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August 1, 1997

Federal Reserve Bank of Cleveland

Wealth, Economic Infrastructure,
and Monetary Policy
by Jerry L. Jordan


country’s choice of institutions profoundly affects its wealth and development. Institutions constitute a nation’s
economic “infrastructure,” the framework on which enterprise is built. Perhaps the most important element separating economic “haves” from “havenots” is whether these institutions—and
particularly public institutions—either
facilitate or confiscate production. One
of those institutional arrangements is the
monetary regime.

s The Nature and Causes
of Economic Prosperity
In 1776, Adam Smith published An
Inquiry into the Nature and Causes of
the Wealth of Nations. His motivation
was to explain the large differences in
economic prosperity observed across
countries. That inquiry continues today,
and for essentially the same reason: The
gaps that separate prosperous from
foundering economies remain huge. As
we near the end of the twentieth century,
the richest countries in the world are
roughly 30 to 50 times wealthier than the
poorest ones—a truly astounding difference.1 Not only do we see large gaps in
wealth, but we also see tremendous variation in development. Some developing
countries—Saudi Arabia, Lesotho, and
Taiwan—tripled their wealth between
1960 and 1985, while others, such as
Zambia, Mozambique, and Madagascar,
were about three times wealthier in 1960
than they were 25 years later!
If we ask simple questions like, “Why
are some nations rich and others poor?”
or “Why do countries grow at different
rates?”, we get a simple answer: Rich
ISSN 0428-1276

economies have greater resources per
capita—more capital, both human and
nonhuman, and better technology connecting the two. But this simple answer
only begs another question: “Why do
some economies have high levels of capital and technology, while others don’t?”
To answer this question, it is useful to
determine whether wealthier or fastergrowing economies share characteristics
that are not observed in poorer or slowergrowing ones. Investigations into this
issue have not been very revealing, and
economists have been frustrated by their
inability to identify common policies that
would explain a significant share of the
wealth differentials.2 But the lack of a
clear link between specific “growth”
policies and an economy’s ultimate prosperity has led us to think more broadly
about the state and prosperity. That is, the
policies that nations adopt may not be
individually revealing, but in their totality they reflect an economic infrastructure that the state helps build.
For example, viewed in isolation, an increase in a nation’s educational effort
should have a decidedly positive influence on its wealth. However, such programs may still fail if the rate of taxation on labor income is high, transfers
between generations are large, or other
policies are in place that reduce people’s incentive to add to their stock of
human capital.
In the realm of economics, controlled
experiments are not possible. At rare
times, though, natural experiments present themselves, and recently we have

Why are some countries rich and others poor? The simple answer—that
rich countries have more resources
per capita—merely begs another
question: Why are some countries
more successful in accumulating resources? Often overlooked is the
state’s role in promoting the development of an “economic infrastructure.”
It’s not the specific “growth” programs that governments enact which
determine a nation’s prosperity, but
the totality of the state’s attitude toward the accumulation of private
wealth, including the central bank’s
management of a nation’s money.

had a unique opportunity to study the
role of the economic infrastructure in
influencing nations’ prosperity. In the
last seven years, at least 15 newly created
market economies have emerged within
the former Soviet Empire, in addition to
the liberated Eastern European countries.
Perhaps not surprisingly, these emerging
economies have experienced vastly varying degrees of prosperity. Consider that
since 1989, the five worst-performing
Soviet spin-offs have seen a decline in
measured output about twice that of their
five best-performing counterparts. More
specifically, the Central European countries appear to have adjusted more easily
than many of the Baltic states and Russia, which in turn appear to have adjusted
more easily than Kazakstan, Uzbekistan,
and the other outlying republics. A reasoned explanation is that the Central
European countries have a history as
market economies and have maintained a
legacy of the business practices that are
common in the West. This implies that
the economic infrastructure of these
nations is more fully developed than in
the remote republics.3
A similar, and perhaps equally dramatic,
revolution may be under way globally—
the new “technology revolution.” The
world is replacing the capital of old technologies, creating a new economic infrastructure. As that infrastructure develops, measured output and productivity
will understate true wealth gains. Moreover, such changes may create a prosperity gap between countries that easily
adopt the new technology and those that
are either heavily invested in the old
technology or have little ability to gain
from it.4 Note, however, that in some
economies or in some industries, the
barriers to adopting new technology
can be formidable. These barriers include regulatory restrictions, the wealthredistributive efforts of others, or even
Nations which adopt an economic infrastructure that favors production over
diversion will be more prosperous than
ones that don’t. In the case of the blossoming Eastern European economies,
the nations which build the infrastructure
that enables markets to flourish—the
assignment of property rights, a system
for enforcing contracts and adjudicating
disputes, and the effective management
of market failures—will be the ones that

prosper. So, too, nations that are quickest
to adopt the emerging new technologies
in the workplace will show the greatest
wealth gains.

