have been talking for decades about why some countries get wealthy, and some
do not. 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
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 U.S. 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 U.S. 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
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
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
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.
originally appeared in Forbes.com on February 14, 2013.)