Sunday, 23 December 2018

Notes from "23 Things They Don't Tell You About Capitalism" by Ha-Joon Chang

This post is based on some notes from reading the very interesting book "23 Things They Don't Tell You About Capitalism" by Ha-Joon Chang, 2010 (it's a great book, covering much more than is in this post, recommend you get a copy!), together with some additional linkage and comments.

Ha-Joon Chang is a South Korean institutional economist, specialising in development economics. Currently a reader in the Political Economy of Development at the University of Cambridge, Chang is the author of several widely discussed policy books, In 2013 Prospect magazine ranked Chang as one of the top 20 World Thinkers. He has served as a consultant to the World Bank, Oxfam and various United Nations agencies. In addition, Chang serves on the advisory board of Academics Stand Against Poverty (ASAP).

23 Things They Didn't Tell You About Capitalism

The boundaries of "Free Trade" are always political
Proponents of unfettered free trade often say that government regulation gets in the way of efficient market operation.

In reality, all markets have some kind of regulated boundaries and free marketeers can be as political as anyone. For example, and perhaps of relevance to todays so-called "gig economy", is the Cotton Mills and Factories Act 1819, which banned children under 9 working in cotton mills, and restricted the hours of 9-16yr olds to a maximum of 12hrs per day.

Not even the most evangelical of free traders would oppose these laws today, but at the time they were opposed on the basis that :
1) The working conditions of the children did not require any legislation.
2) The Bill interfered with free labor (essentially "The mill owners want labour, the kids need to work, what's the problem?")
3) The Bill would make the British industry uncompetitive on the world market.
4) Enlightened Mill owners already had good working conditions, over time the rest would also.
5) Restricting the hours of children would mean millowners would employ men rather than children - rather than benefiting children the Bill would make them unemployable.

More recently, similar arguments have been made against vehicle emissions regulations. Chang comments that "If some markets look free, it is only because we so totally accept the regulations that are propping them up that they become invisible".

These "invisible" regulations cover aspects such as licensing for professions such as doctors; who can sell shares; consumer protections; immigration; and many other areas. And these vary from across time and place revealing that there is no fixed, objective, boundary to the market and that these boundaries are determined by political, not economic, drivers.

To give another example, Chang looks at immigration:

"While they complain about minimum wage legislation, regulations on working hours and various "artificial" entry barriers into the labour market imposed by trade unions, few economists even mention immigration control as one of those nasty regulations hampering the workings of the free labour market" proving Changs point that the boundaries of the market is politically determined."

Chang comments that :

"..when free-market economists say that a certain regulation should not be introduced because it would restrict the "freedom" of a certain market, they are merely expressing an opinion that they reject the rights that are to be defended by the proposed law. Their ideological cloak is to pretend that their politics is not really political but rather an objective economic truth, while the other people's politics is political.."

This is what free market economics used to look like (source)

Shareholders do not always have the company's long term interests at heart
Proponents of unfettered free trade state that shareholders incomes depend solely on company performance (unlike staff, for example, who are paid a fixed wage) so shareholders are most incentivised to maximise company profits.

In reality, as shareholders can switch to a more profitable stock much more easily and frequently(unless the shareholding is very large) than workers can switch to another job, shareholders often care the least about it's long term future and are more likely to favour company strategies that maximise short term profit (or more accurately dividends) at the expense of long term investment. The maximised dividends then further weaken the company as they remove funds that could be used for investment in the future.

Chang comments on how limited liability companies only became practical on a large scale in the UK around the 1850-60's and that, before this, most companies had been "unlimited liability" whereby the shareholders were responsible for ALL the debts a company might rake up if it failed. Famed economist Adam Smith thought this was as it should be, saying:

"The directors of such [joint-stock] companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a [unlimited liability] private copartnery frequently watch over their own...."
However, Chang suggests, the large scale industrial enterprises of the 18th century (railways, steelworks etc) required so much capital that many investors were required, making limited liability more attractive.

