HISTORY OF THE WORLD ECONOMY

1- Introduction and overview

What is economic growth?
- A rise in output over time
- Economic growth is measured through a change in GDP per person (GDP per
capita)
What is GDP? Value of all final goods and services produced by an economy in a
given time (year, quarter, etc.) Limitations of GDP: only markets activities, includes
bads, does not adjust pollution, inequality. It is an underestimated measure for living
standards, misleading→ alternative - Human Development Index- However, in
practice, GDP growth still a decent guide to changes in standards of living.
Why does economic growth matter? Higher living standards?

Is growth sustainable?
- Problem 1: running out of natural resources. Possible solutions: substitution with
other alternatives, be more efficient with the resources we have, recycling. The
role of markets and public policy is critical to manage resources.
- Problem 2: environmental degradation and climate change. Substitution,
efficiency and public policy are key. Environmental Kunetz Curve - Inverted U
shape relationship between level of development and amount of pollution.
Is growth desirable, a good thing?
- Relationship happiness-gdp – higher gdp less happiness.
- A zero growth world – some say if we put less importance into economic growth
we will have more leisure, we will be less materialistic and competitive and
therefore more happy. Problems: option for rich countries only + creates negative
externalities for poor countries, it is an existing option for individuals but no one is
doing it.

Is economic growth common? Present in developed countries and newly industrialised

countries, starts properly in year 1800, from 1870 per head great at 2.5% per year in today’s
rich countries.
- World income today is unequal.
Modern growth began with the industrial revolution in england in 18th century (cotton textiles,
steam engine), spread to wester Europe and US mid 19th century then to southern and
eastern Europe, later to asia.
1700-1870→ Time period witnessed radical and historically momentous changes. In 1700
four features characterized Europe
- high mortality and fertility
- modest educational attainment
- dominance of physical over human capital
- low rates of economic growth
By 1870, significant change in most of Europe - Birth of the modern world: American and
French Revolutions, Demographic Transition, and Industrial Revolution

Great divergence between Europe and the rest of the world:

- Western European GDP p.c. twice East Asian level by 1820

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 - By 1870, Western Europe nearly 4 times East Asian level and Western Offshoots
even further ahead
- By 1950, Western Europe around 7 times better off than East Asia, and the Western
Offshoots nearly 14 times better off
Gap has narrowed considerably since 1978, particularly as China and India began to grow
rapidly

Conclusions:
- Pre industrial growth was very solw (o,25% per year) and often not sustained.
- Modern economic growth started in 1800, it is much higher (2% per year and
sustained)
- This measures are averaged, does not mean living standars rise for everyone.
- New industries emerged and old ones disappeared.

Article Arguments

Maddison, A. Advances in population and income have been sustained by three

(2001): The World interactive processes:
economy: A - Settlement of relatively empty areas which had fertile land,
millennial
new biological resources, or a potential to accommodate
perspective.
transfers of population, crops and livestock
- international trade and capital movements
- technological and institutional innovation

2- The Industrial Revolution

Origins of global economic development:
Began in Europe around 1800, starts in Britain.
Spreads quickly to Western Europe, and then to Southern and Eastern Europe.
Kuznets (1974) defined modern economic growth as having six characteristics:
1. High rates of growth of GDP per capita and population
2. High rate of total factor productivity (efficiency and technology)
3. Transformation from agriculture to industry and services, and from personal
enterprise to large-scale firms
4. Structural and ideological change, including urbanisation and secularisation
5. Opening up of international communications
6. Divergence in living standards between “developed” and “under-developed” nations

- End 19th century in Western Europe was 4 times more developed than Africa, by 200
Western Europe was 10 times richer than Africa, Africa grew at a much slower pace.
This differential economic growth leads to divergence in living standards.
- Also, free time has been increasing over the past 100 years, this means that people
consume more goods and services.
- Structural transformation→ urbanization rates increased in the 19th century.
- Spread of information→ the telegraph was key in the flow of information in the 19th
century.

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Life before the instigation of modern economic growth:
Prior to industrialisation, the world was trapped in low or stagnant growth - stagnation largely
caused by Malthusian trap (there was some economic growth, Smithian growth, due to
commercial activity rather than technological development).

What explains the stagnation of income per capita over time? → Thomas Robert Malthus -
population increased at exponential rate, while the available amount of food supply only
increases at a linear level, this leads to constant living standards over time.
He made assumptions in his model (Malthusian model): Agriculture is characterized by
diminishing returns so any temporary gains in income will be reverted by population growth
(increase in income, more food, will increase fertility and decrease mortality, population
expansion pushes incomes back down), no sustained increase in living standards.
Good and bad for economic growth according to Malthus→

Neo-Malthusians→ 1870 to 1920. Agreed on population growth

being main cause of poverty,. Poverty is consequence of high birth
rates of bottom half. Hence, should restrict birth rates among the
poor.

There was some economic growth in the past→ Smithian growth:

Trade and division of labour allow for expanding output - people
become experts at one part of production process + trade allows for specialisation, trade
allowed from the expansion of markets, so people could specialize on one thing and get the
rest from the market.

Interaction between Malthusian and Smithian growth→ Black death is a big shock in Europe,
It initially caused higher wages which led to higher demand for non-agricultural products,
causing city growth. City growth causes an increase in commercialization and trade, and
thus economic growth.

Today - The Industrial Revolution

Malthusian model broken by industrial revolution- there has been a raise in living standards.
WHy did the Industrial Revolution happen in europe?
- Explanation 1: Political fragmentation in Europe causes frequent wars, this motivates
rulers to develop strong states, strong states are pre-requisites for growth.
- Explanation 2: Small domestic markets motivates European states to look for larger
markets. Foreign markets allow larger industrial production. Trade requires good
institutions (legal protection, enforcing contracts, etc). Colonies bring new resources.
- Explanation 3: Because of the increase in goods imported from other countries,
people worked harder to obtain higher income and be able to buy these goods.
- Explanation 4: european marriage pattern - Marriage behaviour limits population
growth, and thus causes economic growth + later marriage allowed more time for
education for women.
Why England in particular?
Industrial Revolution begins in England in the 1770s
Development of certain technologies: Cotton textiles (first), smelting and steam engine
(later). Use of mechanical energy instead of human energy - Rise of factory system.

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 - Explanation 1: US has much better institutions and property rights. UK establishes
and enforces property rights Strong government and property rights reduces interest
rates. This makes it less costly to invest and innovate, causing economic growth.
England 17th century insecure property rights and weak rule of law: Selling of titles,
forced loans, Royal Prerogative → Parliament rebels against the crown, English Civil
War and the Glorious Revolution (1688) – parliament wins. Secure property rights
and rule of law (North and Weingast, 1989).
- Explanation 2: Culture, Knowledge and Technology (Mokyr). Rise of enlightened,
rational, “Scientific Man” in England. Ecosystem: coffee houses, libraries, learned
societies. Supply of skilled artisans. Geniuses: Roger Bacon, Isaac Newton.
Aplication of scientific methods to day-to-day work, thus causing innovation, thus
economic growth. Facilitated by spread of literacy.
Problem with this argument: in 19th century , the practical application of science to
work was low back then, it was more important in the 2nd revolution.
- Explanation 3: Geography (Bob Allen) - New source of energy: coal. Allowed people
to escape earlier constraints of energy based on wood and muscle power (humans
and animals).
But why did England started using coal first?
Britain was innovating because it was profitable (Allen, 2011) - Coal was cheap and plentiful
and labour was expensive so it made sense to use coal, and save on labour costs.
It was profitable to British firms to use labour-saving machines (replacing labor and using
coal). It didn’t make profit sense elsewhere in Europe (or China) to use labour-saving
machines.
Wages in the UK were high, due to the great intensity of trade before the industrial
revolution, relative to energy costs.
Problems with this argument→ “theoretically defensible” but “oversold” (Craft, 2011). If we
take Allen’s profitability calculations seriously: US, not the UK should have invented the
Spinning Jenny. The Jenny would have been profitable for a century before it was actually
invented.

No single explanation is perfectly convincible. UK had the best overall package of

institutions, geography, culture for growth. It was thus the first country to industrialize.

Conclusions:
● Before the Industrial Revolution, the world was in a Malthusian trap (low or stagnant
growth)
● There was some growth before, but largely caused by trade
● Modern economic growth began with the Industrial Revolution in England
● Institutions, culture, and coal all played an important role
● The Industrial Revolution and spread of economic growth to Europe largely shapes
today’s distribution of income

Allen, B. (2011): Article discusses the importance of economic incentives as a cause of

“Why the Industrial the industrial revolution. Focuses on the sources of invention and
Revolution was analyses these in terms of the demand and supply of new technology.
British: Commerce, International comparison of wages and prices→ british wages were very
induced innovation, high and the prices of capital and energy were low→ this affected:

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and the scientific - the demand for technology, gave business incentive to invent
revolution”, technology that substituted capital and energy for labor +
Economic History incentivated product innovation to satisfy a larger luxury market
Review, 64, - the supply for technology augmented because of the high
357-384. wages, population could buy more education resulting in higher
rates of literacy which contributed to innovation.
- the supply of technology also affected by the culture of
Newtonian science in Britain
Article suggests that the industrial revolution was mainly a story about
research and development (R&D) (perspiration).

Crafts, N. (2011): Robert Allen (2009a) vs Joel Mokyr (2009) on why Britain was first in
“Explaining the first industrial rev.
Industrial Revolution: Allen: the new technologies were invented in Britain because they were
Two views” profitable there but not elsewhere
Mokyr sees the Enlightenment as highly significant and underestimated
by previous scholars.

3- The Building Blocks of Economic Growth

Proximate causes of economic growth:
- Human capital→ health and education of workers who operate machines to produce
output, positive correlation between level of education and gdp per worker.
How to increase human capital (increase output per worker)? Building more schools,
subsidizing education, building hospitals, subsidizing health.
- Physical capital→ structures and machines firms use to produce capital - all structure
and all equipment in a given society. By stimulating physical capital economic growth
increases.
How to increase physical capital? Increasing investment through domestic savings
rate (saving in consumption), import investment () and increase foreign debt.
- Total factor productivity (TFP) → how efficient you are in using the capital available to
produce, the most important factor of economic growth. Efficiency lies on how good
you are in using inputs to produce output
How to increase TFP?
Innovation: develop new technologies, research at universities, R&D in firms. In
developing countries imitating and copying technologies makes more sense, they
buy technology from elsewhere to increase TFP, foreign direct investment and
importing technology is key.
Efficiency: use your existing level of capital and technology in a smarter and better
way, by having better managers, increasing trade (exposing your countries economy
to external competition to make firms within the country to increase their efficiency
levels), increase domestic market competition.

