NS4053 Winter Term 2013 Historical Theories of Growth and Development

1. NS4053Winter Term 2013Historical Theories of Growth and Development

2. Historical Theories: Overview • For years economists have attempted to identify factors responsible for long term growth, business cycles and development • Early attempts – British Classicals in 1700s were primarily interested in growth. • Marx – mid-1800s more interested in stages of development and evolution of economies to higher stages • Schumpeter – early-to-mid 1900s saw the advantages of capitalism – showed why many of Marx’s forecasts were wrong • Hansen-- 1930s-1940s largely concerned with the problems of maintaining growth in mature economies • Each focused on a factor of production – Classicals, land, Marx – capital, Schumpeter entrepreneurship, Hansen technology. • All very pessimistic about the ability of economies to sustain high rates of growth indefinitely – some sort of diminishing returns/constraints would eventually slow growth • Each, in own way, can be considered a stagnationist. • All made bad forecasts.

3. Classical Theory of Economic Stagnation I Overview • Classical theory largely based on work of 19th-century English economists, David Ricardo, Adam Smith • The group was greatly influenced by Newtonian physics – activities not random but subject to some grand design. • Believed as in physics some natural order determined prices, rent, and economic affairs. • For Ricardo – assumption was little continuing technological progress -- growth limited by land scarcity. • Believed in the labor theory of value – value determined by labor inputs • Ricardo primarily interested in the distribution of income between wages, rents and profits – changes in these over time drove the system to eventual equilibrium • Key assumption the division of labor, limited by size of market – advocated laissez-faire capitalism and free trade to develop larger markets.

4. Classical Theory of Stagnation III • For Ricardo, the law of diminishing returns – successively lower extra outputs from adding fixed inputs to land was key element • For him diminishing returns from population growth and a constant amount of land threatened economic growth • Ricardo believed technological change or improved production techniques could only temporarily check diminishing returns. • Increasing capital was seen as the only way of offsetting this long run threat. Process as follows: • In the long run natural wage is at subsistence – cost of perpetuating the labor force. • The wage may deviate, but eventually returns to a natural rate. • In years of good harvests food supplies are greater than what is essential for maintaining the population – wage above subsistence level.

5. Classical Theory of Stagnation V • Ricardian Process (contd) • Extra food means fewer deaths, more births, and the population increases • More people need food and the average wage falls. Population growth continues to reduce wages until they research subsistence again • On the other hand a wage below substance increases deaths and eventually contributes to a labor shortage which raises the wage. • Population decline increases wages once again to the subsistence level • In both cases the tendency is for the wage to return to the natural subsistence wage • Called the iron law of wages – total wages increase in proportion to the labor force

6. Classical Theory of Stagnation VI • Output increases with population but other things equal, output per worker declines with diminishing returns on fixed land – price of food and thus the wage increase. • Thus the surplus value (output minus wages) per person declines with increased population • At same time land rents per acre increase with population growth as land becomes scarcer relative to other factors. • The only way of offsetting diminishing returns is by increased capital per person. • However capitalists require minimum profits and interest payments to maintain or increase capital stock. • Yet because profits and interest per-person decline and rents increase with population growth there is a diminishing surplus (profits interest and rent) available for capital accumulation • Productivity in manufacturing not sufficient to offset rising wages – profits and investment fall.

7. Classical Theory of Stagnation IV • Classical production function – diminishing returns

8. Classical Theory of Stagnation II • Argument for free trade – way of postponing diminishing returns • Increased efficiency allowed higher standard of living. Number of hours required to produce one unit of wine and cloth in England and Portugal

9. Classical Theory of Stagnation VII • Critique of Classicals • Paradoxically theory formulated amid numerous scientific discoveries and technical changes that multiplied output • Since Ricardo’s time rapid technological progress has contributed to unprecedented economic growth. • Iron law of wages did not foresee extent to which population growth could be limited • Later neoclassical economists take the classical stress on savings, free trade and freedom from government restriction and add an emphasis on technological change as an important component of economic growth. • These ideas are major features of the neoclassical theory of growth – the dominant present day theory of economic growth.

