The Lessons Of History

In recent posts I have been emphasising the need to base our understanding of the economy on a dispassionate analysis of facts and logic, completely detached from ideological attachment to notions of “capitalism”, “socialism” or “communism”. (These words have become so broad in their meaning, and so emotionally charged, that they now fail to convey any meaning whatsoever and it would be better not to use them at all.) In the opening posts of this section I described how the popular narrative of how Britain and the US grew rich are just myths. But this begs the question – what are the facts of history? What do the lessons of history teach us about how to create an economy that provides enough for everyone?

For an example of just such a rigorous analysis, there is little to rival the work of Erik Reinert. Reinert has studied exhaustively the history of economic thought and the history of economic policy. And when I say exhaustively, he has amassed a library of over 50,000 items documenting the history of economic thinking and policy over the last 500 years, while also working actively in development economics across the world. His book summarising his ideas – How Rich Countries Get Rich, and Why Poor Countries Get Poor – is quite astounding. Though not without flaws (nothing in life is perfect), it’s probably my favourite economics book.

Reinert explains in much more detail than I the story of how Britain and then the USA grew their economies through protectionism and through an interventionist government policy. He also describes how it was known across Europe throughout the 16th-19th centuries that the way to get rich was to emulate those states that had grown economically, and each nation thus followed the same path through a process of active intervention by the state.

It is an extremely rich book, but for brevity and simplicity I just want to focus on 3 key factors that he identifies that are essential to successful economic development (at the beginning of chapter 4). Trying to convey this briefly and clearly is a challenge, but work through it because at the end we can draw out a broader point that is essential to our understanding of how we create an economy that provides enough for everyone. The 3 factors are:

  • Developing industries with increasing returns to scale, not diminishing returns
  • Focusing on industries with scope for technological change and innovation
  • Creating synergies and cluster effects

Increasing Returns to Scale

The models of mainstream economics always assume diminishing returns to scale – the more you produce, the more the cost per product increases. Indeed, the mathematical structure of intersecting demand and supply curves that “proves” that free markets achieve the optimum outcome for everyone, depends on the assumption of diminishing returns. If you take this assumption away the entire edifice of neo-classical economics collapses.

Which is unfortunate for mainstream economics, as most industries in fact face increasing returns. You might be more familiar with the term “economies of scale”. Indeed, sitting in my A Level economics classes over 30 years ago, at the very beginning of the course I was highly confused by this diminishing returns assumption, because even at the age of 16 I was aware of economies of scale. If you spend millions of pounds investing in research to develop a new drug and then the factory to produce it, the more of that drug you produce and sell, the more product there is to spread these fixed costs across. The average cost of the product will be less the more you can sell.

These high start-up costs are a major barrier to entering such industries, but the financial rewards at the other end can be great. Once a business has established itself in such an industry it is very difficult for it to be unseated. Obvious examples of such businesses are the hi-tech giants (Google, Apple, Microsoft), but any business using advanced or new technologies is likely to be in an increasing returns sector. Green technologies would be a good example.

By contrast, some industries do face diminishing returns. The best example is raw material production. As mentioned in the post demonstrating the falsity of the theory of comparative advantage, raw material extraction will always begin in the most productive areas (the richest mines, the most fertile soils). Expanding production will always involve extending to less productive sources, raising the cost per unit.

Long term economic growth, for the both the individual business or the nation as a whole, will be maximised by focusing on industries with increasing returns to scale.

Technological Change and Innovation

Some industries require technological development. This development is necessary at the level of the infrastructure of the nation or region, at the level of the capacity of individual businesses, and at the level of the skills of the workforce. Once capacity has been built at all these levels it is available to support economic development in general, and therefore economic development is always driven by focusing on industries with scope for on-going technological innovation and development. I have already described how textiles has been the starting point for industrial development in country after country.

This issue is not just about the benefits of developing hi-tech industries – to drive forward economic growth it is necessary to specialise in an area with significant scope for innovation. I have previously described how it is necessary for a government to protect nascent industries until they are ready to compete in a free trade environment. Many Latin American countries tried this approach, with a policy called “import substitution”. The idea was that rather than importing certain goods, they could develop their economies by protecting industries that could produce those goods domestically. One of the weaknesses in this policy is that the imports they were seeking to replace, and therefore the industries they were seeking to develop, were in “mature” industries – industries with very little scope for significant technological innovation. Instead, if a nation focuses on protecting and developing an industry in a new field they are more likely to develop new technologies that can then be exported out to other countries. “Import substitution” by definition fails to focus on the development of products for export, and export is necessary to earn foreign currency, and foreign currency is necessary to buy oil. And oil remains essential to every economy.

Denmark, by contrast, focused on supporting (through subsidies) its wind farm industry. It developed the most efficient wind turbine in the world, and now earns considerable foreign currency exporting this technology throughout the world (see Mazzucato, The Entrepreneurial State, pages 156-161)

There is considerable overlap between these first two factors, because technological innovation tends to go hand in hand with increasing returns to scale. The term Reinert uses is that certain industries “carry” economic development – focusing on a certain industry will promote economic development in the region or nation as a whole. We will come back to this, but first we must consider the third factor.

