Chapter 2

THE ROOTS OF DEVELOPMENT

W. A R T H U R LEWIS

THEORY

Princeton University

Contents

1. Introduction 2. Sectoral imbalance 3. Overall balance 4. Organization 5. Conclusion References

28 28 31 34 36 37

ttandbook of Development Economics, Volume L Edited by 11. Chene O, and T.N. Srinivasan Elsevier Science Publishers B. V., 1988

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1. Introduction

The theory o f economic development established itself in Britain in the century and a half running from about 1650 to Adam Smith's The Wealth of Nations (1776). The purpose of this chapter is to investigate how much of the development theory of today is already to be found in the writings of the eighteenth century. There was of course voluminous writing before 1650, but this differs so much in objective and in methodology that it would prove rewarding only to specialist historians. Jumping back a hundred years we are amongst the schoolmen. Their purpose was to reconcile modern economic life and institutions (especially trading, interest, profit-making, and the right to hold private property) with ethics and religion; and their method was to quote from the Bible and the writings of the early Church. The early mercantilists, who follow, are concerned with strengthening the military power of the state, in part to unify the country, and in part to fight external enemies (especially the Dutch and the French). The military problem is as acute now for some Third World states as it was at that time; although their remedy- to keep the king's war chest full of gold- would not in these days command much support. By the time we have crossed 1650 our economists are no longer occupied with military power. The wealth of the king moves from center stage, and the income of the nation, as reflected in the balance of trade, has taken its place. Economics has also begun to be quantitative, under the leadership of Sir William Petty. The writers of the seventeenth and eighteenth centuries are often disparaged for being confused and confusing. Much of this is due to misuse of words, as in treating as synonyms for wealth: money, gold, treasure, balance of trade, and balance of payments. With hindsight it is easy to recognize anomalies of language, and to correct for them. We can also deal with misunderstandings due to changes in institutional backgrounds. With such adjustments eighteenth-century economics was surprisingly advanced. We also reduce the burden by concentrating on the writings of the three superstars of the eighteenth century, Hume, Steuart and Adam Smith, and two whose influence was more restricted, Cantillon and Wallace. We have also set aside the French and German authors. [See Hume (1748), Cantillon (1755), Steuart (1767), Smith (1776), Wallace (1753).]

2. Sectorai imbalance

We approach the subject by assuming that a manufacturer hires more employees and increases his output, and that the relevant elasticities are such that he must

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buy more raw materials and sell more manufactures. If this is a closed economy, the terms of trade will move against manufactures, and if this goes far enough, the revenue required to sustain the increase in the output of manufactures will not materialize. The size of the non-farm population depends on the size of the agricultural surplus. This doctrine goes back very far. Its main proponents in the eighteenth century are Hume, Steuart, and Adam Smith. Here, in a nutshell, is Smith's formulation: It is the surplus produce of the country only, or what is over and above the maintenance of the cultivators, that constitutes the subsistence of the town, which can therefore increase only with the increase of the surplus produce [Smith (1776, p. 357)]. But there is a way out. Remove the assumption of a closed economy and the towns are no longer limited by the size of the domestic agricultural surplus. They can import and export instead, leaving it to the agricultural community to do the same, or to ignore what is happening in the manufacturing sector or both (this depends on the size of the export multiplier). This alternative is recorded by Adam Smith: The town indeed may not always derive its whole subsistence from the country in its neighborhood, or even from the territory to which it belongs, but from very distant countries; and this, though it forms no exception from the general rule, has occasioned considerable variations in the progress of opulence in different ages and nations [Smith (1776, p. 357)]. The existence of the alternative shifts the constraint on growth of output from the size of the agricultural surplus to potential foreign exchange earnings. But there is also much dispute as to the strength of the foreign exchange constraint. Structuralists maintain that it is very hard to raise the rate of growth of exports, or to cut imports; while "market" economists claim that elasticities are adequate, and that failure to rely on them is mistaken. The two-gap model was invented in the 1950s to illustrate the difficulty of earning foreign exchange. Presumably the facts of each case must be considered separately. It seems likely that the recent years (1973-1988) have been more difficult to manipulate than the two preceding decades. The debate on the gains from trade had been in progress for two centuries, and would still be in progress two centuries later. Here is Hume on the subject: There seems to be a happy concurrence of causes in human affairs, which checks the growth of trade and riches, and hinders them from being confined entirely to one people; as might naturally at first be dreaded from the advantages of an established commerce. Where one nation has gotten the start of another in trade, it is very difficult for the latter to regain the ground it has lost; because of the superior industry and skill of the former, and the greater stocks, of which its merchants are possessed, and which enable them to trade

