PART II: Seven Major Sources of Economic Progress

1. Private Ownership: People Will Be More Industrious and Use Resources More Wisely When Property is Privately Owned

Men always work harder and more readily when they work on that which belongs to them.It is surely undeniable that, when a man engages in remunerative work, the impelling reason and motive of his work is to obtain property and thereafter to hold it as his very own.

- Pope Leo XIII (1878)

PRIVATE OWNERSHIP OF PROPERTY INVOLVES three things: (a) the right to exclusive use, (b) legal protection against invaders, and (c) the right to transfer. Property is a broad term that includes labour services, ideas, literature, and natural resources, as well as physical assets like buildings, machines, and land. Private ownership allows individuals to decide how they will use their property. But it also makes them accountable for their actions. People who use their property in a manner that invades or infringes upon the property rights of another will be subject to the same legal forces that were set up to protect their own property. For example, private property rights prohibit me from throwing my hammer through the screen of a computer that you own, because if I did, I would be violating your property right to your computer. Your property right to your computer restricts me and everyone else from its use without your permission. Similarly, my ownership of my hammer and other things that I own restricts you and everyone else from using them without my permission.

The important thing about private ownership is the structure of incentives that emanate from it. There are four major reasons why this incentive structure will promote economic progress.

First, private ownership encourages wise stewardship. If private owners fail to maintain their property or if they allow it to be abused or damaged, they will bear the consequences in the form of a decline in the value of their property. For example, if you own an automobile, you have a strong incentive to change the oil, have the car serviced regularly, and see that the interior of the car is well kept. Why is this so? If you are careless in these areas, the car's value to both you and potential future owners will decline. Alternatively, if the car is well-maintained and kept in good running order, it will be of greater value to both you and others who might want to buy it from you. With private ownership, wise stewardship is rewarded.

In contrast, when property is owned by the government or owned in common by a large group of people, the incentive to take good care of it is weaker. For example when housing is owned by the government, there is no owner or small group of owners who will pay a dear price if the property is abused and poorly maintained. Therefore, it should not surprise us when we observe that, compared to privately-owned housing, government-owned housing is generally run down and poorly maintained in both capitalist countries like the United States and socialist countries like Russia and Poland. This laxity in care, maintenance, and repair simply reflects the incentive structure that accompanies government ownership of property.

Second, private ownership encourages people to develop their property and use it productively. With private ownership, individuals have a strong incentive to improve their skills, work harder, and work smarter. Such actions will increase their income. Similarly, people have a strong incentive to construct and develop capital assets like houses, apartments, and office buildings. When such developments add more to revenues than to costs, the wealth of the private owners will increase.

Farming in the former Soviet Union illustrates the importance of property rights as a stimulus for productive activity. Under the Communist regime, families were permitted to keep and/or sell all goods produced on small private plots ranging up to an acre in size. These private plots made up only one percent of the total land under cultivation; the other 99 percent was cultivated by state enterprises and huge agricultural cooperatives. Nonetheless, as the Soviet press reported, approximately one-fourth of the total Soviet agricultural output was raised on this tiny fraction of privately farmed land.

Third, private owners have a strong incentive to use their resources in ways that are beneficial to others. While private owners can legally "do their own thing" with their property, their ownership provides them with a strong incentive to heed the wishes of others. Private owners can gain by figuring out how to make their property and its services more attractive to others. If they employ and develop their property in ways that others find attractive, the market value of the property will increase. In contrast, changes that are disapproved of by others - particularly customers or potential future buyers - will reduce the value of one's property.

Your ownership of your labour services provides you with a strong incentive to invest in education and training that will help you provide services that are highly valued by others. Similarly, owners of capital assets have an incentive to develop them in ways that are attractive to others. By way of example, consider the situation of an apartment complex owner. The owner may not care anything about parking spaces, convenient laundry facilities, trees, or well kept "green" open spaces accompanying the apartment complex. However, if consumers value these things highly (relative to their costs), the owner has a strong incentive to provide them because they will enhance both his earnings (rents) and the market value of his apartments. In contrast, those apartment owners who insist on providing what they like, rather than the things that consumers actually prefer, will find that their earnings and the value of their capital (apartments) will decline.

Fourth, private ownership promotes the wise development and conservation of resources for the future. The present development of a resource may generate current revenue. This revenue is the voice of present consumers. But, higher potential future revenues argue for conservation. The potential gain in the form of an increase in the expected future price of the resource is the voice of future users. Private owners are encouraged to balance these two forces.

Whenever the expected future value of a resource exceeds its current value, private owners gain if they conserve the resource for future users. This is true even if the current owner does not expect to be around when the benefits accrue. For example, suppose a 65 year-old tree farmer is contemplating whether to cut his Douglas fir trees. If growth and increased scarcity are expected to result in future sales revenue that exceeds the current value of the trees, the farmer will gain by conserving the trees for the future. When ownership is transferable, the market value of the farmer's land will increase in anticipation of the future harvest as the trees grow and the expected day of harvest moves closer. Thus, the farmer will be able to sell the trees (or the land including the trees) and capture their value at any time even though the actual harvest may not take place until well after his death. [The conservation function of private ownership is also illustrated by examining alternative property right systems that are applied to animals. Animals like cattle, horses, llama, turkeys, and ostriches that are privately owned are conserved for the future. In contrast, the absence of private ownership has led to the excessive exploitation of animals like the buffalo, whale, and beaver. Contrasting approaches to the conservation of elephants in Africa also provide instructive evidence on the importance of private ownership. In Kenya, elephants roam unowned on unfenced terrain. The Kenyan government tries to protect elephants from poachers seeking valuable ivory by banning all commercial use of the elephant except tourism. In the decade that this policy has been in effect, the Kenyan elephant population has declined from 65,000 to 19,000. Other Eastern and Central African countries that have followed this approach have experienced a similar decline in the size of their elephant population. In contrast, Zimbabwe allows the open sale of elephant ivory and hides, but provides rights of private ownership to local people on whose land the elephant roams. Since assigning private ownership rights to elephants, Zimbabwe has seen its elephant population grow from 30,000 to 43,000. Elephant populations in the countries adopting a similar approach - Botswana, South Africa, Malawi, and Namibia - are also increasing. See Randy Simmons and Urs Kreuter, "Herd Mentality: Banning Ivory Sales Is No Way to Save the Elephant," Policy Review (Fall 1989), pp. 46-49, for additional details on this topic.]

