Hystori of economics policy

Evolutionary Economics,
Classical Development Economics, and the History of Economic Policy: A Plea for Theorizing by Inclusion.

Erik S. Reinert, Tallinn University of Technology, Estonia and Norwegian Institute of Strategic Studies (NORISS), Oslo, Norway1. January 2006 the other canon foundation, Norway Tallinn University of Technology, Tallinn

CONTACT: Rainer Kattel, kattel@staff.ttu.ee; Wolfgand Drechsler, drechsler@staff.ttu.ee; Erik S. Reinert, reinert@staff.ttu.ee
Working Papers in Technology Governance and Economic Dynamics no. 1
TECHNOLOGY GOVERNANCE

1 The author is grateful to Carlota Perez and Christopher Freeman for extensive comments and discussion
of this paper. The usual disclaimer applies.
2

This paper argues that bringing evolutionary and Schumpeterian economics
to the Third World would benefit greatly from including insights and elements
from pre-Smithian economics, from the history of economic policy,
and from classical development economics (post World War II). This is particularly
important when evolutionary theory is introduced into new contexts
where institutions and circumstances that can be taken for granted in
the First World are not necessarily present. The paper argues that a truly
evolutionary theory of economic change requires that all neo-classical
assumptions be relaxed at the same time, while re-introducing the many
factors that used to be recognised long ago as contributing to the unevenness
of economic development.

‘New institutional economics’ became neoclassical economics with institutions
(mainly property rights) added; which is a very different type of theory
from a much broader ‘old’ institutional school tracing its roots back to
Thorstein Veblen. As I see it, there is a risk of a similar development within
evolutionary economics, that a ‘new’ evolutionary theory is created consisting
essentially of standard economics with an added ‘Schumpeterian’
variable. Keynesian economics was usurped by mainstream economics in a
similar development. This risk of blending neoclassical and evolutionary elements
is evident today in the European Union. The Lisbon Strategy – in its
conception an evolutionary theory – is increasingly becoming a
Schumpeterian icing on a solidly neo-classical cake. The same danger is
present when applying evolutionary theories in the Third World, where – in
its simplest form – we risk that ‘evolutionary economics’ is created by substituting
‘investment’ for ‘innovation’ in an otherwise standard neoclassical
approach. I suggest here going in another direction: that a series of old
insights – particularly as these are brought together systemically – are both
useful and necessary to complement present approaches. As I see it, by
bringing in underlying technological elements, evolutionary economics may
sometimes even reinforce old arguments and explain why both mercantilists
and classical development economists were often right. This will be illustrated
by a discussion of Hans Singer’s seminal article (1950) below. This
paper attempts to map the most important of these factors which, alone
and cumulatively, add to the complexities of innovation economics.
Economics as theorising by exclusion.
‘Zuerst war die Ganzheit’; ‘In the beginning there was the totality’. This is
a typical statement from the German historical tradition in economics. This
wish to embrace and qualitatively understand ‘the whole’ necessarily yields
a large toolbox for the profession and, on the other hand, not a very
abstract theory. ‘The economy as a whole’ (Das Gesamtbild der
Volkswirtschaft) is also the title of the last chapter of Joseph Schumpeter’s
Theory of Economic Development (Schumpeter 1912), the chapter he left
out of all subsequent editions and translations, arguable to anglo-saxonise
his theory when embarking on a career in the United States2. Economics,
Schumpeter says, presents us with an eternal trade-off of accuracy versus
relevance: ‘We must make up our minds whether we want simple answers
to our questions or useful ones – in economic matters we cannot have
both’.3 As a very young man, Schumpeter’s Salomonic solution to the
fierce Methodenstreit of the economics profession was to have theories at
various levels of abstraction, and then go into the theory at a level of
abstraction where one is likely to find an answer to the question at hand
(Schumpeter 1908). A main contention of this paper is that today’s standard
economics operates at a level of abstraction that is too high to capture
key factors responsible for uneven development. Patching this up by
adding a ‘Schumpeterian’ variable is not possible. ‘The whole’ must be considered.
Until the mid-eighteenth century the trade-off between accuracy and relevance
was generally solved by using holistic theories favouring relevance
rather than abstraction. Although the writers all considered their field a ‘science’,
compared to the present situation one could almost call these predisciplinary
approaches. Whatever was relevant was part of the theory. As
an example: to the extent malnutrition affects economic performance, nutrition
is part of economics. Early attempts at reaching higher levels of
abstraction through the use of mathematics – by Italian eighteenth century
economists – were rapidly abandoned because, as mathematician Ignazio
Radicati warned his economist friends in 1752: ‘You will do with political
economy what the scholastics did with philosophy. In making things more
and more subtle, you do not know where to stop’ (Tubaro 2000: 15; S.
Reinert 2005).
