Economic structures, institutions and economic performance

2.1 Economic structures and institutions

The debate on institutions and development is centred on the direction of causation. While new institutional economists argue that institutions cause growth, the literature on industrial policies (Chang 2003; Khan and Jomo 2000; Reinert 2008), among others, contend that growth and development determine the direction and rate of institutional change. In this article, we make two claims: (1) there is bidirectional causality between institutions and economic structures and (2) the type of economic structure determines the performance or efficacy of formal institutions.

2.2 Economic structures and the allocation of talent

The connection between economic structure and the allocation of talent has not been explored within the literature. The dominant view is that institutions determine the allocation of talent between rent seeking and entrepreneurship (Baumol 1996; Murphy et al. 1991, 1993). But we argue that a given economic structure has a given structure of occupational rents that determines the allocation of talent. For instance, FIRE¹ economies demand financial entrepreneurs, while largely agricultural economies have a labour market structure that corresponds to its economic system. An economy with “excessive” rent seeking or too many lawyers, as in Murphy et al. (1991), is principally a phenomenon of the economic structure as opposed to institutional failure.

Why occupational rents rather than occupational remuneration? The former refers to the income earned by key players of a certain economic structure well above what their entrepreneurial talent justifies. Consider the agrarian economic structure and the landlords’ rent David Ricardo forcefully criticized or the financial rents earned by financiers in FIRE economies, and in the context of less developed countries, consider the political rents earned by political entrepreneurs that control access to the relatively large pool of non-market resources. In a given economic structure, there is a small group of what we may call rentiers that benefit disproportionally from the production structure and the occupational rents become the regulatory mechanism for the labour market. Consequently, occupational rents serve as a source of de facto political power that one can potentially transform into de jure political power. The latter is used to enforce economic institutions that support the production structure and by extension, occupational rents. This generates an equilibrium that explains both structural and institutional rigidities. This equilibrium is unlike the stability between reward structures and the allocation of talent proposed in Acemoglu (1995). Acemoglu explains that the past allocations of talent influence future reward structures and shape the future allocation of talent—note that economic structure is missing from this equilibrium process.

Khan (2010) and Acemoglu et al. (2005) argue that institutional inertia exists because the distribution of benefits derived from the institution is consistent with the distribution of political power in society. But as explained earlier, institutions are underpinned by production structures, thus, the equilibrium is among economic structure, political power and institutions. There can be great political interest in creating structural rigidities in economic systems as long as this is beneficial to powerful groups. The financial entrepreneurs in the FIRE economy have a large cohort of lobbyists to ensure that the sector remains under-regulated and to perpetually justify an unfair tax code. In poor countries, the rural population represents a greater share of the total political constituency and this creates political incentives to maintain an unjustifiably large rural economy. While modernization is always the central objective of poor countries, the rural–urban divide is a formidable political constraint to any modernization project. Further, political entrepreneurs benefit from the rural–urban divide and enact policies to fortify this division.

The contention that economic structures determine the structure of occupational rents is a thesis about the structural origins of the distribution of income. Recent research has established a robust empirical relationship between production structure and the distribution of income (Hartmann et al. 2015). Economic structures determine the pre-tax income across various occupations. In the absence of redistributive transfers, the distribution of income across sectors and occupations affect economic performance, to the extent that these reinforce the economic structure. Piketty (2014) and Stiglitz (2013) explain that the rise of inequality in rich countries is due to the increasing gap of the income share between the 1% and the 99%. Based on the framework presented here, the income share of the top 1% is largely an outcome of the economic structure, specifically, the rise of the FIRE economy (see Onaran and Stockhammer 2011; Stiglitz 2013, 2015a). The latter has become the principal regulator of growth in the USA and other developed countries (Lapavitsas and Powell 2013). This structural change has manifested itself in a labour market geared towards finance, which reinforces the FIRE economy. Over time, this equilibrium engenders Minsky cycles (Minsky 1992) and lead to financial crises.

