23 Things They Don't Tell You About Capitalism

23ThingsTheyDon’tTell

YouaboutCapitalism

HA-JOONCHANG

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ToHee-Jeong,Yuna,andJin-Gyu

Way1.Ifyouarenotevensurewhatcapitalismis, read:

Things1,2,5,8,13,16,19,20,and22

Way2.Ifyouthinkpoliticsisawasteoftime,read: Things1,5,7,12,16,18,19,21,and23

Way3.Ifyouhavebeenwonderingwhyyourlifedoes notseemtogetbetterdespiteever-risingincomeand ever-advancingtechnologies,read:

Things2,4,6,8,9,10,17,18,and22

Way4.Ifyouthinksomepeoplearericherthanothers becausetheyaremorecapable,bettereducatedand moreenterprising,read:

Things3,10,13,14,15,16,17,20,and21

Way5.Ifyouwanttoknowwhypoorcountriesare poorandhowtheycanbecomericher,read:

Things3,6,7,8,9,10,11,12,15,17,and23

Way6.Ifyouthinktheworldisanunfairplacebut thereisnothingmuchyoucandoaboutit,read: Things1,2,3,4,5,11,13,14,15,20,and21

Way7.Readthewholethinginthefollowingorder…

Acknowledgements

Introduction

Thing1 Thereisnosuchthingasafreemarket

Thing2 Companiesshouldnotberunintheinterest oftheirowners

Thing3 Mostpeopleinrichcountriesarepaidmore thantheyshouldbe

Thing4 Thewashingmachinehaschangedtheworld morethantheinternethas

Thing5 Assumetheworstaboutpeopleandyouget theworst

Thing6 Greatermacroeconomicstabilityhasno madetheworldeconomymorestable.

Thing7 Free-marketpoliciesrarelymakepoor countriesrich

Thing8 Capitalhasanationality

Thing9 Wedonotliveinapost-industrialage

Thing10 TheUSdoesnothavethehighestliving standardintheworld

Thing11 Africaisnotdestinedforunderdevelopment Thing12 Governmentscanpickwinners

Thing19 Despitethefallofcommunism,wearestill livinginplannedeconomies

Thing20 Equalityofopportunitymaynotbefair

Thing21 Biggovernmentmakespeoplemoreopen tochange

Thing22 Financialmarketsneedtobecomeless,not more,efficient

Thing23 Goodeconomicpolicydoesnotrequire goodeconomists

Conclusion:Howtorebuildtheworldeconomy

Notes

Index

Acknowledgements

Ihavebenefitedfrommanypeopleinwritingthisbook. Havingplayedsuchapivotalroleinbringingaboutmy previousbook,BadSamaritans,whichfocusedonthe developingworld,IvanMulcahy,myliteraryagent,gaveme constantencouragementtowriteanotherbookwitha broaderappeal.PeterGinna,myeditoratBloomsburyUSA, notonlyprovidedvaluableeditorialfeedbackbutalsoplayed acrucialroleinsettingthetoneofthebookbycomingup withthetitle,23ThingsTheyDon’tTellYouabout Capitalism,whileIwasconceptualizingthebook.William Goodlad,myeditoratAllenLane,tooktheleadinthe editorialworkanddidasuperbjobingettingeverythingjust right.

Manypeoplereadchaptersofthebookandprovided helpfulcomments.DuncanGreenreadallthechaptersand gavemeveryusefuladvice,bothcontent-wiseand editorially.GeoffHarcourtandDeepakNayyarreadmanyof thechaptersandprovidedsagaciousadvice.DirkBezemer, ChrisCramer,ShailajaFennell,PatrickImam,Deborah Johnston,AmyKlatzkin,BarryLynn,KeniaParsons,and BobRowthornreadvariouschaptersandgavemevaluable comments.

Withoutthehelpofmycapableresearchassistants,I couldnothavegotallthedetailedinformationonwhichthe bookisbuilt.Ithank,inalphabeticalorder,Bhargav Adhvaryu,HassanAkram,AntonioAndreoni,Yurendra Basnett,MuhammadIrfan,VeerayoothKanchoochat,and FrancescaReinhardt,fortheirassistance.

IalsowouldliketothankSeung-ilJeongandBuhmLee forprovidingmewithdatathatarenoteasilyaccessible.

Lastbutnotleast,Ithankmyfamily,withoutwhose

supportandlovethebookwouldnothavebeenfinished. Hee-Jeong,mywife,notonlygavemestrongemotional supportwhileIwaswritingthebookbutalsoreadallthe chaptersandhelpedmeformulatemyargumentsinamore coherentanduser-friendlyway.Iwasextremelypleasedto seethat,whenIfloatedsomeofmyideastoYuna,my daughter,sherespondedwithasurprisingintellectual maturityfora14-year-old.Jin-Gyu,myson,gavemesome veryinterestingideasaswellasalotofmoralsupportforthe book.Idedicatethisbooktothethreeofthem.

Introduction

Theglobaleconomyliesintatters.Whilefiscalandmonetary stimulusofunprecedentedscalehaspreventedthefinancial meltdownof2008fromturningintoatotalcollapseofthe globaleconomy,the2008globalcrashstillremainsthe second-largesteconomiccrisisinhistory,aftertheGreat Depression.Atthetimeofwriting(March2010),evenas somepeopledeclaretheendoftherecession,asustained recoveryisbynomeanscertain.Intheabsenceoffinancial reforms,loosemonetaryandfiscalpolicieshaveledtonew financialbubbles,whiletherealeconomyisstarvedof money.Ifthesebubblesburst,theglobaleconomycouldfall intoanother(‘double-dip’)recession.Eveniftherecoveryis sustained,theaftermathofthecrisiswillbefeltforyears.It maybeseveralyearsbeforethecorporateandthe householdsectorsrebuildtheirbalancesheets.Thehuge budgetdeficitscreatedbythecrisiswillforcegovernments toreducepublicinvestmentsandwelfareentitlements significantly,negativelyaffectingeconomicgrowth,poverty andsocialstability–possiblyfordecades.Someofthose wholosttheirjobsandhousesduringthecrisismaynever jointheeconomicmainstreamagain.Thesearefrightening prospects.

Thiscatastrophehasultimatelybeencreatedbythefreemarketideologythathasruledtheworldsincethe1980s. Wehavebeentoldthat,ifleftalone,marketswillproducethe mostefficientandjustoutcome.Efficient,because individualsknowbesthowtoutilizetheresourcesthey command,andjust,becausethecompetitivemarket processensuresthatindividualsarerewardedaccordingto theirproductivity.Wehavebeentoldthatbusinessshouldbe givenmaximumfreedom.Firms,beingclosesttothe

market,knowwhatisbestfortheirbusinesses.Ifweletthem dowhattheywant,wealthcreationwillbemaximized, benefitingtherestofsocietyaswell.Weweretoldthat governmentinterventioninthemarketswouldonlyreduce theirefficiency.Governmentinterventionisoftendesignedto limittheveryscopeofwealthcreationformisguided egalitarianreasons.Evenwhenitisnot,governments cannotimproveonmarketoutcomes,astheyhaveneither thenecessaryinformationnortheincentivestomakegood businessdecisions.Insum,weweretoldtoputallourtrust inthemarketandgetoutofitsway.

Followingthisadvice,mostcountrieshaveintroduced free-marketpoliciesoverthelastthreedecades–privatizationofstate-ownedindustrialandfinancialfirms, deregulationoffinanceandindustry,liberalizationof internationaltradeandinvestment,andreductioninincome taxesandwelfarepayments.Thesepolicies,theiradvocates admitted,maytemporarilycreatesomeproblems,suchas risinginequality,butultimatelytheywillmakeeveryonebetter offbycreatingamoredynamicandwealthiersociety.The risingtideliftsallboatstogether,wasthemetaphor.

Theresultofthesepolicieshasbeenthepolaropposite ofwhatwaspromised.Forgetforamomentthefinancial meltdown,whichwillscartheworldfordecadestocome. Priortothat,andunbeknowntomostpeople,free-market policieshadresultedinslowergrowth,risinginequalityand heightenedinstabilityinmostcountries.Inmanyrich countries,theseproblemsweremaskedbyhugecredit expansion;thusthefactthatUSwageshadremained stagnantandworkinghoursincreasedsincethe1970swas convenientlyfoggedoverbytheheadybrewofcredit-fuelled consumerboom.Theproblemswerebadenoughintherich countries,buttheywereevenmoreseriousforthe developingworld.LivingstandardsinSub-SaharanAfrica havestagnatedforthelastthreedecades,whileLatin Americahasseenitspercapitagrowthratefallbytwo-thirds duringtheperiod.Thereweresomedevelopingcountries

thatgrewfast(althoughwithrapidlyrisinginequality)during thisperiod,suchasChinaandIndia,buttheseareprecisely thecountriesthat,whilepartiallyliberalizing,haverefusedto introducefull-blownfree-marketpolicies.

Thus,whatweweretoldbythefree-marketeers–or,as theyareoftencalled,neo-liberaleconomists–wasatbest onlypartiallytrueandatworstplainwrong.AsIwillshow throughoutthisbook,the‘truths’peddledbyfree-market ideologuesarebasedonlazyassumptionsandblinkered visions,ifnotnecessarilyself-servingnotions.Myaiminthis bookistotellyousomeessentialtruthsaboutcapitalism thatthefree-marketeerswon’t.

Thisbookisnotananti-capitalistmanifesto.Being criticaloffree-marketideologyisnotthesameasbeing againstcapitalism.Despiteitsproblemsandlimitations,I believethatcapitalismisstillthebesteconomicsystemthat humanityhasinvented.Mycriticismisofaparticularversion ofcapitalismthathasdominatedtheworldinthelastthree decades,thatis,free-marketcapitalism.Thisisnottheonly waytoruncapitalism,andcertainlynotthebest,asthe recordofthelastthreedecadesshows.Thebookshows thattherearewaysinwhichcapitalismshould,andcan,be madebetter.

Eventhoughthe2008crisishasmadeusseriously questionthewayinwhichoureconomiesarerun,mostofus donotpursuesuchquestionsbecausewethinkthattheyare onesfortheexperts.Indeedtheyare–atonelevel.The preciseanswersdorequireknowledgeonmanytechnical issues,manyofthemsocomplicatedthattheexperts themselvesdisagreeonthem.Itisthennaturalthatmostof ussimplydonothavethetimeorthenecessarytrainingto learnallthetechnicaldetailsbeforewecanpronounceour judgementsontheeffectivenessofTARP(TroubledAsset ReliefProgram),thenecessityofG20,thewisdomofbank nationalizationortheappropriatelevelsofexecutive salaries.AndwhenitcomestothingslikepovertyinAfrica, theworkingsoftheWorldTradeOrganization,orthecapital

adequacyrulesoftheBankforInternationalSettlements, mostofusarefranklylost.

However,itisnotnecessaryforustounderstandallthe technicaldetailsinordertounderstandwhatisgoingonin theworldandexercisewhatIcallan‘activeeconomic citizenship’todemandtherightcoursesofactionfromthose indecision-makingpositions.Afterall,wemakejudgements aboutallsortsofotherissuesdespitelackingtechnical expertise.Wedon’tneedtobeexpertepidemiologistsin ordertoknowthatthereshouldbehygienestandardsinfood factories,butchersandrestaurants.Makingjudgements abouteconomicsisnodifferent:onceyouknowthekey principlesandbasicfacts,youcanmakesomerobust judgementswithoutknowingthetechnicaldetails.Theonly prerequisiteisthatyouarewillingtoremovethoserosetintedglassesthatneo-liberalideologieslikeyoutowear everyday.Theglassesmaketheworldlooksimpleand pretty.Butliftthemoffandstareattheclearharshlightof reality.

Onceyouknowthatthereisreallynosuchthingasafree market,youwon’tbedeceivedbypeoplewhodenouncea regulationonthegroundsthatitmakesthemarket‘unfree’ (seeThing1).Whenyoulearnthatlargeandactive governmentscanpromote,ratherthandampen,economic dynamism,youwillseethatthewidespreaddistrustof governmentisunwarranted(seeThings12and21). Knowingthatwedonotliveinapost-industrialknowledge economywillmakeyouquestionthewisdomofneglecting, orevenimplicitlywelcoming,industrialdeclineofacountry, assomegovernmentshavedone(seeThings9and17). Onceyourealizethattrickle-downeconomicsdoesnot work,youwillseetheexcessivetaxcutsfortherichforwhat theyare–asimpleupwardredistributionofincome,rather thanawaytomakeallofusricher,asweweretold(see Things13and20).

Whathashappenedtotheworldeconomywasno accidentortheoutcomeofanirresistibleforceofhistory.It

isnotbecauseofsomeironlawofthemarketthatwages havebeenstagnatingandworkinghoursrisingformost Americans,whilethetopmanagersandbankersvastly increasedtheirincomes(seeThings10and14).Itisnot simplybecauseofunstoppableprogressinthetechnologies ofcommunicationsandtransportationthatweareexposed toincreasingforcesofinternationalcompetitionandhaveto worryaboutjobsecurity(seeThings4and6).Itwasnot inevitablethatthefinancialsectorgotmoreandmore detachedfromtherealeconomyinthelastthreedecades, ultimatelycreatingtheeconomiccatastrophewearein today(seeThings18and22).Itisnotmainlybecauseof someunalterablestructuralfactors–tropicalclimate, unfortunatelocation,orbadculture–thatpoorcountriesare poor(seeThings7and11).

Humandecisions,especiallydecisionsbythosewho havethepowertosettherules,makethingshappeninthe waytheyhappen,asIwillexplain.Eventhoughnosingle decision-makercanbesurethatheractionswillalwayslead tothedesiredresults,thedecisionsthathavebeenmade arenotinsomesenseinevitable.Wedonotliveinthebest ofallpossibleworlds.Ifdifferentdecisionshadbeentaken, theworldwouldhavebeenadifferentplace.Giventhis,we needtoaskwhetherthedecisionsthattherichandthe powerfultakearebasedonsoundreasoningandrobust evidence.Onlywhenwedothatcanwedemandright actionsfromcorporations,governmentsandinternational organizations.Withoutouractiveeconomiccitizenship,we willalwaysbethevictimsofpeoplewhohavegreaterability tomakedecisions,whotellusthatthingshappenbecause theyhavetoandthereforethatthereisnothingwecandoto alterthem,howeverunpleasantandunjusttheymayappear.

Thisbookisintendedtoequipthereaderwithan understandingofhowcapitalismreallyworksandhowitcan bemadetoworkbetter.Itis,however,notan‘economicsfor dummies’.Itisattemptingtobebothfarlessandfarmore.

ItislessthaneconomicsfordummiesbecauseIdonot

gointomanyofthetechnicaldetailsthatevenabasic introductorybookoneconomicswouldbecompelledto explain.However,thisneglectoftechnicaldetailsisnot becauseIbelievethemtobebeyondmyreaders.95per centofeconomicsiscommonsensemadecomplicated, andevenfortheremaining5percent,theessential reasoning,ifnotallthetechnicaldetails,canbeexplainedin plainterms.ItissimplybecauseIbelievethatthebestway tolearneconomicprinciplesisbyusingthemtounderstand problemsthatinterestthereaderthemost.Therefore,I introducetechnicaldetailsonlywhentheybecomerelevant, ratherthaninasystematic,textbook-likemanner.

Butwhilecompletelyaccessibletonon-specialist readers,thisbookisalotmorethaneconomicsfor dummies.Indeed,itgoesmuchdeeperthanmanyadvanced economicsbooksinthesensethatitquestionsmany receivedeconomictheoriesandempiricalfactsthatthose bookstakeforgranted.Whileitmaysounddauntingfora non-specialistreadertobeaskedtoquestiontheoriesthat aresupportedbythe‘experts’andtosuspectempiricalfacts thatareacceptedbymostprofessionalsinthefield,youwill findthatthisisactuallyaloteasierthanitsounds,onceyou stopassumingthatwhatmostexpertsbelievemustberight.

MostoftheissuesIdiscussinthebookdonothave simpleanswers.Indeed,inmanycases,mymainpointis thatthereisnosimpleanswer,unlikewhatfree-market economistswantyoutobelieve.However,unlesswe confronttheseissues,wewillnotperceivehowtheworld reallyworks.Andunlessweunderstandthat,wewon’tbe abletodefendourowninterests,nottospeakofdoing greatergoodasactiveeconomiccitizens.

Thing1

Thereisnosuchthingasa freemarket

Whattheytellyou

Marketsneedtobefree.Whenthegovernmentinterferesto dictatewhatmarketparticipantscanorcannotdo, resourcescannotflowtotheirmostefficientuse.Ifpeople cannotdothethingsthattheyfindmostprofitable,theylose theincentivetoinvestandinnovate.Thus,ifthegovernment putsacaponhouserents,landlordslosetheincentiveto maintaintheirpropertiesorbuildnewones.Or,ifthe governmentrestrictsthekindsoffinancialproductsthatcan besold,twocontractingpartiesthatmaybothhave benefitedfrominnovativetransactionsthatfulfiltheir idiosyncraticneedscannotreapthepotentialgainsoffree contract.Peoplemustbeleft‘freetochoose’,asthetitleof free-marketvisionaryMiltonFriedman’sfamousbookgoes.

Thefreemarketdoesn’texist.Everymarkethassomerules andboundariesthatrestrictfreedomofchoice.Amarket looksfreeonlybecausewesounconditionallyacceptits underlyingrestrictionsthatwefailtoseethem.How‘free’a marketiscannotbeobjectivelydefined.Itisapolitical

definition.Theusualclaimbyfree-marketeconomiststhat theyaretryingtodefendthemarketfrompolitically motivatedinterferencebythegovernmentisfalse. Governmentisalwaysinvolvedandthosefree-marketeers areaspoliticallymotivatedasanyone.Overcomingthemyth thatthereissuchathingasanobjectivelydefined‘free market’isthefirststeptowardsunderstandingcapitalism.

Labouroughttobefree

In1819newlegislationtoregulatechildlabour,theCotton FactoriesRegulationAct,wastabledintheBritish Parliament.Theproposedregulationwasincredibly‘light touch’bymodernstandards.Itwouldbantheemploymentof youngchildren–thatis,thoseundertheageofnine.Older children(agedbetweentenandsixteen)wouldstillbe allowedtowork,butwiththeirworkinghoursrestrictedto twelveperday(yes,theywerereallygoingsoftonthose kids).Thenewrulesappliedonlytocottonfactories,which wererecognizedtobeexceptionallyhazardoustoworkers’ health.

Theproposalcausedhugecontroversy.Opponentssawit asunderminingthesanctityoffreedomofcontractandthus destroyingtheveryfoundationofthefreemarket.Indebating thislegislation,somemembersoftheHouseofLords objectedtoitonthegroundsthat‘labouroughttobefree’. Theirargumentsaid:thechildrenwant(andneed)towork, andthefactoryownerswanttoemploythem;whatisthe problem?

Today,eventhemostardentfree-marketproponentsin Britainorotherrichcountrieswouldnotthinkofbringing childlabourbackaspartofthemarketliberalization packagethattheysowant.However,untilthelatenineteenth ortheearlytwentiethcentury,whenthefirstseriouschild

labourregulationswereintroducedinEuropeandNorth America,manyrespectablepeoplejudgedchildlabour regulationtobeagainsttheprinciplesofthefreemarket.

Thusseen,the‘freedom’ofamarketis,likebeauty,inthe eyesofthebeholder.Ifyoubelievethattherightofchildren nottohavetoworkismoreimportantthantherightoffactory ownerstobeabletohirewhoevertheyfindmostprofitable, youwillnotseeabanonchildlabourasaninfringementon thefreedomofthelabourmarket.Ifyoubelievetheopposite, youwillseean‘unfree’market,shackledbyamisguided governmentregulation.

Wedon’thavetogobacktwocenturiestosee regulationswetakeforgranted(andacceptasthe‘ambient noise’withinthefreemarket)thatwereseriouslychallenged asunderminingthefreemarket,whenfirstintroduced.When environmentalregulations(e.g.,regulationsoncarand factoryemissions)appearedafewdecadesago,theywere opposedbymanyasseriousinfringementsonourfreedom tochoose.Theiropponentsasked:ifpeoplewanttodrivein morepollutingcarsoriffactoriesfindmorepolluting productionmethodsmoreprofitable,whyshouldthe governmentpreventthemfrommakingsuchchoices? Today,mostpeopleaccepttheseregulationsas‘natural’. Theybelievethatactionsthatharmothers,however unintentionally(suchaspollution),needtoberestricted. Theyalsounderstandthatitissensibletomakecarefuluse ofourenergyresources,whenmanyofthemarenonrenewable.Theymaybelievethatreducinghumanimpacton climatechangemakessensetoo.

Ifthesamemarketcanbeperceivedtohavevarying degreesoffreedombydifferentpeople,thereisreallyno objectivewaytodefinehowfreethatmarketis.Inother words,thefreemarketisanillusion.Ifsomemarketslook free,itisonlybecausewesototallyaccepttheregulations thatareproppingthemupthattheybecomeinvisible.

Pianowiresandkungfumasters

Likemanypeople,asachildIwasfascinatedbyallthose gravity-defyingkungfumastersinHongKongmovies.Like manykids,Isuspect,IwasbitterlydisappointedwhenI learnedthatthosemasterswereactuallyhangingonpiano wires.

Thefreemarketisabitlikethat.Weacceptthe legitimacyofcertainregulationssototallythatwedon’tsee them.Morecarefullyexamined,marketsarerevealedtobe proppedupbyrules–andmanyofthem.

Tobeginwith,thereisahugerangeofrestrictionson whatcanbetraded;andnotjustbanson‘obvious’things suchasnarcoticdrugsorhumanorgans.Electoralvotes, governmentjobsandlegaldecisionsarenotforsale,at leastopenly,inmoderneconomies,althoughtheywerein mostcountriesinthepast.Universityplacesmaynotusually besold,althoughinsomenationsmoneycanbuythem–eitherthrough(illegally)payingtheselectorsor(legally) donatingmoneytotheuniversity.Manycountriesbantrading infirearmsoralcohol.Usuallymedicineshavetobeexplicitly licensedbythegovernment,upontheproofoftheirsafety, beforetheycanbemarketed.Alltheseregulationsare potentiallycontroversial–justasthebanonsellinghuman beings(theslavetrade)wasoneandahalfcenturiesago.

Therearealsorestrictionsonwhocanparticipatein markets.Childlabourregulationnowbanstheentryof childrenintothelabourmarket.Licencesarerequiredfor professionsthathavesignificantimpactsonhumanlife,such asmedicaldoctorsorlawyers(whichmaysometimesbe issuedbyprofessionalassociationsratherthanbythe government).Manycountriesallowonlycompanieswith morethanacertainamountofcapitaltosetupbanks.Even thestockmarket,whoseunder-regulationhasbeenacause ofthe2008globalrecession,hasregulationsonwhocan

trade.Youcan’tjustturnupintheNewYorkStockExchange (NYSE)withabagofsharesandsellthem.Companies mustfulfillistingrequirements,meetingstringentauditing standardsoveracertainnumberofyears,beforetheycan offertheirsharesfortrading.Tradingofsharesisonly conductedbylicensedbrokersandtraders.

Conditionsoftradearespecifiedtoo.Oneofthethings thatsurprisedmewhenIfirstmovedtoBritaininthemid 1980swasthatonecoulddemandafullrefundforaproduct onedidn’tlike,evenifitwasn’tfaulty.Atthetime,youjust couldn’tdothatinKorea,exceptinthemostexclusive departmentstores.InBritain,theconsumer’srighttochange hermindwasconsideredmoreimportantthantherightof thesellertoavoidthecostinvolvedinreturningunwanted (yetfunctional)productstothemanufacturer.Therearemany otherrulesregulatingvariousaspectsoftheexchange process:productliability,failureindelivery,loandefault,and soon.Inmanycountries,therearealsonecessary permissionsforthelocationofsalesoutlets–suchas restrictionsonstreet-vendingorzoninglawsthatban commercialactivitiesinresidentialareas.

Thentherearepriceregulations.Iamnottalkingherejust aboutthosehighlyvisiblephenomenasuchasrentcontrols orminimumwagesthatfree-marketeconomistslovetohate.

Wagesinrichcountriesaredeterminedmoreby immigrationcontrolthananythingelse,includingany minimumwagelegislation.Howistheimmigration maximumdetermined?Notbythe‘free’labourmarket, which,ifleftalone,willendupreplacing80–90percentof nativeworkerswithcheaper,andoftenmoreproductive, immigrants.Immigrationislargelysettledbypolitics.So,if youhaveanyresidualdoubtaboutthemassiverolethatthe governmentplaysintheeconomy’sfreemarket,thenpause toreflectthatallourwagesare,atroot,politically determined(seeThing3).

Followingthe2008financialcrisis,thepricesofloans(if youcangetoneorifyoualreadyhaveavariablerateloan)

havebecomealotlowerinmanycountriesthankstothe continuousslashingofinterestrates.Wasthatbecause suddenlypeopledidn’twantloansandthebanksneededto lowertheirpricestoshiftthem?No,itwastheresultof politicaldecisionstoboostdemandbycuttinginterestrates. Eveninnormaltimes,interestratesaresetinmostcountries bythecentralbank,whichmeansthatpolitical considerationscreepin.Inotherwords,interestratesare alsodeterminedbypolitics.

Ifwagesandinterestratesare(toasignificantextent) politicallydetermined,thenalltheotherpricesarepolitically determined,astheyaffectallotherprices.

Isfreetradefair?

Weseearegulationwhenwedon’tendorsethemoral valuesbehindit.Thenineteenth-centuryhigh-tariffrestriction onfreetradebytheUSfederalgovernmentoutragedslaveowners,whoatthesametimesawnothingwrongwith tradingpeopleinafreemarket.Tothosewhobelievedthat peoplecanbeowned,banningtradeinslaveswas objectionableinthesamewayasrestrictingtradein manufacturedgoods.Koreanshopkeepersofthe1980s wouldprobablyhavethoughttherequirementfor ‘unconditionalreturn’tobeanunfairlyburdensome governmentregulationrestrictingmarketfreedom.

Thisclashofvaluesalsoliesbehindthecontemporary debateonfreetradevs.fairtrade.ManyAmericansbelieve thatChinaisengagedininternationaltradethatmaybefree butisnotfair.Intheirview,bypayingworkersunacceptably lowwagesandmakingthemworkininhumaneconditions, Chinacompetesunfairly.TheChinese,inturn,canriposte thatitisunacceptablethatrichcountries,whileadvocating freetrade,trytoimposeartificialbarrierstoChina’sexports

byattemptingtorestricttheimportof‘sweatshop’products. Theyfinditunjusttobepreventedfromexploitingtheonly resourcetheyhaveingreatestabundance–cheaplabour.

Ofcourse,thedifficultyhereisthatthereisnoobjective waytodefine‘unacceptablylowwages’or‘inhumane workingconditions’.Withthehugeinternationalgapsthat existinthelevelofeconomicdevelopmentandliving standards,itisnaturalthatwhatisastarvationwageinthe USisahandsomewageinChina(theaveragebeing10per centthatoftheUS)andafortuneinIndia(theaveragebeing 2percentthatoftheUS).Indeed,mostfair-trade-minded Americanswouldnothaveboughtthingsmadebytheirown grandfathers,whoworkedextremelylonghoursunder inhumaneconditions.Untilthebeginningofthetwentieth century,theaverageworkweekintheUSwasaroundsixty hours.Atthetime(in1905,tobemoreprecise),itwasa countryinwhichtheSupremeCourtdeclared unconstitutionalaNewYorkstatelawlimitingtheworking daysofbakerstotenhours,onthegroundsthatit‘deprived thebakerofthelibertyofworkingaslongashewished’.

Thusseen,thedebateaboutfairtradeisessentially aboutmoralvaluesandpoliticaldecisions,andnot economicsintheusualsense.Eventhoughitisaboutan economicissue,itisnotsomethingeconomistswiththeir technicaltoolkitsareparticularlywellequippedtoruleon.

Allthisdoesnotmeanthatweneedtotakearelativist positionandfailtocriticizeanyonebecauseanythinggoes. Wecan(andIdo)haveaviewontheacceptabilityof prevailinglabourstandardsinChina(oranyothercountry, forthatmatter)andtrytodosomethingaboutit,without believingthatthosewhohaveadifferentviewarewrongin someabsolutesense.EventhoughChinacannotafford AmericanwagesorSwedishworkingconditions,itcertainly canimprovethewagesandtheworkingconditionsofits workers.Indeed,manyChinesedon’taccepttheprevailing conditionsanddemandtougherregulations.Buteconomic theory(atleastfree-marketeconomics)cannottelluswhat

the‘right’wagesandworkingconditionsshouldbeinChina.

Idon’tthinkweareinFranceanymore

InJuly2008,withthecountry’sfinancialsysteminmeltdown, theUSgovernmentpoured$200billionintoFannieMaeand FreddieMac,themortgagelenders,andnationalizedthem. Onwitnessingthis,theRepublicanSenatorJimBunningof Kentuckyfamouslydenouncedtheactionassomethingthat couldonlyhappenina‘socialist’countrylikeFrance.

Francewasbadenough,buton19September2008, SenatorBunning’sbelovedcountrywasturnedintotheEvil Empireitselfbyhisownpartyleader.Accordingtotheplan announcedthatdaybyPresidentGeorgeW.Bushand subsequentlynamedTARP(TroubledAssetRelief Program),theUSgovernmentwastouseatleast$700 billionoftaxpayers’moneytobuyupthe‘toxicassets’ chokingupthefinancialsystem.

PresidentBush,however,didnotseethingsquitethat way.Hearguedthat,ratherthanbeing‘socialist’,theplan wassimplyacontinuationoftheAmericansystemoffree enterprise,which‘restsontheconvictionthatthefederal governmentshouldinterfereinthemarketplaceonlywhen necessary’.Onlythat,inhisview,nationalizingahugechunk ofthefinancialsectorwasjustoneofthosenecessary things.

MrBush’sstatementis,ofcourse,anultimateexampleof politicaldouble-speak–oneofthebiggeststate interventionsinhumanhistoryisdressedupasanother workadaymarketprocess.However,throughthesewords MrBushexposedtheflimsyfoundationonwhichthemythof thefreemarketstands.Asthestatementsoclearlyreveals, whatisanecessarystateinterventionconsistentwithfreemarketcapitalismisreallyamatterofopinion.Thereisno

scientificallydefinedboundaryforfreemarket.

Ifthereisnothingsacredaboutanyparticularmarket boundariesthathappentoexist,anattempttochangethem isaslegitimateastheattempttodefendthem.Indeed,the historyofcapitalismhasbeenaconstantstruggleoverthe boundariesofthemarket.

Alotofthethingsthatareoutsidethemarkettodayhave beenremovedbypoliticaldecision,ratherthanthemarket processitself–humanbeings,governmentjobs,electoral votes,legaldecisions,universityplacesoruncertified medicines.Therearestillattemptstobuyatleastsomeof thesethingsillegally(bribinggovernmentofficials,judgesor voters)orlegally(usingexpensivelawyerstowinalawsuit, donationstopoliticalparties,etc.),but,eventhoughthere havebeenmovementsinbothdirections,thetrendhasbeen towardslessmarketization.

Forgoodsthatarestilltraded,moreregulationshave beenintroducedovertime.Comparedeventoafew decadesago,nowwehavemuchmorestringentregulations onwhocanproducewhat(e.g.,certificatesfororganicor fair-tradeproducers),howtheycanbeproduced(e.g., restrictionsonpollutionorcarbonemissions),andhowthey canbesold(e.g.,rulesonproductlabellingandonrefunds).

Furthermore,reflectingitspoliticalnature,theprocessof re-drawingtheboundariesofthemarkethassometimes beenmarkedbyviolentconflicts.TheAmericansfoughta civilwaroverfreetradeinslaves(althoughfreetradein goods–orthetariffsissue–wasalsoanimportantissue).1

TheBritishgovernmentfoughttheOpiumWaragainstChina torealizeafreetradeinopium.Regulationsonfreemarket inchildlabourwereimplementedonlybecauseofthe strugglesbysocialreformers,asIdiscussedearlier.Making freemarketsingovernmentjobsorvotesillegalhasbeen metwithstiffresistancebypoliticalpartieswhoboughtvotes anddishedoutgovernmentjobstorewardloyalists.These practicescametoanendonlythroughacombinationof politicalactivism,electoralreformsandchangesintherules

regardinggovernmenthiring.

Recognizingthattheboundariesofthemarketare ambiguousandcannotbedeterminedinanobjectiveway letsusrealizethateconomicsisnotasciencelikephysics orchemistry,butapoliticalexercise.Free-market economistsmaywantyoutobelievethatthecorrect boundariesofthemarketcanbescientificallydetermined, butthisisincorrect.Iftheboundariesofwhatyouare studyingcannotbescientificallydetermined,whatyouare doingisnotascience.

Thusseen,opposinganewregulationissayingthatthe statusquo,howeverunjustfromsomepeople’spointof view,shouldnotbechanged.Sayingthatanexisting regulationshouldbeabolishedissayingthatthedomainof themarketshouldbeexpanded,whichmeansthatthose whohavemoneyshouldbegivenmorepowerinthatarea, asthemarketisrunonone-dollar-one-voteprinciple.

So,whenfree-marketeconomistssaythatacertain regulationshouldnotbeintroducedbecauseitwouldrestrict the‘freedom’ofacertainmarket,theyaremerely expressingapoliticalopinionthattheyrejecttherightsthat aretobedefendedbytheproposedlaw.Theirideological cloakistopretendthattheirpoliticsisnotreallypolitical,but ratherisanobjectiveeconomictruth,whileotherpeople’s politicsispolitical.However,theyareaspoliticallymotivated astheiropponents.

Breakingawayfromtheillusionofmarketobjectivityis thefirststeptowardsunderstandingcapitalism.

Thing2

Companiesshouldnotberun

Whattheytellyou

Shareholdersowncompanies.Therefore,companiesshould berunintheirinterests.Itisnotsimplyamoralargument.

Theshareholdersarenotguaranteedanyfixedpayments, unliketheemployees(whohavefixedwages),thesuppliers (whoarepaidspecificprices),thelendingbanks(whoget paidfixedinterestrates),andothersinvolvedinthe business.Shareholders’incomesvaryaccordingtothe company’sperformance,givingthemthegreatestincentive toensurethecompanyperformswell.Ifthecompanygoes bankrupt,theshareholdersloseeverything,whereasother ‘stakeholders’getatleastsomething.Thus,shareholders beartheriskthatothersinvolvedinthecompanydonot, incentivizingthemtomaximizecompanyperformance.

Whenyourunacompanyfortheshareholders,itsprofit (whatisleftaftermakingallfixedpayments)ismaximized, whichalsomaximizesitssocialcontribution.

Shareholdersmaybetheownersofcorporationsbut,asthe mostmobileofthe‘stakeholders’,theyoftencaretheleast

aboutthelong-termfutureofthecompany(unlesstheyare sobigthattheycannotreallyselltheirshareswithout seriouslydisruptingthebusiness).Consequently, shareholders,especiallybutnotexclusivelythesmallerones, prefercorporatestrategiesthatmaximizeshort-termprofits, usuallyatthecostoflong-terminvestments,andmaximize thedividendsfromthoseprofits,whichevenfurtherweakens thelong-termprospectsofthecompanybyreducingthe amountofretainedprofitthatcanbeusedforre-investment. Runningthecompanyfortheshareholdersoftenreducesits long-termgrowthpotential.

KarlMarxdefendscapitalism

Youhaveprobablynoticedthatmanycompanynamesinthe English-speakingworldcomewiththeletterL–PLC,LLC, Ltd,etc.TheletterLintheseacronymsstandsfor‘limited’, shortfor‘limitedliability’–publiclimitedcompany(PLC), limitedliabilitycompany(LLC)orsimplylimitedcompany (Ltd).Limitedliabilitymeansthatinvestorsinthecompany willloseonlywhattheyhaveinvested(their‘shares’),should itgobank-rupt.

However,youmaynothaverealizedthattheLword,that is,limitedliability,iswhathasmademoderncapitalism possible.Today,thisformoforganizingabusiness enterpriseistakenforgranted,butitwasn’talwayslikethat. Beforetheinventionofthelimitedliabilitycompanyin sixteenth-centuryEurope–orthejoint-stockcompany,asit wasknowninitsearlydays–businessmenhadtorisk everythingwhentheystartedaventure.WhenIsay everything,Ireallymeaneverything–notjustpersonal property(unlimitedliabilitymeantthatafailedbusinessman hadtosellallhispersonalpropertiestorepayallthedebts) butalsopersonalfreedom(theycouldgotoadebtors’

prison,shouldtheyfailtohonourtheirdebts).Giventhis,itis almostamiraclethatanyonewaswillingtostartabusiness atall.

Unfortunately,evenaftertheinventionoflimitedliability,it wasinpracticeverydifficulttouseituntilthemidnineteenth century–youneededaroyalcharterinordertosetupa limitedliabilitycompany(oragovernmentcharterina republic).Itwasbelievedthatthosewhoweremanaginga limitedliabilitycompanywithoutowningit100percent wouldtakeexcessiverisks,becausepartofthemoneythey wereriskingwasnottheirown.Atthesametime,thenonmanaginginvestorsinalimitedliabilitycompanywouldalso becomelessvigilantinmonitoringthemanagers,astheir riskswerecapped(attheirrespectiveinvestments).Adam Smith,thefatherofeconomicsandthepatronsaintoffreemarketcapitalism,opposedlimitedliabilityonthese grounds.Hefamouslysaidthatthe‘directorsof[jointstock] companies…beingthemanagersratherofotherpeople’s moneythanoftheirown,itcannotwellbeexpectedthatthey wouldwatchoveritwiththesameanxiousvigilancewith whichthepartnersinaprivatecopartnery[i.e.,partnership, whichdemandsunlimitedliability]frequentlywatchovertheir own’.1

Therefore,countriestypicallygrantedlimitedliabilityonly toexceptionallylargeandriskyventuresthatweredeemed tobeofnationalinterest,suchastheDutchEastIndia Companysetupin1602(anditsarch-rival,theBritishEast IndiaCompany)andthenotoriousSouthSeaCompanyof Britain,thespeculativebubblesurroundingwhichin1721 gavelimitedliabilitycompaniesabadnameforgenerations. Bythemidnineteenthcentury,however,withthe emergenceoflarge-scaleindustriessuchasrailways,steel andchemicals,theneedforlimitedliabilitywasfelt increasinglyacutely.Veryfewpeoplehadabigenough fortunetostartasteelmillorarailwaysinglehandedly,so, beginningwithSwedenin1844andfollowedbyBritainin 1856,thecountriesofWesternEuropeandNorthAmerica

madelimitedliabilitygenerallyavailable–mostlyinthe 1860sand70s.

However,thesuspicionaboutlimitedliabilitylingeredon. Evenaslateasthelatenineteenthcentury,afewdecades aftertheintroductionofgeneralizedlimitedliability,small businessmeninBritain‘who,beingactivelyinchargeofa businessaswellasitsowner,soughttolimitresponsibility foritsdebtsbythedeviceofincorporation[limitedliability]’ werefrownedupon,accordingtoaninfluentialhistoryof WesternEuropeanentrepreneurship.2

Interestingly,oneofthefirstpeoplewhorealizedthe significanceoflimitedliabilityforthedevelopmentof capitalismwasKarlMarx,thesupposedarch-enemyof capitalism.Unlikemanyofhiscontemporaryfree-market advocates(andAdamSmithbeforethem),whoopposed limitedliability,Marxunderstoodhowitwouldenablethe mobilizationoflargesumsofcapitalthatwereneededfor thenewlyemergingheavyandchemicalindustriesby reducingtheriskforindividualinvestors.Writingin1865, whenthestockmarketwasstillverymuchaside-showinthe capitalistdrama,Marxhadtheforesighttocallthejoint-stock company‘capitalistproductioninitshighestdevelopment’. Likehisfree-marketopponents,Marxwasawareof,and criticized,thetendencyforlimitedliabilitytoencourage excessiverisk-takingbymanagers.However,Marx consideredittobeaside-effectofthehugematerial progressthatthisinstitutionalinnovationwasabouttobring. Ofcourse,indefendingthe‘new’capitalismagainstitsfreemarketcritics,Marxhadanulteriormotive.Hethoughtthe joint-stockcompanywasa‘pointoftransition’tosocialismin thatitseparatedownershipfrommanagement,thereby makingitpossibletoeliminatecapitalists(whonowdonot managethefirm)withoutjeopardizingthematerialprogress thatcapitalismhadachieved.

Marx’spredictionthatanewcapitalismbasedonjoint-stock companieswouldpavethewayforsocialismhasnotcome true.However,hispredictionthatthenewinstitutionof generalizedlimitedliabilitywouldputtheproductiveforces ofcapitalismontoanewplaneprovedextremelyprescient.

Duringthelatenineteenthandearlytwentiethcenturies limitedliabilityhugelyacceleratedcapitalaccumulationand technologicalprogress.Capitalismwastransformedfroma systemmadeupofAdamSmith’spinfactories,butchers andbakers,withatmostdozensofemployeesand managedbyasoleowner,intoasystemofhuge corporationshiringhundredsoreventhousandsof employees,includingthetopmanagersthemselves,with complexorganizationalstructures.

Initially,thelong-fearedmanagerialincentiveproblemof limitedliabilitycompanies–thatthemanagers,playingwith otherpeople’smoney,wouldtakeexcessiverisk–didnot seemtomatterverymuch.Intheearlydaysoflimited liability,manylargefirmsweremanagedbyacharismatic entrepreneur–suchasHenryFord,ThomasEdisonor AndrewCarnegie–whoownedasignificantchunkofthe company.Eventhoughthesepart-owner-managerscould abusetheirpositionandtakeexcessiverisk(whichthey oftendid),therewasalimittothat.Owningalargechunkof thecompany,theyweregoingtohurtthemselvesifthey madeanoverlyriskydecision.Moreover,manyofthese part-owner-managersweremenofexceptionalabilityand vision,soeventheirpoorlyincentivizeddecisionswereoften superiortothosemadebymostofthosewell-incentivized full-owner-managers.

However,astimeworeon,anewclassofprofessional managersemergedtoreplacethesecharismatic entrepreneurs.Ascompaniesgrewinsize,itbecamemore andmoredifficultforanyonetoownasignificantshareof

them,althoughinsomeEuropeancountries,suchas Sweden,thefoundingfamilies(orfoundationsownedby them)hungonasthedominantshareholders,thankstothe legalallowancetoissuenewshareswithsmaller(typically 10percent,sometimeseven0.1percent)votingrights. Withthesechanges,professionalmanagersbecamethe dominantplayersandtheshareholdersbecameincreasingly passiveindeterminingthewayinwhichcompanieswere run.

Fromthe1930s,thetalkwasincreasinglyofthebirthof managerialcapitalism,wherecapitalistsinthetraditional sense–the‘captainsofindustry’,astheVictoriansusedto callthem–hadbeenreplacedbycareerbureaucrats (privatesectorbureaucrats,butbureaucratsnonetheless). Therewasanincreasingworrythatthesehiredmanagers wererunningtheenterprisesintheirowninterests,rather thanintheinterestsoftheirlegalowners,thatis,the shareholders.Whentheyshouldbemaximizingprofits,it wasargued,thesemanagersweremaximizingsales(to maximizethesizeofthecompanyandthustheirown prestige)andtheirownperks,or,worse,engageddirectlyin prestigeprojectsthataddhugelytotheiregosbutlittleto companyprofitsandthusitsvalue(measuredessentiallyby itsstockmarketcapitalization).

Someacceptedtheriseoftheprofessionalmanagersas aninevitable,ifnottotallywelcome,phenomenon.Joseph Schumpeter,theAustrian-bornAmericaneconomistwhois famousforhistheoryofentrepreneurship(seeThing15), arguedinthe1940sthat,withthegrowingscaleof companiesandtheintroductionofscientificprinciplesin corporateresearchanddevelopment,theheroic entrepreneursofearlycapitalismwouldbereplacedby bureaucraticprofessionalmanagers.Schumpeterbelieved thiswouldreducethedynamismofcapitalism,butthoughtit inevitable.Writinginthe1950s,JohnKennethGalbraith,the Canadian-bornAmericaneconomist,alsoarguedthatthe riseoflargecorporationsmanagedbyprofessional

managerswasunavoidableandthereforethattheonlyway toprovide‘countervailingforces’tothoseenterpriseswas throughincreasedgovernmentregulationandenhanced unionpower.

However,fordecadesafterthat,morepure-blooded advocatesofprivatepropertyhavebelievedthatmanagerial incentivesneedtobedesignedinsuchawaythatthe managersmaximizeprofits.Manyfinebrainshadworkedon this‘incentivedesign’problem,butthe‘holygrail’proved elusive.Managerscouldalwaysfindawaytoobservethe letterofthecontractbutnotthespirit,especiallywhenitis noteasyforshareholderstoverifywhetherpoorprofit performancebyamanagerwastheresultofhisfailureto payenoughattentiontoprofitfiguresorduetoforces beyondhiscontrol.

Theholygrailoranunholyalliance?

Andthen,inthe1980s,theholygrailwasfound.Itwascalled theprincipleofshareholdervaluemaximization.Itwas arguedthatprofessionalmanagersshouldberewarded accordingtotheamounttheycangivetoshareholders.In ordertoachievethis,itwasargued,firstprofitsneedtobe maximizedbyruthlesslycuttingcosts–wagebills, investments,inventories,middle-levelmanagers,andsoon. Second,thehighestpossibleshareoftheseprofitsneedsto bedistributedtotheshareholders–throughdividendsand sharebuybacks.Inordertoencouragemanagerstobehave inthisway,theproportionoftheircompensationpackages thatstockoptionsaccountforneedstobeincreased,sothat theyidentifymorewiththeinterestsoftheshareholders.The ideawasadvocatednotjustbyshareholders,butalsoby manyprofessionalmanagers,mostfamouslybyJackWelch, thelong-timechairmanofGeneralElectric(GE),whois

oftencreditedwithcoiningtheterm‘shareholdervalue’ina speechin1981.

SoonafterWelch’sspeech,shareholdervalue maximizationbecamethezeitgeistoftheAmerican corporateworld.Inthebeginning,itseemedtoworkreally wellforboththemanagersandtheshareholders.Theshare ofprofitsinnationalincome,whichhadshownadownward trendsincethe1960s,sharplyroseinthemid1980sand hasshownanupwardtrendsincethen.3Andthe shareholdersgotahighershareofthatprofitasdividends, whileseeingthevalueoftheirsharesrise.Distributedprofits asashareoftotalUScorporateprofitstoodat35–45per centbetweenthe1950sandthe1970s,butithasbeenon anupwardtrendsincethelate70sandnowstandsat around60percent.4Themanagerssawtheircompensation risingthroughtheroof(seeThing14),butshareholders stoppedquestioningtheirpaypackages,astheywere happywithever-risingsharepricesanddividends.The practicesoonspreadtoothercountries–moreeasilyto countrieslikeBritain,whichhadacorporatepowerstructure andmanagerialculturesimilartothoseoftheUS,andless easilytoothercountries,asweshallseebelow.

Now,thisunholyalliancebetweentheprofessional managersandtheshareholderswasallfinancedby squeezingtheotherstakeholdersinthecompany(whichis whyithasspreadmuchmoreslowlytootherrichcountries wheretheotherstakeholdershavegreaterrelativestrength). Jobswereruthlesslycut,manyworkerswerefiredandrehiredasnon-unionizedlabourwithlowerwagesandfewer benefits,andwageincreasesweresuppressed(oftenby relocatingtooroutsourcingfromlow-wagecountries,such asChinaandIndia–orthethreattodoso).Thesuppliers, andtheirworkers,werealsosqueezedbycontinuedcutsin procurementprices,whilethegovernmentwaspressured intoloweringcorporatetaxratesand/orprovidingmore subsidies,withthehelpofthethreatofrelocatingto countrieswithlowercorporatetaxratesand/orhigher

businesssubsidies.Asaresult,incomeinequalitysoared (seeThing13)andinaseeminglyendlesscorporateboom (ending,ofcourse,in2008),thevastmajorityofthe AmericanandtheBritishpopulationscouldshareinthe (apparent)prosperityonlythroughborrowingat unprecedentedrates.

Theimmediateincomeredistributionintoprofitswasbad enough,buttheever-increasingshareofprofitinnational incomesincethe1980shasnotbeentranslatedintohigher investmentseither(seeThing13).Investmentasashareof USnationaloutputhasactuallyfallen,ratherthanrisen,from 20.5percentinthe1980sto18.7percentsincethen (1990–2009).Itmayhavebeenacceptableifthislower investmentratehadbeencompensatedforbyamore efficientuseofcapital,generatinghighergrowth.However, thegrowthrateofpercapitaincomeintheUSfellfrom around2.6percentperyearinthe1960sand70sto1.6per centduring1990–2009,theheydayofshareholder capitalism.InBritain,wheresimilarchangesincorporate behaviourwerehappening,percapitaincomegrowthrates fellfrom2.4percentinthe1960s–70s,whenthecountry wasallegedlysufferingfromthe‘BritishDisease’,to1.7per centduring1990–2009.Sorunningcompaniesinthe interestoftheshareholdersdoesnotevenbenefitthe economyintheaveragesense(thatis,ignoringtheupward incomeredistribution).

Thisisnotall.Theworstthingaboutshareholdervalue maximizationisthatitdoesnotevendothecompanyitself muchgood.Theeasiestwayforacompanytomaximize profitistoreduceexpenditure,asincreasingrevenuesis moredifficult–bycuttingthewagebillthroughjobcutsand byreducingcapitalexpenditurebyminimizinginvestment. Generatinghigherprofit,however,isonlythebeginningof shareholdervaluemaximization.Themaximumproportionof theprofitthusgeneratedneedstobegiventothe shareholdersintheformofhigherdividends.Orthe companyusespartoftheprofitstobuybackitsownshares,

therebykeepingthesharepricesupandthusindirectly redistributingevenmoreprofitstotheshareholders(who canrealizehighercapitalgainsshouldtheydecidetosell someoftheirshares).Sharebuybacksusedtobelessthan 5percentofUScorporateprofitsfordecadesuntiltheearly 1980s,buthavekeptrisingsincethenandreachedanepic proportionof90percentin2007andanabsurd280per centin2008.5WilliamLazonick,theAmericanbusiness economist,estimatesthat,hadGMnotspentthe$20.4 billionthatitdidinsharebuybacksbetween1986and2002 andputitinthebank(witha2.5percentafter-taxannual return),itwouldhavehadnoproblemfindingthe$35billion thatitneededtostaveoffbankruptcyin2009.6Andinallthis bingeofprofits,theprofessionalmanagersbenefit enormouslytoo,astheyownalotofsharesthemselves throughstockoptions.

Allthisdamagesthelong-runprospectofthecompany. Cuttingjobsmayincreaseproductivityintheshortrun,but mayhavenegativelong-termconsequences.Havingfewer workersmeansincreasedworkintensity,whichmakes workerstiredandmorepronetomistakes,loweringproduct qualityandthusacompany’sreputation.Moreimportantly, theheightenedinsecurity,comingfromtheconstantthreatof jobcuts,discouragesworkersfrominvestinginacquiring company-specificskills,erodingthecompany’sproductive potential.Higherdividendsandgreaterown-sharebuybacks reduceretainedprofits,whicharethemainsourcesof corporateinvestmentintheUSandotherrichcapitalist countries,andthusreduceinvestment.Theimpactsof reducedinvestmentmaynotbefeltintheshortrun,butinthe longrunmakeacompany’stechnologybackwardand threatenitsverysurvival.

Butwouldn’ttheshareholderscare?Asownersofthe company,don’ttheyhavethemosttolose,iftheircompany declinesinthelongrun?Isn’tthewholepointofsomeone beinganownerofanasset–beitahouse,aplotoflandor acompany–thatshecaresaboutitslong-runproductivity?If

theownersarelettingallthishappen,defendersofthestatus quowouldargue,itmustbebecausethatiswhattheywant, howeverinsaneitmaylooktooutsiders.

Unfortunately,despitebeingthelegalownersofthe company,shareholdersaretheoneswhoareleast committedamongthevariousstakeholderstothelong-term viabilityofthecompany.Thisisbecausetheyaretheones whocanexitthecompanymosteasily–theyjustneedtosell theirshares,ifnecessaryataslightloss,aslongastheyare smartenoughnottosticktoalostcausefortoolong.In contrast,itismoredifficultforotherstakeholders,suchas workersandsuppliers,toexitthecompanyandfindanother engagement,becausetheyarelikelytohaveaccumulated skillsandcapitalequipment(inthecaseofthesuppliers) thatarespecifictothecompaniestheydobusinesswith. Therefore,theyhaveagreaterstakeinthelong-runviability ofthecompanythanmostshareholders.Thisiswhy maximizingshareholdervalueisbadforthecompany,as wellastherestoftheeconomy.

Thedumbestideaintheworld

Limitedliabilityhasallowedhugeprogressinhuman productivepowerbyenablingtheamassingofhuge amountsofcapital,exactlybecauseithasoffered shareholdersaneasyexit,therebyreducingtheriskinvolved inanyinvestment.However,atthesametime,thisveryease ofexitisexactlywhatmakestheshareholdersunreliable guardiansofacompany’slong-termfuture.

ThisiswhymostrichcountriesoutsidetheAngloAmericanworldhavetriedtoreducetheinfluenceoffreefloatingshareholdersandmaintain(orevencreate)agroup oflong-termstakeholders(includingsomeshareholders) throughvariousformalandinformalmeans.Inmany

countries,thegovernmenthasheldsizeableshare ownershipinkeyenterprises–eitherdirectly(e.g.,Renault inFrance,VolkswageninGermany)orindirectlythrough ownershipbystate-ownedbanks(e.g.,France,Korea)–andactedasastableshareholder.Asmentionedabove, countrieslikeSwedenalloweddifferentialvotingrightsfor differentclassesofshares,whichenabledthefounding familiestoretainsignificantcontroloverthecorporation whileraisingadditionalcapital.Insomecountries,thereare formalrepresentationsbyworkers,whohaveagreaterlongtermorientationthanfloatingshareholders,incompany management(e.g.,thepresenceofunionrepresentativeson companysupervisoryboardsinGermany).InJapan, companieshaveminimizedtheinfluenceoffloating shareholdersthroughcross-shareholdingamongfriendly companies.Asaresult,professionalmanagersandfloating shareholdershavefounditmuchmoredifficulttoformthe ‘unholyalliance’inthesecountries,eventhoughtheytoo prefertheshareholder-value-maximizationmodel,givenits obviousbenefitstothem.

Beingheavilyinfluenced,ifnottotallycontrolled,by longer-termstakeholders,companiesinthesecountriesdo notaseasilysackworkers,squeezesuppliers,neglect investmentanduseprofitsfordividendsandshare buybacksasAmericanandBritishcompaniesdo.Allthis meansthatinthelongruntheymaybemoreviablethanthe AmericanortheBritishcompanies.Justthinkabouttheway inwhichGeneralMotorshassquandereditsabsolute dominanceoftheworldcarindustryandfinallygone bankruptwhilebeingontheforefrontofshareholdervalue maximizationbyconstantlydownsizingandrefrainingfrom investment(seeThing18).TheweaknessofGM management’sshort-term-orientedstrategyhasbeen apparentatleastfromthelate1980s,butthestrategy continueduntilitsbankruptcyin2009,becauseitmadeboth themanagersandtheshareholdershappyevenwhile debilitatingthecompany.

Runningcompaniesintheinterestsoffloating shareholdersisnotonlyinequitablebutalsoinefficient,not justforthenationaleconomybutalsoforthecompanyitself. AsJackWelchrecentlyconfessed,shareholdervalueis probablythe‘dumbestideaintheworld’.

be

Whattheytellyou

Inamarketeconomy,peoplearerewardedaccordingto theirproductivity.Bleeding-heartliberalsmayfinditdifficult toacceptthataSwedegetspaidfiftytimeswhatanIndian getspaidforthesamejob,butthatisareflectionoftheir relativeproductivities.Attemptstoreducethesedifferences artificially–forexample,byintroducingminimumwage legislationinIndia–leadonlytounjustandinefficient rewardingofindividualtalentsandefforts.Onlyafreelabour marketcanrewardpeopleefficientlyandjustly.

Whattheydon’ttellyou

Thewagegapsbetweenrichandpoorcountriesexistnot mainlybecauseofdifferencesinindividualproductivitybut mainlybecauseofimmigrationcontrol.Iftherewerefree migration,mostworkersinrichcountriescouldbe,and wouldbe,replacedbyworkersfrompoorcountries.Inother words,wagesarelargelypoliticallydetermined.Theother sideofthecoinisthatpoorcountriesarepoornotbecause oftheirpoorpeople,manyofwhomcanout-competetheir

counterpartsinrichcountries,butbecauseoftheirrich people,mostofwhomcannotdothesame.Thisdoesnot, however,meanthattherichintherichcountriescanpattheir ownbacksfortheirindividualbrilliance.Theirhigh productivitiesarepossibleonlybecauseofthehistorically inheritedcollectiveinstitutionsonwhichtheystand.We shouldrejectthemyththatweallgetpaidaccordingtoour individualworth,ifwearetobuildatrulyjustsociety.

Drivestraighton…ordodgethecow (andtherickshawaswell)

AbusdriverinNewDelhigetspaidaround18rupeesan hour.HisequivalentinStockholmgetspaidaround130 kronas,whichwas,asofsummer2009,around870rupees. Inotherwords,theSwedishdrivergetspaidnearlyfiftytimes thatofhisIndianequivalent.

Free-marketeconomicstellsusthat,ifsomethingismore expensivethananothercomparableproduct,itmustbe becauseitisbetter.Inotherwords,infreemarkets,products (includinglabourservices)getpaidwhattheydeserve.So,if aSwedishdriver–let’scallhimSven–ispaidfiftytimes morethananIndiandriver–let’scallhimRam–itmustbe becauseSvenisfiftytimesmoreproductiveasabusdriver thanRamis.

Intheshortrun,some(althoughnotall)free-market economistsmayadmit,peoplemaypayanexcessivelyhigh priceforaproductbecauseofafadoracraze.For example,peoplepaidludicrouspricesforthose‘toxic assets’intherecentfinancialboom(thathasturnedintothe biggestrecessionsincetheGreatDepression)because theywerecaughtinaspeculativefrenzy.However,they wouldargue,thiskindofthingcannotlastforlong,aspeople figureoutthetruevalueofthingssoonerorlater(seeThing

16).Likewise,evenifanunderqualifiedworkersomehow managestogetawell-paidjobthroughdeceit(e.g., fabricatingacertificate)orbluffinginaninterview,hewill soonbefiredandreplaced,becauseitwillquicklybecome apparentthathedoesnothavetheproductivitytojustifyhis wage.So,thereasoninggoes,ifSvenisgettingpaidfifty timeswhatRamispaid,hemustbeproducingfiftytimes moreoutputthanRam.

Butisthiswhatisreallygoingon?Tobeginwith,isit possiblethatsomeonedrivesfiftytimesbetterthananother? Evenifwesomehowmanagetofindawaytomeasure quantitativelythequalityofdriving,isthiskindofproductivity gapindrivingpossible?Perhapsitis,ifwecompare professionalracingdriverslikeMichaelSchumacheror LewisHamiltonwithsomeparticularlyuncoordinated eighteen-year-oldwhohasjustpassedhisdrivingtest. However,Isimplycannotenvisagehowaregularbusdriver candrivefiftytimesbetterthananother.

Moreover,ifanything,Ramwouldlikelybeamuchmore skilleddriverthanSven.Svenmayofcoursebeagood driverbySwedishstandards,buthasheeverhadtododge acowinhislife,whichRamhastodoregularly?Mostofthe time,whatisrequiredofSvenistheabilitytodrivestraight (OK,giveortakeafewevasivemanoeuvrestodealwith drunkendriversonSaturdaynights),whileRamhasto negotiatehiswayalmosteveryminuteofhisdrivingthrough bullockcarts,rickshawsandbicyclesstackedthreemetres highwithcrates.So,accordingtofree-marketlogic,Ram shouldbepaidmorethanSven,nottheotherwayround.

Inresponse,afree-marketeconomistmightarguethat Svengetspaidmorebecausehehasmore‘humancapital’, thatis,skillsandknowledgeaccumulatedthrougheducation andtraining.Indeed,itisalmostcertainthatSvenhas graduatedfromhighschool,withtwelveyearsofschooling underhisbelt,whereasRamprobablycanbarelyreadand write,havingcompletedonlyfiveyearsofeducationbackin hisvillageinRajahstan.

However,littleofSven’sadditionalhumancapital acquiredinhisextrasevenyearsofschoolingwouldbe relevantforbusdriving(seeThing17).Hedoesnotneed anyknowledgeofhumanchromosomesorSweden’s1809 warwithRussiainordertodrivehisbuswell.SoSven’s extrahumancapitalcannotexplainwhyheispaidfiftytimes morethanRamis.

ThemainreasonthatSvenispaidfiftytimesmorethan Ramis,toputitbluntly,protectionism–Swedishworkers areprotectedfromcompetitionfromtheworkersofIndia andotherpoorcountriesthroughimmigrationcontrol.When youthinkaboutit,thereisnoreasonwhyallSwedishbus drivers,orforthatmatterthebulkoftheworkforcein Sweden(andthatofanyotherrichcountry),couldnotbe replacedbysomeIndians,ChineseorGhanaians.Mostof theseforeignerswouldbehappywithafractionofthewage ratesthatSwedishworkersgetpaid,whileallofthemwould beabletoperformthejobatleastequallywell,oreven better.Andwearenotsimplytalkingaboutlow-skillworkers suchascleanersorstreet-sweepers.Therearehuge numbersofengineers,bankersandcomputerprogrammers waitingoutthereinShanghai,NairobiorQuito,whocan easilyreplacetheircounterpartsinStockholm,Linköping andMalmö.However,theseworkerscannotenterthe Swedishlabourmarketbecausetheycannotfreelymigrate toSwedenduetoimmigrationcontrol.Asaresult,Swedish workerscancommandfiftytimesthewagesofIndian workers,despitethefactthatmanyofthemdonothave productivityratesthatarehigherthanthoseofIndian workers.

proverbialelephantintheroom.Itshowsthattheliving standardsofthehugemajorityofpeopleinrichcountries criticallydependontheexistenceofthemostdraconian controlovertheirlabourmarkets–immigrationcontrol. Despitethis,immigrationcontrolisinvisibletomanyand deliberatelyignoredbyothers,whentheytalkaboutthe virtuesofthefreemarket.

Ihavealreadyargued(seeThing1)thattherereallyisno suchthingasafreemarket,buttheexampleofimmigration controlrevealsthesheerextentofmarketregulationthatwe haveinsupposedlyfree-marketeconomiesbutfailtosee.

Whiletheycomplainaboutminimumwagelegislation, regulationsonworkinghours,andvarious‘artificial’entry barriersintothelabourmarketimposedbytradeunions,few economistsevenmentionimmigrationcontrolasoneof thosenastyregulationshamperingtheworkingsofthefree labourmarket.Hardlyanyofthemadvocatestheabolitionof immigrationcontrol.But,iftheyaretobeconsistent,they shouldalsoadvocatefreeimmigration.Thefactthatfewof themdoonceagainprovesmypointinThing1thatthe boundaryofthemarketispoliticallydeterminedandthat free-marketeconomistsareas‘political’asthosewhowant toregulatemarkets.

Ofcourse,incriticizingtheinconsistencyoffree-market economistsaboutimmigrationcontrol,Iamnotarguingthat immigrationcontrolshouldbeabolished–Idon’tneedtodo thatbecause(asyoumayhavenoticedbynow)Iamnota free-marketeconomist.

Countrieshavetherighttodecidehowmanyimmigrants theyacceptandinwhichpartsofthelabourmarket.All societieshavelimitedcapabilitiestoabsorbimmigrants, whooftenhaveverydifferentculturalbackgrounds,andit wouldbewrongtodemandthatacountrygoesoverthat limit.Toorapidaninflowofimmigrantswillnotonlyleadtoa suddenincreaseincompetitionforjobsbutalsostretchthe physicalandsocialinfrastructures,suchashousingand healthcare,andcreatetensionswiththeresidentpopulation.

Asimportant,ifnotaseasilyquantifiable,istheissueof nationalidentity.Itisamyth–anecessarymyth,butamyth nonetheless–thatnationshaveimmutablenational identitiesthatcannotbe,andshouldnotbe,changed. However,iftherearetoomanyimmigrantscominginatthe sametime,thereceivingsocietywillhaveproblemscreating anewnationalidentity,withoutwhichitmayfinditdifficultto maintainsocialcohesion.Thismeansthatthespeedand thescaleofimmigrationneedtobecontrolled.

Thisisnottosaythatthecurrentimmigrationpoliciesof therichcountriescannotbeimproved.Whileanysociety’s abilitytoabsorbimmigrantsislimited,itisnotasifthetotal populationisfixed.Societiescandecidetobemore,or less,opentoimmigrantsbyadoptingdifferentsocial attitudesandpoliciestowardsimmigration.Alsointermsof thecompositionoftheimmigrants,mostrichcountriesare acceptingtoomany‘wrong’peoplefromthepointofviewof thedevelopingcountries.Somecountriespracticallysell theirpassportsthroughschemesinwhichthosewhobringin morethanacertainamountof‘investment’areadmitted moreorlessimmediately.Thisschemeonlyaddstothe capitalshortagethatmostdevelopingcountriesaresuffering from.Therichcountriesalsocontributetothebraindrain fromdevelopingcountriesbymorewillinglyaccepting peoplewithhigherskills.Thesearepeoplewhocouldhave contributedmoretothedevelopmentoftheirowncountries thanunskilledimmigrants,hadtheyremainedintheirhome countries.

Arepoorcountriespoorbecauseoftheir poorpeople?

