What makes poor nations grow? How can countries develop into prosperous societies? Different answers have been given.
In this article, I propose that economic development best occurs in an enabling environment whereby the foundations of a market economy are present and protected. The key ingredients are sound money, property rights, contract rights and the rule of law. Without these core government functions, it is difficult for the market economy to function the way it should.
Economic Freedom is the single-most important factor in determining the welfare and prosperity of a nation. Various indicators have been created to measure this, for instance, the Index of Economic Freedom by the Heritage Foundation and Wall Street Journal, as well as the Economic Freedom of the World created by the Fraser Institute. The latter measures the extent to which countries achieve these four principles: 1) personal choice rather than collective choice, 2) voluntary exchange coordinated by markets rather than allocation via the political process, 3) freedom to enter and compete in markets and also, 4) protection of persons and their property from aggression by others. In practice, it measures directly these aspects:
Size of Government: Expenditures, Taxes, and Enterprises
Legal Structure and Security of Property Rights
Access to Sound Money
Freedom to Trade Internationally
Regulation of Credit, Labor, and Business
Benjamin Powell argues in Defense of Sweatshops and Making Poor Nations Rich that the key to raising the standard of living of the poor around the world is to “stop government from helping the poor”, by ending wars on poverty, reduce government regulation stifling free enterprise, abolishing harmful tariffs that hurt the chances of poor exporters to sell to world markets, and promoting important state institutions like the protection of private property, rule of law and contract enforcement. These are elements that promote economic freedom, and will ultimately lift the poor up from poverty.
From the results gained from years of compilation, higher levels of economic freedom are positively and highly correlated with various indicators of well-being. Significantly, it correlates with UN’s Human Development Index very positively. More economic freedom is related to greater “human development” as measured by the United Nations. Economic freedom has been shown to correlate strongly with:
higher average income per person (Countries with more economic freedom have substantially higher per capita incomes) and higher economic growth (Countries with more economic freedom have higher growth rates)
higher income of the poorest 10% (The amount of income earned by the poorest 10% of the population is much greater in nations with the most economic freedom than it is in those with the least. However, the share of income earned by the poorest 10% of the population is unrelated to the degree of economic freedom in a nation). In fact, seeking a correlation between Economic Freedom and the Gini Coefficient, it is found that economically free nations have a better income distribution and less inequality overall.
higher life expectancy (Life expectancy is over 20 years longer in countries with the most economic freedom than it is in those with the least)
higher literacy (Adult literacy increases with economic freedom)
lower infant mortality (Infant mortality is much lower in countries with high economic freedom)
better child labour conditions (The incidence of child labour declines as economic freedom increases)
higher access to water sources (Access to improved (treated) water increases with economic freedom)
less corruption (With fewer regulations, taxes, and tariffs, economic freedom reduces the opportunities for corruption on the part of public officials)
better political rights and civil liberties (Political rights (e.g., free and fair elections) and civil liberties (e.g., freedom of speech) go hand in hand with economic freedom)
The relevant reports can be found here, here and here.
Importance of property rights
The absence of a functioning legal system and property rights is one of the most serious obstacles to the development of the poorest people in the Third World. The economist Hernando De Soto explored this in his seminal work The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. He explained that no nation can have a strong market economy without adequate participation in an information framework that records ownership of property and other economic information.
Since the fall of the Berlin Wall, responsible nations around the developing world have worked hard to make the transition to a market economy, but have in general failed. Populist leaders have used this failure of the free market system to wipe out poverty in the developing world to beat their “anti-globalization” drums. But De Soto believes that the real enemy is within the flawed legal systems of developing nations that make it virtually impossible for the majority of their people –and their assets– to gain a stake in the market. The people of these countries have talent, enthusiasm, and an astonishing ability to wring a profit out of practically nothing. What the poor majority in the developing world do not have, is easy access to the legal system, which, in the advanced nations of the world and for the elite in their own countries, is the gateway to economic success.
