Much of our understanding of economic growth relies on what economists call the aggregate production function, which is the total output of an economy (its GDP) that results from a combination of various factors of production. The factors of production considered are labor (the total number of hours worked) and capital (equipment, factories, machines). By combining those two factors, companies are able to produce goods and services which increase a nation’s wealth. Sometimes land is included as a means to production, either as part of capital or as a separate factor.
When economists, most notably Robert Solow, came up with that idea in the late 1950’s, they realized that the model was incomplete, that labor and capital alone could not account for the amount of products and services produced in the US or elsewhere. That was in fact the whole point that Solow was trying to make: that the accumulation of labor and capital was insufficient to explain economic growth. One economist from that era referred to the unexplained factors as a ‘measure of our ignorance’. Those unexplained factors were bundled into one variable, initially referred to as the ‘Solow residual’ and nowadays more commonly known as ‘total factor productivity’. Much of it is assumed to be technological progress, both in terms of improved production processes but also more advanced products and services. But there are many other unexplained factors, possibly hundreds of them. Even unexpected ones such as the invention of air conditioning in warm climates has made a difference. The difficulty is finding out which of those numerous factors contribute the most to growth.
One factor which, in my view, is given too much attention is capital. Most developed economies provide annual figures for the proportion of labor in GDP. In the US, it is around 60% and has been in decline since the 1980’s. The share of capital in GDP is more tricky to calculate; recent estimates put it at 19%.
Whatever the actual share of capital may be, it is in fact largely irrelevant because of how quickly it can be accumulated or rebuilt. At the end of WWII, entire cities in Germany and Japan were destroyed. But over the course of the following decade, those nations were able to bounce back. Nowadays, reconstruction would be even quicker. Whilst we (thankfully) haven’t witnessed recent examples of industrialized nations having most of their capital destroyed, there have been more localized tragedies, such as the Sichuan earthquake in 2008 or the Fukushima disaster in 2011. In each case, the houses, factories and other dwellings were rebuilt within a year or two. My point is that the labor matters much more than capital, whatever the relative shares of labor and capital in total production may be. If a nation loses its capital but retains its people, it will quickly bounce back. But if it loses its people and retains its capital, it will struggle badly. People are by far the greatest asset a nation possesses in its quest towards prosperity.
If it really is all about the people, the question then becomes: how do people, with their skills, their values, their ability to organize themselves, manage to create wealth or on the contrary struggle to do so?
4 key factors
I see three main factors that truly determine a nation’s wealth:
- Population
- Hard work
- Free markets
Of course, if our focus is GDP per capital (and not GDP), then the first factor (a nation’s population) becomes irrelevant. Small nations can become very rich on a per capita basis, but will struggle to match the wealth of bigger nations. Switzerland, for all its wealth, is more than three times poorer than India, as measured by GDP.
In more detail:
1. Population
Should we consider population, active population or workers? Workers are really the ones that contribute to an economy by producing goods and services. But that supply would not be possible without a corresponding demand. Children, the retired and the unemployed may not be active in the labor market, but they consume. There are also measurement issues across countries when it comes to evaluating the active population and those employed. For those reasons, we focus on a nation’s actual population.
2. Hard work
This has been discussed at length in Values at the Core. The big question, assuming hard work as a contributor to growth is as important as we believe it to be, is how to measure it. I’ll discuss this point further in a separate article.
3. Free markets
Also discussed at length in Values at the Core. This is about meritocracy, free and fair competition, the ability for entrepreneurs to create new companies and enter new markets, the winding down of insolvent companies. Estimates of free markets across countries include the Index of Economic Freedom and the World Bank’s Ease of Doing Business Index.
Hard Work and Free Markets are both preconditions to becoming a rich nation. One without the other will not be sufficient. Societies with a hard-working population but devoid of free markets will achieve nothing (North Korea, China and India in the 1960’s and 1970’s). Societies with free markets but without a hard-working population will achieve some success, but will become stuck as middle-income nations and never reach the ranks of fully industrialized ones.