When, with Adam Smith and later with David Ricardo, economics increased
its level of abstraction, this was done at the cost of excluding a number of
factors that were integral parts of economics in the 1750s: the importance
of synergies and of balancing different economic activities in a country,
institutions, the role of increasing returns combined with a large division of
labour, the role of innovations and technical change (for example Francis
Bacon4, Cary 1695, Steuart 1769), and the fact that economic activities
are qualitatively different as carriers of economic growth. For most of the
history of the profession, these are all factors that have been seen as impor-
3
2 The chapter is both reproduced in German and translated into English in Backhaus (2003).
3 Schumpeter in the foreword to Zeuthen (1930).
4 For a discussion on the introduction of the concept of innovation into the social sciences, see
Reinert and Daastol (1997).
tant in explaining why economic development is such an uneven process.
Achieving a higher degree of abstraction was made at the cost of reducing
complexity and excluding variables. In economics this is a process which
moves back and forth over time almost as ‘fashions’. It is possible to see
the history of economic thought as consisting of long and almost monotonous
sequences of the same economic factors entering the theory, later to
be thrown out, later to be included again: Increasing returns as an economic
factor were described by the Greeks, and codified into a theory of uneven
growth by Antonio Serra in 1613, forgotten, but resurrected in Italy in the
1750s, abandoned again by Smith and Ricardo, only to be rediscovered by
German economists in the 1840s and 1850s, kept by Alfred Marshall5, formally
developed by US economist Frank Graham (1923), thrown out again
by Jacob Viner in the 1930s on the account that it was incompatible with
equilibrium, reintroduced by Paul Krugman in the 1980s, but its importance
again dismissed by Jagdish Bhagwati as Krugman’s ‘youthful surrender to
irrational exuberance’ (Bhagwati 2002: 22).
The guiding insight of French philosopher Jacques Derrida’s deconstruction
is highly relevant to economics: every structure - be it literary, psychological,
social, economic, political or religious - that organizes our experience is
constituted and maintained through such acts of exclusion. In the process
of creating something, something else inevitably gets left out. These exclusive
structures can become repressive - and that repression comes with
consequences. In a manner reminiscent of Freud, Derrida insists that what
is repressed does not disappear but always returns to unsettle every construction,
no matter how secure it seems (Taylor 2004). We suggest that
a ‘new and improved’ development economics must keep Derrida’s caveat
in mind. Over the last years, the immense economic and political weight of
The Washington Institutions have created a series of single-issue fads, factors
that – added to standard economics – shall solve the problems of
poverty: institutions, property rights, ‘competitiveness’, governance, and so
forth6. Care should be taken that ‘innovation’ does not become yet another
buzzword with which neo-classical economics is kept alive by adding
new factors in the margin. My suggestion for creating an evolutionary
development economics requires an inclusive approach where long-existent
and still relevant notions would be re-introduced in the theoretical structure.
I have referred to this alternative type of economics as The Other Canon
(Reinert 2004a).
4
5 See particularly Marshall (1890: 201) for a policy statement.
6 This is discussed in the foreword to Reinert (2004a).
A study in the history of theorizing by inclusion: why economic development
requires ‘manufacturing’.
From the point of view of the Third World, the most salient feature of standard
economics since Adam Smith is probably that a theory of the international
economy as a harmony-making machinery has been constructed. This
was achieved at the time of Adam Smith mainly by introducing two fundamental
changes in the way economic theory was built, effectively through
exclusion of factors that previously had been deemed important for economic
growth. Successful catching up – from that of the United States and
Continental Europe to East Asia – has therefore all retained key elements of
pre-Smithian economics: among them insisting not to join the world economy
fully until industrialisation had been achieved. In this section we shall
look at how the understanding of the need for manufacturing for development
has evolved over time, and suggest how evolutionary economics can
improve this very long sequence of analysis.
The fundamental changes introduced by Adam Smith to economics were:
1. From Emperor Justinian’s codification of Roman Law around AD 400
until Adam Smith, the metaphor for human society had been the human
body, with its diversity, synergies and division of labour (Reinert and Reinert
2005). Starting with Adam Smith physics-based metaphors have dominated
economics, leading both to methodological individualism (the exclusion
of society as such as a unit of analysis) and an underlying ‘equality assumption’
in the profession (Buchanan 1979), leaving out the diversities, complexities,
and synergies of real life that, in the end, contribute decisively to
making the process of economic growth, by its very nature, into a very
uneven process.
2. Adam Smith unified ‘production’ and ‘trade’ into ‘labour hours’ (Biernacki
1995). As a result of this, economics abdicated from studying the complexities
and vicissitudes inherent in the world of production, and – with
David Ricardo – trade theory could consequently be reduced to an exercise
in bartering of labour hours. These labour hours and the theory itself are
void of any qualitative attributes of understanding of production (skills,
innovations, learning, increasing and diminishing returns, technology, and
so forth).7 Human knowledge, wit and will were excluded from economics
and the profession came to focus on the accumulation of capital rather than
on the diffusion of knowledge (Nelson 2006).
