The three middle classes and populism

In November this year American voters will choose between populism and plutocracy. The choice was clearly highlighted in my Global Inequality (Chapter 4) written more than a year ago although at that time I could not anticipate the extraordinary rise of Donald Trump.

That rise, combined with the populist reaction against globalization, immigration and foreigners, has become the staple of newspaper and magazine articles to the extent that some, like in the recent New York Review of Books, claim (of course with the hindsight) that populism was both inevitable and predictable. It is, not only in the United States, but also in the UK, France, Denmark, Sweden and elsewhere fueled (as is commonly argued), by the very slow or nil real income growth of the middle-income groups in rich countries. The graph below (based on Luxembourg Income Study data) shows this clearly: the shares of the middle four deciles have declined over the past 30 years by between 1 and 4 GDP points in key developed countries. The phenomenon therefore is not only American: it is common to all rich countries. 

But while the origins of populism in the West seem well understood and “reasonable” in the sense that populism is driven by the economic slowdown,  a similar process of rising populism in China seems difficult to explain because it is accompanied not by a declining but by a rising middle class.  The modernization theory leads us to believe that the rising share of the middle class should propel democratization. In effect, this is what we have observed over the past 40 years, from the Carnation Revolution to Portugal  to the fall of Communism or the spread of democracy in South Korea and Taiwan and in all of Latin America.

Could China be an exception to this “regularity”? It is the same question probably that the Communist party leaders ask themselves. If they answer it in the affirmative, they would be throwing in the towel in a fight to maintain their rule. Since they seem unwilling to do so, and are becoming  aware that the ideology of “GDPism”, founded on an infinite growth of real incomes by close to double-digit numbers, cannot be maintained,  they have tried to move the public opinion in the direction of populism, whether of mild Maoist or of soft nationalist kind. Neither of these two tendencies is yet strong enough or sufficiently poisonous, but the potential to crank it up if needed is there. Thus, in the Chinese case, the rising tide of populism is not caused by an economic failure but on the contrary by economic success which is making the maintenance of the old political system more difficult, or is incompatible with it. This is a contradiction between the development of the forces of production and inadequacy of the superstructure that every Marxist would easily recognize.

The third populist reaction is taking place in Russia. It is fueled by yet a different force. Certainly not  by too much economic success, nor so much by economic failure, but by unjust privatizations and by resentment and revanchism, the two feelings that go back to the end of the Cold War that was (mistakenly) interpreted in the West as the victory over Russia. It is this narrative that Putin and the Russian middle classes find abhorrent and which is at the root of their malign populism and nationalism. It is wrong to see it as manufactured by the top; it is more that the top has given it the right to express itself, in a way that the rise of Trump in the United States did not by itself produce populism, but made its expression more acceptable. While in the past people felt some inhibition to air strong xenophobic or racist views, that inhibition is gone when the political leaders freely express such views and moreover get political support for doing so.

Those who therefore personalize the problem and look at Trump, Xi or Putin as somehow guilty of “creating” populism and inflating xenophobia are only partially right. Trump, Xi and Putin allowed populist feelings to express themselves  but did not invent them.  Populism existed before and was based on real and understandable reasons. The diagnosis that sees the cause of our problems primarily in several politicians leads us then to prescribe a wrong remedy. A very imperfect remedy consists in trying to stop such politicians from coming to power or overthrowing them. Such a remedy does not contribute at all to the solution of the underlying problem which either brought them to power, or close to taking power.

A real remedy has to start with the correct diagnosis. And the correct diagnosis is that in the US, populism is rooted in the failure of globalization to deliver palpable benefits to its working class, in Russia, it is rooted in its crony capitalism and inability (or unwillingness) of the West to include Russia as an equal partner, and in China, it is rooted in an inadequate political system. Once we see the correct cause of the problem, we can begin to try to solve it. Otherwise, the sickness of populism, which for all problems blames globalization and foreigners, in the three major powers that control 98% of all nuclear weapons in the world, is indeed a cause for major concern.

The origins of the Great Divergence

While the world is witnessing global convergence (essentially the catch up of Asia with the West), the debates  about the origins of the Great Divergence—the take-off of the West and absence of growth in the Rest—are going strong. I just finished an excellent book ("Escaping poverty") by Peer Vries who reviews the origins of modern economic growth and proposes his own theory on what made the West, and in particular, Great Britain start the Industrial Revolution and China not.

