Cracking the Code of Prosperity

by Arnold Kling

"I had a friend once and he was asked to chair a commission, an international committee, and the title of it was What Causes Poverty. He declined. He said I will do it but on one condition. The condition is that we change the title and I'll chair a committee on What Causes Prosperity. The reason he said that was, the title What Causes Poverty leaves the impression that the natural state of the world is for people to be prosperous and that for whatever reason there are prosperous people running around making people poor...He looked at the world the other way. He said the natural state of people is to be relatively poor and that there are certain ways and things that can be done that can cause prosperity."
--Secretary of Defense Donald Rumsfeld, Nov. 11, 2002

What are the things that can be done that cause prosperity? Because prosperity depends on growth, economists want to understand how to improve the performance of low-growth countries. However, our knowledge is frustratingly incomplete. Certainly, there is no simple, one-dimensional answer.

There is a counter-example to every generalization and an exception to every simple rule. Are a stable currency and an influx of foreign capital the answer? Don't tell that to Argentina, which collapsed after a decade of a "hard peg" to the dollar and large capital inflows. Is privatization a panacea? Don't tell that to Russia and the other republics of the former Soviet Union. Is a high propensity to save a source of economic strength? Not if you look at Japan's lost decade. Is democracy necessary? Not if China's recent success is any guide. Are trade barriers the major impediment to progress? Not if you go by the relatively high growth rate in India, where tariffs are among the highest in the world.

In spite of these counter-examples, I would advise a country that wants to improve economic performance to stabilize its currency, encourage foreign capital, privatize government enterprises, aim for a high rate of national saving, adopt democratic institutions, and reduce tariffs. The counter-examples merely illustrate that none of these policies, individually, is decisive.

Fundamentally, I believe that there are two reasons that economists are unable to develop a fool-proof program for economic growth. The first issue is that growth is what I might term a nonlinear feedback process. The second issue is that economic policies themselves are only one ingredient in the recipe for growth.

A Game with Nonlinear Feedback

I suspect that economic growth is one of those processes that provides nonlinear feedback. When the feedback process is linear, we can grope our way toward an answer fairly systematically. However, when the process provides nonlinear feedback, learning what works is more difficult.

Below is a game that illustrates the difference between linear and nonlinear feedback. It is a standard game where the object is to "crack the code." There are three columns of colors. The computer will randomly pick one color in each column to form a secret code. For example, it might pick red-silver-red.

To win the game, you must guess the code. The computer will give you feedback, based on your guess. Having a right color in a right column is worth 4 points. Having a right color in a wrong column is worth 1 point. For example, if the code is red-silver-red and you guess red-blue-silver, you get 4 points for putting red in the first column and 1 point for putting silver in the third column, for a total of 5 points. You use this feedback to make your next guess. You keep refining your guesses until you solve for the code.

That is how it works with linear feedback, where we add the points to get a total. However, what if we use nonlinear feedback? For example, suppose that the total points you get is equal to the product of the points that you get in each of the three columns. So, if you guess red-red-silver, you get 4 points times 1 point times 1 point = 4 points. Note that if you guess red-blue-silver you will get nonlinear feedback of 0 points.

Got it? Now try the game. First play with linear feedback. After the computer says "You Won," press start to play a new game. Try playing several games. Using logical deduction, you should be able to win most games in 5 or 6 rounds.

Note: The first row of buttons is red, the second row is green, the third row is blue, and the fourth row is silver. It works as intended in Internet Explorer, but Google Chrome ignores the colors.

Crack the Code

Linear Feedback Nonlinear Feedback


Once you get the hang of the game, try switching to nonlinear feedback, and try playing a few games. Do you see how frustrating it can be?

Now, perhaps you can have some sympathy with people trying to research the relationship between education policy and education outcomes. Sounding like someone who has been playing nonlinear "crack the code," E.D. Hirsch, Jr., writes, "If just one factor such as class size is being analyzed, then its relative contribution to student outcomes (which might be co-dependent on many other real-world factors) may not be revealed by even the most careful analysis...And if a whole host of factors are simultaneously evaluated as in 'whole-school reform,' it is not just difficult but, despite the claims made for regression analysis, impossible to determine relative causality with confidence."

The nonlinear version of "crack the code" is a metaphor for complex processes that are difficult to understand and control. Cancer is more complex than smallpox, which is why we have eradicated the latter but not the former. Education is complex, in that educational outcomes depend on a combination of factors. Even though one particular factor may be very important, changing that factor by itself may have almost no impact.

Growth as a Complex Process

It is probably the case that economic growth requires a combination of policies and conditions. No single policy choice can produce significant results in terms of economic growth.

