“The World is a book, and
those who do not travel read
only a page.”
Alternative Economic Systems
Economic systems are dynamic; not static. While they more often
than not change slowly, there are always emergent pressures on
principal institutions which gradually build over time. The nature
and source of these pressures result in either minor changes (new
working rules, institutions, or modifications in existing institutions)
or major changes (e.g. collapse of USSR).
Current forces which will define and explain the development and
change of principal institutions in the early 21st century:
CHAPTER 1: World Economic Systems in the Twenty-First
The Global Economic Tectonic Plates…
1. The end of communism.
2. A technological shift to an era dominated by man-made
3. A demography never before seen - older (impact in democratic
OECD nations) plus a population boom in the world's poorest
countries (immigration from and internal stress in these nations).
4. An era where there is no dominant economic, political, or
5. Environmental forces (pollution, environmental degradation,
resource depletion, climate change).
6. Multinationalism and Globalism.
7. The Developing World (globalizers vs. non-globalizers)
a. Religious fundamentalism, environmental issues.
8. Global Economic Crisis: Financial Crisis to Fiscal
Crisis…conflict between “market” and “social” contract.
The Choice of Economic Systems in the Twenty-First Century.
• Much more pragmatic, less ideological approach… except in
• What works and what doesn’t work for various countries in
• “In our personal and business lives, we copy success. The
same is true of economic systems (on the whole)… Just as
individuals learn from the examples of others, countries learn
from the successes and failures of other countries.” (p. 15 in
Types of Economic Systems
Types of Economic Systems
Types of Economic Systems
Types of Economic Systems
Ownership North Korea
Types of Economic Systems
Origin and Development of the International Eco. Order (IEO)
1) Began with the industrial revolution of the latter 18th century.
2) As the industrial revolution unfolded, nations other than those in
Europe had two challenges: To imitate or to trade.
- Opportunity to imitate was immediate (North America and other
- Opportunity to trade was delayed: need for revolution in
- Reaction to these two challenges was the cleaver which began to
divide the world into industrial and non-industrial countries.
3) Why didn't the whole world immediately adopt the techniques of
the industrial revolution?
- The most important is the dependence of an industrial revolution
on a prior or simultaneous agricultural revolution.
- A second constraint on industrialization was the absence of an
- Period of high colonialism: Import and export trade in many LDCs
were controlled by foreign hands (profits were in the business
complex of wholesaling, banking, shipping and insurance).
- Imperial power was of course an obstacle in the colonial countries
(India: British salt monopoly, Canada: Hudson Bay Co.) or taxation
(siphon off funds).
- Participation in foreign trade whets the appetite for foreign goods,
in the process destroying local industry
- The increase in exports creates a vested, domestic interest of those
who lived by primary production:
... small farmers as well as wealthy landowners - who after the initial
economic pattern is set oppose measures for industrialization.
... opposition could arise from fear resources would be diverted from
primary production (making it more expensive to farm or mine
thereby reducing incomes), because the shift might increase the
prices of manufactured goods consumed, or shift domestic political
power base away from current holders.
4) In any given LDC, the development progress made between 1850-
1929 depended on the relative political power of the industrial and
… comparative case of Australia and Argentina.
5) And so the world divided: countries that industrialized and
exported manufactures, and the other countries that exported
agricultural and primary products.
CHAPTER 2: Definition and Classification of Economic Systems
• The overriding theme of Chapter 2 is that the economic system is
an important variable that has a potentially identifiable impact on
the way an economy performs and develops over time.
• With the declining real-world importance of polar models, the
characteristics of system variants have become increasingly
• The economic system is viewed as multidimensional and as
capable of being characterized by the following five characteristics:
1. The organization of decision-making arrangements:
centralized, decentralized, mixed. The concepts of
centralization and decentralization are defined in terms of the
distribution of authority and the utilization of information in
an economic system. Principal-agent problem is also
2. Mechanisms for providing information and for coordination:
market versus plan. Market and plan are compared with
respect to who makes decisions in the system, that is,
consumer sovereignty versus planners’ preferences.
3. Property rights: public, cooperative, private. Property rights are
defined in terms of rights to use, dispose of, and/or benefit
from the objects generated from the property in question.
4. Incentives: material and/or moral. Incentive mechanisms and
the impact of incentives.
5. Organization of public choice: Dictatorship, democracy.
Relating government structure to social economic choice.
ES = f (I1, I2, … , In)
… where “I” = institution
• Bounded rationality
• Transaction costs
• Principal-agent problems
• Moral hazard
1. Traditional approach in Systems has been to focus on comparing
various countries that rely on different economic systems or
organizational arrangements for the allocation of resources.
- Interest has centered on how to isolate such systems from
other forces that affect the use of resources in order to
understand how differences among economic systems
influence economic outcomes.
- The obvious implication has been that some systems or
system components might be found to be better than others
(in attaining economic growth, consumer well-being, etc.).
=> search for an “objective” evaluation criterion.
2. It has always been difficult to organize economic systems...
- Especially to relate the differences among them to variations in
- However, it has been convenient to think of systems in terms of
basic and important characteristics (e.g., property ownership,
decision-making mechanisms [i.e market versus plan]).
=> Visualize a spectrum of systems ranging from market capitalism
to centrally planned socialism (communism).
- Although systems change over time, the socialist-capitalist
framework of comparison had until 1990 proven to accommodate the
modest changes taking place in economic systems.
- However, since the advent of major political changes in the Soviet
Union, beginning in 1985, unprecedented systemic changes have
been taking place in the USSR and in many of the formerly
planned systems of Eastern Europe (now called “Central”
• Although the roots of the rapid changes now underway reach
back to the 1980's, and earlier, the 1990s ushered in a new world
order. Astonishing events of 1990-91:
1. End of the cold war
2. German reunification
3. The fall of the communist governments of Eastern Europe
4. Collapse of Japanese “bubble economy”
5. Crisis in the Swedish Model of Welfare Socialism.
… Need to clarify some definitions before we go on:
... Institutions are rules of the society that structure the interaction
- Are made up of formal rules and regulations (working rules).
... and informal rules (conventions or traditions) as well at
- They are the informed ways by which people deal with each other
every day => norms of behavior.
- Institutions, collectively, are the framework within which all of
human interaction...political, social and economic...takes place.
The economy of a society is comprised of institutions which perform
economic functions. These institutions are structured and behave
according to established working rules.
Philosophical Basis for an Economy:
A viewpoint which specifies the place of an individual within
society; an ideal state of political, social and economic reality to
serve as a set of ultimate goals for society; and a general program
suggesting broad policy measures that will guide society from its
actual conditions toward the ideal reality. This economic philosophy
will be multidimensional in the sense that social, political, and
cultural, as well as economic elements are contained therein.
…. Capitalism is a “process” ideology. The liberal tradition born of
the Enlightenment (Bill of Rights) + ethos of progress.
1. Adam Smith - dominance of "the invisible hand" in guiding
economic activity. Limited role of government (provide public goods
and define the rules of the game).
2. Thomas Jefferson – “We hold these truths to be self-evident, that
all men are created equal, that they are endowed by their Creator
with certain unalienable Rights, that among these are Life, Liberty
and the pursuit of Happiness.”
3. The Judeo-Christian traditions – our concept of democracy is
deeply influenced by these religious beliefs.
1. Alfred Marshall, a latter classical economist, refocused his
thinking on what he called "economic biology".
- He argued that economics was like biology because they both dealt
with collective systems based on matter.
2. The dominant thinking on evolution in economics today is called
institutional economics and was built upon the work of Veblen,
Mitchell, Commons, North, Olson, and Coase.
- Their work was motivated, in large part, by dissatisfaction with the
neat, deterministic models of classical and neoclassical economics.
3. While there is no hierarchy of importance in the tenets of
institutional economics, one of the most important for our purposes
[a] Economies are fluid rather than static.
- Changes in working rules will spontaneously arise, or are triggered,
and create new working rules or institutions to support them.
[b] The second tenet is that one can understand an economy
only within its historical context.
- The constellation of factors shaping an economy is unique.
- A corollary to this tenet is that what might work for one nation may
not work for some other due to historical inconsistencies or
differences in the stage of development.
[c] Third, the values of a nation's people can be understood
best by studying the philosophical/religious underpinnings of
- Old and new philosophies alter attitudes, which may subsequently
lead to a change in work rules and therefore institutions.
[d] A fourth general tenet is that the values, institutions and
work rules which operate in one nation will not necessarily
function in another nation.
- A corollary tenet is that values, institutions and work rules that
functioned in the past may not function in the future.
G. C. Allen: "One of the most common fallacies in the minds of
academics, or the citizenry of a nation, is that once a trend is
established it will persist indefinitely."
[e] Finally, the basic structure and performance of an
economy are influenced by the dynamics of the society's
social, cultural and political structure.
4. This broad theory is based upon the interrelationship between a
society's beliefs, power structures, and working rules of institutions.
- The theory explains the nature and evolution of economies by
 Most production and distribution activities are coordinated through
 The origin of these institutions, their activities, and the rules
governing them stem from the interrelationships between the society's
historical legacy and context, philosophical basis, and decisions made
be authorities who emerge from the social and political structures.
 Authorities retain, modify, or define new working rules according
to which the society resolves its economic problems.
 Changes in working rules can modify institutions or create new
ones, with the economy evolving in the process.
 The philosophical basis accepted by authorities and the economy's
performance determines whether the working rules are retained,
modified, or replaced.
B. In summary, when analyzing a nation it is important to define and
discuss six interrelated factors:
1. Historical legacy and context:
Schumpeter: “The subject matter of economics is essentially unique
process in historic time. Nobody can hope to understand the economic
phenomena of any, including the present epoch, who has not adequate
command of historical facts and an adequate amount of historical
2. Philosophical basis...
Church + secular philosophical views => attitudes => working rules
3. Social and Political structures...
Who has the power to enforce and establish working rules? (at the
core of DIM)
4. Working rules... Come in integrated sets…
… Establish the boundaries of economic activity between institutions.
Property rights form a critical set of working rules.
… In each economy the rules differ...even where similar, differing
conditions and restrictions exist.
5. Principal institutions...
...Socially determined: not inherent.
[a] Instrumental in establishing and coordinating most production and
distribution patterns of behavior, and giving meaning and durability to
[b] Significant features: origin, the activities participants perform,
working rules governing them, their impact on the economy, and the
philosophical basis for these activities and rules.
6. Behavior of the economy...
- Three components: how it is organized to resolve the economic
problem; institutional change, and… performance.
Analyzing and evaluating economic systems: Foundation
The performance of an economy is influenced by goals and priorities
established by authorities and by environmental factors such as
technology, natural resource endowment, and international economic
and political factors...all interrelate.
• How the economy performs, relative to stated goals and priorities
(prevailing norm), determine which other economic, social or political
policies are necessary.
• Evaluating and comparing economies cannot be purely objective.
• Conclusions influenced by the analyst’s point of view... the
• The comparor’s norm is based on what you, or the organization
your work for, think is most important in evaluating the outcomes
produced by an economic system.
• This is a value based decision and is not objective.
• It must be remembered that an optimal economic system for all
types of environments does not and will never exist => the best
system for any given country depends upon a myriad of factors not
duplicated elsewhere in the world.
• prevailing norm… goals and objectives of the people or the leaders
of the country being studied.
• Final Notes: What is the difference between a stock and a
… Every society has a stock of institutions and working
rules; they comprise the structure of an economic system
through which all economic activity flows. Economic
performance (a flow) has to do with how efficient, given
your comparor’s norm, this economic system meets stated
… Remember that economic performance is always relative
(need for a “benchmark” country).
• Benchmark country: (1) A country with similar
environmental and social attributes; often in the same part of
the world and/or (2) A “successful” country that is not too
radically different in regards to stage of development.
CHAPTER 3: Institutions, Systems, and Economic
• Chapter 3 is devoted to the problems of isolating the impact
of the economic system from other forces at work on
economic outcomes and establishing criteria by which the
impact of the system can be evaluated.
• This chapter introduces a mathematical model that identifies
the relationship of these ”inputs” or forces, to the economic
• To assess an economy’s success, the text presents five
performance criteria in this chapter used frequently to assess
different economic systems.
The five general performance criteria:
1. Economic growth: Increases in the volume of output
generated over time, problems of measurement.
2. Efficiency: static and dynamic. The production possibilities
frontier is used to elaborate both concepts. This criterion is
useful later in making the distinction between intensive and
extensive economic growth and the problems of factor
3. Income distribution.
4. Stability: cyclical stability, inflation, unemployment.
5. Viability of the economic system (e.g. legitimacy, extent of
the use of markets, corruption, social services, government
An equation they set up…
O = f (ES, ENV, POL)
O = economic outcomes
ES = economic system
ENV = environmental factors (endowment, state of development,
size of nation, unique attributes, etc.)
POL = policies/politics
Evaluating the performance of an economy...
1. An economy's performance can be defined in many ways,
depending upon the performance criteria, methods of
measurement and weights attached to each criterion when
overall performance is calculated (the performance index).
…The choice of criteria is up to the analyst.
2. Four steps to follow (after you outline history, philosophical
basis and prevailing norm):
a. The analysts definition of performance (i.e. comparor’s
b. The identification of performance indicators for each
general performance criteria.
c. The measurement of these performance indicators for each
criterion (use secondary data sources).
d. The compilation of a performance index for cross-
- Includes weighting - must be made explicit.
3. Performance criterion examples…
- Economic growth
- Economic stability/viability (corruption index, economic
freedom index, etc.)
- Technical, dynamic, allocative and static efficiency =>
emerges from competitive markets.
Allocative efficiency : Theory of Markets => P=MBs=MCs
=> ideal allocation of society’s scarce resources to producing
any particular good (given non-public good with no
Technical or Productive Efficiency (Static Efficiency: Part #1): Firms
forced to produce at AC on the AC curve - free entry forces producers
to minimum point on AC where AC=MC.
Static Efficiency: Part #2: measured by the capacity utilization rate =>
how close is the country to its production possibility curve.
Dynamic Efficiency: New ideas => new firms or push existing AC
curve down => force others to adapt or leave.
- International balance of trade, payment, and currency values…
relative position and condition in the global economy.
- Income distribution... Lorenz Curve (Gini Coefficient)
- Quality of life… human development index <Japan>
National name: Nippon
monarchy with a
Prime Minister: Prime minister:
Yoshihicko Noda (LDP)
Area: 145,882 sq mi (377,835
Population (2007 est.): 127.5
million (growth rate: .1%;
infant mortality rate:
3.3/1000; life expectancy:
81.0; density per sq mi:
Capital and largest city: Tokyo,
… some statistics to build context:
2007 2008 2009 2010 2011 2012
Real GDP growth (%) 2.1 1 1.2 1.8 1.2 1.5
Consumer price inflation (av; 0.1 1.2 1.2 1.2 1.2 1.1
Budget balance (% of GDP) -2.4 -2.7 -2.4 -2.4 -2.5 -2.6
Current-account balance (% of 4.8 3.5 3.3 3.1 2.7 2.7
Commercial banks' prime rate 1.8 1.9 2.2 2.8 3.1 3.4
Exchange rate ¥:US$ (av) 117.8 103.7 100 94 92 92
• Let’s say I want to analyze Japan and compare it’s economic
performance to China (my benchmark).
