Even with most institutional reform projects failing, it is understandable why trying to change a poor country’s institutions feels so urgent. In many poor countries, the government is often the only game in town and wields significant influence on the economy.
In addition, think about the well-functioning institutions in the United States, the United Kingdom, Japan, or the many other prosperous nations in the world. Prosperity and good institutions seem to go hand in hand. Consider, for instance, the legal systems in the US or the UK, where citizens can generally depend on the enforcement of contracts and the rule of law.
This, in turn, creates trust not only among citizens, but also between citizens and the State. Conversely, Angola, Ecuador, and Bangladesh might be seen, broadly speaking, to have institutions that prevent their economies from flourishing because their institutions have not been able to engender that trust. How likely, for instance, are you to trust the legal system in Angola?
Who would choose to invest millions of dollars in a country in which they couldn’t trust the government or other private sector players in the same way they would if they operated in Japan, or Singapore, or Germany? Fixing institutions is very important. But willing economies to have better institutions and ensuring that they do actually have them are two different things. We have found that the most successful institutions grow out of culture, not the other way around. History is full of examples. We now consider the institutions of Europe to be among the most sophisticated and valued in the world: look no further than the complex negotiations going on as we write this book to extricate the United Kingdom from the binding obligations of the European Union.
As difficult as those negations may be, what’s not in question is that both sides value the process and will honor the ultimate agreement. Europe, however, did not get there overnight; it has taken hundreds and hundreds of years of trial and error, and of success and failure, to build such a culture.
The development of domestic institutions in Venice helped it become one of the world’s capitals of trade as far back as 800 AD. “Long-distance trade enriched a large group of merchants and these merchants used their new-found muscle to push for constraints on the executive i.e., for the end of a de facto hereditary Doge (the Venetian head of state) in 1032 and for the establishment of a parliament or Great Council in 1172,”according to economists Diego Puga and Daniel Trefler.
This period in Venice, from the 1000s to around 1297, saw the rise of many modern-day institutions, one of which was the Colleganza. The Colleganza was essentially a joint stock company created to finance long-distance expeditions. Considering the significant risks associated with long-distance travel at the time, the Colleganza was an innovative way to distribute and democratize the risk across a larger number of people than ever before. More important, however, it also democratized the rewards by creating wealth for many Venetians for whom investing in such trade expeditions had been historically impossible.
“The Colleganza was so innovative because they limited liability for each partnership and to the joint stock of the partners,” journalist Max Nisen writes about the institution. “It was incredibly important to the history of the city [Venice] because it allowed poorer merchants to gain access to international trade by taking on risk as traveling partners.” All of a sudden, poorer merchants could now partake in investing in profitable long-distance trade, an activity that was historically reserved for the rich.
As we noted earlier, market-creating innovations make historically expensive, complex, and out-of-reach products and services accessible to a new class of consumers who could not afford them, thereby creating a new market for the democratized solutions. Because the poor in most societies, and certainly in Venice at the time, “outpopulate” the rich, when a new solution is able to pull the poor into consumption of a particular product or service, that new solution can have a vast impact on society. The Colleganza provided a mechanism that brought many poorer merchants, who had neither the capital nor the collateral, into the investing class.
As a result, this innovation increased economic mobility, international trade, wealth, and, ultimately, political power. Take, for example, the impact the Colleganza had on the shipbuilding industry. Many people were employed in supplying parts to build ships, in designing the ships, in selling or leasing the ships, in staffing the ships for these trade expeditions, and many other components that contributed productively to the economy. And that’s just one of the industries that was affected. As demand for tradeable goods increased, farmers and traders were pressured to innovate to meet those demands.
The impact of creating new jobs, especially for people in impoverished cities, is immense. Overnight, a jobless person is transformed into a productive contributor to that society. The rewards and punishment systems in organizations and societies matter as we look to improve economies.
If there are no jobs that reward people, they will find other means of getting rewards, many of which will not be productive for society. As more and more wealth was created for many more Venetians and the city became one of the richest in Europe, the political structures in Venice began to change as well. Historically, the office of the doge was held by someone from one of three elite families, wielding absolute power over the city.
Once wealth began to be democratized, the balance of power began to shift, and a growing number of wealthy merchants were capable of challenging the doge. And they did. Some of the institutional reforms pushed by this new and growing merchant class included: banning doges from appointing their successors; enacting and enforcing a system of elections; ensuring the office consulted with judges and abided by the judicial decisions; and establishing a parliament known as the Great Council.
These institutions then gave rise to other institutions, which reinforced the role of business, innovation, and investment in societal development. By the early fourteenth century, financial innovations in Venice included the forerunners of limited-liability joint-stock companies; markets for debt, equity, and mortgage instruments; bankruptcy laws that distinguished illiquidity from insolvency; double-entry accounting methods; business education (including the use of algebra for currency conversions); deposit banking; and a reliable medium of exchange (the Venetian ducat).
While all these innovations connect to the “demands of long-distance trade,” we believe they more accurately reflect the “democratization” of long-distance trade. That is the kind of impact market-creating innovations can have on a society.
*This is an excerpt from The Prosperity Paradox: How Innovation Can Lift Nations Out of Poverty (HarperCollins).
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