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Why are Finns richer than Iranians? Consider the environment for the Middle Class

Finland is richer than Iran because it has better governance, lower corruption, and an internal legal framework conducive to doing business. These factors consistently explain countries' economic success or failure.

Summary

Posted 4 January 2017

The Age of Reflection is a magazine published in Iran, in Farsi but also including some articles in English and French. About a year ago, I wrote an article for them: "Iran’s Economy – Which Way Forward?"

The magazine's International Editor recently approached me again to ask if I would like to write an article about "Crony capitalism." I agreed, as it enabled me to reiterate key messages about why some countries successfully grow their economies, while others perform very badly.

The draft I submitted with the title "What can Finland teach Iran about the middle class?" was not quite what the editor wanted. He returned an edited version with the title "How Crony Capitalism Could Bankrupt the Middle Class" to review.

Despite the significant change to the title, the contents of the edited version were relatively close to what I had written. (I always accept the editor's prerogative to change the title, provided that the text being published is acceptable to me.) As the magazine has a wide readership amongst Iranian diplomats and other Iranian opinion formers, I approved the edited version for publication, and it has now been published in The Age of Reflection Issue No. 17 - January 2017.

As I prefer my original text, I have published that below

What can Finland teach Iran about the middle class?

In the early days of underground coal mining, the technology required to identify dangerous gases such as carbon monoxide did not exist. Accordingly, coalminers developed the practice of taking a caged canary with them each time they went into an underground coal mine. The canary, being a small delicate bird, was far more vulnerable to poisoning by carbon monoxide than were the human miners. Accordingly, if the canary became distressed or died, it warned the miners that carbon monoxide, otherwise undetectable, was present and they should evacuate the mine.

In the same way, the condition of the middle class in a country can act as a litmus test for assessing the quality of the country’s governance. Countries which have a legal and economic framework conducive to economic growth also typically have vibrant middle classes. The converse is also true.

This article develops the above proposition, focusing in particular upon the differences between Finland and Iran. However, to show a broader picture, seven other countries are also taken into consideration. Obviously a full comparison would consider every country, but that risks obscuring the message with excessive detail and would also require excessive length.

Why are Finns richer than Iranians?

In 2014 the GDP per capita of Finland, in current US dollars, was $49,864 while that of Iran was only $5,442.

[This and all other GDP per capita numbers, stated in current US dollars, have been extracted from the World Bank website http://databank.worldbank.org/data/]

The trivial answer is that Finns are richer than Iranians this year because they were richer last year, the year before etc. and differences in income are persistent because high levels of income allow the accumulation of high levels of saving which helps to produce further income. However, this trivial answer is insufficient since it does not explain the origin of the differences in income.

Another easy explanation for relative country income levels is that some countries are richer than others due to their endowment of natural resources. At the most extreme example, a country with a very small population and a very large amount of oil will have a high level of per capita GDP. Contrast this with a country whose territory consists of part of the Sahara Desert, which has no mineral resources or arable farmland, and which has no easy communications with the rest of the world. Such a country would be expected to be very poor.

Furthermore, suffering imperialism can distort a country’s economy as its resources are exploited for the benefit of the imperial power. More extremely, suffering massive wartime destruction rapidly impoverishes a country, although as we saw with post World War 2 Germany, rapid recovery may also be possible.

The data below shows that over the decades, in this case a 49-year period, some countries have been able to transform their position in the income rankings, while other countries have not.

The following table ranks the selected countries by their per capita GDP in 1965.

Country

GDP per capita 1965
(Current US$)

Income ranking

Finland

 $ 1,882

1

Chile

 $    702

2

Iran

 $    248

3

Philippines

 $    187

4

Egypt

 $    165

5

Thailand

 $    137

6

Pakistan

 $    115

7

South Korea

 $    105

8

By 2014, some 49 years later, all the countries concerned had seen significant economic growth. While Finland remained at the top of the ranking, there had been significant changes in some of the other positions.

In particular, South Korea had seen a meteoric rise.