• Let’s also say that I believe that economic growth, the spread
of technology and the ability of the people to provide basic
essentials to their families are most important for evaluating
Japan’s economic performance. This is my comparor’s norm.
• In reviewing available statistical series I decide to choose the
following as my performance indicators…
1. GDP per capita as a proxy of the ability of a family to
provide food, shelter and clothing for themselves.
2. The number of cell phones in use as a measure of the
spread of cutting edge technology.
3. The percent change in GDP from year-to-year as the best
measure of economic growth.
GDP per capita, PPP (current international $)
% change from % change from
Year Japan previous year China previous year
1987 16335 1154
1988 18485 13.16% 1341 16.20%
1989 19094 3.29% 1355 1.04%
1990 20183 5.70% 1394 2.88%
1991 21266 5.37% 1541 10.55%
1992 22165 4.23% 1806 17.20%
1993 22589 1.91% 2069 14.56%
1994 23166 2.55% 2349 13.53%
1995 24199 4.46% 2692 14.60%
1996 25159 3.97% 2944 9.36%
1997 25405 0.98% 3152 7.07%
1998 24848 -2.19% 3356 6.47%
1999 25580 2.95% 3643 8.55%
2000 26755 4.59% 3976 9.14%
Mobile phones (per 1,000 people)
Year Japan % change from previous year China % change from previous year
1987 1.235146 0.00064
1988 1.981433 60.42% 0.002876 349.67%
1989 3.97701 100.71% 0.008607 199.23%
1990 7.02266 76.58% 0.015856 84.23%
1991 11.1137 58.25% 0.040632 156.25%
1992 13.76736 23.88% 0.149496 267.92%
1993 17.08047 24.06% 0.533266 256.71%
1994 34.60169 102.58% 1.297154 143.25%
1995 93.27148 169.56% 2.945426 127.07%
1996 213.8169 129.24% 5.498941 86.69%
1997 303.34 41.87% 10.57819 92.37%
1998 374.3312 23.40% 19.00374 79.65%
1999 448.8401 19.90% 34.17638 79.84%
2000 526.197 17.23% 65.82107 92.59%
GDP growth (annual %)
Year Japan China
1987 4.46 11.18
1988 6.51 10.67
1989 5.28 4.12
1990 5.33 3.99
1991 3.12 9.19
1992 0.93 14.27
1993 0.42 13.54
1994 1.00 12.83
1995 1.57 10.53
1996 3.47 9.58
1997 1.80 8.84
1998 -1.10 7.80
1999 0.76 7.05
2000 2.40 7.94
CHAPTER 4: Changing Institutions
• This chapter is designed to present an overview of different
theories about how economies change, and the characteristics
of change in capitalist and socialist economies.
• Prior to the collapse of the Soviet and Eastern European
socialist economic systems, the subject of economic reform
was of limited interest; that is, reform was frequent but with
apparently minimal results.
• Approaches to reform changed in the transition era of the
1990’s, and economists began to study past economic reform
(especially that of the Gorbachev era), and transition or
• Reform and transition are now cast in a broader historical
context to analyze change along a broad spectrum of different
• This subject matter is messy but essential.
• It is also useful to be aware that since the transition era there
has been increased recognition that the simple dichotomy of
”shock therapy” versus ”gradualism” is an important over-
1. Reform of Economic Systems…
• Economic reform: modification of existing system.
• Transition: shift of a system from one type to another.
• In capitalist systems reform tends to be evolutionary and
gradual… yet in planned socialist or planned capitalist
systems change tends to be abrupt.
… this is largely due to the fact that such systems tend toward
institutional inertia and rigidity => pressure builds on the
collection of institutions until they essentially break.
2. Economic Development and Systematic Change
a. Marx’s Theory of Change…
- Karl Marx (1818 – 1883) – most influential of all
communists … worked in close collaboration with Friedrich
Engles (1820 – 1895).
• He believed that a society’s “economic base”, or “mode of
production”, exerted the most powerful influence in
determining the other social institutions as well as social and
• The religions, ethics, laws, mores and institutions of society
he called the “superstructure” … which is built upon and
defined by the economic base, or substructure.
• The institutions … including markets … related to ownership
of the means of production, and their corresponding
distribution of wealth and income, determined the class
structure (bourgeoisie and proletariat).
• To Marx, as to others from Hegel to the Fabians, it is not the
consciousness of people that determines their existence, but
their social existence determines their consciousness.
• The antagonisms between social classes were, to Marx, the
propelling force in history.
• He damned capitalism, arguing that the separation of the
worker from the means of production made it such that
people could not develop their potentialities (they become
alienated) – they can not become emotionally or intellectually
• The Labor Theory of Value – Labor power, and labor power
alone, gives value to products and services => workers should
have direct control over production and be the sole recipients
of its fruits (surplus).
• Over time, irresistible historical forces come into play that
increase the conflict, tensions, and contradictions between the
changing forces of production and the fixed social
• Vested interests resist and pressure builds to the breaking
point (historical dialectic) => Revolution
• Capitalism would be overthrown by the working class, who
would in turn establish a classless society in which the means
of production were owned in common by all (after a period
during which the Dictatorship of the Proletariat would root
out Bourgeoisie remnants).
b. Schumpeter: The Evolution of Capitalism…
- Until Paul Romer’s path-breaking work in the 1980s, Joseph
Schumpeter was one of the few economist who had tried to
explain growth mainly in terms of technological innovation.
- In the 1930s he presented a model that postulated growth
through the interaction of bursts of technological
development and competition between firms.
• Schumpeter saw capitalism as moving in long waves: every
50 years or so, technological revolutions would cause “gales
of creative destruction” in which old industries would be
swept away and replaced by new ones.
• Each wave of technology would fuel an upsurge in
investment and provide a swathe of jobs in new industries.
• In the process new working rules and institutions would be
needed, changing the fundamental structure of the economic
system. Thus he saw systemic change growing naturally out
of the process of economic development through a reactive
• In his view capitalism was characterized by increasing
concentration (monopoly power) which would eventually
snuff out the entrepreneurial ethic leading to the demise of
capitalism and the rise of socialism.
c. The New Institutional Economists… most on slides 16 to 32 so
I won’t repeat it here.
… essential conclusion is that we can study the evolution of
institutions and their effect on economic performance by using
the logic of economic rationality as reflected in the pursuit of
self-interest (examine property rights, transactions costs, and
… any systemic change is “path-dependent” depending upon the
“initial conditions” (as we said before: history, culture, resource
Douglass North: Neoclassical economics can not help us
understand systemic change for it always holds time and
3. Change in Socialism…Hayek and von Mises (the “Austrian”
School of Economics)
• Both saw strong advantages of systems organized around the
principals of free markets and property rights.
• Argued that socialism was inherently unstable and if
established would prove unworkable leading to either collapse
or low efficiency with economic stagnation.
• Friederick Hayak: application of knowledge best done by
those nearest to the task => decentralized decision making
best => a market system will have highest level of efficiency.
• Mises agreed and concluded that without relative prices to
guide economic choices… without the information embedded
in those prices… socialist managers would make decisions
which would be invariably inefficient.
• Also, without private property, socialism would lead to
decisions that would not promote the interests of the majority
of the people.
• Due to the inherent “inferiority” of socialist systems, they
would necessarily revert to capitalism.
… recent history supports their conclusion…with a twist.
b. Janos Kornai: The Economics of Shortage…
• Characterized a planned socialist system as an economy of
• This occurs due to errors in planning, dysfunctional incentives
and perverse working rules.
…“soft” budget constraints (socialist firms) versus “hard”
budget constraints (capitalist firms).
• This systemic feature creates persistent shortages, chronic
imbalances causes a disabling, long-run reduction in
efficiency in socialist systems.
• His analysis adds to that of Hayek and Mises and is also
supported by recent history.
c. The New Institutional Economics Critique of Socialism…
• Based largely on the work of Mancur Olson and Peter Murrell
who argue that the greater the number and power of groups
with “special interests” the less efficient the system will be.
• Distributional coalition: vested-interest coalition that uses the
political process to gain economic rent for itself.
• Interesting to note that a dictator can counter all distributional
coalitions and enforce polices that maximize social
objectives.… rarely the case.
• When a “socialist” dictator’s power weakens, powerful
oligarchs emerge with their own personal agenda. These
“distributional coalitions” re-channel information and
resources away from the center, using it instead for their own
purposes (nomenclatura in Russia).
• Socialism, therefore, will devolve from it’s founding
principals with economic progress suffering.
4. Change in Capitalist Economies
• More open, democratic systems are characterized by gradual,
diffuse, less visible change… still, there are certain issues that
characterize and differentiate capitalist systems.
a. Property Rights: Private versus Public Ownership
- Capitalist systems are “mixed”, having varying proportions
of private and public ownership.
b. Trends in Competition…
- Driven by the concentration of monopoly power across
markets, technological change and changes in public policy
(deregulation…1980s: Reagan: "government is the problem”)
- Income redistribution…dates from the 1930’s.
• Capitalism uses material incentives to motivate and guide
economic activity…but once initial asymmetries are
established, income and wealth inequality increases.
• A progressive tax system, based on the ability to pay concept,
is used to promote social stability and social policies
• Since the 1960s there has been a trend toward an increase in
taxes as a percent of GDP… from 27% to 31% in the USA …
from 28% to 59% in Sweden.
• Yet taxes may have a negative impact on incentives (Laffer
curve) => trend toward higher tax incidence has set off a
backlash in capitalist countries (US & UK since 1980).
d. Worker Participation…
• New incentive schemes: profit sharing, stock options.
e. Government Intervention…
• Move back toward laissez faire in Anglophone capitalist
countries since early ’80s….in the process of reversing.
• Keynesian revolution: fiscal policy… 1930s to 1980. Japan
• Indicative Planning (France)
• Industrial Policy (Japan)
5. Change in Socialist Economies…
a. Backdrop of Reform…1917-1980…Socialist/Communist
… improve planning mechanism: information (input-output
analysis) and incentives.
… organizational reform: devolution of oversight down from
ministerial level to intermediate level (regional or trade
… decentralization of decision making (worker self-
b. Record of Socialist Reform…just put off inevitable in
Communist nations (comment on European Socialism)
6. Transition… no single path (shock therapy to gradualism)…
none are easy (1990 on).
CHAPTER 5: Theory of Capitalism
• This chapter serves as a summary of basic economic
principles. I will only review a few select topics from this
1. The ”Invisible Hand”… Adam Smith: Free markets would
lead people, acting in their own self interest, would advance
… governments only needed action would be in the
provision of public goods and an effective legal system (rules
of law and objective enforcement).
…true in 18th century; but market systems have evolved
significantly since then.
Question: Did ancient Rome have a “market system”?
• Difference between markets and a market system. What do
we need to have an efficient market system?... In no
• Money and deep capital markets (business loans and consumer
credit at reasonable cost, primary and secondary markets).
• Interconnected and well developed supporting product and
commodity markets (i.e. forward and backward linkages).
• Large number of consumers and producers to attain economies to
scale and to reduce monopoly power (extent of the market).
• An effective information system for informing consumers and
producers. ..unified market based on extensive knowledge.
• Affluence: for R&D (dynamic), government (tax base).
• Rule of law (e.g. private property rights plus objective judiciary).
• Public goods (e.g. roads, bridges, ports, utilities).
Types of Capitalism:
1. State-guided capitalism, in which government tries to guide
the market, typically by supporting certain industries that it
expects to become “winners”.
2. Oligarchic capitalism, in which the bulk of the power and
wealth is held by a small group of individuals and families.
3. Big-firm capitalism, in which the main economic activities
are carried out by established giant enterprises.
4. Entrepreneurial capitalism, in which a major role is played by
small, innovative firms.
• The only things that all four of these models of capitalism
have in common is that they recognize the right of private
property ownership and use the market mechanism.
• Nor is there any single country that has exactly any one of
the models described; in most national economies there is
some blend of at least two.
• Moreover, the blend changes over time, and with it, the
performance of the economy.
… Less than two decades after the fall of communism,
Russia is already moving rapidly from oligarchic capitalism
to an authoritarian state-guided capitalism. Neither of those
two Russian models are the best producers of economic
growth, at least in the long run.
• Oligarchic capitalism is the worst performer; state-guided
capitalism can work well for a while, especially when an
economy is in catch-up mode, as Japan once was.
• What will likely work best in the 21st century is a mix of big-
firm capitalism and entrepreneurial capitalism.
… And this happens to describe America's economy during
the past 30 years, during which time it has reversed its
seemingly inevitable long-term decline and delivered a
• The possibility of change is at the heart of capitalism, with
growth rates of economies not being largely predestined by
culture or geography as some have claimed.
• There are no quick fixes, but over time the right policies can
make a big difference, as can the wrong policies.
…e.g. Continental Europe and Japan, currently dominated by
big-firm capitalism, can increase the role of entrepreneurial
capitalism through policy initiatives.
2. Problems of Democratic Public Choice…
a. Seymore Lipset: democracy is strongest in affluent
economies (much empirical support).
b. Mancur Olsen: distributional coalitions “encrust” stable
democracies which in time undermine the democratic
process; leading to the “decline of nations.”
c. Also, existence of public goods and externalities leads to
state allocation of resources and intervention in markets.
… possibility of free riders lead to taxation and regulation.
d. Even when democratic principals are used to determine
resource allocation, majority voting does not allow for
“intensity of feeling” regarding public choice issues (median
voting rule). Leads to less efficient public outcomes.
How expensive is a democracy?
… first lets look at the economic costs of running a
• Larger military (incorporates civil police)
• Streamlined, functional institutions of society plus small judiciary.
• Large pay to a small minority of supporters in society and military.
• Greater expense to a secret service (typically branch of the military).
• Motivation with a heavy dose of negative incentives (fear) to the
majority… not costly in terms of expenditure of resources….but may
create lower output and waste.
• Information system vertically organized with little need to pay for
expensive mechanism to disseminate information to the masses.
• Minimal social services expenses (welfare, health care, education).
Economic Costs of Running a Democracy:
• Smaller military (one savings…maybe)
• Protection of Civil Liberties:
… objective, powerful judiciary system: well paid judges
and lawyers (less susceptible to corruption)
… well paid police and other civil servants (less susceptible to
• Institutions of democracy: executive and legislative
(expensive to pay for people to sit around and talk…
they don’t produce a sellable product… in fact all “output” of
government is a service yet doesn’t produce a sellable product
(public goods) => drain on GDP (apx. 31%)
• Elections are costly affairs
• Communication with constituents and maintenance of two offices
per elected official… again, they have to be paid well to reduce
• Support for various levels of government (federal, state, municipal
or local) => multiple elections and official offices.
• Entitlements… costly (social security, Medicare and other health
care, national parks, welfare initiatives such as food stamps, etc.)
• Education: forefathers thought democracy could only succeed if the
people were educated => public school system (costly).
• Complex information and motivation systems (positive incentives).