Synergies and Cluster Effects

As stated, promoting industries with scope for technological innovation involves not just capacity within individual businesses, but the infrastructure in the region and the skills of the workforce. As this process advances, developments in one industry can benefit other industries in the area – this is the “synergy” achieved from a “cluster” of businesses within a region.

Reinert gives several examples of this in his book, but I particularly like that of 17th century Delft in the Netherlands. A naval centre, it had factories that were experts in making lenses for telescopes and binoculars. The glass manufacturers found other uses for their lenses, leading to the invention of the microscope. This in turn stimulated the development of natural sciences in the city. Meanwhile, Dutch painters were developing a new technique of painting, using oils on canvas, sourcing both from manufacturers serving the naval industry. Similarly, the need for naval maps led to the development of copperplate printing, the manufacture of copper itself already being in the city for – you guessed it – manufacture of naval instruments.

Even in this brief account, we see the way developments in one industry stimulate another. Rather than focus on a single industry of “comparative advantage”, the need is to stimulate growth in industries with scope for technological innovation that can then feed off each other. This need for a diversity of industries was well understood during the Renaissance, when it was recognised that the strength of an economy was indicated by the diversity of professions within it. In the words of Antonio Serra, one of the earliest economists to describe this phenomenon (in 1613), “one factor gives strength to the other”. This is synergy.

This is the briefest summary of just 3 ideas from Reinert’s incredible work, but it enables us to think more deeply about the nature of planning required in creating an economy that provides enough for everyone. Discourse about government planning in the economy tends to rapidly degenerates into a crude dichotomy between “planned economies” and “free markets”. Two weeks ago, in the post on socialism, I pointed out that in fact planning can be thought of in different ways. I likened “planned economies” to the design of a machine in which the placement and functioning of every component is carefully planned in advance, and then the machine is built following the plan with great precision. I then contrasted this with the way we might plan the development of a garden. If you employed a landscape gardener to transform your garden, he might give you an “artists’ impression” of what the garden will look like, but he wouldn’t give you a drawing and promise that your garden will look exactly like that.

Rather, the gardener will work with the environmental factors of that specific garden – the soil, the light, the rainfall and drainage, the existing and neighbouring wildlife – and sow plants suited to that environment. The nature of this garden will evolve over time as plants mature, sometimes in unpredictable ways, and need continual nurturing and intervention.

I stated that the government seeking to stimulate economic growth is like a gardener, and so it needs to understand the factors that enable this growth. So now if we apply the 3 factors above into this model, we see that a government might research which industries show scope for technological innovation and economies of scale. It will look for those industries that most closely suit the existing infrastructure and skills of its region. It will then seek to further develop that infrastructure, to embed training in the necessary skills for that industry in the education system, and to fund departments in universities that can carry out necessary research (just as the US did for its textiles industry, as briefly described last week). And of course, it will strive to directly stimulate and support the creation of businesses within these industries.

But I am not in anyway presenting this as a formula, as the “right” answer. Rather, I am offering this as an example of how we need to think about this question of planning. This brief summary of a small part of Reinert’s book was merely to give us a focus for this example, not to suggest that this is everything we need to know. Indeed, I have only given two examples of approaches to planning – there are many more and each will give us a new way to think about the role of government in nurturing the economy.

So I am not offering a formula, but rather a direction in which society has to travel. We need to freely acknowledge that right now, as a society, we have not developed the skills and expertise in governance and economics for governments to play this role effectively. But this doesn’t mean that it can’t be done, it means that we haven’t been trying, largely because we are held back by the intellectually bankrupt ideology described in earlier posts. We need, as a society, to learn how to do this.

When a toddler takes its first steps it falls down straight away. We don’t then say that this child is disabled and that clearly it will never walk. The first time someone attempts to drive they typically stall the car, sometimes without even moving forward. This doesn’t prove that driving is impossible and no one should attempt to do it.

An unbiased study of economic life, drawing on the rich lessons of history, demonstrates that there is a role for government in planning and coordinating economic activity. But we need, as a society, to learn how to do this effectively. And this appeal to the need learn is not just some vague hope or empty platitude. There is a well developed literature on the process of organisational learning which we can utilise in our efforts to create an economy that provides enough for everyone – indeed we must do so if we are going to approach this subject in a scientific way. So in four weeks time I will briefly describe some highlights from this field and its applicability to economics.

But don’t forget that there are lessons from history that can inform this effort, and over the next three weeks I’m going to look at one that is particularly relevant and recent: the rebuilding of Western Europe after the Second World War through the Marshall Plan. As well as being highly instructive to the theme discussed here, it also extends the earlier discussion of how the West grew rich (and again shows that it wasn’t through free markets and small government). Indeed, it provides a model to think about how we can promote global economic development.

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