Ourstoryaboutthebusdriversnotonlyexposesthemyth thateveryoneisgettingpaidfairly,accordingtoherown

worthinafreemarket,butalsoprovidesuswithan importantinsightintothecauseofpovertyindeveloping countries.

Manypeoplethinkthatpoorcountriesarepoorbecause oftheirpoorpeople.Indeed,therichpeopleinpoor countriestypicallyblametheircountries’povertyonthe ignorance,lazinessandpassivityoftheirpoor.Ifonlytheir fellowcountrymenworkedliketheJapanese,kepttimelike theGermansandwereinventiveliketheAmericans–many ofthesepeoplewouldtellyou,ifyouwouldlisten–their countrywouldbearichone.

Arithmeticallyspeaking,itistruethatpoorpeoplearethe onesthatpulldowntheaveragenationalincomeinpoor countries.Littledotherichpeopleinpoorcountriesrealize, however,thattheircountriesarepoornotbecauseoftheir poorbutbecauseofthemselves.Togobacktoourbus driverexample,theprimaryreasonwhySvenispaidfifty timesmorethanRamisthatheshareshislabourmarket withotherpeoplewhoarewaymorethanfiftytimesmore productivethantheirIndiancounterparts.

EveniftheaveragewageinSwedenisaboutfiftytimes higherthantheaveragewageinIndia,mostSwedesare certainlynotfiftytimesmoreproductivethantheirIndian counterparts.Manyofthem,includingSven,areprobably lessskilled.ButtherearesomeSwedes–thosetop managers,scientistsandengineersinworld-leading companiessuchasEricsson,SaabandSKF–whoare hundredsoftimesmoreproductivethantheirIndian equivalents,soSweden’saveragenationalproductivityends upbeingintheregionoffiftytimesthatofIndia.

Inotherwords,poorpeoplefrompoorcountriesare usuallyabletoholdtheirownagainsttheircounterpartsin richcountries.Itistherichfromthepoorcountrieswho cannotdothat.Itistheirlowrelativeproductivitythatmakes theircountriespoor,sotheirusualdiatribethattheir countriesarepoorbecauseofallthosepoorpeopleistotally misplaced.Insteadofblamingtheirownpoorpeoplefor

draggingthecountrydown,therichofthepoorcountries shouldaskthemselveswhytheycannotpulltherestoftheir countriesupasmuchastherichoftherichcountriesdo.

Finally,awordofwarningtotherichoftherichcountries, lesttheybecomesmug,hearingthattheirownpoorarepaid wellonlybecauseofimmigrationcontrolandtheirownhigh productivity.

Eveninsectorswhererichcountryindividualsare genuinelymoreproductivethantheircounterpartsinpoor countries,theirproductivityisingreatpartduetothesystem, ratherthantheindividualsthemselves.Itisnotsimply,or evenmainly,becausetheyareclevererandbettereducated thatsomepeopleinrichcountriesarehundredsoftimes moreproductivethantheircounterpartsinpoorcountries. Theyachievethisbecausetheyliveineconomiesthathave bettertechnologies,betterorganizedfirms,better institutionsandbetterphysicalinfrastructure–allthingsthat areinlargepartproductsofcollectiveactionstakenover generations(seeThings15and17).WarrenBuffet,the famousfinancier,putthispointbeautifully,whenhesaidina televisioninterviewin1995:‘Ipersonallythinkthatsocietyis responsibleforaverysignificantpercentageofwhatI’ve earned.IfyoustickmedowninthemiddleofBangladeshor Peruorsomeplace,you’llfindouthowmuchthistalentis goingtoproduceinthewrongkindofsoil.Iwillbestruggling thirtyyearslater.Iworkinamarketsystemthathappensto rewardwhatIdoverywell–disproportionatelywell.’

Soweareactuallybacktowherewestarted.Whatan individualispaidisnotfullyareflectionofherworth.Most people,inpoorandrichcountries,getpaidwhattheydo onlybecausethereisimmigrationcontrol.Eventhose citizensofrichcountrieswhocannotbeeasilyreplacedby immigrants,andthusmaybesaidtobereallybeingpaid theirworth(althoughtheymaynot–seeThing14),areas productiveastheyareonlybecauseofthesocio-economic systemtheyareoperatingin.Itisnotsimplybecauseoftheir individualbrillianceandhardworkthattheyareas

Thewidelyacceptedassertionthat,onlyifyouletmarkets be,willeveryonebepaidcorrectlyandthusfairly,according tohisworth,isamyth.Onlywhenwepartwiththismythand graspthepoliticalnatureofthemarketandthecollective natureofindividualproductivitywillwebeabletobuilda morejustsocietyinwhichhistoricallegaciesandcollective actions,andnotjustindividualtalentsandefforts,are properlytakenintoaccountindecidinghowtoreward people.

Thewashingmachinehas changedtheworldmorethan theinternethas

Whattheytellyou

Therecentrevolutionincommunicationstechnologies, representedbytheinternet,hasfundamentallychangedthe wayinwhichtheworldworks.Ithasledtothe‘deathof distance’.Inthe‘borderlessworld’thuscreated,old conventionsaboutnationaleconomicinterestsandtherole ofnationalgovernmentsareinvalid.Thistechnological revolutiondefinestheagewelivein.Unlesscountries(or companiesor,forthatmatter,individuals)changeat correspondingspeeds,theywillbewipedout.We–as individuals,firmsornations–willhavetobecomeevermore flexible,whichrequiresgreaterliberalizationofmarkets. Whattheydon’ttellyou

Inperceivingchanges,wetendtoregardthemostrecent onesasthemostrevolutionary.Thisisoftenatoddswiththe facts.Recentprogressintelecommunicationstechnologies isnotasrevolutionaryaswhathappenedinthelate nineteenthcentury–wiredtelegraphy–inrelativeterms. Moreover,intermsoftheconsequenteconomicandsocial

changes,theinternetrevolutionhas(atleastasyet)notbeen asimportantasthewashingmachineandotherhousehold appliances,which,byvastlyreducingtheamountofwork neededforhouseholdchores,allowedwomentoenterthe labourmarketandvirtuallyabolishedprofessionslike domesticservice.Weshouldnot‘putthetelescope backward’whenwelookintothepastandunderestimatethe oldandoverestimatethenew.Thisleadsustomakeall sortsofwrongdecisionsaboutnationaleconomicpolicy, corporatepoliciesandourowncareers.

EveryonehasamaidinLatinAmerica

AccordingtoanAmericanfriend,theSpanishtextbookthat sheusedinherschoolinthe1970shadasentencesaying (inSpanish,ofcourse)that‘everyoneinLatinAmericahasa maid’.

Whenyouthinkaboutit,thisisalogicalimpossibility.Do maidsalsohavemaidsinLatinAmerica?Perhapsthereis somekindofmaidexchangeschemethatIhavenotheard of,wheremaidstaketurnsinbeingeachother’smaids,so thatallofthemcanhaveamaid,butIdon’tthinkso.

Ofcourse,onecanseewhyanAmericanauthorcould comeupwithsuchastatement.Afarhigherproportionof peopleinpoorcountrieshavemaidsthaninrichcountries.A schoolteacherorayoungmanagerinasmallfirminarich countrywouldnotdreamofhavingalive-inmaid,buttheir counterpartsinapoorcountryarelikelytohaveone–or eventwo.Thefiguresaredifficulttocomeby,but,according toILO(InternationalLabourOrganisation)data,7–8percent ofthelabourforceinBraziland9percentofthatinEgypt areestimatedtobeemployedasdomesticservants.The correspondingfiguresare0.7percentinGermany,0.6per centintheUS,0.3percentinEnglandandWales,0.05per

centinNorwayandaslowas0.005percentinSweden(the figuresareallforthe1990s,exceptforthoseofGermany andNorway,whichareforthe2000s).1So,inproportional terms,Brazilhas12–13timesmoredomesticservantsthan theUSdoesandEgypthas1,800timesmorethanSweden. NowonderthatmanyAmericansthink‘everyone’hasa maidinLatinAmericaandaSwedeinEgyptfeelsthatthe countryispracticallyoverrunwithdomesticservants.

Theinterestingthingisthattheshareofthelabourforce workingasdomesticservantsintoday’srichcountriesused tobesimilartowhatyoufindinthedevelopingcountries today.IntheUS,around8percentofthosewhowere ‘gainfullyemployed’in1870weredomesticservants.The ratiowasalsoaround8percentinGermanyuntilthe1890s, althoughitstartedfallingquitefastafterthat.InEnglandand Wales,wherethe‘servant’culturesurvivedlongerthanin othercountriesduetothestrengthofthelandlordclass,the ratiowasevenhigher–10–14percentoftheworkforcewas employedasdomesticservantsbetween1850and1920 (withsomeupsanddowns).Indeed,ifyoureadAgatha Christienovelsuptothe1930s,youwouldnoticethatitis notjustthepressbaronwhogetsmurderedinhislocked librarywhohasservantsbutalsothehard-upoldmiddleclassspinster,eventhoughshemayhavejustonemaid (whogetsmixedupwithagood-for-nothinggarage mechanic,whoturnsouttobetheillegitimatesonofthe pressbaron,andalsogetsmurderedonp.111forbeing foolishenoughtomentionsomethingthatshewasnot supposedtohaveseen).

Themainreasonwhytherearesomuchfewer(ofcourse, inproportionalterms)domesticservantsintherichcountries –althoughobviouslynottheonlyreason,giventhecultural differencesamongcountriesatsimilarlevelsofincome, todayandinthepast–isthehigherrelativepriceoflabour. Witheconomicdevelopment,people(orratherthelabour servicestheyoffer)becomemoreexpensiveinrelative termsthan‘things’(seealsoThing9).Asaresult,inrich

countries,domesticservicehasbecomealuxurygoodthat onlytherichcanafford,whereasitisstillcheapenoughto beconsumedevenbylower-middle-classpeoplein developingcountries.

Enterthewashingmachine

Now,whateverthemovementsintherelativepricesof ‘people’and‘things’,thefallintheshareofpeopleworking asdomesticservantswouldnothavebeenasdramaticasit hasbeenintherichcountriesoverthelastcentury,hadthere notbeenthesupplyofahostofhouseholdtechnologies, whichIhaverepresentedbythewashingmachine.However expensive(inrelativeterms)itmaybetohirepeoplewho canwashclothes,cleanthehouse,heatthehouse,cookand dothedishes,theywouldstillhavetobehired,ifthese thingscouldnotbedonebymachines.Oryouwouldhaveto spendhoursdoingthesethingsyourselves.

Washingmachineshavesavedmountainsoftime.The dataarenoteasytocomeby,butamid1940sstudybythe USRuralElectrificationAuthorityreportsthat,withthe introductionoftheelectricwashingmachineandelectric iron,thetimerequiredforwashinga38lbloadoflaundry wasreducedbyafactorofnearly6(from4hoursto41 minutes)andthetimetakentoironitbyafactorofmorethan 2.5(from4.5hoursto1.75hours).2Pipedwaterhasmeant thatwomendonothavetospendhoursfetchingwater(for which,accordingtotheUnitedNationsDevelopment Program,uptotwohoursperdayarespentinsome developingcountries).Vacuumcleanershaveenabledusto cleanourhousesmorethoroughlyinafractionofthetime thatwasneededintheolddays,whenwehadtodoitwith broomandrags.Gas/electrickitchenstovesandcentral heatinghavevastlyreducedthetimeneededforcollecting

firewood,makingfires,keepingthefiresalive,andcleaning afterthemforheatingandcookingpurposes.Todaymany peopleinrichcountriesevenhavethedishwasher,whose (future)inventoracertainMrI.M.Rubinow,anemployeeof theUSDepartmentofAgriculture,saidwouldbe‘atrue benefactorofmankind’inhisarticleintheJournalof PoliticalEconomyin1906.

Theemergenceofhouseholdappliances,aswellas electricity,pipedwaterandpipedgas,hastotally transformedthewaywomen,andconsequentlymen,live. Theyhavemadeitpossibleforfarmorewomentojointhe labourmarket.Forexample,intheUS,theproportionof marriedwhitewomeninprimeworkingages(35–44years) whoworkoutsidethehomerosefromafewpercentinthe late1890stonearly80percenttoday.3Ithasalsochanged thefemaleoccupationalstructuredramaticallybyallowing societytogetbywithfarfewerpeopleworkingasdomestic servants,aswehaveseenabove–forexample,inthe 1870s,nearly50percentofwomenemployedintheUS wereemployedas‘servantsandwaitresses’(mostofwhom wecantaketohavebeenservantsratherthanwaitresses, giventhateatingoutwasnotyetbigbusiness).4Increased labourmarketparticipationhasdefinitelyraisedthestatusof womenathomeandinsociety,thusalsoreducing preferenceformalechildrenandincreasinginvestmentin femaleeducation,whichthenfurtherincreasesfemale labourmarketparticipation.Eventhoseeducatedwomen whointheendchoosetostayathomewiththeirchildren havehigherstatusathome,astheycanmakecredible threatsthattheycansupportthemselvesshouldtheydecide toleavetheirpartners.Withoutsideemployment opportunities,theopportunitycostsofchildrenhaverisen, makingfamilieshavefewerchildren.Allofthesehave changedthetraditionalfamilydynamics.Takentogether, theyconstitutereallypowerfulchanges.

Ofcourse,Iamnotsayingthatthesechangeshave happenedonly–orevenpredominantly–becauseof

changesinhouseholdtechnologies.The‘pill’andother contraceptiveshavehadapowerfulimpactonfemale educationandlabourmarketparticipationbyallowing womentocontrolthetimingandthefrequencyoftheir childbirths.Andtherearenon-technologicalcauses.Even withthesamehouseholdtechnologies,countriescanhave quitedifferentfemalelabourmarketparticipationratiosand differentoccupationstructures,dependingonthingslike socialconventionsregardingtheacceptabilityofmiddleclasswomenworking(poorwomenhavealwaysworked), taxincentivesforpaidworkandchildrearing,andthe affordabilityofchildcare.Havingsaidallthis,however,itis stilltruethat,withoutthewashingmachine(andotherlaboursavinghouseholdtechnologies),thescaleofchangeinthe roleofwomeninsocietyandinfamilydynamicswouldnot havebeennearlyasdramatic.

Thewashingmachinebeatstheinternet

Comparedtothechangesbroughtaboutbythewashing machine(andcompany),theimpactoftheinternet,which manythinkhastotallychangedtheworld,hasnotbeenas fundamental–atleastsofar.Theinternethas,ofcourse, transformedthewaypeoplespendtheirout-of-workhours–surfingthenet,chattingwithfriendsonFacebook,talkingto themonSkype,playingelectronicgameswithsomeone who’ssitting5,000milesaway,andwhatnot.Ithasalso vastlyimprovedtheefficiencywithwhichwecanfind informationaboutourinsurancepolicies,holidays, restaurants,andincreasinglyeventhepriceofbroccoliand shampoo.

However,whenitcomestoproductionprocesses,itis notclearwhethertheimpactshavebeensorevolutionary.To besure,forsome,theinternethasprofoundlychangedthe

wayinwhichtheywork.Iknowthatbyexperience.Thanksto theinternet,Ihavebeenabletowriteawholebookwithmy friendandsometimeco-author,ProfessorIleneGrabel,who teachesinDenver,Colorado,withonlyoneface-to-face meetingandoneortwophonecalls.5However,formany otherpeople,theinternethasnothadmuchimpacton productivity.Studieshavestruggledtofindthepositive impactoftheinternetonoverallproductivity–asRobert Solow,theNobellaureateeconomist,putit,‘theevidenceis everywherebutinnumbers’.

Youmaythinkthatmycomparisonisunfair.The householdappliancesthatImentionhavehadatleastafew decades,sometimesacentury,toworktheirmagic, whereastheinternetisbarelytwodecadesold.Thisispartly true.Asthedistinguishedhistorianofscience,David Edgerton,saidinhisfascinatingbookTheShockoftheOld –TechnologyandGlobalHistorySince1900,the maximumuseofatechnology,andthusthemaximum impact,isoftenachieveddecadesaftertheinventionofthe technology.Butevenintermsofitsimmediateimpact,I doubtwhethertheinternetistherevolutionarytechnology thatmanyofusthinkitis.

Theinternetisbeatenbythetelegraph

Justbeforethestartofthetrans-Atlanticwiredtelegraph servicein1866,ittookaboutthreeweekstosenda messagetotheothersideofthe‘pond’–thetimeittookto crosstheAtlanticbysailships.Evengoing‘express’ona steamship(whichdidnotbecomeprevalentuntilthe1890s), youhadtoallowtwoweeks(therecordcrossingsofthetime wereeighttoninedays).

Withthetelegraph,thetransmissiontimefor,say,a300wordmessagewasreducedto7or8minutes.Itcouldeven

bequickerstill.TheNewYorkTimesreportedon4 December1861thatAbrahamLincoln’sStateoftheUnion addressof7,578wordswastransmittedfromWashington, DCtotherestofthecountryin92minutes,givingan averageof82wordsperminute,whichwouldhaveallowed youtosendthe300-wordmessageinlessthan4minutes. Butthatwasarecord,andtheaveragewasmorelike40 wordsperminute,givingus7.5minutesfora300-word message.Areductionfrom2weeksto7.5minutesisbya factorofover2,500times.

Theinternetreducedthetransmissiontimeofa300-word messagefrom10secondsonthefaxmachineto,say,2 seconds,butthisisonlyareductionbyafactorof5.The speedreductionbytheinternetisgreaterwhenitcomesto longermessages–itcansendin10seconds(considering thatithastobeloaded),say,a30,000-worddocument, whichwouldhavetakenmorethan16minutes(or1,000 seconds)onthefaxmachine,givingusanaccelerationin transmissionspeedof100times.Butcomparethattothe 2,500-timereductionachievedbythetelegraph.

Theinternetobviouslyhasotherrevolutionaryfeatures.It allowsustosendpicturesathighspeed(somethingthat eventelegraphorfaxcouldnotdoandthusreliedon physicaltransportation).Itcanbeaccessedinmanyplaces, notjustinpostoffices.Mostimportantly,usingit,wecan searchforparticularinformationwewantfromavastnumber ofsources.However,intermsofsheeraccelerationin speed,itisnowherenearasrevolutionaryasthehumble wired(notevenwireless)telegraphy.

Wevastlyoverestimatetheimpactsoftheinternetonly becauseitisaffectingusnow.Itisnotjustus.Humanbeings tendtobefascinatedbythenewestandthemostvisible technologies.Alreadyin1944,GeorgeOrwellcriticized peoplewhogotoverexcitedbythe‘abolitionofdistance’ andthe‘disappearanceoffrontiers’thankstotheaeroplane andtheradio.

Puttingchangesintoperspective

Whocaresifpeoplethinkwronglythattheinternethashad moreimportantimpactsthantelegraphyorthewashing machine?Whydoesitmatterthatpeoplearemore impressedbythemostrecentchanges?

Itwouldnotmatterifthisdistortionofperspectiveswas justamatterofpeople’sopinions.However,thesedistorted perspectiveshaverealimpacts,astheyresultinmisguided useofscarceresources.

ThefascinationwiththeICT(Informationand CommunicationTechnology)revolution,representedbythe internet,hasmadesomerichcountries–especiallytheUS andBritain–wronglyconcludethatmakingthingsisso ‘yesterday’thattheyshouldtrytoliveonideas.AndasI explaininThing9,thisbeliefin‘post-industrialsociety’has ledthosecountriestoundulyneglecttheirmanufacturing sector,withadverseconsequencesfortheireconomies.

Evenmoreworryingly,thefascinationwiththeinternetby peopleinrichcountrieshasmovedtheinternational communitytoworryaboutthe‘digitaldivide’betweenthe richcountriesandthepoorcountries.Thishasled companies,charitablefoundationsandindividualstodonate moneytodevelopingcountriestobuycomputerequipment andinternetfacilities.Thequestion,however,iswhetherthis iswhatthedevelopingcountriesneedthemost.Perhaps givingmoneyforthoselessfashionablethingssuchas diggingwells,extendingelectricitygridsandmakingmore affordablewashingmachineswouldhaveimproved people’slivesmorethangivingeverychildalaptop computerorsettingupinternetcentresinruralvillages.Iam notsayingthatthosethingsarenecessarilymoreimportant, butmanydonorshaverushedintofancyprogrammes withoutcarefullyassessingtherelativelong-termcostsand

benefitsofalternativeusesoftheirmoney.

Inyetanotherexample,afascinationwiththenewhasled peopletobelievethattherecentchangesinthe technologiesofcommunicationsandtransportationareso revolutionarythatnowweliveina‘borderlessworld’,asthe titleofthefamousbookbyKenichiOhmae,theJapanese businessguru,goes.6Asaresult,inthelasttwentyyearsor so,manypeoplehavecometobelievethatwhateverchange ishappeningtodayistheresultofmonumentaltechnological progress,goingagainstwhichwillbeliketryingtoturnthe clockback.Believinginsuchaworld,manygovernments havedismantledsomeoftheverynecessaryregulationson cross-borderflowsofcapital,labourandgoods,withpoor results(forexample,seeThings7and8).However,asI haveshown,therecentchangesinthosetechnologiesare notnearlyasrevolutionaryasthecorrespondingchangesof acenturyago.Infact,theworldwasalotmoreglobalizeda centuryagothanitwasbetweenthe1960sandthe1980s despitehavingmuchinferiortechnologiesofcommunication andtransportation,becauseinthelatterperiod governments,especiallythepowerfulgovernments,believed intougherregulationsofthesecross-borderflows.Whathas determinedthedegreeofglobalization(inotherwords, nationalopenness)ispolitics,ratherthantechnology. However,ifweletourperspectivebedistortedbyour fascinationwiththemostrecenttechnologicalrevolution,we cannotseethispointandendupimplementingthewrong policies.

Understandingtechnologicaltrendsisveryimportantfor correctlydesigningeconomicpolicies,bothatthenational andtheinternationallevels(andformakingtherightcareer choicesattheindividuallevel).However,ourfascinationwith thelatest,andourunder-valuationofwhathasalready becomecommon,can,andhas,ledusinallsortsofwrong directions.Ihavemadethispointdeliberatelyprovocatively bypittingthehumblewashingmachineagainsttheinternet, butmyexamplesshouldhaveshownyouthatthewaysin

whichtechnologicalforceshaveshapedeconomicand socialdevelopmentsundercapitalismaremuchmore complexthanisusuallybelieved.

Whattheytellyou

AdamSmithfamouslysaid:‘Itisnotfromthebenevolenceof thebutcher,thebrewer,orthebakerthatweexpectour dinner,butfromtheirregardtotheirowninterest.’The marketbeautifullyharnessestheenergyofselfishindividuals thinkingonlyofthemselves(and,atmost,theirfamilies)to producesocialharmony.Communismfailedbecauseit deniedthishumaninstinctandrantheeconomyassuming everyonetobeselfless,oratleastlargelyaltruistic.Wehave toassumetheworstaboutpeople(thatis,theyonlythink aboutthemselves),ifwearetoconstructadurable economicsystem.

Whattheydon’ttellyou

Self-interestisamostpowerfultraitinmosthumanbeings. However,it’snotouronlydrive.Itisveryoftennotevenour primarymotivation.Indeed,iftheworldwerefulloftheselfseekingindividualsfoundineconomicstextbooks,itwould grindtoahaltbecausewewouldbespendingmostofour timecheating,tryingtocatchthecheaters,andpunishingthe caught.Theworldworksasitdoesonlybecausepeopleare

notthetotallyself-seekingagentsthatfree-market economicsbelievesthemtobe.Weneedtodesignan economicsystemthat,whileacknowledgingthatpeopleare oftenselfish,exploitsotherhumanmotivestothefulland getsthebestoutofpeople.Thelikelihoodisthat,ifwe assumetheworstaboutpeople,wewillgettheworstoutof them.

How(not)torunacompany

Inthemid1990s,IwasattendingaconferenceinJapanon the‘EastAsiangrowthmiracle’,organizedbytheWorld Bank.Ononesideofthedebatewerepeoplelikemyself, arguingthatgovernmentinterventionhadplayedapositive roleintheEastAsiangrowthstorybygoingagainstmarket signalsandprotectingandsubsidizingindustriessuchas automobilesandelectronics.Ontheotherside,therewere economistssupportingtheWorldBank,whoarguedthat governmentinterventionhadatbestbeenanirrelevant sideshoworatworstdonemoreharmthangoodinEast Asia.Moreimportantly,theyadded,evenifitweretruethat theEastAsianmiracleowedsomethingtogovernment intervention,thatdoesnotmeanthatpoliciesusedbythe EastAsiancountriescanberecommendedtoother countries.Governmentofficialswhomakepoliciesare(like allofus)self-seekingagents,itwaspointedout,more interestedinexpandingtheirownpowerandprestigerather thanpromotingnationalinterests.Theyarguedthat governmentinterventionworkedinEastAsiaonlybecause theyhadexceptionallyselflessandcapablebureaucratsfor historicalreasons(whichweneednotgointohere).Even someoftheeconomistswhoweresupportinganactiverole forgovernmentconcededthispoint.

Listeningtothisdebate,adistinguished-looking

Japanesegentlemanintheaudienceraisedhishand. IntroducinghimselfasoneofthetopmanagersofKobe Steel,thethenfourth-largeststeelproducerinJapan,the gentlemanchidedtheeconomistsformisunderstandingthe natureofmodernbureaucracy,beitinthegovernmentorin theprivatesector.

TheKobeSteelmanagersaid(Iam,ofcourse, paraphrasinghim):‘Iamsorrytosaythis,butyou economistsdon’tunderstandhowtherealworldworks.I haveaPhDinmetallurgyandhavebeenworkinginKobe Steelfornearlythreedecades,soIknowathingortwo aboutsteel-making.However,mycompanyisnowsolarge andcomplexthatevenIdonotunderstandmorethanhalfthe thingsthataregoingonwithinit.Asfortheothermanagers –withbackgroundsinaccountingandmarketing–they reallyhaven’tmuchofaclue.Despitethis,ourboardof directorsroutinelyapprovesthemajorityofprojects submittedbyouremployees,becausewebelievethatour employeesworkforthegoodofthecompany.Ifwe assumedthateveryoneisouttopromotehisowninterests andquestionedthemotivationsofouremployeesallthe time,thecompanywouldgrindtoahalt,aswewouldspend allourtimegoingthroughproposalsthatwereallydon’t understand.Yousimplycannotrunalargebureaucratic organization,beitKobeSteeloryourgovernment,ifyou assumethateveryoneisoutforhimself.’

Thisismerelyananecdote,butitisapowerfultestimony tothelimitationsofstandardeconomictheory,which assumesthatself-interestistheonlyhumanmotivationthat counts.Letmeelaborate.

Selfishbutchersandbakers

economicagentsareselfish,assummedupinAdam Smith’sassessmentofthebutcher,thebrewerandthe baker.Thebeautyofthemarketsystem,theycontend,isthat itchannelswhatseemstobetheworstaspectofhuman nature–self-seeking,orgreed,ifyoulike–intosomething productiveandsociallybeneficial.

Giventheirselfishnature,shopkeeperswilltrytooverchargeyou,workerswilltrytheirbesttogoofofffromwork, andprofessionalmanagerswilltrytomaximizetheirown salariesandprestigeratherthanprofits,whichgotothe shareholdersratherthanthemselves.However,thepowerof themarketwillputstrictlimitsto,ifnotcompletelyeliminate, thesebehaviours:shopkeeperswon’tcheatyouiftheyhave acompetitoraroundthecorner;workerswouldnotdareto slackoffiftheyknowtheycanbeeasilyreplaced;hired managerswillnotbeabletofleecetheshareholdersifthey operateinavibrantstockmarket,whichwillensurethat managerswhogeneratelowerprofits,andthuslowershare prices,risklosingtheirjobsthroughtakeover.

Tofree-marketeconomists,publicofficials–politicians andgovernmentbureaucrats–poseauniquechallengein thisregard.Theirpursuitofself-interestcannotberestrained toanymeaningfuldegreebecausetheyarenotsubjectto marketdiscipline.Politiciansdofacesomecompetition fromeachother,butelectionshappensoinfrequentlythat theirdisciplinaryeffectsarelimited.Consequently,thereis plentyofscopeforthemtopursuepoliciesthatheighten theirpowerandwealth,atthecostofnationalwelfare.When itcomestothecareerbureaucrats,thescopeforselfseekingisevengreater.Eveniftheirpoliticalmasters,the politicians,trytomakethemimplementpoliciesthatcaterto electoraldemands,theycanalwaysobfuscateand manipulatethepoliticians,aswassobrilliantlydepictedin theBBCcomedyseriesYes,Ministeranditssequel,Yes, PrimeMinister.Moreover,unlikethepoliticians,these careerbureaucratshavehighjobsecurity,ifnotlifetime tenure,sotheycanwaitouttheirpoliticalmastersbysimply

delayingthings.Thisisthecruxoftheconcernsthatthe WorldBankeconomistswereexpressinginthemeetingin JapanthatImentionedatthebeginningofthisThing. Therefore,free-marketeconomistsrecommend,the portionoftheeconomycontrolledbypoliticiansand bureaucratsshouldbeminimized.Deregulationand privatization,inthisview,arenotonlyeconomicallyefficient butalsopoliticallysensibleinthattheyminimizethevery possibilitythatpublicofficialscanusethestateasavehicle topromotetheirownself-interests,atthecostofthegeneral public.Some–theso-called‘NewPublicManagement’ school–goevenfurtherandrecommendthatthe managementofthegovernmentitselfshouldbeexposedto greatermarketforces:amoreaggressiveuseof performance-relatedpayandshort-termcontractsfor bureaucrats;morefrequentcontracting-outofgovernment services;amoreactiveexchangeofpersonnelbetweenthe publicandtheprivatesectors.

Wemaynotbeangels,but…

Theassumptionofself-seekingindividualism,whichisatthe foundationoffree-marketeconomics,hasalotofresonance withourpersonalexperiences.Wehaveallbeencheatedby unscrupuloustraders,beitthefruitsellerwhoputsome rottenplumsatthebottomofthepaperbagortheyoghurt companythatvastlyexaggeratedthehealthbenefitsofit products.Weknowtoomanycorruptpoliticiansandlazy bureaucratstobelievethatallpublicservantsaresolely servingthepublic.Mostofus,myselfincluded,havegoofed offfromworkourselvesandsomeofushavebeenfrustrated byjuniorcolleaguesandassistantswhofindallkindsof excusesnottoputinseriouswork.Moreover,whatweread inthenewsmediathesedaystellsusthatprofessional

managers,eventhesupposedchampionsofshareholder interestsuchasJackWelchofGEandRickWagonerof GM,havenotreallybeenservingthebestinterestsofthe shareholders(seeThing2).

Thisisalltrue.However,wealsohavealotofevidence–notjustanecdotesbutsystematicevidence–showingthat self-interestisnottheonlyhumanmotivationthatmatters eveninoureconomiclife.Self-interest,tobesure,isoneof themostimportant,butwehavemanyothermotives–honesty,self-respect,altruism,love,sympathy,faith,sense ofduty,solidarity,loyalty,public-spiritedness,patriotism,and soon–thataresometimesevenmoreimportantthanselfseekingasthedriverofourbehaviours.1

OurearlierexampleofKobeSteelshowshowsuccessful companiesarerunontrustandloyalty,ratherthansuspicion andself-seeking.Ifyouthinkthisisapeculiarexamplefrom acountryof‘workerants’thatsuppressesindividuality againsthumannature,pickupanybookonbusiness leadershiporanyautobiographybyasuccessful businessmanpublishedintheWestandseewhattheysay. Dotheysaythatyouhavetosuspectpeopleandwatchthem allthetimeforslackingandcheating?No,theyprobablytalk mostlyabouthowto‘connect’withtheemployees,change thewaytheyseethings,inspirethem,andpromote teamworkamongthem.Goodmanagersknowthatpeople arenottunnel-visionedself-seekingrobots.Theyknowthat peoplehave‘good’sidesand‘bad’sidesandthatthe secretofgoodmanagementisinmagnifyingtheformerand toningdownthelatter.

Anothergoodexampletoillustratethecomplexityof humanmotivationisthepracticeof‘worktorule’,where workersslowdownoutputbystrictlyfollowingtherulesthat governtheirtasks.Youmaywonderhowworkerscanhurt theiremployerbyworkingaccordingtotherule.However, thissemi-strikemethod–knownalsoas‘Italianstrike’(and as‘scioperobianco’,or‘whitestrike’,byItalians themselves)–isknowntoreduceoutputby30–50percent.

Thisisbecausenoteverythingcanbespecifiedin employmentcontracts(rules)andthereforeallproduction processesrelyheavilyontheworkers’goodwilltodoextra thingsthatarenotrequiredbytheircontractsorexercise initiativesandtakeshortcutsinordertoexpeditethings, whentherulesaretoocumbersome.Themotivationsbehind suchnon-selfishbehavioursbyworkersarevaried–fondnessoftheirjobs,prideintheirworkmanship,selfrespect,solidaritywiththeircolleagues,trustintheirtop managersorloyaltytothecompany.Butthebottomlineis thatcompanies,andthusoureconomy,wouldgrindtoahalt ifpeopleactedinatotallyselfishway,astheyareassumed todoinfree-marketeconomics.

Notrealizingthecomplexnatureofworkermotivation,the capitalistsoftheearlymass-productionerathoughtthat,by totallydeprivingworkersofdiscretionoverthespeedand theintensityoftheirworkandthustheirabilitytoshirk,the conveyorbeltwouldmaximizetheirproductivity.However,as thosecapitalistssoonfoundout,theworkersreactedby becomingpassive,un-thinkingandevenuncooperative, whentheyweredeprivedoftheirautonomyanddignity.So, startingwiththeHumanRelationsSchoolthatemergedin the1930s,whichhighlightedtheneedforgood communicationswith,andamong,workers,many managerialapproacheshaveemergedthatemphasizethe complexityofhumanmotivationandsuggestwaystobring thebestoutofworkers.Thepinnacleofsuchanapproachis theso-called‘Japaneseproductionsystem’(sometimes knownasthe‘Toyotaproductionsystem’),whichexploitsthe goodwillandcreativityoftheworkersbygivingthem responsibilitiesandtrustingthemasmoralagents.Inthe Japanesesystem,workersaregivenaconsiderabledegree ofcontrolovertheproductionline.Theyarealsoencouraged tomakesuggestionsforimprovingtheproductionprocess. ThisapproachhasenabledJapanesefirmstoachievesuch productionefficiencyandqualitythatnowmanynonJapanesecompaniesareimitatingthem.Bynotassuming

theworstabouttheirworkers,theJapanesecompanies havegotthebestoutofthem.

Moralbehaviourasanopticalillusion?

So,ifyoulookaroundandthinkaboutit,theworldseemsto befullofmoralbehavioursthatgoagainsttheassumptions offree-marketeconomists.Whentheyareconfrontedwith thesebehaviours,free-marketeconomistsoftendismiss themas‘opticalillusions’.Ifpeoplelookasiftheyare behavingmorally,theyargue,itisonlybecausethe observersdonotseethehiddenrewardsandsanctionsthat theyarerespondingto.

Accordingtothislineofreasoning,peoplealwaysremain self-seekers.Iftheybehavemorally,itisnotbecausethey believeinthemoralcodeitselfbutbecausebehavinginthat waymaximizesrewardsandminimizespunishmentsfor thempersonally.Forexample,iftradersrefrainfrom cheatingevenwhenthereisnolegalcompulsionorwhen therearenocompetitorsreadytotakeawaytheir businesses,itdoesnotmeanthattheybelieveinhonesty.It isbecausetheyknowthathavingareputationasanhonest traderbringsinmorecustomers.Ormanytouristswho behavebadlywouldnotdothesameathome,notbecause theysuddenlybecomedecentpeoplewhentheygoback homebutbecausetheydonothavetheanonymityofa touristandthereforeareafraidofbeingcriticizedorshunned bypeopletheyknowandcareabout.

Thereissometruthinthis.Therearesubtlerewardsand sanctionsthatarenotimmediatelyvisibleandpeopledo respondtothem.However,thislineofreasoningdoesnot workintheend.

Thefactisthat,evenwhentherearenohiddenrewardand-sanctionmechanismsatwork,manyofusbehave

honestly.Forexample,whydowe–oratleastthoseofus whoaregoodrunners–notrunawaywithoutpayingaftera taxiride?2Thetaxidrivercannotreallychaseusfar,ashe cannotabandonhiscarfortoolong.Ifyouarelivinginabig city,thereisvirtuallynochancethatyouwillmeetthesame driveragain,soyouneednotevenbeafraidofthetaxidriver retaliatinginsomewayinthefuture.Givenallthis,itisquite remarkablethatsofewpeoplerunawaywithoutpayingafter ataxiride.Totakeanotherexample,onaforeignholiday someofyoumayhavecomeacrossagaragemechanicor astreetvendorwhodidnotcheatyou,evenwhenthere reallywasnowayforyoutorewardherbyspreadingher reputationforhonestdealings–particularlydifficultwhenyou cannotevenspelltheTurkishgarage’snameorwhenyour Cambodiannoodlelady,whosenameyoucannotremember anyway,maynoteventradeinthesameplaceeveryday.

Moreimportantly,inaworldpopulatedbyselfish individuals,theinvisiblereward/sanctionmechanismcannot exist.Theproblemisthatrewardingandpunishingothersfor theirbehaviourscoststimeandenergyonlytothe individualstakingtheaction,whiletheirbenefitsfrom improvedbehaviouralstandardsaccruetoeveryone.Going backtoourexamplesabove,ifyou,asataxidriver,wantto chaseandbeatuparunawaycustomer,youmayhaveto riskgettingfinedforillegalparkingorevenhavingyourtaxi brokeninto.Butwhatisthechanceofyoubenefitingfroman improvedstandardofbehaviourbythatpassenger,whoyou maynotmeeteveragain?Itwouldcostyoutimeandenergy tospreadthegoodwordaboutthatTurkishgarage,butwhy shouldyoudothatifyouwillprobablynevervisitthatpartof theworldeveragain?So,asaself-seekingindividual,you waitforsomeonefoolishenoughtospendhistimeand energyinadministeringprivatejusticetowaywardtaxi passengersorhonestout-of-the-waygarages,ratherthan payingthecostsyourself.However,ifeveryonewereaselfinterestedindividuallikeyou,everyonewoulddoasyoudo.

Asaresult,noonewouldrewardandpunishothersfortheir

goodorbadbehaviour.Inotherwords,thoseinvisible reward/sanctionmechanismsthatfree-marketeconomists saycreatetheopticalillusionofmoralitycanexistonly becausewearenottheselfish,amoralagentsthatthose economistssayweare.

Moralityisnotanopticalillusion.Whenpeopleactina non-selfishway–beitnotcheatingtheircustomers,working harddespitenoonewatchingthem,orresistingbribesas anunderpaidpublicofficial–many,ifnotall,ofthemdoso becausetheygenuinelybelievethatthatistherightthingto do.Invisiblerewardsandsanctionsmechanismsdomatter, buttheycannotexplainall–or,inmyview,eventhemajority of–non-selfishbehaviours,ifonlyforthesimplereasonthat theywouldnotexistifwewereentirelyselfish.Contraryto MrsThatcher’sassertionthat‘thereisnosuchthingas society.Thereareindividualmenandwomen,andthereare families’,humanbeingshaveneverexistedasatomistic selfishagentsunboundbyanysociety.Weareborninto societieswithcertainmoralcodesandaresocializedinto ‘internalizing’thosemoralcodes.

Ofcourse,allthisisnottodenythatself-seekingisoneof themostimportanthumanmotivations.However,ifeveryone werereallyonlyouttoadvancehisowninterest,theworld wouldhavealreadygroundtoahalt,astherewouldbeso muchcheatingintradingandslackinginproduction.More importantly,ifwedesignoureconomicsystembasedon suchanassumption,theresultislikelytobelower,rather thanhigher,efficiency.Ifwedidthat,peoplewouldfeelthat theyarenottrustedasmoralagentsandrefusetoactin moralways,makingitnecessaryforustospendahuge amountofresourcesmonitoring,judgingandpunishing people.Ifweassumetheworstaboutpeople,wewillgetthe worstoutofthem.

Whattheytellyou

Untilthe1970s,inflationwastheeconomy’spublicenemy numberone.Manycountriessufferedfromdisastrous hyperinflationexperiences.Evenwhenitdidnotreacha hyperinflationarymagnitude,theeconomicinstabilitythat comesfromhighandfluctuatinginflationdiscouraged investmentandthusgrowth.Fortunately,thedragonof inflationhasbeenslainsincethe1990s,thankstomuch tougherattitudestowardsgovernmentbudgetdeficitsand theincreasingintroductionofpoliticallyindependentcentral banksthatarefreetofocussingle-mindedlyoninflation control.Giventhateconomicstabilityisnecessaryforlongterminvestmentandthusgrowth,thetamingofthebeast calledinflationhaslaidthebasisforgreaterlong-term prosperity.

Inflationmayhavebeentamed,buttheworldeconomyhas becomeconsiderablyshakier.Theenthusiastic

duringthelastthreedecadeshaveignoredtheextraordinary instabilityshownbyeconomiesaroundtheworldduringthat time.Therehavebeenahugenumberoffinancialcrises, includingthe2008globalfinancialcrisis,destroyingthelives ofmanythroughpersonalindebtedness,bankruptcyand unemployment.Anexcessivefocusoninflationhas distractedourattentionawayfromissuesoffullemployment andeconomicgrowth.Employmenthasbeenmademore unstableinthenameof‘labourmarketflexibility’, destabilizingmanypeople’slives.Despitetheassertionthat pricestabilityisthepreconditionofgrowth,thepoliciesthat wereintendedtobringlowerinflationhaveproducedonly anaemicgrowthsincethe1990s,wheninflationissupposed tohavefinallybeentamed.

That’swherethemoneyis–orisit?

InJanuary1923,FrenchandBelgiantroopsoccupiedthe RuhrregionofGermany,knownforitscoalandsteel.This wasbecause,during1922,theGermansseriouslyfell behindthereparationpaymentsdemandedofthembythe VersaillesTreaty,whichhadconcludedtheFirstWorldWar.

Hadtheywantedmoney,however,theFrenchandthe Belgiansshouldhaveoccupiedthebanks–afterall,‘that’s wherethemoneyis’,asthefamousAmericanbankrobber WillieSuttonallegedlysaid,whenaskedwhyherobbed banks–ratherthanabunchofcoalminesandsteelmills. Whydidn’ttheydothat?Itwasbecausetheywereworried aboutGermaninflation.

Sincethesummerof1922,inflationinGermanyhadbeen gettingoutofcontrol.Thecostoflivingindexrosebysixteen timesinsixmonthsinthesecondhalfof1922.Ofcourse, thehyperinflationwasatleastinpartcausedbytheonerous reparationdemandsbytheFrenchandtheBelgians,but

onceitstarted,itwasentirelyrationalfortheFrenchandthe BelgianstooccupytheRuhrinordertomakesurethatthey werepaidtheirwarreparationsingoods,suchascoaland steel,ratherthaninworthlesspaper,whosevaluewould diminishrapidly.

Theywererighttodoso.Germaninflationgotcompletely outofcontrolaftertheoccupationoftheRuhr,withprices risingbyanother10billiontimes(yes,billion,notthousand orevenmillion)untilNovember1923,whenRentenmark,the newcurrency,wasintroduced.

TheGermanhyperinflationhasleftbigandlong-lasting marksontheevolutionofGerman,andworld,history.Some claim,withjustification,thattheexperienceofhyperinflation laidthegroundsfortheriseoftheNazisbydiscreditingthe liberalinstitutionsoftheWeimarRepublic.Thosewhotake thisviewarethenimplicitlysayingthatthe1920sGerman hyperinflationwasoneofthemaincausesoftheSecond WorldWar.TheGermantraumafromthehyperinflationwas suchthattheBundesbank,theWestGermancentralbank aftertheSecondWorldWar,wasfamousforitsexcessive aversiontoloosemonetarypolicy.Evenafterthebirthofthe Europeansinglecurrency,theeuro,andtheconsequentde factoabolitionofnationalcentralbanksintheEurozone countries,Germany’sinfluencehasmadetheEuropean CentralBank(ECB)sticktotightmonetarypolicyeveninthe faceofpersistentlyhighunemployment,untilthe2008world financialcrisisforcedittojoinothercentralbanksaroundthe worldinanunprecedentedrelaxationofmonetarypolicy. Thus,whentalkingabouttheconsequencesoftheGerman hyperinflation,wearetalkingaboutashockwavelasting nearlyacenturyaftertheeventandaffectingnotjust German,butotherEuropean,andworld,histories.

Howbadisinflation?

Germanyisnottheonlycountrythathasexperienced hyperinflation.InthefinancialpressArgentinahasbecomea bywordforhyperinflationinmoderntimes,butthehighest rateofinflationitexperiencedwasonlyaround20,000per cent.WorsethantheGermanonewastheHungarian inflationrightaftertheSecondWorldWarandthatin Zimbabwein2008inthelastdaysofPresidentRobert Mugabe’sdictatorship(nowhesharespowerwiththeformer opposition).

Hyperinflationunderminestheverybasisofcapitalism,by turningmarketpricesintomeaninglessnoises.Attheheight oftheHungarianinflationin1946,pricesdoubledevery fifteenhours,whilepricesdoubledeveryfourdaysinthe worstdaysoftheGermanhyperinflationof1923.Price signalsshouldnotbeabsoluteguides,asIarguethroughout thisbook,butitisimpossibletohaveadecenteconomy whenpricesriseatsuchrates.Moreover,hyperinflationis oftentheresultorthecauseofpoliticaldisasters,suchas AdolfHitlerorRobertMugabe.Itistotallyunderstandable whypeopledesperatelywanttoavoidhyperinflation.

However,notallinflationishyperinflation.Ofcourse,there arepeoplewhofearthatanyinflation,ifleftalone,would escalateintoahyperinflation.Forexample,intheearly 2000s,MrMasaruHayami,thegovernorofthecentralbank ofJapan,famouslyrefusedtoeasemoneysupplyonthe groundthathewasworriedaboutthepossibilityofa hyperinflation–despitethefactthathiscountrywasatthe timeactuallyinthemiddleofadeflation(fallingprices).But thereisactuallynoevidencethatthisisinevitable–oreven likely.Noonewouldarguethathyperinflationisdesirable,or evenacceptable,butitishighlyquestionablewhetherall inflationisabadthing,whatevertherateis.

Sincethe1980s,free-marketeconomistshavemanaged toconvincetherestoftheworldthateconomicstability, whichtheydefineasverylow(ideallyzero)inflation,should beattainedatallcosts,sinceinflationisbadforthe

economy.Thetargetinflationratetheyrecommendedhas beensomethinglike1–3percent,assuggestedbyStanley Fischer,aformereconomicsprofessoratMITandthechief economistoftheIMFbetween1994and2001.1

However,thereisactuallynoevidencethat,atlowlevels, inflationisbadfortheeconomy.Forexample,evenstudies donebysomefree-marketeconomistsassociatedwith institutionssuchastheUniversityofChicagoortheIMF suggestthat,below8–10percent,inflationhasno relationshipwithacountry’seconomicgrowthrate.2Some otherstudieswouldevenputthethresholdhigher–20per centoreven40percent.3

Theexperiencesofindividualcountriesalsosuggestthat fairlyhighinflationiscompatiblewithrapideconomic growth.Duringthe1960sand70s,Brazilhadanaverage inflationrateof42percentbutwasoneofthefastestgrowingeconomiesintheworld,withitspercapitaincome growingat4.5percentayear.Duringthesameperiod,per capitaincomeinSouthKoreawasgrowingat7percentper year,despitehavinganannualaveragerateofinflationof nearly20percent,whichwasactuallyhigherthanthatfound inmanyLatinAmericancountriesatthetime.4

Moreover,thereisevidencethatexcessiveantiinflationarypoliciescanactuallybeharmfulfortheeconomy. Since1996,whenBrazil–havinggonethroughatraumatic phaseofrapidinflation,althoughnotquiteof hyperinflationarymagnitude–startedtocontrolinflationby raisingrealinterestrates(nominalinterestratesminusthe rateofinflation)tosomeofthehighestlevelsintheworld (10–12percentperyear),itsinflationfellto7.1percentper yearbutitseconomicgrowthalsosuffered,withapercapita incomegrowthrateofonly1.3percentperyear.South Africahasalsohadasimilarexperiencesince1994,whenit startedgivinginflationcontroltoppriorityandjackedup interestratestotheBrazilianlevelsmentionedabove.

Whyisthis?Itisbecausethepoliciesthatareaimedto reduceinflationactuallyreduceinvestmentandthus

economicgrowth,iftakentoofar.Free-marketeconomists oftentrytojustifytheirhighlyhawkishattitudetowards inflationbyarguingthateconomicstabilityencourages savingsandinvestment,whichinturnencourageeconomic growth.So,intryingtoarguethatmacroeconomicstability, definedintermsoflowinflation,wasakeyfactorintherapid growthoftheEastAsianeconomies(apropositionthat doesnotactuallyapplytoSouthKorea,asseenabove),the WorldBankarguesinits1993report:‘Macroeconomic stabilityencourageslong-termplanningandprivate investmentand,throughitsimpactonrealinterestratesand therealvalueoffinancialassets,helpedtoincrease financialsavings.’However,thetruthofthematteristhat policiesthatareneededtobringdowninflationtoaverylow –lowsingle-digit–leveldiscourageinvestment.

Realinterestratesof8,10or12percentmeanthat potentialinvestorswouldnotfindnon-financialinvestments attractive,asfewsuchinvestmentsbringprofitrateshigher than7percent.5Inthiscase,theonlyprofitableinvestment isinhigh-risk,high-returnfinancialassets.Eventhough financialinvestmentscandrivegrowthforawhile,such growthcannotbesustained,asthoseinvestmentshaveto beultimatelybackedupbyviablelong-terminvestmentsin realsectoractivities,assovividlyshownbythe2008 financialcrisis(seeThing22).

So,free-marketeconomistshavedeliberatelytaken advantageofpeople’sjustifiedfearsofhyperinflationin ordertopushforexcessiveanti-inflationarypolicies,which domoreharmthangood.Thisisbadenough,butitisworse thanthat.Anti-inflationarypolicieshavenotonlyharmed investmentandgrowthbuttheyhavefailedtoachievetheir supposedaim–thatis,enhancingeconomicstability.

Sincethe1980s,butespeciallysincethe1990s,inflation controlhasbeenatthetopofpolicyagendasinmany countries.Countrieswereurgedtocheckgovernment spending,sothatbudgetdeficitswouldnotfuelinflation. Theywerealsoencouragedtogivepoliticalindependence tothecentralbank,sothatitcouldraiseinterestratesto highlevels,ifnecessaryagainstpopularprotests,which politicianswouldnotbeabletoresist.

Thestruggletooktime,butthebeastcalledinflationhas beentamedinthemajorityofcountriesinrecentyears. AccordingtotheIMFdata,between1990and2008, averageinflationratefellin97outof162countries, comparedtotheratesinthe1970sand80s.Thefight againstinflationwasparticularlysuccessfulintherich countries:inflationfellinallofthem.Averageinflationforthe OECDcountries(mostofwhicharerich,althoughnotallrich countriesbelongtotheOECD)fellfrom7.9percentto2.6 percentbetweenthetwoperiods(70s–80svs.90s–00s). Theworld,especiallyifyouliveinarichcountry,has becomemorestable–orhasit?

Thefactisthattheworldhasbecomemorestableonlyif weregardlowinflationasthesoleindicatorofeconomic stability,butithasnotbecomemorestableinthewaymost ofusexperienceit.

Onesenseinwhichtheworldhasbecomemoreunstable duringthelastthreedecadesoffree-marketdominanceand stronganti-inflationarypoliciesistheincreasedfrequency andextentoffinancialcrises.Accordingtoastudyby KennethRogoff,aformerchiefeconomistoftheIMFand nowaprofessoratHarvardUniversity,andCarmen Reinhart,aprofessorattheUniversityofMaryland,virtually nocountrywasinbankingcrisisbetweentheendofthe SecondWorldWarandthemid1970s,whentheworldwas muchmoreunstablethantoday,whenmeasuredbyinflation. Betweenthemid1970sandthelate1980s,wheninflation

acceleratedinmanycountries,theproportionofcountries withbankingcrisesroseto5–10percent,weightedbytheir shareofworldincome,seeminglyconfirmingtheinflationcentricviewoftheworld.However,theproportionof countrieswithbankingcrisesshotuptoaround20percent inthemid1990s,whenwearesupposedtohavefinally tamedthebeastcalledinflationandattainedtheelusivegoal ofeconomicstability.Theratiothenbrieflyfelltozerofora fewyearsinthemid2000s,butwentupagainto35percent followingthe2008globalfinancialcrisis(andislikelytorise evenfurtheratthetimeofwriting,thatis,early2010).

6

Anothersenseinwhichtheworldhasbecomemore unstableduringthelastthreedecadesisthatjobinsecurity hasincreasedformanypeopleduringthisperiod.Job securityhasalwaysbeenlowindevelopingcountries,but theshareofinsecurejobsintheso-called‘informalsector’–thecollectionofunregisteredfirmswhichdonotpaytaxesor observelaws,includingthoseprovidingjobsecurity–has increasedinmanydevelopingcountriesduringtheperiod, duetoprematuretradeliberalizationthatdestroyedalotof secure‘formal’jobsintheirindustries.Intherichcountries, jobinsecurityincreasedduringthe1980stoo,duetorising (comparedtothe1950s–70s)unemployment,whichwasin largepartaresultofrestrictivemacroeconomicpoliciesthat putinflationcontrolaboveeverythingelse.Sincethe1990s, unemploymenthasfallen,butjobinsecurityhasstillrisen, comparedtothepre-1980speriod.

Therearemanyreasonsforthis.First,theshareofshorttermjobshasriseninthemajorityofrichcountries,although nothugelyassomepeoplethink.Second,whilethosewho keeptheirjobmaystayinthesamejobalmost(althoughnot quite)aslongastheirpre-1980scounterpartsusedto,a higherproportionofemploymentterminationshavebecome involuntary,atleastinsomecountries(especiallytheUS). Third,especiallyintheUKandtheUS,jobsthathadbeen predominantlysecureevenuntilthe1980s–managerial, clericalandprofessionaljobs–havebecomeinsecure

sincethe1990s.Fourth,evenifthejobitselfhasremained secure,itsnatureandintensityhavebecomesubjectto morefrequentandbiggerchanges–veryoftenforthe worse.Forexample,accordingtoa1999studyforthe JosephRowntreeFoundation,theBritishsocialreform charitynamedafterthefamousQuakerphilanthropist businessman,nearlytwo-thirdsofBritishworkerssaidthey hadexperiencedanincreaseinthespeedortheintensityof workovertheprecedingfive-yearperiod.Lastbutnotleast, inmany(althoughnotall)richcountries,thewelfarestatehas beencutbacksincethe1980s,sopeoplefeelmore insecure,eveniftheobjectiveprobabilityofjoblossisthe same.

Thepointisthatpricestabilityisonlyoneoftheindicators ofeconomicstability.Infact,formostpeople,itisnoteven themostimportantindicator.Themostdestabilizingevents inmostpeople’slivesarethingslikelosingajob(orhaving itradicallyredefined)orhavingtheirhousesrepossessedin afinancialcrisis,andnotrisingprices,unlesstheyareofa hyperinflationarymagnitude(handonheart,canyoureally tellthedifferencebetweena4percentinflationanda2per centone?).Thisiswhytaminginflationhasnotquitebrought tomostpeoplethesenseofstabilitythattheanti-inflationary warriorshadsaiditwould.

Now,thecoexistenceofpricestability(thatis,low inflation)andtheincreaseinnon-priceformsofeconomic instability,suchasmorefrequentbankingcrisesandgreater jobinsecurity,isnotacoincidence.Allofthemarethe resultsofthesamefree-marketpolicypackage.

Inthestudycitedabove,RogoffandReinhartpointout thattheshareofcountriesinbankingcrisesisveryclosely relatedtothedegreeofinternationalcapitalmobility.This increasedinternationalmobilityisakeygoalforfree-market economists,whobelievethatagreaterfreedomofcapitalto moveacrossborderswouldimprovetheefficiencyofthe useofcapital(seeThing22).Consequently,theyhave pushedforcapitalmarketopeningacrosstheworld,

althoughrecentlytheyhavebeensofteningtheirpositionin thisregardinrelationtodevelopingcountries.

Likewise,increasedjobinsecurityisadirect consequenceoffree-marketpolicies.Theinsecurity manifestedinhighunemploymentintherichcountriesinthe 1980swastheresultofstringentanti-inflationary macroeconomicpolicies.Betweenthe1990sandthe outbreakofthe2008crisis,eventhoughunemploymentfell, thechanceofinvoluntaryjobterminationincreased,the shareofshort-termjobsrose,jobsweremorefrequently redefinedandworkintensifiedformanyjobs–allasaresult ofchangesinlabourmarketregulationsthatwereintended toincreaselabourmarketflexibilityandthuseconomic efficiency.

Thefree-marketpolicypackage,oftenknownastheneoliberalpolicypackage,emphasizeslowerinflation,greater capitalmobilityandgreaterjobinsecurity(euphemistically calledgreaterlabourmarketflexibility),essentiallybecause itismainlygearedtowardstheinterestsoftheholdersof financialassets.Inflationcontrolisemphasizedbecause manyfinancialassetshavenominallyfixedratesofreturn,so inflationreducestheirrealreturns.Greatercapitalmobilityis promotedbecausethemainsourceoftheabilityforthe holdersoffinancialassetstoreaphigherreturnsthanthe holdersofother(physicalandhuman)assetsistheirability tomovearoundtheirassetsmorequickly(seeThing22). Greaterlabourmarketflexibilityisdemandedbecause,from thepointofviewoffinancialinvestors,makinghiringand firingoftheworkerseasierallowscompaniestobe restructuredmorequickly,whichmeansthattheycanbe soldandboughtmorereadilywithbettershort-termbalance sheets,bringinghigherfinancialreturns(seeThing2).

Eveniftheyhaveincreasedfinancialinstabilityandjob insecurity,policiesaimedatincreasingpricestabilitymay bepartiallyjustified,hadtheyincreasedinvestmentandthus growth,astheinflationhawkshadpredicted.However,the worldeconomyhasgrownmuchmoreslowlyduringthe

post-1980slow-inflationera,comparedtothehigh-inflation periodofthe1960sand70s,notleastbecauseinvestment hasfalleninmostcountries(seeThing13).Evenintherich countriessincethe1990s,whereinflationhasbeen completelytamed,percapitaincomegrowthfellfrom3.2 percentinthe1960sand70sto1.4percentduring1990–2009.

Allinall,inflation,atlowtomoderatelevels,isnotas dangerousasfree-marketeconomistsmakeitouttobe. Attemptstobringinflationdowntoverylowlevelshave reducedinvestmentandgrowth,contrarytotheclaimthatthe greatereconomicstabilitythatlowerinflationbringswill encourageinvestmentandthusgrowth.Moreimportantly, lowerinflationhasnotevenbroughtgenuineeconomic stabilitytomostofus.Liberalizationsofcapitalandlabour marketsthatformintegralpartsofthefree-marketpolicy package,ofwhichinflationcontrolisakeyelement,have increasedfinancialinstabilityandjobinsecurity,makingthe worldmoreunstableformostofus.Toaddinsulttoinjury, theallegedgrowth-enhancingimpactofinflationcontrolhas notmaterialized.

Ourobsessionwithinflationshouldend.Inflationhas becomethebogeymanthathasbeenusedtojustifypolicies thathavemainlybenefitedtheholdersoffinancialassets,at thecostoflong-termstability,economicgrowthandhuman happiness.

Free-marketpoliciesrarely makepoorcountriesrich

Whattheytellyou

Aftertheirindependencefromcolonialrule,developing countriestriedtodeveloptheireconomiesthroughstate intervention,sometimesevenexplicitlyadoptingsocialism. Theytriedtodevelopindustriessuchassteeland automobiles,whichwerebeyondtheircapabilities,artificially byusingmeasuressuchastradeprotectionism,abanon foreigndirectinvestment,industrialsubsidies,andeven stateownershipofbanksandindustrialenterprises.Atan emotionallevelthiswasunderstandable,giventhattheir formercolonialmasterswereallcapitalistcountriespursuing free-marketpolicies.However,thisstrategyproducedat beststagnationandatworstdisaster.Growthwasanaemic (ifnotnegative)andtheprotectedindustriesfailedto‘grow up’.Thankfully,mostofthesecountrieshavecometotheir sensessincethe1980sandcometoadoptfree-market policies.Whenyouthinkaboutit,thiswastherightthingto dofromthebeginning.Alloftoday’srichcountries,withthe exceptionofJapan(andpossiblyKorea,althoughthereis debateonthat),havebecomerichthroughfree-market policies,especiallythroughfreetradewiththerestofthe world.Anddevelopingcountriesthathavemorefully embracedsuchpolicieshavedonebetterintherecent period.

Contrarytowhatiscommonlybelieved,theperformanceof developingcountriesintheperiodofstate-leddevelopment wassuperiortowhattheyhaveachievedduringthe subsequentperiodofmarket-orientedreform.Therewere somespectacularfailuresofstateintervention,butmostof thesecountriesgrewmuchfaster,withmoreequitable incomedistributionandfarfewerfinancialcrises,duringthe ‘badolddays’thantheyhavedoneintheperiodofmarketorientedreforms.Moreover,itisalsonottruethatalmostall richcountrieshavebecomerichthroughfree-market policies.Thetruthismoreorlesstheopposite.Withonlya fewexceptions,alloftoday’srichcountries,includingBritain andtheUS–thesupposedhomesoffreetradeandfree market–havebecomerichthroughthecombinationsof protectionism,subsidiesandotherpoliciesthattodaythey advisethedevelopingcountriesnottoadopt.Free-market policieshavemadefewcountriesrichsofarandwillmake fewrichinthefuture.

Twobasketcases

Herearetheprofilesoftwodevelopingcountries.Youarean economicanalysttryingtoassesstheirdevelopment prospects.Whatwouldyousay?

CountryA:Untiladecadeago,thecountrywashighly protectionist,withanaverageindustrialtariffratewellabove 30percent.Despitetherecenttariffreduction,important visibleandinvisibletraderestrictionsremain.Thecountry hasheavyrestrictionsoncross-borderflowsofcapital,a

state-ownedandhighlyregulatedbankingsector,and numerousrestrictionsonforeignownershipoffinancial assets.Foreignfirmsproducinginthecountrycomplainthat theyarediscriminatedagainstthroughdifferentialtaxesand regulationsbylocalgovernments.Thecountryhasno electionsandisriddledwithcorruption.Ithasopaqueand complicatedpropertyrights.Inparticular,itsprotectionof intellectualpropertyrightsisweak,makingitthepirate capitaloftheworld.Thecountryhasalargenumberofstateownedenterprises,manyofwhichmakelargelossesbut areproppedupbysubsidiesandgovernment-granted monopolyrights.

CountryB:Thecountry’stradepolicyhasliterallybeenthe mostprotectionistintheworldforthelastfewdecades,with anaverageindustrialtariffrateat40–55percent.The majorityofthepopulationcannotvote,andvote-buyingand electoralfraudarewidespread.Corruptionisrampant,with politicalpartiessellinggovernmentjobstotheirfinancial backers.Thecountryhasneverrecruitedasinglecivil servantthroughanopen,competitiveprocess.Itspublic financesareprecarious,withrecordsofgovernmentloan defaultsthatworryforeigninvestors.Despitethis,it discriminatesheavilyagainstforeigninvestors.Especiallyin thebankingsector,foreignersareprohibitedfrombecoming directorswhileforeignshareholderscannotevenexercise theirvotingrightsunlesstheyareresidentinthecountry.It doesnothaveacompetitionlaw,permittingcartelsand otherformsofmonopolytogrowunchecked.Itsprotectionof intellectualpropertyrightsispatchy,particularlymarredby itsrefusaltoprotectforeigners’copyrights.

Boththesecountriesareuptotheirnecksinthingsthat aresupposedtohampereconomicdevelopment–heavy protectionism,discriminationagainstforeigninvestors, weakprotectionofpropertyrights,monopolies,lackof democracy,corruption,lackofmeritocracy,andsoon.You

wouldthinkthattheyarebothheadedfordevelopmental disasters.Butthinkagain.

CountryAisChinatoday–somereadersmayhave guessedthat.However,fewreaderswouldhaveguessed thatCountryBistheUSA–thatis,around1880,whenit wassomewhatpoorerthantoday’sChina.

Despiteallthesupposedlyanti-developmentalpolicies andinstitutions,Chinahasbeenoneoftheworld’smost dynamicandsuccessfuleconomiesoverthelastthree decades,whiletheUSAinthe1880swasoneofthefastestgrowing–andrapidlybecomingoneoftherichest–countriesintheworld.Sotheeconomicsuperstarsofthe latenineteenthcentury(USA)andoftoday(China)haveboth followedpolicyrecipesthatgoalmosttotallyagainsttoday’s neo-liberalfree-marketorthodoxy.

Howisthispossible?Hasn’tthefree-marketdoctrine beendistilledoutoftwocenturiesofsuccessfuldevelopment experiencesbytoday’stwodozenrichcountries?Inorderto answerthesequestions,weneedtogobackinhistory.

Deadpresidentsdon’ttalk

SomeAmericanscalltheirdollarbills‘deadpresidents’,or ‘deadprez’.Notquiteaccurately.Theyarealldeadallright, butnotallthepoliticianswhoseportraitsadornthedollar billsareformerpresidentsoftheUS.

