Extractive Economies

On a recent road trip, my wife and I listened to the audio version of the book Why Nations Fail by Daron Acemoglu and James Robinson, which tries to answer why some countries are prosperous while others are poor and backwards. Although I do not necessarily agree with all of the authors’ ideas, I found the dichotomy between extractive versus inclusive economies, and its connection to extractive or inclusive political systems, fascinating.

The book’s website can be found at www.whynationsfail.com.

What Are Extractive Economies?

Simply put, an “extractive” economy is an economic system where a small upper class reaps most of the benefits of the work that the large masses put in.

European kingdoms in the middle ages had mostly extractive economies, where a relatively few nobles lived in comfort from the wealth that the peasants produced. The Soviet Union had an extractive economy, where the communist elite lived in luxury but most normal people had to stand in line to get groceries. North Korea has an extractive economy, again with the elite living well while large parts of the country are plagued by famine.

The opposite of extractive economies are inclusive economies, where most people share in the products of the economy. Modern-day Western European countries have inclusive economies, where most people do participate and reap some benefits of economic progress. The United States supposedly has an inclusive economy, or at least had one in the 1950s and 1960s. However, the economy of the United States has been slipping towards the more extractive end of the spectrum; more about that later.

Economies and Political Institutions

Next to laying out the dichotomy between extractive and inclusive economies, Why Nations Fail goes on to then also separate extractive and inclusive political systems and institutions. A democratic system is typically built on inclusive political institutions, whereas a dictatorship is built on extractive political institutions, where the power is typically in the hands of the ruling elite and the people have no influence.

Acemoglu and Robinson then draw a line connecting the economical and the political institutions. They show that extractive political institutions, where the power is in the hands of a few, tend to favor extractive economic systems, where the few that are in power get all the benefits, whereas inclusive economies tend to flourish under inclusive political systems.

There are different forces at work here, which go a long way to explaining this connection. Inclusive political systems are, by necessity, based on a rule of law, which provides stability and consistency. It is worth starting a business or planting a field or investing in your factory if you can feel confident that contracts you enter into will be honored and that you will be able to reap the benefits from your efforts.

Extractive political systems, on the other hand, where a relatively small elite rules the country, tends to have that elite be “above the law” and able to seize anything they can. In those environments, doing well would mean becoming a competitor of the existing elite, which will do everything it can to prevent this. Therefore, there are few if any incentives to work harder or do better.

Interestingly, it is very hard for the elite in an extractive environment to actually work for the best of their country. Even in the poorest extractive countries, the elite lives better than the elite of the richest inclusive countries live. As long as they can hold on to their power, they are better off running their country into the ground then they would be trying to improve the lot of their people.

The example of North and South Korea is very illustrative in this respect. South Korea is a thriving country where many people are very comfortable. It is a country with upward mobility, a country where entrepreneurs are rewarded, but also where everyone shares in the collective wealth. North Korea, on the other hand, is among the poorest of the poor, even though the leaders live in luxury. And there are no signs that those leaders are losing their grip on the country.

What About the United States?

Where does all of this leave the United States? Why Nations Fail doesn’t ask this question, but if there is something to the idea of extractive versus inclusive economies connected to extractive versus inclusive political institutions, you start to see the history of the United States over the past 50 years in an entirely different light.

The middle class was booming in the 1950s and 1960s. Its decline probably started with the oil crisis in the 1970s, but really was accelerated with Reaganomics in the 1980s. Time after time economists have shown that, after compensating for inflation, wages and disposable income for middle-class people rose steadily in the years after World War II, but have stagnated or gone down in the past 30 years. Disposable income for the wealthiest, on the other hand, has continued to rise. In effect, the economy as a whole has grown, but most or all of that growth has gone to the wealthy few, which is a hallmark of an extractive economy.

Although I have to admit that I don’t have any scientific studies to back this up, it is clear to me that the political institutions have more and more become dominated by the same entities (wealthy individuals and corporations) that dominate the economy. Lobbyist have achieved increasing influence and, with the Citizens United decision by the Supreme Court, corporations no longer have to hide their influence peddling. Again, a shift from inclusive to extractive institutions.

Interestingly, it seems that some of the Republican concerns that are being expressed during the current (2012 presidential) election cycle are also indicative of an extractive economy: lack of growth, lack of entrepreneurship, a feeling that things “aren’t getting better.” However, their proposed solutions (more tax breaks for the elite, paid for by the masses) seem to be geared towards increasing the slide towards an extractive system rather than trying to halt that process. Which, in turn, supports the hypothesis that the elite has gotten hold of the political institutions and use them for their own benefit.

It is worth remembering that the study of many of the poorest countries has shown that what is good for the ruling elite is not necessarily good for the country. The intuitive idea that the elite would want a strong economy and prosperity for all, because they would be better off in such an environment, actually turns out to be false. The elite, in an extractive environment (as the examples of North Korea and many other countries show), are actually better off increasing the level of extraction, as long as they can prevent a complete revolution.

What Next?

Knowing that the United States is sliding towards an extractive economy supported by extractive political institution, what can we do? How does this knowledge help us revert the process?

I have to admit that I don’t have any good answers here. One thing is clear, and that is the old adage that “when you are in a hole, the first thing is to stop digging.” Clearly, the one thing we should not be doing is continue to strengthen the elite in this country and their stranglehold on the political and economic institutions.

In the early 20th century, presidents like Theodore Roosevelt and Woodrow Wilson set out to break the stranglehold of the elite of their time — the ”robber barons,” the oil monopolies, the railroads. They were actually faced with a situation not dissimilar to our own, where the American economy was becoming more and more extractive. It took a little time, but they were able to revert the process. In the end their actions led to one of the greatest periods of prosperity in America.

We can take heart from this example and look to them for ideas of what we can do. Break virtual or total monopolies. Stop allowing banks, insurance companies, airlines, phone companies to merge and become bigger and bigger. If necessary, break up industries that are dominated by a very few players, which end up acting as monopolies. It is the lack of competition inherent in monopolies that breaks the backbone of what makes capitalism strong. Break up vertical monopolies, where a single company dominates the entire supply chain.

Increase consumer protections. Again, the backbone of what makes capitalism strong is the ability of the consumers to have choices and to make their choices based on accurate information.

Recognize that it is important for entrepreneurs to be rewarded for not only the effort they put into their business, but also the risk they take. Most people are not the kind of risk taker you need to be to start your own business. But also recognize that, when someone is successful in building a business, that business can only thrive in the entire ecosystem of our economy, which includes the government-sponsored infrastructure as well as the consumers who buy the products and services of the business. That therefore a successful business has the moral responsibility to support those elements of the economy that made their success possible in the first place.

Most of all, we, the people of this country, need to try to understand what is happening and try to engage our friends, our family, our representatives in debates about our policies...