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Development and Social Goals: Balancing Aid and Development to Prevent ‘Welfare Colonialism’1 Erik S. Reinert (The Other Canon Foundation, Norway & Tallinn
University of Technology, Estonia) © Copyright 2005Erik S. Reinert This
paper was prepared for the High-Level United Nations Development Conference
on Millennium Development Goals, New York, March 14 and 15, 2005. ’…just as we may avoid
widespread physical desolation by rightly turning a stream near its source,
so a timely dialectic in the fundamental ideas of social philosophy may spare
us untold social wreckage and suffering.’ Herbert
S. Foxwell, Cambridge economist, 1899. Stating that creating
economic development and employment always has been the best social policy may
appear to be a particularly silly statement. However, today – with the
Millennium Goals – the world community is approaching the social problems in
the poor countries in a way which in my view makes this statement highly
relevant. The Millennium Goals are noble goals for a world which sorely needs
action to solve pressing social problems. Compared to how the world has
solved problems of poverty over the last 500 years, however, the Millennium
Goals represent completely new principles, the long term effects of which
are, in my view, neither well thought through nor well understood. In this paper I shall attempt to explain
why I do not think the Millennium Goals represent a good social policy in the
long run. The novelty in the
Millennium Goal approach lies in the large emphasis on foreign financing of
domestic social goals rather than developing/industrializing countries so
they themselves, internally, can solve their own problems of redistribution.
Disaster relief used to be of a temporary nature. Now, with the disastrous
lack of economic development in many countries, disaster relief finds a more
permanent form in the Millennium Goals. In countries where already more than
50 per cent of the government budget is financed through foreign aid, huge
additional resource transfers are planned. One big question mark is to what
extent this approach will put a large group of nations permanently ‘on the
dole’, a system similar to the ‘welfare colonialism’ which will be discussed
at the end of the paper. The question is similar to that of starting foreign
wars: what is our exit strategy? Several UN Development
Decades were only of limited success. In this perspective the Millennium
Goals may appear as the United Nations institutions abandoning the project of
developing the world poor, abandoning the effort to treat the causes of poverty and instead
concentrating on an effort that to a large extent attacks the symptoms of poverty. In this paper I
shall argue that in my view too much of the development effort has been
abandoned: to a considerable extent palliative
economics has taken the place of development
economics. Indeed the balance of
development economics – radically changing the productive structures of poor
countries – and palliative economics – easing the pains of economic misery –
is, in my view, the key issue, and I think we are planning for a serious
imbalance where the extremely high costs will be much less important than the
long term negative effects. There is little debate around key issues. It is unfortunate
that the Millennium Goals have acquired the proverbial status of motherhood
and apple pie, institutions that no one in their right mind will speak
against. I shall still make an attempt.
How we used to deal with problems of development
In terms of the number of
nations and number of people lifted into relative wealth, this
re-industrialization plan was probably the most successful development
project in human history. The fundamental insight behind the Marshall Plan
was that economic activities were qualitatively different, those of the
countryside (which we could call diminishing returns activities, or
agriculture and raw materials) differed from those of the cities (which we
could call increasing returns activities, or industry). In his famous June
1947 speech at Harvard, US Secretary of State George Marshall (who was later
to be awarded the Nobel Peace Price) stressed that ‘the farmer has always
produced the foodstuffs to exchange with the city dweller for the other
necessities of life’. This division of labour, i.e. between increasing
returns activities in the cities and the diminishing returns activities in
the countryside, was ‘at the present time…threatened with breakdown’. He then
made a remarkable recognition of the cameralist and
mercantilist economic policy of previous centuries: ‘This division of labor is the basis of modern civilization’. Civilisation requires increasing
returns activities, something that economists and politicians from Antonio Serra (1613) to Alexander Hamilton, Abraham Lincoln and
Friedrich List had already been saying for a long time. The principles behind
the toolbox used by nations going from poverty to wealth through the creation
of ‘city activities’ (Appendix 1) have been surprisingly stable from when
they were first used by Henry VII of England starting in 1485 until their use
in Korea in the 1970s. I claim that many of today’s problems are due to the conditionalities of the Washington Institutions
classifying the toolbox needed to create increasing returns activities – a
toolbox employed by all countries that developed after Venice and Holland –
as ‘illegal activities’. After World War II, the
toolbox did not produce the same success in every country. The most
successful countries temporarily protected new technologies for the world
market under competition.(e.g. Korea). The least successful permanently
protected mature technologies for often small home markets under limited or
no competition (typically the small countries of Latin America). However, the
key fact here is that – from Mongolia to Russia and Peru – this inefficient
industrial sector produced higher real
wages than these same countries enjoy today when this structure has been
considerably weakened2 (See Figure 1 http://www.btinternet.com/~pae_news
/ReinertFigure1.htm). For centuries it
was understood that having an ‘inefficient’ industrial (increasing returns)
sector produced higher real wages than no industrial sector at all, and that
this ‘business inefficient’ sector ought to be made more efficient rather
than being closed down. In its most simple form
this argument is born out of the inclusion of both increasing and diminishing
returns in trade theory, as the starting points respectively of virtuous and
vicious circles of growth or poverty. A praxis ignoring these mechanisms may
cause factor price polarization rather than factor prize equalization.
Increasing returns, virtuous circles, and large economic diversity were first
established as necessary elements for wealth by Serra
(1613), who specifically says these mechanisms are not available in the
agricultural sector. The principle thus created was understood almost
continuously – with brief interruptions – up until and including the Marshall
Plan, but was in practice abandoned with the Washington Consensus.
