THE WORLD THROUGH INSTITUTIONAL LENSES

Daron Acemoglu [9.12.12]
Topic:

The issue is that when you look at the world from these sorts of institutional lenses, identifying problems becomes relatively easy. Solving them becomes very hard. It's no mystery how you get economic growth. You need to provide opportunities and incentives. But how do you make that political equilibrium? How do you make it so that everybody in society actually agrees and abides by a system that provides those incentives and opportunities even if it's not in their short-term interests? Those are the real challenges and that's exactly the sorts of issues we're seeing in Europe, it's the sorts of issues we're seeing in the United States, it's the sorts of issues we're seeing in Turkey. The problems are reasonably easy to identify. Developing solutions to them is hard because you cannot develop the solutions from the outside. It's not an engineering problem. At the end of the day you really need the grassroots solution to it. You really need people themselves to start taking part in the political process because any solution you impose from above is not going to stick unless it has the support of the people, unless the people themselves are the ones who push for it, who demand it, and who implement that solution.
 

DARON ACEMOGLU is the Killian Professor of Economics at MIT. In 2005 he received the John Bates Clark Medal awarded to economists under forty judged to have made the most significant contribution to economic thought and knowledge. He is the author of Why Nations Fail.

Daron Acemoglu's Edge Bio Page



[1 hour 4 minutes]


THE WORLD THROUGH INSTITUTIONAL LENSES

[DARON ACEMOGLU:] When I got into economics one of the things that attracted me was thinking about why some nations are rich and some are poor, why some are democratic and others aren't, and why they're socially, politically, and economically so different. I grew up in Turkey and I came of age in the middle of a military regime and the economy wasn't doing well so those questions were in the air. That's the sort of thing that attracted me to economics.

When I came into economics I realized those weren't the issues that most economists worked on. I was still interested in economic development and economic growth, but I tried to think about it using the same approach as economists did. Then about 17 or 18 years ago, I started talking to James Robinson who became my long time collaborator, and James and I both had the same issues with the economics approach. A lot of the interesting issues related to politics, institutions, and the roots of the politics of policies and institutions were left out. We started working, thinking, and discussing to try to write papers on these things. At the time it wasn't a big area within economics.



 

The collaboration with James and my work and thinking on this has been the most defining aspect of my career. The main issues that I have worked on have all come out of that collaboration and that process. At the center of it is the huge difference in prosperity that we see around us. We live in a very integrated globalized world, but if you compare the United States to Haiti, that's not that far, or the United States to some countries in sub-Saharan Africa there are huge differences in prosperity. Depending on how you measure it there are 40, 50, 60-fold differences in income per capita.

 

At the time that Adam Smith wrote the defining text of economics in the 18th Century, the same gaps would have been four or five fold at most. So even though we're in a much more unified world, these gaps, these disparities are huge and I think that's one of the major questions facing social science. What I've been trying to do is trying to understand that. The standard economic approach is all about understanding why countries grow thinking about human capital—education, skills, and so on—thinking about physical capital—machinery or technology—but really at the root of these things there must be some other differences.

We can't really have a satisfactory explanation for why the United States is so much richer than Haiti by saying the United States has much better machinery, has much better education, and so on. The question is why? Why did the United States end up with this better machinery? Why did the people make the choices to go to schooling or why did they organize their production and factories differently?

The perspective that has shaped my thinking on this is all about institutions. 'Institutions' is a catch-all word. Many things in a society are part of its institutions. Douglass North who was one of the leading proponents of the institutions view defined it as the set of humanly designed constraints that shape human behavior. That's a very broad definition. What James and I tried to do is bring greater clarity and discipline to thinking about institutions both empirically and theoretically. We distinguish between economic and political institutions.

Economic institutions are those that really shape the economic incentives. They create opportunities or incentives for investment and innovation. They are crucially related to how level the playing field is. You now have many societies in which only a small fraction of the population are given the opportunity to get into the action. They are the only ones who can work in the modern sector. They're the only ones that can open businesses or open factories or get into trade or get into whatever occupations that they want. So that's really important to have this level playing field, in addition to economic institutions such as property rights and contracting institutions that give incentives to people to take advantage of whatever calling they have in life.

The more important part of both my work and my thinking has been about political institutions because the economic institutions don't exist in a vacuum. Think of a society such as Barbados, for example. If you look at 17th Century or 18th Century Barbados you have a society based on slavery so that doesn't give incentives to a vast majority of the people. 80 percent of the population are slaves. They're not even allowed to acquire human capital. They, of course, have no choice in their occupations and they have no incentives to become anything other than what they're ordered to do.