s The Public
Infrastructure of Nations
An economy’s infrastructure, broadly
speaking, is the climate created by the
institutions that serve as conduits of
commerce. Some of these institutions
are private; others are public. In either
case, their roles can be conversionary—
helping to transform resources into outputs—or diversionary—transferring
resources to non-producers. However,
most private institutions are sustained by
the value they add—either they produce
or they fail. The same cannot be said of
public institutions, which are sustained
by the power of the state.
Given the seemingly inherent danger of
public institutions, perhaps the natural
first question to ask is, “Why aren’t all
institutions private?” At a most basic
level, there can be only two rationalizations for the state’s participation in an
economy. The first is as a social equalizer, redistributing a nation’s resources
under the presumption that some particular social need takes precedence over
private desires. The second justification
for government intervention is the assertion that markets may fail to produce an
efficient outcome.
The rationale underlying government’s
role in the economic infrastructure is crucial to the prosperity of its citizenry. In
the case of equity issues, the role of the
state is unambiguous. Society makes a
choice to accept a lower level of wealth
in exchange for some presumably higher
social objective.
It is as a promoter of market efficiency
that the role of the state raises the most
complex questions. Even if the objective
is to overcome a particular market failure, once the state has been introduced
into the economic system, its influence
can have wide-ranging and unanticipated consequences. And these institutions, which are not bound to obey market forces, exert influence long after
their usefulness has passed.
But market failures do occur, though
probably not as often as activist policymakers presume. Perhaps the most

important failure involves so-called public goods, where providing the good for
anyone makes it possible, without additional cost, to provide it for everyone.
A legal system and national defense
are such goods, as is, I argue, a stable
currency. Cumulatively, these state
activities are part of the economic infrastructure called “the protection of property rights.” This means, more or less,
that individuals can expect to receive the
product of their labor. Although people
could privately undertake actions to prevent the diversion of their output (from
burglary, for example), it is widely accepted that a social institution (such as a
police force) is a less costly mechanism
to do so. Let us be clear, however. In
order to pay for the police, or courts, or
jails, resources must also be diverted to
government from private persons in the
form of taxes.
Indeed, once introduced into the economic infrastructure, the state cannot
help but tax the productive capacity of
the system. Sometimes these taxes are
direct and provide the sustenance for the
government enterprise. But, direct taxes
are probably only a small part of the
overall cost to the economy. Also important are the costs on private agents who
now invest resources to minimize their
tax burdens, either through tax avoidance schemes or through attempts to
influence the taxing authority.
This is the paradox of any state enterprise. While the state may be the most
effective instrument in minimizing the
resource diversions of private agents (for
example, by protecting property rights
and enforcing contracts), it simultaneously introduces the potential for the
debilitating diversion of resources for its
own account. It is here, I think, where
the differences among nations are
grossly understated.
A common distinction among governments is whether they are so-called capitalist or socialist, and in very broad terms
they define the diversionary appetites of
some government entities. Certainly a
government committed to allowing private ownership of capital is, all other
things equal, more committed to putting
in place an economic infrastructure that
favors creation over diversion. But this is
only part of the story. Laws, threat of
expropriation, government repudiation of

contracts—all of the things that cumulatively sum to the protection of property
rights—are important.
In a recent study of the productivity of
nations, capitalist or mixed-capitalist
countries were found to have the most
effective governments with respect to
anti-diversionary commitment. But
Hungary and Czechoslovakia, two noncapitalist countries during the study, provided “approximately the same level of
anti-diversion policies as Taiwan, Italy,
and Hong Kong.” On the other hand,
Sierra Leone and Malawi, two capitalist
nations, offer little protection against
diversionary activity. Similarly, many
nations loosely labeled as capitalist or
mixed-capitalist have borders that are relatively closed to foreign trade. It is important to consider the totality of government
attitude toward diversion to appreciate
that government’s role in either fostering
or inhibiting national productivity.
Jordan enjoys nearly twice the economic
prosperity of Egypt, at least in terms of
per capita income levels. According to
some recent estimates, government participation in the economic infrastructure
has been a prime determinant in that differential.6 Jordan’s anti-diversionary
policies are stronger, it is more open to
trade, and its economic organization is
less statist. These are the “common set”
of characteristics that make an economic
infrastructure successful. According to
some, these characteristics are substantial enough to explain most, if not all, of
the differences in prosperity that separate nations today, and I suspect they are
the same set of characteristics that separated the wealth of nations in the time of
Adam Smith.

s Monetary Policy and
the Economic Infrastructure
Applying this perspective to those of us
who call ourselves monetary policymakers, we ask, “What is the role of a monetary authority in a free society?” Indeed,
“Why is the government in the money
business at all?”
The lesson here is that the relatively
stable purchasing power of the U.S. dollar and a general confidence in its ability
to hold its value over time has allowed
the dollar to become, for a time, a preferred alternative to any commoditybased substitute.

