In sum, both circumstances and design allowed the Social Security Act to assuage the voting public’s concerns about the “undeserving” poor that had thwarted such programs in the past. The United States now had a government-facilitated plan of social insurance, but it was a safety net with significant holes. Health care was not covered, nor was a large part of the historically disadvantaged black population. The first has not been remedied fully to date, and it took the Civil Rights movement in the 1960s to force the United States to act on the latter.
THE CURBS ON COMPETITION
Before we end this chapter, it is important to point to a third consequence of the Great Depression. It was an economic cataclysm worse than anything the citizens of developed countries had experienced before. Captains of industry and finance were pilloried as rogues, while the best economic minds could do little to restore prosperity. Many societies blamed corrupt capitalism for the prolonged downturn, and turned to fascism or socialism instead. Even in the United States, the supposed bastion of free enterprise, there was a broad groundswell of opinion that market competition was to blame, and that capitalism would be more stable if it were muzzled.
Across the market economies, competition was constrained, if not stifled, with official support during the Depression. In the United States, states passed “fair trade” legislation that set floors for retail prices, protecting small-town manufacturers and retailers from competition from big business. Custom tariffs went up to curb imports, including the infamous Smoot Hawley Act passed by the US Congress in 1930, which prompted tit-for-tat tariffs across the developed world. Capital controls limited cross-border investment flows, while industry-wide or even economy-wide agreements between firms, and between firms and labor such as the Saltsjöbaden Agreement in Sweden in 1938, sought to sacrifice competition for stability. Governments effectively suspended antitrust. In country after country, the private sector was significantly more heavily regulated, while many industries were nationalized. These efforts to curb competition did not restore growth. Ultimately, it was World War II, with its enormous demand for the machinery of war, that pulled economies out of the Depression. The centralized management of war production, however, further limited competition. In some of the victorious countries, public faith in government solutions increased further.
CONCLUSION
What makes people both able and willing to organize politically? An effective state, which people can rely on for public services, and a well-administered safety net that people have paid for and are thus entitled to, have the collateral effect of freeing them from requiring political patronage of the kind we saw in India. They are able to engage politically. The decentralization of powers and activities to communities draws them into actual political engagement. The community then serves as a base to mobilize protest.
The engaged community, acting as a watchdog, can push politically to reduce cronyism and preserve competition in markets. In turn, as we emphasized in this chapter, competitive markets forge a confident and efficient private sector, which can stand independently of the state and check it when it tends toward authoritarianism. In these ways, the pillars reinforce or check each other.
By the end of the Second World War, though, the state had taken on more and more, while markets and the community did less and less. The changes were neither linear nor continuous, but over time, they were significant. The initial functions the state took on, such as regulation, were necessary to make the market work better in the public interest. The accent was typically on increasing competition and opportunity, reforms that public movements pushed for. However, the public attitude toward competition reversed during the Great Depression. Consequently, the state started favoring cartelization, and also entered a number of activities that were previously undertaken by private business. The state now encroached on markets.
The state was a helpful support to the community, as we have seen in this chapter, but it also started displacing it. Government bureaucracy followed through the door opened by assistance to the community, if nothing else to monitor the usage of public funds. The bureaucratic temptation to build professional empires often reduced local control, crowded out community engagement, and weakened the community as a key pillar of democratic vigilance. Inevitably, government programs also interfered with intra-community relationship building. Milton and Rose Friedman’s critique of social security was precisely that in the past, “. . . children helped their parents out of love or duty. They now contribute to the support of someone else’s parents out of compulsion or fear. The earlier transfers strengthened the bonds of the family; the compulsory transfers weakens them.”51 Indeed, James Poterba finds the elderly in the United States have been less supportive of education for the young in recent times than before the institutionalization of social security, especially in diverse communities.52
One purpose of our historical excursion was to trace the development of the three pillars, from the chrysalis of the tribal or feudal community into their contemporary avatars. As the world emerged from World War II, the modern shapes of the three pillars were recognizable. Among the pillars, the state was in ascendance. We will now turn to the postwar era, to see how today’s imbalances developed.
PART II
IMBALANCE
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.
FROM W. B. YEATS, “THE SECOND COMING,” 1919
The world economy was in a mess after World War II. Much of Europe and Japan was in ruins, most economies were geared towards war production, and the state had expanded to crowd out markets. The democratic Allies had defeated the Axis powers in the war, but which way countries would turn politically was still uncertain. The United States was pivotal in tilting the world towards democracy, both with the rules-based global order it created, which steadily opened up trade, as well as with its generous funding of development. Pax Americana was founded on the belief that the United States benefited from the prosperity of other democracies, and it worked. Growth in developed countries was spectacular in the three decades after the war. This strengthened democracies but also led them to further expand the state as they made handsome promises of health care and social security to their people based on the rosy view that strong economic growth would continue well into the future.
