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The Magic Formula for Wealth

How nations grow wealthy...

ECONOMISTS have been talking for decades about why some countries get wealthy, and some do not, writes Nathan Lewis of New World Economics.

It was the subject of Adam Smith's famous book, The Inquiry Into the Nature and Causes of the Wealth of Nations. I suggest that the secret could be expressed in four words: Low Taxes, Stable Money. I call this the Magic Formula.

The reason for this is simple. The primary way that countries have become wealthy is via capitalism. Capitalism works best with stable money and low taxes.

If taxes are too high, and money is too unstable, capitalism – the incredibly complex arrangement of relationships that allow humans to cooperate together in vast networks of investment, production and trade, via the market system – becomes impaired, or collapses completely.

Recent books like Why Nations Fail, by Daron Acemoglu and James Robinson, take up this fascinating subject for our own age. In general, they tend to focus on a menagerie of what I would call secondary factors, while missing the foundational importance of the Magic Formula.

If you don't have the Magic Formula, you might maintain a decent standard of living. Many European countries maintain a high standard of living today, despite rather high taxes. But, they didn't become wealthy this way. If you look back into the history of Germany or Japan, or the United States, you typically find a period when the Magic Formula is in full effect. Most of the gains are made during these eras.

In US history, most of the gains were made in the 1870-1914 period, the 1920s, and the 1950-1970 period. Today, we have neither Stable Money nor Low Taxes. The result? The US median male full-time wage has stagnated and declined for forty years.

When hopeful emerging countries imitate this example – the strategy that has produced four decades of stagnation in the United States – they find that they too stagnate, but at a much lower level.

Some communist countries have had periods of substantial progress. The Soviet Union, despite its flaws, was actually quite successful in the 1950s and 1960s. However, even this was dependent on Stable Money. Once the currency fell apart in the late 1980s, the Soviet Union itself disintegrated soon afterwards. Most other communist experiments did not go so well as this.

When the Magic Formula is in place, it tends to create an environment of increasing wealth and prosperity. Usually, there is enough of an indigenous tradition of contract and ownership – what legal experts call "common law" – that business can prosper. The government is popular, which leads to political stability. Over time, various legal, judicial, regulatory, educational, administrative, governmental and other institutions are established, typically by imitating successful models in developed countries.

Yes, we all love education – to take one example of what I am calling a "secondary factor." But the fact of the matter is, most successful economies are built by self-educated businessmen, who are in turn empowered by the Magic Formula. In the United States, we seem to have our own tradition of the college-dropout-turned-business-mogul. On a smaller scale, this can be a neighborhood restauranteur or auto repair shop. These people create the jobs, which then creates the demand for the education to fill those jobs, where technical book-learning is necessary. Henry Ford didn't know how to build an automobile.

Formal contract law and a sophisticated judicial system form one institutional foundation for capitalism in the United States and Britain. However, Asian countries like China or Japan, where formal contract law is vague and the judicial system somewhat unreliable, have also been very successful, as long as they have the Magic Formula.

Asian countries have also been quite successful with capitalism despite having little in the way of democratic political institutions. China remains "communist" today, although this is just a contemporary term for the kind of mandarinate governments that have been running China for centuries. Japan's first great age of wealth-creation, the Meiji era of the late 19th century, took place mostly with a mandarinate government. Hong Kong was never democratic, while Singapore and Malaysia kept the same leaders for decades. South Korea had a military government until 1987. Taiwan had a one-party state until 1986.

The Magic Formula worked in Asia anyway, no matter what kind of government they had.

When the Magic Formula is forgotten – when taxes are excessive and money is unstable — the resulting economic decay delegitimizes the government and all of its institutions. Bribery becomes the norm among government officials. High taxes are evaded by everyone. Contractual commitments become comedy in an environment of currency collapse. Corruption saturates all levels of the government, as theft of existing resources becomes a surer avenue of personal wealth-creation than productive business endeavor. Institutions of all sorts become dysfunctional and oppressive. The government is unpopular – at times so unpopular that civil war, secession and revolution erupt everywhere. Business becomes impossible. This is happening in Greece and Spain today, not surprisingly in places where the tax systems have become comically oppressive.

Today, you have a successful capitalist economy, or you have nothing. It is the foundational source of economic productivity, which we call "wealth." It functions best with Low Taxes and Stable Money.

The Magic Formula is just four words. It is supposed to be easy to remember. However, today many governments are going the other way. With "quantitative easing" the fashion worldwide, money threatens to become a lot more unstable than it already is. Tax rates are generally heading higher throughout the developed world.

Even the flat-taxers of Eastern Europe are headed the wrong way. Effective January 2013, Slovakia, with a 19% flat income tax system, raised its corporate tax rate to 23%, and introduced a second 25% tax bracket for higher personal incomes. The Czech Republic voted to introduce a second 22% bracket, on top of the existing 15% flat income tax. Russia, a former superstar, raised its payroll tax to 34% in 2011, from 26%. Ugh.

At some point – not today, obviously – people are going to be looking for new solutions. Remember the Magic Formula. When you have the Magic Formula, you can gain everything else as well. When you don't have it, all else will crumble before your eyes.

This article originally appeared at Forbes...

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Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.

See the full archive of Nathan Lewis articles.

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