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
Wishing Away Reality

WHY bring the Germans into it? Because they had a lasting effect—outside the Anglo-American bloc. With the arrival of Commodore Matthew Perry and his American warships in 1853, the Japanese realized that the Western world had far outstripped them in both commercial and military technology. Throughout the rest of Asia were examples of what happened to countries that were weaker than the Europeans or the Americans: they turned into colonies. Through the rest of the nineteenth century Japan's leaders devoted themselves to modernizing the country, so that it would no longer be vulnerable. During the decades of sustained creativity known as the Meiji era, from 1868 to 1912, Japanese scholars, industrialists, and administrators carefully studied Western theories about how economies grew. In the writings of List and other continental theorists they found a set of prescriptions more persuasive than the laissez-faire teachings of Adam Smith.

The most important part of the German-Asian argument is its near invisibility in the English-speaking world, especially the United States. The problem is not that Americans don't accept the German analysis: in many ways it is flawed. The problem is that they don't know that it exists. For instance, a popular dictionary of economics, edited by American and British economists and published in 1991, has a long explanation of the Laffer curve but no mention of List.

Some "real" economists are not quite so closed-minded. Since at least the early 1980s economists at several American universities have, in essence, rediscovered Friedrich List. (But not at all universities. In 1992 Robert Wade, the author of the influential book Governing the Market, went looking in the MIT library for List's work. Wade previously had been teaching in Korea, and there he had found plenty of copies of List's works in every campus bookstore. But in the catalogue of MIT's vast library system Wade found an entry for just a single volume by List, The National System of Political Economy, in an edition published in 1885. When Wade finally obtained the book, he found that it had last been checked out in 1966.) They have examined more and more failures in the Anglo-American model. They have found more and more evidence that "cheating," in the form of protectionism, can increase a nation's wealth. But very little of this news has trickled down to the realms where economics is usually discussed—newspaper editorials, TV talk shows, and the other forms of punditry that define reasonable and unreasonable ideas. When Americans talk about wealth, poverty, and their nation's place in the world, they often act as if Adam Smith's theories were the only theories still in play.

After the World Bank's meeting in Bangkok in 1991 an editorial writer for The Wall Street Journal proclaimed that "with a few sickly exceptions, such as the decaying Communist holdouts of China and Vietnam, it seems that the ideas of Adam Smith, of Alfred Marshall, of Milton Friedman, have triumphed. We are all capitalists now."

This is true only if we accept the most vulgar and imprecise statement of what being a capitalist means. The economies that have grown most impressively over the past generation—from Germany to Thailand to Korea to Japan all certainly believe in competition. Toyota and Nissan grow strong fighting each other. Daewoo and Hyundai compete on products from cars to computers to washing machines. But it would be very hard to find a businessman or an official in these countries who would say, with a straight face, that these industries grew "automatically" or in a "natural" way.

Two years ago another Wall Street Journal item, this one a review of a book on trade, said,

[The author] puts it well: 'The benefits of unilaterally adopting free trade now are greater than the benefits of multilateral adoption of free trade ten or fifteen years from now.' Ask Hong Kong, which has totally shunned retaliation and not coincidentally has had the highest growth rate in the world over the past three decades.

Yes, indeed—ask Hong Kong. Since the end of the Second World War its policy has generally been laissez-faire. Compared with the rest of Asia, Hong Kong interferes less, plans less, and leaves market forces more on their own. What has been the result? During the 1980s the real earnings of Hong Kong's people rose more slowly than those of the people of Korea, Singapore, Thailand, and Taiwan. It is a busy, bustling entrepot of merchants, especially those handling commerce in and out of China. But as an industrial center it is falling behind its neighbors.

In the mid-1980s David Aikman, a journalist for Time, wrote a book about the "miracle" economies of Asia. The successes of Taiwan and Hong Kong, he wrote, "demonstrate just how faithful, consciously or not, the rulers of these two countries have been to American conceptions of free enterprise."

Despite Hong Kong's lack of regulations, though, and despite the small businesses that abound in Taiwan, to say that either of these places behaves in an "American" way is to drain the term of all meaning. For example, as late as 1987 most imports of steel into Taiwan had to be approved by the nation's big steel maker, China Steel. The United States, too, protects its steel industry, but this is presumably not what the author meant in saying that Taiwan had been "faithful" to American concepts of free enterprise.

