Why are some countries richer than others?PART I: THE ROOTS OF WEALTH

The UN currently recognises 193 member countries1; some are rich, some are poor, some are desperately poor. What is it that makes some countries richer than others, and what lessons does this hold to help countries become more wealthy? This article looks at a number of global data sources to seek answers to this very big question.Success for a country is rather like success for an individual: a combination of the cards life deals you and the way that you play them. Countries are dealt some of their cards by nature, some by history and some by the rest of the world. Nature determines geography and climate and the resources of land and water, forests and minerals. History sets the boundaries of the country and its access to the sea, the ownership structures of land and industry, the systems of law, government and administration, relationships with the country’s neighbours, and the all-important but elusive factor of national attitudes. The rest of the world makes decisions of how it will deal with the country, and today nobody is immune from the ups and downs of the global economy. Some of these factors are effectively unchangeable: natural resources are largely fixed, though a country has considerable freedom in how it uses them, and it is hard to change the borders of a country without going to war. Other factors, such as the systems of government and administration, represent a starting point from which a country can, with time and effort, move on.Let us start by looking at some of the physical and demographic factors which might influence a country’s wealth, using the measure of Gross National Income per capita, converted to US dollars at “purchasing power parity” so that a dollar in one country represents the same value as in any other country2.

Size doesn’t matterHow important is the size of a country? Does a country have to achieve a certain “critical mass” in order to become wealthy? Is there a size limit above which a country becomes too unwieldy to govern and so economic growth tails off?

1 http://www.un.org/en/members/ 2 http://data.worldbank.org/indicator/NY.GNP.PCAP.PP.CDThe dataset covers 213 countries and territories, slightly higher than the UN number due to the inclusion of territories such as “West Bank and Gaza” that are not UN members. The graph shows the most recent income figure for those 180 countries and territories for which income data are available between 2009 and 2011.

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The following chart shows how per capita Gross National Income (GNI) varies with the overall population of a country, with particularly rich or large countries being labelled:

The sloping line is a linear regression of per capita GNI against population, showing a very slight tendency for larger countries to be poorer, but the R2 correlation coefficient shows that only a quarter of one percent of the inter-country variance in income can be explained by its population size. Excluding China and India, which together account for almost 40 % of the world’s population, the line becomes almost horizontal and the correlation drops to just 0.02 % – effectively zero:

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In other words, there are big rich countries and big poor countries, small rich countries and small poor countries, and there is absolutely no link between population size and per capita income. Small countries may need to apply different strategies from large ones, but neither has a fundamental advantage over the other where wealth-creation is concerned.

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Nor does it matter how dense you areIf total population is not a factor, what about population density? A country with many people in a small area has to spread its limited natural resources more thinly, whilst a very sparsely populated country faces challenges of infrastructure and travel distance, suggesting that there might be some kind of optimum population density. The following chart shows how per capita GNI varies with population density to see whether this is in fact the case:

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Here the tendency is for countries to become richer as their population density increases, but the correlation is less than 10 % and the dataset is strongly influenced by three countries that are very small, very densely populated, and very rich: Hong Kong, Singapore and Macao. Removing these three exceptions gives the following graph and a correlation of just 0.6 %:

So with the exception of three specific south-east Asian countries that together account for just 0.2 % of the world’s population, population density also has no link with per capita GNI.Perhaps this is not surprising when you think about how the population is distributed in many countries. For example, in many north African countries the population is concentrated along the Mediterranean coast, with large areas of almost unpopulated desert below them. So a better measure might be to look at where the people live: spread throughout the countryside or clustered into towns and villages.