These types of economic institutions we call extractive. They're designed to extract resources from the slaves for the benefit of the elite who are the planters who control the land and everything. But if you think about how such a society exists it doesn't exist in a vacuum unless you had a specific set of political institutions and specific distribution of political power in society. Such extractive institutions wouldn't exist. They wouldn't be able to survive. In particular, look at 17th and 18th Century Barbados. What you see is that planter class not only controls the land, but it controls the entire bureaucracy. It is the judiciary. It controls the entire politics, they are the politicians, and even more importantly, perhaps, it controls the military power. They are the military commanders. So that is just a very simple example emphasizing that we have to think of economic institutions situated in the context of the political institutions and in particular of the political institutions that support and make these economic institutions durable.                 

A lot of the work that I have done—and I think now within economics and social science there is a little bit more attention to these issues—is to try to understand the dynamics of these political institutions. How is it that the set of institutions that have emerged in Barbados survived? What makes them actually change in some places? After all, we have democracies in the West today, but those didn't start out as democracies. They were every bit as extractive and repressive as many societies we see around us today, but somehow those political institutions started changing and together with those political institutions, economic institutions started changing also. We want to understand both that dynamic process of the political institutions changing sometimes (sometimes backward, sometimes forward). We also want to understand the interplay, the feedback between these economic and political institutions.

When you have this perspective about political institutions shaping what happens, economically it opens up some new ways of looking at things. It becomes particularly relevant in the context of China. Today, everybody is obsessed with China, to put it mildly. We have a lot of problems in the United States, we have a lot of problems in Europe, and China seems to be weathering the storm much better. Certainly that was the case in the 2008 crisis. This coming at the tails of almost 30 years of around 10 percent economic growth, so that's huge.

Then people look at China. It's very unorthodox. First of all, the market works somewhat differently. It's not as if the United States or Europe has unfettered markets by any stretch of the imagination, but in these markets still, even with government intervention, private enterprise is supposed to be the sort of leading engine in the West. In China, markets are much more guided by political power. The Communist Party decides how resources are allocated. It instructs the largest companies what they should do and instructs banks what they should do and that was part of perhaps why they were able to withstand the financial crisis with opening the taps from the banking sector.                 

The other thing very unorthodox about China when people look at it is they say, "Well, China is a developing modern economy, but under a very different set of political institutions." In the West, economic and political development went hand in hand, and in China, you have the dictatorship of the party, certainly a very repressive regime in many respects, but then you have a market economy so perhaps that's better. It avoids all the sort of wrangling that democracy creates.

Looking at it from this longer perspective and looking at it from the ideal types that James and I label extractive institutions that I've explained (like the ones based on slavery or labor coercion) or the other ideal type we would say is the inclusive institutions is useful. Inclusive institutions are those that economically provide much more of a level playing field and productive incentives, and also politically they provide a more equal distribution of political power to go with that level playing field and private incentive based economy.

When you look at it with those ideal types it looks quite different. It looks different in the following sense that the specific configuration that China has—broadly extractive political institutions that concentrate political power within a very narrow elite—together with somewhat of an inclusive economic institutions that are trying to provide incentives to at least some part of the population, that's a very unstable mixture. It's unstable because as long as political power remains concentrated, there is going to be great impetus for those who control political power to want to start controlling the economy more and more, start controlling it for whatever their interest is.                 

At first it could be controlling it just a little more so that their political power is more consolidated because we don't want to put up with protests or discontent. Then start controlling it a little more so that we can fill our pockets a little more, because China is growing so much. What's wrong with that? Then start controlling it for whatever trophy projects you want to do, who cares about economic growth or economic efficiency, we want to do self-aggrandizement or something like that. But that process is going to go on and on and it's going to start eroding the basis of whatever inclusive economic institutions China has.

At some level this perspective says it's actually a quite fragile situation to have these inclusive economic institutions and extractive political institutions. In fact, when we look at history we see that whenever you have that mixture, things start unraveling. Either you have that finally there's more and more pressure from people who want to share the political power because the economy is becoming more and more dynamic and the politics is like a dinosaur and people want to challenge that. Like in South Korea that happened in the Eighties and the Nineties. That process succeeds and the politics falls in line with the economy.

But often what happens is the opposite. The economics falls in line with the politics. That's the real danger in China. It's not the question of whether the Chinese economy is going to slow down. Yes, the Chinese economy is slowing down. Those are short term issues. The question is whether the Chinese economy is going to be able to go to the next stage of development. It's whether it is going to be able to be really innovative. That's where having a more secure link between politics and economics is really important. Having a more theoretical perspective and a more long term perspective on this is useful because part of what makes people so mesmerized about China is these huge growth rates. We think any economy that has achieved these huge growth rates must have something special. They must really have the formula that we in the West lack.    