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on sO much smaller profits. But these advantages are compensated in some measure, by the low price of labor in every nation which has not an extensive commerce, and does not much abound in gold and silver. Manufactures therefore gradually shift their places, leaving those countries and provinces which they have already enriched, and flying to others, whither they are allured by the cheapness of provisions and labor; till they have enriched those also, and are again banished by the same cause [Hume (1748, "Of Money", pp. 34-35)]. Whatever may be the individual case, the general principle remains the same. Foreign exchange and foreign exchange reserves are a potential constraint on growth. This was not fully appreciated after the Second World War. Some Development Plans were made, for instance, in the 1950s without checking that the proposed allocation of resources would provide enough foreign exchange. The consequences of this neglect are painful. As the country runs short of foreign exchange, it is forced ultimately to reduce the import of raw materials and machinery, so factories close and unemployment swells. I speak of foreign exchange and foreign exchange reserves, but this is an anachronism. Reserves were held in gold or silver, not in paper (bills, notes). The practice of major countries holding their reserves routinely in the form of entries in bankers' books in some other country did not begin until the twentieth century [Lindert (1969)]. When the Mercantilists say that one should have an adequate stock of gold, they sound confused, but when a twentieth-century LDC seeks to increase its foreign exchange reserves, it appears to be highly sensible. Fundamentally what they were saying was that export industries, or, as we would say, "tradeable goods", are more valuable than non-tradeable goods because they can be turned into foreign currency. They felt for this distinction, but they never quite reached it. On the way they got bogged down in other distinctions. A favorite track led to the question whether agriculture or manufacturing was the more important. The Physiocrats voted for agriculture, since manufacturing does not add to the embodied physical resource; whereas the Mercantilists voted for manufacturing partly because its output was easily tradeable at a profit. Twentieth-century development economists are not caught in such a trap because we do not answer questions involving all-or-nothing. We operate at the margin. So our question is by how much to increase both agriculture and manufacturing, respectively, and our answer depends on time, place, and elasticities. But even today non-professional writing and debating are fascinated by this choice in the language of all-or-nothing. We would also not accept that services are inferior to commodities, because there is no tangible product. This trapped even Adam Smith: The labor of some of the most respectable orders in the society is, like that of menial servants, unproductive of any value, and does not see or realize itself in

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any permanent subject or vendible commodity which endures after that labor is past, and for which an equal quantity of labor could afterwards be procured [Smith (1776, p. 315)]. Services add value (in our language) whether they are tradeable, invisible, or permanent. Governments need to be warned about services because they tend to expand health, housing, education, and welfare services much faster than national income grows; but the error turns not on the nature of services but on failure to equilibrate that part of the Development Plan that projects the balance of payments. In sum, the eighteenth-century economists did not find the precise distinction between tradeable and non-tradeable goods and services, but this was what they were feeling for. They were also conscious of the difficulties of exporting imposed constraints on the growth of the economy. If they were obsessed with the balance of payments, it may also be said that mid-twentieth-century economists underestimated the importance of this constraint, and paid the penalty in almost continual international currency crises from 1913 to the time of writing (1985).

3. Overall balance

Now let us close the economy, and concentrate on internal balance. Suppose that there is a balanced expansion (balanced sectorally as between industry and agriculture), and financed by a proportionately equal increase in the quantity of money. Will the money so spent turn up as income more or less equal to that which was originally expanded? In the language of Keynes: Will aggregate demand equal aggregate supply? This is one of the oldest questions in economic development. The first point to note is that the money would circulate. Harvey discovered the circulation of the blood in 1616, and this image was in the mind of most economists from then onwards. Nearer home, the idea of circulation is inherent in Quesnay's Tableau Economique, but this was not published until 1758. What is known as Say's Law was not formulated until 1821, but the question is much older. That all costs become equivalent incomes is tautological. The question is: What happens to the incomes? Adam Smith's proposition that: "What is annually saved is as regularly consumed as what is annually spent" [Smith (1776, p. 321)] assumes that all income will be re-spent, if not for consumption, then on investment. But this need not be so. Income receivers may hoard; savers may fail to invest; the chain of expenditure, to use a different metaphor, may break. Smith would not accept that the level of employment would depend on the division of expenditure between savings and consumption, but he did put

