Our Intangible Riches

World Bank economist Kirk Hamilton on the planet's real wealth.

Ronald Bailey from the August/September 2007 issue

Oil, soil, copper, and forests are forms of wealth. So are factories, houses, and roads. But according to a 2005 study by the World Bank, such solid goods amount to only about 20 percent of the wealth of rich nations and 40 percent of the wealth of poor countries.

So what accounts for the majority? World Bank environmental economist Kirk Hamilton and his team in the bank's environment department have found that most of humanity's wealth isn't made of physical stuff. It is intangible. In their extraordinary but vastly underappreciated report, Where Is The Wealth Of Nations?: Measuring Capital for the 21st Century, Hamilton's team found that "human capital and the value of institutions (as measured by rule of law) constitute the largest share of wealth in virtually all countries."

The World Bank study defines natural capital as the sum of cropland, pastureland, forested areas, protected areas, and nonrenewable resources (including oil, natural gas, coal, and minerals). Produced capital is what most of us think of when we think of capital: machinery, equipment, structures (including infrastructure), and urban land. But that still left a lot of wealth to explain. "As soon as you say the issue is the wealth of nations and how wealth is managed, then you realize that if you were only talking about a portfolio of natural assets, if you were only talking about produced capital and natural assets, you're missing a big chunk of the story," Hamilton explains.

The rest of the story is intangible capital. That encompasses raw labor; human capital, which includes the sum of a population's knowledge and skills; and the level of trust in a society and the quality of its formal and informal institutions. Worldwide, the study finds, "natural capital accounts for 5 percent of total wealth, produced capital for 18 percent, and intangible capital 77 percent."

Social institutions are most crucial. The World Bank has devised a rule of law index that measures the extent to which people have confidence in and abide by the rules of their society. An economy with a very efficient judicial system, clear and enforceable property rights, and an effective and uncorrupt government will produce higher total wealth. For example, Switzerland scores 99.5 out of 100 on the rule of law index and the U.S. hits 91.8. By contrast, Nigeria gets a score of just 5.8, while the war-torn Democratic Republic of the Congo obtains a miserable 1 out of 100. The members of the Organisation for Economic Co-operation and Development-30 wealthy developed countries- have an average score of 90, while sub-Saharan Africa's is 28. "Rich countries are largely rich because of the skills of their populations and the quality of the institutions supporting economic activity," the study concludes. According to Hamilton's figures, the rule of law explains 57 percent of countries' intangible capital. Education accounts for 36 percent.

The rule of law index was created using several hundred individual variables measuring perceptions of governance, drawn from 25 separate data sources constructed by 18 different organizations. The latter include civil society groups, political and business risk-rating agencies, and think tanks.

This new focus on the importance of social and political institutions marks a dramatic shift away from the World Bank's infatuation with financing mega-projects in poor countries. Examples include the $2.5 billion Lesotho Highlands Water Development Project and the $3.7 billion Chad-Cameroon oil pipeline project. Most such projects are failures. The World Bank's own self-audited evaluations found that the projects it financed failed 55 to 60 percent of the time. In its 1997 World Development Report, the bank recognized the failure of such top-down technocratic aid interventions: "Governments embarked on fanciful schemes. Private investors, lacking confidence in public policies or in the steadfastness of leaders, held back. Powerful rulers acted arbitrarily. Corruption became endemic. Development faltered, and poverty endured." Evidently, the World Bank is coming to realize that the late economist Peter Bauer was right when he wrote in his brilliant 1972 book Dissent on Development: "If all conditions for development other than capital are present, capital will soon be generated locally or will be available...from abroad....If, however, the conditions for development are not present, then aid...will be necessarily unproductive and therefore ineffective. Thus, if the mainsprings of development are present, material progress will occur even without foreign aid. If they are absent, it will not occur even with aid."

Where is the Wealth of Nations? convincingly shows what countries need to do to create wealth and lift billions of people out of abject poverty: Establish the rule of law and educate their people. That's a lot harder to do than building giant dams or aluminum factories, but it would be a lot more effective in reducing poverty.

Science Correspondent Ronald Bailey interviewed Hamilton at his office in the World Bank's gleaming headquarters in downtown Washington, D.C. Where Is The Wealth of Nations? can be downloaded from worldbank.org.

Reason: What do you mean by intangible capital?

Kirk Hamilton: Intangible capital is capital that has an economic value but is not something you can drop on your foot.