5
7 Technology continued to play an important role in the Continental European, and particularly
German economic tradition continuously through Marx and Schumpeter. Economics professor
Johann Beckmann published his seminal work on technology the year after Smith’s Wealth of
Nations (Beckmann 1777). For an overview of this tradition see Reinert (2005).
It is interesting to note that the theoretical insights that point to wealth as
a product of systemic factors – as in today’s National Systems of
Innovation approach – are among the oldest of the important economic
insights. This view was ‘mainstream’ from the 1200s with Florentine chancellor
Brunetto Latini (ca.1210-1294) and his concept of wealth being a
result of a ben comune, a common weale (Baron 1966; Latini 1993)8.
However, as physics-based metaphors came to dominate economics, such
systemic elements tended to disappear because theory lost the tools with
which to handle them.
But the most serious consequence of the adoption of physics-based models
in economics was the creation of the ‘equality assumption’9; abandoning
the common sense notion that not all activities are qualitatively alike as
promoters of growth and development. As a consequence the whole
debate on increasing and diminishing returns was silenced, although these
clearly are at the core of the vicious and virtuous cumulative effects in economics.
The elegance of economics was achieved at the price of ignoring
the different conditions and contexts in which wealth creation takes place,
and with it some of the most crucial insights of the mechanisms that cause
wealth and poverty were lost. In the same century when mankind created
order in our world through taxonomic systems – that of Linnaeus being the
most famous – Adam Smith gave birth to an equality assumption that rid
economics of all taxonomies. The irony in this is that England’s own economic
policy was based on a simple taxonomy: ‘buy raw materials, sell
manufactured goods, a formula which, as Friedrich List acutely observed,
for centuries took the place of a whole economic theory in England10.
Diminishing returns has been with us as an economic fact and factor since
the Bible, where it explains why Abraham and Lot parted because ‘the land
was not able to bear them that they might dwell together’ (Genesis xii: 6).
Diminishing returns happens when, at some point, each additional labourer
will add relatively less output than his predecessor did, because he has less
and less of the fixed amount of land to work with, and/or when more marginal
land has to be brought into production.11 Antonio Serra, whom
Schumpeter names ‘the first to write a scientific treatise in economics’,
explained the increasing gap between the wealth of Venice and the poverty
of Naples by juxtaposing the increasing returns, falling costs, increasing
6
8 When Machiavelli, 300 years later, explains why cities are rich, he echoes Latini: il ben comune fa
grandi le città (Reinert and Daastol 1997).
9 See James Buchanan’s chapter on ‘Equality as Fact and Norm’ (Buchanan 1979: 231-252).
10 In the foreword to List (1841). I have not found this observation in the English translation.
11 Genuine diminishing returns are only found in economic activities where one factor of production
has been ‘produced’ by nature, in agriculture, mining or fisheries. In other activities all factors of production
are essentially expandable at the same or better quality.
‘barriers to entry’, and increasing standard of living in Venice with the
poverty of Naples’ production of raw materials where diminishing returns
produced an opposite effect (Reinert and Reinert 2003). Although diminishing
returns are counteracted by technological change, in de-industrialised
countries population pressures combined with diminishing returns to this
very day can produce disasters of almost biblical proportions.12
Although conceptually clearly separable, Schumpeter noted the difficulty of
separating increasing returns and technical change in practice. Since Henry
Ford’s production technology was not available in the scale previously
employed in car production, it was impossible to separate the effects of the
two factors. Schumpeter therefore coined the term historical increasing
returns in order to cover both phenomena (Schumpeter 1996: 263).13 This
insight is even more important today, when the growth of intangibles, services
and intellectual value added have become such a major feature of the
so-called Knowledge Society. At the same time, the process of segmentation
and differentiation in manufacturing markets, as the total market
grows, creates scale and barriers to entry in smaller and smaller niches.
Some types of agricultural production may acquire characteristics that were
previously associated with manufacturing, while some manufactured goods
may behave more like commodities (although with constant rather than
diminishing returns). This development blurs the traditional distinctions
between sectors.
Nevertheless in both cases – the growth of intangible value and the differentiation
processes – a key question remains whether the fruits of production
can be retained thanks to having control over the sources of productivity
and the prices to market. This traditionally happened in manufacturing
through having control of technical change and through the barriers to
entry created by increasing returns.
A key insight from classical development economics was Hans Singer’s
seminal paper discussing how the fruits of technological change spread differently
in the manufacturing industry of the First World and in the raw
materials production of the Third World (Singer 1950). This was an important
part of the Prebisch-Singer thesis, which contained important discussions
of technology and development that at the time were obliterated by
the general preoccupation with the Terms of Trade.