• Maintenance of an efficient tax collection system (e.g. IRS)
• Definitely more red tape (i.e. rules and regulations)
3. Income Distribution…
a. Marginal productivity theory of income distribution. Pay
rate equals the marginal revenue product.
b. Is it a “just” distribution? An open question.
c. Good reasons to support redistributive roll of the state:
… people are not indifferent to the welfare of others.
… John Rawls: People who gain from unequal distribution
are unwilling to accept changes that favor the poor.
… Experiment: we are building a new society yet you do not
know your initial endowment of wealth or distribution of
income… you operate behind a veil of ignorance… what
“initial state” would you choose?
… Rawls argued that people would act to minimize the risks to
being poor and would come to a social consensus in favor of a
fairly equal distribution of income.
… If true, then the state is justified in redistributing income from
the rich to the poor.
4. Macroeconomic Instability…
a. Say’s Law… Depression… Keynesian revolution
(questioned the cyclical stability of capitalism)… state’s role
now enshrined in law…The Great Recession (2007-2008?)
5. Self-Correcting Capitalism: Monetarism and Rational
Expectations…early ’80s: rise of monetarism.
a. Neoclassical school (Friedman)… state will do more harm
than good. Rebalancing works… yet with long lags.
4. Growth and State Policy…
a. Some argue that the process of “creative destruction” is
random and unpredictable. Also, the time may come when this
process destroys more jobs than it creates. Consequently, some
economist argue for a state “industrial policy”.
5. The Performance of Capitalist Economic Systems: Hypotheses
a. Efficiency… better than any other.
b. Stability… we do suffer from bouts of inflation and
c. Income Distribution… tendency for inequality to increase
over time (debasing of progressive tax system due to special
interest loopholes) plus dynamics of wealth creation process.
d. Economic Growth… so far so good… but waves of
technological change are totally unpredictable and becoming
e. Viability of the Capitalist System… without a doubt it is the
most robust systemic form.
Country Focus #1: Japan
• Japan’s GDP exceeded by only US.
• Piloted the Export-Oriented Industrialization Strategy
• From 1940-70 experienced unprecedented average annual rate of
growth of 10.5% per year. “Economic miracle” due to four
1. A unique D (principle institutions) in industry that has given
rise to a successful balance between rivalrous inter-firm
competition and cooperation. (the keiretsu)
2. A unique role of government in D – made possible by a
traditional loyalty to government and government’s control over
information (Guided Market Economy => consistent Industrial
3. A deep sense of organizational unity and purpose (culture).
4. Emphasis on an export-oriented development approach (the Asian
model.) This is changing…1990’s and early 2000’s a time of
transition…to what is unclear.
1. Tokugawa Period (1603-1868)…
- Tokugawa Confucianism: pragmatic => urged obedience,
propriety, benevolence, wisdom => Shinto faith. Root of Japanese
guild system and 20th century management code and solidarity of
- Government established authority over all major aspects of
economic activity (warrior-lords [Shoguns/Samari], similar to
feudal lords and knights in European Middle Ages)
- Government controlled occupations – country closed to foreign
trade – ruling class owned or controlled all major mines and
forests – major financial and commodity markets regulated (a
- Zaibatsu – established principle of concentration of economic D
in hands of a ruling elite.
2. Meiji Restoration – (rapid change of working rules)
- A. Commodore Perry (American) warships in Tokyo Bay – 1853
… in 1854 the Shogun forced to sign treaty opening Japan to
trade => Fear of foreign domination.
- B. Government began to crumble - New central leadership
emerged with vision of rapid industrialization to maintain Japan’s
autonomy – goal achieved through three broad policies:
• Agricultural development to supply surplus for growth.
• Replacement of position within D hierarchy from heredity to
entrepreneurial talent (meritocracy).
• The government took on the role of putting together the
infrastructure. Took on the role of investment in basic industries,
supporting infrastructure and high-risk business.
- Led to a tremendous amount of concentration in heavy
- Still, Japan was the only non-Western nation between 1880-
1940 to have an industrial revolution.
3. The Postwar Economic System – 1946-1952
• The Supreme Commander for the Allied Powers (Occupation
Authority) played a significant role in imposing fundamental
institutional reform throughout Japan.
- Demilitarized nation plus implemented a land reform
program, broke up the four big zaibatsu and introduced economic
policies that enabled the nation to bring inflation under control while
stimulating the economy with supply-side measures.
- Establish parliamentary democracy => from Emperor to Diet.
- Spirit of reform alien to Japanese => move hindered
reconstruction and growth. US softened its stance (1952).
• During the 1950s a new D emerged in production sector … spurred
on by desire for rapid growth => increased incentive for inter-firm
• Emergence of a zaibatsu type structure => keiretsu.
Keiretsu – a closely affiliated confederation of heterogeneous
firms without the strong family control or tight linkages between firms
that characterized their predecessors (e.g. the Toyota group)
• Sogo Shosha – ten great trading companies which handle over half of
Japan’s exports and three quarters of its imports (wholesaling).
Functions: provide marketing support and purchasing assistance
to manufactures, acquiring raw materials, initiating investment
projects, and providing financial assistance to needy small
customers (retailing … family owned and small).
• Despite the high degree of concentration of power in industry, the
presence of monopoly power in Japan has not had the same effect as
that witnessed in western economies.
4. Three big post WWII restructurings:
• After war => heavy industry + light manufacturing for export.
• After oil shock of the 1970s => electronics/high tech hardware
• Current (post-1990) => services/high tech
… How done? … Guided Market Capitalism or Strategic
Industrial Policy or Indicative Planning (all synonyms)
… After WWII the government kept the role of creating equilibrium
and collective growth by …
 Helping to search for a consensus on national economic
 D exercised in a manipulative rather than administrative
 Control maintained in some key sectors.
 Indirect control through monetary and fiscal policy.
 Over time the planning mechanism evolved into the “ringi-
sei” decision making process (described below)
5. Philosophical basis: heavily influenced by the feudal order of pre-
WWII Japanese society and Confucian beliefs; particularly that
society should be divided into strata of differing status and
authority, with respect for authority expected of everyone.
…Culture: in Japan, to a greater extent than in the West, the
functioning of the economy stems from the nature of human
relations. M => traditional, solidarity & altruism.
• One significant informal rule is that loyalty to the nation, firm,
and family, and respect for those with higher status take
precedence over the interests of the individual.
• Isolation reinforced these informal rules, as well as imbuing
within people a sense of uniqueness and homogeneity.
• You must be aware that the informal rules and the importance
of the group are essential if you are to understand Japan’s
contemporary principal institutions and activities within the
private and public sector.
• Contracts are usually vague, without long list of clauses
guaranteeing protection for each party, because what counts is
not the specifics of a particular agreement, but rather the entire
relationship between the contracting parties…keep this in
mind as you explore the economic history and system of
2. Industrial policy in Japan is different from indicative planning
relied upon in France.
• The Economic Planning Agency (EPA) draws up long-range plans
consisting of macroeconomic guidelines and forecast, and
identifies potential trouble areas.
• The primary purposes of the plans are to serve as a basis for state
policies towards infrastructure, and provide a statement of the
state’s projected future policy decisions for use by authorities
representing management, labor, and consumers when they
develop their own plans and policies.
• The state’s intention is to educate these authorities and to promote
greater cooperation among them by decreasing uncertainty about
the state’s intended policy measures.
• Central Market Survey (EPA) – involves a complicated yet
harmonious interaction of business, financial and government
 Led to outsiders coining the term “Japan Inc.”
 Each brings unique D-making authority over different realms
in Japanese economy and a consensus is sought within broad
constraints imposed by government (EPA).
 It has also reinforced organizational unity do to the
participation in the planning process.
 The goal is to achieve harmony (wa) by making decisions
collectively that are deemed in the best interest of the firm,
keiretsu, or nation.
Principal Public Institutions:
• Diet – long tenure of Liberal Democratic Party (to 2009).
• Ministry of International Trade and Industry – MITI
 Important role in regulating the production and distribution
activities of firms in manufacturing, mining, and distribution
industries (diminishing power post-1990).
 Controlling and promoting foreign trade. Developing and
supervising the nation’s energy policy.
• Export/Import Bank – stimulate exports while regulating flow of
• Bank of Japan – controlled money supply while channeling money
to various institutions when needed. Works with Ministry of Finance.
• Economic Planning Agency – conducts the Central Market
• Postal Savings Bank – takes in savings from individuals and
buys government bonds; thereby financing public programs.
Economic Performance: 1946-Present…
• Process by which they develop products for the global market
(Strategic Trade Policy)…Intel in place (EPA)
• Government provides planning of support including generous
loans and subsidies.
• Firms develop products.
• Competition commences with trade barriers in place to protect
domestic competition from foreign entrants.
• The best products are selected through intense competition and
choice by consuming public.
• Firms who develop best products, low cost production are then
supported through the Export/Import Bank and move into global
• Note: Beyond trade policy, agriculture, and research and
development of new technologies, the domestic economy is
• Until the 1990s this was a highly successful systemic formula for
economic growth. Since about 1990, Japan has run into stiff
competition from other Asian nations employing the export-
oriented development strategy in the context of lower priced
labor. The nation is attempting to change with the new economic
driver being domestic aggregate demand.
Labor market – characterized by high immobility.
a. Extremely fragmented.
b. Dominance of “obligation” over contract that leads firms
away from profit maximization.
c. The M leads workers to seek both income and a sense of
identification from employment … all rooted in tradition.
d. Lifetime commitment to employees by firms. Training
(under pay initially – overpay later) accepted due to job
e. Partial compensation to employees by annual or
semiannual bonuses (up to 25% of earnings ) => M to get
labor committed to profitability and efficiency.
• Among the international trade issues involving Japan, the degree
of import penetration into the Japanese economy is important
(member of WTO).
• There are many examples of non-tariff barriers that inhibit
penetration of foreign products in Japan, arbitrary changes in the
size of import quotas, time-consuming procedures at the point of
entry into Japan, and the preference of Japanese consumers for
purchasing Japanese-produced goods.
• Demographics are providing a headwind => population growth
rate for 2011 (estimate) is -.278% or total fertility rate = 1.22.
This is especially important in the context of high national
CHAPTER 6: Theory of Planned Socialism
• This chapter develops two basic themes: First, there is a
preliminary discussion of the nature of a socialist economy.
• Second, the concept of a planned socialist economic system is
developed with emphasis on the nature of economic planning.
• Pay attention to flow diagram on page 121.
1. Note: At the top is the Communist Party that determines all
working rules for the economy.
… responsible for guiding society through a “dictatorship of
the proletariat” (composed of the true believers in the Party)
toward the ultimate historical destiny of society.
• The highest stage of society is “true or pure communism”.
At this stage class conflict will have disappeared while the
state as an institution of central power will have withered
away, so that authorities are not separated in rank and status
from their fellow citizens.
• Such a stage would be possible after the consciousness of
workers was raised to the point that they accept the
following working rule for the distribution of what they
produced: "from each according to his ability, to each
according to his needs." (Socialist Man doctrine)
2. Bolshevik Revolution – 1917 … brought Vladimir Lenin
and the “Red Russians” to power in Moscow.
• The beginning of the USSR (Soviet Union) that would
remain in power for the next 72 years and define a good
portion of 20th century global history.
Story line …
• The New Economic Policy, 1921-1924 (Lenin) … reformed
economy along communist lines.
• The Great Industrialization Debate began in 1924 after the
death of Lenin … Stalin rises to power … forced
collectivization of agriculture.
• One principal institution that emerged was Gosplan, the
state planning committee. Its main responsibility was to
formulate a plan capable of satisfying the goals and
priorities as determined by leading party authorities (rapid
• Central planning was the major socioeconomic process for
economic coordination, a process that distinguishes the Soviet
economy from the economies discussed elsewhere.
- The Communist Party would determine a 5-year plan
outlining broad economic goals within that time frame.
- Plans were established and administered within a strict
hierarchy in which all units must comply with the plan (few
general rules or guidelines existed).
- Planning Agencies evolved over time to employ what is
called the material balances approach to central planning.
- Brain child of Wassily Leontief: “input-output analysis”…
focuses on balancing aggregate demand and supply for basic
industrial commodities such that they simulate an equilibrium
outcome without the use of free markets.
• The “Shadow Economy” evolved over time due to shortages
of raw materials, intermediate goods, and support services
throughout the industrial sector (factor input markets).
- Managers would barter with one another, bribe government
officials responsible for allocating needed materials, or
purchase needed resources and equipment from another
enterprise without planners' knowledge.
• The “Second Economy” was the black & gray markets … an
alternative social process for coordinating production and
distribution (final goods markets).
- It is estimated that the size of this “second” economy grew
continuously, as Soviet citizens unable to purchase high
quality goods from state stores turned to this alternative
- Source of the crime syndicates that riddle contemporary
3. During the 1980s Mikhail Gorbachev and other authorities,
recognizing that the Soviet economy was imploding,
grudgingly ended the Communist Party's monopoly over
• Gorbachev's slogans for restructuring the economy was
“Perestroika” and for openly discussing current problems
“Glasnost” … led to a peaceful transition away from
communism … and won him the Nobel Peace Prize.
• Today the counties of Eastern Europe (Central Europe) …
once the front line of the “Iron Curtin” are free and the USSR
now is a commonwealth of 15 independent countries (CIS …
Commonwealth of Independent States).
- The economic and political paths taken by each of these
national entities are vastly different.
4. China and the USSR had very different interpretations of
Marxian theory from the very beginning.
• The Soviet interpretation is often referred to as Stalinism
while the Chinese interpretation is called Maoism.
- While Stalinism called on a top-down approach within the
“dictatorship of the proletariat” (massive production
facilities), the Maoist approach was a bottom-up approach
(rural communes… much more decentralized with general
rules and guidelines given to be applied by local party
- While the Soviets assisted Mao and his fellow communists
in the early period after the Chinese Revolution (1949), the
fundamental ideological differences, along with a simmering
border dispute and a clash of cultures, led to a chill in
relations between these two great communist powers starting
in the late 1950s.
- This political/ideological schism was never resolved.
4. The Performance of Planned Socialism: Hypotheses
a. Income Distribution: Ideally income should be more
evenly distributed under planned socialism than under
capitalism. Evidence supports this to have been true (Gini
coefficient for Cuba).
b. Efficiency: We have seen that critics argue that planned
socialism’s greatest weakness is it’s expected low level of
efficiency (allocative, productive, dynamic and static). Again,
studies support this under planned socialism.
c. Economic Growth: Given the power of the state to direct
investment and control aggregate savings, one would expect
greater saving, investment and, consequently, economic
… complicating factors: low productivity, lack of incentives,
politically motivated investment decision making and
problems of central planning.
d. Stability: Central authorities have the power to control
employment, inflation and all other macroeconomic variables
of the system => greater stability than that in capitalism.
… still, there exists “concealed instabilities”: disequilibriums
that are ignored and that can cause systemic stress… ruble
overhang (e.g. black markets & rise of crime syndicates).
CHAPTER 7: Theory of Market Socialism
• Market socialism has had considerable appeal over the years,
probably because it has been thought to combine attractive
features of socialism (a more egalitarian distribution of
income) and market capitalism (the efficiency of markets).
