Fault Lines: How Hidden Fractures Still Threaten the World Economy
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How the Early Developers Built Organizational Capital
The great Austrian economist Joseph Schumpeter argued that capitalism grew through innovation, with newcomers bringing in creative new processes and techniques that destroyed the businesses of old incumbents. Much of capitalism’s dynamism in industrial countries does reflect this process: in the past few years, for example, the whole business of film photography has been almost completely eclipsed by the digital photography revolution. Film makers such as Kodak, which did not anticipate the speed of this change, have had to struggle to remake themselves.
With this kind of growth process in mind, what is loosely termed the institutional school of economists has argued that the role of the government in business is to create the institutional environment for competition and innovation—to establish secure property rights, strengthen patent laws, reduce barriers to entry, and reduce taxes—and then let the private sector take charge. There is a small problem with this view. No large country has ever grown rapidly from poverty to riches with this kind of strategy, in part because poor countries do not have the necessary private organizations to take advantage of such an environment, and the environment, in turn, is not conducive to creating the organizations quickly.
For example, British India had many of the qualities that these economists advocate: a small and fairly honest government, low taxes, low tariffs, a focus on building infrastructure like railways, and a laissez-faire attitude (even toward famines).5 However, between 1820 and 1950, per capita incomes in India were virtually stagnant, growing at just 0.1 percent per year because the British did little to nurture local industry. Instead they encouraged imports of both goods and management, especially from Britain: India had among the lowest import tariffs in the world in 1880. As a result, India’s private sector simply did not have the encouragement or the requisite cover behind which to develop organizational capital.
Indeed, economists may overplay the role of institutions in growth. History suggests that institutional change often does not predate but rather accompanies the process of growth.6 For example, sensible governments of developing countries do not have strong laws protecting intellectual-property rights when their industrial sector is starting out: such laws would put an end to the rampant copying from foreigners that is often the basis for initial growth. Instead, they enact property-rights legislation when domestic firms have become strong enough to innovate and demand protection. Generally, institutions seem to develop along with, and in response to, the need for them. They are then refined through use and kept from exercising authority arbitrarily by the complex organizations that use them and pay for their upkeep. In many ways, the real challenge for developing countries is, again, to create effective complex organizations.
Rich early developers such as Australia, Canada, and the United States built their complex organizations over time. New industries often started with many small firms, some of which were exceptionally innovative or well managed. These generated larger profits than their competitors, hired more employees, and, over time, built effective and stable organizational structures. Initially, these firms grew slowly, both because it takes time to build the social relationships, the organizational norms, and the organizational procedures that allow the firm to function efficiently and because the availability of outside finance to an untried, unproven organization is limited. Eventually, some firms gained reputation and wealth: many of these were family firms like Anheuser-Busch or Cargill in the United States, whose reputation could transfer down through generations.7 Because banks would accept these firms’ reputation and wealth as collateral for financing, they could grow faster. All in all, however, growth was slow and steady, with many firms falling by the wayside; failure rates for small, new firms are spectacularly high even today.8
Governments of early developers, in general, simply did not have much capacity to intervene to create a nurturing environment, even if they wanted to. Before the dramatic increase in spending during the Great Depression, the total outlays of the U.S. government in 1930 were only 3.4 percent of GDP.9 The primary roles of the government were thought to be defense and maintaining law and order. However, wealth was a source of military power, and wealthier people were happy and did not foment trouble. Governments, therefore, did try to foster growth, typically through the strategic use of trade barriers and tariffs.
Daniel Defoe, the businessman, journalist, pamphleteer, and author of Robinson Crusoe, among other books, describes in detail in A Plan of the English Commerce one of the earliest documented instances of government-aided development: the way the Tudor monarchs transformed England from a country reliant on raw-wool exports to one that exported manufactured woolens.10 Prior to his coronation following the War of the Roses, Henry VII spent time as a refugee in the Low Countries. Impressed by the prosperity in those lands, derived from wool manufacturing, he decided to encourage manufacturing in England.
The measures he took included identifying locations suitable for manufacturing, poaching skilled workers from the Low Countries, increasing duties on or even banning the export of raw wool, and banning the export of unfinished cloth. The monarchy also started promoting the export of finished woolen garments, with Elizabeth I dispatching trade envoys to the Russian, Mogul, and Persian empires. The calibrated and measured support afforded to industry is best reflected in the fact that raw-wool exports were permanently banned only when the monarchy was confident that domestic manufacturers could use all the raw wool available and were competitive enough internationally to export the additional production. Such managed competition eventually drove manufacturers in the Low Countries to ruin.