Distributional conflicts are essentially a struggle over property rights to the gains from growth. This means that the rise of inequality is not only structurally determined but also represents an increasing concentration of property rights. This is the epitome of “extractive” institutions in the sense that Acemoglu et al. (2005) use this term. If a broad cross section of society has property rights, then the gains from growth must be shared among a broad cross section of society. Yet, growth in the USA and other developed countries over the past four decades have not been inclusive (Piketty 2014), even though these countries are known for having “inclusive” institutions and stable property rights. This means either the theory proposed by Acemoglu et al. (2005) or the empirical assessment of institutions in developed countries is flawed or both. In our view, there are limitations on both fronts.

2.3 Economic structures and political transitions

The central aim of Political Economy is to emphasize the importance of politics for economic outcomes. Acemoglu et al. (2014) have provided empirical support for the claim that liberal democracy does cause growth, but this finding was recently overturned by Pozuelo et al. (2016). It is important to differentiate between liberal and electoral or illiberal democracies (Zakaria 2013). Besides regular elections, electoral democracies violate civil liberties, censor the media and fundamentally establish an authoritarian form.

Can economic structures predict political transitions? Acemoglu and Robinson (2006) in their book, Economic Origins of Dictatorship and Democracy, have proposed a theory of democratic transition and consolidation that is based on a country’s economic structure. The latter is defined as either land or capital intensive and though this view is different from ours, the difference can be easily reconciled. Among the economic activities located at the periphery of the product space are natural resources like oil, gold and land. Also, it is not incorrect to say that the goods/services located at the centre of the product space are capital intensive.

Whether a country transitions to or consolidates democracy depends on whether the source of income of the elites is easily taxed (Acemoglu and Robinson 2006). When a country’s economic structure is land intensive, a democratic transition imposes significant redistributive costs to the landlord elites since the newly empowered masses can easily impose high land taxes. Elites in these economic structures choose repression instead of democracy to forgo the redistributive burden. In contrast, industrial elites facilitate a democratic transition since it is harder to tax capital income and entrepreneurship in capital intensive economic structures. In short, economic development towards a capital intensive economic structure promotes democracy (Acemoglu and Robinson 2006).

It is instructive to recall Acemoglu et al. (2005)’s theory of economic growth. Inclusive political institutions (democracy) and inclusive economic institutions (property rights, etc.) are the fundamental causes of economic growth. Yet, in Acemoglu and Robinson (2006) they posit that it is a country’s economic structure that determines whether a country transitions to or consolidates democracy. Given this examination, it is economic structure that is the fundamental cause of long-run growth.

But our framework provides a richer analysis of the link between economic structure and democracy. An increasing returns economic structure produces commodities with longer career ladders and creates a mechanism to climb the ladders across social classes. This provides the means to larger lifetime earnings for an individual, which can improve the distribution of income. A fairer distribution of income is the anti-thesis to “extractive” institutions, and this makes it easier for “inclusive” political institutions to be enforced.

As explained earlier, in increasing returns production structures both wages and profits are sustained for longer periods. This is a recipe for the creation or maintenance of a strong middle class, an important ingredient to the creation and maintenance of democracies (Acemoglu and Robinson 2006). Note that structural transformation to an increasing returns economic structure does not inevitably lead to democratic transitions or consolidation; it simply makes the enforcement of “inclusive” institutions feasible. It is important to underline the difference between our theory of political transitions and the modernization hypothesis (Lipset 1959), which claims that growth in per capita income causes the creation and consolidation of democracies. There are many non-democratic countries with high per capita incomes but with diminishing returns economic structures—Equatorial Guinea is a case in point. Per capita income is not economic structure. Further, after controlling for country fixed effects, the relationship between per capita income and democracy breaks down (Acemoglu et al. 2008).

