The Puzzle of Growth

We now return to the core question of this part of the course. Why are some countries rich and other countries poor? I'm going to lay out various pieces of the puzzle keeping in mind that it's - it's a complex question with many factors at play which are still being debated.

Let's start with a simple example. How does a farmer goes from this to this? The most immediate reason that some countries are rich is that their workers are very productive. So how do workers become productive? Well, they work with more and better factors of production. That's the first piece of the puzzle. Rich countries - they have a lot of physical capital and a lot of human capital, and that capital is organized using the best technological knowledge. By physical capital, economists mean tools in the broadest sense: shovels, tractors cell phones, roads, buildings.... More and better tools make workers more productive. Human capital is tools in the mind or the stuff in people's heads that makes them productive. Human capital - it's not something we're born with. It's produced by an investment in education and training and experience.

Technological knowledge is knowledge about how the world works, such as an understanding of genetics, soil composition, chemistry. This is the research that informs the books that our farmer reads. The final factor, a factor which is often taken for granted - is organization. Human capital, physical capital and technological knowledge - they've gotta be brought together, they've got to be organized in a way that produces valuable goods and services. In a capitalist society, it's the entrepreneurs who bring ideas, people and capital together in order to produce valuable products.

So rich countries - they have a lot of factors of production. But that's a bit too easy. Why do the rich countries have more factors of production? We've got to go back to the basics. Incentives matter. That's the next piece of the puzzle. Let's give an example. In China during the Great Leap Forward of the late 1950's and early 1960's, private farms were confiscated and consolidated into collectives. Collective property meant that the incentive to invest and to work hard was low. Imagine that if you invest and you work really hard you can produce an extra bag of potatoes in, say, a day. If you're part of a 100-person collective, you don't take home an extra bag of potatoes, but only one, one-hundredth (1/100) of a bag.

What would be the incentives to work hard, to invest? When effort is divorced from payment there's very little incentive to work productively. In fact, there's a incentive not to work and to free ride on the work of others. As a result of this and many other errors on the part of the Chinese leadership, some 20 to 40 million Chinese farmers and workers starved to death during this terrible time. China did not begin to take off as an economic powerhouse until farmers were allowed to keep the product of their efforts. As one Chinese farmer observed, "You can't be lazy when you work for your family and yourself." If you're curious to learn more about China, do check out our website. So, incentives are important.

But now we've gotta ask, "Why?" Why do some countries have good incentives? And the answer is that they have good institutions. So which institutions create incentives that spur prosperity? Well the good news here is that there is considerable agreement about what the key institutions for economic growth are. For example, if you buy a piece of land and you build a farm, do you have an official deed of ownership? ...one that will stand up in a court if someone tries to build, say, a corporate headquarters on top of your farm? Property rights allow you to protect your investment. Our farmer also has to think about our government. She might have to bribe government officials to get permits or worry about the outright seizure of her farm. So honest government is another key institution that allows our farmer to invest.

In some places the legal system is of such poor quality that it can be difficult to resolve disputes, such as collecting on a debt, or even determining the ownership of a piece of property. A dependable legal system lets our farmer enforce contracts and borrow and lend money. But our farmer still needs more. Sometimes the problem isn't too much government but too little. Political instability and the threat of anarchy are reoccurring problems in many countries. Who wants to invest in the future when civil war threatens to wash away all of your plans? Political stability is needed to give investors confidence to invest. We're almost there now, but our farmer still has to worry about inefficient and unnecessary regulations - regulations which can create monopolies and impede voluntary cooperation. Competitive and open markets let market signals do their work, and they let the farmer innovate and grow her business. So, we've covered the key institutions that allow our farmer to prosper: property rights, honest government, political stability, a dependable legal system, and competitive and open markets.

But now we've gotta ask, "Well, why?" Why do some countries have good institutions? This is perhaps the most actively debated question in all of development economics. And here we must answer with a mysterious combination of history, ideas, culture, geography, even a little bit of luck. Take for instance the United States. The US Constitution was fortunately written at a time when the ideas of John Locke and Adam Smith were popular. And it inherited a tendency towards a market economy and democratic institutions from its colonial parent, Great Britain. An open frontier, and plenty of freedom to try new ideas and new ways of living, to leave the old ways behind and to go to the frontier. This idea of the frontier perhaps influences America's entrepreneurial culture even today. And we were also very lucky that George Washington had the virtue to stop at two presidential terms rather than trying to become the next king.

So, what makes some countries rich and some countries poor? Well it's complicated, and the answer differs depending upon whether we want to look at the immediate causes or the ultimate causes. And these processes are also interacting in a dynamic and changing environment. We do know some of the things that matter, however. And the example of growth miracles, like China, Korea and Japan - that's encouraging. It is possible for very poor countries to grow very quickly and to reach their true potential once better incentives and institutions are put into place.

In the next section, we're gonna dive deeper into the factors of production in order to create a simple, but useful model of economic growth. Thanks!