The Great Economists Read online

  The next pair of authors put forward contrasting views about the fundamental drivers of how an economy grows and develops. And both have heavily influenced current policies.

  Douglass North deviated from many of his contemporaries in that he believed that institutions mattered for economic development. North’s views have gained currency in recent years because standard growth theories haven’t been able to explain fully why some countries become rich and others remain poor. Economists have turned to North’s work following the Second World War on the role of institutions to understand why so few countries have become wealthy in the post-war period. As a result, institutions such as the rule of law have come to the forefront of development policies. We’ll ask how North would reform institutions to promote economic development.

  His contemporary Robert Solow holds a different perspective. Solow produced the seminal work on neoclassical economic growth that North deemed to be incomplete. The Solow model aims to explain growth by examining contributions of workers, the investment of firms in the productive capital of an economy and the role of technological progress. Unlike other recessions that saw a V-shaped output drop and quick recovery, the 2008 crisis has seen a sharp fall in national output or GDP (gross domestic product) but a sluggish recovery. Economists have become worried that this is our collective future. There’s even a term revived by Harvard economist Lawrence Summers to describe a slow-growth world: ‘secular stagnation’. This was a term used by Alvin Hansen in the 1930s after the last systemic banking crisis to describe the resultant slow growth due in part to ageing societies, among other issues.2 Japan is the forerunner here, as the most aged economy. How would Solow judge the slow post-crisis recovery, and would he agree that we face a slow-growth future? This question is a pervasive one in the coming years for all developed economies.

  Finally, the consensus around globalization is under challenge. After decades where opening up to the global economy was the priority for governments around the world, there is growing discontent with the uneven gains from trade. The economy as a whole benefits, but there are still winners and losers within a country. In the recent past, both the US and the UK have seen the public vote against the status quo, including a rejection of current trade arrangements. Would the Great Economists say that globalization is in trouble?

  The rapid global economic growth of the post-war period was led in part by the expansion of international trade. So, prosperity is linked to globalization, particularly in the past few decades with the establishment in 1995 of the World Trade Organization (WTO), which has opened global markets. Globalization has linked all of us via the transmission of not just resources but also ideas from around the world. The concept of a bike-sharing programme in London can be picked up quickly around the world and become deployed by an app in Beijing, for instance. But, trade expansion is stalling and the multilateral system is becoming fragmented into an emerging system of regional and bilateral free trade agreements. Moreover, trade deals face voter backlash over the uneven benefits from globalization. What would the Great Economists say about what this means for trade as an engine of economic growth in the future? Most importantly, how should the backlash against globalization be addressed? Nobel laureate Paul Samuelson’s work details the uneven effects of trade on workers in an economy. How should the distributional impact, where the entire economy benefits but some (for example manufacturing workers, farmers) lose, be addressed? Their ideas suggest ways to help even out the winners and losers from trade, and can point the way forward for the future of globalization.

  This book will seek to uncover some of the answers to the big economic issues affecting all of us by drawing on the insights of the Great Economists. Their collective knowledge has already shaped the policies that governed the world economy during a period in which our living standards have significantly improved: from the Industrial Revolution through the Golden Age of economic growth after the Second World War to the current digital age. Perhaps their insights can help guide our economic future too.

  CHAPTER 1

  Adam Smith: Should the Government Rebalance the Economy?

  Widely viewed as the seminal figure in economics, Adam Smith witnessed the beginning of the Industrial Revolution, which fundamentally changed the Western world. During this time and in the decades that followed, Britain became the world’s first industrialized economy. This extraordinary period formed the backdrop to one of the most influential books in economics.

  Adam Smith’s magnum opus, An Inquiry into the Nature and Causes of the Wealth of Nations, took a decade to write. It sets out the concept of the ‘invisible hand’, which refers to the unseen market forces that set prices by equating supply and demand. It has become the mantra for laissez-faire economics. Even though Smith himself never used that term in that specific way, his writings did envision a limited role for the state:

  The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.1

  Smith was even more dubious when it came to taxation: ‘There is no art which one government sooner learns of another than that of draining money from the pockets of the people.’2

  Adam Smith would view a policymaker who intervened in the operation of market forces with scepticism. Yet, that’s what post-industrial nations like Britain and the United States are attempting to do – roll back the deindustrialization process by encouraging manufacturing and reducing the share of national output accounted for by services. This urge to rebalance the economy arose after the 2008 financial crisis which revealed the fragility of a large banking sector that brought the economy to its knees. It led the then-UK Chancellor George Osborne to start wearing hard hats and to promote the ‘March of the Makers’. In the US, President Barack Obama invested in advanced or high-tech manufacturing. His successor, Donald Trump, explicitly extolled companies to bring factories back to America.

