The Greatest Ever Economic Change

13 September 2012

The Greatest Ever Economic Change

Professor Douglas McWilliams

Introduction
I am very grateful to Gresham College for allowing me to borrow the title of Mercers School Memorial Professor of Commerce for three years. I have had many illustrious predecessors and am immensely flattered to have the opportunity to follow in their footsteps. I have known Gresham College since my father was Lord Mayor twenty years ago and I worked with various institutions to support his Mayoral Theme ‘The City and Industry in Partnership.’  The then Gresham Professor of Commerce, Walter Eltis, who is a very important economist of the first rank, was immensely supportive of my father’s objectives.

Summary
What I would like to do this evening is set the background for the eighteen talks that comprise my main lecture series. In addition to these eighteen talks on the main theme there are also three special lectures on unrelated themes, one of which will be on 1 May 2013 on transport in London. It is this lecture that caused the diary columnist in the Evening Standard to comment sardonically that if I could solve the transport problem I deserved to be made Mayor. Somehow I don’t think Boris is quaking in his boots.

My major aim tonight is to justify the title that the economic development of two thirds of the world is the world’s greatest ever economic event and I will compare it with two other major events – the industrial revolution and the so-called discovery of the Americas. Finally this evening I will give a sneak preview of some of the highlights of the future lectures in the hope that I can encourage attendance at them without necessarily having to offer the bribery of free drinks.

I see the series of lectures as a wakeup call to those of us in the West who have not fully appreciated the scale of the challenge to us that is posed by the emerging economies from the East.

There is a risk that the rest of Europe including even countries outside the Single Currency like the UK could slide in the same way that Greece now has into first stagnation and then economic collapse unless we recognise the challenges that we face from the East, analyse them carefully and respond by adjusting our own policies to reflect the changing external situation. We can no longer formulate our economic policies just by thinking about ourselves alone. We need to understand the economic environment in which we are operating.

Background
I seem to have been living with the development of the Asian economy from some of my earliest memories.

I was brought up in what was first Malaya and which became Malaysia. We lived first, in historic Malacca, and then in the area around Kuala Lumpur. My parents went to Malaysia when I was one and left when I was in my mid-twenties.

At the time being brought up in what was before independence in 1957 a far flung part of the British Empire seemed to have quite a lot of disadvantages. Occasionally I would come home and find a cobra wrapped around my rocking horse. There was the omnipresent risk of Communist terrorists, whom we euphemistically called ‘bandits’ with a penchant for murdering ‘Europeans’ as white people where then called.  As a small child I remember vividly sitting on the veranda watching bombs being dropped on what was allegedly a terrorist camp a few miles away. And being sent to boarding school in England at the age of 8 with one’s parents 8,000 miles away was – let me put it this way – character forming.

But as I started work as an economist I began to realise that I had had a unique advantage in my upbringing – a ringside seat at the trailer film for what was going to prove the world’s greatest ever economic event.

Asia in the 1950s and 1960s was mainly thought of economically as a producer of commodities and very cheap basic goods.  In 1968 that changed. The electronics company Fairchild made the first offshore electronics investment in Hong Kong. I have a personal view which has been rarely mentioned in the literature (the main study on this is in Korean, though it has now been translated!)  that the Vietnam War had a bit to do with the first investments in East Asia.[1] Young American soldiers were drafted into the War and sent to Asia. I’m sure that their unusual experience abroad in Asia (remember at that time that very few Americans ever left the US) might have influenced their attitude to investment in East Asia when they returned to civilian life and made business decisions. The peak level of expenditure by the US on Vietnam was (coincidentally) also in 1968 when according to the Congressional Research Service[2] $111 billion was spent on the war, which they have helpfully translated into $738 billion at FY2011 dollars – in other words today’s money.  As Senator Everitt Dirksen pointed out – ‘a billion here, a billion there, pretty soon you’re talking about real money.’ $738 billion is real money and had already started to leach into the domestic Asian economies in the provision of basic supplies before Fairchild came in and started to make electronics products in Hong Kong.