A couple of interesting links for more information:
Early history of limited liability companies
The Impact of the UK Companies Act of 1862 (esp in relation to railway financing

Another factor Chang notes is that many of the first large industrial concerns were headed by visionary entrepreneurs, such as Henry Ford or Andrew Carnegie, and who owned large parts of the company's stock. But over time, as companies grew even more in complexity and size, a new class of professional manager began to replace the original founders.

Henry Ford, one of the early 20th Century industrial tycoons (source)

Economists worried that these professional managers would run the companies in their own interests and not those of the shareholders. A number of different formulas were tried to try and align the two interests, these culminated in the 1980s with the concept of "shareholder value maximisation" which had two aims :

i) Maximise profits by cutting costs in wages, investment, staffing - as well as pushing for reductions in corporation tax
ii) Distribute as much of that profit as possible to shareholders via share buy backs and dividend payments

Chang comments on how this approach has resulted in distributed profits as a share of total profits rising from around 40% in the 1970s to around 60% today - but investment and per capita income fell. In addition, share buybacks rose from 5% of profits to 90% in 2007.. and then to 280% in 2008.

US economist William Lazonick has commented that :

From the end of World War II until the late 1970s, a retain-and-reinvest approach to resource allocation prevailed at major U.S. corporations. They retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth—what I call “sustainable prosperity.”

This pattern began to break down in the late 1970s, giving way to a downsize-and-distribute regime of reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders. By favoring value extraction over value creation, this approach has contributed to employment instability and income inequality.

Separately, Lazonick has commented on GM's buy backs :

GM did $20.4 billion worth of buybacks from 1986 through 2002. If it had saved that money and earned a modest 2.5% on it, the company would have had $35 billion on hand when the financial crisis and Great Recession hit and probably would not have had to file for bankruptcy protection. As Bob Lutz, the veteran auto executive, said recently, stock buybacks are “always a harbinger of the next downturn…in almost all cases, you regret it later.”

And Chang comments that

"The weakness of GM management's short term oriented strategy has been apparent at least from the late 1980s, but the strategy continued until its bankruptcy in 2009, because it made both the managers and the shareholders happy even while debilitating the company".

One result of the buybacks(together with reduced corporate taxation) was that between 1979 and 2006 the top 1% of earners in the US increased their share of the national income from 10% to around 23%; and the ratio of CEO pay to average worker pay increased from 30:1 to 300:1 between the 1960-70s and the 2000s.

Chang comments on how other countries, such as France, Germany or Japan, have ensured that large companies have a significant amount of their shares held by a long term stakeholder, such as the government, or a state controlled bank; or by having differential voting rights (as in Scandinavia); or by having strong worker representation at board level.

Ratio of average compensation of CEOs and production workers, 1965–2009.
Source: Economic Policy Institute. 2011. Based on data from Wall Street Journal/Mercer, Hay Group 2010.

CEO - Worker pay comparison
Source: Reflections on CEO Compensation by John C. Bogle, Academy of Management, May 2008, p.21

People don't just act for their narrow self-interest
Economists often assume that people are only motivated by self-interest.

The reality was demonstrated by a Kobe Steel manager at at World Bank conference whose comments, paraphrased by Chang, were :
"I know a thing or two about steel making. However, my company is now so large that I don't understand half the things that are going on within it. As for the other managers - with backgrounds in accounting and marketing - they really haven't much of a clue. Despite this, our board of directors routinely approves the majority of projects submitted by our employees, because we believe that our employees work for the good of the company. If we assumed that everyone is out to promote their own interests and questioned the motivations of our employees all the time, the company would grind to a halt, as we would spend all our time going through proposals we do not really understand."
Kobe Steel Kobe Plant (source)

Inflation is not the sole means to macroeconomic stability
Economists preach that inflation is the economy's "public enemy number one"

Chang argues that, at levels below around 10%, inflation has no relationship with a country's growth rate and that the policies used to tame inflation have the by product of reducing investment, increasing the frequency of banking crises , making jobs less secure.

However, low inflation is promoted as part of the neo-liberal policy package as many financial assets have fixed rates of return, which are eroded by inflation.

Another part of the package is the easing of capital transfer controls, allowing money to cross borders with ease. This is because, according to Chang, the ability to move money around easily and quickly is the key advantage that holders of financial assets have over holders of physical assets.