Vries has two characteristics which are not abundant, in the same person, among economists: erudition and common sense. Very often common sense and cleverness, exhibited by more business-inclined types in economics, go without much historical knowledge. But heavy erudition sometimes renders authors other-worldly, a strange feature in a social scientist that economists are supposed to be.  

I would like to discuss Vries’s book under four headings: organization of the book, his theory of why the Industrial Revolution happened in England, his view why China’s chances to begin an industrial revolution were “nil”, and (some) of his critiques of other economic historians.

Organization of the book. Vries divides the book in three parts. In  the first, he reviews all factors which, according to economists, are conducive to economic growth in general; in the second part, he discusses each of these factors as it applies to the explanation of the Industrial Revolution, and in the conclusion, he …well…summarizes them again.

The causes of growth are nicely divided into direct causes, the ones that we would readily put in the production function: geography and factor endowments; the proximate causes: trade and innovations; and the “deep causes”: institutions, state and culture.

The structure has certain advantages of symmetry, but I found it a bit tedious. It taxes the patience of the reader and provokes some fatigue because essentially the same issues (and even some sentences) are repeated in the general and “applied” sections. I also think it is unfortunate that Vries has not set up in a separate chapter his own views on the origins of the Great Divergence. As it is, his views have to be pieced together from various parts of the book. To this I turn next, and I hope to faithfully reflect Vries’ opinions.

Why did England take off? I found Vries’ explanation very compelling, perhaps because it is also somewhat eclectic. But the reality seldom obeys our abstract schemata. Vries agrees with Bob Allen’s view that the key ingredients in British industrialization were expensive labor and cheap energy and money. This led to labor-saving innovations which were at the origin of the technological revolution. But England also had, Vries argues, a very strong “infrastructal” state that until 1830 followed protectionist policies and often manipulated tariffs and taxes to help domestic producers, engaging in what would be today viewed as “industrial policy”. Furthermore, England had a big government, high taxes, high government expenditures, “yuge” Navy, enormous debt to GDP ratio, and extravagantly highly paid government officials. Externally, the country pursued  imperialist and mercantilist policies. Finally, and quite importantly, workers became the proletariat who had to go to the market to sell their labor (that is, lacked the cushion of working on own plot of land), and labor force became “commodified”.

England, in this short sketch, presents four distinguishing features:

Favorable factor endowments

Capitalism: rational profit-making and commodification of labor

Big government

Outside projection of power (“fiscal-military, mercantilist and imperialist state”, p. 433).

It is the addition (appendage, as it were) of an acquisitive, determined and big state that distinguishes Vries’ explanation from others which, as he points out, present an idealized Smithian picture of a government of low taxes, strong property rights, and tolerable administration of justice. His views on the importance of the use of force in international trade (on the open seas, “the distinction between peaceful, consensual trade and simple piracy was often very thin if not simply non-existent”, p. 148) makes his views close to Findlay and O’Rourke’s (whose work Vries cites very favorably) and even the world-system theorists. But with the latter, he agrees only that mercantilism and imperialism helped West’s take off but cannot explain it. Which brings us to why China has, as Vries several times mentions, “nil” chance of starting the technological revolution.

Why China did not take off? Here Vries is obviously at odds with the California school as well as with dependency theorists (respectively, Pomerantz and Frank) who believe that China had as great a likelihood, say, around 1750, of becoming the first industrial power as did western Europe. Vries sees many reasons why this was unlikely. Consider the four features that made England take off: they are all reversed in the case of China. China’s labor was cheap, energy and money were expensive. Chinese government was weak, paternalistic and unable to collect taxes. China had no army to speak about and was not engaged in military operations beyond its borders. And finally, production in China was organized in family units: it was the land of household mode of production (p. 204), or as Marx would have said, petty commodity production. Thus, workers could stay at home and work together with their families, often living cklose to the subsistence level. What was lacking was the reserve Army of the unemployed who in order to survive had to “feed” the capitalist engine in the West.

But while China was very unlikely to achieve a technological breakthrough, it was an equally or more market-oriented society as the West, at least as far as market for the consumption goods was concerned; China’s markets were more integrated than European, it conducted greater amount of long-distance trade, and its government was much smaller. So here we would, looking from a neoclassical angle, behold all the ingredients that should help China grow (integrated market, small government, low taxes). Yet  they did not. Qing China, in effect, in Vries’ rendering, sounds much more Smithian than Britain (p. 354) but precisely because it was more Smithian it failed to develop.