10. Modern Malthusians I • Despite their poor forecasts, many observers still look to the Classical school for insight to current trends. • Modern Malthusians usually look to something that is linely to be an impediment or barrier – diminishing returns. • Carliste Ford Runge, “Against the Grain”, Foreign Affairs, 2010 • Notes that in the 1960s, 1970s, and 1980s crop yields continued to increase – “green revolution” greatly increased yields – may have bred over optimism • Recent increases in food prices complex, but one factor is rising populations and incomes even as food being diverted to other uses – bio-fuels – raises specter of hunger • A food crisis is intensifying due to three ominous trends: • First, the rate of increase in crop yields appears to be slowing • Second (and related), agricultural research expenditures have diminished since the 1980s, especially in Africa • Third, global food supplies have begun to fall relative to demand and prices – compounded by the use of food in biofuels.

11. Modern Malthusians II Patterns: • Since World War II gains in agricultural productivity have been defined by grater output per acre of land • Gains primarily resulted from substantial use of agrochemicals, fertilizers, large farm equipment water and (mainly in Asia) labor • All inputs have come at a cost • Over-irrigation and the excessive use of fertilizes and chemicals have polluted and depleted water supplies and sapped soil’s fertility • Reality is that in twenty-first century as water and soil quality has fallen, unsustainable techniques have pushed biophysical systems to their limits • Although yields have continued to increase they have been doing so at diminishing rates.

12. Modern Malthusians III • Problem – appears that yield-increasing technology began slowing in the 1990s • Due only in part to biological limits • Also due to cutbacks in agricultural research – complacency that arose from ever-increasing yields • Appears however that improvements brought by investments in research come with a lag – peak about 25 years and their effects persist for as long as 25 more • Hence consequence of decisions taken in 1970s and 1980s to limit the growth in funding for agricultural research have only recently become apparent • Research also changed– public and private researchers increasingly switched. • Until the late 1970s, public sector, especially U.S. Department of Agriculture had taken lead – much of green revolution came from this effort.

13. Modern Malthusians IV • With public investment lagging, multinational corporations have taken the lead. • Problem public research tends to cast benefits more widely including many traditional farmers, whom it allows to make small but significant improvements • Together, diminished investments in agricultural research, and the shift of research from public sector to private sector have redirected the benefits to large, already successful commercial farmers. • Not getting the broad-based diffusion of technology as in the past in the past – may account in part for the slowing of productivity

14. Marx: Stage Theory I Marx wanted to replace the unhistorical approach of the classicals with a historical dialectic approach • Marxists consider classical and later orthodox economic analysis as a still photograph which describes reality at a certain time • In contrast the dialectical approach, analogous to a moving picture, looks at a social phenomenon by examining where it was and is going and its process of change. • History moves from one stage to another – feudalism, capitalism to socialism on the bases of changes in the ruling and oppressed classes and their relationship to each other • Conflict between the forces of production and the existing relations of production provide the dynamic movement in the materialist interpretation of history. • The interaction between forces and relations of production shapes politics, law, morality, religion, culture and ideas.

15. Marx: Stage Theory II Basic idea is that institutions are relatively inflexible while technology and the mode of production dynamic. • Contradictions develop with institutions becoming out-of tune with the needs of the economy – crisis occurs Accordingly feudalism is undercut by: • Migration of serfs to the town • Factory competition with handicraft and manorial production • Expanded transport, trade, discovery and new international markets on behalf of the business class and • The accompanying rise of nation states • The new class, the proletariat or working class, created by this next stage, capitalism, is the seed for the destruction of capitalism, the next stage. and the transformation into the next stage, socialism.

16. Marx: Stage Theory III • Capitalism faces repeated crisis because the market, dependent largely on worker consumption, expands more slowly than productive capacity • Moreover, this unutilized capacity creates in Marx’s phrase a reserve army of the unemployed – a cheap labor source that expands and contracts with the business cycle • With the growth of monopoly, many small businesspeople, artisans and farmers become propertyless workers who are no longer in control over their workplaces. • Eventually the proletariat revolts, takes control of capital and establishes socialism. • In time, socialism is succeeded by communism, and the state withers away. • From the late 19th century through the first three quarters of 20th century, Socialist, and Labor parties in Western Europe have tried to introduce socialism through parliamentary democracy rather than violent revolution. • Since 1970s and 1980s, however these parties with Marxist origins have limited goals to welfare state under capitalism.