BenjaminFranklin–whofeaturesonthebest-known papermoneyinhumanhistory,the$100bill–neverwas president.However,hecouldwellhavebeen.Hewasthe oldestoftheFoundingFathersandarguablythemost reveredpoliticianofthenew-borncountry.Althoughhewas toooldandGeorgeWashington’spoliticalstaturetoogreat forhimtorunforthefirstpresidencyin1789,Franklinwas theonlypersonwhocouldpossiblyhavechallenged

Therealsurpriseinthepantheonofpresidentsonthe greenbackisAlexanderHamilton,whofeaturesonthe$10 bill.LikeFranklin,HamiltonwasneverapresidentoftheUS. ButunlikeFranklin,whoselifestoryhasbecomeAmerican legend,hewas,well,notFranklin.Hamiltonwasamere TreasurySecretary,eventhoughhewastheveryfirstone. Whatishedoingamongthepresidents?

Hamiltonistherebecause,unbeknowntomost Americanstoday,heisthearchitectofthemodern Americaneconomicsystem.Twoyearsafterbecoming TreasurySecretaryin1789attheoutrageouslyyoungageof thirty-three,HamiltonsubmittedtotheCongresstheReport ontheSubjectofManufactures,wherehesetoutthe economicdevelopmentstrategyforhisyoungcountry.Inthe report,hearguedthat‘industriesintheirinfancy’,likethe Americanones,needtobeprotectedandnurturedby governmentbeforetheycanstandontheirownfeet. Hamilton’sreportwasnotjustabouttradeprotectionism–healsoarguedforpublicinvestmentininfrastructure(such ascanals),developmentofthebankingsystem,promotion ofagovernmentbondmarket–butprotectionismwasatthe heartofhisstrategy.Givenhisviews,wereHamiltonfinance ministerofadevelopingcountrytoday,hewouldhavebeen heavilycriticizedbytheUSTreasuryDepartmentforhis heresy.Hiscountrymightevenhavebeenrefusedaloan fromtheIMFandtheWorldBank.

Theinterestingthing,however,isthatHamiltonwasnot aloneinthis.Alltheother‘deadpresidents’wouldhavemet withthesamedisapprovalfromtheUSTreasury,theIMF, theWorldBankandotherdefendersofthefree-marketfaith today.

Onthe$1billisthefirstpresident,GeorgeWashington. Athisinaugurationceremony,heinsistedonwearing Americanclothes–speciallywoveninConnecticutforthe occasion–ratherthanhigher-qualityBritishones.Today, thiswouldhavebeenaviolationoftheproposedWTOrule

ontransparencyingovernmentprocurement.Andlet’snot forgetthatWashingtonwastheonewhoappointedHamilton asTreasurySecretary,andinfullknowledgeofwhathisview oneconomicpolicywas–HamiltonwasWashington’saidede-campduringtheAmericanWarofIndependenceandhis closestpoliticalallyafterthat.

Onthe$5bill,wehaveAbrahamLincoln,awell-known protectionist,whoduringtheCivilWarraisedtariffstotheir highestlevelever.1Onthe$50bill,wehaveUlyssesGrant, theCivilWarhero-turnedpresident.IndefianceoftheBritish pressureontheUSAtoadoptfreetrade,heonceremarked that‘within200years,whenAmericahasgottenoutof protectionallthatitcanoffer,ittoowilladoptfreetrade’.

BenjaminFranklindidnotshareHamilton’sinfantindustry doctrine,butheinsistedonhightariffprotectionforanother reason.Atthetime,theexistenceofalmost-freelandinthe USmadeitnecessaryforAmericanmanufacturerstooffer wagesaroundfourtimeshigherthantheEuropeanaverage, asotherwisetheworkerswouldhaverunawaytosetup farms(thiswasnoidlethreat,giventhatmanyofthemwere farmersintheirpreviouslives)(seeThing10).Therefore, Franklinargued,theAmericanmanufacturerscouldnot surviveunlesstheywereprotectedfromlow-wage competition–orwhatisknownas‘socialdumping’today–fromEurope.ThisisexactlythelogicthatRossPerot,the billionaire-turned-politician,usedinordertoopposethe NAFTA(NorthAmericanFreeTradeAgreement)inthe 1992presidentialelectioncampaign–alogicthat18.9per centoftheAmericanvoterswerehappytoendorse.

Butsurely,youmaysay,ThomasJefferson(ontherarely seen$2bill)andAndrewJackson(onthe$20bill),the patronsaintsofAmericanfree-marketcapitalism,would havepassedthe‘USTreasuryTest’?

ThomasJeffersonmayhavebeenagainstHamilton’s protectionismbut,unlikeHamilton,whosupportedthepatent system,hearguedstronglyagainstpatents.Jefferson believedthatideasare‘likeair’andthereforeshouldnotbe

ownedbyanyone.Giventheemphasisthatmostoftoday’s free-marketeconomistsputontheprotectionofpatentsand otherintellectualpropertyrights,hisviewswouldhavegone downlikealeadballoonamongthem.

ThenhowaboutAndrewJackson,thatprotectorofthe ‘commonman’andfiscalconservative(hepaidoffall federalgovernmentdebtsforthefirsttimeinUShistory)? Unfortunatelyforhisfans,evenhewouldnotpassthetest. UnderJackson,averageindustrialtariffswereintheregion of35–40percent.Hewasalsonotoriouslyanti-foreign. Whenin1836hecancelledthelicenceforthesemi-public (second)BankoftheUSA(itwas20percentownedbythe USfederalgovernment),oneofthemainexcuseswasthatit was‘toomuch’ownedbyforeign(mainlyBritish)investors. Andhowmuchwastoomuch?Only30percent.Ifsome developingcountrypresidenttodaycancelledthelicencefor abankbecauseitwas30percentownedbytheAmericans, itwouldsendtheUSTreasuryintoafit.

Sotherewego.Everyday,tensofmillionsofAmericans gothroughthedaypayingfortheirtaxisandbuyingtheir sandwicheswithaHamiltonoraLincoln,gettingtheir changewithWashingtons,notrealizingthattheserevered politiciansarenastyprotectioniststhatmostoftheir country’snewsmedia,conservativeandliberalalike,loveto lambast.NewYorkbankersandChicagouniversity professorstut-tutthrougharticlescriticizingtheanti-foreign anticsofHugoChavez,theVenezuelanpresident,incopies oftheWallStreetJournalboughtwithanAndrewJackson, withoutrealizingthathewasfarmoreanti-foreignthan Chavez.

Thedeadpresidentsdon’ttalk.Butiftheycould,they wouldtellAmericansandtherestoftheworldhowthe policiesthattheirsuccessorspromotetodayaretheexact oppositeofwhattheyusedinordertotransformasecondrateagrarianeconomydependentonslavelabourintothe world’sgreatestindustrialpower.

DoasIsay,notasIdid

WhenremindedoftheprotectionistpastoftheUS,freemarketeconomistsusuallyretortthatthecountrysucceeded despite,ratherthanbecauseof,protectionism.Theysaythat thecountrywasdestinedtogrowfastanyway,becauseit hadbeenexceptionallywellendowedwithnaturalresources andreceivedalotofhighlymotivatedandhard-working immigrants.Itisalsosaidthatthecountry’slargeinternal marketsomewhatmitigatedthenegativeeffectsof protectionism,byallowingadegreeofcompetitionamong domesticfirms.

Buttheproblemwiththisresponseisthat,dramaticasit maybe,theUSisnottheonlycountrythathassucceeded withpoliciesthatgoagainstthefree-marketdoctrine.Infact, asIshallelaboratebelow,mostoftoday’srichcountries havesucceededwithsuchpolicies.2And,whentheyare countrieswithverydifferentconditions,itisnotpossibleto saythattheyallsharedsomespecialconditionsthat cancelledoutthenegativeimpactsofprotectionismand other‘wrong’policies.TheUSmayhavebenefitedfroma largedomesticmarket,butthenhowabouttinyFinlandor Denmark?IfyouthinktheUSbenefitedfromabundanceof naturalresources,howdoyouexplainthesuccessof countriessuchasKoreaandSwitzerlandthathadvirtuallyno naturalresourcestospeakof?Ifimmigrationwasapositive factorfortheUS,howaboutallthoseothercountries–from GermanytoTaiwan–thatlostsomeoftheirbestpeopleto theUSandotherNewWorldcountries?The‘special conditions’argumentsimplydoesnotwork.

Britain,thecountrywhichmanypeoplethinkinventedfree trade,builtitsprosperityonthebasisofpoliciessimilarto thosethatHamiltonpromoted.Thiswasnotacoincidence.

industry’argument,manyofhispolicieswerecopiedfrom RobertWalpole,theso-calledfirstBritishPrimeMinister, whoranthecountrybetween1721and1742.

Duringthemideighteenthcentury,Britainmovedintothe woollenmanufacturingindustry,thehigh-techindustryofthe timethathadbeendominatedbytheLowCountries(what areBelgiumandtheNetherlandstoday),withthehelpof tariffprotection,subsidies,andothersupportsthatWalpole andhissuccessorsprovidedtothedomesticwoollen manufacturers.TheindustrysoonprovidedBritain’smain sourceofexportearnings,whichenabledthecountryto importthefoodandrawmaterialsthatitneededtolaunch theIndustrialRevolutioninthelateeighteenthandtheearly nineteenthcenturies.Britainadoptedfreetradeonlyinthe 1860s,whenitsindustrialdominancewasabsolute.Inthe samewayinwhichtheUSwasthemostprotectionist countryintheworldduringmostofitsphaseofascendancy (fromthe1830stothe1940s),Britainwasoneoftheworld’s mostprotectionistcountriesduringmuchofitsown economicrise(fromthe1720stothe1850s).

Virtuallyalloftoday’srichcountriesusedprotectionism andsubsidiestopromotetheirinfantindustries.Manyof them(especiallyJapan,FinlandandKorea)alsoseverely restrictedforeigninvestment.Betweenthe1930sandthe 1980s,Finlandusedtoclassifyallenterpriseswithmore than20percentforeignownershipofficiallyas‘dangerous enterprises’.Severalofthem(especiallyFrance,Austria, Finland,SingaporeandTaiwan)usedstate-owned enterprisestopromotekeyindustries.Singapore,whichis famousforitsfree-tradepoliciesandwelcomingattitudes towardsforeigninvestors,producesover20percentofits outputthroughstate-ownedenterprises,whenthe internationalaverageisaround10percent.Nordidtoday’s richcountriesprotectforeigners’intellectualpropertyrights verywell,ifatall–inmanyofthemitwaslegaltopatent someoneelse’sinventionaslongasthatsomeoneelsewas aforeigner.

Therewereexceptionsofcourse.TheNetherlands, Switzerland(untiltheFirstWorldWar)andHongKongused littleprotectionism,buteventhesecountriesdidnotfollow today’sorthodoxdoctrines.Arguingthatpatentsareartificial monopoliesthatgoagainsttheprincipleoffreetrade(a pointwhichisstrangelylostonmostoftoday’sfree-trade economists),theNetherlandsandSwitzerlandrefusedto protectpatentsuntiltheearlytwentiethcentury.Eventhough itdidnotdoitonsuchprincipledgrounds,HongKongwas untilrecentlyevenmorenotoriousforitsviolationof intellectualpropertyrightsthantheformercountries.Ibetyou knowsomeone–oratleasthaveafriendwhoknows someone–whohasboughtpiratedcomputersoftware,a fakeRolexwatchoran‘unofficial’Calvin&HobbesT-shirt fromHongKong.

Mostreadersmayfindmyhistoricalaccountcounterintuitive.Havingbeenrepeatedlytoldthatfree-market policiesarethebestforeconomicdevelopment,theywould finditmysterioushowmostoftoday’scountriescoulduseall thosesupposedlybadpolicies–suchasprotectionism, subsidies,regulationandstateownershipofindustry–and stillbecomerich.

Theanswerliesinthefactthatthosebadpolicieswerein factgoodpolicies,giventhestageofeconomic developmentinwhichthosecountrieswereatthetime,fora numberofreasons.FirstisHamilton’sinfantindustry argument,whichIexplainingreaterdetailinthechapter‘My six-year-oldsonshouldgetajob’inmyearlierbookBad Samaritans.Forthesamereasonwhywesendourchildren toschoolratherthanmakingthemcompetewithadultsinthe labourmarket,developingcountriesneedtoprotectand nurturetheirproducersbeforetheyacquirethecapabilities tocompeteintheworldmarketunassisted.Second,inthe earlierstagesofdevelopment,marketsdonotfunctionvery wellforvariousreasons–poortransport,poorflowof information,thesmallsizeofthemarketthatmakes manipulationbybigactorseasier,andsoon.Thismeans

thatthegovernmentneedstoregulatethemarketmore activelyandsometimesevendeliberatelycreatesome markets.Third,inthosestages,thegovernmentneedstodo manythingsitselfthroughstate-ownedenterprisesbecause therearesimplynotenoughcapableprivatesectorfirmsthat cantakeuplarge-scale,high-riskprojects(seeThing12).

Despitetheirownhistory,therichcountriesmake developingcountriesopentheirbordersandexposetheir economiestothefullforcesofglobalcompetition,usingthe conditionsattachedtotheirbilateralforeignaidandtothe loansfrominternationalfinancialinstitutionsthattheycontrol (suchastheIMFandtheWorldBank)aswellasthe ideologicalinfluencethattheyexercisethroughintellectual dominance.Inpromotingpoliciesthattheydidnotusewhen theyweredevelopingcountriesthemselves,theyaresaying tothedevelopingcountries,‘DoasIsay,notasIdid.’

Apro-growthdoctrinethatreduces

growth

Whenthehistoricalhypocrisyoftherichcountriesispointed out,somedefendersofthefreemarketcomebackandsay: ‘Well,protectionismandotherinterventionistpoliciesmay haveworkedinnineteenth-centuryAmericaormidtwentiethcenturyJapan,buthaven’tthedevelopingcountries monumentallyscrewedupwhentheytriedsuchpoliciesin the1960sand70s?’Whatmayhaveworkedinthepast, theysay,isnotnecessarilygoingtoworktoday.

Thetruthisthatdevelopingcountriesdidnotdobadlyat allduringthe‘badolddays’ofprotectionismandstate interventioninthe1960sand70s.Infact,theireconomic growthperformanceduringtheperiodwasfarsuperiorto thatachievedsincethe1980sundergreateropeningand deregulation.

Sincethe1980s,inadditiontorisinginequality(which wastobeexpectedfromthepro-richnatureofthereforms–seeThing13),mostdevelopingcountrieshaveexperienced asignificantdecelerationineconomicgrowth.Percapita incomegrowthinthedevelopingworldfellfrom3percent peryearinthe1960sand70sto1.7percentduringthe 1980–2000period,whentherewasthegreatestnumberof free-marketreforms.Duringthe2000s,therewasapick-up inthegrowthofthedevelopingworld,bringingthegrowth rateupto2.6percentforthe1980–2009period,butthis waslargelyduetotherapidgrowthofChinaandIndia–two giantsthat,whileliberalizing,didnotembraceneo-liberal policies.

Growthperformancesinregionsthathavefaithfully followedtheneo-liberalrecipe–LatinAmericaandSubSaharanAfrica–havebeenmuchinferiortowhattheyhad inthe‘badolddays’.Inthe1960sand70s,LatinAmerica grewat3.1percentinpercapitaterms.Between1980and 2009,itgrewataratejustaboveone-thirdthat–1.1per cent.Andeventhatratewaspartlyduetotherapidgrowthof countriesintheregionthathadexplicitlyrejectedneo-liberal policiessometimeearlierinthe2000s–Argentina, Ecuador,UruguayandVenezuela.Sub-SaharanAfricagrew at1.6percentinpercapitatermsduringthe‘badolddays’, butitsgrowthratewasonly0.2percentbetween1980and 2009(seeThing11).

Tosumup,thefree-trade,free-marketpoliciesare policiesthathaverarely,ifever,worked.Mostoftherich countriesdidnotusesuchpolicieswhentheywere developingcountriesthemselves,whilethesepolicieshave sloweddowngrowthandincreasedincomeinequalityinthe developingcountriesinthelastthreedecades.Few countrieshavebecomerichthroughfree-trade,free-market policiesandfeweverwill.

Capitalhasanationality

Whattheytellyou

Therealheroofglobalizationhasbeenthetransnational corporation.Transnationalcorporations,astheirname implies,arecorporationsthathavegonebeyondtheir originalnationalboundaries.Theymaybestill headquarteredinthecountrywheretheywerefounded,but muchoftheirproductionandresearchfacilitiesareoutside theirhomecountry,employingpeople,includingmanytop decision-makers,fromacrosstheworld.Inthisageofsuch nation-lesscapital,nationalisticpoliciestowardsforeign capitalareatbestineffectiveandatworst counterproductive.Ifacountry’sgovernmentdiscriminates againstthem,transnationalcorporationswillnotinvestinthat country.Theintentionmaybetohelpthenationaleconomy bypromotingnationalfirms,butsuchpoliciesactuallyharmit bypreventingthemostefficientfirmsfromestablishing themselvesinthecountry.

Whattheydon’ttellyou

Despitetheincreasing‘transnationalization’ofcapital,most transnationalcompaniesinfactremainnationalcompanies withinternationaloperations,ratherthangenuinelynationlesscompanies.Theyconductthebulkoftheircore

activities,suchashigh-endresearchandstrategizing,at home.Mostoftheirtopdecision-makersarehome-country nationals.Whentheyhavetoshutdownfactoriesorcutjobs, theyusuallydoitlastathomeforvariouspoliticaland,more importantly,economicreasons.Thismeansthatthehome countryappropriatesthebulkofthebenefitsfroma transnationalcorporation.Ofcourse,theirnationalityisnot theonlythingthatdetermineshowcorporationsbehave,but weignorethenationalityofcapitalatourperil.

CarlosGhosnlivesglobalization

CarlosGhosnwasbornin1954toLebaneseparentsinthe BraziliancityofPortoVelho.Attheageofsix,hemoved withhismothertoBeirut,Lebanon.Afterfinishingsecondary schoolthere,hewenttoFranceandearnedengineering degreesfromtwoofthecountry’smostprestigious educationalinstitutions,ÉcolePolytechniqueandÉcoledes MinesdeParis.DuringhiseighteenyearsattheFrench tyre-makerMichelin,whichhehadjoinedin1978,Ghosn acquiredareputationforeffectivemanagementbyturning thecompany’sunprofitableSouthAmericanoperation aroundandbysuccessfullymanagingthemergerofitsUS subsidiarywithUniroyalGoodrich,whichdoubledthesizeof thecompany’sUSoperation.

In1996,Ghosnjoinedthestate-ownedFrenchcar-maker Renaultandplayedakeyroleinrevivingthecompany, affirminghisreputationforruthlesscost-cuttingandearning thesobriquet‘lecostkiller’,althoughhisactualapproach wasmoreconsensualthanthatnamesuggests.When RenaultacquiredNissan,theloss-makingJapanesecarmaker,in1999,GhosnwassenttoJapantoputNissan backintoshape.Initially,hefacedstiffresistancetohisunJapanesewayofmanagement,suchassackingworkers,

butheturnedthecompanycompletelyaroundinafewyears. Afterthat,hehasbeensototallyacceptedbytheJapanese thathehasbeenmadeintoamanga(comicbook) character,theJapaneseequivalentofbeatificationbythe CatholicChurch.In2005,hestunnedtheworldonceagain bygoingbacktoRenaultasCEOandpresident,while stayingonasaco-chairmanofNissan–afeatcomparedby sometoafootballcoachmanagingtwoteamsatthesame time.

CarlosGhosn’slifestorysumsupthedramathatis globalization.Peoplemigrateinsearchofabetterlife, sometimesliterallytotheothersideoftheworld,asGhosn’s familydid.Someofthemigrants,likeGhosn’smother,go backhome.Thisisabigcontrasttothedayswhen,for example,ItalianimmigrantstotheUSrefusedtoteachtheir childrenItalian,astheyweresodeterminednottogoback toItalyandwantedtheirchildrentotallyassimilated.Many youngstersfrompoorercountrieswithambitionandbrains nowgotoarichercountrytostudy,asGhosndid.These days,manymanagersworkforacompanybasedina foreigncountry,whichoftenmeanslivingandworkinginyet anotherforeigncountry(ortwo)becauseyourcompanyis transnational.Ghosn,aLebaneseBrazilianreturn-migrant, workedinBrazil,theUSandJapanfortwoFrench companies.

Inthisglobalizedworld,theargumentgoes,nationalityof capitalismeaningless.Corporationsmayhavestartedand stillbeheadquarteredinaparticularcountry,buttheyhave brokenoutoftheirnationalborders.Theynowlocatetheir activitieswhereverthereturnisthegreatest.Forexample, Nestlé,theSwissfoodgiant,maybeheadquarteredinthe SwisscityofVevey,butlessthan5percentofitsoutputis producedinSwitzerland.EvenifweconsiderNestlé’s ‘home’tobeEurope,ratherthanSwitzerland,itshomebase accountsforonlyaround30percentofitsearnings.Itisnot justtherelativelylow-gradeactivitiessuchasproductionthat transnationalcorporationsareconductingoutsidetheir

homecountries.Thesedays,eventop-endactivitiessuchas R&Dareoftenlocatedoutsidethehomecountry–increasinglyindevelopingcountries,suchasChinaand India.Eventheirtopmanagersaredrawn,likeGhosn,from aninternationalpooloftalent,ratherthanfromexclusively nationalpools.

Theupshotisthatacompanyhasnonationalloyaltyany more.Abusinesswilldowhatithastodoinorderto increaseitsprofit,evenifitmeanshurtingitshomecountry byshuttingplantsdown,slashingjobs,orevenbringingin foreignworkers.Giventhis,manypeopleargue,itisunwise toputrestrictionsonforeignownershipofcompanies,as manygovernmentsusedto.Aslongasthecompany generateswealthandjobswithinitsborders,thecountry shouldnotcarewhetherthecompanyisownedbyits citizensorforeigners.Whenallmajorcompaniesareready tomoveanywhereinsearchofprofitopportunities,making investmentbyforeigncompaniesdifficultmeansthatyour countryisnotgoingtobenefitfromthoseforeigncompanies thathaveidentifiedgoodinvestmentprospectsinyour country.Itallmakessense,doesn’tit?

Chrysler–American,German,American (again)and(becoming)Italian

In1998,Daimler-Benz,theGermanautomobilecompany, andChrysler,theUScar-maker,weremerged.Itwasreally atakeoverofChryslerbyDaimler-Benz.Butwhenthe mergerwasannounced,itwasdepictedasamarriageof twoequals.Thenewcompany,Daimler-Chrysler,evenhad equalnumbersofGermansandAmericansonthe managementboard.Thatwas,however,onlyforthefirstfew years.Soon,theGermansvastlyoutnumberedthe Americansontheboard–usuallytentotwelvetojustoneor

twoAmericans,dependingontheyear.

Unfortunately,thetakeoverwasnotagreatsuccess,and in2007Daimler-BenzsoldChryslerofftoCerberus,an Americanprivateequityfund.Cerberus,beinganAmerican company,madeupChrysler’sboardofdirectorsmostlywith Americans(withsomerepresentationfromDaimler,which stillhelda19.9percentstake).

Intheevent,Cerberusfailedtoturnthecompanyaround andChryslerwentbankruptin2009.Itwasrestructuredwith USfederalgovernmentfinancialaidandamajorequity investmentbyFiat,theItaliancar-maker.WhenFiatbecame theleadingshareholder,itmadeSergioMarchionne,the CEOofFiat,alsothenewCEOofChryslerandappointed anotherFiatmanagertoChrysler’snine-memberboardof directors.GiventhatFiathasonlya20percentstakeatthe momentbuthastheoptiontoincreaseitto35percentand eventuallyto51percent,itishighlylikelythattheproportion ofItaliansontheboardwillincreaseovertime,withthe increaseinFiat’sownershipshare.

SoChrysler,onceoneofthequintessentialAmerican companies,hasinthelastdecadecometoberunby Germans,Americans(again)and(increasingly)Italians. Thereisnosuchthingas‘nation-less’capital.Whentaken overbyaforeigncompany,evenmighty(former-)American firmsendupbeingrunbyforeigners(butthenthatiswhat takeovermeans,whenyouthinkaboutit).Inmost companies,howevertransnationaltheiroperationsmay seem,thetopdecision-makersstillremainthecitizensofthe homecountry–thatis,thecountrywhereownershipresides –despitethefactthatlong-distancemanagement(whenthe acquiringcompanydoesnotdispatchtopmanagerstothe acquiredfirm)canreducemanagementefficiency,while dispatchingtopmanagerstoaforeigncountryisexpensive, especiallywhenthephysicalandtheculturaldistances betweenthetwocountriesaregreat.CarlosGhosnisvery muchanexceptionthatprovestherule.

makersthatcorporationshavea‘homebias’.Homebiasis alsoverystronginresearchanddevelopment,whichareat thecoreofacompany’scompetitivestrengthsinmost advancedindustries.Mostofacorporation’sR&Dactivities stayathome.Insofarastheyarerelocatedabroad,itis usuallytootherdevelopedcountries,andatthatwithaheavy ‘regional’bias(theregionsheremeaningNorthAmerica, EuropeandJapan,whichisaregionuntoitselfinthis respect).RecentlyanincreasingnumberofR&Dcentres havebeensetupindevelopingcountries,suchasChina andIndia,buttheR&Dtheyconducttendstobeatthe lowestlevelsofsophistication.

Evenintermsofproduction,arguablytheeasiestthing thatacompanydoesandthereforethemostlikelycandidate forrelocationabroad,mosttransnationalcorporationsare stillfirmlybasedintheirhomecountries.Thereareodd examplesoffirms,forinstanceNestlé,whichproducemost oftheiroutputsabroad,buttheyareverymuchthe exception.AmongUS-basedtransnationalcorporations, lessthanone-thirdoftheoutputofmanufacturingfirmsis producedoverseas.InthecaseofJapanesecompanies, theratioiswellbelow10percent.InEurope,theratiohas risenfastrecently,butmostoverseasproductionby EuropeanfirmsiswithintheEuropeanUnion,soitshouldbe understoodmoreasaprocessofcreatingnationalfirmsfor anewnationcalledEuropethanasaprocessofEuropean firmsgoingtrulytransnational.

Inshort,fewcorporationsaretrulytransnational.Thevast majorityofthemstillproducethebulkoftheiroutputsintheir homecountries.Especiallyintermsofhigh-gradeactivities suchasstrategicdecision-makingandhigher-endR&D, theyremainfirmlycentredattheirhomecountries.Thetalk ofaborderlessworldishighlyexaggerated.1

Whyisthereahome-countrybias?

Whyisthereahome-countrybiasinthisglobalizedworld? Thefree-marketviewisthatnationalityofcapitaldoesnot–andshouldnot–matter,becausecompanieshaveto maximizeprofitinordertosurviveandthereforethat patriotismisaluxurytheycanillafford.Interestingly,many Marxistswouldagree.Theyalsobelievethatcapitalwillingly destroysnationalbordersforgreaterprofitsandforthe expandedreproductionofitself.Thelanguageisradically different,butthemessageisthesame–moneyismoney, sowhyshouldacompanydolessprofitablethingssimply becausetheyaregoodforitshomecountry?

However,therearegoodreasonswhycompaniesact withhome-countrybiases.Tobeginwith,likemostofus,top businessmanagersfeelsomepersonalobligationstothe societytheycomefrom.Theymayframesuchobligationsin manydifferentways–patriotism,communityspirit,noblesse oblige,orwantingto‘returnsomethingtothesocietythat hasmadethemwhattheyaretoday’–andmayfeelthemto differentdegrees.Butthepointisthattheydofeelthem.And insofarasmosttopdecision-makersinmostcompaniesare home-countrynationals,thereisboundtobesomehomecountrybiasintheirdecisions.Althoughfree-market economistsdismissanymotiveotherthanpureself-seeking, ‘moral’motivesarerealandaremuchmoreimportantthan theyleadustobelieve(seeThing5).

Ontopofthosepersonalfeelingsofmanagers,a companyoftenhasrealhistoricalobligationstothecountry inwhichithas‘grownup’.Companies,especially(although notexclusively)intheearlystagesoftheirdevelopment,are oftensupportedwithpublicmoney,directlyandindirectly (seeThing7).Manyofthemreceivedirectsubsidiesfor particulartypesofactivities,suchasequipmentinvestment orworkertraining.Theysometimesevengetbailedoutwith publicmoney,asToyotawasin1949,Volkswagenin1974 andGMin2009.Ortheymaygetindirectsubsidiesinthe

formoftariffprotectionorstatutorymonopolyrights.

Ofcourse,companiesoftenfailtomention,andeven activelyhide,suchhistory,butthereisanunspoken understandingamongtherelevantpartiesthatcompanies dohavesomemoralobligationstotheirhomecountries becauseofthesehistoricaldebts.Thisiswhynational companiesaremuchmoreopentomoralsuasionbythe governmentandthepublicthanforeigncompaniesare, whentheyareexpected,althoughcannotbelegallyobliged, todosomethingforthecountryagainsttheir(atleastshortterm)interests.Forexample,itwasreportedinOctober 2009thatSouthKorea’sfinancialsupervisoryagencywas findingitimpossibletopersuadeforeign-ownedbanksto lendmoretosmallandmedium-sizedcompanies,even thoughthey,likethenationallyownedbanks,hadalready signedanMOU(memorandumofunderstanding)aboutthat withtheagency,whentheglobalfinancialcrisisbrokeoutin theautumnof2008.

Importantthoughthemoralandhistoricalreasonsare,by farthemostimportantreasonforhome-countrybiasis economic–thefactthatthecorecapabilitiesofacompany cannotbeeasilytakenacrosstheborder.

Usually,acompanybecomestransnationalandsetsup activitiesinforeigncountriesbecauseitpossessessome technologicaland/ororganizationalcompetencesthatthe firmsoperatinginthehostcountriesdonotpossess.These competencesareusuallyembodiedinpeople(e.g., managers,engineers,skilledworkers),organizations(e.g., internalcompanyrules,organizationalroutines,‘institutional memory’)andnetworksofrelatedfirms(e.g.,suppliers, financiers,industrialassociationsorevenold-boynetworks thatcutacrosscompanyboundaries),allofwhichcannotbe easilytransportedtoanothercountry.

Mostmachinesmaybemovedabroadeasily,butitis muchmorecostlytomoveskilledworkersormanagers.Itis evenmoredifficulttotransplantorganizationalroutinesor businessnetworksontoanothercountry.Forexample,when

Japaneseautomobilecompaniesstartedsettingup subsidiariesinSoutheastAsiainthe1980s,theyasked theirsubcontractorsalsotosetuptheirownsubsidiaries,as theyneededreliablesubcontractors.Moreover,these intangiblecapabilitiesembodiedinpeople,organizations andnetworksoftenneedtohavetherightinstitutional environment(thelegalsystem,informalrules,business culture)inordertofunctionwell.Howeverpowerfulitmaybe, acompanycannottransportitsinstitutionalsurroundingsto anothercountry.

Forallthesereasons,themostsophisticatedactivities thatrequirehighlevelsofhumanandorganizational competencesandaconduciveinstitutionalenvironmenttend tostayathome.Homebiasesdonotexistsimplybecause ofemotionalattachmentsorhistoricalreasons.Their existencehasgoodeconomicbases.

‘Princeofdarkness’changeshismind

LordPeterMandelson,thedefactodeputyprimeministerof theUKgovernmentatthetimeofwriting(early2010),hasa bitofareputationforhisMachiavellianpolitics.Agrandson ofthehighlyrespectedLabourpoliticianHerbertMorrison, andaTVproducerbyprofession,Mandelsonwasthechief spindoctorbehindtheriseoftheso-calledNewLabour underTonyBlair.Hisfamousabilitytosenseandexploit shiftsinpoliticalmoodsandaccordinglyorganizean effectivemediacampaign,combinedwithhisruthlessness, earnedhimthenickname‘princeofdarkness’.

Afterahigh-profilebutturbulentcabinetcareer,marred bytworesignationsduetosuspectedcorruptionscandals, MandelsonquitBritishpoliticsandmovedtoBrusselsto becomeEuropeanCommissionerforTradein2004. Buildingontheimageofapro-businesspolitician,gained

duringhisbriefspellastheUK’sSecretaryofStatefor TradeandIndustrybackin1998,Mandelsonestablisheda firmreputationasoneoftheworld’sleadingadvocatesof freetradeandinvestment.

Soitsentoutashockwave,whenMandelson,whohad madeasurprisecomebacktoBritishpoliticsandbecome BusinessSecretaryinearly2009,saidinaninterviewwith theWallStreetJournalinSeptember2009that,thanksto Britain’spermissiveattitudetowardsforeignownership,‘UK manufacturingcouldbealoser’,eventhoughheaddedthe provisothatthiswas‘overalengthyperiodoftime,certainly notovernight’.

WasitatypicalMandelsonantic,withhisinstincttelling himthatthiswasthetimetoplaythenationalistcard?Ordid hefinallycottonontosomethingthatheandotherBritish policy-makersshouldhaverealizedalongtimeago–that excessiveforeignownershipofanationaleconomycanbe harmful?

Now,itmaybeargued,thefactthatfirmshaveahomecountrybiasdoesnotnecessarilymeanthatcountries shouldputrestrictionsonforeigninvestment.True,giventhe homebias,investmentbyaforeigncompanymaynotbein themostdesirableactivities,butaninvestmentisan investmentanditwillstillincreaseoutputandcreatejobs.If youputrestrictionsonwhatforeigninvestorscando–for example,bytellingthemthattheycannotinvestincertain ‘strategic’industries,byforbiddingthemfromholdinga majorityshareordemandingthattheytransfertechnologies –foreigninvestorswillsimplygosomewhereelseandyou willlosethejobsandthewealththattheywouldhave created.Especiallyfordevelopingcountries,whichdonot havemanynationalfirmsthatcanmakesimilarinvestments, rejectingforeigninvestmentbecauseitisforeignmany peoplebelieveisfranklyirrational.Eveniftheygetonly lower-gradeactivitiessuchasassemblyoperation,theyare stillbetteroffwiththeinvestmentthanwithoutit.

Thisreasoningiscorrectinitsownterms,butthereare

moreissuesthatneedtobeconsideredbeforeweconclude thatthereshouldbenorestrictiononforeigninvestment (here,weputasideportfolioinvestment,whichisinvestment incompanysharesforfinancialgainswithoutinvolvementin directmanagement,andfocusonforeigndirectinvestment, whichisusuallydefinedasacquisitionofmorethan10per centofacompany’sshareswithanintenttogetinvolvedin management).

Firstofall,weneedtorememberthatalotofforeign investmentiswhatisknownas‘brownfieldinvestment,’that is,acquisitionofexistingfirmsbyaforeignfirm,ratherthan ‘greenfieldinvestment’,whichinvolvesaforeignfirmsetting upnewproductionfacilities.Sincethe1990s,brownfield investmenthasaccountedforoverhalfoftotalworldforeign directinvestment(FDI),evenreaching80percentin2001, attheheightoftheinternationalmergersandacquisitions (M&A)boom.ThismeansthatthemajorityofFDIinvolves takingcontrolofexistingfirms,ratherthanthecreationof newoutputandjobs.Ofcourse,thenewownersmayinject bettermanagerialandtechnologicalcapabilitiesandrevive anailingcompany–asseeninthecaseofNissanunder CarlosGhosn–butveryoftensuchanacquisitionismade withaviewtoutilizingcapabilitiesthatalreadyexistinthe acquiredcompanyratherthancreatingnewones.And,more importantly,onceyournationalfirmisacquiredbyaforeign firm,thehomebiasoftheacquiringcompanywillinthelong runimposeaceilingonhowfaritprogressesintheinternal peckingorderoftheacquiringcompany.

Eveninthecaseofgreenfieldinvestment,home-country biasisafactortoconsider.Yes,greenfieldinvestment createsnewproductivecapabilities,soitisbydefinition betterthanthealternative,thatis,noinvestment.However, thequestionthatpolicy-makersneedtoconsiderbefore acceptingitishowitisgoingtoaffectthefuturetrajectoryof theirnationaleconomy.Differentactivitieshavedifferent potentialsfortechnologicalinnovationandproductivity growth,andthereforewhatyoudotodayinfluenceswhatyou

willbedoinginthefutureandwhatyouwillgetoutofit.Asa popularsayingamongAmericanindustrialpolicyexpertsin the1980swent,wecannotpretendthatitdoesnotmatter whetheryouproducepotatochips,woodchipsor microchips.Andthechanceisthataforeigncompanyis morelikelytoproducepotatochipsorwoodchipsthan microchipsinyourcountry.

Giventhis,especiallyforadevelopingcountry,whose nationalfirmsarestillunderdeveloped,itmaybebetterto restrictFDIatleastinsomeindustriesandtrytoraise nationalfirmssothattheybecomecrediblealternative investorstoforeigncompanies.Thiswillmakethecountry losesomeinvestmentintheshortrun,butitmayenableitto havemorehigher-endactivitieswithinitsbordersinthelong run.Or,evenbetter,thedevelopingcountrygovernmentcan allowforeigninvestmentunderconditionsthatwillhelpthe countryupgradethecapabilitiesofnationalfirmsfaster–for example,byrequiringjointventures(whichwillpromotethe transferofmanagerialtechniques),demandingmoreactive technologytransfer,ormandatingworkertraining.

Now,sayingthatforeigncapitalislikelytobelessgood foryourcountrythanyourownnationalcapitalisnottosay thatweshouldalwaysprefernationalcapitaltoforeign capital.Thisisbecauseitsnationalityisnottheonlything thatdeterminesthebehaviourofcapital.Theintentionand thecapabilityofthecapitalinquestionalsomatter.

Supposethatyouarethinkingofsellingastruggling nationallyownedcarcompany.Ideally,youwantthenew ownertohavethewillingnessandtheabilitytoupgradethe companyinthelongrun.Theprospectivebuyerismore likelytohavethetechnologicalcapabilitiestodosowhenit isanalreadyestablishedautomobileproducer,whether nationalorforeign,ratherthanwhenitisfinancecapital, suchasaprivateequityfund.

Inrecentyears,privateequityfundshaveplayedan increasinglyimportantroleincorporateacquisitions.Even thoughtheyhavenoin-houseexpertiseinparticular

industries,theymay,intheory,acquireacompanyforthe longtermandhireindustryexpertsasmanagersandask themtoupgradeitscapabilities.However,inpractice,these fundsusuallyhavenointentiontoupgradetheacquired companyforthelongterm.Theyacquirefirmswithaviewto sellingthemoninthreetofiveyearsafterrestructuringthem intoprofitability.Suchrestructuring,giventhetimehorizon, usuallyinvolvescuttingcosts(especiallysackingworkers andrefrainingfromlong-terminvestments),ratherthan raisingcapabilities.Suchrestructuringislikelytohurtthe long-termprospectsofthecompanybyweakeningitsability togenerateproductivitygrowth.Intheworstcases,private equityfundsmayacquirecompanieswiththeexplicit intentiontoengageinasset-stripping,sellingthevaluable assetsofacompanywithoutregardtoitslong-termfuture. Whatthenow-notoriousPhoenixVentureHoldingsdidtothe Britishcar-makerRover,whichtheyhadboughtfromBMW, isaclassicexampleofthis(theso-called‘PhoenixFour’ becameparticularlynotoriousforpayingthemselveshuge salariesandtheirfriendsexorbitantconsultancyfees).

Ofcourse,thisisnottosaythatfirmsthatarealready operatingintheindustrywillalwayshavetheintentionto upgradetheacquiredcompanyforthelongtermeither. WhenGMacquiredaseriesofsmallerforeigncar companies–suchasSweden’sSaabandKorea’sDaewoo –duringthedecadebeforeitsbankruptcyin2009,the intentionwastoliveoffthetechnologiesaccumulatedby thesecompanies,ratherthantoupgradethem(seeThing 18).Moreover,recentlythedistinctionbetweenindustrial capitalandfinancecapitalhascometobeblurred,with industrialcompaniessuchasGMandGEmakingmore profitsinfinancethaninindustry(seeThing22),sothefact thattheacquiringfirmoperatesinaparticularindustryisnot aguaranteeofalong-termcommitmenttothatindustry.

So,ifaforeigncompanyoperatinginthesameindustryis buyingupyournationalcompanywithaseriouslong-term commitment,sellingittothatcompanymaybebetterthan

sellingittoyourownnationalprivateequityfund.However, otherthingsbeingequal,thechanceisthatyournational companyisgoingtoactinawaythatismorefavourableto yournationaleconomy.

Thus,despitetheglobalizationrhetoric,thenationalityof afirmisstillakeytodecidingwhereitshigh-grade activities,suchasR&Dandstrategizing,aregoingtobe located.Nationalityisnottheonlydeterminantoffirm behaviour,soweneedtotakeintoaccountotherfactors, suchaswhethertheinvestorhasatrackrecordinthe industryconcernedandhowstrongitslong-term commitmenttotheacquiredcompanyreallyis.Whileablind rejectionofforeigncapitaliswrong,itwouldbeverynaïveto designeconomicpoliciesonthemyththatcapitaldoesnot havenationalrootsanymore.Afterall,LordMandelson’s belatedlyfoundreservationsturnouttohaveaseriousbasis inreality.

Wedonotliveinapostindustrialage

Whattheytellyou

Oureconomyhasbeenfundamentallytransformedduring thelastfewdecades.Especiallyintherichcountries, manufacturingindustry,oncethedrivingforceofcapitalism, isnotimportantanymore.Withthenaturaltendencyforthe (relative)demandforservicestorisewithprosperityand withtheriseofhigh-productivityknowledge-basedservices (suchasbankingandmanagementconsulting), manufacturingindustrieshavegoneintodeclineinallrich countries.Thesecountrieshaveenteredthe‘post-industrial’ age,wheremostpeopleworkinservicesandmostoutputs areservices.Thedeclineofmanufacturingisnotonly somethingnaturalthatweneedn’tworryaboutbutsomething thatweshouldreallycelebrate.Withtheriseofknowledgebasedservices,itmaybebetterevenforsomedeveloping countriestoskipthosedoomedmanufacturingactivities altogetherandleapfrogstraighttoaservice-basedpostindustrialeconomy.

thatmostofusworkinshopsandofficesratherthanin factories.Butwehavenotenteredapost-industrialstageof developmentinthesensethatindustryhasbecome unimportant.Most(althoughnotall)oftheshrinkageinthe shareofmanufacturingintotaloutputisnotduetothefallin theabsolutequantityofmanufacturedgoodsproducedbut duetothefallintheirpricesrelativetothoseforservices, whichiscausedbytheirfastergrowthinproductivity(output perunitofinput).Now,eventhoughde-industrializationis mainlyduetothisdifferentialproductivitygrowthacross sectors,andthusmaynotbesomethingnegativeinitself,it hasnegativeconsequencesforeconomy-wideproductivity growthandforthebalanceofpayments,whichcannotbe ignored.Asfortheideathatdevelopingcountriescan largelyskipindustrializationandenterthepost-industrial phasedirectly,itisafantasy.Theirlimitedscopefor productivitygrowthmakesservicesapoorengineofgrowth. Thelowtradabilityofservicesmeansthatamoreservicebasedeconomywillhavealowerabilitytoexport.Lower exportearningsmeansaweakerabilitytobuyadvanced technologiesfromabroad,whichinturnleadstoaslower growth.

Isthereanythingthatisnotmadein China?

Oneday,Jin-Gyu,mynine-year-oldson(yes,that’stheone whoappearedas‘mysix-year-oldson’inmyearlierbook BadSamaritans–reallyquiteaversatileactor,heis)came andaskedme:‘Daddy,isthereanythingthatisnotmadein China?’Itoldhimthat,yes,itmaynotlookthatway,butother countriesstillmakethings.Ithenstruggledtocomeupwith anexample.Iwasabouttomentionhis‘Japanese’Nintendo DSigameconsole,butthenIrememberedseeing‘Madein

China’onit.Imanagedtotellhimthatsomemobilephones andflat-screenTVsaremadeinKorea,butIcouldnotthink ofmanyotherthingsthatanine-year-oldwouldrecognize (heisstilltooyoungforthingslikeBMW).NowonderChina isnowcalledthe‘workshopoftheworld’.

Itishardtobelieve,butthephrase‘workshopofthe world’wasoriginallycoinedforBritain,whichtoday, accordingtoNicolasSarkozy,theFrenchpresident,has‘no industry’.HavingsuccessfullylaunchedtheIndustrial Revolutionbeforeothercountries,Britainbecamesucha dominantindustrialpowerbythemidnineteenthcenturythat itfeltconfidentenoughtocompletelyliberalizeitstrade(see Thing7).In1860,itproduced20percentofworld manufacturingoutput.In1870,itaccountedfor46percentof worldtradeinmanufacturedgoods.ThecurrentChinese shareinworldexportsisonlyaround17percent(asof 2007),eventhough‘everything’seemstobemadeinChina, soyoucanimaginetheextentofBritishdominancethen.

However,Britain’spolepositionwasshortlived.Having liberalizeditstradecompletelyaround1860,itsrelative positionstarteddecliningfromthe1880s,withcountries suchastheUSandGermanyrapidlycatchingup.Itlostits leadingpositionintheworld’sindustrialhierarchybythe timeoftheFirstWorldWar,butthedominanceof manufacturingintheBritisheconomyitselfcontinuedfora longtimeafterwards.Untiltheearly1970s,togetherwith Germany,Britainhadoneoftheworld’shighestsharesof manufacturingemploymentintotalemployment,ataround 35percent.Atthetime,Britainwasthequintessential manufacturingeconomy,exportingmanufacturedgoodsand importingfood,fuelandrawmaterials.Itsmanufacturing tradesurplus(manufacturingexportsminusmanufacturing imports)stayedconsistentlybetween4percentand6per centofGDPduringthe1960sand70s.

Sincethe1970s,however,theBritishmanufacturing sectorhasshrunkrapidlyinimportance.Manufacturing outputasashareofBritain’sGDPusedtobe37percentin

1950.Today,itaccountsforonlyaround13percent. Manufacturing’sshareintotalemploymentfellfromaround 35percentintheearly1970stojustover10percent.1Its positionininternationaltradehasalsodramatically changed.Thesedays,Britainrunsmanufacturingtrade deficitsintheregionof2–4percentofGDPperyear.What hashappened?ShouldBritainbeworried?

Thepredominantopinionisthatthereisnothingtoworry about.Tobeginwith,itisnotasifBritainistheonlycountry inwhichthesethingshavehappened.Thedecliningshares ofmanufacturingintotaloutputandemployment–a phenomenonknownasde-industrialization–isanatural occurrence,manycommentatorsargue,commontoallrich countries(acceleratedintheBritishcasebythefindingof NorthSeaoil).Thisiswidelybelievedtobebecause,as theybecomericher,peoplebegintodemandmoreservices thanmanufacturedgoods.Withfallingdemand,itisnatural thatthemanufacturingsectorshrinksandthecountryenters thepost-industrialstage.Manypeopleactuallycelebratethe riseofservices.Accordingtothem,therecentexpansionof knowledge-basedserviceswithrapidproductivitygrowth–suchasfinance,consulting,design,computingand informationservices,R&D–meansthatserviceshave replacedmanufacturingastheengineofgrowth,atleastin therichcountries.Manufacturingisnowalow-gradeactivity thatdevelopingcountriessuchasChinaperform.

Computersandhaircuts:whydeindustrializationhappens

Havewereallyenteredthepost-industrialage?Is manufacturingirrelevantnow?Theanswersare:‘onlyin someways’,and‘no’.

Itisindisputablethatmuchlowerproportionsofpeoplein

therichcountriesworkinfactoriesthanusedtobethecase. Therewasatimeinthelatenineteenthandearlytwentieth centurieswheninsomecountries(notablyBritainand Belgium)around40percentofthoseemployedworkedin themanufacturingindustry.Today,theratioisatmost25per cent,andinsomecountries(especiallytheUS,Canadaand Britain)barely15percent.

Withsomuchfewerpeople(inproportionalterms) workinginfactories,thenatureofsocietyhaschanged.We arepartlyformedbyourworkexperiences(apointwhich mosteconomistsfailtorecognize),sowhereandhowwe workinfluenceswhoweare.Comparedtofactoryworkers, officeworkersandshopassistantsdomuchlessphysical workand,nothavingtoworkwithconveyorbeltsandother machines,havemorecontrolovertheirlabourprocess. Factoryworkerscooperatemorecloselywiththeir colleaguesduringworkandoutsidework,especiallythrough tradeunionactivities.Incontrast,peopleworkinginshops andofficestendtoworkonmoreindividualbasesandare notveryunionized.Shopassistantsandsomeoffice workersinteractdirectlywithcustomers,whereasfactory workersneverseetheircustomers.Iamnotenoughofa sociologistorapsychologisttosayanythingprofoundinthis regard,butallthismeansthatpeopleintoday’srich countriesnotonlyworkdifferentlyfrombutaredifferentfrom theirparentsandgrandparents.Inthisway,today’srich countrieshavebecomepost-industrialsocietiesinthesocial sense.

However,theyhavenotbecomepost-industrialinthe economicsense.Manufacturingstillplaystheleadingrolein theireconomies.Inordertoseethispoint,wefirstneedto understandwhyde-industrializationhashappenedintherich countries.

Asmall,butnotnegligible,partofde-industrializationis duetoopticalillusions,inthesensethatitreflectschanges instatisticalclassificationratherthanchangesinreal activities.Onesuchillusionisduetotheoutsourcingof

someactivitiesthatarereallyservicesintheirphysical naturebutusedtobeprovidedin-housebymanufacturing firmsandthusclassifiedasmanufacturingoutput(e.g., catering,cleaning,technicalsupports).Whentheyare outsourced,recordedserviceoutputsincreasewithoutareal increaseinserviceactivities.Eventhoughthereisno reliableestimateofitsmagnitude,expertsagreethat outsourcinghasbeenasignificantsourceofdeindustrializationintheUSandBritain,especiallyduringthe 1980s.Inadditiontotheoutsourcingeffect,theextentof manufacturingcontractionisexaggeratedbywhatiscalled the‘reclassificationeffect’.2AUKgovernmentreport estimatesthatupto10percentofthefallinmanufacturing employmentbetween1998and2006intheUKmaybe accountedforbysomemanufacturingfirms,seeingtheir serviceactivitiesbecomingpredominant,applyingtothe governmentstatisticalagencytobereclassifiedasservice firms,evenwhentheyarestillengagedinsome manufacturingactivities.

Onecauseofgenuinede-industrializationhasrecently attractedalotofattention.Itistheriseofmanufacturing importsfromlow-costdevelopingcountries,especially China.Howeverdramaticitmaylook,itisnotthemain explanationforde-industrializationintherichcountries. China’sexportsdidnotmakearealimpactuntilthelate 1990s,butthede-industrializationprocesshadalready startedinthe1970sinmostrichcountries.Mostestimates showthattheriseofChinaasthenewworkshopoftheworld canexplainonlyaround20percentofde-industrializationin therichcountriesthathashappenedsofar.

Manypeoplethinkthattheremaining80percentorso canbelargelyexplainedbythenaturaltendencyofthe (relative)demandformanufacturedgoodstofallwithrising prosperity.However,acloserlookrevealsthatthisdemand effectisactuallyverysmall.Itlooksasifwearespending everhighersharesofourincomeonservicesnotbecause weareconsumingevermoreservicesinabsolutetermsbut

mainlybecauseservicesarebecomingevermore expensiveinrelativeterms.

Withthe(inflation-adjusted)amountofmoneyyoupaidto getaPCtenyearsago,todayyoucanprobablybuythree,if notfour,computersofequalorevengreatercomputing power(andcertainlysmallersize).Asaresult,youprobably havetwo,ratherthanjustone,computers.But,evenwithtwo computers,theportionofyourincomethatyouspendon computershasgonedownquitealot(forthesakeof argument,Iamassumingthatyourincome,afteradjusting forinflation,isthesame).Incontrast,youareprobably gettingthesamenumberofhaircutsasyoudidtenyears ago(ifyouhaven’tgonethinontop,thatis).Thepriceof haircutshasprobablygoneupsomewhat,sotheproportion ofyourincomethatgoestoyourhaircutsisgreaterthanit wastenyearsago.Theresultisthatitlooksasifyouare spendingagreater(smaller)portionofyourincomeon haircuts(computers)thanbefore,buttherealityisthatyou areactuallyconsumingmorecomputersthanbefore,while yourconsumptionofhaircutsisthesame.

Indeed,ifyouadjustforthechangesinrelativeprices(or, tousetechnicaljargon,ifyoumeasurethingsinconstant prices),thedeclineofmanufacturingintherichcountrieshas beenfarlesssteepthanitappearstobe.Forexample,in thecaseofBritain,theshareofmanufacturingintotaloutput, withoutcountingtherelativepriceeffects(tousethejargon, incurrentprices),fellbyover40percentbetween1955and 1990(from37percentto21percent).However,when takingtherelativepriceeffectsintoaccount,thefallwasonly byjustover10percent(from27percentto24percent).3In otherwords,therealdemandeffect–thatisthedemand effectaftertakingrelativepricechangesintoaccount–is small.

Thenwhyaretherelativepricesofmanufacturedgoods falling?Itisbecausemanufacturingindustriestendtohave fasterproductivitygrowththanservices.Astheoutputofthe manufacturingsectorincreasesfasterthantheoutputofthe

servicesector,thepricesofthemanufacturedgoodsrelative tothoseofservicesfall.Inmanufacturing,where mechanizationandtheuseofchemicalprocessesaremuch easier,itiseasiertoraiseproductivitythaninservices.In contrast,bytheirverynature,manyserviceactivitiesare inherentlyimpervioustoproductivityincreasewithout dilutingthequalityoftheproduct.

Insomecases,theveryattempttoincreaseproductivity willdestroytheproductitself.Ifastringquartettrotsthrough atwenty-seven-minutepieceinnineminutes,wouldyousay thatitsproductivityhastrebled?

Forsomeotherservices,theapparenthigherproductivity isduetothedebasementoftheproduct.Ateachercan raiseherapparentproductivitybyfourtimesbyhavingfour timesasmanypupilsinherclassroom,butthequalityofher ‘product’hasbeendilutedbythefactthatshecannotpayas muchindividualattentionasbefore.Alotoftheincreasesin retailserviceproductivityincountriessuchastheUSand Britainhasbeenboughtbyloweringthequalityoftheretail serviceitselfwhileostensiblyofferingcheapershoes,sofas andapples:therearefewersalesassistantsatshoestores, soyouwaittwentyminutesinsteadoffive;youhavetowait fourweeks,ratherthantwo,forthedeliveryofyournewsofa andprobablyalsohavetotakeadayoffworkbecausethey willonlydeliver‘sometimebetween8a.m.and6p.m.’;you spendmuchmoretimethanbeforedrivingtothenew supermarketandwalkingthroughthenowlongeraisles whenyougetthere,becausethoseapplesarecheaperthan intheoldsupermarketonlybecausethenewsupermarketis inthemiddleofnowhereandthuscanhavemorefloor space.

Therearesomeserviceactivities,suchasbanking, whichhavegreaterscopeforproductivityincreasethan otherservices.However,asrevealedbythe2008financial crisis,muchoftheproductivitygrowthinthoseactivitieswas duenottoarealriseintheirproductivity(e.g.,reductionin tradingcostsduetobettercomputers)buttofinancial

innovationsthatobscured(ratherthangenuinelyreduced) theriskinessoffinancialassets,therebyallowingthe financialsectortogrowatanunsustainablyrapidrate(see Thing22).

Tosumup,thefallintheshareofmanufacturingintotal outputintherichcountriesisnotlargelyduetothefallin (relative)demandformanufacturedgoods,asmanypeople think.Norisitduemainlytotheriseofmanufacturedexports fromChinaandotherdevelopingcountries,althoughthat hashadbigimpactsonsomesectors.Itisinsteadthefalling relativepricesofthemanufacturedgoodsduetofaster growthinproductivityinthemanufacturingsectorthatisthe maindriverofthede-industrializationprocess.Thus,while thecitizensoftherichcountriesmaybelivinginpostindustrialsocietiesintermsoftheiremployment,the importanceofmanufacturingintermsofproductioninthose economieshasnotbeendiminishedtotheextentthatwe candeclareapost-industrialage.

Shouldweworryaboutdeindustrialization?

Butifde-industrializationisduetotheverydynamismofa country’smanufacturingsector,isn’titagoodthing?

Notnecessarily.Thefactthatde-industrializationis mainlycausedbythecomparativedynamismofthe manufacturingsectorvis-à-vistheservicesectordoesnot tellusanythingabouthowwellitisdoingcomparedtoits counterpartsinothercountries.Ifacountry’smanufacturing sectorhasslowerproductivitygrowththanitscounterpartsin othercountries,itwillbecomeinternationallyuncompetitive, leadingtobalanceofpaymentsproblemsintheshortrun andfallingstandardsoflivinginthelongterm.Inother

words,de-industrializationmaybeaccompaniedbyeither economicsuccessorfailure.Countriesshouldnotbelulled intoafalsesenseofsecuritybythefactthatdeindustrializationisduetocomparativedynamismofthe manufacturingsector,asevenamanufacturingsectorthatis veryundynamicbyinternationalstandardscanbe(and usuallyis)moredynamicthantheservicesectorofthesame country.

Whetherornotacountry’smanufacturingsectoris dynamicbyinternationalstandards,theshrinkageofthe relativeweightofthemanufacturingsectorhasanegative impactonproductivitygrowth.Astheeconomybecomes dominatedbytheservicesector,whereproductivitygrowth isslower,productivitygrowthforthewholeeconomywillslow down.Unlesswebelieve(assomedo)thatthecountries experiencingde-industrializationarenowrichenoughnotto needmoreproductivitygrowth,productivityslowdownis somethingthatcountriesshouldgetworriedabout–orat leastreconcilethemselvesto.

De-industrializationalsohasanegativeeffectona country’sbalanceofpaymentsbecauseservicesare inherentlymoredifficulttoexportthanmanufacturedgoods. Abalanceofpaymentsdeficitmeansthatthecountrycannot ‘payitsway’intheworld.Ofcourse,acountrycanplugthe holethroughforeignborrowingforawhile,buteventuallyit willhavetolowerthevalueofitscurrency,therebyreducing itsabilitytoimportandthusitslivingstandard.

Attherootofthelow‘tradability’ofservicesliesthefact that,unlikemanufacturedgoodsthatcanbeshipped anywhereintheworld,mostservicesrequiretheirproviders andconsumerstobeinthesamelocation.Noonehasyet inventedwaystoprovideahaircutorhouse-cleaninglongdistance.Obviously,thisproblemwillbesolvediftheservice provider(thehairdresserorthecleanerintheabove examples)canmovetothecustomer’scountry,butthatin mostcasesmeansimmigration,whichmostcountries restrictheavily(seeThing3).Giventhis,arisingshareof

servicesintheeconomymeansthatthecountry,otherthings beingequal,willhavelowerexportearnings.Unlessthe exportsofmanufacturedgoodsrisedisproportionately,the countrywon’tbeabletopayforthesameamountofimports asbefore.Ifitsde-industrializationisofanegativekind accompaniedbyweakeninginternationalcompetitiveness, thebalanceofpaymentsproblemcouldbeevenmore serious,asthemanufacturingsectorthenwon’tbeableto increaseitsexports.

Notallservicesareequallynon-tradable.TheknowledgebasedservicesthatImentionedearlier–banking, consulting,engineering,andsoon–arehighlytradable.For example,inBritainsincethe1990s,exportsofknowledgebasedserviceshaveplayedacrucialroleinpluggingthe balanceofpaymentsgapleftbehindbyde-industrialization (andthefallinNorthSeaoilexports,whichhadenabledthe country–just–tosurvivethenegativebalanceofpayments consequencesofde-industrializationduringthe1980s).

However,eveninBritain,whichismostadvancedinthe exportsoftheseknowledge-basedservices,thebalanceof paymentssurplusgeneratedbythoseservicesiswellbelow 4percentofGDP,justenoughtocoverthecountry’s manufacturingtradedeficits.Withthelikelystrengtheningof globalfinancialregulationasaconsequenceofthe2008 worldfinancialcrisis,itisunlikelythatBritaincanmaintain thisleveloftradesurplusinfinanceandotherknowledgebasedservicesinthefuture.InthecaseoftheUS, supposedlyanothermodelpost-industrialeconomy,the tradesurplusinknowledge-basedservicesisactuallyless than1percentofGDP–nowherenearenoughtomakeup foritsmanufacturingtradedeficits,whicharearound4per centofGDP.4TheUShasbeenabletomaintainsucha largemanufacturingtradedeficitonlybecauseitcould borrowheavilyfromabroad–anabilitythatcanonlyshrink inthecomingyears,giventhechangesintheworld economy–andnotbecausetheservicesectorsteppedinto fillthegap,asintheBritishcase.Moreover,itis

questionablewhetherthestrengthsoftheUSandBritainin theknowledge-basedservicescanbemaintainedovertime. Inservicessuchasengineeringanddesign,whereinsights gainedfromtheproductionprocessarecrucial,a continuousshrinkageoftheindustrialbasewillleadtoa declineinthequalityoftheir(service)productsanda consequentlossinexportearnings.

IfBritainandtheUS–twocountriesthataresupposedto bethemostdevelopedintheknowledge-basedservices–areunlikelytomeettheirbalanceofpaymentsneedsinthe longrunthroughtheexportsoftheseservices,itishighly unlikelythatothercountriescan.

Post-industrialfantasies

Believingde-industrializationtobetheresultofthechange ofourengineofgrowthfrommanufacturingtoservices, somehavearguedthatdevelopingcountriescanlargely skipindustrializationandmovedirectlytotheservice economy.Especiallywiththeriseofserviceoffshoring,this viewhasbecomeverypopularamongsomeobserversof India.Forgetallthosepollutingindustries,theysay,whynot gofromagriculturetoservicesdirectly?IfChinaisthe workshopoftheworld,theargumentgoes,Indiashouldtryto becomethe‘officeoftheworld’.

However,itisafantasytothinkthatapoorcountrycan developmainlyonthebasisoftheservicesector.As pointedoutearlier,themanufacturingsectorhasan inherentlyfasterproductivitygrowththantheservicesector. Tobesure,therearesomeserviceindustriesthathave rapidproductivitygrowthpotential,notablytheknowledgebasedservicesthatImentionedabove.However,theseare serviceactivitiesthatmainlyservemanufacturingfirms,soit isverydifficulttodevelopthoseindustrieswithoutfirst

developingastrongmanufacturingbase.Ifyoubaseyour developmentlargelyonservicesfromearlyon,yourlongtermproductivitygrowthrateisgoingtobemuchslowerthan whenyoubaseitonmanufacturing.

Moreover,wehavealreadyseenthat,giventhatservices aremuchlesstradable,countriesspecializinginservices arelikelytofacemuchmoreseriousbalanceofpayments problemsthancountriesthatspecializeinmanufacturing. Thisisbadenoughforadevelopedcountry,wherebalance ofpaymentsproblemswilllowerstandardsoflivinginthe longrun.However,itisseriouslydetrimentalfora developingcountry.Thepointisthat,inordertodevelop,a developingcountryhastoimportsuperiortechnologiesfrom abroad(eitherintheformofmachinesorintheformof technologylicensing).Therefore,whenithasabalanceof paymentsproblem,itsveryabilitytoupgradeandthus developitseconomybydeployingsuperiortechnologiesis hampered.

AsIsaythesenegativethingsabouteconomic developmentstrategiesbasedonservices,someofyou maysay:whataboutcountrieslikeSwitzerlandand Singapore?Haven’ttheydevelopedonthebasisof services?

However,theseeconomiesarenotwhattheyare reportedtobeeither.Theyareinfactmanufacturing successstories.Forexample,manypeoplethinkthat Switzerlandlivesoffthestolenmoneydepositedinitsbanks byThirdWorlddictatorsorbysellingcowbellsandcuckoo clockstoJapaneseandAmericantourists,butitisactually oneofthemostindustrializedeconomiesintheworld.We don’tseemanySwissmanufacturedproductsaround becausethecountryissmall(around7millionpeople), whichmakesthetotalamountofSwissmanufacturedgoods rathersmall,andbecauseitsproducersspecializein producergoods,suchasmachineryandindustrial chemicals,ratherthanconsumergoodsthataremore visible.Butinpercapitaterms,Switzerlandhasthehighest

industrialoutputintheworld(itcouldcomesecondafter Japan,dependingontheyearandthedatayoulookat).

Singaporeisalsooneofthefivemostindustrialized economiesintheworld(onceagain,measuredintermsof manufacturingvalue-addedperhead).FinlandandSweden makeuptherestofthetopfive.Indeed,exceptforafew placessuchastheSeychellesthathasaverysmall populationandexceptionalresourcesfortourism(85,000 peoplewitharound$9,000percapitaincome),nocountry hassofarachievedevenadecent(nottospeakofhigh) livingstandardbyrelyingonservicesandnonewilldosoin thefuture.

Tosumup,eventherichcountrieshavenotbecome unequivocallypost-industrial.Whilemostpeopleinthose countriesdonotworkinfactoriesanymore,the manufacturingsector’simportanceintheirproduction systemshasnotfallenverymuch,oncewetakeintoaccount therelativepriceeffects.Butevenifde-industrializationis notnecessarilyasymptomofindustrialdecline(althoughit oftenis),ithasnegativeeffectsforlong-termproductivity growthandthebalanceofpayments,bothofwhichneed reckoning.Themyththatwenowliveinapost-industrialage hasmademanygovernmentsignorethenegative consequencesofde-industrialization.

Asforthedevelopingcountries,itisafantasytothinkthat theycanskipindustrializationandbuildprosperityonthe basisofserviceindustries.Mostserviceshaveslow productivitygrowthandmostofthoseservicesthathave highproductivitygrowthareservicesthatcannotbe developedwithoutastrongmanufacturingsector.Low tradabilityofservicesmeansthatadevelopingcountry specializinginserviceswillfaceabiggerbalanceof paymentsproblem,whichforadevelopingcountrymeansa reductioninitsabilitytoupgradeitseconomy.Postindustrialfantasiesarebadenoughfortherichcountries,but theyarepositivelydangerousfordevelopingcountries.

