How the World Works

Americans persist in thinking that Adam Smith's rules for free trade are the only legitimate ones. But today's fastest-growing economies are using a very different set of rules. Once, we knew them—knew them so well that we played by them, and won. Now we seem to have forgotten
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IN Japan in the springtime of 1992 a trip to Hitotsubashi University, famous for its economics and business faculties, brought me unexpected good luck. Like several other Japanese universities, Hitotsubashi is almost heartbreaking in its cuteness. The road from the station to the main campus is lined with cherry trees, and my feet stirred up little puffs of white petals. Students glided along on their bicycles, looking as if they were enjoying the one stress-free moment of their lives.

They probably were. In surveys huge majorities of students say that they study "never" or "hardly at all" during their university careers. They had enough of that in high school.

I had gone to Hitotsubashi to interview a professor who was making waves. Since the end of the Second World War, Japanese diplomats and businessmen have acted as if the American economy should be the model for Japan's own industrial growth. Not only should Japanese industries try to catch up with America's lead in technology and production but also the nation should evolve toward a standard of economic maturity set by the United States. Where Japan's economy differed from the American model—for instance, in close alliances between corporations which U.S. antitrust laws would forbid—the difference should be considered temporary, until Japan caught up.

Through the 1980s a number of foreign observers challenged this assumption, saying that Japan's economy might not necessarily become more like America's with the passing years. Starting in 1990 a number of Japanese businessmen and scholars began publicly saying the same thing, suggesting that Japan's business system might be based on premises different from those that prevailed in the West. Professor Iwao Nakatani, the man I went to Hitotsubashi to meet, was one of the most respected members of this group, and I spent the afternoon listening to his argument while, through the window I watched petals drifting down.

On the way back to the station I saw a bookstore sign advertising Western-language books for sale. I walked to the back of the narrow store and for the thousandth time felt both intrigued and embarrassed by the consequences of the worldwide spread of the English language. In row upon row sat a jumble of books that had nothing in common except that they were published in English. Self-help manuals by Zig Ziglar. Bodice-rippers from the Harlequin series. A Betty Crocker cookbook. The complete works of Sigmund Freud. One book by, and another about, Friedrich List.

Friedrich List! For at least five years I'd been scanning used-book stores in Japan and America looking for just these books, having had no luck in English-language libraries. I'd scoured stores in Taiwan that specialized in pirated reprints of English-language books for about a tenth their original cost. I'd called the legendary Strand bookstore, in Manhattan, from my home in Kuala Lumpur, begging them to send me a note about the success of their search (it failed) rather than make me wait on hold. In all that time these were the first books by or about List I'd actually laid eyes on.

One was a biography, by a professor in the north of England. The other was a translation, by the same professor, of a short book List had written in German. Both were slim volumes, which, judging by the dust on their covers, had been on the shelf for years. I gasped when I opened the first book's cover and saw how high the price was—9,500 yen, about $75. For the set? I asked hopefully. No, apiece, the young woman running the store told me. Books are always expensive in Japan, but even so this seemed steep. No doubt the books had been priced in the era when one dollar was worth twice as many yen as it was by the time I walked into the store. I opened my wallet, pulled out a 10,000-yen note, took my change and the biography, and left the store. A few feet down the sidewalk I turned around, walked back to the store, and used the rest of my money to buy the other book. I would always have regretted passing it up.

WHY Friedrich List? The more I had heard about List in the preceding five years, from economists in Seoul and Osaka and Tokyo, the more I had wondered why I had virtually never heard of him while studying economics in England and the United States. By the time I saw his books in the shop beneath the cherry trees, I had come to think of him as the dog that didn't bark. He illustrated the strange self-selectivity of Anglo-American thinking about economics.

I emphasize "Anglo-American" because in this area the United Kingdom and the United States are like each other and different from most of the rest of the world. The two countries have dominated world politics for more than a century, and the dominance of the English language lets them ignore what is being said and thought overseas—and just how isolated they have become. The difference shows up this way: The Anglo-American system of politics and economics, like any system, rests on certain principles and beliefs. But rather than acting as if these are the best principles, or the ones their societies prefer, Britons and Americans often act as if these were the only possible principles and no one, except in error, could choose any others. Political economics becomes an essentially religious question, subject to the standard drawback of any religion—the failure to understand why people outside the faith might act as they do.

