Chapter 1 What is Economics
·
In the run-up to the 2008 financial crisis, the
majority of the economics profession was preaching to the world that markets
are rarely wrong and that modern economics has found ways to iron out those few
wrinkles that markets may have; Robert Lucas, the 1995 winner of the Nobel
Prize in Economics,* had declared in 2003 that the ‘problem of depression
prevention has been solved’. 1 So most economists were caught completely by
surprise by the 2008 global financial crisis.† Not only that, they have not
been able to come up with decent solutions to the ongoing aftermaths of that
crisis.
·
Physical money – be it a banknote, a gold coin
or the huge, virtually immovable stones that were used as money in some Pacific
islands – is only a symbol. Money is a symbol of what others in your society
owe you, or your claim on particular amounts of the society’s resources.
·
Your money – or the claims you have over
resources – may be generated in a number of different ways. And a lot of
economics is (or should be) about those. The most common way to get money –
unless you have been born into it – is to have a job (including being your own
boss) and earn money from it. So, a lot of economics is about jobs. We can
reflect on jobs from different perspectives . in order to understand jobs even
at the individual level, we need to know about skills, technological innovation
and international trade
·
Resources earned or transferred get consumed in
goods or services.
·
Ultimately goods and services have to be
produced
·
My belief is that economics should be defined
not in terms of its methodology, or theoretical approach, but in terms of its
subject matter, as is the case with all other disciplines. The subject matter
of economics should be the economy – which involves money, work, technology,
international trade, taxes and other things that have to do with the ways in
which we produce goods and services, distribute the incomes generated in the
process and consume the things thus produced
Chapter 2 Capitalism 1776 And 2014
·
What is the first ever thing written about in
economics? Gold? Land? Banking? Or international trade? The answer is the pin
·
Smith starts his book by arguing that the
ultimate source of increase in wealth lies in the increase in productivity
through greater division of labour, which refers to the division of production
processes into smaller, specialized parts. He argued that this increases
productivity in three ways
·
So what is the capitalist economy, or
capitalism? It is an economy in which production is organized in pursuit of
profit, rather than for own consumption (as in subsistence farming, where you
grow your own food) or for political obligations (as in feudal societies or in
socialist economies, where political authorities, respectively aristocrats and
the central planning authority, tell you what to produce).
·
Today’s owners in most large corporations have
only limited liabilities. In a limited liability company (LLC) or a public
limited company (PLC), if something goes wrong with the company, shareholders
only lose the money invested in their shares and that is that. In Smith’s time,
most company owners had unlimited liabilities, which meant that when the
business failed, they had to sell their own personal assets to pay back the
debts, failing which they ended up in a debtors’ prison.* Smith was against the
principle of limited liability. He argued that those who manage limited
liability companies without owning them are playing with ‘other people’s money’
(his phrase, and the title of a famous play and then 1991 movie, starring Danny
DeVito) and thus won’t be as vigilant in their management as those who have to
risk everything they have.
·
In Smith’s time, most people did not work for
capitalists as wage labourers. During this era, even many of those who worked
for capitalists were not wage labourers. There were still slaves around. Like
tractors or traction animals, slaves were means of production owned by
capitalists, especially the plantation owners in the American South, the
Caribbean, Brazil and elsewhere. It was two generations after the publication
of The Wealth of Nations (henceforth TWON) that slavery was abolished in
Britain (1833). It was nearly a century after TWON and after a bloody civil war
that slavery was abolished in the US (1862). Brazil abolished it only in 1888.
·
In Smith’s time, markets were largely local or
at most national in scope, except in key commodities that were traded
internationally (e.g., sugar, slaves or spices) or a limited range of
manufactured goods (e.g., silk, cotton and woollen clothes). These markets were
served by numerous small-scale firms, resulting in the state that economists
these days call perfect competition, in which no single seller can influence
the price. Today, most markets are populated, and often manipulated, by large
companies. Some of them are the only supplier (monopoly) or, more typically,
one of the few suppliers (oligopoly) – not just at the national level but
increasingly at the global level. Oligopolistic firms cannot manipulate their
markets as much as a monopolistic firm can, but they may deliberately collude
to maximize their profits by not undercutting each other’s prices – this is
known as a cartel.
·
We now take it for granted that countries have
only one bank that issues its notes (and coins) – that is, the central bank,
such as the US Federal Reserve Board or the Bank of Japan. In Europe in Adam
Smith’s day, most banks (and even some big merchants) issued their own notes.
These notes (or bills, if you are in the US) were not notes in the modern
sense. Each note was issued to a particular person, had a unique value and was
signed by the cashier issuing it. 8 It was only in 1759 that the Bank of
England started issuing fixed-denomination notes (the £10 note in this case –
the £5 note came only in 1793, three years after Adam Smith died). And it wasn’t
until two generations after Smith (in 1853) that fully printed notes, with no
name of the payee and no signature by issuing cashiers, were issued. But even
these fixed-denomination notes were not notes in the modern sense, as their
values were explicitly linked to precious metals like gold or silver that the
issuing bank possessed. This is known as the Gold (or Silver or other) Standard
Chapter 3 A
Brief History of Capitalism
·
Capitalism started in Western Europe, especially
in Britain and the Low Countries (what are Belgium and the Netherlands today)
around the sixteenth and the seventeenth centuries.
The Dawn of
Capitalism: 1500–1820
·
The Western European countries started to expand
rapidly outwards from the early fifteenth century. Euphemistically known as the
‘Age of Discovery’, this expansion involved expropriating land, resources and
people for labour from the native populations through colonialism. Colonialism
was run on capitalist principles. Symbolically, until 1858, British rule in
India was actually administered by a corporation (the East India Company), not
by the government. These colonies brought new resources to Europe.
1820–1870:
The Industrial Revolution
·
In poor areas of Manchester, life expectancy was
seventeen years 7 – 30 per cent lower than what it had been for the whole of
Britain before the Norman Conquest, back in 1000 (then twenty- four years). The
Luddites – textile artisans of England who lost their jobs to mechanized
production in the 1810s – turned to destroying the machines, the immediate
cause of their unemployment and the most obvious symbol of capitalist progress
·
At the end of this period, there were even the
beginnings of the welfare state, which started in Germany with the 1871
industrial accident insurance scheme, introduced by Otto von Bismarck, the
Chancellor of the newly united Germany.
·
The advancement of capitalism in the Western
European countries and their offshoots in the nineteenth century is often
attributed to the spread of free trade and free market. It is only because the
government in these countries, it is argued, did not tax or restrict
international trade (free trade) and, more generally, did not interfere in the
workings of the market (free market) that these countries could develop
capitalism.
·
Starting
with Henry VII (1485–1509), the Tudor monarchs promoted the woollen textile
industry – Europe’s then hi-tech industry, led by the Low Countries, especially
Flanders – through government intervention. Tariffs (taxes on imports)
protected the British producers from the superior Low Country producers.
British government intervention was stepped up in 1721, when Robert Walpole,
Britain’s first prime minister, 10 launched an ambitious and wide-ranging
industrial development programme. By the 1770s, Britain was so obviously ahead
of other countries that Adam Smith saw no need for protectionism and other
forms of government intervention to help British producers. However, it was
only nearly a century after Smith’s TWON – in 1860 – that Britain fully
switched to free trade, when its industrial supremacy was unquestioned
·
Free trade was not responsible for the rise of
capitalism, but it did spread throughout the nineteenth century. Some of it
happened in the heartland of capitalism in the 1860s – Britain’s adoption of
free trade and the signing of a series of bilateral free-trade agreements (or
FTAs). This was the result of something that you would not normally associate
with the word ‘free’ – that is, force, or at least the threat of using it
1870–1913: High Noon
· During its ‘high noon’, capitalism acquired the basic institutional shape that it has today – the limited liability company, bankruptcy law, the central bank, the welfare state, labour laws and so on. These institutional shifts came about basically because of the changes in underlying technologies and politics. Before the 1849 British reform, the bankruptcy law focused on punishing the bankrupt businessman, with a debtors’ prison in the worst case. With larger companies came larger banks. The risk was then heightened that the failure of one bank could destabilisze the whole financial system, so central banks were set up to deal with such problems by acting as the lender of last resort, starting with the Bank of England in 1844.
1914–45: The Turmoil
· The outbreak of the First World War in 1914 signalled the end of an era for capitalism. Some went even further and argued that capitalism had reached a stage in which it could not be sustained without continuous outward expansion, which has to come to an end sooner or later, marking the end of capitalism.
· By 1928, the Soviet Union had an economic system that was definitively not capitalist. It ran without private ownership of means of production, profit motives and markets. As for the other cornerstone of capitalism, wage labour, the picture was more complicated. Yes, in theory the Soviet workers were not wage labourers because they owned all the means of production – through state ownership or cooperatives. To everyone’s surprise, the early Soviet industrialization was a big success, most graphically proven by its ability to repel the Nazi advance on the Eastern Front during the Second World War.
· The Great Depression was an even more traumatic event for the believers in capitalism than the rise of socialism. This was especially the case in the US, where the Depression started (with the infamous 1929 Wall Street crash) and which was the hardest hit by the experience. Between 1929 and 1932, US output fell by 30 per cent and unemployment increased eightfold, from 3 per cent to 24 per cent. 16 It was not until 1937 that US output regained its 1929 level. Most importantly, studies show that the main reason for the collapse in international trade after 1929 was not tariff increases but the downward spiral in international demand, caused by the adherence by the governments of the core capitalist economies to the doctrine of balanced budget. the government is the only economic actor that can maintain the level of demand in the economy by spending more than it earns, that is, by running a budget deficit. However, in the days of the Great Depression, the strong belief in the doctrine of the balanced budget prevented such a course of action. The reforms were particularly widespread and far-reaching in the US, where the Depression was the greatest and lasted the longest. Sweden was another country where significant reforms were introduced
1945–73: The Golden Age of Capitalism
· The period between 1945, the end of the Second World War, and 1973, the first Oil Shock, is often called the ‘Golden Age of capitalism; Some point out that, after the Second World War, there was an unusually large pool of new technologies that were waiting to be exploited, which gave an impetus to growth in the Golden Age. The 1944 meeting of the Allies in the Second World War in the New Hampshire resort of Bretton Woods established two key institutions of the post-war international financial system, which are thus dubbed the Bretton Woods Institutions (BWIs) – the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), more commonly known as the World Bank. The most influential explanation of the Golden Age is, however, that it was mainly the result of reforms in economic policies and institutions that gave birth to the mixed economy – mixing positive features of capitalism and socialism.
· The Golden Age saw widespread decolonization. Starting with Korea in 1945 (which was then divided into North and South in 1948) and India (from which Pakistan separated) in 1947, most colonies gained independence. Upon independence, most post-colonial nations rejected the free-market and free-trade policies that had been imposed on them under colonialism. Some of them became outright socialist (China, North Korea, North Vietnam and Cuba), but most of them pursued state-led industrialization strategies while basically remaining capitalist. The strategy is known as the import substitution industrialization (ISI) strategy – so called because you are substituting imported manufactured goods with your own.
1973–9: The
Interregnum
·
The Golden Age started to unravel with the
suspension of US dollar–gold convertibility in 1971. In the Bretton Woods
system, the old Gold Standard was abandoned on the recognition that it made
macroeconomic management too rigid, as seen during the Great Depression. But
the system was still ultimately anchored in gold, because the US dollar, which
had fixed exchange rates with all the other major currencies, was freely
convertible to gold (at $35 per ounce). This, of course, was based on the
assumption that the dollar was ‘as good as gold’ – not an unreasonable
assumption when the US was producing about half of the world’s output and there
was an acute dollar shortage all around the world, as everyone wanted to buy
American things.
·
In 1971, the US dropped its commitment to
convert any dollar claims into gold, which led other countries to abandon the
practice of tying their national currencies to the dollar at fixed rates over
the next couple of years. This created instability in the world economy, with
currency values fluctuating according to market sentiments and becoming increasingly
subject to currency speculation (investors betting on currencies moving up or
down in value)
·
The Second Oil Shock in 1979 finished off the
Golden Age by bringing about another bout of high inflation and helping
neo-liberal governments come to power in the key capitalist countries,
especially in Britain and the US.
1980–Today: The
Rise and Fall of Neo-liberalism
·
A major turning point came with the election of
Margaret Thatcher as the British prime minister in 1979. Rejecting the
post-Second World War ‘wet’ Tory compromise with Labour, Thatcher began a
radical dismantling of the mixed economy, in the process earning the sobriquet
‘The Iron Lady’ for her uncompromising attitude
·
Ronald Reagan, the former actor and a former
governor of California, became the US president in 1981 and outdid Margaret
Thatcher. The Reagan government aggressively cut the higher income tax rates,
explaining that these cuts would give the rich greater incentives to invest and
create wealth, as they could keep more of the fruits of their investments. Once
they created more wealth, it was argued, the rich would spend more, creating
more jobs and incomes for everyone else; this is known as the trickle-down theory.
At the same time, subsidies to the poor (especially in housing) were cut and
the minimum wage frozen so that they had a greater incentive to work harder.
When you think about it, this was a curious logic – why do we need to make the
rich richer to make them work harder but make the poor poorer for the same
purpose? Curious or not, this logic, known as supply-side economics, became the
foundational belief of economic policy for the next three decades in the US –
and beyond.
·
The most lasting legacy of the high interest
rate policy in the US in the late 1970s and the early 1980s – sometimes called
the Volcker Shock, named after the then chairman of the US central bank (the
Federal Reserve Board) – was not in the US but in the developing countries. When
the US interest rates doubled, so did international interest rates, and this
led to a widespread default on foreign debts by developing nations, starting
with the default of Mexico in 1982. This is known as the Third World Debt
Crisis, thus known because the developing world was then called the Third
World, after the First World (the advanced capitalist world) and the Second
World (the socialist world). Facing economic crises, developing countries had
to resort to the Bretton Woods Institutions (the IMF and the World Bank, just
to remind you). The BWIs made it a condition that borrowing countries implement
the structural adjustment programme (SAP), which required shrinking the role of
the government in the economy by cutting its budget, privatizing SOEs and reducing
regulations, especially on international trade,.
