The Little Book of Economics

John Wiley & Sons

Chapter One

How People, Capital, and Ideas Make Countries Rich

Pop quiz: The year is 1990. Which of the following countries has the brighter future?

The first country leads all major economies in growth. Its companies have taken commanding market shares in electronics, cars, and steel, and are set to dominate banking. Its government and business leaders are paragons of long-term strategic thinking. Budget and trade surpluses have left the country rich with cash.

The second country is on the brink of recession, its companies are deeply in debt or being acquired. Its managers are obsessed with short-term profits while its politicians seem incapable of mustering a coherent industrial strategy.

You've probably figured out that the first country is Japan and the second is the United States. And if the evidence before you persuaded you to put your money on Japan, you would have been in great company. "Japan has created a kind of automatic wealth machine, perhaps the first since King Midas," Clyde Prestowitz, a prominent pundit, wrote in 1989, while the United States was a "colony-in-the-making." Kenneth Courtis, one of the foremost experts on Japan's economy, predicted that in a decade's time it would approach the U.S. economy's size in dollar terms. Investors were just as bullish; at the start of the decade Japan's stock market was worth 50 percent more than that of the United States.

Persuasive though it was, the bullish case for Japan, as fate would have it, turned out completely wrong. The next decade turned expectations upside down. Japan's economic growth screeched to a halt, averaging just 1 percent from 1991 to 2000. Meanwhile, the United States shook off its early 1990s lethargy and its economy was booming by the decade's end. In 2000, Japan's economy was only half as big as the U.S. economy. The Nikkei finished down 50 percent, while U.S. stocks rose more than 300 percent.

What explains Japan's reversal of fortune and its decade-long economic malaise? Simply put, economic growth needs both healthy demand and supply. As is well known, Japan's demand for goods and services suffered when over-inflated stocks and real estate collapsed, saddling companies and banks with bad debts that they had to work off. At the same time, though less well known, deep-seated forces chipped away at Japan's ability to supply goods and services.

The supply problem is critical because in the long run economic growth hinges on a country's productive potential, which in turn rests on three things:

1. Population

2. Capital (i.e., investment)

3. Ideas

Population is the source of future workers. Because of a low birth rate, an aging population and virtually nonexistent immigration, Japan's working-age population began shrinking in the 1990s. A smaller workforce limits how much an economy can produce.

Capital and ideas are essential for making those workers productive. In the decades after World War II, Japan invested heavily in its human and economic capital. It educated its people and equipped them with cutting-edge technology adapted from the most advanced Western economies in an effort to catch up. By the 1990s, though, it had largely caught up. Once it had reached the frontier of technology, pushing that frontier outwards would mean letting old industries die so that capital and workers could move to new ones. Japan's leaders resisted the bankruptcies and layoffs necessary for that to happen. As a result, the next wave of technological progress, based on the Internet, took root in the United States, whose economic lead over Japan grew sharply over the course of the 1990s.

A Recipe for Economic Growth

Numerous factors determine a country's success and whether its companies are good investments. Inflation and interest rates, consumer spending, and business confidence are important in the short run. In the long run, though, a country becomes rich or stagnates depending on whether it has the right mix of people, capital, and ideas. Get these fundamentals right, and the short-run gyrations seldom matter.

Between 1945 and 2007 the United States economy went through 10 recessions yet still grew enough to end up six times larger with the average American three times richer.

We've taken growth for granted for so long that we've forgotten that stagnation could ever be the norm. Yet, it once was. Until the eighteenth century, economic growth was so slight it was almost impossible to distinguish the average Englishman's standard of living from his parents'. Starting in the eighteenth century, this changed. The Industrial Revolution brought about a massive reorganization of production in England in the mid-1700s and later in Western Europe and North America. Since then, steady growth—the kind that the average person notices—has been the norm. According to economic historian Angus Maddison, the average European was four times richer in 1952 than in 1820 and the average American was eight times richer.

In the pre-industrial era, China was the world's largest economy. Its modest standard of living was on a par with that of Europe and the United States. But China then stagnated under the pressure of rebellion, invasion, and a hidebound bureaucracy that was hostile to private enterprise. The average Chinese was poorer in 1952 than in 1820.

