feudalism and serfdom. TCE is a lot less radical than Mr. George was, and looks at land through the view of zoning. Mr. George rightly identified un-, mis- and underused land as a large source of poverty, unemployment and limited growth. Zoning makes these same problems worse by not just stopping labor and capital from freely using land and allocating resources, but by hindering land owners themselves!
Zoning thus reduces development, and further distorts the not-so-free real estate market. Importantly, it is distorted in the direction of less supply. Additionally, the limits to more housing are not capital, labor or even the will of the land owner, but regulation and community input. An interesting case study is Japan, where zoning was massively reduced and simplified as a response to the 2008 financial crisis. This lead to the highest number of architects per capita in the world, and also cheaper housing. I recommend watching this excellent overview, from where I also took the following chart.
It is important to note that zoning in most countries is determined at a state or local level. In addition, neighbors often have the ability to limit what someone is allowed to build on their own property. The group of people blocking local development have been dubbed “NIMBYs”, short for “not in my backyard”. NIMBYism makes complete sense from a selfish perspective - most developments threaten the price of the most valuable asset they own: their house. This kind of attitude makes America a build-nothing country, causing infrastructure to crumble and making growth sluggish.
A more radical solution, which my mathematician side adores, proposed in the book Radical Markets by Eric A. Posner and E. Glen Weyl, is to put every piece of land (including property) up for permanent auction. That means every landowner must name a price for each of land that they own. Anyone is then allowed to buy this piece of land for the named price. Then a x% tax can be raised on the price. While this doesn’t tax the land directly, it does solve the problem of accurate pricing and liquidity.
All of the aforementioned problems with land have been grouped into the Housing Theory of everything. It posits that everything from climate change and air quality to health and educational outcomes can at least partially be attributed to housing. So the institutions regulating it are amongst the most important and should be more resilient to capture.
Concluding Thoughts
The capture of policy making can happen at every level of government, within and across organizations. Furthermore, there is no clear measure of when an institution is captured, and effects might only be noticeable decades after a relevant policy change.
Wherever there are humans with self-interest you will have humans protecting their self-interest. Thus it is down to institutions to turn this self interest into something productive, via good incentives. A priori it is not always clear what incentives structure is the best, but we have a lot of history to learn from. As with everything, there is no one solution to protect from capture. I’ll leave you with the Charlie Munger quote.
Show me the incentive and I'll show you the outcome.