Why Economies Rise or Fall (Guidebook)

Why Economies Rise or Fall
Professor Peter Rodriguez
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Peter Rodriguez, Ph.D.

Associate Dean for International Affairs
Darden School of Business,
University of Virginia
rofessor Peter Rodriguez is Associate Dean

for International Affairs at the Darden School
of Business at the University of Virginia.
He received his B.S. from Texas A&M University
and holds an M.A. and a Ph.D. in Economics from
Princeton University. Since 2008, he has also served
as a trustee of the Darden Foundation. Previously, Professor Rodriguez was
a Lecturer at Princeton University and a Professor at Texas A&M University.
He also served on the faculty of Semester at Sea and has taught in universities
around the world.
Professor Rodriguez is a practicing economist and specializes in the study
of international business and economic development. He is also an active
researcher whose current interests include the interaction of globalization,
economic development, and social institutions; the consequences of
corruption for multinational corporations; and seed-stage finance in emerging
markets. He has published research on international trade policies, firm
investment patterns, the measurement and effects of corruption, and practicebased studies of issues in international business.
Professor Rodriguez worked for several years in the Global Energy Group at
JP Morgan Chase, where his assignments centered on work for multinationals
such as Royal Dutch Shell, Pennzoil, Apache Corporation, Enron, Santa Fe
Energy Resources, and Halliburton.
Professor Rodriguez has extensive experience as a keynote speaker for
academic and corporate conferences and in executive education. His private
teaching engagements include work with the AES Corporation, Harris
Corporation, Rolls Royce, and Visa.
Despite his many activities outside of the classroom, Professor Rodriguez

remains a teacher at heart, and his many teaching awards include the
University of Virginias University Teaching Award and Mead/Colley Award
for Engagement with Students, as well as Princeton Universitys universitywide Teaching Excellence Award. In the fall of 2009, Professor Rodriguez
was named one of DiversityInc magazines Top 100 under 50 in America.
ii
Table of Contents
INTRODUCTION
Professor Biography ............................................................................i
Course Scope .....................................................................................1
LECTURE GUIDES
LECTURE 1
From Free Markets to State Economies .............................................3
LECTURE 2
A Brief History of Economic Growth ...................................................5
LECTURE 3
Economic Growth and Human Behavior ............................................8
LECTURE 4
The Birth of the Western Free Market .............................................. 11
LECTURE 5
American Economic Strategies ........................................................14
LECTURE 6
America and EuropeDivergent Approaches ..................................17
LECTURE 7
State-Led Theories of Economic Growth..........................................20
LECTURE 8
The Secrets of Rapid Growth in Tiger Economies............................23
LECTURE 9
Lessons and Limits of Japans Economic Model ..............................26
LECTURE 10
From Closed to Open Economies ....................................................29
iii
Table of Contents
LECTURE 11
How Can We Manage Global Growth? ............................................32
LECTURE 12
Chinas Policies and the World Economy .........................................35
LECTURE 13
Merging the Theories of East and West ...........................................38
LECTURE 14
Lessons about Economic Success ...................................................40
LECTURE 15
The Roots of Economic Failure ........................................................43
LECTURE 16
Politics, Statecraft, and the Fate of Economies ................................46
LECTURE 17
Corruption and Its Impact on Growth................................................49
LECTURE 18
Informal, Inefficient Markets .............................................................52
LECTURE 19
Technology and the Instant Economy...............................................55
LECTURE 20
Possible Strains on Global Economic Growth ..................................58
LECTURE 21
Latin AmericaMoving Away from Free Markets.............................61
LECTURE 22
Financial Crises and Economic Theory ............................................64
LECTURE 23
The Multipolar Economic World........................................................67
iv
Table of Contents
LECTURE 24
Driving Forces, Emerging Trends .....................................................70
SUPPLEMENTAL MATERIAL
Glossary ...........................................................................................73
Bibliography ......................................................................................76
CREDITS
Data provided by Angus Maddison.
vi
Why Economies Rise or Fall

Scope:
he fundamental basis for all economic theory and policy is to improve

living standards and promote stable, generous societies. Every abstract
construct and each impenetrable phrase describing deep concerns
over the balance of payments or deflationary expectations is designed to offer
sensible guidance on how we can and should manage our private and public
affairs to make life better. Economics is the science that aims to make the
most within our sometimes dismal limits, all the while acknowledging that
to do so requires that we work cooperatively and freely. Much of economics,
however, reflects the complexity of our world and the limits of a science that
must rely heavily on historys natural experiments. We live in the laboratory
of economics, and from it, we observe firsthand the struggles and successes
of nations pursuing the same fundamental objectives.
This course examines the large lessons from experiments using different
strategies and ideologies for economic growth. From these experiments, we
will gather insights into what makes economies successful, strategies that
often lie hidden beneath the larger banner of a particular theory or set of
beliefs. In short, we uncover the roots and secrets of economic growth from
the successes and failures of many nations over the past two centuries. In
this effort, we learn how economies work and why some countries grow
quickly and others dont. The course offers the context and skills needed
to properly discern economic successes and appreciate the objectives and
challenges facing all those who seek to ensure the stability and richness of
their nations. The course examines the most successful economies in recent
history, including the United States, Japan, the Asian Tigers, China, and
others. We also study economies that have experienced a combination of
success and failure, such as the former Soviet Union, Vietnam, and India, as
well as some economies that have struggled mightily but not grown, such as
Nigeria and Venezuela.
To understand the challenges of growth, we must also ask about the
constantly evolving nature of our economic and physical environment
1
Scope
and whether growth can persist. The issues of instantaneity and a

hyper-connected global economy rapidly consuming key resources are
significant though not entirely new obstacles to the quest for continued growth.
We also examine longstanding challenges to economic success and societal
cohesion, including corruption, poverty, and inequality. Understanding how
these issues connect to the larger fabric of economic ideologies and policy
making delivers a fresh perspective on key issues facing the global economy.
Among the most important of these is an understanding of how economic
and financial hegemony may change with the rise of China and the deep
structural issues facing mature Western economies. We will examine the
challenges of financial and economic integration and what they mean for
key economies around the world. From and through all these issues, this
course distills the nature of economic growth in a world where so many of
the secrets of economic success remain elusive.
From Free Markets to State Economies

Lecture 1
Governments arent really the protagonists in the story. People

are, in fact, the only ones that run an economy, the only ones that
make a choice and make a difference. Policy is all about behavior.
Understanding behavior is understanding growth, and thats the
direction were headed.
e hear about different and often-complicated economic policies

frequently, but the basis of all economic policy is to raise the
standard of livingto make peoples lives a little better. In this
course, well look at various recipes for growing the economic pie to see if
we can identify any that really work.
One of the problems with policy is that its always rooted in some argument,
and the argument is always based on some economic theory. The theory is
just a story that tells us the way things are supposed to work. Such stories
are rooted in a semi-scientific approach to studying what has or has not been
successful and under what circumstances. The bases for economic theories
are the isms we all know so well: Keynesianism, classicism, Marxism,
libertarianism, and so on.
This course distills lessons we have learned about economic theories, in
particular, economic theories of growth, from the broad set of growth
experiments that have been undertaken around the world by both leading and
lagging nations. Our goal is to go beyond the stories and ideologies to learn
what really leads to growth.
Throughout most of the 20th century, much of the discussion about economics
was based on the dichotomy of the Cold War. This first lecture is about
dispelling the notion of that polarized economic world and painting a more
honest picture of economic development.
In the end, what were interested in is not what economic courses different
countries have taken, but which ones have succeeded and which ones have
3
failed, noting, of course, that all of them have experienced both success and
failure. To really get behind the story of what works in an economy, we have
to set aside the isms. Good economics is all about incentivizing productive
behavior. It can come in many forms and in many
circumstances, but thats the only thing we need
One of the hard
to remember. The appropriate environment,
however its constructed, makes productivity
realities of this is
profitable. What well learn is that there are many
the truth that
paths to economic success.
macroeconomic
policy and growth
To understand the story of economic growth, we
theories are not
have to understand how well different economies
have fared over the years. To do that, we need
scientific. Theyre
to look at the numbers and the stories behind the
just not. Theyre
numbers. The United States, for example, has
scientific-ish
been the most successful economy in the world
Lecture 1: From Free Markets to State Economies
at best.
for the past 100 years, but the average growth rate
for the U.S. economy over the course of the 20th
centurya period that saw a number of wars, the
Great Depression, and a wide variety of economic policies and precedents
was just about 2 percent per year. In fact, all the wealthy economies of Western
Europe have also grown at about the same slow and steady rate. In this course,
well look at the forces and policies that influence that growth around the world,
in countries from across the political, economic, and sociological spectrums.
Suggested Reading
Keynes, The General Theory of Employment, Interest and Money.
Sachs, The End of Poverty: Economic Possibilities for Our Time.
Smith, An Inquiry into the Nature and Causes of the Wealth of Nations.
Questions to Consider
1. What are the distinctive characteristics of capitalism?
2. How different are the overall economic policies of the United States and
the European Union? What about China and Japan?
4
A Brief History of Economic Growth

