via Adam Smith
..."Top Unsolved [Economic] Question": why are poor countries poor and what can we do about it?
Why is this one of the top unsolved mysteries of economics? Many economist believe the answers to these questions are already known. Those economist would argue poor countries are poor because they violate basic tenets of free markets, and the way to make them wealthy is to get them to embrace free markets (i.e, low taxes, strong property rights, and marginal to no government interference in the market place via either regulations or bribes).
These economist would argue it is not necessary to understand why poor countries are poor to understand how to make them wealthy. Nations only become wealthy when its citizens become wealthy. So obviously, to make poor countries wealthy, nations should strive to make its citizens wealthy.
So, the real question is what can be done to alter the incentives that influence citizens to become wealthier. Before economist can answer this, they need to understand what motivates citizens to accumulate wealth. Every citizens' motivation to accumulate wealth is a function of the following:
- Expected Value of Working
- Expected Value of Leveraging and Acquiring Assets
- Expected Value of Settling and Accruing Liabilities
A citizen's expected value of working is a function of their labor rate minus the opportunity cost of lost free time. A citizen's labor rate is a function of their innate ability, the labor market and the tax rate. The opportunity cost of lost free time is a function of a citizen's wealth (i.e., the citizen is subsidizing his own time), and the value the citizen places on his free time.
This function gives poor nations 5 options to increase a citizen's expected value of working and hence increase their incentive to become wealthy. Those options are:
- Invest in the citizen's innate ability. This option only works if the return on the investment to society is greater than the investment.
- Subsidize the labor rate. This option only works if the return on the investment to society is greater than the investment. It is almost impossible to recoup the investment
- Tax idle time. It is probably pretty hard to tax idle time, but if it can be done, it should increase the return on working.
- Regulate the labor market. Generally, regulating the labor market has adverse affects on the labor rate for society, but maybe there are some regulations that will increase the labor rate.
- Keep taxes low.
A citizen's expected value of leveraging and acquiring assets is a function of the following:
- Value of the assets
- Safety of the investment
- Expected inflation rate
- Expected rate of return.
- Having a sound monetary policy that keeps inflation low which maintains the value of assets.
- Keeping taxes low on both the value of the assets and the expected rate of return.
- Enforcing property rights making investing safer.
- Keeping market regulations minimal making investing safer.
- Enforcing contracts making investing safer.
- Preventing theft and bribery making investing safer.
- Keeping the expected rate of inflation low. In the short run, an increase in the expected rate of inflation increases a citizen's incentive to acquire assets, but over the long run, they erode the value and overwhelm any benefits that are derived from it.
- The interest rate
- The penalty of default
- The inflation rate
- The expected inflation rate
The free market economic argument provides the best explanation of how poor nations can lift themselves out of poverty. Also, it can be used to examine each poor country on a case by case basis to understand why poverty affects those nations.