If you look at it a little bit more broadly you see that that's not necessarily the case. There have been many other societies that have grown very rapidly under broadly extractive institutions, in fact, under worse institutions than China. The best example would be the Soviet Union. We can go further back and come up with other examples, but the one that's closest is the Soviet Union.   

Starting in the late 1920s, for about 40 years the Soviet Union grew at much faster rates than the West. Everybody in the West, not everybody that's an exaggeration, but most people in the West were mesmerized by the Soviet Union. US politicians, the CIA, textbook writers, everybody was talking about the Soviet miracle, even my hero in economics, Paul Samuelson. If Adam Smith is the grandfather of economics, Paul Samuelson is the father. He wrote all the defining textbooks. He is an extremely levelheaded and an astute observer.  

Even Paul Samuelson's textbooks are filled with these statements about how the Soviet Union is this great growth machine and, in fact, they might have a superior economic system than the United States. It's filled with predictions, as many other people were making at the time, about the Soviet Union overtaking the US economy. Khrushchev himself said, "We're going to bury you." The CIA certainly believed it. When you look at the Soviet economy it has draconian control in the political system, but was much worse in economic institutions than of China. It was a command economy, pure and simple.

So how did it grow that rapidly? It grew that rapidly because of a very simple thing. It was so backward technologically that once the Soviet Union started industrializing there was a forceful process with Stalin transferring resources from agriculture to industry. There was a lot of low hanging fruit for the Soviet Union. They could import technology, they could develop technology in relatively simple things that were already very well worked out in many different parts of the world and that process can go very fast.

That's essentially the secret of the Chinese growth as well. This is what we call catch-up growth. China started so poor. It was one of the poorest countries in the world in 1978. Starting from there the first thing they did was—and it wasn't genius from Deng Xiaoping or the Communist Party, it was actually something that people were already experimenting on the ground given the hard conditions they were facing—they started introducing incentives in the rigid agricultural system that they had. That led to a huge agricultural boom. The big reductions in poverty and increase in living standards happened in the 1980s as a result of this agricultural revolution in China. Then the same sort of opening up came in the industrial sector and, of course, China being integrated in the world economy. All that helped this rapid process of catch-up growth to take place.

At some level there is no mystery about how China is growing so rapidly. When you look at the Chinese income per capita, it's still less than one seventh of the United States per capita. It's still a very poor economy and still a lot of room for catch-up growth. But really the question is, how long is it going to go on? For it to go on you really need to go from the catch-up phase to the next phase. You really need to start relying on innovation more: the sort of entrepreneurship that's going to respond to the needs of consumers. For that, this dysequilibrium between economics and politics is going to become more and more of a burden in the case of China.

The natural question that people then ask is, we have these two huge countries, China and India, how does the Chinese model compare to the Indian model? The way I would put it is that they're both imperfect. They both have their problems. There are two superficial answers that you can give. One superficial answer would be the Chinese model is better. Look at the living standards in China. They are much higher now than India and even if India is managing higher growth rates for a couple of years now, China has been doing it for a much more sustained period. You go to India and you go to China, one is more orderly, the other one is more chaotic. That feeds into the stereotype.

Another superficial answer is you can say, India is a democracy and China is an autocracy and that means India is better. But actually, this is where it becomes important to put more flesh on the concept of institutions. Institutions are not just what's in the constitution. There's a very naive view of institutions that says it's the parchment, it's what is written on the parchment, it's what is written on the paper. I write you have a Supreme Court, you have a presidential election, that makes you a democracy. I write something else, that makes you an autocracy. And of course, that's not what we mean by institutions. That would be a very naive view of institutions and one that would have very little empirical power to explain things.

There's a great example that comes from the comparison of two defining events in the United States and Argentina. Argentina, like many other Latin American countries has a constitution that has many similarities to that of the United States: a Senate, a Congress, a Supreme Court, a president, but these work very differently. In the United States, for example, though we sometimes complain about the Supreme Court, that it's just unelected people making political decisions, it's one of the important checks on the abuse of political power. It's not something that you can easily sideline.

For instance, in the middle of the New Deal controversy, FDR tried to sideline the Supreme Court and say, these guys are really slowing my New Deal legislation. He had majorities in both houses. He was a popular president. Many people were at least hopeful about the New Deal policies, but when he came up with his schemes to either fire new justices or add new justices to the Supreme Court so that they wouldn't block or slow down his legislation anymore, nobody supported him. The Senate didn't go along with him. The media took a pretty negative attitude toward it, and FDR gave up. He didn't mess with the Supreme Court although the Supreme Court became more accommodating to him.        