Government failure > Market failure
Many development economists emphasise the role of the state in spearheading economic development, a role that is supposedly made important due to “market failures”. However, the equally important concept of government failure is seldom mentioned and taught.
The first most serious government failure is the incentive problem, an issue highlighted by public choice theorists. They argue that when governments have a regulatory role in the economy, special interests are attracted into the picture. The incentives of the regulators eventually become distorted, and they may now serve the regulated. “Regulatory capture” occurs because groups or individuals with a high-stakes interest in the outcome of policy or regulatory decisions can be expected to focus their resources and energies in attempting to gain the policy outcomes they prefer, while members of the public, each with only a tiny individual stake in the outcome, will ignore it altogether. (Costs are concentrated while benefits are diffuse) This “regulatory capture” is an example of government failure. What this means is that we cannot simply assume that government would act in the public interests: they themselves may be acting in their own interests, which could often be displaced by something other than the public interest.
Another problem is the information problem that Austrian-school economists like Mises and Hayek have explained. According to them, central economic planning cannot succeed because it lacks information that is dispersed amongst many individuals within the market society. Prices act as information signals, and deprived of this, governments that seek to make economic plans do so erroneously. This leads to the “fatal conceit”, which is the arrogant belief that they can create better outcomes than many individuals doing so collectively in the market.
An understanding of these government failures should give caution to anyone who prefer a strong role for government in spearheading economic activity. Governments can often be the cause of poverty and poor growth, rather than a solution to those problems. According to the economist William Easterly, they can create poor incentives for growth by causing high inflation, high black market premiums, high budget deficits, strongly negative real interest rates, trade restrictions, excessive red tape, inadequate public services and corruption.
The role of investment and capital accumulation
The role of investment should not be underestimated. Why is it that there was a burst of growth near the end of the 18th century? Capitalism and industrialisation was a key factor. But specifically, the reason for the takeoff into prosperity that began near the end of the 18th century was an increase in investment. This causes capital accumulation and increases the marginal productivity of labour. This in turn allows workers to demand higher wages, increasing their standard of living. If prosperity requires investment, nations that want to improve need to assure investors that they won’t confiscate their businesses or profits. Sadly, many governments have not done this in the past. On the contrary, they do seize investments.
Compare, for instance, post-WWII India‘s sluggish growth and the historic rise of America. According to Ludwig von Mises, “the average standard of living is in this country (USA) higher than in any other country of the world, not because the American statesmen and politicians are superior to the foreign statesmen and politicians, but because the per-head quota of capital invested is in America higher than in other countries. Average output per man-hour is in this country higher than in other countries, whether England or India, because the American plants are equipped with more efficient tools and machines. Capital is more plentiful in America than it is in other countries because up to now the institutions and laws of the United States put fewer obstacles in the way of big-scale capital accumulation than did those foreign countries.”
Many misguided policies impair this process of capital accumulation, like protective tariffs and trade unionism. Tariffs and foreign exchange controls are exactly the means to prevent the importation of capital and industrialization into the country. The only way to increase industrialization is to have more capital. Protectionism can only divert investments from one branch of business to another branch. Protectionism, in itself, does not add anything to the capital of a country. To start a new factory one needs capital. To improve an already existing factory one needs capital, and not a tariff. Labor unions in many countries have historically used violence against entrepreneurs and against people they call ‘strikebreakers’. Despite their power and their violence, however, unions cannot raise wages continually for all wage earners. Equally ineffective are government decrees fixing minimum wage rates. What the unions do bring about (if they succeed in raising wage rates) is permanent, lasting unemployment. But unions cannot industrialize the country, they cannot raise the standard of living of the workers. And this is the decisive point: One must realize that all the policies of a country that wants to improve its standard of living must be directed toward an increase in the capital invested per capital.