Lecture 2
No matter how fast you grow, no matter how long a path or slow a path
you take to get to the lead, to the head of the pack, once you make the
head of the pack in terms of high-income levels, growth tends to slow
down markedly.
n this lecture, we learn more about growth and what works when it comes
to growth. Which policies succeed and which ones dont? But before we
can ask that question, we have to define success. In baseball, a range of
batting averages serves as a measure of success: 20 percent is terrible and 40
percent is almost impossibly good. The story of economic growth is similar
in that understanding the boundaries is key.
How fast is fast for an economy to grow? Angus Maddison, an economic

historian from Scotland, helps answer that question. According to Maddison,
an economy that grows faster than 5 percent a year for 5 years or more is
truly remarkable. Thats a benchmark for gross domestic product. If we
think about per capita GDP, growth of 4 percent per year for 5 years is
remarkable. The median growth rate for the 150 or so developed and
undeveloped economies around the world is only about 2 percent. Putting
these ideas together, we can say that growth at a rate of above 3 percent per
year in inflation-adjusted terms is relatively fast; growth at a rate of less than
1 percent a year is very slow.
Looking at 5-year windows in the 20th century, the countries with standout
growth rates and GDP per capita are Japan, Ireland, South Korea, Singapore,
Hong Kong, and Botswana. Interestingly, if we look at fast economies in the
19th century, the list would be almost the same. The Western economies
the United States, Australia, Canada, France, Germanyall experienced
relatively slow growth in the 19th century. Note, too, that its difficult
to identify patterns or similarities in the list of fast-growing economies.
About one-third of the 150 countries were looking at are on the list of the
slowest-growing economies. Here, too, identifying patterns or explanations
is difficult.
5
We should note three overall considerations in talking about growth and the
difference between fast- and slow-growing economies. First, the path to riches
is not a single path but many paths. There is great variation, for example, in
the slow, steady growth of the U.S. economy and the surge experienced by
Japan toward the end of the 20th century. Second,
growth is a recent phenomenon. In the West, the
As it is in
set of forces determining economic growth is,
other areas of
perhaps, 150 to 200 years old, and for most of the
rest of the world, its 50 or 60 years old. Finally,
performance,
growthor the lack of ithas produced rising
we see that the
inequality around the world. This isnt a story of
difference between
the rich robbing the poor, but of the rich gaining
fast and slow [in
far more in growth and income than the poor ever
had to lose.
economics] isnt
Lecture 2: A Brief History of Economic Growth
nearly as big as
you might think.
In comparing early economic winnersthe

United States, Western Europeto more recent
onesJapan, South Korea, and so onwe can
see both similarities and differences. First, each of these economies (with
the possible exception of Hong Kong) has a very mixed approachneither
fully capitalist nor fully state-led. Second, unlike the early winners, most
of the recent winners experienced rapid growth over a short period of
time. Finally, the new winners seem to break the classical economic rules
that guided the Western economic growth miracle, beginning with the
Industrial Revolution.
Important Terms
gross domestic product (GDP): A measure of a nations economic activity;
the total value of all goods and services produced in an economy in a
given year.
inflation: A situation of rising prices for goods and services.
per capita GDP: GDP divided by the total population of a country.
Suggested Reading
Diamond, Guns, Germs and Steel: The Fates of Human Societies.
Grossman and Helpman, Innovation and Growth in the Global Economy.
Helpman, The Mystery of Economic Growth.
Kindleberger, The World in Depression.
1. What precise measures can be used to establish that an economy is
significantly more successful than average?
2. How fast would the United States need to grow and for how long to be
considered successful at delivering economic growth?
3. Which countries are the best economic performers of the 20th century?
Economic Growth and Human Behavior

Lecture 3
If you remember nothing else about economics and nothing else about
this course, remember this: People respond to incentives, and thats
what makes economic behavior change and that, ultimately, is what
leads to the differences between successes and failures.
eve already seen that economic policies or schools of thought

arent necessarily helpful in explaining the difference between
successful and unsuccessful economies. The real question we
need to ask is: What makes people change their behavior in ways that lead to
economic growth?
Lecture 3: Economic Growth and Human Behavior
The fact that people respond to incentives is the driver behind economic
behavior change and, ultimately, what makes the difference between success
and failure. The free market, for example, is a story of incentives. In free
markets, you reap all the benefits and incur all the costs of your actions.
Several factors must be true for free markets to work. First, economically
productive behavior must be more profitable than the alternatives. Second,
a tolerance for risk must be present to enable entrepreneurial ventures to get
off the ground. Third, people must have trust in the system and in others.
Even when these factors are present, however, things can go wrong, primarily
because human beings are in charge.
Most productive economic behavior requires coordinated action from
many individuals, but one of the bigger problems in coordinating economic
behavior is getting human beings to trust one another. If we can get past
that problem, its gratifying to note that success tends to beget more success,
but this natural momentum can also work in reverse. During the Depression,
for example, people in general seem to have lost their confidence and their
willingness to take risks. Getting people to break out of such cycles is one
of the hallmarks of a good economy. The good economies weve seen,
with all their diverse ideologies, were somehow able to generate that seed
of confidence.
8
A big problem behind predicting when economic policies will work and
when they wont is, simply, that humans are humans. They dont always act
predictably or rationally. Theyre also skeptical; they want to see success
before they make a commitment. Macroeconomic complexity doesnt
account for these root connections.
In the end, policies arent enough. Even if we were to enact what we thought
were the best policies of the leading economies of the world, people would
have to believe in the policies for them to
work. Thats at least part of the reason why
Humans are
we see both success and failure in such a
human, which means
broad spectrum of economic stories. We
that they dont always
also know that sometimes, success can be so
driven by momentum that people can begin to
act in the same way.
take it for granted and not really scrutinize its
People dont always
source. Thats the problem that seems to lie
do things that are
behind economic bubbles, bursts, recessions,
predictable. Theyre
and depressions.
not always logical or
rational. Theyre also
not likely to believe
you just when you
The fundamental sources of economic

stability and growth are the ones we see at
the level of the individual. We see success
in free-market economies because people
say something.
begin to act productively and take it for
granted that they should act productively.
At the same time, the framing of economic
policies in time, culture, and place is paramount. To understand
macroeconomic growth, we have to go to the individual level and ask:
Why did that policy work with that person at that place and at that point
in time?
Important Terms
bubble: Rapid expansion of an economy, followed by an often-dramatic
contraction.
free market: A system in which business is conducted according to the laws

of supply and demand, without government intervention. Participants in free
markets reap all the benefits and incur all the costs of their actions.
recession: A period of reduced activity in an economy.
Suggested Reading
Gambetta, The Sicilian Mafia: The Business of Private Protection.
Landes, Revolution in Time: Clocks and the Making of the Modern World.
1. Have you ever changed your behavior in direct response to a change in

economic policy? When and why? Would you react again in the same
way if the situation recurred?
2. Are you an optimizer of your future income? What are your biggest
concerns with respect to national economic policy?
10
The Birth of the Western Free Market

Lecture 4
When you and I think about Industrial Revolution, we imagine

factories, and we imagine people working in cities. But those people
couldnt have worked in the factories and they couldnt have gone to
the cities if they didnt have enough food to leave the farm, and its
really what led to this whole process of industrialization.
he idea of a growing economy, a world where successive generations

lived better and better, was once as new as the Internet or cell phones.
In fact, until approximately 1500, world economic growth was so
slow and weak as to be almost imperceptible. Real economic growth didnt
get underway until the late 17th and early 18th centuries, when advances in
agricultural productivity in Great Britain and Western Europe gave people
some security from the threat of famine.
Before the Industrial Revolution, the work of almost 90 percent of the
population was in some way related to agriculture. Scientific advances, such
as the idea of crop rotation, led to increased productivity that brought with it
such benefits as excess labora pool of workers who were no longer needed
on farms. This excess labor, in turn, was the key to scale production; that is,
production on a much larger scale than would be possible from an individual
craftsman. Without this revolution in agriculture, there would have been no
workers to fuel the Industrial Revolution.
The Industrial Revolution represented an overall jump in productivity to
about 20 times its usual rate. This revolution was driven, not by one invention
or idea, but by an entire socioeconomic system. Such innovations as scale
production, mechanization, and specialization played a significant role in
this self-reinforcing system.
In England, these changes absolutely transformed life and society, although
not always for the better. One of the most fundamental secrets of the Western
economic miracle was the idea of open and free marketsmarkets in which
individuals could choose for themselves what to produce and what to charge
11
for it. Adam Smith pointed out that free markets run on the self-interest of
the producers; if someone makes the best product, consumers will buy it, and
the producer will gain. In other words, the
secret to wealth is to eliminate the control of
Thats the only
a central power and let individuals choose
organizing principle
for themselves; when they do, they will
actually be working for the good of society
that free markets run
as a whole.
on: responding to
the incentives of the
The economic miracle of the Industrial
market. Producers
Revolution is still influential today. It
created from relatively average societies the
and consumers
richest economies in the world, and those
coordinate their
economies remain rich more than 100 years
activity through the
later. Is this success solely attributable to
price mechanism and
democracy and the rule of law that arose in
through transacting,
Western Europe? As weve seen, the West
took one path to success, but there seem to
and nothing else is
be other paths, as well.
really needed.
Adam Smiths phrase the invisible hand
sums up the free-market economythe idea that competition, open markets,
and freedom are consistent with socially responsible and beneficial activity.
This is the classical economic story, and for many, it goes hand in hand with
democracy. There are numerous examples throughout history, however, of
economies that are successful without being democratic. Indeed, we might
say that the theories that followed from the Western miracle were, in some
sense, blinded by the fact that the results of that miracle were so profound and
so important.
Important Term
scale production: The ability to produce on a large as opposed to an
individual scale; realized with the advent of the Industrial Revolution.
12
Suggested Reading
Bastiat, Economic Fallacies.
Bhagwati, In Defense of Globalization.
De Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and
Fails Everywhere Else.
Diamond, Guns, Germs and Steel: The Fates of Human Societies.
Keynes, The Economic Consequences of the Peace.
1. Have you ever changed your behavior in direct response to a change in
economic policy? When and why? Would you react again in the same
way if the situation recurred?
2. Are you an optimizer of your future income? What are your biggest
concerns with respect to national economic policy?
13
American Economic Strategies