What causes growth?

There are limits in how much you can grow in terms of human and physical capital.
Ultimately physical capital runs into diminishing returns. Investment share can only increase
to a certain extent until other parts of the economy are compromised. Relying on foreign
investment also has limits, backlash in the form of an unhappy population as the most
productive assets they have are owned by foreigners and give benefits to foreigners.

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 TFP is key to long-run growth - inventing more technology is unlimited and keeps
contributing to economic growth.
3 sources of economic growth→ by influencing these causes you give incentives to firms to
change the proximate causes of economic growth:
- Institutions: rule of law, corruption (the more regulations and limits the government's
places on something the more likelihood there is for corruption). Institutions are the
rules of the game which impact the behaviour of individuals and organizations, formal
rules such as laws and regulations. Provide incentives to individuals to participate in
certain activities like get education, etc.
Bad institutions (extractive institutions) are those that use the goods from the whole
for the benefit of a few, these institutions do not promote economic growth as they
are insecure property rights. Ex: dictatorships, limited markets.
Inclusive institutions are designed to benefit the majority of the population, the are
characterized by secure property rights, democracy and free markets.
The french revolution changed institutions: the ancien regime was a system of
corporate privileges, it overthrew the monarchy and was a major social and political
event which led to the rise of secular ideas and individual rights, fostered democratic
progress and the rule of law.
- Culture: Culture are norms of behaviour and informal rules that shapes the
populations behaviour towards work, education, investment and innovation. Shapes
behaviour without being unaware. Max Weber argued that rich societies are
protestant societies because the role of the clergy is less important and this
stimulates literacy and income was a sign of success in protestantism. In populations
with a higher degree of jew population, there is a higher income as jews have a
higher degree of education and literacy, this increases human capital.
- Geography: impacts the disease environment and the agriculture suitability, some
zones less suitable for certain crops and technologies to grow crops (at equator
many crops cannot grow), market access (distance to large markets matters as being
close to powerful economies gives access to markets, markets access can explain
variations in income across countries, being close to rich neighbours is good for
economic growth)

Geography + institutions→ europeans settle in attractive regiond and extract from

unattractive regions, good institutions arise in attractive regions and bad institutions in
un-attractive regions.

Conclusions
● Economic growth is caused by investment into education and health, new structures
and equipment, and technology and efficiency
● Institutions, geography and culture shape the incentives of individuals to invest into
their education and health, and the incentives of firms to invest into new machines
and technology
● Institutions and culture can be “improved”
● Geography can be improved as well – “elimination” of effective distance to markets
through new technologies (infrastructure, internet)

North, D. and Efficient economic organization is the key to growth: an efficient

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Thomas, R. (1973): economic organization in Wester Europe accounts for the rise of the
The rise of the West → establishment of institutional arrangements and property rights
Western world: A that create an incentive to channel individual economic effort into
new economic activities that bring the private rate of return coles to the social rate of
history. return.
True economic growth implies that total income of society must increase
faster than population.
An increase in the efficiency on the part of one or more factors of
productivity (land, labor, capital) will result in growth. Increase of
productivity can come about because of:
- economies of scale because of improvements in factors of
productivity
- reduction of market imperfections (uncertainty and information
costs)
- organizational changes that reduce market imperfectios
Growth will not occur unless existing organization is efficient and
individual have incentives to undertake socially desirable activities (if
private costs > private benefits people will not undertake activity even if
it is socially profitable).

Acemoglu, D. and Theories that don’t work:

Robinson, J. (2012): - Geography hyposthesis→ the great divide between rich and poor
Why Nations Fail. countries is created by geographical differences. History
illustrates that there is no simple or enduring connection between
climate or geography and economic success. Inequality in the
modern world largely results from the uneven dissemination and
adoption of technologies, and Diamond’s thesis does include
important arguments about this
- Culture hypothesis→ Protestant Reformation and the Protestant
ethic it spurred played a key role in facilitating the rise of modern
industrial society in Western Europe. The culture hypothesis no
longer relies solely on religion, but stresses other types of beliefs,
values, and ethics as well. Other aspects, such as the extent to
which people trust each other or are able to cooperate, are
important but they are mostly an outcome of institutions, not an
independent cause.
- The Ignorance hypothesis→ world inequality exists because we
or our rulers do not know how to make poor countries rich.
To understand world inequality we have to understand why some
societies are organized in very inefficient and socially undesirable ways.
Difference between the poor and rich:
a. extractive vs. inclusive economic institutions
b. engines of prosperity - inlcusive economic institutions create
inclusive markets (give people freedom to pursue the vocations
in life that best suit their talents but also provide a level playing
field that gives them the opportunity to do so), technology and
education (increase productivity).
c. extractive vs. inclusive political institutions

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4- The first globalization
The first globalization period (1870-1914)
Globalization→ international integration of markets, goods, services and ideas. One
measure of globalization is the “law of one price”, as market integration stimulates price
convergence. It creates economic losers and winners.

The first globalization period→ Unprecedented growth in trade, migration, and capital flows.
Migration flows large even by present-day standard.
- Trade: only in1980 the world was as globalized in trade as in 1900, there was a trade
backlash during the interwar period. Now we are more globalized in trade than in the
first globalization period. DIstributional and political consequences.
- Capital, net capital flows as % of global GDP: Only in the 2000s the flows in term of
capital reached the level there was from 1870-1913.
- Labour: now the levels of immigrants as a percentage of the US population are lower
than it was in 1900, so nowadays the world is less globalized in terms of immigration,
this might be due to the restrictions in traveling.

How trade is related to globalization

Why does Trade matter?
- Increases specialization- smithian growth: the larger market you have the more you
can specialize and increase human capital, and thus efficiency and economic growth.
- Bigger market size allows economies of scale
- Higher competition (domestic + international competition, firms have to increase the
level of economic efficiency) and economic efficiency
- Easier diffusion of technology, import equipment easier and at lower price, implies an
increase in the level of technology

Why did trade increase?

- Reduced transportation and transaction costs due to a set of new technologies:
Steam boats (shorter travel times), railways, canals, refrigeration (conserve goods),
telegraph (improve communication).
- Policies pursued in this period: there was peace (1870-1914) which stimulated trade
policies (lower tariffs). Countries such as UK advocated for free trade, rest of Europe:
more protectionist countries than others, US: protectionist.
- Creation of The Gold Standard.

Distributional consequences of trade

Trade driven by comparative advantage (Heckscher-Ohlin model)
Comparative advantage depends on factor endowments (land, labour, capital): When
economies become more open to trade, they should specialise in producing that which uses
their abundant factors and not produce goods that use scarce factors of production.
- Europe→ labour abundant, land scarce = wages low and rents high.
When europe opened to trade→ export of manufactured goods (used the labour very
intensively) and people (emmigration); and imported grain. Result: wages increased
and rents fell.
- America→ opposite situation, opposite outcome.

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Historical case - The Grain Invasion: Grain from US, Canada floods European markets
making cheap grain available→ Impact on food prices, living costs, real wages. Some
parties delighted, others concerned:
- In the case of european labour: 19th Century socialists were pro-free trade , Free
trade led to cheaper bread, Benefited the working classes.
- land owners: Demand protection for the price of their output, land owners have
political importance in many european economies so the Grain Invasion led to
agricultural tariffs in many european countries.

Capital flows and globalization

The Gold Standard
Facilitated globalization, under it a country commits to convert its currency into gold at a
fixed parity, if the two countries are on the gold standard, the exchange rate between their
currencies is essentially fixed.
It promoted price stability, good for investment and trade. Reduced transaction costs and
eliminated exchange-rate risk
”Good housekeeping seal of approval” for investment, this means that countries following the
gold standard were following some rules and policies which were approved by investors.
International investment increased with the introduction of the gold standard, during the war
periods it decrease and it reached the same intensity as before in the 1980s. By the
beggining of WW1 the majority of countries had joined the gold standard.
How did the Gold Standard work? → countries required to maintain the fixed exchange rate.
Balance of payments (BoP) position critical, this measures net value of economic
transactions of a country with the rest of the world.The system ensured an automatic
stabilization of currency and BoP position.

Price-specie-flow mechanism example:

- Balance of Payments DEFICIT (more imports than outputs) is compensated by a
gold OUTFLOW (pay in terms of gold for this deficit), as gold is flowing out of the the
Money supply FALLS which means that there is less money available to pursue the
same amount of goods and services, therefore domestically produced product prices
FALL so imports FALL & exports RISE. Balance of Payments return to
EQUILIBRIUM.
- Balance of Payments SURPLUS → Gold INFLOW→ Money supply RISES→
Domestically produced product prices RISE→ Imports RISE & Exports FALL =
Balance of Payments return to EQUILIBRIUM
Un-competitive economies deflate their economies (austerity) // Competitive economies
inflate their economies (stimulus).

“The Rules of the Game”

The Central Bank can reinforce adjustment by changing the interest rate for credit.
- Balance of Payments DEFICIT → Central Bank INCREASES interest rates→
Investment FALLS→ Output FALLS→ Domestically produced product prices FALL→
Imports FALL & Exports RISE→ Balance of Payments return to EQUILIBRIUM

Distributional consequences of Gold Standard

- The system was intrinsically deflationary (austerity measures) → Cut employment
and wages in recessions to maintain capital flows

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 - Negative impact on labour → Low pressure to maintain full employment when
workers disenfranchised

Labour and globalization

Migration of europeans to US, Canada, Australia, New Zealand, Latin America (Argentina,
Uruguay, Southern Brazil). From 1820 to 1880 the migation to the US was mainly northern
and central europe immigrants (german and english), from 1880 to 1930 from eastern
europe.
People migrate→ for higher future earnings and personal reasons.
Not emigrate→ cost of migrating (transport), opportunity cost of leaving country.
Wage driven migration model→ The poorest countries in the world are not characterized by
emigration, as countries become richer they experience higher emigration (have money to
travel and have better education), the richer the country less incentive to migrate as the
conditions are good to stay.
The macroeconomic consequences of migration
- Wages of local workers goes down or down go up as they would if there was no
inmigration
- Wages of foreign workers goes up
- Stimulates income convergence between countries
Political consequences of migration
- US: Chinese Exclusion Act (1882)
- US: literacy test in 1917, national origins quotas in 1921
- Inequality matters: greater income inequality, more restrictive immigration policy

Conclusions
● Transport costs fell a lot over the 19th century, tariff barriers fell (not everywhere)
● International and domestic markets integrated; price gaps narrowed
● Mass migration from Europe to the Americas/Australasia
● Wage convergence
● Globalization created substantial winners→ Europeans eat more, better, cheaper
grains and meat + Migrants earn higher wages than at home. But it also created
losers→ Owners of previously scarce resources in both areas: landowners in Europe,
low-skill workers in the US. Did this lead to deglobalization, revolution, or war?

