To really figure out what matters most—geography, culture, or institutions—we need to find cases where we can isolate one factor from the others. History provides two incredible “experiments” that do just that.

5.1. Case Study 1: The Korean Experiment

As we saw earlier, Korea before its division after World War II was a place of unparalleled homogeneity. It shared the same geography, culture, ethnicity, and language, and both North and South had roughly the same income per capita at the time of their separation at the 38th parallel.

The “experiment” was the imposition of radically different institutions on these two identical societies.

The Takeaway: Because geography and culture were held constant, the radically different institutions are the only plausible explanation for the dramatically diverging economic paths of the two Koreas. The Korean case not only shows the power of institutions but also illustrates a grim reality: extractive institutions often persist because they serve the interests of a powerful elite. Despite generating widespread poverty and even famine, North Korea’s leaders have used all available means to maintain a system that benefits them, at a horrific cost to the rest of society.

5.2. Case Study 2: The Reversal of Fortune

The second “experiment” reveals a stunning historical puzzle. Among the places colonized by Europeans starting in the 1500s, a “Reversal of Fortune” occurred:

• The regions that were the most prosperous and urbanized in 1500 (like the Aztec and Inca empires in the Americas and the Mughal Empire in India) are relatively poor today.
• The regions that were sparsely populated and less developed in 1500 (like the future United States, Canada, and Australia) are among the richest nations today.

This reversal is a massive problem for the geography and culture hypotheses. Both would predict that prosperous places should remain prosperous. So what explains the reversal? The institutional hypothesis offers a compelling answer.

1. Different Colonization Strategies: Europeans didn’t impose the same institutions everywhere. Their strategy depended on the conditions they found on the ground.
2. “Extractive States”: In places that were already wealthy and densely populated (like Peru and Mexico), it was profitable for colonizers to set up “extractive” institutions. They forced natives to work in mines and on plantations, expropriated their land, and designed the entire system to channel resources back to Europe. Property rights for the vast majority were nonexistent.
3. “Settler Colonies”: In sparsely populated areas where extraction wasn’t profitable (like North America and Australia), Europeans settled in large numbers. These settlers demanded rights and protections for themselves, creating inclusive institutions that protected private property and encouraged investment and commerce—mirroring the institutions developing back in their home countries.
4. The Critical Juncture: For centuries, the institutional differences created by colonization had a meaningful but not dramatic effect. The true, explosive “Reversal of Fortune” was triggered by a critical juncture in history: the Industrial Revolution of the 19th century. This event presented a massive opportunity for economic growth. However, only societies with inclusive, “settler” institutions were poised to capitalize on it. They could mobilize investment, protect innovators, and allow new industries to flourish. In contrast, “extractive” states were structurally incapable of seizing this opportunity; their very purpose was to prevent the kind of broad-based economic change that industrialization required. It was at this moment that the reversal accelerated dramatically, solidifying a new global economic hierarchy.

These two powerful historical examples—one a clean split, the other a global phenomenon spanning centuries—both point to the same powerful conclusion.