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The Determinants of Economic Development The political, economic, and legal systems of a country can have a profound impact on the level of economic development and hence on the attractiveness of a country as a possible market and/or production location for a firm. Here we look first at how countries differ in their level of development. Then we look at how political economy affects economic progress. Differences in Economic Development Different countries have dramatically different levels of economic development. One common measure of economic development is a country's gross national product per head of population. GNP is often regarded as a yardstick for the economic activity of a country; it measures the total value of the goods and services produced annually. Map 2.1 summarizes the GNP per capita of the world's nations in 1997. As can be seen, countries such as Japan, Sweden, Switzerland, and the United States are among the richest on this measure, while the large countries of China and India are among the poorest. Japan, for example, had a 1997 GNP per head of $37,850, whereas China achieved only $860, and India $390. The world's poorest country, Mozambique, had a GNP per head of only $90, while the world's richest, Switzerland, came in at $44,320.27. However, GNP per head figures can be misleading because they don't take into account differences in the cost of living. For example, although the 1997 GNP per head of Switzerland, at $44,320, exceeded that of the United States, which was $28,740, the higher cost of living in Switzerland meant that American citizens could actually afford more goods and services than Swiss citizens. To account for differences in the cost of living, one can adjust GNP per capita to account for differences in purchasing power. Referred to as a purchasing power parity (PPP) adjustment, this adjustment allows for a more direct comparison of living standards in different countries. The base for the adjustment is the cost of living in the United States. Table 2.1 gives the GNP per capita measured at PPP in 1997 for a selection of countries, along with their GNP per capita and their growth rate in GNP over the 1990 - 1997 time period. Map 2.2 summarizes the GNP per capita in 1997 for the nations of the world. As can be seen, there are striking differences between the standard of living in different countries. Table 2.1 suggests that the average Indian citizen can afford to consume only 5.9 percent of the goods and services consumed by the average US citizen. Given this, one might conclude that, despite having a population of close to one billion, India is unlikely to be a very lucrative market for the consumer products produced by many Western international businesses. However, this is not quite the correct conclusion to draw, for India has a fairly wealthy middle class, despite its large number of very poor people. Table 2.1:
Source: World Bank. World Development Report 1998/99. Tables 1, 11. Oxford: Oxford University Press, 1999.
Map 2.1 see Gross National Product Per Capita 1997 Source: GNP per Head 1995. Map 30 "Gross National Product
per Capita," Map 2.2 see Purchasing Power Parity in 1997 Source: Purchasing Power Parity. Source: Map 38, A problem with the GNP and PPP data discussed so far is that they give a static picture of development. They tell us, for example, that China is much poorer than the US, but they do not tell us if China is closing the gap. To assess this, we have to look at the economic growth rates achieved by different countries. Table 2.1 gives the rate of growth in GNP achieved by a number of countries between 1990 and 1997. Map 2.3 summarizes the growth rate in GNP over the 1990 - 97 time period. Although countries such as China and India are currently very poor, their economies are growing more rapidly than those of many advanced nations. Thus, in time they may become advanced nations themselves and huge markets for the products of international businesses. Given their future potential, it may well be good advice for international businesses to start getting a foothold in these markets now. Even though their current contributions to an international firm's revenues might be small, their future contributions could be much larger. One might also note, however, that Table 2.1 tells us that the economy of Russia shrank substantially over the 1990 - 97 time period. A number of other indicators can also be used to assess a country's economic development and its likely future growth rate. These include literacy rates, the number of people per doctor, infant mortality rates, life expectancy, calorie (food) consumption per head, car ownership per 1,000 people, and education spending as a percentage of GNP. In an attempt to estimate the impact of such factors upon the quality of life in a country, the United Nations has developed a Human Development Index. This index is based upon three measures: life expectancy, literacy rates, and whether average incomes, based on PPP estimates, are sufficient to meet the basic needs of life in a country (adequate food, shelter, and health care). The Human Development Index is scaled from 0 to 100. Countries scoring less than 50 are classified as having low human development (the quality of life is poor), those scoring from 50 - 80 are classified as having medium human development, while those countries that score above 80 are classified as having high human development. Map 2.4 summarizes the Human Development Index scores for 1995, the most recent year for which data is available. Political Economy and Economic Progress It is often argued that a country's economic development is a function of its economic and political systems. What then is the nature of the relationship between political economy and economic progress? This question has been the subject of a vigorous debate among academics and policymakers for some time. Despite the long debate, this remains a question for which it is not possible to give an unambiguous answer. However, it is possible to untangle the main threads of the academic arguments and make a few broad generalizations as to the nature of the relationship between political economy and economic