17. Marx: Stage Theory IV Critique: • Number of flaws – theorized worker revolt in industrialized west, but revolution occurred first in Russia, one of the least developed capitalist countries in Europe • Marxists suggest several reasons why Western workers have yet to overthrow capitalism • Having realized dangers of rebellious working class the capitalists have developed tactic of divide and rule that depends on exploitation of workers outside the West. • Capitalist state has powerful legal, police, military and administrative machinery to quell potential resistance. • Marx overlooked possibility that the interests of workers and capitalists might not conflict • Workers in West may have supported capitalism because they gained more in the long run by receiving a constant share of rapidly growing output than trying to acquire a larger share of what might have been a more slowly growing output under an alternative system.

18. Marx: Stage Theory V Assumptions off the mark: • Marx assumed that all technological change was capital intensive and labor saving – we now know technology responds to factor scarcity • Marx assumed a falling rate of return, but return calculated on turnover, not the way most businessmen look at profits. Even on turnover, falling profits would not necessarily occur with changing technology • Much more stability in wage share, capital intensity and other great ratios due to price signals • Marx did not realize that new industries create new jobs and that even if workers are replace by technology jobs in general do not contract • Marx assumed relatively rigid institutions, but institutions may be more adaptable to changing conditions and needs • However, did have sophisticated stage theory where mechanism from one stage to another was specified.

19. Extensions of Marx: Paul Baran I • Marx not interested in Africa, Asia and Latin America – not yet capitalist – he viewed introduction of European capitalism in these regions as beneficial • In 20th century Marxian analysis came to encompass an international class struggle, including the conflict between rich and poor countries. • Lennin argued that it was essential to recognize the difference between the monopoly capitalism of his period and the competitive capitalism of Marx’s day • According to Lenin, a logical outgrowth of the monopoly stage of industrial and financial capitalism is the imperialist domination of poor countries by rich countries. • Ideas incorporated (1940s, 1950s) by a U.S. Marxist Paul Baran into his theory of economic growth and stagnation. • For Baran, capitalism in developing countries not likely to repeat pattern in Europe

20. Extensions of Marx: Paul Baran II • Baran’s point: Capitalism in developing countries arose not through the growth of small competitive firms at home, but through the transfer from abroad of advanced monopolistic businesses. • Baran felt as capitalism took hold the business and middle classes in developing countries, lacking the strength to spearhead through institutional change for major capital accumulation would have to seek allies among other classes. • In certain circumstances business class would ally itself with more moderate leaders of the workers and peasants to form a progressive coalition – Congress Party in India under Nehru. • At outset such a popular movement would be essentially democratic, anti-feudal and anti-imperialist in support of domestic capitalism.

21. Extensions of Marx: Paul Baran III • In time however, indigenous capitalist middle classes would ultimately be either unwilling or unable to provide the leadership for sustained economic development that also would greatly reduce poverty and liberate the masses. • The local capitalist class frightened by the threat of labor radicalism and populist upheaval and the possible expropriation of their property would be forced into an alliance with the landed interests and the foreign capitalists in their midst • Foreign capitalists’ governments could provide economic and military assistance to stave off impending disaster • This coalition would have the common interest of preventing socialism. • However the coalition would be unable to raise the rate of capital accumulation significantly

22. Extensions of Marx: Paul Baran IV • A number of necessary actions would be beyond the coalitions power: • A progressive income tax system to eliminate nonessential consumption • Channeling savings from the landed aristocracy into productive investment; and • Undertaking substantial public investment in sectors in which private capital does not venture, in which monopolistic controls block expansion or in which infrastructure is required • Thus conservative alliance thrusts the popular forces even further along the road of radicalism and revolt leading to further polarization • Baran theorizes only way out of the impasse may be a worker and peasant revolution, expropriating land and capital and establishing a socialist regime

23. Extensions of Marx: Paul Baran V Critique • Baran’s model largely derived from his experience in one country, Guatemala – not necessarily typical setting • Theory fails to examine number of economic and political conflicts of interest • True, many local industrialists, businessmen, politicians benefit considerably from foreign controlled capital and technology. • However there are also some local capitalists whose interests compete with foreign business • These capitalists and their allies frequently lead movements for independence • After independence nationalist elements may become even stronger as colonial economic ties gradually weakened. • The allies and competitors of foreign business are often locked in economic and political conflict.

