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E c o n o m i c

DESA Working Paper No. 88

S/ESA/2009/DWP/88

December 2009

The Terrible Simplifers:Common Origins of Financial Crises and PersistentPoverty in Economic Theory and the new 1848 Moment

Erik S. Reinert

Abstract

One element explaining the nancial crisis is what Hyman Minsky called destabilizing stability:

long periods o stability lead to increasing vulnerability. Tis paper argues that similar mechanisms

are at work inside economics: long periods o economic progress in the core countries lead to in-

creasingly abstract and irrelevant economic theories (terrible simplications). Tis leads to turningpoints towards more relevant economic theories, reerred to as 1848 moments. Te paper urther

outlines the key variables that need to be re-introduced into economic theory in order to urnish

poor countries with the type o productive structures that makes it possible to eliminate poverty.

JEL Classication: A11, B10, F10, O57

Keywords: Uneven economic development, production-based economics, technological change,

innovations, increasing returns, synergies

Erik Reinertestablished Te Other Canon Foundation, Norway, is Proessor at the allinn University

o echnology, Estonia, and author o many works, including How Rich Countries got Rich...and Why

Poor Countries Stay Poor(2007). Te author would like to acknowledge support rom the Estonian

Science Foundation (grant no EF8097) Innovation Policy and Uneven Development.

Comments should be addressed by email to the author: [email protected]; [email protected]


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UN/DESA Working Papers are preliminary

documents circulated in a limited number o

copies and posted on the DESA website at

http://www.un.org/esa/desa/papers to stimulate

discussion and critical comment. Te views

and opinions expressed herein are those o the

author and do not necessarily reect those o

the United Nations Secretariat. Te designations

and terminology employed may not conorm to

United Nations practice and do not imply the

expression o any opinion whatsoever on the part

o the Organization.

ypesetter:Magorzata Juszczak

United Nations

Department o Economic and Social Aairs

2 United Nations Plaza, Room DC2-1428

New York, N.Y. 10017, USA

Tel: (1-212) 963-4761 Fax: (1-212) 963-4444

e-mail: [email protected]

http://www.un.org/esa/desa/papers

Contents

Where economics went wrong: On abstraction vs. simplication .................................................... 2

Reconstructing Relevant Economics ................................................................................................ 4

Economics Abstracted rom Production:

Te Common Element in Financial Crises and Persistent Poverty ................................................ 7Te Challenge: Relearning the Art o Creating Middle Income Countries ....................................... 9

Financial Crisis as a Result o Overshooting Success ........................................................................ 9

Destabilizing Stability and Cyclicality o Economic Teory: the Mechanics..................................... 10

Increasing Distance = Increasing Abstraction and Simplicity ........................................................... 12

Te Failure o Neoliberal Development Policy................................................................................. 14

Increasing Returns as the Key to Wealthy Nations ........................................................................... 17

Increasing Returns and Synergies: Teir Creation and their Destruction ........................................ 18

Conclusion: owards an 1848 Moment when Empirical Knowledge Matters Again ...................... 22

Reerences ............................................................................................................................. 25

Appendix I: Frank Grahams Teory o Uneven Development ......................................................... 27

Figures

1 Comparing Economic Development in Somalia and Korea .................................................... 9

2 Growth rate o GDP per capita o selected world regions;regional average in selected periods between 1820 and 2001;annual average compound growth rate .............................................................................. 16

3 Henry Careys Commodity Map (1858)................................................................................ 19

4 Industrialization, deindustrialization and real wages in Peru ................................................... 20

5 Peru: Deindustrialization and alling wages as a share o GDP, 19501990 ............................. 21

Tables

1 Te Coming Shit in Economic Focus: Beore and ater the 1848 Moment ............................ 25

2 World income and its distribution beore trade ....................................................................... 27

3 World income and its distribution ater each country specializesaccording to its comparative advantage.............................................................................. 27
http://www.un.org/esa/desa/papershttp://www.un.org/esa/desa/papershttp://www.un.org/esa/desa/papershttp://www.un.org/esa/desa/papers


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The Terrible Simplifers:

Common Origins of Financial Crises and PersistentPoverty in Economic Theory and the new 1848 Moment

Erik S. Reinert

...soon or late, it is ideas, not vested interests,

which are dangerous or good or evil.

John Maynard Keynes, closing words o

Te General Teory(1936).

Te United Nations recently announced that the number o chronically hungry people on the planet has

exceeded the billion mark or the rst time. It is extremely unlikely that any o them will ever hold a Swiss

1,000 ranc banknote (worth more than 900 dollars), but i they did, they would see the portrait o a man

who perceived the essence o the explanation as to why extreme poverty and extreme plenty coexist so

naturally on this planet, and o the grim ate o the permanently starvingSwiss historian Jacob Burckhardt

(18181897). Burckhardt, best known as a historian o the Italian Renaissance, coined the term the terrible

simpliers to describe the demagogues whoin his dark vision o what the 20th century would bring

would play central roles in the uture (Dru 2001: 230). Events amply ullled Burckhardts predictions o a

cataclysmic 20th century, o the rule o terrible simpliers, men who Burckhardts colleague at the Universityo Basel, Friedrich Nietzsche, called power-maniacs (Gewaltmenschen), and John Maynard Keynes reerred to

in 1936 as madmen in authority.

A key common element in persistent world poverty and in the nancial and (real) economic crisis is

the terrible simplicationa theoretical overshooting into irrelevant abstractionsthat has taken place in

economic theory ater World War II. As unlikely as it may initially sound, I shall endeavour to explain in this

paper howin spite o its apparent sophisticationequilibrium economics became mathematized dema-

goguery based on an extremely simplistic world view. Joseph Schumpeters solution to the late 19th century

Methodenstreit (battle o methods) o economics had pointed in a very dierent direction, arguing that the

proession needed to have theories at dierent levels o abstraction. According to the problem posed and the

question asked, one should be able to enter the edice o economic theory at a level o abstraction where onewas likely to nd an answer (Schumpeter 1908). Ater World War II, economics experienced the opposite

development: only very abstract theory survived. In this process, the main causes o uneven development as

well as the cause o nancial crises were assumed away rom the theoretical edice. Te nancial crisis appears

to have created a turning point. Te July 18, 2009 edition oTe Economistnormally a weekly that strongly

supports mainstream economic theoryportrays the crisis in economic theory on its ront cover with a book

entitled Modern Economic Teory experiencing a meltdown like an ice-cream abandoned on the beach on a

hot summers day, with the subtitle: Where it went wrongand how the crisis is changing it.


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2 DESA Working Paper No. 88

Where economics went wrong: On abstraction vs. simplifcation

All theories depend on abstractions. When we use the word lealike leaves on a treewe are making a

sweeping generalization by implicitly overlooking the enormous dierences that exist among various types

o leaves. However, opening the theoretical box labelled lea, we nd that botanical science has produceda very detailed classication system or leaves: sword-shaped (ensiormis), lance-shaped (lanceolata), ovate

(ovata), elliptic (elliptica), cordate (cordata) oblanceolate (oblanceolata), etc, etc. Most people eating black-

berries would be satised with recognizing just one species (Rubus ruticosus), but in my country (Norway)

alone, botanists distinguish among a large number o species, or which the main distinguishing actor is the

shape o the leaves (Rubus plicatus,ssus, sulcatus, radula, etc.). Te apparent simplication o using the word

lea is a justied abstraction, not a terrible simplication, becausein the spirit o Schumpeter (1908)it

is possible to arrive at a qualitative understanding o leaves through a taxonomy (a classication system) or

leaves that exists on a multiplicity o levels, down to a level o detail that ar exceeds most peoples needs.

In botany, opening the very abstract box called lea, we nd a very complete taxonomy at dierent

levels o abstraction. I we pry open most o the theoretical abstractions in economics, we shall nd that eventhese static boxes are empty. Economics hardly contains any taxonomies; in act, the most salient eature o

economics as a science is the equality assumption; the economic mainstream eectively assumes away all

dierences among human beings, among economic activities, and among nations. One classic example o

this is the concept o the representative rm, which equates the giant rm Microsot with a twelve year old

sel-employed shoeshine boy in a Lima slum (Reinert 2007).

Assuming that qualitative dierences do not existas does mainstream economics in key areas

is a terrible simplication that has extremely serious consequences in terms o lost human welare. We can

only understand why medical doctors make more money than truck drivers i we are willing to observe the

dierences between the two proessions. In parallel ashion, we can only understand the dierence in wealth

between the United States and Arica by qualitatively understanding the huge dierences in the productivestructures o the two areas.