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The cost of the rural idyllThe following chart shows how GNI varies with the proportion of the population living outside urban areas, as designated by the national statistical authorities3:

Here the relationship between GNI and rurality is best shown by an exponential curve, and the correlation is very strong: 55 % of the differences in GNI between countries can be explained by the share of their population living in rural areas, and the more rural a country is, the poorer it is. Of the countries that have more than a third of their population living in rural areas, just four have managed to achieve gross national incomes of more than $ 25,000 per head and only one, Ireland, has managed to exceed $ 30,000.The question is to what extent is this causation, rather than just correlation. Do countries become wealthier because they urbanise, do they urbanise because they are wealthier, or are both urbanisation and wealth driven by some other factors? A possible explanation is that once a country progresses beyond being purely agrarian, most of the economic growth is in towns and cities, to which people gravitate in search of jobs and a better standard of living. Once there, they contribute to the cycle of urban-centred economic growth, and thus urbanisation and economic growth have tended to go hand-in-hand.A correlation of 55 % is very high, and should certainly make rural development planners stop to consider whether trying to keep people in rural areas is really a sensible goal, yet it still leaves 45 % of the variation unaccounted for. What is it that has let countries as diverse as Qatar and Luxembourg, Switzerland and the USA, the UK and Trinidad and Tobago, achieve levels of per capita income out of all proportion to their level of urbanisation?

3 http://data.worldbank.org/indicator/SP.RUR.TOTL.ZS/countries/1W?display=graph

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To answer this question we must go beyond simple demographics and start looking at how countries govern and organise themselves.

Returns to democracyThe starting point to examine how well government works is perhaps to look at how governments are created in the first place – the extent to which they are formed, directed and changed by democratic processes, as opposed to lying under the control of some ruling elite. One attempt to measure the complex subject of democracy is the “Democracy Index” produced by the Economist Intelligence Unit4. The index is based on 60 questions grouped into five categories:

Electoral process and pluralism; Civil liberties; Functioning of government; Political participation; Political culture.

Scores are based on a combination of public attitude surveys and expert opinion. Averaging the scores across these five areas results in an index from 0 - 10, from which each country is grouped into one of four categories, described as follows:

Score of 8.0 - 10.0 “Full democracies”: Countries in which not only basic political freedoms and civil liberties are respected, but these will also tend to be underpinned by a political culture conducive to the flourishing of democracy. The functioning of government is satisfactory. Media are independent and diverse. There is an effective system of checks and balances. The judiciary is independent and judicial decisions are enforced. There are only limited problems in the functioning of democracies.

Score of 6.0 - 7.9 “Flawed democracies”: These countries also have free and fair elections and even if there are problems (such as infringements on media freedom), basic civil liberties will be respected. However, there are significant weaknesses in other aspects of democracy, including problems in governance, an underdeveloped political culture and low levels of political participation.

Score of 4.0 - 5.9 “Hybrid regimes”: Elections have substantial irregularities that often prevent them from being both free and fair. Government pressure on opposition parties and candidates may be common. Serious weaknesses are more prevalent than in flawed democracies--in political culture, functioning of government and political participation. Corruption tends to be widespread and the rule of law is weak. Civil society is weak. Typically there is harassment of and pressure on journalists, and the judiciary is not independent.

Score below 4.0 “Authoritarian regimes”: In these states state political pluralism is absent or heavily circumscribed. Many countries in this category are outright dictatorships. Some formal institutions of democracy may exist, but these have little substance. Elections, if they do occur, are not free and fair. There is disregard for abuses and infringements of civil liberties. Media are typically state-owned or

4 https://www.eiu.com/public/topical_report.aspx?campaignid=DemocracyIndex12 The report contains a detailed description of the methodology, and also compares it with other measures of democracy, including the measures published by “Freedom House”.

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controlled by groups connected to the ruling regime. There is repression of criticism of the government and pervasive censorship. There is no independent judiciary.

The report for 2012 does not give particularly flattering scores to either the UK (where the Economist Intelligence Unit is based) or the USA, the former because of the widespread distrust of public institutions and the latter because of the partisan political deadlock that is making it hard for the US government to govern. Thus the index should not be simply dismissed as an exercise in the West criticising the rest of the world.

