The Politics of Economic Stagnation
NOVEMBER 01, 1981 by DAVID OSTERFELD
Dr. Osterfeld is Assistant Professor of Political Science, St. Joseph’s College, Renaselaer, Indiana.
Although being gradually undermined throughout much of the twentieth century, the traditional international economic order—free trade and migration, private property, the international division of labor—has recently been subjected to its most serious attack since Lenin’s Imperialism appeared in 1917. This time the attack has come not from Marxists trying to rationalize the failure of Marx’s predictions about the economic self-destruction of capitalism, but from the “third world,” or “less-developed countries” (LDCs), trying to explain their continuing poverty in the face of economic advancement by the capitalist nations of the west. Ac cording to this view the LDCs are poor because the capitalist nations are wealthy. As President Julius Nyerere of Tanzania put it:
In a so-called free-market economy economic power depends on wealth. The wealthy can determine what will be produced because they have the power to invest. They can determine the price levels of the goods produced in their own countries and elsewhere because they have the power to buy, or withhold sale. The poor buy or sell at whatever price suits the wealthy.
In brief, the market process, according to this view, works to the detriment of the poor. Thus, despite having achieved political independence from the west, the “economic power” of these economically advanced capitalist countries still enables them to dominate, to “exploit,” the LDCs. Colonialism may be gone, but it has been replaced by “neocolonialism.”
The policy implications of this “neocolonial” argument are profound. Since the wealth of the capitalist nations is the cause of the continuing poverty of the LDCs, justice dictates that the inequality between the developed and less-developed countries be reduced if not eliminated. As President Nyerere stated:
I am saying that it is not right that the vast majority of the world’s people should be forced into the position of beggars, without dignity . . . . (W)hen I am rich because you are poor, and when I am poor because you are rich, the transfer of wealth from the rich to the poor is a matter of right; it is not an appropriate matter for charity . . . . If the rich nations go on getting richer at the expense of the poor, the poor of the world must demand a change, in the same way as the proletariate in the rich countries demanded change in the past.
This demand has been articulated in a series of measures, commonly referred to as the New International Economic Order, advanced by the LDCs, which now constitute a majority in the United Nations, and passed in that body in the mid-1970s. These measures include the following:
(1) The transfer to the LDCs, with no strings attached, of the financial assets of the developed or capitalist countries equal to seven percent of the latter’s GNP;
(2) The transfer to the LDCs of a larger share of the technology and productive facilities of the developed countries;
(3) The indirect but no less real transfer of wealth to the LDCs in the form of the cancellation of their economic debts to the developed countries; and
(4) The “permanent sovereignty of every State over its natural resources and all economic activities.” This includes such things as “the right to nationalization,” to impose tariffs, etc.
The implementation of this program would be nothing short of the creation of an international welfare state which would have serious ramifications for the traditional international order. But before we can assess the impact of the NIEO we first need to examine the validity of the “neocolonial” position on which it is based.
The “Neocolonial” Charge Examined
Simply put, the “neocolonial thesis,” that the LDCs are poor because they have been exploited by the capitalist nations of the west, cannot withstand scrutiny. There are a host of countries—Singapore, Hong Kong, Taiwan, Brazil and the like—which have advanced so rapidly over the past decade or so that they have been dubbed the “newly industrializing countries.” Singapore’s growth rate between 1960 and 1976 averaged 7.5 percent, Hong Kong’s 6.5 percent, Taiwan’s 6.3 percent and Brazil’s 6.5 percent, all of which were higher than those of such developed nations as the U.S. with 2.3 percent or Britain with 2.2 percent. The very existence of the newly indus trializing countries explodes the idea of “capitalist imperialism.” For if the capitalist countries actually exploited the third world those LDCs with the closest ties with the west should be the poorest. Conversely, those with the fewest contacts should be the most prosperous. But without exception those countries which are the most market oriented and have the most numerous ties with the west are the most prosperous while the poorest of the LDCs are those like Nepal, Mali and Afghanistan which have the fewest contacts. Thus, not only does the thesis fail to account for the empirical evidence, it is the exact reverse of the evidence!