For centuries, doomsday commentators have argued that we are about to run out of trees, vital minerals, or various sources of energy. In sixteenth-century England, fear arose that the supply of wood would soon be exhausted as that resource was widely used as a source of energy. Higher wood prices, however, encouraged conservation and led to the development of coal. The "wood crisis" soon dissipated. In the middle of the nineteenth century, dire predictions arose that the world was about to run out of whale oil, at the time the primary fuel for artificial lighting. As whale oil prices rose, pressures for a substitute energy source heightened. This led to the development of kerosene, and the end of the "whale oil crisis."

Later, as people switched to petroleum, doomsday predictions about the exhaustion of this resource arose almost as soon as the resource was developed. An idea about the extent to which early estimates of petroleum supplies underestimated consistently the potential supply can be gathered from the presidential address of Dr. Campbell Watkins to the International Association for Energy Economics in 1992. Watkins notes that the estimates of Alberta's total gas reserves in 1957 were 75 trillion cubic feet. By 1985 the estimated reserve remaining, in spite of the intervening consumption, was 149 trillion cubic feet. In 1987 the reserve estimated was further adjusted to 170 trillion cubic feet and the 1992 figure was nearly 200 trillion cubic feet. In other words, far from "running out" of natural gas, Canada is actually discovering more gas as time passes.

Doomsday forecasters fail to recognize that private ownership provides people with a strong incentive to conserve a valuable resource and search for substitutes when there is an increase in the relative scarcity of the resource. With private ownership, if the scarcity of a resource increases, the price of the resource will rise. The increase in price provides producers, innovators, engineers, and entrepreneurs with an incentive to (a) conserve on the direct use of the resource, (b) search more diligently for substitutes, and (c) develop new methods of discovering and recovering larger amounts of the resource. To date, these forces have pushed doomsday further and further into the future. For resources that are privately owned, there is every reason to believe that they will continue to do so. [The empirical evidence indicates that, adjusted for inflation, the prices of most natural resources have actually been falling for decades, and in most cases, for centuries. The classic study of Harold Barnett and Chandler Morris, Scarcity and Growth: The Economics of Natural Resource Availability, (Baltimore: The Johns Hopkins University Press, 1963) illustrates this point. Updates and extensions of this work indicate that resource prices are continuing to decline. In 1980 economist Julian Simon bet doomsday environmentalist Paul Ehrlich that the inflation-adjusted price of any five natural resources of Ehrlich's choosing would decline during the 1980s. In fact, the prices of all five of the resources chosen by Ehrlich declined and Simon won the highly publicized bet. A recent study found that of 38 major natural resources, only two (manganese and zinc) increased in price (after adjustment for inflation) during the 1980s. See Stephen Moore, "So Much for `Scarce Resources'," Public Interest (Winter 1992).]

People who have not thought the topic through often associate private ownership with selfishness. This is paradoxical since the truth is nearly the opposite. Private ownership both (a) provides protection against selfish people who would take what does not belong to them and (b) forces resource users to fully bear the cost of their actions. When property rights are well-defined, secure, and tradeable, suppliers of goods and services will have to provide resource owners with at least as good a deal as they can get elsewhere. Employers cannot seize and use scarce resources without compensating their owners. The resource owners will have to be paid enough to attract them away from alternative users.

In essence, securely defined private property rights eliminate the use of violence as a competitive weapon. A producer that you do not buy from is not permitted to burn down your house. Neither is a competitive resource supplier, whose prices you undercut, permitted to slash your automobile tires or threaten you with bodily injury.

Private ownership keeps power dispersed and expands the area of activity that is based on voluntary consent. Power conferred by private ownership is strictly limited. Private business owners cannot force you to buy from them or work for them. They cannot levy a tax on your income or your property. They can acquire some of your income only by giving you something that you believe to be more valuable in return. The power of even the wealthiest property owner (or largest business) is limited by competition from others willing to provide similar products or services.

In contrast, as the experience of Eastern Europe and the former Soviet Union illustrates, when government ownership is substituted for private property, enormous political and economic power is bestowed upon a small handful of political figures. One of the major virtues of private property is its ability to check the excessive concentration of economic power in the hands of the few. Widespread ownership of property is the enemy of tyranny and the abusive use of power.

Thus, it is clear what the former socialist countries need to do. As Nobel laureate Milton Friedman recently stated, the best program for Eastern Europe can be summarized "in three words: privatize, privatize, privatize." [Milton Friedman, "Economic Freedom, Human Freedom, Political Freedom," lecture delivered November 1, 1991 at California State University, Hayward. A booklet containing the lecture is available from the Smith Centre for Private Enterprise Studies of California State University, Hayward.] Private property is the cornerstone both of economic progress and of personal liberty.