The same sort of thing happened in Argentina with Peron. When Peron came to power he also didn't like that the Supreme Court was blocking him in his program. There were a lot of things that he was trying to do. Then lo and behold, he came up with exactly the same scheme. He said, these Supreme Court justices are overworked and they're too old and we need new justices and nobody raised a peep. He was able to fire the Supreme Court justices, and appoint new justices. Ever since then whenever a new president comes in in Argentina, there's a whole turnover of the Supreme Court and the Supreme Court institution is a joke in terms of what it does to restrict the president, as we're seeing right now in Argentina.

You have these same things written in the constitutions, but they work extremely differently. Why is that? Well, the reason is twofold. One is that actually the details of how these institutions work is much more important than what is written in the constitution, than what's written on the parchment. Second, these institutions don't exist independently from how political power is distributed.

In particular in Argentina, political power was highly concentrated in Peron and Peron's party's hands. The media was nonexistent. There was really no within party opposition and between party opposition was largely silenced. So that means that huge monopolization of political power enabled him to sideline whatever he wanted. In the United States that was different.

Going back to India, yes, India is a democracy, but we have to really think about how that democracy works and where political power lies. India is a hugely poor country, but most people are not really represented in politics. It's changing. The lower casts are having more and more of a voice, but for a long time even though the Congress Party pretended to be a party of the people; it was really a party of the elite. It was its own dictatorship of sorts and the Congress Party did nothing to deal with the deep inefficiencies of the economy, the deep injustices in society. It certainly did not create an environment that was conducive for business or innovation or anything like that.

There are some changes going on, but overall, India has a lot of institutional problems coming from its public sector, coming from its private sector, coming from its huge inequality that creates, clearly, a very tilted playing field in India. The fact that it's an electoral democracy doesn't mean that it's got really inclusive political institutions.

They both have these problems and I think in both cases the issue is going to be which one of these two societies is going to be able to take more secure steps towards more durable inclusive institutions. I would still be a little more optimistic about India than China, partly because the Communist party has been able to monopolize power to such an extent that it is able to withstand a lot of the challenges without changing the nature of the political system in any deep way. Whereas in India, just that sort of more chaotic structure of politics creates more challenges and more room for change. There are a lot of grassroots middle class demands for change in India, and it's conceivable that it's going to become more and more a force towards cleaning up the act of Indian politics, and as a result, a more secure institutional transition.

It's important that when we are critical of the institutions in China and India, that it's not some Orientalist perspective that the West is good and the rest isn't. In fact, the West has its own deep problems. It's important to be explicit about them and talk about them and I think the United States is a case in point. The United States never had perfect institutions. If you look at US history, we have freedom coexisting with slavery all throughout and that has shaped things very deeply. Not just until the abolition of slavery and the Civil War, but thereafter too.

The US has always been an unequal society. It has had to deal with all of these challenges, but broadly, it has done okay. When inequality increased hugely in the United States at the end of the 19th Century and institutions were weaker than they were today, the robber barons started dominating the economy, but also the politics. The US political institutions responded to that. The fact that they were relatively open institutions enabled people to organize and protest against it. It first was the Populist Movement and the Progressive Movement and it became a huge social force, and the Progressives ultimately took over both parties. Both the Republicans and the Democrats had progressive presidents.

These progressive reforms not only rolled back the power of the robber barons to some degree, but they also introduced the beginning of the modern regulatory welfare state, income tax, the strengthening of the Sherman Act and the Clayton Act, and just a whole range of regulations so that economic power and political power wouldn't be as closely linked. Important barriers to democracy—such as the not directly elected Senate—was replaced, and so on. That shows that US institutions went through difficulties, but somehow survived.

When we look at it today, perhaps we are in an equally or even more critical period. US society is in the middle of a very deep transformation. I think you need to have both economics and politics to think about that. Superficially, we just see much greater inequality, but I think that's just the tip of the iceberg. The much greater inequality in the United States is not something to belittle. It's really a huge thing. If you look at it today the top one percent in the United States, the richest one percent earn about 25 percent of all national income. A quarter of all national income goes to the wealthiest one percent of America and that's a very, very large number. In the Seventies that number was about ten percent. The US has become really much more unequal in very jarring dimensions. 

You really have to think about how that came about and what its other ramifications are. The first important thing is that the US economy and society have been transformed by a whole range of other changes, and inequality has to be judged in the context of all of these. The first one is that technological change has been very disruptive at some level over the last 30 or 40 years.

