Published on 2 Feb 2016
In today’s video, we discuss a topic critical to understanding economic growth: the power of institutions.
To better shed light on this, we’re going to look at an example that’s both tragic and extreme.
In 1945, North and South Korea were divided, ending 35 years of Japanese colonial rule over the Korean peninsula. From that point, the two Koreas took dramatically different paths. North Korea went the way of communism, and South Korea chose a relatively capitalistic, free market economy.
Now — what were the results of those choices?
In the ensuing decades after 1945, South Korea became a major car producer and exporter. The country also became a hub for music (any K-pop fans out there?), film, and consumer products. In stark contrast, North Korea’s totalitarian path resulted in episodes of famine and starvation for its people.
In the end, South Korea became a thriving market economy, with the living standards of a developed country. North Korea on the other hand, essentially became a militarized state, where people lived in fear.
Why such an extreme divergence?
It all comes down to institutions.
When economists talk about institutions, they mean things like laws and regulations, such as property rights, dependable courts and political stability. Institutions also include cultural norms, such as the ones surrounding honesty, trust, and cooperation.
To put it another way, institutions guide a country’s choices — which paths to follow, which actions to take, which signals to listen to, and which ones to ignore.
More importantly, institutions define the incentives that affect all of our lives.
Going back to our example, in the years after 1945, North and South Korea took dramatically different institutional paths.
In South Korea, the institutions of capitalism and democracy, promoted cooperation and honest commercial dealing. People were incentivized to produce goods and services to meet market demand. Businesses that did not meet demand were allowed to go bankrupt, allowing the re-allocation of capital towards more valuable uses.
Against that grain, North Korea’s institutions produced starkly different incentives. The totalitarian regime meant that the economy was centrally planned and directed. Most entrepreneurs didn’t have the freedom to keep their own profits, resulting in few incentives to do business. Farmers also didn’t have enough incentive to grow sufficient food to feed the population. This was due in part to price controls, and a lack of property rights.
As for capital, it was allocated by the state, mostly towards political and military uses. Instead of going towards science, or education, or industrial advancement, North Korea’s capital went mostly towards outfitting its army, and making sure that the ruling party remained unopposed.
And now, look at how different the two countries are as a result of those differing institutions.
When it comes to economic growth, institutions are critically important. A country’s institutions can have huge effects on long-term growth and prosperity. Good institutions can help turn a country into a growth miracle. Bad institutions can doom a country to economic disaster.
The key point remains: institutions are important.
They represent the choices that a country makes, and as the Korean peninsula shows you, choices on this scale can have staggering effects on a nation’s present, and future.