Critiques. As I already mentioned,  Vries presents a rich, very erudite review of an enormous literature and critiques a number of narratives that have either enjoyed or still enjoy significant currency among economists. Let me mention, for lack of space, but a few them.

Jared Diamond and Ian Morris are “savaged” for their geographical determinism: “As general statements, claims about challenges and responses [are mechanistic], and do not explain anything at all” (p. 165).

Gregory Clark and Oded Galor with their views on the importance of fertility behavior for  human capital formation and innovation cannot explain such seemingly anomalous development where high increase in population does not produce more innovations, or decline in fertility does not improve investment in skills: “unified growth theory has nothing to offer historians” (p. 197).

Daron Acemoğlu and James Robinson start from an unproven assumption that market is always good for growth and their “metanarrative is a stylized generalization of a very...positive interpretation of modern history of Great Britain and the USA” (p. 137).  In addition they never define “extractive” or “inclusive” institutions. David Landes as well as Acemoğlu and Robinson “reproduce all the standard clichés when it comes to Asian institutions” (p. 59).

The California school is just plain wrong on China’s level of development being close to the European level prior to the take-off and Andre Gunder Frank writes “with his usual lack of nuance and overdose of self-assurance” (p. 340).

Peer Vries has written a great book from which one can learn a lot, not solely to improve one’s understanding of the past but to stimulate one’s thinking about the factors that make economies grow today.

On unproductive labor

Today I read an article on shortages and economic collapse in Venezuela. The reason why there are huge lines in front of the stores was the same known to any student of socialist economies: state stores sell heavily subsidized goods and the demand for such goods exceeds their supply. Then, many people buy much more than they need and engage in selling the goods at higher prices to those who are either sufficiently rich to pay higher prices or who have been unlucky that the supply ended before their turn came.

The buyers and resellers of such goods in Venezuela are called, according to the New York Times, bachaqueros.  Ricardo Hausmann, from the Kennedy School at Harvard who was Venezuela’s planning minister in the 1990 was then quoted by the New York Times as saying: “This is the crazy thing about the system. A lot of people are putting in effort [to buy the goods and resell them], and none of that increases the supply of anything. This is perfectly unproductive labor”.

That statement made me stop. “Perfectly unproductive labor”? But that “unproductive labor”, as every economist knows, improves the allocation of goods. The goods flow toward those who have greater ability to pay and since we tend to associate greater ability to pay with greater utility, the goods, thanks to bachaqueros’ activities, are better allocated. If one argues that bachaqueros activity is unproductive because it “does not increase the supply of anything” then one should argue that the activity of any trade or intermediation is unproductive because it does not produce new goods, but simple reallocates. The same argument could be used for the entire financial sector, starting with Wall Street. The entire activity of Wall Street has not produced a single pound of flour, a single loaf of bread or a single sofa. But why we believe that financial intermediation is productive is that it allows money to flow from the places where it would be less efficiently used to the places where it would be used more efficiently. Or for that matter from the consumers who cannot pay much to the consumers who can. Exactly the activity done by bachaqueros.

Hausmann’s view is identical to the (falsely) Marxist view of productive and unproductive activities reflected in socialist countries’ national accounts, called Material Net Product. Socialist countries’ approach was that all services (including health, education and government administration) were unproductive because they did not produce new physical goods. Obviously, speculators like bachaqueros were the very epitome of unproductive, and even (it was held) “socially noxious” or “abhorrent” labor. This view had practical consequences for the calculation of national income because the level of national income in socialist countries was underestimated, compared to what it would be according to the UN’s System of National Accounts, but the rate of growth was overestimated because productivity increases were generally greater in production of goods than in services.

Marx had a distinction between productive and unproductive labor which was more sophisticated. Productive was all labor that resulted in the production of the surplus value. Thus, Marx in a well-known example, shows that a singer (a prototype of activity that does not produce anything tangible) is engaged in productive labor so long as he is hired by a company or an individual and creates profit for his employer. In Marx’s view productive-unproductive dichotomy was not given forever but changed depending on socio-economic formation. The problem with socialist governments in Eastern Europe was that they had trouble deciding what should be productive and unproductive according to Marx in a socialist society and took the easy road to declare unproductive whatever activity did not produce tangible physical goods.

