23 Things They Don't Tell You about Capitalism

by Ha-Joon Chang

  Thus, exactly because finance is efficient at responding to changing profit opportunities, it can become harmful for the rest of the economy. And this is why James Tobin, the 1981 Nobel laureate in economics, talked of the need to ‘throw some sand in the wheels of our excessively efficient international money markets’. For this purpose, Tobin proposed a financial transaction tax, deliberately intended to slow down financial flows. A taboo in polite circles until recently, the so-called Tobin Tax has recently been advocated by Gordon Brown, the former British prime minister. But the Tobin Tax is not the only way in which we can reduce the speed gap between finance and the real economy. Other means include making hostile takeovers difficult (thereby reducing the gains from speculative investment in stocks), banning short-selling (the practice of selling shares that you do not own today), increasing margin requirements (that is, the proportion of the money that has to be paid upfront when buying shares) or putting restrictions on cross-border capital movements, especially for developing countries.

  All this is not to say that the speed gap between finance and the real economy should be reduced to zero. A financial system perfectly synchronized with the real economy would be useless. The whole point of finance is that it can move faster than the real economy. However, if the financial sector moves too fast, it can derail the real economy. In the present circumstances, we need to rewire our financial system so that it allows firms to make those long-term investments in physical capital, human skills and organizations that are ultimately the source of economic development, while supplying them with the necessary liquidity.

  Thing 23

  Good economic policy does

  not require good economists

  What they tell you

  Whatever the theoretical justifications may be for government intervention, the success or otherwise of government policies depends in large part on the competence of those who design and execute them. Especially, albeit not exclusively, in developing countries, government officials are not very well trained in economics, which they need to be if they are to implement good economic policies. Those officials should recognize their limits and should refrain from implementing ‘difficult’ policies, such as selective industrial policy, and stick to less-demanding free-market policies, which minimize the role of the government. Thus seen, free-market policies are doubly good, because not only are they the best policies but they are also the lightest in their demands for bureaucratic capabilities.

  What they don’t tell you

  Good economists are not required to run good economic policies. The economic bureaucrats that have been most successful are usually not economists. During their ‘miracle’ years, economic policies in Japan and (to a lesser extent) Korea were run by lawyers. In Taiwan and China, economic policies have been run by engineers. This demonstrates that economic success does not need people well trained in economics – especially if it is of the free-market kind. Indeed, during the last three decades, the increasing influence of free-market economics has resulted in poorer economic performances all over the world, as I have shown throughout this book – lower economic growth, greater economic instability, increased inequality and finally culminating in the disaster of the 2008 global financial crisis. Insofar as we need economics, we need different kinds of economics from free-market economics.

  Economic miracle without economists

  The East Asian economies of Japan, Taiwan, South Korea, Singapore, Hong Kong and China are often called ‘miracle’ economies. This is, of course, hyperbole, but as far as hyperboles go, it is not too outlandish.

  During their Industrial ‘Revolution’ in the nineteenth century, per capita income in the economies of Western Europe and its offshoots (North America, Australia and New Zealand) grew between 1 per cent and 1.5 per cent per year (the exact number depending on the exact time period and the country you look at). During the so-called ‘Golden Age’ of capitalism between the early 1950s and the mid 1970s, per capita income in Western Europe and its offshoots grew at around 3.5–4 per cent per year.

  In contrast, during their miracle years, roughly between the 1950s and the mid 1990s (and between the 1980s and today in the case of China), per capita incomes grew at something like 6–7 per cent per year in the East Asian economies mentioned above. If growth rates of 1–1.5 per cent describe a ‘revolution’ and 3.5–4 per cent a ‘golden age’, 6–7 per cent deserves to be called a ‘miracle’.1

  Given these economic records, one would naturally surmise that these countries must have had a lot of good economists. In the same way in which Germany excels in engineering because of the quality of its engineers and France leads the world in designer goods because of the talents of its designers, it seems obvious the East Asian countries must have achieved economic miracles because of the capability of their economists. Especially in Japan, Taiwan, South Korea and China – countries in which the government played a very active role during the miracle years – there must have been many first-rate economists working for the government, one would reason.

  Not so. Economists were in fact conspicuous by their absence in the governments of the East Asian miracle economies. Japanese economic bureaucrats were mostly lawyers by training. In Taiwan, most key economic officials were engineers and scientists, rather than economists, as is the case in China today. Korea also had a high proportion of lawyers in its economic bureaucracy, especially before the 1980s. Oh Won-Chul, the brains behind the country’s heavy and chemical industrialization programme in the 1970s – which transformed its economy from an efficient exporter of low-grade manufacturing products into a world-class player in electronics, steel and shipbuilding – was an engineer by training.

