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FUTUREINSIGHTWhat is the ultimate driver of growth?

July 2016

What is the ultimate driver of growth?

Summary

• macronomics has created the concept of the River of Prosperity to help understand what ultimately drives long-term economic performance.

• Imagine a river running upstream to downstream and out into the ocean. The proximate causes of growth are downstream, the ultimate drivers are upstream. Upstream is culture, mid-stream is the role of institutions (the so-called rules of the game) and downstream are competitiveness and productivity.

• Conventional long-term economic analysis has focused very much on downstream economic performance. More recently this has been added to, with mid-stream analysis on the role of institutions, most notably in the work of Daron Acemoglu and James A. Robinson in their international bestseller, Why Nations Fail: The origins of power, prosperity and poverty.

• The mid and downstream contributors to long-term economic performance remain critically important, but they are not, in our view, the ultimate drivers. Institutions shape productivity and competitiveness, but to understand ultimate long-term causes, we need to understand what shapes institutions. macronomics argues that the answer is culture.

• Culture is not easy to define precisely. At times it’s akin to trying to nail jelly to a wall. But despite the challenges, macronomics argues culture should play a much greater role in long-term analysis by investors. It’s a hugely important topic, which has been neglected.

• Support for the culture first thesis comes from many sources, including, surprisingly, the economic performance of the Nordic economies.

• This is not to deny that institutional change can occur without a shift in culture, or that at times a change in the direction of flow can occur, with institutional forces influencing culture. The culture first rule is not absolute.

F U T U R E I N S I G H T 2

PROFESSOR GRAEME LEACH CEO and Chief Economist

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Introduction

One of the world’s leading economic historians, David Landes, wrote in his book, The Wealth and Poverty of Nations that, “if we learn anything from the history of economic development it is that culture makes all the difference.” And yet, economists have been largely dismissive or neglectful of culture (see: Box A for an explanation of culture) as a source of growth.

For most of the second half of the 20th century growth economists tended to ignore the role of culture in explaining cross-country differentials in economic performance. Economists were reluctant to rely on culture as a possible determinant of economic behaviour, because the notion of culture is so broad, and the channels through which it could operate potentially so vague. As economic theory increased its mathematical sophistication economists tended to lose interest in culture.

They tended to see culture as an exogenous influence like technology in the Solow Neo-Classical growth model. Culture was also perceived as so slow-moving, capturing and disentangling its effect empirically, would be a herculean task. But the neglect of culture began to change in the mid 1990s, following the work of Robert Putnam and Francis Fukuyama.

Over recent years there has been something of a renaissance in research on the impact of culture on institutions (see: Box C for an explanation of institutions) and economic behaviour, with links from culture to savings rates, from trust to trade and entrepreneurship, and evidence that Judeo-Christian societies are more opposed to re-distribution than non-religious and atheistic societies. Extending the basic Solow Neo-Classical growth model, to incorporate social capital – defined as interpersonal trust – has also been shown to be an important factor in explaining variations in economic growth. So this is a growing area of analysis.

“If we learn anything from the history

of economic development it is that culture makes all the

difference.”

F U T U R E I N S I G H T 3

What is culture?

Here are some selected quotes on the definition of culture:

“The set of values and beliefs people have about how the world works, as well as the norms of behaviour derived from that set of values.”

“ … those customary beliefs and values, ethnic, religious and social groups transmit fairly unchanged from generation to generation.”

“Individual values and convictions about the scope of application of norms of good conduct … through which distant political history influences the functioning of current institutions.”

“Culture is a set of beliefs, values and preferences, capable of affecting behaviour, that are socially transmitted and shared by some subset of society.”

“The transmission from one generation to the next, via teaching and imitation, of knowledge, values and other factors that influence behaviour.”

“… basic common values that help shape the behaviour of people in a given society.”

“Culture is a set of values and attitudes that guide the actions of individuals and the interaction of people within a society.”

“… historically derived and selected ideas and especially their attached values.”

“Inherited ethical habit.”

“The beliefs, attitudes and values that bear on the economic activities of individuals, organisations and other institutions.”

