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Journal of Economic PerspectivesVolume 27, Number 2Spring 2013Pages 173192

T he fundamental approach to policy prescription in economics derives fromhe fundamental approach to policy prescription in economics derives fromthe recognition that the presence of market failureslike externalities,the recognition that the presence of market failureslike externalities,public goods, monopoly, and imperfect competitioncreates room forpublic goods, monopoly, and imperfect competitioncreates room forwell-designed public interventions to improve social welfare. This tradition, alreadywell-designed public interventions to improve social welfare. This tradition, alreadyclear in Pigou (1912), was elaborated by Samuelson (1947), and still provides theclear in Pigou (1912), was elaborated by Samuelson (1947), and still provides thebasis of most policy advice provided by economists. For example, the rst develop-basis of most policy advice provided by economists. For example, the rst develop-ment economists in the 1950s used market-failureinspired ideas as the intellectualment economists in the 1950s used market-failureinspired ideas as the intellectualbasis for the need for government intervention to promote development in poorbasis for the need for government intervention to promote development in poorcountries (Killick 1978). Though belief in the ability of the government or the effec-countries (Killick 1978). Though belief in the ability of the government or the effec-tiveness of aid has waxed and waned, current approaches to development problemstiveness of aid has waxed and waned, current approaches to development problemshave much in common with this early tradition, even if they have become morehave much in common with this early tradition, even if they have become moresophisticatedin recognizing second-best issues, for instance, by incorporatingsophisticatedin recognizing second-best issues, for instance, by incorporatinginformational frictions explicitly in policy design (for example, Townsend 2011);informational frictions explicitly in policy design (for example, Townsend 2011);in highlighting the speci city of the appropriate policy depending on context (forin highlighting the specicity of the appropriate policy depending on context (forexample, Rodrik 2007); and in emphasizing the role of rigorous empirical methodsexample, Rodrik 2007); and in emphasizing the role of rigorous empirical methodsin determining which sorts of interventions can be effective (for example, Banerjeein determining which sorts of interventions can be effective (for example, Banerjeeand Duo 2011). But in all of these approaches, politics is largely absent fromand Duo 2011). But in all of these approaches, politics is largely absent fromthe scene.the scene.This neglect of politics is often justi edimplicitly or explicitlyin oneThis neglect of politics is often justiedimplicitly or explicitlyin oneof three ways. The rst is to maintain that politicians are basically interested, orof three ways. The rst is to maintain that politicians are basically interested, orinduced to be interested, in promoting social welfare, for example, because sociallyinduced to be interested, in promoting social welfare, for example, because socially

Economics versus Politics: Pitfalls ofPolicy Advice

Daron Acemoglu is the Elizabeth and James Killian Professor of Economics MassachusettsDaron Acemoglu is the Elizabeth and James Killian Professor of Economics, MassachusettsInstitute of Technology Cambridge Massachusetts. James A. Robinson is David FlorenceInstitute of Technology, Cambridge, Massachusetts. James A. Robinson is David FlorenceProfessor of Government Harvard University Cambridge Massachusetts. Their emailProfessor of Government, Harvard University, Cambridge, Massachusetts. Their emailaddresses are [email protected] [email protected] are [email protected]@gov.harvard.edu.http://dx.doi.org/10.1257/jep.27.2.173. doi=10.1257/jep.27.2.173

Daron Acemoglu and James A. Robinson
mailto:[email protected]:[email protected]:[email protected]:[email protected]://dx.doi.org/10.1257/jep.27.2.173http://dx.doi.org/10.1257/jep.27.2.173.http://dx.doi.org/10.1257/jep.27.2.173.http://dx.doi.org/10.1257/jep.27.2.173mailto:[email protected]:[email protected]


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174 Journal of Economic Perspectives

ef cient policy is what helps politicians to stay in power or get re-elected, as inefcient policy is what helps politicians to stay in power or get re-elected, as inmodels like Whitman (1989, 1995) and Mulligan and Tsui (2006, 2008).models like Whitman (1989, 1995) and Mulligan and Tsui (2006, 2008).The second is to view politics as a random factor, just creating potentially severeThe second is to view politics as a random factor, just creating potentially severebut unsystematic grit on the wheels of economic policymaking (for example, Sachs,but unsystematic grit on the wheels of economic policymaking (for example, Sachs,2005, or as in the Banerjee, 2012, argument that the Liberian dictator Samuel2005, or as in the Banerjee, 2012, argument that the Liberian dictator SamuelDoes economic policies were disastrous because he did not understand what wasDoes economic policies were disastrous because he did not understand what wasinvolved in being president).involved in being president).The third justi cation recognizes that political economy matters, but maintainsThe third justication recognizes that political economy matters, but maintainsthat good economics is good politics, meaning that good economic policies neces-that good economics is good politics, meaning that good economic policies neces-sarily relax political constraints (for examples, Boycko, Shleifer, and Vishny 1995;sarily relax political constraints (for examples, Boycko, Shleifer, and Vishny 1995;Banerjee and Duo 2011, in particular, p. 261; Sachs et al. 2004). The implication isBanerjee and Duo 2011, in particular, p. 261; Sachs et al. 2004). The implication isthe same as the rst two views: one could unwaveringly support good economic poli-the same as the rst two views: one could unwaveringly support good economic poli-cies, assured that they will not only solve market failures but also unleash bene cialcies, assured that they will not only solve market failures but also unleash benecialpolitical forceswhatever those may be.political forceswhatever those may be.In this essay, we argue not only that economic advice will ignore politics at itsIn this essay, we argue not only that economic advice will ignore politics at itsperil but also that there are systematic forces that sometimes turn good economicsperil but also that there are systematic forces that sometimes turn good economicsinto bad politics, with the latter unfortunately often trumping the economic good.into bad politics, with the latter unfortunately often trumping the economic good.Of course, we are not claiming that economic advice should shy away from identi-Of course, we are not claiming that economic advice should shy away from identi-fying market failures and creative solutions to them, nor are we suggesting a blanketfying market failures and creative solutions to them, nor are we suggesting a blanketbias away from good economic policy. Rather, our argument is that economic anal-bias away from good economic policy. Rather, our argument is that economic anal-ysis needs to identify, theoretically and empirically, conditions under which politicsysis needs to identify, theoretically and empirically, conditions under which politicsand economics run into conict, and then evaluate policy proposals taking intoand economics run into conict, and then evaluate policy proposals taking intoaccount this conict and the potential backlashes it creates.account this conict and the potential backlashes it creates.Our basic argument is straightforward: the extant political equilibrium may notOur basic argument is straightforward: the extant political equilibrium may notbe independent of the market failure; indeed it may critically rest upon it. Facedbe independent of the market failure; indeed it may critically rest upon it. Facedwith a trade union exercising monopoly power and raising the wages of its members,with a trade union exercising monopoly power and raising the wages of its members,many economists would advocate removing or limiting the unions ability to exercisemany economists would advocate removing or limiting the unions ability to exercisethis monopoly power, and this is certainly the right policy in some circumstances.this monopoly power, and this is certainly the right policy in some circumstances.But unions do not just inuence the way the labor market functions; they also haveBut unions do not just inuence the way the labor market functions; they also haveimportant implications for the political system. Historically, unions have played aimportant implications for the political system. Historically, unions have played akey role in the creation of democracy in many parts of the world, particularly inkey role in the creation of democracy in many parts of the world, particularly inwestern Europe; they have founded, funded, and supported political parties, suchwestern Europe; they have founded, funded, and supported political parties, suchas the Labour Party in Britain or the Social Democratic parties of Scandinavia,as the Labour Party in Britain or the Social Democratic parties of Scandinavia,which have had large effects on public policy and on the extent of taxation andwhich have had large effects on public policy and on the extent of taxation andincome redistribution, often balancing the political power of established businessincome redistribution, often balancing the political power of established businessinterests and political elites. Because the higher wages that unions generate forinterests and political elites. Because the higher wages that unions generate fortheir members are one of the main reasons why people join unions, reducing theirtheir members are one of the main reasons why people join unions, reducing theirmarket power is likely to foster de-unionization. But this may, by further strength-market power is likely to foster de-unionization. But this may, by further strength-ening groups and interests that were already dominant in society, also change theening groups and interests that were already dominant in society, also change thepolitical equilibrium in a direction involving greater ef ciency losses. This case illus-political equilibrium in a direction involving greater efciency losses. This case illus-trates a more general conclusion, which is the heart of our argument: even when ittrates a more general conclusion, which is the heart of our argument: even when itis possible, removing a market failure need not improve the allocation of resourcesis possible, removing a market failure need not improve the allocation of resourcesbecause of its effect on future political equilibria. To understand whether it is likelybecause of its effect on future political equilibria. To understand whether it is likelyto do so, one must look at the political consequences of a policyit is not suf cientto do so, one must look at the political consequences of a policyit is not sufcientto just focus on the economic costs and bene ts.to just focus on the economic costs and benets.


