We show that even in the absence of diminishing returns in production and technological spillovers, international trade leads to a stable world income distribution. This is because specialization and trade introduce de facto diminishing returns: countries that accumulate capital faster than average experience declining export prices, depressing the rate of return to capital and discouraging further accumulation. Because of constant returns to capital accumulation from a global perspective, the world growth rate is determined by policies, savings, and technologies, as in endogenous growth models. Because of diminishing returns to capital accumulation at the country level, the cross-sectional behavior of the world economy is similar to that of existing exogenous growth models: cross-country variation in economic policies, savings, and technology translate into crosscountry variation in incomes. The dispersion of the world income distribution is determined by the forces that shape the strength of the terms-of-trade effects— the degree of openness to international trade and the extent of specialization.

Among countries colonized by European powers during the past 500 years, those that were relatively rich in 1500 are now relatively poor. We document this reversal using data on urbanization patterns and population density, which, we argue, proxy for economic prosperity. This reversal weighs against a view that links economic development to geographic factors. Instead, we argue that the reversal reflects changes in the institutions resulting from European colonialism. The European intervention appears to have created an “institutional reversal” among these societies, meaning that Europeans were more likely to introduce institutions encouraging investment in regions that were previously poor. This institutional reversal accounts for the reversal in relative incomes. We provide further support for this view by documenting that the reversal in relative incomes took place during the late eighteenth and early nineteenth centuries, and resulted from societies with good institutions taking advantage of the opportunity to industrialize.