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What was the role of institutions in economic development before 1870?
Institutions are man-made restrictions that indirectly shape people’s behaviours and can be
formal, such as legal systems, and informal, such as cultural norms (North, 1990). Institutions
are one of the most important factors influencing economic development and can either
facilitate or hinder it. In this essay, we examine the differences between institutions in the
Islamic World and in Britain, and assess how this led to differences in economic development
before 1870 between the two regions.
One role of institutions in economic development in the Islamic World was hindering the
development of large commercial firms and financial organisations. One example of this is the
complex and ineffective Islamic inheritance law which requires assets to be shared with
immediate family members and distant relatives (Kuran, 2018). Due to the sheer number of
heirs, an enterprise’s fragmentation after its initial foundation was likely. Aware of this
possibility, merchants and investors avoided becoming involved in partnerships. Thus, they
deliberately maintained small and short-lived businesses. This phenomenon suggested a
suppressed demand for large enterprises due to institutional factors. Furthermore, the
prohibition of Riba (interest and usury) by Islamic Law delayed the formation of modern banks.
The red tape, namely the need to revise the Qur’an to change the Law, restricted the desire of
the elite class and clerics to break the status quo (Rubin, 2010). Thus, it prevented the
establishment of an open, public credit market. Social attitudes such as the suspicion of
impersonal exchange and large organisations provided little demand for legal and scriptural
reforms (Kuran, 2018). Islamic Law and societal norms, therefore, demonstrate how
institutions can restrict commercial and financial development.
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Conversely, institutions can drive economic growth by facilitating the emergence of capital
markets. In Britain, The Glorious Revolution of 1688 diminished the Crown’s authority in
legislative matters and shifted the balance of power between the Crown and Parliament towards
the latter (Baten, 2016). The Revolution enabled investment without the risk of appropriation
or changing the value of property by the government, which allowed functioning capital
markets to develop (North, 1991). The establishment of secure property rights also increased
the willingness of lenders to lend to the government. After the Glorious Revolution,
government borrowing increased by more than ten times from 1688 to 1697 (North and
Weingast, 1989). Compared to absolute monarchies in continental Europe, a stronger tax base
also resulted in lower interest rates and more extensive borrowing in Britain (Finlay and
O’Rouke, 2009). An increase in the trade value of private securities from an annual average of
£300,000 in the 1690s to over £5,000,000 in 1750 was observed (North and Weingast, 1989).
These observations demonstrate growth in capital markets after the Glorious Revolution.
Capital markets and property rights enabled borrowing to finance capital accumulation, which
was a characteristic of the Industrial Revolution. The relatively high wages and the low cost of
capital in Britain, compared to other European countries also enabled capital accumulation
(Allen, 2009). The Glorious Revolution demonstrates how institutions in Britain paved the way
for development via industrialisation by facilitating capital accumulation.
Another role of institutions in economic development in the Islamic World was to impede
urbanisation. Institutional factors, such as a lack of local autonomy, corporation, and an
ineffective municipal government structure, hampered urban growth. Capital cities outweighed
other cities in importance, which resulted in less discretion for smaller towns and cities (Kuran,
2018). A lack of autonomy restrained local governments’ ability to implement suitable policies
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