counterparties raise credit risk and thereby increase real interest rates.
As a bank regulator for more than eighteen years, I came to recognize
that government regulation cannot substitute for individual integrity. In
fact, any form of government guarantees of credit lessens the need of financial
counterparties to earn a reputation for honest dealings. It is conceivable,
of course, that government guarantees are superior to an individual's
256
THE UNIVERSALS OF ECONOMIC GROWTH
reputation. But guarantees—even the most widely praised, such as deposit
insurance—have costly consequences. I concluded, and I suspect most regulators
agree, that the first and most effective line of defense against fraud
and insolvency is counterparties' surveillance. For example, JPMorgan thoroughly
scrutinizes the balance sheet of Merrill Lynch before it lends. It does
not look to the Securities and Exchange Commission to verify Merrill's
solvency.
While banking and medicine may be the most visible exemplars of the
market value of reputation, it is pervasive throughout all professions. When
I was a child, jokes about the scruples of used-car salesmen were widespread,
but in truth a flagrantly unscrupulous used-car salesman is one who
will be out of business before long. These days, almost every professional
field is constrained by some regulatory framework, so it's harder than it
once was to isolate the reputation effect, but a sector in which one can is
e-commerce. Alibris, for example, is a Web site that acts as a broker between
sellers and buyers of used books. If you were eager to buy an early
edition of Adam Smith's The Wealth of Nations, you might search on Alibris
for the names of booksellers around the country who had copies for sale.
Customers are given the opportunity to rate the reliability of booksellers
from whom they've purchased at least one book, and those ratings no doubt
play an important role in the decision as to which of several booksellers to
use. This form of public feedback is a powerful incentive to booksellers to
be honest about the condition of their wares, and to fulfill orders fully and
promptly. But no one is immune to customer skepticism: as Fed chairman,
I was queried by fellow central bankers with large holdings of U.S. dollars
about whether dollars were safe investments.
More surprising than any list of key factors for growth and improved
standards of living is what would not be on such a list. How is it possible that
a superabundance of natural resources—oil, gas, copper, iron ore—would not
significantly add to a nation's production and wealth? Paradoxically, most analysts
conclude that, particularly in developing countries, natural-resource
bonanzas tend to reduce rather than enhance living standards.
The danger takes the form of an economic affliction nicknamed "Dutch
disease." (The Economist coined the term in the 1970s to describe the travails
of manufacturers in the Netherlands after the discovery there of natu
257
THE AGE OF TURBULENCE
ral gas.) Dutch disease strikes when foreign demand for an export drives up
the exchange value of the exporting country's currency. This increase in the
currency's value makes the nation's other export products less competitive.
Analysts often cite this pattern as a reason why relatively resource-poor
Hong Kong, Japan, and Western Europe have thrived while oil-rich Nigeria
and others have not.*
"Ten years from now, twenty years from now, you will see: Oil will
bring us ruin," is how former Venezuelan oil minister and OPEC cofounder
Juan Pablo Perez Alfonso put it in the 1970s. He correctly foresaw the
inability of virtually all OPEC nations to use their riches to diversify significantly
beyond petroleum and related products. Besides distorting the value
of the currency, natural-resource wealth often has crippling social effects.
Easy, unearned wealth tends to dampen productivity, it turns out. Some
Gulf oil states have extended so many amenities to their citizens that those
without an inbred will to work don't. Mundane tasks fall to immigrants and
guest workers who gladly collect what is to them a good wage. There are
political effects too: a ruling clique can use part of the resource revenue to
placate the population and keep people from marching against the
regime.
No wonder tiny Sao Tome and Principe off the west coast of Africa,
upon the discovery in its territorial waters of significant reservoirs of crude
oil, had a mixed reaction about exploiting them. President Fradique de
Menezes remarked in 2003: "I have promised my people that we will avoid
what some call 'the Dutch disease,' or 'the crude awakening' or 'the curse
of oil.' Statistics show that resource-rich developing countries perform
markedly worse in terms of GDP development than resource-poor coun
*In the Dutch case, heavy foreign demand for the gas led to large purchases of guilders, which
drove up the value of the Dutch currency relative to the dollar, the deutsche mark, and all
other major currencies. This meant that Dutch exports of anything other than natural gas were
put at a competitive disadvantage in world markets. Producers of export goods paid wages and
other costs in guilders, which with their higher foreign-exchange value meant higher costs denominated
in dollars and other currencies. To sell competitively in foreign markets, Dutch
nongas exporters would receive fewer guilders for their wares and would have to live with
lower profit margins, or—more likely—raise prices in dollars and sell less. The condition became
known as the Dutch disease even though the Netherlands handled the problem without
major disruption.
258
THE UNIVERSALS OF ECONOMIC GROWTH
tries. Their social indicators are also below average. In Sao Tome and Principe
we are determined to avoid this paradox of plenty."
Dutch disease primarily afflicts developing countries because they are
ill-prepared to fend it off. At the same time, the scale of the challenge tends
to be greater: since nature distributes its treasures without regard to the
size or sophistication of national economies, resource bonanzas are more
apt to dwarf the GDP of a developing country than that of a developed
one. In general, it appears that if a country is "developed" before the discovery
of a natural-resource bonanza, it is immune to any long-lasting pernicious
effect. Nevertheless, Dutch disease can strike anywhere. Great Britain
went through an apparent bout of it in the early 1980s, following the development
of North Sea oil. As Britain changed from a net importer of oil
to a net exporter, the dollar-sterling exchange rate rose and the prices of
British export goods temporarily became increasingly uncompetitive. Norway,
with a population of less than five million, had to take dramatic action
to insulate its small economy from the North Sea oil bonanza. The
country created a large stabilization fund that reduced pressure on the krone's
exchange rate after it spiked in the late 1970s. And in the wake of the
collapse of Communism, Russia is struggling with a mild form of Dutch
disease today.
