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THE NEIGHBORING TOWNS of Nogales, Arizona, and Nogales, Mexico, figure prominently in the work of Daron Acemoglu and James Robinson, who—together with a colleague—won this year’s Nobel Prize in economics.
In their book Why Nations Fail, Acemoglu and Robinson explain that these two border towns are identical in almost every way—from demographics to geography to climate. But they differ in one key respect: Nogales on the American side of the border is prosperous, while its southern neighbor is not. The authors use the Nogales example to illustrate why, in their view, there are economic differences from country to country.
Prior to Acemoglu and Robinson, academics usually attributed economic differences to factors such as geography, climate or the presence of natural resources. Some researchers pointed to education levels, cultural factors or experience with colonialism. Another popular theory argued that countries with warmer climates tended to be less economically productive because of the destructive impact of malaria. But places like Nogales—where there are essentially no differences in demographics, geography or climate between the neighboring towns—disprove many of these older theories.
Instead, Acemoglu and Robinson argue that differences in wealth stem mainly from differences in political and economic institutions. In the U.S., for example, the concept of patent protection is written into the Constitution. Robinson notes that the first Patent Board meeting was held in 1790, with Thomas Jefferson in attendance. That’s how important it was.
Robinson emphasizes the impact of patent rights on the early American economy, noting that they were granted broadly “to artisans, farmers, elites, non-elites, professional people, uneducated people.” For this reason, Robinson characterizes countries like the U.S. and its peers as having “inclusive” economic institutions. With the protection of patents and generally strong property rights, entrepreneurs are incentivized to start new businesses.
That’s in contrast to less developed countries, which have what Robinson calls “extractive” systems. In these countries, corruption is so widespread that prospective entrepreneurs are disincentivized from starting businesses. Robinson cites Robert Mugabe, the dictator who ruled Zimbabwe for nearly 40 years. In 1999, he awarded himself a 200% pay raise, then in the following year miraculously “won” the top prize in a government lottery. In Robinson’s view, countries aren’t corrupt because they’re poor; they’re poor because they’re corrupt.
This is why we see entrepreneurs like Sergey Brin co-founding Google in the U.S. rather than in his native Russia, or Elon Musk setting up his various companies in the U.S. rather than in his native South Africa. The list of companies founded by first generation Americans is extensive for the reasons Acemoglu and Robinson identified.
Why Nations Fail emphasizes the importance of patents and property rights. But it’s more nuanced than that. Developed countries, the authors argue, walk a fine line, allowing businesses to thrive, but not allowing them to become too powerful. To illustrate this, Robinson likes to show a picture of Bill Gates from 1998, when he was forced to sit and face an antitrust inquiry. Countries with weaker economic institutions don’t constrain monopolistic businesses, and often the government itself owns them.
Antitrust laws in developed countries, on the other hand, ensure that businesses don’t grow to the point that they become extractive, which stifles innovation and harms economic growth. While sometimes seen as heavy-handed, antitrust laws are the reason we have healthy competition today in markets from energy to telecommunications.
Critics of the inclusive-extractive framework often point to China, a country that’s produced significant economic growth but without inclusive institutions. Political power there is highly concentrated, and the government has a heavy hand in directing the economy.
At a presentation in 2015, Robinson discussed China as a potential exception to his rule. He acknowledged the country’s success but argued that it was unsustainable. “The impulse of the Communist party to suffocate anything that looks vaguely threatening to it politically is fundamentally inconsistent with… innovation.”
That was nine years ago. Recent evidence confirms that he was right, that China’s autocratic approach has indeed started to backfire, producing the sort of results Robinson predicted. Most notably, the government’s one-child policy created an imbalance in the numbers of young men and women, making marriage more difficult and damaging the fabric of society in other ways.
In the economic sphere, China’s leadership, which directs most economic activity, put too heavy an emphasis on construction. That resulted in a surplus of housing units at a time when, due to the one-child policy, the population was falling. According to one study, there might now be as many as 90 million vacant homes that will never be sold. That, in turn, has resulted in significant bankruptcies among property developers. None of this has been good for investors.
Japan’s approach to economic development provides an interesting contrast to China. In the past, Japan sought to direct the allocation of resources, but it always stopped short of the sort of iron-fisted approach favored by Beijing. A famous example dates to 1961.
Japan’s Ministry of International Trade and Industry decided that Toyota should make cars, while Honda should limit itself to motorcycles. It further tried to dictate that cars couldn’t be painted red. Soichiro Honda would have none of this. He ignored the government and began making cars, often in red. Today, Honda produces 14 million cars each year. The results of Japan’s lighter touch are consistent with Robinson’s hypothesis that inclusive systems are more successful.