Khan (2010) argues that democratic transitions become more likely when private sector production to GDP expands. Khan explains that entrepreneurs pay more taxes and thus have more at stake in the political system and consequently demand a greater say. This line of thought is consistent with our work: as an economy transitions to an increasing returns production structure, democratic transitions are more likely. This is unlike North et al. (2007) and their necessary conditions for democratic transitions. They posit that: (1) a rule of law for elites, (2) civil society organizations and (3) a centralized and consolidated control of violence are necessary, though not sufficient prerequisites for democratic transitions. But we have already demonstrated that the performance of conditions (1) and (2) depend on economic structures, making these less than robust conditions for democratic transitions. Also, condition (3) is a necessary factor for stability in democratic and non-democratic states, which makes this a less than interesting necessary condition for democratic transitions.

The critical junctures hypothesis (Acemoglu and Robinson 2013; Moore 1966; Eggertsson and Sokoloff 1997 among others) explains that historical events like colonialism are a better explanation for divergent paths. Under diverse colonial strategies, different institutions were established, “inclusive” and “extractive”, and this explains the divergence in political institutions and economic performance. We agree that critical junctures are important. Some colonial strategies deliberately prevented colonies from producing commodities with increasing returns and by extension, prevented growth-enhancing structural change. Colonialism was not anti-development because of “extractive” institutions; it was anti-development because colonialists restricted production to only a handful of commodities with limited scope for structural learning.

In their book, Why Nations Fail, Acemoglu and Robinson (2013) made the observation that poor innovation and “extractive” institutions are correlated while innovations co-exist with “inclusive” institutions. In Acemoglu (2008), the author highlights the political origins of technological change—in less democratic societies, political elites create entry barriers into different economic activities (oligarchic property rights), but in democratic societies, there is free entry and exit (democratic property rights). Over time, as comparative advantage changes in favour of the excluded groups, oligarchic property rights reduce efficiency and slow down technical progress. In contrast, democratic or “inclusive” political institutions promote innovation and long-run growth.

While democratic property rights may diffuse the technical knowledge across society, these democratic property rights are irrelevant in diminishing returns production structures with a low technological base. This is the key difference between our view and Acemoglu (2008). Just as private property rights in the absence of productive capabilities are insufficient to increase production, democratic institutions without a technological base can hardly diffuse or promote technological progress. The observation in Acemoglu and Robinson (2013) is simply reflective of differences in economic structures, and this explains the different political institutions and rate of technical progress. Building on Acemoglu (2008), we now have two routes through which economic structures determine the rate of technical change and economic growth: the economic route, which we have already explained, and now the political route—from economic structures to political transitions to technical change.

2.4 A simple model

Pulling all the pieces together result in the following basic representation of our theory (see Fig. 1). Economic structure determines the distribution of income, and this serves as the basis for de facto and de jure political powers. The acquired political power is used to perpetuate the distribution of income through the enforcement of institutions that reinforce the production structure. Finally, the economic structure determines the rate of economic growth. This is the basic process by which institutions, political power and economic structures reproduce each other.

During structural transformations, the distribution of income and de jure and de facto political powers change and this facilitates the enforcement of new institutions to regulate the new economic structure. Specifically, growth-enhancing structural changes are observed when institutions of production are effectively enforced by the state. This can potentially ignite democratic transitions or consolidation and increase the transmission of technology across the economy. In contrast, economic stagnation and growth accelerations and collapses are observed in many parts of the world and these economies are usually embedded in electoral democracies. The origin of their failure to strengthen their democracies and provide a sustainable base for economic growth lies in their diminishing returns economic structure.

3.1 US case study

During the 1800s, the agrarian economy contributed the most to US GDP and much of the world’s output. But farm productivity shocks and expanded cultivation substantially reduced agricultural prices and incomes in the early 1900s (League of Nations 1931; Timoshenko 1933), and this affected the structure of the economy in important ways. The decline was especially severe between 1929 and 1932—agricultural incomes decreased by 50%. One important implication of this secular decline is the shedding of agricultural employment that led to massive joblessness, since new sectors and economic activities failed to fully utilize the growing pool of the unemployed. In theory, the purchasing power of urban wages increased, but this expansionary effect was stifled by the drastic contraction of agricultural demand for urban commodities (Gatti et al. 2012). This depressed demand in both the rural and urban economies paved the way for a secular stagnation.