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Daron Acemoglu and James A. Robinson 175

To develop this argument more fully, we offer a simple theoretical frameworkTo develop this argument more fully, we offer a simple theoretical frameworkclarifying the links between economic policy and the political equilibrium. Weclarifying the links between economic policy and the political equilibrium. Weemphasize why, in the presence of political economy considerations, economicemphasize why, in the presence of political economy considerations, economiccostbene t analysis is not suf cient, and also how, in contrast to standard second-costbenet analysis is not sufcient, and also how, in contrast to standard second-best reasoning, our argument provides some pointers for what types of marketbest reasoning, our argument provides some pointers for what types of marketfailures, if removed, are most likely to have deleterious impacts on the politicalfailures, if removed, are most likely to have deleterious impacts on the politicalequilibrium. We highlight economic policies that strengthen the already dominantequilibrium. We highlight economic policies that strengthen the already dominantgroups in societyconversely, weakening their political counterweightsas thosegroups in societyconversely, weakening their political counterweightsas thosethat need to be studied more holistically, combining politics with economics, tothat need to be studied more holistically, combining politics with economics, toavoid major unintended political consequences.avoid major unintended political consequences.We then discuss three broad mechanisms generating circumstances underWe then discuss three broad mechanisms generating circumstances underwhich good economic policy may make bad politics. First, economic rents in thewhich good economic policy may make bad politics. First, economic rents in thepresent can affect political equilibria; policies that seek to address market failurespresent can affect political equilibria; policies that seek to address market failurescan reduce the economic rents for certain groups and thus may have unintendedcan reduce the economic rents for certain groups and thus may have unintendedpolitical consequences, particularly when the rents that are destroyed are those ofpolitical consequences, particularly when the rents that are destroyed are those ofgroups that are already weak, further tilting the balance of power in society. Second,groups that are already weak, further tilting the balance of power in society. Second,even in the absence of changing rents, the distribution of income can affect theeven in the absence of changing rents, the distribution of income can affect thepolitical equilibrium, which implies that the distributional effects of the policiespolitical equilibrium, which implies that the distributional effects of the policiesthat enhance economic ef ciency cannot be ignored for an additional, politicalthat enhance economic efciency cannot be ignored for an additional, politicalreason. Once again, policies that lead to a further increase in inequality would bereason. Once again, policies that lead to a further increase in inequality would bethe ones most likely to have counterproductive political implications. Third, polit-the ones most likely to have counterproductive political implications. Third, polit-ical incentive compatibility constraints, which determine the interests a politicianical incentive compatibility constraints, which determine the interests a politicianhas to satisfy to remain in power, may be violated as a result of removing markethas to satisfy to remain in power, may be violated as a result of removing marketfailures, creating a political backlash. In each case, we provide a few examples tofailures, creating a political backlash. In each case, we provide a few examples toillustrate the mechanisms in action.illustrate the mechanisms in action.At this point, our mechanisms are mainly illustrative. Our purpose is to showAt this point, our mechanisms are mainly illustrative. Our purpose is to showthat the issues highlighted by our framework are present in a number of importantthat the issues highlighted by our framework are present in a number of importanthistorical and current episodes, and that there are some important common-historical and current episodes, and that there are some important common-alities consistent with a basic political economy approachin particular, linkingalities consistent with a basic political economy approachin particular, linkingthe counterproductive political implications to economic policies that improve thethe counterproductive political implications to economic policies that improve thestanding of already dominant groups and interests in society. A more systematicstanding of already dominant groups and interests in society. A more systematicempirical and theoretical analysis of these issues is necessary to uncover the majorempirical and theoretical analysis of these issues is necessary to uncover the majorregularities and lessons, to enrich our views of how economics and politics interact,regularities and lessons, to enrich our views of how economics and politics interact,and to delineate the circumstances, if any, where economists can go on abstractingand to delineate the circumstances, if any, where economists can go on abstractingfrom politics.from politics.

A Theoretical Framework

To assist in clarifying these ideas and to organize the discussion of mechanismsTo assist in clarifying these ideas and to organize the discussion of mechanismsin the next section, consider a two-period model. Suppose an economic policyin the next section, consider a two-period model. Suppose an economic policyhas to be chosen in both periods and there are no economic linkages betweenhas to be chosen in both periods and there are no economic linkages betweenthese two periods. In addition suppose that in the rst period politicians havethese two periods. In addition suppose that in the rst period politicians havesome freedom of choice over policyin some sense, there is a window of policysome freedom of choice over policyin some sense, there is a window of policyopportunity so that policy is not completely determined by vested interests oropportunity so that policy is not completely determined by vested interests or


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some political calculations. This policy choice might also be inuenced by advicesome political calculations. This policy choice might also be inuenced by advicefrom economists, for example, aimed at correcting a market failure. In the secondfrom economists, for example, aimed at correcting a market failure. In the secondperiod, policies will be determined in a political equilibrium.period, policies will be determined in a political equilibrium.Let us rst focus on the world of economics without politics, with no politicalLet us rst focus on the world of economics without politics, with no political(or economic) linkage between the two periods. In such a world, the rst-period(or economic) linkage between the two periods. In such a world, the rst-periodpolicy choice can be made without any concern for the political equilibrium inpolicy choice can be made without any concern for the political equilibrium inthe second period.the second period.11 However, the reality is that policy choices in the rst periodHowever, the reality is that policy choices in the rst periodoften strengthen some groups and weaken others, and thus will likely affect theoften strengthen some groups and weaken others, and thus will likely affect thepolitical equilibrium in the second period. In turn, the political equilibrium willpolitical equilibrium in the second period. In turn, the political equilibrium willdetermine the choices made in the second period. Therefore, the objective of thedetermine the choices made in the second period. Therefore, the objective of thewelfare maximizing policymaker, and the advice given by economists, should notwelfare maximizing policymaker, and the advice given by economists, should notjust be to solve market failures today, but should take into account the later politicaljust be to solve market failures today, but should take into account the later politicalrami cations of this rst period choice.ramications of this rst period choice.22The argument so far is similar to a political version of the famous second-bestThe argument so far is similar to a political version of the famous second-bestcaveat to economic policy analysis (Lancaster and Lipsey 1956). But often, morecaveat to economic policy analysis (Lancaster and Lipsey 1956). But often, morecan be said. Much political economy analysis highlights the role of the balancecan be said. Much political economy analysis highlights the role of the balanceof political power in society, emphasizing in particular that (1) economic andof political power in society, emphasizing in particular that (1) economic andpolitical power are linked; and (2) the political dominance of a narrow interestpolitical power are linked; and (2) the political dominance of a narrow interestgroup or segment of society will have deleterious effects (for example, Acemoglugroup or segment of society will have deleterious effects (for example, Acemogluand Robinson 2012). In this light, policies that economically strengthen alreadyand Robinson 2012). In this light, policies that economically strengthen alreadydominant groups, or that weaken those groups that are acting as a counterbal-dominant groups, or that weaken those groups that are acting as a counterbal-ance to the dominant groups, are especially likely to tilt the balance of politicalance to the dominant groups, are especially likely to tilt the balance of politicalpower further and have un ntended, counterproductive implications.power further and have unintended, counterproductive implications.33In addition,In addition,economic reforms that leave the fundamental political and institutional sources ofeconomic reforms that leave the fundamental political and institutional sources of1 Mathematically, in the world of economics without politics, policies in the two periods, x1and x2, arechosen independently to maximize welfare,

t=12 Wt(xt) (where discounting is suppressed without any

loss of generality). Here Wtcaptures social welfare in period t. In this case, the social welfare maximizingpolicy/advice in the rst period would be x1

SWsuch that W1(x1SW) =0.2 Mathematically, we can think of second-period policy being determined as x2=(p2), where p2is anindex of the distribution of political power in the second period. This distribution of political power isitself determined in part by todays policies, which can be summarized by a function , so thatp2=(x1) .In contrast to the situation in footnote 1, social welfare maximization in this world, where economicpolicies and politics in the future are endogenous, will require (assuming differentiability):

W1(x1) + W2(((x1))) d((x1))_

dp2

d(x1)_

dx1

= 0.

