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 incentivised 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 by people in 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 per cent of manufacturing costs. Profit rates of only 6-8 per cent 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 high taxes and government spending. Wage income is effectively taxed at a whopping rate of 50-67 per cent. Economic activity is everywhere hedged by rules, regulations, and restrictions. Yet these are successful economies, producing as much per worker hour as the United States, and growing steadily.

By contrast, in medieval England, typical tax rates on labour and capital income were one per cent or less, and labour 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 per cent 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. The rate of return required on safe investments declined from 10 per cent to four per cent.

Thus the crucial determinants of wealth and poverty are not differences in incentives, but differences in how people respond to them. In successful economies, people work hard, accumulate, and innovate even when their incentives are poor. In failed economies, people work little, save little, and stick with outmoded techniques even when incentives are good.

How can we transform the economic cultures of poor societies to be more like rich ones?

When workers move from a poor to a rich economy, there is rapid adaptation to the economic mores of the new society. In the textile industry in the early 20th century, for example, output per worker hour of Polish workers in New England was four times greater than that of Polish workers using the same machines in Poland. One reason for illegal migration from the poor to the rich economies is many such migrants’ ability to adapt to economic life in rich economies.

Migrants accustomed to conditions in successful economies are a potential nucleus for industrialisation in poor societies. But these workers usually choose to remain in rich economies. A skilled Nigerian immigrant in the US, for example, has more opportunities there than if he returned to Nigeria. The flow of migrants is all from poor to rich economies, particularly for workers with skills and education.

Thus, the problem is to engineer a sufficient flow of return migration to poor societies by those with exposure to the social conditions of economically successful societies. Aid to poor societies in the form of programs designed to expose their students and workers to the experience of living and working in the US before returning home, will be more effective than trying to make these societies’ governments and institutions more like those of the advanced economies. People come first.

Gregory Clark is Chairman of the Department of Economics at the University of California, Davis. His most recent book is A Farewell to Alms: A Brief Economic History of the World.

Copyright: Project Syndicate, 2007.

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