Chang concludes:
"Our obsession with inflation should end. Inflation as become the bogeyman that has been used to justify policies that have mainly benefited the holders of financial assets, at the cost of long-term stability, economic growth and human happiness."

US inflation rate (source)

Protectionism can be a good thing
Economists often say that developing countries should adopt free market policies and avoid protectionist policies.

In reality, the countries that are rich today got that way by using protectionist policies to protect and incubate their domestic industries. China is an obvious current example, but early history of the US shows the same pattern.

Chang describes how, in 1791, US Treasury Secretary Alexander Hamilton submitted a report to Congress in which he recommended that American "industries in their infancy" should be protected and nurtured by the Government until they were strong enough to stand up against foreign competition. If a developing country did that today, they would be heavily critiseised by the US Treasury Dept and might not be able to access IMF or World Bank loans.

George Washington insisted on wearing American clothes for his inauguration- something that might foul of proposed WTO rules on transparency in government procurement today.

Despite British pressure to accept free-trade, Ulysses Grant commented that, "within 200 years, when America has gotten out of protection all that it can offer, it too will adopt free trade"

Thomas Jefferson believed patents should not be owned by anyone, a view that would not fly far with todays US trade policies.

Even today, the US has supported key industries such as semiconductors, aerospace and biotechnology with government R&D funding.

early integrated circuit chip from 1970's - this industry benefitted
from huge amounts of (military) government funding,
which read directly across to civil technologies and sales (source)

And the US was only building on the model of the UK, who, in the mid 1700's used tariff protection, subsidies and other supports to develop a domestic wollen industry to compete with woolen industry in the Low Countries. The British woollen industry became a big export earner, allowing the country to fund the Industrial Revolution in the 18th-19th centuries. According to Chang, Britain only adopted free trade in the 1860s, when it's industrial dominance was absolute (46% of world trade in manufactured goods in 1870, compared the 17% of world trade that China had inn 20007.

Chang comments on how developing countries have been forced to adopt free-market policies in order to access loans from the IMF or World Bank, and that this has resulted in much worse performance in terms of growth, stability and inequality than in developed countries. Chang believes that the world economic system needs to be completely overhauled to provide "policy space" for developing countries, with more allowance for protectionism, regulation of foreign investment and other aspects of international trade. This in turn would require a reform of the WTO and existing many existing trade treaties.

Christine Lagarde, head of IMF (source)

Trickle Down Doesn't
Chang comments on how income distribution is MORE unequal in Germany than in the US....until you add on the effects of taxation and the welfare state, at which point Germany becomes much less unequal - showing that the welfare state is an important part of reducing inequality. This is in contrast to the claims of "Trickle Down Economics" which holds that making the rich richer will result in wealth "trickling down" to the rest of society.

Ronald Reagan outlining "trickle down" tax reforms in 1981 (source)

Keep markets simple
Chang comments that one very valuable reason to have regulation of markets is to reduce the number of choices players can make, and hence also reduce unpredictability - giving the example of firms in the 2008 crisis:

"So many complex financial instruments were created that even financial experts themselves did not fully understand them...nor could the regulatory authorities fully figure out what was going on".

Chang advises that, to avoid similar financial crises in the future, we should ban complex financial instruments unless we fully understand how they work and their effect on the wider economy - similar to the licencing and product approval process required for new drugs, cars and other products.

Financial Complexity in the mortgage market (source)

For equality of opportunity you need some quality of outcome
Chang also points out that many rules against inequality have been changed due to pressure from the discriminated minorities, examples being universal suffrage, the US civil rights movement and campaigns by low caste people in India.

Chang points out that the drive of the market for efficiency tends to overcome inequality of opportunity, and quotes neo-con economist Milton Friedman:
"No one who goes to the market to buy bread knows or cares whether the wheat was grown by a Jew, Catholic, Protestant, Muslim, or atheist; by whites or blacks. Any miller who wishes to express his personal prejudices by buying only from preferred groups is at a competitive disadvantage, since he is keeping himself from buying from the cheapest source"

In contrast to equality of opportunity, free market economists are very much against equality of outcome, warning that this will result in huge disincentives to work (why should you, if your pay is guaranteed whether you work hard or not?). Chang points out that without some baseline minimum equality of outcome for parents (in the form of minimum wage, access to good schooling and healthcare, habitable housing, safe environments) will mean that they (and particularly their children) will not really have equality of opportunity.

