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More than two
hundred years ago, Adam Smith offered the
first comprehensive examination of why some
countries are able to grow and have high
standards of living while others make little
progress. In The Wealth of Nations,
Smith put forward a number of explanations for
the different paths that countries follow. He
accurately identified capital accumulation,
free trade, an appropriate--but
circumscribed--role for government, and good
"institutional infrastructure" as
key drivers of national prosperity. Perhaps
most important, he emphasized the role of
personal initiative:
The natural effort of every
individual to better his own condition, when
suffered to exert itself with freedom and
security, is so powerful a principle, that
it is . . . capable of carrying on the
society to wealth and prosperity . . .1
In his writings, Smith gave
us an invaluable start in our efforts to
answer what is probably the most important
macroeconomic question, that is, "What
makes an economy grow?" In this very real
sense, we are Adam Smith's intellectual
descendants. We are still endeavoring to craft
answers to questions similar to the ones he
asked and, we hope, learning what policies and
institutions are best able to create wealth
and so enable nations to prosper.
The debate regarding the
sources of economic growth has markedly
twisted and turned in recent decades.
Following World War II, some countries seemed
to pull back from the free-market paradigm
articulated by Adam Smith. Many observers
interpreted the economic turmoil of the Great
Depression as a sign that free markets were
flawed, and they increasingly looked to the
apparently successful efforts of wartime
planned economies. They thought that perhaps
governments could also coordinate the far more
complex activities of civilian economies.
These more interventionist
attitudes toward economic policy implied
increased regulation of industry, greater
government ownership of productive assets,
higher tax rates to fund broadened social
welfare initiatives, and in some instances
controls on wages and prices. These policies
were believed to improve the functioning of
markets and to maintain economic stability and
growth. Not until the 1970s--and the economic
difficulties of that decade--did the
realization finally take hold that market
incentives had been reduced and that we were
losing the dividend of efficient uses of
resources that such incentives provide. Even
those observers who derided the more unbridled
forms of capitalism became increasingly aware
that attempts to tame the market could be
costly in terms of economic growth and the
average living standards of a nation.
Over
the past thirty years, as many countries have
struggled to liberalize their economies and
improve the quality of their policies, global
per capita income has steadily risen.2
I recognize that poverty rates are notoriously
hard to quantify, but according to a recent
study, the share of the world's population
living on less than $1 per day, a commonly
used poverty threshold, has fallen
dramatically over the past three decades--from
17 percent in 1970 to 7 percent in 1998,
representing a decline of 200 million people.3
In addition since 1970, the infant mortality
rate has declined by more than half, school
enrollment rates have risen steadily over the
past thirty years, and literacy rates are up.4
While,
from a global perspective, wealth and the
overall quality of life have risen, that
success has not been evenly distributed across
regions or countries. The economies of East
Asia are often-repeated success stories. Some,
including China, Malaysia, South Korea, and
Thailand, stand out not only as growing very
strongly, but also as having seen the greatest
declines in poverty rates. Overall, over the
past three decades, Asia's $1 per day poverty
rate fell by one measure from 22 percent in
1970 to just 2 percent in 1998.5
Moreover, Asia was not alone. Per capita
incomes in Latin America also expanded during
the period, and poverty rates fell, although
progress was somewhat slower.6
But,
sadly, the story in Africa has been quite
different. Levels of per capita income in that
continent have actually fallen.7
The poverty rate, which in 1970 matched the
rate in Asia at the time, is estimated to have
doubled to 40 percent by 1998.8
While Africa's performance has clearly been
subpar, some African countries have had some
success. For example, Botswana, Lesotho, and
more recently Uganda have made some progress
in raising per capita income growth and
reducing poverty rates.9
Modern economic analysis has
confirmed much of what Adam Smith inferred
from a far less impressive set of data.