TheUSdoesnothavethe highestlivingstandardinthe world

Whattheytellyou

Despiteitsrecenteconomicproblems,theUSstillenjoys thehigheststandardoflivingintheworld.Atmarket exchangerates,thereareseveralcountriesthathavea higherpercapitaincomethantheUS.However,ifwe considerthefactthatthesamedollar(orwhatevercommon currencywechoose)canbuymoregoodsandservicesin theUSthaninotherrichcountries,theUSturnsouttohave thehighestlivingstandardintheworld,barringthemini-citystateofLuxemburg.Thisiswhyothercountriesseekto emulatetheUS,illustratingthesuperiorityofthefree-market system,whichtheUSmostclosely(ifnotperfectly) represents.

Whattheydon’ttellyou

TheaverageUScitizendoeshavegreatercommandover goodsandservicesthanhiscounterpartinanyothercountry intheworldexceptLuxemburg.However,giventhecountry’s highinequality,thisaverageislessaccurateinrepresenting howpeoplelivethantheaveragesforothercountrieswitha

moreequalincomedistribution.Higherinequalityisalso behindthepoorerhealthindicatorsandworsecrime statisticsoftheUS.Moreover,thesamedollarbuysmore thingsintheUSthaninmostotherrichcountriesmainly becauseithascheaperservicesthaninothercomparable countries,thankstohigherimmigrationandpoorer employmentconditions.Furthermore,Americanswork considerablylongerthanEuropeans.Perhourworked,their commandovergoodsandservicesissmallerthanthatof severalEuropeancountries.Whilewecandebatewhichisa betterlifestyle–morematerialgoodswithlessleisuretime (asintheUS)orfewermaterialgoodswithmoreleisure time(asinEurope)–thissuggeststhattheUSdoesnot haveanunambiguouslyhigherlivingstandardthan comparablecountries.

Theroadsarenotpavedwithgold

Between1880and1914,nearly3millionItaliansmigrated totheUS.Whentheyarrived,manyofthemwerebitterly disappointed.Theirnewhomewasnottheparadisethey hadthoughtitwouldbe.Itissaidthatmanyofthemwrote backhome,saying‘notonlyaretheroadsnotpavedwith gold,theyarenotpavedatall;infact,wearetheoneswho aresupposedtopavethem’.

ThoseItalianimmigrantswerenotaloneinthinkingthat theUSiswheredreamscometrue.TheUSbecamethe richestcountryintheworldonlyaround1900,buteveninthe earlydaysofitsexistence,ithadastrongholdonthe imaginationofpoorpeopleelsewhere.Intheearly nineteenthcentury,USpercapitaincomewasstillonly aroundtheEuropeanaverageandsomethinglike50per centlowerthanthatofBritainandtheNetherlands.Butpoor Europeansstillwantedtomovetherebecausethecountry

hadanalmostunlimitedsupplyofland(well,ifyouwere willingtopushoutafewnativeAmericans)andanacute labourshortage,whichmeantwagesthreeorfourtimes higherthanthoseinEurope(seeThing7).Mostimportantly, thelackoffeudallegacymeantthatthecountryhadmuch highersocialmobilitythantheOldWorldcountries,as celebratedintheideaoftheAmericandream.

Itisnotjustprospectiveimmigrantswhoareattractedto theUS.Especiallyinthelastfewdecades,businessmen andpolicy-makersaroundtheworldhavewanted,andoften tried,toemulatetheUSeconomicmodel.Itsfreeenterprise system,accordingtoadmirersoftheUSmodel,letspeople competewithoutlimitsandrewardsthewinnerswithout restrictionsimposedbythegovernmentorbymisguided egalitarianculture.Thesystemthereforecreates exceptionallystrongincentivesforentrepreneurshipand innovation.Itsfreelabourmarket,witheasyhiringandfiring, allowsitsenterprisestobeagileandthusmorecompetitive, astheycanredeploytheirworkersmorequicklythantheir competitors,inresponsetochangingmarketconditions.

Withentrepreneursrichlyrewardedandworkershavingto adaptquickly,thesystemdoescreatehighinequality. However,itsproponentsargue,eventhe‘losers’inthis gamewillinglyacceptsuchoutcomesbecause,giventhe country’shighsocialmobility,theirownchildrencouldbethe nextThomasEdison,J.P.MorganorBillGates.Withsuch incentivestoworkhardandexerciseingenuity,nowonder thecountryhasbeentherichestintheworldforthelast century.

Americansjustlivebetter…

Actually,thisisnotquitetrue.TheUSisnottherichest countryintheworldanymore.NowseveralEuropean

countrieshavehigherpercapitaincomes.TheWorldBank datatellusthatthepercapitaincomeoftheUSin2007was $46,040.Thereweresevencountrieswithhigherpercapita incomeinUSdollarterms–startingwithNorway($76,450) atthetop,throughLuxemburg,Switzerland,Denmark, Iceland,IrelandandendingwithSweden($46,060). Discountingthetwomini-statesofIceland(311,000people) andLuxemburg(480,000people),thismakestheUSonly thesixthrichestcountryintheworld.

But,someofyoumaysay,thatcannotberight.Whenyou gototheUS,youjustseethatpeopletherelivebetterthan theNorwegiansortheSwissdo.

OnereasonwhywegetthatimpressionisthattheUSis muchmoreunequalthantheEuropeancountriesand thereforelooksmoreprosperoustoforeignvisitorsthanit reallyis–foreignvisitorstoanycountryrarelygettoseethe deprivedparts,ofwhichtheUShasmanymorethan Europe.Butevenignoringthisinequalityfactor,thereisa goodreasonwhymostpeoplethinkthattheUShasahigher livingstandardthanEuropeancountries.

Youmayhavepaid35Swissfrancs,or$35,fora5-mile (or8-km)taxirideinGeneva,whenasimilarrideinBoston wouldhavecostyouaround$15.InOslo,youmayhavepaid 550kroner,or$100,foradinnerthatcouldnotpossibly havebeenmorethan$50,or275kroner,inStLouis.The reversewouldhavebeenthecaseifyouhadchangedyour dollarsintoThaibahtorMexicanpesosonyourholidays. Havingyoursixthbackmassageoftheweekororderingthe thirdmargaritabeforedinner,youwouldhavefeltasifyour $100hadbeenstretchedinto$200,oreven$300(orwas thatthealcohol?).Ifmarketexchangeratesaccurately reflecteddifferencesinlivingstandardsbetweencountries, thesekindsofthingsshouldnothappen.

Whyaretheresuchhugedifferencesbetweenthethings thatyoucanbuyindifferentcountrieswithwhatshouldbe thesamesumsofmoney?Suchdifferencesexistbasically becausemarketexchangeratesarelargelydeterminedby

thesupplyanddemandforinternationallytradedgoodsand services(althoughintheshortruncurrencyspeculationcan influencemarketexchangerates),whilewhatasumof moneycanbuyinaparticularcountryisdeterminedbythe pricesofallgoodsandservices,andnotjustthosethatare internationallytraded.

Themostimportantamongthenon-tradedthingsare person-to-personlabourservices,suchasdrivingtaxisand servingmealsinrestaurants.Tradeinsuchservices requiresinternationalmigration,butthatisseverelylimited byimmigrationcontrol,sothepricesofsuchlabourservices endupbeinghugelydifferentacrosscountries(seeThings 3and9).Inotherwords,thingssuchastaxiridesandmeals areexpensiveincountriessuchasSwitzerlandandNorway becausetheyhaveexpensiveworkers.Theyarecheapin countrieswithcheapworkers,suchasMexicoandThailand. WhenitcomestointernationallytradedthingssuchasTVs ormobilephones,theirpricesarebasicallythesameinall countries,richandpoor.

Inordertotakeintoaccountthedifferentialpricesofnontradedgoodsandservicesacrosscountries,economists havecomeupwiththeideaofan‘internationaldollar’. Basedonthenotionofpurchasingpowerparity(PPP)–that is,measuringthevalueofacurrencyaccordingtohowmuch ofacommonconsumptionbasketitcanbuyindifferent countries–thisfictitiouscurrencyallowsustoconvert incomesofdifferentcountriesintoacommonmeasureof livingstandards.

Theresultofconvertingtheincomesofdifferentcountries intotheinternationaldollaristhattheincomesofrich countriestendtobecomelowerthantheirincomesatmarket exchangerates,whilethoseofpoorcountriestendto becomehigher.Thisisbecausealotofwhatweconsumeis services,whicharemuchmoreexpensiveintherich countries.Insomecases,thedifferencebetweenmarket exchangerateincomeandPPPincomeisnotgreat.

AccordingtotheWorldBankdata,themarketexchange

rateincomeoftheUSwas$46,040in2007,whileitsPPP incomewasmoreorlessthesameat$45,850.Inthecase ofGermany,thedifferencebetweenthetwowasgreater,at $38,860vs.$33,820(a15percentdifference,sotospeak, althoughwecannotreallycomparethetwonumbersthis directly).InthecaseofDenmark,thedifferencewasnearly 50percent($54,910vs.$36,740).Incontrast,China’s2007 incomemorethandoublesfrom$2,360to$5,370and India’sbynearlythreetimesfrom$950to$2,740,when calculatedinPPPterms.

Now,thecalculationofeachcurrency’sexchangerate withthe(fictitious)internationaldollarisnotastraightforward affair,notleastbecausewehavetoassumethatall countriesconsumethesamebasketofgoodsandservices, whichispatentlynotthecase.ThismakesthePPPincomes extremelysensitivetothemethodologiesandthedataused. Forexample,whentheWorldBankchangeditsmethodof estimatingPPPincomesin2007,China’sPPPincomeper capitafellby44percent(from$7,740to$5,370),while Singapore’sroseby53percent(from$31,710to$48,520) overnight.

Despitetheselimits,acountry’sincomeininternational dollarsprobablygivesusabetterideaofitslivingstandard thandoesitsdollarincomeatthemarketexchangerate. Andifwecalculateincomesofdifferentcountriesin internationaldollars,theUS(almost)comesbacktothetop oftheworld.Itdependsontheestimate,butLuxemburgis theonlycountrythathasahigherPPPincomepercapita thanthatoftheUSinallestimates.So,aslongasweset asidethetinycity-stateofLuxemburg,withlessthanhalfa millionpeople,theaverageUScitizencanbuythelargest amountofgoodsandservicesintheworldwithherincome.

DoesthisallowustosaythattheUShasthehighest livingstandardintheworld?Perhaps.Buttherearequitea fewthingswehavetoconsiderbeforewejumptothat conclusion.

Tobeginwith,havingahigheraverageincomethanother countriesdoesnotnecessarilymeanthatallUScitizenslive betterthantheirforeigncounterparts.Whetherthisisthe casedependsonthedistributionofincome.Ofcourse,inno countrydoestheaverageincomegivetherightpictureof howpeoplelive,butinacountrywithhigherinequalityitis likelytobeparticularlymisleading.GiventhattheUShasby farthemostunequaldistributionofincomeamongtherich countries,wecansafelyguessthattheUSpercapita incomeoverstatestheactuallivingstandardsofmoreofits citizensthaninothercountries.Andthisconjectureis indirectlysupportedbyotherindicatorsoflivingstandards. Forexample,despitehavingthehighestaveragePPP income,theUSranksonlyaroundthirtiethintheworldin healthstatisticssuchaslifeexpectancyandinfantmortality (OK,theinefficiencyoftheUShealthcaresystemcontributes toit,butlet’snotgetintothat).Themuchhighercrimerate thaninEuropeorJapan–inpercapitaterms,theUShas eighttimesmorepeopleinprisonthanEuropeandtwelve timesmorethanJapan–showsthatthereisafarbigger underclassintheUS.

Second,theveryfactthatitsPPPincomeismoreorless thesameasitsmarketexchangerateincomeisproofthat thehigheraveragelivingstandardintheUSisbuiltonthe povertyofmany.WhatdoImeanbythis?AsIhavepointed outearlier,itisnormalforarichcountry’sPPPincometobe lower,sometimessignificantly,thanitsmarketexchange rateincome,becauseithasexpensiveserviceworkers. However,thisdoesnothappentotheUS,because,unlike otherrichcountries,ithascheapserviceworkers.Tobegin with,thereisalargeinflowoflow-wageimmigrantsfrom poorcountries,manyofthemillegal,whichmakesthem

evencheaper.Moreover,eventhenativeworkershave muchweakerfallbackpositionsintheUSthaninEuropean countriesofcomparableincomelevel.Becausetheyhave muchlessjobsecurityandweakerwelfaresupports,US workers,especiallythenon-unionizedonesintheservice industries,workforlowerwagesandunderinferior conditionsthandotheirEuropeancounterparts.Thisiswhy thingsliketaxiridesandmealsatrestaurantsaresomuch cheaperintheUSthaninotherrichcountries.Thisisgreat whenyouarethecustomer,butnotifyouarethetaxidriver orthewaitress.Inotherwords,thehigherpurchasingpower ofaverageUSincomeisboughtatthepriceoflower incomeandinferiorworkingconditionsformanyUScitizens.

Lastbutnotleast,incomparinglivingstandardsacross countries,weshouldnotignorethedifferencesinworking hours.Evenifsomeoneisearning50percentmoremoney thanIearn,youwouldn’tsaythathehasahigherliving standardthanIdo,ifthatpersonhastoworkdoublethe numberofhoursthatIdo.ThesameappliestotheUS.The Americans,befittingtheirreputationforworkaholism,work longerhoursthanthecitizensofanyothercountrythathasa percapitaincomeofmorethan$30,000atmarket exchangeratein2007(Greecebeingthepoorestofthelot, atjustunder$30,000percapitaincome).Americanswork 10percentlongerthanmostEuropeansandaround30per centlongerthantheDutchandtheNorwegians.According toacalculationbytheIcelandiceconomistThorvaldur Gylfason,intermsofincome(inPPPterms)perhour workedin2005,theUSrankedonlyeighth–after Luxemburg,Norway,France(yes,France,thatnationof loungers),Ireland,Belgium,Austria,andtheNetherlands–andwasverycloselyfollowedbyGermany.1Inotherwords, perunitofeffort,theAmericansarenotgettingashigha livingstandardastheircounterpartsincompetitornations. Theymakeupforthislowerproductivitythroughmuchlonger hours.

Now,itisperfectlyreasonableforsomeonetoarguethat

shewantstoworklongerhoursifthatisnecessarytohavea higherincome–shewouldratherhaveanotherTVthanone moreweekofholiday.AndwhoamI,oranyoneelse,tosay thatthepersongotherprioritywrong?

However,itisstilllegitimatetoaskwhetherpeoplewho worklongerhoursevenatveryhighlevelsofincomeare doingtherightthing.Mostpeoplewouldagreethat,atalow levelofincome,anincreaseinincomeislikelytoimprove yourqualityoflife,evenifitmeanslongerworkinghours.At thislevel,evenifyouhavetoworklongerinyourfactory, higherincomeislikelytobringahigheroverallqualityoflife, byimprovingyourhealth(throughbetterfood,heating, hygieneandhealthcare)andbyreducingthephysical demandsofhouseholdwork(throughmorehousehold appliances,pipedwater,gasandelectricity–seeThing4). However,aboveacertainlevelofincome,therelativevalue ofmaterialconsumptionvis-à-visleisuretimeisdiminished, soearningahigherincomeatthecostofworkinglonger hoursmayreducethequalityofyourlife.

Moreimportantly,thefactthatthecitizensofacountry worklongerthanothersincomparablecountriesdoesnot necessarilymeanthattheylikeworkinglongerhours.They maybecompelledtoworklonghours,eveniftheyactually wanttotakelongerholidays.AsIpointedoutabove,how longapersonworksisaffectednotonlybyhisown preferenceregardingwork–leisurebalancebutalsoby thingssuchaswelfareprovision,protectionofworkerrights andunionpower.Individualshavetotakethesethingsas given,butnationshaveachoiceoverthem.Theycanrewrite thelabourlaws,beefupthewelfarestateandeffectother policychangestomakeitlessnecessaryforindividualsto worklonghours.

MuchofthesupportfortheAmericanmodelhasbeen basedonthe‘fact’thattheUShasthehighestliving standardintheworld.WhilethereisnoquestionthattheUS hasoneofthehighestlivingstandardsintheworld,its allegedsuperioritylooksmuchweakeroncewehavea

broaderconceptionoflivingstandardsthanwhatthe averageincomeofacountrywillbuy.Higherinequalityinthe USmeansthatitsaverageincomeislessindicativeofthe livingstandardsofitscitizensthaninothercountries.Thisis reflectedinindicatorssuchashealthandcrime,wherethe USperformsmuchworsethancomparablecountries.The higherpurchasingpowerofUScitizens(comparedtothe citizensofotherrichcountries)isowedinlargeparttothe povertyandinsecurityofmanyoftheirfellowcitizens, especiallyinserviceindustries.TheAmericansalsowork considerablylongerthantheircounterpartsincompetitor nations.Perhourworked,USincomeislowerthanthatof severalEuropeancountries,eveninpurchasingpower terms.Itisdebatablethatthatcanbedescribedashavinga higherlivingstandard.

Thereisnosimplewaytocomparelivingstandards acrosscountries.Percapitaincome,especiallyin purchasingpowerterms,isarguablythemostreliable indicator.However,byfocusingjustonhowmanygoodsand servicesourincomecanbuy,wemissoutalotofother thingsthatconstituteelementsofthe‘goodlife’,suchasthe amountofqualityleisuretime,jobsecurity,freedomfrom crime,accesstohealthcare,socialwelfareprovisions,and soon.Whiledifferentindividualsandcountrieswilldefinitely havedifferentviewsonhowtoweightheseindicators againsteachotherandagainstincomefigures,non-income dimensionsshouldnotbeignored,ifwearetobuild societieswherepeoplegenuinely‘livewell’.

Africaisnotdestinedfor underdevelopment

Whattheytellyou

Africaisdestinedforunderdevelopment.Ithasapoor climate,whichleadstoserioustropicaldiseaseproblems.It haslousygeography,withmanyofitscountrieslandlocked andsurroundedbycountrieswhosesmallmarketsoffer limitedexportopportunitiesandwhoseviolentconflictsspill intoneighbouringcountries.Ithastoomanynatural resources,whichmakeitspeoplelazy,corruptandconflictprone.Africannationsareethnicallydivided,whichrenders themdifficulttomanageandmorelikelytoexperience violentconflicts.Theyhavepoor-qualityinstitutionsthatdo notprotectinvestorswell.Theircultureisbad–peopledo notworkhard,theydonotsaveandtheycannotcooperate witheachother.Allthesestructuralhandicapsexplainwhy, unlikeotherregionsoftheworld,thecontinenthasfailedto growevenafterithasimplementedsignificantmarket liberalizationsincethe1980s.Thereisnootherwayforward forAfricathanbeingproppedupbyforeignaid.

whenallthesupposedstructuralimpedimentstogrowth werepresentandoftenmorebinding,itactuallyposteda decentgrowthperformance.Moreover,allthestructural handicapsthataresupposedtoholdbackAfricahavebeen presentinmostoftoday’srichcountries–poorclimate (arcticandtropical),landlockedness,abundantnatural resources,ethnicdivisions,poorinstitutionsandbadculture. Thesestructuralconditionsseemtoactasimpedimentsto developmentinAfricaonlybecauseitscountriesdonotyet havethenecessarytechnologies,institutionsand organizationalskillstodealwiththeiradverse consequences.TherealcauseofAfricanstagnationinthe lastthreedecadesisfree-marketpoliciesthatthecontinent hasbeencompelledtoimplementduringtheperiod.Unlike historyorgeography,policiescanbechanged.Africaisnot destinedforunderdevelopment.

TheworldaccordingtoSarahPalin…or wasitTheRescuers?

SarahPalin,theRepublicanvice-presidentialcandidatein the2008USelection,isreportedtohavethoughtthatAfrica wasacountry,ratherthanacontinent.Alotofpeople wonderedwhereshegotthatidea,butIthinkIknowthe answer.Itwasfromthe1977DisneyanimationThe Rescuers.

TheRescuersisaboutagroupofmicecalledthe RescueAidSocietygoingaroundtheworld,helpinganimals introuble.Inonescene,thereisaninternationalcongressof thesociety,withmousedelegatesfromallsortsofcountries intheirtraditionalcostumesandappropriateaccents(ifthey happentospeak).ThereistheFrenchmouseinhisberet, theGermanmouseinhersombrebluedressandthe

Turkishmouseinhisfez.Andthenthereisthemouseinhis furhatandbeardrepresentingLatviaandthefemalemouse representing,well,Africa.

PerhapsDisneydidn’tliterallythinkthatAfricawasa country,butallocatingonedelegateeachtoacountrywith 2.2millionpeopleandtoacontinentofmorethan900 millionpeopleandnearlysixtycountries(theexactnumber dependsonwhetheryourecognizeentitiessuchas SomalilandandWesternSaharaascountries)tellsyou somethingaboutitsviewofAfrica.LikeDisney,many peopleseeAfricaasanamorphousmassofcountries sufferingfromthesamehotweather,tropicaldiseases, grindingpoverty,civilwarandcorruption.

WhileweshouldbecarefulnottolumpallAfrican countriestogether,thereisnodenyingthatmostAfrican countriesareverypoor–especiallyifweconfineourinterest toSub-SaharanAfrica(or‘black’Africa),whichisreallywhat mostpeoplemeanwhentheysayAfrica.Accordingtothe WorldBank,theaveragepercapitaincomeofSub-Saharan Africawasestimatedtobe$952in2007.Thisissomewhat higherthanthe$880ofSouthAsia(Afghanistan, Bangladesh,Bhutan,India,Maldives,Nepal,Pakistanand SriLanka),butlowerthanthatofanyotherregionofthe world.

Whatismore,manypeopletalkofAfrica’s‘growth tragedy’.UnlikeSouthAsia,whosegrowthrateshave pickedupsincethe1980s,Africaseemstobesuffering from‘achronicfailureofeconomicgrowth’.1Sub-Saharan Africa’spercapitaincometodayismoreorlessthesame aswhatitwasin1980.Evenmoreworryingisthefactthat thislackofgrowthseemstobeduenotmainlytopoorpolicy choices(afterall,likemanyotherdevelopingcountries, countriesintheregionhaveimplementedfree-market reformssincethe1980s)butmainlytothehandicaps handeddowntothembynatureandhistoryandthus extremelydifficult,ifnotimpossible,tochange.

First,thereareallthoseconditionsdefinedbynature–climate,geographyandnaturalresources.Beingtooclose totheequator,ithasrampanttropicaldiseases,suchas malaria,whichreduceworkerproductivityandraise healthcarecosts.Beinglandlocked,manyAfricancountries finditdifficulttointegrateintotheglobaleconomy.Theyare in‘badneighbourhoods’inthesensethattheyare surroundedbyotherpoorcountriesthathavesmallmarkets (whichrestricttheirtradingopportunities)and,frequently, violentconflicts(whichoftenspilloverintoneighbouring countries).Africancountriesarealsosupposedtobe ‘cursed’bytheirabundantnaturalresources.Itissaidthat resourceabundancemakesAfricanslazy–becausethey ‘canliebeneathacoconuttreeandwaitforthecoconutto fall’,asapopularexpressionofthisideagoes(although thosewhosaythatobviouslyhavenottriedit;youriskhaving yourheadsmashed).‘Unearned’resourcewealthisalso supposedtoencouragecorruptionandviolentconflictsover thespoils.Theeconomicsuccessesofresource-poorEast Asiancountries,suchasJapanandKorea,areoftencited ascasesof‘reverseresourcecurse’.

NotjustnaturebutAfrica’shistoryisalsosupposedtobe holdingitback.Africannationsareethnicallytoodiverse, whichcausespeopletobedistrustfulofeachotherandthus makesmarkettransactionscostly.Itisarguedthatethnic diversitymayencourageviolentconflicts,especiallyifthere areafewequallystronggroups(ratherthanmanysmall groups,whicharemoredifficulttoorganize).Thehistoryof colonialismisthoughttohaveproducedlow-quality institutionsinmostAfricancountries,asthecolonizersdid notwanttosettleincountrieswithtoomanytropical diseases(sothereisaninteractionbetweenclimateand institutions)andthusinstalledonlytheminimalinstitutions neededforresourceextraction,ratherthanforthe developmentofthelocaleconomy.Someevenventurethat Africancultureisbadforeconomicdevelopment–Africans

donotworkhard,donotplanforthefutureandcannot cooperatewitheachother.2

Givenallthis,Africa’sfutureprospectsseembleak.For someofthesestructuralhandicaps,anysolutionseems unachievableorunacceptable.Ifbeinglandlocked,being tooclosetotheequatorandsittinginabadneighbourhood areholdingUgandaback,whatshoulditdo?Physically movingacountryisnotanoption,sotheonlyfeasible answeriscolonialism–thatis,Ugandashouldinvade,say, Norway,andmovealltheNorwegianstoUganda.Ifhaving toomanyethnicgroupsisbadfordevelopment,should Tanzania,whichhasoneofthegreatestethnicdiversitiesin theworld,indulgeinaspotofethniccleansing?Ifhavingtoo manynaturalresourceshampersgrowth,shouldthe DemocraticRepublicofCongotrytoselltheportionsofits landwithmineraldepositsto,say,Taiwansothatitcanpass onthenaturalresourcecursetosomeoneelse?What shouldMozambiquedoifitscolonialhistoryhasleftitwith badinstitutions?Shoulditinventatimemachineandfixthat history?IfCameroonhasaculturethatisbadforeconomic development,shoulditstartsomemassbrain-washing programmeorputpeopleinsomere-educationcamp,as theKhmerRougedidinCambodia?

Allofthesepolicyconclusionsareeitherphysically impossible(movingacountry,inventingatimemachine)or politicallyandmorallyunacceptable(invasionofanother country,ethniccleansing,re-educationcamps).Therefore, thosewhobelieveinthepowerofthesestructuralhandicaps butfindtheseextremesolutionsunacceptablearguethat Africancountriesshouldbeputonsomekindofpermanent ‘disabilitybenefit’throughforeignaidandextrahelpwith internationaltrade(e.g.,richcountriesloweringtheir agriculturalprotectiononlyforAfrican–andothersimilarly poorandstructurallydisadvantaged–countries).

ButisthereanyotherwayforAfrica’sfuturedevelopment beyondacceptingitsfateorrelyingonoutsidehelp?Do Africancountrieshavenohopeofstandingontheirown

AnAfricangrowthtragedy?

Onequestionthatweneedtoaskbeforewetrytoexplain Africa’sgrowthtragedyandexplorepossiblewaysto overcomeitiswhetherthereisindeedsuchatragedy.And theansweris‘no’.Thelackofgrowthintheregionhasnot beenchronic.

Duringthe1960sand70s,percapitaincomeinSubSaharanAfricagrewatarespectablerate.Ataround1.6 percent,itwasnowherenearthe‘miracle’growthrateof EastAsia(5–6percent)oreventhatofLatinAmerica (around3percent)duringtheperiod.However,thisisnota growthratetobesniffedat.Itcomparesfavourablywiththe ratesof1–1.5percentachievedbytoday’srichcountries duringtheirIndustrial‘Revolution’(roughly1820–1913).

ThefactthatAfricagrewatarespectableratebeforethe 1980ssuggeststhatthe‘structural’factorscannotbethe mainexplanationoftheregion’s(whatinfactisrecent) growthfailure.Iftheywere,Africangrowthshouldalways havebeennon-existent.ItisnotasiftheAfricancountries suddenlymovedtothetropicsorsomeseismicactivity suddenlymadesomeofthemlandlocked.Ifthestructural factorsweresocrucial,Africaneconomicgrowthshould haveacceleratedovertime,asatleastsomeofthose factorswouldhavebeenweakenedoreliminated.For example,poor-qualityinstitutionsleftbehindbythecolonists couldhavebeenabandonedorimproved.Evenethnic diversitycouldhavebeenreducedthroughcompulsory education,militaryserviceandmassmedia,inthesame wayinwhichFrancemanagedtoturn‘peasantsinto Frenchmen’,asthetitleofaclassic1976bookbythe AmericanhistorianEugenWebergoes.3However,thisis

notwhathashappened–Africangrowthsuddenlycollapsed sincethe1980s.

So,ifthestructuralfactorshavealwaysbeenthereandif theirinfluenceswouldhave,ifanything,diminishedover time,thosefactorscannotexplainwhyAfricausedtogrowat adecentrateinthe1960sand70sandthensuddenlyfailed togrow.Thesuddencollapseingrowthmustbeexplained bysomethingthathappenedaround1980.Theprime suspectisthedramaticchangeinpolicydirectionaround thetime.

Sincethelate1970s(startingwithSenegalin1979), Sub-SaharanAfricancountrieswereforcedtoadoptfreemarket,free-tradepoliciesthroughtheconditionsimposed bytheso-calledStructuralAdjustmentPrograms(SAPs)of theWorldBankandtheIMF(andtherichcountriesthat ultimatelycontrolthem).Contrarytoconventionalwisdom, thesepoliciesarenotgoodforeconomicdevelopment(see Thing7).Bysuddenlyexposingimmatureproducersto internationalcompetition,thesepoliciesledtothecollapse ofwhatlittleindustrialsectorsthesecountrieshadmanaged tobuildupduringthe1960sand70s.Thus,havingbeen forcedbackintorelyingonexportsofprimarycommodities, suchascocoa,coffeeandcopper,Africancountrieshave continuedtosufferfromthewildpricefluctuationsand stagnantproductiontechnologiesthatcharacterizemost suchcommodities.Furthermore,whentheSAPsdemanded arapidincreaseinexports,Africancountries,with technologicalcapabilitiesonlyinalimitedrangeofactivities, endeduptryingtoexportsimilarthings–betheytraditional productssuchascoffeeandcocoaornewproductssuchas cutflowers.Theresultwasoftenacollapseofpricesinthose commoditiesduetoalargeincreaseintheirsupplies,which sometimesmeantthatthesecountrieswereexportingmore inquantitybutearninglessinrevenue.Thepressureon governmentstobalancetheirbudgetsledtocutsin expenditureswhoseimpactsareslowtoshow,suchas infrastructure.Overtime,however,thedeterioratingquality

ofinfrastructuredisadvantagedAfricanproducerseven more,makingtheir‘geographicaldisadvantages’loomeven larger.

TheresultoftheSAPs–andtheirvariouslater incarnations,includingtoday’sPRSPs(PovertyReduction StrategyPapers)–wasastagnanteconomythathasfailed togrow(inpercapitaterms)forthreedecades.Duringthe 1980sand90s,percapitaincomeinSub-SaharanAfrica fellattherateof0.7percentperyear.Theregionfinally startedtogrowinthe2000s,butthecontractionofthe precedingtwodecadesmeantthattheaverageannual growthrateofpercapitaincomeinSub-SaharanAfrica between1980and2009was0.2percent.So,afternearly thirtyyearsofusing‘better’(thatis,free-market)policies,its percapitaincomeisbasicallyatthesamelevelasitwasin 1980.

So,theso-calledstructuralfactorsarereallyscapegoats wheeledoutbyfree-marketeconomists.Seeingtheir favouredpoliciesfailingtoproducegoodoutcomes,they hadtofindotherexplanationsforAfrica’sstagnation(or retrogression,ifyoudon’tcountthelastfewyearsofgrowth spikeduetocommodityboom,whichhascometoanend). Itwasunthinkableforthemthatsuch‘correct’policiescould fail.Itisnocoincidencethatstructuralfactorscametobe citedasthemainexplanationsofpoorAfricaneconomic performanceonlyaftergrowthevaporatedintheearly 1980s.

Pointingoutthattheabove-mentionedstructuralvariables wereinvokedinanattempttosavefree-marketeconomics fromembarrassmentdoesnotmeanthattheyareirrelevant.

Manyofthetheoriesofferedastohowaparticularstructural variableaffectseconomicoutcomedomakesense.Poor climatecanhamperdevelopment.Beingsurroundedby poorandconflict-riddencountrieslimitsexportopportunities andmakescross-borderspill-overofconflictsmorelikely. Ethnicdiversityorresourcebonanzascangenerate perversepoliticaldynamics.However,theseoutcomesare notinevitable.

Tobeginwith,therearemanydifferentwaysinwhich thosestructuralfactorscanplayout.Forexample,abundant naturalresourcescancreateperverseoutcomes,butcan alsopromotedevelopment.Ifthatweren’tthecase,we wouldn’tconsiderthepoorperformancesofresource-rich countriestobeperverseinthefirstplace.Naturalresources allowpoorcountriestoearntheforeignexchangeswith whichtheycanbuyadvancedtechnologies.Sayingthat thoseresourcesareacurseislikesayingthatallchildren bornintoarichfamilywillfailinlifebecausetheywillget spoiltbytheirinheritedwealth.Somedosoexactlyforthis reason,buttherearemanyotherswhotakeadvantageof theirinheritanceandbecomeevenmoresuccessfulthan theirparents.Thefactthatafactorisstructural(thatis,itis givenbynatureorhistory)doesnotmeanthattheoutcome ofitsinfluenceispredetermined.

Indeed,thefactthatallthosestructuralhandicapsarenot insurmountableisprovenbythefactthatmostoftoday’srich countrieshavedevelopeddespitesufferingfromsimilar handicaps.4

Letusfirsttakethecaseoftheclimate.Tropicalclimate issupposedtocrippleeconomicgrowthbycreatinghealth burdensduetotropicaldiseases,especiallymalaria.Thisis aterribleproblem,butsurmountable.Manyoftoday’srich countriesusedtohavemalariaandothertropicaldiseases, atleastduringthesummer–notjustSingapore,whichis banginthemiddleofthetropics,butalsoSouthernItaly,the SouthernUS,SouthKoreaandJapan.Thesediseasesdo notmatterverymuchanymoreonlybecausethesecountries

havebettersanitation(whichhasvastlyreducedtheir incidence)andbettermedicalfacilities,thankstoeconomic development.Amoreseriouscriticismoftheclimate argumentisthatfrigidandarcticclimates,whichaffecta numberofrichcountries,suchasFinland,Sweden,Norway, CanadaandpartsoftheUS,imposeburdensas economicallycostlyastropicalones–machinesseizeup, fuelcostsskyrocket,andtransportationisblockedbysnow andice.Thereisnoapriorireasontobelievethatcold weatherisbetterthanhotweatherforeconomic development.Thecoldclimatedoesnotholdthose countriesbackbecausetheyhavethemoneyandthe technologiestodealwiththem(thesamecanbesaidof Singapore’stropicalclimate).SoblamingAfrica’s underdevelopmentonclimateisconfusingthecauseof underdevelopmentwithitssymptoms–poorclimatedoes notcauseunderdevelopment;acountry’sinabilityto overcomeitspoorclimateismerelyasymptomof underdevelopment.

Intermsofgeography,thelandlockedstatusofmany Africancountrieshasbeenmuchemphasized.Butthenwhat aboutSwitzerlandandAustria?Thesearetwooftherichest economiesintheworld,andtheyarelandlocked.Thereader mayrespondbysayingthatthesecountriescoulddevelop becausetheyhadgoodrivertransport,butmanylandlocked Africancountriesarepotentiallyinthesameposition:e.g., BurkinaFaso(theVolta),MaliandNiger(theNiger), Zimbabwe(theLimpopo)andZambia(theZambezi).Soit isthelackofinvestmentintherivertransportsystem,rather thanthegeographyitself,thatistheproblem.Moreover,due tofreezingseasinwinter,Scandinaviancountriesusedto beeffectivelylandlockedforhalfoftheyear,untilthey developedtheice-breakingshipinthelatenineteenth century.Abadneighbourhoodeffectmayexist,butitneed notbebinding–lookattherecentrapidgrowthofIndia, whichislocatedinthepoorestregionintheworld(poorer thanSub-SaharanAfrica,asmentionedabove),whichalso

hasitsshareofconflicts(thelonghistoryofmilitaryconflicts betweenIndiaandPakistan,theMaoistNaxaliteguerrillasin India,theTamil–SinhalesecivilwarinSriLanka).

Manypeopletalkoftheresourcecurse,butthe developmentofcountriessuchastheUS,Canadaand Australia,whicharemuchbetterendowedwithnatural resourcesthanallAfricancountries,withthepossible exceptionsofSouthAfricaandtheDRC(Democratic RepublicofCongo),showthatabundantresourcescanbea blessing.Infact,mostAfricancountriesarenotthatwell endowedwithnaturalresources–fewerthanadozen Africancountrieshavesofardiscoveredanysignificant mineraldeposits.5MostAfricancountriesmaybe abundantlyendowedwithnaturalresourcesinrelativeterms, butthatisonlybecausetheyhavesofewman-made resources,suchasmachines,infrastructure,andskilled labour.Moreover,inthelatenineteenthandearlytwentieth centuries,thefastest-growingregionsoftheworldwere resource-richareassuchasNorthAmerica,LatinAmerica andScandinavia,suggestingthattheresourcecursehasnot alwaysexisted.

Ethnicdivisionscanhampergrowthinvariousways,but theirinfluenceshouldnotbeexaggerated.Ethnicdiversityis thenormelsewheretoo.Evenignoringethnicdiversitiesin immigration-basedsocietiessuchastheUS,Canadaand Australia,manyoftoday’srichcountriesinEuropehave sufferedfromlinguistic,religiousandideologicaldivides–especiallyofthe‘medium-degree’(afew,ratherthan numerous,groups)thatissupposedtobemostconduciveto violentconflicts.Belgiumhastwo(andabit,ifyoucountthe tinyGerman-speakingminority)ethnicgroups.Switzerland hasfourlanguagesandtworeligions,andhasexperienced anumberofmainlyreligion-basedcivilwars.Spainhas seriousminorityproblemswiththeCatalansandthe Basques,whichhaveeveninvolvedterrorism.Duetoits 560-yearruleoverFinland(1249to1809,whenitwas cededtoRussia),SwedenhasasignificantFinnishminority

(around5percentofthepopulation)andFinlandaSwedish oneofsimilarscale.Andsoon.

EvenEastAsiancountriesthataresupposedtohave particularlybenefitedfromtheirethnichomogeneityhave seriousproblemswithinternaldivisions.Youmaythink Taiwanisethnicallyhomogeneousasitscitizensareall ‘Chinese’,butthepopulationconsistsoftwo(orfour,ifyou dividethemupmorefinely)linguisticgroups(the ‘mainlanders’vs.theTaiwanese)thatarehostiletoeach other.Japanhasseriousminorityproblemswiththe Koreans,theOkinawans,theAinusandtheBurakumins. SouthKoreamaybeoneofthemostethno-linguistically homogeneouscountriesintheworld,butthathasnot preventedmyfellowcountrymenfromhatingeachother.For example,therearetworegionsinSouthKoreathat particularlyhateeachother(SoutheastandSouthwest),so muchsothatsomepeoplefromthoseregionswouldnot allowtheirchildrentogetmarriedtosomeonefrom‘the otherplace’.Veryinterestingly,Rwandaisnearlyas homogeneousinethno-linguistictermsasKorea,butthat didnotpreventtheethniccleansingoftheformerlydominant minorityTutsisbythemajorityHutus–anexamplethat provesthat‘ethnicity’isapolitical,ratherthananatural, construction.Inotherwords,richcountriesdonotsufferfrom ethnicheterogeneitynotbecausetheydonothaveitbut becausetheyhavesucceededinnation-building(which,we shouldnote,wasoftenanunpleasantandevenviolent process).

PeoplesaythatbadinstitutionsareholdingbackAfrica (andtheyare),butwhentherichcountrieswereatsimilar levelsofmaterialdevelopmenttothosewefindinAfrica currently,theirinstitutionswereinafarworsestate.6Despite that,theygrewcontinuouslyandhavereachedhighlevelsof development.Theybuiltthegoodinstitutionslargelyafter,or atleastintandemwith,theireconomicdevelopment.This showsthatinstitutionalqualityisasmuchanoutcomeasthe causalfactorofeconomicdevelopment.Giventhis,bad

institutionscannotbetheexplanationofgrowthfailurein Africa.

Peopletalkabout‘bad’culturesinAfrica,butmostof today’srichcountrieshadoncebeenarguedtohave comparablybadcultures,asIdocumentedinthechapter ‘LazyJapaneseandthievingGermans’inmyearlierbook BadSamaritans.Untiltheearlytwentiethcentury, AustraliansandAmericanswouldgotoJapanandsaythe Japanesewerelazy.Untilthemidnineteenthcentury,the BritishwouldgotoGermanyandsaythattheGermanswere toostupid,tooindividualisticandtooemotionaltodevelop theireconomies(Germanywasnotunifiedthen)–theexact oppositeofthestereotypicalimagethattheyhaveofthe Germanstodayandexactlythesortofthingsthatpeople nowsayaboutAfricans.TheJapaneseandGermancultures weretransformedwitheconomicdevelopment,asthe demandsofahighlyorganizedindustrialsocietymade peoplebehaveinmoredisciplined,calculatingand cooperativeways.Inthatsense,cultureismoreofan outcome,ratherthanacause,ofeconomicdevelopment.It iswrongtoblameAfrica’s(oranyregion’soranycountry’s) underdevelopmentonitsculture.

Thusseen,whatappeartobeunalterablestructural impedimentstoeconomicdevelopmentinAfrica(and indeedelsewhere)areusuallythingsthatcanbe,andhave been,overcomewithbettertechnologies,superior organizationalskillsandimprovedpoliticalinstitutions.The factthatmostoftoday’srichcountriesthemselvesusedto suffer(andstillsuffertoanextent)fromtheseconditionsis anindirectproofofthispoint.Moreover,despitehaving theseimpediments(ofteninmoresevereforms),African countriesthemselvesdidnothaveaproblemgrowinginthe 1960sand70s.ThemainreasonforAfrica’srecentgrowth failureliesinpolicy–namely,thefree-trade,free-market policythathasbeenimposedonthecontinentthroughthe SAP.Natureandhistorydonotcondemnacountrytoa particularfuture.Ifitispolicythatiscausingtheproblem,the

Governmentscanpickwinners

Whattheytellyou

Governmentsdonothavethenecessaryinformationand expertisetomakeinformedbusinessdecisionsand‘pick winners’throughindustrialpolicy.Ifanything,government decision-makersarelikelytopicksomespectacularlosers, giventhattheyaremotivatedbypowerratherthanprofitand thattheydonothavetobearthefinancialconsequencesof theirdecisions.Especiallyifgovernmenttriestogoagainst marketlogicandpromoteindustriesthatgobeyonda country’sgivenresourcesandcompetences,theresultsare disastrous,asprovenbythe‘whiteelephant’projectsthat litterdevelopingcountries. Whattheydon’ttellyou

Governmentscanpickwinners,sometimesspectacularly well.Whenwelookaroundwithanopenmind,thereare manyexamplesofsuccessfulwinner-pickingby governmentsfromallovertheworld.Theargumentthat governmentdecisionsaffectingbusinessfirmsareboundto beinferiortothedecisionsmadebythefirmsthemselvesis unwarranted.Havingmoredetailedinformationdoesnot guaranteebetterdecisions–itmayactuallybemoredifficult tomaketherightdecision,ifoneis‘inthethickofit’.Also,

therearewaysforthegovernmenttoacquirebetter informationandimprovethequalityofitsdecisions. Moreover,decisionsthataregoodforindividualfirmsmay notbegoodforthenationaleconomyasawhole.Therefore, thegovernmentpickingwinnersagainstmarketsignalscan improvenationaleconomicperformance,especiallyifitis doneinclose(butnottooclose)collaborationwiththe privatesector.

Theworstbusinesspropositionin

humanhistory

EugeneBlack,thelongest-servingpresidentinthehistoryof theWorldBank(1949–63),isreportedtohavecriticized developingcountriesforbeingfixatedonthreetotems–the highway,theintegratedsteelmillandthemonumenttothe headofthestate.

MrBlack’sremarkonthemonumentmayhavebeen unfair(manypoliticalleadersindevelopingcountriesatthe timewerenotself-aggrandizing),buthewasrighttobe worriedaboutthethenwidespreadtendencytogofor prestigeprojects,suchashighwaysandsteelmills, regardlessoftheireconomicviability.Atthetime,toomany developingcountriesbuilthighwaysthatremainedempty andsteelmillsthatsurvivedonlybecauseofmassive governmentsubsidiesandtariffprotection.Expressionslike ‘whiteelephant’or‘castleinthedesert’wereinventedduring thisperiodtodescribesuchprojects.

Butofallthethenpotentialcastlesinthedesert,South Korea’splantobuildanintegratedsteelmill,hatchedin 1965,wasoneofthemostoutlandish.

Atthetime,Koreawasoneofthepoorestcountriesinthe world,relyingonnaturalresource-basedexports(e.g.,fish, tungstenore)orlabour-intensivemanufacturedexports(e.g.,

wigsmadewithhumanhair,cheapgarments).Accordingto thereceivedtheoryofinternationaltrade,knownasthe ‘theoryofcomparativeadvantage’,acountrylikeKorea,with alotoflabourandverylittlecapital,shouldnotbemaking capital-intensiveproducts,likesteel.1

Worse,Koreadidnotevenproducethenecessaryraw materials.Swedendevelopedanironandsteelindustry quitenaturallybecauseithasalotofironoredeposits. Koreaproducedvirtuallynoironoreorcokingcoal,thetwo keyingredientsofmodernsteel-making.Today,thesecould havebeenimportedfromChina,butthiswasthetimeofthe ColdWarwhentherewasnotradebetweenChinaand SouthKorea.Sotherawmaterialshadtobeimportedfrom countriessuchasAustralia,CanadaandtheUS–allof themfiveorsixthousandmilesaway–therebysignificantly addingtothecostofproduction.

NowondertheKoreangovernmentwasfindingitdifficult toconvincepotentialforeigndonorsandlendersofitsplan, eventhoughitproposedtosubsidizethesteelmillleft,right andcentre–freeinfrastructure(ports,roads,railroads),tax breaks,accelerateddepreciationofitscapitalequipment (sothattaxliabilitieswouldbeminimizedintheearlyyears), reducedutilityrates,andwhatnot.

Whilethenegotiationswithpotentialdonors–suchasthe WorldBankandthegovernmentsoftheUS,UK,West Germany,FranceandItaly–weregoingon,theKorean governmentdidthingstomaketheprojectlookevenless appealing.Whenthecompanytorunthesteelmill–the PohangIronandSteelCompany(POSCO)–wassetupin 1968,itwasasastate-ownedenterprise(SOE),despite widespreadconcernsabouttheinefficienciesofSOEsin developingcountries.Andtocapitall,thecompanywasto beledbyMrParkTae-Joon,aformerarmygeneralwith minimalbusinessexperienceastheheadofastate-owned tungsten-miningcompanyforafewyears.Evenforamilitary dictatorship,thiswasgoingtoofar.Thecountrywasaboutto startthebiggestbusinessventureinitshistory,andtheman

putinchargewasnotevenaprofessionalbusinessman!

Thus,thepotentialdonorsfacedarguablytheworst businessproposalinhumanhistory–astate-owned company,runbyapoliticallyappointedsoldier,makinga productthatallreceivedeconomictheoriessaidwasnot suitabletothecountry.Naturally,theWorldBankadvisedthe otherpotentialdonorsnottosupporttheproject,andevery oneofthemofficiallypulledoutofthenegotiationsinApril 1969.

Undeterred,theKoreangovernmentmanagedto persuadetheJapanesegovernmenttochannelalarge chunkofthereparationpaymentsitwaspayingforits colonialrule(1910–45)intothesteel-millprojectandto providethemachinesandthetechnicaladvicenecessaryfor themill.

Thecompanystartedproductionin1973andestablished itspresenceremarkablyquickly.Bythemid1980s,itwas consideredoneofthemostcost-efficientproducersoflowgradesteelintheworld.Bythe1990s,itwasoneofthe world’sleadingsteelcompanies.Itwasprivatizedin2001, notforpoorperformancebutforpoliticalreasons,andtoday isthefourth-largeststeelproducerintheworld(byquantityof output).

Sowehaveagreatpuzzleonourhands.Howdidoneof theworstbusinessproposalsinhistoryproduceoneofthe mostsuccessfulbusinessesinhistory?Actually,thepuzzle isevengreater,becausePOSCOisnottheonlysuccessful Koreancompanythatwassetupthroughgovernment initiative.

Throughoutthe1960sand70s,theKoreangovernment pushedmanyprivatesectorfirmsintoindustriesthatthey wouldnothaveenteredoftheirownaccord.Thiswasoften donethroughcarrots,suchassubsidiesortariffprotection fromimports(althoughthecarrotswerealsosticksinthe sensethattheywouldbedeniedtounder-performers). However,evenwhenallthosecarrotswerenotenoughto convincethebusinessmenconcerned,sticks–bigsticks–

werepulledout,suchasthreatstocutoffloansfromthethen whollystate-ownedbanksorevena‘quietchat’withthe secretpolice.

Interestingly,manyofthebusinessesthuspromotedby thegovernmentturnedouttobegreatsuccesses.Inthe 1960s,theLGGroup,theelectronicsgiant,wasbannedby thegovernmentfromenteringitsdesiredtextileindustryand wasforcedtoentertheelectriccableindustry.Ironically,the cablecompanybecamethefoundationofitselectronics business,forwhichLGiscurrentlyworld-famous(youwould know,ifyouhaveeverwantedthelatestChocolatemobile phone).Inthe1970s,theKoreangovernmentputenormous pressureonMrChungJu-Yung,thelegendaryfounderofthe HyundaiGroup,famousforhisriskappetite,tostarta shipbuildingcompany.EvenChungissaidtohaveinitially baulkedattheideabutrelentedwhenGeneralParkChungHee,thecountry’sthendictatorandthearchitectofKorea’s economicmiracle,personallythreatenedhisbusinessgroup withbankruptcy.Today,theHyundaishipbuildingcompany isoneofthebiggestshipbuildersintheworld.

Pickinglosers?

Now,accordingtothedominantfree-marketeconomic theory,thingslikethesuccessesofPOSCO,LGand Hyundaidescribedabovesimplyshouldn’thappen.The theorytellsusthatcapitalismworksbestwhenpeopleare allowedtotakecareoftheirownbusinesseswithoutany governmentinterference.Governmentdecisionsarebound tobeinferiortothedecisionsmadebythosewhoare directlyconcernedwiththematterinquestion,itisargued. Thisisbecausethegovernmentdoesnotpossessasmuch informationaboutthebusinessathandasthefirmdirectly concernedwithit.So,forexample,ifacompanyprefersto

enterIndustryAoverIndustryB,itmustbebecauseitknows thatAwouldbemoreprofitablethanB,givenits competencesandmarketconditions.Itwouldbetotally presumptuousofsomegovernmentofficial,howeverclever shemaybebysomeabsolutestandard,totellthe company’smanagersthattheyshouldinvestinIndustryB, whenshesimplydoesnothavethosemanagers’business acumenandexperiences.Inotherwords,theyargue,the governmentcannotpickwinners.

Thesituationisactuallymoreextremethanthat,freemarketeconomistssay.Notonlyaregovernmentdecisionmakersunabletopickwinners,theyarelikelytopicklosers. Mostimportantly,governmentdecision-makers–politicians andbureaucrats–aredrivenbythedesiretomaximize power,ratherthanprofits.Therefore,theyareboundtogo forwhiteelephantprojectsthathavehighvisibilityand politicalsymbolism,regardlessoftheireconomicfeasibility. Moreover,sincegovernmentofficialsplaywith‘other people’smoney’,theydonotreallyhavetoworryaboutthe economicviabilityoftheprojectthattheyarepromoting(on thesubjectof‘otherpeople’smoney’,seeThing2). Betweenthewronggoals(prestigeoverprofit)andthe wrongincentives(notpersonallybearingtheconsequences oftheirdecisions),theseofficialsarealmostcertaintopick losers,weretheytointerveneinbusinessaffairs.Business shouldnotbethebusinessofgovernment,itissaid.

Thebest-knownexampleofgovernmentpickingaloser becauseofthewronggoalsandincentivesistheConcorde project,jointlyfinancedbytheBritishandtheFrench governmentsinthe1960s.Concordecertainlyremainsone ofthemostimpressivefeatsofengineeringinhuman history.Istillrememberseeingoneofthemostmemorable advertisingslogansI’veeverencountered,onaBritish AirwaysbillboardinNewYork–iturgedpeopleto‘arrive beforeyouleave’byflyingConcorde(ittookaroundthree hourstocrosstheAtlanticonaConcorde,whilethetime differencebetweenNewYorkandLondonisfivehours).

However,consideringallthemoneyspentonits developmentandthesubsidiesthatthetwogovernments hadtogivetoBritishAirwaysandAirFranceeventobuythe aircrafts,Concordewasaresoundingbusinessfailure.

Anevenmoreoutrageousexampleofagovernment pickingaloserbecauseitisdivorcedfrommarketlogicis thecaseoftheIndonesianaircraftindustry.Theindustrywas startedinthe1970s,whenthecountrywasoneofthe poorestintheworld.Thisdecisionwasmadeonlybecause DrBacharuddinHabibie,numbertwotoPresident MohammedSuhartoforovertwentyyears(andthecountry’s presidentforjustoverayear,afterhisfall),happenedtobe anaerospaceengineerwhohadtrainedandworkedin Germany.

Butifallreceivedeconomictheoriesandtheevidence fromothercountriessuggestthatgovernmentsarelikelyto picklosersratherthanwinners,howcouldtheKorean governmentsucceedinpickingsomanywinners?

OnepossibleexplanationisthatKoreaisanexception. Forwhateverreasons,Koreangovernmentofficialswereso exceptionallycapable,theargumentmightrun,thatthey couldpickwinnersinawaythatnooneelsecould.Butthat mustmeanthatweKoreansarethesmartestpeoplein history.AsagoodKorean,Iwouldnotmindanexplanation thatportraysusinsuchgloriouslight,butIdoubtwhether non-Koreanswouldbeconvincedbyit(andtheyareright–seeThing23).

Indeed,asIdiscussinsomedetailelsewhereinthebook (mostnotably,seeThings7and19),Koreaisnottheonly countryinwhichthegovernmenthashadsuccessinpicking winners.2OtherEastAsianmiracleeconomiesdidthe same.TheKoreanstrategyofpickingwinners,while involvingmoreaggressivemeans,wascopiedfromtheone practisedbytheJapanesegovernment.AndtheTaiwanese andSingaporeangovernmentswerenoworseatthejob thantheirKoreancounterpart,althoughthepolicytoolsthey usedweresomewhatdifferent.

Moreimportantly,itisn’tjustEastAsiangovernmentsthat havesuccessfullypickedwinners.Inthesecondhalfofthe twentiethcentury,thegovernmentsofcountriessuchas France,Finland,NorwayandAustriashapedanddirected industrialdevelopmentwithgreatsuccessthrough protection,subsidiesandinvestmentsbySOEs.Evenwhile itpretendsthatitdoesnot,theUSgovernmenthaspicked mostofthecountry’sindustrialwinnerssincetheSecond WorldWarthroughmassivesupportforresearchand development(R&D).Thecomputer,semi-conductors, aircraft,internetandbiotechnologyindustrieshaveallbeen developedthankstosubsidizedR&DfromtheUS government.Eveninthenineteenthandearlytwentieth centuries,whengovernmentindustrialpoliciesweremuch lessorganizedandeffectivethaninthelatetwentieth century,virtuallyalloftoday’srichcountriesusedtariffs, subsidies,licensing,regulationandotherpolicymeasuresto promoteparticularindustriesoverothers,withconsiderable degreesofsuccess(seeThing7).

Ifgovernmentscananddopickwinnerswithsuch regularity,sometimeswithspectacularresults,youmay wonderwhetherthereissomethingwrongwiththedominant economictheorythatsaysthatitcannotbedone.Yes,I wouldsaythattherearemanythingswrongwiththetheory.

Firstofall,thetheoryimplicitlyassumesthatthosewho areclosesttothesituationwillhavethebestinformationand thusmakethebestdecision.Thismaysoundplausiblebut, ifproximitytothesituationguaranteedabetterdecision,no businesswouldevermakeawrongdecision.Sometimes beingtooclosetothesituationcanactuallymakeitmore, ratherthanless,difficulttoseethesituationobjectively.This iswhytherearesomanybusinessdecisionsthatthe decision-makersthemselvesbelievetobeworksofgenius thatothersviewwithscepticism,ifnotdownrightcontempt. Forexample,in2000,AOL,theinternetcompany,acquired TimeWarnermediagroup.Despitethedeepscepticismof manyoutsiders,SteveCase,AOL’sthenchairman,calledit

a‘historicmerger’thatwouldtransform‘thelandscapeof mediaandtheinternet’.Subsequentlythemergerturnedout tobeaspectacularfailure,promptingJerryLevin,theTime Warnerchiefatthetimeofthemerger,toadmitinJanuary 2010thatitwas‘theworstdealofthecentury’.

Ofcourse,bysayingthatwecannotnecessarilyassume agovernment’sdecisionconcerningafirmwillbeworse thanadecisionbythefirmitself,Iamnotdenyingthe importanceofhavinggoodinformation.However,insofaras suchinformationisneededforitsindustrialpolicy,the governmentcanmakesurethatithassuchinformation.And indeed,thegovernmentsthathavebeenmoresuccessfulat pickingwinnerstendtohavemoreeffectivechannelsof informationexchangewiththebusinesssector.

Oneobviouswayforagovernmenttoensurethatithas goodbusinessinformationistosetupanSOEandrunthe businessitself.CountriessuchasSingapore,France, Austria,NorwayandFinlandreliedheavilyonthissolution. Second,agovernmentcanlegallyrequirethatfirmsin industriesthatreceivestatesupportregularlyreporton somekeyaspectsoftheirbusinesses.TheKorean governmentdidthisverythoroughlyinthe1970s,whenit wasprovidingalotoffinancialsupportforseveralnew industries,suchasshipbuilding,steelandelectronics.Yet anothermethodistorelyoninformalnetworksbetween governmentofficialsandbusinesselitessothattheofficials developagoodunderstandingofbusinesssituations, althoughanexclusiverelianceonthischannelcanleadto excessive‘clubbiness’ordownrightcorruption.TheFrench policynetwork,builtaroundthegraduatesofENA(École Nationaled’Administration),isthemostfamousexampleof this,showingbothitspositiveandnegativesides. Somewhereinbetweenthetwoextremesoflegal requirementandpersonalnetworks,theJapanesehave developedthe‘deliberationcouncils’,wheregovernment officialsandbusinessleadersregularlyexchange informationthroughformalchannels,inthepresenceofthird-

partyobserversfromacademiaandthemedia.

Moreover,dominanteconomictheoryfailstorecognize thattherecouldbeaclashbetweenbusinessinterestsand nationalinterests.Eventhoughbusinessmenmaygenerally (butnotnecessarily,asIarguedabove)knowtheirown affairsbetterthangovernmentofficialsandthereforebeable tomakedecisionsthatbestservetheircompanies’ interests,thereisnoguaranteethattheirdecisionsare goingtobegoodforthenationaleconomy.So,forexample, whenitwantedtoenterthetextileindustryinthe1960s,the managersofLGweredoingtherightthingfortheir company,butinpushingthemtoentertheelectriccable industry,whichenabledLGtobecomeanelectronics company,theKoreangovernmentwasservingKorea’s nationalinterest–andLG’sinterestinthelongrun–better. Inotherwords,thegovernmentpickingwinnersmayhurt somebusinessinterestsbutitmayproduceabetter outcomefromasocialpointofview(seeThing18).

Winnersarebeingpickedallthetime

Sofar,Ihavelistedmanysuccessfulexamplesof governmentpickingwinnersandexplainedwhythefreemarkettheorythatdeniestheverypossibilityofgovernment pickingwinnersisfullofholes.

Bydoingthis,Iamnottryingtoblindyoutocasesof governmentfailure.Ihavealreadymentionedtheseriesof castlesinthedesertbuiltinmanydevelopingcountriesinthe 1960sand70s,includingIndonesia’saircraftindustry. However,itismorethanthat.Governmentattemptstopick winnershavefailedevenincountriesthatarefamousfor beinggoodatit,suchasJapan,FranceorKorea.I’ve alreadymentionedtheFrenchgovernment’sill-fatedforay intoConcorde.Inthe1960s,theJapanesegovernmenttried

invaintoarrangeatakeoverofHonda,whichitconsidered tobetoosmallandweak,byNissan,butitlaterturnedout thatHondawasamuchmoresuccessfulfirmthanNissan. TheKoreangovernmenttriedtopromotethealuminiumsmeltingindustryinthelate1970s,onlytoseetheindustry whackedbyamassiveincreaseinenergyprices,which accountforaparticularlyhighproportionofaluminium productioncosts.Andtheyarejustthemostprominent examples.

However,inthesamewaythatthesuccessstoriesdonot allowustosupportgovernmentspickingwinnersunderall circumstances,thefailures,howevermanythereare,donot invalidateallgovernmentattemptstopickwinners.

Whenyouthinkaboutit,itisnaturalthatgovernmentsfail inpickingwinners.Itisintheverynatureofrisk-taking entrepreneurialdecisionsinthisuncertainworldthatthey oftenfail.Afterall,privatesectorfirmstrytopickwinnersall thetime,bybettingonuncertaintechnologiesandentering activitiesthatothersthinkarehopeless,andoftenfail. Indeed,inexactlythesamewaythateventhose governmentsthathavethebesttrackrecordsatpicking winnersdonotpickwinnersallthetime,eventhemost successfulfirmsdonotmaketherightdecisionsallthetime –justthinkaboutMicrosoft’sdisastrousWindowsVista operatingsystem(withwhichIamveryunhappilywritingthis book)andNokia’sembarrassingfailurewiththeN-Gage phone/gameconsole.

Thequestionisnotthenwhethergovernmentscanpick winners,astheyobviouslycan,buthowtoimprovetheir ‘battingaverage’.Andcontrarytopopularperception, governmentalbattingaveragescanbequitedramatically improved,ifthereissufficientpoliticalwill.Thecountriesthat arefrequentlyassociatedwithsuccessinpickingwinners provethepoint.TheTaiwanesemiraclewasengineeredby theNationalistPartygovernment,whichhadbeenabyword forcorruptionandincompetenceuntilitwasforcedtomove toTaiwanafterlosingtheChinesemainlandtothe

Communistsin1949.TheKoreangovernmentinthe1950s wasfamouslyineptateconomicmanagement,somuchso thatthecountrywasdescribedasabottomlesspitby USAID,theUSgovernmentaidagency.Inthelate nineteenthandearlytwentiethcenturies,theFrench governmentwasfamousforitsunwillingnessandinabilityto pickwinners,butitbecamethechampionofpickingwinners inEuropeaftertheSecondWorldWar.

Therealityisthatwinnersarebeingpickedallthetime bothbythegovernmentandbytheprivatesector,butthe mostsuccessfulonestendtobedoneinjointefforts betweenthetwo.Inalltypesofwinner-picking–private, public,joint–therearesuccessesandfailures,sometimes spectacularones.Ifweremainblindedbythefree-market ideologythattellsusonlywinner-pickingbytheprivate sectorcansucceed,wewillendupignoringahugerangeof possibilitiesforeconomicdevelopmentthroughpublic leadershiporpublic–privatejointefforts.

Thing13

Whattheytellyou

Wehavetocreatewealthbeforewecanshareitout.Likeit ornot,itistherichpeoplewhoaregoingtoinvestand createjobs.Thericharevitaltobothspottingmarket opportunitiesandexploitingthem.Inmanycountries,the politicsofenvyandpopulistpoliciesofthepasthaveput restrictionsonwealthcreationbyimposinghightaxesonthe rich.Thishastostop.Itmaysoundharsh,butinthelongrun poorpeoplecanbecomericheronlybymakingthericheven richer.Whenyougivetherichabiggersliceofthepie,the slicesoftheothersmaybecomesmallerintheshortrun,but thepoorwillenjoybiggerslicesinabsolutetermsinthelong run,becausethepiewillgetbigger.

Whattheydon’ttellyou

Theaboveidea,knownas‘trickle-downeconomics’, stumblesonitsfirsthurdle.Despitetheusualdichotomyof ‘growth-enhancingpro-richpolicy’and‘growth-reducingpropoorpolicy’,pro-richpolicieshavefailedtoaccelerate growthinthelastthreedecades.Sothefirststepinthis

argument–thatis,theviewthatgivingabiggersliceofpie totherichwillmakethepiebigger–doesnothold.The secondpartoftheargument–theviewthatgreaterwealth createdatthetopwilleventuallytrickledowntothepoor–doesnotworkeither.Trickledowndoeshappen,butusually itsimpactismeagreifweleaveittothemarket.

TheghostofStalin–orisit Preobrazhensky?

WiththedevastationoftheFirstWorldWar,theSoviet economywasindirestraitsin1919.Realizingthatthenew regimehadnochanceofsurvivingwithoutrevivingfood production,LeninlaunchedtheNewEconomicPolicy (NEP),allowingmarkettransactionsinagricultureandletting thepeasantskeeptheprofitsfromthosetransactions.

TheBolshevikpartywassplit.Ontheleftoftheparty, arguingthattheNEPwasnomorethanaregressionto capitalism,wasLeonTrotsky.Hewassupportedbythe brilliantself-taughteconomistYevgeniPreobrazhensky. PreobrazhenskyarguedthatiftheSovieteconomywasto developitneededtoincreaseinvestmentinindustries. However,Preobrazhenskyargued,itwasverydifficultto increasesuchinvestmentbecausevirtuallyallthesurplusthe economygenerated(thatis,overandabovewhatwas absolutelynecessaryforthephysicalsurvivalofits population)wascontrolledbythefarmers,astheeconomy wasmostlyagricultural.Therefore,hereasoned,private propertyandthemarketshouldbeabolishedinthe countryside,sothatallinvestiblesurpluscouldbesqueezed outofitbythegovernmentsuppressingagriculturalprices. Suchsurpluswasthentobeshiftedtotheindustrialsector, wheretheplanningauthoritycouldmakesurethatallofit wasinvested.Intheshortrun,thiswouldsuppressliving

standards,especiallyforthepeasantry,butinthelongrunit wouldmakeeveryonebetteroff,becauseitwouldmaximize investmentandthereforethegrowthpotentialofthe economy.