This period of structural change inevitably altered the distribution of occupational rents against rural labour, which increased rural-urban inequality and exacerbated the deflationary tendencies of the transformation. To fully grasp the distributional implications, it is useful to remember that during this period initial levels of inequality were already high. Piketty (2014) notes that from 1800–1910, private capital as a percentage of national income was on average 700% for Germany, France and Britain, while in the USA, it ranged from 300 to 500%. In agrarian economies, the ownership of capital was highly concentrated leading to significant inequalities of wealth and income. Though some landowners had lost private wealth during the agrarian transformation, the loss of agricultural employment countered any tendency to reduce wealth inequality.

During this transformation, manufacturing, construction and trade services were the newly emerging sectors, which demonstrated a structural change towards the centre of the product space or to an increasing returns production structure. But Gatti et al. (2012) explain that the transformation was not complete and could not have been completed under market institutions alone. In other words, labour market forces alone were insufficient to facilitate the necessary rural–urban migration. There were specific labour market rigidities that prevented rural labour from migrating to the cities and sufficient technological bottlenecks that stymied manufacturing growth (Gatti et al. 2012). Therefore, the structural transformation was not growth enhancing, especially in consideration of the deflationary tendencies. World War I (WWI) served as a temporary boost to economic growth in the US economy and accelerated the transformation to an increasing returns economic structure but the process remained incomplete. Based on our theory, we expect institutional reforms to follow that serve only the interests of economic elites.

Increase in rural–urban inequality and mass agricultural unemployment alter de facto political power, which influenced de jure political power to reduce top income tax rates, among other things, and this worsened inequality. High inequality and forced savings during WWI created a large pool of loanable funds that did not find profitable avenues in agriculture, and the newly emerging industrial sector was insufficient to exploit the excess savings. These gave way to the unfortunate idea of cheap credit or buy now and pay later. Consequently, this created a debt-induced growth model since consumption expenditures exceeded the declining agricultural and urban incomes.

It is difficult to sustain economic growth based on high inequality and an incomplete structural transformation. As opposed to a structural change to an increasing returns production structure with longer career ladders and lower inequality, the economic elites chose to fuel a consumption boom based on cheap credit, which facilitated financial speculation and the growth in household debt. Collectively, these created a stock market bubble that led to the great depression. There were two responses to the latter: (1) Keynesian pump priming and (2) forced industrial policies that embodied the war effort in World War II (WWII). The latter was a non-market intervention aimed at industrializing the USA to manufacture airplanes, weaponry and armours. Unlike the earlier period of structural change, the newly industrialized USA forced labour off the farms and absorbed idle labour into factories. This process essentially put an end to the great depression and forged a new equilibrium. The growth effects of this structural transformation are well documented and are best summed up in the phrase—“the golden age of capitalism”.

This period (1950–1975) marked the completion of the transformation to an increasing returns economic structure, where industry accounted for a growing share of output and employment (Rowthorn and Wells 1987; Singh 1977). Glyn et al. (1988) explain that this was a period of massive growth in capital stock and labour productivity and parallel growth in real wages and productivity. While the great depression and WWII were important shocks that reduced inequality (Piketty 2014), the growth of manufacturing jobs and career ladders, strong unions and a tighter relationship between wages and productivity also stabilized the growth of inequality. This was a period of stable property rights that created a sufficient wedge between de facto and de jure political powers. Proof of this is the fact that tax rates on top incomes increased to 90% (Piketty 2014), an important contrast to the periods before the depression.