Topic 4: Did globalisation plant the seeds of its own destruction?

Williamson, J. 2 important features of the world economy of late 19th cent and after 1970
(1998):”Globali - Earlier period of rapid globalization: commodity trade boomed as
zation, labor transport costs dropped.
markets and
- Second, impressive convergence in living standards this stopped
policy backlash
in the past” between 1914 and 1950 because of de-globalization and implosion into
autarchy.
Factor prices converged in the Atlantic economy up to 1914. Where unskilled
wages rise relative to farm rents and skilled wages, inequality falls; where
unskilled wages fall relative to farm rents and skilled wages, inequality rises.
There was a de-globalization implosion after 1914, coinciding with two world
wars, two periods of fragile peace, a great depression and a cold war.

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 Liberal attitudes towards trade were brief, and that protection rose sharply
almost everywhere on the European continent from the 1870s onwards.
Retreat from free trade was manifested by protection of domestic agriculture
from the negative price shocks associated with globalization.
A spreading technology revolution and a transportation breakthrough led first
to a divergence of real wages and living standards between countries. The
evolution of well-functioning global markets in goods and labor eventually
brought about a convergence between nations. This factor price convergence
planted, however, seeds for its own destruction since it created rising
inequality in labor-scarce economies (like the United States) and falling
inequality in labor-abundant economies (like those around the poor Euro- pean
periphery). Interest groups generated a political backlash against immigration
and trade.

Bordo, M. and Interest rates charged on long-term bonds in core capital markets during the
Rockoff, H. era of the classical gold standard differed substantially from country to country,
(1996): “The and these differences were correlated with a country’s long-term commitment
Gold Standard to the gold standard
as the ́good Adhering to the gold standard implied a far more complex set of institutions
housekeeping and economic policies
seal of Countries who adhered (generally):
approval ́” - Lower fiscal deficits
- More stable money growth
- Lower inflation rates
But had to pay the price of giving up flexibility to react to adverse supply
shocks by following expansionary financial policy and altering the exchange
rate + not adhering may compromise long term growth.

5- The globalization backlash, WWI and interwar period

Globalization Backlash: WWI and its economics
Historical background before WWI: Early 20th century→ Globalization period, Second
Industrial Revolution (electricity, chemistry, heavy industries), Spread of Industrialization,
Gold Standard: Stable financial environment, Liberal economic order = Belle Époque.
Start of WWI:
- 14 June: Assassination of Fransic Ferdinand by Gabrilo Princip in Sarajevo.
- 23 July: Ultimatum asking Serbia to condemn the “dangerous propaganda” against
Austria-Hungary
- Declarations of war
- 28 July: Austria-Hungary declares war on Serbia
- 1-3 August: Germany declares war on Russia and France
- 4 August: Britain declares war on Germany

Deeper causes of WWI: Increasing competition among European powers (imperialism were
searching for markets and competing for them), increasing domestic disaffection (rise of
socialism and nationalism, due to the rise of socialism countries were eager to enter war to
mitigate socialist ideas, demotivate the working classes from the ideas of brotherhood
amongst working classes from different countries), unawareness of modern nature of war.

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Idea of war→ that it would be short, soon proved false by trench warfare. The role of states
grew during war: resource reallocation towards war production, capital investment to expand
industrial capacity, price and wage controls, cartelization.

Money and finance during wwi→ Suspension of the Gold Standard (countries pay for imports
by liquidating foreign assets) - How do you finance the war? through taxation (increase of
income taxes, however taxation financed less than ⅓ of war expenses), issuing debt to
private agents and money creation (central banks purchase government debt and pay by
issuing banknotes, this led to hyperinflation).

The 1920s: Hyperinflation

What is it? A very high and accelerating increase in prices, erodes the real value of money-
1922-1924: Dramatic inflation rates in Austria, Hungary and Germany.

Relative prices guide consumer and producer decisions so a change in the price level is
merely a change in the units of measurement, Why is inflation a problem? → Relative price
distortions (causes microeconomic inefficiency in allocation of resources), Increased
uncertainty (complicates financial planning)
One benefits of inflation→ nominal wages are rarely reduced, inflation allows real wages to
fall without nominal wage cuts, so moderate inflation may improve the functioning of labour
markets, and absorb recessionary shocks better.

Distributional consequences of inflation

- Inflation erodes real value of debt; debtors benefit (nominal wage increases and
nominal level of debt is the same, easier to repay), creditors lose
- Inflation erodes real value of taxes; tax payers gain, tax collectors lose

Hyperinflation difficult to stop:

budget deficit → increase in the money supply → more money chasing
the same amounts of goods→ increase in prices - loops restarts.

What caused the budget deficit in Germany? War debt and reparations
paid by Germany, allies could pay war debts only if they got money
from Germany. UK and France: connect debt with reparations, USA:
do not suffocate German economy. Reparations imposed in treaty of
Versailles (6% of GDP of germany).

Hyperinflation in Germany ended abruptly, why? → Rational expectations view by Sargent -

If workers expect higher inflation, they will demand higher wages, this will increase firm’s
costs, and they will charge higher prices, high inflationary expectations cause high inflation.
Inflationary expectations are fueled by government policies, people see money creation, and
thus demand higher wages, causing an inflationary spiral. Ending inflation requires a big
change in the fiscal and monetary policy regime → monetary and fiscal reforms in central
Europe:
- Creation of independent central bank, can’t lend money to government
- Change in fiscal regime: commitment to low government deficit
- Austria and Hungary: League of Nations loan and conditionality

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 End of hyperinflation - Effects→ monetary economy almost destroyed, savings and debts
wiped out. Balanced budgets and fiscal discipline→ commitment to economic orthodoxy.

The 1920: Reconstruction of the Gold Standard

Countries rebuild the Gold Standard after WWI and hyperinflation but economic conditions
were dramatically different compared to pre-1914 → economic consequences of WWI
- countries involved in war: displacement of agriculture, excess capacity in heavy
industry, unemployment and social unrest, trade disintegration.
- neutral countries: augmented productive capacity to supply countries that were at
war, rise of tariffs to protect new industries.
- money and finance: France and Germany became debtor countries, UK ceases to be
a financial superpower, US emerges as the main creditor country.

The return to the Gold Standard

New currencies and new gold parities introduced→ Most European economies return to
Gold: UK (1925), Italy (1927), France (1929)
Countries return to Gold at different parities→ UK: returned to gold standard at pre-war gold
parities (currency overvalued), France: introduced new gold parities (currency devalued in
terms of gold). So there was a currency misalignment: UK’s currency is overvalued, and
economy is un-competitive, France’s currency is undervalued, and economy is competitive,
balance of payments surplus.
Interwar gold standard→ Not only the economic landscape has changed, but political
landscape too (democracy became more important, rise of socialist parties), countries less
likely to accept austerity measures so the gold standard system became more unstable.

Conclusions
● WW1 led to important monetary and financial disruptions
● Postwar period: hyperinflation in Central Europe
● Hyperinflation caused by budget deficits due to WWI, and resolved by drastic
monetary and fiscal reforms
● Monetary reconstruction in the mid-1920s led to the re-emergence of the
international gold standard
● All of these factors directly impacted the Great Depression, and policy-responses to it

Topic 5: Why did fixed exchange rates in the international economy work better in the period
before 1914 than afterwards?
Eichengreen, B. The imperatives of war finance shattered the prewar fiscal system,
(1996): Golden inaugurating a debate over taxes and public spending that plagued
Fetters: The Gold governments and societies throughout interwar years. International
Standard and the finance was modified with the wholesale liquidation of foreign assets and
Great Depression, accumulation of foreign liabilities. International trade was redirected from
1919-1939 other continents to Europe and not vice versa. Domestic politics were
restructured by the rise of labor, extension of franchise and reform of the
electoral system.

Returning to gold wouldn’t be easy

London had occupied a special position in the operation of the prewar
system, it was the leader in the financial services and had served as an

13
 attractive repository for foreign funds.
The war undermined the basis for these relationships and reinforced New
York’s challenge to London. It transformed the United States from a
debtor to a creditor nation and American banks became serious
competitors internationally in international finance. The creation of the
Federal Reserve System lent new flexibility to the American financial
system.
The disruptions suffered by France or Germany had been greater still
Russia was to withdraw from the international financial community and
the prospects of Paris and Berlin were obscured by the reparation
questions. The postwar reconstruction would be costly, leading to large
and persistent government budget deficits with uncertain implications.
These uncertainties heightened the importance of credibility for the
operation of the reconstructed gold standard system, when domestic
markets were disturbed, governments could not afford to let investors
doubt that the steps required to defend convertibility would be taken with
dispatch. More than ever, credibility hinged on international collaboration
between governments and banks.

6- The Great Depression (1929-1933): The Real Economy and Monetary Policy
Great depression→ collapse of output, prices, trade, employment. Global average of
production fell by 40% by 1932. Only after 3 year the world’s production started to increase
again.
The fall in prices and the fall in output were highly correlated.
The recovery from the great depression didn’t start after 35 months (approx 3 years).

What caused the great depression→ start of the Great Depression usually associated with
the stock market crash of 1929 - WRONG. The stock market crash gave an impulse to the
start of the great depression, but it cannot explain why it started.

Background to the 1929 crash

The Roaring 1920s→ high economic growth, new managerial practices (mass production,
assembly lines) and new technologies (cars), change in culture (jazz, new art forms).
Increase in the number of retail investors (individual investors), firms relied on issuing equity
to finance their activity.
Irving Fisher→ microeconomic theories on utility and quantity theory of money. Stock market
prices reached a permanently high plateau - he was wrong→ stock market prices fell by a
factor of 4 during the next three years, stock market prices needed 20 years to recover the
level they had reached in 1929.
Causes of the 1929 crash:
- Investors anticipated the Great Depression?
- Fear of a trade war (Smoot-Hawley tariff)? → no obvious answer
- A change in earnings of firms?
- An increase in interest rates by the FED?
Stock market bubble - when prices do not reflect fundamentals, investors buy stocks only
because other investors are buying them.

14
Were the fundamentals strong during the 1920? → improved management techniques,
emergence of large firms, economies of scale, new technologies. Fundamentals were
stronger than previously, so this could explain why stock prices increased.