Therefore, unless d/dp2=0 (so that future policies are independent of future politics) or d/dx1=0(so that future politics is independent of todays policies), the second term in this equation will benonzero, implying that the objective of the welfare-maximizing policymaker, and the advice given byeconomists, should not just be to solve market failures today but should factor in politics.3 Following up on footnote 2, one rst needs to order policies, for example, such that higher xfavorsthe already politically powerful groups. With this ordering, denote the status quo policies which willapply without any intervention by x1

0and x20. Suppose that x2

0>x2SW, so that the status quo in the future is

already biased in favor of the politically powerful, and that p2increases (shifts in favor of the dominantgroups) when x1increases. Then any policy reform that involves x1>x1

0(so that it favors the politicallypowerful relative to the status quo today) will tend to increasep2and shift the political equilibrium in thesecond period further to the benet of the politically powerful. This tends to lead to yet higher valuesof x2(thus increasing the gap between actual and socially optimal policies in the second period). Ourframework suggests that the political consequences of these types of policies should be carefully studied.


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Economics versus Politics: Pitfalls of Policy Advice 177

inef ciencies unchanged and instead deal with some of their symptoms in a super-inefciencies unchanged and instead deal with some of their symptoms in a super- cial way also risk a political backlash by violating political incentive compatibilitycial way also risk a political backlash by violating political incentive compatibilityconstraints effectively destroying existing political equilibria or coalitions. Weconstraints effectively destroying existing political equilibria or coalitions. Weshow later how this has been an endemic problem with policy reform in Africa,show later how this has been an endemic problem with policy reform in Africa,where rather than being targeted at the fundamental political economy problemswhere rather than being targeted at the fundamental political economy problemsthat create poor policy, reforms often focus on an outcome of these problems, suchthat create poor policy, reforms often focus on an outcome of these problems, suchpoor monetary or scal policy.poor monetary or scal policy.Of course, the devil is in the details. How might current economic policyOf course, the devil is in the details. How might current economic policychoices affect future political equilibria? How do political equilibria affect the levelchoices affect future political equilibria? How do political equilibria affect the levelof welfare that will be achieved in the future? Clearly, these effects may differ acrossof welfare that will be achieved in the future? Clearly, these effects may differ acrosssettings, like democracies versus nondemocracies, but we will argue that in manysettings, like democracies versus nondemocracies, but we will argue that in manyinstances they seem to be present and of rst-order importance.instances they seem to be present and of rst-order importance.

The Organizational Importance of Economic Rents

Economic rents create incentives to organizein particular, to extract and/orEconomic rents create incentives to organizein particular, to extract and/ortake advantage of those rents or to protect them. The existence of organizationstake advantage of those rents or to protect them. The existence of organizationshas potentially powerful political consequences. Thus, eradicating market failureshas potentially powerful political consequences. Thus, eradicating market failuresand removing the resulting rents will often change investments in organizationsand removing the resulting rents will often change investments in organizationsby certain individuals and groups, and via this channel inuence the politicalby certain individuals and groups, and via this channel inuence the politicalequilibrium. This intuition suggests that economic policy making should take intoequilibrium. This intuition suggests that economic policy making should take intoaccountor at least studythe impact of policy on the political organization ofaccountor at least studythe impact of policy on the political organization ofvarious groups.various groups.Rents, Unionization, and DemocracyIn most situations, unions clearly create economic distortions by pushingIn most situations, unions clearly create economic distortions by pushingthe wages of their members up relative to nonunionized employees. Unions maythe wages of their members up relative to nonunionized employees. Unions mayalso create other distortions, like discouraging employers from adopting certainalso create other distortions, like discouraging employers from adopting certaintechnologies and ef ciency-enhancing practices. As a result, reducing the powertechnologies and efciency-enhancing practices. As a result, reducing the powerof unions to push up wages is often mainstream economic advice. The counter-of unions to push up wages is often mainstream economic advice. The counter-arguments rooted in economic theory typically refer either to the role of unionsarguments rooted in economic theory typically refer either to the role of unionsin securing a more equal distribution of income, especially by improving the payin securing a more equal distribution of income, especially by improving the payof lower-wage workers, or to arguments that rms have some monopsony power inof lower-wage workers, or to arguments that rms have some monopsony power insetting wages and unions can counterbalance that power.setting wages and unions can counterbalance that power.In the context of our framework, the key point is that any policy choice thatIn the context of our framework, the key point is that any policy choice thatreduces the ability of unions to push for high wages even if it does not directlyreduces the ability of unions to push for high wages even if it does not directlyinvolve making it harder to organize unionswill indirectly reduce union activity.involve making it harder to organize unionswill indirectly reduce union activity.After all, many workers may no longer nd joining unions worthwhile when theAfter all, many workers may no longer nd joining unions worthwhile when thepremium they receive is limited. In the context of our framework, todays policiespremium they receive is limited. In the context of our framework, todays policiesaffect tomorrows organizational investments and thus the distribution of politicalaffect tomorrows organizational investments and thus the distribution of politicalpowerin this case, the power of unions. Moreover, in many settings, despite thepowerin this case, the power of unions. Moreover, in many settings, despite thepower of unions in the status quo, the balance of power is already tilted in favorpower of unions in the status quo, the balance of power is already tilted in favorof large employers so that weakening unions might create a more tilted balance ofof large employers so that weakening unions might create a more tilted balance ofpolitical power in society, with the potential dynamic costs that this will engender.political power in society, with the potential dynamic costs that this will engender.


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This outcome results because, as we have already noted, unions do not justThis outcome results because, as we have already noted, unions do not justght for higher wages or attempt to inuence the internal organization of rms;ght for higher wages or attempt to inuence the internal organization of rms;they have also been very active politically in ways that seem likely to affect thethey have also been very active politically in ways that seem likely to affect thepolitical equilibrium. One of the most important consequences of the politicalpolitical equilibrium. One of the most important consequences of the politicalpower of unions is the role they have played in creating and supporting demo-power of unions is the role they have played in creating and supporting demo-cratic institutions around the world, particularly starting from a situation in whichcratic institutions around the world, particularly starting from a situation in whichpolitical power was very unequally distributed in a nondemocratic context. A recentpolitical power was very unequally distributed in a nondemocratic context. A recentliterature on the factors inuencing the creation of democracy has moved awayliterature on the factors inuencing the creation of democracy has moved awayfrom earlier work, such as that of Moore (1966), which emphasized the role offrom earlier work, such as that of Moore (1966), which emphasized the role ofthe middle class or the bourgeoisie, and has instead pointed out that it is oftenthe middle class or the bourgeoisie, and has instead pointed out that it is oftenthe working classes or poor segments of society that have played a de ning rolethe working classes or poor segments of society that have played a dening rolein the emergence and ourishing of democracy (Rueschemeyer, Stephens, andin the emergence and ourishing of democracy (Rueschemeyer, Stephens, andStephens 1992; Collier and Mahoney 1997; Acemoglu and Robinson 2000, 2006).Stephens 1992; Collier and Mahoney 1997; Acemoglu and Robinson 2000, 2006).This literature argues that the extent to which the working class is organized or ableThis literature argues that the extent to which the working class is organized or ableto engage in collective action is critical for its ability to push for institutional change.to engage in collective action is critical for its ability to push for institutional change.Since unions are in the business of organizing working people, it makes sense thatSince unions are in the business of organizing working people, it makes sense thatthe presence of unions should facilitate collective action that pushes for regimethe presence of unions should facilitate collective action that pushes for regimechange. A great deal of case study and econometric research supports this emphasischange. A great deal of case study and econometric research supports this emphasison social conict (for example, Aidt and Jensen 2012).on social conict (for example, Aidt and Jensen 2012).Some examples where unions have played a pivotal role in democratizationSome examples where unions have played a pivotal role in democratizationrange from the rst wave of democratization in Europe prior to World War I (Eleyrange from the rst wave of democratization in Europe prior to World War I (Eley2002) through the battle of Solidarity against the communist regime in Poland, to2002) through the battle of Solidarity against the communist regime in Poland, tothe ght against the apartheid regime in South Africa by the Congress of Souththe ght against the apartheid regime in South Africa by the Congress of SouthAfrican Trade Unions (COSATU). One of the clearest recent cases is the formationAfrican Trade Unions (COSATU). One of the clearest recent cases is the formationof the Workers Party (PT) in Brazil in 1979. This party emerged in the context of aof the Workers Party (PT) in Brazil in 1979. This party emerged in the context of astrike at the Scnia truck factory in So Bernardo. The leader of the So Bernardostrike at the Scnia truck factory in So Bernardo. The leader of the So Bernardometalworkers was a 33 year-old activist called Luis Incio Lula da Silva, also knownmetalworkers was a 33 year-old activist called Luis Incio Lula da Silva, also knownas Lula, who helped to organize what was the rst in a series of strikes which sweptas Lula, who helped to organize what was the rst in a series of strikes which sweptacross Brazil, challenging the military dictatorship. On the face of it, these strikesacross Brazil, challenging the military dictatorship. On the face of it, these strikeswere about wages and working conditions, but as Lula later recalled: I think wewere about wages and working conditions, but as Lula later recalled: I think wecant separate economic and political factors . . . The . . . struggle was over wages, butcant separate economic and political factors . . . The . . . struggle was over wages, butin struggling for wages, the working class won a political victory (quoted in Keckin struggling for wages, the working class won a political victory (quoted in Keck1992, p. 65). Formed the year after the strike, the PT was in the vanguard of the1992, p. 65). Formed the year after the strike, the PT was in the vanguard of thesuccessful movement to force the military from power in Brazil.successful movement to force the military from power in Brazil.In summary, policies reducing the effectiveness of unions in negotiating overIn summary, policies reducing the effectiveness of unions in negotiating overwages and working conditions for their members will reduce their political power.wages and working conditions for their members will reduce their political power.Though Lula and COSATU managed to organize in hostile political environments,Though Lula and COSATU managed to organize in hostile political environments,the evidence suggests that unionization rates are sensitive to government policiesthe evidence suggests that unionization rates are sensitive to government policiesthat facilitate the creation of monopoly power and rents (Rothstein 1992, Westernthat facilitate the creation of monopoly power and rents (Rothstein 1992, Western1999, Schmitt and Mitukiewicz 2012). If the political power of unions is important1999, Schmitt and Mitukiewicz 2012). If the political power of unions is importantin supporting a range of other economic and political outcomes, then correctingin supporting a range of other economic and political outcomes, then correctingthe labor market failures associated with union-induced high wages may back re.the labor market failures associated with union-induced high wages may backre.This perspective can also be applied to US experience with unions. The shareThis perspective can also be applied to US experience with unions. The shareof US workers belonging to a union peaked back in the early 1950s. There wasof US workers belonging to a union peaked back in the early 1950s. There wasan element of policy choice here: after encouraging the growth of unions withan element of policy choice here: after encouraging the growth of unions with