Today's economists generally point to three
important characteristics influencing growth:
(1) the extent of a country's openness to
trade and its integration with the rest of the
world, (2) the quality of a country's
institutional infrastructure, and (3) the
success of its policymakers in implementing
the measures necessary for macroeconomic
stability.
By openness and integration
we generally mean the ability for goods and
services, capital, and more broadly, the flow
of information, people, technology, and ideas
to move across the borders of a country. This
freedom of movement may enhance growth by
intensifying competitive pressures, increasing
specialization, and allowing access to larger
markets.
Free
trade allows the more efficient use of
resources which, in turn, raises both the
productivity of the domestic workforce and the
level of national income. Adam Smith cited
comparative advantage. He observed:
If a foreign country can
supply us with a commodity cheaper than we
ourselves can make it, better buy it of them
with some part of the produce of our own
industry employed in a way in which we have
some advantage.10
One
recent study of the effects of openness on
growth demonstrated that when countries are
divided into two groups--those with generally
open economies and those with generally closed
economies--open economies have experienced
average growth that is 2 ½ percentage points
higher than the growth of closed economies.11
Furthermore, when developing economies are
ranked according to their historical record of
openness, economies such as Hong Kong,
Malaysia, Singapore, and Thailand are near the
top of the list.12
These Asian economies are some of the same
ones that participated in the region's
so-called growth miracle.
For another example of a
country that has benefited from free trade, we
need look no further than Mexico--our host
today. During the early 1980s, Mexico's
non-oil merchandise exports were running a bit
below $10 billion a year, or about 5 percent
of its gross domestic product. By 2001,
however, Mexico's exports of such goods had
soared to more than $145 billion, or nearly 24
percent of GDP. The strength of exports has
contributed importantly to the ongoing
transformation of Mexico's economy. A good
portion of this export growth has occurred in
the context of the North American Free Trade
Agreement, but the most important effects of
NAFTA may be the increased openness of
Mexico's domestic economy and the associated
policy reforms.
A second characteristic that
economists have identified as influencing a
country's ability to grow is termed its
"institutional infrastructure." By
this we mean the institutions that help make
an economy work, such as a functioning legal
system, which ensures the rule of law and
protects property rights. These institutions
are responsible for setting the "rules of
the game" and ensuring that those rules
are observed.
Sound institutions provide
the backdrop against which markets operate.
They foster confidence that contracts will be
honored, that debts will be paid, and that the
gains from sound investments will not be
stolen or expropriated.
Researchers
in recent years have found that the rule of
law--defined as a system that emphasizes
creditor rights and rigorously enforces
contracts--facilitates the development of an
efficient banking system and financial markets
more generally; this development, in turn,
supports growth.13
The quality of the institutions in a
country--such as a sound regulatory
environment, political stability, and the
control of corruption--have important effects
on growth.14
Economies with a high quality of governance,
relative to other economies in their regions,
including Hong Kong and Singapore in Asia,
Chile in South America, and Botswana in
Africa, have had some of the fastest growth
rates in their respective regions in recent
decades.15
The
quality of a country's educational system is
clearly a significant part of its broader
institutional infrastructure. Policies that
foster the human resources of a country
improve growth. Many studies exhibit a link
between education and growth, with some
showing that even a small increase in average
education can lead to a sustained rise in the
rate of economic expansion.16
Finally, an undeniable
determinant of economic growth is
macroeconomic stability--having fiscal,
monetary, and exchange rate policies that are
sound and predictable. A prudent government
sets, among other things, the long-run course
of policy variables such as inflation, the
government budget deficit, and debt at levels
that are conducive to, or at least do not
impede, growth. For developing countries, the
management of debt denominated in foreign
currencies has been especially nettlesome.
In all economies, political
constituencies seek to employ the powers of
the state to increase their share of limited
national resources. While the record of
developed economies is far from unblemished,
they have had greater success in fending off
such demands. One indication of that success
is that exchange-rate regimes have not often
been upended by domestic political pressures
in these economies.