The Liberal International Order
Although the “neocolonial thesis,” which was used to justify the passage of the NIEO in the United Nations is unfounded, the NIEO has nevertheless come to pass. What must be considered, therefore, is what would be the probable impact of its implementation. Since the NIEO constitutes severe restrictions on the existing order its impact can best be assessed by first examining this order. Although there are important and growing exceptions, the existing international order may be termed a liberal or capitalist order, i.e., one based on the classical lib eral ideals of respect for private property and its corollaries, freedom of trade and migration.
Since, in an international order based purely on classical liberal principles, private property would be respected and there would be neither tariff nor migration barriers, national boundaries would be devoid of economic significance. In such a world capitalists, anxious to maximize profits, would increase their investment in those areas where the cost of factors—raw materials and labor—were cheap relative to those areas where they were expensive. Conversely, workers anxious to maximize their earnings would migrate from those areas where wages were low to those where they were higher.
This is precisely what served to transform the western world in the nineteenth century. Since Great Britain began to save and invest sooner than other nations it had a higher standard of living than all other European countries. But, as Ludwig von Mises points out, “something happened which caused the headstart of Great Britain to disappear.” That something was the internationalization of capital, which Mises terms “the greatest event in the history of the nineteenth century.” In 1817, he continues,
The great British economist Ricardo still took it for granted that . . . capitalists would not try to invest abroad. But a few decades later, capital investment abroad began to play a most important role in world affairs . . . . . Foreign investment meant that British capitalists invested British capital in other parts of the world. They first invested in those European countries which, from the point of view of Great Britain, were short of capital and backward in their development. It is a well- known fact that the railroads of most European countries . . . were built with the aid of British capital. The gas companies in all the cities of Europe were also British . . . . In the same way British capital developed the railroads and many branches of industry in the United States.
The Great Migration of Capital and Labor
Occurring at the same time was the “great migration” of individuals from Europe, which was relatively overpopulated and in which wages were therefore low, to the U.S., which was underpopulated and, accordingly, wage rates were higher. This dual process of capital and labor migration would continue until equilibrium were reached, i.e., the marginal utilities of both capital and labor were equalized. This is essentially what occurred in the western world, although to the extent that there were tariff and migration barriers complete equalization was pre-vented. And, other things being equal, this is also what would occur throughout the world.
But other things are not equal. Compared to the west, wage rates in the LDCs are quite low while interest rates are notoriously high. This means that there is a “surplus” of labor and a “shortage” of capital and one would expect capitalists to exploit this opportunity for profit by investing in the LDCs. One would also expect this process to continue until wage rates in the LDCs equalled those in the developed countries for the same type and quality of work. In the process, as capital became less scarce interest rates, and thus returns to capital, would decline to the point at which they equalled those in the west. But this has occurred only to a limited extent. The bulk of western foreign investment has gone to other western nations, and even that from non-western countries, such as the Arab nations of the mid-east, has been invested largely in the already capital intensive nations of the west. Why?
(a) Lifestyle. It is sometimes forgotten that the developed countries were not always developed. Until only recently all peoples of all nations were “undeveloped.” It was only in the eighteenth century, in what is now termed the Industrial Revolution, and only in a particular part of the world, in what is now designated as the “west,” that the standard of living began to rise above the subsistence level. What made possible the dramatic transformation of one small section of the world while conditions in the rest of the world remained practically unchanged was, of course, the fact that by the mid- eighteenth century capital had been accumulated in Europe—or more accurately in England—in amounts sufficient to spawn the economic “takeoff.”
An important question is, why was capital accumulated in Europe but not elsewhere? Several scholars have noted the existence of two fundamentally distinct lifestyles. The one has been variously dubbed a traditional or country lifestyle; the other a modern or urban lifestyle. In the former the family is the unit of production, the bulk of production is for immediate consumption, specialization and the division of labor are practically nonexistent, and innovation is eschewed, while the latter is characterized by an inquisitive, innovative turn of mind and a fairly close correlation between individual effort and reward. The factory is the unit of production, functions are specialized, relations are individualized and impersonal and the bulk of production is for sale on the market.
Historically, the relationship between economic progress and urbanization has been a close one. “It is well known,” says Bert Hoselitz, “that beginning with the early eleventh century western Europe underwent a process of economic development which was accompanied by the growth of towns and urban institutions.” He attributes to these cities,
a predominant economic function. They were places in which new forms of economic activity and new types of economic organization were evolved. They were places not merely in which new commodities were traded and whence new markets and sources of supply were explored and conquered but in which ap peared the first signs of new class relations based on alterations in the division of labor.