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forward his own distinction, which is effective in the long run but not in the short. This was the distinction between "productive" and "unproductive" labor. Labor, whose product was sold for a profit, was productive because it yielded an investible surplus. Thus, if a man hires a maid to work in his hotel, her labor is productive, but if he hires her to work in his house, her services are unproductive. So if labor was transferred from productive to unproductive output, the short-term level of employment would not change, but the long-run rate of growth would diminish because of slower growth of the stock of accumulated capital. At the next stage of this argument the sum paid in wages is transmuted into a "fund for the employment of labor". Any change in the structure of national income will alter the proportion of productive to unproductive in the wages fund, and so raise or reduce the growth rate of output in the long run. For example, in our day it was proposed that "surplus labor" be used in the slack agricultural season to build, in parts of India, useful local infrastructure, such as irrigation channels, farm to market roads, schools, etc. Surplus labor can be converted to saving when the labor is willing to work without pay; but if it is not, then extra food and other consumer goods must be mobilized for the villagers along with extra pay. So the program absorbs savings instead of generating savings. One can state this in terms of Smith's formula: unproductive workers are being converted into productive ones, but nothing is gained by doing this, beyond recognizing that the need for savings is a further constraint upon growth even when using surplus labor. The wages fund model spurred a lot of argument among the classical economists but it was confusing and did not contain any useful insight. The fact that it survived into the second half of the nineteenth century is rather surprising. Other writers did not accept Smith's assumptions or his conclusion that output was unaffected by the ratio of consumption to national output. They insisted that what we now call "aggregate demand" might fall short of or exceed aggregate supply, and that it was therefore necessary to bolster consumption if full employment was to be maintained. This was the position taken by Mandeville in his The Fable of the Bees, but it was also the opinion of highly regarded economists like Hume, in whose words: "Luxury, when excessive, is the source of many ills; but is in general preferable to sloth and idleness, which would commonly succeed in its place, and are hurtful both to private persons and to the public" [Hume (1748, " O n Refinement in the Arts", p. 32)]. This, freely translated, means: unemployment (idleness) is bad, and needs to be minimized by spending on consumer goods; but spend on matters that give general pleasure (art museums, etc.) rather than on loose living. These economists needed to have a theory of wages, since the level of wages would determine the size of the surplus available for investment after paying off the laborers. The model was already established in which net saving was done only out of profits income, and not out of rent or wages: the formula that would

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continue to be used over the next century. Here is Hume's version of it: There is no other profession, therefore, except merchandise, which can make the monied interest considerable, or, in other words can increase industry and, by also increasing frugality, give a great command of that industry to particular members of the society. Without commerce the state must consist chiefly of landed gentry, whose prodigality and expense make a continual demand for borrowing; and of peasants who have no sums to supply that demand. The money never gathers into large stocks or sums which can be lent at interest. It is dispersed into numberless hands, who either squander it on idle show and magnificence, or apply it in the purchase of the common necessaries of life. Commerce alone assembles it into considerable sums [Hume (1748, " O f Interest", p. 54)]. The wage level also determined the supply of labor in the short run, since the workers were "slothful" and offered themselves for full employment only as wages fell. Adam Smith thought the opposite, namely that workers worked more as wages rose. He also thought that wages would rise above subsistence level if the economy were growing fast. As he said: "It is not the actual greatness of national wealth, but its continual increase, which occasions [high wages[" [Smith (1776, p. 69)]. Adam Smith favored a wage level beyond subsistence, but other economists, preoccupied with the balance of trade, wanted wages to be as close to subsistence as possible so that exports be stimulated and imports choked by low British prices. Their position was not unlike that of twentieth-century seekers after a prices and incomes policy that will enable a country to keep its money costs per unit of output rising no faster than costs in closely competing countries. So far we have not considered the effects of money on output. Seventeenthand eighteenth-century economists wrote copiously on this subject, establishing how it would be approached until the twentieth century. We can therefore be brief. The Quantity Theory of money was well known to economists throughout the eighteenth century, on account of its formulation by John Locke [Locke (1691)]. It was familiar in its simplest form, where an increase in the quantity of money leads to an equal proportionate increase in prices. But it was also debated in its more sophisticated form, where some increase in employment would occur, as well as more work become available for those already at work but not fully occupied (the disguised unemployed). This was Steuart's position. The synthesis was provided by David Hume in his essay " O f Money". The increase in money would first raise prices by more than costs, but in the long run costs would catch up: We find that in every Kingdom, into which money begins to flow in greater abundance than formerly, everything takes a new face; labor and industry gain

