Author: Ha-Joon Chang
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The making of the pin is the subject of the very first chapter of what is commonly (albeit mistakenly)1 considered to be the first economics book, namely, An Inquiry into the Nature and Causes of the Wealth of Nations, by Adam Smith (1723–90).
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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.
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Following Smith’s example, Charles Babbage, the nineteenth-century mathematician who is known as the conceptual father of the computer, studied pin factories in 1832.
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Economic actors – or those who engage in economic activities – and economic institutions – or the rules regarding how production and other economic activities are organized – have also gone through fundamental transformations.
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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).
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Capitalism is organized by capitalists, or those who own capital goods. Capital goods are also known as the means of production and refer to durable inputs into the production process (for example, machines, but not, say, raw materials).
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Smith believed that competition among sellers in the market will ensure that profit-seeking producers will produce at the lowest possible costs, thereby benefiting everyone.
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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.
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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.
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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)
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Companies may also be the sole buyer (monopsony) or one of the few buyers (oligopsony).
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Unlike the small companies in Adam Smith’s world, monopolistic or oligopolistic firms can influence market outcomes – they have what economists call market power.
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Oligopolistic firms cannot manipulate their markets as much as a monopolistic firm can, but they may deliberately collude to maximize their profits by not under-cutting each other’s prices – this is known as a cartel. As a result, most countries now have a competition law (sometimes called an anti-trust law) in order to counter such anti-competitive behaviours – breaking up monopolies (for example, the US government broke up AT&T, the telephone company, in 1984) and banning collusion among oligopolistic firms.
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The Gold (Silver) Standard is a monetary system in which the paper money issued by the central bank is freely exchangeable with a specified weight of gold (or silver). This did not mean that the central bank had to have in reserve an amount of gold equal to the value of the currency that it had issued; however, the convertibility of paper money into gold made it necessary for it to hold a very large gold reserve
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Stock markets, where company shares (stocks) are bought and sold, had been in existence for a couple of centuries or so by Smith’s time.
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The History Boys – Alan Bennett’s hit play and 2006 film about a bunch of bright but underprivileged Sheffield boys trying to gain admission to Oxford to study history.
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lot of policy recommendations are backed up by historical examples because nothing is as effective as spectacular real-life cases
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For example, if you only read things like The Economist or the Wall Street Journal, you would only hear about Singapore’s free trade policy and its welcoming attitudes towards foreign investment. This may make you conclude that Singapore’s economic success proves that free trade and the free market are the best for economic development – until you also learn that almost all the land in Singapore is owned by the government, 85 per cent of housing is supplied by the government-owned housing agency (the Housing Development Board) and 22 per cent of national output is produced by state-owned enterprises (the international average is around 10 per cent).
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There is no single type of economic theory – Neoclassical, Marxist, Keynesian, you name it – that can explain the success of this combination of free market and socialism.
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The fact is that capitalism developed first in Western Europe.
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New economic institutions emerged to accommodate the new realities of capitalist production. With the spread of market transactions, banks evolved to facilitate them. Emergence of investment projects requiring capital beyond the wealth of even the richest individuals prompted the invention of the corporation, or limited liability company, and thus the stock market.
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New World crops were grown in Europe and beyond and became basic food items. It stretches the imagination to think of the days when the British did not have their chips, the Italians lacked tomatoes and polenta (made with maize, or sweetcorn) and the Indians, the Thais and the Koreans did not eat any chillies.
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Countries were created out of thin air, with arbitrary boundaries, affecting the internal and the international politics of those countries to this day. The fact that so many borders in Africa are straight is a testimony to that; natural borders are never straight because they are usually formed along rivers, mountain ranges and other geographical features.
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In 1835, Lord Bentinck, the Governor-General of the East India Company, famously reported that ‘the bones of the cotton weavers are bleaching the plains of India’.
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Capitalism really took off around 1820, with a visible acceleration of economic growth all around Western Europe and then in the ‘Western offshoots’ in North America and Oceania. The growth acceleration was so dramatic that the half-century following 1820 is typically referred to as the Industrial Revolution.
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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.
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Karl Marx (1818–83), the German economist and revolutionary, who spent most of his time exiled in England – his grave is in Highgate Cemetery in London.
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Marx proposed that a socialist society should be run like a capitalist firm in one important respect – it should plan its economic affairs centrally, in the same way in which a capitalist firm plans all its operations centrally. This is known as central planning.
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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.
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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.
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Tariffs (taxes on imports) protected the British producers from the superior Low Country producers.
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The British government even sponsored the poaching of skilled textile artisans, mainly from Flanders, to gain access to advanced technologies. British or American people with names like Flanders, Fleming and Flemyng are descendants of those artisans:
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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.
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Hamilton argued that the government of an economically backward nation, such as the US, needs to protect and nurture ‘industries in their infancy’ against superior foreign competitors until they grow up; this is known as the infant industry argument.
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following the Anglo-American War (1812–16) – the first and so far the only time that the US mainland was invaded – many Americans came around to Hamilton’s view that a strong country needed a strong manufacturing sector,
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He had been shot dead in a pistol duel in 1804 by a certain Aaron Burr – the serving vice president of the country at the time (yes, those were wild days – a serving vice president shoots a former finance minister dead, and no one goes to prison).
