Economic Development in the Baltics: an Issue of Balance

The causes of wealth and poverty represent the core of economic as well as political inquiry. This paper provides a philosophical framework for development, founded on human nature in relationship to economic theory and with particular emphasis on the Baltic states and their transition to the next stage of prosperity and actualization. In particular we explore changing views about economic growth theory and the region's options.

The process of development predates Adam Smith's 1776 Wealth of Nations. By the time Smith's "shopkeepers" had revealed their propensity to truck, barter, and exchange, Britain was already an economic empire. Smith's astute observations about human behavior and the "invisible hand" first led to the concept of absolute advantage. Ricardo would modify this notion, recognizing that a nation might pursue those industries in which it is relatively most productive. The Heckscher-Ohlin explanation of trade would later expand on these early concepts, proposing that specialization in production would result in countries exporting their abundant goods in exchange for imported goods requiring scarce inputs, helping to mitigate income differences between countries.

From the 1960s through the 1980s, the Solow Growth Model suggested national growth requires increased savings, allowing accumulation of physical capital. The rate of growth, however, is fixed by the rate of technical change, a variable out of the control of policy makers. In the absence of such change, the steady-state rate is equal to the population growth rate (Dornbusch 1987). The Solow model also erroneously suggested poor countries would grow faster than rich countries, an event not borne out by data discussed later in this paper (Table 1).

Something was missing from the old models. Neither comparative advantage nor technical progress alone seemed adequate to explain patterns of international trade or country growth. Porter (1990) argued a need for a new paradigm recognizing differences in national economic structure, culture -and values, history, and institutions that together profoundly affect competitive success. He suggested the competitive advantage of firms in mature nations results from an organizational structure that is fully consistent with and supportive of the process of innovation and upgrading.

Thurow (1999: 223) submits that "chaos must be balanced against order" if creativity is to thrive. "Too much of either one leads to disaster and stagnation, as seen in nineteenth century Russia and fifteenth century China. " Decades earlier, Joseph Schumpeter similarly stressed the flexibility necessary for stimulating innovation, causing "creative destruction" that made old ideas obsolete.

Pistons and hammers aside, the seeds of the Industrial Revolution with its self-sustaining growth were far more subtle. Historian Landes (1999) asks "And in Europe, why Britain?" His answers include private property, liberty, rights of contract, and a stable, responsive, honest, and moderate government. He points out that Britain was also largely free of the religious control and persecution that had fettered the Continent.

Had it not been for such broad cultural differences, Landes proposes that China might have rivaled, if not surpassed, Europe's success. Even with a long list of important technical innovations, China was Severely hampered by the absence of a free market and its companion institution of private property. Possessing technology, but without either economic focus or entrepreneurial curiosity, China never achieved European standards of prosperity or freedom and let bureaucracy, with its inherent complexity, strangle initiative.

Pipes (1999) also makes the important historical connection between guarantees of ownership and liberty, suggesting that while property does not ensure liberty, freedom is not possible without property. He contends that property promotes stability by constraining the power of government, while maintaining personal initiative, economic efficiency, and self-esteem. The decentralization of property helps prevent the centralization of power (tyranny) among the elite. Pipes states "one of the constants of human nature, impervious to legislative and pedagogic manipulation, is acquisitiveness" (1999: 286).

Consider the link between ownership and responsibility in terms of the English "commons, " as discussed by Hardin (1968: 1243-48). Hardin, argued that a commons as a publicly owned resource will be mismanaged, and resolution of this mismanagement requires a change in moral values rather than a technical solution. Likewise, when commonly held resources are spent as if they are free, the general pub-lie good does not follow from everyone serving their own interest, in contrast to market (self-interest) forces promoting the public interest. Both knowing and caring about resource costs is key to their efficient use. The market system is not just a means of exchange, but also a flexible, yet straightforward framework for sustaining and maintaining society.