To make this more specific: Today's Anglo-American world view rests on the shoulders of three men. One is Isaac Newton, the father of modern science. One is Jean-Jacques Rousseau, the father of liberal political theory. (If we want to keep this purely Anglo-American, John Locke can serve in his place.) And one is Adam Smith, the father of laissez-faire economics. From these founding titans come the principles by which advanced society, in the Anglo-American view, is supposed to work. A society is supposed to understand the laws of nature as Newton outlined them. It is supposed to recognize the paramount dignity of the individual, thanks to Rousseau, Locke, and their followers. And it is supposed to recognize that the most prosperous future for the greatest number of people comes from the free workings of the market. So Adam Smith taught, with axioms that were enriched by David Ricardo, Alfred Marshall, and the other giants of neoclassical economics.

The most important thing about this summary is the moral equivalence of the various principles. Isaac Newton worked in the realm of fundamental science. Without saying so explicitly, today's British and American economists act as if the economic principles they follow had a similar hard, provable, undebatable basis. If you don't believe in the laws of physics—actions create reactions, the universe tends toward greater entropy—you are by definition irrational. And so with economics. If you don't accept the views derived from Adam Smith—that free competition is ultimately best for all participants, that protection and interference are inherently wrong—then you are a flat-earther.

Outside the United States and Britain the matter looks quite different. About science there is no dispute. "Western" physics is the physics of the world. About politics there is more debate: with the rise of Asian economies some Asian political leaders, notably Lee Kuan Yew, of Singapore, and several cautious figures in Japan, have in effect been saying that Rousseau's political philosophy is not necessarily the world's philosophy. Societies may work best, Lee and others have said, if they pay less attention to the individual and more to the welfare of the group.

But the difference is largest when it comes to economics. In the non-Anglophone world Adam Smith is merely one of several theorists who had important ideas about organizing economies. In most of East Asia and continental Europe the study of economics is less theoretical than in England and America (which is why English-speakers monopolize Nobel Prizes) and more geared toward solving business problems.

In Japan economics has in effect been considered a branch of geopolitics—that is, as the key to the nation's strength or vulnerability in dealing with other powers. From this practical-minded perspective English-language theorists seem less useful than their challengers, such as Friedrich List.

Two Clashing World Views

BRITONS and Americans tend to see the past two centuries of economics us one long progression toward rationality and good sense. In 1776 Adam Smith's The Wealth of Nations made the case against old-style mercantilism, just as the Declaration of Independence made the case against old-style feudal and royal domination. Since then more and more of the world has come to the correct view—or so it seems in the Anglo-American countries. Along the way the world has met such impediments as neo-mercantilism, radical unionism, sweeping protectionism, socialism, and, of course, communism. One by one the worst threats have given way. Except for a few lamentable areas of backsliding, the world has seen the wisdom of Adam Smith's ways.

Yet during this whole time there has been an alternative school of thought. The Enlightenment philosophers were not the only ones to think about how the world should be organized. During the eighteenth and nineteenth centuries the Germans were also active—to say nothing of the theorists at work in Tokugawa Japan, late imperial China, czarist Russia, and elsewhere.

The Germans deserve emphasis—more than the Japanese, the Chinese, the Russians, and so on because many of their philosophies endure. These did not take root in England or America, but they were carefully studied, adapted, and applied in parts of Europe and Asia, notably Japan. In place of Rousseau and Locke the Germans offered Hegel. In place of Adam Smith they had Friedrich List.

The German economic vision differs from the Anglo-American in many ways, but the crucial differences are these:

* "Automatic" growth versus deliberate development. The Anglo-American approach emphasizes the unpredictability and unplannability of economics. Technologies change. Tastes change. Political and human circumstances change. And because life is so fluid, attempts at central planning are virtually doomed to fail. The best way to "plan," therefore is to leave the adaptation to the people who have their own money at stake. These are the millions of entrepreneurs who make up any country's economy. No planning agency could have better information than they about the direction things are moving, and no one could have a stronger incentive than those who hope to make a profit and avoid a loss. By the logic of the Anglo-American system, if each individual does what is best for him or her, the result will be what is best for the nation as a whole.

Although List and others did not use exactly this term, the German school was more concerned with "market failures." In the language of modern economics these are the cases in which normal market forces produce a clearly undesirable result. The standard illustration involves pollution. If the law allows factories to dump pollutants into the air or water, then every factory will do so. Otherwise, their competitors will have lower costs and will squeeze them out. This "rational" behavior will leave everyone worse off. The answer to such a market failure is for the society—that is, the government—to set standards that all factories must obey.

Friedrich List and his best-known American counterpart, Alexander Hamilton, argued that industrial development entailed a more sweeping sort of market failure. Societies did not automatically move from farming to small crafts to major industries just because millions of small merchants were making decisions for themselves. If every person put his money where the return was greatest, the money might not automatically go where it would do the nation the most good. For it to do so required a plan, a push, an exercise of central power. List drew heavily on the history of his times—in which the British government deliberately encouraged British manufacturing and the fledgling American government deliberately discouraged foreign competitors.