Thoseontherightoftheparty,suchasJosefStalinand NikolaiBukharin,Preobrazhensky’serstwhilefriendand intellectualrival,calledforrealism.Theyarguedthat,evenif itwasnotvery‘communist’toallowprivatepropertyinland andlivestockinthecountryside,theycouldnotaffordto alienatethepeasantry,givenitspredominance.According toBukharin,therewasnootherchoicethan‘ridinginto socialismonapeasantnag’.Throughoutmostofthe1920s, therighthadtheupperhand.Preobrazhenskywas increasinglymarginalizedandforcedintoexilein1927.

However,in1928,itallchanged.Uponbecomingthe soledictator,Stalinfilchedhisrivals’ideasand implementedthestrategyadvocatedbyPreobrazhensky.He confiscatedlandfromthekulaks,therichfarmers,and broughttheentirecountrysideunderstatecontrolthrough collectivizationofagriculture.Thelandsconfiscatedfromthe kulakswereturnedintostatefarms(sovkhoz),whilesmall farmerswereforcedtojoincooperativesorcollectivefarms (kolkhoz),withanominalshareownership.

StalindidnotfollowPreobrazhensky’srecommendation exactly.Actually,hewentrathersoftonthecountrysideand didnotsqueezethepeasantstothemaximum.Instead,he imposedlower-than-subsistencewagesonindustrial workers,whichinturnforcedurbanwomentojointhe industrialworkforceinordertoenabletheirfamiliesto survive.

Stalin’sstrategyhadhugecosts.Millionsofpeople resisting,orbeingaccusedofresisisting,agricultural collectivizationendedupinlabourcamps.Therewasa collapseinagriculturaloutput,followingthedramaticfallin thenumberoftractionanimals,partlyduetotheslaughtering bytheirownersinanticipationofconfiscationandpartlydue totheshortageofgrainstofeedthemthankstoforcedgrain

shipmentstothecities.Thisagriculturalbreakdownresulted intheseverefamineof1932–3inwhichmillionsofpeople perished.

Theironyisthat,withoutStalinadopting Preobrazhensky’sstrategy,theSovietUnionwouldnothave beenabletobuildtheindustrialbaseatsuchaspeedthatit wasabletorepeltheNaziinvasionontheEasternFrontin theSecondWorldWar.WithouttheNazidefeatonthe EasternFront,WesternEuropewouldnothavebeenableto beattheNazis.Thus,ironically,WesternEuropeansowe theirfreedomtodaytoanultra-left-wingSovieteconomist calledPreobrazhensky.

WhyamInatteringonaboutsomeforgottenRussian Marxisteconomistfromnearlyacenturyago?Itisbecause thereisastrikingparallelbetweenStalin’s(orrather Preobrazhensky’s)strategyandtoday’spro-richpolicies advocatedbyfree-marketeconomists.

Capitalistsvs.workers

Fromtheeighteenthcentury,thefeudalorder,whereby peoplewerebornintocertain‘stations’andremainedthere fortherestoftheirlives,cameunderattackfromliberals throughoutEurope.Theyarguedthatpeopleshouldbe rewardedaccordingtotheirachievementsratherthantheir births(seeThing20).

Ofcourse,thesewereliberalsofnineteenth-century vintage,sotheyhadviewsthattoday’sliberals(leastofall Americanliberals,whowouldbecalled‘leftofcentre’,rather thanliberal,inEurope)wouldfindobjectionable.Aboveall, theywereagainstdemocracy.Theybelievedthatgiving votestopoormen–womenwerenotevenconsidered,as theywerebelievedtolackfullmentalfaculty–woulddestroy capitalism.Whywasthat?

Thenineteenth-centuryliberalsbelievedthatabstinence wasthekeytowealthaccumulationandthuseconomic development.Havingacquiredthefruitsoftheirlabour, peopleneedtoabstainfrominstantgratificationandinvest it,iftheyweretoaccumulatewealth.Inthisworldview,the poorwerepoorbecausetheydidnothavethecharacterto exercisesuchabstinence.Therefore,ifyougavethepoor votingrights,theywouldwanttomaximizetheircurrent consumption,ratherthaninvestment,byimposingtaxeson therichandspendingthem.Thismightmakethepoorbetter offintheshortrun,butitwouldmakethemworseoffinthe longrunbyreducinginvestmentandthusgrowth.

Intheiranti-poorpolitics,theliberalswereintellectually supportedbytheClassicaleconomists,withDavidRicardo, thenineteenth-centuryBritisheconomist,asthemostbrilliant ofthemall.Unliketoday’sliberaleconomists,theClassical economistsdidnotseethecapitalisteconomyasbeing madeupofindividuals.Theybelievedthatpeoplebelonged todifferentclasses–capitalists,workersandlandlords–andbehaveddifferentlyaccordingtotheirclasses.Themost importantinter-classbehaviouraldifferencewasconsidered tobethefactthatcapitalistsinvested(virtually)alloftheir incomeswhiletheotherclasses–theworkingclassandthe landlordclass–consumedthem.Onthelandlordclass, opinionwassplit.Some,likeRicardo,sawitasa consumingclassthathamperedcapitalaccumulation,while others,suchasThomasMalthus,thoughtthatits consumptionhelpedthecapitalistclassbyofferingextra demandsfortheirproducts.However,ontheworkers,there wasaconsensus.Theyspentalloftheirincome,soifthe workersgotahighershareofthenationalincome, investmentandthuseconomicgrowthwouldfall.

Thisiswhereardentfree-marketeerslikeRicardomeet ultra-leftwingcommunistslikePreobrazhensky.Despite theirapparentdifferences,bothofthembelievedthatthe investiblesurplusshouldbeconcentratedinthehandsofthe investor,thecapitalistclassinthecaseoftheformerandthe

planningauthorityinthecaseofthelatter,inorderto maximizeeconomicgrowthinthelongrun.Thisisultimately whatpeopletodayhaveinmindwhentheysaythat‘youfirst havetocreatewealthbeforeyoucanredistributeit’.

Thefallandriseofpro-richpolicies

Betweenthelatenineteenthandearlytwentiethcenturies, theworstfearsofliberalswererealized,andmostcountries inEuropeandtheso-called‘Westernoffshoots’(theUS, Canada,AustraliaandNewZealand)extendedsuffrageto thepoor(naturallyonlytothemales).However,thedreaded over-taxationoftherichandtheresultingdestructionof capitalismdidnothappen.Inthedecadesthatfollowedthe introductionofuniversalmalesuffrage,taxationontherich andsocialspendingdidnotincreasebymuch.So,thepoor werenotthatimpatientafterall.

Moreover,whenthedreadedover-taxationoftherich startedinearnest,itdidnotdestroycapitalism.Infact,it madeitevenstronger.FollowingtheSecondWorldWar, therewasarapidgrowthinprogressivetaxationandsocial welfarespendinginmostoftherichcapitalistcountries. Despitethis(orratherpartlybecauseofthis–seeThing 21),theperiodbetween1950and1973sawthehighestevergrowthratesinthesecountries–knownasthe‘Golden AgeofCapitalism’.BeforetheGoldenAge,percapita incomeintherichcapitalisteconomiesusedtogrowat1–1.5percentperyear.DuringtheGoldenAge,itgrewat2–3 percentintheUSandBritain,4–5percentinWestern Europe,and8percentinJapan.Sincethen,thesecountries havenevermanagedtogrowfasterthanthat.

Whengrowthsloweddownintherichcapitalist economiesfromthemid1970s,however,thefreemarketeersdustedofftheirnineteenth-centuryrhetoricand

managedtoconvinceothersthatthereductionintheshare oftheincomegoingtotheinvestingclasswasthereasonfor theslowdown.

Sincethe1980s,inmany(althoughnotall)ofthese countries,governmentsthatespouseupwardincome redistributionhaveruledmostofthetime.Evensomesocalledleft-wingparties,suchasBritain’sNewLabourunder TonyBlairandtheAmericanDemocraticPartyunderBill Clinton,openlyadvocatedsuchastrategy–thehighpoint beingBillClintonintroducinghiswelfarereformin1996, declaringthathewantedto‘endwelfareasweknowit’.

Intheevent,trimmingthewelfarestatedownprovedmore difficultthaninitiallythought(seeThing21).However,its growthhasbeenmoderated,despitethestructuralpressure forgreaterwelfarespendingduetotheageingofthe population,whichincreasestheneedforpensions,disability allowances,healthcareandotherspendingdirectedtothe elderly.

Moreimportantly,inmostcountriestherewerealsomany policiesthatendedupredistributingincomefromthepoorto therich.Therehavebeentaxcutsfortherich–topincometaxrateswerebroughtdown.Financialderegulationhas createdhugeopportunitiesforspeculativegainsaswellas astronomicalpaychequesfortopmanagersandfinanciers (seeThings2and22).Deregulationinotherareashasalso allowedcompaniestomakebiggerprofits,notleast becausetheyweremoreabletoexploittheirmonopoly powers,morefreelypollutetheenvironmentandmore readilysackworkers.Increasedtradeliberalizationand increasedforeigninvestment–oratleastthethreatofthem –havealsoputdownwardpressureonwages.

Asaresult,incomeinequalityhasincreasedinmostrich countries.Forexample,accordingtotheILO(International LabourOrganization)reportTheWorldofWork2008,ofthe twentyadvancedeconomiesforwhichdatawasavailable, between1990and2000incomeinequalityroseinsixteen countries,withonlySwitzerlandamongtheremainingfour

experiencingasignificantfall.1Duringthisperiod,income inequalityintheUS,alreadybyfarthehighestintherich world,rosetoalevelcomparabletothatofsomeLatin AmericancountriessuchasUruguayandVenezuela.The relativeincreaseinincomeinequalitywasalsohighin countriessuchasFinland,SwedenandBelgium,butthese werecountriesthatpreviouslyhadverylowlevelsof inequality–perhapstoolowinthecaseofFinland,which hadanevenmoreequalincomedistributionthanmanyof theformersocialistcountries.

AccordingtotheEconomicPolicyInstitute(EPI),the centre-leftthink-tankinWashington,DC,between1979and 2006(thelatestyearofavailabledata),thetop1percentof earnersintheUSmorethandoubledtheirshareofnational income,from10percentto22.9percent.Thetop0.1per centdidevenbetter,increasingtheirsharebymorethan threetimes,from3.5percentin1979to11.6percentin 2006.2Thiswasmainlybecauseoftheastronomical increaseinexecutivepayinthecountry,whoselackof justificationisincreasinglybecomingobviousinthe aftermathofthe2008financialcrisis(seeThing14).

Ofthesixty-fivedevelopingandformersocialistcountries coveredintheabove-mentionedILOstudy,income inequalityroseinforty-onecountriesduringthesameperiod. Whiletheproportionofcountriesexperiencingrising inequalityamongthemwassmallerthanfortherich countries,manyofthesecountriesalreadyhadveryhigh inequality,sotheimpactsofrisinginequalitywereeven worsethanintherichcountries.

Waterthatdoesnottrickledown

economicgrowthhasactuallysloweddownsincethestartof theneo-liberalpro-richreforminthe1980s.Accordingto WorldBankdata,theworldeconomyusedtogrowinper capitatermsatover3percentduringthe1960sand70s, whilesincethe1980sithasbeengrowingattherateof1.4 percentperyear(1980–2009).

Inshort,sincethe1980s,wehavegiventherichabigger sliceofourpieinthebeliefthattheywouldcreatemore wealth,makingthepiebiggerthanotherwisepossibleinthe longrun.Therichgotthebiggersliceofthepieallright,but theyhaveactuallyreducedthepaceatwhichthepieis growing.

Theproblemisthatconcentratingincomeinthehandsof thesupposedinvestor,beitthecapitalistclassorStalin’s centralplanningauthority,doesnotleadtohighergrowthif theinvestorfailstoinvestmore.WhenStalinconcentrated incomeinGosplan,theplanningauthority,therewasatleast aguaranteethattheconcentratedincomewouldbeturned intoinvestment(eventhoughtheproductivityofthe investmentmayhavebeenadverselyaffectedbyfactors suchasthedifficultyofplanningandworkincentive problems–seeThing19).Capitalisteconomiesdonot havesuchamechanism.Indeed,despiterisinginequality sincethe1980s,investmentasaratioofnationaloutputhas falleninallG7economies(theUS,Japan,Germany,theUK, Italy,FranceandCanada)andinmostdevelopingcountries (seeThings2and6).

Evenwhenupwardincomeredistributioncreatesmore wealththanotherwisepossible(whichhasnothappened,I repeat),thereisnoguaranteethatthepoorwillbenefitfrom thoseextraincomes.Increasingprosperityatthetopmight eventuallytrickledownandbenefitthepoor,butthisisnota foregoneconclusion.

Ofcourse,trickledownisnotacompletelystupididea. Wecannotjudgetheimpactofincomeredistributiononlyby itsimmediateeffects,howevergoodorbadtheymaylook. Whenrichpeoplehavemoremoney,theymayuseitto

increaseinvestmentandgrowth,inwhichcasethelong-run effectofupwardincomeredistributionmaybethegrowthin theabsolutesize,althoughnotnecessarilytherelativeshare, ofincomethateveryonegets.

However,thetroubleisthattrickledownusuallydoesnot happenverymuchiflefttothemarket.Forexample,once againaccordingtotheEPI,thetop10percentoftheUS populationappropriated91percentofincomegrowth between1989and2006,whilethetop1percenttook59 percent.Incontrast,incountrieswithastrongwelfarestate itisaloteasiertospreadthebenefitsofextragrowththat followsupwardincomeredistribution(ifithappens)through taxesandtransfers.Indeed,beforetaxesandtransfers, incomedistributionisactuallymoreunequalinBelgiumand GermanythanintheUS,whileinSwedenandthe NetherlandsitismoreorlessthesameasintheUS.3In otherwords,weneedtheelectricpumpofthewelfarestate tomakethewateratthetoptrickledowninanysignificant quantity.

Lastbutnotleast,therearemanyreasonstobelievethat downwardincomeredistributioncanhelpgrowth,ifdonein therightwayattherighttime.Forexample,inaneconomic downturnliketoday’s,thebestwaytoboosttheeconomyis toredistributewealthdownward,aspoorerpeopletendto spendahigherproportionoftheirincomes.Theeconomyboostingeffectoftheextrabilliondollargiventothelowerincomehouseholdsthroughincreasedwelfarespendingwill bebiggerthanthesameamountgiventotherichthroughtax cuts.Moreover,ifwagesarenotstuckatorbelow subsistencelevels,additionalincomemayencourage workers’investmentineducationandhealth,whichmay raisetheirproductivityandthuseconomicgrowth.In addition,greaterincomeequalitymaypromotesocialpeace byreducingindustrialstrikesandcrime,whichmayinturn encourageinvestment,asitreducesthedangerof disruptiontotheproductionprocessandthustotheprocess ofgeneratingwealth.Manyscholarsbelievethatsucha

mechanismwasatworkduringtheGoldenAgeof Capitalism,whenlowincomeinequalitycoexistedwithrapid growth.

Thusseen,thereisnoreasontopresumethatupward incomeredistributionwillaccelerateinvestmentandgrowth. Thishasnothappenedingeneral.Evenwhenthereismore growth,thetrickledownthatoccursthroughthemarket mechanismisverylimited,asseenintheabovecomparison oftheUSwithotherrichcountrieswithagoodwelfarestate.

Simplymakingtherichricherdoesnotmaketherestof usricher.Ifgivingmoretotherichisgoingtobenefittherest ofthesociety,therichhavetobemadetodeliverhigher investmentandthushighergrowththroughpolicymeasures (e.g.,taxcutsfortherichindividualsandcorporations, conditionaloninvestment),andthensharethefruitsofsuch growththroughamechanismsuchasthewelfarestate.

USmanagersareover-priced

Whattheytellyou

Somepeoplearepaidalotmorethanothers.Especiallyin theUS,companiespaytheirtopmanagerswhatsome peopleconsidertobeobsceneamounts.However,thisis whatmarketforcesdemand.Giventhatthepooloftalentis limited,yousimplyhavetopaylargesumsofmoneyifyou aretoattractthebesttalents.Fromthepointofviewofa giantcorporationwithbillionsofdollarsofturnover,itis definitelyworthpayingextramillions,oreventensofmillions, ofdollarstogetthebesttalent,asherabilitytomakebetter decisionsthanhercounterpartsincompetitorcompanies canbringinextrahundredsofmillionsofdollarsinrevenue. Howeverunjusttheselevelsofcompensationmayappear, weshouldnotengageinactsofenvyandspiteandtryto artificiallysuppressthem.Suchattemptswouldbesimply counterproductive.

Whattheydon’ttellyou

USmanagersareover-pricedinmorethanonesense.First, theyareover-pricedcomparedtotheirpredecessors.In relativeterms(thatis,asaproportionofaverageworker compensation),AmericanCEOstodayarepaidaroundten timesmorethantheirpredecessorsofthe1960s,despite

thefactthatthelatterrancompaniesthatweremuchmore successful,inrelativeterms,thantoday’sAmerican companies.USmanagersarealsoover-pricedcompared totheircounterpartsinotherrichcountries.Inabsolute terms,theyarepaid,dependingonthemeasureweuseand thecountrywecomparewith,uptotwentytimesmorethan theircompetitorsrunningsimilarlylargeandsuccessful companies.Americanmanagersarenotonlyover-priced butalsooverlyprotectedinthesensethattheydonotget punishedforpoorperformance.Andallthisisnot,unlike whatmanypeopleargue,purelydictatedbymarketforces. ThemanagerialclassintheUShasgainedsucheconomic, politicalandideologicalpowerthatithasbeenableto manipulatetheforcesthatdetermineitspay.

Executivepayandthepoliticsofclass

envy

TheaverageCEOcompensation(salaries,bonuses, pensionsandstockoptions)intheUSis300–400timesthe averageworkercompensation(wagesandbenefits).Some peopleareterriblyupsetaboutthis.Forexample,MrBarack Obama,theUSpresident,isfrequentlyquotedcriticizing whatheseesasexcessiveexecutivepay.

Free-marketeconomistsseenoprobleminthispay disparity.IftheCEOsarepaid300timesmorethanthe averageworker,theysay,itmustbebecausetheyadd300 timesmorevaluetothecompany.Ifsomeonedoesnothave theproductivitytojustifyherhighpay,marketforceswill soonensurethatsheissacked(seeThing3).Thosewho raiseissueswithexecutivepay,likeMrObama,are populistswhoengageinthepoliticsofclassenvy.Unless thosewhoarelessproductiveaccept,theyargue,that peopleneedtobepaidaccordingtotheirproductivity,

capitalismcannotfunctionproperly.

Onecouldalmostbelieveintheabovearguments,ifone madeasmallconcession–ignoringthefacts.

Iamnotdisputingthatsomepeoplearemoreproductive thanothersandthattheyneedtobepaidmore–sometimes alotmore(althoughtheyshouldnotbetoosmugaboutit–seeThing3).Therealquestioniswhetherthecurrent degreeofdifferenceisjustified.

Now,accuratelytottingupexecutivepayisverydifficult. Tobeginwith,thedisclosureofexecutivepayisnotvery goodinmanycountries.Whenwelookatcompensationas awhole,ratherthanjustsalaries,weneedtoincludestock options.Stockoptionsgivetherecipienttherighttobuya certainnumberofthecompany’sstocksinthefuture,sothey donothaveanexactvalueinthepresentandtheirvalue needstobeestimated.Dependingonthemethodology usedfortheestimation,thevaluationcanvaryalot.

Asmentionedearlier,bearingthesecaveatsinmind,the ratioofCEOcompensationtoaverageworker compensationintheUSusedtobeintheregionof30to40 to1inthe1960sand70s.Thisratiohasgrownatarapid ratesincetheearly1980s,reachingaround100to1inthe early1990sandrisingto300–400to1bythe2000s.

ContrastthistothechangesinwhattheAmerican workersget.AccordingtotheEconomicPolicyInstitute (EPI),theWashington-basedcentre-leftthink-tank,the averagehourlywagefortheUSworkersin2007dollars(that is,adjustedforinflation)rosefrom$18.90in1973to$21.34 in2006.Thatisa13percentincreaseinthirty-threeyears, whichisaround0.4percentgrowthperyear.1Thepictureis evenbleakerwhenwelookatoverallcompensation(wages plusbenefits)andnotjustwages.Evenifwelookatonlythe recoveryperiods(giventhatworkercompensationfalls duringrecessions),medianworkercompensationroseat therateof0.2percentperyearduring1983–9,attherateof 0.1percentperyearbetween1992and2000anddidnot growatallduring2002–7.2

Inotherwords,workerpayintheUShasbeenvirtually stagnantsincethemid1970s.Ofcourse,thisisnottosay thatAmericanshavenotseenanyriseinlivingstandards sincethe1970s.Familyincome,asopposedtoindividual workercompensation,hasrisen,butthatisonlybecause moreandmorefamilieshavebothpartnersworking.

Now,ifwebelievedinthefree-marketlogicthatpeople arepaidaccordingtotheircontribution,theincreaseinthe relativecompensationoftheCEOsfrom30–40timesthatof averageworkercompensation(whichhasnotchangedvery much)to300–400timesmustmeanthattheAmerican CEOshavebecometentimesmoreproductive(inrelative terms)thantheywereinthe1960sand70s.Isthistrue?

TheaveragequalityofUSmanagersmayhavebeen risingduetobettereducationandtraining,butisitreally plausiblethattheyaretentimesbetterthantheirequivalents wereonegenerationago?Evenlookingbackatonlythelast twentyyears,duringwhichtimeIhavebeenteachingin Cambridge,IsincerelydoubtwhethertheAmericanstudents weget(whoarepotentialCEOmaterial)arethreetofour timesbettertodaythanwhenIstartedteachingintheearly 1990s.Butthatshouldbethecase,ifAmericanCEOpay hadriseninrelativetermspurelybecauseoftherising qualityoftheCEOs:duringthisperiod,theaverageCEO compensationintheUSrosefrom100timestheaverage workercompensationto300–400times.

Acommonexplanationofthisrecentsteepriseinrelative payisthatcompanieshavebecomebiggerandtherefore thedifferencethattheCEOcanmakehasbecomebigger. AccordingtoapopularexampleusedbyProfessorRobert H.FrankofCornellUniversityinhiswidelycitedNewYork Timescolumn,ifacompanyhas$10billionearnings,afew betterdecisionsmadebyabetterCEOcaneasilyincrease thecompany’searningsby$30million.3So,theimplicit messagegoes,whatisanextra$5millionfortheCEO, whenshehasgivenanextra$30milliontothecompany?

Thereissomelogictothisargument,butifthegrowing

sizeofthecompanyisthemainexplanationforCEOpay inflation,whydiditsuddenlytakeoffinthe1980s,whenUS companysizehasbeengrowingallthetime?

Also,thesameargumentshouldapplytotheworkersas well,atleasttosomeextent.Moderncorporationsworkon thebasisofcomplexdivisionsoflabourandcooperation,so theviewthatwhattheCEOdoesistheonlythingthat mattersforcompanyperformanceishighlymisleading(see Things3and15).Ascompaniesgrowbigger,thepotential forworkersbenefitingordamagingthecompanygrows biggeraswellandthereforeitbecomesmoreandmore importanttohirebetterworkers.Ifthatwerenotthecase, whydocompaniesbotherwithhumanresources departments?

Moreover,iftheincreasingimportanceoftopmanagerial decisionsisthemainreasonforCEOsalaryinflation,why areCEOsinJapanandEuroperunningsimilarlylarge companiespaidonlyafractionofwhattheAmericanCEOs arepaid?AccordingtotheEPI,asof2005,Swissand GermanCEOswerepaidrespectively64percentand55 percentofwhattheirAmericancounterpartsreceived.The SwedishandtheDutchwerepaidonlyaround44percent and40percentoftheAmericanCEOs’pay;Japanese CEOsonlyapaltry25percent.TheaverageCEOpayfor thirteenrichcountriesotherthantheUSwasonly44percent oftheUSlevel.4

Theabovefiguresactuallyvastlyunderstatethe internationaldifferencesinCEOremunerationastheydonot includestockoptions,whichtendtobemuchhigherinthe USthaninothercountries.OtherdatafromtheEPIsuggest that,intheUS,CEOpayincludingstockoptionscouldbe easilythreetofourtimes,andpossiblyfivetosixtimes,that oftheirpayexcludingstockoptions,althoughitisdifficultto knowexactlythemagnitudeinvolved.Thismeansthat,ifwe includestockoptions,theJapaneseCEOcompensation (withonlyasmallstockoptioncomponent,ifatall)couldbe aslowas5percent,insteadof25percent,thatofUSCEO

compensation.

Now,iftheAmericanCEOsareworthanythingbetween twice(comparedtotheSwissCEOs,excludingstock options)andtwentytimes(comparedtotheJapanese CEOs,includingstockoptions),theircounterpartsabroad, howcomethecompaniestheyrunhavebeenlosingoutto theirJapaneseandEuropeanrivalsinmanyindustries?

YoumaysuggestthattheJapaneseandEuropeanCEOs canworkatmuchlowerabsolutepaythantheAmerican CEOsbecausetheircountries’generalwagelevelsare lower.However,wagesinJapanandtheEuropean countriesarebasicallyatthesamelevelasthoseintheUS. Theaverageworkerpayinthethirteencountriesstudiedby theEPIwas85percentoftheUSworkerpayin2005.The Japaneseworkersgetpaid91percenttheAmerican wages,buttheirCEOsgetpaidonly25percentofwhatthe AmericanCEOsget(excludingstockoptions).TheSwiss workersandtheGermanworkersgethigherwagesthanthe USworkers(130percentand106percentoftheUSwage, respectively),whiletheirCEOsgetpaidonly55percentand 64percentoftheUSsalaries(onceagain,excludingshare options,whicharemuchhigherintheUS).5

Thusseen,USmanagersareover-priced.TheAmerican workersgetpaidonly15percentorsomorethantheir counterpartsincompetitornations,whiletheAmerican CEOsarepaidatleasttwice(comparedtotheSwiss managers,excludingstockoptions)andpossiblyupto twentytimes(comparedtotheJapanesemanagers, includingstockoptions)thatofwhattheircounterpartsin comparablecountriesarepaid.Despitethis,theAmerican CEOsarerunningcompaniesthatarenobetter,and frequentlyworse,thantheirJapaneseorEuropean competitors.

IntheUS(andtheUK,whichhasthesecondhighestCEO–workerpayratioaftertheUS),thecompensationpackages fortopmanagersareloadedinoneway.Apartfrombeing paidexcessiveamounts,thesemanagersdonotget punishedforbadmanagement.Themostthatwillhappento themistobekickedoutoftheircurrentjob,butthatwill almostalwaysbeaccompaniedbyafatseverancepayment cheque.SometimestheexpelledCEOwillgetevenmore thanwhatisrequiredinthecontract.Accordingtotwo economists,BebchukandFried,‘whenMattelCEOJill Baradresignedunderfire[in2000],theboardforgavea $4.2millionloan,gaveheranadditional$3.3millionincash tocoverthetaxesforforgivenessofanotherloanand allowedherunvestedoptionstovestautomatically.These gratuitousbenefitswereinadditiontotheconsiderable benefitsthatshereceivedunderheremployment agreement,whichincludedaterminationpaymentof$26.4 millionandastreamofretirementbenefitsexceeding $700,000peryear.’6

Shouldwecare?Notreally,free-marketeconomists wouldargue.Ifsomecompaniesarestupidenoughtopay gratuitousbenefitstofailedCEOs,theywouldsay,letthem doit.Theywillbeoutcompetedbymorehard-nosed competitorsthatdonotengageinsuchnonsense.So,even thoughtheremaybesomepoorlydesignedcompensation schemesaround,theywilleventuallybeeliminatedthrough competitivepressuresofthemarket.

Thisseemsplausible.Thecompetitiveprocessworksto eliminateinefficientpractices,betheyobsoletetextile technologiesorbiasedexecutivepayschemes.Andthefact thatAmericanandBritishcompanieshavebeenlosingto foreigncompanies,whichonthewholehavebetter managerialincentives,isaproofofit.

However,itwilltakealongtimeforthisprocessto eliminatewrongmanagerialcompensationpractices(after

all,thishasbeengoingonfordecades).Beforeitsrecent bankruptcy,peoplehadknownforatleastthreedecades thatGMwasonadecline,butnoonedidanythingtostop thetopmanagersfromreceivingcompensationpackages morefittingtotheirpredecessorsinthemidtwentieth century,whenthecompanyhadabsolutedominance worldwide(seeThing18).

Despitethis,littleisdonetocheckexcessiveandbiased (inthatfailuresarehardlypunished)executivepaypackages becausethemanagerialclassesintheUSandBritainhave becomesopowerful,notleastbecauseofthefat paychequestheyhavebeengettingoverthelastfew decades.Theyhavecometocontroltheboardrooms, throughinterlockingdirectorshipandmanipulationof informationthattheyprovidetoindependentdirectors,and asaresultfewboardsofdirectorsquestionthelevelandthe structureofexecutivepaysetbytheCEO.Highandrising dividendpaymentsalsokeeptheshareholdershappy(see Thing2).Byflexingtheireconomicmuscle,themanagerial classeshavegainedenormousinfluenceoverthepolitical sphere,includingthesupposedlycentre-leftpartiessuchas Britain’sNewLabourandAmerica’sDemocraticParty. EspeciallyintheUS,manyprivatesectorCEOsendup runninggovernmentdepartments.Mostimportantly,they haveusedtheireconomicandpoliticalinfluencetospread thefree-marketideologythatsaysthatwhateverexistsmust betherebecauseitisthemostefficient.

Thepowerofthismanagerialclasshasbeenmostvividly demonstratedbytheaftermathofthe2008financialcrisis. WhentheAmericanandtheBritishgovernmentsinjected astronomicalsumsoftaxpayers’moneyintotroubled financialinstitutionsintheautumnof2008,fewofthe managerswhowereresponsiblefortheirinstitution’sfailure werepunished.Yes,asmallnumberofCEOshavelosttheir jobs,butfewofthosewhohaveremainedintheirjobshave takenaseriouspaycutandtherehasbeenanenormous, andeffective,resistancetotheattemptbytheUSCongress

toputacaponpayofthemanagersoffinancialfirms receivingtaxpayers’money.TheBritishgovernmentrefused todoanythingaboutthe£15–20millionpensionspayout (whichgiveshimaround£700,000yearlyincome)tothe disgracedformerbossoftheRBS(RoyalBankofScotland), SirFredGoodwin,althoughtheintensenegativepublicity forcedhimsubsequentlytoreturn£4million.Thefactthatthe BritishandtheAmericantaxpayers,whohavebecomethe shareholdersofthebailed-outfinancialinstitutions,cannot evenpunishtheirnow-employeesforpoorperformanceand forcethemtoacceptamoreefficientcompensationscheme showstheextentofpowerthatthemanagerialclassnow possessesinthesecountries.

Marketsweedoutinefficientpractices,butonlywhenno onehassufficientpowertomanipulatethem.Moreover, eveniftheyareeventuallyweededout,one-sided managerialcompensationpackagesimposehugecostson therestoftheeconomywhiletheylast.Theworkershaveto beconstantlysqueezedthroughdownwardpressureon wages,casualizationofemploymentandpermanent downsizing,sothatthemanagerscangenerateenough extraprofitstodistributetotheshareholdersandkeepthem fromraisingissueswithhighexecutivepay(formoreonthis, seeThing2).Havingtomaximizedividendstokeepthe shareholdersquiet,investmentisminimized,weakeningthe company’slong-termproductivecapabilities.When combinedwithexcessivemanagerialpay,thisputsthe AmericanandBritishfirmsatadisadvantageininternational competition,eventuallycostingtheworkerstheirjobs. Finally,whenthingsgowrongonalargescale,asinthe 2008financialcrisis,taxpayersareforcedtobailoutthe failedcompanies,whilethemanagerswhocreatedthe failuregetoffalmostscot-free.

WhenthemanagerialclassesintheUSand,toalesser extentBritain,possesssucheconomic,politicaland ideologicalpowerthattheycanmanipulatethemarketand passonthenegativeconsequencesoftheiractionstoother

people,itisanillusiontothinkthatexecutivepayis somethingwhoseoptimallevelsandstructuresaregoingto be,andshouldbe,determinedbythemarket.

Whattheytellyou

Entrepreneurshipisattheheartofeconomicdynamism. Unlessthereareentrepreneurswhoseekoutnewmoneymakingopportunitiesbygeneratingnewproductsand meetingunmetdemands,theeconomycannotdevelop. Indeed,oneofthereasonsbehindthelackofeconomic dynamisminarangeofcountries,fromFrancetoallthose statesinthedevelopingworld,isthelackof entrepreneurship.Unlessallthosepeoplewhoaimlessly loiteraroundinpoorcountrieschangetheirattitudesand activelyseekoutprofit-makingopportunities,theircountries arenotgoingtodevelop.

Peoplewholiveinpoorcountrieshavetobevery entrepreneurialevenjusttosurvive.Foreveryloitererina developingcountry,youhavetwoorthreechildrenshining shoesandfourorfivepeoplehawkingthings.Whatmakes thepoorcountriespoorisnottheabsenceofentrepreneurial energyatthepersonallevel,buttheabsenceofproductive

technologiesanddevelopedsocialorganizations,especially modernfirms.Theincreasinglyapparentproblemswith microcredit–verysmallloansgiventopoorpeoplein developingcountrieswiththepronouncedaimofhelping themsetupbusinesses–showsthelimitationsofindividual entrepreneurship.Especiallyinthelastcentury, entrepreneurshiphasbecomeacollectiveactivity,sothe povertyofcollectiveorganizationhasbecomeaneven biggerobstacletoeconomicdevelopmentratherthanthe deficiententrepreneurialspiritsofindividuals.

TheproblemwiththeFrench…

GeorgeW.Bush,theformerUSpresident,isreputedto havecomplainedthattheproblemwiththeFrenchisthat theydonothaveawordforentrepreneurshipintheir language.HisFrenchmaynothavebeenuptoscratch,but MrBushwasarticulatingafairlycommonAnglo-American prejudiceagainstFranceasanun-dynamicandbackwardlookingcountryfulloflazyworkers,sheep-burningfarmers, pretentiousleft-wingintellectuals,meddlingbureaucratsand, lastbutnotleast,pompouswaiters.

WhetherornotMrBush’sconceptionofFranceisright (moreonthislater,andseeThing10),theperspective behindhisstatementiswidelyaccepted–youneed entrepreneurialpeopletohaveasuccessfuleconomy.Inthis view,thepovertyofthedevelopingcountriesisalso attributedtothelackofentrepreneurshipinthosecountries.

Lookatallthosemensittingaroundhavingtheireleventh cupofmintteaoftheday,observersfromtherichcountries say,thesecountriesreallyneedmorego-gettersand movers-and-shakersinordertopullthemselvesoutof poverty.

However,anyonewhoisfromorhaslivedforaperiodin

adevelopingcountrywillknowthatitisteemingwith entrepreneurs.Onthestreetsofpoorcountries,youwill meetmen,womenandchildrenofallagessellingeverything youcanthinkof,andthingsthatyoudidnotevenknowcould bebought.Inmanypoorcountries,youcanbuyaplacein thequeueforthevisasectionoftheAmericanembassy (soldtoyoubyprofessionalqueuers),theserviceto‘watch yourcar’(meaning‘refrainfromdamagingyourcar’)in street-parkingslots,therighttosetupafoodstallona particularcorner(perhapssoldbythecorruptlocalpolice boss)orevenapatchoflandtobegfrom(soldtoyoubythe localthugs).Theseareallproductsofhumaningenuityand entrepreneurship.

Incontrast,mostcitizensofrichcountrieshavenoteven comeneartobecomingentrepreneurs.Theymostlyworkfor acompany,someofthememployingtensofthousands, doinghighlyspecializedandnarrowlyspecifiedjobs.Even thoughsomeofthemdreamof,oratleastidlytalkabout, settinguptheirownbusinessesand‘becomingmyown boss’,fewputitintopracticebecauseitisadifficultand riskythingtodo.Asaresult,mostpeoplefromrichcountries spendtheirworkinglivesimplementingsomeoneelse’s entrepreneurialvision,andnottheirown.

Theupshotisthatpeoplearefarmoreentrepreneurialin thedevelopingcountriesthaninthedevelopedcountries. AccordingtoanOECDstudy,inmostdevelopingcountries 30–50percentofthenon-agriculturalworkforceisselfemployed(theratiotendstobeevenhigherinagriculture).In someofthepoorestcountriestheratioofpeopleworkingas one-personentrepreneurscanbewayabovethat:66.9per centinGhana,75.4percentinBangladeshanda staggering88.7percentinBenin.1Incontrast,only12.8per centofthenon-agriculturalworkforceindevelopedcountries isself-employed.Insomecountriestheratiodoesnoteven reachoneinten:6.7percentinNorway,7.5percentinthe USand8.6percentinFrance(itturnsoutthatMrBush’s complaintabouttheFrenchwasaclassiccaseofthepot

callingthekettleblack).So,evenexcludingthefarmers (whichwouldmaketheratioevenhigher),thechanceofan averagedeveloping-countrypersonbeinganentrepreneuris morethantwicethatforadeveloped-countryperson(30per centvs.12.8percent).Thedifferenceistentimes,ifwe compareBangladeshwiththeUS(7.5percentvs.75.4per cent).Andinthemostextremecase,thechanceof someonefromBeninbeinganentrepreneurisawhopping thirteentimeshigherthantheequivalentchancefora Norwegian(88.7percentvs.6.7percent).

Moreover,eventhosepeoplewhoarerunning businessesintherichcountriesneednotbeas entrepreneurialastheircounterpartsinthepoorcountries. Fordeveloping-countryentrepreneurs,thingsgowrongall thetime.Therearepowercutsthatscrewuptheproduction schedule.Customswon’tclearthesparepartsneededtofix amachine,whichhasbeendelayedanywaydueto problemswiththepermittobuyUSdollars.Inputsarenot deliveredattherighttime,asthedeliverytruckbrokedown –yetagain–duetopotholesontheroad.Andthepettylocal officialsarebending,andeveninventing,rulesallthetimein ordertoextractbribes.Copingwithalltheseobstacles requiresagilethinkingandtheabilitytoimprovise.An averageAmericanbusinessmanwouldnotlastaweekin thefaceoftheseproblems,ifheweremadetomanagea smallcompanyinMaputoorPhnomPenh.

Sowearefacedwithanapparentpuzzle.Comparedto therichcountries,wehavefarmorepeopleindeveloping countries(inproportionalterms)engagedinentrepreneurial activities.Ontopofthat,theirentrepreneurialskillsaremuch morefrequentlyandseverelytestedthanthoseoftheir counterpartsintherichcountries.Thenhowisitthatthese moreentrepreneurialcountriesarethepoorerones?

Theseeminglyboundlessentrepreneurialenergyofpoor peopleinpoorcountrieshas,ofcourse,notgoneunnoticed. Thereisanincreasinglyinfluentialviewthattheengineof developmentforpoorcountriesshouldbetheso-called ‘informalsector’,madeupofsmallbusinessesthatarenot registeredwiththegovernment.

Theentrepreneursintheinformalsector,itisargued,are strugglingnotbecausetheylackthenecessaryvisionand skillsbutbecausetheycannotgetthemoneytorealizetheir visions.Theregularbanksdiscriminateagainstthem,while thelocalmoney-lenderschargeprohibitiveratesofinterest. Iftheyaregivenasmallamountofcredit(knownasa ‘microcredit’)atareasonableinterestratetosetupafood stall,buyamobilephonetorentout,orgetsomechickensto selltheireggs,theywillbeabletopullthemselvesoutof poverty.Withthesesmallenterprisesmakingupthebulkof thedevelopingcountry’seconomy,theirsuccesseswould translateintooveralleconomicdevelopment.

Theinventionofmicrocreditiscommonlyattributedto MuhammadYunus,theeconomicsprofessorwhohasbeen thepublicfaceofthemicrocreditindustrysincehesetupthe pioneeringGrameenBankinhisnativeBangladeshin1983, althoughthereweresimilarattemptsbefore.Despitelending topoorpeople,especiallypoorwomen,whowere traditionallyconsideredtobehigh-riskcases,theGrameen Bankboastedaveryhighrepaymentratio(95percentor more),showingthatthepoorarehighlybankable.Bythe early1990s,thesuccessoftheGrameenBank,andof somesimilarbanksincountriessuchasBolivia,was noticed,andtheideaofmicrocredit–ormorebroadly microfinance,whichincludessavingsandinsurance,andnot justcredit–spreadfast.

getoutofpovertythroughtheirownefforts,byproviding themwiththefinancialmeanstorealizetheirentrepreneurial potential.Intheprocess,theygainindependenceandselfrespect,astheyarenolongerrelyingonhandoutsfromthe governmentandforeignaidagenciesfortheirsurvival.Poor womenareparticularlyempoweredbymicrocredit,asit givesthemtheabilitytoearnanincomeandthusimprove theirbargainingpositionsvis-à-vistheirmalepartners.Not havingtosubsidizethepoor,thegovernmentfeelsless pressureonitsbudget.Thewealthcreatedintheprocess, naturally,makestheoveralleconomy,andnotjustthe informalsectorentrepreneurs,richer.Givenallthis,itisnota surprisethatProfessorYunusbelievesthat,withthehelpof microfinance,wecancreate‘apoverty-freeworld[where the]onlyplaceyoucanseepovertyisinthemuseum’.

Bythemid2000s,thepopularityofmicrofinancereached feverpitch.Theyear2005wasdesignatedtheInternational YearofMicrocreditbytheUnitedNations,with endorsementsfromroyalty,likeQueenRaniaofJordan,and celebrities,liketheactressesNataliePortmanand AishwaryaRai.Theascendancyofmicrofinancereachedits peakin2006,whentheNobelPeacePrizewasawarded jointlytoProfessorYunusandhisGrameenBank.

Thegrandillusion

Unfortunately,thehypeaboutmicrofinanceis,well,justthat–hype.Therearegrowingcriticismsofmicrofinance,evenby someofitsearly‘priests’.Forexample,inarecentpaper withDavidRoodman,JonathanMorduch,along-time advocateofmicrofinance,confessesthat‘[s]trikingly,30 yearsintothemicrofinancemovementwehavelittlesolid evidencethatitimprovesthelivesofclientsinmeasurable ways’.2Theproblemsaretoonumerouseventolisthere;

anyonewhoisinterestedcanreadthefascinatingrecent bookbyMilfordBateman,WhyDoesn’tMicrofinance Work?3Butthosemostrelevanttoourdiscussionareas follows.

Themicrofinanceindustryhasalwaysboastedthatits operationsremainprofitablewithoutgovernmentsubsidies orcontributionsfrominternationaldonors,exceptperhapsin theinitialteethingphase.Somehaveusedthisasevidence thatthepoorareasgoodatplayingthemarketasanyone else,ifyouwilljustletthem.However,itturnsoutthat,without subsidiesfromgovernmentsorinternationaldonors, microfinanceinstitutionshavetocharge,andhavebeen charging,near-usuriousrates.Ithasbeenrevealedthatthe GrameenBankcouldinitiallychargereasonableinterest ratesonlybecauseofthe(hushed-up)subsidiesitwas gettingfromtheBangladeshigovernmentandinternational donors.Iftheyarenotsubsidized,microfinanceinstitutions havetochargeinterestratesoftypically40–50percentfor theirloans,withratesashighas80–100percentin countriessuchasMexico.When,inthelate1990s,itcame underpressuretogiveupthesubsidies,theGrameenBank hadtorelaunchitself(in2001)andstartcharginginterest ratesof40–50percent.

Withinterestratesrunningupto100percent,few businessescanmakethenecessaryprofitstorepaythe loans,somostoftheloansmadebymicrofinance institutions(insomecasesashighas90percent)have beenusedforthepurposeof‘consumptionsmoothing’–peopletakingoutloanstopayfortheirdaughter’swedding ortomakeupforatemporaryfallinincomeduetothe illnessofaworkingfamilymember.Inotherwords,thevast bulkofmicrocreditisnotusedtofuelentrepreneurshipby thepoor,theallegedgoaloftheexercise,buttofinance consumption.

Moreimportantly,eventhesmallportionofmicrocredit thatgoesintobusinessactivitiesisnotpullingpeopleoutof poverty.Atfirst,thissoundsinexplicable.Thosepoorpeople

whotakeoutmicrocreditknowwhattheyaredoing.Unlike theircounterpartsinrichcountries,mostofthemhaverun businessesofonekindoranother.Theirbusinesswitsare sharpenedtothelimitbytheirdesperationtosurviveand sheerdesiretogetoutofpoverty.Theyhavetogenerate veryhighprofitsbecausetheyhavetopaythemarketrateof interest.Sowhatisgoingwrong?Whyareallthesepeople –highlymotivated,inpossessionofrelevantskillsand stronglypressuredbythemarket–makinghugeeffortswith theirbusinessventures,producingsuchmeagreresults?

Whenamicrofinanceinstitutionfirststartsitsoperationin alocality,thefirstposseofitsclientsmayseetheirincome rising–sometimesquitedramatically.Forexample,whenin 1997theGrameenBankteamedupwithTelenor,the Norwegianphonecompany,andgaveoutmicroloansto womentobuyamobilephoneandrentitouttotheir villagers,these‘telephoneladies’madehandsomeprofits–$750–$1,200inacountrywhoseannualaveragepercapita incomewasaround$300.However,overtime,the businessesfinancedbymicrocreditbecomecrowdedand theirearningsfall.TogobacktotheGrameenphonecase, by2005thereweresomanytelephoneladiesthattheir incomewasestimatedtobearoundonly$70peryear,even thoughthenationalaverageincomehadgoneuptoover $450.Thisproblemisknownasthe‘fallacyofcomposition’ –thefactthatsomepeoplecansucceedwithaparticular businessdoesnotmeanthateveryonecansucceedwithit.

Ofcourse,thisproblemwouldnotexistifnewbusiness linescouldbeconstantlydeveloped–ifonelineofactivity becomesunprofitableduetoovercrowding,yousimplyopen upanother.So,forexample,ifphonerentingbecomesless profitable,youcouldmaintainyourlevelofincomeby manufacturingmobilephonesorwritingthesoftwarefor mobilephonegames.Youwillobviouslyhavenoticedthe absurdityofthesesuggestions–thetelephoneladiesof Bangladeshsimplydonothavethewherewithaltomoveinto phonemanufacturingorsoftwaredesign.Theproblemis

thatthereisonlyalimitedrangeof(simple)businessesthat thepoorindevelopingcountriescantakeon,giventheir limitedskills,thenarrowrangeoftechnologiesavailable, andthelimitedamountoffinancethattheycanmobilize throughmicrofinance.So,you,aCroatianfarmerwho boughtonemoremilkcowwithamicrocredit,sticktoselling milkevenasyouwatchthebottomfallingoutofyourlocal milkmarketthankstothe300otherfarmerslikeyouselling moremilk,becauseturningyourselfintoanexporterofbutter toGermanyorcheesetoBritainsimplyisn’tpossiblewith thetechnologies,theorganizationalskillsandthecapitalyou have.

Nomoreheroesanymore

Ourdiscussionsofarshowsthatwhatmakesthepoor countriespoorisnotthelackofrawindividual entrepreneurialenergy,whichtheyinfacthavein abundance.Thepointisthatwhatreallymakestherich countriesrichistheirabilitytochanneltheindividual entrepreneurialenergyintocollectiveentrepreneurship. Verymuchinfluencedbycapitalistfolklore,with characterssuchasThomasEdisonandBillGates,andby thepioneeringworkofJosephSchumpeter,theAustrianbornHarvardeconomicsprofessor,ourviewof entrepreneurshipistoomuchtingedbytheindividualistic perspective–entrepreneurshipiswhatthoseheroic individualswithexceptionalvisionanddeterminationdo.By extension,webelievethatanyindividual,iftheytryhard enough,canbecomesuccessfulinbusiness.However,ifit everwastrue,thisindividualisticviewofentrepreneurshipis becomingincreasinglyobsolete.Inthecourseofcapitalist development,entrepreneurshiphasbecomeanincreasingly collectiveendeavour.

Tobeginwith,evenexceptionalindividualslikeEdison andGateshavebecomewhattheyhaveonlybecausethey weresupportedbyawholehostofcollectiveinstitutions(see Thing3):thewholescientificinfrastructurethatenabled themtoacquiretheirknowledgeandalsoexperimentwithit; thecompanylawandothercommerciallawsthatmadeit possibleforthemsubsequentlytobuildcompanieswith largeandcomplexorganizations;theeducationalsystem thatsuppliedhighlytrainedscientists,engineers,managers andworkersthatmannedthosecompanies;thefinancial systemthatenabledthemtoraiseahugeamountofcapital whentheywantedtoexpand;thepatentandcopyrightlaws thatprotectedtheirinventions;theeasilyaccessiblemarket fortheirproducts;andsoon.

Furthermore,intherichcountries,enterprisescooperate witheachotheralotmorethandotheircounterpartsinpoor countries,eveniftheyoperateinsimilarindustries.For example,thedairysectorsincountriessuchasDenmark, theNetherlandsandGermanyhavebecomewhattheyare todayonlybecausetheirfarmersorganizedthemselves,with statehelp,intocooperativesandjointlyinvestedin processingfacilities(e.g.,creamingmachines)and overseasmarketing.Incontrast,thedairysectorsinthe Balkancountrieshavefailedtodevelopdespitequitea largeamountofmicrocreditchannelledintothem,because alltheirdairyfarmerstriedtomakeitontheirown.For anotherexample,manysmallfirmsinItalyandGermany jointlyinvestinR&Dandexportmarketing,whicharebeyond theirindividualmeans,throughindustryassociations(helped bygovernmentsubsidies),whereastypicaldeveloping countryfirmsdonotinvestintheseareasbecausetheydo nothavesuchacollectivemechanism.

Evenatthefirmlevel,entrepreneurshiphasbecome highlycollectiveintherichcountries.Today,fewcompanies aremanagedbycharismaticvisionarieslikeEdisonand Gates,butbyprofessionalmanagers.Writinginthemid twentiethcentury,Schumpeterwasalreadyawareofthis

trend,althoughhewasnonetoohappyaboutit.He observedthattheincreasingscaleofmoderntechnologies wasmakingitincreasinglyimpossibleforalargecompany tobeestablishedandrunbyavisionaryindividual entrepreneur.Schumpeterpredictedthatthedisplacement ofheroicentrepreneurswithwhathecalled‘executivetypes’ wouldsapthedynamismfromcapitalismandeventuallylead toitsdemise(seeThing2).

Schumpeterhasbeenprovenwronginthisregard.Over thelastcentury,theheroicentrepreneurhasincreasingly becomeararityandtheprocessofinnovationinproducts, processesandmarketing–thekeyelementsof Schumpeter’sentrepreneurship–hasbecomeincreasingly ‘collectivist’initsnature.Yet,despitethis,theworld economyhasgrownmuchfastersincetheSecondWorld War,comparedtotheperiodbeforeit.InthecaseofJapan, thefirmshaveevendevelopedinstitutionalmechanismsto exploitthecreativityofeventhelowliestproduction-line workers.ManyattributethesuccessoftheJapanesefirms, atleastpartly,tothischaracteristic(seeThing5).

Ifeffectiveentrepreneurshipeverwasapurelyindividual thing,ithasstoppedbeingsoatleastforthelastcentury. Thecollectiveabilitytobuildandmanageeffective organizationsandinstitutionsisnowfarmoreimportantthan thedrivesoreventhetalentsofanation’sindividual membersindeterminingitsprosperity(seeThing17). Unlesswerejectthemythofheroicindividualentrepreneurs andhelpthembuildinstitutionsandorganizationsof collectiveentrepreneurship,wewillneverseethepoor countriesgrowoutofpovertyonasustainablebasis.

Wearenotsmartenoughto leavethingstothemarket

Whattheytellyou

Weshouldleavemarketsalone,because,essentially, marketparticipantsknowwhattheyaredoing–thatis,they arerational.Sinceindividuals(andfirmsascollectionsof individualswhosharethesameinterests)havetheirown bestinterestsinmindandsincetheyknowtheirown circumstancesbest,attemptsbyoutsiders,especiallythe government,torestrictthefreedomoftheiractionscanonly produceinferiorresults.Itispresumptuousofany governmenttopreventmarketagentsfromdoingthingsthey findprofitableortoforcethemtodothingstheydonotwant todo,whenitpossessesinferiorinformation.

Whattheydon’ttellyou

Peopledonotnecessarilyknowwhattheyaredoing, becauseourabilitytocomprehendevenmattersthat concernusdirectlyislimited–or,inthejargon,wehave ‘boundedrationality’.Theworldisverycomplexandour abilitytodealwithitisseverelylimited.Therefore,weneed to,andusuallydo,deliberatelyrestrictourfreedomofchoice inordertoreducethecomplexityofproblemswehaveto

face.Often,governmentregulationworks,especiallyin complexareaslikethemodernfinancialmarket,not becausethegovernmenthassuperiorknowledgebut becauseitrestrictschoicesandthusthecomplexityofthe problemsathand,therebyreducingthepossibilitythatthings maygowrong.

Marketsmayfail,but…

AsexpressedbyAdamSmithintheideaoftheinvisible hand,free-marketeconomistsarguethatthebeautyofthe freemarketisthatthedecisionsofisolatedindividuals(and firms)getreconciledwithoutanybodyconsciouslytryingto doso.Whatmakesthispossibleisthateconomicactors arerational,inthesensethattheyknowbesttheirown situationsandthewaystoimprovethem.Itispossible,itis admitted,thatcertainindividualsareirrationaloreventhata generallyrationalindividualbehavesirrationallyonoccasion. However,inthelongrun,themarketwillweedoutirrational behavioursbypunishingthem–forexample,investorswho ‘irrationally’investinover-pricedassetswillreaplowreturns, whichforcesthemeithertoadjusttheirbehaviourorbe wipedout.Giventhis,free-marketeconomistsargue, leavingituptotheindividualstodecidewhattodoisthe bestwaytomanagethemarketeconomy.

Ofcourse,fewpeoplewouldarguethatmarketsare perfect.EvenMiltonFriedmanadmittedthatthereare instancesinwhichmarketsfail.Pollutionisaclassic example.People‘over-produce’pollutionbecausetheyare notpayingforthecostsofdealingwithit.Sowhatare optimallevelsofpollutionforindividuals(orindividualfirms) adduptoasub-optimallevelfromthesocialpointofview. However,free-marketeconomistsarequicktopointoutthat marketfailures,whiletheoreticallypossible,arerarein

reality.Moreover,theyargue,oftenthebestsolutionto marketfailuresistointroducemoremarketforces.For example,theyarguethatthewaytoreducepollutionisto createamarketforit–bycreating‘tradableemission rights’,whichallowpeopletosellandbuytherightstopollute accordingtotheirneedswithinasociallyoptimalmaximum. Ontopofthat,free-marketeconomistsadd,governments alsofail(seeThing12).Governmentsmaylackthe necessaryinformationtocorrectmarketfailures.Orthey mayberunbypoliticiansandbureaucratswhopromotetheir owninterestsratherthannationalinterests(seeThing5).All thismeansthatusuallythecostsofgovernmentfailureare greaterthanthecostsofmarketfailurethatitis(allegedly) tryingtofix.Therefore,free-marketeconomistspointout,the presenceofmarketfailuredoesnotjustifygovernment intervention.

Thedebateontherelativeimportanceofmarketfailures andgovernmentfailuresstillrageson,andIamnotgoingto beabletoconcludethatdebatehere.However,inthis Thing,Icanatleastpointoutthattheproblemwiththefree marketdoesnotendwiththefactthatindividuallyrational actionscanleadtoacollectiveirrationaloutcome(thatis, marketfailure).Theproblemisthatwearenotevenrational tobeginwith.Andwhentherationalityassumptiondoesnot hold,weneedtothinkabouttheroleofthemarketandofthe governmentinaverydifferentwayevenfromthemarket failureframework,whichafterallalsoassumesthatweare rational.Letmeexplain.

notarealNobelprizebutaprizegivenbytheSwedish centralbank‘inmemoryofAlfredNobel’.Asamatteroffact, severalyearsagotheNobelfamilyeventhreatenedtodeny theprizetheuseoftheirancestor’sname,asithadbeen mostlygiventofree-marketeconomistsofwhomAlfred Nobelwouldnothaveapproved,butthatisanotherstory.

In1998,ahugehedgefundcalledLong-TermCapital Management(LTCM)wasonthevergeofbankruptcy, followingtheRussianfinancialcrisis.Thefundwassolarge thatitsbankruptcywasexpectedtobringeveryoneelse downwithit.TheUSfinancialsystemavoidedacollapse onlybecausetheFederalReserveBoard,theUScentral bank,twistedthearmsofthedozenorsocreditorbanksto injectmoneyintothecompanyandbecomereluctant shareholders,gainingcontrolover90percentoftheshares. LTCMwaseventuallyfoldedin2000.

LTCM,foundedin1994bythefamous(nowinfamous) financierJohnMerriwether,hadonitsboardofdirectors–wouldyoubelieveit?–MertonandScholes.Mertonand Scholeswerenotjustlendingtheirnamestothecompany forafatcheque:theywereworkingpartnersandthe companywasactivelyusingtheirasset-pricingmodel.

UndeterredbytheLTCMdébâcle,Scholeswentontoset upanotherhedgefundin1999,PlatinumGroveAsset Management(PGAM).Thenewbackers,onecanonly surmise,thoughtthattheMerton–Scholesmodelmusthave failedbackin1998duetoatotallyunpredictablesuigeneris event–theRussiancrisis.Afterall,wasn’titstillthebest asset-pricingmodelavailableinthehistoryofhumanity, approvedbytheNobelcommittee?

TheinvestorsinPGAMwere,unfortunately,proven wrong.InNovember2008,itpracticallywentbust, temporarilyfreezinginvestorwithdrawal.Theonlycomfort theycouldtakewasprobablythattheywerenotalonein beingfailedbyaNobellaureate.TheTrinsumGroup,for whichScholes’sformerpartner,Merton,wasthechief scienceofficer,alsowentbankruptinJanuary2009.

ThereisasayinginKoreathatevenamonkeycanfall fromatree.Yes,weallmakemistakes,andonefailure–evenifitisagiganticonelikeLTCM–wecanacceptasa mistake.Butthesamemistaketwice?Thenyouknowthat thefirstmistakewasnotreallyamistake.Mertonand Scholesdidnotknowwhattheyweredoing.

WhenNobelPrize-winnersineconomics,especially thosewhogottheprizefortheirworkonassetpricing, cannotreadthefinancialmarket,howcanweruntheworld accordingtoaneconomicprinciplethatassumespeople alwaysknowwhattheyaredoingandthereforeshouldbe leftalone?AsAlanGreenspan,formerchairmanofthe FederalReserveBoard,hadtoadmitinaCongressional hearing,itwasa‘mistake’to‘presumethattheself-interest oforganisations,specificallybanks,issuchthattheywere bestcapableofprotectingshareholdersandequityinthe firms’.Self-interestwillprotectpeopleonlywhentheyknow whatisgoingonandhowtodealwithit.

Therearemanystoriescomingoutofthe2008financial crisisthatshowhowthesupposedlysmartestpeopledidnot trulyunderstandwhattheyweredoing.Wearenottalking abouttheHollywoodbigshots,suchasStevenSpielberg andJohnMalkovich,orthelegendarybaseballpitcher SandyKoufax,depositingtheirmoneywiththefraudster BernieMadoff.Whilethesepeopleareamongtheworld’s bestinwhattheydo,theymaynotnecessarilyunderstand finance.Wearetalkingabouttheexpertfundmanagers,top bankers(includingsomeoftheworld’slargestbanks,such astheBritishHSBCandtheSpanishSantander),and world-classcolleges(NewYorkUniversityandBard College,whichhadaccesstosomeoftheworld’smost reputedeconomicsfacultymembers)fallingforthesame trickbyMadoff.

Worse,itisn’tjustamatterofbeingdeceivedby fraudsterslikeMadofforAlanStanford.Thefailurebythe bankersandothersupposedexpertsinthefieldto understandwhatwasgoingonhasbeenpervasive,even

whenitcomestolegitimatefinance.Oneofthemapparently shockedAlistairDarling,thenBritishChancellorofthe Exchequer,bytellinghiminthesummerof2008that‘from nowonwewillonlylendwhenweunderstandtherisks involved’.1Foranother,evenmoreastonishing,example, onlysixmonthsbeforethecollapseofAIG,theAmerican insurancecompanybailedoutbytheUSgovernmentinthe autumnof2008,itschieffinancialofficer,JoeCassano,is reportedtohavesaidthat‘[i]tishardforus,withoutbeing flippant,toevenseeascenariowithinanykindofrealmof reasonthatwouldseeuslosingonedollarinanyofthe [creditdefaultswap,orCDS]transactions’.Mostofyou–especiallyifyouareanAmericantaxpayercleaningupMr Cassano’smess–mightfindthatsupposedlackof flippancylessthanamusing,giventhatAIGwentbust becauseofitsfailureinits$441billionportfolioofCDS, ratherthanitscoreinsurancebusiness.

WhentheNobelPrize-winnersinfinancialeconomics,top bankers,high-flyingfundmanagers,prestigiouscolleges andthesmartestcelebritieshaveshownthattheydonot understandwhattheyaredoing,howcanweaccept economictheoriesthatworkonlybecausetheyassumethat peoplearefullyrational?Theupshotisthatwearesimply notsmartenoughtoleavethemarketalone. Butwheredowegofromthere?Isitpossibletothink aboutregulatingthemarketwhenwearenotevensmart enoughtoleaveitalone?Theanswerisyes.Actuallyitis morethanthat.Veryoften,weneedregulationexactly becausewearenotsmartenough.Letmeshowwhy.

earth.Hestartedoutasapoliticalscientistandmovedonto thestudyofpublicadministration,writingtheclassicbookin thefield,AdministrativeBehaviour.Throwinginacoupleof papersinphysicsalongtheway,hemovedintothestudyof organizationalbehaviour,businessadministration, economics,cognitivepsychologyandartificialintelligence (AI).Ifanyoneunderstoodhowpeoplethinkandorganize themselves,itwasSimon.

Simonarguedthatourrationalityis‘bounded’.Hedidnot believethatweareentirelyirrational,althoughhehimself andmanyothereconomistsofthebehaviouralistschool(as wellasmanycognitivepsychologists)haveconvincingly documentedhowmuchofourbehaviourisirrational.2 AccordingtoSimon,wetrytoberational,butourabilityto besoisseverelylimited.Theworldistoocomplex,Simon argued,forourlimitedintelligencetounderstandfully.This meansthatveryoftenthemainproblemwefaceinmakinga gooddecisionisnotthelackofinformationbutourlimited capabilitytoprocessthatinformation–apointnicely illustratedbythefactthatthecelebratedadventofthe internetagedoesnotseemtohaveimprovedthequalityof ourdecisions,judgingbythemessweareintoday.

Toputitanotherway,theworldisfullofuncertainty. Uncertaintyhereisnotjustnotknowingexactlywhatisgoing tohappeninthefuture.Forcertainthings,wecan reasonablycalculatetheprobabilityofeachpossible contingency,eventhoughwecannotpredicttheexact outcome–economistscallthis‘risk’.Indeed,ourabilityto calculatetheriskinvolvedinmanyaspectsofhumanlife–thelikelihoodsofdeath,disease,fire,injury,cropfailure,and soon–istheveryfoundationoftheinsuranceindustry. However,formanyotheraspectsofourlife,wedonoteven knowallthepossiblecontingencies,nottospeakoftheir respectivelikelihoods,asemphasized,amongothers,by theinsightfulAmericaneconomistFrankKnightandthe greatBritisheconomistJohnMaynardKeynesintheearly twentiethcentury.KnightandKeynesarguedthatthekindof

rationalbehaviourthatformsthefoundationofmuchof moderneconomicsisimpossibleunderthiskindof uncertainty.

Thebestexplanationoftheconceptofuncertainty–orthe complexityoftheworld,toputitanotherway–wasgivenby, perhapssurprisingly,DonaldRumsfeld,theDefense SecretaryinthefirstgovernmentofGeorgeW.Bush.Ina pressbriefingregardingthesituationinAfghanistanin2002, Rumsfeldopined:‘Thereareknownknowns.Thereare thingsweknowthatweknow.Thereareknownunknowns. Thatistosay,therearethingsthatwenowknowwedon’t know.Buttherearealsounknownunknowns.Thereare thingswedonotknowwedon’tknow.’Idon’tthinkthoseat thePlainEnglishCampaignthatawardedthe2003Footin Mouthawardtothestatementquiteunderstoodthe significanceofthisstatementforourunderstandingof humanrationality.

Sowhatdowedo,whentheworldissocomplexandour abilitytounderstanditsolimited?Simon’sanswerwasthat wedeliberatelyrestrictourfreedomofchoiceinorderto reducetherangeandthecomplexityoftheproblemsthatwe havetodealwith.

Thissoundsesoteric,butwhenyouthinkaboutit,thisis exactlywhatwedoallthetime.Mostofuscreateroutinesin ourlifesothatwedon’thavetomaketoomanydecisions toooften.Theoptimalamountofsleepandtheoptimal breakfastmenudiffereveryday,dependingonourphysical conditionsandthetasksahead.Yetmostofusgotobedat thesametime,wakeupatthesametimeandeatsimilar thingsforbreakfast,atleastduringtheweekdays.

