The Story of Economic Growth and the Variables Behind It
Whether elections are right around the corner or not, economic growth is always a hot topic of discussion. And rightfully so! Imagine you had a child today and the country that they spend their time until adulthood experiences a meager one percent annual growth rate, they will be almost 20% better off. Due to the compound nature of the growth, growth rates of only 3% bring the overall wellbeing to 70% percent, while having a 5% rate leaves him almost two and a half times better off than the starting point we’ve found ourselves 18 years ago. This practically represents the role that economic growth plays in our lives.
In the second half of the 18th century, “little else was required” for Adam Smith in the pursuit of reaching the “highest degree of opulence” than “peace, easy taxes, and a tolerable administration of justice.” Everything else will follow suit “by the natural course of things.” His treatise, An Inquiry into the Nature and Causes of the Wealth of Nations marks the beginning of what we call economics today. Ever since, many economists have followed his footsteps in search of the answers for the age-old question – how do nations grow wealthy?
Nowadays, the role of the institutions, such as property rights, honest government, political stability, a dependable legal system, and competitive and open market are more or less part of mainstream economics. On the other hand, the growth of the savings and investment is pretty much self-explanatory, yet not nearly enough to explain the technological progress. In more recent times, human capital and the role that education plays are introduced/included in the growth models, yet they don’t tell us enough about what leads to innovation and creation of new knowledge. After all, we can save and invest everything we have created thus far, no matter whether that’s physical or human capital. However, on its own, investment does not lead to growth, the student loan crisis being case in point. Investments in diplomas that the markets deem almost ‘worthless’ don’t bring home the bacon.
After the Second World War, the narrative of economic growth changed its course adding emphasis on natural resources and geography. Japan and the Asian tigers proved that countries with no natural resources begged to differ. The passing of time allowed us to learn of the “resource curse, “ which showed us that not only natural minerals and the black gold a.k.a oil were not enough, but in many cases detrimental for the growth rate and the wellbeing of the people. That is why we’re forced to go a full circle and expand on Smith’s foundations, putting the emphasis back on the institutional rules, protection of private property, free trade and the rule of law as much more important benchmarks than natural resources and geography.
Those might be the foundations but judicial efficiency, low level of corruption, well-organized public bureaucracy and economic freedom are other variables that correlate well with high growth rates. One doesn’t have to look no further than Heritage Foundation’s Index of Economic Freedom or Fraser Institute’s Human Freedom Index. The variables used to constitute these indexes are, in one form or another all those mentioned above. If you take a look at long time series and compare the growth rates to the level of freedom, the freest countries experience the highest growth rates. The conclusions would have been different if this was the case only in the developed world. However, even if you focus on the lowest income countries, you’d draw the same conclusion. Maybe the best part of these indexes represent the walk down memory lane of a single country. This way, we’re allowed to see how more economic freedom opens up the doors for more wealth, but at the same time, as is the case with Sweden in the 1970s and 1980s, the opposite stifles growth. Correlation is not causation by any means, but it is hard to dismiss such uncanny correlation based on so much theory.
That is why it should surprise no one that three decades after the fall of the Berlin wall not many ex-communist countries have seen much of the promised land that freedom was supposed to provide. But let’s not forget at the same time, those others that transitioned under the foundations of a free society and free markets, such as Slovenia, the Baltic countries and Georgia in the last fifteen years, came up on top.
In short, the recent breakthrough of institutional economics, helped by ever more evidence on the ground, convincingly demonstrates what stands behind the door of economic growth. And no matter whether a country is ex-communist or a long-lasting democracy, if it wants to grow wealthy or just to continue to ride the gravy train it needs to ride on the right track, already paved by economic theory.