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Daron Acemoglu Speech by Andreas Papandreou

(5/9/2014)

The University of Athens is quite frugal in awarding honorary doctorates in economics. It took exactly one century after political economy, or plutology, had been taught in this establishment (from the inception of the first University in the free Balkans) that an honorary doctorate was awarded in 1937 to Gustav Cassel, Irving Fisher and Sir Josiah Stamp. It was again only in the nineties that our Department awarded such degrees to Harry Markowitz, Frank Hahn and Amartya Sen. These eminent economists and fertile minds had pushed the envelope of our knowledge in economics each in his own special way. What are among the basic criteria that characterize such honours we have bestowed? No special relationship with our University is required. International eminence in scholarship is certainly a necessary condition. But keeping within the liberal tradition of this department that emphasizes pluralism of approaches and the capacity to look beyond the

mainstream orthodoxy, we especially value those who show originality in thought and can transcend the boundaries of normal science (in the Kuhnian sense) even if they work squarely within it.

Daron Acemoglu certainly fulfills both these criteria. His use of theoretical and empirical analysis, combined with unparalleled originality

and thoroughness have propelled him to the frontier of each of the many fields that he has explored, including labor economics, macroeconomics and political economy. The Clark Medal committee noted that «his work is always motivated by real-world questions that arise when facts are difficult to reconcile with existing theory». This is very important; as many people often rightly believe that economic theory has become removed from society and its real problems.

His great breadth has also involved a singular capacity to connect macroeconomic and microeconomic analysis. As he says: "If you want to fully understand the wider picture--growth, political economy, long-run issues--you have to understand underlying micro principles such as incentives, allocation of resources, technological change, and capital accumulation" (Willson 2010). This reasoning goes beyond the sterile insistence on microfoundations and brings us closer to the real political economy. This deeper bridging of the micro and macro picture combined with his exceptional capacity in theoretical modeling and empirical analysis, allow him to explain real world phenomena in ways that defy the conventional wisdom of the mainstream economic paradigm. It shows that in the hands of a social scientist economic theory can go way beyond the simple reinforcement of particular ideological and political viewpoints. Economics, practiced this way, can deeply disrupt political, economic and ideological biases.

Questions that have driven much of his earlier work include: “What determines the accumulation of human capital both during formal schooling and on the job? How do the implications of labor market frictions depend on the information available to job searches? How do economic incentives affect the type of technological change that we observe? Why

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are there such enormous differences in output per worker and total factor productivity across countries?” (Schimmer 2007).

From at least the time of Adam Smith, skills and training of the workforce have been seen as the engine of economic growth, and many economists, including Acemoglu have focused on researching this matter. The standard view from Pigou to Becker was that firms do not have an incentive to provide general training of workers who would have the incentive themselves, while firms did have an incentive to provide specific training related to their own activities. Accordingly, the market for training worked efficiently without any need for state intervention. Acemoglu's work in the early 1990s showed that market failures in the labor market make some form of regulation necessary. While firms may provide some general training, without state intervention the investment in human capital could be inefficiently low. He also showed, that despite the common criticisms against unemployment insurance, such insurance can play a critical role in overcoming these inefficiencies.

From this work Acemoglu moved on to research the relationship between skill levels and technological change and the extent of wage differences between skilled and unskilled workers. He proposed a new theoretical framework for understanding technological change and its relationship to globalization and the differences in productivity among nations and economic sectors.

Acemoglu has focused systematically on the issue of economic growth. His voluminous yet concise textbook on economic growth was published in 2009 and it has become the main reference for teaching in graduate economics. His contributions to mathematical modeling of economic growth and its econometric investigation are great. With these analytical tools in hand he has moved deeper into the heart of the underlying causes of economic growth and the development of nations. This central part of his work has gained him a wide international audience and made him known beyond the confines of the economics profession. Partly because of the limited time I have and the enormous breadth of his research, for the remainder of this speech I will focus on this latest strand of his work.