  If we don’t need economists to have good economic performance, as in the East Asian cases, what use is economics? Have the IMF, the World Bank and other international organizations been wasting money when they provided economics training courses for developing-country government officials and scholarships for bright young things from those countries to study in American or British universities renowned for their excellence in economics?

  A possible explanation of the East Asian experience is that what is needed in those who are running economic policy is general intelligence, rather than specialist knowledge in economics. It may be that the economics taught in university classrooms is too detached from reality to be of practical use. If this is the case, the government will acquire more able economic policy-makers by recruiting those who have studied what happens to be the most prestigious subject in the country (which could be law, engineering or even economics, depending on the country), rather than a subject that is notionally most relevant for economic policy-making (that is, economics) (see Thing 17). This conjecture is indirectly supported by the fact that although economic policies in many Latin American countries have been run by economists, and very highly trained ones at that (the ‘Chicago Boys’ of General Pinochet being the most prominent example), their economic performance has been much inferior to that of the East Asian countries. India and Pakistan also have many world-class economists, but their economic performance is no match for the East Asian one.

  John Kenneth Galbraith, the wittiest economist in history, was certainly exaggerating when he said that ‘economics is extremely useful as a form of employment for economists’, but he may not have been far off the mark. Economics does not seem very relevant for economic management in the real world.

  Actually, it is worse than that. There are reasons to think that economics may be positively harmful for the economy.

  How come nobody could foresee it?

  In November 2008, Queen Elizabeth II visited the London School of Economics, which has one of the most highly regarded economics departments in the world. When given a presentation by one of the professors there, Professor Luis Garicano, on the financial crisis that had just engulfed the world, the Queen asked: ‘How come nobody could foresee it?’ Her Majesty asked a question that had been in most people’s minds since the ou
tbreak of the crisis in the autumn of 2008.

  During the last couple of decades, we were repeatedly told by all those highly qualified experts – from Nobel Prize-winning economists through world-class financial regulators to frighteningly bright young investment bankers with economics degrees from the world’s top universities – that all was well with the world economy. We were told that economists had finally found the magic formula that allowed our economies to grow rapidly with low inflation. People talked of the ‘Goldilocks’ economy, in which things are just right – not too hot, not too cold. Alan Greenspan, the former chairman of the Federal Reserve Board, who presided over the world’s biggest and (financially and ideologically) most influential economy for two decades, was hailed as a ‘maestro’, as the title of the book on him by the journalist Bob Woodward of Watergate fame had it. His successor, Ben Bernanke, talked of a ‘great moderation’, which came with the taming of inflation and disappearance of violent economic cycles (see Thing 6).

  So it was a real puzzle to most people, including the Queen, that things could go so spectacularly wrong in a world where clever economists were supposed to have sorted out all the major problems. How could all those clever guys with degrees from some of the best universities, with hyper-mathematical equations coming out of their ears, have been so wrong?

  Learning of the sovereign’s concern, the British Academy convened a meeting of some of the top economists from academia, the financial sector and the government on 17 June 2009. The result of this meeting was conveyed to the Queen in a letter, dated 22 July 2009, written by Professor Tim Besley, a prominent economics professor at the LSE, and Professor Peter Hennessy, a renowned historian of British government at Queen Mary, University of London.2

  In the letter, Professors Besley and Hennessy said that individual economists were competent and ‘doing their job properly on its own merit, but that they lost sight of the wood for the trees’ in the run-up to the crisis. There was, according to them, ‘a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole’.

  A failure of the collective imagination? Hadn’t most economists, including most (although not all) of those who were at the British Academy meeting, told the rest of us that free markets work best because we are rational and individualistic and thus know what we want for ourselves (and no one else, possibly except for our immediate families) and how to get it most efficiently? (See Things 5 and 16.) I don’t remember seeing much discussion in economics about imagination, especially of the collective kind, and I’ve been in the economics profession for the last two decades. I am not even sure whether a concept like imagination, collective or otherwise, has a place in the dominant rationalist discourse in economics. The great and the good of the economics world of Britain, then, were basically admitting that they don’t know what has gone wrong.

  But this understates it. Economists are not some innocent technicians who did a decent job within the narrow confines of their expertise until they were collectively wrong-footed by a once-in-a-century disaster that no one could have predicted.