There was also a  categorization introduced by Ann Krueger in the 1970s who defined the so-called “directly unproductive activities” or “rent-seeking activities”. The idea was to classify under such heading all activities whose objective is to extract some government concession that would result in higher incomes  for those successful in lobbying. Pharmaceutical and IT companies that pay hundreds of K Street lobbyists in Washington today would fall under that category—even if Krueger’s classification was originally intended mostly to push developing countries’ governments to be less interventionist (was directed especially against “India’s Licence Raj”;  see Bhagwati here). Lobbying was, it was argued, unproductive because it led to the creation of rents. And rent is, of course, an income that can be taken away without affecting the supply and allocation of goods.

Finally, it leads us to the topic of theft. It is not easy to put theft in its right place in economics. Theft for private use can be justified by arguing that the bread stolen by a poor person from a rich one is almost certain  to increase the amount of “social happiness”. (I have often thought of that in New York where that the old-fashioned idea that one should keep $20 in his/her wallet to give it to a mugger certainly made sense in helping "the greatest happiness for the greatest numbers"). The issue is more complicated when we come to theft for resale: burglary of a jewelry store and resale of the jewels might increase overall welfare if burglars are very poor and jewelry owner very rich but it cannot be defended on better allocation grounds because the jewels could have been equally accessible to those who wanted to buy them whether they are sold by the owner or by thieves.

The issue of preventing theft leads us to yet another category of labor that can also be considered unproductive: security personnel or what is  called the “guard labor”.  Their salaries are paid in order to prevent theft. They clearly do not increase the supply of goods, nor do they improve goods’ allocation.  The only defense that their labor does produce something is in the argument that prevention of theft improves protection of property which makes for more investments and increases long-term growth. But this is,  as can be seen, a rather more convoluted justification, which by the way, can be also used to argue why theft, even if it might improve short-term welfare, is likely to be pernicious in the longer-term, a point of view that goes back to Adam Smith.

Deciding for a capitalist economy what is productive and what is unproductive labor is not always easy. How much more difficult if we study economic history: how to classify monks and priests when they are paid by legally compulsory tithes; Robin Hood could be defended on the maximization of utility principle but criticized as inimical to long-term growth; Francis Drake stole goods owned by the Spaniards who extracted them by using forced labor…

Economic reflections on the Fall of Constantinople

This Sunday, May 29 marks the anniversary of the Fall of Constantinople in 1453. I have been recently reading (and in some cases, rereading) books on the last period of Constantinople, after the reprieve of 1402, brought about by the Ottoman defeat by Tamerlane, and how and why this period was not better used. But thinking of Roman Empire and of what is called (somewhat inaccurately) Eastern Roman Empire, led me to two, I hope interesting, observations.

First, why the Industrial Revolution did not happen in Eastern Roman Empire? Asking this question is  going back to the famous query posed by Michael Rostovtzeff in the 1930s: “Why was there a detour of some ten centuries; why did not seemingly modern-looking market institutions of Rome produce at least a Lombardy-like economic development, not in the 14^th but in the 4^th century?” There are many answers to that question. From those who emphasize external factors like the “barbarians at the gate” to those who, like Rostovtzeff himself, believe that the weakening and the break-down of the Empire came because of its inability to incorporate lower classes and because of the “dead hand” of a rising military bureaucracy;  to those like Marx and Aldo Schiavone and Bob Allen who believe that the culprit was slavery:  cheap labor that provided no incentive for the use of labor-saving machines that technically could have been developed.  Finally, there are those who in the debate between the “modernists” and “primitivisms” thought, like Moses Finley and Karl Polanyi, that Roman institutions did not contain at all the seeds that could have led to capitalist development.

Where does Eastern Roman Empire come into that discussion? It seems to me that the most appropriate answer to Rostovtzeff’s question would be to look to the “country” about which he posed the question: the country that was the continuation of the Roman Empire, nay that was the Roman Empire itself (Constantinople become the capital in 330 AD, some 80 years before the first sack of Rome) and that lasted for another 800 to 900 years with no interruption. (That is, if we want to date the end of the Roman Empire in 1204 when Byzantium was conquered by the Crusaders).

