Evaluating the environment for economic growth:

  The remarkable technological advance and prosperity in the United States are attributable primarily to the nation's innovative entrepreneurs and the mass of large established firms that quickly adopt innovations and spread them nationwide.
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Vital factors in the real world are widely disregarded in the mathematical analyses of professional economists. Macroeconomic models fail to distinguish vital characteristics of the economic environment among the mass of factors of production included in the models.

Instead of just quantifiable factor inputs, the authors stress the institutional and cultural frameworks that hinder or facilitate commerce especially with respect to the efforts of innovative entrepreneurs.

  The economic environment that encourages and facilitates these two factors is the key to understanding economic growth and prosperity in the U.S. and in other advanced nations. It is also the key for understanding prospects for development elsewhere, William J. Baumol, Robert E. Litan and Carl J. Schramm explain in "Good Capitalism, Bad Capitalism, and the Economics of Growth and Prosperity."
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  The authors do not offer a recipe for economic success. Instead, they discuss the general reform efforts that can facilitate economic development. Each nation must find its own way of adapting those reforms to its own conditions. That the government role in successful entrepreneurial capitalist systems is essential and elaborate is stressed throughout the book. (See, "Government Futurecast," at Part I, "Economic virtues of the U.S. political system.")

  This has in fact always been the case. Laissez faire capitalist systems have always been a myth. See, "The 'Laissez Faire' Straw Man" segment in "Future Economic Myths."

  The authors assert plausibly that these vital factors in the real world are widely disregarded in the mathematical analyses of professional economists. Macroeconomic models fail to distinguish vital characteristics of the economic environment among the mass of factors of production included in the models. Economists boil everything down to supply curves and demand curves that explain optimal pricing and input combinations without consideration of essential human characteristics among both producers and consumers. (See, "Capital as Purchasing Power" for a review of the many essential macroeconomic elements that mathematical economics can't capture.)
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  The authors recognize the contributions of mathematical economic analysis but stress its limitations. They rely predominantly on a professional analytical approach "informed by a substantial body of facts" that include but are not confined to statistics from measurable factors. Instead of just quantifiable factor inputs, they stress the institutional and cultural frameworks that hinder or facilitate commerce especially with respect to the efforts of innovative entrepreneurs. They provide an appendix that illustrates the difficulties of econometric evaluation of their concepts, especially considering the dubious statistics available.

  "[Economists] cannot run controlled experiments - - - with entire economies, although in some rare cases, social scientists can conduct more modest experiments on selected populations - - -. But no government will allow its country to serve as a control group or a guinea pig for a study on what encourages or inhibits economic growth, especially given the long time lags involved in collecting and analyzing sufficient data for economists to draw definitive conclusions."

  Statistical evidence is of course valuable, but it has limitations.

  "[The] statistical techniques that economists typically use - such as multivariate regression analysis - have their own shortcomings. For one thing, the results they generate are only as useful as the data to which they were applied - - -. For another, statistical techniques often do not generate consistent or even clear answers, which is a limitation that we believe plagues the statistical work on growth in particular. There is always the problem of omitted variables or influences that really matter but which have not been included in the statistical tests, sometimes unintentionally or, more often, because the data to measure those influences do not exist or are highly imperfect."

  These and other weaknesses of mathematical macroeconomic analytical methods have been a persistent theme of FUTURECASTS coverage. See, especially, Hendry and Ericsson, "Understanding Economic Forecasts," and Scott, "The Concept of Capitalism."
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 Even Keynesian economists are increasingly expressing dissatisfaction with the invalidly narrow focus of modern economic analysis in general and mathematical economics in particular. See Akerlof and Shiller, "Animal Spirits," and Cooper, "The Origin of Financial Crises." Cooper broadens the focus to government mismanagement, in this case, central bank mismanagement of monetary policy.
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 The publisher of FUTURECASTS online magazine has been writing about these weaknesses since 1967. See, Blatt, "Dollar Devaluation," Vantage Press (1967). John Maynard Keynes stressed these weaknesses far more eloquently thirty years before that, but this is one aspect of his work that his Keynesian followers have since determinedly ignored. See, Keynes, "The General Theory," Part I, "Elements of the General Theory," at segment on "Labor Market Theory," and Part II, "Interest Rates, Aggregate Demand, and the Business Cycle," at segment on "Aggregate Demand." That this question is here being raised by prominent economists is a welcome development - and long overdue.

  Moreover, the evaluation of policy outcomes is always clouded by intervening factors. Thus, debates over the impacts of tax changes and budget deficits continue unresolved for decades. Analysis of economic potential includes factors like geography, climate, culture and institutions the impacts of which escape statistical measure.
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Innovative entrepreneurship:

  Economic studies of growth concentrate on the "brute force" factors of inputs of capital and labor and "smart growth" factors of "total factor productivity" change.
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While developing countries can advance with mere replicative entrepreneurship, progress in the advanced nations requires innovative entrepreneurship.

  However, the "smart growth" factors are poorly understood and only recently have come under intense analysis by economists. While developing countries can advance with mere replicative entrepreneurship, progress in the advanced nations requires innovative entrepreneurship. The authors thus concentrate on the factors in the economic environment - especially the government policies - that facilitate or inhibit innovative entrepreneurship and the commercialization of innovative products and processes. While there are many such factors, the authors stress four that they consider especially important.

1. The formation of new businesses, and the liquidation of failed businesses, must both be facilitated. The right to fail without undue punishment is as important as the facilitation of success. Financial support must be available and labor markets must be flexible enough to encourage new businesses and their expansion.
2. Incentives for business activities must be in place. This includes the rule of law - especially contract and property rights. The burdens and risks of entrepreneurship are substantial, so the rewards of success must be secure.
3. "Rent seeking" and criminal behaviors must be discouraged. Unproductive efforts to transfer wealth from one pocket to another increase the costs and risks of all productive enterprise. Government income transfers and imposition of unreasonable risks of liability impose burdens that discourage enterprise.
4. Competition, both domestic and foreign, must be encouraged to provide continuous incentives for further innovation.

