Thu, Oct 04, 2007 - Page 9 News List

Creating a culture of wealth, not just increasing incentives

By Gregory Clark

Modern economists have turned Adam Smith into a prophet, just as Communist regimes once deified Karl Marx. The central tenet they attribute to Smith -- that good incentives, regardless of culture, produce good results -- has become the great commandment of economics. Yet that view is a mistaken interpretation of history (and probably a mistaken reading of Smith).

Modern growth came not from better incentives, but from the creation of a new economic culture in societies like England and Scotland. To get poor societies to grow, we need to change their cultures, not just their institutions and associated incentives, and that requires exposing more people in these societies to life in advanced economies. Despite the almost universal belief by economists in the primacy of incentives, three features of world history demonstrate the dominance of culture.

In the past, excellent governments -- that is, governments that fully incentivized the citizenry -- have gone hand in hand with economic stagnation.

The incentives for economic activity are much better in most poor economies, including pre-industrial economies, than in such prosperous and contented economies as Germany or Sweden.

The Industrial Revolution itself was the product of changes in basic economic preferences of people ind England, not changes in institutions.


For example, the cotton textile industry that developed in Bombay between 1857 and 1947 operated with no employment restrictions, complete security of capital, a stable and efficient legal system, no import or export controls, freedom of entry by entrepreneurs from around the world and free access to the British market. Moreover, it had access to some of the world's cheapest capital and labor, in an industry where labor accounted for more than 60 percent of manufacturing costs. Profit rates of only 6percent to 8 percent in the early 20th century were enough to induce construction of new mills. Yet India's textile industry could not compete against Britain's, even though British wages were five times higher. Incentives alone could not produce growth.

At the opposite end of the spectrum, Scandinavia is notorious among economists for its high taxes and government spending. Wage income is effectively taxed at a whopping rate of 50 percent to 67 percent. Economic activity is everywhere hedged by rules, regulations and restrictions. Yet these are successful economies, producing as much per worker hour as the US and growing steadily.


By contrast, in medieval England, typical tax rates on labor and capital income were 1 percent or less, and labor and product markets were free and competitive. Yet there was no economic growth. Even though assets such as land were completely secure (in most English villages, land had passed from owner to owner unchallenged through the courts for 800 years or more), investors had to be paid real returns of 10 percent to hold land.

The Industrial Revolution occurred in a setting where the economy's basic institutional incentives were unchanged for hundreds of years, and, if anything, were getting worse. Yet, over the centuries, the responses to these incentives gradually strengthened and entrepreneurship took hold. Profit opportunities from converting common land into private land, which had existed since the Middle Ages, were finally pursued. Roads that had been largely impassable from neglect for hundreds of years were repaired and improved by local efforts.

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