Chang gives the example of post-apartheid South Africa, where there is theoretically equality of opportunity, but many poor black children are still going to underfunded schools, staffed by poorly trained teachers - what chance to these kids have of getting to the top universities?

And in many countries, children find it hard to concentrate on homework because they are hungry, or do not have help from parents who are lacking in education themselves, and cannot afford tutors.

Chang comments that :
"..there has to be some minimum equality of outcome in terms of parental income, if poor children are to have anything approaching a fair chance. Without this, even free schooling, free school meals, free vaccinations, and so on, cannot provide real equality of opportunity for children"
School children in Cape Town, South Africa (source)

The welfare state is the "the bankruptcy law for workers"
"Free market economists believe that any labor market regulation that makes firing more difficult makes the economy less efficient and dynamic...[these regulations] are bad enough but the welfare state has made things even worse. By providing unemployment benefits, health insurance, free education and even minimum income support, the welfare state has effectively given everyone a guarantee to be hired by the government - as an "unemployer worker" if you like - with a minimum wage. Therefore workers do not have enough incentive to work hard. To make things worse, these welfare states are financed by taxing the rich, reducing their incentives to work hard, create jobs and generate wealth"

Chang describes how, in the early nineteenth century, there were no bankruptcy laws. In particular, people had to pay back all their debts, however long it took. So even if a businessman started a new business, he had to use his profits to pay off his old debts. Over time, people came to the view that this was very discouraging of risk taking so introduced modern bankrupty laws which granted protection from creditors during restructuring and gave courts the power to impose permanent reduction in debts. Together with limited liability, these laws encouraged risk taking.

Chang comments that modern welfare states perform the same "second chance" function for workers by providing a safety net and allowing people to be more open to change in careers and taking a risk with new and emerging industries. Chang also refers to a study ("American exceptionalism in a new light") showing that countries with stronger welfare states have better social mobility than those with weak welfare states, with effective retraining policies being an important factor in allowing people to move between industries as markets shift.

Antipoverty effect of government spending (source)

We need some sand in the wheels of financial markets
The way in which increasingly tall towers of financial products were built on each other in the 2000's, all relying on the same limited pool of dodgy underlying assets, is well known as a significant factor in the resulting financial crash.

This tower of financial products was able to be built partly because money is so easy to move around and, as a result, chases short term profits over long term investments.

To remedy this, James Tobin, 1981 Nobel Laureate in Economics, has talked about need to "to throw some sand in the wheels of our excessively efficient international money markets" to slow down this rapid movement of capital. The idea has since developed into the concept of a tax or charge on financial transactions more widely.

Countries supportive of a transaction tax [green], not in favour[red], undecided[d.grey]
By Spitzl - Own work, CC BY-SA 3.0,

There are other types of economists
Having spent much of the book describing how economics, particularly as practiced in the US and UK, over the last 30 years has been "postively harmful for most people", Chang comments that what saved the world from an even more calamitous recession in 2007 was learning from economists such as Jhn Maynard Keynes, Charles Kindleberger and Hyman Minsky amongst others. Chang also mentions that the economists responsible for the economic growth in South East Asia were probably more familiar with the economics of Karl Marx, Friedrich List, Joseph Schumpeter, Nicholas Kaldor and Albert Hirschman and that these economists, although from a different time, had a commonality of thought that capitalism develops through long term investments and technological improvements that transform the productive structure, not merely expand it. Adding that :
"many of the things that the East Asian government officials did in the miracle years - protecting infant industries, forcefully mobilising resources away from technologically stagnant agriculture to dynamic industrial sectors.. derive from such economic views , rather than the free-market view"
Chang mentions other economists (such as Herbert Simon, Arthur Pigou, Amartya Sem William Baumol and Joseph Stiglitz) who are rarely acknowledged by those of the free market school.