Modern economists have turned Adam Smith into a prophet, just as Communist regimes once deified Karl Marx. The central tenet they attribute to Smith – that good incentives, regardless of culture, produce good results – has become the great commandment of economics. Yet that view is a mistaken interpretation of history (and probably a mistaken reading of Smith).
Modern growth came not from better incentives, but from the creation of a new economic culture in societies like England and Scotland. To get poor societies to grow, we need to change their cultures, not just their institutions and associated incentives, and that requires exposing more people in these societies to life in advanced economies.
Despite the almost universal belief by economists in the primacy of incentives, three features of world history demonstrate the dominance of culture.
- In the past, excellent governments – that is, governments that fully incentivized the citizenry – have gone hand in hand with economic stagnation.
- The incentives for economic activity are much better in most poor economies, including pre-industrial economies, than in such prosperous and contented economies as Germany or Sweden.
- The Industrial Revolution itself was the product of changes in basic economic preferences by people in England, not changes in institutions.
For example, the cotton textile industry that developed in Bombay between 1857 and 1947 operated with no employment restrictions, complete security of capital, a stable and efficient legal system, no import or export controls, freedom of entry by entrepreneurs from around the world, and free access to the British market. Moreover, it had access to some of the world’s cheapest capital and labor, in an industry where labor accounted for more than 60% of manufacturing costs. Profit rates of only 6-8% in the early twentieth century were enough to induce construction of new mills.