Te roots o this problem are already ound in Adam Smiths Wealth o Nations(1776), where the

author bundled all manuacturing, all agriculture, and all tradeall human economic activityinto one sin-

gle category: labour hours. I have previously explained how Adam Smith is at his least convincing when he

tries to prove to his readers that all economic activities are alike (Reinert 1999). Building on labour hours

as the only unit o accounting, David Ricardo (1817) constructed the labour theory o value that provided

the origins o international trade theory that essentially conceived o world trade as the bartering o labour

hours, void o any quality, among nations. Not even the act that some economic activities obviously are able

to absorb more capital or become more mechanized than others is accounted or1.

1 A Heckscher-Ohlin ramework introduces more actors o production, including land and capital, and indeedopens up or what is called the Rybczynski Teorem: as one actor o production (e.g. capital) grows, the outputo the capital-extensive commodity (e.g. innovations-based production) grows, while the output o the labour-intensive product contracts. In other words, some nations will easily specialize in innovation-intensive (generallyalso increasing-returns-intensive and imperect-competition-intensive) products with a large division o labour andget rich, while other nations will specialize in labour-intensive technological dead ends, oten devoid o scale-eectsand innovation potential, producing under perect competition, diminishing returns and monoculture (this is a keypoint in Reinert (2007). By opening up or diversity, this model o international trade also opens up or a theory ounequal development.


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The Terrible Simplifers: Common Origins of Financial Crises and Persistent Poverty ... 3

Economic theory is cyclical, and this paper argues that crises create turning points when theory is

orced to move rom a very high level o abstractionrom practical irrelevanceto something more closely

resembling reality, and thereore becomes more able to solve the problems acing us.

International trade theorys prediction o equalization o wages across countries is, in my view, thekey terrible simplication that causes world hunger. Not only are all qualitative dierences assumed away,

the production process itsel is also abstracted away. Assuming away unemployment, as the World Bank tra-

ditionally does in its models, only adds another dimension to the terrible simplication on which our world

economic order is based. In many countries, 80 per cent o the potentially active population are unemployed

or underemployed. Assuming that act away is a terrible simplication.

One difcult thing with science, o course, is that dierent things are dierent. axonomies are

thereore very important in order to organize scientic knowledge. Establishing taxonomies was an impor-

tant part o the Enlightenment project. Te botanical taxonomy o Linnaeus is the most amous one. During

the Enlightenment, however, the taxonomic project also involved economics, the most complicated taxono-

my o good and bad tradewhat type o trade benetted and what type o trade would hurt the nationisprobably the one contained in Charles Kings three volumes (1721). Linnaeus became proessor o botany at

the University o Uppsala, Sweden, in 1741, the same year Anders Berch received the rst proessorship o

economics anywhere in the world outside Germany, at the same University o Uppsala. Berch (1747) had a

very similar taxonomy to that o King (1721): national wealth is produced by importing raw materials and

exporting manuactured goods.

Even very simple taxonomies may have strong explanatory power. I we divide human beings into

just two dierent categories, men and women, we can explain procreation. Similarly, as Friedrich List (1841)

observed, successul economic strategies have historically been based on the classications ound in King

(1721) and Berch (1747), which have been the basis or all successul strategies o catching up. Te core

theoretical argument explaining this lies in an equally simple binary taxonomy ound in a 1923 paper by USeconomist Frank Graham (see Appendix 1), which will be discussed later in the paper, arguing that a key

point in the career o Nobel laureate Paul Krugman was precisely the elimination o Grahams taxonomy.

US historian Richard Goldthwaite shows the historical importance o the dichotomy between raw

materials and manuacturing in a recent book: what is generally seen as Europes commercial revolution,

Goldthwaite argues, was in act a process o import substitutionmanuactured goods, that had previously

been imported in the Levant, started to be produced in Europe rom the 12th century onwards (Goldthwaite

2009, 6-8). In this paper, I shall argue that this extremely important distinctionbetween raw materials

subject to diminishing returns, monoculture, and perect competition on the one hand, and manuactured

goods subject to increasing returns and a large division o labour on the otherwas lost in the post-WW

II period. Only nations that continued their industrialization strategieslike India and China, startingrom the late 1940shave been successul during the latest process o globalization. I India and China are

removed rom the sample, globalization is a shambles, even more so in terms o real wages than in terms o

GDP per capita (because wages as a percentage o GDP have been reduced across the board).

We intuitively understand that all proessional dishwashers in New York restaurants will have a

considerably lower income than most, i not all, practicing New York lawyers. An intuition that also ollows

automatically is that i all proessional dishwashers in New York are put to live in one nation and all practic-

ing lawyers in another, we shall automatically have one nation o lawyers which will be much wealthier that


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the other nation inhabited by proessional dishwashers. Wealth, at this level o abstraction, is activity-speci-

ic. It is tied to one economic activity rather than to another. US economist Daniel Raymond (1820)one o

the athers o the successul 19th century US manuacturing strategyargued that this same principle applied

to nations: just as human beings could upgrade to more lucrative economic activities, so could nations.

Tis intuition, while still present at the level o understanding income dierences among individuals, hasbeen totally lost in mainstream economic theory. Tis is the reason why, I have argued, economists give very

dierent advice to their own children (based on a notion that dierent economic activities are qualitatively

dierent) than they give to Arican children (specialize according to your comparative advantage, even i that

means specializing in staying poor and washing dishes).

odays mainstream economics, I would argue, has lost not only a key eature o the Enlighten-

mentmaking order by producing classication systems (taxonomies)but also the key eature o the

Renaissance that preceded the Enlightenment: the immense creativity and innovations, in all aspects o hu-

man lie, unleashed during that period. Economics lost what Nietzsche reers to as capital o will and spirit

(Geist- und Willens-Kapital). Our qualitative understanding (vestehen in German philosophy) was crowded

out by a more mechanical orm o understanding (see Drechsler 2004 or a discussion). In this way, the pro-cess o economic development became reduced to a process o adding capital to labour in a quasi-mechanical

ashion, much like adding water to soluble coee. By neglecting the dierences between economic activities,

economics was not able to break the core o the vicious circles that keep poor countries poor, the mutually

reinorcing lack o purchasing power and lack o employment (see Kattel, Kregel and Reinert 2009).

Te accuracy so admired by todays economists has been achieved at the cost o eliminating diver-

sity, o having produced concepts that are empty boxes and o having embraced what Nobel laureate James

Buchanan (1979: 236) calls the equality assumption. At the core o our world economic order lie the ter-

rible simplications o international trade theory. Assuming perect inormation (i.e. that all know the same)

and constant returns to scale or all ranges o output or all goods (i.e. no xed costs), and assuming that all

goods are private, there is no reason why there should be any trade at all (except in raw materials, or reasons

o climate and geography). In its most simple orm, the theory that regulates international trade is based on

assumptions that mimic conditions which would not produce any division o labour or any trade. It describes

a world in which every human being would be a sel-sufcient microcosm. Te WO and our world order are

based on theories that are, at their very core, airly simplistic banalities wrapped in an appearance o science.

Reconstructing Relevant Economics

I oresee that within the next ten or twenty years the now ashionable highly abstract analysis o

conventional economists will lose out. Tough its logical base is weakit is ounded on utterly

unrealistic, poorly scrutinized, and rarely even explicitly stated assumptionsits decline willmainly be an outcome o the tremendous changes which, with crushing weight, are alling upon us

(Gunnar Myrdal, Swedish development economist)

Tis quotation rom Nobel Laureate Gunnar Myrdal dates rom 1956. Tis chapter argues that Myrdal was

wrong only about timing. Te process he describes is happening now, because only nowwith the world-

wide nancial crisisis it possible to see the basic weaknesses o standard textbook economics as they relate

to the nancial crisis and to persistent poverty in the Tird World.


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In his 1952 book, Te Counterrevolution o Science: Studies in the Abuse o Reason, Austrian econo-

mist Friedrich von Hayek (18991992) states that never will man penetrate deeper into error than when

he is continuing on a road which has led him to great success. Hayek pictures a process o scientic decay

that grows out o the excesses that ollow rom the very success o a particular set o ideas. wenty-two years

later, ater having shared the Nobel Prize with the same Gunnar Myrdal, we nd Hayek arguing along thesame lines. Had he been consulted as to whether to establish a Nobel Prize in economics, Hayek says in his

Nobel dinner speech, I should have decidedly advised against it. Hayeks main argument against awarding

a Nobel Prize in economics was that such a prize would tend to accentuate the swings o scientic ashion.