What are the implications of this research for individual investors? A key debate in personal finance is whether it makes sense to include international stocks in a portfolio. Why Nations Fail highlights an important point: that international markets differ significantly from one another, so it’s important to distinguish among them as we allocate our dollars.
This means examining critically a country’s political and economic structures before entrusting it with our money. That’s the reason I generally advise against total international stock market funds, because they weight stocks only according to their size, ignoring political factors which may ultimately pose risks.
The starkest example of this: Russia. Until a few years ago, it was included in the most popular emerging markets and total international funds. But when it invaded Ukraine, it was zeroed out of these indexes.
Instead, I suggest separating your international investments into two groups. The first is easier: An index of developed markets will include all of the world’s major economies outside the U.S. These are the countries with the most inclusive political and economic structures. For this portion of your portfolio, you could use a fund like Vanguard Group’s FTSE Developed Markets ETF (symbol: VEA) or iShares’s Core MSCI EAFE ETF (IEFA). EAFE stands for Europe, Australasia and Far East.
Governmental institutions are more problematic in emerging markets. There, I don’t think any of the standard market indexes is a good choice because China tends to dominate them, with weightings in the neighborhood of 30%. That’s why I prefer an alternative index known as the Freedom 100. Unlike a traditional index, the Freedom index also takes into account political and economic considerations. Result: The index completely excludes China and, even before the Ukraine war, it excluded Russia.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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IMHO, international investing poses risks that Americans don’t understand as well as the risks in domestic stocks. International investing is not really just one thing – there are more than 200 different countries out there, and IMHO, each individual country is its own investing environment. There are too many unknowns for me to put a lot of money there, regardless of the level of diversification, because I believe there are also a lot of what have been called the unknown unknowns. I think I know a lot about US companies and am still routinely surprised. I expect that would increase greatly for me with non-US investments.
And as I have commented before, the discipline on investing that is imposed by the rule of law in other countries is usually nowhere near as strong as the discipline that is imposed in the US. That is a critical and essential difference. We say snarky things about the SEC, and the law, but in this case, we are blessed with its reach. I mostly trust SEC reporting because the obligations to be forthcoming with important information in financial reports and public statements are extensive, and they are enforced. As for other countries? I’m not so sure. (And then there are the political, crime, corruption and other risks outside the US that one can only imagine and about which I confess to great prejudice.) Some commenters say that diversification takes care of all that, and the risks are built into the stock prices. My response is that I see a lot more volatility outside the US among supposed blue chips there, and more surprises that have enduring impact on the performance of stocks in lots of individual countries. I’m mostly happy with the alternative of including among my investments the many US stocks who themselves have large international operations – they have people who are paid to decide where to do business, and know a lot more than I do.
This is poor advice since anything that is generally known, e.g., the quality of a country’s institutions, is already reflected in the price of the stock- that is a basic concept in finance.
I own VEA for the reasons you cited. I am very dubious of emerging markets and funds which own them. I think John Bogle was right that by owning large, global US companies, you have a good slice of international investing. Even VEA has underperformed US funds in recent years.
I went to Nogales with a friend one time. I was very uncomfortable in Nogales, Mexico because I did not feel it was a safe place to be. Just my feeling. I have been to at least a dozen countries on 4 continents, and never felt that way about any other place, including South Africa. I think the law and order we have in the US, even though not perfect, is an underappreciated benefit we have.
What an interesting article. Your articles are always thought provoking.
It made me research a few ETFs, like VEA and FRDM, as I own VTI and VXUS, exclusively. (Except for a smaller holding in BRK-B.)
Lower cost, better performance, and no ESG focus will cause me to avoid FRDM. VEA also doesn’t improve my results so I will also stay in VXUS for now.
I have actually been reducing my VXUS, because like Jack Bogle, I am not a fan of international holdings. It was recommended by my Vanguard PAS advisor so I have a 10% holding of it currently, but as I make withdrawals from my holdings periodically, I try to maximize the amounts withdrawn from VXUS vs. VTI.
I recently designed a T-Shirt that is emblazoned on the front with VTI…UNTIL I DIE!
Good article, although I think it is a stretch to conclude that contrasting Nogales, Mexico with Nogales, AZ disproves previous economic theory. While the standard of living in Nogalex, AZ is much higher than it is in its Mexican counterpart, it is far from prosperous.
According to Wikipedia, Nogales, AZ (population 22,000) has a median family income of less than $25,000 and 1/3 of the population is below the poverty line, including 41% of those below the age of 18 and 33% of those over 65.