We assert a central issue in economic development success is that government agents usually feel no "ownership" in the endeavor, and therefore may be neither responsible nor accountable. It has been the first author's experience, as a manager in two state economic development agencies in the United States, that politics outweighs prudence, and projects are funded with public money by agency directors who would never fund similar ventures with their own resources. The lack of concern for efficient resource utilization is often fueled by a widespread attitude that money—especially flowing from public sources—is "free" (that is, without strings attached or accountability for its efficient use). What we see at work is essentially an If It's Free, It's Abused behavioral tendency that was also at the heart of the Soviet collapse. Bureaucrats (without ownership) had no incentive for efficiency, only encouragement to protect one's own "turf, " adding layer after layer of bureaucratic complexity.

For example, Shen (1996, 1997), in analyzing the reforms in Ukraine and Romania, clearly revealed the demoralizing effects of the interplay (one bureaucracy communicating with another) and mentality of bureaucracies, lack of associated courage within a command/control structure, and the elimination of profit-oriented motivation as an agent for efficiency, freedom, and responsibility. His research also provides instructive case analysis of how hierarchical structures simply do not support either organizations or societies and thwart both creative impulses and ambition, soon leading to domination/corruption as the only means of maintaining control. A "dependency syndrome" with its associated rigidity, passivity, and lack of courage are all the stepchildren of communism.

The basic tenets of the If It's Free, It's Abused maxim are: without ownership there can be no responsibility; without freedom there can be no self-actualization; freedom and responsibility go hand-in-hand; and, while control (government) systems are clearly necessary, unwise use of control can result in loss of both freedom-actualization and ownership-responsibility. This If It's Free, It's Abused principle can best be developed by considering Figure 1, "The Triad of Strains. "

In the above, the first strain or intrinsic tension concerns the relationship between control-bureaucracy and ownership-responsibility. We contend that this relationship is inverse, meaning administrative control increases as individualized ownership, responsibility and, ultimately, logical group behavior decreases. The second strain, between control and freedom-human actualization, is similarly inverse (viz., as control increases, human actualization and freedom decrease). The third strain, between ownership-responsibility and freedom-human actualization is a more complex relationship, but assumed to be direct in nature. That is, freedom-human actualization cannot exist in the absence of ownership-responsibility.

Until both, countries and companies start operating in the forward lower right section of the cube depicted in Figure 1, they will be oblivious to cost—one of the primary attributes of control-driven bureaucracies. On the other hand, ownership helps make countries and corporations (also managers and employees) more responsible. The advantages of efficiency improvements are readily seen. Such changes would be in their self-interest and, ironically, also serve the interests of their citizens and customers.

Money and self-interest together reduce agency (or state-run company) conflicts over budgets, bureaucratic malaise, and keep organizations from collapsing into chaos. Control without ownership (the communist model) must give way to individual freedom with responsible ownership if post-Soviet countries are to advance.

We believe that the following two indices provide empirical evidence supporting the "Triad" and its relevance for economic development policy. The first index illustrates that the path to economic growth begins with economic freedom and ownership (the x axis of the Triad). The purpose of this annual Index of Economic Freedom (IEF), copublished by the Heritage Foundation and the Wall Street Journal, is to track international progress toward development (Johnson et al. 1998). For the period 1980-93, ten key areas were evaluated for 150 countries. Countries were graded on the basis of trade policy, taxation, government intervention, monetary policy, capital flows and foreign investment, banking policy, wage and price controls, property rights, regulation, and black market activity.

The study's results (Holmes and Kirkpatrick 1996) were as follows: (1) Countries with a "free" economic ranking (e. g., Hong Kong, Britain, New Zealand, Switzerland, the United States) experienced real per-capita GDP growth rate averages (1980-93) of 2.9% per year. (2) Countries with a "mostly free" economic ranking (e. g., Germany, Denmark, France, Italy, Norway) experienced average growth rates of 1% per year. (3) Countries with a "mostly not free" economic ranking (e. g., South Africa, Brazil, Russia, India) experienced declines averaging -.3% per year. (4) Countries receiving "depressed" rankings of economic freedom (e. g., Haiti, North Korea, Iran, Cuba, Vietnam) experienced average declines of -1.4% per year.

Holmes and Kirkpatrick (1996) add, "Though the index doesn't measure political freedom, we think there is a crucial link between it and economic freedom. It's no accident that the world's biggest offenders of human rights show up near the bottom of the Index of Economic Freedom."