F U T U R E I N S I G H T 4

BOX A

“The beliefs, attitudes and values

that bear on the economic activities

of individuals, organisations and other institutions.”

The essence of Acomeglu & Robinson’s hypothesis is that: “Economic institutions shape economic incentives: the incentives to become educated, to save and invest, to innovate and adopt new technologies … as institutions influence behaviour and incentives in real life, they forge the success or failure of nations… to understand world inequality we have to understand why some societies are organized in very inefficient and undesirable ways.”

They also state that: “Countries such as Great Britain and the United States became rich because their citizens overthrew the elites who controlled power and created a society where political rights were much more broadly distributed, where the Government was accountable and responsive to citizens, and where the great mass of people could take advantage of economic opportunities…it is the societies with inclusive institutions that have grown over the past 300 years and become relatively rich today.”

We agree as to the importance of institutions to long-term economic performance. There is a vast literature in support of this proposition. However, we disagree with Acomeglu & Robinson’s dismissal of the role of culture. Institutions are very important and yet they also beg the question, what causes them? Their explanation, so-called critical junctures (see: Box B) in history, is unsatisfactory in our view.

This is not to deny that institutional change can occur without a shift in culture. The culture first rule is not absolute. There are instances where:

• The river starts mid-stream - Economic performance changes as a result of institutional change alone.

• The river flows in the opposite direction - Institutional change moves the culture.

The situation can be nuanced. For example, one prominent cultural factor, trust, could be an outcome of institutions, but those very institutions could be the outcome of cultural factors. There is always a root to the story, and our research leads us to believe it is overwhelmingly culture.

However, we acknowledge that the boundary between culture and institutions can be blurred, and for that reason some academics include culture in institutions or define institutions as slow moving (culture) and fast moving (legal and political institutions). Formal institutions are the written rules of the game. In contrast, informal institutions include cultures, norms and conventions enforced by social custom. Informal institutions sit more comfortably in culture but the inter-linkage is obvious and at times difficult to separate.

The culture first rule is not absolute.

F U T U R E I N S I G H T 5

F U T U R E I N S I G H T 6

Critical junctures in history – some examples

• The 1688 Glorious Revolution in Britain, which transformed the economics and politics of the nation, and paved the way for the Industrial Revolution.

• European settlers in the Jamestown Colony, rising up against the elite in North America, in contrast to the Spanish conquistadors taking over an extractive state in Inca Peru. This helped create inclusive institutions in North America, in sharp contrast to South America.

• The abolition of the feudal system in the French Revolution, and the introduction of equality before the law for all. This helped replace the extractive growth, which had previously benefited almost exclusively the First and Second Estates.

• The contrasting economic development between North and South Korea, in the wake of the Korean War, and the creation of the 38th Parallel.

• The impact of the late 19th century Meiji Restoration in Japan, helping initiate a series of transformative institutional reforms.

BOX B

Institutions are very important and yet

they also beg the question, what causes

them?

F U T U R E I N S I G H T 7

What do we mean by culture?

If culture is important, the obvious question then becomes, what exactly do we mean by culture? Culture is a potentially vast sea and yet this body of water has to be channeled in order to be of use in understanding prosperity.

Potential cultural transmission mechanisms might include:

• The role of trust in fostering cooperation and exchange.

• The impact on prosperity through individual virtues.

• Through attitudes towards wealth creation.

• Through attitudes towards technological progress.

Based on our reading of the global literature we have identified 4 cultural values (liberty, trust, responsibility & vitality), which we believe are critical to prosperity. No doubt some will challenge the chosen critical cultural influences, arguing for the exclusion of some and/or the inclusion of others. We acknowledge this is a work in progress.

Liberty – Freedom is paramount for prosperity, because it is so fundamental – politically, religiously and economically, although the precise meaning is hotly contested. Research by macronomics shows that around the world, freer people are generally wealthier and happier. The concept of autonomy freedom, as found in the World Value Survey, is a particularly useful measure we are examining. The WVS measure captures the perception of how much freedom and control people feel they have over the way their lives unfold.