The following graph shows the correlation between per capita GNI and the Democracy Index:

Countries with scores of 6.0 and above (described by the Economist Intelligence Unit as “Flawed Democracies” or “Full Democracies”) are shown in blue and labelled simply as “Democratic”; countries with scores below 6.0 (described by the Economist Intelligence Unit as “Authoritarian Regimes” or “Hybrid Regimes”) are shown in red and labelled simply as “Undemocratic”.Several interesting points emerge:

Below a score of 6, there is almost no correlation between the Democracy Index and GNI. This suggests that there is a minimum level of democracy that has to be reached before a country can develop economically. This might be where the country passes the acid test of having periodic transfers of power without bloodshed, but the report does not provide the information needed to test this theory;

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Above this point the correlation is very strong, with the index accounting for almost 60 % of the difference in per capita GNI between countries.

There are no diminishing returns to democracy: the data suggest that even wealthy and relatively democratic countries would see economic benefits from strengthening their democratic institutions and culture.

For the “undemocratic” countries, where the Democracy Index almost no explanatory power, there are quite wide variations in GNI, with some states equalling or even exceeding the most democratic of countries. Why is this?

Income, democracy and oilThe one-word answer is “oil”, as shown in the following version of the same chart, only with the dots being replaced by bubbles whose size is proportional to the country’s per capita oil production5:

The conclusions from this chart are that: Most of the world’s oil production is in undemocratic hands. It could be

hypothesised that oil is bad for democracy, because it gives undemocratic regimes the resources to suppress dissent and survive longer than they otherwise would ( a

5 Countries with little or no oil production have been assigned a bubble size representing 0.25 barrels per person per year, to keep the points visible on the chart. Oil production data are from the CIA website (https://www.cia.gov/library/publications/the-world-factbook/rankorder/2241rank.html). A few countries are excluded from this version of the graph as oil data were not available, which accounts for the slightly different R2 values for the regression lines.

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view expressed by the Economist Intelligence Unit in their democracy 2012 report). However, there are plenty of countries in the world that have neither oil nor democracy, so the equation is not that simple;

Where countries have managed to achieve wealth without democracy, they have usually done so with the support of oil. Only three countries have managed to reach a GNI of $ 10,000 per head without producing at least one barrel of oil per person per year; these are Singapore and Turkey (with Democracy Index values of 5.88 and 5.76, placing them near the top of the “Hybrid regime category”), and Lebanon (with a score of 5.05 placing it in the middle of the “Hybrid Regimes”).

Amongst the democratic countries, the level of oil production seems to have rather little correlation with per capita GNI – this may be a combination of the fact that they have relatively little oil, and of the strength of their economies in other areas. The blue bubble at the top right represents Norway, which enjoys the world’s highest Democracy Index score as well as having massive reserves of oil, natural gas and hydroelectric power, leading it to be described by UNDP as “the best country in the world”.

The graph presents a strong case that it is almost impossible for a country to become rich without either embracing democracy or striking oil – and that the latter is not necessarily good for the former.There are many other natural resources that could also have been taken into account to help explain differences in countries’ levels of GNI. Natural gas, one of the most important, tends to be found in the same places as oil, but other minerals such as gold, platinum, copper and rare earths are not linked to oil deposits and might be relevant to GNI values for non-oil producers.

Why does democracy matter?Is the strong link between democracy and wealth one of causation, or just correlation? If a country’s success is viewed as a combination of the cards it is dealt and the way that it plays them, then its government must have a pre-eminent role in the way the cards are played, both as a major player in its own right and through the way it creates the conditions in which every individual and business play their own cards. Thus the quality of government is likely to be one of the most important factors – if not the most important factor – in how well a country responds to the opportunities and challenges that it encounters.To some extent the Democracy Index measures this directly, in that “Functioning of government” makes up one-fifth of the index. However, democracy does much more than this, in that it allow an electorate to get rid of a government that fails to deliver, and failure to deliver economically is probably the most common reason for an incumbent party to fail at the polls.There is also another level of correlation, in that a well-functioning democracy requires a complex set of institutions – in government, civil society and the private sector – to support the range of democratic processes and the various systems of checks and balances that keep a democratic society functioning well. A society that manages to handle the intricacies of democracy is likely also to have the capacity to manage the economy, the education system, international trade and all the other complex factors that contribute to a country’s wealth.

