History provides crucial lessons
on how developed economies
have evolved into growth machines.
By George David Smith, Richard
Sylla, and Robert E. Wright
For most of its existence,
humanity neither enjoyed nor understood society’s capacity
for creating wealth and economic growth. Prior to the 18th
century, incomes generally hovered near the subsistence level.
To paraphrase the 17th-century English philosopher Thomas
Hobbes, human life was solitary, poor, nasty, brutish, and
short. In the late 18th century, the English economist Thomas
Robert Malthus warned that the mass of humanity was doomed
to a life at the margins of starvation, as surges of population
growth would inevitably outstrip the finite sources of food
Things began to change in the 17th and
18th centuries, when people in Holland and Britain began
to produce a little more each year. As the gains added up
over time, modern economic growth had arrived. We define
economic growth as increases in aggregate real income per
person, (that is, income adjusted for inflation). For our
purposes, economic growth starts with the Industrial Revolution,
which began in the British Isles and spread from northwestern
Europe to new areas – North
America, parts of central and southern Europe, Scandinavia,
and, late in the 19th century, to the frontier “European” societies
of Australia and New Zealand, to parts of Eastern Europe and
Imperial Russia, and finally, to Japan, the only non-western
society to develop before the mid-20th century. In the late
20th century, the diffusion of industrialization spread rapidly
to the “dragons” of the Pacific Rim: Taiwan, Hong
Kong, South Korea, and Singapore, and then to the former communist
countries of Eastern Europe.
Today, several important
areas, including China, India, and Eastern Europe, seem poised
to experience sustained economic growth as well. And yet
most of the world’s
population remains poor, earning less than the equivalent
of $2 per person per day. Vast areas, including much of Africa,
Latin America, Central Asia, the Middle East, and Micronesia,
remain mired in grinding poverty, as the gap between the
richest and poorest societies continues to increase.
What accounts for such
differences? Many analysts focus on issues like culture,
natural resources, climate, and political systems to explain
the vast differences in economic experiences. But we believe
the answer lies in the intensely historical origins of economic
growth. History shows that over time, healthy, sustainable
economies possess four dynamic, human-made factors: (1) political
systems geared to enabling economic growth, (2) an effective
financial system, (3) vibrant entrepreneurship, and (4) sophisticated
managerial capabilities. In our model, each of these critical
factors is represented as a corner of “the
growth diamond.” As the illustration suggests, each of
the factors interacts with the others dynamically (and over
time). Proceeding counterclockwise from political systems to
managerial capabilities, each of the facets of the diamond
depends on the robustness of the preceding factors.
An effective political system enables economic growth, first
and foremost, by establishing a government that can unify
an economically relevant territory, establish order, and
protect the lives, liberty, and property of its citizens
through an impartial rule of law. A government must be able
to provide defense, address market failures, and ensure broad-based
access to education. Finally governments, over time, have
to address social and wealth inequalities so that they do
not undermine the social consensus and political stability
required to sustain broad-based economic growth.
that over time, healthy, sustainable economies possess
four dynamic, human-made factors: (1) political systems
geared to enabling economic growth, (2) an effective
financial system, (3) vibrant entrepreneurship, and (4)
sophisticated managerial capabilities."
On top of the political
system, a developing society must create a financial system
capable of transferring funds where they are in surplus to
projects where funds are needed. The institutional components
of a modern financial system include banks, capital markets,
and corporations – legal
entities that can borrow and issue ownership shares while
limiting the liabilities of their owners. Through insurance,
diversification, and hedging strategies, corporations also
substantially reduce the risks of entrepreneurial investment
while organizing production and distribution systems on
a large scale.
As enabling governments and financial systems grow strong,
they enhance the prospects for entrepreneurial activity. And
as the economic historian Joseph Schumpeter observed, entrepreneurship
enhances growth by introducing new products or services, opening
new markets, and creating new combinations of land, labor,
and capital. If government does not legitimize economic innovation
and provide a legal foundation for securing property rights
and reducing risks, entrepreneurs cannot thrive. Likewise,
if financial systems are inefficient, the costs of investment
in new projects can be prohibitive.