Governments also tried to create private monopolies in banking or trade (recall the East India Company, which was granted certain monopoly rights over trade with India and ended up ruling much of the subcontinent). But citizens saw these as indirect forms of taxation and, as democratic rights expanded, fought hard to curb them. So competition within the domestic market was typically unfettered, with governments rarely intervening. The extent of government intervention is the critical difference between the early developers and many of the late developers.
The Strategy of Late Developers
The late developers, especially nations that became independent just after World War II, started out with organizational deficiencies similar to those of the early developers. Indian politicians like to recall that when India became independent in 1947, it had to import even sewing needles.11 Their governments were, however, much more impatient for growth, especially given the expectations of their newly free citizens. Moreover, when they started out, they faced much fiercer competition from firms in developed countries than the early developers had faced initially. In the century or so between when the early developers began industrializing and when the late developers started, the cost of transportation had fallen tremendously, and the extent of potential competition from firms in richer countries was commensurately much higher.
Their strategy for advancement, though, was clear: climb the same ladder the rich countries had done, step by step, moving from the least sophisticated technologies to the frontier of innovation, using low labor costs to stay competitive until technologies improved and the available capital stock, including human capital, increased.
The organizational path was less well laid out. Given that the late developers had little faith that their small and underdeveloped private-sector firms could lead growth at a pace that would satisfy their needs, they had two options: they could create government enterprises to undertake business activity, or they could intervene in the functioning of markets to create space for a favored few private firms to grow relatively unhindered by competition. In either situation, the country’s savings were directed through a largely captive financial system to the favored few firms. Governments also typically protected their domestic market from foreign imports through high tariffs and import restrictions, allowing domestic firms the space to flourish.
The Commanding Heights
Consider first the strategy of creating state-owned enterprises. In a developing country, the government typically is the best-developed organization, apart from the army. It is tempting for it to use its existing organizational templates—often put in place by a colonial power—to create additional departments to manage investment and production. Indeed, Lenin, in a famous speech in 1922, pointed the way (ironically while defending his New Economic Policies, which allowed more freedom to farmers and traders) when he declared that the state must control the most important sectors of the economy—the “commanding heights,” as he called them.12
Some countries have grown rich from substantial contributions made by government-owned firms—France and Taiwan are examples—but there aren’t many. The fundamental problem with the government’s implementing projects such as building schools, roads, and dams, let alone running complex firms, is that incentives in the government are not aimed at using resources efficiently. The primary role of the government is to ensure that the superstructure that facilitates private activity—including public security, the functioning of markets, and the enforcement of contracts—functions efficiently. Typically, this means a neutral and transparent exercise of power with the public interest in mind, not power that can be bought by the highest bidder. The sociologist Max Weber postulated that a bureaucrat’s rewards should come from long-term career progress, status, and the knowledge that he has served the public interest, rather than from the spoils of office. In other words, he believed that the absence of monetary incentives for performance accorded well with the nature of the bureaucrat’s work.
Moreover, because performance in many government activities is hard to measure, government officials are typically not given monetary incentives for fear that they might focus on the measurable (for example, the number of files cleared) rather than the useful (the quality of decisions made). Instead, a plethora of rules guide their behavior. Because large organizations find it hard to manage the intra-organizational frictions and jealousies that arise when compensation structures differ considerably within them, it is probably not surprising that even bureaucrats undertaking measurable tasks, such as implementing clear, time-bound projects, are not given strong monetary incentives. As a result, government projects take too long, and administrators do not adapt flexibly to circumstances. Such flexibility would typically mean the bureaucrat’s exercising initiative and violating some rule.
Inefficiency arising from poor incentives within the organization is compounded by the fact that the government is a monopoly and has little fear of running out of resources so long as the taxpayer can be squeezed. The combination of poor incentives and little competition typically results in poor outcomes when governments undertake activities that should belong to the private domain. For instance, Argentina’s telephone system under state ownership in the 1980s was notorious for its inefficiency—the waiting period for a phone line was more than six years, and some businesses employed staff who sole job was to hold a telephone handset for hours on end until they heard a dial tone.13
History does offer some examples of strong state-owned-enterprise-led growth. Under Stalin, the Soviet Union grew rapidly while the rest of the world was mired in the Great Depression. Indeed, much as Japan was the role model for East Asian economies like South Korea, the Soviet Union, with its state-led growth, was the role model for leaders like Jawaharlal Nehru and Mao Zedong.14 Unfortunately, the imitators did not realize that the incentive for bureaucrats to perform in the Soviet Union at that time might have come initially from revolutionary and patriotic fervor, fortified with a dose of terror: if failure to complete a project on time is met with accusations of sabotage and a firing squad, bureaucrats can become surprisingly energetic. However, such incentives cannot be maintained over sustained periods of time: fervor turns to cynicism, and terror eventually turns on itself.