Country

GDP per capita 2014
(Current US$)

Income ranking
2014

Finland

 $         49,864

1

South Korea

 $         27,989

2

Chile

 $         14,566

3

Thailand

 $           5,969

4

Iran

 $           5,442

5

Egypt

 $           3,365

6

Philippines

 $           2,872

7

Moldova

 $           2,244

8

Pakistan

 $           1,315

9

Moldova is included in the above table as a reminder that not all European countries are rich. Indeed, it is significantly poorer than Iran or Egypt. There is no comparative data for 1965 as it was part of the USSR, and accordingly no compound annual growth rate is calculated for it in the table which follows.

The movements in the rankings from 1965 to 2014 are attributable to significant differences in the average annual growth rate of per capita GDP, shown in the table below:

Country

Compound annual growth rate

Growth rate ranking

South Korea

12.07%

1

Thailand

7.99%

2

Finland

6.92%

3

Iran

6.50%

4

Chile

6.38%

5

Egypt

6.34%

6

Philippines

5.73%

7

Pakistan

5.09%

8

There are some key messages from the above table:

  1. Between 1965 and 2014, some countries performed much better than others. Within the sample, over the 49 years South Korea averaged a compound annual growth rate of 12.07% compared with Pakistan’s 5.09%.
  2. Even small differences in economic performance add up over the years. The compound annual growth rate of the Philippines at 5.73% was only 0.64% greater than Pakistan’s of 5.09%. However, this meant that per capita GDP in the Philippines grew 15-fold (from $187 to $2,872) compared with only 11-fold for Pakistan (from $115 to $1,315).
  3. Iran dropped in the rankings of these countries from third place in 1965 to fifth place in 2014 because the higher growth rates of not just South Korea but also Thailand enabled them to overtake Iran despite starting with significantly lower per capita GDP in 1965.

Defining the middle class

Assessing the article’s proposition “Countries which have a legal and economic framework conducive to economic growth also typically have vibrant middle classes.” requires clarity about what we mean by the middle class.

For the purposes of this article, the middle class is taken to include the following categories:

  1. Owners of businesses, both small businesses and large businesses. This includes individual shareholders who are not involved in the management of the business as well as owner-managers.
  2. Self-employed professionals. Such individuals earn money by selling their expertise to a range of different clients, and their income depends upon the ability to sell their services. Individuals in this category can overlap with category (1). For example, the partners in an accounting firm are both selling their own professional expertise and at the same time they own a business since they have employees and the business sells the services of the employees as well as the services of the partners. Some of the well-known categories of self-employed professionals are accountants, lawyers, engineers, management consultants and doctors.
  3. In social terms, it is common to also include in the middle-class category professionals who are employees if a significant degree of skill and expertise is required for that profession. For example, a qualified accountant who works for the partners of an accounting firm would normally be categorised as middle-class despite being an employee who earns a fixed rate of monthly pay.

The characteristics of countries that have vibrant middle classes

There are many factors that need to be present within a country for it to create and sustain a successful middle class. Some of these are listed below.

They are also contrasted with their opposites which are often present in countries that superficially appear to have capitalist free market economies but which are highly distorted by excessive government power leading both to extensive corruption and to inefficiencies from the government attempting to direct economic activity in a manner reminiscent of central planning. This illusory capitalism is often referred to as “crony capitalism.”

As a preliminary point, it is now almost universally agreed that centrally planned economies fail.

The most famous example of a centrally planned economy is the USSR from the Bolshevik revolution in 1917 until its dissolution 1991. Other examples are the People’s Republic of China from 1949 until the inception of the Deng Xiaoping reforms, and the most striking example today is North Korea.

Central planning is superficially attractive since the proposition that the economy should be planned has immediate intellectual appeal compared with leaving individual economic actors to their own devices to make their own apparently haphazard decisions. In the absence of experimental evidence, it would be impossible to show that a centrally planned economy would perform less well than an unplanned market economy. However, the empirical evidence is clear. The economic outcomes from central planning in the USSR were lamentable.

The fundamental reason is that it is simply too difficult to plan an economy taking into account all of the information potentially available. Furthermore, centrally planned economies fail to allow people to act upon their own initiative to improve their personal circumstances. Instead, only a few central planners are empowered to take economic decisions.