2. Freedom of Exchange: Policies that Reduce the Volume of Exchange Retard Economic Progress

VOLUNTARY EXCHANGE IS A FORM OF SOCIAL COOPERATION. It permits both parties to get more of what they want. In a market setting, neither the buyer nor the seller is forced into an exchange. Personal gain provides the motivation for exchange agreements.

As we previously noted, exchange promotes social gain - a larger output and income than would otherwise be achievable. When governments impose blockades that limit cooperation through exchange, they stifle economic progress.

There are various ways that countries stifle exchange. First, many countries impose regulations that limit entry into various businesses and occupations. If you want to start a business or provide a service, you have to fill out forms, get permission from different bureaus, show that you are qualified, indicate that you have sufficient financing, and meet various other regulatory tests. Some officials may refuse your application unless you are willing to pay a bribe or make a contribution to their political coffers. Hernando De Soto, in his revealing book The Other Path, found that in Lima, Peru it took 289 days for five people working full-time to meet the regulations required to legally open a small business producing garments. Furthermore, along the way, ten bribes were solicited and on two occasions it was necessary to pay the bribes in order to get the permission to operate "legally." In many cases, if you are financed with foreign capital there is an additional maze of regulations. Needless to say, policies of this type stifle business competition, encourage political corruption, and drive decent people into the underground (or what De Soto calls the "informal") economy.

Second, countries also stifle exchange when they substitute discretionary political authority for the rule of law. Several countries make a habit of adopting high-sounding laws that grant political administrators substantial interpretive power and discretionary authority. For example, in the mid-1980s customs officials in Guatemala were permitted to waive tariffs if they thought that doing so was in the "national interest." Legislation of this type is an open invitation for government officials to solicit bribes. It creates regulatory uncertainty and makes business activity more costly and less attractive, particularly for honest people. The structure of law needs to be precise, unambiguous, and nondiscriminatory. If it is not, it will be a major roadblock retarding gains from trade.

Third, many countries impose price controls that stifle exchange. When the price of a product is legally fixed above the market level, buyers will purchase fewer units and the quantity exchanged will fall. On the other hand, if the price is fixed lower than the market level, suppliers will be unwilling to produce as many units. This, too, will reduce the volume of exchange. In terms of units produced and sold, it makes little difference whether price controls push prices up or force them down; both will reduce the volume of trade and the gains from production and exchange.

Exchange is productive; it helps us get more from the available resources. Policies that force traders to pass through various political roadblocks are generally counterproductive, even when they are intended to protect a domestic industry. In fact, they are equivalent to shooting oneself in the foot. If a country is going to realize its full potential, restrictions limiting trade and increasing the cost of doing business need to be kept to a minimum. The ability to provide a service that others are willing to purchase voluntarily is powerful evidence that the activity is productive. The market is the best regulator.


3. Competitive Markets: Competition Promotes the Efficient Use of Resources and Provides a Continuous Stimulus for Innovative Improvements

Competition is conducive to the continuous improvements of industrial efficiency. It leadsproducers to eliminate wastes and cut costs so that they may undersell others. It weeds out those whose costs remain high and thus operates to concentrate production in the hands of those whose costs are low. [Clair Wilcox, Competition and Monopoly in American Industry, Monograph no. 21, Temporary National Economic Committee, Investigation of Concentration of Economic Power, 76th Congress, 3rd Session (Washington, DC: U.S. Government Printing Office, 1940).]

- Clair Wilcox

COMPETITION OCCURS WHEN THERE IS FREEDOM of entry into a market and there are alternative sellers in the market. The competition may be among small-scale or large-scale firms. Rival firms may compete in local, regional, national, or even global markets. Competition is the lifeblood of a market economy.

Competition places pressure on producers to operate efficiently and cater to the preferences of consumers. Competition weeds out the inefficient. Firms that fail to provide consumers with quality goods at competitive prices will experience losses and eventually be driven out of business. Successful competitors have to outperform rival firms. They may do so through a variety of methods - quality of product, style, service, convenience of location, advertising, and price - but they must consistently offer consumers as much or more value than they can get elsewhere.

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What keeps McDonald's, General Motors, or any other business firm from raising prices, selling shoddy products, and providing lousy service? Competition. If McDonald's fails to provide an attractively priced sandwich with a smile, people will turn to Burger King, Wendy's, and other rivals. Similarly, as recent experience has shown, even a firm as large as General Motors will lose customers to Ford, Honda, Toyota, Chrysler, Volkswagen, Mazda, and other automobile manufacturers if it fails to keep up with its rivals.

Competition also provides firms with a strong incentive to develop improved products and discover lower-cost methods of production. No one knows precisely what products consumers will want next or which production techniques will minimize per-unit costs. Competition helps us discover the answer. Is that new visionary idea the greatest thing since the development of the fast-food chain? Or is it simply another dream that will soon turn to vapour? Entrepreneurs are free to introduce an innovative new product or a promising production technology; they need only the support of investors willing to put up the necessary funds. The approval of central planners, a legislative majority, or business rivals is not required in a market economy. Nonetheless, competition holds entrepreneurs and the investors who support them accountable; their ideas must face a "reality check" imposed by consumers. If consumers value the innovative idea enough to cover the cost of the good or service that is produced, the new business will prosper and succeed. Conversely, if consumers are unwilling to do so, the business will fail. Consumers are the ultimate judge and jury of business innovation and performance.