Trust - Trust connects morality to economic behaviour. Mutual respect and honesty are the foundations of business ethics. But the influence extends well beyond the personal to the economic system as a whole. Specialisation is required for prosperity and this requires a shift from small to large group societies, and trust is required for this small to large group shift. Trust lowers transaction costs and thereby increases economic activity and GDP. Consequently trust reduces the lost output from opportunistic behaviour – which is greatest when both the private and public sectors are opportunistic.

Trust is based on an internal source of morality, which needs to be passed from generation to generation in order to preserve capitalism. Consequently trust reduces the transaction costs – red tape – and lost output induced by external bureaucratic regulation. Low levels of trust result in individuals engaging in unproductive activities due to a lack of incentives. Trust is seen as a decisive influence in the development of overseas Chinese capitalism, working through family orientated habits and behaviour.

Responsibility – The simple idea is that the more responsibility is taken on by the individual, the less is required of the state, thereby improving economic efficiency. If people behave responsibly and altruistically towards those in need, there is the potential for far greater social capital than by depending entirely on bureaucratic led welfare. There is also an inter-generational aspect to responsibility, namely a responsibility to future generations e.g. over public debt.

Essentially individual responsibility manifests itself in a more responsible form of capitalism, which minimizes the need for distortionary state intervention. There is a tension between the size of state, which maximises innovation, and the size, which maximises re-distribution.

Vitality – Post materialist values can be negative for growth and future prosperity. There is strong evidence that the 19th century global economic take-off was rooted in vitality, and in the 20th and 21st centuries elements of this vitality have been lost or stifled. The link between vitality, competition and innovation has been described by the Nobel Laureate Edmund Phelps, as the ‘imaginarium’ economy.

If culture is important, the obvious question then becomes, what

exactly do we mean by culture?

F U T U R E I N S I G H T 8

What are institutions?

The rules, regulations, laws and policies that affect economic incentives and thus the incentives to invest in physical and human capital. Free people and free markets require the rule of law, property rights, personal liberty and representative government.

Here are some selected quotes describing the role of institutions:

• “Institutions are the rules of the game in a society or more formally, are the humanly devised constraints that shape human interaction [set constraints and shape incentives].”

• “Institutions are the rules of the game in economic, political and social interactions ... or more formally are the humanely devised constraints that shape human interaction.”

• “Institutions are humanly devised, set constraints and shape incentives. Big differences in economic and political institutions are seen in the enforcement of property rights, legal systems, corruption, entry barriers, democracy versus dictatorship and constraints on politicians

• “Institutions are a fundamental determinant of the incentives of private individuals to innovate and invest ... the formal rules of the game that shape incentives and constraints.”

• “Institutions are essentially incentives and constraints that society puts up on individual behaviour … institutions are in a way much like prices in a competitive market: individuals can respond to them differently ... but cannot change them.”

BOX C

“Institutions are the rules of the game in a

society...”

F U T U R E I N S I G H T 9

Which direction does the river flow?

macronomics acknowledges that the culture first rule is not absolute. However, we would also argue that the overwhelming direction of flow is upstream to downstream. Culture first operates as a general rule.

Based on our review of the global literature, here are 15 reasons why we believe this to be the case:

• Institutions need to have an explanation, and this begs the question as to what shaped the thoughts behind them. Culture surely plays a key role in explaining how institutions are accepted or rejected.

• The Enlightenment ideas of equality and human rights, which led to enormous changes in the form of government. In the modern era, the battle of ideas equivalent would be the collapse of communism.

• Economists from Adam Smith to Paul Krugman have argued it is impossible for a society to enjoy a condition of general prosperity if its economic activity is limited to small groups. In order to maximise prosperity, economies need to grow from small to large group societies, and in order to do this, trust is fundamental. It is argued that only culture can create a high trust society, because it has to be internalized and passed from generation to generation.

• The economic performance of the Nordic economies is difficult to explain with conventional models. Alternative explanations based on the role of trust in small homogenous societies, perform better. The Nordic countries display some of the highest levels of trust in the world (the surprising cultural dynamic of the work ethic in the Nordic model is discussed below) and there is research to suggest that the negative economic impact of a large public sector is outweighed by the positive effect of high levels of trust.

• Similar institutions can perform differently, in different countries, suggesting more powerful forces, further upstream, are at work. Cultural differences are important because they

bring about a different functioning of the same formal institutions.