·
The results of the SAP were extremely
disappointing, to say the least. Despite making all the necessary ‘structural’
reforms, most countries experienced dramatic growth slowdown in the 1980s and the
1990s. Per capita income growth rates in Latin America (including the
Caribbean) collapsed from 3.1 per cent in 1960–80 to 0.3 per cent in 1980–2000.
In Sub-Saharan Africa (SSA), per capita income fell during this period; in
2000, it was 13 per cent lower than in 1980. The result was an effective
arresting of the Third World Industrial Revolution, which is the name that Ajit
Singh, the Cambridge economist, used in order to describe the economic
development experience of developing countries in the first few decades
following decolonization. Third World
debt crisis and the end of the Third World Industrial Revolution
·
Then, in 1989, a momentous change happened. That
year, the Soviet Union started to unravel, and the Berlin Wall was torn down.
Germany was reunited (1990), and most Eastern European countries abandoned
communism. By 1991, the Soviet Union itself was dismembered. With China
gradually but surely opening up and liberalizing since 1978 and with Vietnam
(unified under the Communist rule in 1975) also adopting its ‘open door’ policy
(Doi Moi) in 1986, the socialist bloc was reduced to a few die-hard states,
notably North Korea and Cuba.
·
By the mid-1990s, neo-liberalism had spread
throughout the world’ In most countries, this happened rapidly due to the SAP,
but there were some others where it happened more gradually through voluntary
policy changes, such as in India. In 1995, the Uruguay Round of the GATT talks
was concluded, resulting in the expansion of the GATT into the WTO (World Trade
Organization). The WTO covers many more areas (e.g., intellectual property
rights, such as patents and trademarks, and trade in services) and has more
sanctioning power than the GATT did.
·
the Asian financial crisis
·
the 2008 global financial crisis
·
The ‘Keynesian spring’ and the return of the
free-market orthodoxy – with a vengeance : May 2010 was the turning point. The
election of the Conservative-led coalition government in the UK and the
imposition of the Eurozone bail-out programme for Greece in that month
signalled the comeback of the old balanced budget doctrine. Austerity budgets,
in which spending is cut radically, have been imposed in the UK and in the
so-called PIIGS economies (Portugal, Italy, Ireland, Greece and Spain).
·
Chapter
4 How to “DO” Economics ?
·
ECONOMICS
COCKTAILS
Ingredients: A, B, C, D, I, K, M, N and S
or Austrian, Behaviouralist, Classical, Developmentalist,
Institutionalist, Keynesian, Marxist, Neoclassical and Schumpeterian.
1.
On diverging views of the vitality and the
viability of capitalism, take CMSI.
2.
If you want to know why we sometimes need
government intervention, take NDK.
3.
To discover different ways of conceptualizing
the individual, take NAB.
4.
In order
to learn that there is a lot more to the economy than markets, take MIB.
5.
If you
want to see how groups, especially classes, are theorized, take CMKI.
6.
To study
how technologies develop and productivities rise, take CMDS.
7.
To understand economic systems, rather than just
their components, take MDKI.
8.
If you
want to find out why corporations exist and how they work, take SIB.
9.
If exploring how individuals and society
interact is your thing, take ANIB.
10.
For debates surrounding unemployment and
recession, take CK.
11.
For
various ways of defending the free market, take CAN.
The Classical School
·
One-sentence summary: The market keeps all
producers alert through competition, so leave it alone.
·
emerged
in the late eighteenth century and dominated the subject until the late nineteenth
century. Its founder is Adam Smith (1723–90), who we have discussed already.
Smith’s ideas were further developed in the early nineteenth century by three
near-contemporaries – David Ricardo (1772–1823), Jean-Baptiste Say (1767–1832),
and Robert Malthus (1766–1834).
·
The invisible hand, Say’s Law and free trade:
the key arguments of the Classical school :
According to the Classical school, the
pursuit of self-interests by individual economic actors produces a socially
beneficial outcome, in the form of maximum national wealth. This paradoxical
outcome is made possible by the power of competition in the market. In their
attempts to make profits, producers strive to supply cheaper and better things,
ultimately producing their products at the minimum possible costs, thus
maximizing national output. This idea is known as the invisible hand and has
become arguably the most influential metaphor in economics, although Smith
himself used it only once in The Wealth of Nations (TWON) and did not accord it
a prominent role in his theory. Most Classical economists believed in the
so-called Say’s Law, which states that supply creates its own demand. Ricardo
developed a new theory of international trade, known as the theory of
comparative advantage, further strengthening the argument for free trade. His
theory showed that, under certain assumptions, even when a country cannot
produce any product more cheaply than another country can, free trade between
them will allow both to maximize their output. The Classical school viewed the
capitalist economy as being made up of ‘three classes of the community’, in
Ricardo’s words – that is, capitalists, workers and landlords.
·
Ricardo’s theory of comparative advantage, while
having clear limitations as a static theory that takes a country’s technologies
as given, is still one of the best theories of international trade. It is more
realistic than the Neoclassical version, known as the Heckscher-Ohlin-Samuelson
theory (henceforth HOS), which is today the dominant version.* In HOS, it is
assumed that all countries are technologically and organizationally capable of
producing everything.
·
Some of the theories of the Classical school
were simply wrong. The school’s adherence to Say’s Law made it incapable of
dealing with macroeconomic problems, Its theory of the market at the
microeconomic level (namely, the level of individual economic actors) was also
severely limited. It did not have the theoretical tools to explain why
unrestrained competition in the market might not produce socially desirable
outcomes. A lot of ‘iron laws’ of Classical economics turned out to be no such
things. For example, the Classical economists thought that population pressure
would raise agricultural rents and squeeze industrial profits to such an extent
that investment might cease, because they did not – and could not – know how
much the technologies for food production and birth control would develop.
The Neoclassical School
·
One-sentence summary: Individuals know what they
are doing, so leave them alone – except when markets malfunction.
·
The Neoclassical school arose in the 1870s, from
the works of William Jevons (1835–82) and Leon Walras (1834–1910). It was
firmly established with the publication of Alfred Marshall’s Principles of
Economics in 1890. Around Marshall’s time, Neoclassical economists also
succeeded in changing the name of the discipline from the traditional
‘political economy’ to ‘economics’
·
Demand factors, individuals and exchanges:
differences with the Classical school :
Classical economists believed that the
value of a product is determined by supply conditions, that is, the costs of
its production. They measured the costs by the labour time expended in producing
it – this is known as the labour theory of value. Neoclassical economists
emphasized that the value (which they called the price) of a product also
depends on how much the product is valued by potential consumers; the fact that
something is difficult to produce does not mean that it is more valuable.
Marshall refined this idea by arguing that demand conditions matter more in
determining prices in the short run, when supply cannot be changed, while
supply conditions matter more in the long run, when more investments
(disinvestments) can be made in facilities to produce more (less) of what is
demanded more (less). The school conceptualized the economy as a collection of
rational and selfish individuals, rather than as a collection of distinct
classes, as the Classical school did. The Neoclassical school shifted the focus
of economics from production to consumption and exchange. For the Classical
school, especially Adam Smith, production was at the heart of the economic
system ,
·
Self-interested individuals and
self-equilibrating markets: similarities with the Classical school : Despite
these differences, the Neoclassical school inherited and developed two central
ideas of the Classical school. The first is the idea that economic actors are
driven by self-interest but that the competition in the market ensures that
their actions collectively produce a socially benign outcome. The other is the
idea that markets are self-equilibrating. The conclusion is, as in Classical
economics, that capitalism – or, rather, the market economy, as the school
prefers to call it – is a system that is best left alone, as it has a tendency
to revert to the equilibrium
·
Indeed, between the 1930s and the 1970s, many
Neoclassical economists were not free-market economists.
·
Precision and versatility: the strengths of
the Neoclassical school : It may be
very difficult for someone to be a ‘right-wing’ Marxist or a ‘left-wing’
Austrian, but there are many ‘left-wing’ Neoclassical economists, such as
Joseph Stiglitz and Paul Krugman, as well as very ‘right-wing’ ones, like James
Buchanan and Gary Becker.
·
Unrealistic individuals, over-acceptance of the
status quo and neglect of production: limitations of the Neoclassical school
The Marxist School
·
One-sentence summary: Capitalism is a powerful
vehicle for economic progress, but it will collapse, as private property
ownership becomes an obstacle to further progress.
·
Labour theory of value, classes, and production:
The Marxist school as the truer heir of the Classical school. In many ways, it
is truer to the Classical doctrine than the latter’s self-proclaimed successor,
the Neoclassical school. It adopted the labour theory of value, which was
explicitly rejected by the Neoclassical school. It also focused on production,
whereas consumption and exchange were the keys for the Neoclassical school. It
envisioned an economy comprised of classes rather than individuals – another
key idea of the Classical school rejected by the Neoclassical school.
·
Production at the centre of economics
·
Class struggle and the systemic collapse of
capitalism
·
Fatally flawed, but still useful: theories of
the firm, work, and technological progress
The Developmentalist Tradition
·
One-sentence summary: Backward economies can’t
develop if they leave things entirely to the market.
·
there is a tradition in economics that is even
older than the Classical school. It is what I call the Developmentalist
tradition, which started in the late sixteenth and the early seventeenth
centuries – two centuries or so before the Classical school. I don’t call the
Developmentalist tradition a school, because the latter term implies that there
are identifiable founders and followers, with clear core theories.
·
Raising productive capabilities to overcome
economic backwardness
·
Early strands in the Developmentalist tradition:
Mercantilism, the infant industry argument and the German historical school :
Although the policy practice started earlier (for example, under Henry
VII, who reigned between 1485 and 1509), theoretical writings in the
Developmentalist tradition started in the late sixteenth and the early
seventeenth centuries, with Renaissance Italian economists like Giovanni Botero
and Antonio Serra, who emphasized the need for promotion of manufacturing
activities by the government. The Developmentalist economists of the
seventeenth and eighteenth centuries – known as Mercantilists – are these days
typically portrayed as having been solely focused on generating trade surplus,
that is, the difference between your exports and imports when the former is
larger. The critical development came from Alexander Hamilton’s invention of
the infant industry argument, which we encountered in the last chapter.
Hamilton’s theory was further developed by the German economist Friedrich List,
who is these days often mistakenly known as the father of the infant industry
argument. 11 Alongside List, in the midnineteenth century, the German
Historical school emerged and dominated German economics until the
mid-twentieth century. It also heavily influenced American economics.
·
The Developmentalist tradition in the modern
world: Development Economics :
The Developmentalist tradition was advanced
in its modern form in the 1950s and the 1960s by economists such as, in
alphabetical order, Albert Hirschman (1915–2012), Simon Kuznets (1901–85),
Arthur Lewis (1915–91) and Gunnar Myrdal (1899–87) – this time, under the
rubric of Development Economics
The Austrian School
·
One-sentence summary: No one knows enough, so
leave everyone alone.
·
Not all Neoclassical economists are free-market
economists. Nor are all free-market economists Neoclassical. The adherents of
the Austrian school are even more ardent supporters of the free market than
most followers of the Neoclassical school
·
The Austrian school was started by Carl Menger
(1840–1921) in the late nineteenth century. Ludwig von Mises (1881–1973) and
Friedrich von Hayek (1899–1992) extended the school’s influence beyond its
homeland. It gained international attention during the so-called Calculation Debate
in the 1920s and the 1930s, in which it battled the Marxists on the feasibility
of central planning. 14 In 1944, Hayek published an extremely influential
popular book, The Road to Serfdom, which passionately warned against the danger
of government intervention leading to the loss of fundamental individual
liberty
·
Complexity and limited rationality: the Austrian
defence of the free market :
While emphasizing the importance of
individuals, the Austrian school does not believe that individuals are atomistic
rational beings, as assumed in Neoclassical economics. It sees human
rationality as severely limited. It argues that rational behaviour is only
possible because we humans voluntarily, if subconsciously, limit our choices by
unquestioningly accepting social norms – ‘custom and tradition stand between
instinct and reason’, Hayek intoned. The Austrian school also argues that the
world is highly complex and uncertain. As its members pointed out in the
Calculation Debate, it is impossible for anyone – even the all-powerful central
planning authority of a socialist country that can demand any information it
wants from anyone – to acquire all the information needed to run a complex
economy. It is only through the spontaneous order of the competitive market that
the diverse and ever-changing plans of numerous economic actors, responding to
unpredictable and complex shifts of the world, can be reconciled with each
other.
·
Spontaneous vs. constructed order: limits to the
Austrian argument :
The Austrian school is absolutely right in
saying that we may be better off relying on the spontaneous order of the market
because our ability to deliberately create order is limited. But capitalism is
full of deliberately ‘constructed orders’, such as the limited liability company,
the central bank or intellectual property laws, which did not exist until the
late nineteenth century. The diversity of institutional arrangements – and the
resulting differences in economic performances – between different capitalist
economies is also in large part the result of deliberate construction, rather
than spontaneous emergence, of order. The Austrian position against government
intervention is too extreme. Their view is that any government intervention
other than the provision of law and order, especially protection of private
property, will launch the society on to a slippery slope down to socialism – a
view most explicitly advanced in Hayek’s The Road to Serfdom. This is not
theoretically convincing; nor has it been borne out by history.
The (Neo-)Schumpeterian School
·
One-sentence summary: Capitalism is a powerful
vehicle of economic progress, but it will atrophy, as firms become larger and
more bureaucratic.
