The Wealth of Nations — Part 1


Warren Buffett
In his 2016 annual letter (pdf, 28 pp) to the shareholders of Berkshire Hathaway, Warren Buffett makes this observation about America’s economic dynamism.

One word sums up our country’s achievements: miraculous. From a standing start 240 years ago – a span of time less than triple my days on earth – Americans have combined human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law to deliver abundance beyond any dreams of our forefathers.

“You need not be an economist to understand how well our system has worked. Just look around you. See the 75 million owner-occupied homes, the bountiful farmland, the 260 million vehicles, the hyper-productive factories, the great medical centers, the talent-filled universities, you name it – they all represent a net gain for Americans from the barren lands, primitive structures and meager output of 1776. Starting from scratch, America has amassed wealth totaling $90 trillion.”

Buffett is right about the factors that create wealth — ideas (or human ingenuity), ambition, the free market system, and the rule of law. Let’s explore some of these in more details.

Wealth

Buffett estimates the accumulated wealth of the US to be $90 trillion. I assume that it refers to aggregate household wealth.

The accuracy of any estimate related to the total wealth of such a large collective as the US is likely to depend on what one counts as wealth. One way would be to add up the household wealth and government owned wealth. Household wealth is easy enough to estimate using statistical techniques and readily available data. The total value of homes, vehicles, shares of stocks, and savings held by households are easy to aggregate. Estimating government wealth is harder because local, state and federal governments own land which has natural resources that constitute national wealth but cannot be priced.

The 2015 US GDP in 2015 dollars was $18T according to the World Bank. Total world GDP for 2015 was $75T. That is, the US accounted for around 24 percent of world income with only a little over 4 percent of the world population. The question is: why is the US so successful in creating wealth?

(A related question would be why the US tops the rest of the world in the destruction of wealth — through wars and the mass production and stockpiling of a vast array of weapons of mass destruction. I will deal with that in a different piece.)

The one word answer to that question is “Freedom.” Free people create the institutions that help people create wealth. The institution most critically important is what is called “free markets”, and it can only be created by free people. The progression is simple: free people ⇒ free markets ⇒ wealth creation.

Free Markets

We humans exchange all kinds of stuff among ourselves. Why we exchange stuff is because we are not equally good at producing all the things that we want to consume. That is, through exchange individually we are able to consume a larger set of goods than if we were confined to consume only what we individually produce or was available to us. Where exchanges are done is called the market. It need not necessarily be a physical location, although commonly it is, because markets in essence are a mechanism (an institution) where rights are traded, and rights are abstractions. I can buy the right to a piece of land by paying for it by a bank transfer over the web.

Markets are as old as civilization. More precisely, as old as the invention of human laws that established the notion of private property. The important advance was the establishment through some rule the link between something and someone. Without private property, there can be no exchange since what you don’t own, you cannot exchange. A certain set of rules lead to ownership, that creates the possibility of exchange, and therefore markets.

Different sets of rules create different kinds of markets. One special kind is “free markets.” Free markets are those in which there are no barriers to entry or exit. Anyone can participate as a buyer or a seller in a free market, and equally importantly, anyone can exit the market as a buyer or a seller. There is no force or coercion involved in a free market.

Slavery

Examples of not-free markets abound. A slave market is not a free market for one obvious reason: a slave does not own himself. The lack of self-ownership is a consequence of the set of rules in a society that recognizes slavery.

The US used to have a set of rules of that kind until slavery was abolished in December 1865. The UK abolished slavery in 1833 in the British Empire except for the territories held by the East India Company. The Indian Slavery Act of 1843 outlawed slavery in India under East India Company rule.

Self-ownership is a necessary precondition for the existence of a labor market where people can buy and sell labor. But that is not a sufficient condition for free labor market. When there are barriers to entry (or exit) in the labor market, then it is not a free market. These barriers are always created by the government. For instance, a minimum wage is a barrier to entry in the labor market.

British Raj

In India, there are laws that forbid certain firms from letting go of labor at will. That is, there is no free exit from the market as a buyer. This is supposed to help labor but it actually hurts the interests of labor and thus is a major factor that impoverishes India.

For around 150 years until 1947, the British crafted all the rules that governed British India. These rules were understandably designed to keep Indians under British government control, and therefore India lacked free markets. That led to deepening poverty in India. After 1947 when the British left, the Indian leaders took over the task of denying freedom to Indians using essentially those British era rules, including the restrictions on free markets. India’s poverty was engineered by the British and implemented enthusiastically by Indians.

One of the features that distinguishes India and the US, and which explains why India is poor while the US is rich, is that the US has relatively more free markets than India. Of course the lack of free markets is a consequence of a general lack of freedom in India. That’s India’s “license control permit quota raj” that Indian politicians of all stripes absolutely adore.

Competition

Competition is a universal feature of the biological world. Indeed the variety of life on earth is a consequence of that universal biological drive. The origin of species, as Charles Darwin discovered, requires competitive success. Every animal that ever lived has had an unbroken line of successful ancestors.