Deindustrialisation used to be something one would impose on a vanquished
enemy, like on France after the Napoleonic War. Since the 1980s, ‘structural
adjustment’ produced this same effect in many poor countries. Ruling theory
at the time said this would not matter, to the contrary, a free trade shock
would – in the vision of first WTO Secretary
General, Renato Ruggieri
– unleash ‘the borderless economy's potential to equalise relations between
countries and regions’. In the 1930s, placing the
gold standard (Keynes’ ‘barbarous relic’) and budget balances as the
untouchable core of economic theory and practice locked the world into a
sub-optimal equilibrium, for a long time preventing Keynes’ policies to be
carried out with the approval of mainstream economics. In a similar way,
placing free trade as the ideological centrepiece of development policies – to which all other goals become
subservient – since the fall of the Berlin Wall has locked the
non-industrialized countries into a very sub-optimal equilibrium. In my view,
rather than continuing world policies based on the most simplistic version of
mainstream trade theory, we must again take the conflict between free trade
and real wages in non-industrialised countries seriously. A specialisation in
diminishing returns activities with increasing population pressures also has
serious environmental consequences.3 In my opinion the poverty
we can observe in so many countries in the Third and former Second World is not
caused by transitory problems, but by permanent features of nations having
different economic structures. When the US started industrialising, few
(although some) had the ambition for the country to be as wealthy as England.
They just wanted to create a less efficient copy of the kind of production
structure they could observe in England. This required tariffs. Successful
industrialisation under protection, however, carries the seeds of its own
destruction. By the 1880s US economists – using the same arguments based on
scale and technology that were used to protect US industries in the 1820s –
now argued for free trade. The same tariff that for a while created
manufacturing industry, was now hurting the same industry.4 This
is why List, the protectionist, was also the first visionary of global free
trade: when all countries had achieved a comparative advantage outside the
diminishing returns sector.5 The disagreement is not over the
principle of free trade as such, only over its timing. If one, instead of
accepting Adam Smith as an icon of free trade and laissez faire under any
circumstances, reads what he says about economic development at an early
stage, one will find that he is very much in line with classical development
economics, where industrialization is the key recommendation. In his early
work, The Theory of Moral Sentiments (Smith 1759/1810), Adam Smith
argued passionately for ‘the great system of government’ which is helped by
adding new manufactures. Interestingly, Smith argued that new manufactures
are to be promoted, neither to help suppliers nor to help consumers, but in
order to improve this ‘great system of government’. In fact, it is possible to
argue that Adam Smith was also a misunderstood mercantilist, someone who
firmly supported the mercantilist policies of the past, but then argued that
they were no longer necessary for England. In other words, Adam Smith played
the same role later played by Schoenhof (see above,
footnote 3) in the United States. He praises the Navigation Acts protecting
English manufacturing and shipping against Holland, arguing ‘they are as
wise… as if they had all been dictated by the most deliberate wisdom’ and
holding them to be ‘perhaps, the wisest of all the commercial regulations of
England’ (Smith 1776/1976: I, 486-487). All in all, Smith described a
development that had become successfully self-sustained, a kind of
snowballing effect, originating in the wise protectionist measures of the
past. Only once did Smith use the term ‘invisible hand’ in the Wealth of Nations: when it sustained
the key import substitution goal of mercantilist policies, when the consumer
preferred domestic industry to foreign industry (Smith 1776/1976: 477). This
is when ‘the market’ had taken over the role previously played by protective
measures, and national manufacturing no longer needed such protection. If one
cared to look, Adam Smith also argued for tariff protection at an early stage
as a mandatory passage point to development as did Friedrich List. Studying
economic policy without discussing the context is one of the destructive
vices of economic practice. The praxis of economic
development has been to assimilate and produce less efficient ‘copies’ of the
economic structure of wealthy nations. The key features of the economic
structure of wealthy nations have been a large division of labour (a large
number of different industries and professions), an important increasing
returns sector (industry and today also knowledge–intensive services). This
understanding was made into economic theory by economists who codified what
actually took place in wealthy countries: Antonio Serra
(1613), James Steuart (1767), Alexander Hamilton
(1791) and Friedrich List (1841). These principles are at times unlearned
when the natural harmony of physics-based economics totally takes over, as in
France in the 1760s, in Europe in the 1840s, and in the world in the 1990s.
