Public policy, human instincts, and economic growth.

• Author: Wight, Jonathan B.
• Position: Essay

Economic growth occurs whenever people take resources and rearrange them in ways that are more valuable.

--Paul Romer, "Economic Growth"

The world does not appear to make sense. If it did, Botswana would be as miserable and poor as its neighbor Zambia. Instead, Botswana's standard of living of more than $13,000 per person is more than eight times higher, its literacy rate is 12 percentage points greater, and its infant mortality rate is 68 percent lower (World Bank 2010). According to many conventional theories of development, Botswana would never be a candidate for success: it is a sparsely populated country that does not enjoy economies of scale or scope in manufacturing. It is landlocked, with high transactions costs for interacting with global markets. The terrain consists of many deserts and swamps that limit agriculture, but it allows for small and large cattle pastures. Botswana was a British protectorate until 1966 and retained local elites after independence. The country does have diamonds, but other African nations with valuable resources suffer civil wars over them; oil-rich Libya has stable political rule but languishes with roughly the same standard of living today as it had thirty years ago. Despite all the odds, Botswana somehow made the list of the thirteen top "success" stories heralded by the Commission on Growth and Development (2008); it was the only African country to be so honored.

What is the secret of Botswana's success? Is it a fluke, a happy accident? Or is Botswana's feat the result of sensible government plans and policies? If institutions and policies play a reliable role in creating economic progress, can these constructs be readily transferred to other countries? The answers to these questions are not simple. Although markets and stable governments are associated with growth, it is nearly impossible to say how a particular institution or policy would fare in a new legal, cultural, and social setting without supportive complementary institutions and policies. Like transplanted human organs, some institutional transplants are rejected. After sixty-five years of promoting development through financing capital flows to developing countries, the World Bank's own economists despair over their failure to generate growth in Africa (Easterly 2007). Predictions across borders are notoriously poor, and numerous countries followed the "right" policy advice to no avail (see, for example, Stiglitz 2003).

Alfred Marshall (1920) famously insisted that economics is more like biology than physics. Societies are organic ecologies that evolve and produce organized but unplanned complexity (Hayek 1979). Although no public policy reliably produces economic growth across all ecosystems, a key element unites diverse institutions and policies that do seem to work: they all are reasonably compatible with human instinct. Institutions that build on the basic instinct for self-betterment (as in markets) have a much easier time in achieving success than institutions that oppose it (as in communism). Instincts, like gravity, are a force of nature. Adam Smith theorized, for example, that the natural propensity to "truck, barter, and exchange" ([1776] 1981, 25) initially arose not from the impulse for financial reward, but from the social urge to share beliefs and to persuade others (1982a, 493). Exchange spurs growth because it is compatible with deep human intuitions. Sisyphus was the Greek king condemned to push a heavy rock up a hill but never to succeed. Such is the fate of modern-day Cubans, laboring under statist policies that limit their expression of the human experience through exchange.

Diverse institutions and policies can work reasonably well with human instincts, however. Time and place create a path-dependent limitation of feasible options. Nevertheless, such historical processes have not kept modern economists from trying to uncover a few key policies that hold the greatest promise for growth. In this article, I explore the fascinating debates in growth theory and public policy of the past half-century. Adam Smith's theories suggest a practical way to understand how public policies can work with instincts to create economic progress.

A Short History of Growth Theory

Modern mainstream economists like to build simple predictive models. Occam's razor limits the analysis to a few variables, and we hope we can identify the key one that dissolves bottlenecks and brings about rapid growth. Popeye the Sailor had a magic remedy--spinach--that instantly transformed him. Sleeping Beauty needed only a kiss to undo her paralysis. Every generation creates its own mythology about what causes economic takeoff. Stalin thought he had found a panacea in communism, which stabilized investment spending through government ownership. Mao thought he could improve on this approach by mandating a steel mill in every backyard.

Autocrats are not the only deluded ones. In the 1950s, Western economists also had a captivating vision: that economic growth happens through capital infusions from rich countries to poor countries (just as the Marshall Plan apparently had worked in Europe). This theory can be illustrated with a biology metaphor. In an experimental setting, one can vary the amount of fertilizer and record the effect on plant growth, holding constant the type and quality of soil, the amount and intensity of sunlight, the amount of water and humidity, and so on. Initial doses of fertilizer will likely have greater effects on plant growth than later doses. Using this information, an omniscient planner might determine how to subsidize fertilizer usage so as to achieve the desired plant size.

Economists undertake mental experiments of exactly this type. Robert Solow's (1956) growth model predicts that greater amounts of capital investment per worker--holding all else constant--leads to an increase in output per worker. As with fertilizer, Solow anticipated diminishing returns to capital. Given a certain rate of savings, a country would eventually reach an equilibrium level of capital per worker and a corresponding equilibrium output per worker. A policymaker can potentially raise the living standard by promoting capital "deepening"; that is, an investment tax credit can increase the equilibrium amount of capital per worker. But such policies produce only temporary gains, and the economy eventually stabilizes at a new level. Tax policies cannot lead to sustainable growth in per capita income.

In the real world, we cannot do experiments on whole societies. When some countries experience rapid growth, it may be because they have the "fertilizer" of added capital, but growth is likely the result of something else that is changing. When Solow measured the impact of capital deepening on economic output, he reached a startling conclusion: more than 85 percent of the observed increase in output per worker did not derive from greater capital investment--it came from unknown sources (1957, 320). But what are the mysterious factors that produce growth? Solow did not know and simply declared that "technical change" had shifted up the production function (1957, 312). The terminology unfortunately suggests an improvement in machinery (for example, a faster computer). In fact, productivity enhancements may derive from institutions such as laws and norms and from the intangible qualities of inputs. One of Adam Smith's key contributions in The Wealth of Nations([ 1776] 1981), for example, was to highlight the role of exchange in competitive institutions.

The launching of market reforms--in China after 1978, in Latin America in the 1980s, in India and eastern Europe in the 1990s--presaged the widespread recognition that global exchange shifts up growth parameters.

Although economists generally agree on the desirability of markets, they disagree about which public policies work best with markets to produce short- or long-term growth. "New" growth theorists, such as Paul Romer (1990), try to rectify this uncertainty by predicting how public policies enhance productivity. The proposals for ramping up development in the twenty-first century--depending on the source--are strengthened legal systems and property rights (De Soto 2003), greater freedom (Friedman...