Reliable contract enforcement through the courts

If two parties A and B are to be able to do business with each other, they must be able to agree a contract between them and have some confidence that, if the other party fails to perform in accordance with the contract, legal redress will be available.

This requires courts which operate efficiently without undue delay, administering laws that are clear, and with judges who are impartial.

Countries marked by “crony capitalism” typically do not have effective impartial courts. Instead, the ability to enforce contracts depends upon the level of one’s influence with governmental authorities. This automatically gives a significant business advantage to those individuals and companies who have strong government connections since they can rely upon their contracts being enforced whereas parties not favoured in this manner are much less able to rely upon any contracts they enter into. That has the effect of limiting the commercial activities of non-favoured parties.

The table below shows the rankings from "Doing Business 2016 - Measuring Regulatory Quality and Efficiency" published by the World Bank Group of the chosen countries when it comes to the enforcement of commercial contracts. As lists of rankings do not convey any information regarding the absolute magnitude of the differences between countries, the World Bank publication concerned also provides a detailed quantitative assessment in the form of “distance to frontier” showing the score achieved by that country out of a maximum score of 100.

Country

Enforcing contracts
Doing Business rank 2016
Out of 189 countries

Enforcing contracts
Doing Business DTF score 2016
(100=maximum score)

South Korea

2

84.84

Finland

30

70.33

Chile

56

62.81

Thailand

57

62.69

Iran

62

61.85

Moldova

67

60.87

Philippines

140

49.24

Pakistan

151

45.35

Egypt

155

44.60

The above table shows the dramatically higher score of South Korea compared with the laggards in the table.

Because contract enforcement is a vital requirement for free-market commercial activity, this criterion by itself goes a long way in explaining the dramatically better growth performance of South Korea compared with countries such as Pakistan and Egypt, or indeed Iran.

High levels of trust between strangers

Much modern commercial activity involves entering into transactions with people who will be complete strangers, and who may often be geographically remote while still being located within the same country. This again requires the country to have a strong legal framework which is enforced impartially. It also requires trustworthy institutions with low levels of corruption.

A concrete example concerns individual investing activities. An individual who deposits money into a bank needs to have confidence that the bank is not likely to misappropriate his deposit or to fail with either an actual or a contrived insolvency. At a higher level of complexity, individuals who buy shares in stock market listed companies need to be relatively confident that the management of those companies are not stealing the shareholders’ money, and that the accounts they publish can be relied upon for the purposes of assessing the investment merits of the companies concerned.

The table below compares the market value of the stock market listed companies in the country concerned at the end of 2015 with the size of that country’s GDP. Both the stock market capitalisation and the GDP figures are taken from the CIA World Factbook

Country

Market capitalisation of listed shares
As % of GDP end 2015

Ranking

Finland

70.6%

1

South Korea

66.4%

2

Chile

45.0%

3

Philippines

32.1%

4

Thailand

31.4%

5

Iran

6.5%

6

Egypt

5.3%

7

Moldova

5.0%

8

Pakistan

4.7%

9

The dramatically smaller size of the stock market listed sector in the bottom four countries is extremely revealing.

By itself, it shows that the internal economic environment in these countries is not conducive to significant private-sector economic activity. The detailed explanations will vary from country to country but are likely to include excessive state interference, low levels of trust and concerns by potential investors that stock market listed companies will be manipulated for the benefit of favoured insiders.

Freedom to establish businesses

Individuals are generally free to establish businesses without onerous preliminary licensing or registration requirements.

Those licensing or registration requirements which do exist can be demonstrated to have a clear public purpose. For example, in the United Kingdom anyone may start a business of completing individual or corporate tax returns, without requiring any form of licence. However, if one wishes to operate as an auditor of companies then you must demonstrate the required standard and register with the relevant regulatory body.

In comparison, countries marked by “crony capitalism” have very extensive licensing and registration requirements, with licences being granted at the discretion of government authorities. This creates significant opportunity for government officials to require bribes for the granting of such licences. In addition to the scope for corruption, this creates an impediment to economic activity and internal competition.