Producers who wish to survive in a competitive environment cannot be complacent. Today's successful product may not pass tomorrow's competitive test. In order to succeed in a competitive market, businesses must be good at anticipating, identifying, and quickly adopting improved ideas.

Competition also discovers the type of business structure and size of firm that can best keep the per-unit cost of a product or service low. Unlike other economic systems, a market economy does not mandate or limit the types of firms that are permitted to compete. Any form of business organization is permissible. An owner-operated firm, partnership, corporation, employee-owned firm, consumer cooperative, commune, or any other form of business is free to enter the market. In order to be successful, it has to pass only one test: cost-effectiveness. If a form of business organization, such as a corporation or employee-owned firm, is able to achieve low per-unit cost in a market, it will tend to survive. Correspondingly, a business structure that results in high per-unit cost will be driven from a competitive market.

The same is true for size of firm. For some products, a business must be quite large to take full advantage of the potential production economies of scale. When per-unit costs decline as output increases, small businesses tend to have higher production costs (and therefore higher prices) than their larger counterparts. When this is the case, consumers interested in maximum value for their money will tend to buy from the lower-priced larger firm. Most small firms will eventually be driven from the market. Larger firms, generally organized as corporations, tend to survive in such markets. The auto and airplane manufacturing industries illustrate these forces.

In other instances, small firms, often organized as individual proprietorships or partnerships, will be more cost-effective. When personalized service and individualized products are valued highly by consumers, it may be difficult for large firms to compete. Under these circumstances, mostly small firms will survive. For example, this is generally true for law and medical practices, printing shops, and hair-styling salons. A market economy permits cost considerations and the interaction between producers and consumers to determine the type and size of firm in each market.

When large-scale enterprises have lower costs, it will be particularly important that nations do not either limit competition from foreign suppliers or prevent domestic firms from selling abroad. This point is vitally important for small countries. For example, since the domestic market of a country like South Korea is small, a Korean automobile manufacturer would have extremely high costs per unit if it could not sell automobiles abroad. Similarly, domestic consumers in small countries would have to pay an exceedingly high price for automobiles if they were prohibited from buying from large-scale, lower-cost foreign producers.

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In summary, competition harnesses personal self-interest and puts it to work elevating our standard-of-living. As Adam Smith noted in the Wealth of Nations, individuals are motivated by self-interest:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages. [Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, p. 18.]

In a competitive environment, even self-interested individuals and profit-seeking business firms have a strong incentive to serve the interests of others and provide consumers with at least as much value as they can get elsewhere. This is the path to greater income and larger profits. Paradoxical as it may seem, personal self-interest - a characteristic many view as less than admirable - is a powerful source of economic progress when it is directed by competition.


4. An Efficient Capital Market: If a Nation is Going to Realize Its Potential, It Must Have a Mechanism Capable of Allocating Capital into Wealth-Creating Projects

CONSUMPTION IS THE GOAL OF ALL PRODUCTION. However, we can sometimes magnify our production of consumption goods by first using resources to produce machines, heavy equipment, and buildings and then applying these capital resources to the production of the desired consumer goods. Therefore, investment - the construction and development of long-lasting resources designed to help us produce more in the future - is an important potential source of economic growth.

Resources used to produce investment goods will be unavailable for the direct production of consumption goods. Therefore, investment requires savings - the forgoing of current consumption. Someone - either the investor or someone willing to supply funds to the investor - must save in order to finance investment. Funds cannot be invested unless they are saved.

Not all investment projects will create wealth. If an investment project is going to enhance the wealth of a nation, the value of the additional output derived from the investment must exceed the cost of the investment. Conversely, when the value of the additional output is less than the cost of the investment, the project is counterproductive. Projects of this type reduce wealth. If a nation is going to realize its potential, it must have a mechanism capable of attracting savings and channelling them into wealth-creating investment projects.

In a market economy, the capital market performs this function. This highly diverse market includes the markets for stocks, real estate, and businesses, as well as the loanable funds market. Financial institutions such as banks, insurance companies, mutual funds, and investment firms play important roles in this market. The capital market coordinates the actions of savers who supply funds to the market with those of investors seeking funds to finance various business activities. Private investors have a strong incentive to evaluate potential projects carefully and to search for profitable projects. Investors ranging from stockholders to partnership investors to small business owners will search for and undertake profitable ventures because such investments will increase their personal wealth. Profitable investments generally create wealth. A project will be profitable if the revenues derived from the additions to output exceed the cost of the investment. Revenues that exceed the costs of an investment are strong evidence that people value the output of the investment more than the resources required to produce the capital asset. Thus, profitable investments tend to increase not only the wealth of the investor, but also the wealth of the nation.

Of course, in an uncertain world, private investors will sometimes make mistakes; sometimes they undertake projects that prove to be unprofitable. If investors were unwilling to take such chances, many new ideas would go untested and many worthwhile, but risky, projects would not be undertaken. Mistaken investments are a necessary price paid for fruitful innovations in new technologies and products. Counterproductive projects, however, must be brought to a halt. The capital market assures that this will be the case. Private investors will not continue to waste their funds on unprofitable and unproductive projects.

Without a private capital market, it is virtually impossible to attract funds and consistently channel them into wealth-creating projects. When investment funds are allocated by the government rather than the market, an entirely different set of criteria come into play. Political clout replaces the expected return on investment as the basis for allocating funds. Investment funds will often be channelled to political supporters and to projects that benefit individuals and groups with political clout.

