Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism

the Bad Samaritans. Free trade demands that poor countries compete immediately with more advanced foreign producers, leading to the demise of firms before they can acquire new capabilities. A liberal foreign investment policy, which allows superior foreign firms into a developing country, will, in the long run, restrict the range of capabilities accumulated in local firms, whether independent or owned by foreign companies. Free capital markets, with their pro-cyclical herd behaviour, make long-term projects vulnerable. A high interest rate policy raises the ‘price of future’, so to speak, making long-term investment unviable. No wonder neo-liberalism makes economic development difficult – it makes the acquisition of new productive capabilities difficult.

Like any other investment, of course, investment in capability-building does not guarantee success. Some countries (as well as firms or individuals) make it; some don’t. Some countries will be more successful than others. And even the most successful countries will bungle things in certain areas (but then, when we talk about ‘success’, we are talking about batting averages, rather than infallibility). But economic development without investment in enhancing productive capabilities is a near impossibility. History – recent and more distant – tells us that, as I have shown throughout this book.

Why manufacturing matters

Having accepted that increasing capabilities is important, where exactly should a country invest in order to increase them? Industry – or, more precisely, manufacturing industry* – is my answer. It is also the answer that would have been given by generations of successful engineers of economic development from Robert Walpole onwards, had they been asked the same question.

Of course, this is not to say that it is impossible to become rich by relying on natural resources: Argentina was rich in the early 20th century through the trans-Atlantic export of wheat and beef (it was once the fifth richest country in the world); today, a number of countries are rich mainly due to oil. But one has to have a huge stock of natural resources in order to be able to base high living standards solely on them. Few countries are so fortunate. Moreover, natural resources can run out – mineral deposits are finite, while over-exploitation of renewable resources whose supplies are, in principle, infinite (e.g., fish, forests) can make them disappear. Worse, wealth based on natural resources can be rapidly eroded, if technologically more advanced nations come up with synthetic alternatives – in the mid-19th century, Guatemala’s wealth, based on the highly prized crimson dye extracted from the insect, cochinilla (cochineal), was almost instantly wiped out when the Europeans invented artificial dye.

History has repeatedly shown that the single most important thing that distinguishes rich countries from poor ones is basically their higher capabilities in manufacturing, where productivity is generally higher, and, more importantly, where productivity tends to (although does not always) grow faster than in agriculture or services.Walpole knew this nearly 300 years ago, when he asked George I to say in the British Parliament: ‘nothing so much contributes to promote the public well-being as the exportation of manufactured goods and the importation of foreign raw material’, as I mentioned in chapter 2. In the US, Alexander Hamilton knew it when he defied the world’s then most famous economist, Adam Smith, and argued that his country should promote ‘infant industries’.Many developing countries pursued import substitution ‘industrialization’ in the mid-20th century precisely for this reason. Contrary to the advice of the Bad Samaritans, poor countries should deliberately promote manufacturing industries.

Of course, today there are those who challenge this view on the grounds that we are now living in a post- industrial era and that selling services is therefore the way to go. Some of them even argue that developing countries can, and really should, skip industrialization and move directly to the service economy. In particular, many people in India, encouraged by that country’s recent success in service outsourcing, seem to be quite taken by this idea.

There are certainly some services that have high productivity and considerable scope for further productivity growth – banking and other financial services, management consulting, technical consulting and IT support come to mind. But most other services have low productivity and, more importantly, have little scope for productivity growth due to their very nature (how much more ‘efficient’ can a hairdresser, a nurse or a call centre telephonist become without diluting the quality of their services?). Moreover, the most important sources of demand for those high-productivity services are manufacturing firms. So, without a strong manufacturing sector, it is impossible to develop high-productivity services. This is why no country has become rich solely on the basis of its service sector.

If I say this, some of you may wonder: what about a country like Switzerland, which has become rich thanks to service industries like banking and tourism? It is tempting to take the rather condescending but popular view of Switzerland summed up brilliantly in the movie, The Third Man. ‘In Italy for thirty years under the Borgias,’ he said, ‘they had warfare, terror, murder, bloodshed, but they produced Michelangelo, Leonardo da Vinci and the Renaissance. In Switzerland, they had brotherly love – they had five hundred years of democracy and peace, and what did that produce? The cuckoo clock.[2] This view of the Swiss economy, however, is a total misconception.

Switzerland is not a country living off black money deposited in its secretive banks and gullible tourists buying tacky souvenirs like cow bells and cuckoo clocks. It is, in fact, literally the most industrialized country in the world. As of 2002, it had the highest per capita manufacturing output in the world by far – 24% more than that of Japan, the second highest; 2.2 times that of the US; 34 times that of China, today’s ‘workshop of the world’; and 156 times that of India.[3] Similarly, Singapore, commonly considered to be a city state that has succeeded as a financial centre and trading port, is a highly industrialized country, producing 35% more manufacturing output per head of population than the ‘industrial powerhouse’ Korea and 18% more than the US.[4]

Despite what the free trade economists recommend (concentrating on agriculture) or the prophets of post- industrial economy tout (developing services), manufacturing is the most important, though not the only, route to prosperity. There are good theoretical reasons for this, and an abundance of historical examples to prove the point.We must not look at spectacular contemporary examples of manufacturing-based success, like Switzerland and Singapore, and mistakenly think that they prove the opposite. It may be that the Swiss and the Singaporeans are playing us along because they don’t want other people to find out the real secret of their success!

Don’t try this at home

So far, I have shown that it is important for developing countries to defy the market and deliberately promote economic activities that will raise their productivity in the long run – mainly, though not exclusively, manufacturing industries. I have argued that this involves capability-building, which, in turn, requires sacrificing certain short-term gains for the sake of raising long-term productivity (and thus standards of living) – possibly for decades.

But neo-liberal economists may respond by asking: what about the low capacities of developing country governments that are supposed to orchestrate all this? If these countries are to defy the logic of the market, someone has to choose which industries to promote and what capabilities to invest in. But capable government officials are the last thing that developing countries have. If those making these important choices are incompetent, their intervention can only make things worse.

This was the argument used by the World Bank in its famous East Asian Miracle report, published in 1993. Advising other developing countries against emulating interventionist Japanese and Korean trade and industrial policies, it argued that such policies cannot work in countries without ‘the competence, insulation, and relative lack of corruptibility of the public administrations in Japan and Korea’[5] – that is, practically all developing countries. Alan Winters, a professor of economics at the University of Sussex and the director of the Development Research Group at the World Bank, was even more blunt. He argued that ‘the application of second-best economics [economics that allows for imperfect markets and therefore potentially beneficial government intervention – my note] needs first-best economists, not its usual complement of third- and fourth-raters’.[6] The message is clear – ‘Do not try this at home’, as TV captions say when showing people doing dangerous stunts.

There can be no dispute that, in many developing countries, government officials are not highly trained. But it is also not true that countries like Japan, Korea and Taiwan succeeded with interventionist policies because their bureaucracies were manned by exceptionally well-trained government officials. They were not – at least in the beginning.

Korea used to send its bureaucrats for extra training to – of all places – Pakistan and the Philippines until