Evolutionary economics potentially brings new insights to the Terms of
Trade debate and the Prebisch-Singer thesis of classical development eco-
7
12 See Reinert (2004b) for a case study of such developments in Mongolia. See also Reinert
(1996b).
13 Schumpeter attributes this insight to Scottish economist James Anderson (1777).
nomics. This thesis is based on the idea that developing countries’ terms of
trade are determined by asymmetries in the operation of the labour markets
in the country of the centre and of the periphery’ (Ocampo and Parra 2006:
169). Evolutionary economics may in fact move this analysis one step further
back, by analysing the technological variables – such as product and
process innovations – that contribute to the asymmetries in the labour markets.
In commodity agriculture, the fact that the sources of innovation tended
to be outside the sector itself – in Ford’s tractor factory or in Monsanto’s
seed factory – coupled with the low barriers to entry, diminishing returns,
climatic volatility and perfect competition together explain why agriculture
has failed to retain the fruits of technical change. A proper analysis of technological
change will, in many ways, be able to supplement and enrich the
explanations as to why the perceived differences between ‘manufacturing’
and ‘agriculture’ actually came about.
Table 1 puts together this historical process of trying to understand the
sources of wealth and prosperity of nations by understanding the contrast
between manufacturing and agriculture, the city and the countryside, the
self-propelled growth of technology-intensive activities under increasing
returns and the constricted potential for wealth creation of land restrained
commodity production under diminishing returns. These elements work
together cumulatively creating both path dependence and lock-in effects
(Arthur 1989 and 1994).
It is important to keep in mind that it is not manufacturing per se and agriculture
per se that produce these effects, but a bundle of characteristics
that for centuries – and with reasonable accuracy – have been perceived
as typical of the two types of economic activities.14 Today there are many
manufacturing segments and types of services that live under constant
returns to scale, few barriers to entry and almost under commodity competition.
On the other hand, there are both knowledge-intensive services
and some niches in agriculture that can behave like high tech manufactures.
Therefore, the insights and the understanding of the contrast between manufacturing
and agriculture still hold, as long as one keeps in mind who has
the levers of productivity and pricing as growth proceeds.
It must also be emphasised that at the time great care was generally taken
to differentiate purely administrative cities – like Madrid or Naples – from
the manufacturing cities like Milan or Venice. It was the typical urban activities
– subject to increasing returns and a great division of labour in synergy
– that created wealth, not the agglomeration of people per se.
8
14 The discussion of ’good’ and bad’ trade in the 1700s is a particularly sophisticated version of this
type of analysis (King 1721; Reinert and Reinert 2005)
9
‘Manufacturing’
Generalised wealth only found in cities
with artisans and manufacturing, and
explained as a systemic effect:
il ben comune (Florence 1200s).
The experience of 1500s Spain: The
real gold mines are the manufacturing
industries, because the gold from the
Americas ends up in the manufacturing
cities outside Spain (generalised
knowledge 1600s)
Windows of opportunity for innovation
concentrated in few activities (all urban:
Botero 1589) (Perez and Soete 1988)
Generalised wealth caused by a large
diversity/large division of labour/
maximising the number of professions
(Serra 1613)
International specialisation leads to
increasing returns/ economies of scale,
producing falling costs, barriers to entry
and higher profits (Serra 1613)
Increased population a necessity in
order to create scale/markets for
manufactures (European pre-Malthusian
population theory)
Important synergies between city and
countryside: Only farmers near
manufacturing cities produce efficiently
(Europe 1700s to George Marshall
1947)
Export of manufactured goods and
import of raw materials, but also
exchanging manufactures for other
manufactures, is ‘good trade’ for a
nation (King 1721).15
‘Agriculture’
Traditionally very little systemic effects,
no ben commune (common weale)
The experience of 1500s Spain:
de-industrialisation and return to agriculture
creates increased poverty: a nation
is better off with a relatively ineffective
manufacturing sector than with none
Few windows of opportunity for
innovation (until very recent history)
Traditionally only a minimum of diversity
and very little division of labour.
Specialisation will meet the flexible wall
of diminishing returns and increasing
costs/falling productivity (From Bible’s
Genesis to Ricardo and
John Stuart Mill).
Increased population a problem because
of diminishing returns and no new land
(Malthus)
Only farmers who share a labour market
with manufacturing activities are
wealthy: market for products, market
for excess labour, access to technology
(US/Europe 1800s)
Export of raw materials and import of
manufactured goods is ‘bad trade’ for a
nation (King 1721)
Table 1:
Theorising by Inclusion: The qualitative differences between manufacturing and
agriculture as perceived over time as ideal types or stylised facts.
