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 supply.

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.

Growth Diamond

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.

"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."

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 society’s ability 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.

Early Examples

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 and castles.

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 monarchy.

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.

"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."

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.

Looking Back

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.