·
Joseph Schumpeter (1883–1950) is not one of the
biggest names in the history of economics. But his thoughts were original
enough to have a whole school named after him – the Schumpeterian, or
neoSchumpeterian, school.* (Not even Adam Smith has a school named after him.)
Like the Austrians, Schumpeter worked under the shadow of the Marxist school –
so much so that the first four chapters of his magnum opus, Capitalism,
Socialism, and Democracy (henceforth CSD), published in 1942, are devoted to
Marx. 17 Joan Robinson, the famous Keynesian economist, once famously quipped
that Schumpeter was just ‘Marx with the adjectives changed’.
·
Gales of creative destruction: Schumpeter’s
theory of capitalist development :
Schumpeter developed Marx’s emphasis on the
role of technological development as the driving force of capitalism. He argued
that competition through innovation is ‘as much more effective than [price
competition] as a bombardment is in comparison with forcing a door’. He argued
that no firm, however entrenched it may look, is safe from these ‘gales of
creative destruction’ in the long run.
·
Despite being such a believer in the dynamism of
capitalism, Schumpeter was not optimistic about its future. With the
bureaucratization of the management of its firms, capitalism would lose its
dynamism, which ultimately rests on the vision and the drive of charismatic
heroes called entrepreneurs. Capitalism would slowly wither away and morph into
socialism, rather than meeting the violent death predicted by Marx.
·
Having failed to appreciate the role of all
these ‘other guys’ in the innovation process, Schumpeter came to the mistaken
conclusion that the diminishing room for individual entrepreneurs will make
capitalism less dynamic and atrophy.
The Keynesian School
·
One-sentence summary: What is good for
individuals may not be good for the whole economy
·
Before Keynes, most people agreed with Adam
Smith when he said, ‘What is prudence in the conduct of every private family
can scarce be folly in that of a great kingdom.’ And some people still do.
David Cameron, the British prime minister, said in October 2011 that all
Britons should try to pay off their credit card debts, without realizing that
demand in the British economy would collapse if a sufficient number of people
actually heeded his advice and reduced spending to pay off their debts. He
simply did not understand that one person’s spending is another’s income –
until he was forced by his advisors to withdraw the embarrassing remark.
Rejecting this view, Keynes sought to explain how there could be unemployed
workers, idle factories and unsold products for prolonged periods when markets
are supposed to equate supply and demand.
·
Why is there unemployment?: the Keynesian
explanation
Keynes started from the obvious observation
that an economy doesn’t consume all that it produces. The difference – that is,
savings – needs to be invested, if everything that has been produced is to be
sold and if all productive inputs, including the labour service of workers, are
to be employed (this is known as full employment). Unfortunately, there is no
guarantee that savings will equal investment, especially when those who invest
and those who save are not one and the same, unlike in the early days of
capitalism, when capitalists mostly invested out of their own savings and
workers could not save, given their low wages. This is because investment,
whose returns are not immediate, is dependent on investors’ expectations about
the future. In turn, these expectations are driven by psychological factors
rather than rational calculation because the future is full of uncertainty.
·
Active fiscal policy for full employment: the
Keynesian solution :
In an uncertain world, investors may
suddenly become pessimistic about the future and reduce their investments. In
such a situation, there will be more savings than are needed – there will be,
in technical terms, a ‘savings glut’. The Classical economists thought this
glut would be sooner or later eliminated, as the lower demand for savings would
drive the interest rate (that is, the price of borrowing, if you like) down,
making investments more attractive. Keynes argued that this does not happen. As
investment falls, overall spending falls, which then reduces income, as one
person’s spending is another’s income. A reduction in income in turn reduces
savings, as savings are essentially what are left after consumption (which
tends not to change much in response to a fall in income, being determined by
our survival necessities and habit). In the end, savings will contract to match
the now lower investment demand. If excess savings are reduced in this way,
there will be no downward pressure on interest rates and thus no extra stimulus
for investment. The normal state of affairs, in his view, would be that
investment is equated to savings at a level of effective demand (the demand that
is actually backed up by purchasing power) that is insufficient to support full
employment. In order to achieve full employment, Keynes argued, the government
therefore has to use its spending actively to prop up the level of demand.
·
Money gets a real job in economics: the
Keynesian theory of finance
The
prevalence of uncertainty in Keynesian economics means that money is not simply
an accounting unit or merely a convenient medium of exchange, as the Classical
(and the Neoclassical) school thought. It is a means to provide liquidity (or
the means to quickly change one’s financial position) in an uncertain world.
Given this, the financial market is not just a
means to provide money to invest but also a place to make money by taking
advantage of the differences among people’s views about returns on the same
investment projects – in other words, a place for speculation
·
Keynes was absolutely right in emphasizing that
we cannot run economic policies on the hope that in the long run the
‘fundamental’ forces, such as technology and demography, will somehow sort
everything out, as the Classical economists used to argue. Nevertheless, its
focus on short-run macroeconomic variables has made the Keynesian school rather
weak on long-term issues, such as technological progress and institutional
changes.
The Institutionalist School – Old and
New?
·
One-sentence summary: Individuals are products
of their society, even though they may change its rules.
·
From the late nineteenth century, a group of
American economists challenged the then dominant Classical and Neoclassical
schools for underplaying, or even ignoring, the social nature of individuals –
that is, the fact that they are products of their societies. The emergence of
the Institutionalist school can be traced back to Thorstein Veblen (1857–1929),
who made his name for questioning the notion of the rational, self-seeking
individual. Taking inspiration from Veblen’s emphasis on institutions, but also
drawing, overtly and covertly, from Marxism and the German Historical school, a
new generation of American economists emerged in the early twentieth century to
establish a distinctive economic school. The school was officially proclaimed
as the Institutionalist school in 1918 with Veblen’s blessing, under the
leadership of Wesley Mitchell (1874–1948), Veblen’s student and the then leader
of the group . Institutional economists, such as Arthur Burns (chairman of the
Council of Economic Advisors to the US President, 1953–6; then chairman of the
Federal Reserve Board, 1970–78), played important parts in the making of US
economic policy even after the Second World War.
·
Individuals are not fully determined by society:
the decline of the Institutionalist school After the 1960s, the
Institutionalist school went into decline. Part of this was due to the rise of
Neoclassical economics in the US in the 1950s
·
Transaction costs and institutions: the rise
of the New Institutional Economics :
From the 1980s, a group of
economists with Neoclassical and Austrian leanings – led by Douglass North,
Ronald Coase and Oliver Williamson – started a new school of institutional
economics, known as the New Institutional Economics (NIE). The main point of departure
from the OIE was that the NIE analysed how institutions emerge out of
deliberate choices by individuals. The key concept in the NIE is that of
transaction cost. In Neoclassical economics, the only cost is the cost of
production (costs of material, wages, etc.). However, the NIE emphasizes that
there are also costs of organizing our economic activities.
·
Institutions are not just constraints:
contributions and limitations of the New Institutional Economics:
Despite these very important contributions,
the NIE has a critical limit as an ‘institutionalist’ theory. It sees
institutions basically as constraints – on unfettered self-seeking behaviour.
But institutions are not just ‘constraining’ but can also be ‘enabling’.
The Behaviouralist School
·
One-sentence summary: We are not smart enough,
so we need to deliberately constrain our own freedom of choice through rules.
·
The Behaviouralist school is the youngest of the
schools of economics that we have so far examined, but it is older than most
people think. The school has recently come to prominence through the fields of
behavioural finance and experimental economics. But it has its origins in the
1940s and the 1950s, especially in the works of Herbert Simon (1916–2001), the
1978 Nobel economics laureate.*
·
Limits to human rationality and the need for
individual and social rules :
Simon’s central concept is bounded
rationality. He criticizes the Neoclassical school for assuming that people
possess unlimited capabilities to process information, or God-like rationality
(he calls it ‘Olympian rationality’). Simon did not argue that human beings are
irrational
·
Market economy vs. organization economy :
Adopting the Behaviouralist perspective, we
begin to see our economy in a way that is very different from the dominant
Neoclassical one. The Neoclassical economists usually describe the modern
capitalist economy as the ‘market economy’. The Behaviouralists emphasize that
the market actually accounts for only a rather small part of it. Herbert Simon,
writing in the mid-1990s, reckoned that something like 80 per cent of economic
activities in the US happen inside organizations, such as the firm and the
government, rather than through the market. 26 He argued that it would be more
appropriate to call it the organization economy.
·
The Behaviouralist school also provides
persuasive reasons as to why human qualities like emotion, loyalty and fairness
matter – things that most economists, especially the Neoclassicals and the
Marxists, would dismiss as at best irrelevant and at worst as distracting
people from rational decisions.
·
The Behaviouralist school, despite being the
youngest school of economics, has helped us radically rethink our theories
about human rationality and motivations. The Behaviouralist school’s attempt to
understand human society from individuals up – actually from a place ‘lower’
than that, that is, from our thinking process up – is both its strength and its
weakness. Focusing too much at this ‘micro’ level, the school often loses sight
of the bigger economic system.
Chapter 5 Who are the economic actors ?
·
‘There is no such thing as society. There are
individual men and women, and there are families.’ - MARGARET THATCHER
‘The corporations don’t have to lobby the
government any more. They are the government.’ - JIM HIGHTOWER
Individuals as Heroes and Heroines
·
The dominant Neoclassical view is that economics
is the ‘science of choice’. As a consumer, each individual has a self-generated
preference system that specifies what she likes. Using the preference system
and looking at market prices of different things, she chooses a combination of
goods and services that maximize her utility. When aggregated through the
market mechanism, the choices made by individual consumers tell the producers
what the demands are for their products at different prices (the demand curve).
The quantity that the producers are willing to supply at each price (the supply
curve) is determined by their own rational choices, made with a view to
maximizing their profits. In making these choices, producers consider costs of
production, given by technologies specifying different possible combinations of
inputs, and the prices of those inputs. The market equilibrium is attained
where the demand curve and the supply curve meet.
Organizations as the Real Heroes: The
Reality of Economic Decision-making
·
Some economists, most notably Herbert Simon and
John Kenneth Galbraith, have looked at the reality, rather than the ideal, of
economic decision-making. They found the individualistic vision to have been
obsolete at least since the late nineteenth century. Since then, most important
economic actions in our economies have been undertaken not by individuals but
by large organizations with complex internal decision-making structures –
corporations, governments, trade unions and increasingly even international
organizations.
·
The most important producers today are large
corporations, employing hundreds of thousands, or even millions, of workers in
dozens of countries. The 200 largest corporations between themselves produce
around 10 per cent of the world’s output. It is estimated that 30–50 per cent
of international trade in manufactured goods is actually intra-firm trade, or
transfer of inputs and outputs within the same multinational corporation (MNC)
or transnational corporation (TNC), with operations in multiple countries. 1
The Toyota engine factory in Chonburi, Thailand, ‘selling’ its outputs to Toyota
assembly factories in Japan or Pakistan may be counted as Thailand’s export to
the latter countries, but these are not genuine market transactions. The prices
of the products thus traded are dictated by the headquarters in Japan, not by
competitive forces of the market.
·
At the root of corporate decisions lie
shareholders. Typically we say that shareholders ‘own’ corporations. Even
though it would do as a shorthand description, it is, strictly speaking, not
true. These days, few very large companies are majority-owned by a single
shareholder, like the capitalists of old. The Porsche-Piech family, which owns
just over 50 per cent of the Porsche-Volkswagen group, is a notable exception.
Most large companies don’t have one controlling shareholder. Their (share)
ownership is so dispersed that no single shareholder has effective control .
Dispersed ownership means that professional managers have effective control
over most of the world’s largest companies, despite not owning any significant
stake in them – a situation known as the separation of ownership and control.
This creates a principal-agent problem, in which the agents (professional
managers) may pursue business practices that promote their own interests rather
than those of their principals (shareholders). That is, professional managers
may maximize sales rather than profit or may inflate the corporate bureaucracy,
as their prestige is positively related to the size of the company they manage
(usually measured by sales) and the size of their entourage. This was the kind
of practice Gordon Gekko (you’ve met him in Chapter 3) was attacking in Wall
Street, when he pointed out the company that he was trying to take over had no
less than thirty-three vice presidents, doing God knows what.
·
In addition to trade union activities (which
we’ll explore below), workers in some European countries, such as Germany and
Sweden, influence what their companies do through formal representation on
company boards. In particular in Germany, large companies have a two-tier board
structure. Under this system, known as the co-determination system, the
‘managerial board’ (like the board of directors in other countries) has to get
the most important decisions, such as merger and plant closure, approved by the
‘supervisor board’, in which worker representatives have half the votes, even
though the managerial side appoints the chairman, who has the casting vote.
·
In a
number of European countries – Sweden, Finland, Norway, Iceland, Austria,
Germany, Ireland and the Netherlands – trade unions are explicitly recognized
as key partners in national-level decisionmaking. In those countries, they are
involved in policy-making not just in ‘obvious’ areas like wages, working
conditions and training, but also welfare policy, inflation control and industrial
restructuring
·
The World Bank, the IMF and other similar
multilateral financial institutions demand the adoption of particular economic
policies of their borrowing countries. Admittedly, all lenders attach
conditions to their loans, but the World Bank and the IMF are particularly
criticized for imposing conditions that the rich countries think are good,
rather than those that would really help the borrowing countries. This happens
because they are corporations with one-dollar-one-vote rule. The majority of
their shares are owned by the rich countries, so they get to decide what to do.
Most importantly, the US has de facto veto power in the Bank and the Fund, as
the most important decisions in them require an 85 per cent majority, and the
US happens to own 18 per cent of shares.
·
The multiple-self problem shows that individuals
are not atoms because they can be broken down further. They are not atoms also
because they are not clearly separable from other individuals. Economists
working in the individualist tradition do not ask where individual preferences
come from.
