Chapter 3 Review Questions Answer Key

1. The Industrial Revolution created dramatic transformation in parts of western Europe and induced much rethinking about political and social arrangements, planting the seeds of what was later known as political economy. Among the most renowned thinkers were Adam Smith, David Ricardo, and Karl Marx. Smith encouraged the changes happening during the Industrial Revolution, arguing that a society of free individuals using their personal abilities to pursue their individual self-interest—without interference from the state and following the invisible hand of the market via supply and demand—would be more productive and peaceful. David Ricardo built on those observations by making the case that countries should specialize in the production of goods they were comparatively better at, given available land, labour, and capital. This theory of comparative advantage promised that specialization in international trade would create benefits for all participants that were greater than producing all goods and services domestically, without cross-border commerce. The works of Smith and Ricardo provided the intellectual foundation for today’s capitalist economy based on individual self-interest; free market rules governing the use of labour, land, and capital; and free trade among nations. Writing 70 years later than Smith and 30 years later than Ricardo, Karl Marx took a much more critical view. He argued that market rules led to a society in which employers or owners of land and capital accrued most of the benefits while workers (who only had their labour to sell) benefitted least. International trade and investment flows, according to Marx, exported those same exploitative relations to other countries. [pp. 42-3]

 

2. A twentieth-century experience that influenced early ideas on economic development was the Great Depression, a massive economic slowdown that affected the United States starting in 1929 and expanded to Europe, its colonial empires, and Latin America through the early 1930s. John Maynard Keynes, an English economist, is widely credited with having proposed the new economic policies that contributed to resolving it. He argued that supply and demand did not automatically balance in market economies and, most important, that private investors could not be relied upon to make the right investment decisions to help a society achieve its full economic potential. Together with other economists of his time, such as Roy Harrod and Evsey Domar, he argued that national economies should be guided by state actions in order to attain sustained rates of growth. This growth could achieve and maintain the full employment of labour and satisfy the consumption needs of the population. In other words, government regulatory interventions and spending in a market economy was legitimized for goals not only of economic transformation and industrialization but also for maintaining economic stability and providing full employment. This approach to managing the economy was known as Keynesianism or Keynesian economics and was highly influential among developing countries and their elites. The experience of the Second World War—when for six years most of the global economy was refocused on arms production and the support of large-scale armies—dramatically accentuated these beliefs about the centrality of the state to economic growth. Victors and defeated nations alike were convinced that markets could in fact be suspended or drastically curtailed by government actions for the common good, be that military mobilization, food rationing, or industrial and agricultural production. Most economists and other policy-makers who worked on global development issues from the 1940s through the 1970s had their formative years in that context. For them, Keynesian ideas about states guiding economies had been proven, both during the war and afterwards during the reconstruction of western Europe and Japan. [pp. 43-4]

 

3. Walt W. Rostow, an American economist, postulated that economic development as done in Western industrialized countries could be replicated in the developing world by applying a five-stage model. His theory was followed by Western governments that provided foreign aid and policy advice for economic development throughout the post–World War II era. It was also representative of a set of approaches to development known as modernization theory. The initial stage of development was described as “traditional” in which developing-country societies were assumed to be mostly agricultural, focused on subsistence, and employing their economic surpluses for military or religious goals rather than for economic improvement. The second stage, named “transition,” subverted the previous one through the development of internal and external markets that allowed the sale of agricultural surpluses and the import of new goods, often with foreign technology.
   
   The third stage, or “take-off,” was the moment when developing countries started switching to large-scale agriculture and industry, thus causing rapid urbanization and social change. The pressures of urbanization and industrialization demanded significant investments in basic services such as electrification, roads and seaports, and drastic improvements in education systems. For Rostow, these all were areas where Western aid and advice could and should be employed. The fourth stage, called the “drive to maturity,” saw these tendencies deepen, which depended on local firms making investments to increase the volume and quality of their production and adapting or creating their own technologies. The last stage, called the “mass consumption society,” was the stage already attained by industrialized Western economies. At this stage, economies were completely industrialized.
   
   Almost none of the developing countries of the 1950s and 1960s have yet attained this last stage, with the exceptions of some East Asian countries, which did so mostly thanks to their own recipes. While Rostow’s stages of growth are rarely invoked in development policy analysis today, this model and the accompanying political modernization theory have remained as an influential undercurrent for Western policy-making toward the Global South. [p. 45]

 

4. The end of the Second World War inaugurated a protracted confrontation between the capitalist Western powers and the socialist Soviet Union and China known as the Cold War. Early tensions coincided with the collapse of the formal colonial empires, as most developing nations achieved independence in Africa, the Caribbean, the Middle East, and Asia. This coincidence of events framed the politics of international cooperation and development in the Global South.
   
