Economic growth doesn’t happen by itself. It requires a number of different elements to occur. Some of these are obvious—people to make the products and resources to make the products from. But others are less obvious. Consider countries where laws are not equitably enforced. Can sustainable economic growth occur?
The most important element in economic growth is human capital. Human capital consists of the education, skills, and abilities possessed by an individual. Countries that invest heavily in human capital tend to have more economic growth than similarly endowed countries that do not. The United States is one of the world leaders in developing human capital. Compulsory primary and secondary education, mandatory vaccinations, and abundant nutrition have contributed to making America the most productive nation on earth. No nation spends more on educating and developing human capital than the United States.
Individual freedom and the ability to acquire private property are also essential elements in developing human capital. When individuals are free to choose their vocation and enjoy the benefits of private property, their productivity is higher than in places where individual freedom or private property is not valued. By way of comparison, the average German was far more productive in capitalist West Germany than in communist East Germany, and the average South Korean today is far more productive than the average North Korean, because economic freedom provides the incentive to produce more in order to have more.
To have human capital, you must have humans. For economies to develop and grow, it is important that the population grows as well. Population growth must also occur alongside productivity growth. Larger populations are capable of producing more output as well as more innovation because the greater the population, the greater the number of productive resources. The more people a country has, the more probable entrepreneurs it has. And entrepreneurs are one of the drivers of economic growth.
The presence of immense natural resources can sometimes be a deterrent to developing human capital. The paradox of natural resource wealth is that governments are often so eager to exploit their natural resources for export that they neglect to invest in their population’s human capital. At first glance, a comparison of Russia and Japan would lead most observers to believe that Russia is far wealthier than Japan. After all, it has the largest deposits of minerals and natural wealth in the world. Japan, on the other hand, has few natural resources. However, Japan has enjoyed much greater economic growth because it has invested far more in its human capital.
Developing human capital alone is not enough to create economic growth. Economies must also invest in developing physical capital. Physical capital is the tools, factories, and equipment that are used in the production process. As the stock of physical capital increases, the nation experiences capital deepening. Capital deepening refers to the amount of capital available to each worker. Capital deepening provides for a more productive labor force. The average American worker is backed by $130,000 worth of physical capital. This is one of the reasons for America’s productivity edge.
Some capital replaces labor, while other capital enhances it. A robot that welds automobile frames replaces workers, but a pneumatic jackhammer both enhances and replaces workers. One worker with a pneumatic jackhammer can do the work of several workers armed with sledgehammers. Regardless of whether or not it replaces or enhances, capital leads to greater productivity.
Because physical capital is the result of investment, interest rates play a key role in its development. Low, stable interest rates encourage investment. In the short run, investment creates increased aggregate demand, but in the long run it expands the economy’s stock of capital. High interest rates or unstable interest rates are injurious to investment decisions and result in the formation of less capital.
Once capital is deployed, it must be maintained. Capital needs adequate infrastructure to realize its potential. Roads, waterways, rail systems, and reliable utility systems make capital easier to access and greatly improve the chances that it will be used effectively. One of the failures of the Soviet Union was an ineffective use of capital. The Soviets built factories that dwarfed their Western counterparts. But because of inadequate infrastructure, they were often difficult to get to. This made distributing their output more difficult. The developing world lacks steady sources of power and the transportation networks that are necessary for efficient use of factories. Europe, Japan, and the United States, by comparison, have ample infrastructure to facilitate the continuous use and transport of capital’s output.
Creativity, innovation, and invention are necessary for economic growth to continue. Western and Japanese firms spend far more on research and development than do firms in the developing world. Research and development requires sacrificing current profits in order to gain even greater profits in the future. For firms to take this risk, incentives must exist and be protected. Patents, which provide legal protection for inventors, provide the protection firms need to realize the profits of their research and development.
If developing countries want to continue economic growth, they must find ways to encourage innovation. China’s impressive growth over the last fifteen years has mainly come from the production of goods developed elsewhere. Although China has many capable, intelligent, and innovative people, the laws in China do not adequately protect intellectual property. Very little incentive exists for Chinese manufacturers to spend money on research and development of new products if the factory next door can just copy them and produce them without expending the research dollars. Over time, expect to see China make strides in protecting the intellectual property of its manufacturers.
Another condition for growth is the rule of law. Government officials should obey the law and should also apply the law uniformly and fairly. Corruption and cronyism discourage domestic and foreign investment by effectively raising the cost of capital. Firms, individuals, and foreign investors must know that their property is protected by law. One reason that capital investment is lacking in the developing world stems from the fact that corrupt governments are far more likely to seize private property in the name of national interests. Venezuela’s seizure of foreign-owned oil fields in 2007 most likely deters future foreign investment. Unlike Venezuela, former British colonies such as the United States, Canada, Australia, New Zealand, and Hong Kong inherited the English common law with its emphasis on private property, which makes them safe and attractive to foreign investors. Foreign owners of capital have basically the same rights as domestic investors. As a result, more capital accumulates in these countries than in most others.