During one of my trips to Peru, the school, where I have been giving talks on economics, invited me to attend a conference that the school was hosting for high school students. At the beginning of the conference the teachers showed the student’s a power point presentation. The first slide was a bid’s eye view of Hong Kong’s busy harbor. The second slide was of downtown Manhattan. During the third slide, the teachers asked all the students, ‘why doesn’t Peru look like that?’
During a lecture, Adam Smith explained that, “little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.”[i] Even though Smith articulated this nearly 257 years ago, there are still some countries that do not embrace what many economists, and advocates of liberty, have so well articulated. Today, the differences prosperity between countries provide social scientists with the contrast class needed to determine which key factors contribute to prosperity; the answer is clear: prosperous countries embrace and protect individual’s economic freedom. Specifically, some countries prosper because they have institutions that protect the three ‘P’s’ – property, prices, and profit- and have laws that don’t interfere with the three ‘I’s’ – incentives, information, and innovation.
Once well-established property rights are defined, exchange can take place. Property rights give actors an incentive to care for what is theirs and to trade for what is not. Trade incentivizes citizens to produce what is easiest for them to produce and trade for what we cannot make profitably ourselves, which simultaneously encourages a peaceful social order. Trade also gives us an incentive to peruse our comparative advantages in production: as people produce what they are good at producing, their capabilities to produce improve and their actions become more specialized. Division and specialization of labor allow for producers to be more productive, which encourages yet more trade. Because voluntary exchange is mutually beneficial, this process simultaneously increases the wealth of all who participate.
As trade becomes more complex, prices arise. Though they are often only 3-4 digits, prices are incentives wrapped in an immeasurable amount of knowledge. Prices constantly signal consumer demand, along with the relative scarcity of a product’s inputs, to producers. This information allows producers to produce more of what consumers demand, allowing the trading process to generate even more wealth. As Hayek explained to us, these price signals are part of a system so dynamic that the order cannot possibly be ‘planned’ and therefore should not be tampered with. Thus, once property rights are well established, prosperous countries must permit prices to fluctuate freely in order to continue on the path to prosperity.
Freely moving prices and the increased information and trade that result from them will allow producers to earn larger profits. These profits are not just ‘spent’ in the economy but ‘re-invested’ as producers seek to experiment with new products and research new ideas. The innovative process, permitted by the existence of profits, leads to even greater profits for producers and better products for consumers. Better products do not necessitate ‘higher quality’ since often they are simply ‘less expensive’ or some how save consumers time. Innovation allows producers to start creating wealth on an endless number of vectors, all while a country’s prosperity increases. The most prosperous countries minimize taxes on profits and restrictions on innovation since these things deter the entrepreneurial process.
One final element is key in explaining why some countries are prosperous and others are not and that is the stability of their political institutions. Political and legal institutions that are free of corruption, just in their decisions, and principled in their actions, are an important cornerstone to a country seeking to achieve and maintain high levels of prosperity. Predictable legal institutions create a stable investing environment that encourages investment and allows contracts to be predictably enforced. Both of these benefits lower the transactions costs of the trading- wealth generating- process.
Even though ‘trade’ typically provokes a mental image of material things and professional services, free trade, and its requisite institutions, create more than just material prosperity. In prosperous countries citizens that are typically happier, have more freedom to peruse their dreams, receive better healthcare, and ultimately have more autonomy over the direction of their lives. Economic freedom is a requisite to all of these ‘non-material’ measures of prosperity, and in fact these ‘non-material’ measures of prosperity don’t exist in countries that do not have high levels of economic freedom.
To the high school students in Peru, why some countries were wealthy and others poor seemed like a mystery, almost a fact of nature: it isn’t. In fact, even though we live in a highly developed country, our political debates seem to suggest that only after you have an advanced understanding of statistics and economic planning are you qualified to legislate in rules in Congress or manipulate the money supply at The Federal Reserve in such a way that will bring about wealth. Don’t let what seem to be highly intellectual public policy debates confuse you- creating a just and prosperous society is much less complicated. Well established and enforced property rights combined with unrestricted rules to determine prices and make profits, lead to the incentives, information and innovation that that make prosperity possible- anywhere.