This is the gist of List's argument, from The Natural System of Political Economy, which he wrote in five weeks in 1837:

The cosmopolitan theorists [List's term for Smith and his ilk] do not question the importance of industrial expansion. They assume, however, that this can be achieved by adopting the policy of free trade and by leaving individuals to pursue their own private interests. They believe that in such circumstances a country will automatically secure the development of those branches of manufacture which are best suited to its own particular situation. They consider that government action to stimulate the establishment of industries does more harm than good....

The lessons of history justify our opposition to the assertion that states reach economic maturity most rapidly if left to their own devices. A study of the origin of various branches of manufacture reveals that industrial growth may often have been due to chance. It may be chance that leads certain individuals to a particular place to foster the expansion of an industry that was once small and insignificant—just as seeds blown by chance by the wind may sometimes grow into big trees. But the growth of industries is a process that may take hundreds of years to complete and one should not ascribe to sheer chance what a nation has achieved through its laws and institutions. In England Edward III created the manufacture of woolen cloth and Elizabeth founded the mercantile marine and foreign trade. In France Colbert was responsible for all that a great power needs to develop its economy. Following these examples every responsible government should strive to remove those obstacles that hinder the progress of civilisation and should stimulate the growth of those economic forces that a nation carries in its bosom.

* Consumers versus producers. The Anglo-American approach assumes that the ultimate measure of a society is its level of consumption. Competition is good, because it kills off producers whose prices are too high. Killing them off is good, because more-efficient suppliers will give the consumer a better deal. Foreign trade is very good, because it means that the most efficient suppliers in the whole world will be able to compete. It doesn't even matter why competitors are willing to sell for less. They may really be more efficient; they may be determined to dump their goods for reasons of their own. In either case the consumer is better off. He has the ton of steel, the cask of wine, or—in today's terms—the car or computer that he might have bought from a domestic manufacturer, plus the money he saved by buying foreign goods.

In the Friedrich List view, this logic leads to false conclusions. In the long run, List argued, a society's well-being and its overall wealth are determined not by what the society can buy but by what it can make. This is the corollary of the familiar argument about foreign aid: Give a man a fish and you feed him for a day. Teach him how to fish and you feed him for his life.

List was not concerned here with the morality of consumption. Instead he was interested in both strategic and material well-being. In strategic terms nations ended up being dependent or independent according to their ability to make things for themselves. Why were Latin Americans, Africans, and Asians subservient to England and France in the nineteenth century? Because they could not make the machines and weapons Europeans could.

In material terms a society's wealth over the long run is greater if that society also controls advanced activities. That is, if you buy the ton of steel or cask of wine at bargain rates this year, you are better off, as a consumer, right away. But over ten years, or fifty, you and your children may be stronger as both consumers and producers if you learn how to make the steel and wine yourself. If you can make steel rather than just being able to buy it, you'll be better able to make machine tools. If you're able to make machine tools, you'll be better able to make engines, robots, airplanes. If you're able to make engines and robots and airplanes, your children and grandchildren will be more likely to make advanced products and earn high incomes in the decades ahead.

The German school argued that emphasizing consumption would eventually be self-defeating. It would bias the system away from wealth creation—and ultimately make it impossible to consume as much. To use a homely analogy: One effect of getting regular exercise is being able to eat more food, just as an effect of steadily rising production is being able to consume more. But if people believe that the reason to get exercise is to permit themselves to eat more, rather than for longer term benefits they will behave in a different way. List's argument was that developing productive power was in itself a reward. "The forces of production are the tree on which wealth grows," List wrote in another book, called The National System of Political Economy.

The tree which bears the fruit is of greater value than the fruit itself.... The prosperity of a nation is not ... greater in the proportion in which it has amassed more wealth (ie, values of exchange), but in the proportion in which it has more developed its powers of production.

* Process versus result. In economics and politics alike the Anglo-American theory emphasizes how the game is played, not who wins or loses. If the rules are fair, then the best candidate will win. If you want better politics or a stronger economy, you should concentrate on reforming the rules by which political and economic struggles are waged. Make sure everyone can vote; make sure everyone can bring new products to market. Whatever people choose under those fair rules will by definition be the best result. Abraham Lincoln or Warren Harding, Shakespeare or Penthouse—in a fair system whatever people choose will be right.

