Wealth creation is a game without rules

The more we study cause and effect in economics, the less we understand what’s happening, says Ed Conway.

AFEW YEARS ago the World Bank commissioned a Nobel prizewinning economist to answer the biggest question of all: how do you create growth?

In the world of economics this is up there with life, the universe and everything. For while we know many of the ingredients – decent infrastructure, good education and health provision, generous incentives for innovation – there is still no definitive recipe for high productivity growth.

Why do some countries leap forward while others stall? Why, for instance, did South Korea achieve developed world status while Mexico, which back in the 1980s was the richer economy, now languishes in the lower league? Why did the Brazilian economy go gangbusters in the 1960s and 1970s but then stall for the following two decades?

These questions matter because there is no better way of improving lives than generating growth. So the economist chosen by the World Bank, Michael Spence, spent two years searching for an answer. During that time his growth commission spent US$4 million speaking to 300 academics and more than 20 world leaders, only to conclude that we don’t really know.

While the world of physics has laws that are constant, the laws of economics are rarely worth the paper they’re scribbled on. Take one supposed rule: that higher taxes can harm the economy. This principle, sometimes called the Laffer curve after the American economist Art Laffer, is so widely held as to be akin to gospel. If you raise taxes beyond a certain point people work less; if you lower taxes they work more. Right?

It doesn’t always hold true in practice. Consider what happened in the 1990s when some Swiss cantons made changes to tax collection and gave workers a year’s tax holiday as their systems integrated. Here was a perfect test case for whether lower taxes, or indeed no taxes at all, would encourage people to work more. So what happened? Nothing. There was no impact whatsoever on how much people worked. In practice it turns out that taxes do not actually discourage people from working.

This example is one of many in a new book, Good Economics for Hard Times, by the winners of this year’s Nobel prize for economics, Esther Duflo and Abhijit Banerjee. As academics who specialise in small-scale experiments rather than big-picture generalisations, they are sceptical about grand inquiries of the sort commissioned by the World Bank, and for good reason. The problem is not only that we don’t understand how to create growth now and in the future but that we don’t even understand how it was created in the past.

Economists argue over the causes of the 2008 financial crisis but they are still split over the causes of the Great Depression of the 1930s. Or consider another supposed iron law of economic history: what matters most for a country’s development are reliable, respected institutions which help it to grow – everything from the rule of law to the relationship between the military and the state. This idea, proposed by the late economist Douglass North, was that a country’s fate was essentially ordained by its history and whether it was bequeathed those institutions or not.

A few years ago a trio of economists – Daron Acemoglu, Simon Johnson and Jim Robinson (AJR, as they came to be known) – claimed to have discovered statistical proof that North was right. They looked at countries colonised by European settlers and found a common strand: where there was a high mortality rate among the early settlers, the mortality rate remained high today. Countries with low mortality rates among the initial colonisers, they said, had lower mortality and higher growth rates today.

Why? Their conclusion was that there were, broadly speaking, two different types of colonisation. In the countries where the native population was relatively small and there was less danger from disease, Europeans settled in large numbers and created the kinds of institutions they had back home. So New Zealand and Australia got a strong judiciary and political institutions and rapidly developed into the economies they are today.

In other colonies with a high native population and greater risk from disease, the economists argued that Europeans tended not to settle and establish institutions but instead installed authoritarian leaders and treated the colonies as resources to be plundered. This, the economists concluded, explained why, even centuries later, many African and South American nations are still beset by economic problems while other former colonies are an established part of the developed world.

This rule is so well-respected that for most economists, even sceptics like Duflo and Banerjee, it is considered on a par with the laws of physics. Yet in an academic paper to be published next year, the researchers Daniel Seligson and Anne McCants ran the same dataset and found that the AJR analysis didn’t hold water. The sums didn’t add up, according to Seligson, who is, perhaps uncoincidentally, a physicist.

It is yet more proof that nearly two-anda-half centuries after Adam Smith wrote An Inquiry into the Nature and Causes of the Wealth of Nations, we haven’t found an answer. What makes one nation wealthy and another poor? We still don’t really know.

While the world of physics has laws that are constant, the laws of economics are rarely worth the paper they’re scribbled on.

(Ed Conway is economics editor of Sky News UK)

– The Times