Some people think of the last 30 or 40 years as another technological revolution. You may want to think that way or not. Certainly there were huge technological changes in the first half of the 20th Century. Is an I-Pad more important than indoor plumbing? Probably not. But there is something quite distinct about the technological changes that have swept through the world over the last several decades. When you look at many of the technologies from the electrification of the United States, many of the products and many of the new process innovations were making workers more productive and were giving workers more new areas to apply their skills. It was the sort of technologies that created the ideal environment for a rising tide to lift all boats. When you look at wages in the United States, for example, in the three decades following the end of World War II you see that as GDP increases wages both at the bottom and the middle of the income distribution also increased together. This image of the rising tide lifting all boats is not so far off.

Then you get the technology that we have today. Many of them, what they're doing is they're actually replacing tasks that were previously performed by workers, especially semi-skilled factory floor workers. Now those tasks are going to be performed either by machines—the automation, the routinization of production—or they're going to be offshore which is the other major technological or social change that's taking place: the globalization of work. 

Work is no longer just situated in the United States. The entire product chain is divided into parts and some parts of it take place in the United States, some parts of it take place in many, many other different parts of the world. Look at just the simplest product like, an I-Pod. It has parts that are produced in 15 different countries. It's assembled in China. Parts of it are assembled in South Korea. Some parts of it are designed in the United States, implemented in Japan, put together back in China—it's a huge hodge podge, but that's not atypical.

American labor is being replaced either by machines or — through technologies making this globalization possible — by labor in Taiwan, South Korea or China. That creates a whole different set of pressures on the labor market and, lo and behold, what you see is that from 1975 onwards, you don't see the same pattern of wages at different parts of the income distribution increasing in tandem with GDP. You see that top wages are increasing, the top one percent or five percent, but the middle is actually stagnant. It depends on how you measure it. It increases a little bit or it doesn't increase, but it's amazing stagnation when you look at it in the middle of the income distribution. In fact, the middle of the income distribution is being hollowed out. There are fewer workers in the middle in the occupations and industries that you would classify as the middle of the distribution and those that are there are getting paid less and less. That's a technological change that's really shaping it.

It's not just technology. During the same time, we've had unions being decimated. The US private sector was heavily unionized. It's not anymore. We've had a lot of other changes in regulation that have enabled the earnings at the top to become much more unequal. Deregulation in finance, for example, or deregulation in other sectors. That has created, in finance I'm not sure, but in other sectors it has created some efficiency gains, but it also meant that there are just much greater inequalities even at the top of the distribution. Even among those who are businessmen, even among those who are college graduates, MBAs or PhDs.

All of these political, economic and technological changes have created a very different labor market in the United States today. The top of the one percent earning a quarter of all the national income in the United States is just the tip of the iceberg.

What type of a challenge is that for the US? Views on that would differ. Some people would say, "Look, how can you have a society in which the gains are so skewed? It can't be a just society. It can't be a society we want to live in." Certainly many people have that view and that's very legitimate. That's a very legitimate view. A lot of redistributive taxation comes out of that.                 

Then other people would say, "Look, the United States has always been unequal. It's been an entrepreneurial county. The very rich exist with the poor and they would appeal to trickle down, they would appeal to incentives." The views of fairness differs. To somebody who is part of the Occupy Movement, it's unfair that the entrepreneurs in Silicon Valley or the Wall Street bankers in New York are earning so much when other people are earning the minimum wage, but to many people in the Tea Party they say it's unfair that a lot of people are living off government handouts. So what's fair and unfair is also deeply divided in society.    

There are different approaches you can have to this economic inequality question, but I think there is a reason for everybody from the Tea Party to the Occupy Movement to be worried by inequality. Economic inequality doesn't come without political inequality. What we are seeing in the United States today is that the United States is becoming a politically very unequal society.   

It's an image, it's an exaggeration, but the United States had this image of a politically very equal society. It's the Average Joe sort of voice. The political scientist Robert Dahl, for example, had this very famous book called, Who Governs? about New Haven politics. He goes and looks at how local politics work in New Haven and he concludes that there are elites and there are powerful people, but nobody calls the shots. Nobody dominates politics. It's the average person who is governing New Haven in some sense.

You cannot say that about the United States today. The United States today is not listening that much to what's going on in the middle of the distribution of the income. It's listening much more to the very rich. Otherwise why would we be just obsessed about the capital income tax and the income tax of the very, very rich and the estate tax when there are so many other economic problems in the United States?

This comes, for example, clearly in the work of the political scientist, Larry Bartels. He looks at this survey where people are asked as well as their income, a variety of questions that were being debated in the Senate. Then he matches that to the votes of their Senators. The interesting pattern is that if you look at how the Senators vote, they vote in a way that is very, very consistent to what their rich constituent want or think and it's very loosely related to what their middle class constituents want, and it's not related or even negatively related to what their poor constituents want. That's just another snippet of our system being much more responsive to what the rich want and what the wealthy want.