In brief, industrialization and economic development require not simply hard work, which is certainly part of the traditional or country lifestyle, but also frugality, efficiency and risk taking and, related to these, the incentive for saving and investment. Since these are characteristics of the urban lifestyle, economic development required the transition from a traditional or country environment to a modern or city one.
Today the western world may be seen as the “city” and the third world the “country.” This is not to suggest that the west is entirely “urbanized.” The U.S. remains one of the world’s chief producers of agricultural products. Yet what is most significant about this is the degree to which in the west even those in the country have adopted the lifestyle of the city. In America farming is a highly specialized occupation, and the farmer is, in fact, an entrepreneur: he generally consumes little of what he produces and since his production is for the market he must anticipate consumer demand. He must therefore decide not only what and how much to plant but when, where and how much to sell. Thus even in the developed nations the so-called country conducts itself according to the spirit of the city.
In the west even farming is a business. But an entirely different spirit pervades most of the third world: the spirit of the country. It is not just that the agricultural sector is large. What is significant is the prevalence of subsistence farming. Farming is not a business, it is an existence. Since the production unit is the single family, farms or plots are small. This precludes specialization and the division of labor. The emphasis on familial duties greatly inhibits individual mobility, and reverence for one’s ancestors or for the ancient order, which is usually a component of the country, discourages innovations. Finally, the absence of the “cash nexus,” of production for sale on the market, is incompatible with the development of the spirit of enterprise and entrepreneurial acumen.
An Incompatible Lifestyle
One cannot say that such a lifestyle is wrong; but it can be said that it is incompatible with economic development. An assembly line, to take a simple example, requires the coordinated activity of numerous individuals. It cannot function when individuals, unaccustomed to “punching a time clock,” cannot be depended upon to arrive at work on time. The successful functioning of an industrial economy requires discipline. One may reject such a lifestyle for one of, say, religious contemplation or greater leisure. But those who adopt such a lifestyle have no right to complain because their economic position stagnates while that of others, who subject themselves to the rigors of the marketplace, advances. It is this antagonism between the prevailing lifestyle of the LDCs and the successful conduct of economic activity that in large part explains the failure of western capitalists to invest in the third world.
However, to refer to the third world as the “country” does not imply the complete absence of urban centers. They do exist and this is fortunate. For it is through such centers that contacts with the west are made. And these contacts spawned LDC development. Writes Peter Bauer:
Over the last hundred years or so, contact with the west has transformed large parts of the third world for the better. For instance, in the 1890s Malaya was a sparsely populated area of hamlets and fishing villages. By the 1930s it had become a country with populous cities, thriving commerce, and an excellent system of roads, thanks primarily to the rubber industry brought there and developed by the British. Again, before the 1890s there was no cocoa production in what is now Ghana and Nigeria, no exports of peanuts or cotton, and relatively small exports of palm oil and palm kernels. These are by now staples of world commerce all produced by Africans, but originally made possible by European activities . . . . Western activities . . . have thus led to major improvements in the material conditions of life in many parts of the third world. This is not to suggest that there has been significant material progress everywhere in the third world. Over large areas there have been few contacts with the west. And even where such contacts have been established, personal, social, and political determinants of economic performance have often proved unfavorable to material advance. But wherever local conditions permitted, contacts with the west most often resulted in the elimination of the worst epidemic and endemic diseases, the mitigation or disappearance of famines and a general improvement in the material standard of living for all.
In short, the prevailing values throughout much of the third world discourage foreign investment. But values can change, as the existence of the NICs dramatically illustrate. It is through contacts with the west that most of the LDCs have been exposed to values compatible with development. But the degree to which these values are embraced depends on them.
(b) Government Intervention. Another reason for the dearth of foreign investment can be summarized under the heading of government intervention. While this is hardly unique to the third world, the governments of the LDCs are, as a rule, more active in the economy than are those in the developed countries. Licensing restrictions are common, as are tariffs, high taxes and state-sup-ported monopolies. Even the forcible resettlement of entire peoples is not unknown, as the transfer of urban-dwellers to the country in Kampuchea and Tanzania’s resettlement of rural people into “cooperative villages” attests. But what is of concern here are those policies which reduce the inflow of foreign capital. Two such policies, minimum wages and nationalizations, will be discussed.
