Supply-Side Summer School Economics Lesson #3
Memo To: Students of Supply-Side University
From: Jude Wanniski
Re: Reuven Brenner on Economic Growth
[For this summer-school session, Iíve asked Prof. Reuven Brenner of McGill University in Montreal to lecture on the general topic of economic growth. Iíve identified Dr. Brenner as my nominee for the best economist in the world at this moment. He was handpicked for the chair he holds at the McGill Faculty of Management by Prof. Robert Mundell of Columbia University, who I think is the best economist of this half century. Dr. Brenner would be pleased to have you question him on this lecture.]
Thinking About Growth
By Reuven Brenner
Politicians and economists promise growth, prosperity, higher standards of living. What do they mean by these terms? And do they really know how to bring them about?
At times explicitly, at times implicitly, they imply that since the commercialization of innovations is the source of growth, governments' policies must be such as to encourage it. Yet both the pursuit of innovation and its commercialization not only create wealth, but also destroy it. How do we know that in this process more is expected to be created than destroyed?
By innovations having the effect of "destroying wealth," I not only refer to the obvious, visible effect of making a whole industry obsolete with a successful innovation (for example, new communication technologies destroying copper wiring and the telephone infrastructure built around it, or the car destroying the horse-carriage trade). I also mean the frequent case of companies that continuously invest in R & D, which turn out not to lead to any successful commercialization. In both cases, capital is being destroyed, physical as well as human: Equipment and skills become specialized in domains that are or will be discarded.
Neither should one make the mistake of thinking that only technological innovations can have the effect of destroying wealth. Political changes also destroy much physical wealth and ruin opportunities, even those political changes to which we give positive connotations.
In the past decade, for example, such change occurred when many populous countries created more opportunities for their own people and also attracted capital from foreign countries. Yet once political barriers were lowered and hundreds of millions of similarly skilled Asians, Russians, Mexicans and South Americans began competing with people in the dozen countries which were the only stable ones until ten years ago, the ability of the latter to command higher wages was lost. Whatever the latter produced up to this point, millions of ambitious and young entrants from many countries around the world were now eager to match -- and at much lower wages.
Capital, physical and human, which was previously flowing to the politically stable countries, has now been flowing to those that now make promises of stability. Western entrepreneurs and those skilled in the arts of pricing, finance, deal-making and commercialization saw far broader demands for their services. The western governments' power to tax these entrepreneurs and redistribute money toward those who fell behind has accordingly diminished. Thus, political changes opened far greater
opportunities for some, and, at the same time, destroyed many skills and opportunities for others.
Can we then have some objective measure by which to judge whether people in a particular society, or in the world, expect technological and political innovations (including fiscal ones) to be beneficial and indicate the creation of more wealth? How can we be sure that a financial innovation, a change in company strategy, or a change in government policy, makes a society better or worse?
The answer is that changes in the total market value of firms (value of stocks added to the value of outstanding debt) in a society added to the value of its governments' outstanding obligations, would be the best estimate to make such judgment --once financial markets are well-developed. When this sum increases, it means that the society's ability to generate revenues and pay back debt -- whether private or public -- has increased. And the contrary: when this sum drops (measured in terms of a relatively stable unit, rather than a particular currency), people signal that either their government, or the companies' management, is making and persisting with erroneous decisions. The reason is simple: Developed, relatively unhindered financial markets prevent persistence of mistakes. By so doing, they quickly redirect the use of capital and ensure that savings and capital are deployed more effectively.
When the aforementioned sum diminishes, where does the wealth go?
That depends. The smaller the ability of capital and people to move, the more its diminished value can be viewed as a permanent loss. Those things which are expected to be solid -- the effort and ingenuity of people -- melt into thin air. More mistakes can be expected, and their effects can be expected to last longer. The decrease thus reflects diminished expectations of generating future revenues (since every mistake is a cost). Generating future revenues is what "growth" and the ability to pay back debts means. When capital and people move, though, the wealth that disappears in one country reappears in others.
There are few better examples to illustrate these points than look at the wealth created by the various diaspora of history -- Armenians, Chinese, the Huguenots, and Jews -- as well as the poorer immigrants of Europe, who built the newer continents. (Few of the richer moved out of Europe). These were driven out of their homelands by politics and regulations. Let us briefly look at how the movement of the most gifted and energetic of these led to many of the world's economic "miracles."