Economics diers rom other sciences, Hayek notes.

Following Kuhn (1970), the idea o changes in scientic research agendaso paradigmsbecame

common knowledge. Science occasionally makes radical breaks. But economics is dierent rom the hard

sciences in that, through the mechanisms described by Hayek, the paradigm decays by overshooting into ir-

relevance (Reinert 2000), and the need or correction is perceived and carried out. But, here also, economics

diers rom other sciences. Once it has been understood that the world is not at, but round, the idea o a at

earth never comes back. In economics however, the paradigmatic overshooting into excessesas described byHayekbrings back theoretical elements that had previously been present, but were later discarded.

Te theoretical overshooting, then, is caused by making economics gradually excessively abstract,

which eventually necessarily creates a counter-reaction. Economics as a science thus oscillates cyclically over

time between very abstract theory, as the theory ruling rom the stagation o the 1970s until the 2008

nancial crisis, and less abstract theory. A key dierence between the two types o theories is how they relate

to empirical acts. Te ollowing quotes are typical o the two approaches:

Abstract economic theory:

One o the best things with economics is that it is just a way o thinking, actual knowledge is non-existent,

Proessor Victor Norman, Dagens Nringsliv, December 31, 1994, p. 21.

Empirically based economic theory:

Te root o everything we can call theory is to observe things as they are. Hans-Georg Gadamer, Lob der

Teorie. Reden und Austze, 1991, p. 43.

Tese two dierent approaches to economics are largely incompatible. For reasons that shall be

explained later, I reer to the point when the damages caused by overshooting in the level o abstraction be-

come evidentthe moment when abstract economic theory yields, by necessity, to more empirical theory

as the 1848 moment.

Algerian-born philosopher Jacques Derrida (19302004) has contributed to explaining the over-

shooting phenomenon. Every structurewhether literary, psychological, social, economic, political or

religiousthat organizes our experience is constituted and maintained through acts o exclusion, Derrida

says. We cannot include all possible actors in a theory, but i we exclude too muchi theory gets too

abstract and overshootswhat we have let out will come back to haunt us. Abstract structures can become

repressive. Derrida insists that what is repressed does not disappear, but always returns to unsettle every con-

struction, no matter how secure it may seem. Both the nancial crisis and persistent poverty in many Tird

World nations are the result o leaving out o economic theory important empirical phenomena not well


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captured by the increasingly abstract models that became standard textbook economics. And as the theories

attempted to include more complicating actors, like increasing returns, we shall see that this was done in

a way that obliterates the structural dierences among countries. Complexity was added, but not diversity.

As events that cannot happen in theory, only in practicelike nancial crises and persistent Tird World

poverty under a ree trade regimecome back to haunt the economics proession, the proession is orcedto lower its level o abstraction. Tis happened during the French Revolution, ater 1848, ater 1929, and is

happening again in 2009.

Te 2008 nancial crisis and the ailure to eradicate poverty in the Tird World are both results

rom the kind o overshootingpolitical and ideologicalexplained by Hayek. Te nancial crisis and

persistent poverty, I argue, are both the result o a theory that got too abstract and became ascinated with

tools and methods that ailed to take into account extremely important aspects o economic reality. Ater

the nancial crisis, everyone says We are all Keynesians now. Both in the case o the nancial crisis and

in terms o advice to poor countries in the economic periphery, it is time to resurrect the thinking o John

Maynard Keynes.

Financial crises make it clear that markets, i let to themselves without regulation, do not produce

economic harmony. Harmony is the result o wise regulations. Such crises open peoples eyes to the act that

the same principles o potential market-made disharmony also apply to the markets or goods and services.

Also in trade policies economic harmony is a result o wise regulations. Ater the 1847 nancial crisis, John

Stuart Mill recanted David Ricardos trade theory. John Maynard Keynes also tells us how he changed his

mind about the same ree trade theorywhich, in the meantime, had come back into ashionaround the

time o the 1929 crisis. Both Mills and Keynes saw that poor countries need an increasing returns sector2, i.e.

an industrial sector, in order to become wealthy.

Te nancial crisis in 1847 triggered a dramatic shit in economics starting in 1848. I you wentto sleep in 1846 and woke in 1850 you would wake into a dierent world wrote an English university

proessor in his memoirs (Reeves 2007: 202). Tis paper argues that we are now acing a very similar situ-

ation: an 1848 Moment when the economy is seen in a new light, less abstract and more rmly based on

empirical observations.

2 Activities subject to increasing returns are those where production costs all as the volume o production increases.Tese lower costs or established rms orm important barriers to entry or newcomers, and produce a type oimperect competition that orms the basis or extra income, or a rent, that is shared between capital (prots),

workers (in the orm o higher wages), and government (in the orm o higher taxable income) in industrial countries.

I argue that what we call development to a large extent consists in establishing such industrial rents. Resource-basedactivities, on the other hand, always have one actor o production (land, ore, etc) limited by nature, and are thereoresubject to diminishing returns. Costs cannot be lowered beyond a certain point because inputs are only available inpoorer quality than the rst and best resources used: lower quality land, lower grade ore, etc. Te low barriers to entryor the production o raw materials lead to perect competition or commodity competition, and the shared nationalrents that can be created in increasing returns activities are impossible to create in a country where only resource-basedactivities are present. Later in this chapter, we see how Washington Consensus policies ruined industrial rents in poorcountries, thereby lowering the real wages by more than 50 per cent in many cases (see Reinert 2004, 2007, 2009aor urther discussions). Te normal case in economic textbooks is perect competition and diminishing returns.In a sense, Washington Consensus policies succeeded in making poor countries look more like the ideals o standardtextbook economics, but this made these countries much poorer than they would have been with industrial rents.


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Economics Abstracted from Production:

The Common Element in Financial Crises and Persistent Poverty

What unites the ailure to understand that a nancial crisis was coming and persistent poverty in the Tird

World is an economic theory at a level o abstraction whereproduction is let out, a theory where the worldeconomy is perceived as stock markets and reight terminals. In reality, markets and trade are mere comple-

ments o an incredibly complex global system oproduction. By ocusing on stock exchanges and trade, the

complexities o world production have essentially been let out o economic theory. In the case o the nan-

cial crisis, the blind spot was the inability to see the separation o nancial economy rom the real economy

o production o goods and services, and how the uncontrolled growth o the ormer could, in the end,

destroy the latter. Tis separation was clear to the main economists who contributed to our understanding

o nancial crises in the past: Torstein Veblen, Joseph Schumpeter, and John Maynard Keynes. In the case

o persistent poverty, the parallel blind spot is the unwillingness to ace up to the overwhelming historical

proo that middle-income and rich nations can only be built on a large division o labour in the presence o

increasing returns. In both cases the core o the problem is a ailure to qualitatively understand the produc-

tive sector o nations.

As we have seen, the roots o this problem go ar back to when Adam Smith bundled production

and trade together as labour hours and David Ricardoand especially his later ollowersproduced a

theory o international trade representing the world economy by bartering labour hours. Te parallel in the

nancial sector is that David Ricardo also orgot to create money as a separate category. Economic theory

based on such abstraction created blind spots on the collective retina o economists, and the illusion o mar-

kets guaranteeing a harmony. Economists modelled a dam: a system automatically seeking equilibrium when

disturbed. Te nancial crisis and persistent poverty in the Tird World amidst a world o plenty expose the

undamental aws o a science based on the metaphor o equilibrium.

Tis illusion o guaranteed harmony has undermined the productive capacities o poor countries inthe world periphery just as it has undermined world nancial markets, and huge rescue operationsparallel-

ing those in nancial marketsneed to be launched to rebuild the productive sectors in poor countries. Te

blind spots and aulty reasoning behind the proessions misreading o both problemsnancial crises and

persistent povertyare closely related. Tereore, the same economistse.g. Keyneswho understand -

nancial crises also understand why mainstream economics ails to correct persistent poverty in the periphery.

Several key ailures o current academic economics are common to both nancial crises and persistent poverty

in the world periphery:

Not separating the sphere o money, or the nancial economy (Schumpeters1. Rechenpennigeor

accounting units), rom the real economy o goods and services (Schumpeters Gterwelt). Not

distinguishing between the two spheres o the economy, neoclassical economists (as opposed to, say,traditional continental European economists) were blind to the possibility o a nancial crisis. For

the same reason, neoclassical development economics attempted to solve the problems o poverty by

transerring capital rather than by addressing the problems o the productive sectors in poor countries.