We talk these days of wars creating ‘collateral damage’, which I feel is a nastily sanitised phase. But there are occasionally also ‘collateral benefits’ such as the stimulus given to economic development in East Asia.

When I was studying for my Master’s at Oxford in 1972, the phenomenon of offshore electronics manufacturing in Asia already seemed to be developed enough for me chose for my thesis to perform a cost benefit analysis of the first two electronics plants in the Kuala Lumpur area. What my thesis showed was that these plants – set up by Texas Instruments and Motorola – had hugely positive benefits to society in Malaysia, even though they were set up in tax free zones. This was because, as always, the main economic benefits emerging from a company are the salaries paid to employees, the new jobs that are created and the employment, income and other taxes paid by the employees. Those who measure corporate contributions to society simply by looking at corporate tax payments normally completely miss the point.

What I also discovered when doing my studies – and I think enough time has passed for the information that was given to me no longer to be confidential – was that these plants paid off their entire investment in 10 and 12 months respectively.

My conclusion – that this would be a dominant force in the emerging world – was roundly ignored by the professors of economic development who were still in the main hung up on a very top down anti-business model of economic development. This is one of the reasons why, although I am delighted to be the Gresham Professor, I do not generally use the title of Professor. In economics, professors are often those who are following what is going on in the world rather than leading it.

Growth in the Smaller Emerging Economies in East Asia
But what we saw starting to happen in Malaysia and Hong Kong and also in Taiwan, Korea, Thailand and especially Singapore was an important economic theme of the 1970s and 1980s, though because these economies were still relatively small, the impact on the global economy was muted.

The Asian countries plus Taiwan accounted for 3.2% of the world economy in 1870 and was about the same percentage, 3.3% , in 1970.  This rose to a peak of 8.0% in 1997 before the Asian currency crisis[3]. The rise was very rapid but despite this, the net impact on the scale of the world economy was limited.

Japan
Let me digress for a short time just to deal with Japan. Japan was the first East Asian economy to industrialise and starting after the Meiji restoration in 1868 led to a process that finally had Japan catch up with the Western economies. Japan’s standard of living doubled between 1870 and the First World War, doubled again by 1939 and after a major slump during the war – much more than in most of the other belligerent countries – had recovered its pre-war level by 1956 and caught up with Western Europe by 1973.

Japan is an outlier. It was the only Asian economy to industrialise so early. Although it had scale, with a population which reached 100 million in 1967, and its industrialisation was distinctly faster than for Western Europe, nevertheless its total impact on the world economy was still relatively minor because it represented just one country. Japan’s share of world GDP rose from 2.3% in 1870 to 8.7% at its peak in 1991 which is non-trivial but still not enough to mark a qualitative shift in things like world demand for resources.

There are two other reasons why Japan has been (other than in the 2nd world war) less disruptive: first, the speed of industrialisation – though rapid – has been about half that of East Asian and China. The second is that post world war 2, the US have had the power to influence Japanese economic policy and so the Japanese have been forced to allow the Yen to appreciate to reflect its competitiveness. So that the super-competitive conditions that we have seen elsewhere only existed for a short period before the appreciation of the Yen changed the position.

But Japan has been important in the story. First it proved conclusively for any racist who believed that only white people could industrialise that this was emphatically not the case. And of course, Japan’s actions in the Second World War, though ultimately self-defeating, spelt the end of the Western, especially British, empires in the East. My fellow Gresham Professor, Sir Richard Evans, has written eloquently about this.

The Emergence of China
The examples of the emerging economies in East Asia as well as that of Japan were bound to affect other Eastern economies. With Taiwan and Hong Kong on their doorstep, one would have had to be immensely obtuse or blinded by ideology not to realise in China that Chinese people everywhere except in mainland China seemed to be doing remarkably well while those in China were not. And once Chairman Mao had died, the new Chinese leadership was not obtuse or blinded by ideology. From the mid-1970s onwards they decided to copy what was being done in the economies on their doorstep.