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the passage of the National Labor Relations Act (the Wagner Act) in 1935 and bythe passage of the National Labor Relations Act (the Wagner Act) in 1935 and byvarious actions during World War II, the bargaining environment became less favor-various actions during World War II, the bargaining environment became less favor-able for unions with the passage of the Labor Management Relations Act of 1947able for unions with the passage of the Labor Management Relations Act of 1947(the TaftHartley Act). Moreover, starting in the 1970s, policies that encouraged(the TaftHartley Act). Moreover, starting in the 1970s, policies that encouragedfree trade increased the level of competition in the US economy, undercut-free trade increased the level of competition in the US economy, undercut-ting the ability of a number of private sector unions to raise wages. Of furtherting the ability of a number of private sector unions to raise wages. Of furthersigni cance was the anti-union stance of the Reagan administration (Farber andsignicance was the anti-union stance of the Reagan administration (Farber andWestern 2002). The decline in union membership may have had various politicalWestern 2002). The decline in union membership may have had various politicaleconomy consequences, for example, as an important contributing factor to theeconomy consequences, for example, as an important contributing factor to therise in income inequality (Western and Rosenfeld 2011). More speculatively, it mayrise in income inequality (Western and Rosenfeld 2011). More speculatively, it mayhave also contributed to the explosion in compensation of chief executive of cershave also contributed to the explosion in compensation of chief executive ofcers(DiNardo, Hallock, and Pischke 1997, 2000) and to the rapid deregulation of the(DiNardo, Hallock, and Pischke 1997, 2000) and to the rapid deregulation of thenancial sector.nancial sector.

Consequences of the Organization of Resource WealthA popular argument claims that the speci c form of a countrys naturalA popular argument claims that the specic form of a countrys naturalresources have a rst-order impact on economics and politics. Botswanas deep-resources have a rst-order impact on economics and politics. Botswanas deep-mined diamonds, according to this argument, have different consequences formined diamonds, according to this argument, have different consequences forpolitical stability than Sierra Leones alluvial diamonds (Ross 2006). However, thepolitical stability than Sierra Leones alluvial diamonds (Ross 2006). However, theconsequences of minerals can depend not so much on their intrinsic characteristicsconsequences of minerals can depend not so much on their intrinsic characteristicsor on whether their extraction is organized ef ciently from an economic point ofor on whether their extraction is organized efciently from an economic point ofview, but on the political consequences of how their exploitation is structured. Weview, but on the political consequences of how their exploitation is structured. Weillustrate this with the comparison of the exploitation of the alluvial gold depositsillustrate this with the comparison of the exploitation of the alluvial gold depositsof Australia and the diamond deposits of Sierra Leone. In both cases, for basicof Australia and the diamond deposits of Sierra Leone. In both cases, for basiceconomic reasons, free entry into mining was inef cient. Natural resource extrac-economic reasons, free entry into mining was inefcient. Natural resource extrac-tion provides a clear case of the congestion problem: the more others extract,tion provides a clear case of the congestion problem: the more others extract,the less will be left for each participant. One way to address this market failure is tothe less will be left for each participant. One way to address this market failure is toassign exclusive property rights to the natural resources to a large producer, whoassign exclusive property rights to the natural resources to a large producer, whowould plan long-term and eliminate the dissipation of rents that is likely to arisewould plan long-term and eliminate the dissipation of rents that is likely to arisethrough excessive entry. Another way to organize mining is to allow large numbersthrough excessive entry. Another way to organize mining is to allow large numbersof individuals or small rms to search for the resources, possibly subject to regis-of individuals or small rms to search for the resources, possibly subject to regis-tration or other fees. The Australian case suggests that when a large number oftration or other fees. The Australian case suggests that when a large number ofindependent, small-scale miners are doing the extraction and realize their rents mayindependent, small-scale miners are doing the extraction and realize their rents maybe dissipated, this contributes to their political organization as a group, ultimatelybe dissipated, this contributes to their political organization as a group, ultimatelycreating a more balanced political landscape and contributing to the developmentcreating a more balanced political landscape and contributing to the developmentof democratic politics. On the other side, Sierra Leones experience showcases howof democratic politics. On the other side, Sierra Leones experience showcases howthe prevalence of large and very pro table mining interests, as well as the politicalthe prevalence of large and very protable mining interests, as well as the politicalin ghting to control and bene t from these mining interests, often has negativeinghting to control and benet from these mining interests, often has negativeand nondemocratic implications for the distribution of political power.and nondemocratic implications for the distribution of political power.In Australia, gold was discovered in New South Wales and then in the newly-In Australia, gold was discovered in New South Wales and then in the newly-formed state of Victoria in 1851. The immediate reaction of Australian political elitesformed state of Victoria in 1851. The immediate reaction of Australian political eliteswas to try to ban gold mining in the fear that the labor force on farms and rancheswas to try to ban gold mining in the fear that the labor force on farms and rancheswould vanish. If gold mining was to be allowed, it would be only after proper surveyswould vanish. If gold mining was to be allowed, it would be only after proper surveyshad been made and the land leased out to large enterprises (Hirst 2008, p. 375).had been made and the land leased out to large enterprises (Hirst 2008, p. 375).But the gold was on Crown land, and as such outside the direct control of the elitesBut the gold was on Crown land, and as such outside the direct control of the elites