  What would Adam Smith make of these efforts? Should government rebalance the economy towards making things once again? Is it possible to rebalance the economy in countries where the services sector makes up more than three-quarters of national output, as it does in Britain and the US? The answer holds lessons for other economies that may follow those two nations as they embark on the typical economic path of industrialization followed by deindustrialization.

  Industrialization, deindustrialization and reindustrialization

  Great Britain became the first industrialized nation in the late eighteenth and nineteenth centuries, followed by Germany and the United States. The period, which became known as the Industrial Revolution, saw the economy transformed from an agrarian society into one characterized by factories owned and run by merchants who traded their wares both at home and overseas.

  In our own times, Britain and several other advanced economies, including the United States, have experienced yet another fundamental structural change: deindustrialization. Since the 1980s Thatcher-era reforms that liberalized the financial sector – notably the ‘Big Bang’ of 1986, when markets were opened up to greater competition – Britain has seen industry give way to services. (Relatively speaking, that is. The UK is still the ninth biggest manufacturer in the world, and was in the top five until around 2004.) Similarly, although the US remains the second biggest manufacturer in the world (having been overtaken recently by China), its services economy accounts for the larger part of American national output. In the European Union the services sector makes up 70 per cent of the GDP or national output for the bloc, but the EU also counts among its ranks some of the biggest manufacturing nations in the world, for example Germany, France and Italy. Even the world’s biggest manufacturer, China, which is only a middle-income country, ha
s seen its services sector overtake industrial output in the economy.

  When countries grow, they tend to industrialize, so they move out of agriculture and into manufacturing, which has higher productivity or output per worker and thus generates higher wages. Industrialization is how countries become middle class and prosper. Deindustrialization then follows. In advanced economies, manufacturing starts to become relatively less important as a share of output once they become richer and services in the business, retail and finance sectors start to dominate the economy while employment shifts from factories to offices or stores.

  The 2008 crisis revealed the downside to having an economy with a large financial services sector. Banks had become complex and interconnected, and their business became harder to understand and to regulate. Their responsibility for causing the worst recession in a century prompted calls from the public to regulate the banks more tightly in the US and UK. The crash also led the American and British governments to want more manufacturing, thus they have sought to ‘rebalance’ the economy towards making things once again.

  That’s a big task. Manufacturing accounts for around only 11 per cent of Britain’s value-added output, while, as noted, the dominant services sector accounts for over three-quarters of the economy. British manufacturing has declined from contributing a quarter of national output in 1980 to 20 per cent in the 1990s to just 12 per cent in the 2000s. It’s a similar picture in the US. By contrast, manufacturing still makes up about 20 per cent of the German economy on the same value-added basis. At its peak, financial services alone made up some 8 per cent of UK national output, which is not that much smaller than all of Britain’s manufacturing combined. This is the essence of deindustrialization, where industry has given way to a dominant services sector in the same way that agriculture was overtaken by manufacturing during Adam Smith’s time.

  The question is, can the US, and perhaps the UK, reverse deindustrialization? It’s a refrain heard frequently since the crisis. ‘Made in America’ and ‘Made in Britain’ are among the phrases uttered by governments and businesses after the worst recession in a century. But, reversing the process of deindustrialization is challenging in a globalized world economy.

  Emerging economies like China can produce more cheaply while information and communications technology (ICT) has lowered the costs of logistics, so globalization makes it harder for rich nations to compete with lower-cost producers. In fact, Harvard economist Dani Rodrik even points to ‘premature deindustrialization’ in some developing countries which are moving from agriculture directly to services due to the forces of globalization, which holds potentially worrying consequences for countries that have yet to gain a firm foothold in the middle-income stratum.

  We are in unknown territory. The impetus for deindustrialization is greater in Britain and America than in other nations. After suffering their worst financial crisis in a century, they are anxious for change.

  That’s not the sole consideration. Adam Smith may be the economist who named the ‘invisible hand’ that allowed the market to dictate what was produced and how it was priced, but he did not think highly of the services sector. A product of his time, he did not believe that services could produce output that was as valuable as that from a factory or a bakery. In fact, Smith didn’t condone much of what makes up the modern economy, for example he wasn’t in favour of joint-stock companies, which are the basis of modern-day corporations.

  His legacy continues to affect attitudes today. Even the way that national statistics are collected breaks down manufacturing data in great detail while aggregating much of services output. That’s probably also because it’s hard for statisticians to put a figure on what a consultant contributes while he sits at his computer or what a meeting adds to national output. We’ve all been in too many of those to know that they are not all productive!

  So, should the government be trying to rebalance the economy? Can market forces driven by the ‘invisible hand’ be reshaped by the state? What would Adam Smith have to say about it all?