President Johnson in the 1960s used to defend the actions of the US in Vietnam by talking about what he called the Domino Theory – that if one country fell to communism it would knock over its neighbour country. In the end, what happened was the Domino Theory in reverse. The economic success of East Asia, changed China, which was one of the factors leading to President Gorbachev wanting to reform Russia and which over time was one of the factors that led to the fall of the Iron Curtain., I remember once explaining to Lee Kuan Yew that he had caused the fall of the Iron Curtain – he was amused by the idea.

And of course we are not just talking about these economies alone. Latin America saw which way the wind was blowing and changed course. More importantly, other emerging economies of which the most important was India also began to change.

A coincidental factor that was hugely important in all this was the emergence of information and communications technology. I know a bit about this from my time as Chief Economist of IBM UK where I looked rather carefully at the economic impacts of technology.

The new electronic technologies created a mass demand for cheap mass produced electronic components and products which have been the main driving technology for East Asian economic development. It has also reduced the tyranny of location and allowed businesses throughout the world to enter into the software industry. This has been especially important for India, since it allowed Indian software exports to escape the so called permit Raj that had – very much with the help of the professors of economic development – done so much to slow down India’s emergence from the economic doldrums.

The Greatest Ever Economic Change?
The title of this lecture ‘The greatest ever economic change’ is a bold claim and you would expect me to justify it. Obviously the word greatest is as ever difficult to prove objectively. Was Don Bradman a greater cricketer than Gary Sobers?  I think not but I can empathise with the many who disagree!

What I propose to do here is to compare the industrialisation of the emerging economies with the two other major events in economic history that might be considered comparable – the industrial revolution and the so-called discovery of the Americas by Europeans.

And since my claim is explicitly to do with economics I will concentrate on two measures of ‘greatest’ that are economic measures – the impact on world GDP and the impact on GDP per head of population.

Chronologically the first of the two episodes was the so-called discovery of the Americas. I say so-called because there were indigenous populations who would have been surprised to be told that they had been discovered.

The so-called  discovery of America
Columbus sailed in 1492 and I think it is fair to consider the next 200 years as influenced by the European discovery of the Americas.

The major economic effects were the population transfers from Europe to the Americas and of course the subjection and often extermination of many of the indigenous people through conquest and disease, the importation of a range of new plants and herbs that transformed many habits and of course the extraction and import of precious metals.

There was an economic impact. World GDP – which had probably fallen from the year 1AD to 1000 AD – had been rising very gently in the previous 500 years at an annual rate of 0.15%, or 15% a century. In the century after the discovery of the Americas from 1500 to 1600 it rose by 33%, a doubling of the rate of growth. And world GDP per capita started to edge up – by 5% over the century. In Western Europe, GDP per capita rose by 14% during the century.

And the growth continued into the next century, with further GDP growth for the world as a whole of 12% from 1600 to 1700 and in GDP per capita in Western Europe of a further 14%.

Now this is significant for two reasons. First, until then GDP per capita in what was effectively a subsistence society had been essentially ruled by Malthus’s law which argued that populations expanded until they could not feed themselves so gains in living standards were competed away by population growth. And so standards of living not only remained much the same from once century to the next but also varied by only minor amounts between different regions of the globe.

The impact of the discovery of the Americas was to start to break Maltus’s law. Significant world growth appeared so that world GDP 200 years after Columbus was about 50% higher while living standards in Western Europe started to move up from subsistence levels.

There was of course the impact of inflation. The impact of the import of silver from the Americas had a damaging effect on Spain from the latter part of the sixteenth Century to the middle of the seventeenth as inflation caused by the expansion of the monetary base eroded living standards for those who did not have access to this silver bullion. The effects were particularly distributional – poor people on fixed incomes had their living standards reduced and the population of Spain fell from over 8 million in 1600 allegedly to below 7 million by 1650 as the poor died or emigrated. There are parallels with the impact of quantitative easing in Britain today on some older people.

