Fault Lines: How Hidden Fractures Still Threaten the World Economy (9 page)

At this point, though, I want to turn to a problem that was growing in magnitude elsewhere in the world. Even as political compulsions in the United States were pushing it to become more favorable to boosting consumption, countries like Germany and Japan, which were extremely dependent on exports for growth, were accounting for a larger share of the world economy. Why they, and a growing number of emerging markets, have become dependent in this way, and the consequences of such dependence for countries like the United States, are the issues I turn to now.

I
GREW UP IN DIFFERENT PARTS
of the world because my father was an Indian diplomat. My first real memories of India are from my early teens, in the mid-1970s, when he returned to work in Delhi. It was not an easy time. We were not poor, but my parents had to bring up four children on my father’s government salary. More problematic, there was very little to buy, especially for children who had grown used to the plentiful choices in European supermarkets. Every evening, one of us children trudged around the local markets looking for bread. The government was trying to limit the production of “unnecessary” consumer goods, of which bread was deemed one. Moreover, because the government also regulated the official sale price for bread, the little that was produced was diverted to favored clients and sold at black-market prices. So we went around the empty stores, trying to ingratiate ourselves with the shopkeepers in the hope that one would sell us half a loaf of bread from his hidden stock—at twice the fixed price. I remember the joy we felt when a friend’s brother bought a shop in the market. My new connections ensured our bread supply, allowing us to stop haunting the market.

We were not so lucky in our quest for a car. High import duties made foreign cars unaffordable. The government allowed only three domestic firms to produce cars, and only in limited quantities, for cars were deemed unnecessary as well. The only Indian-made car that could accommodate our large family was the Ambassador—a local version of the 1954 Oxford Morris, virtually unchanged from the original. But the waiting list for an Ambassador, which in most other countries would be deemed an antique, was years. So my father settled for a scooter that he rode to work. Because public transport was unreliable, family outings were rare.

The government wanted to limit consumption and encourage savings, and households did save a lot. But there were also unintended consequences. Because goods were in short supply and prices were fixed at ludicrously low levels, little was available in the open market. Black markets flourished: everything could be obtained if you had cash or connections. Few jobs were created: the production of more cars would have meant more demand for restaurants and cinemas and thus more jobs not only for auto workers but also for waiters and ticket clerks. I thought there might be some grand design I did not understand, but the government’s policy clearly was not working, because India was still poor. I was determined to learn more, so I became interested in economics. This book is another unintended consequence of the government’s policies.

Thirty-five years later, it is relatively easy to describe the typical path that successful countries have followed in the search for growth. It has emphasized both substantial government intervention in the early stages—which is why I broadly refer to it as
relationship
or
managed
capitalism—and a focus on exports. Although easy to describe, it is much harder to implement. At key junctures, the government has to take steps that go against its natural inclinations; the India of my youth muffed the game plan. Perhaps this is one reason why only a handful of countries have grown rapidly out of poverty in recent years.

The export-led managed-growth strategy, when implemented well, has been the primary path out of poverty in the postwar era. In the early days of this strategy, the exporters were small enough to allow the rest of the world to boost its spending and absorb the exports easily. Unfortunately, even as exporters like Germany and Japan have become large and rich, the habits and institutions they acquired while growing have left them unable to generate strong, sustainable domestic demand and become more balanced in their growth.

The surpluses they put out into the global goods markets have circled the world, looking for those who have the creditworthiness to buy the goods, and tempting countries, companies, and households around the world into spending. In the 1990s, developing countries ran the trade deficits necessary to absorb these goods: the next chapter shows how many of them suffered deep financial crises and forswore further deficits and borrowing. Even as developing countries dropped the hot potato of foreign-debt-financed spending in the late 1990s, the United States, as well as European countries such as Greece, Spain, and the United Kingdom, picked it up. First, though, I want to describe the export-led managed growth strategy and why it worked.