Consequences of the stock market crash

- wealth effect→ the crash destroyed the wealth and saving of many individuals
(investors), they had lower income and therefore consumption decreased.
- stockholders were usually rich people, so
- decreased consumer confidence, people became more careful of their purchases
and decreased their level of consumption, this impulsed the Great Depression as it
initiated a fall of the level of demand
- increased uncertainty, increase in stock market volatility made people uncertain
about the future which lead to postponement of consumption

Deflation and monetary policy

Deflation = a fall in the level of prices. Deflation and Great Depression are intrinsically linked.
Why is deflation a problem?
- it leads to lower consumer demand- if people expect lower price they will postpone
purchase (they will wait for prices to lower even more),
- Real wages - If nominal wages are rigid, deflation causes higher real wages and this
causes lower labour demand, output, and employment
- Real interest rates increase→ = Nominal interest rate – inflation. Deflation causes
higher real interest rates, lower investment and output. Increasing the cost of making
a loan, so investment is more costly and hence cause a fall in the level of output.
- Effective lower bound- Nominal interest rates cannot fall much below zero, with
deflation real interest rates are positive
- Debt inflation- increases real value of debt. Debtors might become insolvent and
default, become bankrupt and therefore the unemployment rate increases, etc.

What caused deflation?

- Milton Friedman→ the lower the level of money supply in the economy, the lower the
prices are going to be. Central banks influence the money supply - US central bank
made many mistakes, the stock of money supply decreased by 30%. Less money
chasing the same quantity of goods, so prices fall.
Money supply (determined by the monetary base, the amount of notes; and bank
deposits) fell not because the monetary base fell but because deposits collapsed.
Bank deposits collapsed because of banking crises, many banks collapsed, the US
FED must have helped banks by lending them money to prevent them from
collapsing.
- Barry Eichengreen→ deflation caused by the Gold Standard, the US FED was
constrained by the Gold Standard. The Gold Standard was not compatible with large
expansions of the monetary supply. If money supply is larger than gold reserves:p
ublic will doubt the ability of central banks to maintain convertibility. The Gold
Standard will collapse. Central banks were forced to keep money supply tight –
“Golden Fetters”.

15
 With the Gold Standard: deflationary shock is transmitted to other economies, the
Balance of payments under pressure, puts pressure on the currency, countries
cannot pursue inflatory policies because the BoP would collapse.
- Keynesian view→ Declining population in the West caused by emmigration
restrictions, this caused savings to stay high and investment to decrease. This
caused long term unemployment and weak recovery. Weak demand weakened the
level of prices.
Banks trapped in liquidity trap as no one was demanding credit, the central banks
could not do much. It was the roles of the government to invest, this would increase
the level of demand.
- Protectionism→ at the same time as trade, unemployment, etc was falling the Smoot
Hawley Tariff was introduced, which doubled tariffs and caused retaliation by other
countries and caused a trade war.

The economic recovery

Leaving the Gold Standard→ If it’s the problem, leave it! 1931: UK, Denmark, Finland,
Norway, Sweden, Portugal and Japan left. 1933: USA and Germany left. 1935/6: Others
Countries which left Gold Standard earlier recovered faster, they could increase money
supply, save banks and boost investment and consumption.

Conclusions
The 1929-33 period was marked by: A global depression, protectionism, a global monetary
contraction and deflation.
The Gold Standard put constraints on monetary policy - explains monetary contraction and
deflation.
Leaving the Gold Standard allowed countries to expand money supply, and stimulate the
economy.

Topic 6: What caused the Great Depression?

Atack, J. (1994): Aggregate Demand-Based Explanations.
“The Great Keynesian formulation of the identity between aggregate supply (GNP) and
Depression: aggregate demand, where aggregate demand is the sum of consumption
expenditures (C), investment expenditures (I), net exports (X-M) and
Explaining the
government purchases (G):
contraction”. Possible sources of change in aggregate demand:
- Consumption→ During the 1920s labour productivity grew rapidly as a
result of technological advances and managerial improvements, this
increase was not fully reflected in rising real wages. As a result, the
ability to produce goods outstripped the means to buy them, and a
fundamental readjustment of this new reality was eventually required.
These changes in the distribution of income favored those who saved
over those who consumed. Consumption thus failed to keep pace with
production and the marginal propensity to consume may have fallen
- Gross private domestic investment→ changes in investment are of
such magnitude that they can plausibly explain the entire change in
aggregate demand between 1929 and 1933. Change in investment
spending can be traced to variations in construction activity. In the
mid-twenties, the housing industry had boomed. 1924-27 8% of GNP
and half of gross private domestic investment. 1929 residential

16
 construction was less than half its mid-decade peak.
- Net exports→ 1928 net exports declined because of the rapid growth
of imports brought about by the boom conditions and domestic
industry’s inability to satisfy demand + renewed spirit of economic
nationalism
- Government expenditure→ ederal government policy changed from
being countercyclical —whether by accident or design— to
pro-cyclical. This ultimately played a role in converting what was by
then a most severe depression into the Great Depression.
Monetarist explanations for the Great Depression.
1. Milton Friedman and Anna Schwartz: blames the Federal reserve for not
doing enough to ease the liquidity crisis among the nation’s banks. Bank
failures play a pivotal role, failure of one bank had a domino effect, spreading
“contagion of fear”.
2. Followers of Hayek: also blames the FEd, but instead of being blamed for
doing too little, it is criticized for intervienen and thus interrupting the
economy’s readjustment to a new equilibrium.

Eichengreen, B. The gold standard itself was the principal threat to financial stability and
(1996): Golden economic prosperity between the World Wars I and II. The gold standard, I
Fetters: The Gold argue, must be analyzed as a political as well as an economic system. The
stability of the prewar gold standard was attributable to a particular
Standard and the
constellation of political as well as economic forces. Similarly, the instability of
Great the interwar gold standard is explicable in terms of political as well as
Depression, economic changes. Politics enters at two levels. First, domestic political
1919-1939. pressures influence governments' choice of international economic policies.
Oxford University Second, domestic political pressures influence the credibility of governments'
Press. Chapter 1 commitment to policies and hence their economic effects. Credibility and
“Introduction”. cooperation were central to the smooth operation of the classical gold
standard. The scope for both declined abruptly with the intervention of World
War I. The instability of the interwar gold standard was the inevitable result.
Cause GD→ The war greatly strengthened the balance‐of‐ payments position
of the United States and weakened that of other nations. In the mid‐1920s,
the external accounts of other countries remained tenuously balanced
courtesy of long‐term capital outflows from the United States. But if U.S.
lending was interrupted, the underlying weakness of other countries' external
positions suddenly would be revealed. As they lost gold and foreign exchange
reserves, the convertibility of their currencies into gold would be threatened.
Their central banks would be forced to restrict domestic credit, their fiscal
authorities to compress public spending, even if doing so threatened to plunge
their economies into recession. The minor shift in American policy had such
dramatic effects because of the foreign reaction it provoked through its
interaction with existing imbalances in the pattern of international settlements
and with the gold standard constraints.

7- The great depression: banking and financial crisis

Bank failures during the 1930s, more than 2 thousand banks failed in the US in 1933.
Bankfailure is self fulfilling, banks never have enough deposits to honour liabilities.
Money supply made up of currency + deposits, deposits make up for the most part of M1.
The amount of money supply in the 1930 decreased as the amount of bank deposits fell.
1930s characterized by having a high propability for a financial crisis to occur.

17
Chronology concerning the bank crisis→ the highest amount of bank failures occurred in
1931, 1932 and 1933. The collapse of the Bank of the US created a lot of insecurity.

Financial system
Composed of the institutions in the economy that facilitate the flow of funds from savers
(typically households) to borrowers (typically firms and government). An economy with a
highly developed financial system will be characterized by high investment and high
efficiency. Stimulates formation of human and physical capital and of total factor productivity.
Components of the financial system:
- Financial markets - Where firms and households directly provide funds to each other
(stock markets, bond markets, etc)
- Financial intermediaries - Where firms and households indirectly provide funds to
each other (banks, insurance companies, etc). financial intermediaries are more
costly than financial markets.
Why do we need intermediaries?
- Problem of asymmetric information, when one party in a transaction has more
information about it then the another - banks help mitigate the problem of asymmetric
information→ Screen borrowers for adverse hidden attributes that savers might not
detect, restrict how loan proceeds are spent by monitoring the borrowers, particularly
important for borrowing by small businesses and households.
- Maturity transformation, financial intermediaries convert liabilities that have different
maturities into assets. Bank deposits transformed into loans.The problem is that
deposits are short-term and loans are long-term (deposits can be withdrawn at any
time, loans are repaid in the long term).
Why are bank failures important?
- Reduce level of wealth in the economy
- Decrease the money supply
- (Bernanke) Increase the cost of credit intermediation (destroy important information
in the economy). 1st observation: there is repeated interaction between bank and
borrower, both get to know each other well and increase knowledge about each other
- the problem is that banks can’t easily change borrowers overnight nor can
borrowers easily change banks overnight and getting information to make a loan is
costly. So contraction in money supply is not just a monetary phenomenon, bank
failures destroy valuable information about the economy, takes time to create this
information.

The risk faced by banks

- Liquidity risk→ mismatch between assets and liabilities it holds
Why did so many banks fail in the great depression?
- Illiquidity→ Many banks were solvent, but they didn’t have enough cash to honor
deposit withdrawals. FED should have provided emergency liquidity. Central banks
should have been a Lender of Last Resort.
- Illiquidity does not only affect only one bank, it creates CONTAGION. Banks lend to
each other, if a bank has collapsed it can damage other banks that have made loans
with them + reduces confidence in other banks in general which will lead to further
withdrawal in other banks of the financial system→ more risk of iliquidity.

18
Consequences of bank failures
- As banks face risk of illiquidity they engage in FIRE SALES, their assets get sold. To
replace their shrinking reserves, and stave off illiquidity, even solvent banks must sell
assets. This causes steep price declines.
- Solvent banks become reluctant to lend to new borrowers because they do not have
info about them. Households and firms find it harder to get funding, this is a CREDIT
CRUNCH.
- Recession to depression - With less credit available, consumer and business
spending declines, reducing aggregate demand. Output falls, unemployment rises.
What started as a recession in 1929, turned into a
Great Depression in 1930/1931.
- A vicious circle→ The recession reduces profits,
asset values, and household incomes. This increases
defaults, bankruptcies, and stress on financial
institutions. The financial system’s problems and the
economy’s downturn reinforce each other.