24. Extensions of Marx: Naomi Klein • Naomi Klein – contemporary, anti-capitalist, anti-globalist • Basic argument – somewhat conspiracy theorist -- capitalists and corporations exploit situation after conflict or disaster to impose shock therapy • In these situations a ruthless form of capitalism is imposed where it otherwise would never take hold • Crisis enable powerful and wealthy to exploit every advantage to their benefit at the expense of the less fortunate. • Argues that Milton Friedman’s neoliberal market fundamentalism is leading world into a new dark age of wars, mass suffering and exploitation. • Klein – creates a straw-man and looks at a simplistic form of free market fundamentalism – a very first step but one followed by governance and rule of law to control capitalism’s excesses.

25. Modern View of Demographics I • While the Classsicals tended to look at growing populations as a threat to prosperity, we now often view growing populations as important for growth • As countries transition from high to low death and birth rates, the population’s age structure changes and the economically dependent-proportion declines • This transition can create one (or more) forms of “demographic dividend”: • Labor supply increases as a greater proportion of total populations joins the working age group (15-64 years) • As each worker’s number of dependents falls, the worker is able to save more to finance deepening of the capital stock and to raise labor productivity • As dependency declines, more can be invested in healthcare and education for each child raising the quality of the human capital stock • As per capita income increases, demand increases for consumer goods.

26. Modern View of Demographics II • Many countries are now more concerned with declining or slowing rates of population growth • Demand side started with Hansen and the stagnationists in the 1930s – slowing population would require less investments – feeding back to slack demand and slow growth -- vicious circle • Supply side view – neoclassicals 1950s – demographic dividend facilitated East Asia miracle • Over the next 40 years Japan and Europe will see working-age populations shrink by 30 million and 37 million respectively • China’s working age population will keep growing for 15 years or so then turn down. • In 2050 China will have 100 million fewer workers than it does today

27. Trends in Working-Age Populations

28. Schumpeter I Basic Schumpeterian Model • 1. Same basic production function as the Classicals and Marx – output function of labor, capital, land and technological progress • Introduced the entrepreneur as critical element combining inputs • 2. Savings depends on wages, profits and the interest rate – savings increase with the interest rate, with workers now saving. • Introduced idea of financial markets as critical in growth – transfer resources from surplus to deficit individuals • 3. Total investment divided into induced investment and autonomous investment • Induced investment depends on the level of profits and the interest rate • His innovation was to show that induced investment stimulated by recent increases in output income, sales or profits • Autonomous investment brought forth by such long run considerations as technological change

29. Schumpeter II • Schumpeter felt the process of innovation was the critical element in autonomous investment • He though of innovation in general as any change in the production function which would bring about an increase in output – five major forms • Introduction of a new good – that is one which consumers not yet familiar or a new quality of good; • The introduction of a new method of production– not previously tested by experience • The opening of a new market • The development of a new source of supply of raw material/production inputs • The carrying out of the new organization of an industry

30. Schumpeter III • 4. Technological progress and the rate of resource discovery (innovations) depend on the supply of entrepreneurs • Entrepreneur is a visionary – sees opportunity for profits in new discoveries. • Often the entrepreneur simply uses other people’s money and ideas -- an intermediary between the financial and scientific communities • He raises the money to launch new enterprise, assembles the factors of production, chooses top managers and sets the organization going • He may not provide any funds of his own • He may not be a day-to-day manager • Nor is he usually an inventor or explorer • Schumpeter argues inventions or discoveries by themselves have little economic effect– patent registry filled with files of inventions that never see light of day.