Overall, the discovery of the Americas clearly had an economic effect. But one needs to look both at the scale and the length of time over which is occurred to put it into context.

The Industrial Revolution
My second episode is the industrial revolution. Most definitions of the industrial revolution date it from 1750 to 1850 and point to a range of technological changes affecting a wide range of industries from agriculture through mining and transport to manufacturing. These created the modern world as we know it.

The social implications were vast. It is generally argued that the sustained growth in both living standards and population were driven by these technological changes, though we have seen that they started a bit earlier. But certainly, as Nobel Laureate Robert Lucas has argued[4], “For the first time in history, the living standards of the masses of ordinary people have begun to undergo sustained growth ... Nothing remotely like this economic behaviour has happened before."

The industrial revolution had profound effects. Because it occurred in Great Britain, where there had been relative peace and where the unification of Scotland with England and Wales had given a kickstart to trade, and where there was a system of rule of law which not only gave some enforceability to contracts but also permitted the emergence of for example the joint stock company, these factors were seen as important and replicated throughout the world. As were capitalism and the emerging of representative government if not full democracy.

But the industrial revolution only affected directly a small part of the world’s population – the so called Western economies and the Western offshoots who supplied them. Once of the effects of this was to start a period of Western political and military dominance which is now ending.

The effects of the industrial revolution on the world economy were rather greater than those of the discovery of the Americas. Between 1700 and 1820 world GDP nearly doubled, increasing by 87%. And there was a further increase of 60% in the 50 years between 1820 and 1970. GDP per capita lagged the growth in GDP but rose by 8% between 1700 and 1820 and more impressively by 30% from 1820 to 1870. In Western Europe GDP per capita rose by 20% from 1700 to 1820 but by 68% from 1820 to 1870.

And by now the offshoots of the western economies were making their way. In GDP per capita terms the wealthiest economy in the world in 1870 was in fact Australia. And by the late 1880s the largest economy in the world was no longer China, which had held this position since it overtook what is now India in around 1500, but the United States, which remains in that position to the present day.

By comparison, if we take the more recent period since East Asia other than Japan started to industrialise, from 1970 to 2008 world GDP rose by 270% and world GDP per capita rose by 104%. This is an order of magnitude different from the scale of economic growth after the discovery of the Americas and during the industrial revolution. GDP per capita in China, the most important of the fast growing economies, rose by just under 8 times between 1970 and 2008. Over this period, world GDP rose at an average annual rate of 3.5%.

The post WW2 era of Rapid Economic Growth
Now those who are familiar with the figures will point out that I have missed out a period of particularly strong economic growth. Between 1950 and 1970 the pace of world economic growth averaged 4.9%. Over this period world GDP rose by 157% and GDP per capita by 77%.

But much of this represented a catch up from the world depression of the 1930s and from the economic impact of the 2nd world war. Taking a longer period from 1913, world growth was respectable at 2.8% - good but significantly below that more recently during the Asian industrialisation.

Arguably world growth in the 1950s and 1960s was unsustainably fast. This was reflected in the rise in primary commodity prices in the early 1970s and the rise in the price of oil as the West lost control of the Middle Eastern economies and OPEC began to flex its muscles. So it is perhaps misleading to treat it as a self-contained period since growth was exceptional.

Another important feature of the latest period is the dramatic change in the balance of world economic advantage. There was a major change in the balance of world economic advantage between 1820 and 1870 when the share of the world’s GDP emerging from the 30 Western European economies and the 4 economies which Maddison calls Western offshoots (US, Canada, Australia and New Zealand) rose from 25% to 43%. This share then rose relatively slowly to its peak in 1950 at 57%. It edged down from 1950 to 1970 to 52%. But in the period from 1970 to 2008 it fell back very rapidly indeed to 38%. On our calculations the drop in the Western 1share on the Maddison measure has accelerated dramatically in the past 4 years to stand at an estimated 33% in 2012.