Moreover, even if the incentives within government-owned firms can be maintained, the relationships between the firms become far more complicated over time, as poor economies finish catching up on the essential. Growth eventually requires not only more steel but also much more detailed information—which grade of steel is needed, how much, when, and where. The Nobel Laureate Friedrich von Hayek recognized that this information is diffused in society: it is possessed by the various consumers and distributors of steel products around the country. It could be aggregated in the planning ministry if everyone is asked to file reports, but a lot of tacit information would be lost on the way as the respondents’ feel for a market was converted into a hard number. Furthermore, the reported numbers would be distorted by each one’s incentives—with consumers wanting to shade demand numbers up so as to encourage production and producers wanting lower numbers so as to ease the pressure on them.
Hayek’s fundamental contribution was to recognize that market prices can play a role in aggregating information in a way that is not biased by organizational disabilities or biases. The market prices of various grades of steel, for instance, are established every day—sometimes on organized exchanges—by the forces of demand and supply for this product. Producers and consumers do not write reports but simply express their interest—which reflects their unbiased and informed expectations of the future—through the price at which they are willing to sell or buy steel. Most important, they do so not to fulfill a bureaucratic requirement, but from the purest of motives, self-interest. No matter how qualitative each one’s information is, no matter how detrimental it is to some people, so long as the market functions, its prices aggregate all these individuals’ information. In the Soviet Union, the system eventually failed in part because the information on which central planning was based was a fantasy that bore no correspondence to ground realities; but this information was so carefully manipulated that even the CIA had no idea of the true weakness of the Soviet economy.
In sum, there are indeed some well-run state-owned firms. But the best state-run firms typically distance themselves from government norms, procedures, and interference and are often private in all but ownership.
Favoring the Few
Instead of relying on state-owned firms to propel growth, a number of governments have tried to remedy private-sector organizational deficiencies and build domestic champions, even while relying on some market signals to allocate resources. The process of playing midwife, often derided as crony capitalism but better termed relationship or managed capitalism, involved a judicious mix of the government’s giving firms some protection from foreign competition and special privileges so that they could generate the profits around which they could build their organizational capital, while maintaining some incentives for firms to be efficient.
One example is Taiwan’s efforts in the early 1950s to promote its textile industry.15 The first textile manufacturers in Taiwan were mainland Chinese, who put their machines on board ships when the Communists took over in 1949 and relocated on the other side of the straits. Soon after, in the early 1950s, the Taiwanese government imposed restrictions on the entry of any new yarn producers to prevent “excessive competition.” It then supported incumbents by supplying raw cotton to mills directly, advancing them working capital, and buying up the entire production of yarn. It followed a similar approach toward weavers. It also imposed tariffs on imported yarn and cloth and even banned imports when tariffs proved insufficient. As the textile industry boomed, the government encouraged firms to merge so that they could realize economies of scale.
More generally, the tools used by governments have included erecting barriers to entry, offering tax breaks so that private firms can generate larger profits and use their retained earnings to fund investment, encouraging close ties between banks and favored firms so that the former lend abundantly (and cheaply) to the latter, providing raw materials at a subsidized price, and imposing tariffs so that foreign competition is not a threat. With subsidies and protection from the government, some favored champions have grown rapidly and profitably, a
cquiring technology, wealth, organizational capabilities, and stability.
Government intervention has sometimes gone much further. K. Y. Yin, an electrical engineer who was also a voracious reader of economic texts (including Adam Smith), was Taiwan’s chief economic planner in the 1950s and is often referred to as the father of Taiwan’s industrial development.16 He commissioned a study in 1953 that identified plastics as an important area for Taiwan to enter. According to a possibly apocryphal story, Yin used his access to information on bank deposits to identify an individual, Y. C. Wang, as someone who had both enough savings and the entrepreneurial zest to undertake a plastics project, and instructed Wang to do it.17 The first Taiwanese plant for polyvinyl chloride (PVC) was built under government supervision and transferred to Wang in running order in 1957. He went on to build the Formosa Plastics Group, Taiwan’s largest business.
There are, however, a number of problems with government intervention that favors a few. Nothing prevents a corrupt government from distributing favors to incompetent friends or relatives, a problem that has plagued countries like the Philippines. Even if a government starts out with the best intentions and carefully screens incumbents, government protection means that those who become lazy and inefficient are not forced to shut down. A key conundrum for governments therefore has been how to retain the disciplinary incentives provided by the market while still allowing firms the room to make profits and build organizational capabilities.
Some governments tried to instill a sense of efficiency and quality directly. For instance, the Taiwanese planner, Yin, ordered the destruction of twenty thousand substandard light bulbs at a public demonstration in Taipei and confiscated tons of substandard monosodium glutamate, the food additive.18 In those cases, the message to producers got through. But governments need a source of discipline more systematic than the whims of bureaucrats, one that would be applied without sparing the favored few.