"There is a great deal of misinformation abroad about the trade regimes of [Taiwan and Korea], misinformation which is cultivated by the governments to conceal how much real protection there has been," the economist Robert Wade wrote in an exhaustive study that concentrated on Taiwan and rebutted virtually everything in Aikman's book.

East Asian trade regimes are inconsistent in important ways with even a modified version of the standard economist's account of what a good trade regime looks like.... It is amazing and even scandalous that the distinguished academic theorists of trade policy.... have not tried to reconcile these facts about East Asian trade regimes with their core prescriptions [emphasis added]....

Anyone who reads American or British newspapers or listens to political speeches in English could provide other examples. But they're not necessary. The Anglo-American theories have obviously won the battle of ideas—when that battle is carried out in English. The concepts of consumer welfare, comparative advantage, and freest possible trade now seem not like concepts but like natural laws. But these concepts are detached from historical experience.

When We Acted the Way They Do

IN 1991 the economic historian William Lazonick published an intriguing book, Business Organization and the Myth of the Market Economy. It examined the way industrial economies had behaved during the years when they became strongest—England in the eighteenth and nineteenth centuries, the United States in the nineteenth and twentieth centuries, and Japan from the late nineteenth century on.

These countries varied in countless ways, of course. The United Kingdom had a huge empire; the United States had a huge frontier; Japan had the advantage of applying technology the others had invented. Yet these success stories had one common theme, Lazonick showed. None of the countries conformed to today's model of "getting-prices right" and putting the consumer's welfare first. All had to "cheat" somehow to succeed.

Friedrich List had railed on about exactly this point in the 1840s, when England was the only industrial success story to observe. The British were just beginning to preach free-trade theory in earnest. They abolished the famous Corn Laws in 1846, exposing their inefficient domestic farmers to competition from overseas. Yet over the previous 150 years England had strong-armed its way to prosperity by violating every rule of free trade. It would be as if Japan, in the 1990s, finally opened its rice market to competition, in the name of free trade—and then persuaded itself that it had been taking a hands-off approach to industry for the previous 150 years. When England was building its technological lead over the rest of the world, Lazonick said, its leaders did not care just about the process of competition. They were determined to control the result, so that they would have the strongest manufacturers on earth.

British economists began talking about getting prices right only after they succeeded in promoting their own industries by getting prices wrong. Prices were wrong in that cheap competition from the colonies was forbidden. They were wrong in that the Crown subsidized and encouraged investment in factories and a fleet. They were right in that they made British industry strong.

By the time Adam Smith came on the scene, Lazonick said, the British could start lecturing other countries about the folly of tariffs and protection. Why should France (America, Prussia, China...) punish its consumers by denying them access to cheap, well-made English cloth? Yet the British theorists did not ask themselves why their products were so advanced, why "the world the late eighteenth century was so uniquely under British control." The answer would involve nothing like laissez-faire.

The full answer would instead include the might of the British navy, which by driving out the French and Spanish had made it easier for British ships to dominate trade routes. It would involve political measures that prevented the Portuguese and Irish from developing textile industries that could compete with England's. It would include the Navigation Acts, which ensured a British monopoly in a number of the industries the country wanted most to develop. The answer involved land enclosure and a host of other measures that allowed British manufacturers to concentrate more capital than they could otherwise have obtained.

Lazonick summed up this process in a passage that exactly describes the predicament of the United States at the end of the twentieth century.

The nineteenth-century British advocated laissez-faire because, given the advanced economic development that their industries had already achieved, they thought that their firms could withstand open competition from foreigners. [They wanted] to convince other nations that they would be better off if they opened up their markets to British goods....[They] accepted as a natural fact of life Britain's dominant position as the "workshop of the world" [emphasis added]. They did not bother to ask how Britain had attained that position....

But the ultimate critique of nineteenth-century laissez-faire ideology is not that it ignored the role of national power in Britain's past and present. Rather, the ultimate critique is that laissez-faire failed to comprehend Britain's economic future—a future in which, confronted by far more powerful systems of national capitalism, the British economy would enter into a long-run relative decline from which it has yet to recover.