Lecture 5
[Our recovery now is] going to come down to our behavior and
whether well see hope and confidence and reasons to stimulate and
act aggressively again. Its going to come down to the confidence of
the people and the ideas that they have about their own economy and
whether they have faith in it.
Lecture 5: American Economic Strategies
he United States has been the largest economy in the world since
about 1870, and its story is deeply rooted in classical economic ideas.
The classical economic structure is one in which the wealth of a
nation rests not in the kings treasury or the amount of oil beneath the soil
but in the economic prowess and possibilities of the nations people.
The good side of classical economics in the United States is that its ideas
are closely related to freedom. Pursuing ones dreams and generating wealth
are the best things an individual can do for society. However, in a classical
economy, one must also take risks and engage in competition, which can
result in rewards or losses. Classical economics is also a self-correcting
system. If problems occur in the marketplace, classical economics stands
back and waits for the system to achieve its own balance.
The story of the economy that gave birth to the American dream began at the
end of the Civil War. Since that time, the U.S. economy has flourished, but it
has also been severely challenged. In the 1870s, our economy was defined by
a complete lack of control, and although it experienced a boom through the
early part of the 20th century, it also suffered from a lack of competition and
a subsequent loss of public confidence. Around 19131914, the government
stepped in, creating a central bank, regulations, and a national income tax to
promote stability in the financial system.
From 1913 until about 1928, the United States embarked on one of its fastest
growth periods. But that period came to an end with the Great Depression,
an event that challenged the idea that the economy would self-equilibrate.
Unemployment was at 25 percent, but wages werent falling low enough to
14
bring people back to work. Companies failed,

prices collapsed, and the situation kept getting
worse. John Maynard Keynes said, In the
long run, were all dead, meaning that selfcorrection is worthless if it takes too long.
With Keynes came the birth of the idea that
a government in this situation should take
action to get the economy back on track.
[The American
dream is] largely an
economic dream. Its
the embodiment of the
rags-to-riches story, of
the Horatio Alger story,
of entrepreneurs that
go into their parents
The United States wouldnt be challenged

again in the same way until about 2007, with
basement, and with
the Sub-Prime Crisis. Oddly, this crisis began
$25 and duct tape,
because the U.S. economy was so strong
and inspired so much confidence that money
come up with the next
flowed in easily from around the world and
great thing.
was used sloppily. Most people bought
into the idea of the rational investor, that is,
that investors know better than anyone else what they need to do to protect
themselves. We didnt consider the possibility of irrational behavior and its net
effect on the economy. We didnt understand how economic manias take place
or how housing booms and asset bubbles emerge.
When the global capital flows began to shake, when the bubble
began to burst, and when it became obvious that the extraordinary
rise in housing prices could not be sustained, the United States
engaged in the most massive government stimulus and break from
self-correction in economic history. Weve made a huge bet, and if were
right, well have avoided a second Great Depression, but if were wrong, the
United States will no longer be the leading economic light of the world.
Suggested Reading
Faulkner and Shell, eds., America at Risk.
Friedman and Schwartz, A Monetary History of the United States.
Friedman, The World Is Flat.
Krugman, The Return of Depression Economics.
15
1. What is the most critical change facing the United States now that
huge economies, such as those of China and India, are growing more
important to the world economy?
2. How has U.S. leadership of the global economy threatened to undo our
Lecture 5: American Economic Strategies
nations ability to grow?
16
America and EuropeDivergent Approaches

Lecture 6
One of the most significant outcomes of this divergence in path at

the end of the Second World War was on the risk-bearing borne by
individuals and by the populations of each country. In Western Europe,
the government began to take more rein and bear more risk; in the
United States, more of those risks were left to the individual.
t the end of the Second World War, a Western divide emerged between the United States and its peer economies in Western Europe.
At the beginning of the war, the economies of Western Europe and
the United States had reached somewhat similar levels of development. After
the war, Europe was devastated, while the United States was launched into
mega-power status. It was during this period that the economies of Western
Europe and the United States started down different ideological and performance paths.
The economic policies that Europeans had followed before the Second
World War grew more entrenched and more prominent after the war. Broadly
speaking, European nations grew toward deeper government involvement in
most aspects of the economiesin particular, in the provision of a social
safety net and the regulation of business. The United States grew its social
safety net, as well, but it also sharpened the connections between individual
success and individual effort.
The economies of Western Europe moved in three basic directions that
separated them from the United States. First, the Western European
economies aggressively integrated across borders. This move enabled the
sharing of production in order to lower costs, expand the resource base, and
generate more peaceful interactions between nations. Second, European
nations greatly strengthened their support for the unemployed. Finally, they
greatly expanded healthcare benefits and subsidies for education.
Throughout this period of divergence, for the most part, the economies of
Western Europe and that of the United States performed well. Their relative
17
Lecture 6: America and EuropeDivergent Approaches
performance, however, reinforced much of our thinking about what it takes

to succeed economically and what the costs are of providing extensive social
benefits. What we saw in Western
Europe that differentiated it from the [After the Second World
United States was a divergence in the
War,] rather than let
natural level of unemployment and
slower economic growth. In Western businesses produce what
Europe, ever since the end of the they want when they want
Second World War, we see relatively to sell to whom they want
higher unemployment than in the
at what price they want,
United States, higher tax rates, and
Europeans embarked
slower economic growth.
upon a road of more
Unlike the European Union, the United government regulation,
States engaged in a social system of more limitations on private
sharper incentives for productivity, a
weaker social safety net, and greater business, a real firm break
penalties for being unemployed. As we from very classical ideas.
know from previous lectures, people
respond to incentives, and here, they
responded exactly as we might think. They worked harder, they took more
risks, and they worked longer hours than their counterparts in Western
Europe. As a result, there was more production, the economy grew faster,
and the income distribution grew wider.
What was the result of the divergence? In the United States, we had income
levels that were naturally higher than those in Europe throughout this entire
period. At the same time, we had greater economic inequality. The answer
to the question of which approach is better boils down to more of a social
choice than an economic one: How much of a tradeoff is a society willing
to make between productivity and economic growth on the one hand and
income inequality on the other?
18
Suggested Reading
Keynes, The Economic Consequences of the Peace.
. The General Theory of Employment, Interest and Money.
Yergin and Stanislaw, The Commanding Heights.
1. What was the economic tradeoff made by European nations after World
War II? Was it worth it?
2. Is growth the paramount goal of economic policy? How should it be

balanced with other economic and social objectives?
19
State-Led Theories of Economic Growth