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Thus democracy may be seen as both a cause and a correlate of good government, but as different factors go, it is arguably very close to being the prime mover.

However fundamental democracy and effective government may be, they can only start to drive wealth creation once they are translated into operational policies. So what are the main government decisions that influence economic growth, and how important are they in determining Gross National Income?

The importance of doing businessWhilst government is by far the biggest actor in almost every country, most wealth is created by individuals and private organisations doing business, so it seems reasonable that the business climate should have a strong influence on GNI. This is something that the World Bank seeks to measure and monitor through its “Doing Business” rankings, which measure 11 areas of business regulation under the two broad headings of “Complexity and cost of regulatory processes” and “Strength of legal institutions”6:

Complexity and cost of regulatory processeso Starting a business: Procedures, time, cost and paid-in minimum capital

requiremento Dealing with construction permits: Procedures, time and costo Getting electricity: Procedures, time and costo Registering property: Procedures, time and costo Paying taxes: Payments, time and total tax rateo Trading across borders: Documents, time and cost

Strength of legal institutionso Getting credit: Movable collateral laws and credit information systemso Protecting investors: Disclosure and liability in related-party transactionso Enforcing contracts: Procedures, time and cost to resolve a commercial

disputeo Resolving insolvency: Time, cost, outcome and recovery rateo Employing workers7: Flexibility in the regulation of employment

6 http://www.doingbusiness.org 7 Data on the “Employing workers” axis were not included in the 2013 “Doing Business” report, which is used here.

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The main country table in the “Doing Business” report gives country rankings (where 1 is the best and 185 the worst) rather than absolute scores, so it is these rankings that have been used in the following chart showing how per capita GNI varies with the “Doing Business” ranking:

There is a strong correlation between the “Ease of Doing Business” ranking and per capita GNI; it can be described moderately well by an exponential curve, and could probably be improved by a better mathematical function. This regression shows that a country’s ranking in terms of its ease of doing business accounts for 57 % of the overall variation in per capita GNI, placing it only slightly below the 59 % correlation achieved by the Democracy Index.

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It is not especially good practice to compare a ranking with an absolute value, so the following chart compares like with like by showing how shows how a country’s GNI ranking correlates with its Ease of Doing Business ranking:

Now the correlation is a simple straight line, with the R2 correlation coefficient staying almost identical at 57 %.

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Is democracy always good for business?Given the preceding argument on how democracy should generate good government, are these two indices – of democracy and of doing business – simply two ways of measuring the same thing? The following chart examines the correlation between the two:

There is a definite tendency for countries with strong democracies to have good business environments, and vice versa, but with a correlation of 38 % it is clear that these are not the same thing: it is not enough just to be democratic, a country must also use its democratic tools to create a good business environment.The graph labels many of the outlying states, where the normal relationship between democracy and doing business does not hold: at the bottom-right are the Gulf States, which have quite a good score for the business environment whilst ranking very poorly on democracy; also two former socialist countries – Macedonia and Georgia – receive very good “Doing Business” rankings but are only average in terms of democracy.At the top left is a mixed group of countries whose success in creating a good business environment lags far behind their achievements in democracy. This latter group includes major players such as India and Brazil, suggesting that if they could get their regulatory and legal house in order, they might considerably increase their already impressive rate of economic growth. Two of the most struggling Eurozone countries – Italy and even more so Greece – have relatively poor business environments whilst Malta, not yet flagged up as a major part of the Eurozone crisis, scores markedly worse than these two.