Being “poor” in the USA is better than being “middle class” in most other countries in this world.
“Figures never lie, but liars often figure.”
Relative wealth is much higher north of the border, which is what matters, I think.
A thought-provoking piece, Adam, thanks! I love it enough to offer a brief rebuttal, as much as that pains me as a fellow lover of freedom and good business climates. 🙂
As Howard Marks once said, about Efficient Market Hypothesis: “…I think theory should inform our decisions but not dominate them.”
Applying a Why Nations Fail strategy to investing seems like Environmental, Social, and Governance investing — perhaps best for those who want to align their investing with their values. It is great if that’s your game, but there could be costs, both real and opportunity.
If you strictly apply this theory and criteria to emerging markets holdings, you may miss out on some growth or income from countries who have been lucky when measured by Why Nations Fail. South African stocks returned an impressive 7.39% annually in real total return from 1900-2013, almost a full percentage point higher than the U.S.*
How quickly would a Why Nations Fail index change? How objective are its criteria? You may miss gains from countries whose outlook suddenly improves, perhaps after a war (Japan). Or perhaps with new leadership that does improve business climate, as South Korea’s did a decade after that war. And just as we have no idea which companies in a total stock index will wake up and improve their capital allocation decisions (like Microsoft in 2014), we may not be good at predicting which emerging market countries will win or lose over decades. It may be better to own them all.
In the particular case of buying Freedom 100 ETF (FRDM), there is also the matter of concentration and risk: its top three holdings account for over 60% of the fund. If the People’s Republic of China decides to invade a certain southern island, 30% of FRDM could go to zero. When Russia invaded Ukraine in March 2022, and Vanguard Group halted purchases of Russian stocks, they accounted for just 2.9% of Vanguard Emerging Markets ETF (VWO). Long-term investors will prefer VWO’s .08% cost to FRDM’s .49%.
*Credit Suisse Global Investment Returns Yearbook, 2014.
This sounds like a book that I and several of my family members would like to read. Two books that I read many years ago that weren’t about economics except tangentially, were The Health of Nations (about how access to safe water is the decisive factor) and The Tragedy of America Compassion. Both influenced my thinking and it sounds like Why Nations Fail would too. Thanks for the info, Adam.
I understand and agree with the concern about the extra risk inherent in holdings located in authoritarian regimes, but I don’t feel compelled to try to address it.
Yes, China is a big chunk of the emerging markets set. But is that really a lot within a portfolio? The equity portion of my portfolio is about 1/3 international, and most of this is in broad international index funds which include emerging markets. Morningstar’s portfolio X-ray doesn’t drill down to country, but it does show my equity portfolio is 3.6% “Emerging Asia,” so China is some fraction of that.
So now it seems China itself is below 3% of my equity portfolio, nevermind even less of my total portfolio with its more stable bond and cash allocation. I can live with that. To me the risk isn’t worth the complexity and fees of trying to hold a variety of funds to weed out certain markets. And who knows, Chinese stocks may do fine over my time horizon.
Looks like the Freedom 100 ETF has an expense ratio of .49%, more than 6 times the .08% of Vanguard’s Total International Stock ETF (VXUS) and its Emerging Market ETF (VWO): FRDM – Freedom ETFs
As an amateur American Civil War history buff, I was interested to discover a few years ago that the US wouldn’t violate its own patent rights in order to better arm its troops on the battlefield with breech loading (cartridge) firearms, even though doing so would likely have given it a decisive edge in many battles. That’s some pretty healthy respect for patent rights, for sure.
To Adam’s last point, there are now several good alternatives that offer less authoritarian-heavy international investing. I was pleased to see the latest from the Thrift Savings Plan; it now offers an MSCI ACWI IMI ex USA ex China ex Hong Kong Index. There are now several ETF’s that fairly closely mimic this arrangement, which I see as a welcome development.
Interesting. I wonder if that was directed by Congress or if the TSP management just decided to offer it.
As I recall, there was a big fight over this sometime in 2020, it was Trump and Republicans in Congress vs the Thrift Investment Board. The Board had been considering changes to the I (International) Fund, in an attept to give TSP participants a little more diversification. They were wanting to change from tracking the EAFE index to something like the FTSE Global All Cap ex U.S. Index ( Think: Vanguard’s VEA vs VXUS). They ultimately settled on the MSCI index, minus China, Hong Kong, and USA. I’m sure this was to avoid further controversy, but it does appear the choice was still able to give the TSP a little more in the way of diversity.
Thanks, I thought there must have been some backstory.
A splendid article, Mr Grossman. Thank you.