Why Are Some Countries Rich And Others Poor? More than two centuries ago, Adam Smith wrote the book that is generally credited with initiating the science of economics. The central question he addressed is contained in its title, An Inquiry into the Nature and Causes of the Wealth of Nations. What is amazing is how prescient Smith was. Almost everything he said 240 years ago is still true today. Modern economic studies are confirming it. Think of an economy as reflecting three fundamental features: capital, labor and what I will call the “efficiency factor.” A country’s stock of capital consists of machinery, buildings, land, etc. Labor consists of the country’s human resources that are used in production. The efficiency factor determines how well the country turns capital and labor into output. Now let’s jump to the bottom line: which of these three factors is most responsible for differences in GDP per person in countries around the world? The answer: it’s the efficiency factor. A new paper by Stanford University economist Charles Jones surveys the most recent economics literature and reports that across 128 countries. What causes a “misallocation of resources”? In Smith’s day and in the country where he lived (Britain) it was mainly bad government policy. Under mercantilism, the British crown established monopolies that were protected against the rigors of competition in the marketplace. Tariffs and quotas did much of the same thing. Medieval guilds operated under anticompetitive conditions – controlling output, prices and entry into such crafts and trades as textile workers, masons, carpenters, carvers, glass workers, etc. As we look around the world today, we see many vestiges of these practices plus new ones – government created labor monopolies, currency controls, land use controls, etc. Plus, Hernando de Soto has brought our attention to something else. In Adam Smith’s England the existence of stable government and the rule of the common law was taken for granted. In many parts of the world, that is not the case. In the outskirts of Lima, Peru, for example, de Soto describes highly entrepreneurial capitalistic communities. These “informal economies” operate with very little government interference or governmental protection. In one sense you could call these economies “laissez faire.” But they lack the institutions of capitalism. That is, they lack access to a system of courts that enforce contracts. They lack access to a “night watchman” who protects property rights. Let’s return to our simple picture of economies as having capital, labor and an efficiency factor. Capital is valuable because it increases output directly and also because it increases the productivity of labor. Yet Jones reports that capital-output ratio is remarkably stable across countries. Its average value is very close to one, meaning that an extra dollar of capital gives you an extra dollar of output. Even the poorest countries tend to have a capital-output ratio very close to the U.S. value. So differences in physical capital contribute almost nothing to differences in GDP per worker across countries. It has also been documented that the marginal product of capital is very similar in rich and poor countries. What about labor? Because of difference in education and skills, the level of human capital per worker differs considerably among countries around the world. “Loosely speaking, the poorest countries of the world have 4 or 5 years of education, while the richest have 13,” writes Jones. But the contribution of education is still modest. Take the United States and Mexico. GDP per worker is 3 times higher in the U.S. than in Mexico. About 40 percent of this difference is due to inputs – mainly the difference in educational levels between the two countries. But fully 60 percent is due to efficiently, as reflected in the difference in institutions. Going forward, traditional economic theory teaches that with similar institutions, the economies around the world will tend to converge. That is, poorer countries will grow faster, while wealthier economies grow slower. But that is not happening. Jones writes: [a] simplistic view of convergence does not hold for the world as a whole. There is no tendency for poor countries around the world to grow either faster or slower than rich countries. For every Botswana and South Korea, there is a Madagascar and Niger. Remarkably, 14 out of 100 [countries] exhibited a negative growth rate of GDP per person between 1960 and 2011. Overall, the picture that emerges from this kind of analysis is that there is a basic dynamic in the data for the last 50 years or more that says that once countries get on the “growth escalator,” good things tend to happen and they grow rapidly to move closer to the frontier. But if a country doesn’t get on the growth escalator, things may not improve at all. That is worrisome – especially if you care about international inequality of income and wealth.