These periods come to an end because of the great social cost they create. Physiocracy in France created shortages and scarcity of
bread, and started the process that led to the French revolution.6 The free trade euphoria of the 1840s met
its backlash in 1848 with revolutions in all large European countries, with
the exception of England and Russia. Every time Ricardo’s trade theory is proven
wrong when applied asymmetrically to increasing and diminishing return
industries7, Ricardo is proven right that the ‘natural’ wage level
is subsistence. The free trade euphoria of the 1990s has again backlashed and created widespread poverty, but this time
our response is wrong. We are too much attacking the symptoms rather than the
causes of the problem. The situation today Today’s standard economics
tends to see development as largely being driven by accumulation, by investments
in capital, physical and human.8 Standard economic theory which underlies today’s development policies
is normally unable to recognise qualitative differences between economic
activities. I have argued elsewhere that globalization in the periphery
therefore has had the effect of a Morgenthau Plan
in many of the world’s small and poor countries: ‘removing the basis of
modern civilization’. If we look at the list of today’s failed or failing
nations, we will find that they all fail George Marshall’s test for what
creates modern civilisation: They have very weak manufacturing sectors,
unable to create the virtuous exchange between city activities and
countryside activities that Marshall recognised. They also have a very
limited diversity in their economic base, a very limited division of labour,
and are specialised in diminishing returns activities. Historically, modern
democracy was born in the nations where the civilising trade between urban
and rural areas had already been established, in the Italian city states. A
key feature of the most successful city states was that power was not in the
hands of the landowning (diminishing returns) class. The scarcity of arable
land made this easy in Venice and The Dutch Republic, and the fact that the
few islands of wealth in Europe also geographically tended to be islands was
not lost on the early economists. In other areas this was only achieved
through constant political fight. In Florence, 40-odd landowning families had
been banned from political life already in the 13th century,
enabling what we later in this paper shall call Schumpeterian cronyism:
political and economic interests ‘colluded’ in a way that created widespread
wealth. Dependency on raw materials would create feudalism and/or
colonialism, neither of these situations leading to political freedom. If we
wish to establish genuine democracies, we may also here at the moment be
starting at the wrong end of the problem, attacking symptoms rather than real
causes of political freedom. The US Civil War was essentially a war between
landowners with vested interest in agriculture and cheap labour (the South)
and those with a vested interest in industrialization, what the most
visionary of the 19th century US economists called ‘a high wage
strategy’ (the North). The history of Latin America is in many ways the
history of a group of countries where the South won the Civil War. The alternative paradigm,
which we could broadly call evolutionary and historical – which I refer to as
The Other Canon of economics – the key force in development is assimilation:
learning to do what more advanced countries are doing, ‘copying’ not only
their institutions, but more importantly their economic structure.9
In fact institutions like patents and protection, scientific academies and
universities were key elements in the strategy to change national economic
structures in order to assimilate that of the wealthier countries. In this
tradition, economic growth tends to be activity-specific, tied to
clusters of certain economic activities exhibiting increasing returns and
rapid technological progress. This process requires capital, but the
difficulty lies in transferring and mastering the skills and, above all, in
creating a viable market for the increasing returns activities in nations
where the absence of purchasing power and massive unemployment tend to go
hand in hand, each factor reinforcing the other in a deadlock. By generally
insisting on using models assuming full employment, the Washington
Institutions avoid facing a key factor in the mechanisms that lock nations
into poverty: the lack of formal employment. Historically, since 16th
century Holland and Venice, only nations with a healthy manufacturing sector
have achieved anything close to full employment combined with a lack of
sizable rural underemployment. Today’s reigning economic
theory represents what Schumpeter called ‘the pedestrian view that it is
capital per se that propels the
capitalist engine’: development is seen as largely driven by the accumulation
of capital, physical or human. ‘The premise of neo-classical theory is that,
if the investments are made, the acquisition and mastery of new ways of doing
things is relatively easy, even automatic’, as Richard Nelson says. Even more
important, the core thesis of standard economics, albeit seldom expressed, is
that economic structure is irrelevant, capital per se will lead to economic development regardless of the
economic structure into which the investment is made. In the alternative
Other Canon theory, economic activities exhibit very different windows of
opportunity as carriers of economic growth. An intuitive example: Bill Gates
is not likely to have achieved his present economic success specializing in
herding goats or growing broccoli: the technological wave that created
Microsoft is not replicable in a company or country specialising in goat
herding or growing broccoli. In other words we have to get rid of what James
Buchanan calls ‘the equality assumption’ in economic theory, probably the
most important and the least discussed assumption.10 The ability
to absorb innovations and new knowledge – and consequently profitably
to absorb investments – at any time varies enormously from one economic
activity to another. The problem: As a result of seeing capital per
se as the key to growth, loans are given to poor nations which their
productive/industrial structure is unable to absorb profitably. Interest
payments will often very fast exceed the rate of return on the investments
made. ‘Finance for Development’ may therefore take on the characteristics of
a pyramid game or a chain letter fraud: the only ones to gain are those who
started the scheme and are close to the door.11 Correspondingly on
the human side: Investments in human capital are made without corresponding
change in the productive structure that creates a demand for the skills
acquired. As a result education may tend only to promote emigration. In both
cases Gunnar Myrdal’s
‘perverse backwashes’ of economic development will be the result: more capital
– both monetary and human – will flow from the poor to the rich countries
than the other way around. My claim, based on the study of 500 years of
history’s laboratory, is that the main explanation for this lies in the type
of economic structure – locked into a vicious circle of lack of supply and
lack of demand and the absence of increasing returns – that characterises
poor nations. This circle cannot possibly be broken unless we again listen to
500 years who speak in favour of the set of policies listed in Appendix 1.
Abraham Lincoln stands out as a proud representative of this type of national
economic strategy, and US industrial policy from 1820 until 1900 is the best
example for the Third World to follow today until – as the US was towards the
end of the 19th century – these nations are ready to participate
fully in and benefit truly from international trade. Recommendation: As
was the case with the Marshall Plan, financial funds must be matched with the
establishment of industrial and service sectors that profitably can absorb
both the physical and human investments. A diversification out of raw
material production is absolutely indispensable in order to create a basis
both for democratic stability and increased welfare. Initially these sectors will not be able to survive world market
competition. As this process always has required, since England’s ascent to
industrialization starting in 1485, this incipient industrialisation needs
special treatment of the kind the Marshall Plan afforded after 1947. This
requires interpreting the Bretton Woods agreement
as it was done in the post-WW II era, not as it is presently
interpreted. Part of the problem also
lies in neo-classical economics’ poor understanding of successful business.