America's economic history follows the same pattern. While American industry was developing, the country had no time for laissez-faire. After it had grown strong, the United States began preaching laissez-faire to the rest of the world—and began to kid itself about its own history, believing its slogans about laissez-faire as the secret of its success.

The "traditional" American support for worldwide free trade is quite a recent phenomenon. It started only at the end of the Second World War. This period dominates the memory of most Americans now alive but does not cover the years of America's most rapid industrial expansion. As the business historian Thomas McCraw, of the Harvard Business School, has pointed out, the United States, which was born in the same year as The Wealth of Nations, never practiced an out-and-out mercantilist policy, as did Spain in the colonial days. But "it did exhibit for 150 years after the Revolution a pronounced tendency toward protectionism, mostly through the device of the tariff."

American schoolchildren now learn that their country had its own version of the Smith-List debate, when Thomas Jefferson and Alexander Hamilton squared off on what kind of economy the new nation should have. During George Washington's first term Hamilton produced his famous "Report on Manufactures," arguing that the country should deliberately encourage industries with tariffs and subsidies in order to compete with the mighty British. Jefferson and others set out a more pastoral, individualistic, yeoman-farmer vision of the country's future. As everyone learns in class, Hamilton lost. He was killed in a duel with Aaron Burr, he is not honored on Mount Rushmore or in the capital, as Jefferson is; he survives mainly through his portrait on the $10 bill. Yet it was a strange sort of defeat, in that for more than a century after Hamilton submitted his report, the United States essentially followed his advice.

In 1810 Albert Gallatin, a successor of Hamilton's as Secretary of the Treasury, said that British manufacturers enjoyed advantages that could keep Americans from ever catching up. A "powerful obstacle" to American industry, he said, was "the vastly superior capital of Great Britain which enables her merchants to give very long term credits, to sell on small profits, and to make occasional sacrifices."

This, of course, is exactly what American manufacturers now say about Japan. Very little has changed in debates about free trade and protectionism in the past 200 years. If the antique language and references to out-of-date industries were removed from Hamilton's report of 1791, it could have been republished in 1991 and would have fit right into the industrial-policy debate. "There is no purpose to which public money can be more beneficially applied, than to the acquisition of a new and useful branch of industry" was the heart of Hamilton's argument—and, similarly, of many modern-day Democratic Party economic plans.

In the years before the American Revolution most leaders in the Colonies supported the concept of British protectionist measures. They were irritated by new taxes and levies in the 1760s and l770s—but they had seen how effective Britain's approach was in developing industries. Through the nineteenth century the proper level of a national tariff was on a par with slavery as a chronically divisive issue. Northerners generally wanted a higher tariff, to protect their industries; farmers and southerners wanted a lower tariff, so that they could buy cheaper imported supplies. Many politicians were unashamed protectionists. "I don't know much about the tariff," Abraham Lincoln said, in what must have been an aw-shucks way. "But I know this much. When we buy manufactured goods abroad we get the goods and the foreigner gets the money. When we buy the manufactured goods at home, we get both the goods and the money." The United States had, just before Lincoln's term, forced the Japanese to accept treaties to "open" the Japanese market. These provided that Japan could impose a tariff of no more than five percent on most imported goods. America's average tariff on all imports was almost 30 percent at the time.

In the 1880s the University of Pennsylvania required that economics lecturers not subscribe to the theory of free trade. A decade later William McKinley was saying that the tariff had been the crux of the nation's wealth: "We lead all nations in agriculture; we lead all nations in mining; we lead all nations in manufacturing. These are the trophies which we bring after twenty-nine years of a protective tariff." The national tariff level on dutiable goods had varied, but it stayed above 30 percent through most of the nineteenth century. When the United States began to preach or practice free trade, after the Second World War, the average duty paid on imports fell from about nine percent in 1945 to about four percent in the late 1970s.

