Based on my previous post (“The ROI on One’s Own Higher Education”) it might seem reasonable to think that aggregating across all individuals, the ROI to society from education is high. If so, more education would be the top priority to raise the economic well-being of a country. Following this logic, you might be prone to recommend a very large—perhaps unlimited—investment in education to create a wonderful society.

But it’s not that simple. Education unquestionably contributes to economic and social well-being of a nation. But the potential impact that education has on society depends on something else.

For instance, here’s some data on a few countries, randomly chosen. The table shows two measures of education, literacy and spending, by country. And the table shows two measures of productivity, GDP per capita and growth in GDP per capita—these are two of the most widely-cited metrics by pundits who discuss economic well-being of a nation.

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  Adult Literacy Public Expenditures on Education as a % of GDP GDP/Capita Annual Average Growth in GDP/Capita 2001-2011
Brazil 90.0% 5.7% $9,468 3.45%
Chile 99.0% 4.5% $13,832 2.65%
China 92.2% N.A. $8,500 9.50%
Colombia 93.0% 4.8% $8,268 2.50%
Germany 99.0% 4.6% $38,400 0.85%
Indonesia 90.4% 3.0% $3,696 4.00%
Japan 99.0% 3.8% $35,200 0.75%
Kyrgyzstan 99.0% 6.2% $2,060 3.15%
Madagascar 64.0% 3.2% $881 -0.19%
Mexico 93.0% 5.3% $11,936 0.59%
United States 99.0% 5.4% $49,000 0.75%

Scanning the countries, one finds it hard to declare much association between education (the two left-hand columns of numbers) and productivity (the two columns on the right)—the correlation statistics are in the low- to mid-teens. Indeed, in this sample, there is no significant relationship. From data such as these, there seems to be no consistent effect across countries. But using very sophisticated research techniques, some researchers have determined that education accounts for a fraction (between a fifth and a third) of economic growth of a nation. ((Elhanan Helpman (The Mystery of Economic Growth, 2004 page 161) summarizes various studies showing that education accounted for 21-23% of long-term GDP growth in the U.S. He notes, “researchers have found repeatedly that education plays a major role in economic growth.” (p. 41) )) In some national circumstances, education has a massive effect; in others the effect is muted. It is important to understand this dependency because in some countries and regions, education is under attack for failing to deliver the goods, the promise of economic and social well-being for a nation. Any critical thinking about the benefits of education at national levels needs to begin with an understanding about this dependency.

The big idea is that a nation’s investment in education may not have great payoff if the circumstances aren’t right—but what are those circumstances? The experience in China is a case in point—my Darden colleague, Professor Dennis Yang, has contributed some excellent research ((Yang, 2005, “Determinants of schooling returns during transition: Evidence from Chinese cities,” Journal of Comparative Economics. Ge and Yang, 2011, “Labor market developments in China: A neoclassical view” China Economic Review. And Yang, Chen, and Monarch, 2010, “Rising Wages: Has China lost its global labor advantage?” Pacific Economic Review.)) on the returns to education before and after the economic reforms in China. He found a low rate of return to education before the reforms. After the reforms—today—the return on education in China is about at the level of the United States. Education made less difference earlier during China’s centrally-planned economy; and it makes much more difference today in China’s more market-oriented economy.

Professor Yang also found that in regions of China where there is more foreign direct investment (FDI), there is a much higher rate of return on education. FDI brings in new technology and raises productivity. And multinational firms create a competitive market for the talented, educated, and experienced worker. Training is associated with rising wages.

As textbooks say, growth of income and productivity in a nation is fundamentally driven by capital and labor: if you invest in more of each, you are liable to get more growth, up to some point of diminishing returns. In the absence of sufficient labor and adequate tools, education alone won’t add much to the productivity of a nation. But in the presence of an adequate supply of labor and capital, better-trained workers can perform more effectively, adopt global best practices, and operate more sophisticated machines. Not all labor hours are equal: the worker who has more years of education and work experience will likely be a more effective employee. Logically then, education would seem to amplify the benefits of investing to provide more labor and capital.