• Combines social ownership of capital with market allocation
=> necessitates a central planning board (CPB) of some sort
to implement public policy and coordinate public and private
• Objective is to combine attainment of social objectives
centered on “fairness” with the efficiency arising from
Social Foundations & Movements:
1. Robert Owen (1771-1858): three features to his philosophy…
• Conception of happiness within a community – happiness
depends upon social relationships and that families were an
“autonomous and alien element in society.”…breeds loneliness
and self-centeredness. Alternative: scientific
associations/communities (e.g. today: Kibbutzim in Israel).
• Criticisms of the philosophy and working rules of capitalism
disagreed with the belief that “natural laws” governed society.
• Evaluation of society’s behavior – “laws of social dynamics” that
should govern the formation of scientific associations &
• Coined the term “socialism”.
2. John Stuart Mill (1806-1873) – a philosophical radical…
• Deep feelings of the injustices of the capitalist economy.
• Potential social benefits from state intervention, which would
guide self-interest. Advocated new working rules introduced by
government and voluntary participation in local and municipal
associations (to strengthen social cohesion).
• Accepted the laissez faire tenet that production was governed by
nature yet argued that the distribution of personal income
(determined by society’s customs, laws, and institutional
arrangements) was subject to modification.
• Happiness = high moral development (not measured in material
• Test of “social usefulness” when it comes to evaluating
institutions and working rules.
• Education: he believed that behavior could be conditioned.
3. The Fabian Society (1884)
• Henry George in US, George Bernard Shaw, and Sydney Webb.
• Sydney & Beatrice Webb founded the British Labor Party.
Five features of The Fabian Society:
 Preferred morally stimulated beliefs over those arrived at through
 Adopted an eclectic, pragmatic approach to social reform –
rejected Marx…thought entrepreneurs brought something
important to the social table.
 Preference for reform through democratic and
parliamentary action or through other political institutions.
 Reforms should be small-scale and gradual.
 Progress toward a more collectivized, socially conscious
society was inevitable.
• Fabian Society Programs: national social insurance, public
education, collective control over the primary means of production
(proposed socialization of rents on land), establish public enterprises,
nationalization of key industries.
Market Socialism and the question of the use of markets: Theoretical
a. The Lange Model (Oskar Lange)… a trial-and-error model set in a
general equilibrium framework where the solution is sequentially
• Model builds in three levels of D: lowest = firms and
households; middle = industrial authorities; top = CPB.
• CPB sets prices of producer goods based on historical
experience, sending the determined set of prices down I to
middle level with two rules:
 Produce Q such that P = MC (allocative efficiency).
 Minimize cost of production (productive efficiency).
• If imbalances occur, the CPB will react by adjusting Ps…
adjusting “sequentially” until D = S.
• Along with setting prices, the CPB would also allocate the
social dividends or surplus (rents and profits) in accordance
with social policy (public services or investment).
• Pay attention to diagram on page 144.
• Can attain social objectives while incorporating efficiencies
of free markets.
• Can assimilate externalities into prices (e.g. pollution, global
b. Critics of the Lange Model:
• Approach creates a large bureaucracy and concentrates
power at the top.
• Hayek: while plausible in theory, unmanageable in practice.
• Ignores M (especially managerial). May undermine
innovation and invention since the profit motive
compromised (dynamic efficiency).
• Ignores interference of monopoly power at the intermediate
2. Market Socialism: The Cooperative Variant (a bottom-up
• Several forms: cooperative economy, labor-managed
economy or producer cooperatives (employees have most
rights of owners)
• Historical laboratory… Yugoslavia: piloted the worker self-
• Jaroslav Vanek… lays out 5 characteristics of this model:
 Firms will be managed by the people working in them.
 Income earned will be shared equitably.
 Workers have the right to the income earned from the use
of property, they do not own this property (publicly owned
=> must pay to use).
 Free markets are used to organize the broad economy. Any
government involvement is indirect (monetary & fiscal
 Freedom of choice in employment.
Advantages of the Cooperative Model:
• Empowers workers (greater level of motivation).
• All economic processes subject to market forces (produces
• Creates a more equitable society. Maximizes social welfare
(allocative efficiency retained). More equal pay and less
concentration of wealth.
a. Criticism of the Cooperative Model:
• How do you motivate management?
• Entrepreneurial effort is not rewarded (dynamic efficiency
• May lead to underemployment (w << MRP)
• Doesn’t address issue of monopoly power (reduced output to
max profits and therefore employees’ income).
The Performance of Market Socialism: Hypotheses…
a. Income Distribution… greatest chance of equality yet
monopoly rents may arise.
b. Economic Growth… could be higher yet government may be
under pressure to divert social dividend from investment to
consumption. Also, dynamic efficiency may be less (less
retained profits and incentive to take on risk).
c. Efficiency… definitely higher than under planned socialism
and theoretically could be higher than under capitalism
(higher average employee motivation & can include
externalities… “superior” allocative efficiency).
d. Stability… similar to capitalism yet due to fact of
“socialization of investment”, could lead to more stable
macro environment. Still, investment decisions could be
political and, given a bigger role of government than under
capitalism, could lead to long run instability due to broad-
based mistakes and recognition/policy/implementation lags.
• Is public ownership compatible with democracy?
• Will public ownership lead to political totalitarianism
• Discussions today center on the nature and roll of the state
in a socialist system and how agency and incentive
problems can be resolved on the microeconomic level.
• The appeal of a more egalitarian distribution of income and
wealth in the context of a society that empowers a greater
number of people remains a powerful image in the minds
of many people (especially in Europe).
• “Dual Movement” since about 1875…desire to have
economic freedom while at the same time protection from
the excesses and potential abuse of power within
a. Sentiment fluctuates over time given the circumstances
of any given nation.
Country Focus #2: The Swedish Economy: 1932-Present
• The biggest economy in the region… currency the krona… spend
33% of GDP on social protection (US spends 15% of GDP).
• Its past 100 years have been glorious… until 1990. From 1870 to
1990 Sweden grew faster than any country but Japan.
• Sweden has been a constitutional monarchy since 1809, and
universal suffrage was granted in 1919.
• A new written constitution was introduced in stages during the
first half of the 1970s.
• Sweden maintains one of the world’s most advanced social
welfare systems, based on legislation introduced in 1944. The
country became a member of the EU in 1995... But has not yet
adopted the euro (krona).
Prime minister: Fredrik Reinfeldt since
National legislature: Unicameral Riksdag
(parliament) of 349 members directly
elected for a four-year term.
Main economic indicators, 2011
Real GDP growth
inflation (av; %) 1.5
balance (% of
Population (m) 9.4
growth % 2011 2012* 2013 2014 2015 2016
GDP 3.7 1.0 1.5 1.9 2.0 2.0
consumption 1.7 1.2 1.3 1.7 2.0 1.9
consumption 1.4 1.4 1.1 1.0 1.0 1.0
investment 7.5 1.8 2.0 3.0 3.0 2.5
services 7.4 1.6 3.3 3.4 3.8 3.8
services 6.9 2.6 2.7 3.3 3.8 3.5
demand 3.6 0.8 1.1 1.7 1.9 1.7
Agriculture 0.5 0.5 0.5 0.5 0.5 0.5
Industry 7.0 0.0 1.0 2.0 2.5 2.0
Services 2.5 1.4 1.8 1.9 1.9 2.0
* Estimates from 2012 on.
Recent history & trends…
• Most disturbing trend: a sharp slowdown in economic growth since
the early 1970s along with a steady decline in productivity. Downturn
seemed to coincide with oil crisis:
• Went from 4th highest GDP per capita in 1970 to 15th today: Still, at
$47,934 (2010) the standard of living is high.
… Government response back in early 70s: oil shock forced most
economies to deflate sharply - Sweden ploughed on with fiscal
expansion - government debt began to rise and the balance of
payments to deteriorate.
… A series of devaluations rescued the foreign balance, at the cost
of recurrent inflation => pushed wages even higher.
… Whenever the private sector began to flag the public sector
would take over, pouring subsidies into shaky industries and
private housing, and inventing new services to mop up the jobless.
… All this had the effect of causing the state's share of GDP to
balloon to 66% more than the average OECD country and 67% of
GDP by the mid-1990s (brought down since then).
… Pushed interest rates up: to attract international capital and
compensate for risk => banking crisis in 90s (balance sheet crisis)
… So, a clash between the slow-growing economy and the
expanding public sector was inevitable.
… In the fall of 1991 the Social Democrats lost power for the first
time since 1932. Carl Bildt conservative government: didn’t last
long. In 1994 the Social Democratic Party returned to power; but
then lost the election of 2005 to a four-party coalition (this coalition
won again in 2010).
… Voted to join the EU on Sun., Nov. 13, 1994. Decided not to join
the EMU in 1998 and rejected this again in 2003.
… Their economy grew at a health clip from 1996 to the 2000, with
the rate slowing down since…as with all the European economies.
Unemployment has risen as well (6.6% fall 2011).
… On September 17th 2006 a new centrist government under four-
party Alliance for Sweden was elected—comprising the Moderate,
Centre, Liberal and Christian Democratic parties. New prime minister
is Fredrik Reinfeldt, the popular head of the Moderate Party
• The development of the Nordic economies reflects the interaction of
natural, cultural and historic forces indigenous to Scandinavia.
• Geographic isolation from foreign influences and homogeneity of
race and religion has contributed to a high degree of social mobility,
social stability as well as a long democratic political history.
• Despite fact that Sweden now is capable of supplying most of its
agricultural needs, in 1700’s low productivity prompted exploitation
of rich endowments of ore, timber and waterpower to pay for
… In this early period, exploitation of timber resources was
under strict state control to limit forest depredation => traditional
precedent for government intervention in the private sector.
• Sweden entered the industrial revolution a bit behind the rest of
Europe but through specialization, innovation and resource
proximity, maintained a good supplier position.
• Concurrent wave of emigration to New World assisted
development by relieving rural overpopulation. Increased labor
mobility and disrupted archaic social structures.
• The planning of the railway system around 1860 seems to be one of
the earliest attempts by the state to influence the direction and
composition of development.
… Planners mapped out a trunk network that subordinated
links between established economic centers and directed lines
through areas where industry was poorly developed.
• One advantage of entering the industrial revolution late was
awareness of problems with industrialization (awareness of Dual
… 1901: Employment insurance (employers liable to pay
accident compensation to workers).
… 1902: Public employment exchange agencies established.
… 1916: Old age insurance.
• Social Democrats came to power in 1932 at the beginning of the
… Post-1930 developments: “welfare state.” Definition – a
welfare oriented economic system supported by a productive,
private industrial establishment (i.e. market socialism).
… Culturally: General acceptance of the values of collective
social responsibility and public service. Predilection for seeking
pragmatic solutions to social and political problems, intolerance for
mass poverty, and aversion to open conflict.
• Philosophical Basis: Homogeneous + Lutheran (90%).
… jamlikhet: Ideals of social justice…incomes should be
equalized to minimize the differential between socioeconomic
classes => redistribution measures + high marginal tax rates (49%).
… folkhem: “peoples home” … Swedish ideal of equality. Belief
that citizens should receive equal treatment, such as universal
health care or education, as they would in their own home.
At .23 (lower=greater income equality) Sweden’s Gini coefficient
is the lowest in Europe (the US’s Gini coef. = .45)
General Characteristics of the Economy:
1. Market is the dominant coordinating mechanism upon which
economic decisions depend.
2. State participates in markets insofar as it produces goods and
services through state owned enterprises (very few).
3. Swedish government cannot alter composition of the final bill of
goods but it can indirectly influence level of private demand and
prices by means of income redistribution policies.
4. More than 95% of Swedish industry privately owned => private
sector retains principle locus of control over production within
broad limits prescribed by national economic policy.
… A priori restrictions against nationalization of production have
limited direct government ownership to less than 5%: Forest 25%
- iron ore 85% - power generating 50% - trucking 4% - airlines
20% - state monopolies in liquor and tobacco retailing.
4. Private sector export oriented (approximately 20% of GDP).
5. Tendency toward relatively large enterprises (economies of scale
in a small economy) is balanced by the nearly free access of
foreign goods to Swedish markets (one of the lowest tariff
structures in the world).
… Foreign trade effectively maintains incentives for efficient
production and reduces the need for anti-trust legislation.
• Their approach sometimes called DCSE (democratically
controlled social economy) => Market Socialism.
… State paternalism has been an overriding feature of the
Swedish economy. The state, in assuming a paternalistic role
towards its citizens' well being, willingly has intervened to
alleviate social and economic problems.
… The Social Democrats have taken the position that state
intervention in many economic and social areas is warranted if
unregulated market forces do not satisfy the Social Democrats'
ideals or the needs of organized labor (part of prevailing norm).
… The strong central government has the authority to manipulate
and modify market forces to encourage conformity with certain
social and political objectives.
… Employs fiscal and monetary policy extensively for
achieving general goals of full-employment, growth and stability.
… Has several means of influencing investment:
 Substantial backlog of nonessential public works
projects that can be initiated at short notice to absorb labor during
 Finance Minister has the power to release investment
funds through the “investment reserve mechanism.” Not a pot of
funds held by the government. Rather, a counter-cyclical tax
device whereby corporate profits set aside by Swedish
corporations during prosperous times obtains substantial tax
privileges when used for investment purposes during a recession.
… Major national objective is promotion of an equitable
distribution of income.
 Tools: Provision of extensive social welfare benefits and
indirect controls over investment decisions (i.e. use of public funds
in the capital market, control of housing construction and
employment policies). A highly progressive income tax structure and
one of the highest tax incidence in the world as a percent of GDP
(48%). But what do you get as a citizen for your tax krona…
 All families with children under 16 receive a tax-free
allowance for each child.
 Students qualify for liberal support allowances and study
loans and all education is free.
 National health insurance provides free medical care at a
hospital or clinic – medicines distributed at nominal cost.
 Employees eligible for daily sickness and unemployment
benefits as well as generous relocation and training subsidies
(encourages high labor mobility).
 Pension program provides for a yearly income amounting to
2/3 of the income earned by pensioner during his or her 15 best
…and this is just a sampling of prominent social entitlements.
8. 4% of industrial ownership is represented by the consumer
cooperative societies that also control 20% of all retail trade.
… Cooperatives are more significant in Sweden than in most
… Organized on the basis of joint action and self-help,
cooperatives developed as a means to provide cheaper, higher quality
goods and services than private firms were providing. They thereby
serve to offset private economic power in certain sectors.
… Membership is open to anyone, there is no allegiance to any
political party, each member has a single vote, and the expected rate of
return for time, money, and effort is modest.
… They exist in areas such purchasing, production, banking,
housing, travel services, funeral services, childcare, among other
… About one out of twenty Swedes is employed by a
cooperative, while one-fifth of everyday goods and services are sold
Final things you should know:
• Decision making of national and community issues – Joint
participation of unions (strong…90% or workers covered by
collective bargaining agreements), management, financial and
government representatives on investigating and administrative
boards/commissions strengthens cooperation.
…Such commissions and boards responsible for defining and
objectifying community goals.
• Powerful unions with widespread worker participation in the
context of a culture that disdains conflict has resulted in both stable
labor relations (management gives in) yet a tendency for chronic
cost-push inflation at the national level.