Not keeping an eye on a nations productive structure as its economic core, ocusing on nance rather2.

than on the impact o nance on the real economy. In normal times, the nancial sector serves as

scaolding or the real economy. Financial crises begin when the nancial sector starts making money

in ways that do not help the real economy, when banks enter into loan agreements that are so risky


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that the borrowers are not even able to pay interest on their loans: Ponzi nancing (Minsky 1990).

Unsustainable nancial pyramid schemes ll nancial markets with toxic assets, liquidity is with-

drawn, and nancial crisis occurs.

Not recognizing that a unctioning capitalism requires investments to be made in potentially prot-3.

able ventures, not in Ponzi schemes. From this point o view, subprime lending and, to a large extent,lending to the Tird World, were both Ponzi schemes: loans made to people and nations that could

not reasonably be expected to have a cash-ow that would even cover the interest on loans they were

given (Kregel 2004). Here, Kregel makes an extremely important point: Te Myrdalian perverse

backwashesthat more unds tend to ow rom poor to rich countries rather than the other way

around (Myrdal 1956)can be explained by the same Minsky mechanisms that explain the current

nancial crisis. Te current lack o industrial policy in poor countries makes it impossible to generate

sufcient industrial rents to make investments protable (see Cimoli, Dosi and Stiglitz [eds] 2009).

As already mentioned, these three ailures may be traced back to the economics o David Ricardo

and especially to his exceedingly loyal ollowers. His theory made the blind spots o present economics pos-

sible by ailing to create money as a separate category apart rom the economy, and by conceiving world

trade as a barter o labour hourswhere a labour hour in Stone Age technology has the same market value

as a labour hour in Silicon Valleymade it impossible to recognize that some nations specialize according to

their comparative advantage in being poor (Reinert 2007).

Te nancial crisis showed us that Hyman Minsky was right in describing and predicting nancial

ragility. Something apparently very solid, like the global nancial system, in reality proved to be very rag-

ile. As the crisis develops we are experiencing other economic ragilities as well: poor countries are increasing-

ly experiencing wage ragility in productive systems (as an example public sector wages in Latvia were cut by

25 per cent in early 2009). I vicious circles o decreasing wages, decreasing demand, and decreasing tax bases

are allowed to continue as they presently do in the periphery, we may experience increased livelihood ragil-ity there: physical survival may be increasingly threatened. In wealthy countries the inux o poor labour is

already starting to produce technological ragility: a much lower cost o labour eliminates the incentives or

expensive mechanisation and we may experience a degree o primitivization3 o developed economies.

Te presence o huge and increasingly competitive low-wage economies in India and China under a

ree trade regime is likely to give any movement towards actor-prize equalization a strong downward trend:

wages in rich countries are more likely to converge towards the poor than the other way around. Tis is

likely to make clear that at the core o what is called economic development lies an industrial rent which is

potentially ragile much in the same way as the world nancial system. As in the 1930s, under conditions o

rapidly increasing wage ragility and job ragility protectionism will probably be seen as a solution. Pro-

tectionism does not, however, necessarily lead to beggar-thy-neighbour policies and negative-sum games.Te Marshall Plan that rebuilt Europe ater World War II was essentially a symmetrical system o protection

programmed to come to an end with ree trade. Such schemes are possible also today, and the good news

coming rom the crisis is that as rich countries reinvent toolboxes o economic policy, poor countries will

necessary have to be allowed to do the same. Finally.

3 Several mechanisms o economic primitivization are introduced in Reinert (2007, Chapter 5)


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The Challenge: Relearning the Art of Creating Middle Income Countries

Until 1964, the Republic o Korea was poorer than Somalia. Figure 1 shows how Korea started an impressive

growth spurt while Somalia got gradually poorer. Tis happened because Korea consciously changed its compar-

ative advantage in international trade rom products subject to diminishing returns (raw materials) to increasingreturns (manuactured goods and advanced services). In this way, Korea escaped rom the poverty trap explained

in Frank Grahams classic 1923 article Some Aspects o Protection Further Considered (see Appendix 1).

Why are there so ew middle income countries? Why do countries tend to cluster in two conver-

gence groups, developed and underdeveloped? Why is it so difcult to create national economies that are

hal way between Somalia and Korea on Figure 1?

Tis paper argues that

our inability to create middle

income countries is a result o

theoretical overshooting in thesense described by Hayek, while

the policy recommendations

resulting rom this theoretical

overshooting have made the

creation o new middle income

countries virtually impossible.

A middle income nation has an

increasing returns (industrial)

sector which, or a while, is

not yet competitive on world

markets. Opening to ree tradewas supposed to even out world

incomes. Te WOs rst

DirectorGeneral, Renato Rug-

gieri, declared that we should

unleash the borderless economys potential to equalise relations among countries and regions. Instead, this

process ended up killing the incipient industrial sectors in poor countries, lowering real wages. Te belie

that the market, let to itsel, guarantees harmony was at the core o the Washington Consensus ideology o

the International Monetary Fund (IMF) and the World Bank.

Financial Crisis as a Result of Overshooting Success

Since the rst international nancial crisis in 1720simultaneously hitting Amsterdam, Paris and London

overshooting previous successes has been a key element o nancial crises (Het Groote aereel 1720, Cole

1949). An important element in nancial crises is nancial innovations which, originally possibly useul and

legitimate, can gradually become speculative instruments which can subsequently become disastrous (Mackay

1841). Markets perceive that normal economic gravity has ceased to exist due to such new nancial innova-

tions. In 1720, the new nancial instrument was common or joint stock; in 2008, it was the new derivatives

and securitized debt, acilitated by abolishing existing prudential legislation (the 1933 Glass-Steagall Act).

Figure 1.

Comparing Economic Development in Somalia and Korea

Source: Reinert, Amazo and Kattel, 2009

Korea-Somalia, GDP per Capita 1950-2001

0

2000

4000

6000

8000

10000

12000

14000

16000

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Korea (Rep.) Somalia


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Banks were partly allowed to discontinue their traditional and important role in the economyevaluating risk

and carry that risk on their balance sheets. Te risks previously borne by the nancial institutions themselves

were passed on to the system and to society at large and money was made on commissions (Kregel 2004).

Te 1720 crisis also involved overshooting in previously successul colonial ventures. Spains colo-nies were producing wealth in the orm o gold and silver. France was planning to do the same in a colonial

scheme on the Mississippi, and England expected the same in the South Seas. Tese became the amous Mis-

sissippi and South Sea bubbles. Continuing a strategy that had previously led to success now led to disaster.

Carlota Perez (2002) argues that major booms and busts always result rom projecting the real suc-

cess o undamental technological breakthroughs on to other projects which lack this characteristic. When

US Leather wished to be valued as US Steel, and when Parmalat tried to do to milk or Enron to energy what

Bill Gates had done to computing, and markets were willing to believe the story, the road to raud was short.

Hyman Minskys destabilizing stability (Minsky 1990, Kregel 2004) describes how long periods o

stability led to easier credit until a Ponzi schemea raudulent scheme where borrowers are not even ableto cover interest payments (as with the subprime loans)leads to the collapse o the whole nancial sector.

An earlier overshooting theory o nancial crises was produced by Clment Juglar (18191905) who, like

Minsky, emphasized the oversupply o increasingly risky credit. Mikhail ugan-Baranovsky (18651919)

emphasized the role ooverinvestment, the other side ounder-consumption, the perspective with which J.A.

Hobson (18581940) approached the problem. What these theories all have in common is that crises are a

result o what Hayek called continuing on a road which has led...to great success.

Destabilizing Stability and Cyclicality of Economic Theory: the Mechanics

I would argue that economic theory itsel is subject to a similar process o destabilizing stability. Long peri-

ods o economic progress in the core countries lead to increasingly abstract and irrelevant economic theories(terrible simplications). Te present mist between theory and reality rst maniested itsel in the 1970s,

in the world periphery, with deindustrialization and alling real wages (see e.g. the example o Peru below).