·
Individualist economic theories assume that
individuals are selfish. When combined with the assumption of rationality, the
conclusion is that we should let individuals do as they please; they know what
is best for themselves and how to achieve their goals
·
Individualist economic theories assume
individuals to be rational – that is, they know all possible states of the
world in the future, make complicated calculations about the likelihood of each
of these states and exactly know their preferences over them, thereby choosing
the best possible course of action on each and every decision occasion. Once
again, the implication is that we should let people be, because ‘they know what
they are doing’. The individualist economic model assumes the kind of
rationality that no one possesses – Herbert Simon called it ‘Olympian
rationality’ or ‘hyper-rationality’. The standard defence is that it does not
matter whether a theory’s underlying assumptions are realistic or not, so long
as the model predicts events accurately. This kind of defence rings hollow
these days, when an economic theory assuming hyperrationality, known as the
Efficient Market Hypothesis (EMH), played a key role in the making of the 2008
global financial crisis by making policy-makers believe that financial markets
needed no regulation. The problem is, simply put, that human beings are not
very rational – or that they possess only bounded rationality.*
Chapter 6 Output, Income and Happiness
Output
·
The economists’ favoured measure for output is
Gross Domestic Product, or GDP. It is, roughly speaking, the total monetary
value of what has been produced within a country over a particular period of
time – usually a year, but also a quarter (three months) or even a month. I
said ‘roughly’, because ‘what has been produced’ needs definition. In
calculating GDP, we measure output – or product – by value added. Value added
is the value of a producer’s output minus the intermediate inputs it has used.
A bakery may earn £150,000 a year by selling bread and pastries, but if it has
paid £100,000 in order to buy various intermediate inputs – raw materials
(e.g., flour, butter, eggs, sugar), fuel, electricity and so on – it has only
added £50,000 of value to those inputs. If we didn’t take away the value of the
intermediate inputs and simply added up the final outputs of all the producers,
we would be double-, triple- and multiple-counting some components, inflating
the actual output. What about the ‘Gross’ bit in GDP? It means that we still
have not taken away something that could have been removed from the picture, as
when a can of tuna specifies gross weight and net weight (that is, the weight
of the fish without the oil or brine). In this case, that something is the
used-up parts of capital goods – basically machines, so we are talking the
baker’s ovens, dough mixers and bread slicers. Capital goods, or machines, are
not ‘consumed’ and incorporated into the output in the same way in which flour
is to bread, but they experience reduction in economic value with use – this is
known as depreciation. If we take away the wear and tear of machines from GDP,
we get Net Domestic Product, or NDP.
·
As NDP accounts for everything that has gone
into producing the output – intermediate inputs and capital-goods inputs – it
provides a more accurate picture of what the economy has produced than GDP
does. But we tend to use GDP instead of NDP because there is no one agreed way
of estimating depreciation (suffice it to say here there are several contending
ways), which makes the definition of N in NDP quite tricky. Then how about D in
GDP? ‘Domestic’ here means being within the boundary of a country. Not all
producers in a country are its own citizens or companies registered in it.
·
Seen from the other side, not all producers
produce in their home countries; companies run factories abroad, and people get
jobs in foreign countries. The number that measures all the output produced by
your nationals (including companies), rather than the output produced within
your border, is called Gross National Product, or GNP.
·
GDP is more frequently used than GNP, since, in
the short run, it is the more accurate indicator of the level of productive activities
within a country. But GNP is a better measure of an economy’s long-term
strength. A country may have a higher GDP (GNP) than another, but that may be
because it has a larger population than the other. So, we really need to look
at GDP or GNP figures per capita (per head, or per person, if you like) if we
want to know how productive the economy is – it is actually somewhat more
complicated than that, but we can leave this aside; if you are interested, read
the footnote.
·
A critical limitation of GDP and GNP measures is
that they value outputs at market prices. Since a lot of economic activities
occur outside the market, the values of their outputs need to be somehow
calculated – ‘imputed’ is the technical word. Worse, there is a particular
class of non-marketed output whose value isn’t even imputed. Household work –
including cooking, cleaning, care work for children and elderly relatives and
so on – is simply not counted as part of GDP or GNP. The classic ‘joke’ among
economists is that you reduce your national output if you marry your
housekeeper.
Income
·
GDP may be seen as a sum of incomes, rather than
outputs, as everyone who is involved in the production activity is paid for
his/her contribution (whether the amounts paid are ‘fair’ is another matter). In
theory, GDI should be identical to GDP, as it is simply a different way of
adding up the same thing. But in practice it is slightly different, as some of
the data used in compiling the two of them may be collected through different
channels.
·
Like GNP is to GDP, Gross National Income, or
GNI, is to GDI. GNI is the result of adding up the incomes of a country’s
citizens, rather than the incomes of those who are producing within its border,
which gives us GDI
·
The problem is that market exchange rates are
largely determined by the supply and demand for internationally traded goods
and services, such as the Galaxy phones or international banking services,
while what a sum of money can buy in a particular country is determined by the
prices of all goods and services, including those that are not internationally
traded, such as eating out or taking a taxi.
To deal with this problem, economists have come up with the idea of an
‘international dollar’. Based on the notion of purchasing power parity (PPP) – that
is, measuring the value of a currency according to how much of a common set of
goods and services (known as the ‘consumption basket’) it can buy in different
countries – this fictitious currency allows us to convert incomes of different
countries into a common measure of living standards.
·
Even if we are totally rational as consumers,
the existence of positional goods makes income an unreliable gauge of true
living standard (or happiness, satisfaction or what you will). 2 Positional
goods are goods whose values derive from the fact that only a small proportion
of potential consumers can have them
Happiness
·
Richard Layard, the British economist who is a
leading scholar trying to measure happiness, defends such attempts by saying,
‘If you think something matters you should try to measure it [italics added].’
3 But other people disagree – including Albert Einstein, who once famously
said, ‘Not everything that counts can be measured. Not everything that can be
measured counts.’
·
Adaptive preference and false consciousness: why
we cannot totally rely on people’s judgements on their own happiness
·
e Better Life Index, launched in 2011 by the
OECD. This index looks at people’s subjective judgements on life satisfaction,
together with ten other more (although not completely) objective indicators,
ranging from income and jobs to community life and work–life balance (and each
of these indicators has more than one constituent element).
Chapter 7 The World Of Production
Economic Growth and Economic Development
·
Over the last couple of decades, it has been one
of the fastest-growing economies in the world. Between 1995 and 2010, its per
capita GDP grew at the rate of 18.6 per cent per year – more than double the
rate in China, the international growth superstar, which grew at ‘only’ 9.1 per
cent per year. But most people do not take Equatorial Guinea’s phenomenal
income growth seriously mainly because it is due to a resource bonanza. Nothing
about the country’s economy changed other than finding a very large oil reserve
in 1996. What makes Equatorial Guinea different from those other cases is that
its growth has not been achieved through an increase in its ability to produce.
Equatorial Guinea not only cannot produce much else than oil, it does not even
possess the ability to produce oil itself – its oil is all pumped out by
American oil companies. While it is an extreme example, Equatorial Guinea’s
experience powerfully illustrates how economic growth, that is, the expansion
in the output (or income) of the economy, is not the same as economic
development. There is no universally agreed definition of economic development.
But I define it as a process of economic growth that is based on the increase
in an economy’s productive capabilities: its capabilities to organize – and,
more importantly, transform – its production activities.
·
After Germany and Britain developed technologies
to synthesize natural chemicals in the mid-nineteenth century, some countries
saw dramatic falls in their incomes. Guatemala used to earn quite a lot of
money by being the main producer of cochineal (cochinilla), the crimson dye
favoured by the Pope and the European royalties for their robes, until the
invention of the artificial dye alizarin crimson. The Chilean economy was
plunged into years of crisis when the Haber–Bosch process was developed in the
early twentieth century to manufacture chemical substitutes for saltpetre
(nitrate), the country’s main export at the time.
·
Changes in technologies are at the root of
economic development
·
In the early nineteenth century, factory
productivity was further raised by lining up the workers in accordance with the
order of their tasks within the production process. The assembly line was born.
In the late nineteenth century, the assembly line was put on a conveyor belt.
The moving assembly line made it possible for capitalists to increase the pace
of work simply by turning up the speed of the conveyor belt.
·
In
addition to organizing the flow of work more efficiently, attempts have been
made to make workers themselves more efficient. The most important in this
regard was Taylorism, named after Frederick Winslow Taylor (1856–1915), the
American engineer and later management guru. Taylor argued that the production
process should be divided up into the simplest possible tasks and that workers
should be taught the most effective ways to perform them, established through
scientific analyses of the work process. It is also known as scientific
management for this reason. Combining the moving assembly line with the
Taylorist principle, the mass production system was born in the early years of
the twentieth century. It is often called Fordism because it was first
perfected – but not ‘invented’, as the folklore goes – by Henry Ford in his
Model-T car factory in 1908. The idea is that production costs can be cut by
producing a large volume of standardized products, using standardized parts,
dedicated machinery and a moving assembly line. This would also make workers
more easily replaceable and thus easier to control, because, performing
standardized tasks, they need to have relatively few skills. When the mass
production system was widely adopted in the US and Europe after the Second
World War, rising wages expanded markets, which then enabled production at a
higher volume, which then increased productivity further by spreading the fixed
costs (of installing the production facilities) over a larger volume. The mass
production system was so effective that even the Soviet Union was attracted to
it. In the beginning, there was a huge debate there about its adoption because
of its obvious ‘anti-worker’ implications. It destroys the intrinsic value of
work by making it simplistic and repetitive, while vastly reducing the worker’s
control over his/her labour process; standardized tasks make the monitoring of
workers easier while the intensity of work can be easily increased by
accelerating the assembly line. In the end, the efficiency of the system was so
overwhelming that the Soviet planners decided to import it.
·
The mass production system, a century after its
invention, still forms the backbone of our production system. But since the
1980s it has been taken to another level by the so-called lean production
system, first developed in Japan. The system, most famously practised by
Toyota, has its parts delivered ‘just in time’ for the production, eliminating
inventory costs. By working with the suppliers to raise the quality of the
parts they deliver (the so-called ‘zero defect movement’), it vastly reduces
the need for rework and fine-tuning at the end of the assembly line which had
plagued Fordist factories. Unlike the Fordist system, the Toyota system does
not treat workers as interchangeable parts. It equips workers with multiple
skills and allows them to exercise a lot of initiative in deciding work
arrangements and suggesting minor technological improvements.
·
But, if you are comparing different economies
over a relatively long period of time, it is important that you use per capita
growth rates. Between 2000 and 2010, GDP grew at the rate of 1.6 per cent in
the US and 1.0 per cent in Germany. With these figures, you may think that the
US has done substantially better than Germany. However, during the same period
population grew at the rate of 0.9 per cent in the US and -0.1 per cent in
Germany. This means that Germany has actually done better in per capita terms –
1.1 per cent per year growth rate as opposed to 0.7 per cent in the US.
·
The growth rates we use are compound rates (or
exponential rates), meaning that the increased output of every year (or quarter
or whatever period is the unit of measurement) is added to the existing output.
The use of compound rate means that what may seem to be a relatively small
difference in growth rates can create a large gap, if sustained over a
sufficiently long period of time.
·
Share of investment in GDP is the key indicator
of how a country is developing : In order to be used, most technologies have to
be embodied in fixed capital, namely, machines and structures (e.g., buildings,
railways). So, without high investment in fixed capital, technically known as
gross fixed capital formation (GFCF),* an economy cannot develop its productive
potential very much. Thus, the investment ratio (GFCF/GDP) is a good indicator
of its development potential. The investment ratio went above 35 per cent in
Japan in the late 1960s and the early 1970s. During its ‘miracle’ growth period
since the 1980s, China’s investment rate has been 30 per cent and above, going
above 40 per cent in the last decade.
·
The R&D figure is a good indicator for the
richer countries
Industrialization and
Deindustrialization
·
The manufacturing sector has been the ‘learning
centre’ of capitalism. By supplying capital goods (e.g., machines, transport equipment),
it has spread higher productive capabilities to other sectors of the economy,
whether they are other manufacturing activities producing consumer goods (e.g.,
washing machines, breakfast cereals), agriculture or services.
·
It has recently become fashionable to argue that
the manufacturing sector does not matter very much any more, as we have entered
the era of post-industrial society. In the early days of industrialization,
many assumed that the manufacturing sector would keep growing. And for a long
time, it looked to be the case. The share of manufacturing both in output and
in employment was almost constantly rising in most countries. However, from the
1960s, some countries started experiencing deindustrialization – a fall in the
share of manufacturing, and a corresponding rise in the share of services, in
both output and employment. This prompted the talk of a post-industrial
society. This view got a boost in the 1990s, with the invention of the
worldwide web and the alleged rise of the ‘knowledge economy’. But the 2008
crisis was a rude reminder that a lot of this faith in services as the new
engine of growth has been illusory.
·
Until the late nineteenth century, agriculture
was the mainstay of the economy in almost all countries. Even in many of today’s rich countries,
nearly three-quarters of people worked in agriculture until a few generations
ago. Today, agriculture plays a very small role, in terms of both output and
employment, in the rich countries. Only 1–2 per cent of their GDP is produced
in agriculture, while only 2–3 per cent of people work there. This has been
possible because agricultural productivity in those countries has risen
enormously in the last century or so. The fact that the US, France and the
Netherlands – and not some large developing economies, such as India or
Indonesia – are the three largest exporters of agriculture in the world is a
testimony to the height of agricultural productivity in the rich countries.
Agriculture plays an even more important role when it comes to employment. It
employs 80–90 per cent of people in some of the poorest countries, such as
Burundi (92 per cent), Burkina Faso (85 per cent) and Ethiopia (79 per cent).
Despite the country’s impressive industrialization in the last three decades,
37 per cent of people in China still work in agriculture.
