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A Few Notes on Reinventing The Bazaar, A Natural History of Markets

| | Posted in: Big Ideas

In his 2002 book, Reinventing The Bazaar, A Natural History of Markets, John McMillan offers an overview of recent research on the workings of markets. His perspective is empirical rather than ideological as he examines economies worldwide to infer when markets work and when they do not. Some summarizing points on critical factors for economic growth are relevant to equity investors considering international diversification, as follows:

From page 214:

“The countries that were relatively rich at the start of the twentieth century have for the most part continued to grow. The countries that started out poor have followed widely different growth patterns. Some have grown very fast and some have grown steadily, but some of the poorest have grown little or not at all.”

In other words, there is little or no evidence of mean reversion in the wealth of nations. It does not make sense to avoid past outperformers or to concentrate investments in laggard economies with the assumptions that the former are due for a fall and the latter are due to catch up.

From page 217:

“Countries that have a more equal distribution of income grow faster on average than those with wider income gaps. In countries with extreme inequality, conversely, the inequality in itself can be a hindrance to growth… One reason is that wide inequality generates unrest and political instability, harming the economy. Another is that in countries that are both poor and unequal, large numbers of people live in extreme poverty. The poor are unable to take advantage of investment opportunities. Potential entrepreneurs cannot borrow or save the capital they would need to start firms. The children of the poor cannot afford an education and so are precluded from skilled employment. Where there is extreme inequality of opportunity, growth is slow simply because much of the nation’s talent is wasted.”

Consequently, international investors can boost their odds by looking for countries that make economic opportunities available broadly to their populations.

From pages 218-219:

“Investment — broadly defined to include investment in equipment and machinery, in people through education, and in ideas through research and development — is the direct route to growth. Countries that invest more in equipment grow faster, as the statistical studies of growth show. Investment in ever more machines, however, eventually hits diminishing returns… This implies that poor countries should be growing faster than rich countries… But they aren’t.

“The rich countries have been able to avoid diminishing returns to physical investment by means of technological progress. New and better ideas offer an escape from the limits of growth. Further, a country can benefit from the world’s stock of ideas only if it educates its people… Countries that spend more on education grow significantly faster.”

Therefore, focusing international investments in countries with strong public education systems reduces risk.

Continuing, from page 219:

“Investment in machines, people, and ideas is not enough to ensure growth. The investment must be well directed if it is to be productive. For this, markets are needed…”

“We can obtain a measure of the scope of markets by calculating the fraction of national income that is spent by the government… Large government expenditure is associated with low growth. A government that controls too much of the economy’s resources slows down the economy.

“Two further measures of a country’s reliance on markets are its openness to international trade and the degree of development of its financial markets… Low trade barriers…foster an efficient domestic economy. The statistical growth studies corroborate this: countries that are relatively open to international trade tend to invest more and grow faster… Financial markets allow the entry and growth of new firms. The statistical growth studies find that countries that have workable banks and stock markets tend to invest more and grow faster. Also, controlling inflation is part of financial health… Lower inflation turns out to be correlated with faster growth.”

Focusing international investments in countries with relatively low government spending, low trade barriers and stable financial systems reduces risk.

To complement markets, from page 221:

“Markets do not automatically bring growth. It is not enough that the government stays out of the economy and just leaves things to markets. The sustained high investment needed for long-term growth requires more than that. The statistical evidence further indicates that a country grows if it has sound institutions. Growth is faster in countries that have secure property rights, workable rules preventing corruption, functioning laws of contract, and political stability.

“…The causality goes both ways, the evidence indicates: most of these variables both lead and follow economic growth.”

In summation, from pages 221-222:

“The variables that economists have found to be associated with increases in per capita income, to sum up, fall under two headings: investment and institutions. Economic growth requires not only that markets be extensive but also that they be well designed. A sturdy platform is needed: mechanisms to protect property rights and contracting, accessible financial markets, a competitive environment for firms, bounds on government expenditure, stable politics and low inflation to limit the uncertainties of doing business, and adequate public infrastructure for transportation and communication. Given this platform, markets generate growth.”

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