Ater the all o the Berlin Wall, the Secondormer communistWorld received a ree trade shock caus-

ing, as in Peru, real wages (but not GDP) to be halved in many countries (see Reinert 2004 or a descrip-

tion o the Mongolian case). When the Asian crisis hit in the late 1990s, it was blamed on Asian values and

crony capitalism. For a long time, it has been very easy to absolve economic theory and the Washington

institutions rom any wrongdoings in Arica; corrupt Aricans could take the major part o the blame. As

a result, the Millennium Development Goals essentially became a set o palliative measures aimed at reliev-

ing the pain o poverty rather than eradicating it (Reinert 2007). Only when the crisis hits the economically

hegemonic countries themselves, it dawns on the theoretical mainstream that there might be something

wrong with the theory, rather than with the people. Only then is there a turning point towards more relevant

economic theoriesan 1848 moment.

Such 1848 moments have a strong element o the story o the Emperors New Clothes in them.

Suddenly, everyone dares to say that the Emperor is naked, and a precondition or seeing this is the pres-

ence o peoplelike the little boy in the airytalewho have not been corrupted by the prestige, privi-

leges and status associated with power. Andas Veblen would have saidwhose instincts had not been

contaminated by irrelevant higher education. Ten, and only then, is theory orced down several levels o


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abstraction. In a Veblenian sense, the nancial crisis itsel is a result o not having shielded the instinct o

workmanshipthe creative part o capitalismrom the sterile quest or extracting prot rom a nancial

sector divorced rom producing real goods and services (Reinert and Viano, 2010). Te crisis resulted rom

an economic theory largely abstracted rom productiona problem which Veblen so vehemently warned

US society against rom 1899 to 1929. Only ater his death did the American public understand how im-portant his warnings had been (Reinert and Viano, 2010).

Canadian economist Harold Innis (18941952) provided what, in this writers opinion, is a plau-

sible explanation o the mechanics behind the cyclicality o economics. Innis postulates a type o learned

knowledge, which he reers to as Latin, inspired by mediaeval scholasticism, so oten irrelevant (see Rein-

ert 2000 or a comparison o scholasticism and neo-classical economics). Te opposite o this abstract

and learned type o knowledge is what Innis calls the vernacular (i.e. the oral and un-codied mediaeval

language o the commoners). Te vast and, by denition, uncharted knowledge-base o the vernacular is

strongly related to concepts such as tacit knowledge (M. Polanyi, 1967), uzzy logic, and traditional knowl-

edge (Berkes 2008). Tese concepts all conveyas does the vernacularexperienced-based knowledge o a

complexity that dees modelling. Te continuing attempts o the German Historical School to explain thewhole (die Ganzheit) reects the desire to be scientic without oversimpliying. However, authors who aim

at being the opposite o terrible simpliers by attempting to codiy vernacular knowledgelike Friedrich

Nietzsche, Werner Sombart and Torstein Veblenend up appearing chaotic and very difcult to access.

Tis brings us back to the proposition in Schumpeter (1908) that the challenge consists o producing a

theory that possesses various levels o abstraction, where one will nd an appropriate level according to the

nature o problem at hand.

For Innis, the written word starts a new and dierent trajectory o knowledge, where the simpli-

cation inherent in writingby necessarily leaving out, and/or abstracting rom, so much o the vernacular

knowledgecreated a monopoly o knowledge incidental to a specialized skill in writing. In neoclassical

equilibrium economics, that specialized skill has been mathematical modelling, honed to the point o being,at times, ridiculously simple by proessional demands such as one idea, one paper and reinorced by eco-

nomic incentives such as publish or perish.

Te increasing abstraction o Latin into irrelevance can be destructive to culture itsel. As long as

Ricardian international trade theory was used or export purposes only, to advise poor countries, it present-

ed no danger to the United States. But when the very same theory is employed or domestic purposes, the

simplistic Latin models may become dangerous. On the capture o Athens by the Goths in 267 A.D. they

are reported to have said, Let us leave the Greeks these books or they make them so eeminate and unwar-

like, Innis quotes. My worry is that the United States may itsel have been seriously weakened by disregard-

ing its own increasing returns sectors (the core o which is manuacturing), i.e. weakened at the core while

still warlike in the periphery (see Reinert 2009a or a brie discussion o the mechanisms behind the all oeconomic hegemones).

In recent years, neoclassical (mainstream) economics virtually became the only game in town. In

an Innis type ramework, a point is reached when a set o ideas becomes so dominant that it permeates every

discourse, and becauseby thenit is so overextended that its aults become painully obvious. Tis is what

happened to mainstream economics recently with the present nancial crisis, exemplied by the ront cover

oTe Economistreerred to above. Here is where the idea o Minervas owl enters into Innis thinking: our

understanding o a theoretical structure is only reached when that structure is about to collapse (the owl o


14/29


Minerva, the goddess o wisdom, only starts its ight at dusk, an idea rom Hegel). Only when it collapses,

under the weight it has to bear, the blatant shortcomings o neoclassical economics become obvious.

But, reerring to the quote rom Keynes with which this paper starts, the power o ideas and the

power o the vested interests combine here. Tose communicating in Latin become the masters o complex-ity, and in the process, a hierarchy o proessionals and amateurs is created. Monopolies o knowledge by

proessionalssuch as neo-classical economistswill tend to polarize societies into a mass o the ignorant

and a knowledge elite. Such monopolies o knowledge encourage centralization o power, and an alliance

sometimes ragile, sometimes solidis ormed between the holders o the knowledge monopoly and the

political elites. Tose who control knowledge have the power to dene reality. But neo-classical economics

perpetuated the theories o David Ricardo which were developed at a time when England still hoped to con-

vince the rest o the world that its virtual monopoly as the only manuacturing country in the world was in

everyones interest. Making all economic activities qualitatively alikeby modelling labour hours devoid o

any qualitieswas an important methodological tool aimed at achieving this world monopoly. No one saw

this clearer than the ounding athers o the United States, especially those whose portraits adorn the dollar

bills (with the possible exception o Tomas Jeerson who, appropriately, is almost impossible to nd on thevirtually non-existent two dollar banknote).

Te United States violently opposed the idea o ree trade until the country had been industrialized,

and in the 19th century United States, ree traders were primarily slave owners (Jeerson being one) who

eared British retaliation against US industrialization that could hurt the slave production o crops like sugar,

cotton, and tobacco. Indeed, the links between ree trade and slavery were very strong in the 19th century

USA, being the counterpoint to the so-called high-wage strategy proposed by the Northern (later Unionist)

proponents o industrialization. It would be an irony i the relative retrogression o the United States should

been caused by belie in the oversimplication o Ricardian trade theorythe same theory that the United

States saw clearly and or so long exposed as an English blu aimed at maintaining economic supremacy.

Increasing Distance = Increasing Abstraction and Simplicity

Te geographical dimension in this process needs to be emphasized. As already noted, Derrida insisted that

what is excluded, comes back to haunt the theory. What is now haunting trade theory and the global econo-

my is repression o the act that economic activities are qualitatively very dierent rom the point o view o

creating economic growth. At the core o the problem o todays world economic order lies Ricardos trade

theory, based on the barter o labour hours devoid o any qualities. Tis suggests that ree trade between

Arican armers and Silicone Valley will produce economic harmony through actor-price equalization or, at

least, benet both trading partners. Te risk o nations specializing in being poor is ignored.

In general, the level o abstraction used in approaching economic issues increases with the distance

rom the problem. We can call this the Increasing Distance equals Increasing Abstraction Teorem. Questions

close to home are solved by a commonsense historical approach, while problems ar rom home are solved

by applying very abstract principles. As already discussed, most o us intuitively understand that i we put all

engineers in one nation and all people making a living washing dishes in restaurants in another, we shall have

one rich nation o engineers and a poor nation o dish-washers. Tis intuition, however, cannot be translated

into standard trade theory because it violates Ricardos core assumption that labour hours are qualitatively

alike. As Torstein Veblen put it, Education may contaminate the instincts.


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As already discussed, using their common sense, economists advice their children based on the

assumption that economic activities are qualitatively dierent as generators o wealth. When the distance

to the issue grows, when it comes to advising Arica, economists recommendations are based on Ricardian

trade theory where there are no qualitative dierences between an hour o engineers work and an hour o

washing dishes. At best, there is an implicit assumption that capital can be added to increase the productiv-ity o people washing dishes to make as much money as engineers. Which, o course, is not the case.

Paul Krugman made an interesting observation conrming this increasing distance= increasing

abstraction theorem. While the United States insisted on Ricardian trade theory and standard textbook

economics as the oundation or the world economic order, Krugman complained that US trade policy ailed

to ollow the principles o Ricardian trade theory: the view o trade as a quasi-military competition is the

conventional wisdom among policy-makers, business leaders, and inuential intellectualsIt is not just

that economists have lost control o the discourse; the kind o ideas that are oered in a standard economics

textbook do not enter into that discourse at all (Krugman quoted in Reder 1999: 6).