·
When talking about the post-industrial economy,
people frequently cite Switzerland and Singapore as the examples of
service-based success stories. Haven’t these two countries shown, they say,
that you can become rich – very rich – through services such as finance,
tourism and trading? Actually these two countries show the exact opposite.
According to the UNIDO data, in 2002, Switzerland had the highest per capita
manufacturing value added (MVA) in the world – 24 per cent more than that of
Japan. In 2005, it ranked the second, after Japan. Singapore ranked the third
in that year. In 2010, Singapore ranked the first, producing 48 per cent more
MVA per capita than the US. Switzerland ranked the third, after Japan.
Switzerland produced 30 per cent more MVA than the US in that year.
Chapter 8 Finance
Banks and the ‘Traditional’ Financial
System
·
bank run. We have seen examples of it in
the wake of the 2008 global financial crisis. Customers queued up in front of
Northern Rock bank branches in the UK, while online depositors in the UK and
the Netherlands clogged up the website of Icesave, the internet arm of the
collapsing Icelandic bank Landsbanki .
·
The banks’ ability to create new money (that is,
credit) is bought exactly at the cost of instability – that is, the risk of
having runs. But the added difficulty is that, once there is a run on some
banks, there could be a contagion across all the banks. It is also because
banks borrow from and lend to each other in the inter-bank loan market and,
increasingly, buy and sell financial products from each other (more on this
below). This means that confidence in banks has to be managed at the level of
the whole banking system, rather than at the level of individual banks.
·
The classic solution to this confidence problem
is to have a central bank that can ‘print money’ at will, using the monopoly it
has in issuing notes (and coins), and let it lend without limit to a bank that
is experiencing a confidence problem. However, this ‘trick’ works only insofar
as the confidence problem is one of cash flows – or what is called a liquidity
crisis. In this situation, the bank in trouble owns assets (loans that it has
made, bonds and other financial assets it has bought, etc.) whose values are
greater than its liabilities (deposits, bonds it has issued, loans from another
bank, etc.) but it cannot immediately sell those assets and meet all
liabilities that are due. If the bank has a solvency crisis, which means that
the total value of its liabilities exceeds that of its assets, no amount of
central bank lending will fix the problem. Either the bank will go bankrupt or
require a government bail-out, which happens when the government injects new
capital into the troubled bank (as happened with Northern Rock and Icesave).
Government bail-out of banks has become highly visible after the 2008 crisis,
but it is a practice that has been going on throughout the history of
capitalism.
·
A country
can also shore up confidence in its banks through deposit insurance, as well as
through central banking. Another way to manage confidence in the banking system
is to restrict the ability of the banks to take risk. This is known as
prudential regulation. One important measure of prudential regulation is the
‘capital adequacy ratio’. This limits the amount that a bank can lend (and thus
the liabilities it can create in the form of deposits) to a certain multiple of
its equity capital (that is, the money provided by the bank’s owners, or
shareholders). Such regulation is also known as ‘leverage regulation’, as it is
a regulation on how much you can ‘leverage’ your original capital. Another
typical measure of prudential regulation is ‘liquidity regulation’, that is, to
demand that each bank holds more than a certain proportion of its assets in
cash or other highly ‘liquid’ assets (assets that can be quickly sold for cash,
such as government bonds).
The ‘traditional’financial system (as
of the mid-twentieth century)
·
By the middle of the twentieth century, the
advanced capitalist countries had acquired a fairly wellfunctioning financial
system, which facilitated the Golden Age of capitalism. At the heart of the
system was the banking sector, which we have just discussed. The other key
elements were the stock market and the bond market, which can be divided into
the government bond market and the corporate bond market. In the US and the UK,
these (stock and bond) ‘markets’ were bigger (in relative terms) and more
influential than in countries like Germany, Japan or France, where banks played
a much more important role. For this reason, the former countries were known to
have ‘market-based’ financial systems and the latter ‘bank-based’ ones. The
former system is said to generate greater pressure for short-term profits on
the part of enterprises than the latter, as shareholders (and bondholders) have
less commitment to the companies they ‘own’ than banks do to the companies they
lend to.
Investment Banks and the Rise of the
New Financial System (*)
·
So far I have talked about the banks we see: the
ones with branches on every high street. They tell us how willing they are to
give us a loan, should we wish to, say, take an impulsive foreign holiday or
fulfil our life-long dream of opening a muffin shop. These banks are known as
commercial banks or deposit banks.* But then there are banks we do not see.
These are known as investment banks. Some of them share brands with their
commercial bank siblings. Investment banks have existed since the nineteenth
century – sometimes as independent entities but often as parts of universal
banks that perform both types of banking. Investment banks are so called
because they help companies raise money from investors – at least that was
their original purpose. They arrange the issuance of shares and corporate bonds
by their client companies and sell them on their behalf. In addition to selling
shares and bonds for their client companies, investment banks buy and sell
shares and bonds with their own money, hoping to make a profit in the process.
This is known as proprietary trading. Since the 1980s, and especially since the
1990s, investment banks have increasingly focused on the creation and the
trading of new financial products, such as securitized debt products and
derivative financial products, or simply derivatives.
·
In the old days, when someone borrowed money
from a bank and bought something, the lending bank owned the resulting debt and
that was that. But ‘financial innovations’ in the last few decades have led to
the creation of a new financial instrument called asset-backed securities
(ABSs) out of these debts. An ABS pools thousands of loans – for homes, cars,
credit cards, university fees, business loans and what not – and turns them
into a bigger, ‘composite’, bond. Until
the 1980s, ABSs were mainly confined to the US and mostly created out of
residential mortgages. But, from the early 1990s, ABSs made of other loans came
on stream in the US and then gradually took off in other rich countries, as
they abolished regulations that restricted the ability of lending banks to sell
off their loans to a third party. More recently, these financial products have
become even more complex since ABSs have become ‘structured’ and been turned
into Collateralized Debt Obligations (or CDOs). Structuring in this context
involves combining a number of ABSs, such as RMBSs, into yet another composite
bond, such as CDO, and dividing the new bond into a few tranches (slices) with
differential risks. A derivative product called a credit default
swap (CDS) was created to supposedly protect you from default on the CDOs by
acting as an insurance policy against the risk of default of particular CDOs.
·
In addition to the ‘pooled’ and ‘structured’
financial products, investment banks have played a key role in generating and
trading derivative financial products, or simply derivatives, in the last three
decades. Derivatives are so called because they do not have any intrinsic value
of their own and ‘derive’ their values from things or events external to
themselves. You could say that derivatives are bets on how other things are
going to unfold over time. Many
derivatives are ‘custom-made’ – that is, they are between two particular
contracting parties, such as the rice farmer and the rice merchant in the
example above. A more modern example might be a company protecting itself from
fluctuations in exchange rates by going into a forward contract with an
investment bank to convert a particular currency at a pre-agreed exchange rate
in, say, twenty-three days’ time. These custom-made derivatives are called
over-the-counter (OTC) derivatives. Derivatives contracts may be ‘standardized’
and sold in exchanges, or become exchange-traded – the Chicago Board of Trade
(CBOT), set up in the mid-nineteenth century, being the most important example.
In the case of a forward, it is re-christened when standardized – these are
called futures. An oil futures contract might specify that I will buy from
whoever happens to hold that contract, say, in a year’s time 1,000 barrels of a
particular type of oil (Brent Crude, West Texas Intermediate, etc.) at $100 a
barrel. The standard justification for derivatives is that they allow economic
actors to ‘hedge’ against risk. This hedging, or protective, function is,
however, not the only – or these days not even the main – function of
derivatives. They also allow people to speculate (that is, bet) on the
movements of oil prices. In other words, someone who has no inherent interest
in the price of oil itself, whether as a consumer or as an oil refinery, can
make a bet on the movements of oil prices.
·
Over time, derivative families other than
forward/futures have evolved. There are two main types – options and swaps. An
option contract would give a contracting party the right (but not the
obligation) to buy (or sell) something at a price fixed now at some particular
date. Where a forward is like a bet on a single future event, a swap is like a
bet on a series of future events; it is like a number of forward contracts
linked together.
·
Derivative markets were not very significant
until the early 1980s, although exchanges for currency futures and stock
options had been established by the Chicago Board of Trade in the 1970s. 6 Then
a historic change came in 1982. In that year, two key US financial regulatory
bodies, the Securities and Exchange Commission (SEC) and the Commodity Futures
Trading Commission (CFTC) agreed that the settlement of a derivative contract
does not have to involve the delivery of the underlying goods (e.g., rice or
oil) but can be settled in cash. This new regulatory rule enabled the
proliferation of derivative contracts that are derived from ‘notional’ things,
such as the stock market index, which can never be physically delivered, and
not just commodities or particular financial assets.
The New Financial System and Its
Consequences
·
The new financial system was to be more
efficient and safer
·
Increasing complexity has made the financial
system more inefficient and unstable
·
Increasing interconnectedness has also
heightened the instability of the financial system
The rise of new finance has not
just affected the financial sector. It has also significantly changed the way
in which non-financial corporations are run. The first important change has
been a further shrinking time horizon in management. With the rise of hostile
takeovers in the 1980s, companies had already been put under increasing
pressure to deliver short-term profits, if necessary at the cost of long-term
competitiveness. The new financial system has not just made non-financial
corporations operate with a shorter time horizon. It has also made them more
‘financialized’ – that is, more dependent on financial activities of their own.
Given the higher returns that financial assets bring compared with traditional
businesses, many companies have increasingly diverted their resources to the
management of financial assets. Such a shift in focus has made those companies
become even less interested in building up technology-based long term
productive capabilities than what was made necessary by the increasing pressure
from short-term oriented shareholders.
·
According to a widely cited study, 17 virtually
no country was in banking crisis between the end of the Second World War and
the mid-1970s, when the financial sector was heavily regulated. Between the
mid-1970s and the late 1980s, the proportion of countries with banking crisis
rose to 5–10 per cent, weighted by their share of world income. The proportion
then shot up to around 20 per cent in the mid1990s. The ratio then briefly fell
to zero for a few years in the mid-2000s, but went up again to 35 per cent
following the 2008 global financial crisis.
·
The ‘unholy alliance’ between
short-term-oriented shareholders and professional managers has reduced the
ability of corporations to invest
·
Non-financial companies, at least in the US,
have become increasingly dependent on their financial activities for their
profits
Concluding Remarks
·
Capitalism would not have developed in the way
it has without the development of the financial system. The spread of
commercial banking, the rise of the stock market, the advance in investment
banking and the growth of the corporate and the government bond markets have
enabled us to mobilize resources and to pool risk on an unprecedented scale.
Unfortunately, following the rise of ‘new finance’ in the last three decades,
our financial system has become a negative force. Our financial firms have
become very good at generating high profits for themselves at the cost of
creating asset bubbles whose unsustainability they obscure through pooling,
structuring and other techniques. When the bubble bursts, these firms deftly
use their economic weight and political influence to secure rescue money and
subsidies from the public purse, which then has to be refilled by the general
public through tax hikes and spending cuts. This scenario has been playing out
on a gargantuan scale since the 2008 global financial crisis, but it had
already been repeated dozens of times on smaller scales all over the world –
Chile, the US, Sweden, Malaysia, Russia, Brazil, you name it – in the last
three decades. Unless we regulate our financial system much more strictly, we will
see the repeat of these crises.
Chapter 9 Inequality and Poverty
Inequality
·
In the last few decades, the advocates of the
free market have successfully persuaded many others that giving a bigger slice
of national income to the top earners will benefit everyone. When the rich have
more money at their disposal, they will invest more and generate more income
for others; they will hire more workers for their businesses, and their
businesses will buy more from their suppliers. With higher personal incomes,
the rich will spend more, generating more income for those companies that sell,
say, sports cars or designers clothes to the rich. The companies supplying
those things will increase demand for, say, car parts and textiles, while their
workers will earn higher wages and spend more on their own food and
(non-designer) clothes. And so on. Thus, if there is more income at the top,
more of it will eventually ‘trickle down’ to the rest of the economy, making
everyone richer than before. Even though the shares that poorer people get in
the national income may be smaller, they will be better off in absolute terms.
This is what Milton Friedman, the guru of free-market economics, meant when he
said: ‘Most economic fallacies derive from … the tendency to assume that there
is a fixed pie, that one party can gain only at the expense of another.’ 1 The
belief in the trickle-down effect has prompted many governments to employ – or
at least has provided them with the political cover for – pro-rich policies in
the last three decades. Regulations on product, labour and financial markets
were relaxed, making it easier for the rich to make money. Taxes on
corporations and high-income earners were cut, making it easier for them to
keep the money they thus make.
·
Greater inequality also increases economic
instability, which is bad for growth. 2 A larger share of national income going
to the top earners may increase investment ratio. But an increased share of
investment also means that the economy is more subject to uncertainty and thus
becomes less stable, as Keynes pointed out.
·
Many economists have also pointed out that
rising inequality played an important role in the making of the 2008 global
financial crisis. Especially in the case of the US, top incomes have soared
while real wages have been stagnant for most people since the 1970s. Stagnant
wages made people incur high levels of debts to keep up with the ever-rising
consumption standard at the top. The increase in household debts (as a
proportion of GDP) made the economy more vulnerable to shocks. Others have
argued that high inequality reduces economic growth by creating barriers to
social mobility. Reduced social mobility means that able people from poorer
backgrounds are excluded from high-end jobs and thus have their talents wasted
from both an individual and a social point of view.
·
The Kuznets hypothesis:
Simon Kuznets, the Russian-born American
economist, who won one of the first Nobel Prizes in Economics (in 1971 – the
first one was in 1969), proposed a famous theory about inequality over time.
