William J. Bernstein
Of God, Mammon, and Mars
(In the Winter edition, "How Much Pie Can You Buy," I discussed the relationship between GDP growth and security returns. We discovered that in the long run, without economic growth, security prices do not rise. In the Summer edition, "The Two-Percent Dilution," we encountered the unexpectedly large slippage between the growth of the economy and share prices. In this final piece, we look at the surprising history of economic growth over the centuries, its origins, and what it portends for the future.--WB)
I’ll admit it. I was unlucky. Just eleven days after we released the Efficient Frontier Fall 2001 edition, in which I speculated on the under-appreciated possibility of social, economic, and military disaster for both personal and national finance, history once again demonstrated her talent as a cruel mistress. My friends will tell you that I’m normally as clairvoyant as I am good looking. (On an EBITDA basis, I’m often mistaken for Brad Pitt. But the GAAP reality is a good deal less impressive.) The one time in my life I demonstrate random prescience, it’s not something any rational person would want to draw notice for.
But for my nickel, the Seer of the Century Award goes to Yale soccer coach (and history professor) Paul Kennedy for his prognostications in The Rise and Fall of the Great Powers. The book’s 1987 publication created a firestorm of neocon criticism due to its prediction of the ultimate decay of U.S. power. Those tossing the brickbats might as well have proclaimed in neon lights, "I haven’t read this book." Yes, Kennedy did predict that the U.S. would stumble and fall, but he freely admitted he hadn’t the foggiest notion when.
He was more certain about another great power—the Soviet Union. It would implode, and soon. The reason? The proximate cause of the decay of all great powers is falling GDP, almost always the result of excessive military spending. Kennedy figured that the game was up when the amount spent on arms exceeded 15% of a nation’s GDP for more than a few decades, since the remaining 85% would not be enough to sustain the rest of the national economy. He estimated that the Soviet Union was spending over 25% of its national income attempting to keep up with the U.S. and NATO, and detected signs of imminent economic decay. (It actually turned out to be more like half of GDP.) In fact, had the political right taken the time to examine Professor Kennedy’s thesis, they’d likely have canonized him, even if they privately thought he was a dreamer. (Two scant years after The Rise and Fall of the Great Powers was published, Mark Helprin, writing in the op-ed section of the Wall Street Journal, opined that the devolution of the Warsaw Pact was a clever Soviet trick to lull us into complacency in preparation for the occupation of Paris. Guess who continues to grace the Journal's op-ed section and who has to make do with the odd letter to the editor.)
The Kennedy paradigm is powerful—it posits a one-to-one correlation between power and economic health. In the words of one Spanish diplomat, victory goes to he who "possesses the last escudo." Only rarely, as in the case of Vietnam or Persian-Greek wars, does the poorer side win. But in the end, such victories by economic underdogs always prove temporary. Vietnamese communism will shortly be consigned to history’s dustbin, and Athenian power did not long outlive Salamis and Plataea.
Now let’s look at world prosperity through a very wide lens. Per-capita GDP is probably the best way to measure the well-being of the average inhabitant of the planet. Courtesy of Scottish economic historian Angus Maddison, I’ve plotted this parameter since the birth of Christ:
The graph is deceptively simple since the y-axis is plotted on a semilog scale; using this technique, the slope of the curve represents the true rate of wealth growth at the personal level. What we see is that for a millennium after 1 A.D., there was absolutely no net economic progress in the world. Zilch. Yes, during this period Chinese civilization advanced, but we in the West actually regressed, losing most of the advances of Roman civilization, such as cement and road construction. With the invention of the windmill and waterwheel, there was some economic progress after 1000 A.D., but it was anemic. Only after 1820 did growth pick up. This is demonstrated even more dramatically when annualized real world per-capita GDP growth is calculated by era:
Sometime around 1820, the world shifted on its axis and became a progressively more prosperous place. Two percent annualized growth of per-capita GDP implies that the lot of the average world citizen nearly doubles each generation. Unfortunately, this progress was not at all even:
(I’ve not plotted African per-capita GDP because it’s too depressing; in most sub-Saharan nations, there has been almost no real economic growth during the past century.)