   The policy goals of the Western world promoted their own model of economic development, and the strengthening of economic and political linkages with their own bloc. Ideologically, the starting point for those new relationships was based on colonial relationships. European powers (and the United States, to a lesser extent) had maintained expansive colonial empires through much of the Global South, and their understanding of those now-independent nations was grounded the experience of having been their colonial masters. Consequently, societies in the South and their new governments were still seen in the West as being “traditional,” requiring guidance and assistance from developed nations to improve themselves. Taken together, the set of theoretical approaches that envisioned poor and traditional nations transforming into modern copies of Western nations was known as modernization theories. These theories had sociological (Durkheim, Weber, Parsons), economic (Rostow), and political (Huntington) variants. [p. 46]

 

5. For the developing world, the consequences of this change in economic thinking to neo-liberalism were enormous. In terms of North-South relations, the incipient dialogue that had begun in the late 1960s with the New International Economic Order (NIEO) conferences that aimed to facilitate improved trade and financial conditions for developing countries was aborted, replaced by a con­frontational rhetoric that developing countries were solely responsible for their own problems. In terms of financial and technical assistance for development provided via international financial organizations (the World Bank, regional development banks, and, in the case of balance of payment crises, by the International Monetary Fund), the conditions to qualify for such loans were quickly adapted to the ne­oliberals’ preferred menu of policy positions including privatizations, economic and trade deregulation, and financial liberalization. [p. 52]

 

6. The new institutional economics (NIE) is intellectually indebted to Ronald Coase’s 1937 article on the nature of the firm, which departed from the neoclassical tradition by arguing that the existence of firms proved that market relationships were not truly frictionless as conventional economic theorizing expected. Instead markets were characterized by numerous transaction costs, such as a lack of information about suppliers and products, contract and labour negotiations, and costly enforcement of contracts. Firms were vehicles to reduce those frictions in markets by internalizing them within their organizational structure. Coase’s contribution was rediscovered by the Nobel Committee in 1991, as interest in the NIE began to mount. His insights had led to the development of ideas linking institutions, including firms, to the minimization of transaction costs, found in work by Oliver Williamson, Douglass C. North, and others. [p. 56]

 

7. The disciples of economic development swung from elevating the state to command these processes, to later following market forces and foreign investors, while demanding that the state renounce its leadership and capacity. Meanwhile, agnostics promoted alternatives through institutional economics, theories of the developmental state, and economic history, arguing that states and markets could in fact work cooperatively under country-specific circumstances. The simplistic notions of early development economics and modernization theory have not produced a Westernized convergence of the developing world with the industrialized North. Instead, Southern experiences with good and bad policy advice have contributed to creating today a world economy in which the South is evidently less underdeveloped but also less ready to listen to Western recipes for success. [p. 57]

 

8. The influence of new institutional perspectives also extended to the examination of diverse informal institutions at the micro-economic level that influence how people cooperate to solve their development problems. Elinor Ostrom, the first female recipient of the Nobel Prize in Economics (2009), is representative of this current in new institutional economics. Her work was informed by Mancur Olson (1965) who posited that groups of people find it difficult to self-organize to pursue a collective good because it is in each individual’s self-interest to free-ride (to benefit from a common good without contributing to achieving it), resulting in the undersupply of public goods. This is known as the “commons problem” and is frequently invoked to explain the failure to solve collective challenges such as climate change. But Ostrom showed that people can create self-governing institutions to manage common resources (such as fisheries) without the state, under certain conditions that usually include social trust within the group and having a plan to monitor and enforce the rules based on local knowledge. Ostrom rejected the state vs. markets duality, and she was very influential in the study of developing areas, where formal institutions were often weak and ineffective, and where regular people had to find creative solutions to their problems. [p. 57]

 

9. In an influential book, Why Nations Fail (2012), Daron Acemoglu and James Robinson built on Rodrik’s argument to show that historically-generated political institutions were crucial for the possibilities of future growth and development. They showed that the political institutions of a society influenced whether its economic institutions were “inclusive” or “extractive.” Inclusive institutions rewarded individual initiative by protecting everybody’s (or a large majority’s) property rights, while extractive institutions allowed an elite to live off the labour and land of others. Acemoglu and Robinson demonstrated that extractive institutions were often established by colonial authorities in what is now the Global South, and that those contingent choices had long-term consequences. Their analysis also accorded with Rodrik’s view that democracy was an important “meta-institution” that often influenced the quality of economic institutions and development. In sum, these approaches suggest that the quality and appropriateness of institutions influence the outcomes of economic development over time. [p. 56]

 

10. Douglass C. North, who shared the Nobel Prize in Economics (1993), is often viewed as a foundational contributor to the new institutional economics (NIE). North viewed institutions as the rules of game (both formal, like the law and bureaucracies; and informal, like culture and religion) that constrained human behaviour. Institutions encouraged stable and predictable patterns of human interaction by providing key functions that affected the economic decisions of private actors. When they worked well, institutions reduced uncertainty about others’ behaviour; reduced transaction costs, and lowered transformation costs (the cost of producing something). North also underlined that institutions created “path dependence,” which means that once created they were resistant to change and locked-in a set of incentives for human behaviour. In this regard, the problem of developing countries was the continued existence of institutions that discouraged productive economic activity. [p. 56]