15 If we assume that manufactures are produced under increasing returns and raw materials under
diminishing returns this is perfectly compatible with Krugman’s New Trade Theory (Krugman 1980).
10
Dynamic imperfect competition
Activities with high growth in demand
as income grows/Verdoorn’s Law ties
increase in demand to increase in
productivity
Subject to ’productivity explosions’
since the 1400s
Stable production that can be fine-tuned
to demand. Overproduction avoided by
storing raw materials and
semimanufactures.
Stable prices
Creates a middle class and conditions
for democracy (‘City air makes free’)
Creates bargaining power for labour and
irreversible wages: ‘stickiness’ of wages
in money
Dominated by product innovations
which, when products mature, turn to
process innovations
Technological change leads to higher
wages, profits and taxes in the producing
countries (’a Fordist wage regime’)
Terms of Trade tend to improve over
time compared to agriculture
Creates large synergies
(linkages, clusters)
Perfect competition
(commodity competition)
Activities with low income elasticity of
demand
Slow growth in productivity until after
World War II.
Cyclical production/overproduction (no
possibility of storing semimanufactures)
Large price fluctuations. Timing of sales
often more important for income than
production skills
Generally creates a feudal class
structure
Reversible wages and payment in kind
Dominated by process innovations,
product innovations for agriculture are
made outside the agricultural sector
(Ford’s tractors, Monsanto’s seeds,
biotechnology)
Technological change leads mainly to
lower prices in the consuming countries
(Singer 1950)
Terms of Trade tend to deteriorate over
time compared to industrial products
Creates few synergies
How the benefits from innovation spread: a key question for evolutionary
development economics today.
In order to understand wealth and poverty outside the already industrialised
First World, it is necessary to go beyond the promotion of innovation
per se in order to understand in which cases innovation benefits the producing
country or the consuming country or both. Evolutionary economics
has, as I see it, not paid sufficient attention to how different types of innovations
affect different businesses. For example, information technology
creates very different results around Microsoft’s headquarters in Seattle
than what the same information technology does in the hotel industry in
Venice or on the Costa del Sol. In the hotel business as well as in the used
book business across Europe, new technology has caused more perfect
information that leads to falling margins and increased downward pressures
on wages and profits. If we use the standard definition of the term ‘competitiveness’
– its ability to create higher real wages – recent innovations
in these industries, seen in isolation, have caused decreased rather than
increased competitiveness. Innovations have made people in those activities
poorer.16 Innovations may also create pressures towards de-skilling, as
when the fast food industry created new cash registers that could be operated
by illiterate workers.
Although it is well known in innovation economics that product innovations
and process innovations often have different effects on employment (see
Vivarelli and Pianta 2000, Reinert 2000, Pianta 2005), not enough emphasis
has been given to the fact that innovations actually may reduce the realized
value added in certain industries and geographic areas. When extending
innovation economics to the Third World these types of considerations
become much more important than they are in the First World.
Carlota Perez (2002) considers that each major technological revolution has
two complementary but very different aspects: a) a cluster of new basic
innovations creating distinct dynamic inter-related industries, and b) a techno-
economic paradigm that defines the way in which these new generic
technologies will transform how the other activities in the economy will go
about their businesses in the most effective and efficient manner. Figure 1
illustrates these two aspects of paradigm shifts.
11
16 It may be argued that those hotels that transformed their offer into a special niche product through
service innovations and segment differentiation may have escaped this fate. But the essential point
holds for the great majority, which obviously encompasses the majority of those employed in the
sector.
Figure 1: The two main aspects of a techno-economic paradigm shift.
Source: Carlota Perez.
The two aspects of the paradigm shift explain two very different types of
innovations. The paradigm carrying industries generally produce product
innovations that create dynamic imperfect competition. In the rest of the
economy the paradigm shift tends to produce process innovations that
either do not shift the degree of imperfect competition, or - as in the case
of the airline industry - may unleash a price and productivity competition
that will benefit consumers rather than producers. Such innovations may
produce lower rather than higher monetary wages in the industry affected,
but will result in higher real wages for the people consuming their services.
Should one group of nations specialize in product innovations while the
other specializes in process innovations, the standard of living is very likely
to rise much faster in the product-innovating compared to the process-innovating
country, where it might actually fall.
The increased wealth produced by innovations may reach us in two different
ways, either through increased monetary wages or through lowered
prices for what we consume. To the classical economists, productivity
improvements would show up in the economy as lowered prices for the
goods which experienced these improvements (Smith 1776/1976: 269;
Ricardo 1817/1974: 46-47).
12
(New best practice “common sense”)
A powerful cluster of
new and dynamic
techologies, products
and industries
Explosive
growth and
structural
change
Quantum
jump in
potential
productivity
for all
An interrelated set of
generic technologies
and organisational
principles
Change in techno-economic
paradigm
At the time of Smith and Ricardo, the gold standard facilitated the result
they predicted. In a closed economy, holding velocity of circulation constant,
the increase of goods in the economy resulting from technological
progress would chase only the same amount of bullion. Prices would have
to fall. Rapid technological progress would therefore lead to deflation -
which it in fact often did until the gold standard was abolished.