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in the Legislative Assembly of New South Wales, who could neither ban mining norin the Legislative Assembly of New South Wales, who could neither ban mining norallocate mining rights in large lots. The concerns of the British colonial state aboutallocate mining rights in large lots. The concerns of the British colonial state aboutthe growing power of local Australian economic and political elites led to the deci-the growing power of local Australian economic and political elites led to the deci-sion to allow anyone to take out a mining license as long as they paid 30 shillingssion to allow anyone to take out a mining license as long as they paid 30 shillingsper month. Though this fee was high, it did not stop a massive gold rush. Soonper month. Though this fee was high, it did not stop a massive gold rush. Soon50 percent of the men in Victoria were working in the gold elds. Of Melbournes50 percent of the men in Victoria were working in the gold elds. Of Melbournes40 police constables, 38 resigned to go and dig gold. Ships were unable to sail from40 police constables, 38 resigned to go and dig gold. Ships were unable to sail fromMelbournes harbor because their crews deserted (Blainey 2006, p. 40).Melbournes harbor because their crews deserted (Blainey 2006, p. 40).As Australias mining camps spread, resentment grew about the license, whichAs Australias mining camps spread, resentment grew about the license, whichhad to be paid whether or not the miner found gold, and further restrictions werehad to be paid whether or not the miner found gold, and further restrictions wereplaced on the size of claims miners could stake. Punishments were also increased forplaced on the size of claims miners could stake. Punishments were also increased forthose found without a license. The miners began to organize to protect their inter-those found without a license. The miners began to organize to protect their inter-ests and increase their rents by reducing mining licenses. In 1854, they founded theests and increase their rents by reducing mining licenses. In 1854, they founded theBallarat Reform League in the town of that name in the middle of the gold elds.Ballarat Reform League in the town of that name in the middle of the goldelds.In November 1854, the diggers in Ballarat delivered a set of Resolutions to theIn November 1854, the diggers in Ballarat delivered a set of Resolutions to thegovernor, which were heavily inspired by the agenda of the Chartists, a movementgovernor, which were heavily inspired by the agenda of the Chartists, a movementof working-class people seeking greater political participation in Britain. (Indeed,of working-class people seeking greater political participation in Britain. (Indeed,the secretary of the Ballarat Reform League, John Humffray, had been a Chartist inthe secretary of the Ballarat Reform League, John Humffray, had been a Chartist inWales before emigrating to Australia.) The demands included manhood suffrage,Wales before emigrating to Australia.) The demands included manhood suffrage,no property requirements to become a member of the Victorian Legislativeno property requirements to become a member of the Victorian LegislativeCouncil, and payment of the members of that council (Hirst 2002, p. 48). TheyCouncil, and payment of the members of that council (Hirst 2002, p. 48). Theyalso demanded an end to licenses and the disbanding of the commissioners whoalso demanded an end to licenses and the disbanding of the commissioners whocollected the license fees on the gold elds. A group of miners, diggers as they werecollected the license fees on the goldelds. A group of miners, diggers as they wereknown, led by Peter Lalor, decided to refuse to pay for their licenses, took up arms,known, led by Peter Lalor, decided to refuse to pay for their licenses, took up arms,and built a stockade at Eureka. On December 3, 1854, armed police stormed theand built a stockade at Eureka. On December 3, 1854, armed police stormed thestockade, and 30 diggers and ve policemen died.stockade, and 30 diggers and ve policemen died.In the outrage that followed, a Royal Commission recommended reform ofIn the outrage that followed, a Royal Commission recommended reform ofthe license system, also xing a fee of one pound for a yearly license. Under thethe license system, also xing a fee of one pound for a yearly license. Under the1853 Victoria Constitution, someone in possession of an annual mining license was1853 Victoria Constitution, someone in possession of an annual mining license wasdeemed to have suf cient wealth to be eligible to vote. Thus, at one fell swoop, anydeemed to have sufcient wealth to be eligible to vote. Thus, at one fell swoop, anydigger willing to pay one poundand many werewas enfranchised. At the samedigger willing to pay one poundand many werewas enfranchised. At the sametime, to placate the diggers further, the Legislative Council was expanded to allowtime, to placate the diggers further, the Legislative Council was expanded to allowfor representation from the gold elds. In 1855, Humffray and Lalor were electedfor representation from the goldelds. In 1855, Humffray and Lalor were electedto the Victoria Legislative Council along with six other diggers. In March 1856, theto the Victoria Legislative Council along with six other diggers. In March 1856, theLegislative Council introduced the worlds rst effective secret ballot, henceforthLegislative Council introduced the worlds rst effective secret ballot, henceforthknown as the Australian Ballot. All eight diggers voted in favor, and the measureknown as the Australian Ballot. All eight diggers voted in favor, and the measurepassed by 33 votes to 25 (Hirst 2006).passed by 33 votes to 25 (Hirst 2006).The contrast between the Australian experience, where the organization ofThe contrast between the Australian experience, where the organization ofgold deposits created a large pro-democratic force, and that in Sierra Leone isgold deposits created a large pro-democratic force, and that in Sierra Leone isstriking. Prospecting for diamonds began in Sierra Leone in the 1920s, with the rststriking. Prospecting for diamonds began in Sierra Leone in the 1920s, with the rstdiscoveries being made in 1931. Small-scale mining started in 1933 in the east of thediscoveries being made in 1931. Small-scale mining started in 1933 in the east of thecountry, and in 1935 the colonial government gave the Sierra Leone Selection Trustcountry, and in 1935 the colonial government gave the Sierra Leone Selection Trust(SLST) practically exclusive prospecting and mining rights for the entire country.(SLST) practically exclusive prospecting and mining rights for the entire country.To protect these rights from illegal mining, SLST had its own security force. InTo protect these rights from illegal mining, SLST had its own security force. Inhis study, van der Lann (1965, p. 79) poses the question: What is better for thehis study, van der Lann (1965, p. 79) poses the question: What is better for the


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Sierra Leone economy: to have the diamond deposits slowly and steadily exploitedSierra Leone economy: to have the diamond deposits slowly and steadily exploitedby a mining company, or rapidly worked by diggers? He argues that the SLST wasby a mining company, or rapidly worked by diggers? He argues that the SLST was(economically) better both because the recovery rate of the diggers . . . falls far(economically) better both because the recovery rate of the diggers . . . falls farshort of the rate of close to 100% achieved by SLST (p. 80), and also because theshort of the rate of close to 100% achieved by SLST (p. 80), and also because theSLST monopoly generated more revenues for the government.SLST monopoly generated more revenues for the government.Yet the really important feature of the organization of the diamond mining inYet the really important feature of the organization of the diamond mining inSierra Leone was not the economic costs and bene ts of the SLST, but its politicalSierra Leone was not the economic costs and benets of the SLST, but its politicalconsequences. While the SLST struggled to control illegal mining by diggers, theconsequences. While the SLST struggled to control illegal mining by diggers, theorganization of the mining did not create the type of democratic impulse as it hadorganization of the mining did not create the type of democratic impulse as it hadin Australia. One consequence of this was that the independence movement of thein Australia. One consequence of this was that the independence movement of the1950s was spearheaded by paramount chiefs and other elites favored by British colo-1950s was spearheaded by paramount chiefs and other elites favored by British colo-nialism. In 1952, when these elite Sierra Leoneans began to control the Legislativenialism. In 1952, when these elite Sierra Leoneans began to control the LegislativeCouncil, they chose not to open up diamond mining to Sierra Leoneans, but ratherCouncil, they chose not to open up diamond mining to Sierra Leoneans, but ratherto extract greater taxes from the SLST. In exchange, they helped to enforce theto extract greater taxes from the SLST. In exchange, they helped to enforce themonopoly rights by aggressively punishing illegal mining. The Minister of Minesmonopoly rights by aggressively punishing illegal mining. The Minister of Minesin charge of this was the future kleptocratic prime minister and president of Sierrain charge of this was the future kleptocratic prime minister and president of SierraLeone, Siaka Stevens. In 1956, the number of illegal diggers had become so largeLeone, Siaka Stevens. In 1956, the number of illegal diggers had become so largepossibly 75,000 (van der Laan 1965, p. 65)that security forces were overwhelmed.possibly 75,000 (van der Laan 1965, p. 65)that security forces were overwhelmed.SLSTs monopoly was now restricted to two areas, but these were still the primeSLSTs monopoly was now restricted to two areas, but these were still the primedeposits of Kono and Tongo Fields. Elsewhere, mining licenses were issued but notdeposits of Kono and Tongo Fields. Elsewhere, mining licenses were issued but notto strangersmeaning anyone who was not an indigenous resident of the chief-to strangersmeaning anyone who was not an indigenous resident of the chief-taincy where the mining was to take place.taincy where the mining was to take place.

Naturally, as we discuss in Acemoglu and Robinson (2012), there were otherNaturally, as we discuss in Acemoglu and Robinson (2012), there were otherhistorical and institutional factors stacking the cards against the development of thehistorical and institutional factors stacking the cards against the development of thetype of inclusive economic and political institutions and policies that would havetype of inclusive economic and political institutions and policies that would havestimulated economic growth in Sierra Leone. But the arrangements that had beenstimulated economic growth in Sierra Leone. But the arrangements that had beenmade for accessing natural resources were a key contributor to the fact that duringmade for accessing natural resources were a key contributor to the fact that duringthe critical period of the founding of the rst political parties in Sierra Leone, theythe critical period of the founding of the rst political parties in Sierra Leone, theywere formed by elites, particularly by the Paramount Chiefs and those connectedwere formed by elites, particularly by the Paramount Chiefs and those connectedto them, without the input of the broad mass of Sierra Leoneans (Cartwright 1970,to them, without the input of the broad mass of Sierra Leoneans (Cartwright 1970,provides an overview). The scene was set for the creation of one-party and authori-provides an overview). The scene was set for the creation of one-party and authori-tarian rule after independence in 1961.tarian rule after independence in 1961.