In addition to the tariff, nineteenth-century America went in heavily for industrial planning—occasionally under that name but more often in the name of national defense. The military was the excuse for what we would now call rebuilding infrastructure, picking winners, promoting research, and coordinating industrial growth. As Geoffrey Perret has pointed out in A Country Made by War, many evolutions about which people now say "That was good for the country" occurred only because someone could say at the time "This will be good for the military"—giving the government an excuse to step in.

In the mid-nineteenth century settlers moving west followed maps drawn by Army cartographers, along roads built by Army engineers and guarded by Army forts. At the end of the century the U.S. Navy searched for ways to build bigger, stronger warships and along the way helped foster the world's most advanced steel industry.

Just before Thomas Jefferson took office as President, the U.S. government began an ambitious project to pick winners. England surpassed America in virtually every category of manufacturing, and so, to a lesser degree, did France. Wheels turned and gears spun throughout Europe, but they barely did so in the new United States. In 1798 Congress authorized an extraordinary purchase of muskets from the inventor Eli Whitney, who was at the time struggling and in debt. Congress offered him an unprecedented contract to provide 10,000 muskets within twenty-eight months. This was at a time when the average production rate was one musket per worker per week. Getting the muskets was only part of what Congress accomplished: this was a way to induce, and to finance, a mass-production industry for the United States. Whitney worked round the clock, developed America's first mass-production equipment, and put on a show for the congressmen. He brought a set of disassembled musket locks to Washington and invited congressmen to fit the pieces together themselves—showing that the age of standardized parts had arrived.

"The nascent American arms industry led where the rest of manufacturing followed," Perret concluded. "Far from being left behind by the Industrial Revolution the United States, in a single decade and thanks largely to one man, had suddenly burst into the front rank." America took this step not by waiting for it to occur but by deliberately promoting the desired result.

For most of the next century and a half the U.S. government was less interested in improving the process of competition than in achieving a specific result. It cared less about getting prices right and more about getting ahead. This theme runs through the Agriculture Extension Service, which got information to farmers more rapidly than free-market forces might have; the shipbuilding programs of the late nineteenth century, which stimulated the machine-tool and metal-working industries; aircraft-building contracts; and medical research.

What America actually did while industrializing is not what we tell ourselves about industrialization today. Consumer welfare took second place; promoting production came first. A preference for domestic industries did cost consumers money. A heavy tariff on imported British rails made the expansion of the American railroads in the 1880s costlier than it would otherwise have been. But this protectionist policy coincided with, and arguably contributed to, the emergence of a productive, efficient American steel industry. The United States trying to catch up with Britain behaved more or less like the leaders of Meiji (and postwar) Japan trying to catch up with the United States. Alexander Hamilton, dead and unmourned, won.

Thomas McCraw says that the American pattern was not some strange exception but in fact the norm. The great industrial successes of the past two centuries—America after its Revolution, Germany under Bismarck, Japan after the Second World War—all violated the rules of laissez-faire. Despite the obvious differences among these countries, he says, the underlying economic strategy was very much the same.

Neat Theory, Messy Reality

NEAR the end of his long career the great economist Joseph Schumpeter speculated on what he would do if he were young again. Suppose he woke up as a bright-eyed graduate student in economics rather than a wizened professor. What would he choose to do with his new allotment of years?

Modern economics research followed three main branches: economic theory, statistics, and economic history. By the time Schumpeter wrote, economic theory was clearly the most glamorous of the callings, and statistics seemed the most practical. But, Schumpeter said, he would surely devote his life to studying economic history.

This may seem a boring choice, and if it does, it goes to the heart of how we think about economic life. Since the end of the Second World War, and perhaps since the time of Adam Smith, the glamorous work in economics has been deeply unhistorical. In part this is just a matter of cosmetics. With each passing year since 1945 American economics textbooks have been jammed fuller and fuller of formulas, graphs, mathematical variables, and regression analyses. At the same time, they have lightened the dosage of real examples from the real world. In the mid-1980s researchers surveyed 212 students at the most prestigious American graduate schools of economics, asking them what factors were more or less essential for success as a professional economist. Sixty-five percent of the graduate students said it was very important to be "smart in the sense of being good at problem-solving" in order to succeed as an economist. Only three percent said it was very important to have "a thorough knowledge of the economy."