  The authors do not contend that these four factors provide a complete explanation of economic growth, but these factors are clearly essential and prominent parts of that explanation. Culture, geography, education, democracy and many other factors are clearly involved, but these all fail in economic environments characterized by weaknesses in the four factors that the authors consider most important.

  The authors do not mention the role of civil society in economic development. In combating corruption and oligarchic behavior, in supporting rule of law, education and infrastructure development, in assuring the fairness of democratic processes, and much more, a politically, legally and economically empowered civil society is essential. Its absence or weakness repeatedly proves to be a limiting factor in economic development and the viability of democracy.

There are diminishing returns for investments in additional "brute force" economic factor inputs, but not for investments in technological innovation and development.

  For the United States to maintain its rate of economic progress, these four factors are especially important. There are always special interest groups that seek to constrain new competition and the creative destruction aspects of competitive innovative entrepreneurial systems. In the 1970s, they succeeded in the U.S. to a large extent in imposing burdens on entrepreneurial startups and are still a force to be reckoned with. Established "big firm capitalism" alone can accomplish much, especially in developing nations where replicative entrepreneurship can drive development, but for nations already advanced to the technological frontiers, the innovative entrepreneurial element is essential and must be facilitated. There are diminishing returns for investments in additional "brute force" economic factor inputs, but not for investments in technological innovation and development.
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  Statistical studies support the beneficial impact on technological development of various government policies such as openness to globalization, support for R&D and education, and "sound" macroeconomic policies including reasonably balanced budgets and avoidance of inflationary monetary policies. These "endogenous" economic factors appear operable regardless of "exogenous" factors outside the economic system such as climate, culture and institutions.

  "But unlike investment in a new machine, which has more or less predictable productivity-enhancing consequences, investment in knowledge discovery - and, if successful, its subsequent commercialization - is fraught with uncertainty. It is not surprising, therefore, that the statistical work that has gone into trying to explain the sources of technological advance has come up with varied answers, and some controversy over certain variables - such as openness to foreign trade - still continues."

The ability of nations to finance benefits for their aging populations crucially depends on the maintenance of substantial rates of growth. Growing societies are observably more vibrant and hopeful than stagnant societies.

  Economic growth has come under attack from a variety of modern critics, so several pages are spent in defending it. The authors address resource limitations, pollution, global warming, and readily demonstrate that feasible approaches for dealing with such problems all require healthy expanding market systems. Criticism of globalization is similarly easily dispatched, although a faulty analogy is drawn between trade across national boundaries and across state lines within the U.S. (Globalization does not involve uniform commercial laws or - despite impressive immigration flows - free movement of labor across boundaries.)
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  The U.S. - and the whole world - benefits from growth and innovation anywhere in the world because of the obvious benefits of a rapidly expanding market system. An increasingly prosperous world of nations enmeshed in global commerce is also likely to be a more democratic and peaceful world. (Somehow, this did not apply to Europe prior to WW-I.) The ability of nations to finance benefits for their aging populations crucially depends on the maintenance of substantial rates of growth. Growing societies are observably more vibrant and hopeful than stagnant societies.
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Reform efforts:

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  The "Washington Consensus" reform agenda in vogue since about 1990 has had relatively disappointing results where applied. Latin American nations and the transition economies of Eastern Europe and the former Soviet Union have had uneven and sometimes disappointing results with the ten listed Washington Consensus policies. China, on the other hand, has had huge success by slow incremental reforms rather than a "big bang" effort to do everything at once.
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  However, simplistic evaluations of reform efforts can be misleading, the authors warn. Nations like Argentina may have enthusiastically adopted some of the reforms - privatization, property rights, globalization - but been woefully derelict in budgetary, currency and exchange rate discipline. The list of Washington Consensus reforms says nothing about their relative importance or about timing and sequence of adoption. Subsequent efforts to create lists of the factors that are important for economic growth are similarly flawed.

  The transition economies from within the old Soviet Union are actually not reliably analogous with each other or with China. There were different conditions - different starting points - in each of the communist nations. Efforts at incremental reform failed repeatedly outside China because domestic power had devolved sufficiently to the party apparatchiks so they could - and routinely did - thwart the efforts of party leadership to initiate incremental reforms. In China, in the immediate aftermath of the Cultural Revolution, the apparatchiks' ability to thwart the reforms that were reducing their power and influence was still limited. See, "Third World Developing Nations," below.

  Efforts to reduce development policy to simple lists has fallen out of fashion because they lack nuance and ignore the particular characteristics of national starting points. "Context, culture and history all matter," the authors emphasize. "There is no single detailed blueprint that can or should be imposed on every country." However, some factors are clearly more important than others, and some are plainly essential.
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Four types of capitalist systems:

  To make sense of this complex array of factors and subtle relationships, the authors offer a general analytical framework.
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The provision of "government goods" such as infrastructure, education, utilities, research and development funding, etc., is carefully distinguished by the authors depending on whether the programs provide a platform that all can benefit from or are directed in favor of chosen "winners."

  For analytical purposes, capitalist systems are divided by the authors into four general types. There is, of course, great variation and overlap in the mix of economies judged predominantly to fit into each of the four archetypes, and economic systems change over time - often surprisingly quickly - enough to shift their overall characteristics.

• State-guided capitalism is dominated by government industrial policy that picks winners and losers. The stated objective is faster economic growth, but other political considerations and blatant rent-seeking activities frequently dominate policy.

  Government industrial policy is frequently implemented through ownership or control of the banking system or influence over credit allocation. Additional means of government influence are tax laws, regulatory provisions, exclusive licenses, government contracts, protection from foreign competition and regulation of foreign investors.
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  The provision of "government goods" such as infrastructure, education, utilities, research and development funding, etc., is carefully distinguished by the authors depending on whether the programs provide a platform that all can benefit from or are directed in favor of chosen "winners." State guided systems are common in Southeast Asia where export sectors are frequently favored. Latin American states had "import substitution" policies that favored sectors competing with foreign suppliers. Major advanced economic systems like those in Germany, France and the U.S. have all had some state planning elements. U.S. and EU agricultural policies are primary examples, along with housing and energy in the U.S.
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As long as state guided systems can obtain advanced technology from abroad and combine it with relatively low labor costs, rapid growth rates are attainable.

