REVERSAL OF FORTUNE:

GEOGRAPHY AND INSTITUTIONS IN THE MAKING OF THE MODERN WORLD INCOME DISTRIBUTION

Daron Acemoglu

Simon Johnson

James A. Robinson

NATIONAL BUREAU OF ECONOMIC RESEARCH

1050 Massachusetts Avenue

Cambridge, MA 02138

September 2001

ABSTRACT

Among countries colonized by European powers during the past 500 years those that were relatively rich in 1500 are now relatively poor. We document this reversal using data on urbanization patterns and population density, which, we argue, proxy for economic prosperity. This reversal is inconsistent with a view that links economic development to geographic factors. According to the geography view, societies that were relatively rich in 1500 should also be relatively rich today. In contrast, the reversal is consistent with the role of institutions in economic development. The expansion of European overseas empires starting in the 15th century led to a major change in the institutions of the societies they colonized. In fact, the European intervention appears to have created an "institutional reversal" among these societies, in the sense that Europeans were more likely to introduce institutions encouraging investment in regions that were previously poor. This institutional reversal accounts for the reversal in relative incomes. We provide further support for this view by documenting that the reversal in relative incomes took place during the 19th century, and resulted from societies with good institutions taking advantage of industrialization opportunities.

1. Introduction

The “geography hypothesis” explains most of the differences in economic prosperity by geographic, climatic or ecological differences across countries. The list of scholars who have emphasized the importance of geographic factors includes, inter alia, Niccolo Machiavelli, Charles de Montesquieu, Arnold Toynbee, Alfred Marshall, Ellsworth Huntington, and Gunnar Myrdal. All of these authors viewed climate as a key determinant of work effort, productivity, and ultimately, the success of nations. In a recent influential book, Jared Diamond (1997) has argued for the importance of the geographic determinants of the Neolithic revolution, and linked modern prosperity to the timing of the emergence of settled agriculture. He forcefully states that “the striking differences between the long-term histories of peoples of the different continents have been... [due to]... differences in their environments” (p. 405). Similarly, Jeffrey Sachs (2001) has argued for the importance of technology, disease environment and transport costs, which are determined by physical geography and climate, for example as proxied by distance from the equator.

An alternative view, which we refer to as the institutions hypothesis, relates differences in economic performance to the organization of society. Societies that provide incentives and opportunities for investment will be richer than those that fail to do so (e.g., North and Thomas, 1973, North and Weingast, 1989, and Olson, 2000). This view dates back at least to John Locke, who argued for the necessity of property rights for productive activities, and to Adam Smith, who stressed the role of “peace, easy taxes, and a tolerable administration of justice” in generating prosperity (quoted in Jones, 1981, p. 235).

In this paper, we attempt to distinguish between these two broad hypotheses. If geography is the key determinant of income differences across countries, economic performance should be highly persistent, since geographic factors have not changed much during recent history. To the extent that other factors also matter for income, persistence will not be perfect, but we should expect relatively rich countries today to have been, on average, richer 100, 200, 500 or even 1000 years ago (see, e.g., Diamond, 1997). Since institutions and the way that societies are organized are persistent, the institutions hypothesis also predicts persistence in income levels. Nevertheless, if there is a major change in institutions, then we should expect a significant change in the distribution of income across countries.

The expansion of European overseas empires starting at the end of the 15th century provides an appealing “natural experiment” to distinguish between these two contrasting predictions. Despite the radical social changes caused in the colonies by the European intervention, the geography view predicts persistence in relative incomes: the same geographic, climatic and ecological factors making countries prosperous before should also contribute to prosperity after European colonization. In contrast, if European dominance came with a major change in the organization of these societies, the institutions hypothesis implies that there should not necessarily be such persistence.