It is almost curiously amusing that at the core of the economic theory behind
capitalism is a situation of perfect competition and equilibrium, a situation
where no one makes any money to speak of. In standard economics successful
businessmen like Bill Boeing and Bill Gates – who both contributed
importantly to the wealth of Seattle – are ‘rent-seekers’, generally an
odious term. In fact it is the poverty-stricken Third World that most closely
corresponds to the conditions assumed in international trade theory, diminishing
returns and perfect competition. The rich countries, whose export items are
produced under Schumpeterian dynamic imperfect competition, are ‘rent
seekers’ whose rents, spreading through society as higher wages and a higher
tax base, are what we call ‘economic development’. This failure to understand
development as Schumpeterian imperfect competition is at the root of the
present arguments against an industrial policy. Anything which causes
imperfect competition tends to be seen as ‘cronyism’. Keynes saw investments
resulting from what he called ‘animal spirits’. Without this ‘animal spirit’
– without the initiative to invest in uncertain conditions – capital is
sterile, both in the world of Joseph Schumpeter and in that of Karl Marx,
each representing one side of the political spectrum. The motivating force
behind this animal spirit is to make profits, to break the equilibrium of
perfect competition. From this
businessman’s point of view the very simple explanation for the lack of
investments in poor countries is the lack of profit opportunities. He
does not invest because he sees no opportunity to make profits outside the
extraction of raw materials. This lack of opportunities for profitable
investments is largely tied to the extremely low purchasing power and the
very high unemployment rate. Subsistence farmers do not represent profitable
customers for most producers of goods and services. Tariffs create incentives
to move production into the labour markets of the poor. Historically, this
has been seen as a conscious trade-off between the interest of
man-the-consumer and man-the-producer. The idea that industrialization would
cause a rapid increase in employment and wages that more than offset the
temporary higher cost of manufactured goods was at the core of the Prebisch import-substitution industrialization, but also
of US economic theory around 1820.12 The idea that greater
‘openness’ in any way should improve the situation of the poor countries is
both counterintuitive and contrary to historical experience. If anything, the
first effect of sudden ‘openness’ in a backward society is likely to kill off
what little manufacturing activity that might exist, making the situation
worse.13 In effect historical experience shows that opening up for
free trade between nations of very different levels of development tends
first to destroy the most efficient industries in the least efficient
countries (The Vanek-Reinert Effect), from the
unification of Italy in the 19th century to the integration of Mongolia
and Peru in the 1990s. Figure 1
visualizes how the highly successful export increases that followed the
opening up of the Peruvian economy were accompanied by falling real wages. In
Peru, as in many other Latin American countries, real wages peaked during the
period of ‘inefficient’ import substitution. The ports, airports, roads,
power stations, schools, hospitals, and service industries that were created
by this inefficient industrial sector, led by rent-seekers, were real and could not have been created
without the demand for labour and infrastructure that this inefficient
industrial sector generated.14
Economic theory must again open up to understanding synergies of this
type, where temporary ‘business inefficiency’ in certain sectors activates
more efficient activities and/or the upgrading of human capital in other
sectors, in the end leading to increased welfare. The timing of the opening
of an economy is crucial. Opening up the economy too late will seriously
hamper growth. Opening up an economy too early results in
de-industrialization, falling wages15 and increasing social
problems. An anonymous traveller who in 1786 observes the effects of economic
policy in different European countries reaches this same conclusion: ‘Tariffs
are as harmful to a country after manufacturing industry has been established
there, as they are useful to it in order to introduce this industry’.16 In Southern Mexico we can
observe the destructive sequence of de-industrialization,
de-agriculturalization17 and de-population. That large numbers of
subsistence farmers should be made ‘uncompetitive’ by subsidized First World
agriculture is a relatively new, but alarming, trend that may persist even if
the subsidies are removed. There are around 650 million farmers in India, and
a large proportion of them are as ‘uncompetitive’ as their Mexican colleagues
if and when free trade opens up, but without the possibility to migrate to
the US. In the poorest countries today a trade-off exists between maximizing
international trade – which is what present policies achieve – and maximizing
human welfare (Figure 1).
In my view we must address this trade-off in a different way than trying to
compensate the losses of the poor countries through increased aid. More than five centuries of
history – from England’s ascent starting in 1485 – show that there is only
one point where the complex deadlock of vicious circles of poverty and
underdevelopment can effectively be attacked: by changing the productive
structure of the poor and failing states. This means increasing
diversification away from the diminishing returns sectors (traditional raw materials
and agriculture) into an increasing returns sector (technology intensive
manufacturing), creating a large division of labour and the synergies and
social structures which emerge from this structure. This is also the only way
to make it possible for subsistence agriculture to break away from its
chains: creating an urban market for their goods, which will induce
specialization and innovation, bring in new technologies and create
alternative employment. Foreign markets cannot play the same role, they break
economies into advanced and backward sectors and regions: the key to cohesive
development is a national18 interplay between increasing and
diminishing returns sectors. The arguments against industrial policy: Malthusian vs. Schumpeterian
cronyism. 2005: A Filipino sugar
producer uses his political influence in order to achieve import protection
for his products. 2000: Major Daley in
Chicago does not listen to the Chicago economists, but provides subsidies to
already wealthy high-tech investors through an incubator. 1950s and 1960s: Swedish
industrialist Marcus Wallenberg uses his close political contacts with Labour
Party Minister of Finance, Gunnar Sträng, to achieve political support and favours in order
to carry out his plans for companies Volvo and Electrolux. 1877: Steel producers in
the United States use their political clout to achieve a 100 per cent duty on
steel rails.19 1485: Industrialists use
their political connections to King Henry VII in order to achieve subsidies
and an export duty on raw wool that will increase the raw material prices for
their competitors on the Continent, slowly killing the wool industry
elsewhere, e.g., in Florence. These are all blatant
examples of crony capitalism, very far from the nice perfect level playing
field we are all supposed to prefer. These are all rent seekers that purist
economic theory tends to abhor. There is, however, a crucial difference
between the first example and the rest. The Filipino crony differs from the
other cronies in that he gets subsidies in a diminishing returns raw material
that competes under perfect competition on the world market. He is a
Malthusian crony leading his country down the path of diminishing returns (in
spite of technological change which counteracts this). The others are
Schumpeterian cronies, producing under what Schumpeter calls historical
increasing returns (a combination of both increasing returns and fast
technological change). If we couple this to trade theory we see that the
tilted playing fields providing Schumpeterian cronyism produce widely
different results than those of the Filipino crony. Bismarck used to say that
there are two things whose production process one should better not watch:
sausages and government budgets. We should probably add industrial policy to
this group of aesthetically unpleasant production processes. We can live
without sausages, but not without government budgets or industrial policy.