Krugman deends Canadian protectionist policies: it seems reasonable to argue that Canadas nation-alistic economic policies were the key actor in creating this (industrial) strength (Krugman 1991: 92). Based

on his knowledge o US neighbour Canada, Krugman recognizes the value o inant industry protection, but

then, surprisingly, goes out o his way to show that the Canadian casethe only empirical case he usesis

dierent to that o other periphery nations. I nd it very difcult to understand why Krugman does not make

recommendations o this kind also to other laggard countries, but seemingly the common sense close to

home, abstract theories urther away mechanism has been at work: increasing distance = increasing abstraction.

For the same reason, we observe domestic changes in the hegemonic countries beore they are ap-

plied in the rest o the world. During the 1991 minimum wage debate in the United States, virtually all

economists violently opposed tampering with the labour market, ostensibly leaving the market to determine

wages. When the same debate took place again in 2007, virtually all US economists supported an increase inminimum wages. Paul Samuelson, the ather o modern trade theory, withdrew his across-the-board recom-

mendation o ree trade when ree trade started causing poverty in the United States (Samuelson 2004). Tat

markets, let to themselves, can increase poverty, not only in the United States, but also in the Tird World,

is now generally acknowledged.

A urther example o the increasing distance = increasing abstraction theorem is the way neo-Schum-

peterian economicsplacing innovation, rather than equilibrium, at the core o economicshas had grow-

ing inuence in the developed world, e.g. in Europes Lisbon Strategy, but so ar has had very little impact

on Tird World policies4. Ater some initial ground-work (Nelson and Winter 1982, Dosi et al. 1988), the

OECD dedicated a whole research program (EP, echnology and Economy) to this approach in the early

1990s. So ar, the tendency has been to ocus on innovation in rich countries, but to leave poor countrieswith their comparative advantage, oten in activities beret o possibilities or innovation (Reinert 2007).5

Tis line o investigation is bringing back important elements o classical development economics, associated

with Albert Hirschman, Ragnar Nurkse, Gunnar Myrdal and others (Kattel, Kregel and Reinert 2009).

4 Reinert (2004) represents an attempt to do so.

5 A new volume on industrial policy written using a neo-Schumpeterian ramework (Cimoli, Dosi and Stiglitz (eds)2009) is likely to initiate a phase o innovation-based theories o poverty eradication in the Tird World.


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It is important to understand, then, that intellectuals may have modes o thought that operate on

very dierent levels o abstraction. Krugman is an interesting example o how dierent these modes can be.

In his piece How I work, Krugman, the Nobel Prize winner, says: A minor regret is that I have never en-

gaged in really serious empirical work. Its not that I dislike acts or real numbers. Indeed, I nd light empiri-

cal work in the orm o tables, charts, and perhaps a ew regressions quite congenial. Every year I promiseto try to do some real empirical work. Next year I really will! In Harold Innis terms, this is the Krugman

who writes in Latin, in this case, science virtually void o categories and experience.

Another very dierent Paul Krugman exists, however: the one who writes extremely insightul and

heavily empirically-based columns in the New York imes, ounded on a wealth o vernacular knowledge

and with strong ethical views. I the vernacular Krugman would just be as well inormed and interested in

Aricas productive structure as he is in US health care reorm, I am convinced the result would be very good.

Unortunately, so ar, the empirical and well inormed Krugman is reserved or issues regarding the United

State: increasing distance = increasing abstraction and simplicity. Simpliy, simpliy is one o the important

rules Krugman the Nobel economist has set or himsel in How I work. In his New York imescolumns, he

is doing the opposite, and with very good results.

Using the terminology o Francis Bacon (15611623), mainstream economics at this time represents

degenerate learning, rather than good and solid knowledge:

Surely, like as many substances in nature which are solid, do putrey and corrupt into worms; so it is the

propriety o good and solid knowledge to putrey and dissolve into a number o subtle, idle, unwholesome

and, as I may term them, vermiculite questions, which have indeed a kind o quickness, and lie o spirit,

but no soundness o matter, or goodness o quality. Tis kind o degenerate learning did chiey reign

amongst the schoolmen6, who, having sharp and strong wits, and abundance o leisure, and small variety

o reading, but their wits being shut up in the cells o a ew authors (chiey Aristotle their dictator), as

their persons were shut up in the cells o monasteries and colleges, and knowing little history, either o

nature or time, did, out o no great quantity o matter, and innite agitation o wit, spin out unto us thoselaborious webs o learning which are extant in their books. For the wit and mind o man, i it work upon

matter, which is the contemplation o the creatures o God, worketh according to the stu, and is limited

thereby: but i it work upon itsel, as the spider worketh his web, then it is endless, and brings orth indeed

cobwebs o learning, admirable or the neness o thread and work, but o no substance or prot (quoted

in Reinert 2000).

What happens during 1848 momentssuch as the one we are in nowis that abstract models are

increasingly seen as irrelevant, as a degenerate orm o knowledge, and economic theory increasingly opens

up to and re-accommodates empirical acts, again becoming good and solid knowledge. As a result, ar away

countries have the possibility to be treated with the same empirically based knowledge which is normally

only used close to home.

The Failure of Neoliberal Development Policy

Until the mid-1970s, development economics was based on the notion that a middle income country is a

country with the same type o economic structurea large manuacturing sectoras a rich country. It was

understood that or a variety o reasonsamong them market size, technological sophistication, relatively

high price o capital relative to labour, etc.the industrial sector o a poor country would need a lot o

6 Te reerence is to Scholasticism.


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time beore it would be strong enough to ace competition rom wealthier countries. Tis period o inant

industry protectionas John Stuart Mill called itis comparable to the many years amazon.com operated

its business with great losses. Slowly industrializing a nation represents the same kind o trade-o between

present costs and greater returns (e.g. wages) in the uture. In the meantime the poor country would earn

scarce oreign exchange rom the export o commodities. For developing countries, customs duties tend toprovide a large share o government revenue, and because ports were relatively easy to control, even weak

governments could easily secure this revenue (e.g. compared to a value added tax).

As already alluded to, i China and India are separated rom the rest o the developing world the

development record over the last 35 years has been poor in most developing countries. China and India have

based their national development on continuing their industrialization eorts7 started around 1950 (Nay-

yar 2007). In no way can these countries be considered showcases o the neo-liberal policies propagated by

the Washington Consensus. On the contrary, they ollowed the policy advice o Friedrich List (1841) that

industrialized Continental Europe and the United States: industrializing and then slowly opening up bor-

ders. China and India may have allowed too little competition or too long, and may have opened up late,

but these are small mistakes compared to the policy errors o the Washington Consensus responsible or thedeindustrialization o so many developing countries in the periphery.

Te term creative destruction, inspired by Joseph Schumpeter, has grown increasingly popular, and

is sometimes used to justiy all kinds o changes.8 However, destruction and creativity may take place in

dierent parts o the globe, as when the textile mills o Manchester replaced the weavers o Bengal during

the rst Industrial Revolution. Tis paper argues that trade liberalization divided the Tird World into two

groups: 1) thoselike India and Chinathat pursued industrialization or more than 50 years and benet-

ed rom access to the world market, and 2) those countries where industrialization was too weak to survive,

the synergies o industrialization were put in reverse, and the economies de-industrialized and thus became

primitivized(Reinert 2007: Ch 5).

Early economic writers repeated again and again that all wealthy nations had one important thing

in common: a large number o dierent manuacturing industries all subject to increasing returns (Reinert

2009a). It has been common knowledge since the 1400s that a wealthy city was created by a common weal,

a ben commune. Te rst author to pinpoint increasing returns and diversied manuacturing as the key

to wealth creation was the Italian economist, Antonio Serra, who in 1613 explained why Venice, virtually

void o natural resources, was so rich, while his own Naples, rich in natural resources, was so poor. Without

increasing returns, there was no dynamic capitalism, a very limited division o labour, and no high wages.

From this perspective, colonialism involves a technology policy preventing increasing returns activities rom

being established in the colonies (Reinert 2007).

Serras 1613 treatise argued that increasing returns was at the core o the wealth-producing mecha-

nisms in each o these many dierent activities. Maximizing the division o labour was at the core o any

policy o good government (S. Reinert 2010). A large number o activities subject to increasing returns was

the key to national wealth, andmost importantlymiddle income nations were those where the same type

7 Here I am reerring to their domestic industrialization policy rom around 1950, not their specialization ininternational trade much later.