Then in the early 1970s economic growth slowed significantly. The state had to give room back to markets if economies were to get to even moderate levels of growth. Across the developed world, the emphasis in the 1980s shifted to deregulation and reductions in barriers to trade and capital flows.
Even as markets regained ascendance, the disruptive effects of the ICT Revolution started being felt. Even though its impact on productivity has been limited thus far, its impact on jobs, both through automation and through trade, as well as its impact on incomes, have been sizeable. The consequences have been very different across communities within large countries, with some communities experiencing significant economic distress and social breakdown and others unimaginable prosperity. The skewness in incomes in developed countries has been exacerbated by incumbents protecting themselves from competition in a variety of ways.
We will examine the roots of popular resentment in developed countries today. Especially concerning is the breakdown of the economically mixed community as the well-to-do move into localities with others from their own income class, which leaves poorer classes stuck in communities with lower quality public services like schools. The reason for such residential sorting is that parents want the best learning environment for their children, given the technology-induced premium accorded to capabilities. In turn, residential sorting ensures that the emerging technology-induced meritocracy b
ecomes a hereditary one. Popular resentment, already at a high pitch after the Global Financial Crisis, has boiled over with Obamacare in the United States and the immigration crisis in Europe. Society has become imbalanced once again, and radicals of all kinds are pushing for change.
Before moving to reform proposals in Part III, we will turn to the two largest emerging markets, China and India. After outlining the reasons for their extraordinary growth, we will see that each one has a different kind of imbalance to deal with. China has a strong state, dominated by the Communist Party. Can China’s increasingly sophisticated and complex markets grow while the state continues to be under Party control? For democratic India, the challenge is to make the state more effective, while placing stronger constitutional limits on it. This requires a more independent private sector. As these countries, especially China, play a greater role in global governance, the future is worrying. Populist nationalism in the developed countries will strengthen incipient nationalism in the emerging markets, and make divisive conflict at the international level more likely. This is yet more reason why reforms are urgent.
5
THE PRESSURE TO PROMISE
Competition and markets became terms of abuse in many countries during the Great Depression. The state grew at the expense of markets and the community, and continued growing during the subsequent world war as it organized the war effort. After the defeat of fascism in World War II, various varieties of socialism or communism seemed the natural alternative to capitalism in much of the world, even if not directly imposed by China or the Soviet Union on client states. Postwar Italy and Greece had strong communist parties, and the French Communist Party participated in postwar French cabinets.
Politically, therefore, the market system had to offer an attractive alternative to socialism. After all, the Soviet Union was the development success in the 1940s and 1950s (as China is the success today), having moved from a peasant economy to challenging the United States for world leadership in one generation. As the Second World War ended, the United States, victorious and confident, rebuilt the postwar international system. It created the necessary institutions to manage global trade, investment, and capital flows, and made loans and grants where needed to help countries recover or develop. The United States set in motion the forces that would encourage the formation of liberal market democracies around the world.
Nevertheless, with deep and widespread skepticism about competition dominating public sentiment even in the United States, the revival of the developed economies entailed a significant state presence in the markets. Nationalized firms accounted for a sizeable share of key industries in many countries, a number of prices and interest rates were regulated or fixed, and many market activities were limited or banned. Government-supported cartels permeated the private sector, and industry-wide wage agreements were rife. The visible hand of the state or state-like agencies was everywhere, including in international trade; the International Monetary Fund (IMF) monitored a system where countries had fixed exchange rates, which could be adjusted only after discussion with the IMF; and the General Agreement on Tariffs and Trade (GATT) tried to push all countries toward tariff reduction.
There was also widespread public revulsion with the divisive politics of the 1930s, especially in Western Europe. The establishment parties remembered that they had been outflanked by the radicals even while they were engaged in fighting one another. Perhaps further held together by a fear of the communists, especially with the Soviet Union’s reach extending beyond the Iron Curtain into various communist organizations across Western Europe, mainstream parties did their best to accommodate one another and build consensus.