Commitment to industrial dinosaurs and financial zombies is perhaps the most pervasive weakness in state guided capitalist nations. They have difficulty "pulling the plug" and redirecting resources.

  State guided capitalism has been successful for developing nations that have adopted the export-driven growth model. As long as they can obtain advanced technology from abroad and combine it with relatively low labor costs, rapid growth rates are attainable. However, once per capita income approaches the levels in the more advanced nations, this strategy tends to break down.

  "[States] can often successfully guide their economies when they have well-defined targets to aim for. But as economies catch up to the technological frontier, the low-hanging fruit will have been picked. At this point, or perhaps well before it, the drawbacks of state-guided capitalism become more evident: excessive investment, an inability to come up with radical innovation, susceptibility to corruption, and the reluctance to channel resources from low-yielding activities toward potentially more rewarding ventures become the norm."

  Governments tend to direct over-expansion in favored industries - as S. Korea did with steel, chemicals and semiconductors in the 1990s, leading to the collapse of the banks that had supported the expansion. China, too, has had a huge banking problem as a result of government requirements that they lend to state owned enterprises. Japan's "administrative guidance" also drove its banks into a deep hole in the 1990s. (Government allocation of financial resources to housing had the same results in the U.S.)
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  Governments can pick the wrong winners and losers. "[Once] economies are at the frontier where success is not so easy to generate -- because there are no clear leaders to copy or follow -- mistakes are easy to make." Malaysia's huge but underused high technology parks, and Singapore's bet on biotechnology that has yet to pay off, are mentioned by the authors.

  U.S. investments in synthetic fuels in the 1970s were clearly premature, and its adoption of space shuttle technology has proven very costly. So far, its bet on corn ethanol has been a disaster.

  Commitment to industrial dinosaurs and financial zombies is perhaps the most pervasive weakness in state guided capitalist nations. They have difficulty "pulling the plug" and redirecting resources. Rich nation agricultural subsidies are a prime example. "Indeed, it is ironic that political pressures often force governments to support failing industries rather than those industries with promise for the future, largely because the dying industries and their employees can be counted upon to cry most loudly for government assistance." (The U.S. automobile manufacturers provide a current example.)

Revolution may be the only way to relieve a population from the constraints of oligarchic systems.

• In Oligarchic Capitalism, which frequently amounts to "kleptocracy," the economy is run for the benefit of the politically influential. "It is prevalent in much of Latin America, in many states of the former Soviet Union, in most of the Arabic Middle East, and in much of Africa." (The weakness or absence of an empowered civil society in these regions is not mere coincidence.)

  The authors conclude sadly that revolution may be the only way to relieve a population from the constraints of these systems. Income inequality is typically much greater in these nations, and the populace is compelled to engage in widespread gray market activities. To protect the favored few, governments "backed by oligarchic elites seem to go out of their way to make it difficult  for informal firms and individuals to operate formally" within the law.
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  Gray market "informal economy" activities are prevalent throughout Latin America as well as in Africa, Asia, India, China and Russia. See, de Soto, "The Mystery of Capital." Regulatory obstruction of the conduct of legitimate business provides opportunities for widespread corruption, and the need to retain political influence subjects the oligarchs to corruption, too. Widespread corruption inhibits both domestic and foreign investment and smothers innovative enterprise. Nations subject to the "natural resources curse," where oil or some other easily accessible raw material wealth supports the government, fall into this category.

Big firm capitalism is frequently oligopolistic. Large firms work hand in glove with government to protect themselves from competition and for rent seeking.

• Big firm capitalism is characterized by professional management acting as the "agents" for widely dispersed shareholder "principals" who have no direct control over management. It is prevalent in continental Europe, Japan, S. Korea. It has a widespread presence in the U.S. and elsewhere.

  Shareholders still play a vital supervisory role, left wing mythology to the contrary notwithstanding. By selling their shares - by "voting with their feet" - shareholders can punish management by causing share prices to plummet. This increases the difficulty of raising capital and increases management vulnerability to hostile takeover. Although far from perfect, stock market prices are a far more efficient and effective form of supervision than any government administered or regulatory alternative. When stock market discipline fails, regulators generally fail also.
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  The "principal-agent" problem - identified originally by Adam Smith, (See, "The Wealth of Nations," Part II, "Economic Policy," at segment on "Regulatory Companies.") - arises because the interests of the management "agents" are not identical to those of the shareholder "principals." This leads to trouble whenever management decides to milk corporate assets for its own short term benefit rather than build them for shareholder benefit. Every recession reveals some of the more extensive abuses of this sort, as well as instances of outright fraudulent conduct. It is generally the recession phase of the business cycle rather than regulation that cleanses the economic system of these houses of cards.

  Big firm capitalism is frequently oligopolistic. Large firms work hand in glove with government to protect themselves from competition and for rent seeking. Innovation is often pushed to the margins and suppressed.

  "The U.S. automobile and steel industries are prime examples of large firms in oligopolistic markets that lost their competitive zeal and then sought and obtained trade protection to blunt -- but not totally thwart -- more efficient competitors from abroad. The domestic counterpart of trade protection here is antitrust litigation aimed at benefiting particular big-firm competitors rather than the entire economy, with such litigation mounted by increasingly enterprising plaintiff's lawyers, state attorneys general, and occasionally federal antitrust authorities."