31. Schumpeter – Entrepreneurship II His model one of the first to explain the business cycle: • Innovation sets up only a temporary monopoly gain which is soon wiped out by imitation • For profits to continue, it is necessary to keep ahead of one’s rivals • New bank credit finances the innovation, which once successfully set up is more easily imitated by competitors • Innovations are not isolated events evenly distributed in time, place and sector • They arise in clusters as a result of lowered risk • Eventually the waves of entrepreneurial activity not only force out old firms but also exhaust the limited possibilities of gain from innovation • As borrowing diminishes and loans are repaid, the entrepreneurial activity slackens and finally ceases • Innovation, saving, credit creation, and imitation explain economic growth whereas their ebb and flow determines the business cycle.

32. Schumpeter IV • 5. The supply of entrepreneurs depends on the rate of profits and the social climate • Like Mark Schumpeter put considerable stress on sociological factors • “Social Climate” a complex phenomenon reflecting the whole social political and socio-psychological atmosphere in which entrepreneurs operate • Includes the social values of a particular country, the class structure, the educational system • While entrepreneurs usually non-conformists, and often outcasts, social climate includes the attitudes of society toward business success and the nature and extent of the prestige and other social rewards apart from profits • Particularly important factor in “climate” is the entrepreneur’s understanding of the “rules of the game” – the conditions under which he must operate • Sudden changes in the rule of the game are particularly harmful to investment and enterprise

33. Schumpeter V • 6. The social climate is reflected by the distribution of income • Imperfect measure, hard to come up with good operational definition of entrepreneurship • Schumpeter felt any development tending to squeeze profits such as growing strength of trade unions, progressive income taxes, social welfare programs or any other government intervention designed to limit profits or redistribute income caused a deterioration of the climate. • Explained depth and duration of depression in 1930s in terms of labor legislation, social security, public works spending progress tax structure – changed rules of the game • In model the entrepreneurial success drives economies to high levels of prosperity – creative destruction needed for advancement • Problem: prosperity supports a whole class of people – academics, politicians and the like who are not part of capitalism and thus do not understand its workings

34. Schumpeter VI • Over time, these groups undermine public support for entrepreneurs – increase restrictions on entrepreneurial activities. • One of motives of entrepreneurs is to leave a large estate to their children/relatives • Progressive taxation, wealth taxation undermines the motive for entrepreneurial activity • With time the supply of entrepreneurs slows and the capitalist countries converge with communism: • a hybrid system of large firms built around managers, teams and organizations where the individual plays a small role • As in Marx, the capitalist system destroys itself. • In Marx it is to productive causing output to run ahead of demand --unemployment, • In Schumpeter it is too successful in creating a large surplus, thus facilitating the growth of groups that undermine the its foundations.

35. Schumpeter – Extensions Schumpeter’s model assumes that perfect competition is the norm. In today’s world: • Many economists now see pressures for innovation under oligopolistic competition with a few giant firms dominating the market providing incentives for unprecedented growth in the last century or so • Among large, high-tech business firms, innovation has replaced price as the important competitive weapon in the market • Capitalism is more likely to encourage productive entrepreneurship rather than rent seeking (non- productive) pursuit of profit. • Problem – Schumpeter’s concept of the entrepreneur is somewhat limited in developing countries. • The majority of LDC Schumpeterian entrepreneurs are trades whose innovations are opening new markets • Also, entrepreneurship in developing countries is often gap filling – seeing opportunities and responding. • In light of technical transfers from advanced economies the development of entirely new combinations should not unduly limit what is and is not considered entrepreneurial activity.

36. Expeditionary Economics I • The Schumpeterian model has recently formed the starting point for a new branch of applied economics, expeditionary economics (ExpECON) • ExpECON was introduced in a path-breaking article in the May/June 2010 issue of Foreign Affairs by then Kauffman Institute President and CEO Carl Schramm • ExpECON offered as an alternative to the top-down aid-driven approaches taken in Iraq and Afghanistan • Schramm’s basic points: • Economic growth is vital for stabilizing post-conflict/disaster settings • The U.S. military as often the dominant player in these environments must sharpen its ability to encourage indigenous entrepreneurship • The conventional US approach in recent post-conflict recoveries has failed largely because it has abandoned approach so successful in building the U.S. Economy – the encouragement and support of indigenous entrepreneurial initiative and activity.