Modern economics has become exceedingly precise about one kind of problem but less and less interested in another. Anglo-American economists devote much of their effort to "equilibrium studies" and "constrained optimization"—in essence, laboratory experiments involving economics. In a laboratory you can control many variables—the temperature, the amount of lighting or contamination—so as to focus on the single factor you want to understand. In mathematical economics you can "control" many variables by taking them for granted, and then focus on what you want to understand. You assume, as a given, that some people are owners and others are laborers, that Korea has a semiconductor industry and Mali does not, that women earn less than men. Then you calculate, within these constraints, the best possible outcome—what trade policy Mali should pursue, what rate of inheritance tax will make an economy grow fastest.

Within this set of laboratory conditions the tools of economic analysis are very powerful. By getting prices right Mali will make the best use of the resources it has at hand. But the most interesting and important economic questions concern the assumptions and constraints themselves. Why are some countries chronically so poor? Why have others done so much to pull ahead?

Economic analysis can tell you where you can get the best return on an investment this week. It can tell you how a change in tax rates might affect the unemployment rate this year. It can even tell you how a new tariff level is likely to affect the volume of world trade over the course of this decade. But it has a very hard time accounting for the larger rises and falls in world affairs: why it was England and not France that dominated the nineteenth-century world economy; why it was Germany and not Poland that industrialized so rapidly at the end of that century; why Japan caught up in the early twentieth century and again now. Economics is a wonderful tool for analyzing trends and changes once nations have assumed their ranks. But getting prices right is not so good for understanding how they got to those ranks, and why the ranks change.

This would not be a serious failing except that most people believe that getting prices right tells us about the long run as well as the short. Indeed, the long-run evidence suggests that getting prices wrong—that is, violating the rules of Anglo-American economics may be indispensable for nations that are trying to get ahead.

In the late 1980s the economist Alice Amsden wrote a book about the Korean economy called Asia's Next Giant. In that book and subsequent writings she said that Korea's post-Second World War rise had much in common with Japan's industrial miracles and with Germany's industrialization in the nineteenth century. In none of these cases, she said, did the country get prices right, letting investors and consumers freely decide where they would put their money. The real secret, she said, was that unless a country deliberately rigged the markets so as to get prices wrong, it had no hope of catching up in the industrial race.

THE key to capitalistic development, in this view, is finally capital. If you want to build factories, leapfrog your competitors in efficiency, train your people so that they can outproduce others, you need money. If you are a poor nation, you don't have enough money sitting around to begin with; and if you are a rich nation, you are likely to have committed your extra money to pension and benefit programs, as the United States has now. Still, you need the money—for new factories, for research, for distribution networks. How do you get it?

Historically, Amsden concluded, successful nations have gotten extra money by rigging their markets. The goal is to get people to save more of their paychecks, and banks to lend more money for long-term industrial expansion, than normal market forces would allow. To make its people save, a country needs to jack up interest rates; to allow businesses to invest, it needs to keep the rates low. Under Anglo-American theory the country would just let these two forces fight it out until they reached the natural equilibrium. But that is not how successful development has actually occurred, Amsden said.

Industrial expansion depends on savings and investment, but in 'backward' countries especially savings and investment are in conflict over the ideal interest rate, high in one case, low in the other. In Korea and other late-industrializing countries, this conflict has been mediated by the subsidy.... Thus, the government established multiple prices for loans, only one of which could possibly have been "right" according to the law of supply and demand. Moreover, the most critical price—that for long-term credit—was wildly 'wrong' in a capital-scarce country, its real price, due to inflation, being negative.

That is, in order for Korea to get enough money into the hands of its industries, it needed to bend the rules. The crucial thing about this undertaking, Amsden emphasized, is that it was not some Korean quirk. Every country that has caught up with others has had to do so by rigging its rules: extracting extra money from its people and steering the money into industrialists' hands.

Today's Americans and Britons may not like this new system, which makes their economic life more challenging and confusing than it would otherwise be. They are not obliged to try to imitate its structure, which in many ways fits the social circumstances of East Asia better than those of the modern United States or Britain. But the English-speaking world should stop ignoring the existence of this system—and stop pretending that it doesn't work.

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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.

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