When I crossed through Checkpoint Charlie from West Berlin to East Berlin in March 1990, I witnessed two worlds colliding. On one side stood a beautiful, economically flourishing metropolitan city; on the other, a gray landscape of economic failure. While witnessing the dismantling of the Berlin Wall was exhilarating, the stark contrast in living conditions between West and East Germany was sobering.

Today, a similar story plays out along the US–Mexico border. Stand in Nogales, Arizona, then cross into Nogales, Mexico, and you’ll find two cities sharing the same geography — separated by just a fence — to be worlds apart in quality of life. Even more dramatic is the Korean Peninsula, where North and South Korea share historical heritage but couldn’t be more different: South Korea boasts a vibrant, innovative economy, while North Korea struggles to feed its people.

From first traveling through Europe more than 45 years ago to recently visiting Latin America and Asia, I’ve been fascinated by why nations with similar geography and shared borders often deliver dramatically different standards of living for their citizens. I’ve found that one factor matters most: the strength of a nation’s institutions.

Very simply, institutions are the complex web of formal and informal rules governing how society functions. They shape economic outcomes and are fundamental to any country’s economic prosperity.

How institutions work

While other nations may attempt to replicate individual pieces, it’s really the entire ecosystem working in concert that has made American institutions the envy of the world and the foundation responsible for building great wealth. These include the rule of law, property rights that protect investments, an independent judiciary that ensures legal protections, a free press and a government with effective checks and balances.

The result: The United States has one of the highest scores based on per capita income, life expectancy and education levels compared to other countries, according to the United Nations’ Human Development Index.

Robust American institutions support an environment of political and economic freedom. This has given rise to stable and efficient markets. Confident their investments are protected by the law, individuals and businesses are more incentivized to make long-term investments in physical and human capital, engage in innovation and research, and take entrepreneurial risks. They can create new enterprises that hire employees to innovate and produce products and services that improve our lives.

Trading goods and services freely, in both domestic and international markets, optimizes the allocation of resources, fosters competition that ultimately reduces costs for consumers, and impacts consumer confidence. Importantly, sound institutions typically offer opportunities to climb the economic ladder and produce a well-educated and healthy population that supports a productive and innovative workforce.

The culture of a nation and its institutions are deeply intertwined, with each influencing and reinforcing the other. In societies with high levels of interpersonal trust, people are more willing to engage in business with strangers knowing that their contracts will be protected by the law. Cultural attitudes toward work, education and self-improvement matter greatly.

The institutional divide

The relationship between institutions and prosperity isn’t new. The signing of the Magna Carta in England in 1215 established foundational principles for modern governance and civil liberties. This early framework evolved into today’s sophisticated institutional structures that support market economies.

British colonial legacies offer a natural experiment in institutional impact. Former British colonies like the United States, Canada and Australia inherited a strong institutional framework leading to sustained economic success. Meanwhile, regions that received different institutional templates have often struggled to achieve similar results.

For example, the economic institutions that Spain’s government entrenched in Latin America were perhaps less geared toward free markets and property rights than those established by the British in the northern part of North America. Today, these differences are reflected in standards of living.

Nations with weak institutions produce poor economies, and in turn, low standards of living. Former East Germany, the former Soviet Union and Russia today are examples of countries with poor institutions and relatively low living standards for the vast majority of their citizens.

Nations with similar starting points, like former East and West Germany or North and South Korea, have diverged dramatically based on their institutional choices. Previously poor countries that developed strong institutions, like Singapore and South Korea, have achieved prosperity. Oil-rich nations, like Nigeria, have struggled despite natural advantages. Meanwhile, Venezuela has transitioned from one of the wealthiest countries to one of the poorest due to severe institutional deterioration leading to economic collapse.

While resources and geography matter, it’s the quality of institutions that ultimately determines whether a nation can convert its potential into prosperity. The ability of a country to build or maintain effective institutions likely is the defining factor in economic success.

The China dilemma

Over the last several decades, China has lifted millions of people out of poverty through sustained economic growth. This success, however, has occurred despite having weak institutions. Why? The answer lies in understanding how institutions affect different stages of economic development. During a catch-up phase, when a young economy focuses on adopting existing technologies and a business model, weak institutions may not significantly impede growth. However, as an economy matures and requires more innovation and efficient capital allocation, institutional weaknesses become increasingly problematic.

According to the Heritage Foundation’s 2024 Index of Economic Freedom report, “The Chinese Communist Party leadership holds ultimate authority and directly controls economic activity.” This reality has constrained the country’s institutions, putting China in the lowest “repressed” category with a score of 151 out of 169 countries. This measure is based on a nation’s strength or weakness of its rule of law, property rights, business freedom, investment freedom, judicial effectiveness, government integrity and other factors.

China displays institutional limitations in many ways. The Communist Party’s pervasive control restricts personal freedoms, undermines the rule of law and restrains entrepreneurial independence. The system is often characterized by relationship-based contract enforcement, preferential treatment of state enterprises over private firms when allocating capital, inadequate intellectual property protection and party control over the judiciary, media and information access.

The consequences of these institutional weaknesses are increasingly evident, revealing deep-seated flaws and severe economic difficulties from China’s real estate crises to high youth unemployment. Consequently, China’s version of state-controlled capitalism is unlikely to survive “as-is” unless it reengages the reform process that initially drove its economic miracle and confronts its institutional deficiencies. History suggests that systems where authoritarian leaders dictate all economic policies, arbitrarily select industry winners and losers and hijack market mechanisms tend to fail.

The crisis of American institutional trust

Today, America faces the challenge of declining public confidence in its institutions. According to “Americans’ Deepening Mistrust of Institutions,” published in October 2024 by the Pew Charitable Trusts, Americans’ trust in some key national institutions is at historic lows. Although Americans have been mistrustful of the federal government for some time, trust in several historically respected institutions has also taken a hit in the post-pandemic years.

“Data Behind Americans’ Waning Trust in Institutions,” published by Pew in 2024, indicates that average confidence in major US institutions has declined since 1979. Other organizations are indicating similar trends. A 2024 Harvard Political Review publication, “Declining Youth Trust in American Institutions Shows No Signs of Stopping,” indicates this decline is likely to continue.

American institutional trust serves as the bedrock of our democratic system. Its erosion can lead to fewer business startups, less willingness to invest, innovate and maintain social bonds, and greater vulnerability to antidemocratic movements.

This erosion of trust is not just a matter of public opinion — it directly threatens our economic future and is tantamount to chipping away at the building blocks that support America’s wealth, prosperity and our standard of living. It is time to address the reasons for this mistrust, which may include political polarization, economic inequality, the erosion of the middle class, the displacement of workers by automation, and yes, the failure of some institutions to perform as designed.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.