Lecture 7
Growth is really all about economic productivityfull stop. Thats it. If

you achieve productivity growth, which is the ability to take resources
and extract more value from them over time, if you can continue that
process, in some ways, it doesnt matter how you get there as long as
you get there.
I
Lecture 7: State-Led Theories of Economic Growth
n Lecture 2, we asked the question: How fast is fast when it comes to

economic growth? In answering that question, we found a puzzle: Some
of the best-performing economies are those in which there is heavy
government involvementquite different from the classical policies that led
to the Western economic miracle. Could it be that free markets dont have as
much to do with growth as we think?
To answer that question, we look at Japan, uncontested as a speed demon
for growth. Between 1950 and 1973, nominal GDP in Japan was regularly
growing at more than 10 percent per year. Between 1965 and 1970, real
growthreal buying power of individualsaveraged nearly 11 percent per
year. How did Japan manage to grow at such a rapid rate for such a long
period of time?
The story of a low-income economy catching up to a high-income economy
was first described by Robert Solo, a Nobel Prizewinning economist.
According to Solo, a backward nation can actually grow at a much faster rate
than a highly developed one. The economic and technological leaders, such
as the United States and the nations of Western Europe, buck the headwinds,
so to speak, of technological advance, and those behind, if they have the
ability, can copy those advances and catch up much more quickly.
Japan was able to make its great economic leap for a number of reasons.
First, there was heavy cooperation and planning between business and
government. The government subsidized such firms as Toyota, Honda, and
Sony and structured favorable export policies, while ensuring that those firms
didnt have significant domestic competition. A second key to Japans success
20
was that the nation had very high savings rates, not only by individuals but
also in government and business. This enabled investment in education and
infrastructure and kept the value of the yen low, making Japanese products
even more competitive in international markets.
In some sense, Japan is the prototypical example of a state-led government
economy, which would seem to contradict our story that the free market is
golden. What lessons can we learn here? One truth is that growth is really
about economic productivitytotal
productionand nothing else. And if we
divide all economic activity into three By 25 years after the
buckets, we can begin to understand end of the Second
where productivity comes from and World War, a war
how it relates to different government that devastated their
approaches. The first bucket is the labor
economy, [the Japanese]
force, the second is the employment
level, and the third and most important is were really back on top.
average worker productivity. Japan had They were really back at
favorable conditions in all three buckets.
the top of world income
levels and living at
Perhaps the takeaway here is that high
investments, funded by high savings, income levels that were
generated and supported by an economy only enjoyed by a select
with political stability and a workforce few rich nations.
thats growing in skill, results in more
productive people throughout the
economyeven without the free-market approach. But that higher average
worker productivity is hard to sustain, and the fact is that after 40 years of
growth, around 1990, Japan entered its own great depression. The good
news is that Japan is largely back on track, and it has, to some degree,
regained much of the stability it lost in the period of the 1990s to at least
the year 2000.
Important Term
average worker productivity: Calculated by dividing total economic output
(GDP) by the number of employed workers in an economy.
21
Suggested Reading
1. How was Japan able to sustain high growth rates long after its recovery
from the devastation of World War II? What did the Japanese do that can
be copied elsewhere?
2. Was the Japanese miracle evidence of a different economic model

Lecture 7: State-Led Theories of Economic Growth
of growth?
22
The Secrets of Rapid Growth in Tiger Economies

Lecture 8
These are miracles of a different kind. Theyre not like the Japanese
and the U.S. and the Western European miracles. These are miracles of
a more recent vintage, miracles of poor countries and small countries,
countries that one might think the world could easily overlook, but
didnt, and they made it happen.
o far, weve looked at the growth of countries that were already

relatively rich when they began to grow. In this lecture, we turn to our
first examples of low-income countries that experienced the kind of
economic growth we associate with the modern era. This is the story of the
Asian Tigers: Hong Kong, Taiwan, Singapore, and South Korea.
These economies are studied together for a number of reasons: They all
experienced amazing growth at about the same time. They were all Asian
and had somewhat similar cultural roots. And in all these countries, the
workers had an extraordinary work ethic and great trust in their leadership.
If we look carefully at the Asian Tigers, however, we find some significant
differencesin culture, history, geography, and economic strategy. Hong
Kong, for example, probably had the most economic freedom of any country
in the world, while Singapore might be the ultimate exemplar of government
control; nonetheless, the two experienced remarkable growth during the
same period.
If the differences were large and the similarities werent all that apparent,
what was the secret of the Asian Tigers? We can find the answer by working
backwards. We know, for example, that the secret to economic growth is
increasing average worker productivity. Whatever the Tigers were doing,
they were making their average workers more productive. They did this with
very high savings rates at the national level, stable and relatively low wages
over a long period of time, and political stability.
High savings rates are important because they enable investments in
infrastructure and education. The Tigers had both high savings rates and high
23
Lecture 8: The Secrets of Rapid Growth in Tiger Economies
investment rates, which they funded themselves. At the same time, they kept
wages low so that they could pass along their increased productivity at low
prices to consumers around the world. The Tigers also managed to sustain
political stability and generate some level of confidence among the people,
no mean feat in a poor economy.
Its difficult to identify anything other than these three general factors that led
to growth, but they seem to be enough to teach us a few lessons about how
growth can be generated in a poor economy. As we saw with Japan, starting
out poor can itself be an advantage. Our three
buckets also give us a partial explanation for the
Tigers economic success. Most of the Tigers In that short
had a high labor force relative to the population, period of time,
which results in rapid growth in per capita GDP.
The Tigers also had low unemployment rates, [the Asian Tigers]
which generated buy-in from the people and really became a big
laid the groundwork for political stability.
part of the workshop
of the world. They
The Tigers remain in extraordinarily good
werent just regional
positions, and they represent a different kind
of economic miraclemiracles of small, players expanding
poor countries coming to the economic fore. locally; they were
They teach us that there is no single culture expanding globally.
or strategy that is perfectly adapted to growth.
They also teach us that a mix of some freemarket activity and some government control
may be a wise approach. Finally, they show us that the Industrial Revolution
wasnt just a feature of Western European economies. It could be spread
about, democratized to the rest of the world, but doing so isnt easy, and
the experience of the Asian Tigers raises questions about why their miracles
cant be replicated elsewhere.
Suggested Reading
Rajan and Zingales, Saving Capitalism from the Capitalists.
24
1. Can the success of Asian Tiger economies be attributed to common
policies or cultural characteristics?
2. How important to the world economy are the Asian Tigers? Can poorer
countries in Africa and Latin America follow the same course as these
economies? Why or why not?
25
Lessons and Limits of Japans Economic Model

Lecture 9
[N]o one really knows what the economic models of Japan will look
like in the future or whether or not theyll teach us that, in fact, they are
less vulnerable to some of the other ills that befall other strategies and
other economies. Perhaps its a lesson that all glory passes and that no
economy, no leader, is ever invulnerable.
Lecture 9: Lessons and Limits of Japans Economic Model
s weve seen, the Japanese economy was one of the most successful
ever, but it went from the stuff of legend to a cautionary tale in a very
short period of time. In the 1970s, it seemed that Western economic
models were stagnating. The U.S. economy at the time was lackluster, with
relatively high inflation and high unemployment. The world was primed to
believe in a new model of growth, and Japan provided it. By the 1980s, the
lessons of Japanese success were being taught in business schools around
the world.
During Japans 40 years of spectacular growth, low interest rates had driven
an extraordinary degree of investment in land, resulting in a huge surge in
property values. Then, around 1990, this property bubble began to wobble
and, eventually, burst. The secret to bubbles growing large and being very
difficult to live in when they shrink is leveragethe degree to which an
investor uses borrowed money. Through the use of leverage, corporations
and investors in Japan drove the Nikkei Index to a high of about 40,000.
Then, the economic miracle of Japan came to an abrupt stop. Most hoped the
resulting recession would pass quickly, but it didnt.
Whenever an economy is recovering from a huge asset decline, such as a

property bubble bursting, the resulting deflation is extremely difficult to
overcome. In Japan, property values fell so far and so fast that the thin margin
of leverage protecting investors began to erode rapidly, and they couldnt
pay off their debts. The scramble to sell property then added fuel to the fire
of deflation. In this situation, property values fall, people panic and cut prices
in an attempt to sell, and others wait to buy because prices are falling.
26
One of the first casualties in any property bubble is the banks, which
supplied the money to pay for the property to begin with. In Japan, the banks
realized that the values they had loaned to were way off, and with no way to
recoup their losses quickly, they faced collapse. The Japanese government
stepped in in a big way, injecting
substantial amounts of money into
the banking system and the economy [T]he miracle of Japan
(monetary easing) and engaging in really came to a full,
massive expenditures.
complete, and abrupt
Did the strategy of the Japanese stop. Suddenly, everything
government work? The short answer seemed to be going wrong.
is no. Japan experienced more than a It wasnt just a hiccup. The
decade of economic loss. The country Nikkei began to plummet
went massively into debt without
and plummet quickly.
government spending really making a
difference. We can draw a few simple Property values began
lessons from the Japanese experience: to plummet and plummet
First, the government waited too long quickly. That economy
to rescue the banks. It also seems true
and that miracle absolutely
that the dynamism that motivated Japan
for so long was a necessary component seemed to be over.
to its success and has never really
been regained. Further, bubbles are
deadly; letting asset values rise beyond what seems reasonable will topple
any economy. Finally, deflation is absolutely paralyzing. Despite its fall from
grace, Japan is still a rich country. But the experience of Japan showed the
world that its model was just as vulnerable to economic ills as any other.
Important Terms
deflation: A situation of falling prices for goods and services.
leverage: The use of credit to enhance an investors ability to make
additional investments.
27
Suggested Reading
1. What were the principal causes of Japans lost decade of economic
growth? Were they predictable?
2. What lessons do we learn about economic growth from Japans meteoric
Lecture 9: Lessons and Limits of Japans Economic Model
rise and precipitous fall?
28
From Closed to Open Economies