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life, the merchant becomes more enterprising, the manufacturer [i.e. industrial worker] more diligent and skillful, and even the farmer follows his plow with greater alacrity and attention... At first no alteration is perceived; by degrees the price rises, first of one commodity, then of another; till the whole at last reaches a just proportion with the new quantity of specie which is in the Kingdom. In my opinion it is only in this interval or intermediate situation, between the acquisition of money and rise of prices that the increasing quantity of gold and silver is favorable to industry [Hume (1748, " O f Money", p. 37)]. Hume took the same "intermediate" position on the effects of an increase in the quantity of money on the rate of interest; he thought that the rate would fall at first, but thereafter return to its previous level. He was flanked by Cantillon and Smith on the one side, insisting on the neutrality of money, and by Locke and Steuart on the other side, establishing the monetary case. This debate continues. Note the apparent expectation that in normal times the labor market is slack, and that it comes to full employment only in response to a monetary stimulus. As Petty put it, "There are spare hands enough among the King of England's subjects to earn two million more per annum than they do now" [quoted from Johnson (1937, p. 113)]. There was, however, no suggestion of a regular trade cycle, even though with hindsight we' can see that money and commerce were already showing such a pattern (industry was still too small to matter in this context). Population theory was still in confusion. While there was not much dispute about the short-term effects on wages of an increase in the demand for labor, the long-run effects were disputed by at least three groups: those who believed in increasing returns, those who saw an infinitely elastic supply of labor, and a third group that expected diminishing returns. The issues would not be clearly sorted out until the nineteenth century.

4. Organization
Economic institutions were different then from now, and this is reflected in the shape of development theory. First, in the pure model the economy consists of landlords, capitalists, and wage earners, and the theory of distribution explains how the product is divided amongst these classes. English agriculture did indeed have that pattern, but in other countries the labor force consisted of small farmers, working in various legal forms, from near slavery upwards. Their ways of living were not represented in current theory.

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Similarly, the farmer in this model represents the entrepreneur, and also the bearer of innovations. The entrepreneur as such seems to have had his function and procedures analyzed by only one economist of our period, namely Richard Cantillon. He stressed the risk-beating function, instead of capital provision, which was in those days more common. One can understand the general lack of interest. The typical entrepreneur at this time was neither a farmer nor an industrial tycoon, but a merchant adventurer in foreign trade. His capital was working capital rather than fixed capital; and his ability to supplement it by borrowing was restricted by the fact that financial institutions were rather rudimentary. We do not have to ask, like Max Weber, where all these capitalists came from. Once the schoolmen had given their blessing to commerce, there would be no shortage of merchant adventurers. Many countries today are in the situation that they have an "unlimited supply" of businessmen while sorely lacking industrial entrepreneurship. Adam Smith detested businessmen; Cantillon and Hume thought they were wonderful [Smith (1776, p. 250), Cantillon (1755, pp. 63-73), Hume (1748, " O f Interest", p. 52)]. The economics of land tenure invited interest from the time of Cromwell's conquest of Ireland, but did not blossom until the nineteenth century. Part of this problem is that the Law of Diminishing Returns, which would dominate distribution theory until the 1960s, was not formulated until after the end of our period [West (1815)]. The eighteenth century could not contribute spectacularly to the monetary theory of the twentieth century since the institutional background differed so greatly as between the two periods. Ours is an age of paper money-banknotes checks and so o n - whereas theirs was still an age of precious metals circulating as money. But the transition to paper had begun. Banks were issuing notes and creating credit (though denying the latter). And the ambiguity of deciding what was and what was not to be included in the count as money had already begun. How far apart we are is illustrated by Adam Smith's pronouncement that: The whole paper money of every kind which can easily circulate in any country can never exceed the value of the gold and silver of which it supplies the place, or which (the commerce being supposed the same) would circulate there if there was no paper money [Smith (1776, p. 284)]. This statement is either a tautology or false. The role of government occupied eighteenth-century economists as much as it occupies our own generation. Government was indeed much smaller, almost certainly not exceeding 5 percent of national income, including defense. They argued as to where to draw the line between private enterprise and ownership and government enterprise and ownership, and possible mixtures; the argument turning principally on inefficiency and corruption, much as it does in the Third World today. Adam Smith uses the concept of external economies in describing