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In the first half of this protectionist century, together with slavery and federalism, protectionism remained a constant bone of contention between the industrial North and the agrarian South.
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Free trade was not responsible for the rise of capitalism, but it did spread throughout the nineteenth century.
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Colonization was the obvious route to ‘unfree free trade’, but even many countries that were not colonized were also forced to adopt free trade. Through ‘gunboat diplomacy’, they were forced to sign unequal treaties that deprived them of, among other things, tariff autonomy
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The most infamous unequal treaty is the Nanking Treaty, which China was forced to sign in 1842, following its defeat in the Opium War.
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The inability to protect and promote their infant industries, whether due to direct colonial rule or to unequal treaties, was a huge contributing factor to the economic retrogression in Asia and Latin America during this period, when they saw negative per capita income growths
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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.
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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.
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The ‘high noon’ of capitalism is often described as the first age of globalization, that is, the first time in which the whole world economy was integrated into one system of production and exchange.
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the ideas behind liberalism can be traced back to at least the seventeenth century, starting with thinkers like Thomas Hobbes and John Locke. The classical meaning of the term describes a position that gives priority to freedom of the individual.
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Today, liberalism is usually equated with the advocacy of democracy, given its emphasis on individual political rights, including the freedom of speech.
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What makes it even more confusing is that, in the US, the term ‘liberal’ is used to describe a view that is the left-of-centre. American ‘liberals’, such as Ted Kennedy or Paul Krugman, would be called social democrats in Europe.
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In political terms, neo-liberals do not openly oppose democracy, as the classical liberals did. But many of them are willing to sacrifice democracy for the sake of private property and the free market.
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Germany and Sweden were the best examples of this ‘new protectionism’ – famously called the ‘marriage of iron and rye’ in Germany.
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Soviet socialism was a huge economic (and social) experiment. Until then, no economy had been centrally planned. Karl Marx had left the details rather vague, and the Soviet Union had to make things up as it went along this untrodden path.
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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.
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After a big financial crisis like the 1929 Wall Street crash or the 2008 global financial crisis, private-sector spending falls. Debts go unpaid, which forces banks to reduce their lending. Being unable to borrow, firms and individuals cut their spending. This, in turn, reduces demands for other firms and individuals that used to sell to them (e.g., firms selling to consumers, firms selling machinery to other firms, workers selling labour services to firms). The demand level in the economy spirals down.
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As tax revenues were falling due to reduced levels of economic activity, the only way for them to balance their budgets was to cut their spending, leaving nothing to arrest the downward demand spiral.18 To make things worse, the Gold Standard meant that their central banks could not increase the supply of money for fear of compromising the value of their currencies.
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The so-called First New Deal programme (1933–4) under the new president, Franklin Delano Roosevelt, separated the commercial and investment arms of banks (the 1933 Glass-Steagall Act), set up the bank deposit insurance system to protect small savers against bank failures, tightened stock market regulation (the 1933 Federal Securities Act), expanded and strengthened the farm credit system, provided a minimum farm price guarantee and developed infrastructure (such as the Hoover Dam
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There were even more reforms under the so-called Second New Deal (1935–8), including the Social Security Act (1935), which introduced old age pensions and unemployment insurance, and the Wagner Act (1935), which strengthened trade unions.
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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’. The period really deserves the name, as it achieved the highest growth rate ever.
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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.23
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The IMF was established to provide short-term funding to countries in balance of payments crises (balance of payments is the statement of a country’s position in economic transactions with the rest of the world
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The World Bank was established to provide loans for ‘project lending’ (that is, money that is given to particular investment projects, such as building a dam).
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Making up the third leg of the post-war world economic system was the GATT (General Agreement on Trade and Tariffs), which was signed in 1947.
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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.
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These changes in policies and institutions are seen to have contributed to the making of the Golden Age in a number of ways – creating social peace, encouraging investment, increasing social mobility and promoting technological innovations.
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Soon after the Second World War, many European countries took private enterprises into public ownership or set up new public enterprises, or state-owned enterprises (SOEs), in key industries, such as steel, railways, banking and energy (coal, nuclear and electricity).
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Learning the lessons of the Great Depression, governments in all ACCs started to deploy deliberately counter-cyclical macroeconomic policies, also known as Keynesian policies (see Chapter 4), expanding government spending and money supply from the central bank during economic downturns and reducing them during upturns.
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Governments in countries such as France, Japan and South Korea did not stop at promoting particular industries and explicitly coordinated policies across industrial sectors through their Five Year Plans – an exercise known as indicative planning, to distinguish it from the ‘directive’ Soviet central planning.
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Independence came later to Sub-Saharan Africa, with Ghana becoming the first independent country in 1957.
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The ‘miracle’ economies of South Korea, Taiwan, Singapore and Hong Kong grew at 7–8 per cent per year in per capita terms during this period, achieving some of the fastest growth rates in human history
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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.
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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).
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More importantly, the next several years were characterized by stagflation. This newly coined term referred to the breakdown of the age-long economic regularity that prices fall during a recession (or stagnation) and rise during a boom. Now, the economy was stagnating (albeit not exactly in a prolonged recession, like during the Great Depression) but prices were rising fast, at 10, 15 or even 25 per cent per year.27