Simon’sfavouriteexampleofhowweneedsomerulesin ordertocopewithourboundedrationalitywaschess.With onlythirty-twopiecesandsixty-foursquares,chessmay seemtobearelativelysimpleaffair,butinfactinvolvesa hugeamountofcalculation.Ifyouwereoneofthose‘hyperrational’beings(asSimoncallsthem)thatpopulate standardeconomicstextbooks,youwould,ofcourse,figure

outallthepossiblemovesandcalculatetheirlikelihoods beforeyoumakeamove.But,Simonpointsout,therebeing around10120(yes,thatis120zeroes)possibilitiesinan averagegameofchess,this‘rational’approachrequires mentalcapacitythatnohumanbeingpossesses.Indeed, studyingchessmasters,Simonrealizedthattheyuserules ofthumb(heuristics)tofocusonasmallnumberofpossible moves,inordertoreducethenumberofscenariosthatneed tobeanalysed,eventhoughtheexcludedmovesmayhave broughtbetterresults.

Ifchessisthiscomplicated,youcanimaginehow complicatedthingsareinoureconomy,whichinvolves billionsofpeopleandmillionsofproducts.Therefore,inthe samewayinwhichindividualscreateroutinesintheirdaily livesorchessgames,companiesoperatewith‘productive routines’,whichsimplifytheiroptionsandsearchpaths.They buildcertaindecision-makingstructures,formalrulesand conventionsthatautomaticallyrestricttherangeofpossible avenuesthattheyexplore,evenwhentheavenuesthus excludedoutrightmayhavebeenmoreprofitable.Butthey stilldoitbecauseotherwisetheymaydrowninaseaof informationandnevermakeadecision.Similarly,societies createinformalrulesthatdeliberatelyrestrictpeople’s freedomofchoicesothattheydon’thavetomakefresh choicesconstantly.So,theydevelopaconventionfor queuingsothatpeopledonothaveto,forexample, constantlycalculateandrecalculatetheirpositionsata crowdedbusstopinordertoensurethattheygetonthenext bus.

Thegovernmentneednotknowbetter Sofarsogood,youmaythink,butwhatdoesSimon’stheory ofboundedrationalityreallyhavetosayaboutregulation?

Free-marketeconomistshavearguedagainst governmentregulationonthe(apparentlyreasonable) groundthatthegovernmentdoesnotknowbetterthanthose whoseactionsareregulatedbyit.Bydefinition,the governmentcannotknowsomeone’ssituationaswellasthe individualorfirmconcerned.Giventhis,theyargue,itis impossiblethatgovernmentofficialscanimproveuponthe decisionsmadebytheeconomicagents.

However,Simon’stheoryshowsthatmanyregulations worknotbecausethegovernmentnecessarilyknowsbetter thantheregulated(althoughitmaysometimesdo–see Thing12)butbecausetheylimitthecomplexityofthe activities,whichenablestheregulatedtomakebetter decisions.The2008worldfinancialcrisisillustratesthis pointverynicely.

Intherun-uptothecrisis,ourabilitytomakegood decisionswassimplyoverwhelmedbecausethingswere allowedtoevolveintoocomplexamannerthroughfinancial innovation.Somanycomplexfinancialinstrumentswere createdthatevenfinancialexpertsthemselvesdidnotfully understandthem,unlesstheyspecializedinthem–and sometimesnoteventhen(seeThing22).Thetopdecisionmakersofthefinancialfirmscertainlydidnotgraspmuchof whattheirbusinessesweredoing.Norcouldtheregulatory authoritiesfullyfigureoutwhatwasgoingon.Asdiscussed above,nowweareseeingafloodofconfessions–some voluntary,othersforced–fromthekeydecision-makers.

Ifwearegoingtoavoidsimilarfinancialcrisesinthe future,weneedtorestrictseverelyfreedomofactioninthe financialmarket.Financialinstrumentsneedtobebanned unlesswefullyunderstandtheirworkingsandtheireffectson therestofthefinancialsectorand,moreover,therestofthe economy.Thiswillmeanbanningmanyofthecomplex financialderivativeswhoseworkingsandimpactshave beenshowntobebeyondthecomprehensionofeventhe supposedexperts.

YoumaythinkIamtooextreme.However,thisiswhatwe

doallthetimewithotherproducts–drugs,cars,electrical products,andmanyothers.Whenacompanyinventsanew drug,forexample,itcannotbesoldimmediately.Theeffects ofadrug,andthehumanbody’sreactiontoit,arecomplex. Sothedrugneedstobetestedrigorouslybeforewecanbe surethatithasenoughbeneficialeffectsthatclearly overwhelmtheside-effectsandallowittobesold.Thereis nothingexceptionalaboutproposingtoascertainthesafety offinancialproductsbeforetheycanbesold.

Unlesswedeliberatelyrestrictourchoicesbycreating restrictiverules,therebysimplifyingtheenvironmentthatwe havetodealwith,ourboundedrationalitycannotcopewith thecomplexityoftheworld.Itisnotbecausethegovernment necessarilyknowsbetterthatweneedregulations.Itisinthe humblerecognitionofourlimitedmentalcapabilitythatwe do.

Whattheytellyou

Awell-educatedworkforceisabsolutelynecessaryfor economicdevelopment.Thebestproofofthisisthecontrast betweentheeconomicsuccessesoftheEastAsian countries,withtheirfamouslyhigheducational achievements,andtheeconomicstagnationofSubSaharanAfricancountries,whichhavesomeofthelowest educationalrecordsintheworld.Moreover,withtheriseof theso-called‘knowledgeeconomy’,inwhichknowledgehas becomethemainsourceofwealth,education,especially highereducation,hasbecometheabsolutekeyto prosperity.

Whattheydon’ttellyou

Thereisremarkablylittleevidenceshowingthatmore educationleadstogreaternationalprosperity.Muchofthe knowledgegainedineducationisactuallynotrelevantfor productivityenhancement,eventhoughitenablespeopleto leadamorefulfillingandindependentlife.Also,theviewthat theriseoftheknowledgeeconomyhascriticallyincreased theimportanceofeducationismisleading.Tobeginwith,

theideaoftheknowledgeeconomyitselfisproblematic,as knowledgehasalwaysbeenthemainsourceofwealth.

Moreover,withincreasingde-industrializationand mechanization,theknowledgerequirementsmayevenhave fallenformostjobsintherichcountries.Evenwhenitcomes tohighereducation,whichissupposedtomattermoreinthe knowledgeeconomy,thereisnosimplerelationship betweenitandeconomicgrowth.Whatreallymattersinthe determinationofnationalprosperityisnottheeducational levelsofindividualsbutthenation’sabilitytoorganize individualsintoenterpriseswithhighproductivity.

Education,education,education

‘Education,education,education’–thisishowtheformer BritishPrimeMinisterTonyBlairsummeduphis prospectivegovernment’stopthreepolicyprioritiesduring the1997electioncampaign,whichbroughthis‘New’Labour partytopowerafternearlytwodecadesinthewilderness.

ThesubsequentsuccessorotherwiseofNewLabour’s educationpolicymaybedisputed,butwhatisindisputable isthatthecommentperfectlycapturedMrBlair’sexceptional abilitytosaytherightthingattherighttime(thatis,beforehe losthisheadoverIraq).ManyapoliticianbeforeMrBlair hadtalkedaboutandpushedforbettereducation,buthe wasspeakingatatimewhen,havingwitnessedtheriseof theknowledgeeconomysincethe1980s,thewholeworld wasbecomingconvincedthateducationwasthekeyto economicprosperity.Ifeducationhadbeenimportantfor economicsuccessinthedaysofsmoke-stackindustries, moreandmorepeoplewerebecomingconvinced,itwould bethebe-allandend-allintheinformationage,whenbrains, andnotbrawn,arethemainsourceofwealth.

Theargumentseemsstraightforward.Moreeducated

peoplearemoreproductive–asevidencedbythehigher salariestheyget.Soitisamatterofmathematicallogicthat aneconomywithmoreeducatedpeoplewillbemore productive.Thefactthatpoorercountrieshavealowerstock ofeducatedpeople–or‘humancapital’insome economists’jargon–alsoprovesthepoint.Theaverage durationofschoolingisaroundnineyearsinOECD countries,whileitisnoteventhreeinSub-SaharanAfrican countries.Alsowellknownaretheexceptionallyhigh educationalachievementsofthe‘miracle’economiesin EastAsia–suchasJapan,SouthKorea,Taiwan,Hong KongandSingapore.Theireducationalachievementsare manifestednotjustinquantitativetermssuchashighliteracy ratesorenrolmentratesatvariouslevelsofeducation.The qualityoftheireducationisveryhighaswell.Theyrankright atthetopoftheleagueininternationallystandardizedtests suchastheTrendsinInternationalMathematicsand ScienceStudy(TIMSS)forfourthandeighthgraders,and theProgramforInternationalStudentAssessment(PISA), whichmeasuresfifteen-year-olds’abilitytoapplymaths knowledgetoreal-worldproblems.Needwesaymore?

Self-evidentthoughtheimportanceofeducationinraising aneconomy’sproductivitymayseem,thereisactuallyalot ofevidencethatquestionsthispieceofconventional wisdom.

Let’sfirsttakethecaseoftheEastAsianmiracle economies,inwhosedevelopmenteducationissupposed tohaveplayedacriticalrole.In1960,Taiwanhadaliteracy rateofonly54percent,whilethePhilippines’was72per cent.Despiteitslowereducationlevel,Taiwanhassince thennotcheduponeofthebesteconomicgrowth

performancesinhumanhistory,whilethePhilippineshas doneratherpoorly.In1960,thePhilippineshadalmost doublethepercapitaincomeofTaiwan($200vs.$122),but todayTaiwan’spercapitaincomeisaroundtentimesthatof thePhilippines($18,000vs.$1,800).Inthesameyear, Koreahada71percentliteracyrate–comparabletothatof thePhilippinesbutstillwellbelowArgentina’s91percent. Despitethesignificantlylowerliteracyrate,Koreahassince grownmuchfasterthanArgentina.Korea’spercapita incomewasjustoverone-fifththatofArgentina’sin1960 ($82vs.$378).Todayitisthreetimeshigher(around $21,000vs.around$7,000).

Obviously,therearemanymorethingsthaneducation thatdetermineacountry’seconomicgrowthperformance. Buttheseexamplesunderminethecommonmyththat educationwasthekeytotheEastAsianmiracle.TheEast Asianeconomiesdidnothaveunusuallyhigheducational achievementatthestartoftheireconomicmiracles,while countrieslikethePhilippinesandArgentinadidverypoorly despitehavingsignificantlybetter-educatedpopulations.

Attheotherendofthespectrum,theexperienceofSubSaharanAfricaalsoshowsthatinvestingmoreineducation isnoguaranteeofbettereconomicperformance.Between 1980and2004,literacyratesinSub-SaharanAfrican countriesrosequitesubstantiallyfrom40percentto61per cent.1Despitesuchrises,percapitaincomeintheregion actuallyfellby0.3percentperyearduringthisperiod.If educationissoimportantforeconomicdevelopment,as mostofusbelieve,somethinglikethisshouldnothappen.

Theapparentlackofpositiveeffectsofeducationon growthisnotfoundonlyintheextremecasesthatIhave chosen–EastAsiaatoneendandSub-SaharanAfricaat theother.Itisamoregeneralphenomenon.Inawidelycited 2004article,‘Wherehasalltheeducationgone?’,Lant Pritchett,aHarvardeconomistwhoworkedattheWorld Bankforalongtime,analysedthedatafromdozensofrich anddevelopingcountriesduringthe1960–87periodand

conductedanextensivereviewofsimilarstudies,inorderto establishwhethereducationpositivelyinfluencesgrowth.2 Hisconclusionisthatthereisverylittleevidencetosupport theviewthatincreasededucationleadstohighereconomic growth.

Don’tknowmuchabouthistory,don’t knowmuchbiology

Whyistheresolittleevidencetosupportwhatseemstobe suchanobviouspropositionthatmoreeducationshould makeacountryricher?Itisbecause,toputitsimply, educationisnotasimportantinraisingtheproductivityofan economyaswebelieve.

Tobeginwith,notalleducationisevenmeanttoraise productivity.Therearemanysubjectsthathavenoimpact, evenindirectly,onmostworkers’productivity–literature, history,philosophyandmusic,forexample(seeThing3). Fromastrictlyeconomicpointofview,teachingthese subjectsisawasteoftime.Weteachourchildrenthose subjectsbecausewebelievethattheywilleventuallyenrich theirlivesandalsomakethemgoodcitizens.Eventhough thisjustificationforeducationalspendingisincreasingly underattackinanageinwhicheverythingissupposedto justifyitsexistenceintermsofitscontributiontoproductivity growth,itremainsaveryimportant–inmyview,themost important–reasontoinvestineducation.

Moreover,evensubjectslikemathematicsorsciences, whicharesupposedtobeimportantforraisingproductivity, arenotrelevantformostworkers–investmentbankersdo notneedbiologyorfashiondesignersmathematicsinorder tobegoodatwhattheydo.Evenforthosejobsforwhich thesesubjectsarerelevant,muchofwhatyoulearnatschool

orevenuniversityisoftennotdirectlyrelevantforpractical work.Forexample,thelinkbetweenwhataproductionline workerinacarfactorylearnedinschoolphysicsandhis productivityisrathertenuous.Theimportanceof apprenticeshipandon-the-jobtraininginmanyprofessions testifiestothelimitedrelevanceofschooleducationfor workerproductivity.So,eventhesupposedlyproductivityorientedpartsofeducationarenotasrelevantforraising productivityaswethink.

Cross-countrystatisticalanalyseshavefailedtofindany relationshipbetweenacountry’smathsscoresandits economicperformance.3Butletmegiveyoumoreconcrete examples.Inthemathematicalpartofthe2007TIMSS,US fourth-graderswerebehindnotonlythefamously mathematicalchildrenoftheEastAsiancountriesbutalso theircounterpartsfromcountriessuchasKazakhstan, Latvia,RussiaandLithuania.4Childreninallotherrich Europeaneconomiesincludedinthetest,exceptEngland andtheNetherlands,scoredlowerthantheUSchildren.5 Eighth-gradersfromNorway,therichestcountryintheworld (intermsofpercapitaincomeatmarketexchangerate–seeThing10),werebehindtheircounterpartsnotonlyinall otherrichcountriesbutalsoinmuchpoorercountries, includingLithuania,CzechRepublic,Slovenia,Armeniaand Serbia(itisinterestingtonotethatallthesecountriesare formersocialistcountries).6Eighth-gradersfromIsrael,a countryfamousforitseducationalzealandexceptional performanceinhigh-endresearch,scoredbehindNorway, fallingbehindBulgariaaswell.Similarstorieswere observedinsciencetests.

Howabouttheknowledgeeconomy?

Evenifeducation’simpactongrowthhasbeenmeagreso far,youmaywonderwhethertherecentriseofthe knowledgeeconomymayhavechangedallthat.Withideas becomingthemainsourceofwealth,itmaybeargued, educationwillfromnowonbecomemuchmoreimportantin determiningacountry’sprosperity.

Againstthis,Imustfirstofallpointoutthattheknowledge economyisnothingnew.Wehavealwayslivedinoneinthe sensethatithasalwaysbeenacountry’scommandover knowledge(orlackofit)thatmadeitrich(orpoor).China wastherichestcountryintheworldduringthefirst millenniumbecauseitpossessedtechnicalknowledgethat othersdidnot–paper,movabletype,gunpowderandthe compassbeingthemostfamous,butbynomeanstheonly, examples.Britainbecametheworld’seconomichegemon inthenineteenthcenturybecauseitcametoleadtheworld intechnologicalinnovation.WhenGermanybecameaspoor asPeruandMexicorightaftertheSecondWorldWar,no onesuggestedthatitshouldbereclassifiedasadeveloping country,becausepeopleknewthatitstillhadcommandover technological,organizationalandinstitutionalknowledgethat hadmadeitoneofthemostformidableindustrialpowers beforethewar.Inthatsense,theimportance(orotherwise) ofeducationhasnotchangedintherecentperiod.

Ofcourse,theknowledgestockthatthehumanity collectivelycommandstodayismuchbiggerthaninthepast, butthatdoesnotmeanthateveryone,oreventhemajorityof thepeople,hastobebettereducatedthaninthepast.If anything,theamountofproductivity-relatedknowledgethat anaverageworkerneedstopossesshasfallenformany jobs,especiallyinrichcountries.Thismaysoundabsurd,but letmeexplain.

Tobeginwith,withthecontinuousriseinmanufacturing productivity,agreaterproportionoftheworkforceinrich countriesnowworksinlow-skilledservicejobsthatdonot requiremucheducation–stackingshelvesinsupermarkets, fryingburgersinfastfoodrestaurantsandcleaningoffices

(seeThings3and9).Insofarastheproportionofpeoplein suchprofessionsincreases,wemayactuallydowithan increasinglyless,notmore,educatedlabourforce,ifweare onlyinterestedintheproductivityeffectsofeducation.

Moreover,witheconomicdevelopment,ahigher proportionofknowledgebecomesembodiedinmachines. Thismeansthattheeconomy-wideproductivityincreases despiteindividualworkershavinglessunderstandingof whattheydothantheircounterpartsinthepast.Forthemost strikingexample,thesedaysmostshopassistantsinrich countriesdonotevenneedtoknowhowtoadd–askillthat theircounterpartsinearliertimesdefinitelyneeded–asbarcodemachinesdothatforthem.Foranotherexample, blacksmithsinpoorcountriesprobablyknowmoreaboutthe natureofmetalsinrelationtotool-makingthandomost employeesofBoschorBlack&Decker.Foryetanother example,thosewhoworkatthesmallelectronicsshops litteringthestreetsofpoorcountriescanfixmanymore thingsthancanindividualworkersatSamsungorSony.

Alargepartofthisisduetothesimplefactthat mechanizationisthemostimportantwaytoincrease productivity.ButaninfluentialMarxistschoolofthought arguesthatcapitalistsdeliberately‘de-skill’theirworkersby usingthemostmechanizedproductiontechnologies possible,eveniftheyarenotthemosteconomical,inorder tomaketheworkersmoreeasilyreplaceableandthus easiertocontrol.7Whatevertheexactcauseofthe mechanizationprocess,theupshotisthatmore technologicallydevelopedeconomiesmayactuallyneed fewereducatedpeople.

developmentmaynotnecessarilyrequiretheaverage workertobemoreeducated,itneedsmoreeducated peopleatthehigherend.Afterall,asIhavepointedout above,theabilitytogeneratemoreproductiveknowledge thanothersiswhatmakesacountryricherthanothers.Thus seen,itmaybeargued,itisthequalityofuniversities,rather thanthatofprimaryschools,thatdeterminesanation’s prosperity.

However,eveninthissupposedlyknowledge-drivenera, therelationshipbetweenhighereducationandprosperityis notstraightforward.Letustakethestrikingexampleof Switzerland.Thecountryisoneofthetopfewrichestand mostindustrializedcountriesintheworld(seeThings9and 10),butithas,surprisingly,thelowest–actuallybyfarthe lowest–universityenrolmentrateintherichworld;untilthe early1990s,onlyaroundone-thirdoftheaverageforother richcountries.Untilaslateas1996,theSwissuniversity enrolmentratewasstilllessthanhalftheOECDaverage(16 percentvs.34percent).8Sincethen,Switzerlandincreased itsrateconsiderably,bringingitupto47percentby2007, accordingtoUNESCOdata.However,theSwissratestill remainsthelowestintherichworldandiswaybelowwhat wefindinthemostuniversity-heavycountries,suchas Finland(94percent),theUS(82percent)andDenmark(80 percent).Itis,interestingly,alsofarlowerthanthatofmany considerablypoorereconomies,suchasKorea(96per cent),Greece(91percent),Lithuania(76percent)and Argentina(68percent).

HowisitpossiblethatSwitzerlandhasstayedatthevery topoftheinternationalproductivityleaguedespiteproviding muchlesshighereducationthannotjustitsmain competitorsbutalsomanyeconomiesthataremuch poorer?

Onepossibleexplanationisthatuniversitiesindifferent countrieshavedifferentqualities.So,ifKoreanorLithuanian universitiesarenotasgoodasSwissuniversities,itmaybe possibleforSwitzerlandtobericherthanKoreaor

Lithuania,evenifamuchlowerproportionoftheSwisshave universityeducationthandotheKoreansortheLithuanians. However,thisargumentlosesmuchofitsforcewhenwe compareSwitzerlandwithFinlandortheUS.Wecannotin allseriousnesssuggestthatSwissuniversitiesaresomuch betterthanFinnishorAmericanonesthatSwitzerlandcan getawaywithuniversityenrolmentrateshalftheirs.

Themainexplanationforthe‘Swissparadox’shouldbe found,onceagain,inthelowproductivitycontentof education.However,inthecaseofhighereducation,the non-productivitycomponentisnotsomuchaboutteaching peoplesubjectsthatwillhelpthemwiththingssuchas personalfulfilment,goodcitizenshipandnationalidentity,as inthecaseofprimaryandsecondaryeducation.Itisabout whateconomistscallthe‘sorting’function.

Highereducation,ofcourse,impartscertainproductivityrelatedknowledgetoitsrecipients,butanotherimportant functionofitistoestablisheachindividual’srankinginthe hierarchyofemployability.9Inmanylinesofwork,what countsisgeneralintelligence,disciplineandtheabilityto organizeoneself,ratherthanspecialistknowledge,muchof whichyoucan,andhaveto,actuallypickupon-the-job.So, evenifwhatyoulearninauniversityasahistorymajorora chemistmaynotberelevanttoyourworkasaprospective managerinaninsurancecompanyorasagovernment officialintheDepartmentofTransport,thefactthatyouhave graduatedfromauniversitytellsyourpotentialemployers thatyouarelikelytobesmarter,moreself-disciplinedand betterorganizedthanthosewhohavenot.Byhiringyouasa universitygraduate,youremployeristhenhiringyoufor thosegeneralqualities,notforyourspecialistknowledge, whichisoftenirrelevanttothejobyouwillbeperforming.

Now,withtheincreasingemphasisonhighereducationin therecentperiod,anunhealthydynamichasbeen establishedforhighereducationinmanyhigh-incomeand upper-middle-incomecountriesthatcanaffordtoexpand universities(Switzerlandhasnotbeenimmunetothis,as

figuresabovesuggest).Oncetheproportionofpeoplegoing touniversitygoesoveracriticalthreshold,peoplehaveto gotouniversityinordertogetadecentjob.When,say,50 percentofthepopulationgoestouniversity,notgoingto universityisimplicitlydeclaringthatyouareinthebottom halfoftheabilitydistribution,whichisnotthegreatestwayto startyourjobsearch.So,peoplegotouniversity,fully knowingthattheywill‘wastetime’studyingthingsthatthey willneverneedfortheirwork.Witheveryonewantingtogoto university,thedemandforhighereducationincreases,which thenleadstothesupplyofmoreuniversityplaces,which raisesuniversityenrolmentratefurther,increasingthe pressuretogotouniversityevenmore.Overtime,thisleads toaprocessofdegreeinflation.Nowthat‘everyone’hasa universitydegree,youhavetodoamaster’s,orevenaPhD, inordertostandout,eveniftheproductivitycontentofthose furtherdegreesmaybeminimalforyourfuturejobs.

GiventhatSwitzerlandwasuntilthemid1990sableto maintainoneofthehighestnationalproductivitiesinthe worldwithauniversityenrolmentof10–15percent,we couldsaythatenrolmentratesmuchhigherthanthatare reallyunnecessary.Evenifweacceptthatskillsrequirement hasrisensomuchwiththeriseoftheknowledgeeconomy thatthe40-pluspercentenrolmentratethatSwitzerlandnow hasistheminimum(whichIseriouslydoubt),thisstillmeans thatatleasthalfofuniversityeducationincountriessuchas theUS,KoreaandFinlandis‘wasted’intheessentially zero-sumgameofsorting.Thehighereducationsystemin thesecountrieshasbecomelikeatheatreinwhichsome peopledecidedtostandtogetabetterview,prompting othersbehindthemtostand.Onceenoughpeoplestand, everyonehastostand,whichmeansthatnooneisgettinga betterview,whileeveryonehasbecomemore uncomfortable.

Ifnotjustbasiceducationbutalsohighereducationdoesnot mattersomuchindetermininganation’sprosperity,we mustseriouslyrethinktheroleofeducationinoureconomy.

Inthecaseofrichcountries,theirobsessionwithhigher educationhastobetamed.Thisobsessionhasledto unhealthydegreeinflationandtheconsequentoverinvestmentofhugescaleinhighereducationinmany countries.Iamnotagainstcountrieshavingaveryhigh–or even100percent–universityenrolmentrateforother reasons,buttheyshouldnotdeludethemselvesinto believingthatitwouldhaveasignificantproductivityeffect.

Inthecaseofdevelopingcountries,anevenmoreradical changeofperspectiveisneeded.Whiletheyshouldexpand educationinordertopreparetheiryoungstersforamore meaningfullife,whenitcomestothequestionofproductivity increase,thesecountriesneedtolookbeyondtheeducation ofindividualsandpaymoreattentiontobuildingtheright institutionsandorganizationsforproductivitygrowth.

Whatreallydistinguishestherichcountriesfromthe pooreronesismuchlesshowwelleducatedtheirindividual citizensarethanhowwelltheircitizensareorganizedinto collectiveentitieswithhighproductivity–bethatgiantfirms suchasBoeingorVolkswagenorthesmallerworld-class firmsofSwitzerlandandItaly(seeThing15).Development ofsuchfirmsneedstobesupportedbyarangeof institutionsthatencourageinvestmentandrisk-taking–a traderegimethatprotectsandnurturesfirmsin‘infant industries’(seeThings7and12),afinancialsystemthat provides‘patientcapital’necessaryforlong-term productivity-enhancinginvestments(seeThing2), institutionsthatprovidesecondchancesforboththe capitalists(agoodbankruptcylaw)andfortheworkers(a goodwelfarestate)(seeThing21),publicsubsidiesand

Educationisvaluable,butitsmainvalueisnotinraising productivity.Itliesinitsabilitytohelpusdevelopour potentialsandliveamorefulfillingandindependentlife.Ifwe expandededucationinthebeliefthatitwillmakeour economiesricher,wewillbesorelydisappointed,forthelink betweeneducationandnationalproductivityisrather tenuousandcomplicated.Ouroverenthusiasmwith educationshouldbetamed,and,especiallyindeveloping countries,fargreaterattentionneedstobepaidtotheissue ofestablishingandupgradingproductiveenterprisesand institutionsthatsupportthem.

Whattheytellyou

Attheheartofthecapitalistsystemisthecorporatesector. Thisiswherethingsareproduced,jobscreatedandnew technologiesinvented.Withoutavibrantcorporatesector, thereisnoeconomicdynamism.Whatisgoodforbusiness, therefore,isgoodforthenationaleconomy.Especiallygiven theincreasinginternationalcompetitioninaglobalizing world,countriesthatmakeopeningandrunningbusinesses difficultormakefirmsdounwantedthingswilllose investmentandjobs,eventuallyfallingbehind.Government needstogivethemaximumdegreeoffreedomtobusiness.

Whattheydon’ttellyou

Despitetheimportanceofthecorporatesector,allowing firmsthemaximumdegreeoffreedommaynotevenbe goodforthefirmsthemselves,letalonethenational economy.Infact,notallregulationsarebadforbusiness. Sometimes,itisinthelong-runinterestofthebusiness sectortorestrictthefreedomofindividualfirmssothatthey donotdestroythecommonpoolofresourcesthatallofthem

need,suchasnaturalresourcesorthelabourforce. Regulationscanalsohelpbusinessesbymakingthemdo thingsthatmaybecostlytothemindividuallyintheshortrun butraisetheircollectiveproductivityinthelongrun–suchas theprovisionofworkertraining.Intheend,whatmattersis notthequantitybutthequalityofbusinessregulation.

HowDetroitwonthewar

TheysaythatDetroitwontheSecondWorldWar.Yes,the SovietUnionsacrificedthemostpeople–theestimated deathtollintheGreatPatrioticWar(asitisknownin Russia)wasupwardof25million,nearlyhalfofalldeaths worldwide.Butit–and,ofcourse,theUK–wouldnothave survivedtheNazioffensivewithoutthearmssentoverfrom whatFranklinRooseveltcalled‘thearsenalofdemocracy’, thatis,theUnitedStates.Andmostofthosearmswere madeintheconvertedfactoriesoftheDetroitcar-makers–GeneralMotors(GM),FordandChrysler.So,withoutthe industrialmightoftheUS,representedbyDetroit,theNazis wouldhavetakenoverEuropeandatleastthewesternpart oftheSovietUnion.

Ofcourse,historyisneverstraightforward.Whatmade theearlysuccessofNaziGermanyinthewarpossiblewas theabilityofitsarmytomovequickly–itsfamousBlitzkrieg, orLightningWar.Andwhatmadethathighmobilityofthe Germanarmypossiblewasitshighdegreeofmotorization, manytechnologiesforwhichweresuppliedbynoneother thanGM(throughitsOpelsubsidiary,acquiredin1929). Moreover,evidenceisemergingthat,indefianceofthelaw, throughoutthewarGMsecretlymaintaineditslinkwithOpel, whichbuiltnotonlymilitarycarsbutaircraft,landminesand torpedoes.SoitseemsthatGMwasarmingbothsidesand profitingfromit.

EvenamongtheDetroitcar-makers–collectivelyknown astheBigThree–GMbythenstoodpre-eminent.Underthe leadershipofAlfredSloanJr,whoranitforthirty-fiveyears (1923–58),GMhadovertakenFordasthelargestUScarmakerbythelate1920sandgoneontobecometheallAmericanautomobilecompany,producing,inSloan’s words,‘acarforeverypurseandpurpose’,arrangedalong a‘ladderofsuccess’,startingwithChevrolet,movingup throughPontiac,Oldsmobile,Buickandfinallyculminatingin Cadillac.

BytheendoftheSecondWorldWar,GMwasnotjustthe biggestcar-makerintheUS,ithadbecomethebiggest companyinthecountry(intermsofrevenue).Itwasso importantthat,whenaskedintheCongressionalhearingfor hisappointmentasUSDefenseSecretaryin1953whether hesawanypotentialconflictbetweenhiscorporate backgroundandhispublicduties,MrCharlieWilson,who usedtobetheCEOofGeneralMotors,famouslyrepliedthat whatisgoodfortheUnitedStatesisgoodforGeneral Motorsandviceversa.

Thelogicbehindthisargumentseemsdifficulttodispute. Inacapitalisteconomy,privatesectorcompaniesplaythe centralroleincreatingwealth,jobsandtaxrevenue.Ifthey dowell,thewholeeconomydoeswellbyextension. Especiallywhentheenterpriseinquestionisoneofthe largestandtechnologicallymostdynamicenterprises,like GMinthe1950s,itssuccessorotherwisehassignificant effectsontherestoftheeconomy–thesupplierfirms,the employeesofthosefirms,theproducersofgoodsthatthe giantfirm’semployees,whocannumberinthehundredsof thousands,maybuy,andsoon.Therefore,howthesegiant firmsdoisparticularlyimportantfortheprosperityofthe nationaleconomy.

Unfortunately,proponentsofthislogicsay,thisobvious argumentwasnotwidelyacceptedduringmuchofthe twentiethcentury.Onecanunderstandwhycommunist regimeswereagainsttheprivatesector–afterall,they

believedthatprivatepropertywasthesourceofalltheevils ofcapitalism.However,betweentheGreatDepressionand the1970s,privatebusinesswasviewedwithsuspicioneven inmostcapitalisteconomies.

Businesseswere,sothestorygoes,seenasanti-social agentswhoseprofit-seekingneededtoberestrainedfor other,supposedlyloftier,goals,suchasjustice,social harmony,protectionoftheweakandevennationalglory.As aresult,complicatedandcumbersomesystemsoflicensing wereintroducedinthebeliefthatgovernmentsneedto regulatewhichfirmsdowhatintheinterestofwidersociety. Insomecountries,governmentsevenpushedfirmsinto unwantedbusinessesinthenameofnationaldevelopment (seeThings7and12).Largefirmswerebannedfrom enteringthosesegmentsofthemarketpopulatedbysmall farms,factoriesandretailshops,inordertopreservethe traditionalwayoflifeandprotect‘smallmen’againstbig business.Onerouslabourregulationswereintroducedinthe nameofprotectingworkerrights.Inmanycountries, consumerrightswereextendedtosuchadegreethatithurt business.

Theseregulations,pro-businesscommentatorsargue, notonlyharmedthelargefirmsbutmadeeveryoneelse worseoffbyreducingtheoverallsizeofthepietobeshared out.Bylimitingtheabilityoffirmstoexperimentwithnew waysofdoingbusinessandenternewareas,these regulationssloweddownthegrowthofoverallproductivity.In theend,however,thefollyofthisanti-businesslogicbecame tooobvious,theargumentgoes.Asaresult,sincethe 1970s,countriesfromallaroundtheworldhavecometo acceptthatwhatisgoodforbusinessisgoodforthe nationaleconomyandhaveadoptedapro-businesspolicy stance.Evencommunistcountrieshavegivenuptheir attemptstostifletheprivatesectorsincethe1990s.Need weponderuponthisissueanymore?

Howthemightyhasfallen

FivedecadesafterMrWilson’sremark,inthesummerof 2009,GMwentbankrupt.Notwithstandingitswell-known aversiontostateownership,theUSgovernmenttookover thecompanyand,afteranextensiverestructuring,launched itasanewentity.Intheprocess,itspentastaggering$57.6 billionoftaxpayers’money.

ItmaybearguedthattherescuewasintheAmerican nationalinterest.LettingacompanyofGM’ssizeandinterlinkagescollapsesuddenlywouldhavehadhugenegative rippleeffectsonjobsanddemand(e.g.,fallinconsumer demandfromunemployedGMworkers,evaporationof GM’sdemandforproductsfromitssupplierfirms), aggravatingthefinancialcrisisthatwasunfoldinginthe countryatthetime.TheUSgovernmentchosethelesserof thetwoevils,onbehalfofthetaxpayers.Whatwasgoodfor GMwasstillgoodfortheUnitedStates,itmaybeargued, eventhoughitwasnotaverygoodthinginabsoluteterms.

However,thatdoesnotmeanthatweshouldnotquestion howGMgotintothatsituationinthefirstplace.Whenfaced withstiffcompetitionfromimportsfromGermany,Japanand thenKoreafromthe1960s,GMdidnotrespondinthemost natural,ifdifficult,wayitshouldhave–producingbettercars thanthoseofitscompetitors.Instead,ittriedtotakethe easywayout.

First,itblamed‘dumping’andotherunfairtradepractices byitscompetitorsandgottheUSgovernmenttoimpose importquotasonforeign,especiallyJapanese,carsand forceopencompetitors’homemarkets.Inthe1990s,when thesemeasuresprovedinsufficienttohaltitsdecline,ithad triedtomakeupforitsfailingsincar-makingbydeveloping itsfinancialarm,GMAC(GeneralMotorsAcceptance Corporation).GMACmovedbeyonditstraditionalfunction offinancingcarpurchasesandstartedconductingfinancial

transactionsfortheirownsake.GMACitselfprovedquite successful–in2004,forexample,80percentofGM’sprofit camefromGMAC(seeThing22).1Butthatcouldnotreally hidethefundamentalproblem–thatthecompanycouldnot makegoodcarsatcompetitiveprices.Aroundthesame time,thecompanytriedtoshortcuttheneedforinvestingin thedevelopmentofbettertechnologiesbybuyingupsmaller foreigncompetitors(suchasSaabofSwedenandDaewoo ofKorea),butthesewerenowherenearenoughtorevivethe company’sformertechnologicalsuperiority.Inotherwords, inthelastfourdecades,GMhastriedeverythingtohaltits declineexceptmakingbettercarsbecausetryingtomake bettercarsitselfwas,well,toomuchtrouble.

Obviously,allthesedecisionsmayhavebeenbestfrom GM’spointofviewatthetimewhentheyweremade–after all,theyallowedthecompanytosurviveforafewmore decadeswiththeleasteffort–buttheyhavenotbeengood fortherestoftheUnitedStates.ThehugebillthatAmerican taxpayershavebeenlandedwiththroughtherescue packageistheultimateproofofthat,butalongtheway,the restoftheUScouldhavedonebetter,hadGMbeenforced toinvestinthetechnologiesandmachinesneededtobuild bettercars,insteadoflobbyingforprotection,buyingup smallercompetitorsandturningitselfintoafinancial company.

Moreimportantly,allthoseactionsthathaveenabledGM togetoutofdifficultieswiththeleastefforthaveultimately notbeengoodevenforGMitself–unlessyouequateGM withitsmanagersandaconstantlychanginggroupof shareholders.Thesemanagersdrewabsurdlyhighsalaries bydeliveringhigherprofitsbynotinvestingforproductivity growthwhilesqueezingotherweaker‘stakeholders’–their workers,supplierfirmsandtheemployeesofthosefirms. Theyboughttheacquiescenceofshareholdersbyoffering themdividendsandsharebuybackstosuchanextentthat thecompany’sfuturewasjeopardized.Theshareholdersdid notmind,andindeedmanyofthemencouragedsuch

practices,becausemostofthemwerefloatingshareholders whowerenotreallyconcernedwiththelong-termfutureof thecompanybecausetheycouldleaveatamoment’snotice (seeThing2).

ThestoryofGMteachesussomesalutarylessonsabout thepotentialconflictsbetweencorporateandnational interests–whatisgoodforacompany,howeverimportantit maybe,maynotbegoodforthecountry.Moreover,it highlightstheconflictsbetweendifferentstakeholdersthat makeupthefirm–whatisgoodforsomestakeholdersofa company,suchasmanagersandshort-termshareholders, maynotbegoodforothers,suchasworkersandsuppliers. Ultimately,italsotellsusthatwhatisgoodforacompanyin theshortrunmaynotevenbegoodforitinthelongrun–whatisgoodforGMtodaymaynotbegoodforGM tomorrow.

Now,somereaders,evenoneswhowerealready persuadedbythisargument,maystillwonderwhetherthe USisjustanexceptionthatprovestherule.Under-regulation maybeaproblemfortheUS,butinmostothercountries, isn’ttheproblemover-regulation?

299permits

Intheearly1990s,theHongKong-basedEnglish-language businessmagazine,FarEasternEconomicReview,rana specialissueonSouthKorea.Inonearticlethemagazine expressedpuzzlementatthefactthat,eventhoughitneeded upto299permitsfromupto199agenciestoopenafactory inthecountry,SouthKoreahadgrownatover6percentin percapitatermsforthepreviousthreedecades.Howwas thispossible?Howcanacountrywithsuchanoppressive regulatoryregimegrowsofast?

Beforetryingtomakesenseofthispuzzle,Imustpoint

outthatitwasnotjustKoreabeforethe1990sinwhich seeminglyonerousregulationscoexistedwithavibrant economy.ThesituationwassimilarinJapanandTaiwan throughouttheir‘miracle’yearsbetweenthe1950sandthe 1980s.TheChineseeconomyhasbeenheavilyregulatedin asimilarmannerduringthelastthreedecadesofrapid growth.Incontrast,overthelastthreedecades,many developingcountriesinLatinAmericaandSub-Saharan Africahavede-regulatedtheireconomiesinthehopethatit wouldstimulatebusinessactivitiesandacceleratetheir growth.However,puzzlingly,sincethe1980s,theyhave grownfarmoreslowlythaninthe1960sand70s,whenthey weresupposedlyheldbackbyexcessiveregulations(see Things7and11).

Thefirstexplanationforthepuzzleisthat,strangeasit mayseemtomostpeoplewithoutbusinessexperience, businesspeoplewillget299permits(withsome circumventedalongthewaywithbribes,iftheycangetaway withit),ifthereisenoughmoneytobemadeattheendof theprocess.So,inacountrythatisgrowingfastandwhere goodbusinessopportunitiesarecroppingupallthetime, eventhehassleofacquiring299permitswouldnotdeter businesspeoplefromopeninganewlineofbusiness.In contrast,ifthereislittlemoneytobemadeattheendofthe process,eventwenty-ninepermitsmaylooktooonerous.

Moreimportantly,thereasonwhysomecountriesthat haveheavilyregulatedbusinesshavedoneeconomically wellisthatmanyregulationsareactuallygoodforbusiness.

Sometimesregulationshelpbusinessbylimitingthe abilityoffirmstoengageinactivitiesthatbringthemgreater profitsintheshortrunbutultimatelydestroythecommon resourcethatallbusinessfirmsneed.Forexample, regulatingtheintensityoffishfarmingmayreducetheprofits ofindividualfishfarmsbuthelpthefish-farmingindustryasa wholebypreservingthequalityofwaterthatallthefishfarms havetouse.Foranotherexample,itmaybeintheinterestof individualfirmstoemploychildrenandlowertheirwagebills.

However,awidespreaduseofchildlabourwilllowerthe qualityofthelabourforceinthelongerrunbystuntingthe physicalandmentaldevelopmentofchildren.Insuchacase, childlabourregulationcanactuallybenefittheentire businesssectorinthelongrun.Foryetanotherexample, individualbanksmaybenefitfromlendingmore aggressively.Butwhenallofthemdothesame,theymayall sufferintheend,assuchlendingbehavioursmayincrease thechanceofsystemiccollapse,aswehaveseeninthe 2008globalfinancialcrisis.Restrictingwhatbankscando, then,mayactuallyhelptheminthelongrun,evenifitdoes notimmediatelybenefitthem(seeThing22).

Itisnotjustthatregulationcanhelpfirmsbypreventing themfromunderminingthebasisoftheirlong-term sustainability.Sometimes,regulationscanhelpbusinesses byforcingfirmstodothingsthatmaynotbeintheir individualinterestsbutraisetheircollectiveproductivityin thelongrun.Forexample,firmsoftendonotinvestenough intrainingtheirworkers.Thisisbecausetheyareworried abouttheirworkersbeingpoachedbyotherfirms‘freeriding’ontheirtrainingefforts.Insuchasituation,the governmentimposingarequirementforworkertrainingon allfirmscouldactuallyraisethequalityofthelabourforce, therebyultimatelybenefitingallfirms.Foranotherexample, inadevelopingcountrythatneedstoimporttechnologies fromabroad,thegovernmentcanhelpbusinessachieve higherproductivityinthelongrunbybanningtheimportation ofoverlyobsoleteforeigntechnologiesthatmayenabletheir importerstounderminecompetitorsintheshortrunbutwill lockthemintodead-endtechnologies.

KarlMarxdescribedthegovernmentrestrictionof businessfreedomforthesakeofthecollectiveinterestof thecapitalistclassasitactingas‘theexecutivecommittee ofthebourgeoisie’.Butyoudon’tneedtobeaMarxistto seethatregulationsrestrictingfreedomforindividualfirms maypromotethecollectiveinterestoftheentirebusiness sector,nottospeakofthenationasawhole.Inotherwords,

therearemanyregulationsthatarepro-ratherthanantibusiness.Manyregulationshelppreservethecommon-pool resourcesthatallfirmsshare,whileothershelpbusinessby makingfirmsdothingsthatraisetheircollectiveproductivity inthelongrun.Onlywhenwerecognizethiswillwebeable toseethatwhatmattersisnottheabsoluteamountof regulation,buttheaimsandcontentsofthoseregulations.

Thing19

Whattheytellyou

Thelimitsofeconomicplanninghavebeenresoundingly demonstratedbythefallofcommunism.Incomplexmodern economies,planningisneitherpossiblenordesirable.Only decentralizeddecisionsthroughthemarketmechanism, basedonindividualsandfirmsbeingalwaysonthelookout foraprofitableopportunity,arecapableofsustaininga complexmoderneconomy.Weshoulddoawaywiththe delusionthatwecanplananythinginthiscomplexandeverchangingworld.Thelessplanningthereis,thebetter.

Capitalisteconomiesareinlargepartplanned. Governmentsincapitalisteconomiespractiseplanningtoo, albeitonamorelimitedbasisthanundercommunistcentral planning.Allofthemfinanceasignificantshareof investmentinR&Dandinfrastructure.Mostofthemplana significantchunkoftheeconomythroughtheplanningofthe

sectorsthroughsectoralindustrialpolicyoreventhatofthe nationaleconomythroughindicativeplanning.More importantly,moderncapitalisteconomiesaremadeupof large,hierarchicalcorporationsthatplantheiractivitiesin greatdetail,evenacrossnationalborders.Therefore,the questionisnotwhetheryouplanornot.Itisaboutplanning therightthingsattherightlevels.

UpperVoltawithrockets

Inthe1970s,manyWesterndiplomatscalledtheSoviet Union‘UpperVoltawithrockets’.Whataninsult–thatis,to UpperVolta(renamedBurkinaFasoin1984),whichwas beingbrandedthequintessentialpoorcountry,whenit wasn’tevennearthebottomoftheworldpovertyleague.The nickname,however,succinctlysummarizedwhatwaswrong withtheSovieteconomy.

Herewasacountrythatcouldsendmenintospacebut hadpeoplequeuingupforbasicfoodstuffssuchasbread andsugar.Thecountryhadnoproblemchurningout intercontinentalballisticmissilesandnuclearsubmarines, butcouldnotmanufactureadecentTV.Itisreportedthatin the1980sthesecond-biggestcauseoffiresinMoscowwas –believeitornot–explodingTVs.ThetopRussian scientistswereasinventiveastheircounterpartsincapitalist countries,buttherestofthecountrydidnotseemabletolive uptothesamestandard.Whatwasgoingon?

Inpursuitofthecommunistvisionofaclasslesssociety basedoncollectiveownershipofthe‘meansofproduction’ (e.g.,machines,factorybuildings,roads),theSovietUnion anditscommunistalliesaimedforfullemploymentanda highdegreeofequality.Sincenoonewasallowedtoown anymeansofproduction,virtuallyallenterpriseswererunby professionalmanagers(withminorexceptionssuchassmall

restaurantsandhairdressers),preventingtheemergenceof visionaryentrepreneurs,likeHenryFordorBillGates.Given thepoliticalcommitmenttohighequality,therewasaclear caponhowmuchabusinessmanager,howeversuccessful, couldget.Thismeantthattherewasonlyalimitedincentive forbusinessmanagerstoturntheadvancedtechnologies thatthesystemwasclearlycapableofproducinginto productsthatconsumersactuallywanted.Thepolicyoffull employmentatallcostsmeantthatmanagerscouldnotuse theultimatethreat–thatofsacking–todisciplineworkers. Thiscontributedtosloppyworkandabsenteeism;whenhe wastryingtoreformtheSovieteconomy,Gorbachev frequentlyspokeoftheproblemoflabourdiscipline.

Ofcourse,allthisdidnotmeanthatnooneincommunist countrieswasmotivatedtoworkhardortorunagood business.Evenincapitalisteconomies,wedon’tdothings justforthemoney(seeThing5),butcommunistcountries relied,withsomesuccess,muchmoreonthelessselfish sidesofhumannature.Especiallyintheearlydaysof communism,therewasalotofidealismaboutbuildinga newsociety.IntheSovietUnion,therewasalsoahuge surgeofpatriotismduringandshortlyaftertheSecond WorldWar.Inallcommunistcountriesthereweremany dedicatedmanagersandworkerswhodidthingswelloutof professionalismandself-respect.Moreover,bythe1960s, theidealegalitarianismofearlycommunismhadgivenway torealismandperformance-relatedpayhadbecomethe norm,mitigating(althoughbynomeanseliminating)the incentiveproblem.

Despitethis,thesystemstillfailedtofunctionwell becauseoftheinefficiencyofthecommunistcentral planningsystem,whichwassupposedtobeamoreefficient alternativetothemarketsystem.

Thecommunistjustificationofcentralplanningwasbased onsomequitesoundlogic.KarlMarxandhisfollowers arguedthatthefundamentalproblemwithcapitalismwasthe contradictionbetweenthesocialnatureoftheproduction

processandtheprivatenatureofownershipofthemeansof production.Witheconomicdevelopment–orthe developmentofproductiveforces,inMarxistjargon–the divisionoflabourbetweenfirmsdevelopsfurtherandasa resultthefirmsbecomeincreasinglymoredependenton eachother–orthesocialnatureoftheproductionprocess isintensified.However,despitethegrowing interdependenceamongfirms,theMarxistsargued, ownershipofthefirmsfirmlyremainsinseparateprivate hands,makingitimpossibletocoordinatetheactionsof thoseinterdependentfirms.Ofcourse,pricechanges ensurethatthereissomeexpostcoordinationoffirm decisions,butitsextentislimitedandtheimbalance betweendemandandsupply,createdbysuch(innonMarxistterms)‘coordinationfailures’,accumulatesinto periodiceconomiccrises.Duringaneconomiccrisis,the argumentwent,alotofvaluableresourcesarewasted.Many unsoldproductsarethrownaway,machinesthatusedto producenow-unwantedthingsarescrapped,andworkers whoarecapableandwillingtoworkarelaidoffduetothe lackofdemand.Withthedevelopmentofcapitalism,the Marxistspredicted,thissystemiccontradictionwould becomelargerandconsequentlyeconomiccriseswould becomemoreandmoreviolent,finallybringingthewhole systemdown.

Incontrast,undercentralplanning,theMarxistargued,all meansofproductionareownedbythewholeofsocietyand asaresulttheactivitiesofinterdependentproductionunits canbecoordinatedexantethroughaunifiedplan.Asany potentialcoordinationfailureisresolvedbeforeithappens, theeconomydoesnothavetogothroughthoseperiodic crisesinordertobalancesupplyanddemand.Undercentral planning,theeconomywillproduceonlyexactlywhatis needed.Noresourcewilllieidleatanytime,sincetherewill benoeconomiccrisis.Therefore,thecentralplanning system,itwasargued,willmanagetheeconomymuchmore efficientlythanthemarketsystem.

That,atleast,wasthetheory.Unfortunately,central planningdidnotworkverywellinpractice.Themain problemwasthatofcomplexity.TheMarxistsmayhave beenrightinthinkingthatthedevelopmentinproductive forces,byincreasinginterdependenceamongdifferent segmentsofcapital,makesitmorenecessarytoplan centrally.However,theyfailedtorecognizethatitalso makestheeconomymorecomplex,makingitmoredifficult toplancentrally.

Centralplanningworkedwellwhenthetargetswere relativelysimpleandclear,asseeninthesuccessofearly Sovietindustrialization,wherethemaintaskwastoproduce arelativelysmallnumberofkeyproductsinlargequantities (steel,tractors,wheat,potatoes,etc.).However,asthe economydeveloped,centralplanningbecameincreasingly difficult,withagrowingnumberof(actualandpotential) diverseproducts.Ofcourse,witheconomicdevelopment, theabilitytoplanalsoincreasedthankstoimprovementsin managerialskills,mathematicaltechniquesofplanningand computers.However,theincreaseintheabilitytoplanwas notsufficienttodealwiththeincreaseinthecomplexityof theeconomy.

Oneobvioussolutionwastolimitthevarietyofproducts, butthatcreatedhugeconsumerdissatisfaction.Moreover, evenwithreducedvarieties,theeconomywasstilltoo complextoplan.Manyunwantedthingswereproducedand remainedunsold,whiletherewereshortagesofotherthings, resultingintheubiquitousqueues.Bythetimecommunism startedunravellinginthe1980s,therewassomuchcynicism aboutthesystemthatwasincreasinglyincapableof deliveringitspromisesthatthejokewasthatinthe communistcountries,‘wepretendtoworkandtheypretend topayus’.

Nowondercentralplanningwasabandonedacrossthe boardwhentherulingcommunistpartieswereousted acrosstheSovietbloc,followingthefalloftheBerlinWall. EvencountriessuchasChinaandVietnam,which

ostensiblymaintainedcommunism,havegradually abandonedcentralplanning,althoughtheirstatesstillhold highdegreesofcontrolovertheeconomy.So,weallnow liveinmarketeconomies(well,unlessyouliveinNorth KoreaorCuba).Planningisgone.Orisit? Thereisplanningandthereisplanning

Thefactthatcommunismhasdisappearedforallpractical purposesdoesnotmeanthatplanninghasceasedtoexist. Governmentsincapitalisteconomiesalsoplan,albeitnotin thesamecomprehensivewaythatthecentralplanning authoritiesincommunistcountriesdid.

Eveninacapitalisteconomy,therearesituations–a war,forexample–inwhichcentralplanningismore effective.Forexample,duringtheSecondWorldWar,the economiesofthemajorcapitalistbelligerents,theUS,the UKandGermany,wereallcentrallyplannedineverythingbut name.

But,moreimportantly,manycapitalistcountrieshave successfullyusedwhatisknownas‘indicativeplanning’. Thisisplanningthatinvolvesthegovernmentinacapitalist countrysettingsomebroadtargetsconcerningkey economicvariables(e.g.,investmentsinstrategicindustries, infrastructuredevelopment,exports)andworkingwith,not against,theprivatesectortoachievethem.Unlikeunder centralplanning,thesetargetsarenotlegallybinding;hence theadjective‘indicative’.However,thegovernmentwilldoits besttoachievethembymobilizingvariouscarrots(e.g., subsidies,grantingofmonopolyrights)andsticks(e.g., regulations,influencethroughstate-ownedbanks)atits disposal.

Francehadgreatsuccessinpromotinginvestmentand technologicalinnovationthroughindicativeplanninginthe

1950sand60s,therebyovertakingtheBritisheconomyas Europe’ssecondindustrialpower.OtherEuropean countries,suchasFinland,NorwayandAustria,also successfullyusedindicativeplanningtoupgradetheir economiesbetweenthe1950sandthe1970s.TheEast AsianmiracleeconomiesofJapan,KoreaandTaiwanused indicativeplanningtoobetweenthe1950sandthe1980s. Thisisnottosaythatallindicativeplanningexerciseshave beensuccessful;inIndia,forexample,ithasnot. Nevertheless,theEuropeanandEastAsianexamplesshow thatplanningincertainformsisnotincompatiblewith capitalismandmayevenpromotecapitalistdevelopment verywell.

Moreover,evenwhentheydonotexplicitlyplantheentire economy,eveninanindicativeway,governmentsinmost capitalisteconomiesmakeandimplementplansforcertain keyactivities,whichcanhaveeconomy-wideimplications (seeThing12).

Mostcapitalistgovernmentsplanandshapethefutureof somekeyindustriesthroughwhatisknownas‘sectoral industrialpolicy’.TheEuropeanandEastAsiancountries whichpractisedindicativeplanningallalsopractisedactive sectoralindustrialpolicy.Evencountriesthathavenot practisedindicativeplanning,suchasSwedenand Germany,havepractisedsectoralindustrialpolicy.

Inmostcapitalistcountries,thegovernmentowns,and oftenalsooperates,asizeablechunkofthenational economythroughstate-ownedenterprises(SOEs).SOEs arefrequentlyfoundinthekeyinfrastructuresectors(e.g., railways,roads,ports,airports)oressentialservices(e.g., water,electricity,postalservice),butalsoexistin manufacturingorfinance(morestoriesaboutSOEscanbe foundinthechapter‘ManExploitsMan’ofmybookBad Samaritans).TheshareofSOEsinnationaloutputcouldbe ashighas20percent-plus,inthecaseofSingapore,oras lowas1percent,inthecaseoftheUS,buttheinternational averageisaround10percent.Asthegovernmentplansthe

activitiesofSOEs,thismeansthatasignificantpartofthe averagecapitalisteconomyisdirectlyplanned.Whenwe considerthefactthatSOEsusuallyoperateinsectorswith disproportionateimpactsontherestoftheeconomy,the indirecteffectofplanningthroughSOEsisevengreaterthan whatissuggestedbytheshareofSOEsinnationaloutput.

Moreover,inallcapitalisteconomies,thegovernment plansthenationaltechnologicalfuturebyfundingaveryhigh proportion(20–50percent)ofresearchanddevelopment. Interestingly,theUSisoneofthemostplannedcapitalist economiesinthisregard.Betweenthe1950sandthe 1980s,theshareofgovernmentfundingintotalR&Dinthe supposedlyfree-marketUSaccountedfor,dependingonthe year,between47percentand65percent,asagainst around20percentinJapanandKoreaandlessthan40per centinseveralEuropeancountries(e.g.,Belgium,Finland, Germany,Sweden).

1Theratiohascomedownsincethe 1990s,asmilitaryR&Dfundingwasreducedwiththeendof theColdWar.However,evenso,theshareofgovernmentin R&DintheUSisstillhigherthaninmanyothercapitalist economies.Itisnotablethatmostoftheindustrieswherethe UShasaninternationaltechnologicalleadaretheindustries thathavebeenreceivingmajorgovernmentR&Dfunding throughmilitaryprogrammes(e.g.,computers, semiconductors,aircraft)andhealthprojects(e.g., pharmaceuticals,biotechnology).

Ofcourse,sincethe1980stheextentofgovernment planninginmostcapitalisteconomieshasdeclined,not leastbecauseoftheriseofpro-marketideologyduringthis period.Indicativeplanninghasbeenphasedoutinmost countries,includingintheoneswhereithadbeen successful.Inmany,althoughnotall,countries,privatization hasresultedinafallingshareofSOEsinnationaloutputand investment.TheshareofgovernmentfundingintotalR&D fundinghasalsofalleninvirtuallyallcapitalistcountries, althoughnotbyverymuchinmostcases.However,Iwould argue,despitetherelativedeclineofgovernmentplanningin

therecentperiod,thereisstillextensive,andincreasing, planninginthecapitalisteconomies.WhydoIsaythat?

Toplanornottoplan–thatisnotthe question

SupposethatanewCEOarrivedinacompanyandsaid:‘I amagreatbelieverinmarketforces.Inthisfast-changing world,weshouldnothaveafixedstrategyandshould maintainmaximumpossibleflexibility.So,fromnowon, everyoneinthiscompanyisgoingtobeguidedbyeverchangingmarketprices,andnotbysomerigidplan.’What doyouthinkwouldhappen?Wouldhisemployeeswelcome aleaderwithavisionfitforthetwenty-firstcentury?Would theshareholdersapplaudhismarket-friendlyapproachand awardhimwithapayrise?

Hewouldn’tlastaweek.Peoplewouldsayhedoesnot haveleadershipqualities.Hewouldbeaccusedoflacking the‘visionthing’(asGeorgeBushSronceputit).Thetop decision-maker,itwouldbepointedout,shouldbewillingto shapethefutureofthecompany,ratherthanlettingitjust happen.Blindlyfollowingmarketsignals,theywouldsay,is nothowyourunabusiness.

PeoplewouldexpectanewCEOtosaysomethinglike: ‘Thisiswhereourcompanyistoday.ThatiswhereIwantto takeitintenyears’time.Inordertogetthere,wewill developnewindustriesA,BandC,whilewindingdownD andE.OursubsidiaryinindustryDwillbesoldoff.Wewill shutdownoursubsidiaryinindustryEathome,butsome productionmaybeshiftedtoChina.Inordertodevelopour subsidiaryinindustryA,wewillhavetocross-subsidizeit withtheprofitsfromexistingbusinesses.Inorderto establishapresenceinindustryB,wehavetogointo strategicalliancewithKaishaCorporationofJapan,which

mayinvolvesupplyingitwithsomeinputsthatweproduceat below-marketprices.Inordertoexpandourbusinessin industryC,wewillneedtoincreaseourR&Dinvestmentin thenextfiveyears.Allthismaymeanthecompanyasa wholemakinglossesintheforeseeablefuture.Ifthatisthe case,sobeit.Becausethatisthepricewehavetopayin ordertohaveabrighterfuture.’Inotherwords,aCEOis expectedtobea‘man(orawoman)withaplan’ .

Businessesplantheiractivities–oftendowntothelast detail.Indeed,thatiswhereMarxgottheideaofcentrally planningthewholeeconomy.Whenhetalkedabout planning,therewasinfactnoreal-lifegovernmentthatwas practisingplanning.Atthetime,onlyfirmsplanned.What Marxpredictedwasthatthe‘rational’planningapproachof thecapitalistfirmswouldeventuallyprovesuperiortothe wastefulanarchyofthemarketandthuseventuallybe extendedtothewholeeconomy.Tobesure,hecriticized planningwithinthefirmasdespotismbycapitalists,buthe believedthat,onceprivatepropertywasabolishedandthe capitalistseliminated,therationalelementsofsuch despotismcouldbeisolatedandharnessedforthesocial good.

Withthedevelopmentofcapitalism,moreandmore areasoftheeconomyhavebecomedominatedbylarge corporations.Thismeansthattheareaofthecapitalist economythatiscoveredbyplanninghasinfactgrown.To giveyouaconcreteexample,thesedays,dependingonthe estimate,betweenonethirdandonehalfofinternational tradeconsistsoftransfersamongdifferentunitswithin transnationalcorporations.

HerbertSimon,the1978Nobellaureateineconomics whowasapioneerofthestudyofbusinessorganizations (seeThing16),putthispointsuccinctlyin1991in ‘OrganisationsandMarkets’,oneofthelastarticleshe wrote.IfaMartian,withnopreconceptions,cametoEarth andobservedoureconomy,Simonmused,wouldhe concludethatEarthlingsliveinamarketeconomy?No,

Simonsaid,hewouldalmostcertainlyhaveconcludedthat Earthlingsliveinanorganizationaleconomyinthesense thatthebulkofearth’seconomicactivitiesiscoordinated withintheboundariesoffirms(organizations),ratherthan throughmarkettransactionsbetweenthosefirms.Iffirms wererepresentedbygreenandmarketsbyred,Simon argued,theMartianwouldsee‘largegreenareas interconnectedbyredlines’,ratherthan‘anetworkofred linesconnectinggreenspots’.2Andwethinkplanningis dead.

Simondidnottalkmuchaboutgovernmentplanning,but ifweaddgovernmentplanning,moderncapitalist economiesareevenmoreplannedthanhisMartian examplesuggests.Betweentheplanningthatisgoingon withincorporationsandvarioustypesofplanningbythe government,moderncapitalisteconomiesareplannedtoa veryhighdegree.Oneinterestingpointthatfollowsfrom theseobservationsisthatrichcountriesaremoreplanned thanpoorcountries,owingtothemorewidespread existenceoflargecorporationsandoftenmorepervasive (albeitoftenlessvisible,onaccountofitsmoresubtle approach)presenceofthegovernment.

Thequestion,then,isnotwhethertoplanornot.Itiswhat theappropriatelevelsandformsofplanningarefordifferent activities.Theprejudiceagainstplanning,while understandablegiventhefailuresofcommunistcentral planning,makesusmisunderstandthetruenatureofthe moderneconomyinwhichgovernmentpolicy,corporate planningandmarketrelationshipsareallvitalandinteractin acomplexway.Withoutmarketswewillendupwiththe inefficienciesoftheSovietsystem.However,thinkingthat wecanlivebythemarketaloneislikebelievingthatwecan livebyeatingonlysalt,becausesaltisvitalforoursurvival.

Thing20

Equalityofopportunitymay notbefair

Whattheytellyou

Manypeoplegetupsetbyinequality.However,thereis equalityandthereisequality.Whenyourewardpeoplethe samewayregardlessoftheireffortsandachievements,the moretalentedandtheharder-workinglosetheincentiveto perform.Thisisequalityofoutcome.It’sabadidea,as provenbythefallofcommunism.Theequalityweseek shouldbetheequalityofopportunity.Forexample,itwasnot onlyunjustbutalsoinefficientforablackstudentinapartheid SouthAfricanottobeabletogotobetter,‘white’, universities,evenifhewasabetterstudent.Peopleshould begivenequalopportunities.However,itisequallyunjust andinefficienttointroduceaffirmativeactionandbeginto admitstudentsoflowerqualitysimplybecausetheyare blackorfromadeprivedbackground.Intryingtoequalize outcomes,wenotonlymisallocatetalentsbutalsopenalize thosewhohavethebesttalentandmakethegreatest efforts.

Butit’snotenough.Ofcourse,individualsshouldbe rewardedforbetterperformance,butthequestioniswhether theyareactuallycompetingunderthesameconditionsas theircompetitors.Ifachilddoesnotperformwellinschool becauseheishungryandcannotconcentrateinclass,it cannotbesaidthatthechilddoesnotdowellbecauseheis inherentlylesscapable.Faircompetitioncanbeachieved onlywhenthechildisgivenenoughfood–athomethrough familyincomesupportandatschoolthroughafreeschool mealsprogramme.Unlessthereissomeequalityof outcome(i.e.,theincomesofalltheparentsareabovea certainminimumthreshold,allowingtheirchildrennottogo hungry),equalopportunities(i.e.,freeschooling)arenottruly meaningful.

MoreCatholicthanthePope?

InLatinAmerica,peoplefrequentlyusetheexpressionthat someoneis‘moreCatholicthanthePope’(masPapista queelPapa).Thisreferstothetendencyofsocietiesinthe intellectualperipherytoapplydoctrines–religious, economicandsocial–morerigidlythandotheirsource countries.

Koreans,myownpeople,areprobablytheworld championsatbeingmoreCatholicthanthePope(notquite intheliteralsense–onlyaround10percentofthemare Catholics).Koreaisnotexactlyasmallcountry.The combinedpopulationofNorthandSouthKoreas,whichfor nearlyamillenniumuntil1945usedtobeonecountry,is about70milliontoday.Butithappenstobebanginthe middleofazonewheretheinterestsofthegiants–China, Japan,RussiaandtheUS–clash.Sowehavebecomevery adeptatadoptingtheideologyofoneofthebigboysand beingmoreorthodoxaboutitthanheis.Whenwedo

communism(upinNorthKorea),wearemorecommunist thantheRussians.WhenwepractisedJapanese-stylestate capitalism(intheSouth)betweenthe1960sandthe1980s, weweremorestate-capitalistthantheJapanese.Nowthat wehaveswitchedovertoUS-stylecapitalism,welecturethe Americansonthevirtuesoffreetradeandshamethemby deregulatingfinancialandlabourmarketsleft,rightand centre.