Over the past thirty-five years, as many countries have labored to liberalize
their economies and improve the quality of their policies, global per
capita income has risen steadily. This has especially been the case in countries
that previously were fully or partially centrally planned and that, since
the fall of the Berlin Wall, have embraced some form of market capitalism.
I recognize that poverty rates are notoriously hard to quantify, but according
to the World Bank, the number of people living on less than $1 per day,
a commonly used extreme-poverty threshold, has fallen dramatically from
1,247 million in 1990 to 986 million in 2004. In addition, since 1970, the
infant mortality rate has declined by more than half, school enrollment
rates have risen steadily, and literacy rates are up.*
*Figures on world poverty rates are from the World Bank and a 2002 study by Columbia
University economist Xavier Sala-i-Martin. The $l-per-day threshold is measured in 1985 dollars
on a purchasing power parity basis. Economists use purchasing power parity as an alternative
to market exchange rates when gauging and comparing outputs and incomes across
259
THE AGE OF TURBULENCE
While, from a global perspective, wealth and the overall quality of life
have risen, that success has not been uniform across regions or countries.
The economies of East Asia are often-cited success stories. Some, including
China, Malaysia, South Korea, and Thailand, stand out not only as growing
very strongly but also as having seen the greatest declines in poverty rates.
Moreover, Asia was not alone. Per capita incomes in Latin America also expanded
during the period, and poverty rates fell, although progress was
somewhat slower. But, sadly, levels of per capita income in many countries
in sub-Saharan Africa have fallen.
It is striking to me that our ideas about the efficacy of market competition
have remained essentially unchanged since the eighteenth-century Enlightenment,
when they first emerged, to a remarkable extent, largely from
the mind of one man, Adam Smith. With the demise of central planning at
the end of the twentieth century, the forces of capitalism have had free
rein, prodded by ever-expanding globalization. No doubt economists' views
of what works to enhance material well-being will continue to evolve over
time. Still, in a sense, the history of market competition and the capitalism
it represents is the story of the ebb and flow of Smith's ideas. Accordingly,
the story of his work and its reception repays special attention. It also serves
to pave the way for my next chapter, which addresses the great "problem"
inherent in capitalism: that creative destruction is often, and by a great many,
viewed simply as destruction. The history of Smith's ideas is the history of
attitudes toward the social dislocation capitalism brings and its potential
remedies.
Born in Kirkcaldy, Scotland, in 1723, Smith lived in an era influenced by
the ideas and events of the Reformation. For the first time in the history of
Western civilization, individuals began to view themselves as able to act independently
of ecclesiastic and state restraint. Modern notions of political
and economic freedom gained currency. Those ideas taken together were the
beginnings of the Age of Enlightenment, especially in France, Scotland, and
countries. It is a useful if inexact way to measure the standard of living of residents of an economy,
in part because it takes into account "nontradable" goods and services—for example, a
man's haircut. The World Bank bases PPP on the 1985 prices of basic goods and services in local
currencies, adjusting for inflation. It uses purchasing power parity in its calculations of
world poverty rates at $1 and $2 a day.
260
THE UNIVERSALS OF ECONOMIC GROWTH
England. Suddenly, there was a vision of a society in which individuals guided
by reason were at liberty to choose their destinies. What we now know as
the rule of law—specifically, the protection of the rights of individuals and
their property—became firmly established, encouraging people to produce,
trade, and innovate. Market forces began eroding the rigid customs that had
lingered from feudal and medieval times.
At the same time, the nascent Industrial Revolution was causing turmoil
and dislocation. Factories and railroads reconfigured the English landscape,
farmlands were converted to sheep meadows to supply a new,
booming textile industry, and enormous numbers of peasants were uprooted.
The new industrialist class came into conflict with the aristocracy,
whose wealth was based on inherited estates. The protectionist thinking
known as mercantilism, which served the interests of landowners and colonialists,
began losing its hold over commerce and trade.
Amid these complex and bewildering circumstances, Adam Smith
identified a set of principles that brought conceptual clarity to the seeming
chaos of economic activity. Smith framed a global view of how market
economies, just then emerging, worked. He offered the first comprehensive
examination of why some countries are able to achieve high standards of
living while others make little progress.
Smith started out as a lecturer in Edinburgh; he soon moved to Glasgow,
where he had first attended university, as a professor. One of his areas of
expertise was what he called "the progress of opulence" in society (as a profession,
economics didn't yet even have a name). Over the years Smith's
fascination with market behavior intensified, and after a lucrative two-year
sojourn in France as tutor of a young Scottish lord, he came home to his
birthplace in Kirkcaldy in 1766 and devoted himself full-time to his magnum
opus.
The book he produced ten years later, which came to be known simply
as The Wealth of Nations, is one of the great achievements in intellectual
history. In effect, Smith tried to answer what is probably the most important
macroeconomic question: What makes an economy grow? In The
Wealth of Nations, he accurately identified capital accumulation, free trade,
an appropriate—but circumscribed—role for government, and the rule of
law as keys to national prosperity. Most important, he was the first to em
261
THE AGE OF TURBULENCE
phasize personal initiative: "The natural effort of every individual to better
his own condition, when suffered to exert itself with freedom and security
is so powerful a principle, that it is alone, and without any assistance ... capable
of carrying on the society to wealth and prosperity" He concluded
that to enhance the wealth of a nation, every man, consistent with the law,
should be "free to pursue his own interest his own way" Competition was