progress. Innovation Is the Engine of Growth There is general agreement now that innovation is the engine of long-run economic growth.28 Those who make this argument define innovation broadly to include not just new products, but also new processes, new organizations, new management practices, and new strategies. Thus, Toys "R" Us's strategy of establishing large warehouse-style toy stores and then engaging in heavy advertising and price discounting to sell the merchandise can be classified as an innovation because Toys "R" Us was the first company to pursue this strategy. One can conclude that if a country's economy is to sustain long-run economic growth, the business environment within that country must be conducive to the production of innovations. Innovation Requires a Market Economy This leads logically to a further question--What is required for the business environment of a country to be conducive to innovation? Those who have considered this issue highlight the advantages of a market economy.29 It has been argued that the economic freedom associated with a market economy creates greater incentives for innovation Map 2.3 see Growth in Gross National Product, 1990 - 97 Source: Economic Growth: Source: Map 31, Map 2.4 see The Human Development Index, 1995 Source: Quality of Life: The Human Development Index. Source: Map 28, John Allen, Student Atlas of World Geography, Dushkin/McGraw-Hill, p. 46. Data are from "Human Development Report 1998" by the United Nations Development Programme. Copyright 1998 by the United Nations Development Programme. Used by permission 1999 of Oxford University Press, Inc. than either a planned or a mixed economy. In a market economy, any individual who has an innovative idea is free to try to make money out of that idea by starting a business (by engaging in entrepreneurial activity). Similarly, existing businesses are free to improve their operations through innovation. To the extent that they are successful, both individual entrepreneurs and established businesses can reap rewards in the form of high profits. Thus, in market economies there are enormous incentives to develop innovations. In contrast, in a planned economy the state owns all means of production. Consequently there is no opportunity for entrepreneurial individuals to develop valuable new innovations, since it is the state, rather than the individual, that captures all the gains. The lack of economic freedom and incentives for innovation was probably a main factor in the economic stagnation of so many former communist states and led ultimately to their collapse at the end of the 1980s. A similar stagnation phenomenon occurred in many mixed economies in those sectors where the state had a monopoly (such as health care and telecommunications in Britain). This stagnation provided the impetus for the widespread privatization of state-owned enterprises that we witnessed in many mixed economies during the mid-1980s and is still going on today (privatization refers to the process of selling state-owned enterprises to private investors). A recent study of 102 countries over a 20-year period provided compelling evidence of a strong relationship between economic freedom (as provided by a market economy) and economic growth.30 The study found that the more economic freedom a country had between 1975 and 1995, the more economic growth it achieved and the richer its citizens became. The six countries that had persistently high ratings of economic freedom during the 1975 - 1995 period (Hong Kong, Switzerland, Singapore, the United States, Canada, and Germany) were also all in the top 10 in terms of economic growth rates. In contrast, no country with a persistently low rating achieved a respectable growth rate. For the 16 countries for which the index of economic freedom declined the most during the 1975 - 95 period, average annual gross domestic product fell at an annual rate of 0.6 percent. Innovation Requires Strong Property Rights Strong legal protection of property rights is another requirement for a business environment to be conducive to innovation and economic growth.31 Both individuals and businesses must be given the opportunity to profit from innovative ideas. Without strong property rights protection, businesses and individuals run the risk that the profits from their innovative efforts will be expropriated, either by criminal elements, or by the state itself. The state can expropriate the profits from innovation through legal means, such as excessive taxation, or through illegal means, such as demands from state bureaucrats for kickbacks in return for granting an individual or firm a license to do business in a certain area. According to the Nobel prize-winning economist Douglass North, throughout history many governments have displayed a tendency to engage in such behavior. Inadequately enforced property rights reduce the incentives for innovation and entrepreneurial activity--since the profits from such activity are "stolen"--and hence reduce the rate of economic growth. The Required Political System There is a great deal of debate as to the kind of political system that best achieves a functioning market economy where there is strong protection for property rights.32 We in the West tend to associate a representative democracy with a market economic system, strong property rights protection, and economic progress. Building on this, we tend to argue that democracy is good for growth.33 However, some totalitarian regimes have fostered a market economy and strong property rights protection and have experienced rapid economic growth. Four of the fastest-growing economies of the last 30 years--South Korea, Taiwan, Singapore, and Hong Kong--all have grown faster than the Western democracies. All these economies had one thing in common at the start of their economic growth-undemocratic governments! At the same time, there are examples of countries with stable democratic governments, such as India, where economic growth remained sluggish for long periods. In 1992, Lee Kuan Yew, Singapore's leader for many years, told an audience, "I do not believe that democracy necessarily leads to development. I believe that a country needs to develop discipline more