[Smart Economics] Economic Growth Begins with Law and Institutions

An Era of Companies “Voting with Their Feet” by Moving to More Favorable Places for Economic Activity

… Improvements in laws and institutions drive growth

If conditions allow, people naturally move to places with better, more competitive laws and institutions. As a result, the phenomenon of “voting with their feet” emerges, leading to competition in laws and institutions among local governments or between countries on the social and political level. Examples include the fact that each U.S. state has different laws and institutions, and that one country benchmarks another country’s laws or institutions. The same is true in the economy. Companies flock to societies with laws and institutions that are more favorable for economic activity, and economic growth takes place more successfully there. As recently as the 1960s, Venezuela’s per capita national income was about 30% higher than Japan’s. But by the 1990s, the situation had been completely reversed.

Even after taking inflation into account, Venezuela’s national income had not changed much compared to 30 years earlier. In Japan, however, per capita national income had increased more than fivefold, making it more than three times higher than Venezuela’s. Why did this reversal occur? The cause lay in the economic system.

Sweden, Where Global Companies No Longer Emerge

Japan had a market in which companies could operate freely, with almost no regulation on business activity or imports and exports, and with low taxes. Venezuela, by contrast, imposed numerous restrictions on business activity due to all kinds of regulations, including price controls, along with high taxes. That made it much harder to achieve economic growth. Meanwhile, Sweden, with a population of only around 10 million, produced many global companies during its period of a free market economy. These included the automakers Volvo and Saab, the electronics company Ericsson, the home appliance maker Electrolux, and the truck manufacturer Scania. But after a socialist government came to power, the structure changed so that no new large companies emerged.

Yet unlike Sweden, there are also countries that shifted from socialism to capitalism but still failed to achieve economic growth. In the early 1990s, the Soviet Union, a communist state, was reborn as the capitalist country of Russia. Its laws and rules also changed to fit a capitalist system, but the market economy did not function properly. Naturally, people found this puzzling, but the problem lay in the scope of institutions. Even if the economic system changes and laws and institutions are revised, a society’s moral norms, its ability to enforce the law, and its social order do not improve overnight. If “the law is one thing and reality another,” people are given incentives to break promises and ignore the rules.

Laws and institutions can largely be divided into negative and positive systems. A negative system specifies in law actions that must not be committed, such as murder, robbery, and theft, and permits all actions except those illegal acts. By contrast, a positive system describes in detail which actions are permitted by law and treats everything not explicitly permitted as illegal.

Under a negative system, new business methods can be developed freely. Under a positive system, however, new business methods are often not legally permitted. As a result, companies seek out countries with negative-style laws and institutions, and countries that want to attract companies sometimes compete by adopting negative-style laws and institutions. Sheikh Mohammed, the ruler of Dubai, also actively implemented negative-style laws and institutions, transforming Dubai from a small desert country into a global “business kingdom.”

Dubai Reborn as a Global “Business Kingdom”

Dubai was a country that lacked the basic factors of production necessary for economic growth. Of course, like other Middle Eastern countries, it did produce oil, but not in quantities large enough to justify optimism about the future. Sheikh Mohammed understood this reality better than anyone, and from his time as crown prince he began leading innovative changes to promote Dubai’s economic growth. The core of this transformation was to overhaul institutions and policies so that resources could be brought into the country by attracting foreign capital and companies.

Sheikh Mohammed first created as many as 17 free economic zones and exempted various taxes, including corporate tax, import and export tariffs, and personal income tax. He also abolished various financial regulations, liberalized foreign exchange transactions, and introduced an efficient one-stop administrative system that could issue a certificate of registration to a foreign bank in just two hours. In this way, Dubai created incentives so attractive that foreign companies and capital could hardly resist entering. In addition, Sheikh Mohammed’s creative ideas further encouraged investment of foreign capital and technology. As a result, Dubai succeeded in attracting around 7,000 global companies and $6 billion in foreign capital, and in a short time rose to become a center of global business and a paradise on earth. With the world’s tallest building, the world’s most luxurious hotel, fantastic artificial islands, a ski resort in the middle of the desert, a massive theme park covering an area equal to half of Seoul, and the world’s largest duty-free free trade zone, Dubai has now become “the country where imagination becomes reality” and has grown into the Middle East’s premier tourism hub after Egypt.

Some people even describe Dubai’s remarkable development as “the world’s eighth wonder,” and companies and politicians around the world have rushed to benchmark Dubai and emulate Sheikh Mohammed’s leadership. In this way, national competitiveness achieved through improvements in laws and institutions serves as a driving force that encourages business activity and leads to more efficient economic growth.

△ Please remember

When conditions allow, the phenomenon of people “voting with their feet” by moving to more competitive places gives rise to competition in laws and institutions among local governments and countries on the social and political level. Companies seek out countries with negative-style laws and institutions, and countries that want to attract companies also compete by adopting negative-style laws and institutions.

Sung-no Choi, President of the Center for Free Enterprise (CFE)

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Original title: [스마트 경제 읽기] 경제성장은 법과 제도로부터

Author: Sung-no Choi

Date: 2021-05-03

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=column&pn=4&idx=23677