1931 financial crisis

1931 when the recession in the US became a global crisis because there was a sudden stop
in capital flows, from 1924-1929 Boom in international lending and capital flows →
1929-1931 Decline in capital inflows (sudden stop) creatend massive pressure on the
balance of payment positions that these countries encountered.
- The Austrian crisis - may 1931: A banking panic triggered by the failure of one large
bank, the Creditanstalt → Currency collapses
- The Hungarian crisis - Hungarian economy dependent on agricultural exports, and
severely hit by the decline in raw material prices, May 1931: Banking panic and a
collapse in currency
- The German crisis - Germany much larger economy than Austria and Hungary, 13
July 1931: Darmstädter und Nationalbank fails, triggers a run on banks and a
currency crisis (fall in Reichsbank’s gold and foreign exchange reserves).
Policy response to the 1931 crisis
Capital controls→ Tight restrictions on all foreign exchange payments to prevent further
capital outflows (tax a british firm that operates in germany when they send money back to
uk). De facto abandonment of the gold standard.

Why do worst things come in pairs: banking and currency crisis?

Causes of currency crises
1. Speculative currency attacks result from excessive monetary/fiscal expansion
2. Expectations can be self-fulfilling
3. Speculative attacks occur together with banking crises - twin crises, mutually
reinforce each other
Banking Crisis→ Currency Crisis - If central bank responds to banking panic by providing
money to banks. This is incompatible with maintenance of fixed exchange rates.
Currency Crisis→ Banking Crisis - If bank debts are denominated in foreign currency (banks
borrow in different currency, if domestic value falls the debt becomes more expensive), a
depreciation in the domestic currency weakens the banks.

19
Recovery from the Great Depression
- Main argument - Exit from the Gold Standard – Eichengreen (1992) and Romer
(1992) → The exchange rate is no longer the constraint on policy, allowed central
banks to boost money supply, decrease interest rates, and stimulate the economy,
central banks could lend freely to banks to save them.
- Recovery also brought about by fiscal expansion→ “New Deal” in the US, increase in
gov exp. matched by increase in taxes - controversial, but positively impacted
expectations about the economy (Eggertson, 2008). Debt-financed fiscal expansion
in Japan. Nazi fiscal stimulus for WWII - controversial.
- Recovery influenced by legislative measures→ Glass-Steagall Act of 1933-
Separation between commercial and investment banking. Federal deposit insurance,
even if bank fails the gov honours the debt. Boosted confidence in the banking
system.

Conclusion
● The recession of 1929/1930 turned into a Great Depression lasting until 1933
because of bank failures and financial crises
● Bank failures are catastrophic for the economy
● The 1931 financial crisis was a global crisis where banking and currency problems
were closely intertwined, magnifying each other
● The recovery was mostly led by monetary expansion, fiscal expansion was mostly
not tried
Topic 7: Why did the banking crises increase the severity of the Great Depression?

8- Growth in Europe since 1945

The ”Golden Age” of economic growth in Europe (c. 1950-1970)
Subsequent deindustrialization (c. 1970s+)
Economic growth around the world:
- 1950-1970 fastest economic growth trades globally
- not in Africa, it only reached 2.07% growth, during the war period it had higher growth
as it was neutral
- Latin America→ higher economic growth than global average growth in interwar
period and during WW2, however during 1973-88 lower growth than average, from
1800 to 1820 was their best moment.
- Asia→ from 1973-98 theyr economic growth was much larger than the average, 1,33
vs. 3,54
- Socialist europe→ 1973-98 negative growth
- Western europe→ 1950-73 much larger growth than average, 2,93 vs 4,08
Divergence in world development but convergence in western europe.

EXPLAINING THE GOLDEN AGE

How was growth achieved?
- Part of if is due to catch-up growth, a poor economy has a large potential for growth
by copying the rich economy. Catch up growth in europe, Spain, Italy and Germany
poor in 1950, high economic growth in 1970, the poorest european countries grew
more due to the catch up potential.
- TFP→ strong convergence in labour productivity. Proximate causes of labor
productivity growth - Growth accounting relates growth of output to: growth of inputs

20
 (TFI = total factor inputs) and growth of efficiency with which inputs are used (total
factor productivity). TFI growth divided between capital, education and other inputs -
Capital most important source of TFI growth. TFP growth divided between catch-up,
foreign trade, structural and other - “other” or unexplained most important source of
TFP growth.
- Capital accumulation

The fundamental causes of economic growth

1. Postwar reconstruction: A large scope for recovering lost ground by repairing WWII
damage, A large technological atraso induced by the Great Depression
2. Structural modernization: A large transfer of population from agriculture to modern
industry and services, increasing productivity
3. New international institutions decrease tariffs, and increase trade: GATT
(predecessor of WTO) stimulates international trade, EU stimulates intra-European
trade and capital flows.
4. Keynesian demand management, and increased role of government: countercyclical
fiscal policy to avoid recessions, government provision of services can increase the
returns to private investment but taxation can reduce incentives.
5. Technology transfers: lower barriers to trade and investment , US firms invest
abroad, common market makes Europe more suited to mass production, allows
economies of scale & specialization, increasing efficiency.
6. Domestic institutions: Social Contract - An implicit, economy-wide deal between
labour and capital: workers agree to wage moderation→ profits channelled to
investment→ investment strategy encourages productivity growth, (moderated) wage
increases► virtuous circle.

Avoiding the 1930s

- After the second world war european policymakers avoided those policies in place
during the Interwar: return to gold standard, high tariffs, traty of versailles, no
countercyclical economic policies.
- So postwar policies:
- Bretton Woods - Economic integration
- GATT - Keynesian demand
- Marshall Plan management

The case of success: Germany

There was Rapid growth, early 1950s-1960s due to social contract & industrial relations,
effective vocational education, market friendly policies and European integration.
Case of relative failure; UK
They had less scope for catch-up, Keynesian macro management at expense of supply side
reform. Low investment, especially in education. Poor industrial relations, inappropriate
industrial policy.

Why did the Golden Age end?

- Scope for catch-up growth declined - unavoidable
- Stagflation & oil price shocks: policy responses
- Distributional conflict & breakdown of social contract: 1930s fade from memory

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 DEINDUSTRIALISATION
% of world manufacturing exports decline,
In most european countries share of workforce in manufacturing sector declined from 1970.
Manufacturing as proportion of GDP (current prices) has fallen since mid-1950s.
Manufacturing as proportion of GDP (constant prices) has fallen since early 1970s. But total
industrial production is rising, it is just a smaller share.
Is the relative fall of industry a problem?
Possibly causes unemployment
Possibly increases regional inequality - If industry is highly spatially concentrated
Might harm economic growth - If labor shifts from high productivity industry to low
productivity services (e.g. from factories to restaurants)
Explaining deindustrialization
1. Increase of international competition (e.g. China)
2. Relative price changes -- Prices of manufactured goods have fallen relative to those
of services, largely because of faster technology gains in manufacturing.
3. Engel’s Law→ As income rises, the proportion spent on food declines. In this case,
as income rises, the proportion spent on manufactured goods declines, people tend
to spend more on services as they get richer. Largely implies that deindustrialization
is inevitable as countries get richer.

Conclusions
- The period c. 1950-1970 saw unprecedently high growth rates everywhere in the
world, but especially in Europe
- This was largely stimulated by: Recovery from Great Depression and WWII, New
international and domestic institutions
- Since c. 1970, most European countries started de-industrializing- This doesn’t mean
that manufacturing output is falling per se, but rather that GDP is growing faster than
industrial output

Topic 8: What caused the Golden Age of economic growth in Europe?

Golden age period of rapid economic growth started after theWW2, 1945 to 1973. This great
economic growth was possible thanks to
1. the catch up growth;because of the gap between poor countries and rich contrives (easy
for poor countries to copy rich countries due to liberalization)
2. TFP: advances in technology allowed to increase production and efficiency
3. Capital accumulation: more production increased money which was used in investment
and improvement
The Causes of the Golden Age of Economic Growth
1. Technological transfers and Structural modernisation: poorer countries adaptive
technologies from richer countries taking advantage of the new international openness.
Technology is helped to increase labour efficiency and industry and service sectors gain
importance. Thus, workers were needed in factories and cities and many people see
their opportunity and decided to leave the agricultural world.
2. Post war reconstruction: The war left damages to repair giving job opportunities in the
construction sector. But destruction was not only material. WWII also brought an
opportunity to reinvent the economic system. The Bretton Woods system replaced the

22
 Gold standard. It was a system much more flexible since it was based in the dollar
instead of gold.
3. Investment: to finance reconstruction and new technologies investment was needed, but
most countries were devastated after the war and it was difficult to find any other country
to lend them money. New forms of finding capital for investment were needed.
3.1. Wage moderation: Workers accept to reduce their salaries so the business uses the
money to invest in the company. At the end wages might increase.
3.2. Growth of exports and trade: Countries facilitate trade (free trade, openness of
barrier) in order to be able to import those goods difficult for them to produce and
concentrate on exploiting their competitive advantages.

How to ensure those compromises? → Institutions

- Domestic institutions (unions, employers associations, state): they shared information
with the workers so they could control what the firm was doing with the money. This way
they ensured that the firm was investing the money and not giving it as dividends. These
associations also set bonds to promote the acceptance of the treaty among firms.
(Example: limiting the payment of dividends by public companies)
- International institutions (European coal and steel community (ECSC), European
Payments Union (EPU)): their mission was to enforce the commitments and help to
coordinate the countries actions to improve trade.

Reasons why the economic golden age ended

1. Selfish interests born inside institutions: special interest groups gain leverage over the
operation of institutions and turn them to their selfish ends.
2. End of catch up: poor countries started to get to the level of rich countries and copying
was not still possible. They had to invent which is more costly and difficult.
3. Capital mobility: International capital mobility now gave management the option of
investing abroad rather than at home. Domestic workers no longer assured that way
wage moderation would translate subsequently into higher productivity and labour
incomes had less incentive to be moderate.
4. Oil shocks: oil prices increase and firms have to pay for it, having less money to invest.
5. Breakdown of Bretton Woods: speculations brought a devaluation of the dollar and
capital value was strongly reduced. This allowed recessions to emerge and investment
lost its appeal.

9- The Rise and Fall of Socialism

Economic growth in socialist europe→ easter europe growth trends higher than average
1913-1973, after this negative growth. However, since 1928 when central planning was
established, until 1970 the soviet union experienced really high economic growth. Golden
age of socialist economies, mostly URSS, very high economic growth.
Russia's economic growth→ GDP per capita increased enormously from 1930 to 1980,
during the postwar period the economic growth slowed down and by the late 1970 the
relative economic performance of Russia reached a peak (in comparison to the western
countries, ratio russia/wester europe russia reached a 65%). After 1980 there was a fall of
40% in the GDP compared to the wester countries, this was due to the change in social
institutions and informal institutions, people did not know what structure of power was set.