Why is that? There are many different reasons for it. One is obviously lobbying and campaign contributions. That has become even more important than it was because of the age of media, because of the lifting of all sorts of implicit and explicit regulations on the importance of money in politics. But there is also just a general change in our society that the status and the prestige that the very wealthy get have increased enormously.

What happened in the financial crisis is very telling. One can be simplistic, but I think it's not an exaggeration to say that the financial crisis was largely created by the financial industry. The financial industry took excessive risks and it came back to haunt it. What happened when the financial crisis hit? All the politicians from the Federal Reserve, bank governors, to Treasury Secretary and everybody immediately turned to the bankers themselves and said, "How can we save the economy? How can we save the financial system?"

When we want to deal with a problem that the financial industry has created the only thing we can do is to turn to the financial industry itself to tell us what to do. I think that's part of a symptom of the problem, that the political system for a variety of reasons is just listening to the very elite businessmen, the very wealthy. But I think there is a real deep danger unless the United States starts changing that and starts going back to an era of greater political equality because the danger is exactly the sort of thing that I talked about in the context of China. If you start creating political inequality, if political power becomes more and more vested in the hands of a small group it's going to be very difficult to stop that group who are starting to change the rules of the game so that it benefits them at the expense of the rest, so that it starts creating a non-level playing field that will be the collapse of the inclusive institutions of the United States.

We're not there yet. The United States is not China. It's not the Caribbean plantation economies that I talked about. It's still a fairly open society, but it's changing and I think that's a real warning sign. Having a long-term perspective here is useful. History has many examples like this. I think Venice became one of the richest societies in the world by having an open system. What happened in Venice is that at the end, just like in the United States, at some point the rich merchants said, "Look, why should we share our political power with the rest? Why should we have the Parliament, the Ducal Council and the Great Council in Venice be open to everybody?" And they started clamping it down. They created political inequality by saying, "No, no, nobody else can get into the Parliament. We are going to dominate the Parliament. Only our sons can get into the Parliament." Once they did that, the next step was, now that they had monopolized political power, they started slowly changing the rules of the game.

Venice had become rich by enabling people to take risks just like the United States—encouraging them to go into long-term voyages. It had done that with technological change, with very creative contracts and they started banning those things so that these new people wouldn't be able to take risks and compete against these established rich families, and that was the beginning and the end of Venice. We don't want to be like Venice and I think the way to deal with that is to really be aware and understand that economic inequalities is the tip of the iceberg. The real political inequality that is accompanying it is the main thing to deal with and be afraid of.                 

The question is how do you actually get out of this mess? It's not easy because the entire political establishment is in the middle of it. The optimistic view is to say, "We got of it in the Gilded Age, why not now? We have a more open system today." But I think it has to be led somehow and money is everywhere in politics.

Today what politicians do is raise money. Governing is a secondary thing. Look at Obama versus Romney. The entire focus of the campaign is who is going to raise more money. At some level the regulation to deal with it is easy. Just get money out of politics and that's going to do wonders, but nobody is going to have the guts or the support to do that.

At the end of the day, when you look at examples of successful institutional change, it never ever starts from the top. You never have the elite or a politician who is sitting on top of political power and can do whatever he or she wants to say, "Okay, now I'm going to reform the system." It only happens when they are challenged, when there are demands that things cannot go on as they are. That's what happened, again, in the Gilded Age. It happened, as I said, with the Populists and the Progressives. We need the same sort of pressure on the system.  

That's why I saw both the Occupy Movement and the Tea Party as sort of positive developments. Of course, the Tea Party became a wing of the Republican Party and it has now transformed, but if you look at its original roots it was a grassroots movement and it was reacting to politics as usual. Exactly with the Occupy Movement. You can say many things critical about the Occupy Movement, but today many more people are talking about economic inequality. That's thanks to the Occupy Movement. It really brought a lot of the issues and put it on the agenda.                 

But are we there yet? Are we going to have a movement that's broader based than the Occupy or the Tea Party Movements that's going to start putting pressure on the political system? No, we're not there yet. The Occupy Movement is certainly not it. It's not going to get involved in politics. It's very much a fringe movement. The Tea Party, as I said, is taken over by the Republican Party, but I think they are symptoms of a general discontent. When that discontent becomes channeled into a more organized protest movement and political movement then there is hope for things to change. There is hope for people, even from inside the political parties, to actually start passing campaign reforms and things like that. There are going to be some steps towards getting some of the most problematic effects of money out of politics.

The United States is not alone in having problems. Europe is in the middle of an economic and political crisis. The problems in Europe are quite severe. But again, I think having a slightly longer-term perspective is useful both for thinking about why we are here in Europe and perhaps also for ways forward. The first thing in my thinking on this is people blame the European Union, but to me the European Union is a huge success.                 

