19.

THE
DONATION
DELUSIONS

In the Medieval Age, the central political struggle in the West was between the privileged classes and the rest. Being “bourgeois” (in French), or “burgerlich” (in German) meant being part of the rest, and these people defended the view that all citizens should have equal opportunities, in the same way as we now expect that all are equal before the law, or the players on a football field must all follow the same rules.

The opposition to these bourgeois were people who enjoyed innate privileges such as royals and nobles. These people were born with much better opportunities than the rest.

This power struggle was gradually won by the bourgeois, who managed to create societies largely based on merit, where people were rewarded in accordance with their skills and effort. This “meritocracy” incentivised creativity and industriousness and was central to the creative explosion that followed.

The next big idea was socialism, which pointed out that people are not equally fortunate from birth, which is why meritocracy isn’t fair. Fair is when everyone receives roughly the same.

However, as many (former) socialists later realized that pure socialism didn’t work, they would often, instead, aim for combinations of highly-regulated market economies and strong welfare states. Some of this was not entirely new. At least since the early medieval ages there had been local informal welfare communities organized primarily around either gilts or churches. These would organize funerals, pension aid for widows, etc, but always with a focus on getting people to work, if they could. However, as people increasingly migrated to cities to work in big factories after the industrial revolution, these decentralized and often rather informal welfare structures were broken up. Within the cities people would oftentimes experience brutal mass layoffs, and this inspired the creation of both unions and welfare states, where the latter was pioneered by Otto von Bismarck of Germany. The early versions of welfare systems tied welfare to companies, but this led to excessive demands for protection against redundancy and thus lack of flexibility in the job markets. Some countries then transferred welfare systems to the state and created thus so-called “flexicurity”, and this is how the big centralized welfare states happened.

Later some countries went further and used the tax systems to create more general income equalization. This was the beginning of the Western entitlement societies.

It should soon become clear that something in the entitlement societies didn’t pan out as expected. Even when welfare programs began to grow in the 1970s, early signs of adverse side-effects turned up. First, contrary to predictions, the trend in inequality, which had been falling steadily before the build-up of the welfare states, stopped or reversed in some countries, as argued by aforementioned scientist Thomas Piketty.

One reason could be that the welfare institutions compelled more people to stop working. For example, in 1960 the US was home to 687,000 registered disabled people, and one would expect that this figure would fall rather quickly, as medical treatments improved rapidly on many fronts. After all, previously debilitating diseases such as malaria, polio and smallpox had disappeared, and one could now remedy or cure many other diseases that had previously been debilitating. However, since disability support was raised, the opposite happened: In 1965, the number of disability pension claiments rose to 1.739 million – in fact, it almost tripled in just five years, and in 1975 it even reached 4.352 million.³⁸⁷ This was an increase of 533% in just 15 years. Then it remained largely stable as a proportion of the population for several years, after which it increased further by approximately 50% between 1994 and 2010.³⁸⁸ As a proportion of the workforce, disability rose almost seven-fold from approx. 0.8% to about 4.6%. A similar effect has been observed in other countries, where in the UK, for example, the number of registered disabled people grew from approximately 400,000 in 1970 to 2.6 million in 2011 - more than six times as many within 40 years.³⁸⁹

In spite of longer life expectancy and better healthcare, similar patterns have been seen in other countries with welfare states, and the more generous the disability insurance systems are, the more sick people there appear to be. In Norway, which has one of the world’s healthiest populations and therefore highest average life span, 9 % of the workforce was registered as disabled in 2012, and another 5-6% of workers were, on average, absent from work due to illness.

What about helping the poor? In 1960 22.2% of Americans lived in poverty, but this had fallen to 12.6% in 1970, while the country had very limited social spending. After 1966, it began significant increases in marginal tax rates and social spending programmes, and by 1970 social spending had more than doubled. Then something amazing happened: the previous decline in the number of poor ceased, and in 1980 it had, for the first time since World War II, begun to increase.³⁹⁰

But the situation was actually even worse when you included what is known as the “latent poor”. This describes people who would have been poor if they had not received benefits. The number of latent poor in the US had fallen evenly and steadily until 1967. However, with the introduction of greater entitlements and increased social spending, the number of latent poor soared. And after a delay, the number of actual poor people also started to rise.³⁹¹