23
From 1952-1970 the socialists economies were not as developed as capitalist societies, and
their rate of development was really low. These countries did not exploit their potential as
much as the Soviet Union or Yugoslavia. 1979.89 fell further behind the income levels of
their neighboring capitalist countries

Background on the Soviet Union

a. Tsarist Russia
19th century Russia: very backward economy, high illiteracy, there was some
industrialization.
1861 – onset of modernisation:
- Emancipation of servants
- Improvement of banking system
- Foreign Direct Investment arrives
- Government led-industrialisation
Marked imperial russia→ role of state was very important in increasing industrialization -
construction of railways, army…
b. World War I
Very devastating→ west front was in Russia.
People starved, to keep towns happy, the government imposed maximum prices. But:
peasants chose not to sell, leading to hungry towns. Consequence→ The Russian
Revolution of 1917.
War disrupted transport system
c. War comunism
After October 1917 revolution, comunism total control of economy.
All foreign debt repudiated, Firms nationalised, Land redistributed to peasants, Grain
requisitioned to fight civil war. During this period state intervention was very high in all
countries, in Russia it was taken to the extreme.
By 1921, Russian economy was in ruins→ rapid inflation, Material shortages, Famine
(1921/22) & mass starvation. Loss of urban support for Bolshevik party.
d. New Economic Policy interwar
In March 1921, NEP introduced - greater role for markets but 75% of industrial production
remained state owned. Small & medium firms were denationalised. Peasants allowed to sell
some output at market prices. International trade was encouraged. Market-socialist
system→ strong recovery of the economy, industry and agriculture reached pre war levels.
e. The end of NEP
This system created many tensions. NEP created affluent, landowning peasants - this led to
inequality. NEP created capitalist merchants. Use of the market reduced party power.
Change in political leadership to Stalin.

The Soviet development debate

Nikolai Bukharin→ State should support agriculture. Richer peasants will increase demand
for consumer goods, leading to industrialization.
Yevgeni Preobrazhensky → State should support industry. Extract income from peasants, to
fund rapid industrialization. Stalin took both ideas and stablished central planning.

Central planning, 1928-1991

1928 saw beginning of the Soviet communist system that lasted until 1991, with a series of
Five Year Plan→ Total re-nationalization, strict price controls, role of markets is very small.

24
 - The state plans and controls the economy
- Output targets replaced profits as objective of firms. State decides who gets
resources, investment, what kind of income, and at what prices.
Plans emphasised→ Investment over consumption, factories over housing and
infrastructure, industrial goods over consumer goods, heavy industry over light industry.
Main characteristics of central planning - hierarchical structure of authority
Soft budget constraint, if firms were reaching their trargets, the cost was not that important.
Massive resource mobilization – e.g. collectivization. Rationing of goods and price controls.
Did this system work?
As the economy grew, absolute consumption levels grew too, even though consumption was
sacrificed.

After WW2
Soviet Union – like all economies – recovered well after the war
Soviet Union appeared to do well in the 1950s, with growth averaging 5.8%
As a less developed country, Soviet Union had large catch-up potential
Why was economic growth rapid?
- Economic growth was ”extensive” ( human capital was more important) - Based on
rapid investment growth into heavy industries (but also human capital), stimulated by
restricting wages, and releasing funds for investment, stimulated by very low cost of
capital. Investment grew from 15% to 30%.
- Structural change - Very rapid transfer of labor, Stimulated by shifting prices against
agriculture, and incentivizing farmers to move to factories. Large catch-up potential -
by copying technologies from the US.

Economic growth started to slow down in a more dramatic way than western countries. Why
did economic growth decrease?
Unavoidable → Decrease in scope for catch-up. Elimination of surplus labor in agriculture.
Return on investment eventually started declining.
Avoidable→ Soft budget constraint – firms bailed out if bankrupt, causing inefficiency. Price
mechanism highly distorted (von Mises, Hayek) - causing resource misallocation. Poor
incentives to work because of guaranteed employment. Poor incentives to innovate because
of emphasize on output targets (quantity rather than quality of goods). - Actually, labor
efficiency was good, so the issue was capital efficiency, capital efficiency in the soviet union
since the introduction of central planning was dramatically decreasing (soft budget
constraint, investment policy, innovation wee causes to capital inefficiency).

What about inequality under socialism? Inequality under socialism was very low, lower than
france of united states.

Economic growth in Yugoslavia

Socialism typically associated with central planning
But Yugoslavia developed a decentralized system – market socialism: Republics main
political players, much greater role for markets and prices, devolution of power to
labor-managed firms - workers themselves were organized in work organizations and they
managed firms and made decisions.

25
Economic performance in Yugoslavia→ increase in GDP per capita from 1952 to 1980s, but
during 1980s growth decreased. Very rapid growth until the late 1970s, by any benchmark.
Then the country entered a deep crisis during the 1980s (financial crisis, austerity measures,
etc).
Sources of growth
- Total factor productivity
- Capital markets
- Investment policies
- Labour market policies
Problems already start in 1965 with labor efficiency (”labor wedge”). Largely related to
devolution of power to labor-managed firms in 1965. These firms maximized income per
worker- They were boosting wages above productivity, creating inefficiency, they were
restricting new labor entry, causing unemployment.

TOPIC 9. WAS THE Features of the Socialist System: USSR→ main exponent of socialism in
ECONOMIC the Cold War period. Gur Ofer points out, characterized by the state
FAILURE OF ownership of the means of production and the central planning of production
SOCIALIST and distribution. Objective -develop an autarkical system able catch up
ECONOMIES rapidly with the Wes. Prioritize short-term goals and look for a quick growth
INEVITABLE? without taking sustainability into account→ supposed to be achieved by
accumulation of capital and labor driven by huge investments on the
industrial sector, provide massive employment. Agriculture collectivized and
expected to pay heavy taxes to finance industrialization.
Rapid Growth: analysis, causes and consequences: 30s-40s, outstanding
growth rate. During this period, investment rose hugely, consumption
increased by ¼. GDP per capita rose by 4 times between 1920 and 1980,
but how did they do it?
- Allocation of producer goods: huge investments in industrialization,
mainly in producer goods. Industries demand more input, they
create machinery to use it in the creation of more. This generates
employment, boosts consumption, and demand for goods demands
also more production. Growth based on generating more
employmentdrives economic growth.
- Output targets and soft budgets: industry was organized into trusts
and directed to maximize profits. Soft budgets, firms were given
output targets as incentives and the banks gave credits to finance
them.
- Collectivization of agriculture: agriculture was supposed to pay the
heavy industrialization process. Caused impoverishment of the rural
population. Allen - this not contributed directly to economic growth,
but impoverishment led to migration to cities and helped
industrialization.
Causes of growth decline and economic failure
- Technological failure: Bergson-socialism provides inadequate
incentives to promote technological progress. Managers rewarded
meeting output targets (little incentive to innovate) + during

26
 Brezhnev arms race with USA, resources and machinery relocated
to military industry.
- Diminishing returns on capital: Weitzman - Elasticity of substitution
between labor and capital was low. A rise in investment rate caused
a rapid growth in the 30s and the 40s as surplus labor was put into
work, but later when structural unemployment was eliminated growth
slowed down as capital ran into diminishing returns. As the economy
accumulated capital, it reached a point where capital accumulation
failed to generate growth.
- Investment policy: Allen - 30s and 40s, the policy was adequate
because there was a high surplus in labor, but when unemployment
was eliminated, it required new policies that never took place.
- Investment shifted from the construction of new manufacturing
facilities to the modernization of the old ones, returns of it were very
low because those facilities weren’t as productive as new ones could
have been. Oil fields and mining districts depleted due to the
short-term goals we talked about before, redirected investment to
the extraction of resources in Siberia, which was much more costly.
- Failure to incentivize the provision of labour: Kukic - diminishing TFP
or returns on capital were important, but the main driver of socialist
economic failure in Yugoslavia was the lack of incentives to provide
labor. Workers were not incentivized to work and to give their
maximum because they earned almost a fixed salary and it was
difficult for them to be dismissed.

10. Inequality
Facts:
What happened from the Roman Empire to today?
Inequality has followed cycles since the 7000 bc. Falls in inequality come with major shocks
to the society and economy. Inequality fell after the 1930 and has started to rise again and
reach levels similar to before the great depression since 1980s. Inequality has not grown as
much in southern europe countries as in anglosaxon countries. There are interwar shocks,
after WW1 and WW2. In emerging economies, since the 80s there has been a tremendous
increase in inequality. In russia associated with the transition to capitalism in the 90s, similar
inequality case to the US.

Indicator of inequality - proportion of income that is captured by the top 1% of income

earners. Income share by bottom 50%, there is no data on the bottom 1% of income
earners, has been dropping since the 1980s in a linear manner. In the US in 2015 13% of
the income was capture by the bottom 50% and 20% of the income by the top 1%. In
Western Europe the top 1% income earners earned 13% of the income while the bottom
50% earn 22% of the income.
Income inequality is not wealth inequality (what you have, stock of assets someone has).
Inequality in terms of wealth is similar to income inequality, difference→ beginning of 20th
century the US had lower levels of inequality than Europe (land of opportunities back then),
but now the US is more unequal.

27
Wealth inequality amongst the top 1% is driving the increase in inequality (top 0,1% hold
10% of the household wealth in the US).

Measuring inequality
Relative factor incomes:
- Skilled/unskilled labour (skill premium)
- Capital/labour ratio
- Income and wealth shares: top 10% / 1% / .01%
- Gini coefficients
These measures capture different aspects of inequality and are not necessarily correlated
Inequality data sources:
- Household budget surveys
- Most used methods to calculate income inequality = Tax records (income tax)
- Population and GDP statistics, done when a country is unable to tax their population
(developing countries)

Inequality as something good

● Signal of successful individuals and companies
● Might motivate people to work harder (“keeping up with the Jones”)
● Richer individuals have a greater marginal propensity to save and invest
Inequality as something bad
● Inequality is tightly related to social mobility→ income and wealth inequality are
related to social mobility, the more unequal the country the higher the probability that
you will be in the same income bracket as your parents. Affected by inherited wealth
as a fraction of total wealth, in the US in 2010 60% of the wealth of people was that
that they had inherited
● Might handicap human capital acquisition
● Can be politically toxic

Causes of inequality: the kuznets curve

Inequality tends to follow an inverted U shape relationship.
- Pre-industrial societies: mainly subsistence, thin crust of
elites - inequality low.
- Industrial Revolution: rising incomes mainly to owners of capital (richest people),
inequality rises.
- Post Industrial Revolution: rising incomes for labour (everybody), inequality falls.
Supported by actions of the state.
Increase in inequality in the last 20 years caused by capital owners. Labour share is still high
but during the last 20 years the capital share has increased.
For the bottom 90% of the society, capital income does not matter, they earn their income
through labour. But 0,1% top of the society is driven by capital.