Although the range of
outcomes has been wide, many emerging-market
nations have had less success in insulating
their international financial positions from
domestic political pressures. Those pressures,
at times, have become exceptionally difficult
to deal with. To close the gap between the
financial demands of political constituencies
and the limited real resources available to
their governments, many countries too often
have bridged the difference by borrowing from
foreign investors. In effect, the path of
least resistance has been external borrowing,
usually at the lower interest rates of
internationally tradable currencies, rather
than confronting politically difficult
tradeoffs.
Periodically, as an economy
borrows its way to the edge of insolvency with
debt denominated in foreign currency,
government debt-raising capacity appears to
vanish virtually overnight. This vanishing
capacity characterizes almost all financial
crises. Lending institutions will provide
funds beyond the immediate visible short-term
cash flow of a borrower only if they perceive
that maturing debt will be rolled over. The
first whiff of inadequacy in debt-raising
capacity induces a run to the exits--not
unlike a bank run. Thus, an economy's
necessary condition for solvency--indeed, a
necessary condition for economic growth--is
the maintenance of significant unused
financing capacity. Too often governments have
endeavored to contain impending debt crises
with inflationary policies that inhibit
growth.
Controlling
inflation is essential to creating an
environment of sustained growth. Once
inflation gets above a certain point, it has a
large negative effect on growth, according to
most research. Stanley Fischer, for example,
concluded that if a country with inflation of
10 percent becomes a country with inflation of
110 percent, its annual growth rate would fall
4 percentage points; the consequences of this
for standards of living can hardly be
overemphasized.17
This effect may help to explain why East Asia,
where inflation has been relatively low on
average, has been more successful than Latin
America, where many countries have suffered
bouts of hyperinflation.
More
generally, Latin America provides a good
example of both the deleterious effects of
macroeconomic instability and the benefits of
putting sound policies in place. Between 1975
and 1990, when many Latin American countries
struggled with large budget deficits and high
inflation, average per capita income in these
countries expanded at a pace of just ½
percent per year.18
Economic performance in the region improved
markedly in the early 1990s, as these
countries reduced inflation, liberalized their
foreign exchange regime, increased their
openness to trade, and developed their
financial markets.19
More recently, while Argentina, Brazil, and
several other countries in the region have
experienced economic disruptions, Mexico and
Chile have remained relatively insulated,
apparently reflecting market confidence that
these countries are committed to sound
policies.
Mexico is a particularly
interesting case. In the two decades before
1995, the Mexican economy suffered several
severe crises. Yet in recent years, with the
implementation of NAFTA, a floating exchange
rate regime, relatively stable fiscal
policies, and much lower inflation, Mexico's
vulnerability appears to have declined
markedly. This country now seems to be viewed
by international investors as a relative
"safe haven" within the region.
As
Easterly and Levine indicate, much of Africa's
plight can also be linked to macroeconomic
instability. Empirical evidence suggests that
Africa's large government budget deficits,
underdeveloped financial markets, and
black-market foreign-exchange premiums (which
likely proxy for a host of deficiencies in the
financial and legal system) apparently explain
roughly half the growth divergence between
East Asia and Africa over the past several
decades. In other words, these results suggest
to Easterly and Levine that growth of per
capita annual income in Africa would have been
about 2-1/2 percentage points a year higher
had countries in Africa followed policies
adopted by the East Asian economies.20
Central bank independence
has not received a great deal of attention in
the recent literature on growth. Given the
importance of keeping inflation under control,
the policies of the central bank--and the
freedom of the central bank to set those
policies without political intervention--can
play a key role in creating an environment
conducive to growth.