Political Consequences of Inequality

Removing a market failure will also generally alter the distribution of income inRemoving a market failure will also generally alter the distribution of income insociety. For example, when unions are less able to exercise monopoly power, not onlysociety. For example, when unions are less able to exercise monopoly power, not onlywill their organization dwindle, but (at least in the absence of robust competition)will their organization dwindle, but (at least in the absence of robust competition)pro ts will rise. Income will typically be redistributed from workers to the managersprots will rise. Income will typically be redistributed from workers to the managersand owners of rms. However, this shift will also inuence the political equilibrium.and owners of rms. However, this shift will also inuence the political equilibrium.An example of how an altered distribution of income can have a rst-orderAn example of how an altered distribution of income can have a rst-orderimpact on future politics is provided by the effect of Atlantic trade opportunitiesimpact on future politics is provided by the effect of Atlantic trade opportunitieson the English political system in the seventeenth century. Because Atlantic tradingon the English political system in the seventeenth century. Because Atlantic tradingactivities were not the monopoly of the Crown in England at this time, this trade wasactivities were not the monopoly of the Crown in England at this time, this trade was


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dominated by independent merchants, adventurers, and privateers. Pro ts fromdominated by independent merchants, adventurers, and privateers. Prots fromAtlantic trade enriched many of these men, who opposed the Stuart monarchsAtlantic trade enriched many of these men, who opposed the Stuart monarchsabsolutism and sought to limit the Crowns prerogatives. As they became richer, theyabsolutism and sought to limit the Crowns prerogatives. As they became richer, theyalso became more powerful and bolder, and were even able to eld armies to defeatalso became more powerful and bolder, and were even able to eld armies to defeatthe monarchy in the English Civil War of the 1640s and then during the Gloriousthe monarchy in the English Civil War of the 1640s and then during the GloriousRevolution of 1688. The papers Acemoglu, Johnson, and Robinson (2005) and JhaRevolution of 1688. The papers Acemoglu, Johnson, and Robinson (2005) and Jha(2010) provide historical and empirical evidence linking the rise of inclusive institu-(2010) provide historical and empirical evidence linking the rise of inclusive institu-tions in England and the Dutch Republic to the rise of merchants and industrialiststions in England and the Dutch Republic to the rise of merchants and industrialistsbene ting from Atlantic trade. Tellingly, this trajectory is very different than the onebeneting from Atlantic trade. Tellingly, this trajectory is very different than the oneobserved in Portugal or Spain, where Atlantic trading activities were monopolizedobserved in Portugal or Spain, where Atlantic trading activities were monopolizedand allocated by the Crown. In these countries, the riches of trade owed into theand allocated by the Crown. In these countries, the riches of trade owed into thecoffers of the already dominant monarchs, strengthening the monarchy, weakeningcoffers of the already dominant monarchs, strengthening the monarchy, weakeningthe parliaments of these nations, and contributing to the tilted balance of politicalthe parliaments of these nations, and contributing to the tilted balance of politicalpower, which persisted and underpinned the lack of economic and political devel-power, which persisted and underpinned the lack of economic and political devel-opment in these parts of Western Europe.opment in these parts of Western Europe.Money and Politics in the United StatesThe experience of nancial deregulation over the past 30 years in the UnitedThe experience of nancial deregulation over the past 30 years in the UnitedStates, as analyzed by Johnson and Kwak (2010), provides an illustration of howStates, as analyzed by Johnson and Kwak (2010), provides an illustration of howeconomic policy designed with a disregard for political implications can be in uriouseconomic policy designed with a disregard for political implications can be injuriousto social welfare. The system of nancial and banking regulation that emergedto social welfare. The system of nancial and banking regulation that emergedfrom the Great Depression had many features that were irrational from a purelyfrom the Great Depression had many features that were irrational from a purelyeconomic viewpoint. These included the prohibition of interstate banking and theeconomic viewpoint. These included the prohibition of interstate banking and theseparation of commercial from investment banking. Jayaratne and Strathan (1996),separation of commercial from investment banking. Jayaratne and Strathan (1996),among others, found that the removal of some of these banking restrictions spurredamong others, found that the removal of some of these banking restrictions spurredrapid economic growth. Such reforms are akin to those directly addressing marketrapid economic growth. Such reforms are akin to those directly addressing marketfailures in the sense that they were removing distortions partly introduced byfailures in the sense that they were removing distortions partly introduced byprevious policies. But in common with the other economic policies with potentiallyprevious policies. But in common with the other economic policies with potentiallycounterproductive political consequences, these reforms also tended to strengthencounterproductive political consequences, these reforms also tended to strengthenan already powerful constituency, the nancial sector.an already powerful constituency, the nancial sector.Financial deregulation started small, for example, ending xed commissionsFinancial deregulation started small, for example, ending xed commissionson stock trading in 1975. Then Regulation Q which limited interest rates on savingson stock trading in 1975. Then Regulation Q , which limited interest rates on savingsaccounts, was abolished in 1980. As Johnson and Kwak (2010) argue, while theaccounts, was abolished in 1980. As Johnson and Kwak (2010) argue, while thebanking and nancial services industry was not powerful enough at this time tobanking and nancial services industry was not powerful enough at this time toget all the deregulation it wanted, it was strong enough to block new regulation.get all the deregulation it wanted, it was strong enough to block new regulation.This was relevant because considerable nancial innovation was starting to takeThis was relevant because considerable nancial innovation was starting to takeplace: as one example, Salomon Brothers originated interest rate swaps in 1981.place: as one example, Salomon Brothers originated interest rate swaps in 1981.As these new nancial instruments developed, and as regulations that limited whatAs these new nancial instruments developed, and as regulations that limited whatnancial services banks could perform were incrementally relaxed during this timenancial services banks could perform were incrementally relaxed during this timeby regulators and courts, the nancial sector became bigger and more pro table.by regulators and courts, the nancial sector became bigger and more protable.Between 1980 and 2005, nancial sector pro ts grew 800 percent in real terms,Between 1980 and 2005, nancial sector prots grew 800 percent in real terms,while non nancial pro ts rose by 250 percent ( Johnson and Kwak 2010, chap. 3).while nonnancial prots rose by 250 percent ( Johnson and Kwak 2010, chap. 3).Between 1998 and 2007, nancial sector pro ts were on average about 30 percent ofBetween 1998 and 2007, nancial sector prots were on average about 30 percent oftotal pro ts in the private sector. During this period, the nancial sector expandedtotal prots in the private sector. During this period, the nancial sector expandedfrom 3.5 percent to almost 6 percent of GDP.from 3.5 percent to almost 6 percent of GDP.