While still a Ph.D. student at LSE Acemoglu met his longtime collaborator James Robinson, now a professor of government at Harvard University, and they agreed that the key factor in starting economic development was democracy.

It probably comes as no surprise to you here, but when Acemoglu started working on this subject he asked the question: How did democracy come about? It is not a question one expects from an economist and you’ll have difficulty finding economists before Acemoglu raising this question.

This was the start of a political economy research focus on the big themes of what determines the wealth and poverty of nations. In The Economic Origins of Dictatorship and Democracy published in 2006, Acemoglu and Robinson investigate which factors determine whether a country becomes a democracy and why democracy persists in some countries and collapses in others.

I think the Greeks among us will wonder about our own country that is celebrating 40 years of continuous democracy; the longest duration in the past century.

Let’s see briefly what he says. Before 1800 all societies lived under authoritarian regimes. This meant low or no investment in human capital – what non-economists call education. Economies were essentially static. The growth and death of firms, what we now call creative destruction, was not part of the fabric of economies partly because elites resisted new technologies that undermined their power.

Essentially, nations were not growing because elites saw technological advancement and innovation as threats.

How then did nations move from a state of stasis to continuous growth? Received theory posits that growth occurred in Western Europe because international trade rose with

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the discovery of the New World and the opening of new sea routes. Acemoglu convincingly argues that this is not the actual reason.

The increase in trade itself was not what brought about growth. Trade however boosted economic and political power of a new group of merchants, traders and industrialists. The increased competition for power weakened the European monarchies and sewed the seeds for new institutions. This was accompanied by greater protection of property rights, i.e., a weakening of the power of the monarchy, and increased democratic practices. This formation of more participatory or inclusive institutions is what let to the strong and continuing development of Western Europe.

Let's stay with this argument a little while longer because it is original and path breaking.

Acemoglu follows up the work on Europe by examining the joint evolution of political and economic institutions throughout history; from the Romans to the Chinese dynasties, the Incas and the Aztecs to modern economies throughout the world - a sweeping view indeed. This is all part of his most recent best-selling book published in 2012 Why Nations Fail: the origins of power, prosperity and poverty.

What is the main thesis? It is that inclusive economic and political institutions provide the key to the mystery

of long-run growth. Let's give two examples. The Incas and North America. 500 years ago the Inca

Empire was rich and technologically sophisticated while North America was not. The Incas were into extraction of wealth from their citizens. This meant they could not last as an empire. Everything produced went to the big guys, the kings. This absence of sharing, this permanent extraction economy, the domination of the country's surplus by "special interests" if you will, was not sustainable. On the other hand, North America followed a different path with more inclusive institutions and it flourished. What determines whether economies share their wealth or hoard it at the top are the institutions in place.

Institutions then, how humans organise their economic and political activity, are the key to prosperity, they also explain why certain societies fail. Countries that have institutions that are inclusive and thus facilitate factor accumulation, innovation and efficient allocation will prosper. This argument is quite refreshing but also very different than received economic theory for the last two centuries. Until today economists claimed that growth depends on things like savings rates, preferences or other exogenous factors like trade. This theory also goes against popular theories that focus on geography (climate, agriculture, "disease burden"), culture (values, preferences and beliefs) or luck.

Let's give a more recent historical example. The border separating the US and Mexico, cuts across two regions sharing identical

geography and climate yet very different levels of prosperity and growth. The difference is in their institutions. For instance, looking just at financial institutions, the authoritarian regime in Mexico generated monopolies in the banking sector, while the federal and more democratic US prevented politicians from appropriating rents that could flow from monopoly banking. In the US we had better financial institutions. Competition in the banking sector led to innovation for the benefit of the broader community rather than lining the pockets of political elites as it did in Mexico. One could also argue that the recent financial crisis is the result in part of the great concentration in economic and political power over the last 20 years of the American financial institutions.

There is still the question of how institutions themselves arise? In the Acemoglu model they arise from within society itself. They are what economists call endogenously determined.