Facts Behind Miracles
The Cinderella stories of sudden rags-to-riches of poor or impoverished societies leapfrogging others have provoked admiration, envy, and intense discussions about why the outdone stumbled, and the humbler rose. The riches of oil-producing Middle East countries did not provoke discussions because their riches fit the "finding treasure" pattern. But how do societies do it when they not only lack any particular natural resources, but even suffer from disasters? Can other countries emulate them and achieve similar high growth rates?
The miracle of 17th century Europe was neither Spain nor Portugal -- both in the "finding treasure" mold -- but below sea level Amsterdam and Holland, whose riches were created overcoming natural obstacles. There was also West Germany, rising miraculously from the ashes of WWII. There were some Asian miracles that deserve our attention, such as those in Hong Kong and Singapore. And there was the somewhat forgotten example of Scotland, which teaches a particular lesson.
What's common among these miracles?
The Dutch were the first European republic, both tolerant toward all religions (when the rest of Europe was still severely discriminating against many), and establishing sound rights to property, opening opportunities for relatively unhindered trade and financial innovation.
But it would be misleading to say that "the Dutch" did it. The openness of the new republic attracted to Amsterdam well-connected and educated immigrants, merchants and moneymen -- Jew and Huguenot, discriminated against elsewhere in Europe, were prominent among them. They helped turn Amsterdam into the financial and trading center of the 17th century world. It had the world's first stock market, where French, Venetians, Florentines, Genoese, as well as Germans, Poles, Hungarians, Spaniards, Russians, Turks, Armenians and Hindus traded not only in stocks but also in sophisticated derivatives. Much capital active in Amsterdam was foreign-owned, or owned by Amsterdammers of foreign birth. There was "globalization" during the 17th century, even if nobody bothered to use the term. The difference now and then, of course, is largely the speed of information flows.
Max Weber never bothered to look at migratory patterns when he came up with his speculation that somehow religion -- the Protestant ethic -- had much to do with Amsterdam's spectacular success. Although Weber's idea has been quoted frequently enough to pass for fact, it wasn't true in Amsterdam or in any other prosperous trading cities or states. Educated and ambitious trading immigrants, with networks around the world -- brains and trust, that is -- turned 17th century Amsterdam into a "miracle." And these same factors have been behind other miracles as well.
The histories of Hamburg, Hong Kong, Singapore, Taiwan, and West Germany have much in common with Amsterdam's, but shared religion is not a factor. In each of these places, the state provided an umbrella of law and order, had relatively low taxes, and gave people a stake in what the business society was doing -- thereby attracting immigrants and entrepreneurs from around the world.
Sir Stamford Raffles designed Singapore as a port at the beginning of the 19th century, and backed it with an administrative, legal and educational system, the latter being offered to its multiracial population. From a small settlement, Singapore rose, attracting Chinese, Malays, and Europeans. Trade and security brought prosperity to the penniless immigrants from Indonesia, and, in particular China. Taiwan (after the 17th century), Singapore and Hong Kong offered emigrants opportunities denied them by the Chinese hinterland, which was dominated at first by warlords and status-conscious bureaucracy and later by communist bureaucracy. Hong Kong benefited from waves of emigration from China, in particular from the inflow of Shanghai merchants and financiers when Mao Zedong "liberated" China in 1949 -- much as Amsterdam rose to prominence when Antwerp's merchants and financiers fled the Iberian peninsula in earlier centuries, when the Huguenots fled France, and when Jews fled from many parts of Europe.
Hong Kong's textile and shipping industries were initiated by emigrants from Shanghai. These Chinese emigrants also established the network of merchants, traders, moneymen, and manufacturers -- as Jewish, Italian, Armenian, Parsee and other immigrant groups did throughout history in various parts of the world.
The post-World War II West German miracle fits this pattern too, though in popular memory its success is associated more with the Marshall Plan. The impact of that aid has been greatly exaggerated. Historians and economists (subsidized by governments) are very good at creating and perpetuating mythologies. At times, they are about nationalism, falsely suggesting that economic miracles have been due to the genius of people living within arbitrary national borders. At times they are about the extremely beneficial roles of foreign aid. Both mythologies conveniently justify increasing the power placed in the hands of government.
Economists have estimated that from 1948 to 1950, Marshall Plan aid was between 5 and 10 percent of European GNP, although these numbers are dubious. European statistics from that period vastly underestimate national incomes because of price regulation, and extensive black markets due to confiscatory taxation. There were, after all, no miracles in Europe after WWI, when loans and aid to Europe were also estimated to amount to roughly 5 percent of its GNP. True, the world moved toward lower tariffs after World War II, which it did not after World War I. But if that is the case, the correct inference would be that miracles are linked with lowered tariffs rather than foreign aid.