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As the banks got bigger and more pro table, they also became more asser-As the banks got bigger and more protable, they also became more asser-tive and inuential. They started to lobby more and contribute more to politicaltive and inuential. They started to lobby more and contribute more to politicalcampaigns. While in 1990 the nancial sector donated $61 million dollars tocampaigns. While in 1990 the nancial sector donated $61 million dollars topolitical campaigns, by 2006 this was $260 million (the industry which was the nextpolitical campaigns, by 2006 this was $260 million (the industry which was the nextlargest donor, health care, gave only $100 million in 2006). Of course, rising wealthlargest donor, health care, gave only $100 million in 2006). Of course, rising wealthand campaign contributions were not the only source of rising political power forand campaign contributions were not the only source of rising political power forthe nancial industry. There was a revolving door between Wall Street and execu-the nancial industry. There was a revolving door between Wall Street and execu-tive appointments in Washington as well. As Johnson and Kwaak (2010) point out,tive appointments in Washington as well. As Johnson and Kwaak (2010) point out,there was also an intellectual revolution in academic nance involving the pricingthere was also an intellectual revolution in academic nance involving the pricingof derivative nancial instruments and a body of studies arguing for deregulation,of derivative nancial instruments and a body of studies arguing for deregulation,all of which was interpreted as bolstering the nancial sectors position.all of which was interpreted as bolstering the nancial sectors position.So nancial deregulation continued. In 1994, the Riegle-Neal InterstateSo nancial deregulation continued. In 1994, the Riegle-Neal InterstateBanking and Branching Ef ciency Act relaxed constraints on interstate bankingBanking and Branching Efciency Act relaxed constraints on interstate bankingand led to a series of mergers which constructed large nationwide banks. JPMorganand led to a series of mergers which constructed large nationwide banks. JPMorganChase and Citicorp were formed, and the Bank of America transformed. In 1999, theChase and Citicorp were formed, and the Bank of America transformed. In 1999, theGrammLeachBliley Act effectively codi ed the demolition of most of the barriersGrammLeachBliley Act effectively codied the demolition of most of the barriersbetween commercial and investment banking, barriers that had already been fallingbetween commercial and investment banking, barriers that had already been fallingincrementally for several decades as a result of regulatory and court decisions. Butincrementally for several decades as a result of regulatory and court decisions. Butperhaps more important than these changes was the avoidance of regulations:perhaps more important than these changes was the avoidance of regulations:for example, regulations that might have altered how accountants and regulatorsfor example, regulations that might have altered how accountants and regulatorstreated the collateralized debt obligations based on mortgage-backed securities andtreated the collateralized debt obligations based on mortgage-backed securities andthe credit default swaps sold by insurance companies like the American Insurancethe credit default swaps sold by insurance companies like the American InsuranceGroup (AIG). The political power of the nancial industry also accentuated theGroup (AIG). The political power of the nancial industry also accentuated themoral hazard problem in nance (that large nancial institutions can take risksmoral hazard problem in nance (that large nancial institutions can take risksexpecting to be bailed out by the government when things get bad). Ultimately,expecting to be bailed out by the government when things get bad). Ultimately,these regulatory changes and the regulatory void, in conjunction with the moralthese regulatory changes and the regulatory void, in conjunction with the moralhazard problem, created an environment that encouraged excessive risk-taking andhazard problem, created an environment that encouraged excessive risk-taking andcontributed to the 20072008 nancial crisis.contributed to the 20072008 nancial crisis.In terms of our framework, this account illustrates how potentially ef ciency-In terms of our framework, this account illustrates how potentially efciency-enhancing deregulation may have increased the size and political power of theenhancing deregulation may have increased the size and political power of thenancial industry, which then altered the structure of future regulations and alloca-nancial industry, which then altered the structure of future regulations and alloca-tions in favor of the nancial industry, with potentially adverse consequences for thetions in favor of the nancial industry, with potentially adverse consequences for therest of society. Put differently, any analysis of these economic policies that focusedrest of society. Put differently, any analysis of these economic policies that focusedonly on their economic costs and bene ts but did not take into account the politicalonly on their economic costs and benets but did not take into account the politicalconsequences of the changes they unleashed would dramatically understate theconsequences of the changes they unleashed would dramatically understate thelikelihood of the costs that actually occurred.likelihood of the costs that actually occurred.Russian PrivatizationMost economists favor privatization of industry, and few argue that governmentMost economists favor privatization of industry, and few argue that governmentownership of industry is ef cient from a costbene t perspective. Like deregulation,ownership of industry is efcient from a costbenet perspective. Like deregulation,privatization is also proposed as a way of improving economic ef ciency by reversingprivatization is also proposed as a way of improving economic efciency by reversingexisting (government-imposed) distortions. Yet the privatization of rms in Russiaexisting (government-imposed) distortions. Yet the privatization of rms in Russiaduring the 1990s is another example of a policy with a major effect on incomeduring the 1990s is another example of a policy with a major effect on incomedistribution, creating a group of very wealthy individuals and putting in motiondistribution, creating a group of very wealthy individuals and putting in motionsigni cant political changesnot only in terms of the direct negative consequencessignicant political changesnot only in terms of the direct negative consequences


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of the policy, but also in terms of the potential weakening of the reform processof the policy, but also in terms of the potential weakening of the reform processand the backlash that these policies created, paving the way for the rise of Vladimirand the backlash that these policies created, paving the way for the rise of VladimirPutins authoritarian regime.Putins authoritarian regime.In summer 1991, Boris Yeltsin won the election for the newly created RussianIn summer 1991, Boris Yeltsin won the election for the newly created Russianpresidency. His platform, on the basis of which he beat four Communists and apresidency. His platform, on the basis of which he beat four Communists and ahardcore nationalist, included a radical program of market-oriented reform. Tohardcore nationalist, included a radical program of market-oriented reform. Toimplement it, he picked Yegor Gaidar, who in turn asked Anatoly Chubais to beimplement it, he picked Yegor Gaidar, who in turn asked Anatoly Chubais to bein charge of privatization. Of all the policies that Yeltsin wanted to implement, thein charge of privatization. Of all the policies that Yeltsin wanted to implement, theprivatization of the countrys thousands of state-owned rms was perhaps the mostprivatization of the countrys thousands of state-owned rms was perhaps the mostcritical; but he had no speci c plan about how to accomplish it. Gaidar and Chubaiscritical; but he had no specic plan about how to accomplish it. Gaidar and Chubaiscame up with a strategy to put the main assets of the Soviet Union into private hands.came up with a strategy to put the main assets of the Soviet Union into private hands.Starting in the spring of 1992, small rms like stores and restaurants began to beStarting in the spring of 1992, small rms like stores and restaurants began to besold off. People could take ownership of their own apartment for free or almost forsold off. People could take ownership of their own apartment for free or almost forfree. In late 1992, Chubais turned to the big rms. Yeltsins team tried to get the publicfree. In late 1992, Chubais turned to the big rms. Yeltsins team tried to get the publicinvolved in this initial distribution of assets. Large- and medium-sized enterprises wereinvolved in this initial distribution of assets. Large- and medium-sized enterprises wererequired to sell 29 percent of their shares in voucher auctions, and in October 1992,required to sell 29 percent of their shares in voucher auctions, and in October 1992,each Russian adult was issued vouchers with a nominal value of 10,000 rubles; oneseach Russian adult was issued vouchers with a nominal value of 10,000 rubles; onesvouchers could be acquired at a local bank for a fee of just 25 rubles. By January 1993,vouchers could be acquired at a local bank for a fee of just 25 rubles. By January 1993,97 percent of Russians had claimed their vouchers. These vouchers could be sold97 percent of Russians had claimed their vouchers. These vouchers could be soldor used to bid for the shares of speci c companies when they privatized. The rstor used to bid for the shares of specic companies when they privatized. The rstvoucher auctions were held in December 1992, and in total, about 14,000 enterprisesvoucher auctions were held in December 1992, and in total, about 14,000 enterprisesheld such auctions. However, most assets of these rms went to their workers andheld such auctions. However, most assets of these rms went to their workers andmanagers. The law allowed for workers and managers to buy 51 percent of the votingmanagers. The law allowed for workers and managers to buy 51 percent of the votingshares of a rm at a discount and using the rms own funds. In effect, the majority ofshares of a rm at a discount and using the rms own funds. In effect, the majority ofprivatizing rms assets were handed to insiders at huge discounts.privatizing rms assets were handed to insiders at huge discounts.The most controversial stage of the privatizationand in hindsight the mostThe most controversial stage of the privatizationand in hindsight the mostclearly deleteriouswas the loans-for-shares deal in 1995. State shares in twelve highlyclearly deleteriouswas the loans-for-shares deal in 1995. State shares in twelve highlypro table enterprises concentrated in the energy sector were used as collateral forprotable enterprises concentrated in the energy sector were used as collateral forbank loans to the government. If the loans were not paid off, and the governmentbank loans to the government. If the loans were not paid off, and the governmentnever had any intention of paying them off, the banks would have the right to sell thenever had any intention of paying them off, the banks would have the right to sell theshares. Between November 1996 and February 1997, sales happened for the shares ofshares. Between November 1996 and February 1997, sales happened for the shares ofseveral large rms including Yukos, Sidanko, and Surgutneftegaz, and in each case,several large rms including Yukos, Sidanko, and Surgutneftegaz, and in each case,the shares were bought by the banks themselves in auctions where outside bids werethe shares were bought by the banks themselves in auctions where outside bids wereignored or disquali ed. Freeland (2000) and Hoffman (2002) provide overviews ofignored or disqualied. Freeland (2000) and Hoffman (2002) provide overviews ofthese events and a description of the resulting rise of the oligarchs. Not only did thisthese events and a description of the resulting rise of the oligarchs. Not only did thistype of privatization massively enrich and empower the oligarchs, but it also failedtype of privatization massively enrich and empower the oligarchs, but it also failedto create a large number of small shareholders. In 1994, workers owned 50 percentto create a large number of small shareholders. In 1994, workers owned 50 percentof the average Russian enterprise; by 1999, this gure had dropped to 36 percent.of the average Russian enterprise; by 1999, this gure had dropped to 36 percent.By 2005, 71 percent of medium and large industry and communications enterprisesBy 2005, 71 percent of medium and large industry and communications enterpriseshad a single shareholder who owned half the stock (Treisman 2011, pp. 22324).had a single shareholder who owned half the stock (Treisman 2011, pp. 22324).The driving force behind privatization was textbook economics, to moveThe driving force behind privatization was textbook economics, to moveRussia from central planning and state ownership to a much more ef cient marketRussia from central planning and state ownership to a much more efcient marketeconomy. This was certainly the view of many economists at the time, and the maineconomy. This was certainly the view of many economists at the time, and the maindebate was about how fast to privatize (Aghion and Blanchard 1994), not whetherdebate was about how fast to privatize (Aghion and Blanchard 1994), not whetherto maintain state ownership or not. (Arguments that privatization might create ato maintain state ownership or not. (Arguments that privatization might create a