• Can the Swedes maintain their way of life in the future? Depends in
part on what goes on in the rest of Europe over the next several years.
CHAPTER 8: The Anglo-Saxon Model of Capitalism
• Summary and Objectives…
This chapter is a survey of the main capitalist variant, the
United States. The emergence of transition issues to center
stage has brought new attention to the fundamentals of the
market model and the relevance of this model to
understanding system variants in theory and in practice.
• Moreover, there is an attempt to cast the American economy
in a systems perspective. This is intended to enhance our
understanding of contemporary systems’ issues, and also to
create some uniformity of approach as we look at other real-
world systems in subsequent chapters.
Models of Capitalism… three major variants:
1. Anglo-Saxon model:
• Began in England and built upon the classical liberal ideals of
Adam Smith and the constitutional precepts of classical
liberalism => based on principal that government intervention
in the economy should be limited.
• Working rule regime based on “common law”… operates
with lay judges, broader legal principles, oral arguments and
• Today the US economy is the best real-world example of this
model (big firm/entrepreneurial form: high levels of
2. European model:
• Evolved in France and Germany in the 19th century.
• Places less faith in the invisible hand and calls for more state
intervention in economic affairs, including more state
• Pays relatively more attention to the common good as
opposed to individual rights, and provides for more regulation
of private economic activity.
• Legal foundation: Civil Law (Roman Law)… working rules
spelled out by professional judges, legal codes, and written
• Modern-day France is a good example… we will look at in
the next chapter.
• Some say there are two European models: a northern and a
southern model => same but with differing prevailing norms.
3. Asian model… not really a distinct model yet an example of
transition from primarily traditional economies to capitalist
through a process of emphasizing exports as main driver.
• Taps the global financial and product markets with state
guidance to create high rates of capital formation with the
goal of overcoming backwardness in as short a time as
possible. Applies the “export-oriented industrialization <or
• Institutional arrangements more similar to the European
model than the Anglo-Saxon model…heavy hand of
government minus the Welfare State.
• Examples: China, Japan, South Korea, Taiwan, others.
Points in chapter I want to emphasize…
1. Constitutional Foundations of the U.S. Economy…
• Madison was the principal architect: rejected the strong state
of Hamilton as a danger to its polity. The best way to limit
the power of the government was the separation of powers.
• This led to the Constitution (Jefferson wrote) embracing the
idea of strict restraints on government interventions that
would reduce the liberties of private individuals in their
2. The Private Versus the Public Sector…
• Note Figure 8.1 (p. 165): Continual increase in the share of
national income associated with government. This
contradicts popular opinion since 1980 (a matter of public
choice: Dual Movement again).
• Note figure 8.2: Our government is relatively small as a
percent of GDP as are taxes.
• Right of Eminent Domain… clear invasion of private
property rights by the government… the right of the state to
take property under certain conditions in the public interest.
• Exercised by local, state and federal agencies through a
system of administrative regulation (either by an official of
executive government or by semi-independent commissions
operating under general legislative authority).
• When US businesses are regulated by the government, it is in
the interest of protecting the public good (e.g. public utilities
=> natural monopolies, SEC, hazardous waste [EPA], etc.).
• In all there is approximately a $1 trillion regulatory burden
due to the system in place: acts like a tax… some paid by
business, some paid by consumers… depends upon market
conditions (tax burden & relative elasticity)
• In the 1960’s and 1970’s a belief that the high cost of
regulation outweighed the benefits; which brought about a
multi-decade long movement to reduce the incidence of
government regulation. Began in earnest in the late 1970s
with the airline industry.
• Principal of self-regulation by business applied under the
belief that if business failed in doing so they would lose self-
• Supported by the argument that deregulation would result in
lower prices, better service and a more efficient economy.
All supported by microeconomic theory.
• Has reduced costs for most consumers… but backlash
brewing in post-credit crisis environment.
5. The Labor Market…
• Model based on highly flexible, mobile labor force and
markets. Today mobility diminished: housing market,
mismatch of skills vs. the unemployed.
• Unions… reached peak in early 1950’s with membership and
influence waning over ensuing years. Even so, US labor
union members are accustomed to periodic layoffs thus
creating a flexible labor market.
• Implicit contracts in unionized industries… unwritten
understanding covering hiring and layoff practices.
• Flexible labor market along with labor mobility permits
market forces to create a uniform wage structure across the
nation with variable wages and employment adjusting to
changes in the economy.
6. Government Intervention in the Labor Market
• Fair Labor Standards Act of 1938… minimum wage.
• Occupational Safety and Health Act of 1970 (OSHA)…
covers occupational safety and health with an enforcement
• Limited to public education, some low-cost health care for
the poor and elderly (Medicaid and Medicare), social
security in retirement, for disability, and unemployment
insurance…costly: “pay as you go.”
• Over the past 50 years there has been a shift in public attitude
toward government responsibility and provision.
• Two rules have governed provision in the US:
1. If feasible, goods should be provided on an “in-kind” basis
(e.g. food stamps).
2. Families should not have the power to shop around for
education or public health (under scrutiny today… battle over
vouchers in public education).
• Note: Since about 1980 there has been a growing movement
toward privatization in all capitalist nations: a shift of
economic activity from the public sector to the private sector.
• Ongoing… yet may have reached limits early in ’08 and began
reversing with $700 billion Wall Street bail-out package.
• The “pure” Anglo-Saxon (American) model espouses the
principle of self-reliance. The state is not responsible for the
income or security of its citizens. The responsibility lies first
with individuals, then with their families and then with local
communities and private charities.
… there has been a tension in our politics about this since
Franklin Roosevelt began his “New Deal” program that
included a call to created both jobs and a social insurance
program (this is our ongoing struggle with the dual
movement…very evident today).
CHAPTER 9: The European Model
1. Legal Foundations: Civil Law…
• Grew out of the European tradition of monarchies and feudal
• Often feudal lords were as powerful as the monarch: in such a
case, written laws with clear rules were found to work better
than unwritten laws based on tradition and precedent (avoids
abuse by local potentates, Magna Carta 1215).
• Written laws approved by the sovereign and enforced by
professional judges were the only alternative.
• Civil law gives less weight to individual rights, Such as the
right to property and private contract, and more to the rights
of the state.
• In general, Common law is much more flexible, adaptive and
supportive of civil liberties and economic growth.
• Note table on page 209 that list countries that apply Civil Law
or Common Law.
2. Codetermination… grew out of the dual movement:
• Results in worker representatives being placed on the board
of directors of corporations.
• One of the most distinctive features of the European model
since it gives non-owners of capital (e.g. employees) the same
rights as owners over decisions affecting private capital.
• Objective of policy: industrial democracy (State-guided
Capitalism) => forcing management to consider workers’
interest when making policy.
• Law passed in 1976 specified that shareholders and workers
should have equal numbers of representatives on the board of
• Reflects the “stakeholder” orientation of the D in Europe.
3. The Labor Market…
• Much more highly regulated than in US (rooted in guild
• Increased governmental regulation began in the second half
of the 19th century… the dual movement emerged earlier in
Europe than the US (A European depression started in the
1870s and lasted until the mid-1890s).
• Characteristic of the “market socialist economy” is to build
social consensus between management and workers through
regulating the conditions of work through the process of
• Over time has resulted in distinctive social welfare features:
 35-hour workweek in France
 2 years maternity leave available in Germany.
 In Sweden parents can take 480 days off for each child at
80% of pay.
 Unemployment insurance for 32 months in Germany and the
unemployed do not have to take available jobs that
necessitate their moving or that offer lower wages than
 Most important: employers cannot easily fire or lay off
… typical regulation (in Germany): 30 days notice has to be
given before any termination. There are a lot of rules and
regulations governing this “notice” that must be submitted to
the State Employment Office.
… as a consequence, hours worked per employed person has
dropped dramatically in Europe.
• Also, all EU member countries must implement EU’s labor
regulations. Has resulted in an extremely high labor cost.
• Paradoxically has created a relatively wealthy group of
nations, whose per capita income is 60% of the US, with
labor costs equal to that of a US worker.
• European workers work only 80% of the hours of American
• One consequence has been persistent high unemployment
(employers don’t want to hire if they can’t fire) as well as use
of temporary workers and capital alternatives (robots).
• Another consequence is that the generous pay-as-you-go
welfare/retirement system gives relatively little incentive to
save => Europeans save mainly to buy a house and travel.
4. Nationalization, Privatization & Deregulation…
• Postwar period politically has been balanced between social
democratic (trade union) and conservative political parties.
• Until the late 90’s social democratic parties have favored
nationalization while conservative governments have
• Consequently, for nearly 60 years nationalizations were
followed by privatizations of major industries in metallurgy,
transportation, and banking as political regimes changed.
• When conservative governments were in power
denationalization was achieved in two ways:
 the sale of public enterprise to private persons or
 social denationalization: selling a new type of equity, the
so-called “popular share” to low-income citizens or workers
on a preferential basis.
 governments often retain a “golden share.” <next slide>
• In the 1990s and 2000s, discussion of nationalization was
replaced by discussion of “privatization”… the conversion of
enterprises owned by the state into enterprises at least
partially owned by private owners.
… began in England under the Thatcher government (early
… idea was to convert unprofitable, bureaucratic enterprises
into profitable, well-managed companies (e.g. British
Telecom, Lufthansa, etc.)
Country Focus #3: The French Economy: 1946-Present
Five aspects of French economy to keep in mind…
1. Distrust of laissez-faire policies.
2. The philosophical basis and institutionalized means for guiding the
3. Belief it is possible for an economy with a substantial segment of
its industries nationalized to realize above-average rates of
economic growth (Oil giant Total… most profitable oil company).
4. Deep commitment to the welfare state.
5. Influence of EC membership on the French economy. Influence of
EC’s supranational institutions and working rules.
… Especially rules related to the agricultural sector, competition
within France and trade agreements with member and non-
Senate of 331 and a National Assembly
of 577 members; may be dissolved by
President: Directly elected for a five-
year term, currently Nicolas Sarkozy
(UMP: Union pour un mouvement
populaire), elected in May 2007.
Currency: the Euro
Area: Metropolitan France, 543,965 sq
km (size of Texas); including 51.4%
used for agriculture and 27% woods or
Population: 63 million
Economic growth % 2011 2012* 2013 2014 2015 2016
GDP 1.6 0.3 1.4 1.6 1.7 1.8
Private consumption 0.7 0.8 1.3 1.7 1.9 2.0
Government consumption 0.8 0.6 0.4 0.9 1.0 1.0
Gross fixed investment 2.8 0.8 2.3 3.1 3.8 4.0
Exports of goods &
services 4.0 1.5 3.3 3.6 3.8 4.0
Imports of goods &
services 5.1 2.7 3.0 3.7 4.7 4.7
Domestic demand 2.0 0.7 1.3 1.7 2.1 2.1
Agriculture 2.5 1.4 1.2 1.0 1.0 1.0
Industry 1.3 0.1 1.0 1.4 1.5 1.6
Services 1.7 0.4 1.5 1.7 1.8 1.9
* Estimates from 2012 on.
• The political foundations of contemporary France go back to
the 1789 revolution.
• The constitution of the Fifth Republic came into force in early
• The president is elected by universal suffrage for a five-year
term (currently Nicolas Sarkozy). Next election in 2012.
• Parliament comprises two chambers: the Senate (the upper
chamber), members of which are elected by an electoral
college and serve for nine years (with one-third retiring every
three years); and the more important National Assembly (the
lower chamber), to which deputies are elected by universal
suffrage and which serves for a five-year term (although it
may be dissolved by the president).
• France has a long history of state intervention in economic
• Post-WWII philosophical basis focused in the work of Jean
• Practical approach to postwar reconstruction and stimulation of
the economy by developing the means for promoting effective
cooperation between the public and private sectors.
• Came to be known as indicative planning…process not unlike
Japanese ringi-sei decision making… set up to complement and
control market forces.
• Government has always played a more important role than in most
industrialized nations. Has protected domestic firms from foreign
competition, encouraged cartels to eliminate domestic competition
and subsidized certain favored firms and industries.
• Indicative or State-Guided Planning (State-Guided
Capitalism): Use of a central plan, imperfect markets and a
type of central market survey as mechanism for coordinating
• “Commissariat General du Plan” (planning agency) established
1947 in response to post-WWII economic stagnation.
• Implementation of the plan is achieved by a combination of
market processes and government action to limit the feasible
sets of acts open to private enterprises and to provide incentives
that affect the consequences of the acts.
National plan serves two basic functions…
• Provides the context whereby the government guides
economic activity, primarily by influencing investment
• Provides for a central market survey program with the
potential for giving management better and more up-to-date
information on the plans of other production
agents…including the government.
• Results in more vertical I and D than in the US. And given
that the process is more directly manipulative (e.g. using
strong positive and negative incentives), it is more vertical
• Central Market Survey – represents a mechanism whereby a
government or other unit collects information about production
and consumption plans of firms and households, processes this
information and then disseminates it to all market participants.
… Forecasts must be credible (The Planning Commission).
… Reduces uncertainty, leading to more rational decisions.
• Government has and uses a variety of controls and
positive/negative incentives to encourage production agents to
conform to plan targets… key aspect of plan implementation is
the allocation of investment funds among firms.
1. 25% of total French investment financed out of public funds and
another 25% under state control (gives them considerable
leverage) … Ministry of Finance.
2. Influence through state ministries and enterprises => pricing
policies and placement or refusal to place purchase orders.
3. Various tax, subsidy and tariff incentives, trading rules and
regulations are freely manipulated by French officials.
4. Implementation of plan goals achieved primarily by voluntary
cooperation and manipulation. Although a secondary means is
through administrative command measures.
• By permitting the market to operate as the coordination
mechanism for all but the key investment decisions, and by
letting enterprises to operate within this market framework, the
French have run into three problems:
1. The use of two coordination mechanisms =>
… conflict due to plan’s attempt to guide an enterprise into a certain
production pattern unprofitable for the enterprise (from a free
market perspective: away from profit maximization and
2. When government uses its considerable power to force
enterprises to follow the plan, a truly innovative manager will
find it difficult to implement his or her ideas => economic
growth will suffer ... May fall behind more dynamic, freer
3. Powerful special interest groups arise to oppose any change.
French history of public protest and culture of entitlement.
• Witnessed a significant increase in public enterprises (under the
influence of the Francois Mitterand government: a socialist).
• Reasons for nationalization included dissatisfaction with laissez-
faire outcomes and a desire of authorities to guide modernization of
• Studies conducted in the 1990s indicated that in France state owned
enterprises were be more productive than many enterprises in the
private sector (e.g. Renault, Michelin, LaFarge, Pernod-Ricard,
L’Oreal, Carrefour, Alcatel-Lucent, Canal +, AXA, Suez, Société
Générale, Total, Vivendi, BNP Paribas, etc.).
The Present …
• France's economy today features a multitude of state owned and
controlled institutions and working rules for financing, managing,
regulating, rationing and delivering comprehensive social insurance
and welfare benefits to the population.
• Such benefits are aimed at providing citizens more security and
stability than prevails in most OECD nations.