Lecture 10
Something very profound began to happen at the very end of the 20th
century that really changed all of our ideas about what the world would
look like going forward. So important were the changes that began to
take place, so important were the countries in which those changes
began to take place, that most of us believe it will change the world
economic order for centuries.
ntil the time of the Industrial Revolution, economic power

generally equaled the size of the country. Then, starting in about the
mid-18th century, relatively small countries, such as England,
France, and Germany, grew very large in terms of total economic output. At
the same time, the giants of the world, such as China and India, weakened
considerably. These historically strong economies, with rich cultures and
abundant resources, fell farther and farther behind, and it seemed that
they would never catch up. Relative to most of the world, where material
living standards were rising, the economies of China and India were almost
completely impoverished.
Part of the explanation for the decline of these economies may have
been their aversion to free markets. China, for example, was a complete
command economy, one in which the central government made all
relevant economic decisions. For this reason, China absorbed almost none
of the advances of the Industrial Revolution and experienced virtually no
growth for nearly 100 years. Then, in the mid-1970s, during the boom of
the Asian Tigers, the Chinese leader Deng Xiaoping decided it was time for
China to change course. He instituted incentives for farmers and encouraged
experimentation around the margins of the command economy. The result was
amazing growth.
In the late 1970s, China began to open its markets to external trade, entering
the world economy with a huge population that would work for very low
wages. All the production that flowed to the Asian Tigers as the workshops
of the world began to flow into China. This, in turn, energized the population
29
further and solidified the experimentations and reforms. China also invested
in infrastructure, which led to further productivity. In a sense, the country
was leading itself into its own Industrial Revolution.
Lecture 10: From Closed to Open Economies
The story in India was slightly different. Although India became a democracy
after it gained its independence, it took for its economic model the Soviet
Union. The Indian government exercised strict central control of the economy
up until the fall of the Soviet Union, when
it became apparent that this approach was
fatally flawed. In 1990, India teetered on If we look at what
the brink of collapse. But again, a leader,
happened, we can
Finance Minister Manmohan Singh,
saw the need for change and began to say that these two
implement straightforward plans to open economies [China and
the economy and allow India to trade more India], in their opening
freely in the world.
up, have great potential.
Both India and China had a degree of If their potential is what
political stability, which ensured that the potential was of the
people bought into the changes taking Asian Tigers, if they can
place. India also opened itself at an early match growth rates of
stage of the information technology
Japan decades earlier,
revolution, to which it was able to apply its
abundance of human talent. When Indians theyll revolutionize the
who had emigrated to other countries saw entire world.
the emergence of growth, they began to
send money back home to fund additional
investment. These two economies now have the potential to revolutionize
the world. Through increased openness, they can earn foreign exchange
currency, which they can invest around the world and solidify their own
economies. In short, they can become richer and take bigger stakes in the
small economies that surpassed them centuries before.
Important Term
command economy: An economy in which the central government makes
all relevant economic decisions.
30
Suggested Reading
Prahalad, The Fortune at the Bottom of the Pyramid.
1. How will the world likely change with its two most populous nations
growing faster than ever before in their history?
2. What kept China and India from rapid growth for the first 200 years of
the period of modern economic growth?
31
How Can We Manage Global Growth?

Lecture 11
Think about it this waysome things that are really personal, the
mortgage rate that you pay on your home, the rate that you buy your
car with, the job that you hold, all heavily depend on actions that take
place completely outside the United States, by people who dont live
under your same laws and your same culture. Thats a bit interesting,
maybe disquieting, but it also offers lots of opportunities.
W
Lecture 11: How Can We Manage Global Growth?
ithout question, the world economy is much more connected than

ever before. Our fatesthe ways in which we livedepend not
only on our fellow citizens but on people who live under different
political and economic systems. Global financial markets are now almost
perfectly integrated, no longer separated by ideologies or national borders.
What happens in one financial market is exactly what happens almost
automatically and instantaneously in another.
Having integrated, highly connected marketsone giant pool of savings and
investmentmeans that people can earn more money from their wealth and
can borrow at lower cost. It also means that those who live in an unstable
economy dont have to suffer the consequences of having all their money
tied up there. They can achieve a more balanced portfolio with stable
investments in the economies of the West. These types of activities have
always been beneficial to savers and investors, but they are not without costs.
In such a flat world, were a bit more exposed, and our competition is now
virtually everyone.
Understanding the balance of payments helps us understand just how
integrated the world is. The balance of payments measures the flow of
resourcesgoods and services, as well as financial fundsfrom one
economy into another and aggregates them around the world. Its the
summary of any individual nations economic relationship with the rest
of the world. Components of the balance of payments include the current
account, which provides information about the flow of goods and services,
32
and the capital and financial account,

which tells us about flows of
financial resources.
All the markets around

the world are just one big
financial market. Buying
and selling assets across
We can see the degree to which we are

living in a single world economy by
examining some of the activities among bordersthats the
the worlds largest economies. The United definition of financial
States, for example, is a consumer-heavy marketsits one big
country and has a large trade deficit.
pool and they operate
Others in the world use the excess cash
were sending them to buy our assets absolutely seamlessly.
stocks and bonds, companies, and land.
For us, the result is lower interest rates
and higher asset values. In this way, our fatesthe value of our 401(k)
accounts, for exampleare determined by the actions of people in other
countries. Its likely that this imbalance cant last forever, which means well
have to export more, others will buy fewer of our assets, and our asset values
will fall. These factors matter a lot for the shape, color, and character of
our economy.
Integration also carries some risks. For example, a financial hiccup in one
part of the world will be immediately felt in another. Integration also means
that producers have the opportunity to sell in much bigger markets and have
access to cheaper financing, but the costs here are connections to competitors
around the world. Today, we live in a world thats much more like one giant
economy than ever before. This more integrated, more connected, flatter
world, offers us a world of benefits, but it asks an awful lot of us, too. We
must learn much more about this integrated world to live peacefully in it and
to prosper as weve done in previous decades.
33
Important Terms
balance of payments: An accounting system that measures the flows of
resources from one economy into another and aggregates them across the
world. Provides a summary of an individual nations economic relationship
with the rest of the world.
current account: One component of the balance of payments; provides
information about the flow of goods and services in an economy.
Suggested Reading
Lecture 11: How Can We Manage Global Growth?

Naim, Illicit.
1. Is the world economy truly flat? What will be required of the United
States and other Western nations to benefit from a more integrated
global economy?
2. How does financial market integration affect daily life?
34
Chinas Policies and the World Economy

Lecture 12
China is almost certainly the future of the world economy; at a billion

plus people, growing at 8 or 9 or 10 percent per yearand already the
second largest economy in the worldtheyd almost have to be.
s weve discussed, no country has the potential to affect the world

economy as much as China does, although at the time of the Great
Leap Forward, just a few decades ago, the Chinese made some
disastrous mistakes. Then, Deng Xiaoping realized that the nation had to
break away from the command economy and begin to adopt free-market
ideas. As he said, It doesnt matter what color a cat is as long as it catches
mice. In other words, the particular ideology of change wasnt as important
as the change itself.
Deng started his experimentation rather modestly, by allowing farmers
to keep their own excess production. Almost immediately, there began
a period of much higher agricultural productivity and, with it, the birth of
real markets. The situation was similar to how the Industrial Revolution
began in Western Europe. Next came the need for more infrastructure to
bring these markets together, and the Chinese government responded. The
population grew excited; people began to invest in themselves and to offer
political support to the idea that opening up could lead to a rebirth of the
Chinese economy.
Despite these changes, at the beginning of the 1980s, China was still
profoundly poor, but then the nation began to grow rapidly. It did so through
investment in infrastructure, education, and technology. Further, wages
in China were so low that Chinese products were attractive to consumers
around the world.
By keeping their currency relatively cheap, the Chinese also ensured that
their production was attractive and that new exports could come from China
to service the rest of the world. This strategy led to the birth of jobs and
manufacturing in China on a scale that solidified the buy-in and ensured
35
Lecture 12: Chinas Policies and the World Economy
further economic growth. After about the mid-1980s, Chinese growth

averaged more than 8 percent per year. Throughout this process, China
moved into the position of uncontested factory of the world, and prices for
manufactured goods plummeted.
Global capital began to flow into China to create manufacturing facilities
there. At the same time, the Chinese were using the excess income they
received to buy other currencies, increasing the demand for dollars or euros,
increasing the supply of renminbi or yuan, and keeping Chinese wages low
in foreign currency terms. This had a significant
impact on the world economy. Manufacturing in
Investment is
the West or in middle-income countries couldnt
so critical. Its
compete with China. Further, this economic
growth in China had the potential to affect the
really the key to
environment, sovereignty around the world,
growth because
quality of life in the workplace, and many other
investment is the
aspects of life. Its also important to note that
key to productivity,
Chinas growth lifted hundreds of millions of
and productivity is
people out of poverty.
the key to growth.
By the middle of the 21st century, China could
easily be significantly larger than any other
economy in the world. Its already the global center of production, but will
it be the center of finance? The Chinese Communist Party still holds a good
deal of control and still restricts capital flows, which wont allow the nation
to become a banking center. But if the Chinese gradually become more open,
it makes sense the China will become the economic center of the world.
Suggested Reading
36
1. What are the similarities between Chinas economic success and that
of the West during the Industrial Revolution? Are the fundamentals of
growth the same for both examples?
2. What will China need to do to sustain high growth rates?
37
Merging the Theories of East and West