Minimum Wage Laws Aggravate the Problem
It has become fairly common for the governments in the LDCs to adopt minimum wage laws in order to raise wages. But wages are low because the bulk of the workforce is unskilled and/or unaccustomed to the discipline of the industrial sector, and such laws do not change that condition. By preventing workers from offering a “compensating difference” for these drawbacks, minimum wages reduce the attractiveness of investing in the LDCs, thereby restricting the inflow of capital and increasing unemployment. In the long run such policies prevent workers from acquiring those skills which would increase their productivity, thus making investment more attractive. Hence, they retard economic development. It should not be forgotten that low labor costs, which moralists often condemn as “exploitation,” has been a major factor in the rapid development of Hong Kong, Malaysia and other NICs and, subsequently, their higher living standards.
More serious, however, is the nationalization of foreign-owned enterprises. The reluctance of western capitalists to invest in the third world has been observed by many and some have even charged that the west is deliberately boycotting the third world. The reason for this reluctance is not hard to find. Investment always entails risk. But in the third world this is often aggravated by the uncertainty of the economic environment. If the investment fails, the speculator loses all or part of his investment. But if it succeeds he is usually subject not only to high taxes but the ever- present possibility of nationalization. The Mexican expropriation of foreign-owned oil holdings in 1938 was neither the first nor the most extensive nationalization. But it does exemplify the attitude of many LDCs. In response to the American demand for “prompt, adequate and effective compensation,” the Mexican government stated:
There is in international law no rule universally accepted in theory nor carried out in practice which makes obligatory the payment of immediate compensation nor even of deferred compensation for expropriations of a general and impersonal character.
Although American holdings were valued at $200 million they eventually received slightly less than $25 million.
Other nationalizations include Russia (where all foreign-owned industrial property was confiscated after the revolution in 1917), Iran, Guatemala, Bolivia, Argentina, Cuba, Peru and Chile. Such nationalizations have cost western capitalists billions of dollars. While the result is windfall gains for the nationalizing country, in the long run it slows development by making access to capital more difficult. The LDCs often complain of high interest rates. What they apparently fail to realize is that their interest rates are high because of a shortage of capital which, in turn, is in large part a result of their policy of nationalization.
To summarize, while there is a tendency for both wage rates and returns to capital to equalize throughout the world, this has been offset in the third world by such factors as the prevailing lifestyle and extensive government intervention.
A Note on Mercantilism
Since the role of government has just been discussed, some mention should be made of mercantilism. Too often being pro-free enterprise is confused with being pro-business. But the two are not identical. Being pro-business usually means advocating policies such as tariffs and li censing restrictions designed to insure profits by insulating businesses from competition. But being pro-free enterprise means opposing institutional restraints on competition. Thus, as Friedman has noted, “Tariffs are anti-free enterprise, yet pro-business.” The pro-business system, or mercantilism, is a profit system; the pro-free enterprise system, or capitalism, is a profit and loss system. The distinction is fundamental. When individuals are free to go elsewhere, a business can avoid losses only by providing what consumers desire to buy. But when businesses are freed from the threat of competition, this incentive for service is absent. When the possibility of loss is present, profits are earned by serving others; when they are not, profits can be earned at the expense of others.
There are no doubt examples of multinational corporations seeking, and receiving, special privileges from foreign governments. The role of ITT in Chile in the 1970s is one example; that of United Fruit in Guatemala in the 1950s is another. But since poverty is greatest in those LDCs with the fewest western contacts, such cases do not explain the plight of the third world. Nor is it necessary for one who is pro-free enterprise to defend such mercantilist practices. The Wealth of Nations, Adam Smith’s great treatise on free enterprise, was written, after all, precisely to rebut the mercantilist practices of his day.
The NIEO Evaluated
We are now ready to assess the impact of the NIEO. The measures in the NIEO can be categorized as follows: (a) the transfer of wealth, (b) nationalizations, and (c) the imposition of tariffs. Each will be discussed in turn.