The government's role, according to this outlook, is not to tell people how they should pursue happiness or grow rich. Rather, its role is that of referee—making sure no one cheats or bends the rules of "fair play," whether by voter fraud in the political realm or monopoly in the economic.

In the late twentieth century the clearest practical illustration of this policy has been the U.S. financial market. The government is actively involved—but only to guard the process, not to steer the results. It runs elaborate sting operations to try to prevent corporate officials from trading on inside information. It requires corporations to publish detailed financial reports every quarter, so that all investors will have the same information to work from. It takes companies to court—IBM, AT&T—whenever they seem to be growing too strong and stunting future competitors. It exposes pension-fund managers to punishment if they do not invest their assets where the dividends are greatest.

These are all ways of ensuring that the market will "get prices right," as economists say, so that investments will flow to the best possible uses. Beyond that it is up to the market to decide where the money goes. Short-term loans to cover the budget deficits in Mexico or the United States? Fine. Long-term investments in cold-fusion experimentation? Fine. The market will automatically assign each prospect the right price. If fusion engines really would revolutionize the world, then investors will voluntarily risk their money there.

The German view is more paternalistic. People might not automatically choose the best society or the best use of their money. The state, therefore, must be concerned with both the process and the result. Expressing an Asian variant of the German view, the sociologist Ronald Dore has written that the Japanese—"like all good Confucianists"—believe that "you cannot get a decent, moral society, not even an efficient society, simply out of the mechanisms of the market powered by the motivational fuel of self-interest." So, in different words, said Friedrich List.

* Individuals versus the nation. The Anglo-American view focuses on how individuals fare as consumers and on how the whole world fares as a trading system. But it does not really care about the intermediate levels between one specific human being and all five billion—that is, about communities and nations.

This criticism may seem strange, considering that Adam Smith called his mighty work The Wealth of Nations. It is true that Smith was more of a national-defense enthusiast than most people who now invoke his name. For example, he said that the art of war was the "noblest" of the arts, and he approved various tariffs that would keep defense-related industries strong—which in those days meant sailcloth making. He also said that since defense "is of much more importance than opulence, the act of navigation is, perhaps, the wisest of all the commercial regulations of England." This "act of navigation" was, of course, the blatantly protectionist legislation designed to restrict the shipment of goods going to and from England mostly to English ships.

Still, the assumption behind the Anglo-American model is that if you take care of the individuals, the communities and nations will take care of themselves. Some communities will suffer, as dying industries and inefficient producers go down, but other communities will rise. And as for nations as a whole, outside the narrow field of national defense they are not presumed to have economic interests. There is no general "American" or "British" economic interest beyond the welfare of the individual consumers who happen to live in America or Britain.

The German view is more concerned with the welfare, indeed sovereignty, of people in groups—in communities, in nations. This is its most obvious link with the Asian economic strategies of today. Friedrich List fulminated against the "cosmopolitan theorists," like Adam Smith, who ignored the fact that people lived in nations and that their welfare depended to some degree on how their neighbors fared. In the real world happiness depends on more than how much money you take home. If the people around you are also comfortable (though, ideally, not as comfortable as you), you are happier and safer than if they are desperate. This, in brief, is the case that today's Japanese make against the American economy: American managers and professionals live more opulently than their counterparts in Japan, but they have to guard themselves, physically and morally, against the down-and-out people with whom they share the country.

In the German view, the answer to this predicament is to pay explicit attention to the welfare of the nation. If a consumer has to pay 10 percent more for a product made by his neighbors than for one from overseas, it will be worse for him in the short run. But in the long run, and in the broadest definitions of well-being, he might be better off. As List wrote in The National System of Political Economy

Between each individual and entire humanity, however, stands the NATION, with its special language and literature, with its peculiar origin and history, with its special manners and customs, laws and institutions, with the claims of all these for existence, independence, perfection, and continuance for the future, and with its separate territory; a society which, united by a thousand ties of mind and of interests, combines itself into one independent whole.

Economic policies, in the German view, will be good or bad depending on whether they take into account this national economic interest. Which leads to

* Business as peace versus business as war. By far the most uplifting part of the Anglo-American view is the idea that everyone can prosper at once. Before Adam Smith, the Spanish and Portuguese mercantilists viewed world trade as a kind of battle. What I won, you lost. Adam Smith and David Ricardo demonstrated that you and I could win at the same time. If I bought your wine and you bought my wool, we would both have more of what we wanted, for the same amount of work. The result would be the economist's classic "positive sum" interaction. Your well-being and my well-being added together would be greater than they were before our trade.

