How Do Countries Become Rich?

Although I found econ prof Deirdre N. McCloskey’s Wall Street Journal article about the sources of American, British, etc. wealth thought-provoking and a good point of departure for reflecting not only on what was done in the past but what we might want to be doing in the future:

Nothing like the Great Enrichment of the past two centuries had ever happened before. Doublings of income—mere 100% betterments in the human condition—had happened often, during the glory of Greece and the grandeur of Rome, in Song China and Mughal India. But people soon fell back to the miserable routine of Afghanistan’s income nowadays, $3 or worse. A revolutionary betterment of 10,000%, taking into account everything from canned goods to antidepressants, was out of the question. Until it happened.

What caused it? The usual explanations follow ideology. On the left, from Marx onward, the key is said to be exploitation. Capitalists after 1800 seized surplus value from their workers and invested it in dark, satanic mills. On the right, from the blessed Adam Smith onward, the trick was thought to be savings. The wild Highlanders could become as rich as the Dutch—“the highest degree of opulence,” as Smith put it in 1776—if they would merely save enough to accumulate capital (and stop stealing cattle from one another).

Although I think there’s an element of truth in her preferred explanation, personal freedom:

If capital accumulation or the rule of law had been sufficient, the Great Enrichment would have happened in Mesopotamia in 2000 B.C., or Rome in A.D. 100 or Baghdad in 800. Until 1500, and in many ways until 1700, China was the most technologically advanced country. Hundreds of years before the West, the Chinese invented locks on canals to float up and down hills, and the canals themselves were much longer than any in Europe. China’s free-trade area and its rule of law were vastly more extensive than in Europe’s quarrelsome fragments, divided by tariffs and tyrannies. Yet it was not in China but in northwestern Europe that the Industrial Revolution and then the more consequential Great Enrichment first happened.

Why did ideas so suddenly start having sex, there and then? Why did it all start at first in Holland about 1600 and then England about 1700 and then the North American colonies and England’s impoverished neighbor, Scotland, and then Belgium and northern France and the Rhineland?

The answer, in a word, is “liberty.” Liberated people, it turns out, are ingenious. Slaves, serfs, subordinated women, people frozen in a hierarchy of lords or bureaucrats are not. By certain accidents of European politics, having nothing to do with deep European virtue, more and more Europeans were liberated.

I don’t think she’s got it quite right. Why did the United States and the countries of Western Europe become rich while China, India, etc. did not?

Let me begin my interpretation of events by explaining what borrowing and investment are. Borrowing is shifting future consumption into the present. Investment is postponing present consumption until some time in the future.

Armed with that let’s start listing the critical success factors for a country’s becoming rich. First, you need to be able to produce a surplus. That’s something that nomads, bands of hunter-gatherers, and subsistence farmers can’t do.

Second, you must be able to invest—to defer consumption. If your surplus is taxed away or if you consume everything you produce (or consume more than you produce by borrowing), you won’t become rich. Once modernization allowed the Japanese to grow beyond subsistence farming, Japan became rich in part because of distinctively Japanese cultural traits which encouraged Japanese people to invest rather than consuming what they produced.

Third, you must have not just one or two but a whole complex of institutions that support the accumulation of national wealth. Those include the rule of law, a sound currency, a government that maintains a fairly stable set of rules, and a general agreement that you should play by the rules.

I’m skeptical of Dr. McCloskey’s favored explanation for a number of reasons, the most important being that “liberty” is pretty hard to define and few countries including England have the absolutist sort of notions of freedom that have prevailed in the United States and to some extent still do. Germany is a rich country, too, and Anglo-American notions of liberty have never prevailed there.

And, most importantly, you do not have to resort to liberty as an explanation. Compound interest will do.