Historical and econometric evidence suggests that European colonialism caused not only a major change in the organization of these societies, but also an “institutional reversal”– European colonialism led to the development of relatively better institutions in previously poor areas, while introducing extractive institutions or maintaining existing bad institutions in previously prosperous places. The main reason for the institutional reversal is that relatively poor regions were sparsely populated, and this enabled or induced Europeans to settle in large numbers and develop institutions encouraging investment by a broad cross-section of the society. In contrast, a large population and relative prosperity made extractive institutions more profitable for the colonizers, for example to force the native population to work in mines or plantations, or tax them by taking over existing tax and tribute systems. The institutions hypothesis, together with the institutional reversal caused by European colonialism, suggests the possibility of a reversal among the former European colonies: countries that were relatively rich in 1500 should be relatively poor today.

The major finding of this paper is that there is a reversal in relative incomes among the former European colonies. For example, the Mughals, Aztecs and Incas were among the richest civilizations in 1500, while the civilizations in North America, New Zealand and Australia were less developed. Today the U.S., Canada, New Zealand and Australia are orders of magnitude richer than the countries now occupying the territories of the Mughal, Aztec and Inca Empires. This reversal is consistent with the institutions hypothesis, but not with the geography hypothesis.

The obvious difficulty in our empirical investigation is lack of data on economic prosperity in 1500. The first contribution of our paper is to justify and use urbanization rates as a proxy for differences in economic prosperity across regions during preindustrial periods. Bairoch (1988) argues that only areas with high agricultural productivity could support large urban populations, while de Vries (1976, p.164) emphasizes the necessity of improvements in transportation and fuel technology to provide sufficient energy supplies for cities as they grow. Similarly, many economic historians note that increasing urbanization is associated with economic development (see, e.g., Bairoch 1988, De Long and Shleifer, 1993, de Vries, 1984, Kuznets, 1968, Tilly, 1990). We also present evidence that both in the time series and the cross section there is a close association between urbanization and income per capita.

As another proxy for prosperity we use population density, for which there are relatively more extensive data (McEvedy and Jones, 1978). Although the theoretical relationship between population density and prosperity is more complex, it seems clear that during preindustrial periods only relatively prosperous areas could support dense populations.

With either measure, there is a negative association between economic prosperity in 1500 and today. Figure 1 shows a negative relationship between the percent of the population living in towns with more than 5000 inhabitants in 1500 and income per capita today (see below for data details). Figure 2 shows the same negative relationship between population density (number of inhabitants per square km) in 1500 and income per capita today. The relationships shown in Figures 1 and 2 are robust–for example, they are unchanged when we control for continent dummies, the identity of the colonial power, and religion, and when we exclude the “Neo-Europes”, the U.S., Canada, New Zealand and Australia, from the sample.

There is also no evidence that the reversal is related to geography as proxied by temperature, humidity, distance from the equator, and whether the country is landlocked. While the reversal in relative incomes among the former colonies weighs strongly against the basic geography hypothesis, it is also important to consider a more sophisticated geography view, which we refer to as the “temperate drift hypothesis”. According to this hypothesis, the center of gravity of economic activity has been gradually shifting away from the equator. In 1500 the tropical areas were relatively rich, and today they are among the poorest places in the world. It can be argued that areas in the tropics had an early advantage, but later agricultural technologies, such as the heavy plow, crop rotation systems, domesticated animals, and high-yield crops, have favored countries in the temperate areas (e.g., Bloch, 1966, Mokyr, 1990, White, 1962). However, the nature and timing of the reversal in relative incomes are not consistent with this hypothesis. The reversal in relative incomes seems to be related to population density before Europeans arrived, not to any inherent geographic characteristics of the area.

Furthermore, according to the temperate drift hypothesis, the reversal should have occurred when European agricultural technology spread to the colonies. Yet, while the introduction of European agricultural techniques, at least in North America, took place earlier, the reversal occurred mostly during the 19th century, and is closely related to industrialization. There is also no evidence that geography either triggered or delayed industrialization.