37. Expeditionary Economics II • Scharamm’s work draws on many of the frustrations with the lack of success in Iran and Afghanistan as well as conventional economic approaches to development also critiqued by: • Dambisi Moyo – ineffectiveness of aid • Hernando DeSoto’s – lack of property rights as an element restricting entrepreneurship • To apply ExpECON Shramm feels the military needs to • Expand its areas of competence, • Rid itself of its central planning mentality, and • Become a more flexible force that can facilitate economic growth while stabilizing the regions in which it is engaged • ExpECON has generated considerable interest because provides deeper understanding than aid-based strategies of the dynamics at work in most conflict and post conflict disaster settings

38. Expeditionary Economics III • It lays out an optimistic plan to quickly jump-start economies in what were previously considered impossible situations. • ExpEcon has the potential to provide a considerably less expensive alternative than direct foreign assistance • There is also growing feeling in the U.S. military that economic conditions are increasingly important relative to military action in creating long-standing peace and stability in many trouble spots • At a minimum ExpEcon has shifted the focus of much work on post-conflict recovery to the role of entrepreneurship • ExpEcon main propositions: • The strategic use of economic development to fix failed economies in crisis states • Fundamentally about business development • Based on the assumption that economies growth when businesses grow; and • Focused on local communities and local businesses

39. Expeditionary Economics IV • ExpECON is not: • A blueprint for Western foreign direct investment; • A call for promoting multinational corporations to set up businesses in conflict zones; and • Focused on empowering Western aid agencies or NGOs. • The recent experiences of Afghanistan and Iraq are cited as a reason for shifting to ExpECON leading to these propositions • Afghanistan • Despite billions of dollars spent over past decade in Afghanistan, the capacity of the Afghan government to deliver basic services has remained severely limited • In the more remote areas, the government’s presence is sporadic at best

40. Expeditionary Economics V • With little in the way of local governance or finance, illegal activity continues to thrive, further undermining the authority and influence of the central government • Still the aid effort has been so massive that an estimated 97 percent of Afghanistan’s licit gross domestic product (GDP) is derived from NATO’s military activities and donor community present • Little evidence aid has been effective in stabilizing the country • Some argue that aid facilitated corruption of government officials has made the situation even worse. • Similarly little indication the aid effort has stimulated private sector activity and associated job creation. • Rather than benefit the population and prepare them for the future, billions of aid dollars have gone to foreign contractors and Afghan elites

41. Expeditionary Economics VI • Given the fact that by 2015 the US and its allies plan to hand over security and other responsibilities to the Afghan government • There will be significant cuts in spending and assistance with little or no indigenous production (outside of drugs) to pick up the slack • A recession is likely to occur, derailing the transition process and condemning the country to a long period of further violence and conflict • From the perspective of ExpECON – despite government and donor community neglect of the private sector, this segment of the economy had tremendous potential for growth and employment generation • Further many of the broad based stereo-types often painted of entrepreneurs in conflict settings were completely wrong.

42. Expeditionary Economics VII • Extensive surveys have found: • Afghan businesses are responding rationally to economic incentives in a highly distorted economic environment • Uncertainty and unpredictability, not physical insecurity are the fundamental obstacles to business • Business are adapting strategies such as vertical integration, pursuing short term trading over long-term enterprise and “buying” security in multiple ways • Many business people believe that the Afghan government not only fails to provide basic services but also engages in corruption that directly threatens their businesses; and • International actors distort the business environment in ways harmful to Afghan businesses • From these findings, easy to conclude the Afghan private sector had the poential for growth and positive change – if only given a chance in the form of some degree of stability and institutional reliability

43. Expeditionary Economics VIII Some questions concerning the application of expeditionary economics in Afghanistan: • What other kind of activities should complement this model or even be a prerequisite for it at the local level? • How should the U.S. military reinvent themselves in the eyes of many Afghans from military actors to agents for economic opportunities and peace? • How can the U.S. military ensure that what they does to create economic opportunities does not create new sources of conflict by destabilizing existing forces in the communities? • How can the U.S. military ensure that expeditionary economics does not delegitimize the government at the national and local level? • How should the transition from military-led to civilian-led reconstruction take place? and • How can the U.S. military ensure that what they do in terms of reactivating the economy is sustainable after they leave?