Unfortunately, research does not support that suggestion. It’s true that labor and capital explain much of the variation in productivity across nations. But simply adding education as a factor doesn’t explain much more of the variation. This is a surprise, since the ROI on education is so high at the level of individuals (as my earlier post documented). You would think that across whole societies, education alone would yield a high boost in productivity. Here’s where the mystery deepens.

Edward Prescott, the Nobel Laureate in Economics (2004), summarized studies of the production of textiles in various countries and found some countries were far more productive. ((Edward C. Prescott, “Needed: A Theory of Total Factor Productivity” International Economic Review Vol. 39, No. 3, (August 1998).)) Why? It had to do with resistance to the adoption of global best practices of operation. Such resistance can arise from culture—especially attitudes regarding work ethic and shirking—as well as corruption, unionization, and concentrated ownership.

Nobel Laureate (1993), Douglas C. North, argued that institutional developments, are crucially important to economic growth throughout history. Rules of the game, such as property rights, cultural norms of behavior, democratic regimes, zoning laws, tariffs, tax codes, and many kinds of regulations matter greatly to growth—all of these institutional considerations affect the incentives to innovate, develop new technologies, reorganize production and distribution, and to accumulate physical and human capital.

An important illustration of the role of institutions is to consider the great Industrial Revolution that began about 1750 and ended about 100 years later. Economists and historians have asked why the Industrial Revolution began in Britain. David Landes discussed this in his magisterial work, The Wealth and Poverty of Nations. He wrote that Britain closely conformed to an ideal (pages 217-18):

“…the society theoretically best suited to pursue material progress and general enrichment…would be one that:

  1. Knew how to operate, manage, and build the instruments of production and to create, adapt, and master new techniques on the technological frontier.
  2. Was able to impart this knowledge and know-how to the young, whether by formal education or apprenticeship training.
  3. Chose people for jobs by competence and relative merit; promoted and demoted on the basis of performance.
  4. Afforded opportunity to individual or collective enterprise; encouraged initiative, competition, and emulation.
  5. Allowed people to enjoy and employ the fruits of their labor and enterprise.”

Landes adds that a high-growth society will secure the rights of personal liberty and private property, and provide stable, responsive, and honest government.

The economist, Elhanan Helpman, wrote, “Institutions are more fundamental determinants of economic growth than R&D or capital accumulation, human or physical” (The Mystery of Economic Growth, p. 141). Other economists have produced numerous studies across other countries and industries with a similar conclusion: education in the context of free and competitive markets has a substantial and positive impact on productivity. Where employees and entrepreneurs can readily apply the benefits of education and the transfer of global best practices of operation, education will lift productivity. Thus, it seems that the negative impact of bad institutions can overpower the benefits of education—and presumably, good institutions can amplify the benefits of education.

In their new book, Why Nations Fail, Daron Acemoglu and James Robinson give abundant evidence that the impact of education is deeply affected by the societal context. In reviewing the book, Simon Johnson wrote, “ Countries rise when they put in place the right pro-growth political institutions and they fail—often spectacularly—when those institutions ossify or fail to adapt.  Powerful people always and everywhere seek to grab complete control over government, undermining broader social progress for their own greed. Keep those people in check with effective democracy or watch your nation fail.”

So what?

So institutions matter. What should the practical business executive, educational leader, or student do with this? I think that this insight raises several important questions for consideration.

Should nations invest in more education? The answer is unquestionably “yes…and.” Without rising educational levels, there is no hope of escaping from poverty for developing economies—or for the developed economies, no hope for greater social mobility and higher economic equality. But the big implication of this story is that education pays off for society if society makes it possible to realize the benefits of education through strong social, legal, and political institutions. A command economy like North Korea probably renders the benefits of education nil: central planning, cronyism, the absence of incentives for personal initiative, and the gulag for too much personal expression create a society of the lowest common denominator. On the other hand, relatively liberal and developed economies offer attractive venues in which to exercise one’s education. Yes, a nation should invest in more education and that nation should seek to strengthen the institutions of society that make such education valuable.