When politics replaces markets, investment projects often reduce wealth rather than enhance it. The experience of Eastern Europe and the former Soviet Union illustrates this point. For four decades (1950-90), the investment rates of these countries were among the highest in the world. Central planners allocated approximately one-third of the national output into investment. Even these high rates of investment, however, did little to improve living standards because political rather than economic considerations determined which projects would be funded. Resources were often wasted on political boondoggles and high visibility investments favoured by important political leaders.

Sometimes governments fix interest rates and thereby hamper the ability of markets to channel personal savings toward wealth-creating projects. Worse still, when an interest rate ceiling is combined with inflationary monetary policy, the interest rate adjusted for inflation - what economists call the "real interest rate" - will often be negative! When the government-mandated interest rate is less than the rate of inflation, the wealth of people who save is reduced. Their savings and interest earnings will buy less and less with the passage of time. Under these circumstances, there will be little incentive to save and supply funds to the domestic capital market. "Capital flight" will result as domestic investors seek positive returns abroad and foreign investors completely shun the country. Such policies destroy the domestic capital market. Lacking both financial capital and a mechanism to direct investment toward wealth-creating projects, productive investment in such countries comes to a standstill. Income stagnates and even regresses.

As Exhibit 1 illustrates, Argentina, Zambia, Somalia, Uganda, Sierra Leone, Ecuador, Ghana and Tanzania followed this course during the 1980s. All of these countries fixed the interest rate and followed an inflationary monetary policy. As a result, the inflation-adjusted interest rate - the real return on savings deposits - was negative throughout much of the 1980s in each of these countries! So, too, was their growth rate.

These countries followed policies that destroyed the mechanism that would normally provide potential private investors with loanable funds and channel those funds toward wealth-creating projects. Lacking a mechanism to perform this vitally important function, they regressed during the 1980s. Countries that destroy their capital markets pay a severe price for their folly.

5. Monetary Stability: Inflationary Monetary Policies Distort Price Signals and Undermine a Market Economy

FIRST AND FOREMOST, MONEY IS A MEANS OF EXCHANGE. It reduces transaction costs because it provides a common denominator into which all goods and services can be converted. Money makes it possible for people to engage in complex exchanges involving the receipt of income or payment of a purchase price across lengthy time periods. Money provides us with a means through which we can store purchasing power for future use. Money is also a unit of accounting that enhances our ability to keep track of revenues and costs that are incurred over time.

The productive contribution of money, however, is directly related to the stability of its value. In this regard, money is to an economy what language is to communication. Without words that have clearly defined meanings to both the speaker and listener, communication is impossible. So it is with money. If money does not have a stable and predictable value, it will be more costly for borrowers and lenders to conduct exchanges; saving and investing will involve additional risks; and time-dimension transactions (for example, the payment of the purchase price for a house or automobile over a time period) will be fraught with additional danger. When the value of money is unstable, exchange is retarded and the gains from specialization, large-scale production, and social cooperation are reduced.

There is no mystery about the cause of monetary instability. Like that of other commodities, the value of money is determined by supply and demand. When the supply of money is constant or increases at a slow steady rate, the purchasing power of money will be relatively stable. In contrast, when the supply of money expands rapidly and unpredictably relative to the supply of goods and services, prices are inflated and the purchasing power of money declines. This often happens when governments print money (or borrow from a central bank) in order to pay their bills.

Politicians often blame inflation on greedy businesses, powerful labour unions, big oil companies, or foreigners, for example. But their efforts are a ruse - a diversionary tactic. Both economic theory and historical experience indicate that persistent inflation arises from a single source: rapid growth in the supply of money. Exhibit 2 illustrates this point. Countries that increased their money supply at a slow rate experienced low rates of inflation during the 1980s. This was true for large countries like Germany, Japan, and the United States, as well as for small countries like Switzerland, Netherlands, Cote d'Ivoire, and Cameroon. As the growth of the money supply of a country increased, however, so too did the rate of inflation (see data for Portugal, Venezuela, Costa Rica, Turkey, Ghana, Zaire, and Mexico). Extremely high rates of monetary-growth led to hyperinflation. This point was illustrated vividly by the experience of Israel, Peru, Argentina, and Bolivia. A triple-digit annual growth rate in the money supply of these countries led to a triple-digit annual rate of inflation.

Every country in the world with a low inflation rate in recent decades has adopted a policy of slow monetary growth. Conversely, every country that has experienced rapid inflation has followed a course of rapid monetary expansion. This link between rapid monetary growth and inflation is one of the most consistent relationships in all of economics.

Inflation undermines economic prosperity. It makes the planning and undertaking of capital investment projects extremely hazardous. Unexpected changes in the inflation rate can quickly turn an otherwise profitable project into a personal economic disaster. Given the additional uncertainty that accompanies high rates of inflation, many decision-makers will simply forgo capital investments and other transactions involving long-term commitments. Because of this, mutually advantageous trades will be curtailed and the potential gains from these exchanges will be lost.

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When governments inflate, people will spend less time producing and more time trying to protect their wealth. Since failure to anticipate the rate of inflation accurately can have a substantial effect on one's wealth, individuals will divert scarce resources away from the production of goods and services and into the acquisition of information on the future rate of inflation. The ability of business decision-makers to forecast changes in prices becomes more valuable than their ability to manage and organize production. Speculative practices are encouraged as persons try to outwit each other with regard to the future direction of prices. Funds flow into speculative investments like gold, silver, and art objects rather than into productive investments like buildings, machines, and technological research. As resources move from productive to unproductive activities, economic progress is retarded.

