Shanghai, China. Photo: Getty Images

The events of the past 12 months provide a firm reminder of how interconnected our investment world has become, with national economies hanging in the balance and investor capital under threat.

For anyone attempting to make sense of these challenges, the book “Why Nations Fail – The Origins of Power, Prosperity, and Poverty”, co-authored by Massachusetts Institute of Technology economist Daron Acemoglu and Harvard political scientist James A. Robinson, is a must-read.

Based on 15 years of research, it is hard to overstate the scale of their effort, which examines extraordinary historical evidence from every corner of the globe.

Unlike most economic works, “Why Nations Fail” is an entertaining and informative ride through history.

In the style of Dr Who, each chapter transports you to a different time and place.

On arrival, you meet a range of goodies and baddies – inclusive institutions, extractive institutions, and the odd decentralised regime.

As one would expect, it is the self-interested elites who provide the best entertainment.

These include the Russian tsars who feared that the spread of information, should railways be constructed, might threaten their rule, or the Sierra Leone president who went one step further and dug up existing track.

One intriguing destination is the town of Nogales – which is divided by a fence.

On the north side is the United States, and on the south side, Mexico.

The inhabitants of the northern side face lower crime rates, live longer and earn three times as much as their southern neighbours.

The authors set out to answer how two places – which share an ethnic background, a geographical location and a climate – could be so different.

They argue that success or failure is determined by the economic and political institutions that have been put in place.

To prosper, citizens need “inclusive institutions” which create virtuous circles of innovation, economic expansion and more widely-held wealth.

Nations thrive when they develop “inclusive” political and economic institutions.

Regrettably nations fail when their institutions become “extractive” and concentrate power and opportunity in the hands of only a few.

Is China headed for stagnation?

With Australia’s iron ore exports impacted by China’s economic slow-down, the question arises: can China continue to expand if the Communist Party refuses to loosen its grip?

Acemoglu and Robinson are pessimistic.

Chinese people ride bicycles in Chengdu Province. Photo: Getty Images

According to their matrix of processing this scenario, China’s past success may not translate into sustained growth.

There are parallels with the development of the former Soviet Union, which underwent rapid growth as the economy industrialised and grew, only to grind to a halt.

The booming Chinese economy may appear impressive, but for Acemoglu and Robinson, China’s leaders revealed a critical flaw in 2003 when they arrested Chinese entrepreneur Dai Guofang, sentencing him to five years imprisonment.

Dai’s crime was to start a low-cost steel company that would compete with Party-sponsored factories, and was forcibly shut down.

Their theory asserts that members of an extractive elite will not allow creative destruction to eliminate their own enterprises; the potential of existing technologies is fully exploited, but no innovation develops—and growth cannot be sustained.

However there is a lack of a real explanation of what’s going on in China – a nation ravaged by extractive institutions, if there ever was one.

China’s economic growth is still the envy of the western world, despite slowing to its weakest level in 13 years.

Hence the author’s view of China’s future in “Why Nations Fail” has created heated controversy in the academic and development communities.

Opponents, including Bill Gates, contend that making sense of the Chinese success story is simply too complex for such an institutional theory.

Extractive states can have bursts of growth.

The elites have an incentive to invest in and grow their own businesses.

But can authoritarian growth miracles last?

Has guanxi devolved into cronyism?

The Chinese concept of guanxi describes building a network of mutually beneficial relationships which can be used for personal and business purposes.

For millennia, China has lacked a strong rule of law, so guanxi networks arose, as there was no real legal framework in place to determine outcomes.

Daily life in China. Photo: Getty Images

However one of the problems with guanxi in China today is that due to the entrenched damage wrought by the chaos and fear of the Cultural Revolution, the Chinese family and social systems which underpin the traditional hierarchical value systems have broken down.

As a result, any distortion of guanxi ensures winners in business are often the best-connected, not necessarily the most economically efficient.

Slow progress

The challenge for China’s ruling elite is how much ground will they concede, if any.

On November 15, the Chinese Communist Party released its reform plan.

Accompanying the release, President Xi Jinping wrote a letter highlighting 11 key features of the plan.

This included integrated rural-urban development, with land reform for farmers being the key.

In addition, a landmark pilot “Stock Connect” scheme was launched on 17 November, with the aim of creating mutual market access between the Shanghai and Hong Kong stock exchanges.

Both these initiatives are small indicative steps.

However, whether one agrees with their theory in relation to China, Acemoglu and Robinson have most certainly provided a thought-provoking book, not to mention a great read.

steve[at]blizard.com.au

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