Lecture 13
What we learn is that being completely closed just doesnt work,

period. Weve seen examples, weve seen mixed models work well,
but those governments, those economies that have been shut off from
the world, where all the planning is centralized and where theres no
external competition, they just simply fail.
Lecture 13: Merging the Theories of East and West
n this lecture, we look at two other economies, those of India and

Vietnam, that like China, had also fallen far behind much of the rest
of the world but managed to make a comeback late in the 20th century.
The economic history of India is a mystery. How could a country with such
abundance, wealth, and technological knowledge, as well as ties to the
British Empire, miss the Industrial Revolution? Part of the answer is that
the British viewed India as a place for the extraction of resources rather than
for investment in production. In 1947, independence brought an opportunity
to re-craft the Indian economy, but Nehru, the first prime minister of India,
instituted a state-led approach that crippled the entrepreneurial energy of
the country.
The overall idea that growth can be manufactured by government is appealing
because it offers bureaucrats a way to plan and protect people against some
of the vagaries and inequities of markets. But this idea has proved to be an
awesome failure of ideology everywhere it has been practiced. An entire
economy cannot be scripted.
By the end of the 1980s, India was desperately poor and viewed as an
economy that couldnt turn around. Then, out of the balance-of-payments
crisis (essentially a deficit in the current account) came a deep change.
Finance Minister Manmohan Singh loosened trade and restrictions on
entrepreneurs and, with that, came tremendous growth. Per capita GDP
growth averaged about 4.8 percent per year for the next 15 years. The three
main causes of this renewed growth were trade openness, devaluation of the
rupee, and Indias longstanding tradition of democracy.
38
At least one other world economy made a similar changeVietnam. From

1964 to 1984, Vietnam had been engaged in one type of war or another and
had experienced virtually no economic growth. By 1990, it was even poorer
than India. Finally, in 1994, the United States
lifted its trade embargo against Vietnam
and quickly became the nations largest Vietnams success
trade partner. With this new demand in the meant that openness
Vietnamese economy came the opportunity was possible, and
to create jobs and manufacturing facilities it was possible
and the need to institute laws and policies that
to combine trade
would allow the nation to export even more.
The government responded by opening up openness and some
and allowing a high degree of foreign direct elements of the free
investment. Before long, per capita GDP in market in a communist
Vietnam was rising at 7.5 percent per year.
country. Those ideas
One lesson we can draw from the experience really didnt seem to
of India and Vietnam is that by simply go together very well,
relinquishing control, governments can but they did now.
make a significant difference. Openness
gives people a reason for hope, and the
subsequent growth builds the momentum that is desperately needed to
transform the economy. We might also say that if these economies can make
such a significant change in 1990 and beyond, perhaps any country can do
the same.
Suggested Reading
1. How important is democracy to rapid or stable growth, or both?
2. Are state interventions into free markets helpful or harmful to growth?
When and why?
39
Lessons about Economic Success

Lecture 14
Remember its that productivity has to be more profitable than

the alternatives. The way that you ensure its more profitable
than the alternatives is by some form of rule of law, a socially
constructed mechanism of eliminating these alternatives or sufficiently
disincentivizing them so much that theyre avoided or at least that that
path is minimized.
S
Lecture 14: Lessons about Economic Success
o far, weve completed a broad examination of economic growth

across countries and across time. In this lecture and the next, well ask
what lessons we can take away from our study of economic success
stories and cautionary tales.
As weve seen, growing the average amount of income per person is the first
and primary step in any successful economic policy. With this definition, we
find a number of economic winners that are all very different: Western
Europe and the United States, Japan, the Asian Tigers, China, India, and
Vietnam. No one story, ideology, or ism seems to drive these successes.
Broadly speaking, the successful economies weve studied have all managed
to get people to behave more productively by rewarding them for doing
so. Its also true that economies can succeed simply by letting go a little
bit, by having the government just stop doing bad things. At other times,
governments have to take a more active role in jumpstarting an economy by
funding investments. Investments are the key to productivity growth, and
productivity growth is what ultimately raises living standards. The essence
of investment is agreeing to delay consumption, and thats not an easy sell.
Saving to fund investment also has a critical role in generating success.
Successful governments have found ways to make local savings attractive
rather than seeing people send their money abroad. This, again, requires
stability and trust. People need to believe that the current government will
remain intact long enough for the promised future to become a reality.
To retain stability, governments have to make productivity possible and
40
profitableto make what is profitable productive and what is productive

profitable. In other words, even with a good reward system, such as a
capitalist system, governments must have a set of rules in place to eliminate
corruption and other unacceptable forms of behavior.
Another aspect of a strong economy is competition, which brings the forces
of innovation and survival to the commercial environment. Still another
quality is openness to trade, which ties in with the idea of being competitive.
An economy that is open to trade is open to
competition with a broader set of efficient
firms, and that situation sharpens incentives When we think about
to become more productive over time. In ideologies and
a commercial system that is bounded by strategies, we tend to
law and open to competition, economies of think in larger scale.
scale typically result.
But by focusing on
Over time, good economies invest in individuals and what we
education and in research and development can do to make them
or in efficient copying. Being open to more productive in
ideas and being able to assimilate and
their jobs and in their
adapt them for local uses is a hallmark
of virtually all these success stories. In pursuits, we understand
some cases, however, adaptability can a lot more about where
create instability.
successes come from.
Growth is not an easy formula. Its about
productivity, incentives, stability, confidence, competition, and many
other things. Successful economies must also continue to adapt to new
challenges and needs. But if the winners weve seen teach us anything, its
that although growth is complicated, its not a closed club; it seems to be
possible everywhere.
Important Term
corruption: The abuse of power for private gain.
41
Suggested Reading
Gambetta, The Sicilian Mafia.
1. What two or three characteristics are most common to the diverse set of
economic winners from the past two centuries?
2. Do these lessons point toward one particular economic ideology or
Lecture 14: Lessons about Economic Success
school of thought more than others?
42
The Roots of Economic Failure

Lecture 15
Perhaps the ultimate problem [in Africa] is that productivity has not
been made possible through a system and a rule of law that has really
rewarded and ensured productive, fair economic behavior. In
some of the countries, its been true that thats because of political
instability. In others, a very dark history of repression has led to the
instability and efforts to contain it.
eve talked about a number of economic success stories, but the

reality is that growth often fails to materialize, especially where
its needed most. In this lecture, we look at some of the great
misses, some of the times when an economy seemed to be on the verge of
growth, yet it didnt materialize. We might identify the causes of economic
failure as simply the factors that lead to success in reverse: disincentivizing
productive behavior, stifling competition, deterring investment, and so on.
Yet many economies do a lot of things right and still manage to fail.
The Soviet Union is a classic example of failure. This was a full command
economy, with the state making every decision about what was produced,
bought, and sold. In such an economy, peoples jobs are decided for them,
as are their wants and needs. The result is a disaster of personal incentives.
The Soviet Union also made the mistake of using sticks more than carrots.
One of the good things about a capitalist system or a free-market system is
that it has built-in rewards for good behavior. Its almost impossible to have
those rewards in an economy in which everyones incomes and consumption
patterns are equilibrated. Further, the Soviet Union had effectively no
competition and no trade except with other economies in the Soviet bloc.
Without competition, there was no pressure to become more productive.
Finally, the Soviets had no personal property. The land, the resources, and
the labor that could be used make the economy grow were all owned by
people with political power. They, in turn, had no incentives to make the
entities they owned more productive.
43
What you have in this

command economy [the
Soviet Union] is a fully
repressed entrepreneurial
system, a fully repressed
Lecture 15: The Roots of Economic Failure
system of commerce that

bubbled up at the edges,
wanted to be free, but
never really was. Thats
really, really difficult to
live with. Thats a recipe
The one key element for success that

the Soviets had was a relatively stable
system. This stability enabled the Soviets
to marshal resources and generate
investment, leading to a short period
of growth after the Second World War.
Then, after the 1950s, the Soviet Union
began to stagnate, and in 1989, the
country basically dissolved.
Unfortunately, there are many examples

of economic failures in other countries.
Despite trillions of dollars in foreign
aid, Africa remains the primary location
of todays world poverty. Nations in
for disaster.
Africa have missed on a number of
counts. They lack political stability,
strong incentives for productivity, and in
many cases, a rule of law that rewards fair economic behavior. Many of the
countries in Africa also need large-scale infrastructure development. The
story of Zimbabwe serves as just one example of grave mismanagement on
a massive scale.
Unfortunately, economic failure is terribly easy to come by. In fact, once
a country misses, its easier to miss again. In the great miss economies,
governments often try to restrict economic freedoms, or they go in
the other direction, getting too far out of the way too quickly. Lack of
leadership or lack of a long-term vision also seems to be an element in all
the great misses, along with an inability to move the people in the direction
needed to get the economy growing. Some believe that the great misses
are bedeviled by original sin: the idea that once you fail, no one ever really
forgives you or forgets.
44
Suggested Reading
De Soto, The Mystery of Capital.
Diamond, Guns, Germs and Steel.
Easterly, The Elusive Quest for Growth.
Naim, Illicit.
Sachs, The End of Poverty.
1. What is so hard about igniting economic growth? What is so hard about
keeping the growth going?
2. Why do countries that have abundant natural resources and other

advantages sometimes fail to grow for long periods?
45
Politics, Statecraft, and the Fate of Economies