It's the preponderant form of wealth. When we look at the shares of intangible capital across income classes, you see it goes from about 60 percent in low-income countries to 80 percent in high-income countries. That accords very much with that notion that what really makes countries wealthy is not the bits and pieces, it's the brainpower and the institutions that harness that brainpower. It's the skills more than the rocks and minerals.

Reason: What sorts of institutions help countries become rich?

Hamilton: I tend to think of them as social structures that allow societies to achieve certain outcomes. An institution could be a village-level committee that deals with how common property is used. It could be something as abstract as the legal system.

We know quite a bit about how to create human capital. It's called education. But we're learning more and more about the inefficiencies in the education system in many developing countries. There's a famous study in Uganda: The government reports that it spends 2 or 3 percent of GDP on education. The study found that maybe 13 cents on the dollar made it to the schoolhouse. [In the U.S. the figure is about 60 to 65 cents.] So there's the question of how much money are we spending on education broadly, and then there's a question of how effective that money is: how much of it is reaching the school, whether the school has books, whether it has a qualified teacher, etc. We can see ways to increase the efficiency and improve the teacher training, be sure the books are there, etc. It's a matter of money, effort, and reforming institutions to make these things happen.

But investing in these broader institutions is hard and slow. Just think of what it means to build a legal system. Start with a body of law, a system of courts, a legal tradition that determines the role of prosecutor versus defense. Is it a common law system or a Napoleonic system? There's a whole large set of issues, and all of the interlocking pieces have to fit.

Reason: You try to capture some of what you mean by "institutional capital" with measures like the rule of law index.

Hamilton: There's reasonable quantification of things like education because we have estimates of average years of education that have been obtained country by country; we know the stock of human capital in terms of formal education. Then we have this whole wonderful piece of work on governance that Daniel Kaufmann and Aart Kraay and others at the World Bank have been working on for the last several years. They've come up with these five or six broad indicators of governance measuring different aspects of institutional quality.

The problem with the governance indices is that they're all very highly correlated with each other. If you have good rule of law, you tend to have good voice [freedom of expression] and accountability [the extent to which citizens of a country are able to participate in the selection of governments]. To do our analysis, we had to choose one. The logical strongest contributor to intangible capital-rule of law-fit into the story that we're telling.

Reason: How do you define rule of law?

Hamilton: It's partly a question of the efficiency of the legal system and how many days it takes to get to trial, how many days it takes to get a decision once you're at trial, lack of corruption, degree of transparency-a whole set of issues that go into this one number called "rule of law."

Reason: The development economist Peter Bauer made the argument that the British imposed the rule of law in its colonies and they began developing economically very rapidly compared to what they had been before. Then when the colonial period came to an end, the systems that the British had imposed collapsed, and their economies began, especially i the case of Nigeria, to fail.

Hamilton: Objectively, if you look at outcomes in terms of GDP growth, that's a supportable argument. Now, from the point of view of the Nigerians, they were colonized, conquered, imposed upon. If you were being pressed into forced labor of one sort or another, you might not have felt the benefits of the colonial experience. We have to be careful about how countries themselves view that experience.

Nonetheless, it's fair to say that there's a certain level of institutions created up to the point of independence. There was a deterioration of institutions beyond that, with economic consequences.

Reason: You write that in Nigeria there is now "negative intangible capital."

Hamilton: It's mostly in the oil-producing countries where this happens. If the best way to get rich is to somehow get a piece of the oil action, schooling might not be the most important thing on your mind. What we think the negative numbers are telling us is that for this set of countries-typically the very resource-dependent ones-that resource dependence has manifested itself in very low efficiency in the rest of the economy. That depresses the level of sustainable consumption that the population can enjoy, and our measure of total wealth is the present value of the future stream of consumption, so that's how we get a negative number.

Reason: Moving on to more hopeful things: You suggest that if a country saves and invests more in both produced capital and human capital than in the value of the natural resources that are depleted, there are no limits to growth.

Hamilton: As countries get richer they're using smaller and smaller amounts of natural capital-minerals, energy, soils, forests, fish, etc. It's closer and closer to zero, but you're able to use it productively to maintain your level of output. [In crude terms, richer countries increase their efficiency faster than they use up natural resources.]

By and large, we can say that rich countries are doing a reasonable job on managing their environment. That's much less true in developing countries, and what we have in the poorest countries is problems of natural resource management. In the middle-income countries, we have problems of pollution. Think of China compared with Malawi. Malawi's problem is not a pollution problem.

Reason: They should be so lucky.

Hamilton: Yeah. It's not a pollution problem; it's a natural resources management problem. How do you maintain soil quality? How do you generate profits with the assets that you have, which in this case is land that can be invested in other things? The problem in China is they've figured out how to grow 9 percent a year pretty successfully but they're now facing the environmental consequences of uncontrolled growth.

