Why do some societies maintain institutions that cause economic backwardness? This is the vital question that MIT economist Daron Acemoglu and Harvard economist James Robinson asked in their seminal 2006 article, “Economic Backwardness in Political Perspective” in the American Political Science Review. Their analysis concluded that all too many rulers have clearly calculated that it’s better to keep their people in poverty than risk losing the privileges of political power.

Acemoglu and Robinson assume that all things being equal, politically-powerful groups would welcome superior institutions and technologies. Acemoglu and Robinson forthrightly and correctly define superior institutions as free markets for labor, capital, and resources, strong property rights, and the rule of law. This set of institutions more or less defines economic liberalization. They are superior because they produce prosperity, longer lives, and more civil peace. The conundrum is understanding why so many regimes fail to adopt these superior institutions.

The answer to this puzzle is what the two economists call the “political replacement effect.” As they explain, “Political elites will block beneficial economic and institutional change when they are afraid that these changes will destabilize the existing system and make it more likely that they will lose political power and future rents.” Rent in this case is the wealth that political elites divert from the productive parts of society to themselves via taxes, corruption, exclusive licenses, import restrictions, monopoly ownership, and the like.

In their analysis, Acemoglu and Robinson conclude that well-entrenched elites will permit and encourage economic liberalization because they will benefit from the increased prosperity but will not be overthrown. On the other hand, countries in which there is considerable competition among political elites will also tend to encourage economic liberalization because all factions recognize that citizens will remove incumbents who do not adopt prosperity-enhancing innovations. However, innovation is stifled in those regimes where the elites are somewhat entrenched but fear replacement. In such cases, the elites calculate that economic liberalization might empower rivals and end up depriving them of the looted wealth their current political position affords them.

Acemoglu and Robinson also suggest that threats of invasion by more technologically advanced rival nations and the rise of a more educated citizenry might promote liberalization. Improved industry produces improved weaponry and an educated populace can operate new technologies and take more advantage of entrepreneurial opportunities.  Conversely, incumbent elites are more likely to block economic liberalization when their share of the loot from the current system is high and an illiterate citizenry would hinder technological modernization.

Acemoglu and Robinson then speculatively applied their hypothesis to the historical trends in industrialization and economic liberalization that occurred in 19th century Britain, Germany, the United States, Austria-Hungary, Russia, and Japan. They argue that elites in Britain and Germany favored liberalization because they were sufficiently entrenched and not so dependent on political plunder. Elites in the United States had to cope with a very competitive political environment and so turned to economic liberalization as a way to compete for votes. On the other hand, the potentates of Russia and Austria-Hungary blocked economic development because their regimes were relatively insecure and very dependent on semi-feudal arrangements for extracting income from their peasant populations. Japan’s elites chose to industrialize out of fear of the colonial ambitions of Western nations in Asia. After presenting this somewhat potted history of economic development, Acemoglu and Robinson end their article by calling for empirical research to test the validity of their model.

Now a fascinating new article, “Testing the Political Replacement Effect: A Panel Data Analysis,” in the Oxford Bulletin of Economics and Statistics does just that. The study uses data on trends in economic freedom and political organization for 102 countries spanning the period 1980 to 2005 to investigate the “political replacement effect” hypothesis. “Our results strongly support the theory,” report three economists from the University of Messina in Italy, Leone Leonida, Dario Maimone Ansaldo Patti, and Pietro Navarra.

For their analysis, the three researchers use the Fraser Institute’s Economic Freedom Index as a proxy for trends in economic liberalization. The index ranks 141 countries by their degree of economic freedom based on 42 measures grouped in five categories: the size of government, legal structure, monetary policy, openness to international trade, and regulatory burden. The Fraser Institute’s Economic Freedom Index uses a 10-point scale to measure economic freedom, with the higher score indicating greater economic freedom. To get at the amount of political competition faced by incumbent elites, the researchers use data from the Polity IV Project that ranks countries on a 20-point scale with a +10 signifying full democracy and -10 indicating total autocracy.