Once without the gold standard, people in the industrialized countries got
rich in a different way. Instead of seeing the price of industrial goods fall,
they now saw their monetary income rise in nominal terms. Previously
deflation had caused awkward social problems: it was difficult to convince
people who had to take continuous pay cuts that, in spite of these pay cuts,
they were still getting richer, because the price of the goods they purchased
fell at an even faster rate than their wages. From the point of view of the
industrialized nations, the monetary policy that followed after abolishing the
gold standard was a more sensible one: money supply kept rising with the
amount of goods in the economy, or slightly faster, creating a small inflation
which seems to have served to lubricate the machinery of development.
Now the producer in an activity not exhibiting productivity improvements
- for example the barber - got rich by raising his prices at the rate
everybody else had their salaries raised, not only by having the price of
manufactured goods lowered.
A monetary policy that increased supply at par with productivity improvements
not only prevented deflation, combined with the new-won power of
labour unions it made possible what the French regulation school calls
'Fordist wage regime': the regime which dominated wage formation in all
the developed world, particularly after World War II, where it was accepted
that nominal wages to industrial workers would roughly correspond to
the productivity increases in industry. This was the underlying cause of the
asymmetry in the labour markets in Singer's analysis. This Fordist wage
regime could not be copied in the Third World because these countries generally
failed to have the market power required to achieve this effect, created
as it was by the First World 'countervailing powers' of imperfect oligopoly
competition of industry and labour union power. This mechanism
increased the wage differential between the First and the Third World significantly
during most of the twentieth century.
A previous paper (Reinert 1994) elaborates a number of factors which
determine whether innovations and productivity improvements spread in
the economy as lower prices to the consumers (which I call a 'classical'
spread17) or as higher prices to the producers (a 'collusive' spread). When
13
17 Because this is the effect assumed by classical economists Smith and Ricardo.
bringing evolutionary economics to the Third World this type of analysis is
in my view crucial, particularly because what little there was of a Fordist
wage regime in the Third World has now completely broken down. This is
shown dramatically by the percentage of wages and salaries falling rapidly
as a percentage of GDP in most Third World countries. While wages and
salaries constitute close to 70 per cent of GDP in Norway, in Peru this percentage
had dropped to around 23 per cent in 1990 when the statistical
office stopped calculating this figure.
Adding the technology element brings new perspectives to the terms of
trade debate. History shows that the terms of trade do not move against
the industrialised countries with the most technology-intensive production.
If the terms of trade - the relationship between the relative prices of exports
and imports - remain unchanged over time, this must mean in practice that,
on the average, every nation can 'pocket' its own average productivity
improvements in the form of higher welfare. Faced with a large diversity
between economic activities, a world with fixed terms of trade would bring
with it a new logic. If the potential - the windows of opportunity - for productivity
improvements are much higher in some economic activities than
in others, national welfare may be increased by imposing an import duty on
the product with the high-productivity potential. This would make it possible
to capture what we could call a Schumpeterian rent. This argument
becomes even stronger if the presence of the high-tech industries, their high
wages, their potential for creating jobs, the markets and the technologies
they bring with them are each and all a necessity in order to create an efficient
agricultural sector (as was accepted common sense in the eighteenth
and nineteenth centuries).
Schumpeterian economics also bring new perspectives on colonialism.
From an innovation economics point of view, colonialism was - and is - in
its very essence a technology policy. In 1729 English economist Joshua
Gee described 'Colonialism 101' in a nutshell:
'That all Negroes shall be prohibited from weaving either Linnen or
Woollen, or spinning or combing of Wooll, or working at any Manufacture
of Iron, further than making it into Pig or Bar iron: That they
be also prohibited from manufacturing of Hats, Stockings, or Leather
of any Kind… Indeed, if they set up Manufactures, and the
Government afterwards shall be under a Necessity of stopping their
Progress, we must not expect that it will be done with the same
Ease that now it may"18.
14
18 Quoted in Reinert and Reinert (2005).
Colonialism made the metropolitan country benefit doubly from technological
change. On the one hand the colonial power pockets the fruits from
technological change at home through the Fordist wage regime, a collusive
spread of the fruits of technological change. On the other hand the colonial
power also benefits from the productivity improvements in the colonies,
since the fruits of the improvements hit the mother country as lowered
prices (classical spread). Technologically, the colonial power wins doubly
while the colony loses doubly.
The transfer of technological dead-ends, bereft of any scale effects, to poor
countries (maquila-type industries) is a variant of the same system.19 Once
the world has been divided into a high-wage and a low-wage area, the market
logic will automatically assign the technological dead-ends to the poor.