If you look at Europe at the end of World War II it's a terrible place. It's ravaged by war. The population is destroyed, distraught. The ravaging armies are going through pillaging, raping people, killing people and anybody who looks at history would say, "Oh, we'll have a couple of years of peace and there will be another war in Europe." The European Union comes within that context. The European Union provided that sort of institutional structure for peace within Europe.

Look at the European economies, they all grew so rapidly since World War II and that's partly because of the stability and broadly democratic environment that was created in Europe and the European Union was all about that. At some level the European Union was a political project and that political was broadly successful. 

One thing about political projects is that they're going to make choices that are costly for other reasons. I think the unification of Europe under the monetary union and the Euro was such a choice that it was done in a great haste. As a result, it created a lot of distortions along the way. It's a very simple economic problem. When you create a monetary union and a form of joint liability on the fiscal front, but without any sort of effective fiscal union, that's going to be very unstable.                 

We went through that in the United States after the Articles of Confederacy. The original 13 colonies were put together in a monetary union, but all of the colonies themselves having their own debts, their own fiscal policy—the federal union being extremely weak. Exactly the same sort of problems as Europe is witnessing today were present in the United States.

The United States Constitution was a solution to that. The way that it solved the problem was two-fold. First of all, it centralized powers. The states still had powers and this was a federal union. But the fiscal power of the state increased greatly, and in the process of going to that there was a bailout of the states. The indebted states were bailed out and their debts were transferred to the central government.

As you can see, that was a political solution. There were many people who were opposed to that and it was a political deal that finally enabled it. It was the fact that, first, people were very worried about the United States defaulting both because there would be great losers if the United States defaulted and, second, because the United States as a new country would be cut out of financial markets and that would determine its future course if it really defaulted in that way. So those concerns were sufficient to convince people finally to go to the US Constitution. It wasn't an easy process, but it happened. 

In Europe, you have the same sort of pressures, but I think politically the problem is much harder. It's much harder for three reasons. The first is because there is so much greater institutional heterogeneity in Europe that a union of that sort is going to be more painful. There is such a gap in politics and institutions and how the way the economy and society is organized between Germany and, say, Greece, that it's really in a different league than what we see between Massachusetts and New York. 

The second problem is that as a result of where we are right now, the redistribution that will be involved here is greater. Some countries are very indebted, and moreover, there are a lot more problems of where this comes from because their ability to raise taxes, their fiscal ability, is very restricted. The first problem says even if you were able to go to a union it's going to create a lot of issues because of this greater heterogeneity that you have to live with. The second problem says the creditors are not going to be so happy doing it. And that's exactly what we're seeing. People criticize Angela Merkel, but she's subject to her own constituency, and Germans, rightly, want to say there's a limit to how much we want to pay.

Then there's a third problem, which is that even if Germany and France said, "Okay, fine, we're going to go to a fiscal union." What makes that fiscal union real? Is Greece going to give all fiscal power to the European Union? Is it going to let the European Union pass taxation laws and enforce these taxation laws? What is there to stop Greece, Portugal or another country to say, "Fine. In three years time, no, we don't want to be part of this union and we're going to go out of it." Or, "We're not going to follow the policies and we're going to want to have our own fiscal policy."                 

What made it possible in the United States was the fact that political power really became centralized. Political and military power really became centralized and that's really not in the cards in Europe. Europe has these very difficult institutional problems that it has to grapple with. Again, it underscores that you really have to think of the future health of the economy together with the institutions that you're designing and you're changing as you go along.

Another really interesting country to talk about, and one that is very important for me, is Turkey. I'm originally from Turkey. Turkey has come a long way. I said at the beginning, I grew up in Turkey when it was a dictatorship. It was highly unstable economically, politically, socially. It's a transformed country today. Every time I go back I see the infrastructure has changed. It's modernized. In many ways it makes great strides.

The biggest stride of them all perhaps is that Turkey is no longer living under the shadow of the military. From its inception, the Turkish Republic was a militarized state. Power was very much in the hands of the military and any elite who tried to control society had to be aligned with the military. That's what we were taught in school. You're not taught to question things in school. You're taught to respect authority. Authority of the state and authority of the army—those are at the root of it.

From 2002 onwards a series of governments that the military opposed came and stayed in power despite threats and disgruntlement from the military and has changed the constitutions, has changed who is in different parts of the bureaucracy now and was in control of the army so that the army has come more and more under civilian control. That's a great development. As a result, Turkish society has become much more dynamic. Turkey has now gone through ten years of very healthy economic development.