Clearly, the welfare states had unintended consequences, and we now know a great deal about why it goes wrong.³⁹² The first problem is that entitlements and welfare offerings can change people’s moral compasses. In earlier times, people often took great pride in fending for themselves. You had a pleasure in getting a meal on your table, but also in knowing that you had earned it. Here, it was important for parents to teach their children to work hard and take the initiative, perhaps also because parents could expect that they would have to help their children, if they didn’t help themselves. If people knew that they had to work in order to live decently, they made a virtue of necessity: it became a question of pride and self-esteem to support yourself. However, as the concept of welfare and entitlements spread, the mindsets of many changed. An international study from 2013 showed a clear and significant negative correlation between the degree of redistribution via taxes and welfare systems and the average work ethics in different societies.³⁹³ In the previously mentioned World Values Surveys, respondents are asked whether they think it is important that parents teach their children the value of hard work. Among Chinese, 86% agreed with that. Similarly, many Poles (86%), Singaporeans (64%), Turks (74%) and Vietnamese (75%) agreed that hard work was important. In the Western world without large welfare states, a smaller but significant proportion of the populations also agreed.

However, when it came to countries with large welfare states, the picture was quite different. In the Netherlands, only 14% felt that parents should teach their children the value of hard work. In Sweden the figure was 4%, and in Denmark only 2% - the lowest in the world. So 98 % of the Danes did not think that it was a good thing to teach children to test themselves through hard work. This is vital, because a society will be far more innovative if a fair proportion of the population is willing to work very hard. That’s how you start companies.³⁹⁴

This question related to hard work. But what about work in general? A study of Danes showed that, among those born before World War II, 45% believed that it was a “duty” to work. However, among those who were born between 1955 and 1963, the figure was just 12%, although this figure has since risen to approximately 15-20%.³⁹⁵ But even with these higher numbers, what it means is that 80-85% of Danes no longer believe that working is a duty – living off others people’s money is fine.³⁹⁶

Studies of attitude changes as well as behavioural changes indicate strongly that the option of avoiding work offered by welfare states has led to a change in culture. Working tends to mean you rise early in the morning, dress smartly and go to a job where you have to work co-operatively with colleagues and clients. This means that you stay sober, go to bed at a reasonable time, and generally take care of yourself. All of these memes form a part of a culture, which can erode if many people don’t work, and if children of such people have never seen a normal, responsible lifestyle practised by their own parents.

It’s all about incentives, and the problem inherent in entitlements is that they very often give incentives that displace merits. However, the welfare state in its current form is not the only example of state dependency systems that create unintended side-effects: Corporate subsidies (sometimes called “corporate welfare” by critics) and foreign aid have parallel problems. This does not mean that these activities are always wrong or damaging, but upon closer scrutiny, it turns out that they surprisingly often are.

Let’s start with business subsidies. The philosophy behind these may be that a country benefits from having business activities in special locations that are short of jobs or are becoming depopulated. Or it may mean stimulating particularly promising sectors.

However, in practice, the vast majority of Western business subsidies have been given to farmers. This has led to widespread fraud, costly and bureaucratic administration and unfair competition for producers in developing countries. Partly to compensate developing countries for this loss, Western nations have provided foreign aid, which, unfortunately, also has led to significant administration overheads, fraud and other problems – we shall return to that shortly.

One of the countries in the world that is most dependent on food exports is New Zealand, which up until 1984, provided subsidies amounting to approximately 30 % of the farm turnover. However, then the country experienced major economic problems, including inflation rates of around 15%. Its Labour government consequently decided to abolish subsidies for agriculture while lowering corporate and income taxes and deregulating across the economy. Over the following ten years, New Zealand increased its GDP per capita by more than 50%, while inflation fell to 3-5%. Still today, New Zealand’s agriculture operates without support and is highly competitive.

Perhaps the previous farm subsidies in New Zealand had their benefits, but they were clearly outweighed by their overall costs, and this brings us to the need to do cost-benefit analysis. For instance, a university study of the Spanish government’s very ambitious attempt to create “green jobs” showed what happens if you don’t calculate costs against benefits, as it included the following conclusions:

“The study calculates that since 2000 Spain spent €571,138 to create each ‘green job’, including subsidies of more than €1 million per wind industry job. The study calculates that the programs creating those jobs also resulted in the destruction of nearly 110,500 jobs elsewhere in the economy, or 2.2 jobs destroyed for every “green job” created. Each ‘green’ megawatt installed destroys 5.28 jobs on average elsewhere in the economy: 8.99 by photovoltaics, 4.27 by wind energy, 5.05 by mini-hydro. These costs do not appear to be unique to Spain’s approach but instead are largely inherent in schemes to promote renewable energy sources.³⁹⁷