So what fueled the West German miracle? From 1945 to 1961, Western Germany accepted 12 million immigrants, for the most part well-trained. About 9 million were Germans from Poland and Czechoslovakia. Others fled the promise of East Germany's communist paradise. Although the movement of this capital did not appear at the time on the books, its importance can be inferred from the significantly higher ratio of active to total population in West Germany relative to the rest of Europe in the 1950s and 1960s: 50% in Germany vs. 45% in France, 40% in the UK, 42% in the U.S. and 36% in Canada. And when the inflow of human capital stopped, the massive inflow of hard working Gastarbeiter from Mediterranean lands brought new waves of young ready-made employees possessing skills for which West Germany did not have to pay either. In other words, the West German miracle was not due to foreign aid, but to the same features that brought about earlier and later miracles elsewhere: Migration of skilled people and significantly lower tax rates.
And West German taxes were significantly lowered! In 1948, marginal income tax rates stood at 50% for a $600 income, and a confiscatory 95% for $15,000. In 1948 the code was drastically revised and the 50% bracket applied for income of $2250, though effectively lower because of numerous deductions for savings and investments. By 1955, the top rate was lowered to 63% for incomes over $250,000, and 50% brackets starting at $42,000. Hong Kong, for accidental, unique circumstances, practiced an approximation of a flat rate, the top being at 18%.
What brought about economic miracles? Movement of people with brains and networks, and low taxes -- when the rest of your neighborsí experiment with disastrous policies that tax people's hopes, aspirations and ambitions.
The Scottish lesson, however, rarely mentioned in history books, shows what else can hide behind economic miracles.
The Scottish Miracle
Scotland of 1750 was a very poor country. The land was of poor quality, with illiterate people engaged in near-subsistence agriculture; there were no navigable rivers, barren mountains and rocky hills hindered communications. The main export at the time was tobacco. Yet, less than a century later, Scotland stood with England at the forefront of the world's industrial nations, with the same standard of living as England, whereas in 1750 it was about half. How did they do it?
The Union of 1707 made Scotland part of England. It came under Englandís system of taxes, laws, and currency and was allowed access to English markets. The union also abolished the Scottish parliament, leaving Scotland without a distinct administration until 1885. This turned out to be the biggest blessing (reminding one of Hong Kong's under the now rapidly evaporating British rule), as it prevented the banking system and financial markets from becoming an instrument of government finance. The result was a financial market that developed in response to the demands of the private economy.
By 1810, there were 40 independent banks. The orthodoxy of the times held that banks should lend only if the loans are backed by the security of goods in transit or in process, and for no more than 90 days. In contrast, the banks could now lend for unspecified periods of time with no tangible securities. The credits of Scottish banks thus had become the precursors of junk bonds.
Bills of exchange, the main assets of banks in other countries at the time, were the least important for Scottish banks. The largest volume of loans was given to manufacturers and merchants who received credit backed only by their own signature with two or more people as sureties. The banks flourished with tiny reserves (1% of its liabilities in specie -- does the Basel Committee know about this?), and irregular financial reports (annual balance sheets were prepared only from 1797).
A.W. Kerr, Scotland's earliest, and still arguably its best financial historian, captures the specific feature of the country's financial markets: "The comparative immunity from legislative interference which characterizes banking in Scotland until the year 1844 had been an unmistakable blessing to the country, and has saved the banks from those vexatious and unnecessary distinctions and restrictions which have hampered and distorted English banking. In Scotland, banking was permitted to develop as the country advanced in wealth and in intelligence. Nay, it was even enabled to lead the nation on the path of prosperity, and to evolve, from practical experience, a natural and healthy system of banking, which would have been impossible under close state control similar to that followed in other countries." No wonder Adam Smith was Scottish: The country showed how to become prosperous quickly through trade and finance, unhindered by tariffs (although covered by a reliable English political and legal umbrella), while starting from scratch.
Contrast this process with France in the same period, where the great majority of requests for charters for financial institutions were rejected until 1857. Only a severe depression that year led to the liberalization of procedures. Yet even in 1870, France was far behind in the level of its banking services at the beginning of that century, its regulations preventing small industrialists access to credit.