It is not a coincidence that this period accompanied extensive industrial policies to promote growth-enhancing structural change. The USA was the only country with a trade surplus after WWII and was in a unique position to create what Varoufakis (2013) calls a global reserve recycling mechanism (GRM). The Marshal Plan, to rebuild war torn Europe, was the creation of this mechanism. It also served the purpose of containing the Soviet Union through the re-industrialization of Germany, Britain and France. After the Korean crisis, a second Marshal Plan became essential and the USA through its (GRM), aided Japan in its industrialization process. The principal point is that there was a convergence towards an increasing returns economic structure among the leading countries in the world economy and this created a global engine of sustainable growth.

After the completion of both Marshal Plans the USA lost significant global market share (Varoufakis 2013). This ushered in yet again, a new phase of structural transformation. The success of the global reserve recycling mechanism, similar to the success of technical progress in the farm economy, led to de-industrialization and the subsequent loss of manufacturing employment. Occupational rents changed against industrial labour and deflationary tendencies emerged. Further, career ladders became shorter in both industry and the service sector. As manufacturing employment declined, wage shares trended downwards and the overall functional income distribution worsened. As the income share of the middle class declined, the de facto political power of economic elites, who are increasingly financiers, increased.

These changes in the distribution of income and political power led to new institutions like tax cuts, financial de-regulation, de-unionization, etc., in the early 1980s. This paved the way for a new economic structure that is now reproduced by the FIRE economy. Unlike the earlier periods of structural change, there was no world war to compensate for the deflationary effects associated with rising inequality, so the old strategy of credit booms was used to boost growth. This was sustained by cheap credit, debt accumulation and a housing bubble that eventually collapsed, as the strategy did in the great depression.

The rise of the FIRE economy worsened inequality (Stockhammer 2013) and stalled the new process of structural transformation. Growth was not based on economic activities with increasing returns; rather, a financial bubble stimulated the economy. Given this analysis, the recent global financial crisis is the consequence of a stalled structural transformation, where the top 1% income earners, through their de facto influence, hold the levers of de jure political power to reinforce the system. What is missing today is a modern Marshal Plan or new institutions of production to accelerate the pace of the transformation so that advanced technologies in the USA can be applied to new increasing returns economic activities.

3.2 A brief discussion

This case study supports the view that the direction and rate of structural change are the ultimate determinants of economic performance. One key mechanism by which structural transformations affect growth is through the changes in the distribution of income and its corresponding influence on political institutions. This insight leads to an important conclusion that the distribution of property rights is endogenous. Even if broad-based property rights are well defined and enforced, there can be external shocks that ignite structural changes and disturb this equilibrium. This undermines Acemoglu and Robinson (2013)’s contention that “good” institutions have feedback loops that prevent the efforts of elites to undermine them. More fundamentally, Acemoglu et al. (2005)’s distinction of “inclusive” and “extractive” institutions may be an over simplification. The case study demonstrates periods of extractive growth, meaning the co-existence of rising inequality and economic growth. But this is contrary to the predictive outcomes associated with “inclusive” institutions, and Acemoglu et al. (2005) do consider the USA to be a robust example of a society with strong and “inclusive” institutions.

The evidence in this case study supports our view that economic structures and institutions reinforce each other. As the economic structure changed, so did occupational rents and political power. This in turn created and enforced new institutions that were consistent with the new distribution of occupational rents and economic structure. It is this equilibrium dynamic that creates structural rigidities. An additional insight is that high inequality is the likely outcome of structural changes away from increasing returns production structures. This has the consequence of creating deflationary outcomes that may be papered over by credit booms and a debt-induced growth model, which increases the likelihood of financial crises.

It is also useful to note that WWII and the (GRM) not only accelerated structural transformation but were specific institutions of production that nudged structural change in the direction of increasing returns economic activities. Though the recent decline in manufacturing was not a change in knowledge base per se, it was an important loss of production capabilities that provided ladders across social classes and a wide scope for structural learning. Unless new economic activities are produced with similar characteristics the social and economic consequences for the US economy are nothing short of dismal.