Causes of inequality:
- Skill-biased technical change → Technical change raised the demand for skilled
labour. Skill-biased technology increases inequality by raising wages of skilled
workers more than wages of unskilled (ICT revolution).

28
 - Migration → can increase the relative supply of skilled or unskilled labour, large
unskilled migration into the United States. Relative supply shifts affect relative wages
(of skilled and unskilled), all else equal.
- Trade→ More exposure to trade affects the demand for domestically produced
goods, will affect demand for labour (skilled or unskilled) as a consequence, hence
their wages. Rise of Asian exporters, offshore services.
- Institutions→ Tax Policy, minimum wages, welfare payments and benefits, unions
and employer organizations, wage setting arrangements.
The Great Compression (1930-1980)
World Wars and Great Depression led to decimation of top capital incomes and decline in
inequality. Wartime concerns with fairness called for heavier taxation of the rich
(=capital-owners), and decrease in inequality → introduction of progressive taxation,
inheritance taxation critical for wealth inequality.
Policies and institutions leading to decline in inequality were direct result of war exigencies -
wartime measures such as heavier progressive taxation, rent, controls, restrictions on capital
mobility remained in place. War mobilization promoted labour unionization, etc. The Soviet
bloc also acted as a constraint on policy in capitalist countries.

The recent increase of inequality, 1980+

Much higher increase of inequality in the US than Europe.
- US ideological reversal: stagnant minimum wage, rising elitism in education, reduced
tax progressivity, etc.
- Europe kept welfare state: retained quality public education, extensive social transfer
system

Causes of Inequality: Piketty, Capital in 21st century

A more technical elaboration of Marx’s view that inequality would always rise
Rate of return on capital (r) is almost always greater than economic growth (g)
- Over time inequality increases, because r > g, and because capital income is highly
concentrated among the richest
- This is a natural process interrupted by disasters

Global inequality
Has global inequality been increasing or decreasing over time? Global inequality trends:
Nature of global inequality has shifted<
- In 1820, global inequality was mostly caused by within country inequality - ‘class’
inequality.
- Today most inequality is caused
by between country income
differences - ‘location’
inequality. Today what truly
matters in global inequality is
what country you are born into,
the nature of global inequality
has shifted from within country
inequality to between country
inequality. Makes a Marxist
revolution difficult.

29
 Conclusions
- During the 20th century, inequality has dramatically decreased between 1930-1980,
and rebounded since
- But, there are very important differences between countries. This suggests that
institutions and policy matter a great deal
- Global inequality has levelled off since about 1980, attributed to rise of East Asia
(China)
- Changes in growth and internal inequality in rich societies an important part of this
development

Topic 10: Does inequality rise with economic growth?

Bourguignon, F. and From 1820 to the eve of WorldWarI, inequal- ity rose almost
Morrisson, C. (2002): continuously. The Gini coeffi- cient went from 0.50 to 0.61, and the Theil
“Inequality among index from 0.52 to 0.79. The increase in in- equality decelerated
World Citizens: somewhat between the wars and slowed even more after 1950. By
1820-1992”, then, however, the world Gini coefficient had reached 0.64, a level of
inequality unknown in most contemporary societies (even today's more
in-egalitarian countries have Gini coefficients less than 0.60). Roughly
speaking, world inequality peaked in the middle of the 20th century after
more than a century of continuous divergence. Changes during the last
50 years look minor compared with that dramatic evolution,and the
situation appears to be stabilizing.
The apparent stabilization of world income distribution since 1950
reflects a relative slowing of economic growth among European
countries and their offshoots, a catching up by Japanand East Asia,
and the take-off of China beginning in the 1980's.
In the long run, however, the increase in inequality across countries was
the leading factor in the evolu- tion of the world distribution of income.

Atkinson, A., Piketty, T. Most countries experienced a sharp drop in top income shares in the
and Saez, E. (2011): first half of the twentieth century concentrated around World Wars or
“Top incomes in the Great Depression. In some countries however, those stayed
long-run of history”, outside World War II, the fall is more gradual during the period. 1st
part of the century, top percentile incomes were overwhelmingly
composed of capital income. Top income shares fall because of a
reduction in top wealth concentration. Upper income groups below
the top percentile, comprised primarily of labor income, fall much
less.

Further declines postwar decades followed by increases in recent

decades. U-shape varies dramatically across coun- tries. Western
English speaking countries + China and India, there was a
substantial increase in top income shares in recent decades, with
the United States leading the way both in terms of timing and
magnitude of the increase. Southern European countries and
Nordic countries in Europe also experience an increase in top
percentile shares although less in magnitude than in English
speaking countries. In contrast, Continental European countries
(France, Germany, Netherlands, Switzerland) and Japan experience a
very flat U-shape with either no or modest increases in top income
shares in recent decades.

30
 The increase in top income shares in recent decades has been
quite concentrated with most of the gains accruing to the top
percentile, sig- nificant portion of gains due to increase in top labor
incomes, and especially wages and salaries. As a result, the
fraction of labor income in the top percentile is much higher today in
most countries than earlier in the twentieth century.

T.11- Rise of the Global Periphery: China and East Asia

East Asian Tigers→ Beggining
1950, Asian income levels below Africa
Completely changed by 2020
Asian development lead by “Tigers” (superfast economic growth)= Japan, then Singapore,
Malaysia, Hong Kong, Thailand, Taiwan, China, South Korea

GDP per capita growth - Japan- first non western country to experience rapid economic
growth at the start of the 20th century, in the 50s, 60s, 70s Japan started experiencing
supercharged growth.
Other Tigers higher growth than in the west 70s-90s.
Approaches to Development
- Washington Consensus→ 90s, consensus in terms of how the policymaking elites
view development, the role of the state in development is important but is focused on
the markets, market based. Limited role for government activity, should only
strengthen the macroeconomic fundamentals (fiscal and monetary policies), the
public infrastructure and public goods and should enforce law and order.
- Developmental States→ bigger role of government in directing economic activity.
Direct involvement in many aspects of economic development- ensure public goods,
mobilize savings, control banks, owning enterprises to hire people and stimulate
employment or create legislation to avoid unemployment, focus on international
markets.

What caused east asian success?

- Factor accumulation→ Investment, Human Capital
- Investment
East Asian tigers generate large investment shares
Sources of investment vary:
- Savings: especially Japan, Korea, Taiwan
- Foreign Direct Investment (FDI): Hong Kong, Singapore - Stock of Foreing Direct
Investment was higher in asia than in western countries.
Human capital stimulated economic growth→ increase of years of schooling in places such
as Japan or Singapore, reaching UK leves.
- Export orientation → What really marked east asian economies was the export
orientation - exports as % of GDP larger in east asian economies than in western
economies or other emerging economies.
- Employment→ High labor participation rates, long working hours

Pre-conditions matter
Korea and Taiwan - Educational attainment around 1950 suggests “impoverished
sophisticates” with growth potential, similar to Scandinavia in 1870. Low initial inequality.

31
What governments got right
- Creating markets→ tried to fix coordination failures which held back development (for
example not having public infrastructure connecting major cities that allow to export
from one place to another). Return to individual investments lower than return to
coordinated investments. Government subsidized, coordinated private investment.
- Cooperation→ Importance of cooperation between firms, with employees, within
corporate groups. Conglomerates of firms which operate under the same bank were
beneficial to the economy as they reduced information costs (cost of cronyism).
- Labour Market Management→ east asian countries very different regarding lifetime
employment (enter a firm and stay there for a long period of time). Firms have market
power over employees, but willing to invest in training as a consequence, and get
loyal workforce. In contrast to “Anglo-Saxon” practices.

Limitations of the developmental state?

- Productivity growth was limited- Impressive GDP/capita gains, but Total Factor
Production performance much more modest (output per worker was impressive, but
total factor productivity was lower)
- Growth was/is largely extensive (factor accumulation), not intensive (productivity
growth)
- Market orientation seems to matter Young (1994)

Why did South East Asia differ from other state-led economies?
- Export oriented
- Little “picking winners”
- Low inequality – fewer elites to capture rents from policy direction

China→ Story of china - relative income levels have decreased since 1000 to 1978.
Economic growth in China was not negative, but other economies achieved more economic
growth while china did not.
China pre 1949
Living standards were stagnant, China was poorer than India or Africa in 1949.
Income per head was only 5% of American levels.
China 1949-78. After communists came to power the economy started growing.
- Chinese economy grew at 2.3% per annum - given catch-up potential, this is a low
rate of growth. Institutions of china at this time were the same as the soviet union.
- Disaster of ‘Great Leap Forward’, 1958-62 → Enforced agricultural collectivization
and rural industrialization, widespread coercion and terror. Considered a cause of
Great Chinese Famine (est. 18-55m deaths)
- Central planning caused economic growth, in comparison to catch up potential this
was low.
China since 1978
In 1978 China has huge catch-up potential. Since 1978 has grown almost 7% annually (per
capita).
Rapid catch-up growth has led to strong income convergence (close to ⅓ of US income
level), from a low initial starting point.
Achieved through big policy changes.
Sources of growth

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 Increase in output per worker. TFP growth was much more important in stimulating
economic growth than other sources of growth.
Explaining Chinese growth
Chinese savings rates among highest in the world → Recycled from state banks to state
enterprises (~10% GDP in 1990) state ensured that after 1978 banks are still state owned
and savings are channeled saving to enterprises which then invest these savings. High
savings are a response to demography, the need to provide for retirement.
Sectoral shift from agriculture to industry - Economies of scale

Explaining Chinese growth: Policy

Household Responsibility System (HRS), 1978 → Agricultural households are assigned land
for fifteen years (not given ownership). Enhanced role for agricultural markets, in contrast to
People’s Communes under Mao. Enhanced role for private investment. Boosts incentive to
produce and invest.
Contract Management Responsibility System→ Like HRS for industry. Firms managers
acquire discretionary powers, employment (hiring, firing, wages, bonuses), Production
planning and sales, Investment and use of retained profits

Openness
Special Economic Zones (SEZ) in Guangdong and Fujian → Special privileges for foreign
companies. Foreign Direct Investment magnets, often overseas Chinese. Labour-intensive
orientation, just as labour costs rise in Asian Tigers.
Foreign asset stocks in chine in comparison to other countries was huge.