Of the 154 countries ranked in the 1998 IEF, Latvia's position was 62nd, Lithuania's was 74th, Russia's was 104th, while Estonia was tied for 17th from the top—a level comparable to the rest of Europe. In terms of changes in the index value for the three or four years of available estimates, Estonia's index value was comparatively stable but high, Lithuania's showed significant improvement, Latvia's moderate improvement, and Russia's no significant change.

It is interesting to note that those countries that rank highest on the Index of Economic Freedom (see Johnson et al. 1998) also ranked high on the 1995 Human Development Index (HDI), published by the United Nations Development Program (UNDP) in their Human Development Report (1998). In fact, of the top 26 countries on the Index of Economic Freedom (25 of which were also rated on the HDI), 24 received a high Human Development Index rating, while only one received a medium HDI score. The HDI was composed of a Life Expectancy Index, an Education Index, and a GDP (Gross Domestic Product) Index, with per capita income adjusted to include real purchasing power. Human development was defined as a "process of enlarging people's choices" (Human Development Report 1998) and was not just based on income levels or on a country's wealth. As such, the index, while not exclusively a measure of actualization/freedom, represents a good proxy for the z axis of the Triad.

When ranked by the HDI, Russia was 72nd, Estonia was 77th, Lithuania was 79th, and Latvia was 92nd—illustrating considerable variation from the IEF ratings, at least in this part of the world. The HDI ratings for the Baltics were lower than the IEF values, especially for Estonia and, to a lesser degree, for Latvia. Nevertheless, both measures (IEF and HDI) are highly related overall, with a simple correlation coefficient of. 82 (across 150 countries), suggesting that the marriage of ownership and freedom along both axes (x and z) in Figure 1 helps to explain variations in prosperity and its opposite, control.

Table 1, entitled "Comparative Statistics by Tier of Country, " ranks all nations by the average of the IEF (1998) and HDI (1995) values and provides some additional analogical data. When ranked in this way, Estonia falls into Tier 2 while Latvia, Lithuania, and Russia are grouped in Tier 3 at the middle of the world economic development spectrum.

	1995 GNP Per Capita	Growth Rate (1960-95)	Literacy Rate (1995)	Life Expectancy Years (1995)	Population Growth Rate (1970-95)	Expenditure % of GNP (1995)	Expenditure % of GDP (1996)
Tier 1 Tier 2 Tier 3 Tier 4 Tier 5	$21, 201 $4, 666 $1, 746 $656 $336	2.52% 2. 99% 1. 24% 0. 42% -0. 79%	97. 4% 88. 4% 83. 7% 72. 0% 58. 4%	76. 6 72. 1 66. 0 60. 8 53. 4	1. 15% 2. 10% 1. 89% 2. 30% 2. 72%	5. 5% 5. 1% 4. 9% 4. 8% 4. 5%	2. 3% 4. 0% 3. 1% 4. 2% 3. 6%

Source: Human Development Database 1998, User's Guide, United Nations Development Programme

Several important observations and questions quickly emerge from the data in Table 1. Although not shown here, there are no Tier 4 or Tier 5 countries found in North America, Oceania, Europe, or South America. Poverty and low IEF and HDI scores are concentrated in Asia, Central America, and Africa. Countries like Cambodia, Haiti, Iraq, and Niger fit this high control, and low freedom and ownership paradigm as is graphically illustrated by points simultaneously high on the control axis and low on both the freedom and ownerships axes of Figure 1. Indeed, economic development can be envisioned as the process of moving down the control scale toward the forward right portion of the Triad.

Table 1 additionally reveals that income levels, growth rates, literacy, life expectancy, and population growth variables are all intertwined. Tier 4 and 5 countries have low (or negative) growth rates, low literacy, low life expectancy, and high population growth. They also tend to be more militaristic—a pattern consistent with control-driven societies and their need to maintain order with force rather than through economic cohesion.

Table 1 also begs the question, do literacy and health spark growth? Or do free societies and markets allow the human condition to improve? On the positive side, the HDI data indicate the literacy rate in the Baltic states and Russia is 99 percent, higher than the Tier 1 country average. This may become an element of the Baltic states' competitive advantage in the emerging "knowledge economy, " but only if cultural values permit.