The Germans had a more tragic, or "zero sum"-like, conception of how nations dealt with each other. Some won; others lost. Economic power often led to political power, which in turn let one nation tell others what to do. Since the Second World War, American politicians have often said that their trading goal is a "level playing field" for competition around the world. This very image implies a horizontal relationship among nations, in which they all good-naturedly joust as more or less equal rivals. "These horizontal metaphors are fundamentally misleading," the American writer John Audis has written in the magazine In These Times.

Instead of being grouped horizontally on a flat field, nations have always been organized vertically in a hierarchical division of labor. The structure of the world economy more accurately resembles a pyramid or a cone rather than a plane. In the 17th century, the Dutch briefly stood atop the pyramid. Then, after a hundred year transition during which the British and French vied for supremacy, the British emerged in 1815 as the world's leading industrial and financial power, maintaining their place through the end of the century. Then, after about a forty-year transition, the U.S. came out of World War II on top of the pyramid. Now we are in a similar period of transition from which it is likely, after another two decades, that Japan will emerge as the leading industrial power.

The same spirit and logic run through List's arguments. Trade is not just a game. Over the long sweep of history some nations lose independence and control of their destiny if they fall behind in trade. Therefore nations must think about it strategically, not just as a matter of where they can buy the cheapest shirt this week.

In The Natural System of Political Economy, List included a chapter on this theme, "The Dominant Nation." Like many other things written about Britain in the nineteenth century, it makes bittersweet reading for twentieth-century Americans. "England's manufactures are based upon highly efficient political and social institutions, upon powerful machines, upon great capital resources, upon an output larger than that of all other countries, and upon a complete network of internal transport facilities," List said of the England of the 1830s, as many have said of the United States of the 1950s and 1960s.

A nation which makes goods more cheaply than anyone else and possesses immeasurably more capital than anyone else is able to grant its customers more substantial and longer credits than anyone else....By accepting or by excluding the import of their raw materials and other products, England—all powerful as a manufacturing and commercial country—can confer great benefits or inflict great injuries upon nations with relatively backward economies.

This is what England lost when it lost "dominance," and what Japan is gaining now.

* Morality versus power. By now the Anglo-American view has taken on a moral tone that was embryonic when Adam Smith wrote his book. If a country disagrees with the Anglo-American axioms, it doesn't just disagree: it is a "cheater." Japan "cheats" the world trading system by protecting its rice farmers. America "cheats" with its price supports for sugar-beet growers and its various other restrictions on trade. Malaysia "cheated" by requiring foreign investors to take on local partners. And on and on. If the rules of the trading system aren't protected from such cheating, the whole system might collapse and bring back the Great Depression.

In the German view, economics is not a matter of right or wrong, or cheating or playing fair. It is merely a matter of strong or weak. The gods of trade will help those who help themselves. No code of honor will defend the weak, as today's Latin Americans and Africans can attest. If a nation decides to help itself—by protecting its own industries, by discriminating against foreign products—then that is a decision, not a sin.

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James Fallows is a national correspondent for The Atlantic and has written for the magazine since the late 1970s. He has reported extensively from outside the United States and once worked as President Carter's chief speechwriter. His latest book is China Airborne. More

James Fallows is based in Washington as a national correspondent for The Atlantic. He has worked for the magazine for nearly 30 years and in that time has also lived in Seattle, Berkeley, Austin, Tokyo, Kuala Lumpur, Shanghai, and Beijing. He was raised in Redlands, California, received his undergraduate degree in American history and literature from Harvard, and received a graduate degree in economics from Oxford as a Rhodes scholar. In addition to working for The Atlantic, he has spent two years as chief White House speechwriter for Jimmy Carter, two years as the editor of US News & World Report, and six months as a program designer at Microsoft. He is an instrument-rated private pilot. He is also now the chair in U.S. media at the U.S. Studies Centre at the University of Sydney, in Australia.

Fallows has been a finalist for the National Magazine Award five times and has won once; he has also won the American Book Award for nonfiction and a N.Y. Emmy award for the documentary series Doing Business in China. He was the founding chairman of the New America Foundation. His recent books Blind Into Baghdad (2006) and Postcards From Tomorrow Square (2009) are based on his writings for The Atlantic. His latest book is China Airborne. He is married to Deborah Fallows, author of the recent book Dreaming in Chinese. They have two married sons.

Fallows welcomes and frequently quotes from reader mail sent via the "Email" button below. Unless you specify otherwise, we consider any incoming mail available for possible quotation -- but not with the sender's real name unless you explicitly state that it may be used. If you are wondering why Fallows does not use a "Comments" field below his posts, please see previous explanations here and here.
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