Home > Government, inequality, macro, politics > Have the west’s institutions become extractive?

Have the west’s institutions become extractive?

I recently finished reading Acemoglu and Robinson’s (A&R) new book, Why Nations Fail.   Really, even before I even started–ever since I first heard the premise of their thesis–I’ve had this uncomfortable feeling.   For the last 30 or 40 years, with (pretax) inequality rising everywhere in the western world (and overall growth slowing), are we in fact witnessing the early stage of the formation or transition to extractive institutions in Europe and North America?

Before I get into the argument, let me first say that my own answer is somewhere between “I have no idea” and “maybe, maybe not”.   This is not an open and shut case, by any means.   I do, however, have this uncomfortable feeling.

I’ve been meaning to write this post for some time, but part of the current impetus is, via Thoma, this excellent essay in the Democracy Journal by James Kwak.   James, it seems, has the same worry I do; you should read him in full to get the entire pro argument.   Reflecting my own uncertainty, my case is going to be much more muddled.

Background:  what are extractive/inclusive institutions and why do we care?

The basic case that A&R make revolves around a simple intuition about the functioning of the political economy of prosperity and inequality.   It can be separated into two distinct feedback loops:

  1. The vicious circle (extractive institutions):  essentially, great wealth buys political power and political power leads to greater wealth. Historically, the easiest way to become richer is to dominate the political process, which shapes the economic institutions and those economic institutions (i.e. contract enforcement, property rights) define the economic incentives of everyone.  By rigging the economic playing field in their favor, the wealthy elite has the resources to dominate the political process.   Wash, rinse repeat.   A&R document (sometimes in excruciatingly repetitive detail) how this pattern shows up again, and again around the world leading inevitably to the impoverishment of the nation.
  2. The virtuous circle (inclusive institutions):   widely distributed power leads to widely distributed wealth which in turn makes accumulating power far more difficult (though not impossible).   Far less inevitable than the vicious circle, it is nonetheless the case that under the proper circumstances these inclusive political institutions (i.e. democracy) provide voters with the tools to undo excessive concentrations of wealth and power–which might threaten, for example, one’s right to sell one’s own labor in a free and fair market or one’s property (i.e. inclusive economic institutions).   The ‘populists’ are (often) the heroes of this story.   Always working against the virtuous circle is the fact that finance and markets–necessary to provide healthy incentives to work and innovate–have a tendency to concentrate wealth while the centralization of political power–necessary to distribute power broadly–also concentrates power in the hands of a few; you can’t have 300 million presidents.

Much of history can be interpreted as one or the other of these feedback processes operating to make a nation poor or rich, respectively.   Starting with the glorious revolution in England and the French revolution, the west has been mostly in the process of the virtuous circle.

Turning Extractive in the US

This is the subject of James Kwak’s essay and I don’t have much to add to it.   It is true that the the US is a democracy with broad suffrage rights.   However, as he rightly points out, this simple thinking ignores the real feedback mechanism in the vicious circle.   As the concentration of wealth  and power increase, the ability and incentive to expropriate more wealth and power increase.

I am reminded of a paper from Roger Lagunoff which shows how this might work in a relatively simple dynamic model of endogenous political change.   What’s interesting is that there emerges a simple notion of the virtuous circle in the sense that a majority rule voting model is stable.   There is also a vicious circle in that a model in which political outcomes rely on majority wealth (imagine every dollar of wealth gets its own vote) will be unstable (“admits reform”)–either the political system must become ever more concentrated or it must collapse back to majority voting.

Contra James, I’m only moderately worried about this.   After all, the naked power grab by the rich must eventually become obvious enough even to Republican voters.   No matter how much money the rich pour into elections, ultimately it is voters who vote and there’s only so much you can do to sell a defective product.

After all, as A&R point out, we’ve seen this movie before.   In the guilded age, the robber barons bought elections even more egregiously than they do now.   Eventually, this process led not to permanent political domination by the robber barons, but to the eventual collapse of their power during the progressive age.   In the Lagunoff paper, either the situation continually gets worse, or eventually it collapses back to majority vote.   In a nation with firmly entrenched democracy, the latter seems far more likely.

That’s not to say that we wouldn’t all be better off short-circuiting the process and returning to majority rule sooner rather than later.

Are Central Banks Extractive?

The one thing I really wanted to add is my main fear–there’s something profoundly anti-democratic about central bank independence.   In a sense, “insulating” the bank from politics is the point.   But then, a central bank is at the heart of a modern economy’s economic institutions.   To be honest, I don’t know the answer.   A couple of random thoughts:

  1. Central Banks are isolated from political pressures from the government, but not political pressure from banks.   For example, Jamie Dimon is still on the board of the New York Fed (as I write this) which is the regional bank which regulates JP Morgan Chase.   To put it another way, Nancy Pelosi or John Boehner have less power over the regulation of JP Morgan Chase–a systemically important institution–than Jamie Dimon.   Maybe I’m exaggerating, but not by much.
  2. Supporting point 1, note that there is evidence suggesting central banks internalize bank welfare rather than national welfare:  1) The ECB LTRO facility lent money at sub-market rates to banks, rather than democratically elected governments 2) TARP passed easily in the US, the stimulus did not 3) The ECB has insisted on austerity in the eurozone periphery–in contradiction of standard macroeconomics and often despite ambivalence or even hostility from local polities–as a condition of doing its job of macroeconomic stabilization 4) In effect, the ECB has removed at least two democratically elected governments who failed to implement austerity quickly enough.
  3. Following a negative shock to NGDP, inflation targeting redistributes 100% of loses onto debtors.   Why have most central banks been so insistent on inflation targeting?   The evidence was never really strong that IT was ever particularly superior, even in standard models which have not performed well recently.   Conversely, it seems Israel has made an NGDP target work, and an NGDP target is much more equitable in theory.   To see this, if your “sticky price” is the shadow price of debt service, than an inflation target magnifies the damage done by a shock to nominal income (say, the collapse of a housing bubble) via a classical Fisherian debt deflation dynamic as the real burden of debt rises compared to income.   So, again, why are we still targeting inflation?   Could it be that banks and the wealthy are the creditors?

To be frank, I’m really not sure about any of these points.  Just worried.

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  1. David
    June 15, 2012 at 11:12 am

    No major comment, but when I think of extractive institutions in the U.S. I tend to think of the Jim Crow south. I just came upon (and haven’t read yet) this paper: http://tuvalu.santafe.edu/~snaidu/papers/suffrage_may_25_2012_combined.pdf

    If you’re looking for power grabs by the elite today, one would expect it to come in the form of disenfranchising people. You can argue the current setup of the criminal justice system has a similar effect.

    • BSEconomist
      June 15, 2012 at 11:30 am

      I agree with that. Although there is a sense in which a central bank disenfranchises people also, which was the point I wanted to make. At the moment, this is more of a “worry” than anything else–mostly because in the US the Fed doesn’t have much power over the specifics of economic institutions. It is the specifics of institutions which, I would think, make them extractive or not. The recent behavior of the ECB maybe is suggesting otherwise–or perhaps it is the structure of the eurozone itself–that Greeks don’t vote for German politicians who control their fate–that is the problem.

  2. June 23, 2012 at 3:07 pm

    This was a really nice post. Where by “nice,” I mean “well written and reasoned.” The content was actually a touch depressing. Sobering or no, this blog is off to a good start!

  1. June 15, 2012 at 11:20 am

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