It worked miraculously! The developed world reached levels of prosperity that could not have been imagined in dark days of the Great Depression. Few, however, realized during these decades of high growth that their economy’s spectacular performance owed in substantial part to a one-time repair of the damage done by depression and war, as well as a reaping of the remaining fruits of the Second Industrial Revolution. Interestingly, the socialist countries behind the Iron Curtain also grew reasonably, suggesting that command economies could flourish when growth was a matter of catching up with the leaders of the developed world. Communism’s lure dimmed, though, as Soviet incursions into Hungary in 1956 and into Czechoslovakia in 1968 suggested that there was no real room for dissent in the Soviet empire, and as growing cynicism about the appropriation of benefits by the favored few in communist economies dampened worker incentives to work hard.
All was not well, though, even in developed countries. In the years of strong growth, the impulse to reward populations for the enormous hardships they had suffered led democratic governments to make promises of social benefits that relied heavily on continued strong economic growth. Government spending expanded enormously in the 1960s. A number of countries also got used to a steady stream of immigrant workers, with immigrants having second-class status and bearing the brunt of job losses in the mild postwar downturns. In the meantime, the inefficiencies stemming from state intervention and private-sector cartelization were masked by the continuing productivity benefits as the Second Industrial Revolution spread to the corners of every country. When these benefits came to an end toward the end of the 1960s, growth slowed considerably in the 1970s, inflation picked up, and resource-strapped governments had to look for new ways of energizing growth.
With the zeal of the long-suppressed and the ignored, the proponents of the market blamed state overreach for the growth slowdown, and pushed back against the state everywhere. The pendulum of public sentiment swung against the state again. The new consensus in developed democracies was to bring down inflation, to liberalize in order to remove the competitive barriers erected during the Depression, to deregulate to give business a freer hand, and to integrate economies further, including allowing freer movement of capital and people. Interestingly, the more individualistic Anglo-American economies emphasized deregulation while the more collectivist continental European economies emphasized integration to revive competition.
Growth picked up in developed democracies from the mid-1980s, though not to the previous heights. This growth, combined with greater openness, created markets for developing country exports, allowing a number to climb out of poverty. Left behind was the communist world, unable to liberalize or innovate to grow further without undermining their defining characteristic—state domination of the economy. Communist governments could manage large state-driven defense or space projects, but were not very good at consumer-oriented innovation. The competitive pressure capitalist innovation and efficiency placed on them proved intolerable. The Soviet empire broke up, with many of its successor countries discarding socialism. China never actually abandoned socialism but, economically, “socialism with Chinese characteristics” seemed a euphemism for managed competition, with privileges carved out for the state sector.
Even as some in the West celebrated the victory of liberal market democracy, the old fault lines started to become exposed. Growth was still insufficient to redeem the social promises that had been made, and government debt grew relentlessly. Furthermore, the early effects of the ICT revolution were exacerbating all kinds of inequality, without contributing significantly to growth. The pressure for workers to acquire new capabilities increased, even as immigration increased the diversity of the workforce, and a stronger embrace of civil rights for all made it impossible for developed societies to neglect anyone. Worried about fiscal sustainability, countries rolled back the welfare state, with its emphasis on post-market support. However, they did not redirect state spending sufficiently into enhancing pre-market worker capabilities. Social attitudes had swung all the way from assuming the state could do no wrong to believing it could get nothing right.
This chapter explains the postwar antecedents of the problems developed countries are experiencing today, which we will detail in the next chapter. It is also important to recognize th
e tremendous benefits of the postwar rules-based international order, the widespread trust in policy makers, and the political compact between establishment parties, all of which are under threat today. We will also see that public policy has impact with long lags, and tends to persist into futures its makers never envisaged, something we must always remind ourselves of.
THE POSTWAR MIRACLE
In the three decades or so after World War II, the developed world experienced the strongest growth it has ever seen. It was perhaps not so surprising that the United States, which emerged from World War II as the most powerful economic and military power on the planet, would grow strongly. However, Japanese growth was spectacular, as was Western Europe’s, even though many of their cities had been bombed into rubble and significant portions of the population faced hunger, homelessness, and unemployment as the war ended.
Many parts of Europe were genuinely underdeveloped as the war ended. Countries like Spain and Portugal were poor even though the war had largely passed them by—one person in two in Spain and Portugal was in agriculture, while 40 percent of the Italian labor force was thus employed. In the late 1940s, the average age of machinery in France, one of the more advanced European economies, was twenty years old, compared to an average age of five years old in the United States. French farm productivity was one-third of the farm productivity in the United States.1 It was not that the United States itself was uniformly developed. In 1940, only one-sixth of rural farms in the southern United States had electric lights, while over 80 percent still used kerosene or gasoline for lighting. Indeed, fewer than 60 percent of households in the United States had an exclusive indoor flush toilet or a bathing facility at that time; the rest had to do with outdoor privies or shared facilities.2
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