Empirical
evidence for industrial countries indicates
that countries with a higher degree of central
bank independence are also generally countries
with lower rates of inflation.21
In emerging markets and transition economies,
the evidence of an association between
measured central bank independence and
inflation rates is not well-established,
although a couple of very recent studies do
find a negative relationship.22
To sum up, none of today's
recognized fundamental determinants of
growth--openness, institutional
infrastructure, and macroeconomic
stability--are recent insights. Adam Smith and
his colleagues proffered them more than two
centuries ago. Yet assuming that Smith's
complex insights into what creates the wealth
of nations are accurate, why have they been
embraced and largely implemented by some
societies and not others? As history amply
demonstrates, unless a broad majority of a
population implicitly or otherwise believes
that a competitive free market paradigm
advances their welfare, it cannot for long be
imposed on them by an authoritarian or even a
democratically elected government.
That an "invisible
hand" converts self-centered behavior
into a greater good is a profoundly abstract
notion that--while largely, but by no means
fully, embraced by developed nations--has been
held only tentatively, even recently, by many
developing nations. If not in some sense seen
as generally equitable and fair, the
distribution of income that emerges from
competitive free-market capitalism will not
have the support in law that is a necessary
condition for markets to produce wealth. Now
that the central planning paradigm of earlier
decades has been largely discarded, the
differential rewards of competitive markets
based on skill do seem to be accepted though
rewards from what is perceived as monopolistic
or corrupt are not.
It is hence incumbent on
those of us who see broader and market-based
globalization as fundamental to the creation
of wealth to defend and advocate the tenets of
Adam Smith.
References
Alesina, Alberto, and
Lawrence H. Summers (1993), "Central Bank
Independence and Macroeconomic Performance:
Some Comparative Evidence," Journal
of Money, Credit, and Banking, vol. 25
(May), pp. 151-62.
Barro, Robert J. (1997), Determinants
of Economic Growth: A Cross-Country Empirical
Study, Cambridge, Mass.: MIT Press.
Cukierman, Alex, Geoffrey
Miller, and Bilin Neyapti (2002),
"Central Bank Reform, Liberalization, and
Inflation in Transition Economies: An
International Perspective," Journal
of Monetary Economics, vol. 49 (March),
pp. 237-64.
Easterly, William, and Ross
Levine (1997), "Africa's Growth Tragedy:
Policies and Ethnic Divisions," Quarterly
Journal of Economics, vol. 112
(November), pp. 1203-50.
Easterly, William (2001), The
Elusive Quest for Growth: Economists'
Adventures and Misadventures in the Tropics,
Cambridge, Mass.: MIT Press.
Fischer, Stanley (1993),
"The Role of Macroeconomic Factors in
Growth," Journal of Monetary
Economics, vol. 32 (December), pp.
485-512.
Gutierrez, Eva (2002),
"Inflation Performance and Constitutional
Central Bank Independence: Evidence from Latin
America," IMF Working Paper (June).
Kaufmann, Daniel, Aart Kraay,
and Pablo Zoido-Lobaton (1999),
"Governance Matters," World Bank
Policy Research Working Paper No. 2196.
Levine, Ross (1998),
"The Legal Environment, Banks, and
Long-Run Economic Growth," Journal of
Money, Credit, and Banking, vol. 30
(August, pt. 2), pp. 596-613.
Levine, Ross, and Sara
Zervos (1998), "Stock Markets, Banks, and
Economic Growth," American Economic
Review, vol. 88 (June), pp. 537-58.
Sachs, Jeffrey, and Andrew
Warner (1995), "Economic Reform and the
Process of Global Integration," Brookings
Papers on Economic Activity, 1995:1, pp.
1-118.
Sala-i-Martin, Xavier
(2002), "The World Distribution of Income
(Estimated from Individual Country
Distributions)," National Bureau of
Economic Research Working Paper 8933.
Smith, Adam (1776), An
Inquiry into the Nature and Causes of the
Wealth of Nations, 5th ed. (edited by
Edwin Cannan, 1930), vols. I and II, London:
Metheun and Co.
World Bank (2002), World
Development Indicators, Washington, D.C.
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