In this case, the government proudly promoted the benefits, but it didn’t understand (or communicate) the much bigger costs. It was even worse in the US, where a government programme to create green jobs cost, on average $11 million per job.³⁹⁸

The general fallacy behind this is the issue of concentrated benefit versus scattered expense. Those who benefit from public spending are easy to identify, and they have strong motives to fight for it, while those who pay will each pay so little that they do not find it worth their while to take up the fight against it. This scenario of concentrated benefits versus dispersed damage is precisely the opposite of what happens in business. In the private sector, the pain of cost-cutting is typically focused, but the collective gain dispersed. This makes the pain more visible, but this process tends to be far more effective for society. What business undertakes was coined “creative destruction” by Joseph Schumpeter, whereas what the public sector achieves, when it does the opposite, seems to amount to “destructive creation”.

Another complication with business subsidies is that politicians and bureaucrats are rarely good at foretelling the future. On 24 March 2000, for example, the EU issued the Lisbon Strategy Declaration, where you could read that “the Union is experiencing its best macro-economic outlook for a generation” and it was said that this was “a result of stability-orientated monetary policy supported by sound fiscal policies”. The declaration also informed readers that “the Euro has been successfully introduced and is delivering the expected benefits for the European economy.” Furthermore, Europe’s goals for 2010 included increased employment and “to become the most dynamic and competitive knowledge-based economy in the world, capable of sustainable economic growth with more and better jobs”.³⁹⁹

It took just three days from the publication of this upbeat report before one of the biggest stock market crashes in history began, followed by recessions and countless bankruptcies. This did not deter the EU from issuing a directive on working time in June the same year, under which it was to be forbidden for all EU citizens to work more than 48 hours a week, even if entrepreneurial projects and small independent companies often require people to work 60-80 hours a week to have even the slightest chance of survival.

With regard to the EU prognosis that the EU would be the world’s most competitive economy by 2010, the actual situation in 2010 was a massive crises, 10% unemployment in the Euro area and a huge build-up of national debt burdens.

The private sector is much better positioned to identify growth opportunities than is the state because it has more relevant and better distributed information. It has private angel investors (private investors in entrepreneurial ventures), banks, investment funds, hedge funds and private equity funds to identify investment opportunities. In particular, many equity-and-venture funds are led by former successful entrepreneurs from hightech companies who are well positioned to choose what to invest in and who would know, for instance, that you need to work more than 48 hours a week in order to succeed with a start-up project. Conversely, civil servants and politicians rarely have any direct management experience from the private sector and can have quite naive attitudes to these things, no matter how intelligent, well educated, well-meaning and hard-working they might otherwise be.

The impact of state aid will often become completely absurd, such as when the US government offered tax credits of $6,000 for each electric car, which meant that golf carts became free. The American television host John Stossel then picked up a free golf cart, which he gave to a park, but one of his friends picked up seven for nothing.⁴⁰⁰

What about foreign aid? Presumably only evil people can have any objections to that? Well, no. It turns out that many people who have vast experience with foreign aid conclude that it often creates similar problems as the welfare state and business subsidies.

Foreign aid, it should be said, comes in three different forms: disaster relief, private charity projects and state aid. The first two can work extremely well, especially when they focus on helping people to help themselves (which, it should be said, is rarely relevant for acute disaster relief).

The problem comes, predominantly, when rich states transfer money to governments of poor countries, which they have done on a massive scale and over a very long period. In fact, during the years after World War II, rich nations have pumped in the order of $2.3 trillion in foreign aid into poor countries, of which approximately one trillion went to Africa.⁴⁰¹ This corresponded to approximately 15% of the continent’s GDP, and compared to the GDP over the period, it has corresponded to approximately four times the level of the Marshall Plan for Europe after World War II.

One of the world’s leading experts on the effects of foreign aid is William Easterly, who after working for 16 years with foreign aid projects in the World Bank became a professor specializing in foreign aid at the University of New York in the US. Easterly has made a number of statistical studies of the effects of foreign aid, and many of his findings are surprising, to put it mildly.