Claim of Greatest Change Justified
If we take the various features together – the rapid world economic growth for the whole period since 1970, the amazing rise in living standards in China and the extraordinary change in the non-Western share of the world economy since 1970, I think we can reasonably claim that the economic change that we are currently going through is the greatest change ever.

But this is just the past.

Looking Forward
What is dramatic about what is currently going on is that we are only part way through a major process that is set to continue for the next fifty years at least.

And what is also unusual is the speed with which the change in competitive advantage is taking place. The reason for this is that the pace of economic change in the East has been so massive that attitudes have not adjusted in line.

When prosperity comes gradually, societies tend to ease up. People work less hard; they spend a rising proportion on public services even at the cost of higher taxes, they introduce welfare systems, they stop saving and investing and let others do that for them; they start taking economic growth for granted; they indulge in anti-business posturing. That is where we are in the West today.

But in the East prosperity has come so rapidly that attitudes have yet to shift. They behave with the hunger of societies that are poor even though they are becoming (and in some cases like Hong Kong and Singapore have already become) rich. They don’t take prosperity for granted.

In Singapore, GDP per capita is already 30% higher than in the UK. In Hong Kong it is 50% higher. Yet they both work just as many hours per year as they did when they were poor. Compared with us, they work about 5 more months a year.

They have held down public spending. Singapore in the East has a reputation for being a bit ‘socialist’ and so they have public spending at 17.3% of GDP (compared with 50% in the UK). In Hong Kong, which is thought of as being a bit more capitalist, public spending is only 16.7% of GDP. The top rate of tax in Singapore is 20%: in Hong Kong it is 15%.

And their public services are generally better than ours. Their health services are so good that their life expectancy has rocketed past ours – Hong Kongers live longer now than anyone else on the planet – two years longer than us. Singaporeans live one year longer on average than us. And anyone who has travelled on the Singapore or Hong Kong Metro systems will know how they compare with ours.

It is not surprising that jobs are flowing out from the UK to these centres already. It is the rapid pace of change which is so important. The discontinuity between attitudes both in the West and the East that have been predetermined by history and a pace of economic change far outstripping the pace at which attitudes are adjusting is why this change is so disruptive. Its consequences so far include the Western financial crisis and the Eurozone crisis.

A Preview of the Future Lectures
But there will be more to come. I will go into more detail on different aspects of this in my forthcoming series of lectures.

Let me now just give you a short preview of what I plan to cover over the eighteen lectures and with rather more detail for the other five this year.

My main programme of lectures covers three years with six lectures for each year. This year’s six lectures are mainly analytical covering what is likely to happen. Next year’s six look at the economic policy options we have in the West to improve the outcomes for us. I will among other things look at the implications from a Marxist perspective. The final year’s six lectures look at the implications beyond the field of economics, covering items like diplomacy, the rule of law, equality and inequality.

Here is a bit more detail over what I am going to cover in this year’s other five lectures.

Next month’s lecture looks at the constraints on growth – whether world growth will be held back by economic disruption, by environmental constraints or by shortages of primary products. Obviously I am not a primary products expert so I will be joined for this by two people who are, Thras Moraitis, member of the executive board of Xstrata and my more intelligent brother Michael McWilliams who is worldwide head of hydro power for the engineering consultants Mott MacDonald.

The following month’s lecture in November is titled ‘A new theory of economic growth’ and looks at how we should forecast economic growth in the medium term for the Western Economies. It will explain why the approach currently taken by the Office for Budget Responsibility has proved so inaccurate and will suggest a better basis for the government to base its spending plans. Some of my office colleagues from Cebr who have helped me develop this theory will help explain it.

In January we get to grips with the fact that, cursed with apparent affluence, we have allowed a high cost economy to develop in the west with costs that are not entirely necessary built in throughout the cost chain. We could afford these when we were rich and had a monopoly on wealth – we need to strip them out now that we are in a competitive situation. This lecture will look at where we should be doing this.

