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Some nations are rich in natural resources, have educated workers, and are industrially advanced, and yet their standard of living is behind that of other comparably positioned nations. What they lack are healthy institutions, ones that create incentives which encourage economic growth. We will review four of these.
Political Stability and the Rule of Law
Obviously, growth is easier when a country is not torn by civil strife. But beyond that, economies benefit from predictability. Firms can deal with regulations that limit how much the firms can pollute, for example. But regulations that are imposed, then withdrawn, then imposed again as different political parties take turns wielding power present a problem for firms trying to plan for the future. Inability to plan discourages spending on projects that will not come online for years. In short, uncertainty disincentivizes investment.
The rule of law means fair, equal treatment under the law as administered and enforced by competent and honest police, judges, and bureaucrats. Building inspectors who can be bribed into approving a shoddily built warehouse incentivize poor-quality construction, and inspectors who demand bribes before they will approve even a well-built warehouse disincentivize construction by adding to project costs.
A Stable Financial System
The financial system of a country includes the nation’s money supply and the banks and other institutions tasked with safeguarding it. A stable financial system means price stability, which promotes capital investment. A low, steady inflation rate is preferable to a high inflation rate that fluctuates wildly up and down. (The inflation rate is never high and stable.) Decisions about investment in physical capital, especially, are often based in part on assumptions about future revenue the capital will generate. If future prices are hard to make even a reasonable guess about, it becomes hard to justify spending the money on the project in question. Again, uncertainty disincentivizes investment.
A stable financial system also means that banks are secure and can be trusted to keep enough reserves on hand to satisfy withdrawal requests. Depositors’ loss of confidence in a bank can lead to a bank run, in which a cascade of panicked withdrawal requests causes the bank to run out of money. Needless to say, a nation where this kind of thing regularly happens is less growth-friendly than one where it does not.
Private Property Rights
In a free market, people are motivated by the prospect of earning a profit. The underlying assumption is that an individual or a firm that produces something will own it, has the right to sell it (after securing any necessary licensing), and will then own the revenue. This scheme falls apart if land is subject to government confiscation, or if anything a person produces automatically becomes the property of the state, or if there is no effective deterrent to theft of one’s cash earnings by a private party. Changes in a country’s legal system that strengthen the right of ownership over the means of production, of the goods and services produced, and of the proceeds from selling them naturally contribute to economic growth.
Of special note are intellectual property rights. An invention—that is, a discovery which constitutes a piece of technology—is a form of capital in a broad sense. Developing an invention can involve both time costs and monetary costs for materials. When inventions are patentable and the legal system can be counted on to enforce them, there is an incentive to develop the invention and use it to bring a product to market. Without enforceable patents, innovation makes much less sense from a commercial point of view.
Business-Friendly Taxes and Regulations
The government can promote economic growth by taxing and regulating businesses appropriately. Some level of taxation is necessary to fund government services that businesses (like everyone else) depend on. But excessive taxation, by depriving producers of most of their profits, takes away the incentive to produce. In a similar vein, some level of regulation is necessary to control for externalities (see the chapter on that topic), to protect workers, and so on. But excessive regulation discourages production by adding to production costs.