Here is an example: he examined statistics from 138 developing nations to clarify whether - as is generally believed – there was a statistical correlation between increased investment and higher economic growth. He could only find that in four of them (Tunisia, Israel, Liberia and Reunion), of which, only Tunisia had received foreign aid to increase investments.⁴⁰² So if you give state aid to increase investments with the aim of creating growth, you seem to be wasting your money.⁴⁰³

Another popular aid model has been to support birth control via provision of free condoms. However, this has also disappointed for the simple reason that about 90% of births in countries with high birth rates actually are wanted, which is why condom-dissemination is mostly ineffective.⁴⁰⁴

But giving people aid in the form of education most surely be good? No, generally not. A well known World Bank study called Where Has All the Education Gone? concluded, that on average, there had been no positive effects of giving people in emerging markets education - in fact, more sophisticated statistical methods indicated, that if anything, the effect was statistically significant and ... negative.⁴⁰⁵

Actually, there is a similar problem in rich nations. In 2012, Ulf Berg, a former director of the Swiss industrial giant Sulzer, assembled European statistics on the correlation between gaining a high school diploma and youth unemployment in a number of European countries. The correlation he found was astonishing: the greater the number of students, the higher the level of youth unemployment. He then examined the same for German federal states (länder) and Swiss cantons, and the pattern was, in both cases, replicated: high numbers of high school graduates equated to increased youth unemployment.⁴⁰⁶

The previously mentioned social scientist Charles Murray found similar results in the US and concluded that America produced too many high school graduates and academics (plus drop-outs). He pointed out that one of the problems with academic study is that it mostly works for students who have unusually high analytical talents and typically with a special emphasis on literacy and numeracy skills. If you are instead - as goes for the vast majority - more gifted in intuitive, practical, social, physical or artistic areas, an academic education is often useless or worse. A US study from 2010 showed that 45 % of 2,300 students showed no significant improvement in Collegiate Learning Assessment (CLA) scores after two years in college, and 36 showed no improvement at all. That is 81% who showed little or no improvement of two years of studies.⁴⁰⁷ Another study concluded that: “a reasonable conclusion is that over-education remains the persistent and even growing situation of the US labor force with respect to skills.”⁴⁰⁸

The result of excessive education is too many sadly wasted years, student loans that cannot be paid back, dispelled illusions, unemployment and bitterness, whereas vocational educations often could have led to a much better lives and the launch of new companies. The state is trying to create winners through education, but the opposite is all too often the consequence.

Going back to foreign aid, the money the West has spent on this has largely been wasted or caused damage. A large meta-analysis from 2008 concluded as follows:

“Our central conclusion is there is no robust positive relationship between foreign aid and growth.”⁴⁰⁹

Another study showed equally that foreign aid did not provide growth, and scientists here could not find a single example anywhere in the world where foreign aid had led to higher economic growth. Not one. In fact, they concluded that foreign aid on average did economic damage to recipient countries:

“We find that aid inflows do have systematic adverse effects on growth, wages, and employment in labor intensive and export sectors.”⁴¹⁰

So it has been a general disaster, and in her book Dead Aid, African economist Dambisa Moyo suggest why. The problem, she says, is that aid programmes support bureaucrats and rent-seekers in both donor countries and (worse) in the recipient nations. Donor countries have approximately half a million aid workers, and, in recipient countries, the funds are often used by governments to finance networks of cronies, rewarded for their loyalty via contracts, government jobs and cash under the table. They do this because the societies are tribal, and in tribal societies, you favour your own and make extractive institutions. So the money, says Moyo, create a dependency culture, corruption and crony capitalism, and it attracts talent to the public bureaucracy rather than to private entrepreneurship. It simply provides nourishment for extractive organizations.

So how do you create growth in poor countries? Moyo recommends stopping giving foreign aid to governments and instead just giving it directly to end-users in return for reciprocal concessions, such as sending their children to school every day. Moreover, one can focus on micro-credit, where groups of local business people can borrow small amounts for personal business investments of mutual or individual liability. Such micro-finance projects have been implemented in a number of countries with enormous success.

Another take on the matter comes from William Lewis from McKinsey Global Institute, whom we met earlier. In the long term, he says, it is predominantly productivity growth that will move the load, and the key ingredient to this is to create a clear commercial incentive to do business. This will stimulate entrepreneurship and attract business and talent from abroad. In either circumstance, these businesses will ensure that their staff receives the relevant training.

