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A business thinking about committing funds to, say, build a factory faces any number
Property rights are laws
of risks. Construction costs might run higher than estimates. Interest rates might rise. De-
and/or conventions that as-
sign owners the rights to use mand for the product might prove weaker than expected. The list goes on and on. These
their property as they see fit are the normal hazards of entrepreneurship, an activity that is not for the faint of heart.
(within the law)”for exam-
But, at a minimum, business executives contemplating a long-term investment want as-
ple, to sell the property and
surances that their property will not be taken from them for capricious or political rea-
to reap the benefits (such as
sons. Republican businesspeople in the United States do not worry that their property will
rents or dividends) while
be seized if the Democrats win the next election. Nor do they worry that court rulings will
they own it.
deprive them of their property rights without due process.
By contrast, in many less-well-organized societies, the rule of law is regu-
larly threatened by combinations of arbitrary government actions, political
Selected Countries Ranked by Level
instability, anticapitalist ideology, rampant corruption, or runaway crime.
of Investor Protection
Such problems have posed serious impediments to long-term investment in
Country Rating (0 “10 scale) many poor countries throughout history. They are among the chief reasons
these countries have remained poor. And the litany of problems that
Singapore 9.3
United States 8.3 threaten property rights is not just a matter of history”these issues remain
Canada 8.3 relevant in countries as different as Russia, much of Africa, and parts of
United Kingdom 8.0
Latin America today. Where businesses fear that their property may be ex-
Japan 7.0
propriated, a drop in interest rates of a few percentage points will not en-
Mexico 6.0
courage much investment.
India 6.0
Sweden 5.7 Needless to say, the strength of property rights, adherence to the rule of
Brazil 5.3 law, the level of corruption, and the like are not easy things to measure. Any-
Italy 5.0
one who attempts to rank countries on such criteria must make many subjec-
China 5.0
tive judgments. Nevertheless, due to its recent interest in the subject, the
Swaziland 2.3
World Bank currently ranks 175 countries on various aspects of their business
SOURCE: World Bank web site, www.doingbusiness.
climate, including their degree of investor protection. Some of their data are
org, accessed August 2007. The index is constructed
displayed in Table 3. The ranking of the various countries is roughly what you
by rating countries on transparency of transactions,
liability for self-dealing, and shareholders™ ability to
might expect.
sue for misconduct.

Numerous studies in many countries confirm the fact that more-educated and better-
trained workers earn higher wages. Economists naturally assume that the people who
earn more are also more productive. Thus, more education and training presumably

To Grow Fast, Get the Institutions Right
A few years ago, the World Bank surveyed the ways the govern- mattress. When it takes 19 steps, five months and more than an
ments of around 100 countries either encourage or discourage average person™s annual income to register a new business in
market activity. Its conclusion, as summarized in The Economist, was Mozambique, it is no wonder that aspiring, cash-strapped entre-
that “when poor people are allowed access to the institutions richer preneurs do not bother.
people enjoy, they can thrive and help themselves. A great deal of The Bank™s conclusion reminded many people of the central
poverty, in other words, may be easily avoidable.” message of a best-selling 2000 book by Peruvian economist and
The World Bank study highlighted the importance of making businessman Hernando de Soto”who found to his dismay that, in
simple institutions accessible to the poor”such as protection of his own country, it took 700 bureaucratic steps to obtain legal title
property rights (especially over land), access to the judicial system, to a house!
and a free and open flow of information”as key ingredients in suc-
cessful economic development. The Economist put it graphically:
SOURCES: “Now, Think Small,” The Economist, September 15, 2001, pp. 40“42.
If it is too expensive and time-consuming, for example, to open Hernando de Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and
a bank account, the poor will stuff their savings under the Fails Everywhere Else (New York: Basic Books), 2000.

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Chapter 7 141
Economic Growth: Theory and Policy

contribute to higher productivity. Although private institutions play a role in the educa-
tional process, in most societies the state bears the primary responsibility for educating
the population. So education policy is an obvious and critical component of growth policy.
A modern industrial society is built more on brains than on brawn. Even ordinary blue-
collar jobs often require a high school education. For this reason, policies that raise rates
of high school attendance and completion and, perhaps as importantly, improve the qual-
ity of secondary education can make genuine contributions to growth. Unfortunately,
such policies have proven difficult to devise and implement. So the debate over how to
improve our public schools goes on and on, with no resolution in sight. President Bush™s
No Child Left Behind program is only the latest in a long list of educational reforms.
Finally, if knowledge is power in the information age, then sending more young people
to college and graduate school may be crucial to economic success. It is well documented
that the earnings gap between high school and college graduates in the United States has
risen dramatically since the late 1970s. One graphical depiction of this rising disparity is
shown in Figure 4. It shows clearly that the job market was rewarding the skills acquired
in college ever more generously from about 1978 until about 2000. To the extent that high
wages reflect high productivity, low-cost tuition (such as that paid at many state colleges
and universities), student loans to low-income families, and other policies to encourage
college attendance may yield society rich dividends.
Devoting more resources to education should, therefore, raise an economy™s growth
rate. By suitable reinterpretation, Figure 3 (on page 139) can again be used to illustrate
the trade-off between present and future. Because expenditures on education are naturally
thought of as investments in human capital, just interpret the vertical axis as now represent-
ing educational investments. If a society spends more on them and less on consumer
goods (thus moving from point C toward point I), it should grow faster. China, to cite the
most prominent example, is doing that with great enthusiasm right now.
But education is not a panacea for all of an economy™s ills. Education in the former
On-the-job training
Soviet Union was outstanding in some respects. But it proved insufficient to prevent the
refers to skills that workers
Soviet economy from falling ever further behind the capitalist economies in terms of eco- acquire while at work,
nomic growth. rather than in school or in
On-the-job training may be just as important as formal education in raising productiv- formal vocational training
ity, but it is less amenable to influence by the government. For the most part, private programs.