State enterprises
Market based economy but state enterprises account for almost 80% of industrial production
in 1978, no market-economy experience.
State enterprises received autonomy without privatization, bank loans instead of state
grants, contract workers instead of lifetime employees.
Today considered Achille's heel of Chinese economy, much less efficient than private owned
enterprises.

The future?
China should continue to grow rapidly in the medium-run: still has rapid catch up potential.
Continued factor reallocation and accumulation (esp. human capital)- farms to factories,
expansion of human capital (better universities) a lot of room for improvement in education
of the general population.
Continued decline of state sector - tension between private sector and state sector.
Faces a challenging demographic change - old population, savings are going to decline (old
population stops saving and starts consuming). Sustained productivity growth is uncertain.
Large state firms remain stubbornly inefficient.State management of economy: encourages
rent-seeking, which winners are being picked? Development hindered by massive
corruption. Are the institutions “wrong” for sustained growth?

Topic 11: Does history suggest that China's fast growth will continue?
Zhu, X. (2012): Argue that China’s rapid growth over the last three decades has been
“Understanding driven by productivity growth. Despite the rapid growth of the last three

33
China’s Growth: decades, China’s productivity is still only 13 percent of the U.S. level,
Past, Present, which suggests that China still has plenty of room for productivity growth
and Future“, through further economic reforms.
Journal of Why did China’s growth performance differ so much before and after
Economic 1978? look at the sources of growth
Perspectives, 26, - capital accumulation was the main source of economic growth in
103-124. 1952–197. capital-investment-led growth of the 1952–1978 period
was unsustainable. Increases in both physical and human capital
rather than increases in productive effificiency. Total factor
productivity actually deteriorated during this period.
- productivity growth has been the main source of growth since then.
Experiences from other economies (East Asian economies) suggest that
periods of extremely rapid growth eventually slow down. China’s per capita
GDP is now around 20 percent of the U.S. level. Many other countries also
heald economic reforms ath the same time as china and did not achieve
such growth - china different because:
- China’s backwardness at the start of economic reform in 1978,
which increased China’s potential for catch-up growth
- China’s economy still has large opportunities for raising productivity
growth through reducing the still-existing distortions and
inefficiencies in its production.

Stiglitz, J. (1996): The East Asian miracle had many dimensions: rents were created, used to
“Some lessons encourage growth, not rent-seeking. Government and businesses
from the East cooperated closely, collaborated without collusion. A high rate of saving
Asian miracle”, leads to high growth; allocating resources on the basis of contests and
World Bank other performance-based measures can both provide high-powered
Research incentives and reduce the scope for corruption; egalitarian policies,
Observer, 11, including active education policies, can contribute to a more stable political
151-177. and economic environment and lead to faster growth through a more
productive labor force. Governments that use markets and help create
markets are likely to be more successful in promoting growth than
governments that try to replace markets.
- Policies that sustained a more equitable distribution of
income—and that supported basic education for women as well as
men—contributed to economic progress by encouraging political
stability and cooperative behavior within the private sector. The
result was a better business climate for investment and more
effective use of human resources.
- Government policies adapted to changing economic
circumstances, rather than remaining fixed. As the East Asian
economies grew more complex, government had less need to
assume an active role and found it more difficult to act effectively
on a broad scale.
- Governments played an active role in creating market institutions,
such as long-term development banks and capital markets to trade
bonds and equities- helped ensure that the high volume of savings
was invested efficiently.
- Promoting accumulation of physical and human capital. Postal
savings institutions and provident funds resulted in higher domestic
savings. Programs increased the returns to private investment and
facilitated the development and transfer of technology; these
included policies that promoted education and training, provided
infrastructure, and, in most countries, established a receptivity to

34
 foreign investment.
- Altering the allocation of resources. Governments in East Asia
used industrial policies to affect the allocation of resources in ways
that would stimulate economic growth. They took an
entrepreneurial role in identifying industries in which research and
development would have high payoffs.

T12- Stagnation and Failure of the Global Periphery: Africa and Latin America
Growth in Africa
Africa has seen some growth since pre-industrial era. “Some” growth is much less than
almost anywhere else. No takeoff nations in sub saharan africa with sustained economic
growth. Decline from 1980 to about 2000 in GDP per Capita.
From early 2000s some increase in economic growth.
- Health and life expectancy→ Life expectancy is lower in Africa than elsewhere, but
has increased considerably. No post -1980 reversal, despite shock of HIV/AIDS.

Understanding African growth:

a. Poverty traps→ Poor people and poor countries might be too poor to save and
invest. A role for aid to “push” states out of trap? A role for governments to solve
externalities?
b. Geography→ Is Africa “unlucky?”. Many landlocked countries, no access to sea for
trade, poor market potential (poor neighbours), bad disease environment (e.g.
malaria) and western agricultural technology not developed for African conditions.
c. Poor natural transport→ many countries without sea access.
d. State fromation: State formation happens late in Africa relative to Europe. When
states were formed, they were absolutist, extracting rents for social elites. Ex:
Ethiopian feudalism and gult, when gult was abolished Land reform in 1975 gave
land to peasants, led to lower ag productivity, land fragmentation and insecurity of
tenure.
e. Slavery→ When Europeans traders arrived they stimulated demand for slave trade.
Institutions support human capture and sale of slaves: Creates weak human capital +
Creates weak trust in other people (social capital).
f. Colonia institutions→ When Europeans set up colonies, they often created
“extractive” institutions on the ground (settle extractive institutions where diseases
were very prevalent, as they cannot settle there they exploit the place and leave). On
the other hand, where colonists settled in numbers, “dual economy” institutions
favour Europeans, create pools of reserve African labour ex: Apartheid in South
Africa.
g. Modern institutions→ Colonial and pre-colonial institutions breed post-independence
difficulties. New elites that came to power maintained extractive institutions, there are
few constraints on exercise of power. New domestic elites consolidate power, seek
rents, do not invest in growth-promoting activities. Exacerbated by “ethno-linguistic
fractionalization”, reinforced by colonial borders crafted by people who did not
understand about the tribes living there, etc.
h. Government policy→ Unconstrained (and unelected) leaders engage in policy
choices that retard potential for economic growth. Objective: keep support base
happy, support base is urban, educated elite (usually) so they tend to expand public
sector and control private sector activity - high expenditure, poor service productivity.

35
 Affects quantity (and quality) of education, health, infrastructure. Also, there are price
controls and direct interventions in private agricultural markets, reduces private
incentives for productive activity, protectionism, policy regime discourages
investment, entrepreneurship.

South american growth

Until WW2 south american has achieved better economic growth than the rest of the world.
After WW2 south american growth trades have been lower than the average. Income per
capita has been increasing, however less than in western potencies.

Understanding Lating American growth:

a. Colonial Institutions→ introduced before 19th century, were in an environment
characterized by high abundance of natural resources (sugar, tobacco...) but very low
labour quantity. In order to ensure production and exportation, european implanrted
extractive insitutions introducinh slavery institutions to ensure cheap labour. This
causes high inequality and low incentives to save and invest.

Lating American growth since 1945

Latin American economic growth was relatively weak after WWII → due to inward-looking
policy of Import Substituting Industrialisation?
- Development during c. 1870-1950 generally consistent with neoclassical ideas of
comparative advantage and free trade
- From 1940s, most Latin American countries changed tack and pursued policy of ISI
→ Influence of Raul Prebisch and United Nations Economic Commission for Latin
America (ECLA)

ISI (import substituting industrialuzation)→ Prebisch thought primary product exporting

countries (south american economies were this) suffered because of adverse movement in
terms of trade, prices of agricultural goods fall over time relative to prices of manufactured
goods. Need to shift comparative advantage to manufacturers.
Components of ISI in Latin America
- Promote heavy industrialization
- Inward-looking state-led development - protectionist. Produce the stuff they are
importing domestically.
- Monetary policy - Devalued currency to make imports expensive, imports of
manufactured goods more expensive.
- Fiscal and trade policy - High tariffs on imports, tariffs on agricultural exports,
subsidies to industry.

Consequences of ISI (Taylor)

- Price distorsions→ Weakens investment and economic growth, channels investment
into “wrong” sectors, causing inefficiency.
- Government picks “winners” → gov chooses what firms are the top producers of
products. Breeds corruption, weakens efficiency and economic growth.
- ISI became increasingly costly as world economy re-globalised → Latin America’s
share of world exports declined sharply (from 11% in 1950 to 4% in 1975).

36
 Why stick with ISI?
Beginnings of reform only visible from mid-1980s
Puzzle: why were ISI policies pursued for so long despite poor performance? → A tool of
redistributing income, rather than creating it. Shield domestic constituencies from global
markets. In time they became a policy of social welfare, people work in bankrupt companies,
but at least people are working.

Conclusions
● Africa suffers from a unique combination of bad geography, bad institutions, and bad
policies
● Since 2000; improvements in institutional environment, spread of democracy,
constraint on executive. But, fragile improvements.
● Latin American growth since 1945 was largely disappointing, mostly a result of
constant flirtation with high protectionism.

Topic 12: Why is Africa still so poor?

Acemoglu, D. and Poverty in Africa can be largely explained because of the lack of effective
Robinson, J. (2010): and well-functioning institutions.
“Why is Africa - POLITICAL CENTRALIZATION→ emerged later and in a more
fragmented way. Main problem lack of authority, and the absence
poor?”, Economic
of political organization makes economic growth very difficult if not
History of impossible. Without a proper state, public goods cannot be
Developing Regions, provided, there is no legal system, education system, etc.
25, 21-50. - ABSOLUTISM→ no constraint for rulers to do whatever they want
to, they increase the wealth of the elites at the expense of the rest
of society. Transition from absolutist to non-absolutist states took
place in Europe, did not happen in Africa.International trade
(including slavery) controlled by the ruler. Consequences - insecure
property rights and the formation of extractive institutions.
- SLAVERY→ has had a perverse effect on political and economic
institutions in Africa, being a source of inefficiency in the allocation
of resources. Institutions were perverted by the desire to capture
and sell slaves. Demographic impact on Africa: a massive
reduction of inhabitants. Slavery continued to exist in Africa and
slaves worked in plantations in the continent which were aimed at
exportation.
- TECHNOLOGICAL BACKWARDNESS→ impossibility of applying
technological developments because of geographical or other
conditions, or if it is the unwillingness of rulers to imply them.
- COLONIALISM→ blocked any possibility of endogenous
institutional reforms.
- AFRICA SINCE INDEPENDENCE→ organization of colonial states
intensified absolutist structures. During colonialism many different
ethnicities were put together and after independence this has
created political instability and conflict. Favoured winner takes all
political institutions do not promote economic growth.

37