Of course, institutions such as fair courts, efficient police and land registries, are critical, but in many cases, very simple barriers at the micro-level prevent growth. One example, among many possible ones, is practical obstacles to the establishment of supermarkets. Supermarkets are often an extremely important driver of growth, because supermarkets place huge demands on suppliers’ efficiency and affordability. If you only have small “mum-and-dad” retail outlets, you will lack such pressure for efficiency and that will be reflected along the entire supply line.

So in the long term, it is primarily - if not entirely - attractive framework conditions for the private sector, which have a positive effect - not public aid. These framework conditions can include low taxation, few bureaucratic obstacles, an efficient and reliable rule of law, effective protection of private property, and the possibility of attractive lifestyle for creative and executive officers.

There is a common denominator in the histories of the welfare state, foreign aid, business subsidies and educational over-kill and it is this: donating substantial quantities of tax money to solve social problems is rarely as efficient as facilitating voluntary win-win transactions within the respective fields.

In their book Why Nations Fail, Daron Acemoglu of MIT and James Robinson of Harvard concluded something similar after 450 pages of analysis:

“Nations fail because their extractive economic institutions do not create the incentives needed for people to save, invest, and innovate.”

So it’s actually pretty simple: If individuals or businesses enjoy strong incentives and few hindrances to innovate and grow, it will usually happen. If this requires training and learning, training and learning will follow. And people typically have amazing untapped creative potential that can be released, if the incentives are right.

In this context, it is interesting that Harvard professor Jacob Schmookler made an extensive literature study of the causes of 934 groundbreaking innovations in agriculture, petroleum, paper manufacturing and railway industry in the 157 years 1800-1957 and concluded:

“…in a significant majority of cases, the stimulus is identified, and for almost all of these that stimulus is a technical problem or opportunity conceived by the inventor largely in economic terms. When the inventions themselves are examined in their historical context, in most cases either the inventions contain no identifiable scientific component, or the science that they embody is at least 20 years old.”⁴¹¹

Note how radical this really is. Out of 934 inventions, almost none were directly triggered by scientific discoveries. Instead, the driver was the desire to make money by solving a practical problem. Of course, as Schmookler also noted, in many cases the innovations could not have been made without previous scientific discoveries. But that is not the point. The point is that these discoveries are only turned into products and services because someone wants to make money by solving a practical problem. This again shows how great ideas and clear incentives to undertake voluntary win-win transactions are far more powerful drivers of progress than welfare and aid systems.

Here there is just something we have to note: typically all the net employment growth in developed nations comes from the creation of new businesses. Studies in the US show, for example, that virtually all net job growth between 1980 and 2010 came from firms that were less than five years old, and that approximately one third of all existing jobs in the country in 2010 were within firms that had been founded after 1980. In contrast to young companies, the well established ones will typically seek profit growth, predominantly via rationalization.⁴¹²

Another important finding is the aforementioned alchemists’ fallacy, which means that entrepreneurs, on average, only retain approximately 4% of the value they create; the rest goes to society as a whole. An obvious conclusion is that the creative community should stimulate entrepreneurs and inventors significantly by giving them very strong incentives (such as keeping most of their 4 %) and by removing barriers to their activities (such as legal tangle).

So that works, but if people, conversely, have incentives to receive benefits without working for them, they will also adapt to this and they will do this individually as well as collectively by developing extractive institutions for that purpose. The classic example is countries that have natural resources and therefore focus on creating institutions that can create unearned gains from that. Having resources can be like having a constant flow of foreign aid (and vice versa), and that’s why such resource-rich nations often end up being poorer than those who had no resources and no aid. As an example, Acemoglu and Robinson point out that the countries in South America that had the most natural resources, developed the most extractive institutions, neglected human potential and experienced widespread corruption, inflation and often civil war. Conversely, North America had fewer resources and focused instead on efficient human transactions.

The rich, Western countries were once destitute, and they did not become rich because of foreign aid, business support, welfare states or free university education for all, since they had none of this in their strong growth phases. But they had clear incentives to save, invest and innovate. No one asked them to read thousands of pages of legal text or demanded taxes that were so high that artisan Smith would have to be five times as efficient as Johnson before it made sense for the two to co-operate.

The core reason why systems primarily built on voluntary win-win transactions in a state of competition become most successful is because co-operation generates creativity. Donations are also voluntary, but they are only win-win, if it makes the donor happy. And they become lose-lose, if they are forced on the donor and have negative, behaviourally- pacifying effects on the receiver.

The donation delusion is about always sending money to fix problems. The much better alternative is often to organize society so that people are strongly incentivized to show creativity, take initiative and thereby help themselves.