Entrepreneurship and growth: a Latin American paradox?

• Author: Larroulet, Cristian
• Position: Essay

In recent Latin American history, economists have advanced many different recipes to promote the region's economic growth. Given these differences of professional opinion and the region's on-again, off-again development, populism and political instability have been frequent responses to economic setbacks in many countries.

That economic growth continues to be discussed as a mystery seems, in any case, surprising to us. A convincing argument can be made that economic growth is intimately related to the development of productive entrepreneurial activities in the context of an appropriate institutional setup. Historical evidence shows that the great improvements in standards of living achieved during the past two centuries have been associated with the development of personal resourcefulness and ingenuity under a system of private-property fights and contractual liberty (Landes 1999; Baumol 2002). To be sure, entrepreneurship may take various forms, and certain forms are antithetical to economic growth, so we must bear this fact in mind as we develop our arguments here.

In this article, we examine the evolution of entrepreneurship in Latin America as presented in the Global Entrepreneurship Monitor (GEM) studies. These studies present a key set of internationally comparable statistics on entrepreneurship, which have supplied the data for important studies of the role and determinants of entrepreneurship. Here we propose another study along these lines, relating changes in entrepreneurship to changes in economic performance. We obtain an apparently paradoxical result: Latin America has high levels of entrepreneurship, but relatively modest rates of economic growth. Is it possible that, after all, entrepreneurship does not matter much for economic growth? Or is Latin America somehow immune to the beneficial effects of entrepreneurship? We attempt to explain this apparent puzzle.

Economic Growth and Entrepreneurship

Economic growth has been studied extensively over the years. In a highly influential contribution to economic theory, Robert Solow (1956) identified technological progress as the key to a process of sustained growth. Yet Solow's neoclassical growth model, however useful it might have been in accounting exercises related to the sources of sustained growth, failed to explain the causes of such growth.

Developments in the field of endogenous growth theory may be seen as attempts to deal with this fundamental problem. The point of departure for these developments was the fact that the neoclassical model explained growth by relying on an exogenous factor, technological progress, which was not explicitly modeled. Endogenous-growth theorists took into consideration that agents can make conscious decisions to invest in technology, whether in the form of physical innovations, new knowledge, or specialized human capital. (1) Moreover, to the extent that these investments take forms with increasing returns to scale, they serve as a mechanism for attaining a process of sustained economic growth (Romer 1986, 1990; Lucas 1988).

More recently, attention in the literature has focused on the role that institutions play in upholding responsible economic policies, respecting the principles of private property and contract, and hence promoting economic growth. Institutions determine the structure of incentives in the economy. William Easterly (2001) has been especially effective in arguing that because people respond to incentives, when a nation's incentive structure is not set up correctly, the agents who interact under those rules may not find it advantageous to undertake growth-enhancing activities. In modern times, these ideas owe a great deal to Douglass North's (1990) work. Today, economists and professionals in the field of development economics widely appreciate these observations on the relationship between institutional design and economic performance (see Acemoglu, Johnson, and Robinson 2005).

The relevance of these contributions notwithstanding, we believe that entrepreneurial effort is ultimately the key element in the process of economic growth. Entrepreneurship is human action (Mises [1949] 1996), and such action, expressing human ingenuity and creativity, is, as Ludwig von Mises and Israel Kirzner have emphasized, the driving force of economic growth. Although modern economic theorists recognize that economic agents do not act in a vacuum and that they respond to incentives (that is, institutions do guide individual choices), the fundamental point remains that entrepreneurship, understood as purposeful behavior, represents the ultimate source of innovation and economic progress.

In Kirzner's (1973) well-known model of entrepreneurship, this predisposition toward entrepreneurship involves recognizing ("discovering") previously unnoticed opportunities for profit in the economic system. Action based on this recognition leads to a greater degree of coordination of economic agents' plans. Moreover, to the extent that entrepreneurs reallocate scarce resources to more valuable uses, they may also be said to promote economic growth (Steele 1998).

Joseph Schumpeter has more thoroughly and convincingly explained the specific mechanism by which entrepreneurship influences economic growth in his classic books The Theory of Economic Development (1934) and Capitalism, Socialism, and Democracy (1950). As emphasized in the former work, entrepreneurship plays the key role in driving the process of economic development. Schumpeter also describes clearly the mechanisms through which entrepreneurs act. In his framework, innovation is the central activity undertaken by entrepreneurs, who, as personality types, are leaders, not followers. For Schumpeter, entrepreneurship influences economic growth through the well-known process of "creative destruction," described and analyzed in Capitalism, Socialism, and Democracy: new innovations cause constant change in the marketplace, where competition occurs not only at the margin, but at the very foundations of existing firms. The upshot is a continuous process of business firms' entry and exit, leading to ongoing increases of total factor productivity and thus to high rates of economic growth. (2)

Despite economists' fascination with the study of markets, few seem to recognize the fundamental relevance of this type of dynamic competition and the key role that entrepreneurs play in it for economic growth. Arnold Harberger, a long-time student of economic development, may be an exception; he shows an awareness of this issue in his 1998 treatment of rising total factor productivity as a Schumpeterian entrepreneurial process. Other studies that consider market rivalry as a key factor in economic growth (for example, Aghion and Howitt 1992; Peretto 1998) do not account properly for the entrepreneur himself in this process.

The importance of entrepreneurial activities appears much more clearly in the work of economists who are also interested in the analysis of comparative economic systems (again, Schumpeter's work is germane). The difference between progressing and retrogressing (or stationary) societies is that the former have productive entrepreneurs. In a recent work, William Baumol (2002), who over the years has undertaken a vigorous research program on the economics of entrepreneurship, argues convincingly that the "growth miracle of capitalism" is inextricably linked to the innovation efforts spurred by a competitive system in a setting where private property and contract are respected. In different works, Baumol has placed greater or lesser emphasis on the role of individual entrepreneurs as promoters of this innovation; in the 2002 work cited, for example, he underscores the relevance of what we may call a corporate form of entrepreneurship, firms caught up in a fierce process of oligopolistic competition. The entrepreneur's role in driving the engine of economic growth features prominently in his important 1990 article on "productive, unproductive, and destructive" entrepreneurship, where institutional considerations decisively affect the allocation of entrepreneurial effort.

Recognition of how entrepreneurs advance economic growth has important policy implications. Let us consider two different scenarios. If we assume that entrepreneurship is not uniformly distributed across the population or across countries, we will be led to conclude that low-growth countries simply do not have enough entrepreneurs.

If we proceed more conservatively, however, by assuming that entrepreneurial ability is uniformly distributed across the population or across countries, low-growth countries are those in which the existing entrepreneurs are for some reason less productive. As Peter Boettke and Christopher Coyne (2006) have explained, the entrepreneurs' unproductiveness may reflect either a lack of profit opportunities owing to restricted markets or the growth-retarding nature of the entrepreneurial activities being undertaken, in the sense of "unproductive" and "destructive" entrepreneurship a la Baumol (1990). The allocation of entrepreneurship to these activities would spring from the nature of incentives determined by an economy's institutional matrix.

These alternative settings point to differences across countries either in the supply of entrepreneurship or in the allocation of a given supply of entrepreneurship to different types of activities. In this article, we focus on the relevance of the latter issue.

Entrepreneurship around the World

Research in the field of entrepreneurship is fortunate to have the GEM studies. GEM data sets, in particular, are an invaluable resource in shedding light on the evolution of entrepreneurship and its determinants because they provide an almost unique internationally comparable data set on entrepreneurial activities. (3) These studies measure entrepreneurship by a variable called "early-stage entrepreneurial activity," which identifies nascent...