23 Things They Don't Tell You about Capitalism

by Ha-Joon Chang

  Worse, Korea did not even produce the necessary raw materials. Sweden developed an iron and steel industry quite naturally because it has a lot of iron ore deposits. Korea produced virtually no iron ore or coking coal, the two key ingredients of modern steel-making. Today, these could have been imported from China, but this was the time of the Cold War when there was no trade between China and South Korea. So the raw materials had to be imported from countries such as Australia, Canada and the US – all of them five or six thousand miles away – thereby significantly adding to the cost of production.

  No wonder the Korean government was finding it difficult to convince potential foreign donors and lenders of its plan, even though it proposed to subsidize the steel mill left, right and centre – free infrastructure (ports, roads, railroads), tax breaks, accelerated depreciation of its capital equipment (so that tax liabilities would be minimized in the early years), reduced utility rates, and what not.

  While the negotiations with potential donors – such as the World Bank and the governments of the US, UK, West Germany, France and Italy – were going on, the Korean government did things to make the project look even less appealing. When the company to run the steel mill – the Pohang Iron and Steel Company (POSCO) – was set up in 1968, it was as a state-owned enterprise (SOE), despite widespread concerns about the inefficiencies of SOEs in developing countries. And to cap it all, the company was to be led by Mr Park Tae-Joon, a former army general with minimal business experience as the head of a state-owned tungsten-mining company for a few years. Even for a military dictatorship, this was going too far. The country was about to start the biggest business venture in its history, and the man put in charge was not even a professional businessman!

  Thus, the potential donors faced arguably the worst business proposal in human history – a state-owned company, run by a politically appointed soldier, making a product that all received economic theories said was not suitable to the country. Naturally, the World Bank advised the other potential donors not to support the project, and every one of them officially pulled out of the negotiations in April 1969.

  Undeterred, the Korean government managed to persuade the Japanese government to channel a large chunk of the reparation payments it was paying for its colonial rule (1910–45) into the steel-mill project and to provide the machines and the technical advice necessary for the mill.

  The company started production in 1973 and established its presence remarkably quickly. By the mid 1980s, it was considered one of the most cost-efficient producers of low-grade steel in the world. By the 1990s, it was one of the world’s leading steel companies. It was privatized in 2001, not for poor performance but for political reasons, and today is the fourth-largest steel producer in the world (by quantity of output).

  So we have a great puzzle on our hands. How did one of the worst business proposals in history produce one of the most successful businesses in history? Actually, the puzzle is even greater, because POSCO is not the only successful Korean company that was set up through government initiative.

  Throughout the 1960s and 70s, the Korean government pushed many private sector firms into industries that they would not have entered of their own accord. This was often done through carrots, such as subsidies or tariff protection from imports (although the carrots were also sticks in the sense that they would be denied to under-performers). However, even when all those carrots were not enough to convince the businessmen concerned, sticks – big sticks – were pulled out, such as threats to cut off loans from the then wholly state-owned banks or even a ‘quiet chat’ with the secret police.

  Interestingly, many of the businesses thus promoted by the government turned out to be great successes. In the 1960s, the LG Group, the electronics giant, was banned by the government from entering its desired textile industry and was forced to enter the electric cable industry. Ironically, the cable company became the foundation of its electronics business, for which LG is currently world-famous (you would know, if you have ever wanted the latest Chocolate mobile phone). In the 1970s, the Korean government put enormous pressure on Mr Chung Ju-Yung, the legendary founder of the Hyundai Group, famous for his risk appetite, to start a shipbuilding company. Even Chung is said to have initially baulked at the idea but relented when General Park Chung-Hee, the country’s then dictator and the architect of Korea’s economic miracle, personally threatened his business group with bankruptcy. Today, the Hyundai shipbuilding company is one of the biggest shipbuilders in the world.

  Picking losers?

  Now, according to the dominant free-market economic theory, things like the successes of POSCO, LG and Hyundai described above simply shouldn’t happen. The theory tells us that capitalism works best when people are allowed to take care of their own businesses without any government interference. Government decisions are bound to be inferior to the decisions made by those who are directly concerned with the matter in question, it is argued. This is because the government does not possess as much information about the business at hand as the firm directly concerned with it. So, for example, if a company prefers to enter Industry A over Industry B, it must be because it knows that A would be more profitable than B, given its competences and market conditions. It would be totally presumptuous of some government official, however clever she may be by some absolute standard, to tell the company’s managers that they should invest in Industry B, when she simply does not have those managers’ business acumen and experiences. In other words, they argue, the government cannot pick winners.