  The life and times of Adam Smith

  Adam Smith was born in 1723 in Kirkcaldy, a seaport near Edinburgh in Scotland. His deceased father was a Customs officer, and his well-to-do family was friendly with members of the Scottish Enlightenment. The Scottish movement paralleled the European Enlightenment, which counted among its ranks writers like Voltaire, and was characterized by a focus on science and rationality. This period has been called the Golden Age of Scotland, and Smith would figure prominently among its leading thinkers as the father of economic science.

  Like many early economists, he wasn’t taught the subject. Instead, he studied physics and mathematics at Glasgow University from 1737 to 1740. It was at this time that he also developed an interest in Stoic philosophy. Most early economists were also philosophers, among whom the likes of David Hume and John Stuart Mill were influential in shaping economic thinking.

  Smith then studied at Balliol College, Oxford University until 1746. As he wasn’t a member of the Church of England, he could not matriculate at that time, so was more like a visiting student. Suffice it to say he did not enjoy his time at Oxford: ‘The discipline of colleges and universities is in general contrived, not for the benefit of the students, but for the interest, or more properly speaking, for the ease of the masters.’3

  So, in the tradition of self-learning that has characterized a number of Oxford experiences, Smith spent his time there on the classics and immersed himself in modern languages. Since, in his view: ‘In the university of Oxford, the greater part of the public professors have, for these many years, given up altogether even the pretence of teaching.’4

  Afterwards, Smith returned to Scotland and gave a series of public lectures at Edinburgh University in 1748. It was there that he became friends with David Hume, a leading figure in the Scottish Enlightenment. That was when Smith’s views on the ‘invisible hand’ started to form. He thought government intervention in the economy was a disruption of the ‘natural course’ of markets, a view which he later developed in The Wealth of Nations. His seminal work argued for a limited state that allowed markets to operate freely. As he stressed in one of his lectures: ‘Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice.’5

  Smith’s successful lectures led to a professorship at his alma mater. From 1751 to 1764 he taught at the University of Glasgow. First, he took up the Chair in Logic, and was subsequently appointed Chair of Moral Philosophy. During this time he gained fame with the publication of his ethics lectures. In 1759 The Theory of Moral Sentiments was published, leading him to become a well-known figure in the European Enlightenment. He described his time as an academic as ‘by far the most useful, and, therefore, as by far the happiest and most honourable’ of his career.6

  Nevertheless, in 1764 Smith was tempted to leave academia for a lucrative stint as private tutor to the third Duke of Buccleuch, who was the stepson of Charles Townshend, a politician. He accompanied the young duke for a two-year tour abroad, and spent 1764–6 in Paris, Toulouse and Geneva.

  It was in France that he came across the Physiocrats, a prominent group of economists, who viewed agriculture, not manufacturing, as the source of wealth. For Smith, this jarred with the British experience of industrialization, and it is somewhat ironic that Smith’s arguments in favour of manufacturing over services share some parallels with Physiocrat thinking.

  Upon returning to Britain, Smith moved to London and spent 1766–7 researching public finances for Charles Townshend, who was now Chancellor of the Exchequer. He subsequently returned to Kirkcaldy to live with his mother, and focused for the next six years on writing The Wealth of Nations. From 1773–6, he returned to London to finish the book. Smith’s publication aimed to influence British MPs to support a peaceful resolution to the American colonies’ War of Independence. In the final paragraph of The Wealth of Nations, Smith wrote that Br
itain should ‘endeavour to accommodate her future views and designs to the real mediocrity of her circumstances’.7 It was a sentence retained in all subsequent editions and reflected Smith’s enduring belief that the market, and not the state, should dictate economic progress in all respects, including colonialism.

  Adam Smith retired in 1776, the year that America declared independence, and he spent the next two years in Kirkcaldy writing another book, on the ‘Imitative Arts’, which covered painting, music and poetry. But, in 1778, he re-entered public life and became the Commissioner of Customs for Scotland, following in his father’s footsteps. He moved to Edinburgh, where he lived again with his mother, Janet Douglas, a cousin who was also the housekeeper, and his heir, a cousin’s son, David Douglas, who was to become Lord Reston, a distinguished jurist.

  In 1784 he finished the third edition of The Wealth of Nations. A few years later, he also completed the sixth edition of Moral Sentiments, which included his thoughts on framing a constitution, which was highly topical at the time of the American Revolution as well as burgeoning revolutions on the Continent, notably in France.

  Despite his path-breaking work, Adam Smith was highly self-critical of the slow pace of his writing. In 1785 he claimed the ‘indolence of old age’ and was uncertain that he could finish the ‘Imitative Arts’ or another book on the theory of jurisprudence. He had envisaged his major works as a trilogy: Moral Sentiments, The Wealth of Nations and a third book on Law and Jurisprudence, which was never written. Rather surprisingly, Smith expressed disappointment that he had not achieved more, and insisted that his manuscripts should be burned after his death.8

  Why rebalance the economy?