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This creates an empirical problem - a sort of chicken and egg issue. What comes first, the chicken or the egg? Do good institutions create strong growth or is it strong growth that determines the institutions?

Acemogly and Robinson tried to test this question empirically and here is what they did. They wanted to test the impact of inclusive institutions on long-term growth. Let's look at the case of Latin American colonies. In countries where the European settlers were dying all the time and had high mortality rates, the colonizers did their best to get most out of the economies - they followed an extractive policy - get as much out of the country and get out of there! In fact it was easy because extractive institutions, like those of the Inca Empire were already in place. In places that were sparsely settled like North America, the European settlers did not die as fast, settlers ended up taking root and started to promote property rights and more egalitarian institutions. They eventually were able to rise up against elites supported by the English Crown. So countries that at the time of colonization had high mortality rates that proxy well for extractive institutions were unable to grow while those with low mortality rates were settled and inclusive institutions brought long-term growth. Inclusive institutions were the cause of growth and not the other way around.

If institutions are the key to prosperity, how do these come about? For Acemoglu the most promising approach to understanding institutional change and persistence of institutions is to see it as the result of social conflict over their distributional implications.

Groups with political power will favor the institutions that will increase or maintain their control over resources and power. This contrasts with a common view that the most efficient institutions are the ones that will evolve. There is no 'invisible hand' to select institutions. Powerful interest groups drive institutional change. This means that the same groups may make more money or retain their power by preserving or forming inefficient or ‘bad’ institutions.

The explanation of selection and persistence of inefficient institutions is related to the commitment problem in politics. What does this mean? Those wielding power (a monarch, a dictator, an oligarchy, plutocrats, kleptocrats or cronies) cannot commit to not exploiting productive investments from other groups. In other words, even if a King promises to commit to productive investments, this commitment is not credible because there is no independent enforcement. This means that institutions like a dictatorship or plutocracy cannot bargain with the rest of society in a meaningful fashion. So if the number one man says "let me remain your king and I will make sure no one takes the riches that will flow from your hard work and investment," he won’t be believed. For that reason, there will be no incentive to take risks and invest in the long run.

On the other hand, inclusive institutions, with their many checks and balances are the only credible means by which individuals in society are assured that they all will share in the wealth that they generate. In that sense, the citizen is protected by competition in the political sphere.

There is a somewhat simple implicit and radical implication of this theory. Greater prosperity is linked to a broader spread of political and economic power. Extractive political and economic institutions can generate growth for periods of time but ultimately they will stunt Schumpetarian creative destruction.

Protecting citizens from the risk of government expropriation is thus critical for economic growth. Democracy (or deepening democracy) and economic growth go hand in hand.

The apparent simplicity of his institutional approach is in fact full of critical nuances. While democracy has been shown to cause economic growth, Acemoglu's recent empirical work also shows that democracy does not necessarily bring about greater economic equality.

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One possible explanation is that democratic reform may go hand in hand with the capturing of the democratic process by the elites. Many countries may undertake democratic reform in ways that leave intact the underlying power structure. Even though the institution of slavery was abolished in the US, the elites in the Southern States found ways to maintain the same labor market conditions. Similarly, in many Latin American countries, democratization of political institutions has not diminished the de facto power of existing elites or the persistence of extractive economic institutions.

Indeed, elites may not resist reforms that appear to increase democracy. They will find other means of capturing democracy through control of the judiciary, media, lobbying, and other ways of influencing the party system. Rich elites will often favour an inefficient state with overemployment of bureaucrats through patronage. This all sounds too familiar. I cannot help but wonder about the unprecedented Greek crisis that is certainly also related to weak and extractive institutions: Have the recent reforms in Greece altered the de facto power of its elites? Acemoglu has been critical of standard IMF type reforms for not focusing on the underlying problem that is the extractive nature of existing power structures. Do we have a deep understanding of the extractive and crony power structures in Greece and are we doing something about it?