Humans are not only not immune but are masters of the competition game. Wealth creation depends on competition. Even cooperation — the seeming opposite of competition — is at least partly motivated by the competitive instinct in the sense that absent the necessary cooperation of others, one would be handicapped in any competition.

Free markets, with their characteristic lack of barriers to entry and exit, is the battle ground for competition, and the source of all the wealth that we enjoy. Free markets create wealth through competition.

Look around yourself and see all the material goods that you value. Take the computer that I am using to write this, the internet that will make this piece accessible to anyone who is interested in reading this perhaps on a smart phone. All of them the products of intense competition. The big corporations such as Google, Apple, Tesla, Microsoft etc., and the innumerable small firms all the way down to the little corner stores — all of them products of competition that markets enable. Also note that the greater the extent of free markets, the greater the range and scope of wealth producing firms.

South Korea is a rich country, while North Korea is a poor country. The South Koreans have freedom that the North Koreans don’t have. Hence South Korea produces great wealth. The distinction between the two comes down to the set of rules.

South Korea’s Samsung competes with Apple. Apple is forced to be as good as it is because of Samsung, and vice versa. The same story can be told in any industry. The auto industry keeps innovating and turning out ever better products because of the competition among automotive firms. Boeing and Airbus keep improving their jetliners not because they love airlines but because they want a greater share of the commercial jetliner pie. Airlines compete with each other by providing the best price-services value not because they love airline passengers but because they love to make a profit.

Love and Self-love

Love is always in short supply relative to demand. Therefore economizing on love is always a great idea. What makes the world go around given the scarcity of love is the desire for the easily attainable commercial profits. The great Scottish enlightenment moral philosopher, Adam Smith, the granddaddy of economics, put it very nicely in his book An Inquiry into the Nature and Causes of the Wealth of Nations, published by happy coincidence the same year that the US became independent, 1776.

Without apology and with great delight, I present an extended quote from Volume 1, Chapter 2 of the book. Smith discusses exchange and cooperation, and how self-interest, far from impoverishing the world, leads to socially beneficial outcomes even though that is not the primary interest of the participants in a market exchange:

Wealth of Nations “Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. Nobody ever saw one animal by its gestures and natural cries signify to another, this is mine, that yours; I am willing to give this for that. When an animal wants to obtain something either of a man or of another animal, it has no other means of persuasion but to gain the favour of those whose service it requires. … In civilised society [man] stands at all times in need of the cooperation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons. In almost every other race of animals each individual, when it is grown up to maturity, is entirely independent, and in its natural state has occasion for the assistance of no other living creature. But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show them that it is for their own advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. 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 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.

Not love but self-love that makes motivates people to do what they do, and that creates wealth.

Alice’s Insight

I cannot leave this topic without a respectful nod toward another great mind — the logician, mathematician, author Lewis Carroll (born Charles Lutwidge Dodgson 1832 – 1898). Most people know of his famous books Alice’s Adventures in Wonderland (1865), and Through the Looking Glass and What Alice Found There (1871). But only scholars interested in voting methods know that he is the author of the Dogdson’s Method that selects a Condorset winner in an election.

Don’t bother yourself with what a Condorset winner is. I mention that only BTW. What I really want to point to is that matter of love. In Wonderland, Alice meets the Duchess and in one exchange, the Duchess makes the extraordinary claim that the moral of a particular event is that:

“Oh, ’tis love, ’tis love, that makes the world go round!”

Clearly Alice was not going to buy that leftist bile.

“Somebody said,” Alice whispered, “that it’s done by everybody minding their own business!”

I’d like to believe that it was good ol’ Adam Smith whom Alice was quoting. I will go into minding your own business in part 2 of this piece.

Be well, do good work and please keep in touch. Hat tip Rajan Parrikar for the Buffett letter.

{This is part of a work in progress called “The Wealth of Nations.”}

7 thoughts on “The Wealth of Nations — Part 1

  1. Very well articulated. Corruption is one big pain point in the economic growth of a country. I have this funny idea but would like your inputs from an economists perspective. If things get costly it reduces its demand. Can corruption be made costly? This may increase compliance. Just to illustrate. If we raise fine for a fault, say traffic violation, which suppose today is Rs 500 to Rs 5000. Today the violator gets away by paying Rs 100 to traffic police. This is 20% of legal cost. If the penalty is 5000 and assuming traffic police acts rationally thereby asking for bigger bribe…won’t that deter future violations by the offender? Here I presume that traffic police will act smart knowing fully well that offender isn’t going to pay 5000 but at the same time he himself won’t settle for just Rs 100 and may raise ‘price’ to Rs 200 or 300. This is effective 100-200%% jump in bribe money that may pinch offender at some point in time. Pls throw some light.

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  2. Sir, What about China. China is not a free country but still manages to create tremendous wealth in a very short span of time.

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    1. Of course China is not a free country. But it is freer than India, if you care to notice. That is why China is more prosperous than India. India is a more socialist country than China, although China was more restricted around 1978 than India. But Deng Xiopeng changed that and China became richer than India in a couple of decades and India still continues to be socialist and desperately poor. That’s a lesson about the power of free markets.

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