And, as Keynes said, ‘the worse the situation, the less laissez-faire works’.
If we insist that we cannot have industrial policy because moving away from
perfect competition will cause some cronies to get rich, we have totally
misunderstood the nature of capitalism. Capitalism is about getting away
from perfect competition; this is what people spend years at business schools
learning. Economic development is
caused by structural change which breaks equilibrium, creating rents.
Insisting on the absence of rents is insisting on a steady and stationary
state. This is the reason why tariffs in many ways are the least
crony-friendly of the policy tools. However, there is still the need to
choose which activities to protect, which almost by definition will create
cronies. Abraham Lincoln protected the steel cronies, and he was very proud
of it. He saw that by paying a little more for steel20, he managed
to create a huge steel industry with many jobs paying high wages that also
provided a base for government taxation. Economic development strategy is
about getting the public interests of the nation lined up with the private
vested interests of the capitalists. As stated above, the failure of standard
economics to understand the dynamics of the world of business is a serious
problem. This also leads to a failure to understand the economic essence of
colonialism. At its economic core colonialism is a technology policy: the
colonies were not allowed to have manufacturing industries. The economic
activities with high potential for economic growth and mechanization were to
remain in the metropolis, the diminishing returns activities went to the
colonies. The immense transfers that
accompany The Millennium Goals process will necessarily also lead to
cronyism. Some people will get wealthy through this initiative, and a huge aid
industry-cum-lobby is working very actively. Crony-free economics only exists
in neo-classical models. My choice is that we go for Schumpeterian cronyism
more than aid-based cronyism, because in this way we also make it possible
for the poor countries to free themselves from economic dependency. Is it
because the apparent motivation of the businessman is greed and avarice,
while the apparent motivation of the aid lobby is charity that the presently
preferred solution tilts so heavily in favour of charity rather than
development? Again we may have unlearned our basic Adam Smith: it is not by
the charity of the baker, but by his greed that we get our daily bread. We also seem to have
unlearned the logic behind policy tools for economic development. Patents and
modern tariffs were created at about the same time, in the late 1400s. It is
crucial to understand that these rent-seeking institutions were created by
the very same understanding of the process of economic development. To create
protection and rents in order to produce new knowledge (in the case of
patents) and to make it possible to move the new knowledge in order to
produce with this new knowledge in new geographic areas (the case of tariffs)
are two aspects of the same understanding of Schumpeterian economic dynamics.
From the point of view of those who think that perfect competition is the
ideal economic situation, both patents and tariffs represent legalized rent
seeking in order to promote goals that are not achievable under perfect
competition. I
suggest looking at this set of problems as the poor countries might look at
them. Why is the rent seeking and crony argument not applied also against
patents, only against tariffs and other policy instruments used in poor
countries? Why does the economic profession accept legalized rent-seeking by
pharmaceutical companies and by Bill Gates, but abhor the rent-seeking of an
industrialist who tries to set up a small business in Lima, Peru? The poor
countries may, with some justification, say that the wealthy countries are
establishing rules that legalize constructive rent seeking in their own
countries, but prohibit them in the poor countries. Over time
industrialization has proved as beneficial to mankind as many highly
protected drugs. The Washington Consensus and sequential
single issue management. By
the time of what The New Yorker appropriately called the ‘triumphalism’
following the fall of the Berlin Wall, neo-classical economics with its
variations had become the only game in town. The logic of the post-WW II
years that had built wealth along the belt bordering communism, from Norway
to Japan, was gone, and economics had fossilized into a war between two
utopias: the communist utopia that promised that each should give according
to ability and receive according to need, and the neo-classical utopia that
promised that under capitalism everyone would receive the same wages
world-wide (Paul Samuelson’s factor-price
equalization). Both of these theories, the communist planned economy and
neo-classical economics, were based on David Ricardo’s theories (1817).
Ricardo and his successors show a disregard for economic structure, for
technology and innovations, for entrepreneurship and leadership, and for the
fact that economic activities are qualitatively as different as carriers of
economic welfare. In both its communist and its liberalist forms Ricardian economics sees no need for a state (Marx’
‘withering away of the State’). However,
neo-classical economics was, to use Nicholas Kaldor’s
term, an un-tested theory.
Neo-classical theory had provided an effective ideological shield during the
Cold War, but no nation had ever been built on this type of theoretical
framework. In its most extreme form, as it was practiced around 1990, the
only predicament was that nations should ‘get their prices right’ and
economic growth would follow automatically, disregarding economic structures.