• Their willingness to pay for such benefits has enabled the French
to establish an Etat-Protecteur (welfare state) designed to embrace
all citizens and to deliver regulatory and income transfer schemes
carried out by the authorities for the purpose of improving the
well-being of the nation as a whole and to alter the distribution of
that well-being within the population.
• The result is one of the most extensive, and expensive, social
insurance and welfare schemes in Europe.
• The French point with pride to their standard of living, which
remains among the highest in Europe.
• Although it’s per capita GDP is twenty-third in world rankings,
France's human development index ranks twentieth…
… This ranking reflects France's low incidence of poverty, efficient
public transportation system, public aerospace and energy enterprises
which are working well, cultural and architectural amenities which
receive world-wide admiration, and systems of education, health
care, retirement, and employee benefits that compare quite favorably
to any other OECD member.
• However, the traditional state interventionist role in France and the
maintenance of its redistribution schemes at current levels may be
undermining the nation's ability to achieve favorable economic
performance (e.g. French Google clone: Quaero)
… Ultimately what is at issue is the efficiency (allocative,
productive, static, dynamic) versus equity trade-off.
1. Macro problems include below OECD average GDP growth and
growth of per capita income.
2. France's annual average real GDP growth has declined from
4.4% over 1951-73 to only 1.2% today.
3. Major unemployment problem: 9% overall and slightly more
than 25% for young workers.
4. Face major problems with older citizens - average retirement age
is 60 … early retirement program (aggravate public debt) … big
problem seen in 2030 (15% of GDP to care for old - 10% now).
5. 2008: As the financial crisis unfolded Sarkozy established a
“strategic national investment fund” to take stakes in French
companies to protect them from foreign predators.
• 2005 law passed to reduce the
maximum number to hours a
worker could work per week
down to 36 (lowest in Europe)
with the idea of spurring
… Of course the French loved
this when added to their 5
weeks of paid vacation.
• Powerful vested interests =>
internal political conflict that
may lead to stagnant economic
• The euro zone debt crisis has far-reaching political and economic
implications for France. A substantial increase in fiscal support for
the weakest member states may be needed if the break-up of the
euro area is to be avoided.
• The centre-right president, Nicolas Sarkozy, will remain in office
until the presidential election in May 2012. Mr Sarkozy will
struggle to boost his low approval ratings given high unemployment
and austerity measures.
• Despite a weak economy, fiscal policy will remain restrictive in
2012, as the government tries to reduce the budget deficit from
close to 6% of GDP in 2011 (external debt = 82% of GDP).
• The euro zone debt crisis will weigh on confidence. The French
economy is now forecast to contract in the final quarter of 2011.
Growth is expected to be weakly positive in 2012, before a gradual
recovery takes hold in 2013 (all hopeful and contingent).
Country (Region) Study #4: European Union
An international organization of 27 European states
Members of the European Council
• Population Total (2010): 501,259,840
• GDP Total (2010): $14.820 trillion (nominal US dollars)
Note: Larger than US’s $14.660 trillion
• Nominal per capita GDP (2010): $32,615 (€25,000)
• The EU economy is expected to grow further over the next
decade as more countries join the union - especially considering
that the new members are usually poorer than the EU average,
and hence the expected fast GDP growth will help achieve the
dynamic of the united Europe.
• However, GDP per capita growth for the whole Union will lag
behind the US. In the long-term, the EU's economy suffers from
below-replacement birth rate, low productivity and a rapidly
aging population in the context of generous social welfare
Percent unemployment rate – total (seasonally adjusted)
April 2010–September 2011
External debt as a percentage of national GDP
The European Union and other nations in international trade 2008
Value in billions of Euros
… Good example of evolution of supranational institutions and
… Also a unique example of where institutions follow working rules.
1. Levels of economic integration:
• Free trade area – each member has their own trade barriers
(tariffs/quotas/regulations) with non-member nations yet have
none between members. (e.g. NAFTA)
• Customs union – uniform trade barriers with non-members. (e.g.
EEC, Mercosur)…only covers finished and semi-finished goods.
• Common market – free flow of factors of production between
member nations (most important: labor).
• Economic and monetary union – Supranational institutions
power increases … common currency. (e.g. the Euro/EMU)
• Full economic integration – unified government. (e.g. USA)
2. Economic effects resulting from economic integration:
• Trade creation – elimination of trade barriers generate gains
=> increasing the volume of imports from member nations –
each country concentrates more on producing the goods in
which it has a comparative advantage relative to other
member nations (trade and GDP expands).
• Trade diversion – trade diverted away form lower-cost, non-
member nation producers toward higher-cost member nation
producers. Necessarily inefficient since purchase is made
from a higher cost producer.
3. Two descriptions of the EU…
• One economy - comprised of the combination of member
nations' economic performances (growth of GDP, trade flows,
rates of unemployment, inflation, investment, etc.)
• Second pertains to the level of integration (=> 27 nations
seeking to achieve the economic and monetary union level of
4. EU is comprised of four separate organizations:
• European Coal and Steel Community (ECSC)
• European Atomic Energy Community (Euratom)
• European Economic Community (EEC)
• European Central Bank – 1999 (EMU …euro)
... In reality the four are one entity. Members have surrendered
some national sovereignty to supranational authorities.
5. Treaty of Rome - 1957
• Six signators: Belgium, France, Italy, Luxembourg, the
Netherlands, and West Germany.
• Cornerstone of EU: established the goals and formal working
rules which provided the basic tenets for European economic
• History… A united Europe was first proposed in 1834 by a
group known as Young Europe. After WWI another
unification group began calling for the establishment of a
Pan-European Union. Neither resulted in EU yet established
"important precedents" and helped promote the idea across
• More history - after WWII Europe was in ruins and in a weak
position of global power vis a vi America and the USSR.
Prominent European leaders began to push for the EU ('46
Churchill called for establishing a “United States of
Europe”… Within a decade, formal means for unification
came into existence (OECD, the Western European Union,
the North Atlantic Treaty Organization (NATO), the Council
of Europe, and the European Community).
• A gradual emergence of formal rules beginning with the
ECSC (1951) - considered a success - led to formation of…
• EEC in 1957 - intent was to promote economic integration “by
means of four progressive harmonization processes.”
 Elimination of internal barriers to trade through removing
 Achieve of a customs union through applying a common
external tariff toward nonmember nations.
 Establish of a common market by permitting the free flow
of factors of production plus goods and services.
 Attainment of further integration by adopting common
policies (e.g. agricultural, competition, social, transportation).
• Goal was to have a common market by 1970 (common
working rules and policies should be implemented that applies
to all aspects of economic and social life of member nations).
6. Monetary Union (no provision for in the Treaty of Rome) -
first proposed at the Hague Summit in 1969 with a proposed
target date for full harmonization of macroeconomic and
monetary policies. Proposed in response to a collective sense
that they were still behind and that they had little control
individually in the global economy.
• Global oil crisis of 1973 + collapse of the Bretton Woods
agreement => inflation and unstable exchange rates
throughout Europe => 1979 the European Monetary System
(EMS) established … designed to reduce currency
fluctuations through an exchange-rate mechanism (keep
exchange rates in bands).
• In 1986: signing of the Single European Act - agreement to
enlarge the scope of economic and social cooperation to the
• European Parliament established a commission to investigate
and in Aug. 1990 presented a proposal for an Economic and
Monetary Union (EMU) … primary purpose: to tighten
coordination of economic and monetary policies throughout
• Called for a common currency, a central bank and a single
monetary policy, close coordination of fiscal policy,
prohibition of monetizing public deficits, and avoidance of
large fiscal deficits for all members (each state's deficit must
not exceed 3% of GDP).
• Approved by members in 1991 - Maastrict Treaty: set target
• EMU went off without a hitch. More rapid adoption of the
euro than expected – new bond issuance in Euros initially
(mergers and acquisitions).
… Still, the euro was weaker than expected and fell below parity
with the dollar in 2000 (in mid-2002 rose above parity and
has stayed there since). Due almost totally to the fact that the
European Central Bank kept interest rates relatively low.
… While euros were initially used exclusively for government
payments and financial markets in 1999-2000, they began to
be substituted for national currencies on 1/1/2001 by being
issued to the general public.
Need to turn our attention to outlining the major institutions
of the European Union.
First, let’s take a diagrammatic look at the evolution of the
• Lisbon Treaty of 2009 = Amends previous treaties to streamline EU.
The European Union has several major institutions:
1. The European Parliament…
The European Parliament is one half of a bicameral legislature
(the other half is the Council of the European Union). It has co-
legislative power with the Council in most EU policy areas,
able to accept, amend or reject proposals as it sees fit. Unique
in that it is directly elected by the people and has legislative
2. The European Council…
The European Council, sometimes informally called the
European Summit, is a meeting of the heads of state or
government of the European Union, and the President of the
European Council (pictured at beginning of EU lecture).
3. The Council of the European Union (or “Council of
Along with the European Parliament, the legislative arm of the
European Union (EU). It contains ministers of the
governments of each of the member-states of the EU. The
Council of the European Union is sometimes referred to in
official European Union documents simply as the Council, and
it is often informally referred to as the Council of Ministers.
4. The European Commission…
The European Commission (formally the Commission of the
European Communities) is the “executive” of the European
Union. The Commission is headed by a President (Since
November 19, 2009, Herman Van Rompuy). Its primary role is
to propose legislation and to carry it out.
5. The European Court of Justice…
The ECJ is the supreme court of the European Union. It
adjudicates on matters of interpretation of European law.
6. The European Court of Auditors…
The Court of Auditors checks that all the Union's revenue has
been received and all its expenditure incurred in a lawful and
regular manner and that the EU budget has been managed
soundly (their Treasury).
There are several financial bodies, yet the most important is:
7. European Central Bank…
The main goal of the ECB is to focus on price stability (single
mandate). In order to keep prices stable, the ECB may cut or
raise interest rates.
• Decision-making procedures:
… The decision-making procedure within EC institutions is
significant, since working rules passed at the supranational
level influence each member nation.
… Prior to the Single European Act unanimity, was required
for new initiatives or objectives, not majority rule. By the late
1980s, under the cooperation procedure specified in the
Single European Act, qualified majority votes were to be
taken when EC institutions passed certain measures,
regulations or administration actions. The cooperation
procedure has enhanced the efficiency and reduced time spent
in decision-making at the EC level.
• Enlargement process – (accepting a new member or members)
is important, for …
 It increases the opportunity for trade creation while
changing the political face of Europe.
• The Maastricht criteria establishes basic standards to be met by
European countries if they seek to become full members of the
EU. The economic criteria are:
Candidate countries must have price stability and an inflation
rate of no more than 1.5 percentage points above the rate for
the three EU countries with the lowest inflation over the
In terms of budget deficit, a candidate must have a rate below
3 percent of its GDP. Its public debt must not exceed 60
percent of GDP, but if debt levels are in steady decline, it may
be allowed to adopt the euro as its basic currency even though
its debt level may be higher than this rate.
The long-term interest rate should be no more than 2
percentage points above the rate in the three EU countries
with the lowest interest rates over the previous year.
The exchange rate of the currency of a candidate country
should have stayed within certain pre-set margins of
fluctuation for two years.
• The enlargement issue hinges on whether advantages to
existing members in the form of trade creation, gains from
greater specialization of labor, and a stronger political bond
with European neighbors outweigh the disadvantages.
… The latter include reduced political influence for each
member, more social divergence within the EC, a larger
agricultural sector (necessitating more funds to support the
new member's agricultural sector), the possibility of trade
diversion, and the threat of migration of labor if the applicant
nation has high rates of unemployment plus lower wages than
• Nations seeking to join the EC recognize the potential
economic benefits they can enjoy while increasing their
political influence in world matters.
• New members must be committed to democratic political and
economic institutions, and be accepted by vote of existing
• Common agricultural policy … costly yet politically
expedient. Affects price and production decisions for most
… Some goals of the policy are to enhance the EC's ability to
lessen dependence on outside sources for its agricultural
needs, reduce the risk of food shortages, continue farming
as away of life for many people currently engaged in the
agricultural sector, stabilize food prices, and protect
farmers’ incomes. Interventionist measures, such as
regulating the volume of imports, are employed to
manipulate market prices to desired levels. Such measures
are costly, accounting for almost two thirds of all EC
• Things a country would have to do if it were to leave the Euro zone:
Prepare for a run on banks through bank holidays, limits to deposit
Prepare for capital flight by introducing temporary capital controls,
Change the law to re-denominate wages/incomes in new national
Re-denominate mortgages and other debts in new currency.
Prepare plan to recapitalize banks.
Plan to balance budget for government would lose ability to borrow.
Set fiscal and monetary framework to rebuild policy credibility.
Prepare new notes and coins for distribution.
Reprogram computers, change vending and payment machines.
CHAPTER 10: The Asian Model
Summary and Objectives:
• With more than 40 percent of the world’s population in India
and China alone, much of the economic progress of the
twenty-first century will depend on Asian economies. The
focus of this chapter is to understand the basic Asian
approach to economic development, change, and growth.
Primarily, this chapter explores how economic practices have
evolved into their present form, and the manner in which
system, policy and setting have unfolded throughout Asia.
• Note: In the past 10 years China has contributed to 25% of
the increase in global GDP.
• This chapter focuses on Japan and the four “Asian Tigers,”
with a later chapter dedicated to the special case of China.
• The roots of the Asian model originated in Japan with the
policies first implemented during the Meiji Restoration
(1860s - 1870s).
• Asian model spread to Korea after its annexation by Japan in
1910 (chaebol = keiretsu…Samsung: 87 companies).
• Theory of Relative Backwardness (Gershenkron):
Explains how a poor country can quickly overcome its
relative economic backwardness once it realizes that it is
grossly underutilizing its potential.
Key policy steps:
 borrow technology from other countries.
 encourage a high rate of savings and use the institutions of
the state to direct investment to critical industries.
… involves non-economic factors such as effective,
coordinated government planning and policy.
… must have a compliant citizenry, strong central
government or both.
 utilize pool of underemployed labor (must have a “growth-
conducive” attitude => entrepreneurial and pro-business).
 Post-WWII period government policy focused on export-
oriented industrialization (openness to international trade).
• With the exception of Japan, the rest of Asia had to wait until
the postwar period for its Gershenkronian burst of growth.
• First needed to dismantle the vestiges of colonial empire.
• The Four Tigers: Hong Kong, Singapore, South Korea and
Taiwan (early 1970s).
… employing the export-led industrialization strategy,
exports were primarily manufactured goods in the beginning
with a diversification into high-technology and services
commencing in the 1990s.
… regional governments promoted a stable investment
climate, reasonably secure property rights and tranquil
… some created development banks to oversee the effective
deployment of capital to sustain long-term growth.
• Governments promoted universal education and investment
in human capital (e.g. public health).
• Export-oriented industrialization requires:
 undervalued exchange rates.
 avoidance of import restrictions (e.g. tariffs, quotas,
 trade liberalization policies (force domestic producers to be
globally efficient and assimilate new technologies).
 run trade surpluses and use to import raw materials and
capital goods (for which the country has a comparative
 Maintain a relatively low tax burden: helps to attract and
keep FDI. (Europe’s average tax burden = 40% of GDP;
Japan’s = 27%; Hong Kong = 14%... US = 30% and Sweden
The Lewis Two-Sector Model (W. Arthur Lewis)…
• Assumes a traditional agricultural sector characterized by
over population, underemployment and low productivity
(marginal revenue product for one more worker equals zero).