Those countries that ignore the importance of capital so do at their own peril. In those countries, there is no-or not sufficient-domestic saving, and capital investment from abroad is seriously reduced by the fact that these countries are openly hostile to foreign investment. How can they talk about industrialization, about the necessity to develop new plants, to improve conditions, to raise the standard of living, to have higher wage rates, better means of transportation, if they are doing things that will have precisely the opposite effect? They need to allow capital and investment and not deter them! What their closed/socialistic policies actually accomplish is to prevent or to slow down the accumulation of domestic capital and to put obstacles in the way of foreign capital.
Stop foreign aid
Foreign aid is also another big-government giveaway that has done much more harm than good. The famous development economist Peter Bauer had shown in his book that foreign aid to poor countries have done more harm than good, and are not a good tool in international development. He was widely opposed to state controlled foreign aid. It was neither necessary nor sufficient for development, and may actually hinder it. The danger of aid, according to Bauer, is that it increases the power of government, leads to corruption, misallocates resources, and erodes civil society.
In a similar note, Dambisa Moyo, Zambian author of Dead Aid: Why Aid Is Not Working and How There Is Another Way For Africa is a prominent critic of government controlled foreign aid. She argues that what Africa needs is not more aid, is more accountability by government officials to the domestic citizenry and not to donors. Also, aid has also become an industry riddled with special interests. She also showed how large amounts of aid end up in the pockets of African dictators like Mugabe, who has received almost 300million of aid money so far from the UK and USA. She argued that you cannot separate the issue of aid and poor leaders. Therefore, we cannot believe that you can just maintain the aid and increase it while reforming the leaders. They are intimately related and cannot be de-linked. Aid makes good leaders bad and makes bad leaders worse. She believes that the perpetuation of aid is rooted in pity and a belief that Africans are unable to help themselves out of poverty. The aid model delays much needed market reforms that can lift the people out of poverty. Governments need to allow private initiative to flourish.
Those who believe in aid usually cite the Marshall Plan as their greatest success. But till date it cannot be proven that it was essential to Europe’s post-War recovery. In fact, Germany, who received less aid than Great Britain grew much faster. This was due to the actions of the German minister Ludwig Erhard, who abolished price controls and restored the market. As Dr. Erhard himself described his action: “We decided upon and reintroduced the old rules of a free economy, the rules of laissez-faire. We abolished practically all controls over allocation, prices and wages and replaced them with a price mechanism controlled pre-dominamtly by money.” The result was that German industrial production in the second half of 1948 rose from 45 percent to nearly 75 percent of the 1936 level, while steel production doubled that year.
Trade and Globalisation
Trade and globalisation aids the economic development of countries. We should not misunderstand their effects. There is a common perception that the economic welfare of people in poor countries has been harmed by the increasing globalisation of business – through trade, industrialisation and the growth of multinational corporations. This global corporate juggernaut is supposedly bulldozing the cultures of other nations as well as the environment. The spread of the economic crisis from the United States to the rest of the world supposedly demonstrates the dangers of the global economy. However, the reality is that since WWII, a historic era of free trade has brought unprecedented prosperity and opportunities to millions of people around the world, bringing greater freedom to many nations that were once dictatorships. The best way to expand the global middle class and increase prosperity is to continue reducing trade barriers and establishing stable monetary policies. Trade is ultimately a job creator, not job destroyer.
Some feel that poor countries protest globalisation since they are unhappy with trade competition, especially farmers. However, the real culprit here is not global capitalism and free trade that it promotes, but rather government failures, for instance US farm subsidies that create artificially cheap American agricultural exports that make it difficult for these farmers to compete. à Solution here is to correct the government failure by ending the subsidies and special interests. For example, in 2008 hundreds of farmers on tractors converged in Mexico City protesting NAFTA, because NAFTA’s liberalised agricultural trade provisions resulted in cheap corn and grains flooding Mexico from the US and Canada, causing the poor farmers to be unable to compete. However in this case, it was the long standing US farm subsidies that were to be blamed. What started out as a temporary program in the 1930s became permanent. Like other bad government policies, they created a brutal imbalance in the world agricultural markets: artificially cheap wheat and corn grown by government-subsidised US producers are threatening the livelihoods of poor farmers priced out of the market.