But perhaps the most destructive impact of inflation is that it undermines the creditability and confidence of citizens in their government. At the most basic level, people expect government to protect their person and property from intruders who would take what does not belong to them. When government become an intruder - when it cheats citizens by "watering down" the value of their currency - how can people have any confidence that the government will protect their property against other intrusions, enforce contracts, or punish unethical and criminal behaviour? When the government "waters down" its currency, it is in a weak position to punish, for example, an orange juice producer that dilutes juice sold to customers or a business that waters down its stock (issues additional stock without permission of current stockholders).

Certain general principles are vital to the establishment of a stable monetary regime. First, if a country has a central bank that conducts monetary policy, the bank must be (a) independent of the political authorities and (b) held accountable for the maintenance of price stability. The most independent central bank in the world is the German Bundesbank. The Bundesbank Act of 1957 states that the bank "shall be independent of instructions from the federal government." Furthermore, the Bundesbank is obligated to support the economic policies of the government "only insofar as this support does not undermine its assigned task of preserving monetary stability."

In contrast, the central banks of Latin American countries have been almost entirely beholden to political officials. Under these regimes, central banking authorities who are unwilling to fund budget deficits with printing press money are often fired and replaced by someone "more cooperative." Not surprisingly, the German Bundesbank has one of the best inflation records in the world, while the politicized central banks of Latin America are best known for their inflationary policies.

Central bank authorities can be held accountable in various ways. They can be required by law to maintain the inflation rate (or a general price index or the rate of monetary growth) within a narrow range. Failure to do so might result in the dismissal of the bank's governing board. Alternatively, the salaries of the board and funds for operation might be tied to their record of monetary and price stability.

Some countries like Hong Kong and Singapore, for example, have set up a currency board as a means of achieving monetary stability. The currency board establishes a fixed rate of exchange between the currency that it issues and the currency of the reserve assets that it maintains. Under this arrangement, the currency board is required to maintain 100 percent reserves in the form of reserve assets such as U.S. dollars (and bonds). In essence, the 100 percent reserve requirement and agreement to exchange its currency for the foreign currency at the fixed rate ties the domestic currency to the foreign currency. Therefore, the inflation rate in a currency board country will be about the same as for the country whose bonds and currency are held as reserves.

While there are various ways that monetary and price stability can be achieved, there can be little question about its importance as a source of economic prosperity. Without monetary stability, potential gains from capital formation and other exchanges involving time commitments will be eroded and the people of the country will fail to realize their full potential.

6. Low Tax Rates: People Will Produce More When They are Permitted to Keep More of What They Earn

Taxes are paid in the sweat of every man who labours. If those taxes are excessive, they are reflected in idle factories, in tax-sold farms, and in hordes of hungry people tramping streets and seeking jobs in vain.

- Franklin Roosevelt
in Pittsburgh, Oct. 19, 1932

WHEN HIGH TAX RATES TAKE a large share of income, the incentive to work and to use resources productively is reduced. The marginal tax rate - the share of additional income that is taxed away - is particularly important. As marginal tax rates increase, the share of additional earnings that individuals are permitted to keep declines.

There are three reasons why high marginal tax rates will reduce output and income. First, high tax rates discourage work effort and reduce the productive efficiency of labour. When marginal tax rates soar to 55 percent or 60 percent, individuals get to keep less than half of what they earn. People who do not get to keep much of what they earn tend not to earn very much. Some (for example, someone with a working spouse) will drop out of the labour force. Others will simply work fewer hours. Still others will decide to take more lengthy vacations, forgo overtime opportunities, retire earlier, be more particular about accepting jobs when unemployed, or forget about pursuing that promising but risky business venture. In some cases, high tax rates even drive a nation's most productive citizens to countries where taxes are lower. These substitutions reduce the available labour supply, causing output to decline.

High tax rates also result in inefficient utilization of labour. Some individuals will substitute less-productive activities that are not taxed (for example, do-it-yourself projects) for work opportunities yielding taxable income. Waste and economic inefficiency result.

Second, high tax rates reduce both the level and efficiency of capital formation. High tax rates repel foreign investment and cause domestic investors to search for investment projects abroad where taxes are lower. Therefore, capital formation - which provides the fuel for economic growth - is retarded. Domestic investors will also turn to projects that shelter current income from taxation and away from projects with a higher rate of return but fewer tax-avoidance benefits. Business ventures that are designed to show an accounting loss in order to shelter income from the tax collector will become more widespread. As the result of the tax-shelter benefits, people are often able to gain from projects that reduce the value of resources. Scarce capital is wasted and resources are channelled away from their most productive uses.

Third, high marginal tax rates encourage individuals to substitute less-desired tax-deductible goods for more-desired, nondeductible goods. Here the inefficiency stems from the fact that individuals do not bear the full cost of tax-deductible purchases. High marginal tax rates make tax deductible expenditures cheap for persons in high tax brackets. Since the personal cost, but not the cost to society, is cheap, taxpayers confronting high marginal tax rates will spend more money on pleasurable, tax-deductible items, such as plush offices, Hawaiian business conferences, and various fringe benefits (for example, a company luxury automobile, business entertainment, and a company retirement plan). Since such tax deductible purchases reduce their taxes, people will often buy such goods even though they do not value them as much as it costs to produce them. Waste and inefficiency are by-products of this incentive structure.

In short, economic analysis indicates that high tax rates will reduce productive activity, retard capital formation, and promote wasteful use of resources. Predictably, the income of a country that imposes high marginal tax rates will fall below its potential.