Soitwasnaturalthatuntilthenineteenthcentury,whenwe wereundertheChinesesphereofinfluence,weweremore ConfucianthantheChinese.Confucianism,forthosewho arenotfamiliarwithit,isaculturalsystembasedonthe teachingsofConfucius–theLatinizednameoftheChinese politicalphilosopher,KongTze,wholivedinthefifthcentury BC.Today,havingseentheeconomicsuccessesofsome Confuciancountries,manypeoplethinkitisaculture particularlywellsuitedtoeconomicdevelopment,butitwas atypicalfeudalideologyuntilitcametobeadaptedtothe requirementsofmoderncapitalisminthesecondhalfofthe twentiethcentury.1

Likemostotherfeudalideologies,Confucianism espousedarigidsocialhierarchywhichrestrictedpeople’s choiceofoccupationaccordingtotheirbirths.This preventedtalentedmenfromlowercastesfromrisingabove theirstation.InConfucianism,therewasacrucialdivide betweenthefarmers(whowereconsideredtobethe bedrockofsociety)andotherworkingclasses.Thesonsof farmerscouldsitforthe(incrediblydifficult)governmentcivil serviceexaminationandgetincorporatedintotheruling class,althoughthishappenedrarelyinpractice,whilethe sonsofartisansandmerchantswerenotevenpermittedto sitfortheexam,howeverclevertheymightbe.

China,beingthebirthplaceofConfucianism,hadthe confidencetotakeamorepragmaticapproachin interpretingtheclassicaldoctrinesandallowedpeoplefrom merchantandartisanalclassestositforthecivilservice examination.Korea–beingmoreConfucianthanConfucius

–adamantlystucktothisdoctrineandrefusedtohire talentedpeoplesimplybecausetheywereborntothe ‘wrong’parents.Itwasonlyafterourliberationfrom Japanesecolonialrule(1910–45)thatthetraditionalcaste systemwasfullyabolishedandKoreabecameacountry wherebirthdoesnotsetaceilingtoindividualachievement (althoughtheprejudiceagainstartisans–engineersin modernterms–andmerchants–businessmanagersin modernterms–lingeredonforanotherfewdecadesuntil economicdevelopmentmadetheseattractiveprofessions).

ObviouslyfeudalKoreawasnotaloneinrefusingtogive peopleequalityofopportunity.Europeanfeudalsocieties operatedwithsimilarsystems,andinIndiathecastesystem stilloperates,albeitinformally.Norwasitonlyalongthe castelinesthatpeoplewererefusedequalityofopportunity. UntiltheSecondWorldWar,mostsocietiesrefusedtolet womenbeelectedtopublicoffice;infacttheywererefused politicalcitizenshipaltogetherandnotevenallowedtovote. Untilrecently,manycountriesusedtorestrictpeople’s accesstoeducationandjobsalongraciallines.Inthelate nineteenthandtheearlytwentiethcenturies,theUSA prohibitedtheimmigrationof‘undesirable’races,especially Asians.SouthAfrica,duringtheapartheidregime,had separateuniversitiesforwhitesandfortherest(the ‘coloureds’andtheblacks),whichwereverypoorlyfunded.

Soithasnotbeenlongsincethemajorityoftheworld emergedfromasituationwherepeoplewerebannedfrom self-advancementduetotheirrace,genderorcaste. Equalityofopportunityissomethingtobehighlycherished.

largepartbecauseofpoliticalstrugglesbythediscriminated against–suchastheChartistdemandforuniversal(male) suffrageinBritaininthemidnineteenthcentury,theCivil RightsmovementbyblacksintheUSinthe1960s,theantiapartheidstruggleinSouthAfricainthesecondhalfofthe twentiethcenturyandthefightbylowcastepeopleinIndia today.Withouttheseandcountlessothercampaignsby women,oppressedracesandlowercastepeople,wewould stillbelivinginaworldwhererestrictingpeople’srights accordingto‘birthlottery’wouldbeconsiderednatural.

Inthisstruggleagainstinequalityofopportunity,the markethasbeenagreathelp.Whenonlyefficiencyensures survival,free-marketeconomistspointout,thereisnoroom forracialorpoliticalprejudicestocreepintomarket transactions.MiltonFriedmanputitsuccinctlyinhis CapitalismandFreedom:‘Noonewhobuysbreadknows whetherthewheatfromwhichitwasmadewasgrownbya CommunistoraRepublican…byaNegroorawhite.’ Therefore,Friedmanargued,themarketwilleventuallydrive racismout,oratleastreduceitsignificantly,becausethose racistemployersinsistingonemployingonlywhitepeople wouldbedrivenoutbymoreopen-mindedoneswhohirethe bestavailabletalents,regardlessofrace.

Thispointispowerfullyillustratedbythefactthateventhe notoriouslyracistapartheidregimeinSouthAfricahadto designatetheJapanese‘honorarywhites’.Therewasno waytheJapaneseexecutivesrunningthelocalToyotaand NissanfactoriescouldgoandliveintownshipslikeSoweto, wherenon-whiteswereforcedtoliveunderapartheidlaw. Therefore,thewhite-supremacistSouthAfricanshadto swallowtheirprideandpretendthattheJapanesewere whites,iftheywantedtodrivearoundinJapanesecars.That isthepowerofthemarket.

Thepowerofthemarketasa‘leveller’ismore widespreadthanwethink.AstheBritishwriterAlan Bennett’splay-turned-movie,HistoryBoys,sopoignantly shows,studentsfromdisadvantagedgroupstendtolack

intellectualandsocialconfidenceandarethus disadvantagedingettingintoeliteuniversities–andby extension,better-payingjobs.Obviously,universitiesdonot havetorespondtomarketpressuresasquicklyasfirms haveto.However,ifsomeuniversityconsistently discriminatedagainstethnicminoritiesorworking-class kidsandtookinonlypeoplefromthe‘right’backgrounds despitetheirinferiorquality,potentialemployerswould cometopreferthegraduatesfromnon-racistuniversities. Thenarrow-mindeduniversity,ifitistorecruitthebest possiblestudents,wouldhavetoabandonitsprejudices soonerorlater.

Givenallthis,itistemptingtoarguethat,onceyouensure equalityofopportunity,freefromanyformaldiscrimination otherthanaccordingtomerit,themarketwilleliminateany residualprejudicesthroughthecompetitivemechanism. However,thisisonlythestart.Alotmorehastobedoneto buildagenuinelyfairsociety.

Theendofapartheidandthe cappuccinosociety

Whiletherearestilltoomanypeoplewithprejudicesagainst certainraces,poorpeople,lowercastesandwomen,today fewwouldopenlyobjecttotheprincipleofequalityof opportunity.Butatthispoint,opinionsdividesharply.Some arguethatequalityshouldendwiththatofopportunity. Others,includingmyself,believethatitisnotenoughtohave mereformalequalityofopportunity.

Free-marketeconomistswarnthat,ifwetrytoequalize theoutcomesofpeople’sactionsandnotjusttheir opportunitiestotakecertainactions,thatwillcreatehuge disincentivesagainsthardworkandinnovation.Wouldyou workhardifyouknewthat,whateveryoudo,youwillgetpaid

thesameasthenextguywhoisgoofingoff?Isn’tthatexactly whytheChineseagriculturalcommunesunderMaoZedong weresuchfailures?Ifyoutaxtherichdisproportionatelyand usetheproceedstofinancethewelfarestate,won’ttherich losetheincentivetocreatewealth,whilethepoorlosethe incentivetowork,astheyareguaranteedaminimum standardoflivingwhethertheyworkhardornot–orwhether theyworkatall?(seeThing21.)Thisway,free-market economistsargue,everyonebecomesworseoffbythe attempttoreduceinequalityofoutcome(seeThing13).

Itisabsolutelytruethatexcessiveattemptstoequalize outcomes–say,theMaoistcommune,wheretherewas virtuallynolinkbetweensomeone’seffortandthereward thatshegot–willhaveanadverseimpactonpeople’swork effort.Itisalsounfair.ButIbelievethatacertaindegreeof equalizationofoutcomesisnecessary,ifwearetobuilda genuinelyfairsociety.

Thepointisthat,inordertobenefitfromtheequal opportunitiesprovidedtothem,peoplerequirethe capabilitiestomakeuseofthem.Itisnousethatblack SouthAfricansnowhavethesameopportunitiesaswhites togetahighlypaidjob,iftheydonothavetheeducationto qualifyforthosejobs.Itisnogoodthatblacksnowcanenter better(formerwhite-only)universities,iftheystillhaveto attendpoorlyfundedschoolswithunderqualifiedteachers, someofwhomcanbarelyreadandwritethemselves.

FormostblackkidsinSouthAfrica,thenewlyacquired equalityofopportunitytoentergooduniversitiesdoesnot meanthattheycanattendsuchuniversities.Theirschools arestillpoorandpoorlyrun.Itisnotasiftheirunderqualified teachershavesuddenlybecomesmartwiththeendof apartheid.Theirparentsarestillunemployed(eventhe officialunemploymentrate,whichvastlyunderestimatestrue unemploymentinadevelopingcountry,is,at26–28per cent,oneofthehighestintheworld).Forthem,therightto enterbetteruniversitiesispieinthesky.Forthisreason, post-apartheidSouthAfricahasturnedintowhatsome

SouthAfricanscalla‘cappuccinosociety’:amassofbrown atthebottom,athinlayerofwhitefrothaboveit,anda sprinklingofcocoaatthetop.

Now,free-marketeconomistswilltellyouthatthosewho donothavetheeducation,thedeterminationandthe entrepreneurialenergytotakeadvantageofmarket opportunitieshaveonlythemselvestoblame.Whyshould peoplewhohaveworkedhardandobtainedauniversity degreeagainstalloddsberewardedinthesamewayas someone,comingfromthesamepoorbackground,who goesintoalifeofpettycrime?

Thisargumentiscorrect.Wecannot,andshouldnot, explainsomeone’sperformanceonlybytheenvironmentin whichhehasgrownup.Individualsdohaveresponsibilities forwhattheyhavemadeoutoftheirlives.

However,whilecorrect,thisargumentisonlypartofthe story.Individualsarenotbornintoavacuum.Thesocioeconomicenvironmenttheyoperateinputsserious restrictionsonwhattheycando.Orevenonwhattheywant todo.Yourenvironmentcanmakeyougiveupcertainthings evenwithouttrying.Forexample,manyacademically talentedBritishworking-classchildrendonoteventrytogo touniversitiesbecauseuniversitiesare‘notforthem’.This attitudeisslowlychanging,butIstillrememberseeinga BBCdocumentaryinthelate1980sinwhichanoldminer andhiswifewerecriticizingoneoftheirsons,whohadgone toauniversityandbecomeateacher,asa‘classtraitor’.

Whileitissillytoblameeverythingonthesocio-economic environment,itisequallyunacceptabletobelievethat peoplecanachieveanythingiftheyonly‘believein themselves’andtryhardenough,asHollywoodmovieslove totellyou.Equalityofopportunityismeaninglessforthose whodonothavethecapabilitiestotakeadvantageofit.

Today,nocountrydeliberatelykeepspoorchildrenfrom goingtoschool,butmanychildreninpoorcountriescannot gotoschoolbecausetheydonothavethemoneytopayfor thetuition.Moreover,evenincountrieswithfreepublic education,poorchildrenareboundtoperformpoorlyin school,whatevertheirinnateabilitymaybe.Someofthem gohungryathomeandalsoskiplunchatschool.This makesitimpossibleforthemtoconcentrate,with predictableresultsfortheiracademicperformance.In extremecases,theirintellectualdevelopmentmayhave alreadybeenstuntedbecauseofalackoffoodintheirearly years.Thesekidsmayalsosuffermorefrequentlyfrom illness,whichmakesthemskipschoolmoreoften.Iftheir parentsareilliterateand/orhavetoworklonghours,children willhavenoonetohelpthemwiththeirhomework,while middle-classchildrenwillbehelpedbytheirparentsandrich kidsmayhaveprivatetutors.Helpedornot,theymaynot evenhaveenoughtimeforhomework,iftheyhavetotake careofyoungersiblingsortendthefamilygoats.

Givenallthis,asfarasweacceptthatweshouldnot punishchildrenforhavingpoorparents,weshouldtake actiontoensurethatallchildrenhavesomeminimum amountsoffood,healthcareandhelpwiththeirhomework. Muchofthiscanbeprovidedthroughpublicpolicy,as happensinsomecountries–freeschoollunches, vaccinations,basichealthchecksandsomehelpwith homeworkafterschoolbyteachersortutorshiredbythe school.However,someofthisstillneedstobeprovidedat home.Schoolscanprovideonlysomuch.

Thismeansthattherehastobesomeminimumequality ofoutcomeintermsofparentalincome,ifpoorchildrenare tohaveanythingapproachingafairchance.Withoutthis, evenfreeschooling,freeschoolmeals,freevaccinations, andsoon,cannotproviderealequalityofopportunityfor children.

Eveninadultlife,therehastobesomeequalityof outcome.Itiswellknownthat,oncesomeonehasbeen unemployedforalongtime,itbecomesextremelydifficultfor thatpersontogetbackintothelabourmarket.Butwhether someonelosesherjobisnotentirelydeterminedbythe person’s‘worth’.Forexample,manypeoplelosetheirjobs becausetheychosetojoinanindustrythatlookedlikea goodprospectwhentheyfirststartedbutsincehasbeenhit hardbyasuddenincreaseinforeigncompetition.Few AmericansteelworkersorBritishshipbuildingworkerswho joinedtheirindustriesinthe1960s,orforthatmatteranyone else,couldhavepredictedthatbytheearly1990stheir industrieswouldbevirtuallywipedoutbyJapaneseand Koreancompetition.Isitreallyfairthatthesepeoplehaveto sufferdisproportionatelyandbeconsignedtothescrapheap ofhistory?

Ofcourse,inanidealizedfreemarket,thisshouldnotbe aproblembecausetheAmericansteelworkersandthe Britishshipbuilderscangetjobsinexpandingindustries.But howmanyformerAmericansteelworkersdoyouknowwho havebecomecomputerengineersorformerBritish shipbuilderswhohaveturnedthemselvesintoinvestment bankers?Suchconversionrarely,ifever,happens.

Amoreequitableapproachwouldhavebeentohelpthe displacedworkersfindanewcareerthroughdecent unemploymentbenefits,healthinsuranceevenwhenoutofa job,retrainingschemesandhelpwithjobsearches,asthey doparticularlywellinScandinaviancountries.AsIdiscuss elsewhereinthebook(seeThing21),thiscanalsobea moreproductiveapproachfortheeconomyasawhole.

Yes,intheory,ashoeshineboyfromapoorprovincial towninPerucangotoStanfordanddoaPhD,astheformer PeruvianPresidentAlejandroToledohasdone,butforone ToledowehavemillionsofPeruvianchildrenwhodidnot evenmakeittohighschool.Ofcourse,wecouldarguethat allthosemillionsofpoorPeruvianchildrenarelazygood-fornothings,sinceMrToledohasproventhattheytoocould

havegonetoStanfordiftheyhadtriedhardenough.ButI thinkitismuchmoreplausibletosaythatMrToledoisthe exception.Withoutsomeequalityofoutcome(ofparental income),poorpeoplecannottakefulladvantageofequality ofopportunity.

Indeed,internationalcomparisonofsocialmobility corroboratesthisreasoning.Accordingtoacarefulstudyby agroupofresearchersinScandinaviaandtheUK,the Scandinaviancountrieshavehighersocialmobilitythanthe UK,whichinturnhashighermobilitythantheUS.2Itisno coincidencethatthestrongerthewelfarestate,thehigher themobility.ParticularlyinthecaseoftheUS,thefactthat lowoverallmobilityislargelyaccountedforbylowmobilityat thebottomsuggeststhatitisthelackofabasicincome guaranteethatispreventingpoorkidsfrommakinguseof theequalityofopportunity.

Excessiveequalizationofoutcomesisharmful,although whatexactlyisexcessiveisdebatable.Nevertheless, equalityofopportunityisnotenough.Unlesswecreatean environmentwhereeveryoneisguaranteedsomeminimum capabilitiesthroughsomeguaranteeofminimumincome, educationandhealthcare,wecannotsaythatwehavefair competition.Whensomepeoplehavetoruna100metre racewithsandbagsontheirlegs,thefactthatnooneis allowedtohaveaheadstartdoesnotmaketheracefair. Equalityofopportunityisabsolutelynecessarybutnot sufficientinbuildingagenuinelyfairandefficientsociety.

Thing21

Biggovernmentmakespeople moreopentochange

Whattheytellyou

Biggovernmentisbadfortheeconomy.Thewelfarestate hasemergedbecauseofthedesirebythepoortohavean easierlifebymakingtherichpayforthecostsof adjustmentsthatareconstantlydemandedbymarketforces. Whenthericharetaxedtopayforunemploymentinsurance, healthcareandotherwelfaremeasuresforthepoor,thisnot onlymakesthepoorlazyanddeprivestherichofan incentivetocreatewealth,italsomakestheeconomyless dynamic.Withtheprotectionofthewelfarestate,peopledo notfeeltheneedtoadjusttonewmarketrealities,thereby delayingthechangesintheirprofessionsandworking patternsthatareneededfordynamiceconomic adjustments.Wedon’tevenhavetoinvokethefailuresofthe communisteconomies.Justlookatthelackofdynamismin Europewithitsbloatedwelfarestate,comparedtothe vitalityoftheUS.

less,opentochanges.Thisisonereasonwhythereisless demandfortradeprotectionisminEuropethanintheUS. Europeansknowthat,eveniftheirindustriesshutdowndue toforeigncompetition,theywillbeabletoprotecttheirliving standards(throughunemploymentbenefits)andgetretrainedforanotherjob(withgovernmentsubsidies),whereas Americansknowthatlosingtheircurrentjobsmaymeana hugefallintheirlivingstandardsandmayevenbetheendof theirproductivelives.ThisiswhytheEuropeancountries withthebiggestwelfarestates,suchasSweden,Norway andFinland,wereabletogrowfasterthan,oratleastasfast as,theUS,evenduringthepost-1990‘American Renaissance’.

Theoldestprofessionintheworld?

RepresentativesofdifferentprofessionsinaChristian countryweredebatingwhichprofessionistheoldest.

Themedicaldoctorsaid:‘Whatwasthefirstthingthat Goddidwithhumans?Heperformedanoperation–he madeEvewithAdam’srib.Themedicalprofessionisthe oldest.’

‘No,thatisnottrue,’thearchitectsaid.‘Thefirstthinghe didwastobuildtheworldoutofchaos.That’swhat architectsdo–creatingorderoutofchaos.Wearethe oldestprofession.’

Thepolitician,whowaspatientlylistening,grinnedand asked:‘Whocreatedthatchaos?’

Medicinemayormaynotbetheoldestprofessioninthe world,butitisoneofthemostpopularallovertheworld. However,innocountryisitmorepopularthaninmynative SouthKorea.

Asurveydonein2003revealedthatnearlyfouroutoffive

‘top-scoringuniversityapplicants’(definedasthosewithin thetop2percentofthedistribution)inthesciencestream wantedtostudymedicine.Accordingtounofficialdata, duringthelastfewyears,eventheleastcompetitiveofthe country’stwenty-sevenmedicaldepartments(at undergraduatelevel)hasbecomemoredifficulttoenterthan thebestengineeringdepartmentsinthecountry.Itcannot getmorepopularthanthat.

Theinterestingthingisthat,eventhoughmedicinehas alwaysbeenapopularsubjectinKorea,thiskindofhyperpopularityisnew.Itisbasicallyatwenty-first-century phenomenon.Whathaschanged?

Anobviouspossibilityisthat,forwhateverreason(e.g., anageingpopulation),therelativeearningsofmedical doctorshaverisenandtheyoungstersaremerely respondingtochangesintheincentives–themarketwants moreabledoctors,somoreandmoreablepeopleare goingintotheprofession.However,therelativeincomesof medicaldoctorsinKoreahavebeenfalling,withthe continuousincreaseintheirsupply.Anditisnotasifsome newgovernmentregulationwasintroducedthatmakesit difficulttogetjobsasengineersorscientists(theobvious alternativechoicesforwould-bemedicaldoctors).Sowhat isreallygoingon?

Whatisdrivingthisisthedramaticfallinjobsecurityover thelastdecadeorso.Afterthe1997financialcrisisthat endedthecountry’s‘miracleyears’,Koreaabandonedits interventionist,paternalisticeconomicsystemand embracedmarketliberalismthatemphasizesmaximum competition.Jobsecurityhasbeendrasticallyreducedinthe nameofgreaterlabourmarketflexibility.Millionsofworkers havebeenforcedintotemporaryjobs.Ironicallyenough, evenbeforethecrisis,thecountryhadoneofthemost flexiblelabourmarketsintherichworld,withoneofthe highestratiosofworkerswithoutapermanentcontractat around50percent.Therecentliberalizationhaspushedthe ratioupevenhigher–toaround60percent.Moreover,even

thosewithpermanentcontractsnowsufferfromheightened jobinsecurity.Beforethe1997crisis,mostworkerswitha permanentcontractcouldexpect,defactoifnotdejure, lifetimeemployment(asmanyoftheirJapanese counterpartsstilldo).Notanymore.Nowolderworkersin theirfortiesandfifties,eveniftheyhaveapermanent contract,areencouragedtomakewayfortheyounger generationattheearliestpossiblechance.Companies cannotfirethematwill,butweallknowthattherearewaysto letpeopleknowthattheyarenotwantedandthustomake them‘voluntarily’leave.

Giventhis,Koreanyoungstersare,understandably, playingsafe.Iftheybecomeascientistoranengineer,they reckon,thereisahighchancethattheywillbeoutoftheir jobsintheirforties,eveniftheyjoinmajorcompanieslike SamsungorHyundai.Thisisahorrendousprospect,since thewelfarestateinKoreaissoweak–thesmallestamong therichcountries(measuredbypublicsocialspendingasa shareofGDP).1Aweakwelfarestatewasnotsuchabig problembefore,becausemanypeoplehadlifetime employment.Withlifetimeemploymentgone,ithasbecome lethal.Onceyouloseyourjob,yourlivingstandardfalls dramaticallyand,moreimportantly,youdon’thavemuchofa secondchance.Thus,brightKoreanyoungstersfigure,and areadvisedbytheirparents,thatwithalicencetopractise medicinetheycanworkuntiltheychoosetoretire.Ifthe worstcomestotheworst,theycansetuptheirownclinics, eveniftheydonotmakemuchmoney(well,foramedical doctor).NowondereveryKoreankidwithabrainwantsto studymedicine(orlaw–anotherprofessionwithalicence–iftheyareinthehumanitiesstream).

Don’tgetmewrong.Ireveremedicaldoctors.Iowemy lifetothem–Ihavehadacoupleoflife-savingoperations andbeencuredofcountlessinfectionsthankstoantibiotics theyhaveprescribedforme.ButevenIknowthatitis impossiblefor80percentofthebrainiestKoreankidsinthe sciencestreamalltobecutouttobemedicaldoctors.

So,oneofthefreestlabourmarketsintherichworld,that is,theKoreanlabourmarket,isspectacularlyfailingto allocatetalentinthemostefficientmanner.Thereason? Heightenedjobinsecurity.

Thewelfarestateisthebankruptcylaw forworkers

Jobsecurityisathornyissue.Free-marketeconomists believethatanylabourmarketregulationthatmakesfiring moredifficultmakestheeconomylessefficientand dynamic.Tostartwith,itweakenstheincentiveforworkers toworkhard.Ontopofthat,itdiscourageswealthcreation bymakingemployersmorereluctanttohireadditional people(forfearofnotbeingabletofirethemwhen necessary).

Labourmarketregulationsarebadenough,itisargued, butthewelfarestatehasmadethingsevenworse.By providingunemploymentbenefits,healthinsurance,free educationandevenminimumincomesupport,thewelfare statehaseffectivelygiveneveryoneaguaranteetobehired bythegovernment–asan‘unemployedworker’,ifyoulike–withaminimumwage.Therefore,workersdonothave enoughincentivetoworkhard.Tomakethingsworse,these welfarestatesarefinancedbytaxingtherich,reducingtheir incentivestoworkhard,createjobsandgeneratewealth.

Giventhis,thereasoninggoes,acountrywithabigger welfarestateisgoingtobelessdynamic–itsworkersare lesscompelledtowork,whileitsentrepreneursareless motivatedtocreatewealth.

Thisargumenthasbeenveryinfluential.Inthe1970s,a popularexplanationofBritain’sthenlacklustreeconomic performancewasthatitswelfarestatehadbecomebloated anditstradeunionsoverlypowerful(whichisalsopartlydue

tothewelfarestate,insofarasthelatterdullsthethreatof unemployment).InthisreadingofBritishhistory,Margaret ThatchersavedBritainbyputtingunionsintheirplaceand reducingthewelfarestate,eventhoughwhatactually happenedismorecomplicated.Sincethe1990s,thisview ofthewelfarestatehasbecomeevenmorepopularwiththe (allegedly)superiorgrowthperformanceoftheUStothose ofotherrichcountrieswithbiggerwelfarestates.2When governmentsinothercountriestrytocuttheirwelfare spending,theyfrequentlyciteMrsThatcher’scuringofthe so-called‘BritishDisease’orthesuperiordynamismofthe USeconomy.

Butisittruethatgreaterjobsecurityandabiggerwelfare statemakeaneconomylessproductiveanddynamic?

AsinourKoreanexample,alackofjobsecuritycanlead youngsterstomakeconservativechoiceswiththeircareer, favouringsecurejobsinmedicineorthelaw.Thismaybe therightchoiceforthemindividually,butitleadstoa misallocationoftalentsandthusreduceseconomic efficiencyanddynamism.

TheweakerwelfarestateintheUShasbeenone importantreasonwhytradeprotectionismismuchstronger therethaninEurope,despiteagreateracceptanceof governmentinterventioninthelatter.InEurope(ofcourse,I amignoringnationaldifferencesinthedetails),ifyour industrydeclinesandyouloseyourjob,itisabigblowbut nottheendoftheworld.Youwillstillkeepyourhealth insuranceandpublichousing(orhousingsubsidies),while receivingunemploymentbenefits(upto80percentofyour lastpay),government-subsidizedretrainingandgovernment helpinyourjobsearch.Incontrast,ifyouareaworkerinthe US,you’dbettermakesureyouholdontoyourcurrentjob,if necessarythroughprotectionism,becauselosingyourjob meanslosingalmosteverything.Unemploymentinsurance coverageispatchyandofshorterdurationthaninEurope. Thereislittlepublichelpwithretrainingandjobsearch.More frighteningly,losingyourjobmeanslosingyourhealth

insuranceandprobablyyourhome,asthereislittlepublic housingorpublicsubsidiesforyourrent.Asaresult,worker resistancetoanyindustrialrestructuringthatinvolvesjob cutsismuchgreaterintheUSthaninEurope.MostUS workersareunabletoputupanorganizedresistance,but thosewhocan–unionizedworkers–will,understandably, doeverythingtheycantopreservethecurrentjob distribution.

Astheaboveexamplesshow,greaterinsecuritymay makepeopleworkharder,butitmakesthemworkharderin thewrongjobs.AllthosetalentedKoreanyoungsterswho couldbebrilliantscientistsandengineersarelabouringover humananatomy.ManyUSworkerswhocould–after appropriateretraining–beworkingin‘sunrise’industries (e.g.,bio-engineering)aregrimlyholdingontotheirjobsin ‘sunset’industries(e.g.,automobiles),onlydelayingthe inevitable.

Thepointofalltheaboveexamplesisthat,whenpeople knowtheywillhaveasecond(orthirdorevenfourth)chance, theywillbemuchmoreopentorisk-takingwhenitcomesto choosingtheirfirstjob(asintheKoreanexample)orletting gooftheirexistingjobs(asintheUS–Europecomparison).

Doyoufindthislogicstrange?Youshouldn’t.Because thisisexactlythelogicbehindbankruptcylaw,whichmost peopleacceptas‘obvious’.

Beforethemidnineteenthcentury,nocountryhada bankruptcylawinthemodernsense.Whatwasthencalled bankruptcylawdidnotgivebankruptbusinessmenmuch protectionfromcreditorswhiletheyrestructuredtheir business–intheUS,‘Chapter11’nowgivessuch protectionforsixmonths.Moreimportantly,itdidnotgive themasecondchance,astheywererequiredtopayback alldebts,howeverlongittook,unlessthecreditorsgave thema‘discharge’fromtheduty.Thismeantthat,evenifthe bankruptbusinessmansomehowmanagedtostartanew business,hehadtouseallhisnewprofitstorepaytheold debts,whichhamperedthegrowthofthenewbusiness.All

thismadeitextremelyriskytostartabusinessventureinthe firstplace.

Overtime,peoplecametorealizethatthelackofa secondchancewashugelydiscouragingrisk-takingby businessmen.StartingwithBritainin1849,countrieshave introducedmodernbankruptcylawswithcourt-granted protectionfromcreditorsduringinitialrestructuringand, moreimportantly,thepowerforcourtstoimposepermanent reductionsindebts,evenagainstthewishesofthecreditors. Whencombinedwithinstitutionslikelimitedliability,which wasintroducedaroundthesametime(seeThing2),this newbankruptcylawreducedthedangerofanybusiness undertakingandthusencouragedrisk-taking,whichhas mademoderncapitalismpossible.

Insofarasitgivesworkerssecondchances,wecansay thatthewelfarestateislikeabankruptcylawforthem.Inthe samewaythatbankruptcylawsencouragerisk-takingby entrepreneurs,thewelfarestateencouragesworkerstobe moreopentochange(andtheresultingrisks)intheir attitudes.Becausetheyknowthatthereisgoingtobea secondchance,peoplecanbebolderintheirinitialcareer choicesandmoreopentochangingjobslaterintheir careers.

Countrieswithbiggergovernmentscan growfaster

Whatabouttheevidence?Whataretherelativeeconomic performancesofcountriesthatdifferintermsofthesizesof theirwelfarestates?Asmentioned,theconventional wisdomisthatcountrieswithsmallerwelfarestatesare moredynamic.However,theevidencedoesnotsupportthis view.

Untilthe1980s,theUSgrewmuchmoreslowlythan

Europedespitethefactthatithadamuchsmallerwelfare state.Forexample,in1980,publicsocialexpenditureasa shareofGDPwasonly13.3percentintheUS,compared to19.9percentfortheEU’sfifteencountries.Theratiowas ashighas28.6percentinSweden,24.1percentinthe Netherlandsand23percentin(West)Germany.Despite this,between1950and1987,theUSgrewmoreslowlythan anyEuropeancountry.Percapitaincomegrewat3.8per centinGermany,2.7percentinSweden,2.5percentinthe Netherlandsand1.9percentintheUSduringthisperiod. Obviously,thesizeofthewelfarestateisonlyonefactorin determiningacountry’seconomicperformance,butthis showsthatalargewelfarestateisnotincompatiblewithhigh growth.

Evensince1990,whentherelativegrowthperformance oftheUShasimproved,somecountrieswithlargewelfare stateshavegrownfaster.Forexample,between1990and 2008,percapitaincomeintheUSgrewat1.8percent.This isbasicallythesameasinthepreviousperiod,butgiventhe slowdownintheEuropeaneconomies,thismadetheUS oneofthefastest-growingeconomiesinthe‘core’OECD group(thatis,excludingthenot-fully-rich-yetcountries,such asKoreaandTurkey).

Theinterestingthing,however,isthatthetwofastestgrowingeconomiesinthecoreOECDgroupduringthe post-1990periodareFinland(2.6percent)andNorway(2.5 percent),bothwithalargewelfarestate.In2003,theshare ofpublicsocialspendinginGDPwas22.5percentin Finlandand25.1percentinNorway,comparedtothe OECDaverageof20.7percentand16.2percentinthe US.Sweden,whichhasliterallythelargestwelfarestatein theworld(31.3percent,ortwiceaslargeasthatoftheUS), at1.8percent,recordedagrowthratethatwasonlya shadebelowtheUSrate.Ifyoucountonlythe2000s(2000–8),thegrowthratesofSweden(2.4percent)andFinland (2.8percent)werefarsuperiortothatoftheUS(1.8per cent).Werethefree-marketeconomistsrightaboutthe

detrimentaleffectsofthewelfarestateonworkethicandthe incentivesforwealthcreation,thiskindofthingshouldnot happen.

Ofcourse,byallthisIamnotsuggestingthatthewelfare stateisnecessarilygood.Likeallotherinstitutions,ithasits upsidesanddownsides.Especiallyifitisbasedon targeted,ratherthanuniversal,programmes(asintheUS),it canstigmatizewelfarerecipients.Thewelfarestateraises people’s‘reservationwages’anddetersthemfromtaking low-payingjobswithpoorworkingconditions,although whetherthisisabadthingisamatterofopinion(personallyI thinktheexistenceofalargenumberof‘workingpoor’,asin theUS,isasmuchofaproblemasthegenerallyhigher unemploymentratesweseeinEurope).However,ifitiswell designed,withaviewtogivingworkersasecondchance, asitisinScandinaviancountries,itcanencourage economicgrowthbymakingpeoplebemoreopento changesandthusmakingindustrialrestructuringeasier.

Wecandriveourcarsfastonlybecausewehavebrakes. Ifcarshadnobrakes,eventhemostskilfuldriverswouldnot daretodriveatmorethan20–30milesperhourforfearof fatalaccidents.Inthesameway,peoplecanaccepttherisk ofunemploymentandtheneedforoccasionalre-toolingof theirskillsmorewillinglywhentheyknowthatthose experiencesarenotgoingtodestroytheirlives.Thisiswhy abiggergovernmentcanmakepeoplemoreopento changeandthusmaketheeconomymoredynamic.

Thing22

Whattheytellyou

Therapiddevelopmentofthefinancialmarketshasenabled ustoallocateandreallocateresourcesswiftly.Thisiswhy theUS,theUK,Irelandandsomeothercapitalisteconomies thathaveliberalizedandopeneduptheirfinancialmarkets havedonesowellinthelastthreedecades.Liberalfinancial marketsgiveaneconomytheabilitytorespondquicklyto changingopportunities,therebyallowingittogrowfaster. True,someoftheexcessesoftherecentperiodhavegiven financeabadname,notleastintheabove-mentioned countries.However,weshouldnotrushintorestraining financialmarketssimplybecauseofthisonce-in-a-century financialcrisisthatnoonecouldhavepredicted,however bigitmaybe,astheefficiencyofitsfinancialmarketisthe keytoanation’sprosperity.

sectorhasbecomemoreefficientingeneratingprofitsfor itselfintheshortrun.However,asseeninthe2008global crisis,thesenewfinancialassetshavemadetheoverall economy,aswellasthefinancialsystemitself,muchmore unstable.Moreover,giventheliquidityoftheirassets,the holdersoffinancialassetsaretooquicktorespondto change,whichmakesitdifficultforreal-sectorcompaniesto securethe‘patientcapital’thattheyneedforlong-term development.Thespeedgapbetweenthefinancialsector andtherealsectorneedstobereduced,whichmeansthat thefinancialmarketneedstobedeliberatelymadeless efficient.

Threeuselessphrases

VisitorstoIcelandinthe1990sreportedthattheofficial touristguidehandedoutatReykjavikairporthad,likeall othersuchguides,a‘usefulphrases’section.Unlikethem,I wastold,theIcelandicguidealsohada‘uselessphrases’ section.Apparentlyitcontainedthreephrases,whichwere, inEnglish:‘Whereistherailwaystation?’,‘It’saniceday today’,and‘Isthereanythingcheaper?’

Therailwaysthingis,surprisingthoughitmaybe,true–Icelanddoesnothaveanyrailways.Abouttheweather,the guidewasperhapsbeingoverlyharsh.Ihaven’tlivedthere, butbyallaccountsIcelanddoesseemtohaveatleastafew sunnydaysayear.Asforeverythingbeingsoexpensive, thiswasalsoprettyaccurateandaconsequenceofthe country’seconomicsuccess.Labourservicesareexpensive inhigh-incomecountries(unlesstheyhaveaconstantsupply oflow-wageimmigrants,astheUSorAustralia),making everythingmoreexpensivethanwhattheofficialexchange rateshouldsuggest(seeThing10).Onceoneofthe pooresteconomiesinEurope,by1995Icelandhad

developedintotheeleventhrichesteconomyintheworld (afterLuxemburg,Switzerland,Japan,Norway,Denmark, Germany,theUnitedStates,Austria,Singaporeand France).

Richasitalreadywas,theIcelandiceconomygotaturbochargedboostinthelate1990s,thankstothethen government’sdecisiontoprivatizeandliberalizethe financialsector.Between1998and2003,thecountry privatizedstate-ownedbanksandinvestmentfunds,while abolishingeventhemostbasicregulationsontheir activities,suchasreserverequirementsforthebanks. Followingthis,theIcelandicbanksexpandedatan astonishingspeed,seekingcustomersabroadaswell.Their internetbankingfacilitiesmadebiginroadsinBritain,the NetherlandsandGermany.AndIcelandicinvestorstook advantageoftheaggressivelendingbytheirbanksand wentoncorporateshoppingsprees,especiallyinBritain,its formeradversaryinthefamous‘CodWars’ofthe1950sto 1970s.Theseinvestors,dubbedthe‘Vikingraiders’,were bestrepresentedbyBaugur,theinvestmentcompany ownedbyJónJóhanneson,theyoungbusinesstycoon. Burstingontothesceneonlyintheearly2000s,by2007 BaugurhadbecomeamajorforceintheBritishretail industry,withmajorstakesinbusinessesemployingabout 65,000people,turningover£10billionacross3,800stores, includingHamleys,Debenhams,OasisandIceland(the temptinglynamedBritishfrozen-foodchain).

Forawhile,thefinancialexpansionseemedtowork wondersforIceland.Onceafinancialbackwaterwitha reputationforexcessiveregulation(itsstockmarketwas onlysetupin1985),thecountrywastransformedintoa vibrantnewhubintheemergingglobalfinancialsystem. Fromthelate1990s,Icelandgrewatanextraordinaryrate andbecamethefifthrichestcountryintheworldby2007 (afterNorway,Luxemburg,SwitzerlandandDenmark).The skyseemedtobethelimit.

Unfortunately,aftertheglobalfinancialcrisisof2008,the

Icelandiceconomywentintomeltdown.Thatsummer,all threeofitsbiggestbankswentbankruptandhadtobetaken overbythegovernment.Thingsgotsobadthat,inOctober 2009,McDonald’sdecidedtowithdrawfromIceland, relegatingittotheborderlandofglobalization.Atthetimeof writing(early2010),theIMFestimatewasthatitseconomy shrankattherateof8.5percentin2009,thefastestrateof contractionamongtherichcountries.

TheriskynatureofIceland’sfinancialdrivesincethelate 1990sisincreasinglycomingtolight.Bankingassetshad reachedtheequivalentof1,000percentofGDPin2007, whichwasdoublethatoftheUK,acountrywithoneofthe mostdevelopedbankingsectorsintheworld.Moreover, Iceland’sfinancialexpansionhadbeenfuelledbyforeign borrowing.By2007,netforeigndebt(foreigndebtsminus foreignlending)reachednearly250percentofGDP,up from50percentofGDPin1997.Countrieshavegoneto pieceswithfarlessexposure–foreigndebtswere equivalentto25percentofGDPinKoreaand35percent ofGDPinIndonesiaontheeveoftheAsianfinancialcrisis in1997.Ontopofthat,theshadynatureofthefinancial dealsbehindtheIcelandiceconomicmiraclewasrevealed–veryoftenthemainborrowersfromthebankswerekey shareholdersofthosesamebanks.

Newengineofgrowth?

WhyamIspendingsomuchtimetalkingaboutasmall islandwithjustover300,000peoplethatdoesnotevenhave atrainstationoraMcDonald’s,howeverdramaticitsrise andfallmayhavebeen?ItisbecauseIcelandepitomizes whatiswrongwiththedominantviewoffinancetoday.

ExtraordinarythoughIceland’sstorymaysound,itwas notaloneinfuellinggrowthbyprivatizing,liberalizingand

openingupthefinancialsectorduringthelastthree decades.Irelandtriedtobecomeanotherfinancialhub throughthesamestrategy,withitsfinancialassetsreaching theequivalentof900percentofGDPin2007.LikeIceland, Irelandalsohadabadfallinthe2008globalfinancialcrisis. Atthetimeofwriting,theIMFestimatewasthatitseconomy contractedby7.5percentin2009.Latvia,anotheraspiring financialhub,hashaditevenworse.Followingthecollapse ofitsfinance-drivenboom,itseconomywasestimatedby theIMFtohaveshrunkby16percentin2009.Dubai,the self-appointedfinancialhuboftheMiddleEast,seemedto holdonabitlongerthanitsEuropeanrivals,butthrewinthe towelbydeclaringadebtmoratoriumforitsmainstateownedconglomerateinNovember2009.

Beforetheirrecentfallsfromgrace,theseeconomies weretoutedasexamplesofanewfinance-ledbusiness modelforcountriesthatwanttogetaheadintheeraof globalization.AslateasNovember2007,whenthestorm cloudswererapidlygatheringintheinternationalfinancial markets,RichardPortes,aprominentBritishpolicy economist,andFridrikBaldursson,anIcelandicprofessor, solemnlydeclaredinareportfortheIcelandChamberof Commercethat‘[o]verall,theinternationalisationofthe Icelandicfinancialsectorisaremarkablesuccessstorythat themarketsshouldbetteracknowledge’.1Forsome,even therecentcollapsesofIceland,IrelandandLatviahavenot beenenoughreasontoabandonafinance-ledeconomic strategy.InSeptember2009,Turkeyannouncedthatitwill implementaseriesofpoliciesthatwillturnitselfinto(yet another)financialhuboftheMiddleEast.Eventhe governmentofKorea,atraditionalmanufacturing powerhouse,isimplementingpoliciesaimedatturningitself intothefinancialhubofNortheastAsia,althoughits enthusiasmhasbeendentedsincethecollapseofIreland andDubai,afterwhichitwashopingtomodelthecountry.

Now,therealtroubleisthatwhatcountrieslikeIceland andIrelandwereimplementingwereonlymoreextreme

formsoftheeconomicstrategybeingpursuedbymany countries–agrowthstrategybasedonfinancial deregulation,firstadoptedbytheUSandtheUKintheearly 1980s.TheUKputitsfinancialderegulationprogrammeinto ahighergearinthelate1980s,withtheso-called‘BigBang’ deregulationandsincethenhasprideditselfon‘light-touch’ regulation.TheUSmatcheditbyabolishingthe1933GlassSteagallActin1999,therebytearingdownthewallbetween investmentbankingandcommercialbanking,whichhad definedtheUSfinancialindustrysincetheGreat Depression.Manyothercountriesfollowedsuit.

Whatwasencouragingmoreandmorecountriesto adoptagrowthstrategybasedonderegulatedfinancewas thefactthatinsuchasystemitiseasiertomakemoneyin financialactivitiesthanthroughothereconomicactivities–orsoitseemeduntilthe2008crisis.AstudybytwoFrench economists,GérardDuménilandDominiqueLévy–oneof thefewstudiesseparatelyestimatingtheprofitrateofthe financialsectorandthatofthenon-financialsector–shows thattheformerhasbeenmuchhigherthanthelatterinthe USandinFranceduringthelasttwoorthreedecades.2 Accordingtothisstudy,intheUStherateofprofitfor financialfirmswaslowerthanthatofthenon-financialfirms betweenthemid1960sandthelate1970s.But,following financialderegulationintheearly1980s,theprofitrateof financialfirmshasbeenonarisingtrend,andranged between4percentand12percent.Sincethe1980s,ithas alwaysbeensignificantlyhigherthanthatofnon-financial firms,whichrangedbetween2percentand5percent.In France,theprofitrateoffinancialcorporationswasnegative betweentheearly1970sandthemid1980s(nodatais availableforthe1960s).However,withthefinancial deregulationofthelate1980s,itstartedrisingandovertook thatofnon-financialfirmsintheearly1990s,whenbothwere about5percent,androsetoover10percentby2001.In contrast,theprofitrateofFrenchnon-financialfirmsdeclined fromtheearly1990s,toreacharound3percentin2001.

IntheUS,thefinancialsectorbecamesoattractivethat evenmanymanufacturingcompanieshaveturned themselvesessentiallyintofinancecompanies.JimCrotty, thedistinguishedAmericaneconomist,hascalculatedthat theratiooffinancialassetstonon-financialassetsownedby non-financialcorporationsintheUSrosefromaround0.4in the1970stonearly1intheearly2000s.3Evencompanies suchasGE,GMandFord–oncethesymbolsofAmerican manufacturingprowess–havebeen‘financialized’througha continuousexpansionoftheirfinancialarms,coupledwith thedeclineoftheircoremanufacturingactivities.Bytheearly twenty-firstcentury,thesemanufacturingfirmsweremaking mostoftheirprofitsthroughfinancialactivities,ratherthan theircoremanufacturingbusinesses(seeThing18).For example,in2003,45percentofGE’sprofitcamefromGE Capital.In2004,80percentofprofitsofGMwerefromits financialarm,GMAC,whileFordmadeallitsprofitsfrom FordFinancebetween2001and2003.4

Weaponsoffinancialmassdestruction?

Theresultofallthiswasanextraordinarygrowthinthe financialsectoracrosstheworld,especiallyintherich countries.Thegrowthwasnotsimplyinabsoluteterms.The moresignificantpointisthatthefinancialsectorhasgrown muchfaster–no,much,muchfaster–thantheunderlying economy.

AccordingtoacalculationbasedonIMFdatabyGabriel Palma,mycolleagueatCambridgeandaleadingauthority onfinancialcrises,theratioofthestockoffinancialassets toworldoutputrosefrom1.2to4.4between1980and 2007.5Therelativesizeofthefinancialsectorwaseven greaterinmanyrichcountries.Accordingtohiscalculation, theratiooffinancialassetstoGDPintheUKreached700

percentin2007.France,whichoftenstylesitselfasa counterpointtoAnglo-Americanfinancecapitalism,hasnot laggedfarbehindtheUKinthisrespect–theratioofits financialassetstoGDPisonlymarginallylowerthanthatof theUK.Inthestudycitedabove,Crotty,usingAmerican governmentdata,calculatesthattheratiooffinancialassets toGDPintheUSfluctuatedbetween400and500percent betweenthe1950sandthe1970s,butstartedshootingup fromtheearly1980swithfinancialderegulation,tobreak throughthe900percentmarkbytheearly2000s.

Thismeantthatmoreandmorefinancialclaimswere beingcreatedforeachunderlyingrealassetandeconomic activity.Thecreationoffinancialderivativesinthehousing market,whichwasoneofthemaincausesofthe2008 crisis,illustratesthispointverywell.

Intheolddays,whensomeoneborrowedmoneyfroma bankandboughtahouse,thelendingbankusedtoownthe resultingfinancialproduct(mortgage)andthatwasthat. However,financialinnovationscreatedmortgage-backed securities(MBSs),whichbundletogetheruptoseveral thousandmortgages.Inturn,theseMBSs,sometimesas manyas150ofthem,werepackedintoacollateralizeddebt obligation(CDO).ThenCDOs-squaredwerecreatedby usingotherCDOsascollateral.AndthenCDOs-cubedwere createdbycombiningCDOsandCDOs-squared.Even higher-poweredCDOswerecreated.Creditdefaultswaps (CDSs)werecreatedtoprotectyoufromdefaultonthe CDOs.Andtherearemanymorefinancialderivativesthat makeupthealphabetsoupthatismodernfinance.

BynowevenIamgettingconfused(and,asitturnsout, sowerethepeopledealingwiththem),butthepointisthat thesameunderlyingassets(thatis,thehousesthatwerein theoriginalmortgages)andeconomicactivities(the income-earningactivitiesofthosemortgage-holders)were beingusedagainandagainto‘derive’newassets.But, whateveryoudointermsoffinancialalchemy,whetherthese assetsdelivertheexpectedreturnsdependsultimatelyon

whetherthosehundredsofthousandsofworkersandsmallscalebusiness-ownerswhoholdtheoriginalmortgagesfall behindtheirmortgagepaymentsornot.

Theresultwasanincreasinglytallstructureoffinancial assetsteeteringonthesamefoundationofrealassets(of course,thebaseitselfwasgrowing,inpartfuelledbythis activity,butletusabstractfromthatforthemoment,since whatmattershereisthatthesizeofthesuperstructure relativetothebasewasgrowing).Ifyoumakeanexisting buildingtallerwithoutwideningthebase,youincreasethe chanceofittopplingover.Itisactuallyalotworsethanthat. Asthedegreeof‘derivation’–orthedistancefromthe underlyingassets–increases,itbecomesharderand hardertopricetheassetaccurately.So,youarenotonly addingfloorstoanexistingbuildingwithoutbroadeningits base,butyouareusingmaterialsofincreasinglyuncertain qualityforthehigherfloors.NowonderWarrenBuffet,the Americanfinancierknownforhisdown-to-earthapproachto investment,calledfinancialderivatives‘weaponsoffinancial massdestruction’–wellbeforethe2008crisisprovedtheir destructiveness.

Mindthegap

Allmycriticismssofarabouttheoverdevelopmentofthe financialsectorinthelasttwoorthreedecadesarenotto saythatallfinanceisabadthing.HadwelistenedtoAdam Smith,whoopposedlimitedliabilitycompanies(seeThing 2)orThomasJefferson,whoconsideredbankingtobe ‘moredangerousthanstandingarmies’,oureconomies wouldstillbemadeupofthe‘Satanicmills’oftheVictorian age,ifnotnecessarilyAdamSmith’spinfactories. However,thefactthatfinancialdevelopmenthasbeen crucialindevelopingcapitalismdoesnotmeanthatallforms

offinancialdevelopmentaregood.

Whatmakesfinancialcapitalnecessaryforeconomic developmentbutpotentiallycounterproductiveoreven destructiveisthefactthatitismuchmoreliquidthan industrialcapital.Supposethatyouareafactoryownerwho suddenlyneedsmoneytobuyrawmaterialsormachinesto fulfilunexpectedextraorders.Supposealsothatyouhave alreadyinvestedeverythingyouhaveinbuildingthefactory andbuyingthemachinesandtheinputsneeded,forthe initialorders.Youwillbegratefulthattherearebanksthat arewillingtolendyouthemoney(usingyourfactoryas collateral)intheknowledgethatyouwillbeabletogenerate extraincomewiththosenewinputs.Orsupposethatyou wanttosellhalfofyourfactory(say,tostartanotherlineof business),butthatnoonewillbuyhalfabuildingandhalfa productionline.Inthiscase,youwillberelievedtoknowthat youcanissuesharesandsellhalfyourshares.Inother words,thefinancialsectorhelpscompaniestoexpandand diversifythroughitsabilitytoturnilliquidassetssuchas buildingsandmachinesintoliquidassetssuchasloansand shares.

However,theveryliquidityoffinancialassetsmakesthem potentiallynegativefortherestoftheeconomy.Buildinga factorytakesatleastmonths,ifnotyears,while accumulatingthetechnologicalandorganizationalknow-how neededtobuildaworld-classcompanytakesdecades.In contrast,financialassetscanbemovedaroundand rearrangedinminutes,ifnotseconds.Thisenormousgap hascreatedhugeproblems,becausefinancecapitalis ‘impatient’andseeksshort-termgains(seeThing2).Inthe shortrun,thiscreateseconomicinstability,asliquidcapital sloshesaroundtheworldatveryshortnoticeandin ‘irrational’ways,aswehaverecentlyseen.Moreimportantly, inthelongrun,itleadstoweakproductivitygrowth,because long-terminvestmentsarecutdowntosatisfyimpatient capital.Theresulthasbeenthat,despiteenormous progressin‘financialdeepening’(thatis,theincreaseinthe

ratiobetweenfinancialassetsandGDP),growthhas actuallysloweddowninrecentyears(seeThings7and13).

Thus,exactlybecausefinanceisefficientatresponding tochangingprofitopportunities,itcanbecomeharmfulfor therestoftheeconomy.AndthisiswhyJamesTobin,the 1981Nobellaureateineconomics,talkedoftheneedto ‘throwsomesandinthewheelsofourexcessivelyefficient internationalmoneymarkets’.Forthispurpose,Tobin proposedafinancialtransactiontax,deliberatelyintendedto slowdownfinancialflows.Atabooinpolitecirclesuntil recently,theso-calledTobinTaxhasrecentlybeen advocatedbyGordonBrown,theformerBritishprime minister.ButtheTobinTaxisnottheonlywayinwhichwe canreducethespeedgapbetweenfinanceandthereal economy.Othermeansincludemakinghostiletakeovers difficult(therebyreducingthegainsfromspeculative investmentinstocks),banningshort-selling(thepracticeof sellingsharesthatyoudonotowntoday),increasingmargin requirements(thatis,theproportionofthemoneythathasto bepaidupfrontwhenbuyingshares)orputtingrestrictions oncross-bordercapitalmovements,especiallyfor developingcountries.

Allthisisnottosaythatthespeedgapbetweenfinance andtherealeconomyshouldbereducedtozero.Afinancial systemperfectlysynchronizedwiththerealeconomywould beuseless.Thewholepointoffinanceisthatitcanmove fasterthantherealeconomy.However,ifthefinancialsector movestoofast,itcanderailtherealeconomy.Inthepresent circumstances,weneedtorewireourfinancialsystemso thatitallowsfirmstomakethoselong-terminvestmentsin physicalcapital,humanskillsandorganizationsthatare ultimatelythesourceofeconomicdevelopment,while supplyingthemwiththenecessaryliquidity.

Thing23

Whattheytellyou

Whateverthetheoreticaljustificationsmaybefor governmentintervention,thesuccessorotherwiseof governmentpoliciesdependsinlargepartonthe competenceofthosewhodesignandexecutethem. Especially,albeitnotexclusively,indevelopingcountries, governmentofficialsarenotverywelltrainedineconomics, whichtheyneedtobeiftheyaretoimplementgood economicpolicies.Thoseofficialsshouldrecognizetheir limitsandshouldrefrainfromimplementing‘difficult’ policies,suchasselectiveindustrialpolicy,andsticktolessdemandingfree-marketpolicies,whichminimizetheroleof thegovernment.Thusseen,free-marketpoliciesaredoubly good,becausenotonlyaretheythebestpoliciesbutthey arealsothelightestintheirdemandsforbureaucratic capabilities.

Goodeconomistsarenotrequiredtorungoodeconomic policies.Theeconomicbureaucratsthathavebeenmost successfulareusuallynoteconomists.Duringtheir‘miracle’

years,economicpoliciesinJapanand(toalesserextent) Koreawererunbylawyers.InTaiwanandChina,economic policieshavebeenrunbyengineers.Thisdemonstratesthat economicsuccessdoesnotneedpeoplewelltrainedin economics–especiallyifitisofthefree-marketkind. Indeed,duringthelastthreedecades,theincreasing influenceoffree-marketeconomicshasresultedinpoorer economicperformancesallovertheworld,asIhaveshown throughoutthisbook–lowereconomicgrowth,greater economicinstability,increasedinequalityandfinally culminatinginthedisasterofthe2008globalfinancialcrisis. Insofarasweneedeconomics,weneeddifferentkindsof economicsfromfree-marketeconomics.

Economicmiraclewithouteconomists

TheEastAsianeconomiesofJapan,Taiwan,SouthKorea, Singapore,HongKongandChinaareoftencalled‘miracle’ economies.Thisis,ofcourse,hyperbole,butasfaras hyperbolesgo,itisnottoooutlandish.

DuringtheirIndustrial‘Revolution’inthenineteenth century,percapitaincomeintheeconomiesofWestern Europeanditsoffshoots(NorthAmerica,AustraliaandNew Zealand)grewbetween1percentand1.5percentperyear (theexactnumberdependingontheexacttimeperiodand thecountryyoulookat).Duringtheso-called‘GoldenAge’of capitalismbetweentheearly1950sandthemid1970s,per capitaincomeinWesternEuropeanditsoffshootsgrewat around3.5–4percentperyear.

Incontrast,duringtheirmiracleyears,roughlybetween the1950sandthemid1990s(andbetweenthe1980sand todayinthecaseofChina),percapitaincomesgrewat somethinglike6–7percentperyearintheEastAsian economiesmentionedabove.Ifgrowthratesof1–1.5per

centdescribea‘revolution’and3.5–4percenta‘golden age’,6–7percentdeservestobecalleda‘miracle’.1

Giventheseeconomicrecords,onewouldnaturally surmisethatthesecountriesmusthavehadalotofgood economists.InthesamewayinwhichGermanyexcelsin engineeringbecauseofthequalityofitsengineersand Franceleadstheworldindesignergoodsbecauseofthe talentsofitsdesigners,itseemsobvioustheEastAsian countriesmusthaveachievedeconomicmiraclesbecause ofthecapabilityoftheireconomists.EspeciallyinJapan, Taiwan,SouthKoreaandChina–countriesinwhichthe governmentplayedaveryactiveroleduringthemiracle years–theremusthavebeenmanyfirst-rateeconomists workingforthegovernment,onewouldreason.

Notso.Economistswereinfactconspicuousbytheir absenceinthegovernmentsoftheEastAsianmiracle economies.Japaneseeconomicbureaucratsweremostly lawyersbytraining.InTaiwan,mostkeyeconomicofficials wereengineersandscientists,ratherthaneconomists,asis thecaseinChinatoday.Koreaalsohadahighproportionof lawyersinitseconomicbureaucracy,especiallybeforethe 1980s.OhWon-Chul,thebrainsbehindthecountry’sheavy andchemicalindustrializationprogrammeinthe1970s–whichtransformeditseconomyfromanefficientexporterof low-grademanufacturingproductsintoaworld-classplayer inelectronics,steelandshipbuilding–wasanengineerby training.

Ifwedon’tneedeconomiststohavegoodeconomic performance,asintheEastAsiancases,whatuseis economics?HavetheIMF,theWorldBankandother internationalorganizationsbeenwastingmoneywhenthey providedeconomicstrainingcoursesfordeveloping-country governmentofficialsandscholarshipsforbrightyoungthings fromthosecountriestostudyinAmericanorBritish universitiesrenownedfortheirexcellenceineconomics? ApossibleexplanationoftheEastAsianexperienceis thatwhatisneededinthosewhoarerunningeconomic

policyisgeneralintelligence,ratherthanspecialist knowledgeineconomics.Itmaybethattheeconomics taughtinuniversityclassroomsistoodetachedfromreality tobeofpracticaluse.Ifthisisthecase,thegovernmentwill acquiremoreableeconomicpolicy-makersbyrecruiting thosewhohavestudiedwhathappenstobethemost prestigioussubjectinthecountry(whichcouldbelaw, engineeringoreveneconomics,dependingonthecountry), ratherthanasubjectthatisnotionallymostrelevantfor economicpolicy-making(thatis,economics)(seeThing 17).Thisconjectureisindirectlysupportedbythefactthat althougheconomicpoliciesinmanyLatinAmerican countrieshavebeenrunbyeconomists,andveryhighly trainedonesatthat(the‘ChicagoBoys’ofGeneralPinochet beingthemostprominentexample),theireconomic performancehasbeenmuchinferiortothatoftheEast Asiancountries.IndiaandPakistanalsohavemanyworldclasseconomists,buttheireconomicperformanceisno matchfortheEastAsianone.

JohnKennethGalbraith,thewittiesteconomistinhistory, wascertainlyexaggeratingwhenhesaidthat‘economicsis extremelyusefulasaformofemploymentforeconomists’, buthemaynothavebeenfaroffthemark.Economicsdoes notseemveryrelevantforeconomicmanagementinthereal world.

Actually,itisworsethanthat.Therearereasonstothink thateconomicsmaybepositivelyharmfulfortheeconomy.

Howcomenobodycouldforeseeit?

InNovember2008,QueenElizabethIIvisitedtheLondon SchoolofEconomics,whichhasoneofthemosthighly regardedeconomicsdepartmentsintheworld.Whengiven apresentationbyoneoftheprofessorsthere,Professor

LuisGaricano,onthefinancialcrisisthathadjustengulfed theworld,theQueenasked:‘Howcomenobodycould foreseeit?’HerMajestyaskedaquestionthathadbeenin mostpeople’smindssincetheoutbreakofthecrisisinthe autumnof2008.

Duringthelastcoupleofdecades,wewererepeatedly toldbyallthosehighlyqualifiedexperts–fromNobelPrizewinningeconomiststhroughworld-classfinancialregulators tofrighteninglybrightyounginvestmentbankerswith economicsdegreesfromtheworld’stopuniversities–that allwaswellwiththeworldeconomy.Weweretoldthat economistshadfinallyfoundthemagicformulathatallowed oureconomiestogrowrapidlywithlowinflation.People talkedofthe‘Goldilocks’economy,inwhichthingsarejust right–nottoohot,nottoocold.AlanGreenspan,theformer chairmanoftheFederalReserveBoard,whopresidedover theworld’sbiggestand(financiallyandideologically)most influentialeconomyfortwodecades,washailedasa ‘maestro’,asthetitleofthebookonhimbythejournalist BobWoodwardofWatergatefamehadit.Hissuccessor, BenBernanke,talkedofa‘greatmoderation’,whichcame withthetamingofinflationanddisappearanceofviolent economiccycles(seeThing6).

Soitwasarealpuzzletomostpeople,includingthe Queen,thatthingscouldgosospectacularlywrongina worldwhereclevereconomistsweresupposedtohave sortedoutallthemajorproblems.Howcouldallthoseclever guyswithdegreesfromsomeofthebestuniversities,with hyper-mathematicalequationscomingoutoftheirears,have beensowrong?

Learningofthesovereign’sconcern,theBritishAcademy convenedameetingofsomeofthetopeconomistsfrom academia,thefinancialsectorandthegovernmenton17 June2009.Theresultofthismeetingwasconveyedtothe Queeninaletter,dated22July2009,writtenbyProfessor TimBesley,aprominenteconomicsprofessorattheLSE, andProfessorPeterHennessy,arenownedhistorianof

Intheletter,ProfessorsBesleyandHennessysaidthat individualeconomistswerecompetentand‘doingtheirjob properlyonitsownmerit,butthattheylostsightofthewood forthetrees’intherun-uptothecrisis.Therewas,according tothem,‘afailureofthecollectiveimaginationofmanybright people,bothinthiscountryandinternationally,tounderstand theriskstothesystemasawhole’.

Afailureofthecollectiveimagination?Hadn’tmost economists,includingmost(althoughnotall)ofthosewho wereattheBritishAcademymeeting,toldtherestofusthat freemarketsworkbestbecausewearerationaland individualisticandthusknowwhatwewantforourselves (andnooneelse,possiblyexceptforourimmediate families)andhowtogetitmostefficiently?(SeeThings5 and16.)Idon’trememberseeingmuchdiscussionin economicsaboutimagination,especiallyofthecollective kind,andI’vebeenintheeconomicsprofessionforthelast twodecades.Iamnotevensurewhetheraconceptlike imagination,collectiveorotherwise,hasaplaceinthe dominantrationalistdiscourseineconomics.Thegreatand thegoodoftheeconomicsworldofBritain,then,were basicallyadmittingthattheydon’tknowwhathasgone wrong.

Butthisunderstatesit.Economistsarenotsomeinnocent technicianswhodidadecentjobwithinthenarrowconfines oftheirexpertiseuntiltheywerecollectivelywrong-footedby aonce-in-a-centurydisasterthatnoonecouldhave predicted.

Overthelastthreedecades,economistsplayedan importantroleincreatingtheconditionsofthe2008crisis (anddozensofsmallerfinancialcrisesthatcamebeforeit sincetheearly1980s,suchasthe1982ThirdWorlddebt crisis,the1995Mexicanpesocrisis,the1997Asiancrisis andthe1998Russiancrisis)byprovidingtheoretical justificationsforfinancialderegulationandtheunrestrained pursuitofshort-termprofits.Morebroadly,theyadvanced

theoriesthatjustifiedthepoliciesthathaveledtoslower growth,higherinequality,heightenedjobinsecurityandmore frequentfinancialcrisesthathavedoggedtheworldinthe lastthreedecades(seeThings2,6,13and21).Ontopof that,theypushedforpoliciesthatweakenedtheprospects forlong-termdevelopmentindevelopingcountries(see Things7and11).Intherichcountries,theseeconomists encouragedpeopletooverestimatethepowerofnew technologies(seeThing4),madepeople’slivesmoreand moreunstable(seeThing6),madethemignorethelossof nationalcontrolovertheeconomy(seeThing8)and renderedthemcomplacentaboutde-industrialization(see Thing9).Moreover,theysuppliedargumentsthatinsistthat allthoseeconomicoutcomesthatmanypeoplefind objectionableinthisworld–suchasrisinginequality(see Thing13),sky-highexecutivesalaries(seeThing14)or extremepovertyinpoorcountries(seeThing3)–arereally inevitable,given(selfishandrational)humannatureandthe needtorewardpeopleaccordingtotheirproductive contributions.

Inotherwords,economicshasbeenworsethan irrelevant.Economics,asithasbeenpractisedinthelast threedecades,hasbeenpositivelyharmfulformostpeople.

Howaboutthe‘other’economists?

IfeconomicsisasbadasIsayitis,whatamIdoingworking asaneconomist?Ifirrelevanceisthemostbenignsocial consequenceofmyprofessionalactionsandharmthemore likelyone,shouldInotchangemyprofessiontosomething moresociallybeneficial,suchaselectronicengineeringor plumbing?

IsticktoeconomicsbecauseIbelievethatitdoesnot

havetobeuselessorharmful.Afterall,throughoutthisbookI havemyselfusedeconomicsintryingtoexplainhow capitalismreallyworks.Itisaparticulartypeofeconomics–thatis,free-marketeconomicsasithasbeenpractisedin thelastfewdecades–thatisdangerous.Throughout history,therehavebeenmanyschoolsofeconomicthinking thathavehelpedusbettermanageanddevelopour economies.