Scotland's success stands out not only with its unique banking system, but also with the emphasis it put on education. In a piece titled "The Output of Scientists in Scotland," R.H. Robertson shows the relevant statistics. The output of "outstanding Scottish scientists" is at its height between 1800 and 1850, diminishing rapidly after 1870. The reason? The most brilliant Scots migrated -- and there was no more Scottish miracle. It is not accidental that Scotland's relative decline in the twentieth century has also been correlated with the increasing assimilation of Scottish education and banking practices into those of England (with banking starting slowly in 1845). If one allows a large fraction of a region's most energetic and bright to migrate, and constrains access to credit to those who remain, what else can one expect but decline?
There are other lessons to be drawn from the Scottish case. Savings were certainly not a pre-condition for their prosperity. They did not have any to speak of. Nor did they receive foreign aid. But once opportunities were open and financial markets developed relatively unhindered, not only did the Scots save, but their savings were put to good use. In Scotland, savings moved to private enterprises, whereas in England and elsewhere they went to governments. And, yes, no state was needed to encourage the Scottish entrepreneurial spirit. In contrast to the previously mentioned miracles, there was no large scale movement of talent from around the world to Scotland. However, the miracle did end with the emigration of Scottish talent, more regulated financial markets, and higher taxes.
What Are the Lessons?
Human creative sparks are always there, probably randomly distributed around the world. Prosperity, though, is due not to new ideas, but to the commercialization of new ideas. And the incentives to commercialize ideas depend on taxation and access to financial markets. The Scottish experiment suggests that entrepreneurship will thrive when the state will not even try to get a stake in financial markets to encourage these traits. Once England interfered in these markets and increased taxation, the entrepreneurs moved to greener pastures. Yes, Scotland's financial markets were unique. But exceptions -- Scotland and the other economic miracles -- disprove rules. Here are some others.
Arguments for a greater direct role by government to regulate financial markets or entrepreneurship are strange, although people today are accustomed to them, and do not give second thoughts to their real meaning. Yet consider for the moment the meaning of these cliche statements. People employed by governments -- and, more important, the incentives to which they respond -- are not those that could make financial markets work better or encourage entrepreneurship, never mind their vague speeches on commitments to these goals. With rare exceptions, these officials never worked in business, have no experience in financial markets, and never started their own business. So how could they improve on their functioning? Film critics may not like some of the movies produced, and they may be right. Many movies are very bad. But do they know how to make better movies? They do not, and they do not have to: after a string of failures, it is unlikely that financial markets would advance more money to the same team of producers and directors.
The great advantages of private financial markets are that they decentralize decision-making and prevent persistent mistakes. By so doing, when the small scale enterprises meet financial tests, they expand. If they fail, the loss to society is much smaller than the case of the government-sponsored failed grandiose project -- which frequently is not allowed to fail.
The continued spending is then justified by a large army of government sponsored economists, the priesthood of our times, who never fail to come up with half-baked theories of market failures to be remedied by the smart, altruistic, government regulators and bureaucrats. The result of this myth-creation is that more good money is being thrown after bad -- and nevermind mismeasured aggregates.
Economists in the future may estimate how much exactly of the U.S.'s spectacular performance since World War II can be attributed to the large movement to its shores of extremely skilled, ambitious, well-connected people from around the world, a world which until ten years ago was hostile to initiative and hope. Then one will know how much the transfer of this unmeasured human capital helped cover for many costly and mistaken government policies in the U.S. What should be clear from the historical episodes is that when and if the rest of the world retains its talents, the U.S. will no longer be able to count on attracting that talent to cover its costly mistakes.
Governments have a number of options to increase growth rates. One is to offer a package of taxes and benefits that would attract more talent and capital from abroad. Because such policy may discourage growth elsewhere, it could lead to retaliations. The better alternative would be to encourage more entrepreneurship domestically. This can be done by lowering both income and capital gains taxes, which would rapidly increase both the sums of money people would be ready to invest in venture capital (since with the lower income taxes they can accumulate savings more rapidly and experiment more), and also speed up the redirection of funds toward financing entrepreneurial ventures. Both effects would lead to greater efficiencies -- squeezing out mistakes (and thus costs) that prevent higher growth rates.
How best do we put numerical values on wealth creation? Certainly not by government statistics that collect mismeasured, backward looking aggregates. The most reliable measure is instead the significant changes in the value of market securitizations -- measured in a relatively stable unit of account, gold, rather than a floating paper unit. This is because the opinions of a wide variety of people who back their opinions with money has proven to be a better predictor of where things were heading than the opinions of all those who did not.