Few people realize that many of today’s wealthy nations are rich today because they grew steadily for a long time, not because they grew particularly fast. Between 1820 and 1870, the per capita incomes of Australia and the United States, the fast-growing emerging markets of their time (I refer to them as
early developers),
grew annually at 1.8 percent and 1.3 percent, respectively.
¹
By contrast,
late developers
like Chile, South Korea, and Taiwan, which joined the ranks of wealthier nations only in recent decades, grew at multiples of these rates over a shorter period. Japan was not quite a poor country in 1950 (though in 1950 its per capita income was lower than Mexico’s). However, between 1950 and 1973, Japanese per capita income grew at a rate of around 8 percent a year. These late developers have set the aspirational level for today’s developing countries, but theirs is a very different path from that of the early developers especially with respect to the speed of their growth.

How did the late developers grow so fast? In the entire history of humankind, no country had grown as fast as Japan did between 1950 and 1973. But since then, South Korea, Malaysia, Taiwan, and China have approached and even exceeded this rate of growth. To understand these developments, we have to understand why countries are poor in the first place and how they attempt to climb out of poverty.

A difference obvious to anyone who travels from a rich country to a poor country is the varying levels of physical capital. In rich countries, vast airports accommodating big planes, enormous factories packed with high-tech machinery, huge combines in well-irrigated fields, and households with appliances and gadgets for every imaginable use suggest to us that far more physical capital is in use than in poor countries. Physical capital increases income because it makes everyone more productive. A single construction worker with a backhoe can shift far more mud than several workers with shovels and wheelbarrows.

If, however, the only difference between the rich and the poor countries is physical capital, the obvious question, posed by the University of Chicago Nobel laureate Robert Lucas in a seminal paper in 1990, is, Why does more money not flow from rich countries to poor countries so as to enable the poor countries to buy the physical capital they need?
²
After all, poor countries would gain enormously from a little more capital investment: in some parts of Africa, it is easier to get to a city a few hundred miles away by taking a flight to London or Paris and taking another flight back to the African destination than to try to go there directly. Commerce would be vastly increased in Africa if good roads were built between cities, whereas an additional road would not make an iota of difference in already overconnected Japan. Indeed, Lucas calculated that a dollar’s worth of physical capital in India would produce 58 times the returns available in the United States. Global financial markets, he argued, could not be so blind as to ignore these enormous differences in returns, even taking into account the greater risk of investing in India.

Perhaps, Lucas concluded, the explanation is that the returns in poor countries are lower than suggested by these simple calculations because these countries lack other factors necessary to produce returns: perhaps education or, more broadly, human capital. It may seem that an Egyptian farmer, using the ox and plow that his ancestors used five thousand years ago, could increase his efficiency enormously by using a tractor. By comparison, it would seem likely that a farmer in Iowa who already owns an array of agricultural machinery would improve his yield only marginally by buying an additional tractor. But the Egyptian farmer is likely to be far less educated than the farmer in Iowa and to know less about the kinds of fertilizers and pesticides that are needed or when they should be applied to maximize crop yields. As a result, the additional income the Egyptian farmer could generate with a single tractor might be far less than what the Iowa farmer could generate by buying one more machine to add to the many he already has.

However, even accounting for differences in human capital between rich and poor countries, Lucas surmised that capital should still be far more productive in the latter. Moreover, evidence suggests that the enormous investments in education around the world in recent years have not made a great difference to growth.
³
Something else seems to be missing in poor countries that keeps machines and educated people from maximizing productivity and the countries from growing rich—something that dollops of foreign aid cannot readily supply.

The real problem, in my view, is that developing countries, certainly in the early stages of growth, do not have the organizational structure to deploy large quantities of physical capital effectively.
⁴
You cannot simply buy a complicated, high-speed machine tool and hire a smart operator to run it: you need a whole organization surrounding that operator if the machine is to be put to productive use. You need reliable suppliers to provide the raw materials, buyers to take the output from the tool and use it in their production lines, managers to decide the mix of products that will be made, a maintenance team to take care of repairs, a purchasing team to deal with suppliers, a marketing team to deal with buyers, a security outfit to guard the facility at night, and so on. The organizational differences between a small car repair shop and Toyota, or between a medical dispensary housed in a shed and the Mayo Clinic, are enormous, and determine their ability to use large modern sophisticated machines effectively.

Of course, these complex organizations do not operate in a vacuum either. They need other complex organizations to provide inputs and sometimes to buy their output. Equally important, they need finance, infrastructure—for example, electric power, and transport and communication networks—and governance institutions to provide security to property and life as well as to facilitate business transactions.

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.