8 Te term creative destruction entered economics via Friedrich Nietzsche and Werner Sombart (Hugo Reinertand Erik Reinert 2006). Te nancial instruments creating toxic assets have added a new Schumpeterian term:destructive creation.


18/29


o activities and the same large division o labour were present, but in a system slightly less efcient than in

those o the world leaders. A slightly less efcient manuacturing and service nation was much wealthier than

the most efcient producers o raw materials (subject to diminishing returns). o make a comparison appeal-

ing to the readers intuition: it is much better to be a mediocre lawyer than to be the worlds most efcient

cotton-picker. Tis is the principle upon which all successul industrial policy has been built rom Henry VIIcame to power in England in 1485 until the post-WW II Marshall Plan in Europe. It has been articulated

by classical development economics, but undermined by the Washington Consensus. Te rest o this section

shows the mechanisms with which the Washington Consensus policies haveprimitivizedthe periphery.

Figure 2 shows how rates o economic development improved and peaked at the height o classical

development economics in the mid-1970s. Only East Asia, with its recent tradition o industrial policy, has

managed to keep up the positive trend.

Figure 2 shows the

dismal perormance o

neoliberal developmentpolicies that came into

eect starting in the

late 1970s, when debt

crises in the Tird World

orced Tird World

countries to open up

abruptly.

Deindustrialization was

the price paid or being

saved by the IMF and

the World Bank.9

Te dismal results rom neo-liberal development policy can be explained as a result o thecumulative eect o a number o vices producing theories at excessive levels o abstraction, andthereore, o irrelevance. Te rst vice is what Schumpeter reerred to as the Ricardian vice, that ispiling a heavy load o strong policy recommendations upon very shaky assumptions. Milton Fried-man (1953) deended this thus: ruly important and signicant hypotheses will be ound to haveassumptions that are wildly inaccurate descriptive representations o reality, and, in general, themore signicant the theory, the more unrealistic the assumptions(Friedman 1953: 14). Friedmanthus justied an adverse relationship between theory and reality, legitimizing a proession whereunrealistic assumptions are rewarded with scientic prestige. Tis we can reer to as the Friedmanianvice. I have dubbed the third vice the Krugmanian vice, the production o theoretical models thatexplain the real world better than Ricardo did, but not applying them to actual economic policy(Reinert 2007). ogether these vices combine to create and maintain the blind spots o economictheory that have prevented the proession rom seeing nancial crises and persistent poverty.

9 Detailed case studies show how this process evolved in Mongolia and Peru (Reinert 2004; Roca and Simabuko 2004).

Figure 2.

Growth rate o GDP per capita o selected world regions; regional average in selected

periods between 1820 and 2001; annual average compound growth rate

Source: Kattel, Kregel and Reinert (2009). Original data rom Maddisson 2003.

-2

-1

0

1

2

3

4

5

1820-1870 1870-1913 1913-1950 1950-1973 1973-2001

Africa

Asia (Japan excluded)

Latin America

Eastern Europe

Former USSR


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Increasing Returns as the Key to Wealthy Nations

Persistent poverty in the Tird World is a result o trade policy overshooting. For more than 500 years, it

has been recognized that middle income nations have the same type o economic structure as rich nations,

albeit slightly less efcient. Tereore, all currently rich countries have been through a period o emula-tioncopying the structure o rich countriesbeore embarking on a strategy o specializing according to

comparative advantage (Reinert 2007, 2009b). Te burden o proo rests with those who argue in avour o

ree trade under all circumstances to nd historical cases o nations that have grown wealthy in the absence

o a signicant manuacturing sector.

Economic theory has emphasized capital and trade, seriously neglecting the role o a nations pro-

ductive structure, o technology, o entrepreneurship and o unemployment. Te Washington international

nancial institutions have promoted models assuming ull employment when lack o employment has been

at the core o the problem o poverty. Te more abstract the theoretical model in a social science, the more

likely it is that the relevant acts will be excluded.

By modelling the global economy as a system in which nations barter labour hours, David Ricardo

implicitly made all economic activities qualitatively alike. He made no eort to consider they could be di-

erent. I we divide human labour into only two dierent categoriesthose who work under diminishing

returns and those who work under increasing returnswe can, to a great extent, explain what distinguishes

poor countries rom rich ones. Rich countries have a large increasing returns sector, poor nations have very

small ones, typically below 6 per cent o GDP (Reinert, Amazo and Kattel 2009).

Increasing returns means that, as the volume o production increases, xed costs per unit o produc-

tion all. I it cost Microsot 500 million dollars to develop Windows Vista, that would be the cost o the

rst copy. I two copies were sold, the unit cost would be 250 million dollars. But since copies can be distrib-

uted at extremely low cost, on the web, unit price comes down very ast. Te act that the initial investmentis so high makes it very difcult to compete with Microsot. High initial investments imply high barriers to

entry into many industries. Te same barriers to entry protect protability, but can also lead an industry

the airline industry is one exampleinto periods when all lose money. High capital intensity also implies

barriers to exit.

Importantly, increasing returns invalidate the core assumption o standard economics: perect compe-

tition. Te higher the increasing returns, the larger the barriers to entry and the more imperect the competi-

tion. Behind these barriers, rich countries have managed to elevate their wage levels. Because o these barriers

to entry, by demanding a larger share o the pie, labour unions have actually created a larger pie. As long as

all manuacturers in the same labour market are subject to the same wage demands, they can all concede to

the demands without going bankrupt as their competitors have to yield to the same demands. Higher wages

increase the relative price o labour, which in turn makes mechanization increasingly protable. Tis spiral o

increasing wages (i.e. increasing demand) and increasing productivity due to mechanizationinduced by the

same wage increasesis at the core o the impressive growth o developed economies since the 1850s. Tis is

the same type o sel-reinorcing mechanism described by Serra as regards increasing returns and increased ex-

ports rom Venice: because increased production volumes lead to lowered costs and prices, gaining even more

customers, which again lowers prices (and raises barriers to entry and competition) even more: cumulatively

one actor reinorces the other, as Serra says (Serra in Sophus Reinert 2010: Chapter 10).


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Te existence o increasing returnso alling production costs as volume increaseswas implicitly

recognized in conscious industrial policy as ar back as 1485 (Reinert 2007). Frank Graham (1923) showed

howwith international specializationnations specializing in increasing returns activities (manuacturing

industry) grow richer while nations specializing in diminishing returns activities (raw materials) grow poorer

(Appendix I). In other words, as some nations specialize in becoming richer, other nations specialize in beingpoor. In an early work (Reinert 1980), I showed that mechanisms described by Serra and Graham were active-

ly at work in the main 20th century export commodities o three Andean republics: tin in Bolivia, bananas in

Ecuador, and cotton in Peru. Every time national production increased, labour productivity decreased as the

nations moved urther and urther into the realm o diminishing returns: increasingly marginal and less pro-

ductive land or mines were put to work. When national production diminished, productivity again increased,

oten dramatically. Tis is, o course, the complete opposite eect o what can be observed in manuacturing

industry, where increasing returns produce lower, not higher, costs as production is increased.

Paul Krugmans early work was partly inspired by the taxonomy in Frank Grahams 1923 article: a

nation specializing in diminishing returns activities will grow poorer, while a nation specializing in increasing

returns activities will grow richer. In an early paper (rade, Accumulation, and Uneven Development, inKrugman 1990), Krugman indeed argues that Lenin and the classical development economists were right. As

I have tried to show (Reinert 2007), the increasing and diminishing returns actor is, in act, just the tip o a

sizable theoretical iceberg, butas English classical economists, rom Malthus to Mill, understood so well

it is the key point rom which to start the process o qualitatively understanding poverty. Unortunately, Paul

Krugman soon let the bad news o diminishing returns out o his writings, concentrating on the good news

about increasing returns and trade.

In isolation, increasing returns provides an argument or ree trade, but only when nations are as-

sumed to have similar degrees o increasing returns. A classication system dividing economic activities in

increasing and diminishing returns activities, like Grahams, describes situations where nations will be better

o by protecting increasing returns activities than with ree trade. During the period when neoliberalismtotally dominated economic theory, no demand obviously existed or theories that undermined the ideology

o ree trade. In that sense, economic theory is much more driven by demand than we are generally willing

to admit, but it is now relatively easy to see the neoliberal theory was indeed totally dependent on a theory

lacking taxonomies: introducing dierences would undermine the desired theoretical conclusions. Introduc-

ing qualitative dierences into the theoretical structure o economics would be to admit potential dishar-

mony. By leaving out situations where ree trade leads to increased povertyby starting to ignore Grahams

simple, but exceedingly important taxonomyKrugman, in eect, became a simplier who contributed to

the serious overshooting o the ree trade argument.