F I GU R E 4
Wage Premium for College Graduates over High School Graduates
SOURCE: Lawrence Mishel, Jared Bernstein, Sylvia Allegretto, and Heather Boushey, The State of

Working America, 2006“2007 (Ithaca, N.Y.: Cornell University Press, 2007).

Percentage Wage Advantage




1973 1975 1980 1985 1990 1995 2000 2005

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Part 2
142 The Macroeconomy: Aggregate Supply and Demand

businesses decide how much, and in what ways, to train their workers. Various public
policy initiatives”ranging from government-run training programs, to subsidies for
private-sector training, to mandated minimum training expenditures by firms”have been
tried in various countries with mixed results. In the United States, mandates on compa-
nies have always been viewed as improper interferences with private business decisions,
and they have been avoided. The government runs some training programs, though the
biggest (by far) is the armed forces.

Our third pillar of growth is technology, or getting more output from given supplies of in-
puts. Some of the most promising policies for speeding up the pace of technical progress
have already been mentioned:

More Education Although some inventions and innovations are the product of
dumb luck, most result from the sustained application of knowledge, resources, and
brainpower to scientific, engineering, and managerial problems. We have just noted that
more-educated workers appear to be more productive per se. In addition, a society is
likely to be more innovative if it has a greater supply of scientists, engineers, and skilled
business managers who are constantly on the prowl for new opportunities. Modern
growth theory emphasizes the pivotal role in the growth process of committing more
human, physical, and financial resources to the acquisition of knowledge.
High levels of education, especially scientific, engineering, and managerial education,
contribute to the advancement of technology.
There is little doubt that the United States leads the world in the quality of its graduate
programs in business and in many of the scientific and engineering disciplines. As evi-
dence of this superiority, one need only look at the tens of thousands of foreign students
who flock to our shores to attend graduate school”many of whom remain in America. It
seems reasonable to suppose that America™s unquestioned leadership in scientific and
business education contributes to our leadership in productivity. On this basis, many
economists and politicians endorse policies designed to induce more bright young people
to pursue scientific and engineering careers”such as scholarships, fellowships, and re-
search grants”and worry that too few young Americans are choosing these career paths.

More Capital Formation We are all familiar with the fact that the latest versions of
cell phones, PCs, personal digital assistants (PDAs), and even televisions embody new
features that were unavailable a year or even six months ago. The same is true of indus-
Invention is the act of trial capital. Indeed, new investment is the principal way in which the latest technological
discovering new products or
breakthroughs get hard-wired into the nation™s capital stock. As we mentioned in our ear-
new ways of making
lier discussion of capital formation, newer capital is normally better capital. In this way,
High rates of investment contribute to rapid technical progress.
Innovation is the act of
putting new ideas into effect So all of the policies we discussed earlier as ways to bolster capital formation can also be
by, for example, bringing
thought of as ways to speed up technical progress.
new products to market,
changing product designs,
Research and Development But there is a more direct way to spur invention and
and improving the way in
innovation: devote more of society™s resources to research and development (R&D).
which things are done.
Driven by the profit motive, American businesses have long invested heavily in indus-
Research and
trial R&D. According to the old saying, “Build a better mousetrap, and the world will beat
development (R&D)
a path to your door.” And innovative companies in the United States and elsewhere have
refers to activities aimed at
been engaged in research on “better mousetraps” for decades. Polaroid invented instant
inventing new products or
photography, Xerox developed photocopying, and Apple pioneered the desktop com-
processes, or improving
puter. Boeing improved jet aircraft several times. U.S.-based pharmaceutical companies
existing ones.

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Chapter 7 143
Economic Growth: Theory and Policy

have discovered many new, life-enhancing drugs. Intel has developed generation after
generation of ever-faster microprocessors. The list goes on and on.
All these companies and others have spent untold billions of dollars on R&D to dis-
cover new products, to improve old ones, and to make their industrial processes more
efficient. Although many research dollars are inevitably “wasted” on false starts and
experiments that don™t pan out, numerous studies have shown that the average dollar
invested in R&D has yielded high returns to society. Heavy spending on R&D is, indeed,
one of the keys to high productivity growth.
The U.S. government supports and encourages R&D in several ways. First, it subsi-
dizes private R&D spending through the tax code. Specifically, the Research and Experi-
mentation Tax Credit reduces the taxes of companies that spend more money on R&D.
Second, the government sometimes joins with private companies in collaborative re-
search efforts. The Human Genome Project may be the best-known example of such a
public“private partnership (some called it a race!). But there also have been cooperative
ventures in new automotive technology, alternative energy sources, and elsewhere.
Last, and certainly not least, the federal government has over the years spent a great
deal of taxpayer money directly on R&D. Much of this spending has been funneled
through the Department of Defense. But the National Aeronautics and Space Administra-
tion (NASA), the National Science Foundation (NSF), the National Institutes of Health
(NIH), and many other agencies have also played important roles. Inventions as diverse


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