  The situation is actually more extreme than that, free-market economists say. Not only are government decision-makers unable to pick winners, they are likely to pick losers. Most importantly, government decision-makers – politicians and bureaucrats – are driven by the desire to maximize power, rather than profits. Therefore, they are bound to go for white elephant projects that have high visibility and political symbolism, regardless of their economic feasibility. Moreover, since government officials play with ‘other people’s money’, they do not really have to worry about the economic viability of the project that they are promoting (on the subject of ‘other people’s money’, see Thing 2). Between the wrong goals (prestige over profit) and the wrong incentives (not personally bearing the consequences of their decisions), these officials are almost certain to pick losers, were they to intervene in business affairs. Business should not be the business of government, it is said.

  The best-known example of government picking a loser because of the wrong goals and incentives is the Concorde project, jointly financed by the British and the French governments in the 1960s. Concorde certainly remains one of the most impressive feats of engineering in human history. I still remember seeing one of the most memorable advertising slogans I’ve ever encountered, on a British Airways billboard in New York – it urged people to ‘arrive before you leave’ by flying Concorde (it took around three hours to cross the Atlantic on a Concorde, while the time difference between New York and London is five hours). However, considering all the money spent on its development and the subsidies that the two governments had to give to British Airways and Air France even to buy the aircrafts, Concorde was a resounding business failure.

  An even more outrageous example of a government picking a loser because it is divorced from market logic is the case of the Indonesian aircraft industry. The industry was started in the 1970s, when the country was one of the poorest in the world. This decision was made only because Dr Bacharuddin Habibie, number two to President Mohammed Suharto for over twenty years (and the country’s president for just over a year, after his fall), happened to be an aerospace engineer who had trained and worked in Germany.

  But if all received economic theories and the evidence from other countries suggest that governments are likely to pick losers rather than winners, how could the Korean government succeed in picking so many winners?

  One possible explanation is that Korea is an exception. For whatever reasons, Korean government
officials were so exceptionally capable, the argument might run, that they could pick winners in a way that no one else could. But that must mean that we Koreans are the smartest people in history. As a good Korean, I would not mind an explanation that portrays us in such glorious light, but I doubt whether non-Koreans would be convinced by it (and they are right – see Thing 23).

  Indeed, as I discuss in some detail elsewhere in the book (most notably, see Things 7 and 19), Korea is not the only country in which the government has had success in picking winners.2 Other East Asian miracle economies did the same. The Korean strategy of picking winners, while involving more aggressive means, was copied from the one practised by the Japanese government. And the Taiwanese and Singaporean governments were no worse at the job than their Korean counterpart, although the policy tools they used were somewhat different.

  More importantly, it isn’t just East Asian governments that have successfully picked winners. In the second half of the twentieth century, the governments of countries such as France, Finland, Norway and Austria shaped and directed industrial development with great success through protection, subsidies and investments by SOEs. Even while it pretends that it does not, the US government has picked most of the country’s industrial winners since the Second World War through massive support for research and development (R&D). The computer, semiconductors, aircraft, internet and biotechnology industries have all been developed thanks to subsidized R&D from the US government. Even in the nineteenth and early twentieth centuries, when government industrial policies were much less organized and effective than in the late twentieth century, virtually all of today’s rich countries used tariffs, subsidies, licensing, regulation and other policy measures to promote particular industries over others, with considerable degrees of success (see Thing 7).

  If governments can and do pick winners with such regularity, sometimes with spectacular results, you may wonder whether there is something wrong with the dominant economic theory that says that it cannot be done. Yes, I would say that there are many things wrong with the theory.

  First of all, the theory implicitly assumes that those who are closest to the situation will have the best information and thus make the best decision. This may sound plausible but, if proximity to the situation guaranteed a better decision, no business would ever make a wrong decision. Sometimes being too close to the situation can actually make it more, rather than less, difficult to see the situation objectively. This is why there are so many business decisions that the decision-makers themselves believe to be works of genius that others view with scepticism, if not downright contempt. For example, in 2000, AOL, the internet company, acquired Time Warner media group. Despite the deep scepticism of many outsiders, Steve Case, AOL’s then chairman, called it a ‘historic merger’ that would transform ‘the landscape of media and the internet’. Subsequently the merger turned out to be a spectacular failure, prompting Jerry Levin, the Time Warner chief at the time of the merger, to admit in January 2010 that it was ‘the worst deal of the century’.

  Of course, by saying that we cannot necessarily assume a government’s decision concerning a firm will be worse than a decision by the firm itself, I am not denying the importance of having good information. However, insofar as such information is needed for its industrial policy, the government can make sure that it has such information. And indeed, the governments that have been more successful at picking winners tend to have more effective channels of information exchange with the business sector.