As Exhibit 3 shows, several less-developed countries levy exceedingly high marginal tax rates and these rates are often applied at a very low income level. For example, in 1989 Tanzania levied a 50 percent tax on virtually all personal income. Thus, people got to keep only half of what they earned. Similarly, people with equivalent incomes of less than $10,000 U.S. dollars confronted marginal tax rates of between 55 percent and 75 percent in Zambia, Ghana, and Zaire. Top marginal tax rates of 60 percent or more were levied in Iran, Morocco, Dominican Republic, Zimbabwe, and Cameroon. Not surprisingly, the average real per capita Gross Domestic Product (GDP) of these high tax countries actually declined during the 1980s. Only one of the high tax countries (Morocco) was able to achieve any growth during the decade.

In contrast, marginal tax rates were much lower in five less developed countries; Hong Kong, Indonesia, Mauritius, Singapore, and Malaysia. These low-tax countries enjoyed rapid economic growth. Their real per capita GDP grew at an annual rate of 4.2 percent during the 1980s. High tax rates are an obstacle to prosperity and the growth of income. Governments that want to promote prosperity will strive to keep tax rates, particularly marginal tax rates, low.

7. Free Trade: A Nation Can Gain by Selling Goods that It Can Produce at a Relatively Low Cost and Using the Proceeds to Buy Things that It Can Produce Only at a High Cost

Free trade consists simply in letting people buy and sell as they want to buy and sell. Protective tariffs are as much applications of force as are blockading squadrons, and their objective is the same - to prevent trade. The difference between the two is that blockading squadrons are a means whereby nations seek to prevent their enemies from trading; protective tariffs are a means whereby nations attempt to prevent their own people from trading. [Henry George, Protection or Free Trade (1886, reprinted edition, New York: Robert Schalkenbach Foundation, 1980), p. 47.]

- Henry George (1886)

THE PRINCIPLES INVOLVED IN INTERNATIONAL trade are basically the same as those involved in any other voluntary exchange: the exchange enables each trading partner to produce and consume more than would otherwise be achievable. There are three reasons why this is so.

First, with international trade the people of each nation will be able to use more of their resources to produce and sell things that they do well and use the proceeds to purchase goods that they could produce only at a high cost. Resource endowments differ substantially across countries. These differences influence costs. Goods that are quite costly to produce in one country may be economical to produce in other countries. The people of each country can gain by specializing in those things that they can produce at a relatively low cost. For example, countries with warm, moist climates such as Brazil and Colombia find it advantageous to specialize in the production of coffee. People in countries such as Canada and Australia, where land is abundant and population sparse, tend to specialize in land-intensive products, such as wheat, feed grains, and beef. In contrast, in Japan where land is scarce and there is a highly skilled labour force, the Japanese specialize in manufacturing such items as cameras, automobiles, and electronic products for export. As the result of this specialization and trade, aggregate output increases and people in each country are able to achieve a higher standard of living than would otherwise be possible.

Second, international trade allows both domestic producers and consumers to gain from reductions in per-unit costs that often accompany large-scale production, marketing, and distribution. This point is particularly important for small countries. With trade, domestic producers can operate on a larger scale and therefore achieve lower per-unit costs than would be possible if they were solely dependent on their domestic market. For example, textile manufacturers in Hong Kong, Taiwan, and South Korea would have much higher per-unit costs if they were unable to sell abroad. The domestic textile market of these countries would be too small to support large, low-cost firms in this industry. With international trade, however, textile firms in these countries are able to produce (and sell) large outputs and compete quite effectively in the world market.

International trade also benefits domestic consumers by permitting them to purchase from large-scale producers abroad. The aircraft industry provides a vivid illustration of this point. Given the huge designing and engineering costs, the domestic market of almost all countries would be substantially less than the quantity required for the efficient production of jet planes. With international trade, however, consumers around the world are able to purchase planes economically from large-scale producers, such as Boeing or McDonnell-Douglas.

Third, international trade promotes competition in domestic markets and allows consumers to purchase a wide variety of goods at economical prices. Competition from abroad helps keep domestic producers on their toes. It forces them to improve the quality of their products and keep costs low. At the same time, the variety of goods that are available from abroad provides consumers with a much broader array of choices than would be available in the absence of international trade.

The recent experience of the North American automobile industry illustrates this point. Faced with stiff competition from Japanese firms, the Big Three automobile manufacturers worked hard to improve the quality of their vehicles. As a result, the reliability of the automobiles and light trucks available to North American consumers - including those vehicles produced by domestic manufacturers - is almost certainly higher than would have been the case in the absence of competition from abroad.

When countries impose tariffs, quotas, exchange rate controls, bureaucratic regulations on importers or exporters, or other types of trade restraints, they increase transaction costs and reduce the gains from exchange. As Henry George noted (see above quote), trade restraints are like a blockade that a nation imposes on its own people. Just as a blockade imposed by an enemy will harm a nation, so too will a self-imposed blockade in the form of trade restrictions.

Exhibit 4 presents data on the relationship between trade restrictions and economic growth during the 1980s for eighteen less developed countries - eight with low trade restrictions and ten with high trade restrictions. The eight low-restriction countries had relatively low tariff rates (taxes on international trade), and they reduced their tariff rates during the 1980s. For the most part, the low-restriction countries also refrained from the use of exchange rate controls. Thus, the black market premium for currency conversion was either nonexistent or quite small. Reflecting the fact that trade barriers were low, the size of the international trade sector for each of the eight low-restriction countries was large, compared to other countries of similar size. The annual growth rate of per capita income for the low-restriction countries was 5 percent during the 1980-90 period.