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[The capital of the country consists] fourthly of acquired and useful abilities of all the inhabitants or members of the society. The acquisition of such talents, by the maintenance of the acquirer during his education, study or apprenticeship always costs a real expense, which is a capital fixed and realized, as it were, in his person. Those talents, as they make a part of this fortune, so do they likewise of that of the society to which he belongs [Smith (1776, pp. 265 -266)]. The duty of the government to do whatever was needed to improve the economy was not challenged; this, after all, was implied in two centuries of argument about foreign trade. We look for a theory of shadow prices, but this was still a century ahead. Monopoly was denounced not so much for reasons of allocation, as because it was seen as an obstacle to the division of labor and also an unjust tax upon the public. Finally, a note on public finance. Our economists created the mold within which this subject would live for the next hundred and fifty years. There was no theory of public expenditure; the emphasis was rather on the theory of the incidence of different kinds of taxes.

5. Conclusion

We set out to see how much of modern development theory was already available in the year 1776. By development theory I mean those parts of economics that play crucial roles when one tries to analyze the growth of the economy as a whole. There was quite a good beginning, that gave us the constraints imposed on growth by the agricultural surplus, or foreign exchange, or saving. Also we had Say's Law, the "Quantity Theory of Money", inflation, continual unemployment, entrepreneurship as a separate factor of production, the theory of bank credit, human capital, and the incidence of taxes. Just ahead of us in the first half of the nineteenth century would come the law of diminishing returns, the law of comparative cost, population theory, and the theory of land tenure. After that, interest in development theory would almost die out until the theoretical explosion of the 1950s and after. Finally, economics may change, but not economists. Let us give the last word to Adam Smith: The annual produce of the land and labor of England, for example, is certainly much greater than it was, a little more than a century ago at the restoration of Charles II. Though at present, few people, I believe, doubt of this, yet during this period five years have seldom passed away in which some book or

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pamphlet has not been published, written too with such abilities as to gain some authority with the public, and pretending to demonstrate that the wealth of the nation was fast declining, that the country was depopulated, agriculture neglected, manufacturers decaying, and trade undone. Nor have these publications been all party pamphlets, the wretched offspring of falsehood and venality. Many of them have been written by very candid and very intelligent people; who wrote nothing but what they believed, and for no other reason but because they believed it [Smith (1776, p. 327)].

References
Cantillon, Richard (1755) Essai sur la nature du commerce en general. London: Fletcher Gyles. Hume, David (1748) Essays moral and political (edited by Eugene Rotwein; London: Nelson, 1955). Johnson, E.A.J. (1937) Predecessors of Adam Smith. New York: Prentice Hall, Inc. Lindert, P.H. (1969) Key currencies and gold, 1900-1913, Princeton Studies in International Finance, no. 24, Princeton University. Locke, J. (1691) Some consideration of the consequences of lowering the rate of interest. Reprinted in: M. Cranston, ed., Locke on politics, religion, and education. New York: Collier Books, 1965. Smith, Adam (1776) The wealth of nations (edited by Edwin Cannan; New York: The Modern Library, 1937). Steuart, James (1767) Enquiry into the principles of political economy (edited by Andrew S. Skinner; London: Oliver & Boyd, 1966). Wallace, Robert (1753), A dissertation on the numbers of mankind in ancient and modern times. Edinburgh: Hamilton & Balfour. West, Sir Edward (1815) Essay on the application of capital to land. Reprinted as: Sir Edward West on the application of capital to land 1815. Baltimore: The Lord Baltimore Press, 1903.