• Assumes a second, smaller, modern industrial sector utilizing
rational business practices (urban based).
• The task of development is to transfer labor from agriculture
to industry where its marginal product is positive.
• Figures on page 250. Conclusions =>
1. Can only happen if the demand for industrial labor can be
2. This means there needs to be an increase in industrial
investment. This raises the marginal product of labor and
thereby increases the demand for labor.
3. Given the infinitely elastic supply curve of labor, the
migration of labor to the cities and into industry will not
bring about increasing labor costs.
4. Note that as labor leaves the agricultural sector there is no
loss of output and no increased pressure on farm wages.
5. At the same time industrial output rises generating a surplus
that can be plowed back into industrial development.
6. So, the theory is clear… the problem is that it is not clear what
“mechanism” will trigger the migration of agricultural
workers to industry? In other words, how do you boost
investment in the industrial sector to start the migration?
• Establish financial intermediaries marketed to farmers that
will gather funds and channel to industry.
• Offer agricultural entrepreneurs ownership shares in
• Impose taxes and extract savings. The government then uses
accumulated funds to underwrite investment.
• Government could collectivize (nationalize) agriculture to
boost productivity and siphon off funds for industrialization.
• Also could borrow from international capital markets.
• These are all structural changes or strategic actions… the fact
remains that you need an active, powerful agent to get the
process started (i.e. government).
7. Characteristics of the Asian Model:
• Read through the sections on “Corporate Governance”
(dominated by large industrial groupings: Japan => kieretsu;
Korea => chaebols), “Capital Markets”, “Labor Markets”
(share economy), “Income Distribution” (relatively
equitable), “Industrial Policy” (e.g. Japan’s “ringi-sei”
Indicative Planning), “Provision of Income Security” (note
Singapore’s defined contribution, privatized Central
Provident Fund: 20% by employee, 15.5% employer)…yet
social welfare system is virtually non-existent.
growth % 2010 2011* 2012 2013 2014 2015
GDP 10.3 9.0 8.6 8.4 8.2 8.2
consumption 5.1 9.0 9.4 10.2 9.9 9.4
consumption 15.3 10.0 9.0 8.9 9.0 9.3
investment 11.9 9.5 8.8 9.8 9.1 8.8
services 20.4 9.8 9.2 9.1 9.0 8.9
services 20.8 10.6 10.0 12.2 11.6 10.9
demand 9.9 9.2 8.9 9.7 9.2 9.0
Agriculture 4.3c 2.6 3.0 2.7 2.8 2.8
Industry 12.2c 9.5 8.8 8.4 8.3 7.8
Services 9.5 9.7 9.5 9.5 9.0 9.6
•* Estimates for 2011 on.
• Size of reserve account in 2011: 3.197 trillion
USD (world’s largest)
Chapter 12: China: Market Socialism?
• For hundreds of millions of Chinese, the past 75 years have
required adaptation to a series of political, economic and
cultural revolutions, punctuated by cycles of order and chaos,
liberalization and repression, plan and market, social protection
and individual responsibility.
• During the mid-90s, after a decade of gradual market reform,
China recorded the world's most rapid rate of economic growth
… nearly 10% per year.
• Based on comparisons of economic performance, many
observers conclude that the policy of gradualism in China had
proved more effective than the "shock therapy“ used in Eastern
Europe and the new CIS countries.
• Indeed, based on its enormous population, its expanding
consumer market, and its strategic position in Asia, a rising
chorus of voices claimed that China will become an economic
superpower in the 21st century.
History and Environment:
• With about 1.3 billion people, China constitutes more than
one-fifth of the world's population.
• In surface area, only Russia and Canada are larger.
• Only 10% of China's land is suitable for cultivation.
• Thus, with more than 70% of the Chinese labor force engaged
in agriculture, the average farm worker controls less than one
acre of land (India - 2 acres on average; in USA - 100 acres).
• The Chinese empire was the only giant of the ancient world to
survive into the twentieth century.
- The post-1949 civil war China provides an opportunity to
study both the effects of ideology on system design and also
some major experiments with new strategies and forms of
1. CCP came to power Oct. 1949 – faced two problems:
• Had to consolidate its political position.
• Had to establish itself as the center of a reorganized decision-
making system based on communist ideology.
2. The Peoples’ Liberation Army and its related organizations
penetrated into every area of economic activity yet do to its
military orientation the government had neither trained
personnel nor information to assume complete control of the
economy in 1949.
• Economy was totally disorganized … government under
Kuomintang in 1930s and Japanese during WWII required
thorough overhauling and rebuilding.
• Government embarked on a course of gradual change …
despite Marxian theory Mao proposed to skip the capitalist
stage replacing it briefly with a stage of “democratic
• To gain support of rural population and to alter the decision-
making structure, widespread land reform was pursued.
• By 1952 CCP had nationalized most foreign firms.
• By the late 50s, CCP had succeeded in its initial goals – now
faced choice of a system that would best promote the ideas of
A period of centralized command and bureaucracy … framework
1. Decision-making system with CCP at center – individual
agent under the influence of party cadres, trade and labor
organizations, agricultural communes, and state enterprises at
the lowest echelons.
2. During this whole period there was constant friction between
two party factions…
• Moderates – believed growth as a balanced, orderly process
… careful, methodical planning and progress.
• Radical Left (Mao) – feared CCP losing sight of inherent
dynamism of the broader social revisions and the
confrontation of opposites and was being stifled by the
preoccupation with bureaucratic and technical considerations.
The Great Leap Forward – 1957
• Radical Left gained control … put aside 5 year plan in favor
of The Great Leap Forward … in which China would elude
the timetable imposed by the rate of capital accumulation by
calling upon the vast resources of its industrial and
agricultural force, thus “walking on two legs.”
• Vast initiatives implemented in five months … too brief for
proper preparation … organizational chaos … Russia
withdraws support … radicals forced to abandon the effort
due to falling agricultural/industrial output.
• Entered a period of “Readjustment, Consolidation and
Repair” (1961-65) … with the abandonment of the GLF, the
moderates within the CCP effected sharp changes in policy to
restore order and to repair damage done to economy.
Particular emphasis was given to agriculture to reduce threat
of mass malnutrition and starvation. … focus on communes.
Next came “The Great Proletariat Cultural Revolution”
(Jan. 1967) …
• Not intended as a systematic reform … SR impact on
economy was minor … basically it was a more intense
expression of Mao Tse-tung’s beliefs.
• Witnesses sweeping change in organizational structure from
the CCP down to communes.
• Power shifted to newly formed networks of “revolutionary
committees” (often young, uneducated, inexperienced
members of the communist youth brigades).
• Tremendous decentralization in decision making structure.
• Anti-intellectual and professional.
• Time of great suffering.
• By 1970 Mao had to back off … disruptions/starvation in the
• Moderates held sway although Mao and his radicals present
Transition of Power: 1976-1978
• In 1976, China was shaken by the death of Zhou Enlai in
January, an earthquake in July that killed 240,000 people, the
death of Marshal Zhu De in July, major floods on the Yellow
river in August, and the death of Mao Zedong in September.
• An intense battle for succession erupted between Deng
Xiaoping, Zhou's hand-picked successor, and Jian Qunig
(Ching), who was Mao's widow, a leader of the Cultural
Revolution, and a member of the radical Gang of Four.
• The power struggle, together with mass demonstrations, riots,
and natural disasters interrupted economic growth in 1976
and caused Deng Xiaoping to fall from power once again.
• Hua Guofong - compromise candidate - had the Gang of Four
arrested in an attempt to consolidate power - grudgingly
rehabilitated Deng Xiaoping for a second time - China
reached crossroads in 1978 at Party Congress over Hua's
ambitious industrialization scheme (7 year plan to build 120
large scale projects) … Industrialization scheme was found to
be unrealistic and Deng made serious political ground.
Following decisions were made in this Congress:
1. The focus of the party's work would shift from political
agitation and class struggle to socialist modernization and
improvement of living standards.
2. To remedy the effects of long-term ruination and neglect,
economic modernization would begin in the agricultural
sector, supported by a substantial increase in agricultural
prices paid by the government.
3. Work incentives would be strengthened in the communes,
based on the Marxian prescription for early stages of
socialism: "To each according to his work.“
4. Local authorities and industrial and agricultural enterprises
would gain greater autonomy under the guidance of unified
5. The Party would continue to play a leading role in society, but
clear lines would be drawn between the responsibilities of the
Party, government, and enterprise leaders.
• 1984 Central Committee called for development of a
"socialist commodity economy with the following 4 major
 China would continue "on the whole" to have a planned
economy, but planning would become indicative:
macroeconomic guidance would replace mandatory targets.
 Markets would establish a "rational price system," which
would be "the key to reform of the entire economic structure";
nevertheless, markets would not allocate or control ownership
of labor, land, mines, banks, railways, or state owned
 The economic functions of the government would be
defined more narrowly, and the enterprises would be allowed
to make more of their own decisions.
Socialism with Chinese Characteristics (1979-Present)
• Early in 1979, Deng initiated an enormous agricultural reform
- the household responsibility system - that led to dissolution
of the people's communes.
• In 1980 Deng rose to power after the Gang of Four were
convicted of crimes causing more than 34,000 deaths during
the Cultural Revolution and Hua offered his resignation (he
was implicated as an accomplice in conspiring to overthrow
Mao in 1971).
• With Deng in power China entered a remarkable period of
[a] Introduced a new philosophy of pragmatism (1983),
displacing the leftist ideology of Mao.
 State enterprises would remain "the leading force" in the
economy, but other forms of collective, individual, and
foreign joint venture ownership would be encouraged.
 Special enterprise zones begun (1980 … in south of country).
• After 1984, the scope of market activity grew very rapidly.
Price controls lifted across the board.
• Also in 1984, the rural communes were disbanded with
ownership of their industrial holdings transferred to the new
units of local government: TVEs – “township and village
 Between 1984-1995 they created 95 million new jobs, and
their rates of productivity growth were twice as high as those
in the state sector.
 Reasons for success...
…Strong kinship links among rural villagers create implicit
property rights in a setting of collective ownership.
… Chinese public finance has been decentralized since 1984,
so financial benefits and burdens of the TVEs are felt locally.
… Communities with TVEs engage in stiff competition with
one another to attract local and foreign investment.
… TVEs have acted flexibly to supply light industrial goods
and services that were neglected by the state system.
… Many of the TVEs have taken advantage of their freedom
to form supply and technology alliances with state industries
and foreign investors.
• Chinese leaders had at this point in time a lasting enthusiasm
for a reinterpretation of communist ideology.
• Articulated in October 1987 by Premier Zhoa Ziyang... at l3th
… China would continue to operate in the primary stage until
al least 2050.
2. “Primary stage of socialism”… idea of professor Li Yining… a
Marxian rationale for a wide range of market reforms and
ownership arrangements… argued that China did not achieve
a high level of capitalist development before its socialist
revolution, so it must employ institutions usually associated
with capitalism to prepare it for a higher stage of socialism.
(Same reasoning used by Lenin in the 1920s to justify his
“New Economic Policy” in Russia)
[a] Until 2050, to develop “Socialism with Chinese
Characteristics”, the government should encourage
individuals to engage in market exchange and pursue
individual wealth, but it should carefully preserve the political
monopoly of the Communist Party.
[b] Reforms proceeded most rapidly in agriculture, population
policy (one child), and foreign trade, and were accompanied
by modest efforts in industry and finance.
… Special economic zones - localize experiments.
[c] reforms seemed to go smoothly until second half of 1985
at which time a wave of consumer price inflation began =>
caused a temporary tightening of economic controls.
[d] Despite a new "anti-bourgeois liberalization" campaign
supported by Party conservatives, the Thirteenth Party
Congress in 1987 reaffirmed China's commitments to
ideological pragmatism, economic reform, and the “Open
Door” (...of foreign travel, trade and investment), but it
continued to oppose national political reform at the national
level (it had been supported at local level since early 80's).
[e] The conservatives succeeded in having Hu Yaobang, the
reform-minded General Secretary, resign and when he died in
April 1989, university students honored his memory with a
memorial service in Tienanmen Square… subsequent events
[d] Conservatives in Party again gained ground and pushed for
recentralization of authority and imposition of controls on
prices and foreign investment.
[f] Still, in 1992 Deng Xaiping led another campaign for
acceleration of economic reforms, culminating in the
declaration of the 1992 Party Congress that China would
build a "socialist market economy.”
… Constitution amended in 1993 to acknowledge that China
was operating in the "primary stage of socialism", that its
immediate goal was to build a "socialist market economy ,
and that effective reform would require continued "opening to
the outside world."
[g] After Deng's death in 1997, Deng's successors declared their
continuing allegiances to his pragmatic ideology and
policies… today chief of state: President Hu Jintao (since
March 2003) and head of government: Premier Wen Jiabao
(since March 2003).
Financial market reform:
• Banking … Peoples Bank of China
at the center (primarily controlled
by the Ministry of Finance)
=> disequilibrium: Sm Dm
… Interest rates and exchange rates still centrally determined.
… Four publicly owned banks under PBOC: Bank of China,
Construction Bank, Industrial and Commercial Bank,
… Much of Chinese financial reform centers on this system.
By late 1980’s central authorities recognized the need for
developing a private financial system paralleling the state
• 1990 ... Shanghai exchange officially opened.
• 1991 a stock market was established in Shenzen, adjacent to
Hong Kong, trading shares of joint venture companies with
• Chinese Securities Regulation Commission created in 1993.
• “A”, “B” and “H” shares:
1. “A” shares … about 1,400 companies … denominated in Yuan
and can only be traded in domestic equity markets among
2. “B” shares … first issued in 1993 … about 110 companies …
denominated in US $ and can only be traded in international
equity markets among non-Chinese nationals.
3. “H” shares … denominated in Hong Kong dollars (96)…
represents stock of Hong Kong based companies trading in
domestic equity markets (traded on the Shenzen).
• T – bonds and T- bills are important yet private trading only
began in 1995. During the Asian financial crisis, 1997,
China’s government began to fiscally stimulate the economy.
There is not an active secondary bond market so standard
western techniques for implementing monetary policy
[h] Current problems & issues:
• Economic crisis in South East Asia in 1997... China had a lot
in common with the smaller Asian Tigers… a commercial
real-estate bubble, industrial overcapacity, rampant corruption
and unsound banks.
… still, due to its foreign sector economic and financial
controls, China was not significantly affected by the 1997
• Growing income disparities between rural workers, with
declining incomes, and urban workers enjoying rising incomes
and standards of living.
… migration to urban areas with the consequence of a
growing number of unemployed city dwellers.
• Needed reduction in number and extent of state owned
enterprises (SOEs: public services, construction, defense,
steel) … inefficient, over-staffed and drain on public funds.
• Improvement of regulatory framework, accounting
standards…The Opacity Index (rated a “high-opacity”
country at 42…55 (Nigeria) is the highest)
and… needs a deep, efficient secondary debt market.