High levels of internal competition

Competition improves the overall performance of a country because well-run firms can produce more revenues for the same level of costs than can badly run firms. Accordingly, badly run firms are driven out of business, and their assets (employees and physical assets) fall under the control of better run firms in a process of “creative destruction” to use Joseph Schumpeter’s famous phrase.

The government of a genuinely free market economy typically promotes internal competition by having laws which restrict the creation of monopolies by putting limits on large firms acquiring other large firms. In exceptional cases, even if a firm grows extremely large by its own successful organic growth, it may be forced to break up into smaller parts which then must compete against each other.

In comparison, countries marked by “crony capitalism” limit internal competition by facilitating, perhaps even creating monopolies. For example, a licence to operate passenger buses in a city may be given to one business with all competition being prohibited. Quite often such lucrative monopolies are given to favoured individuals who are connected with those controlling the government, either by family background, personal friendship or the payment of bribes.

Openness to external competition

The importation of goods from overseas is relatively straightforward, without onerous licensing requirements, and tariff barriers on imports are relatively low or non-existent. This requires businesses operating within the country to be efficient as they have to compete not only with other domestic competitors but with foreign competitors.

Conversely, countries marked by “crony capitalism” typically restrict imports as a way for the government to increase the profitability of favoured domestic producers.

Openness to inward foreign direct investment

One of the most important ways for free-market economies to increase their efficiency is enabling foreigners who have developed new business methods to set up businesses within the country. This can be done either with a greenfield start-up or by the foreign business acquiring an existing business within the country.

Where “crony capitalism” is found, there are typically severe restrictions on inward foreign direct investment in order to limit competition that might harm friends of the government. For example, many countries prohibit the ownership of land by foreigners.

Alternatively, inward foreign direct investment may be permitted but subject to a proportion of the business having to be owned by domestic individuals. This is a very common way for governments in such countries to confer benefits on favoured individuals who can acquire shareholdings in such inward foreign investments at a favourable price, since the investment cannot take place without their participation.

Prices are set by the free market

In a free market, prices reflect the full economic cost (including profit at the economic opportunity cost of capital) of providing particular goods and services. Accordingly, prices provide essential information to economic actors making decisions regarding alternative forms of production.

Conversely, many economies subsidise particular goods for social reasons. Common examples are bread and petrol. This distorts the economy and discourages production of those goods whose price is artificially reduced. Furthermore, in many cases as with petrol the goods subsidised are disproportionately consumed by elites closely connected with the government with the subsidy acting as an implicit financial transfer from the poor to the elite. Subsidies also frequently create scope for corruption.

Low levels of government corruption

Countries marked by “crony capitalism” display many of the failings listed in the above subsections. The consequence is that overall they display high levels of government corruption as measured by the Transparency International rankings.

Country

Corruption Rank
Out of 167 countries
(Low is good)

Score out of 100
(High is good)

Finland

2

90

Chile

23

70

South Korea

37

56

Thailand

76

38

Egypt

88

36

Philippines

95

35

Moldova

103

33

Pakistan

117

30

Iran

130

27

What is striking about the above table is how damaging high levels of corruption are to economic growth rates. The countries identified earlier as having the lowest growth rates are those with the highest levels of corruption.

Such corruption stultifies the development of a true middle class which is independent of government favours.

As a simple example, the middle-class profession of tax adviser (the author’s profession) cannot develop in a country where the main mechanism used by businesses to reduce their tax liabilities consists of bribing government tax officials. Businesses which pay such bribes have no need for experts on tax law.

The same point applies to many other professions. For example, if success in a court case depends upon bribing the judge or finding relatives of that judge who can influence his decision, nobody has any requirement for lawyers who are expert in the law.

Specific policy recommendations for Iran

Fundamentally, countries’ economies grow when they follow policies that are consistent with promoting growth.

There are a small number of policies which follow naturally from the earlier explanation of the environment needed for developing a successful middle class. These policies would have negligible budgetary costs but would dramatically improve Iran’s economic growth if implemented.

The most obvious key priority for Iran is to reduce levels of corruption.

While this is easy to state, it is difficult to implement, because the main beneficiaries from corruption will be those who are closest to the government which creates the rules that make corruption possible, and which controls the enforcement agencies which are nominally responsible for rooting out corruption.

 

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