  Over the last three decades, economists played an important role in creating the conditions of the 2008 crisis (and dozens of smaller financial crises that came before it since the early 1980s, such as the 1982 Third World debt crisis, the 1995 Mexican peso crisis, the 1997 Asian crisis and the 1998 Russian crisis) by providing theoretical justifications for financial deregulation and the unrestrained pursuit of short-term profits. More broadly, they advanced theories that justified the policies that have led to slower growth, higher inequality, heightened job insecurity and more frequent financial crises that have dogged the world in the last three decades (see Things 2, 6, 13 and 21). On top of that, they pushed for policies that weakened the prospects for long-term development in developing countries (see Things 7 and 11). In the rich countries, these economists encouraged people to overestimate the power of new technologies (see Thing 4), made people’s lives more and more unstable (see Thing 6), made them ignore the loss of national control over the economy (see Thing 8) and rendered them complacent about de-industrialization (see Thing 9). Moreover, they supplied arguments that insist that all those economic outcomes that many people find objectionable in this world – such as rising inequality (see Thing 13), sky-high executive salaries (see Thing 14) or extreme poverty in poor countries (see Thing 3) – are really inevitable, given (selfish and rational) human nature and the need to reward people according to their productive contributions.

  In other words, economics has been worse than irrelevant. Economics, as it has been practised in the last three decades, has been positively harmful for most people.

  How about the ‘other’ economists?

  If economics is as bad as I say it is, what am I doing working as an economist? If irrelevance is the most benign social consequence of my professional actions and harm the more likely one, should I not change my profession to something more socially beneficial, such as electronic engineering or plumbing?

  I stick to economics because I believe that it does not have to be useless or harmful. After all, throughout this book I have myself used economics in trying to explain how capitalism really works. It is a particular type of economics – that is, free-market economics as it has been practised in the last few decades – that is dangerous. Throughout history, there have been many schools of economic thinking that have helped us better manage and develop our economies.

  To start from where we are today, what has saved the world economy from a total meltdown in the autumn of 2008 is the economics of John Maynard Keynes, Charles Kindleberger (the author of the classic book on financial crises, Manias, Panics, and Crashes) and Hyman Minsky (the greatly undervalued American scholar of financial crises). The world economy has not descended into a rerun of the 1929 Great Depression because we absorbed their insights and bailed out key financial institutions (although we have not properly punished the bankers responsible for the mess or reformed the industry yet), increased government spending, provided stronger deposit insurance, maintained the welfare state (that props up the incomes of those who are unemployed) and flushed the financial market with liquidity on an unprecedented scale. As explained in earlier Things, many of these actions that have saved the world are ones opposed by free-market economists of earlier generations and of today.

  Even though they were not trained as economists, the economic officials of East Asia knew some economics. However, especially until the 1970s, the economics they knew was mostly not of the free-market variety. The economics they happened to know was the economics of Karl Marx, Friedrich List, Joseph Schumpeter, Nicholas Kaldor and Albert Hirschman. Of course, these economists lived in different times, contended with different problems and had radically differing political views (ranging from the very right-wing List to very left-wing Marx). However, there was a commonality between their economics. It was the recognition that capitalism develops through long-term investments and technological innovations that transform the productive structure, and not merely an expansion of existing structures, like inflating a balloon. Many of the things that the East Asian government officials did in the miracle years – protecting infant industries, forcefully mobilizing resources away from technologically stagnant agriculture into the dynamic industrial sector and exploiting what Hirschman called the ‘linkages’ across different sectors – derive from such economic views, rather than the free-market view (see Thing 7). Had the East Asian countries, and indeed most of the rich countries in Europe and North America before them, run their economies according to the principles of free-market economics, they would not have developed their economies in the way they have.

  The economics of Herbert Simon and his followers has really changed the way we understand modern firms and, more broadly, the modern economy. It helps us break away from the myth that our economy is exclusively populated by rational self-seekers interacting through the market mechanism
. When we understand that the modern economy is populated by people with limited rationality and complex motives, who are organized in a complex way, combining markets, (public and private) bureaucracies and networks, we begin to understand that our economy cannot be run according to free-market economics. When we more closely observe the more successful firms, governments and countries, we see they are the ones that have this kind of nuanced view of capitalism, not the simplistic free-market view.

  Even within the dominant school of economics, that is, the neo-classical school, which provides much of the foundation for free-market economics, there are theories that explain why free markets are likely to produce sub-optimal results. These are theories of ‘market failure’ or ‘welfare economics’, first proposed by the early twentieth-century Cambridge professor Arthur Pigou, and later developed by modern-day economists such as Amartya Sen, William Baumol and Joseph Stiglitz, to name just a few of the most important ones.

  Free-market economists, of course, have either ignored these other economists or, worse, dismissed them as false prophets. These days, few of the above-mentioned economists, except those belonging to the market-failure school, are even mentioned in the leading economics textbooks, let alone properly taught. But the events that have been unfolding for the last three decades have shown that we actually have a lot more positive things to learn from these other economists than from free-market economists. The relative successes and failures of different firms, economies and policies during this period suggest that the views of these economists who are now ignored, or even forgotten, have important lessons to teach us. Economics does not have to be useless or harmful. We just have to learn right kinds of economics.