The 1998 HDI data set reports 1995 GNP per capita values and annual growth rates from 1990-95 as $2,270 and -11.5 percent for Latvia, $2,860 and -7.3 percent for Estonia, $1,900 and -9.1 percent for Lithuania, and $2,240 and -9.1 percent for Russia. Even though income in all four countries declined steeply, it raises the questions why Estonia's income level is a quarter higher and why Estonian losses were lower than the other countries'.

King and Barnowe (1998) provide possible answers, reporting how societal values play an important role in any culture, either supporting or retarding economic activities. They measure profiles of value patterns from six surveys in Latvia and provide baseline comparisons from a number of other countries where similar surveys have been conducted. The survey instrument allows calculation of respondents' primary value orientation, classifying them as pragmatists, moralists, affect oriented, or mixed. They find that the Estonian managers are far more "pragmatic" (entrepreneurial) and "less moralistic" (bureaucratic) than their counterparts in Russia, Latvia or Lithuania. Not surprisingly, ethnic Russian civil servants in Latvia were found to be the most moralistic. Importantly, the Estonian managers' values are almost identical to those found in Canada, Australia, South Korea, Japan, and the United States. Those countries that have the highest levels on the "pragmatic" scale and lowest on the "moralistic" scale are better off economically and score higher on the IEF and HDI indices.

Government's role in either economic development or the general provision of public services should not exceed its efficient scope. Holmes and Kirkpatrick (1996) warn that as countries become wealthy, they tend to reintroduce restrictions on economic freedom and begin to add "extensive welfare and other social programs that were not affordable when they were poorer. Protecting the people whom rapid economic growth has left behind is important, but in Europe in particular it has been carried to levels that impede growth and depress living standards. " After three years of generating index values, the researchers noted in 1996 that Germany was the only country in Europe that had received a worse score each year (the decline had continued through 1998), largely due to their inability to complete the privatization of state-owned industry and an increase in government regulation, with its inherent bureaucracy.

Other analysts (such as Gwartney et al. 1998: 163-90) suggest that within fully developed countries large governments significantly reduce growth rates, a finding supported by our own analysis of the HDI data set. Countries with moderate governments have the highest economic growth rates and the highest levels of development. Differential growth rates, however, may have nothing to do with economic/political ideology per se.

Smaller companies within the United States, and presumably around the world, tend be more profitable (higher rates of return) and efficient (lower overhead rates). Finnie et al. (2000) suggest a nonpolitical view that complex organizational systems inevitably deteriorate through a process of organizational entropy, the tendency within corporate bureaucracies for secondary support groups to absorb the function of primary units. The authors conceptualize that, as organizations grow, managerial overhead and complexity rise, resulting in a systematic collapse in efficiency. High level communication complexity makes information flow and individual responsibility virtually impossible, resulting in "natural limits" to firm size. As those boundaries are approached, the organization becomes less efficient as a function of both size and complexity. In an attempt to establish order, large bureaucracies tend to gravitate toward randomness and disorder. Perhaps the same is true for government agencies.

When the United States rose to preeminence among world economies, its success was attributed to fertile farmland, abundant natural resources, and cheap immigrant labor. The Soviet Union, China, Brazil, and India had the same natural advantages, but failed to capitalize on them. The power of individual freedom, responsible ownership, and reasonable government made the U. S. prosperous—allowing ingenuity to convert rocks and dirt to wealth. People are at the center of development, not technology or development agencies.

Enforceable property rights, capital accumulation, a moderate government, free trade, and investment in education might help the Baltic states rise to the next level, but only if their cultural values permit. Conversely, privatization may ultimately help to change their cultures.

All economic activity is subject to political social, control. Our analysis shows that control can frequently be excessive, especially in countries with autocratic traditions. For optimal development, there must be limits to such control.

Bureaucracies, driven more by rules rather than reason, nearly always systemically implode, due to a lack of meaningful consideration of human nature and the need for ownership to help ensure responsible and rational behavior. In other words, actions and consequences should be linked. Markets provide this essential link by both directing and simplifying activity and organizations. Consequently, development policy should be nonbureaucratic, understandable, and uniform—not preferential to insider groups—and support responsible private enterprise.

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