This brings us to the third major theory. The institutions hypothesis argues that the most important factor driving economic prosperity is a society’s economic institutions—the formal and informal rules that govern economic activity. Think of institutions as the “rules of the game” that shape our incentives to invest, innovate, and work hard.

The logic is straightforward and centers on how institutions structure incentives:

• Inclusive Institutions These are rules that encourage investment in technology, physical capital, and human capital because people are confident they will be rewarded for their efforts. Inclusive institutions are those that provide secure property rights, an unbiased legal system, and public services that create a level playing field, allowing broad participation in economic activities. When people are confident that their profits won’t be stolen, their land won’t be expropriated, and their businesses won’t be shut down by the powerful, they invest and innovate. Prosperity follows.
• Extractive Institutions These are rules that fail to protect property rights and create an uneven playing field, allowing the politically powerful to expropriate resources from the rest of society. When individuals expect their hard-earned rewards to be stolen or heavily taxed by corrupt officials, they lose the incentive to engage in productive activity. They won’t invest in a new farm or factory if they believe the profits will just be taken away. Economic stagnation is the result.

The argument is that institutions are the most important fundamental cause of long-run growth. To see if this powerful claim holds up, we can look at “natural experiments” from history—unique situations where we can test these competing theories against the evidence.