Now the reasons behind the modern balance of power become clear. While prosperity is best gauged with per-capita GDP, using the Kennedy paradigm, gross national GDP is the best measure of geopolitical power. Consider, for example, this plot of the gross GDP of the U.S. and U.K. over the past two centuries:
During most of the 19th century, the sun never set on the British Empire precisely because it had the world’s largest economy. Until 1871, that is, when the U.S. surpassed it in size. It took five more decades and a devastating world war for the United Kingdom to realize that it no longer ruled the waves. Similarly, before the U.S. entered World War II, its outcome was in great doubt. Using data from Maddison, the total GDP (in 1990 dollars) of Britain and France in 1939 was $475 billion, whereas that of Germany and Italy was about $400 billion. But when the U.S., Soviet Union and Japan joined their respective sides in 1941, the tally became $1,750 billion to $600 billion; Allied victory was just a matter of time.
Similarly, by 1987 the outcome of the Cold War was clearly obvious to Professor Kennedy (and to nearly no one else), with U.S. GDP at $5.1 trillion and a reported Soviet GDP of $2.0 trillion, the latter GDP likely over-inflated with propagandistic legerdemain.
But I digress. The world financial revolution began sometime around 1820 in Europe. Why 1820? The reasons have to do with the rise of property rights, scientific rationalism, capital markets, and transportation and communications technology. Not until all four were in place could real economic growth occur.
It is indisputable that Western liberal democracies foster these four conditions best. Today, a fascist or communist state can easily provide for adequate transport and communications. It can also obtain small amounts of capital from abroad, but will not deploy it as efficiently as an economy run by private enterprises. It can also support scientific rationalism, although ideology frequently interferes with scientific rigor; in any case, totalitarian states are usually not able to keep their best and brightest at home, particularly in a world of $300 intercontinental plane tickets. But where totalitarian states decisively founder is property rights—if citizens cannot keep what they earn, they will not produce.
We thus arrive at the happy conclusion that, as far as the eye can see, the Western liberal democracies should have little problem keeping a lid on the totalitarian tendencies of the rest of the globe, for the simple reason that they will continue to out-produce them. From a Darwinian perspective, until such time as a more economically productive system than liberal democracy develops, societies that do not adopt it will not prevail because they will not be able to produce and afford the kind of military hardware necessary for victory on the modern battlefield. They may be able to disrupt Western nations in "asymmetrical combat," but they will not overcome them. (Francis Fukuyama, in The End of History, describes yet another advantage of liberal democracy. In totalitarian states, the brightest and most aggressive are attracted to politics and the military, where they can cause great mischief, whereas in liberal Western states, they are attracted to more productive and peaceful pursuits. Try to imagine Larry Ellison in control of a squadron of ICBMs or Bill Gates in command of a carrier group.)
If the Western and Moslem worlds are said to be in conflict, then rarely have two opposing ideologies been so unevenly matched. At the present time, the GDP of the five largest liberal democracies—the U.S., Japan, Britain, France, and Germany ($14 trillion, in 1990 dollars)—is more than ten times that of the five largest Moslem nations—Pakistan, Egypt, Malaysia, Indonesia, and Iran ($1.4 trillion, in 1990 dollars). It is likely that the root of Western-Moslem friction is precisely this gross economic disparity. The reasons for the gap are obvious: capital markets and scientific rationalism get short shrift in the Koran, and property rights are not particularly well developed in most Moslem nations. If you want an Islamic republic, do not complain when you also get an Islamic economy and military.
I’ve ventured far afield in this piece, but there’s a method to my madness. In the preceding two pieces, we discussed the interplay between the growth of the economy and share prices. We discovered that, yes, productivity growth (as reflected in per-capita GDP) drives corporate profits, but there’s a Catch-22: This occurs as a consequence of technological progress, which dilutes common shares and depresses stock returns. In this final piece of the series, we lay bare the blessed sources of economic growth and find that low expected stock returns are a necessary consequence of our society’s good fortune.
Copyright © 2002, William J. Bernstein. All rights reserved.
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