(a) The Transfer of Wealth. It is dubious that the transfer of wealth can improve the position of the LDCs. In fact, it is likely to make them even worse off. Such aid, as is foreign aid now, would no doubt be administered by and through government. This would promote even greater government control over the economic life of the nation. Apart from the serious restrictions on individual freedom that are likely to occur, such a policy would have several other ramifications.
Private investors, risking their own capital, must serve consumers. But a government, especially one receiving aid, is relieved from this economic constraint. This permits public officials to substitute their own individual priorities for those of the marketplace, thereby allowing them to pursue policies that are economically unsound. These include everything from imposing restrictions on the economic activities of productive but unpopular minorities to lining the pockets of themselves and their friends. It also permits officials to divert resources from the satisfaction of consumer demand to use in such capital intensive projects as the construction of steel mills or hydro-electric dams even when either there is no demand for their products or they can be bought much cheaper elsewhere. Although such projects are undertaken in the name of industrialization, they do not contribute to economic growth but are a wasteful drain of the resources of the country. “The availability of resources at little or no cost to the country in question inevitably stimulates monument-building,” Friedman notes. “Thus . . . foreign aid grants . . . lead to a notable increase in the amount of capital devoted to economically wasteful projects.”
In addition, wealth transfers have other drawbacks. It is a mistake to regard such aid as a net addition to the capital stock of a country. The expansion of government control over the economy reduces “the pressure on the government to maintain an environment favorable to private enterprise.” Since this discourages private investment, domestic and foreign, the result could well be a net reduction in the amount of capital available.
Finally, it should be noted that by increasing dependency on government, the politicization of economic life created by wealth transfers works to retard the acquisition of those attitudes—thrift, industry, self-reliance—which are necessary for development. None of the western capitalist countries required transfers of wealth for their development and, for the reasons given above, the transfers proposed by the NIEO would probably harm rather than benefit the LDCs. As Bauer has written:
If all conditions for development other than capital are present, capital will soon be generated locally or will be available . . . from abroad . . . . If, however, the conditions for development are not present, then aid . . . will be necessarily unproductive and therefore ineffective. Thus, if the mainsprings of development are present, material progress will occur even without foreign aid. If they are absent, it will not occur even with aid.
(b) Nationalization. This issue can be dealt with quickly. We have seen that past nationalizations have retarded development. There is no reason to suppose that their effect in the future will be different simply because they have been termed an “inalienable right” by the NIEO.
(c) Tariffs. The one final issue raised by the NIEO is that of tariffs. The major LDC argument for tariffs is that they would stimulate development by encouraging industrialization.
While tariffs may stimulate industrialization, industrialization should not be confused with development. Industrialization is usually correlated with development because on the free market new technologies are utilized only when they reduce costs by increasing output per unit of input. But such is not the case with tariffs. Manufactured goods that were previously imported because their total cost of production, including transportation, was below that incurred by domestic producers now become, with the tariff, more expensive. The result is the substitution of local for foreign production.
However, as Harry Johnson points out, “the use of protection to promote substitution of local for foreign production does nothing to reduce the comparative disadvantage of local as contrasted with foreign entrepreneurship.” For example, since it is often the case, especially in the LDCs, that the domestic market for a particular good is too small to permit exploitation of economies of scale and specialization, the costs of production are inordinately high. Thus, although tariffs may artificially stimulate industrialization, this can hardly be viewed as economic advancement. In fact, what has occurred was the shifting of resources from more to less productive uses with the result that everyone except perhaps the domestic producers of the good, is less well off.
The Free Market Serves to Overcome Poverty
A common criticism of capitalism is that the businessman is concerned solely with profit. He does not care whether the goods he produces are useful. Nor is he concerned with the well-being of his workers. Production, runs the popular argument, should be for use, not just for profit, and everyone should be guaranteed a living wage. Thus, Indian President Indira Gandhi has recently called for a “new approach to foreign investment” in which in place of the quest for profit, investment would be undertaken on the basis of “service to community.” This view, which permeates much of the literature on the LDCs, fails to distinguish between intention and con sequence.
It may be true that a businessman cares only about his profit; that he is unconcerned about the use to which his product is put or about the well-being and happiness of the workers he employs. But it does not follow from this that the goods he produces are not useful, or that his workers are underpaid or unhappy. On the contrary. Since people only buy what they intend to use, the distinction between production for profit and for use is fallacious.