Lecture 16
[T]he use of power can really alter institutions and the rules of the
game for the long term. Maybe being colonized by the right group or
the wrong group can make all the difference. All the rest of the things
that we do in the 20th century and 21st to change policy and plans maybe
dont matter nearly as much we think. Maybe the real outcomes
were scripted hundreds of years ago.
Lecture 16: Politics, Statecraft, and the Fate of Economies
ur discussions of growth have been based on the assumption that

countries control their own economic destinies, but history is replete
with examples of dominant countries exploiting less powerful ones
and determining their economic success. The British East India Company,
perhaps the first limited liability company, generated massive funds to
travel the world and extract riches wherever it chose to go. The Portuguese,
Dutch, Germans, and Americans have also changed the course of events in
particular countries.
Daron Acemoglu, a professor at MIT, has studied how colonization affected
growth around the world. Looking at the pattern of economic performance
in Latin America, for example, can we say that its the result of actions
taken today or the shadow of some longstanding problem? In many cases,
colonization seems to have had one of two purposes: to extract wealth or
to establish a long-term home. Each of these purposes calls for a different
set of institutions, which would have an influence even after the period of
colonization ended. The Soviet Union and the nations it dominated serve
as modern examples. Consider, too, the United States and its domination of
Latin America. The fates of the economies there depended heavily on the
chess match played by the two superpowers of the world during the period
of the Cold War.
When any dominant economy favors a small economy, it can grant or remove
access to a large market. There is often an implicit guarantee that should the
smaller economy run into trouble, the larger one will provide support, as
is the case with the United States and Israel or Mexico. While a powerful
46
friend can be good, there are also many examples of countries that have a
powerful enemy. Any country that is dominated by a larger economic power
is likely to have a great deal of instability in political leadership, and as we
know, instability deters investment and results in a loss of faith.
Power isnt always targeted at keeping other countries down. It has also been
used to create peace and stability. In some cases, the use of power can create
negative and positive effects at the same
time. The Roman Empire, for example,
created powerful institutions that led to Perhaps this is really
exploitation but also a sense of stability.
the best way around
the abuses and larger
Hegemony can explain why some
political manipulations:
economies fail, but it cant explain why
some large economies dont succeed. the spreading of ideas,
After all, if power is everything, then the spreading of
being large should mean that the nation economic growth and
could choose to succeed all the time. But stability, the transfer of
as weve seen, countries have to enact the
wealth, and the ability to
right policies, as well.
teach other economies to
It seems to be in most countries interest be wealthy on their own.
to engage in private enterprise because Theres great stability in
doing so produces profits, which create
that, and in that stability
wealth, and wealth is really much more
cooperative today than it is coercive. is peace and prosperity.
Creating wealth requires the melding of
economies and the use of manufacturing
talent and the appeal to consumers around the world. Wealth needs to be
spread, and that means that countries have to work together more than
ever before.
Important Term
hegemony: Economic or other influence exerted by a dominant nation.
47
Suggested Reading
1. How important are political and military power in determining which
countries grow and which dont?
2. What will be the principal sources of power in the coming decades?
Lecture 16: Politics, Statecraft, and the Fate of Economies
What two or three nations will be the most powerful and/or economically
important in the near future?
48
Corruption and Its Impact on Growth

Lecture 17
While pervasiveness is bad, arbitrariness is even worse. Corruption

when you cant predict it really takes its toll on an economy and really
guts the system. It really is the full break in the free-market story that
leads an economy from rags-to-riches, and thats important.
erhaps the most enduring force that can damage economic growth,
stability, and harmony is corruption. As weve seen, a good free-market
economy has incentives to be productive. A system that encourages
people to work hard and invest in being trained to be efficient works in
much the same way that evolution does. A better, more talented organism
reaps rewards. But this system works only if the actors find investment and
risk-taking more profitable than the alternatives. The environment and the
consequences determine whether its easier to get profits by being productive
or predatory.
The story of corruption is familiar. If you want to build a better mousetrap,
you can do all the hard work of design, or you might just be able to pay
off the government official whose job it is to select the best mousetraps.
Corruption here reflects a fundamental misalignment of incentives between
productivity and profit that breaks down the capitalist system. Moreover, it
results in a misallocation of resources from productive activities. Instead of
working hard to build a better product, you figure out how you can cheat the
system. Once you succeed, others follow suit, and very quickly, a vicious
cycle emerges that is absolutely toxic to growth.
Corruption is simply the abuse of power for private gain. It occurs when
power is delegated, and the more delegation an organization hasthe more
complex a bureaucracy or a society isthe more opportunities there are for
corruption. Corruption is everywhere, but its not the same everywhere, and
that fact may make the difference in economic performance. Environments
in which corruption is pervasive are not as damaging as those in which
corruption is arbitrary.
49
Lecture 17: Corruption and Its Impact on Growth
Corruption has numerous ill effects on an economy. It slows overall investment

and tends to skew the marketplace toward places where corruption can survive.
In corrupt economies, we often see overinvestment in projects where corruption
can be easily hidden, such as construction,
and lack of investment in programs where
I remember actually
it cant be hidden, such as healthcare and
seeing a political
education. Further, corruption goes along
with increased inequality in income levels.
sign from a resilient
Once youre in the system and have a little
politician from the 1970s.
bit of money, its easier to perpetuate your
Amazingly, translated
wealth and more difficult for others to
from Portuguese, it read:
get in.
He steals, but he also
There is no shortage of examples of
achieves. Thats sort
corruption around the world. In Nigeria,
of the way we look at
President Sani Abacha effectively
corruption in some ways.
stole about $5 billion from his country.
Its immutable, but we
Ferdinand Marcos is alleged to have
accepted hundreds of millions of dollars
learn to live with it.
in bribes from U.S. corporations seeking
to build facilities in the Philippines.
Closer to home is the Teapot Dome Scandal that unseated Warren G. Harding,
perhaps the most corrupt president in U.S. history.
Corruption is difficult to eliminate because its rewarding, and because there
is always some market for influence. Its also hard to address because its
hard to define, hard to measure, and hard to observe. Perhaps a partial answer
can be found in channeling corrupt activity into appropriate forms, such as
lobbying, and minimizing it or subjecting it to sunlight.
Suggested Reading
Helpman, Elhanan. The Mystery of Economic Growth.
50
Naim, Illicit.
1. Is corruption always harmful to an economy? When is it most harmful?
2. How does corruption influence behavior in markets? How do these
influences impede policy making?
51
Informal, Inefficient Markets

Lecture 18
Even if the little guys beat the big guys in what seems to be a fair
competition, when you have informality and firms that reject the value
proposition of the state, as they did in Brazil, you dont get that. That
breaks this incredibly important chain between competition, productive
activity, and growth.
I
Lecture 18: Informal, Inefficient Markets
n the last lecture, we saw that corruption can be deadly to growth. One
of the outgrowths of corruption in a low-income, developing economy
can be an informal marketplace, also known as a gray market. Here,
hawkers sell general merchandise, along with more sophisticated items, such
as software or music CDs. All transactions are conducted in cash, and the
enterprises seem to operate outside the formal economic and legal system.
Such gray-market firms tend to be much more prevalent in lower-income
economies and almost completely absent from rich or developed economies.
The fact that they seem to follow some laws and not others means that it
must be profitable to operate that way, but this extra-legal approach comes
with some consequences. In exchange for operating outside the system,
gray-market firms give up legal protections.
The existence of informal markets might seem like a symptom, but its
also a cause of more difficult challenges for an economy to overcome. The
experience of Dell Computers in entering the market of Brazil in the 1990s
serves as an example. In every market it had entered, Dell had been able
to command at least double-digit market share against such competitors as
Compaq, IBM, and Apple. In Brazil, however, Dell was also competing
against the gray market, where 50 percent of home computer owners made
their purchases. After 5 years, although Dell had the largest market share of
any single computer manufacturer in Brazil, it was only 4 percent. During
the same time, the gray markets market share grew to 75 percent. Part of the
problem was that the cost of operating in the legal commercial environment
in Brazil was extremely high, while an informal firm could, perhaps, offer
a few bribes to avoid Brazils high labor costs and heavy import taxes and
52
provide products at much lower prices. The GoliathsDell, Compaq, and