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Top place in the “Doing Business” rankings goes to Singapore, which may help to explain how it achieves a GNI of over $ 59,000 whilst still counting as a “Hybrid Regime” on the Democracy Index.

One of the 11 elements of the “Doing Business” ranking deals with trading across borders, but addressing only the administrative aspects. International exchange of goods and services can do much to enhance the wealth of nations, provided the countries’ protectionist tendencies do not get in the way...

The cost of protectionismThe best source of data on international trade and tariffs is the World Trade Organisation which publishes, amongst other measures, the “Average Applied Tariff Equivalent”. This measure combines all the elements of customs duties (ad valorem duties, specific duties and seasonal duties) into one value. It has a number of weaknesses, such as not taking account for trade under preferential “tariff rate quotas” (which can often account for a large proportion of the whole) and being a simple rather than weighted average (so the tariffs for wheat and whale meat have the same impact on the final figure, despite their massively different shares of world trade). However, it is a commonly-used and well-studied figure, and one of the headline variables used in trade negotiations.The following chart shows how per capita GNI varies with average applied tariff equivalent:

A logarithmic curve is used to show the relationship: the less protection a country applies, the richer it is, with an overall correlation of 29 %. In this chart the European Union is

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shown as one country, since all 27 Member States apply the same tariffs under their customs union, and the GNI figure of $ 32,600 is an average for the whole EU.A number of major trading countries, including the USA, EU, Australia and New Zealand, have levels of per capita GNI distinctly higher than even their relatively low tariff equivalents would suggest, as factors such as urbanisation, democracy and business environment also come into play.Once again Georgia stands out as having one of the world’s lowest levels of protection, as well as a good business environment, but having a GNI of just $ 5,300 per head.Singapore, as well as coming first in the “doing business” ranking, also takes third place in the liberal trade stakes, with its average tariff equivalent of 0.02 % beaten only by Hong Kong and Macao, each having just 0.01 %, representing almost complete free trade. The decision of these very small countries to open up their economies entirely is one example of the way in which small countries sometimes have to pursue different strategies in order to match the economic performance of their larger competitors.

The average tariff does quite a good job of explaining the difference between rich and poor countries but amongst the poorer nations – those with a GNI of less than $ 15,000 per capita – the correlation is much weaker, at just over 7 %. This might be because these countries are less able to stand up to international competition, or it might simply be that other factors such as democracy, business climate and level of urbanisation play a more dominant role.

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Big government, small governmentOf the many factors that might be used to measure governments and see what drives their economic fortunes, one should be the overall size of the government in relation to the economy. The following chart, again using World Bank data, looks at how per capita GNI varies with government revenue as a percentage of GDP:

The graph shows a tendency for countries with a higher level of government spending to have higher GNI, though with many outliers.

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The following chart tries to deal with the outliers by splitting the data into two: “rich countries” with GNI of at least $ 25,000 per head, and middle-income and poor countries with per capita GNI below $ 25,000:

This graph shows a relatively strong correlation (29 %) for the poorer countries, but almost no correlation (below 1 %) for the rich countries.The level of government spending may not be the best way to capture the difference between “big government” and “small government” since many other factors not directly linked to government spending, such as low tariffs and light regulation of businesses, are also important elements of “small government”. To take two examples, Norway and Singapore have similar high levels of GNI, good scores for business environment, and medium and low levels of trade protection respectively, yet the share of total GDP spent by government in Norway is almost three times higher than that in Singapore.This suggests that for the most wealthy countries, the balance between public and private spending is largely a matter of political choice, whilst for developing countries and emerging market economies, there is an important link between government size and wealth.In this area the question of causality or correlation is even more than usually complex:

Countries that spend more on things like education, training, research and development could quite plausibly increase their wealth by so doing (i.e. government spending driving GNI);

As countries become richer they may well choose to spend more on things such as health care, pensions and social benefits (i.e. GNI driving government spending);

Countries that get a lot of income from oil and gas (e.g. Norway) may see a lot of their income coming straight into the government’s hands, and then being

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redistributed to the population in various ways (i.e. natural resources driving government revenue, driving GNI);

If governments have a large revenue from running nationalised industries and applying large taxes to some parts of the economy in order to subsidies others, then the effects on wealth creation are more questionable;

The link between military spending – a large item in many government budgets – and GNI could be debated at great length.