Now look at the data for the ten countries that imposed substantial restrictions on international trade. The tariff rates of the high-restriction countries were generally greater than 10 percent, approximately four times the rates imposed by the low-restriction countries. Exchange rate controls resulted in a black market currency conversion premium of 50 percent or more in six (Iran, Brazil, Peru, Bangladesh, Argentina, and Sierra Leone) of the high-restriction countries. Compared to countries of similar size, the international trade sector was small for each of the ten high-restriction countries. On average, the per capita income of the ten high-restriction countries was unchanged during the 1980s. Per capita GDP declined in six of the ten countries. Only two (India and Pakistan) were able to achieve a growth rate equal to that of a low-restriction country. Thus while the low-restriction countries prospered, the high-restriction countries stagnated.

Non-economists often argue that import restrictions can create jobs. When analyzing this view, it is once again important to keep in mind that it is production that really matters, not jobs. With free trade, domestic consumers are permitted to buy whatever they want wherever they can get the lowest prices. Similarly, domestic producers are able to sell their products wherever they can get the highest prices. The result is that consumers get more for their money and resource owners produce more goods and services that people value. If jobs were the key to high incomes, we could easily create as many as we wanted. All of us could work one day digging holes and the next day filling them up. We would all be employed, but we would also be exceedingly poor because such jobs would not generate goods and services that people value.

Of course, import restrictions may expand employment in industries shielded by the restraints. This does not mean that they expand total employment, however. Exports provide the purchasing power for imports. When Canadians erect tariffs, quotas, and other barriers limiting the ability of foreigners to sell in Canada, they are simultaneously limiting the ability of foreigners to buy goods produced in Canada. If foreigners are unable to sell as much to Canadians, they will have fewer of the Canadian dollars required to buy from Canadians. Thus, import restrictions will indirectly reduce exports. Output and employment in export industries will decline, offsetting any "jobs saved" in the protected industries. In essence, import restraints direct resources away from areas where domestic firms are low-cost producers and into areas where the domestic firms are high-cost producers. Thus, more of our resources will be employed producing things that we do poorly and fewer will be employed doing those things that we do best. Such policies waste resources and reduce domestic incomes.

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Many Canadians believe that trade restrictions are necessary to protect Canadian workers from imported goods produced by cheap labour. This view is also false. Countries export goods to us so they can acquire dollars with which to buy from us. The relative prices of goods will determine the direction of this trade. High-wage countries will tend to import things that are relatively cheap abroad and export goods that are relatively cheap at home. Therefore, high wage countries like Canada and the United States will tend to import labour-intensive goods, such as wigs, rugs, toys, handicrafts, fine glass and some manufactured goods. On the other hand, they will tend to export goods like grains, petro-chemicals, leading edge computers, aircraft and scientific instruments that are produced with high-skill labour, fertile farm land, petroleum and knowledge capital, resources that are relatively abundant in both countries. Trade between two countries like Canada and the United States which have similar endowments of resources will tend to be intra-industry trade: cars for cars, beer for beer, cheese for cheese, softwood lumber for hardwood lumber. In intra-industry trade two countries specialize in the production of particular kinds of goods and then trade with others to get a variety of them. So, for example, in the recent past Canada has produced all of the Plymouth Voyager minivans and all of the Chevrolet Lumina cars for North America in single plants and then imported the other Chrysler and GM vehicles. The long production runs made possible by producing only one type of vehicle per plant enable Canadians and Americans to get access to a wide selection of cars at lower prices than would other wise be possible. Nearly 80 percent of Canada-U.S. trade is intra-industry trade and this is expected to increase in the future.

When a country can get a product more cheaply from foreigners than it can produce the good domestically, it can gain by importing the product and using domestic resources to produce other things. Perhaps an extreme example will illustrate this point. Suppose a foreign producer such as a Santa Claus who pays workers little or nothing, were willing to supply Canadians with free winter coats. Would it make sense to enact a tariff barrier to keep out the free coats? Of course not. Resources that were previously used to produce coats could now be freed to produce other goods. Output and the availability of goods would expand. It makes no more sense to erect trade barriers to keep out cheap foreign goods than to keep out the free coats of a friendly, foreign Santa Claus.

If the "job savers" and proponents of trade restraints think such policies are a good idea, why don't they favour tariffs and quotas limiting trade among the provinces of Canada? After all, think of all of the jobs lost when, for example, Ontario "imports" lumber and apples from B.C., wheat from Saskatchewan, and fish from Nova Scotia. All of these products could be produced in Ontario. However, the residents of Ontario generally find it cheaper to "import" these commodities rather than produce them locally. Ontario gains by using its resources to produce and "export" automobiles. In turn, the auto sales generate the purchasing power that makes it possible for people from Ontario to "import" goods that would be expensive for them to produce locally.

Most people recognize that free trade among the provinces is a major source of prosperity for each of them. They recognize that "imports" from other provinces do not destroy jobs; they merely release workers for employment in "export" industries, where they will be able to produce more value and therefore generate more income. The underlying source of gains from trade among nations is exactly the same as for trade among people in different provinces. If free trade among the 10 provinces promotes prosperity, so too will free trade among nations.

If trade restraints retard economic prosperity, why do so many countries adopt them? The answer is straightforward: the political power of special interests. Trade restrictions benefit producers (and resource suppliers) at the expense of consumers. In general, the former group - investors and workers in a specific industry - are well organized and highly visible, while consumers are generally poorly organized and their gains are more widely dispersed. Predictably, the organized interest group will have more political clout - more votes and more campaign funds. Thus, politicians will often cater to their views. In the case of trade restrictions, sound economics often conflicts with a winning political strategy.