Increased poverty as the result of the break-down of the Fordist wage
regime.
High wages in a country are the result of combined effects of technological
change and Schumpeterian imperfect competition; of market power exercised
both by industry and labour unions under technical change. This increases
both wages and purchasing power, which feeds back to more growth in a
virtuous circle aided by Schumpeter's historical increasing returns. A core
problem of standard economics and of the economics of the Washington
Institutions is that they see 'perfect competition' as a goal, not realising what
every businessman knows, that perfect competition is a formula for not making
money and not being able to pay high wages. The havoc created in the
world coffee market is just one example of how the Washington Institutions
have produced a race to the bottom. This section will look at some of the
mechanisms that made this race almost the only game in town.
What we call 'development' is in a sense a gigantic Schumpeterian rent
which a relatively small percentage of the world population has achieved. It
is not understood that today's policies may lead into a depression spiral built
up through the cumulative interaction of falling wages and falling demand
into a 'classical' overproduction crisis of the capitalist system. 2.5 Billion
Chinese and Indians - rapidly upgrading technologically but not in wages -
added to the global labour market only fuel these pressures. Why do economists
seem to assume that the famous factor-price equalisation should be
upwards? More perfect competition in labour markets would make it most
likely that factor-price equalisation will be downwards. Both the United
States and core European Union countries are experiencing falling real
wages (often through longer hours for the same pay), in Europe for the first
time since the 1930s.
15
19 I have referred to this as Schumpeterian Underdevelopment (Reinert 1996a).
The break-down of the Fordist wage regime is clearly an important element
in the vicious circles of faltering demand and jobless growth in many Third
World countries (Cimoli, Correa and Primi 2005). The world is shifting to a
'classical' form of distribution of the gains from technological change,
which means that rich countries will get richer through cheaper imports and
improving terms of trade while poor countries see their exports rise while
their real wages fall.
Import substation policies in Latin America brought with it elements of the
Fordist wage regime. In fact, real wages in most Latin American countries
where I have had access to data peak some time in the 1970s. Freer trade
at the wrong time did not necessarily bring with a lowering of GDP, but it
did bring with it falling real wages and salaries for the common man. The
percentage of GDP 'reserved' for wages, which English classical economists
thought was fixed for eternity at a very low level (the wage fund doctrine),
collapsed as discussed above. Figure 2 shows how the Fordist wage
regime collapsed in Mexico in the late 1970s, wages and productivity split
up: productivity continues up while wages fall. The resulting lack of
demand is a key element in the 'jobless growth' that followed through what
is called 'the lost decades' in Latin America. Falling real wages prevent the
growth of the high end of the service sector which is so important in the
developed world.
Figure 2: The break-down of the Fordist wage regime: The case of Mexico.
16
Source: Palma (2002)
Mexico: average real wages and productivity, 1950-2000
1976=100 (3-year moving average) constant 1980 prices
150
125
100
75
50
25
P W
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
150
125
100
75
50
25
Figure 3 shows a similar development in Peru, but focusing on exports and
wages. The export figures show a resounding success, which is combined
with falling real wages and, in most years, with a big trade deficit. The
global economy has crated a system that maximises international trade (and
accompanying transportation costs and pollution) while decreasing the real
wages of a majority of the population in many countries. Wages and
salaries compose a sharply falling percentage of national GDP. The FIRE
sector (finance, insurance and real estate) appropriates not only all that is
registered as economic growth, but also an increasing share of what used
to go to wages and salaries. We have established a type of winner-take-all
globalisation (Frank and Cook 1995).
Figure 3. Peru 1960-1990: Diverging paths of real wages and exports.
The export figures are in current US dollars, exaggerating the visual effect.
Source: Income data from Roca and Simabuco (2004), export data from (Webb and
Fernández Baca 2001)
An increased focus on innovation alone will not solve these structural problems.
If the fruits of innovation all go to the customers abroad, a poor nation
must look for other alternatives where it is possible to create a 'collusive'
distribution of technology rents. The long list of arguments in table 1 will
prove still to be valid, adapted to today's context.
17
Conclusion - creating evolutionary development economics.
'He who heals is right' goes an old saying in medicine. This paper has made
a plea for returning to the type of analysis that has successfully 'healed'
poverty and created wealth from fifteenth century England to Korea in the
1970s. In this tradition economic development is activity-specific, tied to
certain economic activities exhibiting high productivity growth and increasing
returns in a synergetic system formed by the presence of a large division
of labour (Reinert 1994), in short what German economist Werner
Sombart called 'the industrial system'. That only the presence of such an
industrial system will create efficient agriculture was a key insight of the
1700s. Historically, successful processes of catching-up have created
copies of the economic structures dominating in the wealthy countries at
any time, that is the same balance between manufacturing and agriculture
and the same paradigm-carrying industries. Initially, for a variety of reasons,
these copies are initially necessarily less efficient than the original economic
structure they try to emulate, and therefore need some form of targeting
and protection.