Reason: You note that the level of natural wealth per capita actually rises with income. This contradicts the common assumption that development necessarily entails the depletion of the environment and natural resources. Do your findings imply that the richer people become, the more they're withdrawing from the natural world?

Hamilton: Well, no. What it's saying is that they've got more natural resources in terms of dollars. There's the endowment and the management. The difference in natural capital-$2,000 per person in low income countries, $9,000 in high income countries-is saying that the rich countries are managing their endowment in a way that's giving higher yields from the endowment that they have.

Reason: So even in rich countries, nature becomes more valuable over time.

Hamilton: Yes. We don't have enough data to prove this, but I think it's a reasonable proposition to say that's linked to better management of the natural resources you have. Better technologies and techniques being applied to the soil make the soil more productive. Better management of the forests makes the forests more valuable.

Reason: And we have strong private property rights, too.

Hamilton: I don't doubt the importance of property rights in determining economic outcomes, but we shouldn't assume that this is something that can be imposed on every community everywhere and lead to improved welfare overnight.

Reason: You claim that "there's no apparent empirical relationship between current net savings and future well being." This seems astonishing to me. Why is that?

Hamilton: When we look at this question of what explains future growth, it doesn't seem to be very closely tied to accumulation of things. It doesn't seem to be tied to accumulating buildings, machines, and infrastructure, and the corresponding using-up of some types of natural resources.

So it must be something else. But what is the something else? It's the technologies and the institutions that are making that difference. The other side of that coin is that for the poorest countries we do find a fairly strong link between accumulation of physical and natural assets and future growth. Which tells us that the development problem is rather different if you're a rich country or a poor country. And that shouldn't be surprising.

Reason: The economic historian Angus Madison calculates that it took 1,800 years for average incomes in Western Europe to rise from $450 per capita in the Roman Empire to $1,250 in 1820. About that time, the West somehow stumbled onto the institutions that allow people to create wealth at exponential rates. If we know what kind of institutions work to create wealth, it would seem we should try to duplicate that in poor countries if we want them to develop.

Hamilton: The only difficulty is that the institutions are local creations. They reflect a particular place and a particular history. If you think of some of the most important institutions we have in the Anglo-Saxon world-things like the beginnings of rule of law and control of the power of the elites-the roots go back to the Magna Carta. The roots of English Common Law go back even farther than that.

Some people tend to be a little bit pessimistic about our ability to impose or create institutions. If it's true that it actually took centuries of slow, painful, incremental building to get to the point where you are, that's not a very good message for developing countries. So we have to hope that pessimistic point of view is wrong. We do have some examples in recent history in developing countries-South Korea, India, Thailand -where some sort of crisis or impetus came and institutional change occurred very quickly and had a major impact. So it's important not to be too pessimistic.

We have recently been putting more focus on investing in countries where there are better institutions, but it leaves us with the question of what do you do with the rest, the poor countries, the low-income countries under stress? We have to think hard about how humanitarian needs can be met, and how we start to change the institutions, how we start countries down that road, because it does seem to be a pretty fundamental part of the development story. There are no easy answers that I've seen.

Reason: I was struck by your statement that there are no sustainable diamond mines but there are sustainable diamond mining countries. Could you explain?

Hamilton: At any given diamond mine there's a finite amount of diamonds. Someday, the diamonds run out. But in Botswana, a diamond-mining country, before the diamonds run out you have the opportunity to take the profits that you're getting from diamonds and invest those profits in other types of assets. In particular, you can invest them in the other types of assets we have been talking about: human capital, better institutions, infrastructure. You transform one form of wealth that you know is going to run out-a finite asset, a wasting asset-into other types of assets that can give you a sustainable income stream and human capital. Good institutions in particular have that quality.

Reason: In your book, you say that the average wealth in the United States per capita is $513,000. People are sure to ask, "Where the hell is my half million?"

Hamilton: Add up bank accounts, other financial assets, houses, other land-and what you're carrying around in your head. The value of that asset is the present value of the earning power it's giving you, and the institutions that allow you to realize the brainpower that you've got.

Reason: Fifty years ago at the World Bank, it was all about tangible capital-factories, railroads, dams, and roads. Now it seems that enhancing intangible capital is huge, comparatively speaking, if the bank wants to spur more development.

Hamilton: In the old days, we thought if you built the infrastructure then development would come-the Field of Dreams model of development. It turns out to be a lot harder than that.