The so-called Kuznets hypothesis. According to Kuznets, in the earliest stage
of economic development income distribution remains quite equal. It is because
most people are poor farmers at that stage. As the country industrializes and
grows, more and more people move out of agriculture and into industry, where wages
are higher. This increases inequality. As the economy develops even further,
Kuznets argued, inequality begins to decrease. Most people now work in the
industrial sector or in the urban service sector that serves the industrial
sector, while few remain in the agricultural sector with low wages. The result
is the famous inverted-U-shaped curve, known as the Kuznets curve. Despite its
popularity, the evidence for the Kuznets hypothesis is rather weak. Until the
1970s, it seemed to have been borne out by the experiences of today’s rich
countries. They saw rising inequality in the early days of their
industrialization, peaking, for example, in the mid-nineteenth century in
England and in the early twentieth century in the US, and then a fall later.
However, since the 1980s, most of these countries have experienced an increase
in inequality – dramatically in some cases, such as the US and the UK –
starting a new upswing in the curve at the tail end, so to speak. The
hypothesis has not really held up well in today’s developing countries either.
Inequality has increased with the start of economic development in most of them
(exceptions include Korea and Taiwan), but it has hardly decreased with further
economic development in the majority of them. The main explanation for the lack
of evidence for the Kuznets hypothesis is that economic policy matters hugely
in determining the level of inequality. The absence of inequality upswing in
Korea or Taiwan in their early stages of economic development between the 1950s
and the 1960s can also be explained by policies. During this period, these
countries implemented programmes of land reform, in which landlords were forced
to sell most of their land to their tenants at below-market prices. Their
governments then protected this new class of small farmers through import
restrictions and the provision of subsidized fertilizer and irrigation
services. They also heavily protected small shops from competition by large
stores. Indeed, Kuznets himself did not believe that the decrease in inequality
in the later stage of economic development would be automatic. While believing
that the nature of modern economic development made the inverted-U curve
likely, he emphasized that the actual degree of the decrease in inequality
would be strongly affected by the strengths of trade unions and, in particular,
of the welfare state.
·
Of all these inequalities, only income and
wealth inequalities are readily measurable. Of these two, the data on wealth
are much poorer, so most of the information on inequality we see is in terms of
income. There are number of different ways of measuring the extent to which
income is unequally distributed. 5 The most commonly used measure is known as
the Gini coefficient, named after the early twentiethcentury Italian
statistician Corrado Gini. it compares real-life income distribution (denoted
in the graph by the Lorenz curve) 6 with the situation of total equality
(denoted by the forty-five-degree line in the graph)
·
In real life, no country has a Gini coefficient
below 0.2 and none has one above 0.75. The most equal societies, mainly found
in Europe, have Gini coefficients between 0.2 and 0.3. Any country with a Gini
coefficient above 0.5 can be considered very unequal. Roughly speaking, Gini of
0.35 is the dividing line between relatively equal countries and ones that are
not.
·
Wealth inequality is much higher than income
inequality
·
Income inequality has risen in the majority of
countries since the 1980s
Poverty
·
Different definitions of poverty: absolute vs. relative
poverty
·
Different dimensions of poverty: income poverty
vs. multidimensional poverty
·
Measuring the extent of poverty: head count or
poverty gap
·
At the moment, the international (absolute)
poverty line is set at PPP $1.25 per day. People below this line are seen as
having such little income that they are unable to reach the critical minimum
even in terms of nutrition. Translated into yearly income, this is PPP $456,
which means that the average PPP incomes in the world’s three poorest countries
in PPP terms (the DRC, Liberia and Burundi) are below this line. One
counterintuitive fact is that most poor people do not live in the poorest
countries. Over 70 per cent of people in absolute poverty actually live in
middle-income countries. As of the mid-2000s, over 170 million people in China
(around 13 per cent of its population) and 450 million people in India (around
42 per cent of its population) lived with incomes below the international
poverty line.
·
One in five people in the world still live in
absolute poverty. Even in a number of rich countries, such as the US and Japan,
one in six people live in (relative) poverty. Outside a handful of countries in
Europe, income inequality ranges between serious and shocking. Given the high
inequality in many poor countries, absolute poverty (and relative poverty) can
be reduced without an increase in output, if there is appropriate
redistribution of income. In the longer run, however, a significant reduction
of absolute poverty requires economic development, as has been shown by China
in the recent period.
Chapter 10 Work And Unemployment
Work
·
In the dominant Neoclassical view, we put up
with the disutility from work only because we can derive utility from things we
can buy with the resulting income. In this framework, we work only up to the
point where the disutility from an additional unit of work is equalized with
the utility that we can derive from the additional income from it. But for most
people, work is a lot more than simply a means to earn income. When we spend so
much time on it, what happens in the workplace affects our physiological and
psychological well-being. It may even shape our very selves.
·
After the abolition of slavery in the nineteenth
century, around 1.5 million Indians, Chinese (the ‘coolies’) and even Japanese
went overseas as indentured labourers to replace the slaves. Indentured labour
was not slavery, in the sense that the worker was not owned by the employer.
But an indentured labourer had no freedom to change jobs and had only minimal
rights during the contract period (three to ten years).
·
Adam Smith, while praising the positive
productivity effects of the finer division of labour (see Chapter 2), was
concerned that excessive division of labour might cripple the worker’s mental
capacity
·
Indeed, it was exactly on these grounds that in
1905 the US Supreme Court declared (in the Lochner vs. New York case) that a
tenhour restriction on the working hours for bakery workers introduced by the
New York state was unconstitutional, as it ‘deprived the bakers of the liberty
of working as long as they wished’
Unemployment
·
There are quite a few different types of
unemployment – at least five of them, as I shall discuss below.
1. frictional unemployment
2. technological
unemployment or structural unemployment.
3. political
unemployment : Believing in the modern version of Say’s Law, many
Neoclassical economists have argued that, except in the short run, the law of
supply and demand ensures that everyone who wants to work will find a job at the
going wage rates. If some people are unemployed, these economists argue, it is
because something – the government or trade unions – is preventing them from
accepting the wage rates that will clear the market.
4. cyclical
unemployment : As we talked about when discussing Keynes in Chapter 4,
there are instances of involuntary unemployment that arise from deficiencies in
the aggregate demand, as during the Great Depression or in today’s Great
Recession, as the aftermath of the 2008 global financial crisis is often
called. For such unemployment, known as cyclical unemployment, the
above-mentioned supply-side solutions, such as lowering wages or retraining
workers with redundant skills, are powerless. The main solution to cyclical
unemployment is to boost demand through government deficit spending and loose
monetary policy (such as the lowering of interest rates) until the private
sector recovers and starts creating enough new jobs
5. systemic
unemployment: While the Keynesians see unemployment as a cyclical thing,
many economists – from Karl Marx to Joseph Stiglitz (in his ‘efficiency wage’
model) – have argued that unemployment is something that is inherent to
capitalism. Marx called the unemployed workers the reserve army of labour, who
can be called upon any time if the hired workers become too unwieldy. It is on
this ground that Michal Kalecki (1899–1970), the Polish economist who invented
Keynes’s theory of effective demand before Keynes, argued that full employment
is incompatible with capitalism. We might call this form of unemployment
systemic unemployment.
·
However, there was a time – during the Golden
Age – when many developed capitalist countries had very low unemployment. They
strived to have none and sometimes very nearly succeeded; in the early 1970s,
there were less than ten unemployed people in the Swiss city of Geneva
(population of around 200,000 at the time). During the Golden Age, unemployment rates in
Japan and the Western European countries were 1–2 per cent, compared to 3–10
per cent typically found in the periods before that. In countries like
Switzerland, West Germany and the Netherlands, it was often less than 1 per
cent. The US, with 3–5 per cent unemployment rate, was then considered a
high-unemployment country
·
Despite all this, in most economic discussions,
people are mainly conceptualized as consumers, rather than workers. Especially
in the dominant Neoclassical economic theory, we are seen as working ultimately
to consume. Insofar as work is discussed, it ends at the factory gate, or shop
entrance, so to speak. No intrinsic value of work is recognized, whether it is
creative pleasure, sense of fulfilment or the feeling of dignity that comes
from being ‘useful’ to society
Chapter 11 The
Role of the State
The State and Economics
·
Sometimes, an old, forgotten name conveys the
essence of the thing it is describing much better than the modern one does. The
same goes for the old name of economics – political economy, or the study of
political management of the economy. y. In this day and age, when economics has
become the ‘science of everything’, one can easily get the impression that
government economic policy is really not particularly central to economics.
However, much of economics is still about actions by the state, or the
government – or recommendations against them.* And indeed even those economists
who try to sell economics as a science of everything by showing that ‘economic’
(rational) decision is everywhere are – at least unwittingly – contributing to
the debate on the role of the state in the economy. When they show that people
behave rationally even in the most unlikely areas of life – family life, sumo
wrestling and what not – they are saying that, in plain terms, people know what
is good for them and how to achieve it. The implication is that they should be
left alone: no paternalistic government telling people what to do, believing
that it knows what is good for them.
·
Of
course, no serious economic theory says that the government should be abolished
altogether. But there is a huge spectrum of opinion on the appropriate role of
the state. At one end of the spectrum, we have the free-market view, which
wants no more than the minimal state that provides military defence, protection
of property rights and infrastructure (like roads and ports). At the other end,
we have the Marxist view, which believes that markets should be marginalized –
or even abolished altogether – and the whole economy coordinated through
central planning by the state.
The Morality of State Intervention
·
Most economists these days believe in
individualism, namely, the view that there can be no higher authority than
individuals. In its purest form, this philosophical stance leads to the view
that the government is a product of a social contract between sovereign
individuals and thus cannot be above individuals. In this view, known as
contractarianism, a state action can be justified only when every individual
gives his/her consent. There are different theories of social contract, but the
currently most influential version is based on the ideas of the
seventeenth-century English political philosopher Thomas Hobbes. In his famous
1651 book, Leviathan, named after the biblical sea monster, Hobbes starts by
presuming a ‘state of nature’, in which free individuals existed without a
government. In that world, Hobbes argued, individuals were engaged in what he
called the ‘war of all against all’, and as a result their lives were
‘solitary, poor, nasty, brutish, and short’. In order to overcome this state of
affairs, individuals voluntarily agreed to accept certain restrictions on their
freedom imposed by a government so that they could have social peace.
·
Hobbes himself actually used this theory to
justify absolute monarchy. He advocated a total submission by individuals to
the monarch’s authority, which is justified by its ability to elevate humanity
out of its state of nature. However, the philosopher Robert Nozick, the
economist James Buchanan, the winner of the 1986 Nobel Prize in Economics, and
other modern advocates of contractarianism have developed Hobbes’s ideas in a
different direction and advanced a political philosophy to justify the minimal
state. In this pro-free-market version of contractarianism, more commonly known
as libertarianism in the US, Leviathan came to depict the state as a potential
monster that needs to be restrained (which is not what Hobbes intended). This
view is best summed up in Ronald Reagan’s comment that ‘Government exists to
protect us from each other. Where government has gone beyond its limits is in
deciding to protect us from ourselves.’
·
According to the libertarians, any state
intervention without the unanimous consent of all individuals in society is
illegitimate. Therefore, the only justified actions of the government are
things like provision of law and order (especially the protection of property
rights), national defence and supply of infrastructure. These are services that
are absolutely necessary for a functioning market economy to exist and thus
whose provision by the state would be accepted by all individuals (were they to
be asked). Anything beyond these minimal functions – whether it is minimum
wages legislation, the welfare state or tariff protection – is seen as
violating the sovereignty of individuals and thus the first step on ‘the road
to serfdom’, as the title of Friedrich von Hayek’s famous 1944 book goes.
·
Nevertheless, the contractarian position also
has some important limitations. To begin with, it is based on a fictional,
rather than real, history, as Buchanan and Nozick themselves readily admit.
Human beings have never existed as free-contracting individuals in a ‘state of
nature’ but have always lived as members of some society. The very idea of the
free-standing individual is a product of capitalism, which emerged well after
the state.
Market Failures
·
Markets may fail to produce socially optimal
outcomes – this is known as market failure.
·
there are some goods whose use by non-payers
cannot be prevented, once they are supplied. Such goods (and services) are
known as public goods. The existence of public goods is arguably the most
frequently cited type of market failure, even more than externality, the original
market failure. Classic examples of public goods include roads, bridges,
lighthouses, flood defence systems and other infrastructure. if you can
free-ride on other people to pay for a public good, you don’t have the
incentive to voluntarily pay for it. But if everyone thinks the same way, no
one will pay for it, which means that the good is not going to be provided at
all. It is therefore widely accepted that public goods can be supplied in
optimal quantities only if the government taxes all potential users (which
often means all citizens and residents) and uses the proceeds either to provide
them itself or to pay some supplier to provide them.
·
More controversially, many economists talk of
market failure when there is monopoly or oligopoly – states of affairs
collectively known as imperfect competition in Neoclassical economics. In a
market with a lot of competitors, producers do not have the freedom to set the
price, as a rival can always undercut them until the point where lowering the
price further will result in a loss. But a monopolistic or oligopolistic firm
has the market power to decide – fully in the case of the former and partly in
the case of the latter – the price it charges by varying the quantity it
produces. In the case of oligopoly, the firms can form cartels and behave as if
they are a monopoly, which allows them to charge the higher, monopoly, price.
However, according to Neoclassical economics, it is not the transfer of extra
profit from consumers to the firms with market power that is considered to be a
market failure. The failure is due to the social loss that even the firms with
market power cannot appropriate – known as allocative deadweight loss. If a
market is dominated by firms with market power, it is argued, the government may
try to reduce the deadweight loss by reducing their market power. The most
drastic of such measures is to break up the firm(s) with market power and thus
increase competition in the market. The US government actually did this in 1984
with AT&T, the telephone service giant, which was divided into seven ‘Baby
Bells’.