Changes in the aforementioned value is not a perfect indicator of things to come. Nothing is. But it is a better measure and more reliable measure of wealth creation than the alternatives. The one important caveat is that financial markets must have the proper depth. That is, security markets must be able to reflect expectations about government and central bank policies, whose laws, policies and regulations affect companies' managements. When there are few sources of information in a society, or if information is controlled and the players' hands are tied, the stock exchanges will not fulfill their roles. Without proper depth, they will become decapitalized.
Americaís stock market now has the greatest depth of all. This was not always the case. Recall that in the second half of the 19th century, the U.S. stock markets experienced spectacular booms and busts, lacking proper depth. Channels of information were few; the few who had access to information did not always have the incentive to tell the truth, and often had incentives to collude. Not surprisingly, people without privileged access to information withdrew from the markets.
However, the United States has been an open society, and people were allowed to try and overcome these problems. By so doing they democratized access to capital, and created the proper depth. It was following the booms and busts a century ago that Charles Dow, Edward Jones and Charles Bergstresser were among the first to come up with the idea of publishing a financial newsletter in 1880; that the U.S. stock exchange proposed in 1895 the radical innovation of publishing annual reports; that 100 years ago information began to flow through New York's streets from offices to banks -- by couriers running through streets rather than by todayís satellites, cable and optical fibers. And it is not accidental that cities with developed stock exchanges also saw the emergence of a critical mass of people specializing in the information industry: newspapers, radio, broadcasting, Bloomberg, financial and political analysts. It's this information industry that allows stock exchanges to acquire the proper depth.
Societies which, for political reasons, put impediments in the ways of this information industry -- as China has been doing, when, for example, Xinhua, the state-run central news agency, set restrictions on all aspects of Dow Jones' business in the country -- will see the same wild fluctuations on their stock exchanges as New York's exchange saw a century ago. When this happens, neither security markets nor official statistics will tell us much about what is happening to growth and wealth creation. Remember: on paper, countries were growing wonderfully under communism, but those of us who grew up under communism all knew that political statistics about growth were all one great lie.
Though the pseudo-science of macro-economics was a myth and not a lie, it ranks among those which left on its trail devastating wreckage, unpleasant surprises, and confusion of confusions. Why did it become a myth? The emphases on national aggregates kept out of sight the view that in one country such products measured something that people wanted, whereas elsewhere they measured things that rulers and the establishment wanted. The fact that behind the aggregate counting there was, initially, a strong assumption that the relation between governments and citizens is, as in a private transaction, based on an exchange of services, was soon forgotten. The macro-economic models, summarizing the working of the economy in a few simple-minded equations, have led to the same predictions whether "production" and "output" referred to something disastrous or something positive.
Since employment by governments and the governments' "output" have been added to employment and to whatever was produced in the non-government sector, respectively, and since there are good reasons, although not "macro-economic ones," for governments to intervene and be able to do constructive things at times, it is no wonder that government expenditures were found to create both jobs and output from time to time. By using these numbers unquestioned, economists transformed a self-serving political idea with the help of extensive government subsidies to bureaus of statistics and to academics into a neutrally-sounding scientific debate about numbers and statistical methods, keeping political institutions out of sight. Macroeconomics thus became a non-threatening theory that could be taught at many universities around the world.
The students became teachers, and macroeconomics and the illusion of comprehensible "objective," national aggregates, a myth, one that governments and bureaucracies have had the incentives to subsidize and promote. Students, some ambitious and others passionate to find and understand the best, living with the illusion that what they are taught at universities must have passed scientific scrutiny, drove themselves hard to understand the obscure languages of macroeconomics and the shallow, silly works.
By the time some matured and noticed that emperors had no clothes, they may have faced the dilemma of the astronomer Kepler, who, although not believing in astrology, wrote treatises about the latter because the monarchs paid for them. Economists can now either do as he did and disguise their true beliefs, or drop out of the "scientific" enterprise. As to the mediocre followers -- they stayed and sustained the enterprise unquestioned, writing most of the "scientific output," checking it, publishing it and insisting that everyone should go through channels controlled by them.
That is how false ideas have always been turned into "science." To conclude: the broad ranging evidence suggests that, in general (excluding wars and military threats), prosperity would be hindered less if governments just created the institutions on the background of which entrepreneurship and financial markets flourished. If we live with ideas that governments can frequently do more than that, we can be sure this is a consequence of government-subsidized myth creation.