In fact, it is the genius of the market process that, Prime Minister Gandhi notwithstanding, profit and “service to community” are correlated: the more efficiently one produces the goods others desire, the more profit one will earn. And since what an entrepreneur can bid for factors—land, labor and capital—is limited by his expected yield from the sale of his product, those who are able to produce the most in-tensely desired goods at the cheapest price receive the highest return on the sale of their goods. They are therefore able to make the highest bids for the resources they need. Conversely, those who either produce goods that are not highly demanded or who produce intensely demanded goods but at higher costs than their competitors earn smaller returns or even suffer losses and cannot therefore bid as much for factors. In this way factors are channeled from the production of goods which are less intensely demanded by consumers to the production of goods which are more intensely demanded. Thus, while the intention of the capitalist is to make profit, the consequences of his actions are the most efficient production of those goods most intensely demanded.
Since the free market works to allocate all factors of production to their most value-productive point, any restriction on this process can only reduce the value of what is produced, thereby hurting the great bulk of participants. Wealth transfers, nationalizations and tariffs are clearly just such restrictions. Thus, far from promoting development, the NIEO is likely to perpetuate the stagnation of the LDCs, or even worsen their plight.
The twentieth century has witnessed the continual encroachment on the liberal international order. If spokesmen for the LDCs seriously desire to overcome their poverty, they should not propose further restrictions; they should advocate the repeal of existing ones. 
3. The text of the NIEO declaration, adopted May 1, 1974, can be found in Louis Henkin, et al, International Law (St. Paul: West Pub., 1980), pp. 695-99. Also see William Cline (ed.), Policy Alternatives for a New International Economic Order (New York: Praeger, 1979), and Deekpak Lal, “Behind the North-South Confrontation,” and Richard Steade, “Multinational Corporations and the Changing World Economic Order,” both in World Politics, 80/81, ed. Chau T. Phan (Guilford, Conn.: Dushkin Pub., 1980), pp. 147-49 and 118-23 respectively.
5. See, for example, P. T. Bauer, “Western Guilt and Third World Poverty,” Commentary (January, 1976), pp. 31-38. For an in-depth and devastating criticism of the neocolonial thesis see Peter Bauer, Dissent on Development (Cambridge: Harvard University Press, 1972). Also of interest are Gottfried Haberler, “Terms of Trade and Economic Development,” Economics of Trade and Development, ed. James Theberge (New York: Wiley, 1968), pp. 328-29; and John Kimball, “The Trade Debate: Patterns of U.S. Trade,” World Politics, 80/81, ed. Chau T. Phan (Guilford, Conn.: Dushkin Pub., 1980), 104-13.
7. Bert Hoselitz, “The Role of Cities in the Economic Growth of Underdeveloped Countries,” Chicago Essays in Economic Development, ed. David Wall (Chicago: University of Chicago Press, 1972), pp. 61-67.
12. Milton Friedman, “Foreign Economic Aid: Means and Objectives,” Yale Review (June, 1958), pp. 205-06. Also see Fleming, pp. 7879; and P. T. Bauer and B. S. Yamey, “East- West/North-South: Peace and Prosperity?,” Commentary (September, 1980), p. 61.
15. Harry Johnson, “Tariffs and Economic Development: Some Theoretical Issues,” Economics of Trade and Development, ed. James The-berge (New York: Wiley, 1968), pp. 371-75. For an excellent and readable presentation of the law of comparative advantage see Stephen J. Rosen and Walter Jones, The Logic of International Relations (Cambridge: Winthrop, 1980), pp. 344- 47. For a more technical presentation see Roy Harrod, International Economics (Chicago: University of Chicago Press, 1958).
Government in Business
It is not the business of governments to go into business, and when they do, they do not do it well. Their proneness to display, and their comparative indifference to costs, markets, or innovation, lead them to dissipate the energies of their peoples in spectacular and comparatively unproductive ventures.
Many economically fastidious governments, for ideological or political reasons, mind the business of their citizens to a degree that cuts down energy in both national and international circuits.
The efforts of “welfare” governments, in particular, to protect certain interests and discourage others, often work against the prosperity of both their own and other nations.
Harold Fleming, States, Contracts and Progress