So why do some countries grow and some stagnate? In a nutshell, growth rests on two building blocks: population and productivity.

1. Population determines how many workers a country will have.

2. Productivity, or output per worker, determines how much each worker earns.

The total output a country can produce given its labor force and its productivity is called potential output, and the rate at which that capacity grows over time is potential growth. So if the labor force grows 1 percent a year and its productivity by 1.5 percent, then potential growth is 2.5 percent. Thus, an economy grows.

Take a Growing Population

Let's recap. An economy needs workers in order to grow. And, usually, the higher the population, the higher the number of potential workers. Population growth depends on a number of factors including the number of women of child-bearing age, the number of babies each woman has (the fertility rate), how long people live, and migration.

In poor countries, many children die young so mothers have more babies. As countries get richer and fewer children die, fertility rates drop and, eventually, so does population growth. As women have fewer children, more of them go to work. This demographic dividend delivers a one-time kick to economic growth. For example, it was a major contributor to East Asia's growth from the 1960s onward and to China's growth after the introduction of its one-child policy. But a country only gets to cash in its demographic dividend once. Eventually, as population growth slows, it ages and each worker must support a growing number of retirees. If fertility drops much below 2.1 babies per woman, the population will shrink unless it is offset by higher immigration. For this reason, a demographic cloud hangs over China. It may be "the first country to grow old before it grows rich," say population experts Richard Jackson and Neil Howe. Its fertility rate is below two and its working-age population will start to decline around 2015.

Add Capital

A country is not rich, though, just because it has a lot of people—just look at Nigeria, which has 32 times as many people as Ireland but an economy of roughly equal size. The reason for this population/economic size disparity is that the average Nigerian is much less productive than the average Irishman. For a country to be rich—that is, for its average citizen to enjoy a high standard of living—it must depend on productivity, which is the ability to make more, better stuff out of the capital, labor, and land it already has.

Productivity itself depends on two factors: capital and ideas.

You can raise productivity by equipping workers with more capital, which means investing in land, buildings, or equipment. Give a farmer more land and a bigger tractor or pave a highway to get his crops to market, and he'll grow more food at a lower cost. Capital is not free, though. A dollar invested for tomorrow is a dollar not available to spend on the pleasures of life today. Thus, investment requires saving. The more a society saves, whether it's corporations or households (governments could save but are more likely to do the opposite), the more capital it accumulates.

Capital, though, will only take a country so far. Just as your second cup of coffee will do less to wake you up than your first, each additional dollar invested provides a smaller boost to production. A farmer's second tractor will help his productivity far less than his first. This is the law of diminishing returns.

Season with Ideas

How do you overturn the law of diminishing returns? With ideas. In 1989, Greg LeMond put bars on the front of his bicycle that enabled him to ride in a more aerodynamic position. This simple idea sliced seconds off his time, allowing him to beat Laurent Fignon and win the Tour de France.

New ideas transform economic production the same way. By combining the capital and labor we already have in a different way, we can produce different or better products at a lower cost. "Economic growth springs from better recipes, not just from more cooking," says Paul Romer, a Stanford University economist. For example, DuPont's discovery of nylon in the 1930s transformed textile production. These man-made fibers could be spun at far higher speeds and required far fewer steps than cotton or wool. Combined with faster looms, textile productivity has soared, and clothes have gotten cheaper and better.

The productive power of ideas is nothing short of miraculous. Investing in more buildings and machines costs money. But a new idea, if it's not protected by patent or copyright, can be reproduced endlessly for free. Just as other cyclists quickly copied Greg LeMond's aerobars, companies catch up to their competitors by copying their ideas. Although this can be frustrating for the person who came up with the idea, it's great for the rest of us as we benefit from the improvements made with the existing idea. Here are a few examples:

• New Business Processes. Some of the most powerful ideas involve rearranging how a company runs itself. In 1776, in the first chapter of The Wealth of Nations, Adam Smith marveled how an English factory divides pin making into 18 different tasks. Smith calculated that one worker, who could by himself make one pin a day, could now make 4,000. "The division of labor occasions, in every art, a proportionable increase in the productive powers of labor," he wrote. Two centuries later Wal-Mart revolutionized retailing by using big box stores, bar codes, wireless scanning guns, and exchanging electronic information with its suppliers to track and move goods more efficiently while scheduling cashiers better to reduce slack time. As competitors like Target and Sears copied Wal-Mart, customers of all three benefited from lower prices and more selection, a McKinsey study found.