Shortcuts
Aside from those main factors, there are 3 ‘shortcuts’ to prosperity. Even countries without a hard-working or educated population and without free markets can still become very rich if they are able to take advantage of any of those 3 shortcuts:
1. Natural resources
Monetizing natural resources can be done without any of the 4 factors described above. No skilled or hard-working labor is required. Nor is there any need for well-functioning, competitive markets and institutions. Countries endowed with valuable natural resources can always hire foreign expertise to extract and commercialize their commodities. Consider Equatorial Guinea. Population of 1.4 million, mostly uneducated. One of the most corrupt places on Earth. And yet it is the richest nation in Africa on a GDP per capita basis. The only reason for their wealth is huge oil reserves and the fact that they have managed to remain fairly stable politically.
This factor is fairly easy to measure: most countries provide estimates of GDP per sector, whether it relates to energy, metals or agricultural products. Another way to look at it is to calculate the present value of estimated reserves or resources, but that quickly gets messy, so not a great alternative.
For countries that solely rely on their natural resources, the two biggest threats are instability, especially when a small elite benefits at the expense of the wider population; and a significant slowdown in revenues from their commodities, either because reserves are running out or because the value of the commodity is in (permanent) decline.
2. Becoming an offshore financial center (OFC)
Countries that became offshore financial centers and marketed themselves as a stable place of business have been able to attract foreign investments in a much larger proportion compared to the size of their economy. Malta, the Cayman Islands, Mauritius derive most of their income from their position as OFC’s. Dubai, Singapore, Hong-Kong, Ireland have also, to some extent, acted as OFC’s.
OFC’s are often viewed negatively because of minimal tax rates and their involvement in money laundering scandals, but they also play an important role as providers of financial services.
3. Economic integration
The third ‘shortcut’ is for a country to have its economy integrated within larger, wealthier trading partners. This allows local companies to tap into new markets by exporting their cheaper products or services. It also allows companies in the richer countries to capitalize on a cheaper workforce by relocating their operations. When the European Union expanded to southern Europe and Ireland, those peripheral countries grew their economies much faster. As did countries after joining the WTO. As will the poorest south-eastern nations that joined RCEP last year. But in some cases of economic integration, there have been few gains. Mexico’s economic performance since joining NAFTA in 1994 has been rather weak, compared to other Latin American countries.
Poorer countries will benefit from free trade agreements, whether they are bilateral, regional or global, as long as they are able to compete with richer countries (they can easily compete on price; the question is, can they compete on quality?).
Taking this forward
Economic development is a rather crowded space, which is understandable given the implications of what it would mean to resolve it. Countless economists and authors have come up with their own explanations, focusing what they believe are the key factors leading to long-lasting growth. In their academic research and published books, they explain why other theories are unconvincing and why theirs makes the most sense. Admittedly, we have done the same thing in Values at the Core. The latest example in a long list of authors that claim to have uncovered the holy grail of economic development is hedge fund manager Ray Dalio’s Principles for Dealing with The Changing World Order, published last month, in which he argues that countries go through long (50-70 years) cycles of debt and inflation.
The fact that there is no consensus on what those main factors are and that many counter-examples exist to invalidate each theory is evidence that we are not there yet. Probably the economic growth theory that has acquired the greatest legitimacy is Acemoglu and Robinson’s idea of inclusive or extractive institutions. The main counter-example to their theory is China, which has thrived despite institutions that could hardly be labelled as inclusive.
My objective is a highly ambitious one. I’d like to come up with a falsifiable theory, possibly in the form of a mathematical equation, that would accurately calculate the GDP of any country at any point in time and would also accurately predict future GDP.
If history serves as a guide, this attempt at explaining and forecasting the rise and fall of nations, like so many others before it, is doomed to fail. Despite the unfavorable odds, I am very keen to give it a try and see where this may lead to.
How do economies work? 