• There is weak evidence of institutional effects within countries, where cultural factors appear to play a more decisive economic role e.g. the North-South divide in Italy, the contrasting post-industrial performance of Detroit and Pittsburgh in the USA, Liverpool versus the South East in the UK etc.

• Normative values are acquired early in life and become hardwired and resistant to change. These cultural values then shape political views and institutions in adulthood. There is evidence for the role of religious influences on attitudes towards property rights, the role of government and the distribution of income.

• Indicators of cultural attitudes are strongly correlated with economic performance e.g. research showing the impact of post-materialism and self-achievement motivation on economic performance.

• Economic and policy outcomes are often very persistent and remain unaffected by sudden changes in formal

macronomics acknowledges that the culture first rule is not

absolute. However, we would also argue

that the overwhelming direction of flow

is upstream to downstream. Culture

first operates as a general rule.

F U T U R E I N S I G H T 10

institutions, suggesting that a greater cultural influence is at work. Policy distortions and government inefficiencies are often clustered together, as if they had a common cause. An obvious contemporary example is the possibility that EU institutional weakness is directly attributable to cultural rigidity.

• Research isolating the impact of cultural attitudes on institutions, shows they are significant determinants of institutional quality. Well functioning institutions are often observed in countries or regions where individuals share values consistent with general morality.

• The contrasting economic performance of individualist versus collectivist societies. Those advocating a culture first thesis state that is difficult to think of a concept like individualism being a matter of institutions rather than culture.

• The transmission mechanism of general morality to well functioning institutions, through easier law enforcement, law-abiding citizens, reduced bureaucratic corruption and higher voter expectations for the standard of political behaviour.

• The role of culture as a driving force can be seen in the economic performance of certain ethnic groups outside their home country e.g. the Chinese diaspora. It might also be seen in the possibility that China is experiencing some form of ‘mean reversion’ due to a legacy of values from preceding periods when China experienced economic success up until the 17th and 18th centuries.

• If the river of prosperity flows from downstream to upstream, we could be left with the dangerous impression that economic prosperity will make radical Islamic fundamentalism quietly disappear.

• The most important impediment to growth for countries beyond a certain level of development may be repressed circulation of ideas. Countries governed by dictatorships tend to fall behind in economic development.

• The final argument for a culture first thesis, relates to the - still controversial -Protestant work ethic and the comparative economic performance of Protestant versus Catholic countries in the wake of the Industrial Revolution. There is a surprising modern day example of the ‘work ethic’ in the Nordic economies. A recent study, from the IEA, states that: “Culture has played a key role in Scandinavian success. This is much more important than the welfare state. Traditionally in Scandinavian countries it was difficult to survive without working exceptionally hard in a hostile environment. The population, out of necessity, adopted a culture with a great emphasis on individual responsibility and hard work … the homogenous Scandinavian countries, influenced positively in many cases by strong religious norms, also had high levels of mutual trust. Even today, the descendants of Scandinavian immigrants in the US have the highest levels of mutual trust in that country … paradoxically, this strong work ethic and high levels of mutual trust were very helpful as the welfare state was created because high taxes and welfare benefits did not discourage work as much as might have been expected. Over the generations however, welfare state policies have eroded these strong working norms.”

“Culture has played a key role in

Scandinavian success. This is much more

important than the welfare state...”

Concluding thoughts

This paper has argued that cultural factors are very important to economic performance in the long-term, but receive too little attention at present. macronomics is engaged in a large research project aimed at directly quantifying the impact of culture on long-term performance, which will be released to clients in due course.

The role of culture raises fundamental questions about the impact of institutional change on economic performance.

F U T U R E I N S I G H T 11

Nobel Laureate Edmund Phelps has stated that:

“The empirical results lend support to the Enlightenment theme that a nation’s culture ultimately makes a difference for the nation’s economic performance in all its aspects, activity as well as productivity ... thus a country’s initiation of a program to reform the institutional machinery with the aim of achieving a major improvement of economic performance … would, if undertaken alone, very likely succeed only to a degree and thus cause considerable disappointment.”

Disclaimer

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