• New Products. Netscape's Navigator was the first commercially successful browser but was soon supplanted by Microsoft's Internet Explorer, which is now under siege by Mozilla Firefox, Apple Safari, and Google Chrome. Browsers keep getting better but consumers still pay the same price, zero. Drugs provide another example. According to Robin Arnold of IMS Health, Eli Lilly's introduction of the antidepressant Prozac in 1986 inspired competitors to develop similar drugs like Zoloft and Celexa, providing alternatives for patients who didn't respond well to Prozac.

It's not just companies that thrive by imitating their competitors. Entire countries can turbo-charge their development by strategically copying the ideas and technologies that other countries already use. For example, Japanese steelmakers didn't invent the basic oxygen furnace; they adapted it from a Swiss professor who had devised it in the 1940s. They thus leapfrogged U.S. steelmakers who were using less efficient open hearth furnaces. Their mainframe computer makers benefited from a government edict that IBM make its patents available as a condition of doing business there.

More recently, China's adaptation of existing ideas from other countries has resulted in significant economic growth. Since 1978, it has moved workers from unproductive farms and state-owned companies to more productive privately owned factories that used machinery bought or copied from foreign companies, expertise acquired from foreign universities or joint venture partners, and intellectual property adapted and occasionally stolen from foreign creators.

Still, once a country has copied all the ideas it can, future growth depends on waiting for new ideas or developing its own. Inevitably, a country at the technological frontier grows more slowly than one catching up to the frontier. As we learned earlier in this chapter, that's just what happened to Japan.

Nurturing Growth

Getting the ingredients right is essential to economic growth, but so is the environment that the government creates in order to foster its development. Like the temperature on the oven, the wrong setting can ruin the recipe. So, what do governments do that matters most?

• Human Capital. It's no use equipping workers with the most advanced equipment in the world if they can't read the instructions. Education and training, both forms of human capital, are essential to productivity. Korea went from third world status to the ranks of the industrialized nations in a generation in part by rigorously educating all its children. Its high school graduation rates now exceed those of the United States.

• Rule of Law. Economic growth needs investors to know that if they invest today, they get to keep the rewards years later. That requires transparent laws, impartial courts, and the right to property. The United States' army of lawyers sue at the drop of a hat and wrap every transaction in legalese, but in a maddening way that signifies its respect for laws.

Small government is better than big government, but size is less important than quality. For example, Sweden's government spends more than half of gross domestic product (GDP) while Mexico's spends only a quarter of its GDP. But Swedish government is efficient and honest while Mexico's is inefficient and rife with corruption. That's one reason Sweden is rich and Mexico is poor.

Does government have to be democratic for growth? There's no firm rule. The authoritarian governments of China, Korea, and Chile ran smart policies that produced strong growth early in their development. Conversely, sometimes democratic governments are pressured by voters to expropriate private property, run up unsupportable debts, or shelter politically favored groups at everyone else's expense. But dictators have done all those things and worse, bringing on social unrest that ruins the investment climate. Democracy provides essential feedback to government just as free markets do to companies, and elections are generally less disruptive than civil wars.

• Letting Markets Work. Entrepreneurs and workers get rich coming up with new, cheaper ways to make things. In the process, they drive someone else out of business. Joseph Schumpeter, the Austrian-born Harvard economist, called this "creative destruction." Governments squelch creative destruction by forbidding new companies from entering a market, granting monopolies, restricting imports or foreign investment, or making it hard for companies to lay off workers. A financial system that would rather lend to government-owned companies than small entrepreneurs also holds back growth.

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Excerpted from The Little Book of Economicsby Greg Ip Mohamed El-Erian Copyright © 2010 by John Wiley & Sons, Ltd. Excerpted by permission of John Wiley & Sons. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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