So here we are: Acemoglu has put political power and political conflict at the epicenter of economic development in a way that makes sense. This element is treated as central to understanding the success and failure of economies.

If we want to understand what makes an economy "good" we need to understand how institutions affect the distribution of power and income. We need to understand whether too much power is wielded by small elites or is spread more evenly. This is why economics is inseparable from an understanding, inter alia, of politics, the nature of political and economic institutions, power, forms of democracy, inequality. This is what Acemoglu has demonstrated so effectively both empirically and theoretically, and in doing so has critically helped move political and institutional analysis from the periphery of economics to its core, from an add-on or an alternative perspective, to the key to understanding economics.

Acemoglu's work is emblematic of the kind of pluralistic approach and political economy focus that our economics department aspires to. His substantial work on the relevance of democracy for economic development adds some nice symbolism to being honored in the cradle of democracy.

The timing of this honorary degree with his delivery today of the Amartya Sen Lecture is propitious. Nobel Laureate Amartya Sen has also received an honorary degree from our department. He is one of the greatest theorists of democracy. Few have done more than Amartya Sen to underscore the importance of human freedoms - both as ends in themselves as well as means for removing poverty and achieving prosperity. Sen's observation that no famine has ever occurred in a democratic society is one of the most widely known empirical findings. Sen's book Development as Freedom powerfully presents the normative value of protecting and expanding freedoms while also showing that these ends are often their own best means. Daron Acemoglu wonderfully and parsimoniously captures this consequential role of expanding freedoms. We can now see, through his empirical and theoretical work, the central role of inclusive political and economic institutions for human flourishing.

References Acemoglu, Daron. "Technical Change, Inequality, and the Labor Market." Journal of

Economic Literature XL, no. March (2002): 7-72.

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Acemoglu, Daron, Simon Johnson, James Robinson, and Yunyong Thaicharoen. 2003. Institutional causes, macroeconomic symptoms: Volatility, crises and growth. Journal of Monetary Economics 50 (1): 49-123.

Acemoglu, D. (2005). Institutions as a fundamental cause of long-run growth. In P. Aghion & S. N. Durlauf (Eds.), Handbook of economic growth (pp. 386-420). Amsterdam: Elsevier.

Acemoglu, Daron and James A. Robinson. 2006. Economic origins of dictatorship and democracy. In Economic Origins of Dictatorship and Democracy. Cambridge, UK: Cambridge University Press.

Acemoglu, D, and J A Robinson. "De Facto Political Power and Institutional Persistence." The American economic review 96, no. 2 (2006): 325-330.

Acemoglu, Daron, and James A Robinson. "Persistence of Power, Elites, and Institutions." American Economic Review 98, no. 1 (2008).

Acemoglu, Daron. Introduction to Modern Economic Growth. Princeton, New Jersey: Princeton University Press, 2009.

Acemoglu, Daron, Georgy Egorov, Konstantin Sonin, and Bureau Bureau of Economic National. 2009. Political selection and persistence of bad governments

Acemoglu, Daron, Davide Ticchi, and Andrea Vindigni. "Emergence and persistence of inefficient states" Journal of the European Economic Association 9, no. 2 (2011).

Acemoglu, Daron, and James A Robinson. Γιατί Αποτυγχάνουν Τα Έθνη: Οι Καταβολές Της Ισχύος, Της Ευηµερίας Και Της Φτώχειας. Α.Α. Λιβάνης, 2012.

Acemoglu, Daron, Suresh Naidu, Pascual Restrepo, and James A. Robinson. 2013. Democracy, public policy and inequality. Comparative Democratization 11 (3).

Acemoglu, Daron, Suresh Naidu, Pascual Restrepo, and James A Robinson. 2014. Democracy does cause growth National Bureau of Economic Research.

Shimer, R. (2007). Daron acemoglu : 2005 john bates clark medalist. The Journal of Economic Perspectives (Nashville), 21(01), 191-207.

Willson, Simon. "Breacher of the Peace: A Profile of Daron Acemoglu." People in Economics, 2010.