than democracy. The exuberance of democracy leads to undisciplined and disorderly conduct which is inimical to development."34 Others have argued that many of the current problems in Eastern Europe and the states of the former Soviet Union arose because democracy arrived before economic reform, making it more difficult for elected governments to introduce the policies that, while painful in the short run, were needed to promote rapid economic growth. It has become something of a cliché to argue that Russia got its political and economic reforms in the wrong order-unlike China, which maintains a totalitarian government but has moved rapidly toward a market economy. However, those who argue for the value of a totalitarian regime miss an important point-if dictators made countries rich, then much of Africa, Asia, and Latin America should have been growing rapidly for the past 40 years, and this has not been the case. Only a certain kind of totalitarian regime is capable of promoting economic growth. It must be a dictatorship that is committed to a free market system and strong protection of property rights. Moreover, there is no guarantee that a dictatorship will continue to pursue such progressive policies. Dictators are rarely so benevolent. Many are tempted to use the apparatus of the state to further their own private ends, violating property rights and stalling economic growth. Given this, it seems likely democratic regimes are far more conducive to long-term economic growth than are dictatorships, even benevolent ones. Only in a well-functioning, mature democracy are property rights truly secure.35 Economic Progress Begets Democracy While it is possible to argue that democracy is not a necessary precondition for establishment of a free market economy in which property rights are protected, subsequent economic growth often leads to establishment of a democratic regime. Several of the fastest-growing Asian economies have recently adopted more democratic governments, including South Korea and Taiwan. Thus, while democracy may not always be the cause of initial economic progress, it seems to be one consequence of that progress. A strong belief that economic progress leads to adoption of a democratic regime underlies the fairly permissive attitude that many Western governments have adopted toward human rights violations in China. Although China has a totalitarian government in which human rights are abused, many Western countries have been hesitant to criticize the country too much for fear that this might hamper the country's march toward a free market system. The belief is that once China has a free market system, democracy will follow. Whether this optimistic vision comes to pass remains to be seen. Nevertheless, such a vision was an important factor in the US government's 1996 decision to grant China most favored nation trading status (which makes it easier for Chinese firms to sell products in the United States) despite reports of widespread human rights abuses in China. Other Determinants of Development: Geography and Education While a country's political and economic system is probably the big locomotive driving its rate of economic development, other factors are also important. One that has received attention recently is geography.36 But the belief that geography can influence economic policy, and hence economic growth rates, goes back to Adam Smith. The influential Harvard University economist Jeffrey Sachs argues that Throughout history, coastal states, with their long engagements in international trade, have been more supportive of market institutions than landlocked states, which have tended to organize themselves as hierarchical (and often military) societies. Mountainous states, as a result of physical isolation, have often neglected market-based trade. Temperate climes have generally supported higher densities of population and thus a more extensive division of labor than tropical regions.37 Sachs's point is that by virtue of favorable geography, certain societies were more likely to engage in trade than others and were thus more likely to be open to and develop market-based economic systems, which in turn would promote faster economic growth. He also argues that, irrespective of the economic and political institutions a country adopts, adverse geographical conditions, such as the high rate of disease, poor soils, and hostile climate that afflict many tropical countries, can have a negative impact on development. Together with colleagues at Harvard's Institute for International Development, Sachs tested for the impact of geography on a country's economic growth rate between 1965 and 1990. He found that landlocked countries grew more slowly than coastal economies and that being entirely landlocked reduced a country's annual growth rate by roughly 0.7 percent per year. He also found that tropical countries grew 1.3 percent more slowly each year than countries in the temperate zone. Education emerges as another important determinant of economic development. The general assertion is that nations that invest more in education will have higher growth rates because an educated population is a more productive population. Some rather striking anecdotal evidence suggests this is the case. In 1960 Pakistanis and South Koreans were on equal footing economically. However, just 30 percent of Pakistani children were enrolled in primary schools, while 94 percent of South Koreans were. By the mid-1980s, South Korea's GNP per person was three times that of Pakistan's.38 More generally, a survey of 14 statistical studies that looked at the relationship between a country's investment in education and its subsequent growth rates concluded investment in education did have a positive and statistically significant impact on a country's rate of economic growth.39 Similarly, the recent work by Sachs discussed above suggests that investments in education help explain why several countries in Southeast Asia, such as Indonesia, Malaysia, and Singapore, have been able to overcome the disadvantages associated with their tropical geography and grow far more rapidly than tropical nations in Africa and Latin America. |
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