This may have to be left as an important and fascinating area for further research.

The value of sound moneyFor most governments, one of their most important economic policies is monetary policy, with controlling inflation usually set as the primary target; the following graph shows how per capita Gross National Income varies with annual Consumer Price Inflation8:

Here it is rather harder to describe the correlation by a line or curve. Most wealthy countries (i.e. with a GNI of at least $ 20,000) seek to keep CPI in low single digits, and none gets into double figures. Seventy percent of these wealthy countries fall in the range of 2-5%, and almost 90 lie between 1-6 %.However, many poorer countries also have inflation within this range, so sound monetary policy alone is not enough to ensure national wealth. That said, high inflation does appear to be bad for the economy: average inflation in countries with GNI below $ 20,000 is 7.7 %

8 http://data.worldbank.org/indicator/FP.CPI.TOTL.ZG

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as compared to 3.3 % for the wealthier countries, and once inflation rises above 10 % very few countries manage to reach an income of even $ 10,000 per head.However, deflation is not so good for the economy either, as countries like Japan and Bahrain have found to their cost.

It is not clear to what extent keeping inflation around the range of 2-5 % is a direct cause of national wealth, or how much it reflects the current consensus amongst the economists and international financial institutions that influence government policy. But letting the data speak for themselves suggests that keeping inflation in low single figures is almost a prerequisite for a wealthy economy.

What these graphs do not showThe number of factors that could be compared with national income is almost endless. The importance of other natural resources besides oil has already been mentioned, and other geographic factors such as topography and access to the sea might also be taken into account. In terms of government policy it would be informative to look at what governments spend their money on, with education and infrastructure seeming particularly likely to correlate well with GNI.Everything presented in this paper has been a snapshot, showing the latest year’s GNI against the latest data available for population, democracy etc. The analysis therefore reflects the cumulative effect of countries’ actions over a long period of time resulting in their current level of wealth, rather than focussing on their current rate of growth with its susceptibility to the ups and downs of the global economy.

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SummaryThe regression lines for each factor give the following correlation coefficients:

Factor Correlation with GNI

Democracy Index(higher democratic score is best for 1st group)

59 % linear (DI of 6 +)0.1 % linear (DI below 6)

Ease of Doing Business ranking(high ranking/low number is best)

57 % exponential

Share of population in rural areas(least rural is best)

55 % exponential

Average applied tariff(lowest tariff is best)

29 % logarithmic

Government revenue as share of GDP(higher GDP is best for 1st group)

29 % linear (GNI below $ 25,000)0.6 % linear (GNI above $ 25,000)

Population density(more dense is marginally better)

9.7 % linear including Hong Kong, Macao & Singapore0.6 % linear excluding them

Total population(bigger is marginally better for 1st group, insignificantly worse for 2nd group)

0.2 % including India & China0.02 % excluding them

Consumer Price Inflation No obvious regression, but a clear tendency for wealthy countries to lie in the range of 1-6 %

ConclusionsThere are many things a country should do to increase its wealth, with a good business environment and a liberal trading regime being particularly important. However, the three cardinal rules seem to be these: urbanise, democratise, strike oil.

Dr Steve Goss20 May 2013

In “Part II: Money isn’t everything”, how rurality, democracy and ease of doing business affect human development and equality9.

9 http://issuu.com/steve_goss/docs/why_are_some_countries_richer_II

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