Fiat money economizes on scarce resources in at least two ways. First, using
a printing press is vastly more cost
effective than scouring the landscape for
a rare material. Second, in a fiat monetary system, all traders in the economy
have nearly the same advantage in judging the quality of a paper’s “moneyness.” And here is the public good in
money—its acceptance in transaction.
Money is like language: It is part of the
infrastructure that allows productive
people to trade, and the more people
who use the language, the more efficient
is the communication process. And once
created, its use is not diminished by the
use of others. Indeed, its use by others
only strengthens its value in the economic infrastructure.
Some economists challenge the view that
fiat monetary standards are more efficient
than commodity money standards with
the following analogy: “A similar argument could be made for bicycle locks and
chains. If metal locks could be replaced
with symbolic paper locks, resources
would be released that could be used productively elsewhere. As long as thieves
honor paper locks as they would metal
locks, your bike would be perfectly
secure.”7 This brings us directly to the
question faced by modern monetary
authorities: Can the state be trusted to
provide a relatively costless monetary
system without succumbing to the
seigniorage incentive that redirects resources from the private sector to the government sector? Or, stated alternatively, is
commodity money—which can be costly
to produce and subject to the uncertainties
of nature—ultimately more secure than
the goodwill of the state? Only the passage of time will offer an answer.
The monetary authority, like any state
institution, faces a clear conflict. As a
component of the economic infrastructure, it has the opportunity to provide an
efficient payments mechanism that
would otherwise not be provided by private enterprise, and thereby also has the
opportunity to help the conversion of
resources into their productive ends.
But, central banks also introduce the
ability to divert the flow of resources to
the state, or to those favored by the
state and, in so doing, represent a threat
to the national infrastructure. I believe
it was the wisdom of Congress to rec-

ognize this conflict when it established
an independent central bank more than
80 years ago.
But even as an independent, statesponsored enterprise, the Federal Reserve
still has a diversionary face. To begin
with, we, like any public institution, are
subject to political pressure, although
perhaps less so than more direct forms of
government enterprise. Moreover, many
economists, including in the Federal Reserve System, continue to hold the view
that markets are inherently unstable, and
some degree of “management” should
be provided by the monetary authority.
These are the economic activist philosophies of the post-Depression era, where
money is used to direct resources toward
the manipulation of national joblessness.
Despite whatever good intentions motivate such policies, this too is a clear form
of diversion—it presumes that the monetary authority is in a better position to
judge the appropriate level and distribution of national production than is the
I believe that the failed attempts at finetuning economic performance during the
late 1960s and 1970s are a clear warning
of the damaging diversionary power of
the central bank, and it is a policy that
we must never repeat. In the end, such
efforts broke down the efficient transmission of economic information through
the monetary standard, which in turn reduced national investment, discouraged
productivity growth, and diminished our
position in the marketplace of international trade.

s Conclusion
It’s easy to see that many of the development disasters of the post–World War II
era have been orchestrated by brutes
whose economic agendas have been dictated by military force, and whose political tenure has often been short-lived and
bloody. But we needn’t go to such extremes to find examples where the state
commandeers resources. We can point to
the extent to which government controls
or manufactures goods, creates barriers
to trade, or impedes the adoption of new
technologies; the tax regimes imposed by
the fiscal authority; and, of course, the
choices made by the monetary authority.

Today, the Federal Reserve has restored
much of its lost credibility as the provider
of a monetary standard, and we have
committed ourselves to the achievement
of a stable currency— so that among the
uncertainties that always confront private
enterprise, the value of the trade medium,
the dollar, is not among them.
Is our promise not to repeat the failures
of the past sufficient? Perhaps for the
moment it will have to be. But, we continue to call for a change in the environment in which monetary policy is
conducted. We believe specific and verifiable objectives must be imposed on the
monetary authority so that in addition to
its good intention, the power of the state
is brought to bear on the central bank’s
responsibility to protect money holders’
property rights. Rather than being an
instrument of diversion, the central bank
must remain a strong and stable component of the national infrastructure—an
infrastructure that has become the model
for nations around the world, and a foundation for the strongest economy in the
history of the world.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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s Footnotes
1. Measured by per capita GDP. For perspective, consider that this is approximately the
same difference separating the U.S. standard
of living today from that of approximately
200 years ago.
2. For an analytical examination of this
point, see Ross Levine and David Renelt,
“A Sensitivity Analysis of Cross-Country
Growth Regression,” American Economic
Review, vol. 82, no. 4 (September 1992),
pp. 942–63.
3. See Olivier Blanchard and Michael
Kremer, “Disorganization,” Massachusetts
Institute of Technology, Working Paper
No. 9630, 1996.
4. See J. Huston McCulloch, Money and
Inflation, New York: Academic Press, 1975.
5. See Stephen L. Parente and Edward C.
Prescott, “Barriers to Technology Adoption
and Development,” Journal of Political
Economy, vol. 102, no. 2 (April 1994),
pp. 298–321.

6. Much of this discussion is based on Robert
E. Hall and Charles I. Jones, “The Productivity of Nations,” National Bureau of Economic Research, Working Paper No. 5812,
November 1996.
7. See J. Huston McCulloch, Money and
Inflation (footnote 4).

Jerry L. Jordan is president and chief executive officer of the Federal Reserve Bank of
Cleveland. These remarks are excerpted from
a speech he presented at the Association of
Private Enterprise Education’s twentysecond annual conference in Arlington,
Virginia, on April 13, 1997.
Economic Commentary is available electronically through the Cleveland Fed’s site on
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