·
the Schumpeterians and the Austrians denounce
the state of perfect competition, which the Neoclassical economists idealize,
as a state of economic stasis, where there is no innovation. When the lure of
(temporary) monopoly profit is exactly what motivates firms to innovate,
clamping down on – or even breaking up – monopolies will reduce innovation and
bring about technological stagnation. In what Schumpeter calls the ‘gales of
creative destruction’, they argue, no monopoly is safe in the long run. I have
just shown that the same market dominated by a monopoly can be seen as a most
successful one by one school of economics (the Schumpeterian school or the
Austrian school) and as a case of most abject failure by another (the
Neoclassical school). The case of monopoly may be the most extreme example, but
throughout the book we have seen many cases in which some schools see a market
success where others see a market failure. For example, I have pointed out that
a Neoclassical economist might praise free trade for allowing all nations to
maximize their incomes, given their resources and productive capabilities, but
a developmentalist economist might criticize it for preventing more backward
economies from changing their productive capabilities and thus maximizing their
incomes in the long run. The point is that what constitutes a market failure –
and thus a justification for government action – depends on your theory of how
markets work.
Government Failure
·
The fact that a market is failing, some
free-market economists rightly point out, does not necessarily mean that we
will be better off with government intervention. According to this argument,
known as the government failure argument or sometimes the public choice theory,
the costs of government failure are usually higher than those of market
failures. Thus, it is usually better to accept a failing market than to have
the government intervene and mess things up even more.
·
In some cases, the government is controlled by a
dictator who is interested not in citizens’ welfare but in their own personal
enrichment. In a democracy, the government is controlled by politicians whose
primary goal is to gain and retain power, rather than promote public interests.
They will consequently implement policies that maximize their chances in
elections – increasing government spending without simultaneously increasing
revenues. Even if politicians somehow choose the right policies, they may not
be properly implemented because bureaucrats who run them have their own
agendas. They will design policies in such a way that serves themselves rather
than the electorate – inflating their departmental budgets, minimizing their
efforts, reducing cooperation with other departments in order to defend their
own ‘turf’ and so on. This theory is known as that of ‘self-seeking
bureaucrats’. Last but not least, there is lobbying from various interest
groups – bankers lobbying for more lenient financial regulation, industrialists
asking for increased trade protection, trade unions pushing for higher minimum
wages, whatever the consequences, respectively, for national financial
stability, consumer prices or unemployment. Sometimes those interest groups do
not simply lobby but effectively take over the very government agencies that
are supposed to regulate them – this is known as the theory of ‘regulatory
capture’
Market and Politics
·
Markets run according to the
‘one-dollar-one-vote’ rule, while democratic politics run on the principle of
‘one-person-one-vote’. Thus, the proposal for greater depoliticization of the
economy in a democracy is in the end an anti-democratic project that wants to
give more power in the running of the society to those with more money.
·
The size of the government, measured by
government expenditure as a proportion of GDP, has grown a lot in the last
century and a half
·
Now, note that a lot of government expenditure
is not consumed or invested by the government itself. It involves transfer of
money from one part of the economy to another, especially social protection
programmes, such as income support for the poor and unemployment benefits.
Therefore, when you calculate GDP you need to count the transfer elements out.
Transfer payments are equivalent to between 10 per cent and 25 per cent of GDP
in the rich countries. So, for example, a government whose total expenditure is
equivalent to 55 per cent of GDP may actually account for only 30 per cent of
GDP, if the transfer payments it makes are equivalent to 25 per cent of GDP.
·
Until the 1980s, many people believed that the
‘miracle’ economies of East Asia, such as Japan, Taiwan or Korea, were paragons
of free-market policies on the grounds that they had small governments
(measured by their budget). However, being small did not mean that these
governments were following a laissez-faire approach. During the ‘miracle’
years, they exercised a huge influence on the evolution of their economies
through economic planning, regulation and other directive measures. By looking
at only the budgetary numbers, people had come to seriously misunderstand the
true nature and significance of the government in these countries.
Chapter 12 The International Dimension
International Trade
·
In 1792, George III of Britain sent Earl
Macartney to China as his special envoy. Macartney was to convince the Chinese
emperor, Qianlong, to allow Britain to freely conduct trade in all of China,
not just through Canton (Guangzhou), which was then the only port open to
foreigners. At the time, Britain was running a large trade deficit with China
(so, what’s new?) in large part due to its new-found taste for tea. The British
thought that they might be able to reduce the gap if they could engage in freer
trade. The mission completely failed. Qianlong sent Macartney back with a
letter to George, telling him that the Celestial Empire saw no need to have
more trade with Britain. He reminded the British king that China had allowed
the European nations to trade in Canton only as a ‘signal mark of favour’, as
‘the tea, silk and porcelain which the Celestial Empire produces, are absolute
necessities to European nations’. Qianlong declared that ‘our Celestial Empire
possesses all things in prolific abundance and lacks no product within its own
borders. There was therefore no need to import the manufactures of outside
barbarians in exchange for our own produce.’ 1 As it was not even allowed to
try to persuade the Chinese customers to buy more of its manufactured products,
Britain resorted to stepping up its opium exports from India. The resulting
spread of opium addiction alarmed the Chinese government into banning opium
trade in 1799. That did not work, so in 1838 the Daoguang Emperor, Qianlong’s
grandson, appointed a new ‘drug czar’, Lin Zexu, to start a major crackdown on
opium smuggling. In response, the British started the Opium War in 1840, in
which China was pulped. Victorious Britain forced China into free trade,
including of opium, with the Nanjing Treaty in 1842. A century of external
invasions, civil war and national humiliation followed.
·
Qianlong’s view on international trade was
actually in line with the mainstream view among European economists, including
Adam Smith himself, at the time. His view of trade is known as the theory of
absolute advantage; the idea that a country does not need to trade with
another if it can produce everything more cheaply than can its potential
trading partner. Indeed – our common sense tells us – why should it? But it
should – according to the theory of comparative advantage, invented by
David Ricardo. According to this theory, a country can benefit from
international trade with another country, even when it can produce everything
more cheaply than the other, like China could, compared to Britain, in the late
eighteenth century – at least according to Qianlong’s view. All that is needed
is that it specializes in something in which its superiority is the greatest.
Likewise, even if a country is rubbish at producing everything, it can benefit
from trade if it specializes in things which it is least rubbish at.
International trade benefits every country involved.
·
Since Ricardo invented it in the early
nineteenth century, the theory of comparative advantage has provided a powerful
argument in favour of free trade and trade liberalization, that is, reduction
in government restrictions on trade. The logic is impeccable – that is, insofar
as we accept its underlying assumptions. Once we question those assumptions,
its validity becomes much more limited. Let me explain this, focusing on two
key assumptions behind the Heckscher-Ohlin-Samuelson version of the theory of
comparative advantage (henceforth HOS), which we first encountered in Chapter 4
as lying at the heart of the modern argument for free trade.
The
most important assumption underlying HOS is that all countries have equal
productive capabilities – that is, they can use any technology they want. According to this assumption, the only reason
why a country might specialize in one product rather than another is because
that product happens to be produced using a technology that is in line with its
relative factor endowment – that is, how much capital and labour it has. There
is no possibility that the technology might be too difficult for the country
(recall the BMW and Guatemala example from Chapter 4). This totally unrealistic
assumption rules out a priori the most important form of beneficial
protectionism, namely, infant industry protection, whose key role in the historical
development of today’s rich countries we discussed in detail throughout the
book.
In HOS, not only is free trade good for the
country but moving towards it in countries that have not practised it produces
no casualties. When tariffs on, say, steel are reduced, consumers of steel
(e.g., carmakers who use steel plates and final consumers of cars) immediately
benefit because they can import cheaper steel. This will damage the producers
(capitalists and workers) in the domestic steel industry in the short run, as
companies lose money due to cheaper imports and workers lose their jobs. But,
soon, even they benefit. It is because activities that are more in line with
the country’s comparative advantage – say, the production of micro-chips or
investment banking – will now be relatively more profitable and thus expand.
The expanding industries would absorb the capital as well as the labour
formerly employed in the steel industry and, thanks to their higher
productivities, pay them higher profits and wages. Everyone wins in the end.
But the reality is that most capitalists and workers in the industry that has
lost protection remain hurt. HOS can present such a positive view of trade
liberalization because it assumes that all capital and labour are the same
(‘homogeneous’ is the technical term) and thus can be readily redeployed in any
activity (technically this is known as the assumption of perfect factor
mobility). Even the use of the compensation principle cannot quite hide the
fact that a lot of people get hurt by trade liberalization.
·
Apart from the benefits of specialization that
the theory of comparative advantage extols, international trade can bring many
benefits. By providing a bigger market, it allows producers to produce more
cheaply, as producing a larger quantity usually lowers your costs (this is
known as economies of scale). International trade is particularly important for
developing countries. In order to increase their productive capabilities and
thus develop their economies, they need to acquire better technologies. The
case for international trade is indisputable. However, this does not mean that
free trade is the best form of trade, especially (but not exclusively) for
developing countries. When they engage in free trade, developing countries have
their chances of developing productive capabilities hampered, as I have pointed
out in earlier chapters. The argument that international trade is essential
should never be conflated with the argument that free trade is the best way to
trade internationally
·
In the early 1960s, international trade, defined
as the average of exports and imports, in goods and services used to be
equivalent to around 12 per cent of world GDP (average for 1960–64). Thanks to
the fact that international trade has grown much faster than has world GDP, the
ratio now stands at 29 per cent (average for 2007–11). Listening to the
American media over the last three decades, you might have got the impression
that the US is a country that is uniquely suffering from the negative impacts
of international trade – first with Japan and now with China. Averaging the
export/GDP and the import/GDP figures, you get a trade dependence ratio of 15
per cent. This is way below the world average of 29 per cent, cited above.
Indeed, the US is one of the least trade-dependent countries in the world. At
the other extreme, we have small trade-oriented economies like Hong Kong (206
per cent) and Singapore (198 per cent). Such economies not only trade a lot for
their own needs because they are small. They also specialize in international
trading itself, thus importing certain things only to sell on to others – this
is known as ‘re-exporting’. Many countries have a trade dependence ratio that
is well above average (say, above 60 per cent). This group includes some small
rich countries (e.g., the Netherlands and Belgium), several oil-exporting
countries (e.g., Angola and Saudi Arabia) and developing countries that have
deliberately promoted manufactured exports through policy measures (e.g.,
Malaysia and Thailand).
·
Changing structure of international trade:
the (exaggerated) rise of services trade and the rise of manufacturing trade,
especially that from developing countries.
Developing countries have increased their
shares in international manufacturing trade significantly from around 9 per
cent in the mid1980s to around 28 per cent today. 10 This rise has been in
large part propelled by the rapid development of export-oriented manufacturing
industries in China. China used to account for only 0.8 per cent of world
manufacturing export in 1980, but by 2012 the share had risen to 16.8 per cent.
Balance of Payments
·
Balance of payments is a statement that shows
how much a country is in debt or credit in which areas of its economic
transactions with the rest of the world. Trade involves not only the movements
of goods and services but also the flows of money that go with them. When a
country imports more goods and services than it exports, it is said to have a
trade deficit, or a negative trade balance. When it exports more than it
imports, it is said to have a trade surplus, or a positive trade balance.
·
How do countries with trade deficits manage?
They can do this in two ways. One is to earn money in ways other than through
international trade (this is called ‘income’ in the technical language
of balance of payments statistics) or to be given money by someone else (this
is called ‘current transfers’).
Income includes compensation of employees
and investment income. ‘Compensation of employees’ in this context is earnings
of people working for foreign entities while being resident in the home
country, such as Mexican workers commuting to their work in the US. ‘Investment
income’ is income from financial investment abroad, such as dividends from
shares of foreign companies owned by a country’s residents.
Current transfers include workers’
remittances, that is, money sent from workers resident abroad (more on this
later) and foreign aid, namely, grants given by foreign governments.
Even after adding up trade, income and
current transfers, a country may still have a current account deficit. In this
case, it has to either borrow money (that is, run debts) or sell assets it has.
The activities on this front are captured in the ‘capital and financial
account’ (CFA), which is more often known simply as capital account. CFA is
– surprise, surprise – made up of two main components – capital account and
financial account.
The
capital account is divided into ‘capital transfers’ (mainly debt
forgiveness by foreign countries or, conversely, your country forgiving debts
of other countries) and the ‘acquisition/disposal of non-financial assets’,
such as selling and buying patents.
The financial account is mainly made up of
portfolio investment, (foreign) direct investment, other investments and
reserve assets. Portfolio investment refers to the acquisition of
financial assets, such as equity (company shares) and debt (including bonds and
derivatives). Foreign direct investment involves acquisition by a
foreign entity of a significant (10 per cent is the convention) proportion of
shares in a company, with a view to getting involved in its management. ‘Other investments’ include trade
credits (companies lending money to their buyers by letting them pay for their
purchases later) and loans (especially bank loans). ‘Reserve assets’
include foreign currencies and gold that a country’s central bank has. They are
often referred to as foreign exchange reserves.
Note: A country’s current account balance and its
capital and financial account balance, in theory, should add up to zero, but in
practice there are always ‘errors and omissions’ that make the sum different
from zero.
·
A country’s current account deficit (surplus) is
usually smaller (larger) than its trade deficit (surplus), as other items in
the current account are likely to reduce (magnify) it. For the rich countries,
investment incomes are typically the items that reduce the deficits (or swell
the surpluses) created by the trade component of the current account. For the
developing countries, the main items that close the gap between trade deficit
and current account deficit are foreign aid and, increasingly more importantly,
workers’ remittances, which these days are around three times foreign aid. In
2010, Haiti had a trade deficit equivalent to 50 per cent of GDP, but its
current account deficit was only equivalent to 3 per cent of GDP. This was
possible because there was a large amount of current transfers, such as foreign
aid (equivalent to 27 per cent of GDP) and remittances (equivalent to 20 per
cent of GDP).
