The roots of poverty

If Pakistan wants to escape poverty, it needs to move past the rhetoric of ‘elimination’ of corruption/terrorism.

“Poverty is the worst form of violence”, said Gandhi.

Why is it that the US, Australia and Norway are so wealthy, while Pakistan is mired in poverty? To answer this question, we have to ask the most fundamental question in economics: “Why are some countries rich, while others are poor?”

It is no coincidence that the father of modern economics, Adam Smith, in 1776, grappled with this same problem. According to Smith, some countries were rich because they had been able to ‘specialise’ their production processes and, hence, could produce more output from the same amounts of inputs. In 330 BC, Aristotle had argued that education is the source of all progress. He postulated that higher educated people are more dexterous in finding new solutions to problems and improving technology which, in turn, led to a reduction in poverty.

Many other explanations on the roots of poverty such as culture, weather, geography and religion were also put forth. Yet, none could robustly claim to be the defining characteristic to explain the varying standards of living which we witness in the world today.

All of these factors play a role as evidenced by their strong ‘correlations’ with economic development. Nevertheless, the problem of missing variables driving this correlation and reverse causality persisted. This made it difficult to assess the extent of relevance of these factors. For example, in contrast to rise in education levels causing economic development, higher incomes made it easier for countries to invest in more and better education. More importantly, education spearheading development leaves open the question: why are some countries ‘more’ educated than others?

The missing link was provided by Douglass North, which later won him the Nobel Prize in economics. He argued that the fundamental cause of economic development depends on “the rules of the game in a society or, more formally, the humanly-devised constraints that shape human interaction”. He provided a formal framework to analyse institutional change and gave historical evidence that institutions are the fundamental cause for economic development.

Daron Acemoglu of MIT and James Robinson of Harvard University left economists around the world awestruck when they not only empirically tested the abstract notion of  ‘institutions’ with economic development, but also found strong evidence that institutions cause growth (understanding exactly how their inferences can plausibly be justified as causal would require an understanding of instrumental variables). They show that what matters the most are the man-made political and economic institutions that limit the power and wealth of the ‘government’ to expropriate rents from the populace.

It was emphatically shown that the different kind of colonising behaviour and consequent institutions put in place by the colonists not only persist up to this day but also explain most of the unequal income distribution we witness in the world today. When Acemoglu and Robinson added institutions to their equations, the effect of education and other determinants of development became marginal. It seems that good institutions not only make access to education easier but are also much stronger determinants of economic development.

The conclusion from all corners of the world is strong and simple: societies that installed institutions that rewarded innovation, created accountability and, in general, allowed everyone to participate in economic opportunities were the ones that flourished, while others remained mired in poverty. If Pakistan wants to escape poverty, it needs to move past the rhetoric of increases in tax-to-GDP ratios and ‘elimination’ of corruption/terrorism. As the Planning Commission’s “Framework for Economic Growth” rightly argues, Pakistan has to change its ‘software’ of economic development. It needs institutional reforms in civil service and the legal and judicial systems. It also needs a complete replacement of the old extractive bureaucratic institutional structures set in place by the British colonists with inclusive institutions.

Published in The Express Tribune, June 15^th, 2013.

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