Increasing Returns and Synergies: Their Creation and their Destruction

In many ways, the United States can be seen as the prototype successul developmental state. Ater US

independence, the Continental European understanding o development as synergies among a large number

o increasing returns industries was retrieved rom European literature and rediscovered by US economists.

Tese economists insisted that the United States, in spite o its abundance o natural resources and obvi-

ous comparative advantage in agriculture, would grow poor without manuacturing industry (Hamilton

1791; Raymond 1820; M. Carey 1822). Later, along the same lines o reasoning, Henry Carey (17931879)

insisted that trading too much with Britain would preclude the United States rom enjoying the bounties


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o uture technological change. Carey also devised what he called a commodity map, which illustrates how

the presence o a manuacturing sector changes the way income is distributed within a nation. Careys map,

which could also have been called a development synergy map, is an illustration o the centuries-old obser-

vation o the eects o a manuacturing sector. oday, the map can be used to explain the mechanisms by

which Washington Consensus policies increased poverty in the world periphery.

Figure 3 represents the breakdown

o a typical dollars worth o goods, i.e. a

proxy or what we would call output or

GDP. Te height o the graph represents

100 per cent o GDP. Carey shows how di-

erent the composition o GDP was in the

developed East compared to the undevel-

oped West o the United States at the time;

the graph indicates how the composition

o output changes as one moves graduallyrom Boston to St. Louisrom right to

let in the gureor vice versa. Economic

developmentincreasing the division o

labour and manuacturingis represented

by moving east rom St. Louis, Missouri

towards Boston. Poverty and backwardness

grows as one moves west rom Boston to St. Louis. St. Louis thus represents the situation in the undeveloped

world or periphery today. Here, raw materialse.g. cotton or cattleare produced; land is abundant and

cheap, labour is unskilled and cheap, tasks are simple, and the division o labour is limited. Under such condi-

tions, Carey says, prots take up a large share o the GDP.

Te East, Boston, represents todays developed world with a large division o labour that adds a lot

o value to a raw materials base. In the East, in contrast to the underdeveloped West, a multitude o workers

combine their eorts within a complex social division o labour to work raw materials into ever more sophis-

ticated products. More skills are required, increasing returns create higher prots and higher barriers to entry.

Here, wages and rents orm a much larger portion o the value o products, while prots shrink to a smaller

percentage o GDP.

I a nation should move over time rom Boston to St. Louis, that means undoing the synergies o

development, reversing the critical mass that creates wealth, in a sense travelling rom capitalism back in time

towards something resembling eudalism. Tis more than 150 year old graph shows how Washington Con-

sensus policies that started in the late 1970s have produced the same regressive eect as Henry Carey claimsmoving rom Boston to St. Louis would have done in 1858: wages as a percentage o GDP sank slowly, while

rents and protsthe FIRE sector: nance, insurance and real estategrew correspondingly.

Market ailure is a term oten used when actual developments ail to behave the way economic

theory would predict. Cimoli, Dosi and Stiglitz (2009) acknowledge that market ailure is not a useul

way to approach the problem o poverty. In act, rom a Schumpeterian angle, what we generally reer to as

development is, in act, a market ailure compared to the standard neo-classical model assuming perect

Source: Perelman (2002: 90)

wages

prots

rent

Distribution of

typical dollars

worth of goods

St.Louis Boston

Figure 3.

Henry Careys Commodity Map (1858)

(Modifed rom Carey 1858a, iii, p.187)


22/29


competition and diminishing returns. What all developed countries have in common is a large increasing re-

turns sector that has created huge barriers to entry, imperect competition, and a rent that has been divided

among capitalists (high prots), labour (high wages), and the government sector (larger tax base) (Reinert

2009a). In this section, we shall see how the policies o the Washington institutions led to the destruction o

these industrial rents, and to huge alls in real wages. Te shock therapies o the Washington institutionsinstant ree trade and structural adjustmentssent poor countries, whose industrial sectors were not yet

competitive on the world market, rom Boston to St. Louis in Careys scheme.

Looking at the example o Peru since 1950, waves o industrialization and de-industrialization have

been associated with uctuations in living standards. Te standard o living o the population has been

inversely related to the weight o the primary sector in the total economy. During the period 1950 to 1997,

a one percentage point decrease in manuacturing as a share o GDP led to a all in white-collar wages by

5.4 per cent, and a all in blue-collar wages by 7.5 per cent. Conversely, when manuacturing increased by

one percentage point in total GDP, white-collar and blue-collar real wages increased by 10.6 and 15.5 per

cent respectively (Roca and Simabuko 2004). Going back to Careys map, we can conclude that every time

manuacturing increased as a percentage o GDP, this corresponding to moving east on the Carey map:wages went up. Every time the manuacturing sector shrank, it corresponded to moving west on the Carey

map: wages went down.

Figure 4 shows how real wages

in Peru peaked in the mid-

1970s when the country did

everything wrong according

to the Washington Consensus.

Peruvian industry was kept up

by high taris and represented

a bad orm o protection.Industrialization was articial,

but the wages, roads, schools,

and hospitals created by this

industrialization were all real.

It is also important to see how

exports took o and made the

country look very successul

while real wages were plum-

meting at the same time. Te

Washington Consensus shock

therapy hit Peru on two ronts simultaneouslywith de-industrialization plus downsizing the public sector.By killing o the two sectors with strong union powerone private, one publicthe whole national wage

level collapsed. Tis was accompanied by a rapid all in the terms o trade (Reinert 2007: Figure 15).

Peruvian wage levels ell much aster than GDP, as the composition o Peruvian GDP changed.

Figure 5 shows how dramatic this change was. At the height o industrialization in Peru in 1972, wages

amounted to 51.2 per cent o GDP and the income o the sel-employed was 26.5 per cent, a total o 77.7

per cent o GDP. Figure 5 shows how wages, salaries and the income o the sel-employed shrank rapidly as

the country prematurely opened up to ree trade. In 1990, the last year the Peruvian central bank provided

Figure 4.

Industrialization, deindustrialization and real wages in Peru

Source: Reinert 2007.

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

1960

1970

1980

1990

0

0.5

1

1.5

2

2.5

3

3.5

4

White collar wages Blue col lar wages Ex port


23/29


a break-down o GDP in this way, the share o wages in GDP had been almost halved to 26.5 per cent, and

the share o the income o the sel-employed had allen to 15.9 per cent. In total, the wages, salaries and the

income o the sel-employed as a share o GDP had shrunk by 45 per centrom 77.7 per cent to 42.4 per

cent o GDPas a result o Washington Consensus policies rom the mid-1970s to 1990. Te national

industrial rent had been destroyed, with devastating consequences or real wages that had been more thanhalved in real terms.

Rapid trade liberaliza-

tion led to rapidly alling real

wages, worsening income dis-

tribution, and primitivization

o the economy back to a more

eudal structure, correspond-

ing to a voyage rom developed

Boston to underdeveloped St.

Louis in Henry Careys model.Tis underscores why a poor

nation is much better o with

a relatively inefcient manu-

acturing sector than with no

manuacturing sector at all. I

have argued that successul eco-

nomic policy has been based on

a cult o manuacturing beore

introducing ree trade since

the late 1400s (Reinert 2007).

Occasionallyas just beorethe French Revolution (1789),

just beore 1848, and ater

the stagation o the 1970s

theoretical overshooting based on excessively abstract models has led to this understanding being abandoned.

In all three cases the result has been seriously worsening social conditions or the poor. Just beore the French

Revolution ree trade in grain had led to a shortage o bread in Paris. Te Storming o the Bastille, mark-

ing the start o the Revolution, was triggered when news o the dismissal o the last anti-physiocrat (anti-ree

trader) Jacques Necker as Minister o Finance reached Paris. Just as in 1848which will be discussed in the

concluding section o the paperill-timed ree trade was seen as a source o human suering. Free trade may

come into conict with the right to ood, as French economist Simon Linguet (17361794) argued.

John Maynard Keynes was not only right about nancial crises, but his advice to poor peripheral

countries, in the early 1930s, should be given to poor countries today, adapted to the current technologica

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