Because it is so counterintuitive (why should stockbrokers and shoe-shine
boys get the same wages just by being put in different nations??), Paul
Samuelson’s theory of factor-price equalization had long been the pride of
the economics profession. Now, by 1990, policy recommendations were
formulated as if this ‘law’ of factor-price equalization was comparable to
the law of gravity. This neglected not only important theoretical
contributions pointing elsewhere (Krugman,
Grossman, Helpman, Lucas, etc.), key insights of
the founding father of neo-classical economics, Alfred Marshall, were also
neglected. Alfred Marshall not only describes taxes on diminishing returns
activities in order to subsidize increasing returns activities as a good
development policy, he also emphasizes the importance for a nation to produce
where most technical change is found, and the role of synergies (industrial
districts). These are the principles behind all successful catching up since
Henry VII started the industrialization of England by taxing diminishing
returns activities (an export tax on raw wool) in order to subsidize industry
manufacturing woolen cloth. These elements,
representing first successful practice and then sound theory over more than
500 years, have disappeared from the policy space. In
the 1990s, as the world economy failed to deliver results corresponding to
the crudest version of Samuelson’s law of free trade, the search began for
other explanations. This search was, and still is, always based on the
premises of neo-classical economics, the search is for a factor which in addition to neo-classical economics would set free the magic of the market
in providing factor-price equalization with instant global free trade:
The
vision of ‘the borderless economy's potential to equalise relations between countries
and regions’ was based on the wrong theory. This theoretical fantasy
developed into a practical nightmare in many poor countries. None of the
sequential focuses on single issues will unleash a magic of factor-price
equalization under instant free trade; this never existed in history nor will
it ever exist. Economic growth is by the very nature of things an uneven
process, and only wise political intervention can even out the factor-price
polarizations which are the natural results of an unrestrained market. The latest fad in the sequence, attributing
poverty to a lack of entrepreneurship, comes across as being particularly
uninformed. As contrasted to most people in the wealthy countries who can
safely live within their mostly routine jobs, the poor of the world have to
prove their initiatives and entrepreneurship every day in order to ensure
physical survival for themselves and their families. The
problem is that the sequence of theoretical fads for policy fails to address
the fundamental blind spots of neo-classical economics: a) its inability to
register qualitative differences, including the different potentials of
economic activities as carriers of economic growth, b) its inability to
register synergies and linkages21 and c) its inability to cope with innovationists and novelties, and
how differently these are distributed among economic activities. Together, these blind spots of present-day
mainstream economics prevent many poor countries from developing. The
successful ones, like China and India, have, both for more than fifty years,
followed the recommendations of the Marshall Plan: creating a division of
labour between urban and rural activities. Learning
is a key element in development, but learning may spread in the economy also
simply as falling prices to foreign consumers. The key insight of
Schumpeter’s student Hans Singer was that learning and technological change
in the production of raw materials, particularly in the absence of a
manufacturing sector, tend to lower export prices rather than to increase the
standard of living in the raw material producing nation.22
Learning tends to create wealth to producers only when they are part of that
finely knit network that was once called ‘industrialism’: a dynamic system of
economic activities subject to increasing productivity through technical
change and a large division of labour. The absence of increasing returns,
dynamic imperfect competition, and synergies in the raw material producing
countries are all part of the mechanisms that perpetuate poverty. Part of the
explanation is also that only ‘industrialism’ gives the necessary critical
mass and political clout to create the countervailing power of labour unions.
What the French Regulation School economists call ‘fordism’,
that workers’ pay raise parallel to productivity improvements, was an
important part of industrialism. Further
explorations along the mainstream route taken since 1990 are in my view
rapidly running into diminishing returns. Huge resources are employed by
well-intentioned governments along a largely sterile path of inquiry, a main
problem being that radically different alternative theoretical approaches are
not financed or explored. In my opinion the only way to raise the standard of
living in the poorest countries of the world is to follow the only successful
formula that ever worked, from England in 1485 to Europe and the Asian Tigers
in the 1960s and 70s and China today. This formula is included as Appendix 1.
The best social policy is to create development, not by the rich creating
subsidized reservations where the poor are kept, largely underemployed and
‘underproductive’. The Indian reservations in North America are sad examples
of a policy of the kind that subsidizes without changing productive
structures. In short, the Millennium Goals are in my view far too much biased
towards palliative economics rather than structural change, towards treating
the symptoms of poverty rather than its causes. I am not denying they could
be an unavoidable emergency measure under the present critical conditions,
but without confronting the deeper roots of the problem it is simply poor
social policy. Conclusion: Are we creating ‘welfare
colonialism’? Present policies run a risk of creating
serious imbalances between the efforts to create development and the
palliative efforts of aid. What we may be creating is a system that could be
described as ‘welfare colonialism’. This term was coined by anthropologist
Robert Paine to describe the economic integration of the native population in
Northern Canada.23 The
essential features of welfare colonialism are: 1) The often observed colonial
drain of the old days is reversed, the net flow of funds is to the colony
rather than to the mother country, and 2) the native population is integrated
in a way that radically changes their previous livelihood, and 3) they are
put on the dole. In Paine’s view, welfare colonialism
identifies welfare as the potential vehicle for a stable internal ‘governing
at a distance’ through the exercise of a particularly subtle,
‘non-demonstrative’ and dependency-generating form of neo-colonial social
control that pre-empts local autonomy through ‘well-intentioned’ and
‘generous’ – but ultimately ‘morally wrong’ – policies. Welfare colonialism
creates paralyzing dependencies on the ‘centre’ in a peripheral population, a
centre exerting control through incentives that create total economic
dependency, thus preventing political mobilization and autonomy. The social
conditions in which the native inhabitants of Arctic North America find
themselves today, show us that in their case the final effect of massive
transfer payments was to create a dystopia rather than a utopia. We already see aid and
transfers creating passivity and disincentives to work in poor nations. My
Haitian colleagues point to family transfer payments from the United States
creating disincentives to work for a going rate of 30 US cents an hour in
Haiti. A Brazilian research project on the highly laudable Zero Hunger
project, carried out at different government levels (national, state and
local) on different programs targeted to fight hunger, concludes that to a
large extent these projects are ineffective, since they treat symptoms of
poverty either by distributing food or by subsidizing food prices, rather
than creating situations where the poor are converted into breadwinners.24