The analogy with picking a color from a column is picking a policy option from among alternatives. Some of the most difficult choices include:

Although the standard economic prescription calls for privatization, in many prosperous countries governments are involved in a number of industries. In the United States, for example, government is significantly involved in agriculture, education, telecommunications, banking, transportation, and housing. For a developing country, it must be challenging to assess which of these various interventions should be imitated, which ones are counterproductive, and which ones are irrelevant.

The wide array of policy choices can be particularly challenging when it is combined with the problem of nonlinear feedback. A country may fail to see positive results from good policies, because other policies are not well chosen.

Growth Ethics?

The other major difficulty in arriving at policies to achieve prosperity is that cultural and political factors may be involved. I myself do not claim to have "cracked the code" for growth and prosperity. However, based on my reading of the works of economists, including DeLong, Parente and Prescott, de Soto, Easterly, and Barro, as well as non-economists such as Robert Kaplan and Ralph Peters, I have formed some hypotheses about the issue.

What I believe is that to achieve prosperity, a country must foster three "ethics."

  1. A work ethic.
  2. A public service ethic.
  3. A learning ethic.

The work ethic will exist if and only if people feel that work is fairly rewarded. If instead it becomes evident that rewards accrue to those who steal, deal in black markets, or serve a warlord or clan leader, then those behaviors will be more widespread than work.

My guess is that one reason that privatization performed less well than expected in the former Soviet Union is that the work ethic had been too badly undermined. Suppose that employees are used to stealing from their state-run government enterprises to sell into the black market. When privatization takes place, the black markets are still functioning, and old habits may linger. Before the enterprise can get on its feet, it fails.

A public service ethic is something that we take for granted in the United States. If you want to open a restaurant, you may find the paperwork and regulations irritating. However, at least you can count on the public officials to process your application in a reasonable time without requiring a large bribe. In many other countries, the conduct of state employees ranges from routine petty corruption to organized extortion.

The learning ethic has at least three dimensions. First, education must be valued and accessible to all demographic groups. Second, the scientific method must be understood and appreciated, overcoming superstitions and traditions. Finally, mistakes must be recognized and corrected.

Dictatorships do not seem conducive to recognizing mistakes. Faced with a failing state enterprise, the natural tendency has to be to prop up the troubled institution rather than allowing the firm to go out of business. In fact, I surmise that one reason that the United States has been able to rebound from financial scandals more rapidly than Japan is that we have a competitive two-party democracy. The Japanese elite closed ranks around its troubled financial firms, keeping capital tied up in failing enterprises and prolonging the crisis. In contrast, our political leaders have felt obliged to distance themselves as much as possible from the Enrons and the Worldcoms.

Given the importance of the learning ethic, I have difficulty sharing the enthusiasm of George Gilder and others for China. Instead, I am inclined to agree with Ralph Peters, who writes

In China, the situation regarding the state's attempt to control information and the population's inability to manage it is immeasurably worse. Until China undergoes a genuine cultural revolution that alters permanently and deeply the relationship among state, citizen, and information, that country will bog down at the industrial level. Its sheer size guarantees continued growth, but there will be a flattening in the coming decades and, decisively, China will have great difficulty transitioning from smokestack growth to intellectual innovation and service wealth.

China, along with the world's other defiant dictatorships, suffers under an oppressive class structure, built on and secured by an informational hierarchy. The great class struggle of the 21st century will be for access to data, and it will occur in totalitarian and religious-regime states.

Limits of Economic Policy

Even if my hypotheses are correct that prosperity can be achieved if a country develops a work ethic, a public service ethic, and a learning ethic, that only begs the question: how are those ethics fostered?

Standard economic prescriptions, such as letting the incentives of free markets operate, are only part of the answer. Free markets are particularly helpful in maintaining a work ethic. However, without a public service ethic, governments will undermine property rights rather than protect them. Without a learning ethic, agriculture, manufacturing, and services will stagnate rather than evolve.

Should we be surprised that the so-called "Washington Consensus" or "neoliberal" recommendations for deregulation, financial liberalization, and privatization have not brought rapid prosperity to countries that lack some of the necessary ethics? On the contrary, I would say that in retrospect we should be surprised that anyone had high expectations for success under such circumstances.

However, even though "neoliberal" policies have not always received high-scoring feedback in the game of cracking the code of prosperity, that does not mean that they are bad guesses. As Brad DeLong somewhat forlornly put it, "The hope is that privatization and world economic integration will in the long run help create the rest of the preconditions for successful development. But we are playing this card not because we think it is a winner, but because it is the last one in our hand."