Wasn’t there enough time to find out if ancient institutions could become capitalistic? Eight or nine centuries seems plenty. Moreover, what, culturally and institutionally, better place to develop than the Eastern Empire: direct continuator of the larger Roman whole with an educated elite, same institutions, stable currency (solidus, “the dollar of the middle ages”), reasonable protection of property rights, people knowledgeable of Greek and Latin and thus able to read everything from Herodotus to Columella’s agricultural treatises without the intermediation of translation, with Roman laws codified and simplified by Justinian. Why did not there develop “bourgeois virtue”, “inclusive institutions”, Landes’ “culture”?  Or does it all have to do with “serendipity” of having coal and expensive labor in one place? Yet despite all of these advantages, no one reading the history of the Eastern Roman Empire would come thinking that there was any chance of it developing in the capitalistic direction. It was as feudalistic as they come.

I do not know why market economy with wage labor failed to develop there and can only speculate that it might have been because of a militarized bureaucracy, land magnates (and thus high inequality), obsession with Christian theology which sucked the best minds into sterile disputes (it would be nice to have an anti-Christian like Gibbon tell us why the Eastern Empire could not become a capitalistic power!), its frequent wars with Arabs, Persians, Russians, Normans, Bulgars, Pechinegs, Avars, Ottomans… Any other candidates?

There is plenty of recent scholarly work on why China failed to become capitalist and start the Industrial Revolution (for an excellent discussion  see Peer Vries “Escaping poverty”, and especially the chapter entitled “Why it does not make sense to call Qing China capitalist…”), but it seems to me that equally revealing and rewarding would be to study why the  Eastern Roman Empire, seemingly full of all the necessary prerequisites, failed to do so. The ingredients were present in both China and Eastern Rome, but in neither case did development occur: why?

The second observation has to do with trade and war. The reading of Eastern Mediterranean history is extremely instructive  for a way in which we should think of trade. A benevolent approach, starting with Ricardo, always regarded  trade as an activity freely undertaken by two parties with no extra-economic compulsion. No reader of history of the Eastern Roman Empire can share that view. Trade and military underpinning of it went hand-in-hand. This is at its most obvious not in large empires which anyway had to have armies but in trading city-states like Venice and Genoa. If you believe that trade is all about peace there would be no reason why these city-states had to maintain large naval fleets, fight battles, conquer islands, negotiate, under military threat, special rights to tariff-free imports and exports. Trade, debt and the army always moved together. No tourist to any Greek island today will fail to observe large Venetian  and Genoan fortresses that could not have been built without money and labor but also without a naval presence that allowed the control or conquest of the islands in the first place.

When the Fourth crusade started, the first city to have been sacked by the Crusaders was a Christian port-city of Zara (today’s Zadar in Croatia), a rival to Venice. The doge paid the Crusaders to start their path of destruction with a city populated by their co-religionaries. The association between trade and war which continued throughout the rest of history, and certainly throughout the 19^th century, helps us to have a much more clear-eyed view about colonialism too.  As said by a Dutch Proconsul in Batavia in a letter written to the Directors of the Dutch East India Company (that I cite in my recent book),

Your Honors should know by experience that trade in Asia must be driven and maintained under the protection of Your Honors’ own weapons, and that the weapons must  be paid for by the profits from the trade, so that we cannot carry on trade without war nor war without trade.

Trade followed the flag in Africa and Asia (Leif Wenar and I wrote an article on that criticizing Rawls’ rather quick acceptance of the “doux commerce” view of trade).  “The unequal treaties” with China would be unimaginable without European military superiority and the threat it implied; the Opium War—another example of the close association between the two—was won by arms.  “Free trade” came to India and Africa “out of the barrel of a gun”.

Trade, helped by arms, was often at the origin of the fortunes which grew further by monopolistic or monopsonistic  practices, lending or usury, or in some cases through entrepreneurship. The origin of fortunes was thus often extra-economic. But that need for military power, if one wishes to trade and be rich, is best seen on the example of trading city-states that, in a world without coercion and ruled by the benevolent comparative advantage, would not require fleets, cannons and mercenaries.

History is useful---even for economists.

PS. The electoral/referendum season is upon us, so tempers flare, and I should explain more clearly my own thinking on trade and war. When Leif Wenar and I argued that trade and war are linked, we took a position against a somewhat naïve and mechanistic view (shared by Rawls) that liberal peoples who trade are necessarily peaceful. Indeed, military power was often used to extract advantages in trade or simply to pillage weaker nations. But that does not imply that military power is always used for that purpose. Sometimes, as in the US control of today’s shipping routes in the Pacific or Pompey’s campaign against the Cilician pirates, the military underpinning is needed to make trade and development possible.  There, arms play a role similar to domestic monopoly of violence which guarantees  property  rights and human rights more generally.