Is the reversal related to institutions? We document that the reversal in relative incomes from 1500 to today can be explained, at least statistically, by differences in institutions across countries. The institutions hypothesis also suggests that institutional differences should matter more when new technologies requiring investments from a broad cross section of the society become available. We therefore expect societies with institutions of private property to take advantage of industrialization opportunities, while societies with extractive institutions, where political power is concentrated in the hands of the small elite, fail to do so. The data support this prediction.

We are unaware of any other work that has noticed or documented this change in the distribution of economic prosperity, or used the experiences of the former colonies to distinguish between the geography and institutions hypotheses. Nevertheless, many scholars, including Abu-Lughod (1989), Braudel (1992), Chaudhuri (1990), Hodgson (1993), Kennedy

(1987), McNeill (1999), Reid (1988 and 1993), Pomeranz (2000) and Wong (1997), emphasize that in 1500 the Mughal, Ottoman and Chinese Empires were highly prosperous,2 but grew slowly during the next 500 years. Coatsworth (1993) and Engerman and Sokoloff (1997, 2000) document that North America was no more developed than South America in the early 18th century and the data presented by Eltis (1995) and Engerman and Sokoloff (2000) suggest that Carribean islands such as Haiti and Barbados were richer than the United States during early colonial times.

The link between colonialism and economic development has been emphasized by many Marxist historians and dependency theorists, for example, Frank (1978), Rodney (1972), Wallerstein (1974-1980) and Williams (1944). Beckford (1972), Coatsworth (1999) and Engerman and Sokoloff (1997, 2000) also point out the long-run adverse consequences of the “plantation complex” and the associated institutions in Latin America. Our approach differs from these contributions in two important dimensions. First, we view European colonialism as a “natural experiment” potentially distinguishing between the geography and institutions hypotheses. Therefore, we emphasize not the negative effects of European colonialism relative to what would have happened without colonialism, but the differential effect of European colonialism in some countries compared with others–societies where colonialism led to the establishment of good institutions prospered relative to those where colonialism imposed extractive institutions. Second, in our theory the negative effects of colonialism do not result from the plunder of the colonies by the Europeans or dependency as emphasized by Williams, Rodney or Frank, but because extractive institutions stacked the cards against industrialization. Put differently, according to these authors, countries in Central America, the Caribbean and Africa are poor because of “too much capitalism,” whereas in our thesis they are poor because of “the wrong type of capitalism”.

Our overall interpretation of comparative development in the former colonies is related to our previous paper, Acemoglu, Johnson and Robinson (2001), where we proposed the disease environment at the time Europeans arrived as an instrument for European settlements and subsequent institutional development of the former colonies, and used this to estimate the causal effect of institutional differences on economic performance. The current paper has a different focus and a number of innovations relative to our earlier work. First, our focus here is on the persistence of economic performance, which we argue can distinguish between the geography and institutions hypotheses. Second, we point out and document the major reversal in the distribution of economic prosperity among the former colonies. Third, our thesis here emphasizes the influence of population density and prosperity on the policies pursued by the Europeans, for example, by encouraging labour-oppressive production methods, and the takeover of existing tax and tribute systems. Finally, we show that the interaction between institutions and the opportunity to industrialize during the 19th century played a central role in the long-run development of the former colonies.

The rest of the paper is organized as follows. The next section discusses the construction of urbanization and population density data, and provides evidence that these are good proxies for economic prosperity. In Section 3, we outline the geography and institutions hypotheses and explain why we should expect an institutional reversal resulting from European colonialism. Section 4 documents the “Reversal of Fortune”–the negative relationship between economic prosperity in 1500 and income per capita today among the former colonies. Section 5 discusses the temperate drift hypothesis, and presents evidence against this view. Section 6 documents that the reversal in relative incomes reflects the institutional reversal caused by European colonialism, and that institutions started playing a much more important role during the age of industry. Section 7 concludes.

2. Urbanization and Population Density

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