Sale to a large firm may be the winning strategy for a successful innovative entrepreneur

  However, large firms have advantages in public utility markets. Their financial resources permit them to fund R&D and to acquire innovative advances and quickly commercialize them. A few - such as GE and 3M - specialized in R&D - at least in the recent past. Honda and Toyota are also prime examples of big firms running successful R&D programs.
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  Indeed, sale to a large firm may be the winning strategy for a successful innovative entrepreneur who nears the end of his commitment to his enterprise. Successor management is very unlikely to be as innovative as the founder. Frequently, good innovators are poor managers and can only succeed by selling out after demonstrating the advantages of their products or processes. (Recent increases in the regulatory costs of going public have made initial public offerings less attractive as a method of exploiting innovation, so innovation is less likely to generate new competitors in the market.)
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  This suits large firms, most of whose R&D may involve only the refining of existing products and processes. Large pharmaceutical companies regularly buy their breakthrough products from innovative small firms. The large firms have the financial strength to push these products through the regulatory hoops and further improve them. In turn, the presence of large firms as buyers stimulates innovative efforts by many who lack the ability to finance regulatory approvals and mass marketing. Large information technology firms like Cisco, Intel and Microsoft also operate in this way. Unless the big firms are willing buyers, innovation in big firm economies is frequently thwarted by regulatory hurdles, rigid labor markets and lack of financing..

• Entrepreneurial capitalism facilitates and rewards innovative efforts and the commercialization of new products and processes. It drives the technological advance that improves living standards throughout the capitalist world. (The Soviet Union had very innovative scientists but notoriously poor ability to commercialize their work.)

  "Radical breakthroughs tend to be disproportionately developed and brought to market by a single individual or new firm, although frequently, if not generally, the ideas behind the breakthroughs originate in large firms - or universities - that, because of their bureaucratic structures, do not exploit them." (emphasis in original)

  Innovative entrepreneurs can generally "only be found in capitalist economies, where the risk of doing something new -- and spending time and money to make it happen -- can be handsomely rewarded and the rewards safely kept."

  "Successful entrepreneurial economies embrace and generally encourage change. They do not erect barriers that prevent money and people from shifting from slow-moving or dying sectors to dynamic industries. They do not wall off their existing producers from more efficient ones in foreign countries. And they seek out better ideas wherever they can find them, even abroad." (emphasis in original)

For nations near the technological frontier, only a combination of entrepreneurial capitalism with a mix of big firms can achieve the best results.

  Creative destruction is an essential feature of entrepreneurial capitalism. Old products and methods are constantly being displaced, and the flock of entrants in any new industry is ultimately culled to a successful few in a boom and bust flurry of activity. Properly constructed safety nets may be essential for innovative entrepreneurial systems to keep those threatened by change from acting politically to prevent change. "Big firms remain essential to refine and mass-produce the radical innovations that entrepreneurs have a greater propensity to develop and introduce."
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  The authors point out that the largest firms in Europe in 1998 were all large in 1960, while eight of the 25 largest firms in the U.S. were very small or did not exist in 1960.
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  State guided capitalism has had successes in developing nations, the author point out without judging whether progress would have been faster under entrepreneurial capitalism. However, for nations near the technological frontier, only a combination of entrepreneurial capitalism with a mix of big firms can achieve the best results.
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The entrepreneurial economy:

  Four principal factors are identified by the authors as essential for an entrepreneurial economy.

• It must be easy to start a "formal" business. The regulatory environment, labor market, financial system, bankruptcy system must not pose substantial obstacles or risks. 

  Only businesses organized formally within legal requirements are capable of development and growth - and the creation of "live capital." See, de Soto, "The Mystery of Capital." The authors review the statistical evidence concerning national obstacles to business formation. Receptiveness to foreign direct investment is also considered. Reasonable bankruptcy laws are especially important. Penalties for failure must not be so great as to deter risk-taking. Availability of financing for high-risk, high-reward activities is essential. This is far more likely in a decentralized financial system like that in the U.S. The authors stress the role of the venture capital funds and "angel investors."

Private property rights are the most important factor common to all forms of capitalism.

It is the legal and regulatory environment that distinguishes the capitalist free market from the free market of the third world bazaar.

• The rewards for successful innovation must be substantial and secure enough to provide incentives for the risks and hard work required.

  Success is reinforced by appropriate rule of law legal rules, adequately enforced, especially protecting contract and property rights. Private property rights are the most important factor common to all forms of capitalism. This implies a stable government capable of assuring such property rights. It is the legal and regulatory environment that distinguishes the capitalist free market from the free market of the third world bazaar.
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  Incentives are reduced by high tax rates - especially for income taxes. The regulatory environment should facilitate enterprise instead of obstructing it.
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  Patent protections are a traditional incentive for innovation that has been used as far back as the 14th century. The patent monopoly today in the U.S. lasts for 20 years and is actually very inexpensive. By some estimates, inventors garner only about 3% of the benefits of their inventions and society gets the rest. Abuse of the patent process, however, has been an increasing problem. There is no question that protection for "intellectual property" for some length of time provides essential incentives for the assumption of the costs and risks of innovation. This is one area where competition is counterproductive, but the protections offered can be overdone. After a reasonable length of time, competition has to be permitted to work its magic.
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  Government and university research, especially basic research, has also proven useful. For developing nations, the innovation that is most efficient may involve the replicating or imparting of first world technology.

• Corruption and "rent seeking" must be minimized. These are methods of acquiring wealth without contributing to its creation. They can actually reduce total wealth.

  "Rents" in this context have been defined as "profits in excess of the competitive level." Lobbying for special benefits and obstructive litigation are two examples of rent seeking that are typical in the U.S. It is the legal constraints on corruption and political limitations on rent seeking first in England and then in other advanced nations that has made it possible for modern capitalist market economic systems to flourish.
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  Redistributive welfare benefits may be considered a price worth paying if they do not impose too heavy an economic burden. They reduce the risk of populist backlash that can be even more costly than the welfare benefits.

Import competition and incentives to compete broadly in global markets undermine local rent seeking activities.

• Competition is the essential disciplinarian of the markets. Competition drives the successful to improve their game instead of just resting on their laurels and engaging in efforts to protect their turf through rent-seeking activities and suppression of new competitors.