·
Sudden surges in capital inflows and outflows
can create serious problems :
Sudden surges in
capital inflows can lead to a significant increase in deficits on the current
account, especially the trade component of it, as I mentioned above. As long as
capital keeps flowing in, current account deficits equivalent to, say, several
percentage points of GDP, or even higher, might not be a problem. The trouble
is that capital inflow can suddenly fall dramatically or even turn negative;
foreigners might, for example, sell assets they own and take the proceeds out.
This sudden change can push countries into a financial crisis, as their
economic actors suddenly find that the assets they have are worth a lot less
than their liabilities. In the case of developing countries, whose currencies
are not accepted in the world market, such a situation will also lead to a
foreign exchange crisis, as they now have insufficient means to pay for their
imports. The shortage in the supply of foreign exchanges leads to devaluation
of the local currency, which makes the financial crisis even worse, as the
repayment burden for the country’s foreign loans would skyrocket in local
currency terms. This is what happened, for example, in Thailand and Malaysia
during the 1990s. Between 1991 and 1997, the annual capital account surplus
averaged 6.6 per cent and 5.8 per cent of GDP in Thailand and Malaysia
respectively. This allowed them to maintain high current account deficits,
equivalent to 6.0 per cent and 6.1 per cent of GDP respectively. When the
capital flows were reversed – the capital account deficit suddenly surged to
10.2 per cent and 17.4 per cent of their respective GDP in 1998 – they
experienced combined financial and foreign exchange crises.
Foreign Direct Investments and
Transnational Corporations (TNCs)
·
In the last three decades, foreign direct
investment (FDI) has emerged as the most dynamic element in the balance of
payments. It has grown faster than international trade, albeit with a much
greater fluctuation. What makes FDI particularly important is the fact that it
is not a simple financial flow. It can also directly affect the host
(receiving) country’s productive capabilities.
·
FDI is different from other forms of capital
inflows in that it is not a pure financial investment. It being an investment
with a view to influencing how a company is run, FDI by definition brings in
new management practices. It frequently, although not always, also brings in
new technologies. As a result, FDI affects the productive capabilities of the
company that is receiving it, whether it is greenfield FDI, that is, a foreign
company setting up a new subsidiary (like the Intel subsidiary established in
Costa Rica in 1997) or it is brownfield FDI, that is, a foreign company taking
over an existing company (like Daewoo, the Korean carmaker bought by GM in
2002).
·
Especially when the gap in productive
capabilities between the investing country and the recipient country is large,
FDI might have particularly strong indirect influences on the productive
capabilities of the rest of the economy. This might happen in a number of ways.
To begin with, there would be ‘demonstration effects’. Then there is the
influence through the supply chain. Then there are effects from the employees
of TNC subsidiaries leaving them to join other firms or even to set up their
own enterprises. Collectively, these indirect positive effects of FDI are known
as spill-over effects.
Many TNC subsidiaries might actually buy
very little from local producers and import most of their inputs – they are
said to exist as enclaves. In these cases the benefits through supply chains
will be non-existent. TNC subsidiary in question has just come to exploit
natural resources or cheap labour in your country rather than to establish a
long-term production base.
·
Some of the biggest companies don’t make
any money – in the places they choose not to
In 2012, a public outrage broke out when it
was revealed that Starbucks, Google and other big international companies have
paid very little in corporation tax in Britain, Germany, France and other
European countries over the years. This was not because they have not paid the
taxes that they owe. It was because they never made much money and thus owed
very little in tax. These companies minimized their tax obligations in
countries like Britain by inflating the costs for their British subsidiaries by
having their subsidiaries in third countries ‘over-charge’ (that is, charge
more than what they would have in open markets) the British subsidiaries for
their services. These third countries were countries with a corporate tax rate
that is lower than the UK rate (e.g., Ireland, Switzerland or the Netherlands)
or even tax havens, namely, countries that attract foreign companies to set up
‘paper companies’ by charging very low, or even no, corporate taxes (e.g.,
Bermuda, the Bahamas). Taking advantage of the fact that they operate in
countries with different tax rates, TNCs have their subsidiaries over-charge or
under-charge each other – sometimes grossly – so that profits are highest in
those subsidiaries operating in countries with the lowest corporate tax rates.
In this way, their global post-tax profit is maximized.
·
Transfer pricing is only one of the possible
negative effects of FDI, especially when it comes to FDI into developing
countries. Another one is that TNC subsidiaries may ‘crowd out’ local firms in
the credit market. TNC subsidiaries hogging the local credit market may mean
loans going into less efficient uses. Another reason is that TNC subsidiaries
will be big firms in a monopolistic or oligopolistic position in the developing
country market, even though they are small parts of the TNC that owns them.
Moreover, TNCs, having a lot of money and the political backing of their home
countries, can change the policies of the host country in a way that is
beneficial for them, rather than for the host economy.
Nevertheless, what seems certain is that
countries, especially developing countries, can maximize the benefits from FDI
only when they use appropriate regulations. Many countries have established
rules on in which industries FDI may be made. They have demanded that TNCs have
a local investment partner (known as joint venture requirement). Many
governments have required that the TNC making the investment transfers their
technologies to its local joint venture partner (technology transfer
requirement) or that they train local workers. Countries have also demanded
that TNC subsidiaries buy certain proportions of inputs locally (known as the
local contents requirement)
·
In the long run, the most important negative
effect of FDI is that it may make it more difficult for the host country to
increase its own productive capabilities. Once you allow TNCs to establish
themselves within your border, your local firms will struggle to survive. This
is why many of today’s rich countries – especially countries like Japan, Korea,
Taiwan and Finland – strictly restricted FDI until their companies acquired the
ability to compete in the world market. For example, had the Japanese
government opened its automobile industry to FDI in the late 1950s, as was widely
suggested following the debacle of Toyota’s first car exports to the US, 18
Japanese car-makers would have been either wiped out or taken over by American
or European TNCs, given the state of the industry at the time; back in 1955
General Motors alone produced 3.5 million cars whereas the whole of the
Japanese automobile industry produced a mere 70,000.
·
The recent period has seen an increase in the
share of brownfield investment in total FDI, changing the global industrial
landscape. This rise in brownfield investment is closely linked with what the
Cambridge economist Peter Nolan calls the global business revolution. 26 In the
last couple of decades, through an intense process of crossborder M&As,
virtually all industries have become dominated by a small number of global
players. The global aircraft industry is dominated by two firms, Boeing and
Airbus, while industry observers are debating whether more than the top six
mass-market automobile firms (Toyota, GM, Volkswagen, RenaultNissan,
Hyundai-Kia and Ford) can survive in the long run, which means that they are
not even sure about such major companies as Peugeot-Citroën, Fiat-Chrysler and
Honda. Moreover, through what Nolan calls the ‘cascade effect’, even many of
the supplier industries have become concentrated. For example, the global
aircraft engine industry is now dominated by three firms (Rolls-Royce, Pratt
& Whitney and Fairfield, a GE (General Electric) subsidiary).
Immigration and Remittances
·
Free-market economists wax lyrical about the
benefits of open borders. Any restriction on the cross-border movement of any
potential object of economic transaction – goods, services, capital, you name
it – would be harmful, they say. There are very few free-market economists who
advocate free immigration or crossborder movement of people in the way they
advocate free trade. Many free-market
economists do not even seem to realize that they are being inconsistent when
they advocate free movement of everything except for people. Immigration
reveals the political and the ethical nature of markets.
·
Some native workers lose out but not by much and
their woes are mostly created by ‘wrong’ corporate strategies and economic
policies, not migrants. Much bigger causes of stagnant wages and declining
working conditions are in the realm of corporate strategy and government
economic policy: shareholder value maximization by corporations, which requires
squeezing workers, poor macroeconomic policies that create unnecessary amounts
of unemployment, inadequate systems for skills training that make local workers
uncompetitive and so on. Unfortunately, the inability and the unwillingness of
mainstream politicians to tackle those underlying structural issues have
created the space for anti-immigrant parties in many rich countries.
·
As of 2010, there were 214 million immigrants
worldwide; 145 million of them lived in the rich countries and the rest (69
million people) in developing countries, which means around a third of the
world’s immigrants live in developing countries.
·
On the negative side, however, high remittances
have fed financial bubbles, as in the notorious case of the 1995–6 pyramid
scheme of Albania, which collapsed in 1997. A sudden large inflow of foreign
currencies in the form of remittances can also weaken the recipient country’s
export competitiveness by abruptly raising the value of its currency, thus
making its exports relatively more expensive in terms of foreign currencies.
Concluding Remarks
·
The rapidly changing international environment
in the last three decades has significantly affected national economies in many
ways. Greatly increased cross-border flows of goods, services, capital and
technologies have changed the way in which countries organize their production,
earn foreign currencies to import what they need and make and receive financial
and physical investments.
·
These changes, often summed up as the process of
globalization, have been the defining feature of our time. Claiming the process
to be driven by technological progress, they have criticized anyone who is
trying to reverse or modify any aspect of it as backward-looking. The 2008
global financial crisis has somewhat dented the confidence with which these
people make their case, but the thinking behind it still dominates our world:
protectionism is always bad; free capital flows will ensure that the best
managed companies and countries get money; you have to welcome TNCs with open
arms; and so on. However, globalization is not an inevitable consequence of
technological progress. During the Golden Age of capitalism (1945–73), the
world economy was much less globalized than its counterpart in the Liberal
Golden Age (1870–1913).
How can we use Economics to
make our economy better ?
·
Economics is a political argument. It is not –
and can never be – a science; there are no objective truths in economics that
can be established independently of political, and frequently moral,
judgements. Therefore, when faced with an economic argument, you must ask the
age-old question ‘Cui bono?’ (Who benefits?), first made famous by the Roman
statesman and orator Marcus Tullius Cicero. Some theories are better than
others, depending on the situation at hand. But it does mean that you should
never believe any economist who claims to offer ‘scientific’, value-free
analysis.
·
Don’t become a ‘man with a hammer’: there is
more than one way to ‘do’ economics, each with its strengths and weaknesses.
The various economic theories conceptualize basic economic units differently
(e.g., individuals vs. classes), focus on different things (e.g., macro-economy
vs. micro-economy), ask different questions (e.g., how to maximize the
efficiency with which we use given resources vs. how to increase our abilities
to produce those resources in the long run) and try to answer them using
different analytical tools (e.g., hyper-rationality vs. bounded rationality).
You are bound to have your favourite theory. There is nothing wrong with using
one or two more than others – we all do. But please don’t be a man (or a woman)
with a hammer – still less someone unaware that there are other tools
available. To extend the analogy, use a Swiss army knife instead, with
different tools for different tasks.
·
Many people would assume that numbers are
straightforward and objective, but each of them is constructed on the basis of
a theory. This applies to even the most basic figures that we take for granted,
like GDP or the rate of unemployment. The exclusion of household work and
unpaid care work from GDP has inevitably led to the under-valuation of those
types of work. GDP’s inability to take into account positional goods has
directed consumption in the wrong direction and made it an unreliable measure
of living standards for rich countries, where those goods are more important.
The standard definition of unemployment underestimates the true extent of it by
excluding discouraged workers in the rich countries and the under-employed in
the developing countries . We need numbers to be able to get the sense of
magnitude of our economic world and monitor how it changes; we just shouldn’t
accept them unthinkingly.
·
Much of economics these days is about the
market. Most economists today subscribe to the Neoclassical school, which
conceptualizes the economy as a web of exchange relationships – individuals buy
various things from many companies and sell their labour services to one of
them, while companies buy and sell from many individuals and other companies.
But the economy should not be equated with the market. The market is only one
of many different ways of organizing the economy – indeed, it accounts for only
a small part of the modern economy. Many economic activities are organized
through internal directives within firms, while the government has influence
over – and even commands – large sections of the economy. Governments – and
increasingly international economic organizations like the WTO – also draw the
boundaries of markets while setting rules of conduct in them. Herbert Simon,
the founder of the Behaviouralist school, once estimated that only about 20 per
cent of economic activities in the US are organized through the market. The
neglect of production at the expense of exchange has made policy-makers in some
countries overly complacent about the decline of their manufacturing
industries. The view of individuals as consumers, rather than producers, has
led to the neglect of issues such as the quality of work (e.g., how interesting
it is, how safe it is, how stressful it is and even how oppressive it is) and
work–life balance.
·
Harry S. Truman, in his typical no-nonsense
style, once said that ‘An expert is someone who doesn’t want to learn anything
new, because then he would not be an expert.’ Expert knowledge is absolutely
necessary, but an expert by definition knows well only a narrow field and we
cannot expect him or her to make a sound judgement on issues that involve more
than one area of life (that is, most issues), balancing off different human
needs, material constraints and ethical values. You should be willing to
challenge professional economists (and, yes, that includes me). They do not
have a monopoly on the truth, even when it comes to economic matters.
Sometimes, their judgements may even be better than those of professional
economists, since they may be more rooted in reality and less narrowly focused.
·
‘Audite et alteram partem’(listen even to the
other side): the need for humility and an open mind. I have argued that there
is something to learn from all those different schools of economics – from the
Marxist school on the left to the Austrian school on the right.
·
Just remember: 200 years ago, many Americans
thought it was totally unrealistic to argue for the abolition of slavery; 100
years ago, the British government put women in prison for asking for votes;
fifty years ago, most of the founding fathers of today’s developing nations
were being hunted down by the British and the French as ‘terrorists’. As the
Italian Marxist Antonio Gramsci said, we need to have pessimism of the
intellect and optimism of the will.
·
The 2008 global financial crisis has been a
brutal reminder that we cannot leave our economy to professional economists and
other ‘technocrats’. We should all get involved in its management – as active
economic citizens.
Prepared
( Notes taken from book ) By : M.S. Bhusal
e-mail : antarmukhibhusal@gmail.com
Blog : https://www.msbhusal.blogspot.com
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