Sun, Jun 08, 2008 - Page 9 News List

Gambler’s Ruin: to keep betting everything on neo-liberalism

by J. Bradford DeLong

From Adam Smith (1776) until 1950 or so, capital was considered by economists to be absolutely essential for economic growth. You also needed a few good basic institutions. “Security of property and tolerable administration of justice,” as Smith put it.

If these fundamental institutions were right, then landlords, merchants and manufacturers would invest and improve. In investing and improving, they would add to the capital stock: “In all countries where there is a tolerable security [of property], every man of common understanding will endeavor to employ whatever [capital] stock he can command, in procuring either present enjoyment or future profit ... A man must be perfectly crazy, who, where there is a tolerable security, does not employ all the stock which he commands, whether it be his own, or borrowed of other people...”

A larger capital stock would mean thicker markets, a finer division of labor, and a more productive economy. A highly productive society based on a sophisticated division of labor was how you secured “the wealth of nations.”

Reverse the process, however, and you get the poverty of nations, which Smith believed he saw in the Asia of his time. For Smith and his successors over the first 175 years, any episode of sustained economic growth overwhelmingly required investment capital. We economists were by and large capital boosters, and our magic formula for economic development was saving, investment, thrift and wealth accumulation. The last and fullest expression of this line of thought comes at the end of the 1950s with W.W. Rostow’s book The Stages of Economic Growth.

Then Robert Solow and Moses Abramovitz challenged this near-consensus. They calculated that 75 percent to 80 percent of economic growth did not come from increasing the capital-output ratio — at least not if the private marginal product of capital was taken as an indicator of the social marginal product. Instead, the keys to growth and development appeared to lie beyond an increase in capital intensity as measured by capital-output ratios: skills, education, technology broadly understood and improvements in organizational management.

Yet capital continued to be seen as necessary, if not sufficient. In the framework developed by the development economist Dani Rodrik, a shortage of capital can be a binding “growth constraint”: the place where “the biggest bang for the [policy] reform buck can be obtained.” And even when other factors constrain growth more, they cannot be changed without changing the shape and form of the economy’s capital stock. Indeed, high investment serves as a sign that other binding constraints to growth are absent, implying prosperity and that things are going right.

The problem is that for poor economies, raising the capital needed to relax binding growth constraints is difficult. That’s why the world took the neo-liberal bet in the 1990s: International capital mobility would come to the rescue by relaxing capital constraints where they were binding, and by reducing the scope for corruption and rent-seeking, which was often a more significant binding growth constraint.

The hope was that, like the pre-1913 era of British overseas investment, which financed a huge amount of industrialization in the resource-rich, temperate periphery of the world economy, net capital outflows from the industrial core would finance much late twentieth and twenty-first century industrialization.

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