These are welfare colonialism type effects: results of treating symptoms
rather than causes of poverty. The idea of nations
producing under increasing returns (industrialized nations) paying an annual
compensation to nations producing under constant or diminishing returns (raw
material producers) is not a new one. It is a logical conclusion from
standard trade theory once both increasing, constant, and diminishing returns
are included, and this recommendation – a forerunner of the Millennium
Strategy – is present already in a US college textbook from the 1970s.25
Until very recently, however, the favoured option was to industrialize the
poor countries, even if it meant that for a long time these industries would
not be competitive on the world market. Making free trade the linchpin of the
world economic system – one to which all other considerations must yield –
has made a type of welfare colonialism appear as the only option. We must
compensate the poor for the welfare loss from free trade, seems to be the
underlying idea. The other option, to develop the poor world, is not there
because we do not wish to abolish free trade as the core of the world
economic order. However, the long term and cumulative effects of having
groups of nations specializing in pre-industrial economic structures will be
staggering. In my view the policies successfully followed between 1485 and
the 1960s are – in spite of their being decidedly out of fashion – still the
better alternative. There are also
neo-classical tools that could be used with great benefits. The Washington
Institutions should stop using models assuming full employment also in
countries like Haiti, where only between 20 and 30 per of the potential
workforce have a job. By using shadow prices they will find back to the
original logic of the Bretton Woods Institutions
and their rules as they were interpreted in the 1950s and 60s, making
possible the reconstruction of Europe. This will mean that we temporarily must let the principle of
free trade yield to the principle of economic development and structural
change. Both after 1848 – in order
to solve the perennial ‘social question’ in Europe – and in 1947, political
pressure from the spectre of communism unleashed successful development
practices. Few are aware that Karl Marx stated that the only reason he was in
favour of free trade was that it hastened the revolution. In 1947, the free
traders in Washington had to yield to the political need for protectionist
development policy around the communist block. This Marshall Plan was a truly
astonishing success. It is perhaps a faint hope that today’s terrorist threat
will unleash a similar situation where free trade is temporarily abandoned in
order to create development as a political,
rather than as a social, goal. During
the Enlightenment, civilization and democracy were understood, through the
analysis of people like Montesquieu and Voltaire, as products of a specific type
of economic structure. We find the origins of this understanding already in
Francis Bacon more than 100 years earlier: ‘There is a startling
difference between the life of men in the most civilised province of Europe, and
in the wildest and most barbarous districts of New India. This difference
comes not from the soil, not from climate, not from race, but from the arts.’26 When
German economist Johan Jacob Meyen in 1770 stated ‘It is known that a primitive people does not
improve their customs and institutions later to find useful industries, but
the other way around’, he expressed something which could be considered
common sense at the time. We find the same idea – that civilisation is crated
by industrialisation – in the 19th century in thinkers across the
whole political spectrum from Abraham Lincoln to Karl Marx. Industrialisation
‘draws all, even the most barbarian, nations into civilization’ as Marx puts
it. We
ought to use our understanding of successful policies in past history, which
is the only laboratory economics has, in order to create something brand new
and adequate for solving today's challenges. We should attempt to create
something as brilliant and practical as did the visions and accompanying policy
recommendations of Alexander Hamilton and Abraham Lincoln, but firmly
grounded in an understanding of the present technological and historical
context. We ought to be as
enlightened again in understanding the connection between production and
civilization, by moving our theoretical focus away from trade and on to
production. Compared to Meyen’s statement above,
our present understanding has reversed the arrows of causality, and we
therefore risk creating an increasing number of failed states. We now ought
to focus on how differently technological development hits different economic
activities, creating huge variations in the windows of opportunity to
innovate, and how this makes it possible for nations to specialize in being
poor and uneducated. We should focus more on core issues like economies of
scale, scope, speed and specialization, on avoiding the negative effects of
diminishing returns and lock-in effects, on the assimilation of knowledge rather than the accumulation of capital,
on changing the economic structures of poor countries so they become more
like those of the rich ones. We should read not only Schumpeter on technical
change, but also Schumpeter’s essay on imperialism. Read not only Schumpeter
on ‘creative destruction’, but also open our eyes and minds to the type of
‘destructive destruction’ that can be observed. Appendix 1. ‘Mercantilist’ Economic Policies of the Generic Developmental State.…the fundamental things apply, as time
goes by. Sam, the pianist, in ‘Casablanca’. 1.
Observation
of wealth synergies clustered around increasing returns activities and
continuous mechanization in general. Recognition that ‘We are in the wrong
business’. Conscious targeting, support and protection of these
increasing returns activities. 2.
Temporary
monopolies/patents/protection given to targeted activities in a certain
geographical area. 3.
Recognizing
development as a synergetic phenomenon, and consequently the need for a
diversified manufacturing sector (‘maximizing the division of labor’, Serra 1613 +
observations of the Dutch Republic and Venice) 4.
Empirical
evidence accumulated showed that the manufacturing sector solves three policy
problems endemic to the Third World in one go: increasing national added
value (GDP), increasing employment, and solving balance of payment
problems. 5.
Attraction
of foreigners to work in the targeted activities (historically religious
prosecutions have been important) 6.
Relative
suppression of landed nobility (from Henry VII to Korea). (Physiocracy as a landowners’ rebellion against this
policy) 7.
Tax
breaks for targeted activities. 8.
Cheap
credits for targeted activities. 9.
Export
bounties for targeted activities. 10.
Strong
support for agricultural sector, in spite of this sector clearly being seen
as incapable of independently bringing the nation out of poverty. 11.
Emphasis
on learning/education (UK apprentice system under Elizabeth I, Child (1693) 12.
Patent
protection for valuable knowledge (Venice from 1490s) 13.
Frequent
export tax/export ban on raw materials in order to make raw materials more
expensive to competing nations (starting with Henry VII in late 1400s, whose
policy was very efficient in severely damaging the woolen
industry in Medici Florence). Source: Reinert
E. & S. ‘Mercantilism and
Economic Development: Schumpeterian Dynamics, Institution Building and
International Benchmarking’, in Jomo, K. S. and
Erik S. Reinert (editors), Origins of
Economic Development, London,
Zed Publications, forthcoming 2005. Endnotes 1. This paper was prepared
for the High-Level United Nations Development Conference on Millennium
Development Goals, New York, March 14 and 15, 2005. 2. This analysis is complicated by the fact that
wages and the income of the self-employed as a percentage of GDP are falling
in most countries, whereas the FIRE sector (finance, insurance, real state)
increases. In Norway this wage/self
employed share of GDP has been close to 70 per cent, in Peru it was around 23
per cent when the national statistical office stopped publishing this figure
in 1990. 3. Reinert, Erik S.