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private monopoly, with even worse economic consequences than public ownership,private monopoly, with even worse economic consequences than public ownership,as suggested by Borenstein (2002) in the context of California, were not commonlyas suggested by Borenstein (2002) in the context of California, were not commonlyraised at that time. Since then some authors, including Black, Kraakman, andraised at that time. Since then some authors, including Black, Kraakman, andTarassova (2000), Stiglitz (2002), and Goldman (2003), have argued against privati-Tarassova (2000), Stiglitz (2002), and Goldman (2003), have argued against privati-zation on purely economic grounds.) To the extent that economists worried aboutzation on purely economic grounds.) To the extent that economists worried aboutthe political economy of the process, they did not consider that privatization mightthe political economy of the process, they did not consider that privatization mighthave adverse political consequences. Rather, they focused on how to structure thehave adverse political consequences. Rather, they focused on how to structure thetransition so that the political coalition in favor of privatization would stay on tracktransition so that the political coalition in favor of privatization would stay on track(Dewatripont and Roland 1992), or on the political constraints shaping what form(Dewatripont and Roland 1992), or on the political constraints shaping what formof privatization would be able to occur (Shleifer and Treisman 2000). In fact, aof privatization would be able to occur (Shleifer and Treisman 2000). In fact, acommon view was that the particular details of Russias privatization were not ofcommon view was that the particular details of Russias privatization were not ofrst-order importance, essentially because of the good economics is good politicsrst-order importance, essentially because of the good economics is good politicsargument. Boycko, Shleifer, and Vishny (1995, pp. 1011), for example, asserted:argument. Boycko, Shleifer, and Vishny (1995, pp. 1011), for example, asserted:[A]t least in Russia, political inuence over economic life was the fundamental[A]t least in Russia, political inuence over economic life was the fundamentalcause of economic inef ciency, and the principal objective of economic reformcause of economic inefciency, and the principal objective of economic reformwas, therefore, to depoliticize economic life . . . Privatization fosters depoliticizationwas, therefore, to depoliticize economic life . . . Privatization fosters depoliticizationbecause it robs politicians of control over rms.because it robs politicians of control over rms.There is indeed evidence that Russias privatization was initially good for theThere is indeed evidence that Russias privatization was initially good for theeconomy, and even the oligarchs appear to have at rst invested heavily in their neweconomy, and even the oligarchs appear to have at rst invested heavily in their newrms (Treisman 2011; slund 2007, chap. 6). For example, Shleifer and Treismanrms (Treisman 2011; slund 2007, chap. 6). For example, Shleifer and Treisman(2004, p. 29) ask: Have the oligarchs stripped assets from the companies they(2004, p. 29) ask: Have the oligarchs stripped assets from the companies theyacquired in privatization, rather than investing in them? The audited nancialacquired in privatization, rather than investing in them? The audited nancialstatements of these companies suggest that their assets have grown dramatically,statements of these companies suggest that their assets have grown dramatically,especially since 1998 . . . And the major oligarchs have been investing hundreds ofespecially since 1998 . . . And the major oligarchs have been investing hundreds ofmillions of dollars annually in their companies . . .millions of dollars annually in their companies . . .But our emphasis here is on the political consequences of the privatization,But our emphasis here is on the political consequences of the privatization,which turned out to be highly damaging. The privatization enriched and alsowhich turned out to be highly damaging. The privatization enriched and alsotemporarily politically empowered a group of unscrupulous oligarchs; in fact, sotemporarily politically empowered a group of unscrupulous oligarchs; in fact, somuch so that inequality in Russia rose signi cantly following privatization (Alexeevmuch so that inequality in Russia rose signicantly following privatization (Alexeev1999). Even more importantly, the economic and political inequality it created1999). Even more importantly, the economic and political inequality it createdinduced a backlash against the process of economic and political reform in Russia,induced a backlash against the process of economic and political reform in Russia,ultimately re-creating authoritarianism and rmly entrenching a form of state-ledultimately re-creating authoritarianism and rmly entrenching a form of state-ledcrony capitalism (see Guriev and Sonin 2008, for a theoretical analysis). Therecrony capitalism (see Guriev and Sonin 2008, for a theoretical analysis). Thereare several layers to understanding how this political equilibrium evolved. First,are several layers to understanding how this political equilibrium evolved. First,privatization failed to create the type of broad distribution of assets which wouldprivatization failed to create the type of broad distribution of assets which wouldhave provided the economic underpinning for the nascent democracy and sociallyhave provided the economic underpinning for the nascent democracy and sociallydesirable economic policies. Second, the distribution of gains was not just narrow,desirable economic policies. Second, the distribution of gains was not just narrow,it was illegitimatebecause the large increase in inequality favored the politicallyit was illegitimatebecause the large increase in inequality favored the politicallyenterprising and the connected. Third, the concentrated nature of the assetsenterprising and the connected. Third, the concentrated nature of the assetswhich emerged from this process and the huge rents that were up for grabs madewhich emerged from this process and the huge rents that were up for grabs madeit very easy for the KGB, re-energized under the leadership of Putin, to wrestle backit very easy for the KGB, re-energized under the leadership of Putin, to wrestle backcontrol of the economy. Finally, the way in which the privatization took place maycontrol of the economy. Finally, the way in which the privatization took place mayhave undermined the incentives of the oligarchs to push for better institutionshave undermined the incentives of the oligarchs to push for better institutions(Sonin 2003), and may also have fueled popular support for Putins authoritarian(Sonin 2003), and may also have fueled popular support for Putins authoritarianpolitical strategy.political strategy.


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Our bottom line on the experience of Russian privatization is that a purelyOur bottom line on the experience of Russian privatization is that a purelyeconomic approach to moving from collectively to privately owned assets turnedeconomic approach to moving from collectively to privately owned assets turnedout to be woefully inadequateas was a political economy approach based on theout to be woefully inadequateas was a political economy approach based on theassertion that good economics is good politics. The evidence instead suggests thatassertion that good economics is good politics. The evidence instead suggests thatprivatization, particularly its form, had a de ning impact on Russian politics andprivatization, particularly its form, had a dening impact on Russian politics andcontributed to the rise of an authoritarian and repressive regime ruling over a muchcontributed to the rise of an authoritarian and repressive regime ruling over a muchmore unequal society.more unequal society.

Violating Political Incentive Constraints

Politicians typically face political incentive compatibility constraints, whichPoliticians typically face political incentive compatibility constraints, whichdetermine the expected utility that a political leader in power must obtain himselfdetermine the expected utility that a political leader in power must obtain himselfor give to organized interests if he or she wishes to stay in power. Removing marketor give to organized interests if he or she wishes to stay in power. Removing marketfailures, without recognizing and addressing the fundamental political and insti-failures, without recognizing and addressing the fundamental political and insti-tutional sources of distortions, may violate these constraints. Put differently, a settutional sources of distortions, may violate these constraints. Put differently, a setof policies which may seem deeply misguided by the standards of basic textbookof policies which may seem deeply misguided by the standards of basic textbookeconomics may nonetheless be serving the political economy purpose of holdingeconomics may nonetheless be serving the political economy purpose of holdingtogether a governing coalition. By implication, removing such market failures cantogether a governing coalition. By implication, removing such market failures canweaken existing coalitions or disrupt equilibria. The result may be the rise of newweaken existing coalitions or disrupt equilibria. The result may be the rise of newcoalitions or new types of equilibria, which might reinstate the market failures orcoalitions or new types of equilibria, which might reinstate the market failures orcreate new ones, because they are useful in binding together the governing coalitioncreate new ones, because they are useful in binding together the governing coalitionor creating rents for the rulers. In our study of central bank independence underor creating rents for the rulers. In our study of central bank independence underweak institutions, Acemoglu, Johnson, Querubn, and Robinson (2008), we calledweak institutions, Acemoglu, Johnson, Querubn, and Robinson (2008), we calledthis type of re-creation of distortions the seesaw effect. But more ominously, thethis type of re-creation of distortions the seesaw effect. But more ominously, theresults of violating political incentive compatibility constraints might also be a periodresults of violating political incentive compatibility constraints might also be a periodof civil unrest, with high costs of its own, or even civil war. Thus, addressing marketof civil unrest, with high costs of its own, or even civil war. Thus, addressing marketfailures in this setting

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