The theory asserts that the likelihood of liberalization is dependent upon the degree of political competition faced by incumbent elites. Firmly entrenched elites and those subject to a lot of competition will favor liberalization.  Incumbent governing elites are more likely to block market-oriented reforms when political competition is neither high nor low because they calculate that such reforms might significantly reduce their chances of staying in power.

The Italian researchers also use data on a country’s degree of corruption, average level of education, and risk of international violence to see how they affect the liberalization choices of incumbent elites. Cranking all of these data through their model, the researchers find that entrenched regimes and those subject to lots of political competition tend to liberalize. Entrenched elites calculate they can weather the political turbulence generated by reforms while elites in competitive regimes believe that the boost in prosperity sparked by reforms helps them stay in power by winning the favor of voters. The data show that insecurely entrenched incumbent elites will block liberalization because they fear market-oriented reforms will reduce the amount of loot they extract from the current system and, worse yet, empower competitive groups.

Not too surprisingly, regimes characterized by higher levels of corruption also were much less likely to adopt market-liberal reforms. After all, why exchange the certainty of politically extorted income for the vagaries of the competitive marketplace? On the other hand, regimes that faced a higher risk of international violence do have a greater tendency to liberalize. Interestingly, the Italian researchers found that high levels of human capital, e.g., an educated citizenry, did not strongly correlate with a tendency to adopt liberal reforms.

Since the Italian researchers were investigating overall trends, they did not offer clues to how the liberalization calculations of various incumbent elites in specific countries might be made. Let’s take a brief stab at that now.

Consider first China. Its economic freedom score rose from 3.74 in 1980 (when it was first ranked) to 6.16 in 2010. In the meantime, its Polity IV regime score has remained stuck at -7 for decades. China clearly fits the case where an entrenched elite has calculated that it can remain in power while adopting some market-liberal reforms. Singapore is another such example where its economic freedom score rose from 7.61 in 1970 to 8.56 in 2010 while its Polity IV score of -2 (an autocracy with some democratic elements) has remained flat since 1970.

Many countries freed from entrenched communist elites formerly backed by the now-defunct Soviet Union happily show both rising economic and political freedom scores. The Czech Republic is now a model of a regime in which its political elites are subject to lots of competition and that have promoted market-liberal reforms. The Czech political freedom score rose from -7 before 1990 to +7 today while its economic freedom score has risen from 5.08 in 1995 to 7.08 in 2010.

Algeria provides a pretty good example of an insecure regime that has blocked economic liberalization. Algeria’s Polity IV score of +2 puts suggests that its incumbent elites face some political competition and its economic freedom score has barely budged rising from 3.82 in 1980 to 4.88 in 2010. Meanwhile, the case of Venezuela should worry both the researchers and us. In 1970 its Polity IV score was a highly democratic +9 and it has since fallen steeply in the direction of increased autocracy at +1. The Bolivarian Republic’s economic freedom score has dropped from 7.31 in 1970 to only 3.88 today. Is this a case where reactionary voters have chosen to reverse both economic and political liberalization?

For the record, the United States’ Polity IV score is a flat +10 while its economic freedom index number was 7.60 in 1970 rising to 8.65 in 2000, since sliding to down a bit to 7.70 in 2010. 

The evidence supports the claim that the political replacement effect stands in the way to achieving prosperity in many countries. Incumbent political elites will undertake economic liberalization only when they believe that they will benefit from it. However, until the 19th century, elites in all societies used political power to loot their citizens and stifle economic and political liberalization. An analysis of how some societies got set on the happy trend toward greater economic and political liberalization resulting in more prosperity, longer lives, and less violence must be dealt with elsewhere. One final observation: The datasets used here are not long enough to show it, but I think it's a good bet that the current elites in China and other autocratic regimes will find that economic liberalization must eventually result in political liberalization.