  One obvious way for a government to ensure that it has good business information is to set up an SOE and run the business itself. Countries such as Singapore, France, Austria, Norway and Finland relied heavily on this solution. Second, a government can legally require that firms in industries that receive state support regularly report on some key aspects of their businesses. The Korean government did this very thoroughly in the 1970s, when it was providing a lot of financial support for several new industries, such as shipbuilding, steel and electronics. Yet another method is to rely on informal networks between government officials and business elites so that the officials develop a good understanding of business situations, although an exclusive reliance on this channel can lead to excessive ‘clubbiness’ or downright corruption. The French policy network, built around the graduates of ENA (École Nationale d’Administration), is the most famous example of this, showing both its positive and negative sides. Somewhere in between the two extremes of legal requirement and personal networks, the Japanese have developed the ‘deliberation councils’, where government officials and business leaders regularly exchange information through formal channels, in the presence of third-party observers from academia and the media.

  Moreover, dominant economic theory fails to recognize that there could be a clash between business interests and national interests. Even though businessmen may generally (but not necessarily, as I argued above) know their own affairs better than government officials and therefore be able to make decisions that best serve their companies’ interests, there is no guarantee that their decisions are going to be good for the national economy. So, for example, when it wanted to enter the textile industry in the 1960s, the managers of LG were doing the right thing for their company, but in pushing them to enter the electric cable industry, which enabled LG to become an electronics company, the Korean government was serving Korea’s national interest – and LG’s interest in the long run – better. In other words, the government picking winners may hurt some business interests but it may produce a better outcome from a social point of view (see Thing 18).

  Winners are being picked all the time

  So far, I have listed many successful examples of government picking winners and explained why the free-market theory that denies the very possibility of government picking winners is full of holes.

  By doing this, I am not trying to blind you to cases of government failure. I have already mentioned the series of castles in the desert built in many developing countries in the 1960s and 70s, including Indonesia’s aircraft industry. However, it is more than that. Government attempts to pick winners have failed even in countries that are famous for being good at it, such as Japan, France or Korea. I’ve already mentioned the French government’s ill-fated foray into Concorde. In the 1960s, the Japanese government tried in vain to arrange a takeover of Honda, which it considered to be too small and weak, by Nissan, but it later turned out that Honda was a much more successful firm than Nissan. The Korean government tried to promote the aluminium-smelting industry in the late 1970s, only to see the industry whacked by a massive increase in energy prices, which account for a particularly high proportion of aluminium production costs. And they are just the most prominent examples.

  However, in the same way that the success stories do not allow us to support governments picking winners under all circumstances, the failures, however many there are, do not invalidate all government attempts to pick winners.

  When you think about it, it is natural that governments fail in picking winners. It is in the very nature of risk-taking entrepreneurial decisions in this uncertain world that they often fail. After all, private sector firms try to pick winners all the time, by betting on uncertain technologies and entering activities that others think are hopeless, and often fail. Indeed, in exactly the same way that even those governments that have the best track records at picking winners do not pick winners all the time, even the most successful firms do not make the right decisions all the time – just think about Microsoft’s disastrous Windows Vista operating system (with which I am very unhappily writing this book) and Nokia’s embarrassing failure with the N-Gage phone/ game console.

  The question is not then whether governments can pick winners, as they obviously can, but how to improve their ‘batting average’. And contrary to popular perception, governmental batting averages can be quite dramatically improved, if there is sufficient political will. The countries that are frequently associated with success in picking
winners prove the point. The Taiwanese miracle was engineered by the Nationalist Party government, which had been a byword for corruption and incompetence until it was forced to move to Taiwan after losing the Chinese mainland to the Communists in 1949. The Korean government in the 1950s was famously inept at economic management, so much so that the country was described as a bottomless pit by USAID, the US government aid agency. In the late nineteenth and early twentieth centuries, the French government was famous for its unwillingness and inability to pick winners, but it became the champion of picking winners in Europe after the Second World War.

  The reality is that winners are being picked all the time both by the government and by the private sector, but the most successful ones tend to be done in joint efforts between the two. In all types of winner-picking – private, public, joint – there are successes and failures, sometimes spectacular ones. If we remain blinded by the free-market ideology that tells us only winner-picking by the private sector can succeed, we will end up ignoring a huge range of possibilities for economic development through public leadership or public–private joint efforts.

  Thing 13

  Making rich people richer doesn’t

  make the rest of us richer

  What they tell you

  We have to create wealth before we can share it out. Like it or not, it is the rich people who are going to invest and create jobs. The rich are vital to both spotting market opportunities and exploiting them. In many countries, the politics of envy and populist policies of the past have put restrictions on wealth creation by imposing high taxes on the rich. This has to stop. It may sound harsh, but in the long run poor people can become richer only by making the rich even richer. When you give the rich a bigger slice of the pie, the slices of the others may become smaller in the short run, but the poor will enjoy bigger slices in absolute terms in the long run, because the pie will get bigger.