• Economic growth slowed in the late 1990s … from 10% in
1997 to 7.3% in 2001. Threat => growth recession.
• 7% mark is seen as the minimum needed to create sufficient
jobs to maintain unemployment rate (officially = 8%).
• At the time the government stepped in with a fiscal stimulus
package…but the economy began rebounding naturally.
• Most important for the long run: China admitted to the WTO on
November 10, 2001: Will demand deeper and more rapid reform at
all levels of the economy. Specified a 5 year phase-in.
…Will force China to more rapidly integrate with the global
economy. Dec. ’06: open financial markets to foreign banks.
• The main risk of recent high real GDP growth is not a surge in
inflation, but the inability of China's financial system to allocate
• Excessive borrowing has fed a series of waves of bad debts. On
some estimates, these surged to 40-50% of all bank loans in early
2000s, then diminished, but likely rising in last few years.
• In a developed economy, the obvious solution would be to raise
interest rates. But it is a truism of economics that a country cannot
control both its exchange rate and its interest rate simultaneously.
• While the Yuan remains pegged in a range to the dollar, the
People's Bank can do little about monetary conditions. Huge
inflows of capital put upward pressure on the Yuan. To hold it
down, the central bank must buy foreign currency, which injects
new liquidity into the banking system. This creates the monetary
base that fuels more capital spending...and more bad debts.
Important other issues:
2. Income distribution—worsening (Paul Krugman).
4. Bilateral trade imbalance, undervalued exchange rate (up to
35%) part of the cause of the current global problems.
5. Domestic unrest: 180,000 demonstration in 2010.
• There is little likelihood of major political since China’s rulers
will concentrate on maintaining stability during the transition to a
younger generation of political leaders in 2012-13.
• After reaching an impressive 10.3% in 2010, economic growth
will slow to an average of 8.5% a year in 2011-15.
• In August 2011 the People’s Bank of China (the central bank)
confirmed that it would maintain a "prudent", or fairly tight,
monetary policy for the rest of the year, as consumer price
inflation hit 6.5% year-on-year in July.
• The current policy-tightening process has largely focused on
cooling speculation in the housing market, limiting growth in
bank credit and raising bank reserve requirements. Interest rates
have also been increased.
• The Renminbi should appreciate slightly against the US dollar in
2011-15—partly to combat inflation, partly to appease critics in the
• Since 2008-09 China has adopted a more forceful position on the
international stage over a range of issues, such as global warming,
exchange-rate policies and territorial claims over Taiwan and the
South China Sea.
CHAPTER 22: Prospects for 2050
• Summary and Objectives:
• The market economy has emerged as the dominant paradigm
going into the 21st century. As the old system slowly dies
away, new economic cultures are spreading across the world.
Consumerism, international competition, cheaper, faster
production, technology are the result of a general acceptance
of open trade and industry liberalization.
• This chapter is a survey of the general world economic trends
and prospects for each region over the next 50 years.
• Little mention is made of Africa or Latin America in our text:
You are encouraged to apply the ideas of transition,
development and change to these regions who have suffered
from dictatorships, corruption and periodic economic crisis.
1. Changing Views of Economic Systems:
• In the 1950s, economists and politicians naively believed in
state planning. Soviet Union was growing rapidly so others
sought to emulate (e.g. India).
• In the 1960’s a different form of planning arose in Japan and
France: Indicative Planning. This was a “Golden Age” of
growth in Europe and many concluded that government
intervention and the social welfare state was not incompatible
with rapid economic growth.
• In the 1970’s attention moved from Europe to Japan, which
was experiencing relatively higher economic growth and was
rapidly penetrating global markets. It’s particular form of
indicative planning with its high degree of cooperation
between all agents was seen as the winning model.
• The 1980’s and 1990’s were decades of deregulation and free
enterprise (primarily in the Anglophone countries). There was
a dominant change in attitude toward government from being
an important agent of economic growth to being
predominantly an obstacle to growth. Early successes here has
brought attention to this systemic approach in the early 2000s.
… It was also the time when the Asian economic miracle
continued to unfold with China moving into the spotlight.
• What will be the 21st century systemic approach for success?
2. Golden Ages…
• Global economic growth appears to go through cycles.
Extensively studied by many scholars.
• First: 40-year period before WWI (2.1% per year until 1914).
• Second: 1950 to 1972 (global oil shock)... 4.9% per year.
• The most recent began in the 1980s. This golden age gained
momentum in the 1990s and is now spreading around the
globe (this one may have ended in the Great Recession of
• Factors causing the upsurge in growth in the 1990s:
1. Vast expansion of economic freedoms and property rights.
2. Reduction in the scope of government.
3. A new technological revolution: whole new industries sprang
up from computer networking to biotechnology.
4. Foreign direct investment surged around the globe. Between
1990 and 2000 FDI from developed to developing countries
rose to $238 billion US $.
… This leads to a transfer to technology, ideas and capital;
creating a better distribution of global capital (Table 22.2)
Theory of Convergence (in global per capita incomes):
• Sources of convergence:
1. Labor and capital are free to move from country to country.
2. Where there is free trade in goods and services.
3. Enhanced by the post-WWII supranational organizations:
GATT/WTO, World Bank, IMF.
4. Tendency toward regional free-trade zones: European Union.
• Yet the nature of the convergence process has turned out to
be very different than that forecast from theory.
… Europe => Eurosclerosis (Macur Olson… distributional
coalitions in stable, mature economies… each seeking
monopoly rent seeking… administrative gridlock)
• Paul Krugman: Asia’s growth achieved through the rapid
growth of the capital stock and through shift in resources
from agriculture to industry (Lewis’ two-sector model).
• In other words, the Asian growth “miracle” has been
“extensive” in nature.
• While a rapid expansion in resources can lead to higher
growth, such growth cannot be sustained (simply because a
country cannot indefinitely expand its resources without
exhausting the resource generating ability of the population).
It is a self-limiting process.
• Krugman built on the work of Alwyn Young who had broken
the growth experience into that due to expansion of inputs
and that due to expansion of Total Factor Productivity (TFP).
• TFP reflects growth derived from producing “smarter” using
knowledge and technology.
• Young had found that very little of the Asian counties growth
was do to increases in TFP => process is not sustainable in
• Asian Crisis of 1997 was a recognition of essential
weaknesses in the regional economies… and with its model
of economic growth.
Africa and Latin America?
• Pervasive corruption, dictatorships, weak rule of law and
weak social institutions. Lack of infrastructure, health and
• All adds up to economic inertia.
• Largest democracy in the world.
• Potential is there yet it is still a relatively closed economy.
Growth prospects will depend on continuation of reforms
over the next couple decades.
The “Transition” economies?
• Those that have just joined the EU will do fine.
• For the CIS countries to the East it is too early to tell: rich in
resources, poor in stability.
And the Middle East?
• Can not tell. The “Islamic Model” is based on traditional
notions of how to run an economy: Not conducive to modern
growth. May survive for some time due to oil revenue.
Rising and Falling Economic Fortunes…
• As we move deeper into the 21st century important to
remember that underdevelopment and low incomes are more
typical than development and high incomes… less than 20%
of humanity live in high income countries.
• At the present time, what seems to be the deciding factor in a
nation’s prospects to provide a rising standard of living for its
people is participation in the global economy.
• The World Bank classifies countries that are home to 1/3 of
humanity (about 2 billion people) as non-globalizers. In these
countries during the 1990’s and early 2000’s per capita
incomes declined! Most of these counties are to be found in
Africa, the Middle East and Central Asia (these countries are
a reason for concern).
End of material for fall 2012
Chapter #14: Transformation Issues
• When the reforms in the USSR under Gorbachev got under
way, the ideas of a "pan-European home" and increasing
internationalization were employed to fight growing
nationalist sentiments in the republics.
• The disintegration of the Soviet Union created 15 new
independent states for the constituent union republics, many
joining together as the Commonwealth of Independent
• Individual reform in the former Soviet republics depend on
their ethnic heritage and economic experience within the
USSR and on their dependence on each other.
• New countries differ tremendously economically, culturally,
ethnically, and demographically.
• Yet all share the legacy of having been integrated into a
centrally planned economy in which allocative and
redistributive economic mechanisms served the purpose of
reinforcing the authority of the center (largely Russia) over the
• The legacy is a vertically integrated industrial and trade
structure that shaped an essential asymmetry of
interdependence (book says that these systems were
At the same time, East Europe emerged from the grip of the
• While they had been integrated into the Soviet Empire via
the Warsaw Pact and CMEA (Comecon), they had
maintained a greater degree of economic, cultural and
political autonomy than the Soviet republics.
• Having committed to abandoning the philosophical basis and
working rules of a CSE (Command over a Social Economy),
the newly independent republics, Russia and all of Eastern
Europe were faced with introducing reforms that would
facilitate there newly found independence and improve their
Reforms: Necessary changes in working rules and principal
 Organization of decision making - Decentralization of
 Production and distribution institutions and networks
 Degree of decentralization.
 Nature of property rights for productive resources - extent of
private ownership and control permitted.
 Extent to which markets are to be relied upon as a social
process to coordinate production and distribution.
• Reform of this magnitude is unparallel in history.
• In 1989-90 these nations were unprepared for beginning
• Reform would confront political resistance: nomeclatura.
• Inculcated with Marxian ideology: not mentally or culturally
• Lack of knowledge and experience with alternatives…
 macroeconomy + workers and managers functioning in a
more competitive economy (prevailing work ethic created
economic inertia + widespread corruption) - lack of
entrepreneurial ethic - problem of creating the social and
psychological environment to create faith in the integrity of
the government's new openness. (Lenin - War Communism)
• Privatization: fear that it would be inequitable and create high
 Monopolies + obsolete technology
• Underground economy: ruled by "Mobs" connected to the
• Comecon dissolved => decreasing trade among member nations
(loss of guaranteed buyers).
Lessons from the 1990’s …
1. Transformation will take longer than originally anticipated.
Jeffery Saks - "shock therapy": Get painful restructuring over
early while the people still have goodwill. Study by the World
Bank showed without a doubt that the faster that reforms were
initiated in the early 90s, the faster the growth in GDP. (fastest:
Czech Republic, Estonia and Poland - suffered deep recessions
in the early 90s, doing well now).
a. Prices and trade were liberalized fast, inflation was choked
by tight monetary policy, and the privatization and
demonopolization of industry was started (if not finished)
2. Recent study indicates that it will still take 25 yrs + to attain
70% of the EU average per capita GDP). This time frame
may be shorter for those countries that recently joined the
3. Political support is necessary for successful implementation
of institutional change.
4. Democracy increases fragmentation and complicates and
slows the pace of transformation. China, which introduced
gradual market reforms in the context of communist party
rule, is booming … yet World Bank study indicates that
China stands apart.
5. Still, fast reform (shock therapy) in the context of democracy
and early on, did not have a clear process of choosing leaders
and few checks on their actions - this allowed the timing and
intensity of reform to be determined by the new leaders
without the resistance of well established special interest
6. Much western advise has been inappropriate, misguided, and
7. Jeff Sachs: insensitive to culture and the plight of the common
person. IMF: standard policy. Untested ideas. Overly
ambitious and optimistic (over by 1994) - also ridden with
ideological assumptions inherent in neoclassical economics.
a. High pressure: do what we say or we won't lend you money.
Goals: To secure markets for Western exports and to access the
CEE's raw materials and to strengthen political influence
throughout the area.
8. Active State policies can be productive:
• Infrastructure and setting the rules of the game (legal system +
• Maybe strategic investment in industries in which the nation
has a natural comparative advantage.
• Studying the development experience of other nations is
9. Privatization is a slow, uncertain press for providing
stabilization and economic recovery. - akin to throwing
people into the ocean without compass, swimming lessons
boat or paddle.
10. Significant foreign aid and investment should neither be
relied upon nor expected.
11. Trade liberalization does not mean more trade with the west.
a. These countries have been denied access to western
markets for certain products (steel, agricultural products and
Economic Outcomes …
• Tables in book
• Big problem: Government fiscal crisis worsened by
avoidance of paying taxes.
• Another problem: The window of opportunity is closing
1. Poverty and inequality has increased tremendously.
Policymakers were naive to think that rationality would
dominate the transformation.
2. The "soft" factors of humans was ignored too much (de
Tocqueville - habits, mentalities, and cultural routines).
Historical legacy of values, norms, and standards of behavior
are the primary impediments to development. These are: lack
of individualistic competitiveness that is achievement
oriented, lack of a civic culture by which people willingly
adhere to the rule of law, absence of a business environment.
3. Policymakers failed to account for the institutional legacy =>
the behavioral shortcomings and economic incompetence
means a long learning process is necessary.
a. Remember that it took from the fall of the Roman Empire
until the mid-1770s for the cultural, social and political
environment to be ripe for the industrial revolution in Europe.
Fascism/Nazism: Command over a market economy
(CME): Germany, 1933-1945
• Background…WWI => 1914… Depression of 1870s…Rise
of communism…Weimar Republic (Hindenberg)
• Philosophical basis: The leadership principle: a variation on
the Empire philosophy of Rome => the Third Reich (the
glorious, strong, superior state)
• Institution #1: Fuhrer (Adolph Hitler) – personally
approved working rules
• Nazi Party (socialist) – All important positions of authority
occupied by its members.
• Led to D becoming highly centralized.
• Joint manipulation of M & I:
• Used a perceptorial system to control the population.
Mechanism for control was education (some would argue
propaganda): used to mobilize support throughout the
German society for goals determined by the “elite.” M =>
influence perception and to change utilities.
• This elite would instruct the population concerning working
• Gestapo (M = coercion): shadow structure to Nazi
party…followed centralized lines of D & I.
• Corporative state – harmonious behavior throughout the
economy was enhanced by. Organization was
hierarchical…with elite at the pinnacle. Corporations were
• associations (a sub-structure) – organized along functional
lines…workers/management accepted: homogeneous,
disciplined, prone to ethnocentrism.
• Employers and workers were required, eventually, to
reorganize into confederations, and all confederations were
united into one national federation (an additional sub-
• While ownership of productive resources private, state
control over resources was extensive: It’s not who owns, it’s
• Germans, during this period, mistrusted unregulated markets
(tell them why…legacy of
• Worked, in part, because the former evolution of markets
and channels of distribution already well developed. Result:
a tightly controlled, efficient economy.
• Marched into Poland in Sept. 1939: Official beginning of
• Notes: Germany of the 1930s represents an alternative type
of economy that developed in response to poor performance
by economies relying upon unregulated markets and laissez-
• Risk for Russia today
• there was not a coherent economic policy during the Hitler
years (issue was command and control)
• chapter also illustrates that policies similar to those proposed
by Keynes for alleviating unemployment and low growth
worked in Germany.
• …but also it demonstrates the danger of an authoritarian
regime to human rights => importance of rule of
law/impartial judicial system.
• What were the major tenets of the CME philosophy?
• Why did the German people accept the “leadership
• Why did Germany and other European nations abandon
laissez-faire economic policies? (double movement: a
reaction against the adverse affects upon society of
unregulated market forces)
• From an economic point of view, discuss positive and
negative aspects of the CME in Germany?
• Are there any contemporary economies (such as Iraq under
Saddam Hussein) similar to the German economy during the