Tostartfromwherewearetoday,whathassavedthe worldeconomyfromatotalmeltdownintheautumnof2008 istheeconomicsofJohnMaynardKeynes,Charles Kindleberger(theauthoroftheclassicbookonfinancial crises,Manias,Panics,andCrashes)andHymanMinsky (thegreatlyundervaluedAmericanscholaroffinancial crises).Theworldeconomyhasnotdescendedintoarerun ofthe1929GreatDepressionbecauseweabsorbedtheir insightsandbailedoutkeyfinancialinstitutions(althoughwe havenotproperlypunishedthebankersresponsibleforthe messorreformedtheindustryyet),increasedgovernment spending,providedstrongerdepositinsurance,maintained thewelfarestate(thatpropsuptheincomesofthosewho areunemployed)andflushedthefinancialmarketwith liquidityonanunprecedentedscale.Asexplainedinearlier Things,manyoftheseactionsthathavesavedtheworldare onesopposedbyfree-marketeconomistsofearlier generationsandoftoday.

Eventhoughtheywerenottrainedaseconomists,the economicofficialsofEastAsiaknewsomeeconomics. However,especiallyuntilthe1970s,theeconomicsthey knewwasmostlynotofthefree-marketvariety.The economicstheyhappenedtoknowwastheeconomicsof KarlMarx,FriedrichList,JosephSchumpeter,Nicholas KaldorandAlbertHirschman.Ofcourse,theseeconomists livedindifferenttimes,contendedwithdifferentproblems andhadradicallydifferingpoliticalviews(rangingfromthe veryright-wingListtoveryleft-wingMarx).However,there wasacommonalitybetweentheireconomics.Itwasthe

recognitionthatcapitalismdevelopsthroughlong-term investmentsandtechnologicalinnovationsthattransformthe productivestructure,andnotmerelyanexpansionofexisting structures,likeinflatingaballoon.Manyofthethingsthatthe EastAsiangovernmentofficialsdidinthemiracleyears–protectinginfantindustries,forcefullymobilizingresources awayfromtechnologicallystagnantagricultureintothe dynamicindustrialsectorandexploitingwhatHirschman calledthe‘linkages’acrossdifferentsectors–derivefrom sucheconomicviews,ratherthanthefree-marketview(see Thing7).HadtheEastAsiancountries,andindeedmostof therichcountriesinEuropeandNorthAmericabeforethem, runtheireconomiesaccordingtotheprinciplesoffreemarketeconomics,theywouldnothavedevelopedtheir economiesinthewaytheyhave.

TheeconomicsofHerbertSimonandhisfollowershas reallychangedthewayweunderstandmodernfirmsand, morebroadly,themoderneconomy.Ithelpsusbreakaway fromthemyththatoureconomyisexclusivelypopulatedby rationalself-seekersinteractingthroughthemarket mechanism.Whenweunderstandthatthemoderneconomy ispopulatedbypeoplewithlimitedrationalityandcomplex motives,whoareorganizedinacomplexway,combining markets,(publicandprivate)bureaucraciesandnetworks, webegintounderstandthatoureconomycannotberun accordingtofree-marketeconomics.Whenwemoreclosely observethemoresuccessfulfirms,governmentsand countries,weseetheyaretheonesthathavethiskindof nuancedviewofcapitalism,notthesimplisticfree-market view.

Evenwithinthedominantschoolofeconomics,thatis,the neo-classicalschool,whichprovidesmuchofthefoundation forfree-marketeconomics,therearetheoriesthatexplain whyfreemarketsarelikelytoproducesub-optimalresults. Thesearetheoriesof‘marketfailure’or‘welfare economics’,firstproposedbytheearlytwentieth-century CambridgeprofessorArthurPigou,andlaterdevelopedby

modern-dayeconomistssuchasAmartyaSen,William BaumolandJosephStiglitz,tonamejustafewofthemost importantones.

Free-marketeconomists,ofcourse,haveeitherignored theseothereconomistsor,worse,dismissedthemasfalse prophets.Thesedays,fewoftheabove-mentioned economists,exceptthosebelongingtothemarket-failure school,areevenmentionedintheleadingeconomics textbooks,letaloneproperlytaught.Buttheeventsthathave beenunfoldingforthelastthreedecadeshaveshownthat weactuallyhavealotmorepositivethingstolearnfrom theseothereconomiststhanfromfree-marketeconomists. Therelativesuccessesandfailuresofdifferentfirms, economiesandpoliciesduringthisperiodsuggestthatthe viewsoftheseeconomistswhoarenowignored,oreven forgotten,haveimportantlessonstoteachus.Economics doesnothavetobeuselessorharmful.Wejusthaveto learnrightkindsofeconomics.

Conclusion

Howtorebuildtheworld economy

Thedauntingtaskaheadofusistocompletelyrebuildthe worldeconomy.Thingsarenotasbadastheywereduring theGreatDepressiononlybecausegovernmentshave proppedupdemandthroughhugedeficitspendingand unprecedentedeasingofmoneysupply(theBankof Englandhasneverhadalowerinterestratesinceitwas foundedin1644),whilepreventingbankrunsthrough expansionofdepositinsuranceandthebailing-outofmany financialfirms.Withoutthesemeasures,andthesubstantial automaticincreaseinwelfarespending(e.g.,unemployment benefit),wecouldbelivingthroughamuchworseeconomic crisisthanthatofthe1930s.

Therearepeoplewhobelievethecurrentlydominantfreemarketsystemtobefundamentallysound.Theyassumethat tinkeringonthemarginswillbeasufficientsolutiontoour condition–abitmoretransparencyhere,atadmore regulationthere,andamodicumofrestraintsonexecutive payoverthere.However,asIhavetriedtoshow,the fundamentaltheoreticalandempiricalassumptionsbehind free-marketeconomicsarehighlyquestionable.Nothing shortofatotalre-envisioningofthewayweorganizeour economyandsocietywilldo.

Sowhatistobedone?

Thisisnotaplacetospelloutallthedetailedproposals requiredforthereconstructionoftheworldeconomy,many ofwhichhavebeendiscussedintheforegoing23Things anyway.HereIwillonlyoutlinesomeprinciples–eightof them–thatIthinkweneedtohaveinmindinredesigning oureconomicsystem.

Tobeginwith:paraphrasingwhatWinstonChurchillonce saidaboutdemocracy,letmerestatemyearlierposition thatcapitalismistheworsteconomicsystemexceptforall theothers.Mycriticismisoffree-marketcapitalism,andnot allkindsofcapitalism.

Theprofitmotiveisstillthemostpowerfulandeffective fueltopoweroureconomyandweshouldexploitittothefull. Butwemustrememberthatlettingitloosewithoutany restraintisnotthebestwaytomakethemostofit,aswe havelearnedatgreatcostoverthelastthreedecades.

Likewise,themarketisanexceptionallyeffective mechanismforcoordinatingcomplexeconomicactivities acrossnumerouseconomicagents,butitisnomorethan that–amechanism,amachine.Andlikeallmachines,it needscarefulregulationandsteering.Inthesamewaythata carcanbeusedtokillpeoplewhendrivenbyadrunken driver,ortosaveliveswhenithelpsusdeliveranemergency patienttohospitalintime,themarketcandowonderful thingsbutalsodeplorableones.Thesamecarcanbemade betterbyputtinginimprovedbrakes,morepowerfulengines ormoreefficientfuel,andthesamemarketcanbemadeto performbetterthroughappropriatechangestotheattitudes oftheparticipants,theirmotivesandtherulesthatgovernit.

Therearedifferentwaystoorganizecapitalism.Freemarketcapitalismisonlyoneofthem–andnotaverygood oneatthat.Thelastthreedecadeshaveshownthat,contrary totheclaimsofitsproponents,itslowsdowntheeconomy, increasesinequalityandinsecurity,andleadstomore frequent(andsometimesmassive)financialcrashes.

Thereisnooneidealmodel.Americancapitalismisvery differentfromScandinaviancapitalism,whichinturndiffers fromtheGermanorFrenchvarieties,nottospeakofthe Japaneseform.Forexample,countrieswhichfind American-styleeconomicinequalityunacceptable(which somemaynot)mayreduceitthroughawelfarestate

financedbyhighprogressiveincometaxes(asinSweden) orthroughrestrictionsonmoney-makingopportunities themselvesby,say,makingtheopeningoflargeretailstores difficult(asinJapan).Thereisnosimplewaytochoose betweenthetwo,eventhoughIpersonallythinkthatthe SwedishmodelisbetterthantheJapaneseone,atleastin thisrespect.

Socapitalism,yes,butweneedtoendourloveaffairwith unrestrainedfree-marketcapitalism,whichhasserved humanitysopoorly,andinstallabetter-regulatedvariety. Whatthatvarietywouldbedependsonourgoals,values andbeliefs.

Second:weshouldbuildourneweconomicsystemonthe recognitionthathumanrationalityisseverelylimited.The 2008crisishasrevealedhowthecomplexityoftheworldwe havecreated,especiallyinthesphereoffinance,hasvastly outpacedourabilitytounderstandandcontrolit.Our economicsystemhashadamightyfallbecauseitwas rewiredfollowingtheadviceofeconomistswhobelievethe humanabilitytodealwithcomplexityisessentiallyunlimited. Thenewworldshouldbeformedwithaclearrecognition thatwehaveonlylimitedpowersofobjectivereasoning.Itis suggestedthatwecanpreventanothermajorfinancialcrisis byenhancingtransparency.Thisiswrong.Thefundamental problemisnotourlackofinformationbutourlimitedability toprocessit.Indeed,iflackoftransparencywasthe problem,theScandinaviancountries–famouslytransparent –wouldnothaveexperiencedafinancialcrisisintheearly 1990s.Aslongaswecontinuetoallowunlimited‘financial innovations’,ourabilitytoregulatewillalwaysbeoutstripped byourabilitytoinnovate.

Ifwearereallyseriousaboutpreventinganothercrisis likethe2008meltdown,weshouldsimplybancomplex financialinstruments,unlesstheycanbeunambiguously showntobenefitsocietyinthelongrun.Thisideawillbe dismissedbysomeasoutrageous.It’snot.Wedothatall

thetimewithotherproducts–thinkaboutthesafety standardsforfood,drugs,automobilesandaeroplanes. Whatwouldresultisanapprovalprocesswherebythe impactofeachnewfinancialinstrument,concoctedby ‘rocketscientists’withinfinancialfirms,isassessedinterms ofrisksandrewardstooursystemasawholeinthelong run,andnotjustintermsofshort-termprofitsforthosefirms.

Third:whileacknowledgingthatwearenotselflessangels, weshouldbuildasystemthatbringsoutthebest,rather thanworst,inpeople.

Free-marketideologyisbuiltonthebeliefthatpeople won’tdoanything‘good’unlesstheyarepaidforitor punishedfornotdoingit.Thisbeliefisthenapplied asymmetricallyandreconceivedastheviewthatrichpeople needtobemotivatedtoworkbyfurtherriches,whilepoor peoplemustfearpovertyfortheirmotivation.

Materialself-interestisapowerfulmotive.Thecommunist systemturnedouttobeunviablebecauseitignored,or ratherwantedtodeny,thishumandriver.Thisdoesnot, however,provethatmaterialself-interestisouronlymotive. Peoplearenotasmuchpropelledbymaterialself-interest asfree-markettextbooksclaim.Iftherealworldwereasfull ofrationalself-seekingagentsastheonedepictedinthose textbooks,itwouldcollapseundertheweightofcontinuous cheating,monitoring,punishmentandbargaining.

Moreover,byglorifyingthepursuitofmaterialself-interest byindividualsandcorporations,wehavecreatedaworld wherematerialenrichmentabsolvesindividualsand corporationsofotherresponsibilitiestosociety.Inthe process,wehaveallowedourbankersandfundmanagers, directlyandindirectly,todestroyjobs,shutdownfactories, damageourenvironmentandruinthefinancialsystemitself inthepursuitofindividualenrichment.

Ifwearetopreventthiskindofthinghappeningagain,we shouldbuildasystemwherematerialenrichmentistaken seriouslybutisnotallowedtobecometheonlygoal.

Organizations–betheycorporationsorgovernment departments–shouldbedesignedtorewardtrust, solidarity,honestyandcooperationamongtheirmembers. Thefinancialsystemneedstobereformedtoreducethe influenceofshort-termshareholderssothatcompaniescan affordtopursuegoalsotherthanshort-termprofit maximization.Weshouldbetterrewardbehaviourwith publicbenefits(e.g.,reducingenergyconsumption, investmentintraining),notsimplythroughgovernment subsidiesbutalsobybestowingitwithahighersocial status.

Thisisnotjustamoralargument.Itisalsoanappealto enlightenedself-interest.Bylettingshort-termself-interest ruleeverythingweriskdestroyingtheentiresystem,which servesnoone’sinterestinthelongrun.

Fourth:weshouldstopbelievingthatpeoplearealways paidwhatthey‘deserve’.

Peoplefrompoorcountriesare,individually,oftenmore productiveandentrepreneurialthantheircounterpartsinrich countries.Shouldtheybegivenequalopportunitythrough freeimmigration,thesepeoplecan,andwill,replacethe bulkoftheworkforceinrichcountries,eventhoughthat wouldbepoliticallyunacceptableandundesirable.Thus seen,itisthenationaleconomicsystemsandimmigration controloftherichcountries,ratherthantheirlackofpersonal qualities,thatkeeppoorpeopleinpoorcountriespoor.

Emphasizingthatmanypeoplestaypoorbecausethey donothavetrueequalopportunityisnottosaythatthey deservetoremainpoorinsofarastheyhavehadequal opportunity.Unlessthereissomeequalizinginoutcome, especially(althoughnotexclusively)sothatallchildrencan havemorethanminimumnutritionandparentalattention,the equalityofopportunityprovidedbythemarketmechanism willnotguaranteetrulyfaircompetition.Itwillbelikearace wherenoonehasaheadstartbutsomepeoplerunwith weightsontheirlegs.

Attheotherendofthespectrum,executivepayintheUS hasgoneintothestratosphereinthelastfewdecades.US managershaveincreasedtheirrelativepaybyatleastten timesbetweenthe1950sandtoday(anaverageCEOused togetpaidthirty-fivetimesanaverageworker’ssalarythen, whiletodayheispaid300–400timesthat),butthatisnot becausetheirproductivityhasrisententimesfasterthanthat oftheirworkers.Evenexcludingstockoptions,US managersarepaidtwoandahalftimeswhattheirDutch counterpartsareorfourtimeswhattheirJapanese counterpartsare,despitenoapparentsuperiorityintheir productivity.

Onlywhenwearefreetoquestionthehandofcardsthat themarkethasdealtuswillwebeabletofindwaysto establishamorejustsociety.Wecan,andshould,change therulesofthestockmarketandthecorporategovernance systeminordertorestrainexcessiveexecutivepayin limitedliabilitycompanies.Weshouldnotonlyprovideequal opportunitybutalsoequalize,toanextent,thestartingpoints forallchildrenforatrulymeritocraticsociety.Peopleshould begivenareal,notsuperficial,secondchancethrough unemploymentbenefitsandpubliclysubsidizedretraining. Poorpeopleinpoorcountriesshouldnotbeblamedfortheir poverty,whenthebiggerexplanationslieinthepovertyof theirnationaleconomicsystemsandimmigrationcontrolin therichcountries.Marketoutcomesarenot‘natural’ phenomena.Theycanbechanged.

Fifth:weneedtotake‘makingthings’moreseriously.The post-industrialknowledgeeconomyisamyth.The manufacturingsectorremainsvital.

EspeciallyintheUSandtheUK,butalsoinmanyother countries,industrialdeclineinthelastfewdecadeshas beentreatedasaninevitabilityofapost-industrialage,ifnot activelywelcomedasasignofpost-industrialsuccess.

Butwearematerialbeingsandcannotliveonideas, howevergreattheknowledgeeconomymaysound.

Moreover,wehavealwayslivedinaknowledgeeconomyin thesensethatithasalwaysbeenacommandoversuperior knowledge,ratherthanthephysicalnatureofactivities,that hasultimatelydecidedwhichcountryisrichorpoor.Indeed, mostsocietiesarestillmakingmoreandmorethings.Itis mainlybecausethosewhomakethingshavebecomeso muchmoreproductivethatthingshavebecomecheaper,in relativeterms,thanservicesthatwethinkwedon’tconsume asmanythingsasbefore.

Unlessyouareatinytaxhaven(astatusthatisgoingto becomemoreandmoredifficulttomaintain,followingthe 2008crisis),suchasLuxemburgandMonaco,orasmall countryfloatingonoil,suchasBruneiorKuwait,youhaveto becomebetteratmakingthingsinordertoraiseyourliving standard.SwitzerlandandSingapore,whichareoftentouted aspost-industrialsuccessstories,areinfacttwoofthemost industrializedeconomiesintheworld.Moreover,mosthighvalueservicesaredependent(sometimesevenparasitic) onthemanufacturingsector(e.g.,finance,technical consulting).Andservicesarenotverytradable,soanoverly largeservicesectormakesyourbalanceofpayments situationmoreprecariousandthusyoureconomicgrowth moredifficulttosustain.

Themythofthepost-industrialknowledgeeconomyhas alsomisdirectedourinvestments.Ithasencouraged excessiveemphasison,forexample,formaleducation, whoseimpactoneconomicgrowthturnsouttobehighly complexanduncertain,andonthespreadoftheinternet, whoseproductivityimpactsareactuallyquitemodest.

Investmentin‘boring’thingslikemachinery,infrastructure andworkertrainingneedstobeencouragedthrough appropriatechangesintaxrules(e.g.,accelerated depreciationformachinery),subsidies(e.g.,toworker training)orpublicinvestment(e.g.,redirectioninto infrastructuraldevelopment).Industrialpolicyneedstobe redesignedtopromotekeymanufacturingsectorswithhigh scopeforproductivitygrowth.

Sixth:weneedtostrikeabetterbalancebetweenfinance and‘real’activities.

Aproductivemoderneconomycannotexistwithouta healthyfinancialsector.Financeplays,amongotherthings, thecrucialroleofresolvingthemismatchbetweentheactof investmentandthebearingofitsfruits.By‘liquidizing’ physicalassetswhosecharacteristicscannotbechanged quickly,financealsohelpsustoreallocateresources quickly.

However,inthelastthreedecades,financehasbecome theproverbialtailthatwagsthedog.Financialliberalization hasmadeiteasierformoneytomovearound,evenacross nationalborders,allowingfinancialinvestorstobecome moreimpatientforinstantresults.Asaconsequence,both corporationsandgovernmentshavebeenforcedto implementpoliciesthatproducequickprofits,regardlessof theirlong-termimplications.Financialinvestorshaveutilized theirgreatermobilityasabargainingchipinextractinga biggershareofnationalincome.Easiermovementof financehasalsoresultedingreaterfinancialinstabilityand greaterjobinsecurity(whichisneededfordeliveringquick profits).

Financeneedstobesloweddown.Nottoputusbackto thedaysofdebtors’prisonandsmallworkshopsfinancedby personalsavings.But,unlesswevastlyreducethespeed gapbetweenfinanceandtherealeconomy,wewillnot encouragelong-terminvestmentandrealgrowth,because productiveinvestmentsoftentakealongtimetobearfruit.It tookJapanfortyyearsofprotectionandgovernment subsidiesbeforeitsautomobileindustrycouldbean internationalsuccess,evenatthelowerendofthemarket.It tookNokiaseventeenyearsbeforeitmadeanyprofitinthe electronicsbusiness,whereitisoneoftheworldleaders today.However,followingtheincreasingdegreeoffinancial deregulation,theworldhasoperatedwithincreasingly shortertimehorizons.

movementofcapital(especiallymovementsinandoutof developingcountries),greaterrestrictionsonmergersand acquisitionsaresomeofthemeasuresthatwillslowdown financetothespeedatwhichithelps,ratherthanweakens orevenderails,therealeconomy.

Seventh:governmentneedstobecomebiggerandmore active.

Inthelastthreedecades,wehavebeenconstantlytoldby free-marketideologuesthatthegovernmentispartofthe problem,notasolutiontotheillsofoursociety.True,there areinstancesofgovernmentfailure–sometimes spectacularones–butmarketsandcorporationsfailtoo and,moreimportantly,therearemanyexamplesof impressivegovernmentsuccess.Theroleofthegovernment needstobethoroughlyreassessed.

Thisisnotjustaboutcrisismanagement,evidentsince 2008,evenintheavowedlyfree-marketeconomies,suchas theUS.Itismoreaboutcreatingaprosperous,equitable andstablesociety.Despiteitslimitationsanddespite numerousattemptstoweakenit,democraticgovernmentis, atleastsofar,thebestvehiclewehaveforreconciling conflictingdemandsinoursocietyand,moreimportantly, improvingourcollectivewell-being.Inconsideringhowwe canmakethebestoutofthegovernment,weneedto abandonsomeofthestandard‘trade-offs’bandiedaboutby free-marketeconomists.

Wehavebeentoldthatabiggovernment,whichcollects highincometaxesfromthewealthyandredistributesthemto thepoor,isbadforgrowth,asitdiscourageswealthcreation bytherichandmakeslowerclasseslazy.However,ifhaving asmallgovernmentisgoodforeconomicgrowth,many developingcountriesthathavesuchagovernmentshoulddo well.Evidentlythisisnotthecase.Atthesametime,the Scandinavianexamples,wherealargewelfarestatehas coexistedwith(orevenencouraged)goodgrowth performance,shouldalsoexposethelimitstothebeliefthat

smallergovernmentsarealwaysbetterforgrowth.

Free-marketeconomistshavealsotoldusthatactive(or intrusive,astheyputit)governmentsarebadforeconomic growth.However,contrarytocommonperception,virtuallyall oftoday’srichcountriesusedgovernmentinterventiontoget rich(ifyouarestillnotconvincedaboutthispoint,seemy earlierbook,BadSamaritans).Ifdesignedand implementedappropriately,governmentinterventioncan increaseeconomicdynamismbyaugmentingthesupplyof inputsthatmarketsarebadatsupplying(e.g.,R&D,worker training),sharingriskforprojectswithhighsocialreturnsbut lowprivatereturns,and,indevelopingcountries,providing thespaceinwhichnascentfirmsin‘infant’industriescan developtheirproductivecapabilities.

Weneedtothinkmorecreativelyhowthegovernment becomesanessentialelementinaneconomicsystem wherethereismoredynamism,greaterstabilityandmore acceptablelevelsofequity.Thismeansbuildingabetter welfarestate,abetterregulatorysystem(especiallyfor finance)andbetterindustrialpolicy.

Eighth:theworldeconomicsystemneedsto‘unfairly’ favourdevelopingcountries.

Becauseoftheconstraintsimposedbytheirdemocratic checks,thefree-marketadvocatesinmostrichcountries haveactuallyfounditdifficulttoimplementfull-blownfreemarketreform.EvenMargaretThatcherfounditimpossible toconsiderdismantlingtheNationalHealthService.Asa result,itwasactuallydevelopingcountriesthathavebeen themainsubjectsoffree-marketpolicyexperiments.

Manypoorercountries,especiallyinAfricaandLatin America,havebeenforcedtoadoptfree-marketpoliciesin ordertoborrowmoneyfromfree-market-lovinginternational financialorganizations(suchastheIMFandtheWorld Bank)andrich-countrygovernments(thatalsoultimately controltheIMFandtheWorldBank).Theweaknessoftheir democraciesmeantthatfree-marketpoliciescouldbe

implementedmoreruthlesslyindevelopingcountries,even whentheyhurtalotofpeople.Thisistheultimateironyofall –peopleneedingmosthelpwereworsthit.Thistendency wasreinforcedbythestrengtheningofglobalrulesoverthe lastcoupleofdecadesonwhatgovernmentscandoto protectanddeveloptheireconomies(morenecessaryinthe poorcountries)throughtheestablishmentand/or strengtheningoforganizationssuchastheWTO,theBIS andvariousbilateralandregionalfree-tradeandinvestment agreements.Theresulthasbeenamuchmorethorough implementationoffree-marketpoliciesandmuchworse performanceintermsofgrowth,stabilityandinequalitythan indevelopedcountries.

Theworldeconomicsystemneedstobecompletely overhauledinordertoprovidegreater‘policyspace’forthe developingcountriestopursuepoliciesthataremore suitabletothem(therichcountrieshavemuchgreaterscope tobend,orevenignore,internationalrules).Thedeveloping countriesneedamorepermissiveregimeregardingtheuse ofprotectionism,regulationofforeigninvestmentand intellectualpropertyrights,amongothers.Thesearepolicies thattherichcountriesactuallyusedwhentheywere developingcountriesthemselves.Allthisrequiresareform oftheWTO,abolitionand/orreformofexistingbilateraltrade andinvestmentagreementsbetweenrichandpoor countries,andchangesinthepolicyconditionsattachedto loansfrominternationalfinancialorganizationsandto foreignaidfromtherichcountries.

Ofcourse,thesethingsare‘unfairlyfavourable’tothe developingcountries,assomerichcountrieswouldargue. However,developingcountriesalreadysufferfromsomany disadvantagesintheinternationalsystemthattheyneed thesebreakstohaveahopeofcatchingup. Theeightprinciplesalldirectlygoagainstthereceived economicwisdomofthelastthreedecades.Thiswillhave madesomereadersuncomfortable.Butunlesswenow

abandontheprinciplesthathavefailedusandthatare continuingtoholdusback,wewillmeetsimilardisasters downtheroad.Andwewillhavedonenothingtoalleviate theconditionsofbillionssufferingpovertyandinsecurity, especially,butnotexclusively,inthedevelopingworld.Itis timetogetuncomfortable.

THING1

1 Onhowtariff(hamperingfreetradeingoods)was anotherimportantissueinthemakingofthe AmericanCivilWar,seemyearlierbookKicking AwaytheLadder–DevelopmentStrategyin HistoricalPerspective(AnthemPress,London, 2002),pp.24–8andreferencesthereof.

THING2

1 A.Smith,AnInquiryintotheNatureandCausesof theWealthofNations(ClarendonPress,Oxford, 1976),p.741.

2 N.RosenbergandL.Birdzell,HowtheWestGrew Rich(IBTauris&Co.,London,1986),p.200.

3 A.Glyn,CapitalismUnleashed–Finance, Globalisation,andWelfare(OxfordUniversityPress, Oxford,2004),p.7,fig.1.3.

4 J.G.Palma,‘Therevengeofthemarketonthe rentiers–Whyneo-liberalreportsontheendof historyturnedouttobepremature’,Cambridge JournalofEconomics,2009,vol.33,no.4,p.851, fig.12.

5 SeeW.LazonickandM.O’Sullivan,‘Maximising shareholdervalue:Anewideologyforcorporate governance’,EconomyandSociety,2000,vol.29, no.1,andW.Lazonick,‘Thebuybackboondoggle’, BusinessWeek,24August2009.

THING4

1 R.Sarti,‘Domesticservice:Pastandpresentin SouthernandNorthernEurope’,GenderandHistory, 2006,vol.18,no.2,p.223,table1.

2 AscitedinJ.Greenwood,A.SeshadriandM. Yorukoglu,‘Enginesofliberation’,Reviewof EconomicStudies,2005,vol.72,p.112.

3 C.Goldin,‘Thequietrevolutionthattransformed women’semployment,education,andfamily’, AmericanEconomicReview,2006,vol.96,no.2,p. 4,fig.1.

4 I.Rubinow,‘Theproblemofdomesticservice’, JournalofPoliticalEconomy,1906,vol.14,no.8,p. 505.

5 ThebookisH.-J.ChangandI.Grabel,Reclaiming Development–AnAlternativeEconomicPolicy Manual(ZedPress,London,2004).

6 K.Ohmae,TheBorderlessWorld:Powerand StrategyintheInterlinkedEconomy(Harper&Row, NewYork,1990).

THING5

1 Anaccessiblesummaryoftheacademicliteratureon thecomplexityofhumanmotivationscanbefoundin B.Frey,NotJustfortheMoney–EconomicTheory ofPersonalMotivation(EdwardElgar,Cheltenham, 1997).

2 TheexampleisanelaborationoftheoneusedbyK.

Basu,‘Onwhywedonottrytowalkoffwithoutpaying afterataxi-ride’,EconomicandPoliticalWeekly, 1983,no.48.

THING6

1 S.Fischer,‘Maintainingpricestability’,Financeand Development,December1996.

2 AstudybyRobertBarro,aleadingfree-market economist,concludesthatmoderateinflation(10–20 percent)haslownegativeeffectsongrowth,and that,below10percent,inflationhasnoeffectatall.

SeeR.Barro,‘Inflationandgrowth’,Reviewof FederalReserveBankofStLouis,1996,vol.78,no. 3.AstudybyMichaelSarel,anIMFeconomist, estimatesthatbelow8percentinflationhaslittle impactongrowth–ifanything,hepointsout,the relationshipispositivebelowthatlevel–thatis, inflationhelpsratherthanhindersgrowth.SeeM. Sarel,‘Non-lineareffectsofinflationoneconomic growth’,IMFStaffPapers,1996,vol.43,March.

3 See:M.Bruno,‘Doesinflationreallylowergrowth?’, FinanceandDevelopment,1995,vol.32,pp.35–8; M.BrunoandW.Easterly,‘Inflationandgrowth:In searchofastablerelationship’,ReviewofFederal ReserveBankofStLouis,1996,vol.78,no.3.

4 Inthe1960s,Korea’sinflationratewasmuchhigher thanthatoffiveLatinAmericancountries(Venezuela, Bolivia,Mexico,PeruandColombia)andnotmuch lowerthanthatofArgentina.Inthe1970s,theKorean inflationratewashigherthanthatfoundinVenezuela, EcuadorandMexico,andnotmuchlowerthanthatof ColombiaandBolivia.TheinformationisfromA. Singh,‘HowdidEastAsiagrowsofast?–Slow

progresstowardsananalyticalconsensus’,1995, UNCTADDiscussionPaper,no.97,table8.

5 Therearemanydifferentwaystocalculateprofit rates,buttherelevantconcepthereisreturnson assets.AccordingtoS.Claessens,S.Djankovand L.Lang,‘Corporategrowth,financing,andrisksinthe decadesbeforeEastAsia’sfinancialcrisis’,1998, PolicyResearchWorkingPaper,no.2017,World Bank,Washington,DC,fig.1,thereturnsonassetsin forty-sixdevelopedanddevelopingcountriesduring 1988–96rangedbetween3.3percent(Austria)and 9.8percent(Thailand).Theratiorangedbetween4 percentand7percentinfortyoftheforty-six countries;itwasbelow4percentinthreecountries andabove7percentinthreecountries.Another WorldBankstudyputstheaverageprofitratefornonfinancialfirmsin‘emergingmarket’economies (middle-incomecountries)duringthe1990s(1992–2001)atanevenlowerlevelof3.1percent(net income/assets).SeeS.Mohapatra,D.RathaandP. Suttle,‘Corporatefinancingpatternsand performanceinemergingmarkets’,mimeo.,March 2003,WorldBank,Washington,DC.

6 C.ReinhartandK.Rogoff,ThisTimeisDifferent (PrincetonUniversityPress,PrincetonandOxford, 2008),p.252,fig.16.1.

THING7

1 OnLincoln’sprotectionistviews,seemyearlierbook KickingAwaytheLadder(AnthemPress,London, 2002),pp.27–8andthereferencesthereof.

2 Thisstoryistoldingreaterdetailinmyearlierbooks: KickingAwaytheLadderisaheavilyreferencedand annotatedacademic–butbynomeansdifficult-to-

read–monograph,focusedparticularlyontrade policy;BadSamaritans(RandomHouse,London, 2007,andBloomsburyUSA,NewYork,2008)covers abroaderrangeofpolicyareasandiswrittenina moreuser-friendlyway.

THING8

1 Forfurtherevidence,seemyrecentbookBad Samaritans(RandomHouse,London,2007,and BloomsburyUSA,NewYork,2008),ch.4,‘TheFinn andtheElephant’,andR.Kozul-WrightandP. Rayment,TheResistibleRiseofMarket Fundamentalism(ZedBooks,London,2007),ch.4.

THING9

1 K.Coutts,A.GlynandB.Rowthorn,‘Structural changeunderNewLabour’,CambridgeJournalof Economics,2007,vol.31,no.5.

2 Thetermisborrowedfromthe2008reportbythe Britishgovernment’sDepartmentforBERR (Business,EnterpriseandRegulatoryReform), GlobalisationandtheChangingUKEconomy (2008).

3 B.Alford,‘De-industrialisation’,ReFRESH,Autumn 1997,p.6,table1.

4 B.RowthornandK.Coutts,‘De-industrialisationand thebalanceofpaymentsinadvancedeconomies’, CambridgeJournalofEconomics,2004,vol.28,no. 5.

THING10

1 T.Gylfason,‘WhyEuropeworkslessandgrows taller’,Challenge,2007,January/February.

THING11

1 P.CollierandJ.Gunning,‘WhyhasAfricagrown slowly?’,JournalofEconomicPerspectives,1999, vol.13,no.3,p.4.

2 DanielEtounga-Manguelle,aCameroonianengineer andwriter,notes:‘TheAfrican,anchoredinhis ancestralculture,issoconvincedthatthepastcan onlyrepeatitselfthatheworriesonlysuperficially aboutthefuture.However,withoutadynamic perceptionofthefuture,thereisnoplanning,no foresight,noscenariobuilding;inotherwords,no policytoaffectthecourseofevents’(p.69).Andthen hegoesontosaythat‘Africansocietiesarelikea footballteaminwhich,asaresultofpersonalrivalries andalackofteamspirit,oneplayerwillnotpassthe balltoanotheroutoffearthatthelattermightscorea goal’(p.75).D.Etounga-Manguelle,‘DoesAfrica needaculturaladjustmentprogram?’inL.Harrison andS.Huntington(eds.),CultureMatters–How ValuesShapeHumanProgress(BasicBooks,New York,2000).

3 AccordingtoWeber,in1863,aroundaquarterof France’spopulationdidnotspeakFrench.Inthe sameyear,11percentofschoolchildrenagedseven tothirteenspokenoFrenchatall,whileanother37 percentspokeorunderstooditbutcouldnotwriteit.

E.Weber,PeasantsintoFrenchmen–The ModernisationofRuralFrance,1870-1914 (StanfordUniversityPress,Stanford,1976),p.67.

4 SeeH-J.Chang,‘Under-exploredtreasuretrovesof developmentlessons–lessonsfromthehistoriesof smallrichEuropeancountries(SRECs)’inM. Kremer,P.vanLieshoustandR.Went(eds.),Doing GoodorDoingBetter–DevelopmentPoliciesina GlobalisingWorld(AmsterdamUniversityPress, Amsterdam,2009),andH-J.Chang,‘Economic historyofthedevelopedworld:LessonsforAfrica’,a lecturedeliveredintheEminentSpeakers ProgrammeoftheAfricanDevelopmentBank,26 February2009(canbedownloadedfrom: http://www.econ.cam.ac.uk/faculty/chang/pubs/ ChangAfDBlecturetext.pdf).

5 SeeH-J.Chang,‘Howimportantwerethe“initial conditions”foreconomicdevelopment–EastAsia vs.Sub-SaharanAfrica’(ch.4)inH-J.Chang,The EastAsianDevelopmentExperience:TheMiracle, theCrisis,andtheFuture(ZedPress,London, 2006).

6 Forcomparisonofthequalityofinstitutionsintoday’s richcountrieswhentheywereatsimilarlevelsof developmentwiththosefoundintoday’sdeveloping countries,seeH-J.Chang,KickingAwaytheLadder (AnthemPress,London,2002),ch.3.

THING12

1 Forauser-friendlyexplanationandcriticismofthe theoryofcomparativeadvantage,see‘Mysix-yearoldsonshouldgetajob’,ch.3ofmyBad Samaritans(RandomHouse,London,2007,and

2 Furtherdetailscanbefoundfrommyearlierbooks, KickingAwaytheLadder(AnthemPress,London, 2002)andBadSamaritans.

THING13

1 Thesixteencountrieswhereinequalityincreasedare, indescendingorderofincomeinequalityasof2000, theUS,SouthKorea,theUK,Israel,Spain,Italy,the Netherlands,Japan,Australia,Canada,Sweden, Norway,Belgium,Finland,LuxemburgandAustria. Thefourcountrieswhereincomeinequalityfellwere Germany,Switzerland,FranceandDenmark.

2 L.Mishel,J.BernsteinandH.Shierholz,TheStateof WorkingAmerica,2008/9(EconomicPolicyInstitute, Washington,DC,2009),p.26,table3.

3 AccordingtotheOECD(OrganizationforEconomic DevelopmentandCooperation),beforetaxesand transfers,theUS,asofmid2000s,hadaGini coefficient(themeasureofincomeinequality,with0 asabsoluteequalityand1asabsoluteinequality)of 0.46.Thefigureswere0.51forGermany,0.49for Belgium,0.44forJapan,0.43forSwedenand0.42 fortheNetherlands.

THING14

1 L.Mishel,J.BernsteinandH.Shierholz,TheStateof WorkingAmerica,2008/9(EconomicPolicyInstitute, Washington,DC,2009),table3.2.

2 Ibid.,table3.1.

3 ‘ShouldCongressputacaponexecutivepay?’,New YorkTimes,3January2009.

4 Misheletal.,op.cit.,table3.A2.Thethirteen countriesareAustralia,Belgium,Canada,France, Germany,Italy,Japan,theNetherlands,NewZealand, Spain,Sweden,SwitzerlandandtheUK.

5 Ibid.,table3.A2.

6 L.A.BebchukandJ.M.Fried,‘Executive compensationasanagencyproblem’,Journalof EconomicPerspectives,2003,vol.17,no.3,p.81.

THING15

1 OECD,‘Isinformalnormal?–Towardsmoreand betterjobsindevelopingcountries’,2009.

2 D.RoodmanandJ.Morduch,‘Theimpactof microcreditonthepoorinBangladesh:Revisitingthe evidence’,2009,workingpaper,no.174,Centerfor GlobalDevelopment,Washington,DC.

3 M.Bateman,WhyDoesn’tMicrofinanceWork?(Zed Books,London,2010).

THING16

1 MansionHousespeech,19June2009.

2 Foraveryengaginganduser-friendlypresentationof theresearchesontheirrationalsideofhumannature, seeP.Ubel,FreeMarketMadness:WhyHuman NatureisatOddswithEconomics–andWhyit Matters(HarvardBusinessSchoolPress,Boston, 2009).

THING17

1 J.Samoff,‘EducationforallinAfrica:Stilladistant dream’inR.ArnoveandC.Torres(eds.), ComparativeEducation–TheDialecticofthe GlobalandtheLocal(RowmanandLittlefield PublishersInc.,Lanham,Maryland,2007),p.361, table16.3.

2 L.Pritchett,‘Wherehasalltheeducationgone?’,The WorldBankEconomicReview,2001,vol.13,no.3.

3 A.Wolf,DoesEducationMatter?(PenguinBooks, London,2002),p.42.

4 Intheeighthgrade,theUSovertookLithuania,but wasstillbehindRussiaandHungary;fourth-grader scoreforHungaryandeighth-graderscoresfor LatviaandKazakhstanarenotavailable.

5 TheotherEuropeancountrieswere,inorderoftheir rankingsinthetest,Germany,Denmark,Italy,Austria, Sweden,ScotlandandNorway.Seethewebsiteof theNationalCenterforEducationalStatisticsofthe USDepartmentofEducationInstituteofEducation Sciences,http://nces.ed.gov/timss/table07 1.asp.

6 Theotherrichcountrieswere,inorderoftheir rankingsinthetest,Japan,England,theUS, Australia,Sweden,ScotlandandItaly.Seetheabove website.

7 Themostinfluentialworksinthisschoolofthought wereHarryBraverman’sLaborandMonopoly Capital:TheDegradationofWorkintheTwentieth Century(MonthlyReviewPress,NewYork,1974) andStephenMarglin’s‘Whatdobossesdo?’, publishedintwopartsinTheReviewofRadical PoliticalEconomyin1974and1975.

8 Wolf,op.cit.,p.264.

9 Ontheissueofsortingandmanyotherinsightful

op.cit.

THING18

1 R.Blackburn,‘Financeandthefourthdimension’, NewLeftReview,May/June2006,p.44.

THING19

1 TheshareoffederalgovernmentintotalR&D spendingintheUSwas53.6percentin1953,56.8 percentin1955,64.6percentin1960,64.9percent in1965,57.1percentin1970,51.7percentin1975, 47.2percentin1980,47.9percentin1985and47.3 percentin1989(estimated).SeeD.MoweryandN. Rosenberg,‘TheU.S.NationalInnovationSystem’in R.Nelson(ed.),NationalInnovationSystems (OxfordUniversityPress,NewYorkandOxford, 1993),p.41,table2.3.

2 H.Simon,‘Organizationsandmarkets’,Journalof EconomicPerspectives,1991,vol.5,no.2,p.27.

THING20

1 OnhowtheConfucianculturewasnotacauseof EastAsianeconomicdevelopment,see‘Lazy JapaneseandthievingGermans’,ch.9inmybook BadSamaritans(RandomHouse,London,2007, andBloomsburyUSA,NewYork,2008).

2 M.Jänttietal.,‘Americanexceptionalisminanew light:acomparisonofintergenerationalearnings mobilityintheNordiccountries,theUnitedKingdom andtheUnitedStates’,TheWarwickEconomic ResearchPaperSeries,DepartmentofEconomics, UniversityofWarwick,October2005.

THING21

1 OECDistheOrganizationforEconomic CooperationandDevelopment.Itistheclubofthe richcountries,withseveralmembersdescribing whomas‘rich’maybedebatable,suchasPortugal, Korea,CzechRepublic,Hungary,SlovakRepublic, Poland,MexicoandTurkey(indescendingorderof percapitaincome).Ofthese,PortugalandKoreaare therichest,witharound$18,000percapitaincome (in2006),andTurkeythepoorest,withpercapita incomeof$5,400(in2006).ThenextpoorestOECD memberafterPortugalandKoreaisGreece,which hasapercapitaincomeover$24,000.In2003(the latestyearforwhichtheOECDhasthedata),public socialspendingaccountedfor5.7percentofGDPin Korea.ThehighestwasSweden,with31.3percent. TheOECDaveragewas20.7percent.SeeOECD Factbook2008:Economic,Environmentaland SocialStatistics.

2 In2003(thelatestyearforwhichtheOECDhasthe data),publicsocialspendingaccountedfor16.2per centofGDPintheUS,comparedtotheOECD averageof20.7percentandtheEU15averageof 23.9percent.AmongtheOECDmemberstates, onlyKorea(5.7percent)andMexico(6.8percent)–twocountriesthatareusuallynotconsideredfully developed–hadalowerratio.Ibid.

1 R.PortesandF.Baldursson,The InternationalisationofIceland’sFinancialSector (IcelandChamberofCommerce,Reykjavik,2007),p. 6.

2 G.DuménilandD.Lévy,‘Costsandbenefitsof neoliberalism:Aclassanalysis’,inG.Epstein(ed.), FinancialisationandtheWorldEconomy(Edward Elgar,Cheltenham,2005).

3 J.Crotty,‘Iffinancialmarketcompetitionisso intense,whyarefinancialfirmprofitssohigh?–Reflectionsonthecurrent“goldenage”offinance’, WorkingPaper,no.134,PERI(PoliticalEconomy ResearchInstitute),UniversityofMassachusetts, Amherst,April2007.

4 TheinformationforGEisfromR.Blackburn, ‘Financeandthefourthdimension’,NewLeftReview, May/June2006,p.44.J.Froudetal., FinancialisationandStrategy:Narrativeand Numbers(Routledge,London,2006),estimatesthat theratiocouldbeashighas50percent.TheFord numbercomesfromtheFroudetal.studyandthe GMnumberfromtheBlackburnstudy.

5 J.G.Palma,‘Therevengeofthemarketonthe rentiers–Whyneoliberalreportsoftheendofhistory turnedouttobepremature’,CambridgeJournalof Economics,2009,vol.33,no.4.

THING23

1 Yourpercapitaincomewilldoubleintenyears,ifyou area‘miracle’economygrowingat7percent.Ifyou area‘goldenage’economygrowingat3.5percent peryearpercapita,itwilltakearoundtwentyyearsto doubleyourpercapitaincome.Inthosetwentyyears, percapitaincomeofthemiracleeconomywillhave quadrupled.Incontrast,itwilltakearoundseventy yearsforan‘industrialrevolution’economy,growing at1percentinpercapitaterms,todoubleitsper capitaincome.

2 Thelettercanbedownloadedfromthewebsite, http://media.ft.com/cms/3e3b6ca8-7a08-11de-b86f00144feabdc0.pdf.

activeeconomiccitizenshipxvi,xvii

AdministrativeBehaviour(Simon)173–4

AfricaseeSub-SaharanAfrica

AIG172–3

AirFrance131

AOL132–3

apartheid214–16

Argentina

educationandgrowth181 growth73

hyperinflation53–4

Austria geography121

governmentdirection132 protectionism70

balanceofpayments97–100,101

Baldursson,Fridrik235

Bangladesh

entrepreneurship159–60

andmicrofinance161–2,163,164

BankofEngland252 (second)BankoftheUSA68

BankforInternationalSettlements(BIS)262

bankruptcylaw227–8

Barad,Jill154

BardCollege172

Bateman,Milford162

Baugur233

Baumol,William250

Bebchuk,Lucian154

behaviouralistschool173–4

Belgium

ethnicdivision122

incomeinequality144,146

manufacturing70,91

R&Dfunding206

standardofliving109

Benin,entrepreneurship159

Bennett,Alan214

Besley,Tim246

biggovernment221–2,260–61

andgrowth228–30

seealsogovernmentdirection;industrialpolicy

BIS(BankforInternationalSettlements)262

Black,Eugene126

Blair,Tony82,143,179

borderlessworld39–40

boundedrationalitytheory168,170,173–7,250,254

Brazilianinflation55

Britain

industrialdominance/decline89–91

protectionism69–70

BritishAcademy246–7

BritishAirways131

brownfieldinvestment84

Brunei258

Buffet,Warren30,239

Bukharin,Nikolai139

Bunning,SenatorJim8

BurkinaFaso(formerlyUpperVolta)121,200

Bush,GeorgeW.8,158,159,174

BushSr,George207

businesssectorseecorporatesector

Cameroon116

capital

mobility59–60

nationality74–5,76–7

capitalism

GoldenAgeof142,147,243

models253–4

capitalists,vs.workers140–42

captainsofindustry16

Carnegie,Andrew15

Case,Steve132–3

Cassano,Joe172–3

CDOs(collateralizeddebtobligations)238

CDSs(creditdefaultswaps)238

CEOcompensationseeexecutivepay,inUS

Cerberus77–8

Chavez,Hugo68

chess,complexityof175–6

child-labourregulation2–3,197

China

businessregulation196 communes216

economicofficials244

industrialpredominance89,91,93,96

asplannedeconomy203–4

PPPincome107

protectionismandgrowth63–4,65

Chocolatemobilephone129

Chrysler77–8,191

Chung,Ju-Yung129

Churchill,Winston253

climatefactors120–21

Clinton,Bill143

cognitivepsychology173–4

collateralizeddebtobligations(CDOs)238

collectiveentrepreneurship165

communistsystem200–204

Concordeproject130–31

conditionsoftrade5

Confucianism212–13

Congo(DemocraticRepublic)116,121

consumptionsmoothing163 cooperatives166 corporatesector importance190–91 planningin207–9 regulationeffect196–8 suspicionof192–3 seealsoregulation;transnationalcorporations

CottonFactoriesRegulationAct18192 creditdefaultswaps(CDSs)238

Crotty,Jim236–8 cultureissues123,212–13

Daimler-Benz77–8

Darling,Alistair172 de-industrialization91

balanceofpayments97–100,101 causes91–6 concerns96–9 deflation,Japan54

deliberationcouncils134

Denmark cooperatives166 protectionism69 standardofliving104,106,232–3 deregulationseeunderregulation derivatives239

Detroitcar-makers191–2 developingcountries entrepreneurshipandpoverty158–60 andfreemarketpolicies62–3,71–3,118–19,261–2 policyspace262–3 digitaldivide39 dishwashers34

distributionofincomeseedownwardredistributionof income;incomeirregularity;upwardredistribution ofincome

domesticservice32–3

double-diprecessionxiii

downwardredistributionofincome142–3,146–7

Dubai235

Duménil,Gérard236

EastAsia economicofficials249–50 educationalachievements180–81 ethnicdivisions122–3 governmentdirection131–2 growth42,56,243–4 industrialpolicy125–36,205

ÉcoleNationaled’Administration(ENA)133 economiccrises247

EconomicPolicyInstitute(EPI)144,150 economists alternativeschools248–51 asbureaucrats242–3 collectiveimagination247 andeconomicgrowth243–5 roleineconomiccrises247–8 Ecuador73

Edgerton,David37 Edison,Thomas15,165,166 education andenterprise188–9 highereducationeffect185–8 importance178–9 knowledgeeconomy183–5 mechanizationeffect184–5 outcomeequality217–18 andproductivity179–81 relevance182–3

ElizabethII,Queen245–7

ENA(ÉcoleNationaled’Administration)133 enlightenedself-interest255–6

entrepreneurship,andpoverty157–8 andcollectiveinstitutions165–7

asdevelopingcountryfeature158–60

financeseemicrofinance environmentalregulations3

EPI(EconomicPolicyInstitute)144,150 equalityofopportunity210–11,256–7 andequalityofoutcome217–20,257 andmarkets213–15

socio-economicenvironment215–17

equalityofoutcome217–20 ethnicdivisions122–3 executivepay andnon-marketforces153–6 internationalcomparisons152–3 relativetoworkers’pay149–53,257 US148–9

fairtrade,vs.freetrade6–7

FannieMae8

FarEasternEconomicReview196 FederalReserveBoard(US)171,172,246 femaleoccupationalstructure35–6 Fiat78

financialcrisis(2008)xiii,155–6,171–2,233–4,254 financialderivatives239,254–5 financialmarkets deregulation234–8,259–60 effects239–41 efficiency231–2,240–41 sectorgrowth237–9

Finland governmentdirection133 incomeinequality144

industrialproduction100

protectionism69,70

welfarestateandgrowth229

Fischer,Stanley54

Fordcars191,237

Ford,Henry15,200

foreigndirectinvestment(FDI)83–5

France andentrepreneurship158 financialderegulation236 governmentdirection132,133–4,135 indicativeplanning204–5 protectionism70

Frank,RobertH151

Franklin,Benjamin65–6,67

FreddieMac8 freemarket boundaries8–10

anddevelopingcountries62–3,71–3,118–19,261–2 labourseeunderlabour

nineteenth-centuryrhetoric140–43 aspoliticaldefinition1–2 rationalexiii–xiv,169–70 resultsxiv–xv,xvi–xvii systemredesign252,263

seealsomarkets;neo-liberalism freetrade,vs.fairtrade6–7

Fried,Jesse154

Friedman,Milton1,169,214

Galbraith,JohnKenneth16,245

Garicano,Luis245

Gates,Bill165,166,200

GeneralElectric(GE)17,45,86,237

GeneralMotorsAcceptanceCorporation(GMAC)194, 237

GeneralMotors(GM)20,22,45,80,86,154,190–98 decline193–6

financialization237

pre-eminence191–2 geographicalfactors121

Germany

blitzkriegmobility191

CEOremuneration152–3 cooperatives166

emigration69

hyperinflation52–4

industrialpolicy205 manufacturing90

R&Dfunding206

welfarestateandgrowth228–9

Ghana,entrepreneurship159

Ghosn,Carlos75–6,78 globalization ofmanagement75–6 andtechnologicalchange40

GMseeGeneralMotors

GMAC(GeneralMotorsAcceptanceCorporation)194, 237

GoldenAgeofCapitalism142,147,243

Goldilockseconomy246 Goodwin,SirFred156

Gosplan145 governmentdirection balanceofresults134–6 andbusinessinformation132–4

failureexamples130–31 andmarketdiscipline44–5,129–30,134 shareownership21

successexamples125–6,131–4

seealsobiggovernment;industrialpolicy GrameenBank161–4

Grant,Ulysses67

GreatDepression192924,192,236,249,252 greenfieldinvestment84

Greenspan,Alan172,246

Hamilton,Alexander66–7,69

Hayami,Masaru54

Hennessy,Peter246–7

highereducation185–8

Hirschman,Albert249

HistoryBoys(Bennett)214

Hitler,Adolf54

homecountrybias78–82,83,86–7

Honda135

HongKong71

householdappliances34–6,37

HSBC172

Humanrelationsschool47

Hungary,hyperinflation53–4

hyperinflation52–4

seealsoinflation

HyundaiGroup129,244

Iceland financialcrisis232–4,235

foreigndebt234

standardofliving104–5

ICT(InformationandCommunicationTechnology)39

ILO(InternationalLabourOrganization)32,143–4

IMFseeInternationalMonetaryFund

immigrationcontrol5,23,26–8,30

income

percapitaincome104–11

seealsodownwardredistributionofincome;income inequality;upwardredistributionofincome

incomeinequality18,72–3,102,104–5,108,110, 143–5,147,247–8,253,262

India99,121

indicativeplanning205

indicativeplanning204–6

Indonesia234

industrialpolicy84,125–36,199,205,242,259,261

governmentdirection

IndustrialRevolution70,90,243

infantindustryargument66–8,69–70,71–2

inflation control51–2 andgrowth54–6,60–61 hyperinflation52–4 andstability56–61

InformationandCommunicationTechnology(ICT)39 institutionalquality29–30,112–13,115,117,123–4, 165–7

interestratecontrol5–6

internationaldollar106–7

InternationalLabourOrganization(ILO)32,143–4

InternationalMonetaryFund(IMF)54–5,57,66,72, 244,262

SAPs118

InternationalYearofMicrocredit162

internetrevolution31–2 impact36–7,38,39 andrationality174

investment brownfield/greenfield84

foreigndirectinvestment83–5 share18–19

invisiblereward/sanctionmechanisms48–50 Ireland financialcrisis234–5

Italy cooperatives166 emigrantstoUS103

Jackson,Andrew68 Japan

businessregulation196 CEOremuneration152–3 deflation54

deliberationcouncils134

governmentdirection133–4,135,259

indicativeplanning205

industrialpolicy131,135,242–5

industrialproduction100 productionsystem47,167 protectionism62,70

R&Dfunding206

Jefferson,Thomas67–8,239

jobsecurity/insecurity20,58–61,108–9,111,225–8, 247,253,259

JournalofPoliticalEconomy34

Kaldor,Nicolas249

Keynes,JohnMaynard249

Kindleberger,Charles249 knowledgeeconomy183–5 KobeSteel42–3,46

KongTze(Confucius)212

Korea

traditional211–13

seealsoNorthKorea;SouthKorea

Koufax,Sandy172

Kuwait258 labour

freemarketrewards23–30

jobsecurity58–60 inmanufacturing91–2 marketflexibility52 regulation2–3 relativeprice33,34

LatinAmerica32–3,55,73,112,122,140,196–7, 211,245,262

Latvia235

Lazonick,William20

Lenin,Vladimir138

Levin,Jerry133

Lévy,Dominique236

LGGroup129,134

liberals

neo-liberalismxv,60,73

nineteenth-century140–42

limitedliability12–15,21,228,239,257

Lincoln,Abraham37,67

List,Friedrich249

LondonSchoolofEconomics245–6

LTCM(Long-TermCapitalManagement)170–71

Luxemburg,standardofliving102,104–5,107,109, 232–3,258

macro-economicstability51–61,240,259,261

Madoff,Bernie172

Malthus,Thomas141 managerialcapitalism14–17

Mandelson,Lord(Peter)82–3,87 manufacturingindustry comparativedynamism96 employmentchanges91–2 importance88–101,257–9 productivityrise91–6,184–5 relativeprices94–5 statisticalchanges92–3

MaoZedong215–16

Marchionne,Sergio78 markets

andboundedrationalitytheory168,173–6,177,254 conditionsoftrade5 andequalityofopportunity213–15 failuretheories250

financialseefinancialmarkets governmentdirection44–5,125–36 governmentregulation4–6,168–9,176–7 participationrestrictions4

priceregulations5–6

andself-interest44–5

seealsofreemarket

Marx,Karl14,198,201,208,249

Marxism80,185,201–3

mathematics180,182–3

MBSs(mortgage-backedsecurities)238

medicine’spopularity222–4

Merriwether,John171

Merton,Robert170–71

Michelin75–6

microfinance

critique162anddevelopment160–62

Microsoft135

Minsky,Hyman249

Monaco258

morality,asopticalillusion48–50

Morduch,Jonathan162

mortgage-backedsecurities(MBSs)238

motivationcomplexity46–7

Mugabe,Robert54

NAFTA(NorthAmericanFreeTradeAgreement)67

NationalHealthService(UK)261

nationalityofcapital74–87

naturalresources69,115–16,119–20,121–2

neo-liberalismxv,60,73,145

neo-classicalschool250

seealsofreemarket

Nestlé76–7,79

Netherlands

CEOremuneration152–3

cooperatives166

intellectualpropertyrights71

protectionism71

welfarestateandgrowth228–9

NewYorkTimes37,151

NewYorkUniversity172

Nissan75–6,84,135,214

Nobel

PeacePrize162

Prizeineconomics170,171–2,173,208,246

Nobel,Alfred170

Nokia135,259–60

NorthAmericanFreeTradeAgreement(NAFTA)67

NorthKorea211

Norway governmentdirection132,133,205

standardofliving104

welfarestateandgrowth222,229

Obama,Barack149

OECD(OrganizationforEconomicCooperationand Development)57,159,229

Oh,Won-Chul244

Ohmae,Kenichi39

Opel191

OpiumWar9

opportunitiesseeequalityofopportunity

OrganizationforEconomicCooperation andDevelopment(OECD)57,159,229

organizationaleconomy208–9

outcomesequality217–20

Palin,Sarah113

Palma,Gabriel237

Park,Chung-Hee129

Park,Tae-Joon127–8

participationrestrictions4

Perot,Ross67

Peru219

PGAM(PlatinumGroveAssetManagement)171

Philippines,educationandgrowth180,181

Pigou,Arthur250

Pinochet,Augusto245

PISA(ProgramforInternationalStudentAssessment) 180

PlainEnglishCampaign175 plannedeconomies

communistsystem200–204 indicativesystems204–6

survival199–200,208–9

PlatinumGroveAssetManagement(PGAM)171

PohangIronandSteelCompany(POSCO)127–8 pollution3,9,169

poorindividuals28–30,140–42,216–18

Portes,Richard235

Portman,Natalie162

POSCO(PohangIronandSteelCompany)127–8 post-industrialsociety39,88–9,91–2,96,98,101, 257–8

PovertyReductionStrategyPapers(PRSPs)118

seealsoSAPs

PPP(purchasingpowerparity)106–9

Preobrazhensky,Yevgeni138–40,141 price regulations5–6 stability51–61

Pritchett,Lant181

privateequityfunds85–6,87 professionalmanagers14–22,44–5,166,200

ProgramforInternationalStudentAssessment(PISA) 180

protectionism andgrowth62–3,72–3

infantindustryargument66–8,69–70,71–2

positiveexamples63–5,69

PRSPsseePovertyReductionStrategyPapers

purchasingpowerparity(PPP)106–9

R&Dseeresearchanddevelopment(R&D)

Rai,Aishwarya162

Rania,Queen162

rationalityseeboundedrationalitytheory

RBS(RoyalBankofScotland)156

realdemandeffect94

regulation

business/corporate196–8 childlabour2–3,197

deregulation234–8,259–60

legitimacy4–6

markets4–6,168–9,176–7

price5–6

Reinhart,Carmen57,59

Renault21,75–6

ReportontheSubjectofManufactures(Hamilton)66

TheRescuers(Disneyanimation)113–14

researchanddevelopment(R&D)78–9,87,132,166 funding206

reward/sanctionmechanisms48–50

Ricardo,David141

richindividuals28–30,140–42

rivertransport121

Rogoff,Kenneth57,59

Roodman,David162

Roosevelt,Franklin191

Rover86

RoyalBankofScotland(RBS)156

Rubinow,I.M.34

Ruhroccupation52

Rumsfeld,Donald174–5

Rwanda123

Santander172

SAPs(StructuralAdjustmentPrograms)118,124

Sarkozy,Nicolas90

Scholes,Myron170–71

Schumpeter,Joseph16,165–7,249

SecondWorldWarplanning204 (second)BankoftheUSA68 self-interest41–2,45

critique42–3

enlightened255–6

invisiblereward/sanctionmechanisms48–50 andmarketdiscipline44–5 andmotivationcomplexity46–7

Sen,Amartya250

Senegal118 serviceindustries92–3

balanceofpayments97–100,101 comparativedynamism94–5,96–7 knowledge-based98,99

Seychelles100 sharebuybacks19–20 shareholdervaluemaximisation17–22

shareholders government21

ownershipofcompanies11 short-terminterests11–12,19–20 shipbuilders219

Simon,Herbert173–6,208–9,250 Singapore governmentdirection133 industrialproduction100 PPPincome107 protectionism70 SOEs205 SloanJr,Alfred191–2

Smith,Adam13,14,15,41,43,169,239 socialdumping67

socialmobility103–4,220 socio-economicenvironment215–17

SOEs(state-ownedenterprises)127,132,133,205–6 SouthAfrica55,121

andapartheid213–16

SouthKorea

bankloans81

economicofficials244

educationandgrowth181 ethnicdivisions123

financialdrive235 foreigndebt234

governmentdirection126–9,133–4,135,136 indicativeplanning205

industrialpolicy125–36,205,242–5 inflation55,56

jobinsecurityeffect222–4,226,227

post-war212–14 protectionism62,69,70

R&Dfunding206 regulation196–7

SovietUnion200–204

Spain122

Spielberg,Steven172

SriLanka121

Stalin,Josef139–40,145 standardofliving comparisons105–7 US102–11

Stanford,Alan172

stateownedenterprises(SOEs)127,132,133,205–6 steel millsubsidies126–8 workers219

Stiglitz,Joseph250

StructuralAdjustmentPrograms(SAPs)118,124

Sub-SaharanAfrica73,112–24 cultureissues123

educationandgrowth181 ethnicdivisions122–3

freemarketpolicies118–19,262

geographicalfactors121 growthrates73,112,116–19

institutionalquality123

naturalresources119–20,121–2

structuralconditions114–16,119–24 underdevelopment112–13,124

Sutton,Willie52

Sweden15,21–2

CEOremuneration152

incomeinequality144 industrialpolicy205 industrialproduction100 percapitaincome104

R&Dfunding206

welfarestateandgrowth229

Switzerland

CEOremuneration152–3 ethnicdivisions122 geography121

highereducation185–6,188 intellectualpropertyrights71 manufacturing100,258 protectionism69,71 standardofliving104–6,232–3

Taiwan

businessregulation196

economicofficials244 educationandgrowth180

governmentdirection136 indicativeplanning205 protectionism69,70

Tanzania116

TARP(TroubledAssetReliefProgram)8 taxhavens258

technologicalrevolution31–2,38–40 telegraph37–8

Telenor164

Thatcher,Margaret50,225–6,261

Time-Warnergroup132–3

TIMSS(TrendsinInternationalMathematicsand ScienceStudy)180,183

Toledo,Alejandro219

Toyota andapartheid214 productionsystem47

publicmoneybail-out80

traderestrictions4

transnationalcorporations historicaldebts80

homecountrybias78–82,83,86–7 nationalityofcapital74–5,76–7

productionmovement79,81–2

seealsocorporatesector

TrendsinInternationalMathematicsandScienceStudy (TIMSS)180,183

trickle-downeconomics137–8

andupwarddistributionofincome144–7

Trotsky,Leon138

TroubledAssetReliefProgram(TARP)8

2008financialcrisisxiii,144,155–6,171–2,197–8, 233–4,236,,238–9,245–7,249,254

Uganda115–16 uncertainty174–5 unemployment218–19

UnitedKingdom

CEOremuneration153,155–6 financialderegulation235–6,237 NHS261

shipbuilders219 seealsoBritain

UnitedNations162

UnitedStates

economicmodel104

FederalReserveBoard171,172,246

financialderegulation235–8

immigrantexpectations103–4

incomeinequality144

inequalities107–11

protectionismandgrowth64–8,69 R&Dfunding206

standardofliving102–11

steelworkers219

welfarestateandgrowth228–30

UnitedStatesAgencyforInternationalDevelopment (USAID)136

universityeducationeffect185–8

UpperVolta(nowBurkinaFaso)200

upwardredistributionofincome143–4 andtrickle-downeconomics144–7

Uruguay growth73

incomeinequality144

USAID(UnitedStatesAgencyforInternational Development)136

vacuumcleaners34

Venezuela144

VersaillesTreaty52 Vietnam203–4

Volkswagen governmentshareownership21 publicmoneybail-out80

wagegaps

politicaldetermination23–8 andprotectionism23–6,67 wagelegislation5 Wagoner,Rick45

WallStreetJournal68,83

Walpole,Robert69–70

washingmachines31–2,34–6

Washington,George65,66–7

Welch,Jack17,22,45

welfareeconomics250

welfarestates59,110–43,146–7,215,220,221–30 andgrowth228–30

Wilson,Charlie192,193

WindowsVistasystem135

woollenmanufacturingindustry70 worktorule46–7

workinghours2,7,109–10

WorldBank andfreemarket262 andfreetrade72 andPOSCO126–8

governmentintervention42,44,66 macro-economicstability56 SAPs118

WTO(WorldTradeOrganization)66,262

Yes,Minister/PrimeMinister(comedyseries)44 Yunus,Muhammad161–2

Zimbabwe,hyperinflation53–4