‘Diminishing Returns and Economic Sustainability: The dilemma of
resource-based economies under a free trade regime.’ Published in Hansen,
Stein, Jan Hesselberg and Helge
Hveem (Eds.), International
Trade Regulation, National Development Strategies and the Environment:
Towards Sustainable Development?, Oslo, Centre for Development and the Environment,
University of Oslo, 1996. 4. Schoenhof, J. The destructive influence of the Tariff
upon Manufacture and Commerce and the figures and facts relating thereto. New York, published for the New York Free
Trade Club, 1883. 5. Reinert, Erik ‘Raw Materials
in the History of Economic Policy; or, Why List (the Protectionist) and
Cobden (the Free Trader) Both Agreed on Free Trade in Corn.’, in Parry, G.
(editor), Freedom and Trade. 1846-1996.
London, Routledge, 1998. 6.See the works of Steven Kaplan, e.g. The Bakers of Paris and the Bread
Question, 1700-1775, Durham, Duke University Press, 1996. 7..This asymmetry is the core of te
argument in Frank Graham’s 1923 article, a basis for Krugman’s
New Trade Theory. 8.This discussion builds on a recent paper by Richard
Nelson, ‘Economic Development From the Perspective of Evolutionary Economic
Theory’, draft, Sept. 18, 2004. 9. Historical evidence for this practice in the
European theatre is found in my paper ‘Benchmarking Success: The Dutch Republic (1500-1750) as seen by
Contemporary European Economists’, in How Rich Nations got Rich.
Essays in the History of Economic Policy. Working Paper Nr. 1, 2004, SUM - Centre for
development and the Environment, University of Oslo. Downloadable on http://www.sum.uio.no/publications 10. At its core, the Enlightenment project was one of
ordering the world by creating taxonomies or classification systems, of which
that of Linnaeus is the best known. Neo-classical economics achieves its
analytical accuracy precisely because it lacks any taxonomy: everything is
qualitatively alike. Therefore its conclusions, like factor-price
equalization, are essentially already built into the assumptions. 11. See Kregel, Jan,
‘External Financing for Development and International Financial Stability, UNCTAD G-24 Discussion Paper Series , No. 32, October
2004. Downloadable at www.unctad.org 12. See e.g.
Raymond, Daniel, Thoughts on political economy,
Baltimore, Fielding Lucas, 1820. 13. I have showed this effect in ‘Globalisation in
the Periphery as a Morgenthau Plan: The
Underdevelopment of Mongolia in the 1990s’, in Reinert,
Erik (editor), Globalization, Economic Development and Inequality: An Alternative
Perspective, Cheltenham, Edward Elgar, 2004.
See also my paper ‘Increasing Poverty
in a Globalised World: Marshall Plans and Morgenthau Plans
as Mechanisms of Polarisation of World Incomes’, in Chang, Ha-Joon (editor), Rethinking Economic Development,
London, Anthem, 2003. 14.I am grateful to Carlota Perez for having
formulated this insight. 15. But not
necessarily falling GDP/capita. See footnote 1. 16. Anonymous (1786).
Relazione di una scorsa per varie
provincie d’Europa del M. M.... a Madama G.. in Parigi. Pavia: Nella Stamperia
del R. Im. Monastero di S. Salvatore. p. 31. I am grateful to Sophus Reinert for this
reference. 17. As imported and subsidized US food takes over
from local maize and wheat production. 18. Essentially within the same labour market. 19. Taussig, F.W. The Tariff
History of the United State, New York, Putnam’s, 1897, page 222. 20.That the steel tariff later got as high as 100 per
cent, was a result of technological change and rapidly falling prices in a
situation where the tariff was not based on value, but determined in dollars
per ton. 21. The slogan ‘get the national innovation systems
right’ proves an exception, because it does refer to a synergetic phenomenon.
However, this does not lead very far because of the theory’s inability to
recognize the different windows of opportunity for innovation in Microsoft,
under hugely increasing returns, and in a goat herding firm in Mongolia,
under critically diminishing returns.
In standard analysis Schumpeterian economics tends to be added like a
thin icing on a thoroughly neoclassical cake.
22. Singer, Hans W. ‘The Distribution of Gains
between Investing and Borrowing Countries’. In International Development:
Growth and Change.
McGraw-Hill, New York. 1964 (1950) 23. Paine, Robert (editor), The White Arctic. Anthropological Essays on Tutelage and Ethnicity, Institute
of Social and Economic Research,
Memorial University of Newfoundland, 1977. 24. Lavinas L and
Garcia E. (2004) Programas Sociais de
Combate à Fome. O legado dos anos de estabilização econômica,.Rio de
Janeiro, editora UFRJ/IPEA, Coleção Economia e Sociedade, 2004. 25. ‘Thus the country which eventually specializes
completely in the production of X (that is, the commodity whose production
function is characterized by increasing returns to scale) might agree to make
an income transfer (annually) to the other country, which agrees to
specialize completely in Y (that is, the commodity whose production function
is characterized by constant returns to scale’ (Chacholiades,
Miltiades, International
Trade Theory and Policy, New York, McGraw-Hill, 1978, p. 199; see also Reinert 1980) 26. Francis Bacon, Novum Organum,
1620. MA degree at Tallinn University on
Technology and Other Canon Economics ___________________________ |