If you look at previous periods of economic growth in Turkey, it has this jagged pattern. It grows for a while and then it has a big, sharp recession and it's been doing much better. This doesn't mean things are hunky dory, but there is a reason why the Turkish economy is doing so well.

It is also related to the institutions. If you look at the Turkish economy in the Eighties and the Nineties it was centered on Istanbul and its surroundings, and a few large holding companies and a few large sectors. 

If you look at the Turkish economy today, it's much more broad based. People from every part of Turkey are forming businesses. They're trying to export. They're trying to compete. This more broad based participation in the economy, I believe, is not independent from the more broad based participation in politics. People feel empowered and when they feel empowered they feel they can actually take their economic decisions into their own hands. As a result, the Turkish economy is much more diversified. It's not just a few companies. It's not just a single city. It's everywhere. That is making the Turkish economy more stable, but there are also deep problems.

Turkey is suggested as a role model for the Arab Spring because it's an Islamic government, because it has been able to bring the military under control, because it has been democratic for a while now. Those are all valid, but I think it's also going through very difficult times.        

It's wrong to think that Turkey is a role model. It's not a role model because Turkey has also made a lot of mistakes and it's much more useful to actually learn from these mistakes. The main issue is that Turkey has sent the army back to the barracks, but it hasn't really transitioned to a true democracy. In particular, what you're seeing right now in Turkey is that the party in power, the AKP, the Justice and Development Party, is now trying to set up its own brand of authoritarian government because it is now thinking, look, until now the army called the shots. Now that we've sent the army back to the barracks we can call the shots. In fact, the checks on our power have disappeared because the army is not there. We have gotten rid of the elements in the bureaucracy and the judiciary that were most opposed to us. In fact, they're using this sort of vacuum as an opportunity to settle score.  

Turkey is one of the countries that has the highest number of journalists that are in jail and many of them are in jail because they are critical of the government. There are witch-hunt trials going on in Turkey. That's no role model. Turkey risks repeating the same mistakes that it did under the military dictatorship under a different guise if it doesn't start building the most indispensible part of an inclusive society. Which is what I said before, it's political equality.    

You don't get political equality when political power fluctuates from one group to another, but whichever group has political power can exercise it without any constraint. By political equality I mean that when I have political power I know that there are limits to what I can do and you and others who are opposed to me also have a say. And that's not what we have been able to achieve in Turkey yet and politics is still very distorted. At some level it's also very corrupt. Again, the AKP became very successful by fighting corruption. Corruption was much worse in the 1980s and the 1990s, but now that they're becoming stronger the same sorts of problems are recurring, and there is no easy solution.

The issue is that when you look at the world from these sorts of institutional lenses, identifying problems becomes relatively easy. Solving them becomes very hard. It's no mystery how you get economic growth. You need to provide opportunities and incentives. But how do you make that political equilibrium? How do you make it so that everybody in society actually agrees and abides by a system that provides those incentives and opportunities even if it's not in their short-term interests? Those are the real challenges and that's exactly the sorts of issues we're seeing in Europe, it's the sorts of issues we're seeing in the United States, it's the sorts of issues we're seeing in Turkey. The problems are reasonably easy to identify. Developing solutions to them is hard because you cannot develop the solutions from the outside. It's not an engineering problem. At the end of the day you really need the grassroots solution to it. You really need people themselves to start taking part in the political process because any solution you impose from above is not going to stick unless it has the support of the people, unless the people themselves are the ones who push for it, who demand it, and who implement that solution.

The same thing is true in Turkey. We cannot talk about a solution to Turkish problems unless the people in Turkey become more critical of the government and they say, "No, you cannot do those things. And even if we don't like the opposition we're going to put them in power because we don't like what you're doing." It's the same thing in the Arab world. The Arab Spring can only succeed if it actually starts doing that.

When you talk about these problems, it's very easy to be pessimistic because the problems are severe. They're deep. They have deep rooted historical origins and every problem comes with its constituency that is going to be opposed to solutions. But at the end of the day I'm also an optimist. I'm an optimist because I see that we live in a world that's so much better than any of our great grandparents or any of our ancestors could have even dreamed of.

At the end of the day, we live in such a world because the political and the social environment has changed. I think the reason we live in such a world is because society in many parts of the world, not in all—and that's very important—but in many parts of the world has become much more respectful of individual rights and that respect is part of a process in which political power is shared. It's not just in the hands of the narrow elite. It's not just in the hands of the state and also controlled by the state who can tell people what to do. I am optimistic that the rights revolution, which started more than 200 years ago empowering people, minorities of all sorts and most importantly individuals against the state, is contagious. That once it's in place, it will keep on going. If it is, it will be the strongest bulwark for the endurance and expansion of inclusive institutions.