  Appropriate antitrust law enforcement and free trade policies that broaden competitive markets are two of the most effective methods for keeping successful firms on their toes and driving them to keep improving their products and processes. Of these two forces, free trade is by far the most effective. Import competition and incentives to compete broadly in global markets undermine local rent seeking activities.
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  The authors refer to the impact of foreign competition on the big three U.S. automobile manufacturers. Constrained oligarchic competition resulted in poor quality standards and a lack of innovation until foreign competition forced desperate efforts to catch up that continue to this day. The landline telephone monopoly was another prominent example where even modest levels of competition led to vast rapid improvements (although the AT&T monopoly system was then the best major system in the world).

  "The United States' experience, in other words, demonstrates that even economies at the so-called technological frontier can benefit significantly from open borders -- to goods, ideas, and people. If the developing world needs a similar example from the ranks of its own, it need look no further than Hong Kong, a once poor city-state without any natural resources that on a per capita basis has become one of the world's economic powerhouses - even after it was absorbed by mainland China in 1997 -. Hong Kong achieved its success by attracting FDI primarily in the financial sector, and in the process it has become the financial hub for Southeast Asia."

Productive and even entrepreneurial characteristics blossom in all manner of peoples once they enter the U.S.

  Culture, education, macroeconomic stability and democracy are other factors that can benefit innovative entrepreneurial activity, but the impacts of these factors are not as clear as the impacts of the first four.
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  Culture is heavily influenced by economic policies and institutions. Productive and even entrepreneurial characteristics blossom in all manner of peoples once they enter the U.S. (It must be something in the air.)
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  Education seems to be an obviously important factor, but excellent primary and secondary education in the Soviet Union and Eastern Europe during the Cold War failed to translate into commercial economic performance. The Soviet system essentially wasted its education resources except with respect to weaponry and government projects like space flight. Indeed, since 1960, there has been measurable improvement in education levels in third world nations, many of which have shown reduced rates of economic growth or none at all.
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  Other factors - predominantly the authors' primary four - such as rule of law, property and contract rights, security for persons and their property - are clearly more important. "The institutions must be right for education to work its magic." (But factors can still be essential even when not alone sufficient.) Education is likely to be even more important as our technological age progresses. Innovations in biotechnology, nanotechnology or information technology will undoubtedly depend on highly educated people.
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  However, education and R&D initiatives aimed at increasing innovation unfortunately deal only with inputs, not outputs. As long as the overall commercial environment is not conducive to new firm formation and growth, there will continue to be a lack of large social gains from such efforts.
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  Macroeconomic stability is essential for all economic systems, not just innovative entrepreneurial and big firm capitalism. However, it does not determine maximum growth rates.
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  Democratic capitalism is today being challenged by autocratic capitalism - in Singapore, Hong Kong and China - to determine which system best promotes economic growth. The authors optimistically suggest that political rights will eventually follow economic rights (as they did in Taiwan and S. Korea).
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Governments must make it easy to form businesses, see to it that successful entrepreneurs earn handsome rewards, discourage corruption and rent-seeking activities, and facilitate domestic and foreign competition in the broadest possible markets.

  The authors thus identify four primary government policies for maximizing the odds of generating and commercializing radical innovation. Governments must make it easy to form businesses, see to it that successful entrepreneurs earn handsome rewards, discourage corruption and rent-seeking activities, and facilitate domestic and foreign competition in the broadest possible markets.

  "[We] believe that state-guided economies eventually must find ways of transitioning toward a blend of big-firm and entrepreneurial capitalism for a simple reason: at some point, the opportunities for imitation, the predicate for state guidance, will have been exhausted. At some point, economies must innovate rather than simply replicate. That is when state guidance will have run its course."

Third world developing nations:

  For countries to grow, governance is the key.
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  Government leaders must want widespread growth and be prepared to work for it. Some form of revolution may be the only way to move oligarchic leadership out of the way, but unfortunately not all revolutions move nations towards economic freedom. Latin American nations with oligarchic economies have been repeatedly subjected to revolutionary overthrow. However, many were subjected by their revolutions to military or populist despotisms and then returned to oligarchic systems.
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The remarkable growth rates achieved by successfully developing nations were due to the elimination of obstacles to what was predominantly replicative entrepreneurship. State guidance and resource allocation policies do not seem to have improved economic performance.

  State guided capitalism has been a feature of many of the development success stories since WW-II and since the collapse of the socialist alternatives in the 1980s. The authors note several extensive studies, however, that indicate that the remarkable growth rates achieved by successfully developing nations were due to the elimination of obstacles to what was predominantly replicative entrepreneurship. State guidance and resource allocation policies do not seem to have improved economic performance.
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  Nevertheless, state guidance is popular with political elites because of the political and financial opportunities for rent seeking and bribery that it offers. Indeed, there is strong evidence - most notably in India - that state guidance has been a substantial obstacle to economic growth, and that the best results actually occurred outside the state favored programs. Government policies that do work include development of physical infrastructure, education, rule of law, and support for the financial framework. Policies that encourage exports and discourage imports - primarily by maintaining an undervalued currency - have proven useful.

  This mercantilist effort may increase the wealth of influential elites and the power of the government over its own people, but it observably reduces living standards for the people as a whole by, most obviously, reducing the purchasing power of the currency that they hold. When it involves the artificial reduction of exchange rates, it results in acquisition of huge investments in U.S. government securities that pay low interest rates and are denominated in a depreciating dollar.

"Economies grow because individuals and the firms they form are the engines that turn labor, capital, and technology into products and services that consumers, inside countries and beyond, want and are willing to pay for."

  Even the success of state guided capitalism in China is remarkable in the observable constraints on economic growth imposed by state industrial policies. China is still a mixed bag as one would expect of a huge complex slowly - carefully - reforming nation with a political elite determined to remain in control. Reform has come a long way in China, but still has mountains to climb.

  "China has advanced despite not fully having two of the ingredients for a successful entrepreneurial economy [previously highlighted]: effectively enforced property and contract rights, and a financial system that affords entrepreneurs access to capital to finance their ventures. - - - As a result, Chinese entrepreneurs typically borrow from informal lenders or investors - including family and friends - to back their enterprises [cite]. Below, we will suggest that informal law and finance eventually will reach their limits and that for Chinese entrepreneurship to move to the next stage, the country will have to develop more formal ways of doing business. Already foreign investors have demanded greater formality, and as more Chinese firms do business with them, formal law and finance should gradually spread to the rest of Chinese enterprise."