Werner Sombart defined capitalism as consisting of 1) the entrepreneur, 2)
the modern state, and 3) the industrial system (Sombart 1928). By this definition,
the production system of the colonies was never capitalism. As we
have argued, from an evolutionary point of view colonialism was for centuries
in effect a technology policy aimed at keeping industrial dynamics out
of the colonies. Today's world order has kept a similar pattern, with the
new element that some manufacturing industries with little technological
change and void of scale effects are farmed out to poor countries (maquila
type assembly activities). Changing this centuries-old path-dependence will
require strong policies.
The economics of innovation today brings together elements describing
what Sombart calls the industrial system, a system similar to what Friedrich
List in 1841 called the national system of political economy, what we today
would call national innovation systems, associated with the names of
Christopher Freeman, Bengt-Åke Lundvall and Richard Nelson. As has been
pointed out (Lundvall et al. 2002: 226), one of the greatest challenges facing
this body of theory is that much of the work done on national systems
of innovation is post facto, in the sense that most research is done on systems
that are already mature, already diversified and successful. Theories
and concepts that work wonders in countries with an industrial tradition
dating back centuries, may, however, become much less productive-if not
downright destructive-in the context of developing countries unless filtered
through a historical lens.
18
In this paper I have argued that a necessary part of the solution to this problem
lies in the introduction of a number of factors, some of which have
been part of the economic discourse for centuries, but also elements (like
the different effects of process and product innovations) that are part of
evolutionary economics itself, but which will be much more central to a
Third World discourse. In order to create a qualitative understanding of the
factors polarising the world in growing wealth and growing poverty we
need to create economics by inclusion, a system where all relevant factors
are considered simultaneously. This will bring back the historical/institutional
approach to economics that died after World War II. This economics
by inclusion will also open the way for policies of inclusion, a system that
will put the accent on the wellbeing of the majority and not on the growth
of the export sector.
A marriage of evolutionary economics, as is gathered in this issue, and New
Development Economics (Chang 2003, de Paula and Dymski 2005, Jomo
and Fine 2006) would enlarge the toolboxes and the potential explanatory
powers of both economic schools. Doing so would bring back the key
insights from classical development economics, and also insights from the
only laboratory economists have: the history of economic policy (Jomo and
Reinert 2005). The resulting synergy would create economics without equilibrium
(to use Nicolas Kaldor's term), something very close to the approach
of the now extinct historical schools of economics where relevance was the
only criterion by which the economists' tolls were chosen. Instead of equilibrium,
we would have an optimum as a moving target ahead of us as the
never-ending frontier of knowledge is pushed ahead, but with the fruits of
technological change distributed in a more equitable way by re-distributing
production rather than by redistributing income in the form of aid.
19
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23
Working Papers in Technology Governance and Economic Dynamics
The Other Canon Foundation, Norway, and the Technology Governance
program at Tallinn University of Technology (TUT), Estonia, have launched
a new working papers series, entitled “Working Papers in Technology
Governance and Economic Dynamics”. In the context denoted by the title
series, it will publish original research papers, both practical and theoretical,
both narrative and analytical, in the area denoted by such concepts as
uneven economic growth, techno-economic paradigms, the history and
theory of economic policy, innovation strategies, and the public management
of innovation, but also generally in the wider fields of industrial policy,
development, technology, institutions, finance, public policy, and economic
and financial history and theory.
The idea is to offer a venue for quickly presenting interesting papers –
scholarly articles, especially as preprints, lectures, essays in a form that
may be developed further later on – in a high-quality, nicely formatted version,
free of charge: all working papers are downloadable for free from
http://hum.ttu.ee/tg as soon as they appear, and you may also order a free
subscription by e-mail attachment directly from the same website.
The first four working papers are already available from the website.
They are
24
1.
2.
3.
4.
Erik S. Reinert, Evolutionary Economics, Classical Development
Economics, and the History of Economic Policy: A Plea for
Theorizing by Inclusion.
Richard R. Nelson, Economic Development from the Perspective
of Evolutionary Economic Theory.
Erik S. Reinert, Development and Social Goals: Balancing Aid and
Development to Prevent ‘Welfare Colonialism’.
Jan Kregel and Leonardo Burlamaqui, Finance, Competition,
Instability, and Development Microfoundations and Financial
Scaffolding of the Economy.
The working paper series is edited by Rainer Kattel (kattel@staff.ttu.ee),
Wolfgang Drechsler (drechsler@staff.ttu.ee), and Erik S. Reinert (reinert@staff.ttu.ee),
who all of them will be happy to receive submissions, suggestions or referrals.