The debate about the key drivers of economic growth, and how it can be generated in different countries at different times, is complex. However economists have a fairly good understanding of what needs to be in place for growth to occur.
Certain moments in history have generated natural experiments that allow us to see the impact of alternative economic institutions. From 1910–1945 the Korean peninsula was economically, culturally, and ethnically homogenous, and under Japanese rule. At the end of the Second World War it was divided in two, with the North becoming a Soviet controlled planned economy, and the South an American controlled capitalist economy. Never before had there been such a clean test of two different economic systems. As the twentieth century progressed, the results became clearer and clearer, with South Korea benefiting from income per capita that outgrew the North by a factor of 14, significantly lower infant mortality, and unfathomable leads in consumption capabilities. The differences were so stark you could see them from space: the border is where the lights all go out.
By and large, what happened to South Korea worked, and demonstrates the triumph of a system where goods and services are traded based on voluntary decisions, rather than allocated based on central command.
When countries attempt to stimulate growth there is a temptation to look for a quick fix. Many policies can generate an illusion of growth, and over a short enough time horizon appear to be working. But governments don’t create wealth; they spend it. Real advances in living standards only occur when real wages rise. And real wages rise when real productivity does. Government is an enabler of prosperity, but companies are in the driving seat.
The fundamental question is how to allow people to compete successfully, to be competitive, and to boost productivity. We can split the main determinants of productivity into three components — the hardware, the software, and the operating system.
The hardware of the economy is the factors of production. Traditionally these are referred to as land, labour and capital. But it’s not really the amount of land that underpins a country’s potential, but the location and climate. Together with the human capital contained within the population, and access to raw materials and other physical capital, these constitute our endowments. In some societies, their growth is “factor driven” in that it depends on better access to basic inputs. Some countries are still disadvantaged by being away from a port, or having uncongenial weather. Indeed classical growth theory rests on the importance of the accumulation of capital — to get more output you need more inputs. Although this may explain why some countries can get an early burst of growth, it fails to explain how some countries can achieve sustained growth, year after year. Indeed for most of human history economic growth has been rare and temporary. It is only since the industrial revolution that we have seen countries grow around 1% per year; and only since the mid twentieth century that 2%-3% growth has become more common. These wealth gains can only occur when we do more with less. This type of growth is “innovation driven”. It means we don’t rely on having more ingredients, but that we find ways to discover better recipes.
The software of an economy accounts for the innovation, science and know how. It can be found at a microeconomic level and is driven by three main areas: the quality of the business environment; the state of cluster development (i.e. the capital connectivity); and the strength of management capabilities. The sophistication of local competition establishes and directs the specific economic actions that generate trade and create wealth.
The effectiveness of this software depends on the right operating system. These are institutions that cut across the entire economy, and can also be split into three categories. Firstly, is the policy framework, which includes monetary policy (control of the money supply); and fiscal policy (control of the government budget). Secondly, is the social infrastructure, which includes human development and health outcomes. Thirdly, are political institutions, which can be formal (for example law and order), or informal (such as norms and customs). These institutions set the rules of the game, and will shape behaviour. They will determine whether people win by being productive and creating wealth, or by being destructive, and attempting to capture existing wealth.
When all three components — the hardware, the software and the operating system — are in place, prosperity is the result.
Unfortunately, for many countries, an understanding of what constitutes good economic policy is not enough to deliver it. This is often because key groups have an interest in preserving the status quo, be it bureaucrats who want to protect their positions of power and authority; or the business community who want to restrict competition and preserve their advantages. Indeed crony capitalism is one of the biggest threats to the free enterprise system because it diverts resources to rent-seeking behaviour and simultaneously undermines the general public’s appetitive for market solutions. The challenge facing those who champion prosperity is two fold: to consistently promote beneficial policy reforms that affect the policy debate; but also to communicate the basis of these policies to the general public.
The danger of waiting for an opportunity for reform to present itself is that these typically occur during a crisis, and often times this involves a battle with authoritarians and populists that exploit the situation to increase the scale and scope of the state. Therefore the latter mission of widespread education is crucial. Although some moments in history have provided the circumstances for ideas to outweigh interests, these windows of opportunity are rare. During the period of ordinary politics it is important to nurture a widespread awareness and appreciation for the foundations of a commercial civilization. Winning the hearts and minds of the typical person is a long-term effort with no easy way to measure progress. But the promotion of economic education through books, public talks and videos — whether it’s famous professors explaining their own important research or specialist communicators of ideas utilising popular culture — all affect the climate of opinion and shift the boundaries of possible reform.
Prosperity follows when free people are able to utilise their talents as they see fit, and engage in voluntary trade and association with their neighbours. This requires a stable legal environment that protects people’s rights, and a cultural commitment to tolerance and individual responsibility and integrity. The free society has permitted unimaginable gains in human flourishing, wherever it’s been embraced. As countries like China and India have moved in this direction, billions of people have been lifted out of poverty. Market exchange is the greatest force for peace and prosperity that we have. The upside to expanding its reach is infinite.
Higgs, R., “Results of a Fifty-Year Experiment in Political Economy” The Independent Review Volume 5 Number 1 Summer 2000
Kling, A., and Schulz, N., From Poverty to Prosperity, Encounter, 2009
Porter, M.E., Competitive Advantage of Nations, New York: Free Press, 1990