Monday, February 4, 2013

Why are some societies rich and others poor?

Short answer: institutions + entrepreneurship.

Perhaps the most important question for modern economists, discovering why some societies have achieved great affluence while others remain in grinding poverty has spurred much important research. Obviously, under-developed societies lack the abundance of productive capital and labor which promotes growth in other parts of the world. However, this observation only scratches the surface; more than two trillion dollars has been given in foreign aid over the last fifty years so if capital investment alone were sufficient to end poverty, the problem would be solved already. In my view, there are two necessary elements for a society to prosper: a culture of entrepreneurship, and stable institutions which protect private property. If either alone were sufficient then poverty would be much easier to combat, but in reality both entrepreneurship and institutions are needed to create economic growth.

Entrepreneurship, defined broadly, is risk-taking aimed at exploiting previously untapped benefits from exchange. All humans almost certainly have some spark of entrepreneurship within them, but depending on the society they live in, that drive may be expressed along different margins. In cultures which promote group conformity, entrepreneurship which causes divergence from societal expectations may not be accepted. Individualistic culture, as is most often seen in Europe and the United States, has proven the most open to entrepreneurship, and led to more opportunities for economic growth. Entrepreneurs find new ways to use low valued resources and new ways to connect buyers and sellers, in ways that enrich both themselves and other members of society.

While by definition all freely chosen exchanges are mutually beneficial, not all exchange is voluntary. As Baumol (1990) famously observed, entrepreneurs can be either productive or destructive. The way entrepreneurial talents are deployed depends on another set of factors, referred to broadly as institutions. This encompasses the stability of the legal system, ability to enforce contracts, security of private property against state expropriation, and so on. Entrepreneurs operating in a weak institutional environment may exploit non-market methods to coerce others into involuntary exchanges. Coerced exchange transfers resources from higher-valued to lower-valued uses, causing society’s total wealth to shrink.

Institutions with consistent rules, applied impersonally, are best able to avoid destructive entrepreneurship. The Anglo-Saxon common law inherited by the United States from Britain is a good example of such an institutional structure. It is no coincidence that Hong Kong, which was also governed under British law for many years, outpaced the rest of East Asia in economic growth throughout the 20th century. The people of Hong Kong are presumably not very different from mainland Chinese, but because they acted under a different set of institutions their productivity was much higher, leading to rapid economic development.

To use a mechanical analogy, one can think of economic growth as a moving vehicle with entrepreneurship as the fuel and institutions as the engine. Without any fuel, even the best engine will not move forward; on the flip side, a badly constructed engine with lots of fuel will lose energy as waste and ultimately self-destruct. As almost any person is a potential entrepreneur to fuel economic growth, I think this second scenario is much more prevalent in poor parts of the world. There is nothing innately wrong with the people, except that the institutions they live under cause productive energies to be wasted and resources to be expended on rent-seeking rather than innovation.

 The reason that some societies are prosperous is that their people were free act entrepreneurially, and they were guided by strong institutions toward making mutually beneficial exchanges. In some under-developed societies entrepreneurship is hobbled by cultural attitudes which do not respect individual achievement, and by institutions which reward predation rather than creation (or both). This is why transferring capital from the rich to the poor alone is not enough to solve poverty; without the institutional and cultural preconditions for development in place, resources cannot be productively employed to bring lasting prosperity.

(Context: I wrote this essay for another purpose but I like it enough to recycle as a blog).

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