Finally, as new enterprises grow, they
rely on more sophisticated methods of coordination and control.
Sophisticated management (the coordination of complex organizations)
is predicated on robust education and is essential to any
to realize economies of scale and economies of scope, both
of which help bring down costs. Management also enables enterprises
to plan for the future, to adjust to changing market conditions,
and to invest in new, large projects.
The growth diamond can be applied to every society on earth.
The poorest almost never established enabling political systems,
if only because their governments abused, suppressed, or robbed
their citizens. Poor, but not destitute, societies never established
financial systems or created conditions for entrepreneurship
to flourish, often because their governments restricted economic
liberty or failed to secure property rights adequately. Many
societies that were able to achieve middling income may have
achieved some measure of progress in all corners of the diamond
temporarily but were not able to sustain their gains.
The Netherlands, the first nation
in modern history to develop the four elements of the growth
diamond, was also the first to experience sustained economic
growth. By the 17th century the Netherlands was a thriving
commercial society populated with what later generations
would call a broad-based bourgeoisie, or middle class.
The Dutch then lacked the technologies that would power
the Industrial Revolution from the late 18th century onward.
But the people of the Netherlands were relatively free
to pursue their economic self-interests under the protection
of a government that saw itself not as the country’s
owner, but rather as the people’s employee. The citizens
(note the change from “subjects”) of the Netherlands
willingly paid the world’s highest per-capita taxes because
they could see that tax revenues were spent on public goods,
such as defense and the country’s extensive network of
windmill-driven water pumps and dikes, and not on lavish parties
The Dutch also managed
to create a representative form of government that did
not descend easily into tyranny. While certainly not perfect,
the government of the Netherlands provided the kind of
political foundation on which financial systems, entrepreneurship,
and management could anchor. The Dutch formed what historians
recognize as the first modern financial system – an
interconnected network composed of private banks and insurance
companies, a proto central bank, and securities markets
for public debt instruments, foreign exchange, commercial
paper, and corporate equities. Entrepreneurs blossomed,
finding it relatively easy and cheap to obtain financing
for an impressive array of business projects – from
domestic canals to shipbuilding to tulip horticulture.
As some of those businesses grew and matured, they became
too big and complex for the original entrepreneurs to handle,
so a class of specialized administrators developed to run
the larger business organizations.
Great Britain became the next nation
to develop a robust growth diamond. The British would lead
the world into the Industrial Revolution – the era of machine-driven, factory-based
mass production. Again, the formation of a non-predatory government
that looked unlikely to slide into tyranny was a prerequisite.
It came in the wake of 1688, when the British Parliament replaced
the royalist Stuart monarchy with a Dutch prince who would
be checked by the will of Parliament and bound by laws as interpreted
by an independent judiciary – the first modern constitutional
The British shrewdly borrowed best
practices from more economically advanced societies. Soon
after the Glorious Revolution, Dutch-style financial institutions
and markets arose in Britain. Not long after, British entrepreneurs
began a vast array of new enterprises that led directly
to revolutions in agriculture, transportation, and manufacturing.
People with highly developed management skills emerged,
making new strides in efficiency. Based on superior institutions
in public finance, new mass production industries, and
organizational capabilities, Britain transformed from a
peripheral island racked by political instability into
the planet’s most potent economic and military force.
In the 18th century,
Britain remained highly mercantilist, enacting tariffs
and other policies that it thought would enrich the home
islands at the expense of its colonies and enemies. But
in the 19th century, political economists such as David
Ricardo and John Stuart Mill elaborated on Adam Smith’s
critique of protectionism, which helped Britain to enact pro-growth
policies, including free trade and anti-slavery legislation
by the mid-19th century. The British continued to extend their
empire until it was said that the sun never set upon it.