Where should the educated person go to work? Personal freedom, low corruption and crime, and moderate-to-low taxes create the attractive stew for the educated. Perhaps this explains the “brain drain” that authoritarian societies experience. Of course, people are motivated more by ideals than by money. Working in a developed economy with strong institutions may yield a big payoff, but not grant the kind of social impact that one might like to have. Many students from developing economies choose to start their careers in a developed economy and then later return to their homelands to help strengthen institutions there.

In light of the new research that reveals that institutions’ impact depends on education, where might we anticipate that business education is most likely to have its greatest impact? One infers from the research findings that education will have the greatest impact in those societies with property rights, civil rights, democracy, and relatively less-regulated markets are all associated with higher impact of education. We’ve talked of education as enhancing productivity, but can education enhance institutions?

Over 13,000 institutions in the world offer degrees of some kind in business. I know of no rigorous study that tests the relationship between business education and measures of wealth creation and productivity in a country. But two years ago, a task force of business school Deans that I chaired produced a report, Globalization of Management Education (AACSB, 2011). Our report shows conclusively that management education is no longer confined to the developed countries. In fact, it is growing quite rapidly in the emerging economies. The mobility of students, teachers, and whole institutions is already high and rising still. We are seeing stunning growth of cross-border partnerships among business schools, the development of curricula on globalization, and a serious deepening of the respect for cross-border differences. The world is not “flat;” it is “curved.” Differences in culture, laws, geography, and economies mean that we must produce a new generation of leaders who can navigate through those differences. If one believes in the benefits from education, these trends are a very good thing for the welfare of future generations.

What should business leaders do? Educators are moving to promote the benefits of management development globally. What role should business practitioners play in this effort? In his book, The Competitive Advantage of Nations, Michael Porter wrote,

“Advanced and specialized factors of production, such as highly skilled personnel, industry-specific infrastructure, and local scientific expertise in particular fields are the sine qua nons of competitive advantage. The level of competitive advantage that a nation’s firms can achieve is set by the quantity and especially the quality of factors. Yet they are not inherited by a nation but created. While government has a constructive and important role in creating factors, it cannot be left to government alone. In nearly every competitive industry we studied, no matter what the nation, leading firms took explicit steps to create factors or ensure that institutions were established or influenced to do so. Companies did not accept the status quo of factor development in the nation, but sought to upgrade it. … Firms must invest directly in factor creation through their own training, research, and infrastructure building. Internal efforts at factor creation lead to the most specialized and often most important factors. The competitive firms we studied usually had well-developed internal training programs…Failing to invest in factor creation is a fatal error in international competition. …Investments in factor creation have a medium- to long-term payback. It takes sustained investment over a number of years to see the return. Stop and start patterns of investment are often ineffective. …Firms have a responsibility, not to mention a self-interest, in influencing the type and character of degree programs, research directions, and public services. …Firms can shape factor creation in educational institutions in many ways. One is by sponsoring students or sending personnel from the firm to study. Others include playing an active role in helping institutions identify the needs of the industry, planning curriculum, placing graduates, and providing financial support for equipment and facilities, faculty positions, scholarships, and recognition programs for outstanding teachers and student. Firms can establish working relationships with faculty in disciplines of interest to help such faculty understand the needs of industry and advise students accordingly.” (pages 592-595)

To bring to bear the immense power of education as a transforming force in business and society, business leaders have an important role to play. Louis Pasteur famously said that “fortune favors the prepared mind.” Based on our growing understanding about the role of education in promoting the creation of economic value we could adapt Pasteur’s saying, “fortune favors the trained individuals and nation.”