  China has the advantage of its huge market, making it too big to pass up despite the risks of corruption and limited legal protections. For smaller nations, attracting the foreign direct investment that plays such a major role in China's success requires making such investment attractive by reducing corruption and providing rule of law safeguards. An educated workforce and improved infrastructure are also needed both to attract foreign direct investment and for domestic entrepreneurs.

  "In short, the examples of India, China, and Taiwan provide striking evidence supporting the World Bank's finding that state guidance is not the silver bullet for accelerating economic growth that some of its advocates may believe. Rather, economies grow because individuals and the firms they form are the engines that turn labor, capital, and technology into products and services that consumers, inside countries and beyond, want and are willing to pay for. Firms, in turn, just don't appear from nowhere. They are started and nurtured by entrepreneurs, who take on often seemingly unimaginable risks. Countries that want to grow cannot overlook this simple but powerful fact."

  Governance that facilitates entrepreneurship is always an effective strategy for economic development. The authors provide numerous examples of successful "bottom-of-the-pyramid" innovations and successful commercial enterprises in third world nations. Mobil phone services, solar powered electric units and clean water services and small unit brand name product sales are mentioned. The "savings trap" mythology of economist Jeffrey Sachs is disparaged by the authors.

  "[Sooner] or later, economic development, even in supposedly poor countries, eventually requires a healthy dose of entrepreneurship."

  As FUTURECASTS has repeatedly explained, poor countries stay poor because of poor governance. There is no other cause.

Almost all poor nations maintain onerous obstacles to business formation.

A functioning rule of law legal system is essential so that commercial relationships can widen beyond family and trusted relationships.

  Reduction of barriers to business formation allow small informal businesses to grow into taxpaying, employment giving legally registered businesses. Almost all poor nations maintain onerous obstacles to business formation. The authors highlight some of the obvious governance reforms needed.

  "[Eliminate] the involvement of courts in business registration; do not require publication of the registration in a newspaper; introduce standardized and streamlined registration forms, with a fixed - and modest - fee; and impose a nominal or zero-capital requirement - unless the public interest unquestionably requires it, as in a newly established bank or provider of insurance -. Furthermore, as telecommunications improve, allow online registration."

  Establishment of legal protection for contract and property rights is a more difficult proposition. A functioning rule of law legal system is essential so that commercial relationships can widen beyond family and trusted relationships, but most third world nations lack the necessary sophistication.

  "In a world of strangers, law must be present to provide comfort and confidence to the parties that their deals will be honored and that their disputes, if they arise, will be resolved amicably, or at least fairly, through some kind of legal process. Foreign investors, in particular, will not do business in a country unless they not only know the rules of the game, but also have confidence that the rules will be enforced fairly, consistently, and expeditiously."

  Even in China, there has been continuing adoption of rule of law reforms for commercial transactions.
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Finding appropriate purchasers for the frequently vast and influential bank assets poses political as well as practical economic problems.

  The political allocation of credit to established, politically favored enterprises is decreased and the financial resources available to facilitate the expansion of successful new enterprises is increased by the privatization of banks. This, too, is a difficult reform to implement because of the powerful political and private interests that benefit from state control of banks. Finding appropriate purchasers for these frequently vast and influential assets poses political as well as practical economic problems.
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  Thus, the authors recommend  liberal licensing of new private financial institutions as a means of getting around difficulties. Foreign as well as domestic banking should be facilitated. Here, too, however, there is a practical need for sophisticated regulation that matches the increasing sophistication of modern finance. This is not an easy thing for third world governments to provide. (It's not that easy for advanced nations to provide, either.)
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  Education is an important contributing factor that third world governments can provide to facilitate economic development. The authors note that developing nations generally choose to increase education in breadth - to increase widespread access to K-12 education - rather than in depth - to develop elite domestic universities for their most talented students. Developing nations generally don't have the resources for both. India and China are the most prominent exceptions where excellent technological institutions have been developed leaving a weak K-12 system. Other developing nations frequently outsource the training of their most talented students by subsidizing study abroad.

  "Both the universal and elite educational models have been quite successful in stimulating aggregate economic growth but with very different distributional outcomes. As one would expect, if educational opportunities are afforded widely, then earnings should be distributed more evenly than in societies where educational resources are concentrated on a limited portion of the population. This helps explain the contrast in the relatively flat income distributions in the Southeast Asian economies, on one hand, and the much wider disparities found in India and China, on the other."

  Ultimately, economic development provides resources for both universal and elite education. For small third world countries, the authors believe that the universal model will provide the best results. The meritocratic approach in India has taken generations to bear fruit and owes much of its current success to unique factors.
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  Shock therapy was an apparently miserable failure for Russia, and the authors recognize the political opposition that it generates. The measured but persistent reform efforts of China are often viewed as the superior alternative.

  "[Any] reform strategy of moving away from state guidance is most likely to succeed if it facilitates entrepreneurship without at the same time transparently and immediately threatening large vested interests [in either the  private or public sectors]. Over time, however, as new ventures form and become successful, economic and political power naturally will gravitate in their direction, and the power of the previous regimes will wane."

  The vastness, complexity and sophistication of the governance activities required to facilitate modern entrepreneurial capitalist systems is the bad news. The good news, as amply demonstrated in China, is that a cornucopia of benefits becomes quickly available from even the initial phases of any motivated, persistent reform program.
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  Radical reform - "shock therapy" - in Soviet bloc transformation nations had many initial difficulties, as one would expect after decades of socialist mismanagement. However, the radical reform states have since been doing quite well, and the comparison with China is inapt due to fundamental differences in initial conditions. It is noteworthy that those Soviet bloc transformation states that chose radical reform have done much better with political reform than those that adopted gradual reform programs that left communist elites in positions of economic power and political influence. See, Åslund, "How Capitalism Was Built," to be reviewed next month, and Kotkin, "Armageddon Averted: The Soviet Collapse 1970-2000,"

Iinitial elections frequently bring populist autocrats into power who proceed to strip the people of both political and whatever economic freedom that they had.