A Colony Rises
Britain’s relatively prosperous North American colonies,
chafing under imperial restrictions on their economies, would
eventually outstrip Britain as the world’s leading economy
after establishing their own growth diamond. Here, again, government
took the lead. Suffused with myriad checks and balances – three
branches of government, property protections, political and
economic liberties, and protections for minority rights – the
US constitution formed the core of an enabling political system.
Soon after its ratification, the rest of the country’s
growth diamond crystallized.
great lesson that economic history teaches us is that
when it comes to developing a healthy private sector,
the public sector serves as the crucial foundation, and
financial systems matter – both in fostering entrepreneurship
and supporting the efficient managerial systems that
any society needs to sustain growth over the long term."
Just a few years after the
new government took effect, Americans enjoyed a financial
system that included a monetary unit (the US dollar), a central
bank (the Bank of the United States), and a growing number
of private commercial banks and insurers. As in the Netherlands
and Britain, the financial system unleashed the forces of “creative destruction” by
linking investors to entrepreneurs with good business ideas.
Canals and turnpikes appeared, connecting the frontier
to the major seaports, which encouraged American farmers
to look for ways to grow more wheat and raise more livestock
so that they could enjoy more manufactured goods. Later,
railroad and telegraph systems emerged and, in just a few
decades, sprawled across the continent in a dense network.
The sheer size of the United States, along with its distance
from potential enemies, conferred enormous advantages for its
economic development. The enormous size of the American market
by the late 19th century also enabled firms to grow to enormous
scale, as capital-intensive industries and retail businesses
in particular drove down costs and prices while driving up
demand, resulting in the creation of ever more businesses,
small and large, local and national.
Railroad managers helped
develop the tools of modern management – concepts
like cost accounting, managerial accountability, fixed versus
variable costs, and corporate structure. Those tools, in turn,
made possible the great industrial corporations of the late
19th and early 20th centuries. To some degree, the large corporation – embodied
in companies like Standard Oil, General Motors, and DuPont,
replaced the “invisible hand” of the laissez-faire
market with the “visible hand” of coordinated management.
By World War I, the rich societies that
had successfully built growth diamonds had evolved further
into open access economies – ones
that provided reasonably widespread economic opportunity
and encouraged competition. Open access economies provided
for social mobility based relatively more on merit rather
than birthright. They sought to educate everyone and to reduce
discrimination. They also kept the costs of entry into and
exit out of markets low. At any given time, small-, medium-,
and large-sized companies tended to co-exist, each challenging
the others to greater efficiency and quality.
Today, economists, politicians, and
development professionals continue to seek ideas for crafting
policies that will enable long-suffering poor countries to
join the developed world. As they do so, they would be well-advised
to keep the growth diamond in mind. Of course, it does not
explain everything. Such factors as geography, climate, war,
demographics, disease, culture, and changing technological
and competitive environments, to name a few, matter greatly.
Yet a great lesson that economic history teaches us is that
when it comes to developing a healthy private sector, the
public sector serves as the crucial foundation, and financial
systems matter – both in fostering entrepreneurship
and supporting the efficient managerial systems that any society
needs to sustain growth over the long term.
Governments are vital
for economic growth, but they can also keep societies in
poverty. Once the government is right – not
predatory, and not overly prone to caving in to special interests – the
other factors of the economic growth diamond can turn ideas
into marketable goods. Many new business projects will fail,
but the costs will be small and will fall on those willing
to bear them – entrepreneurs and their investors. Most
important, a few of the ideas will succeed, enriching the lives
of both producers and consumers. The market economy in that
sense works like a giant supercomputer, but one that computes
correctly only when the government ensures that conditions
are favorable and supportive of financial, entrepreneurial,
and managerial enterprise.
George David Smith is clinical professor of economics and
international business, Richard Sylla is Henry Kaufman Professor
of the History of Financial Institutions and Markets and professor
of economics, and Robert Wright is clinical associate professor
of economics at NYU Stern.