Why Nations Fail: The Origins of Power, Prosperity, and Poverty is a key book for understanding the building blocks of political risk analysis in the modern world, especially how politics has paved the road to success for some nations while leading to poverty and frustration in others.
In their 2012 book, Why Nations Fail: The Origins of Power, Prosperity, and Poverty, Daron Acemoğlu and James Robinson ask the central question: why are some nations rich and others poor? Using historical examples, the authors explain that politics, how a society organizes itself and how its leadership is created, ultimately determines if a country will "succeed" or "fail" economically.
The book is insightful, well-informed and timely given the stark divide that continues to grow between developed and developing states today. It is also a crucial addition to the field of political risk analysis in the way it demonstrates how political power can be used to shape, alter or regulate market conditions.
A history of bad politics equals bad economics
Why Nations Fail argues that at the heart of market inequality is the existence of bad, extractive political institutions that hinder the potential for economic progress. In areas where political power is narrowly concentrated and used to create wealth for those who possess it, there are limited opportunities for indigenous market growth.
The differences between states' political institutions and their respective economic climates are deeply rooted in history. Once societies are organized in a particular way, this tends to persist.
A prime example the authors use is the case of the United States and Mexico. Despite the fact that these two countries are neighbors, a history of revolutions, expropriations, and political instability brought along military governments and various types of dictatorship in Mexico. Power-hungry leaders engaged in exploitative economic activities, monopolizing the banking industry, setting high interest rates, and using their access to credit as a way to further increase their grip on power.
The United States, on the other hand, fought a revolution that created democracy, delegating power amongst government officials, holding elections, and embracing the philosophy of competition in both politics and business. The result is that greater economic growth and capitalism occurred in the US, while Mexico suffered years of policies inimical to prosperity.
Extractive versus inclusive political economies
Acemoğlu and Robinson categorize the types of political institutions introduced above as being either extractive or inclusive. Extractive political institutions are authoritative. Power is relegated to a narrow elite that rules over a society for its own benefit at the expense of a vast mass of people. Inclusive political institutions, on the other hand, embrace political participation and offer checks and balances on those in power.
This distinction is the book's most important contribution to the field of political risk in the way it links political and economic institutions together:
"The ability of economic institutions to harness the potential of inclusive markets, encourage technological innovation, invest in people, and mobilize the talents and skills of a large number of individuals is critical for economic growth."
Given the diversity of political institutions and economies in the world today, however, the authors qualify these two categories by explaining that extractive institutions do not always create weak economies.
China is a good example. Though its political system is closed and citizens do not have the ability to participate in politics, Chinese leaders have been successful in investing in their people through education, manufacturing, and technology to create economic growth on a vast scale.
Similarly, in the United Arab Emirates, leadership is in the hands of one family, but President Khalifa bin Zayed Al Nahyan has been key in promoting infrastructure projects, bringing in foreign investment, and using LNG and oil funds to create a culture of investment promotion in the Middle East.
While inclusive political institutions play an essential role in promoting economic prosperity, there are certainly exceptions. In any case, the inclusive political institutions we tend to see in the West, as opposed to extractive systems in most of the developing world, have played a role in determining high growth in the West, and corruption and poverty in these other areas.
The importance of political risk analysis
Perhaps the biggest shortcoming of the book is the authors' refusal to accept alternative explanations for why some countries are more economically sound than others. Geography and culture play a large role in shaping societies and how people think and organize themselves. Geography determines what kind of natural resources a state will have, while cultural influences like religion shape people's political aspirations.
But the authors decide that politics is most important and are nevertheless successful in promoting this idea. In doing so, Why Nations Fail emphasizes the essence of political risk analysis. It shows us that politics holds the key to understanding the uncertainty or risks associated with economic endeavors.