"Free elections alone are insufficient to produce substantively democratic government."

  Oligarchic systems do not change themselves. Unfortunately, democratic political reforms don't necessarily assure that newly elected regimes will move towards pro-growth forms of capitalism - or even maintain the democratic political process. Instead, initial elections frequently bring populist autocrats into power who proceed to strip the people of both political and whatever economic freedom that they had.

  "The democratic revolutions in Latin America in the 1970s and 1980s, and in many African nations in the 1990s, brought elites to power who quickly established or perpetuated oligarchic capitalist systems -- that is, economies that benefited the few and not the many. Indeed, although many Latin American countries introduced market-oriented reforms after they adopted democracy, their economies and governments still were tightly controlled by these elites, whose firms had licenses and other privileges not available to the many informal enterprises that operated in these economies. And, as noted, the populist backlashes of the past decade have only replaced one set of oligarchs with another, all of whom have handed out subsidies to satisfy their populist base of support but done little or nothing to encourage the formation and growth of new enterprises."

  Indeed, "free elections alone are insufficient to produce substantively democratic government." A prospering capitalist economy increases the likelihood that people will reject populist rhetoric and support the institutions of political and economic freedom. (The "shock therapy" radical reform states of the old Soviet bloc have generally also achieved and maintained democratic systems, whereas those that chose gradual reforms became politically dominated by the ruling elites that entrenched themselves during the gradual reform period.) Some form of guided capitalism may as a practical matter be more likely to succeed among peoples who have never known capitalist market economic freedom.
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  The authors suggest that business internships and business school scholarships be offered to college students and recent graduates from oligarchic third world nations. This would be similar to the cultural exchange programs that proved successful over several decades during the Cold War. There are several other methods used to influence oligarchic systems in favor of reforms, but success has been elusive.
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Whatever benefits economic aid may initially provide, it clearly cannot sustain economic growth.

  Decades of increasingly massive foreign aid flows have achieved only dubious results at best. The reasons for this failure and prospects for current aid programs are summarized by the authors. Whatever benefits economic aid may initially provide, it clearly cannot sustain economic growth. Without the economic reforms discussed in this book, undeveloped aid recipients will remain undeveloped. (Indeed, aid may actually serve to prop up the autocrats responsible for the failure to develop.)

  "[There] remains much truth in the proverbial story that while giving fish can stave off starvation, the only way to continue to do that is to teach recipients how to fish. Thus, less developed countries need entrepreneurship to advance growth precisely because they have low savings. Even in the rich world, the evidence indicates that investment contributes only a small part of overall growth. Where savings and investment are limited, more emphasis on enterprise and innovation becomes indispensable, as the one way for those who have little to make do today, and to do better tomorrow. Once incomes grow above a certain level, saving and investment can increase -- Southeast Asia demonstrates that -- but, still, substantial progress always entails a need for innovation. Later, after success arrives, big firms can and need to contribute, just as they do in rich countries."

  The micro-credit movement is viewed favorably by the authors. Micro credit initiatives have proven of great value in the alleviation of poverty, but by themselves offer no route to continued development. Micro-credit just enables the poor to reach the first rung in the economic ladder. For recipients to climb higher requires laws and institutions that facilitate growth.
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Europe and Japan:

  The "corporatist" economic models of Japan and Continental Europe are described and discussed by the authors.
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  The success of this model after WW-II was impressive but clearly had limits.

  "[Large] firms, with the ability to mobilize large pools of capital and labor, have an inherent advantage in mass-producing others' innovations or in imitating products and services developed elsewhere. Because they literally were starting over, firms in both economies were well positioned after the war to do little more than imitate or adopt American technology, either through licensing, joint ventures, or simply basic observation. And that is exactly what they did until a number of the more successful enterprises introduced incremental and in some cases radical innovation that outpaced their American counterparts."

  Most notably, their automobile manufacturers soon displaced American competitors as the innovative leaders. However, for the most part, innovation lagged in Europe and Japan.

  "[What] happens when one runs out of things to imitate? That is essentially the problem that confronted both Europe and Japan at the end of the twentieth century."

  Employment levels and per capita income have lagged behind U.S. rates since 1990. This is called "Eurosclerosis." The policies and other factors reinforcing Eurosclerosis in both Europe and Japan are summarized by the authors. (Their description of the Japanese bubble economy of the 1980s fits surprisingly well with that of the U.S. prior to the Credit Crunch, with U.S. banks undermined by mortgage-backed securities rather than stocks.)

  "When the property boom turned to bust, property collateral values fell, as did demand for the products that the firms were producing. Furthermore, the sharp drop in stock prices wiped out much or all of the unrealized gains in the company shares held by the banks, which forced a sharp reduction in the banks' capital and thus their ability to lend. In combination, all these things -- the bursting of the property and stock market bubbles and the downturn in demand -- meant that the Japanese banks were in deep trouble on two accounts: their capital base had dwindled and their borrowers had difficulty repaying their loans. Meanwhile, many borrowers were stuck with excess capacity."

  An aversion to competition is Europe's primary problem. Vested economic interests - both labor and industrial (and agricultural) - are sheltered from domestic and foreign competition, rendering the economy incapable of adjusting to changing conditions.

  "As one study has documented, in these countries the companies in the bottom quartile of performance -- the least productive firms -- have grown more rapidly than the best-performing companies. As the study authors conclude, 'the United States eliminates its least productive companies; the EU does not,' a result they attribute to the oppressive combination of excessive product and labor market regulation and zoning rules that inhibit entry by more innovative firms."

  However, electorates in core continental EU nations prefer the security of their current economic system. They prefer security to growth, even if their children have trouble finding permanent employment and the continent declines in relative power and influence.
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  Reforms that facilitate innovative entrepreneurship are needed to change this. The barriers must at least be removed. In the lower and medium income EU nations, the need is clearer and reform more likely. The authors discuss the measures governments can adopt to facilitate innovative entrepreneurship, including improvements in higher education, reductions in barriers to entry for new competitors, and especially some flexibility in labor markets. The authors are properly dubious about credit allocation measures, but favor a shift to Keynesian flexibility in monetary and fiscal macroeconomic policy. (Apparently, they want Europe to suffer from as much inflation and currency weakness as in the U.S.)