In February I will look at how the economic changes are leading to a glut of savings and the consequences of this. I will look at what Keynes would have said in response.

My final lecture of this year’s series covers the winners and losers. I will produce a quantified forecast using the Cebr global macroeconomic model. Again I will be helped by my Cebr colleagues. Some of the nuggets that will emerge from this are:

We expect Chinese economic growth to slow down quite sharply. We are looking for growth of about 4% per annum by the 2020s.

Despite this, it is almost inevitable that the Chinese economy will overtake that of the United States around 2023 to retrieve the leading position it lost in the 1880s. It will not only have faster growth (though not by much by then) but also Chinese prices will rise relative to those in the US and the internationalisation of the renminbi will lead ultimately to a rising currency against the dollar.

But by 2050 the Indian population will be about 40% larger than the Chinese population and so we expect that around then  - our numbers say 2048 but obviously there is a huge margin of error – the Indian economy despite its current travails will overtake the Chinese economy to become the world’s largest. This is also a return to the past, since the Maddison data indicates that what is now India was the world’s largest economy until the late 1400s.

Other winners will include the commodity producers. One of these is of particular interest, Australia. Both immigration and commodity wealth are likely to boost the Australian economy. This is important in the UK, since I have written about how Australian sporting success is negatively correlated with its economic success. So we will need to understand the Australian economic prospects carefully to see who will win the Ashes!

There will also be losers. We can already see what is happening in Greece and other parts of Southern Europe. It would be a mistake to blame the economic declines taking place simply on the euro. The euro has exacerbated their problems but it is not the only cause. The loss of growth from lost competitiveness has caused tax revenues to collapse which has been a major cause of the deficit problems and is the major reason why these deficits cannot easily be reduced.

But the underlying factors will affect the UK as well. Our slide will be more genteel and will be cushioned by the fact that we can control our own currency. But many of the factors affecting Greece apply in a more diluted way to the UK. This is well set out in Larry Elliot and Dan Atkinson’s book Going South, though I believe that they shy away from the implications of their analysis – that Mrs Thatcher’s policies would appear to have been very moderate compared with what will be required if the UK is to be prevented from a fate where GDP virtually stagnates and consumers expenditure per household – which has declined by 8 per cent in the past five years – continues to fall.

If we are to avoid this fate, policies to encourage growth are not just one option among many for politicians – they are an absolutely essential precondition.

So I hope that you can see the wealth of treasures that will be on display for those who are prepared to be gluttons for punishment and follow the entire lecture series.

The heart of my message is that we need to understand what is going on in the world around us and match our economic policy to the underlying reality.

 

© Professor Douglas McWilliams 2012

[1]The only study that I can find in the academic literature that even considers this issue is ‘The Vietnam War and the ‘Miracle of East Asia’, Keunho Park & Hiroko Kawasakiya Clayton Inter-Asia Cultural Studies, Volume 4, Issue 3, 2003,pages 372-398, which points out that it is traditional for economic development studies ‘to search for general theories of economic development…..accidental factors, including the Vietnam War, should be abstracted from economic development…’
[2]‘Costs of Major U.S. Wars’ Stephen DaggettSpecialist in Defense Policy and Budgets,June 29, 2010Congressional Research Service 7-5700www.crs.govRS22926
[3]All the numbers for the world economic history used here are from the Maddison Data Archive at the Groningen Growth and Development Center at Groningen University in the Netherlands. Angus Maddison was a major scholar whose life work was in producing historically comparable data. His series cover world GDP, population and GDP per capita and go back to the year 1. The figures are calculated in Geary-Khamis dollars at 1990 prices. This is essentially a purchasing power parity measure. This is appropriate for the historical data for periods when market exchange rates often did not exist or were unrepresentative. For the forecasts in this lecture I prefer to use actual cash dollars because they give a better indication of buying power.
[4]Lucas, Robert E., Jr. (2002). Lectures on Economic Growth. Cambridge: Harvard University Press. pp. 109–10. ISBN 978-0-674-01601-9.