  "Our answer here is similar to the advice we provided in the last chapter for developing -- and more advanced -- countries wedded to state guidance: reform at the margin. Thus, in the case of continental Europe, in addition to the measures we have already favorably mentioned, European countries could exempt new enterprises -- those legally formed after a certain date -- entirely -- or nearly so -- from the current labor protections that apply to other firms. We suggest an exemption based on date rather than size, which is already present in the laws of a 'notch' at the threshold but also, for reasons just noted, a strong barrier to the formation of potentially high-growth enterprises in the first place." (emphasis in original)

  This, of course, has the weakness of any two tier legal arrangements. Existing businesses would begin to outsource operations to "new" businesses formed for that purpose. Dealing with this would require complex legal and regulatory responses. (It would be a legal and regulatory nightmare - and is hardly likely to win labor union acceptance.)

  "Young voters [in Japan and Europe] are the obvious potential beneficiaries of reforms that lead to more entrepreneurial success and hence economic growth. Our advice to leaders in these countries is to sell the reforms to them, while assuring their parents that the reforms will not immediately threaten their own interests. Indeed, such steps are the best hope for providing for their children's welfare while also ensuring that health and retirement benefits promised to them by their governments can be paid for out of the resulting future growth.

Economic growth in the United States:

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  For the U.S., the challenge is to maintain "the critical balance of big-firm and entrepreneurial capitalism." The U.S. must continue "to provide incentives for productive entrepreneurship and discourage diversion of entrepreneurial talent into unproductive or destructive sources of wealth." (High marginal tax rates notoriously divert talent into unproductive tax avoidance schemes.)
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  The proliferation of "rent seeking" activities is a clear danger. Trade associations, lobbyists, labor unions, etc., all seek government intervention for favorable treatment. Rationalizations that support interest group rent seeking efforts are readily manufactured by the intellectual community.
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  Continued rapid growth in productivity is essential for the continued rapid economic growth of an advanced economy. Only with such growth can the U.S. government meet its burgeoning social obligations. Thus, productive entrepreneurship must be encouraged with adequate incentives and a legal and regulatory regime that facilitates commerce. Unproductive activities must be discouraged. Competitive markets must be maintained to force successful firms to remain innovative.
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   The authors list a number of pertinent problems.

• The "exit strategy" of successful start-up companies has increasingly involved sale to a large firm rather than initial public offerings of stock that would allow the new firms to grow rapidly as increasingly influential factors in their economic markets. This may reflect increasing barriers and liability risks raised by the 2002 Sarbanes-Oxley Act and related regulations.
• Recent increases in bankruptcy law requirements may deter risk-taking.
• The tax statute is a recognized obstruction to economic growth, but the politics of taxation prevent any rational reform.
• Growing entitlements will eventually require higher tax rates that will inhibit economic growth.
• Patents increasingly granted for "obvious" innovations have become an obstruction instead of an incentive for innovation. The authors discuss some alternatives but recognize the complexity of the problems and the difficulty of getting the right balance.
• Unproductive entrepreneurship is a growing problem in the U.S. While outright corruption is low, rent seeking is widespread. Presciently, the authors -- writing in 2005 -- include government sponsored entities like Fannie May and Freddy Mac that use implicit government guarantees to dominate their market. Farm subsidies, extension of the period of copyright protection, rent-seeking litigation, are examples of costly efforts that create no wealth and just transfer wealth from one pocket to another. Antitrust and class actions are especially prone to abuse, but they also serve important legitimate purposes.

  The authors offer some suggestions but admit there are no easy answers for these problems.
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Competition:

  Competition is the disciplinarian of the market. It forces established firms to keep innovating and commercializing the innovations of others.
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Capitalist market competition is not a zero sum game.

  The competitive pressures and opportunities of the broadest possible markets are available through domestic and international free trade and foreign direct investment. Globalization and reasoned application of antitrust laws remove private obstacles to market mechanisms. 
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  Capitalist market competition is not a zero sum game, the authors emphasize. The U.S. benefits from growth and innovation elsewhere in the world just as foreign nations benefit from growth and innovation in the U.S. The authors suggest programs for monitoring and translating to English the technological advances increasingly reported in foreign journals, and facilitating cross border university study for foreign students in the U.S. and for U.S. students abroad.
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  However, change always threatens some established interests, and change from free trade is no exception. The politics of globalization is thus a continuing challenge.
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  Several particular problems in the U.S. are focused on in the conclusion of the book.

• Stock options that reward holders for short term share price spikes have played a noxious role in recent corporate scandals. Restricting tax benefits to options that are performance based and restricted for some substantial time are favored by the authors.
• Technology transfer procedures at major universities have in many instances become bureaucratic and obstructive.

Incentives matter, the authors emphasize, and U.S. policy should be based on generous incentives for and reduced obstructions to innovative entrepreneurship.

• Problems with U.S. K-12 education are acknowledged but criticism generally ignores some mitigating factors.

1. Low average test scores for U.S. students mask the very good test scores achieved in numerous excellent schools. This is more an income inequality problem. The education system does turn out many excellent students.
2. Improvement in poor schools requires competition by means of vouchers and other alternatives. Simply adding money has no proven impact. Increases in teacher pay have to somehow be tied to performance. (Not as long as the teachers unions can prevent it!)
3. If the U.S. needed more engineers and scientists, their salaries would be higher. Other nations are better at turning out large numbers of engineers, the the U.S. remains the leader in quality. (Remember the fears raised over the greater numbers of engineers trained in the Soviet Union? Somehow, the Soviets didn't get much economic advantage our of that.)
4. The U.S. attracts the world's best technical talent because it offers them the best commercial opportunities. Incentives matter, the authors emphasize, and U.S. policy should be based on generous incentives for and reduced obstructions to innovative entrepreneurship.