IBMhad to operate within the system, while the Davids operated outside
the system and offered a better value to consumers.
One of the reasons a firm might act legally in a high-income economy is
because its worth it to do so. In other words, the value proposition of the
state is high enough that firms elect to
be mostly legal. If the government isnt
strong and the laws arent always enforced, It turns out that when you
the result is informality. In some cases, looked a little bit behind
it may be good for David to win against the story, you learned
Goliath, but in the long run, an unfair win that these informal guys,
is a strike against productivity, which in
these firms that sort of
turn, affects competition and growth. In
Brazil, the success of the informal players knew how to operate on
was really a product of the state and its small scalethey werent
particular failures.
a Dell and they werent
super-sophisticated, but
Until corruption is reduced and the rule
of law is strengthened, the Davids are they could get parts with
destined to win in these wars. That may a little corruption and
result in some positives, but in the end, the save a lot of money.
gray market keeps more productive firms
from winning market share, which is how
the system is supposed to work. If the free-market process is interrupted,
so is the overall process of growth. Bringing in productive firms from
around the world becomes a challenge because they know theyre going to
lose. The value of the state isnt evident to the very entrepreneurs needed to
sustain it.
Important Term
gray market: Trade that falls outside of normal distribution channels. Graymarket trade can often be found in developing economies, where sellers
with no connection to the original manufacturer offer for sale such items as
electronics and DVDs at discounted prices.
53
Suggested Reading
1. Why do informal markets arise? Why are they more prevalent in
developing economies than in developed ones?
Lecture 18: Informal, Inefficient Markets
2. How do informal markets challenge growth?
54
Technology and the Instant Economy

Lecture 19
The idea of comparative advantage is, in itself, absolutely true. its

been called the least intuitive but absolutely true idea in all of economics.
Its not easy to understand, but comparative advantage tells us a lot
about the world, particularly of the 19th and 20th centuries, when trade
was a little easier to understand.
he rapid pace of technological change forces us to ask whether our

theories of economic growth, developed in early centuries, are still
relevant today. Electronic commerce offers a world of nonphysical
value creation and trade that occurs instantly. What does this mean for our
understanding of the benefits of trade and growth in modern economies?
Since antiquity, trade has been at the center of economic development. It
has brought together cultures and fostered innovation and exploration. In
The Wealth of Nations, Adam Smith described a concept known as absolute
advantage: When one country has an absolute advantage over another in
the production of some product, why not let that country produce enough
for both and simply trade for another commodity? Many years later, David
Ricardo refined that story with the idea of comparative advantage, that
is, that trade is always beneficial. Even when one country has an absolute
advantage over another, specialization allows both to benefit from production
of the same commodity.
Throughout history, there has been some tension around the idea of trade
because it introduces competition with others who arent like us. But the
argument that we gain by producing everything at home isnt true. Trade
works because it minimizes opportunity costs. Through specialization,
people are able to make the most of their talents and, therefore, to sacrifice
the least by doing what theyre best at.
One of the risks of trade is the loss of local production, to which economies
must adapt. Traditionally, buffers, such as geographic distance, offered some
assistance in this adaptation so that it didnt have to take place overnight. Of
55
Lecture 19: Technology and the Instant Economy
course, with the Internet, that situation has changed, and many things have
gone from the realm of being non-tradable goods to being tradable goods.
If you can put it on a computerif your value can be put into bytesthen
it can be sent anywhere, and youre subject to the risk of being outsourced,
off-shored, or traded against. Economies
will have to redeploy workers displaced
by modern trade, and its the speed and In fact, it might even
cost of that adaptation that challenges be a surprise to learn
modern policymakers.
that some of the richest
Comparative advantage is just as true as economies in the world,
before, but the ability to adapt quickly is like Japan and the
more apparent, is spread to more people, United States, really
and is more costly for us to deal with. arent mostly trading
Further, financial flows are also now
economies. Most of their
instantaneous, which means that entire
economies are at risk. Our adaptation economies are domestic,
must be instantaneous, or nearly so, and most of their
as well.
economies arent really
all that open, it would
With the Internet, low-income economies
are connected to high-income ones, seem, to competition
creating a connection of low-cost services from foreigners.

and high-value production to wealthy
consumers. That can mean more value
creation but also risk and social disruption. Economies may need to find
some safe haven in the midst of all this competition, something less subject
to instantaneous trade, which could mean rewriting many of the rules for
how economies operate. The technology of the 20th and 21st centuries has
proven to be great at eliminating scarcity and allowing rapid trade, but that
doesnt mean that we humans and our societies are ready to adapt to this
new world.
56
Important Terms
absolute advantage: A concept originated by Adam Smith. If one economy
can produce more of a product than another using the same amount of
resources, the higher producer is said to have an absolute advantage over
the lower producer. In this situation, it is beneficial for the two producers to
engage in trade of the products that give them an absolute advantage.
comparative advantage: An extension of Adam Smiths concept of absolute
advantage, developed by David Ricardo. The idea that even in a situation
of absolute advantage, trade is still beneficial between two economies if the
lower-producing economy specializes in some aspect of production.
opportunity cost: The cost of an alternative that must be eliminated in
making a decision. The classic example is the money a student would have
earned had he or she chosen to work rather than attend college.
Suggested Reading
Naim, Illicit.
1. Has the Internet made economic growth easier or harder to achieve
and sustain?
2. In what ways has the Internet changed the skills and behaviors needed
to succeed in business and the workplace?
57
Possible Strains on Global Economic Growth

Lecture 20
In short, if we just run out of resources or if we just run scarce of

them, then everybody could lose, even the winners, if you will. Even
the producers, who gained so much wealth because they had the scarce
resource, even they could run short of value. The world could topple so
far so quickly that perhaps it spins completely out of control.
A
Lecture 20: Possible Strains on Global Economic Growth
s weve seen, two factors characterize successful economic growth:

efficiency and productivity. These are the paths that lead us from
worlds of limited resources to worlds of abundance. So far, the
free-market system has enabled us to get more bang for the buck from our
resources without exhausting them. But can this system continue to engender
growth in a finite world?
Thomas Malthus addressed this question at the dawn of the Industrial
Revolution. To Malthus, the success of economic growth in elevating
population levels and lengthening lives would inevitably lead the world back
to poverty. In some sense, he was right, but Malthus didnt give much credit
to the possibilities of technology and science or even human resourcefulness.
At the same time, its also true that the world is now being tested in way that
it has never been before.
At the beginning of the 21st century, we live in a world economy that has
never grown faster, has never had more people in it, and has never been
larger. Perhaps part of the reason that the Malthusian check hasnt pulled
back the world economy yet is precisely because the Industrial Revolution
began in the West, in relatively smaller, less populated countries. If theyre
the ones who invented growth, then they could rapidly expand and soak up
resources before the more populous areas of the world, such as China or
India, begin their path to growth. Now, however, the Chinese and Indian
economies are growing at rapid rates.
In the 1930s, economist Harold Hotelling studied the optimum path for
natural resource use. He discovered that in a free market, there is incentive
58
not to overproduce too quickly but also not to hold the resource away from
the world for so long that it becomes defunct or useless. What Hotelling really
learned is that private markets have a natural mechanism for seeking out and
producing new resources, but he left out what we might call externalities,
that is, outside costs of resource use, such as pollution.
A free-market system is supposed to correct for scarcity. When a resource is
scarce, the natural thing to happen is for the price to rise, sometimes rapidly.
Then, the market goes through rationing,
meaning that those who are willing to pay
the most to use the resource will command [G]rowth can
it. In a poorer country, such rationing could be stopped almost
disrupt the process of development. The oil completely when a
shocks of the 1970s clearly produced two
natural resource thats
sharp drops in growth rates throughout the
so critical, like [oil],
world economy.
becomes so scarce
During the late 1970s and early 1980s, a overnight. It worked
conservation movement took hold in such
right through the price
economies as Japan and Western Europe
that incentivized the efficient use of mechanism, and there
resources. Nonetheless, a genuine scarcity was rationing all around,
of a resource such as oil could have but it still didnt help.
frightening consequences. The winners
in that situation would be the OPEC
nations, who could destabilize the world to the extent that growth could stop
altogether. We need to ensure that we have the education, resourcefulness,
and cooperation to meet this and other challenges of world growth.
Suggested Reading
59
1. Is there a speed limit for the overall growth of the global
economy? Why?
2. How should national and international governmental institutions adapt
Lecture 20: Possible Strains on Global Economic Growth
to meet the challenges of historically high levels of global growth?
60
Latin AmericaMoving Away from Free Markets

Lecture 21
That was the view on Latin America: We had a few decades when it
was our turn to ascend. We did everything we were supposed to and, in
fact, those who were further behind leapt over us. In leaping over us,
they evidenced our own weaknesses and the failure of our policies and
our politicians.
hroughout this course, weve talked about the fact that many
countries have struggled to understand what strategies and policies
lead to economic growth. But they also struggle with the question
of whether economic growth in itself is truly the right goal or even the only
goal. Since at least the 1940s, societies in Latin America have asked whether
an economy should stand for something more than just a bigger pie.
Throughout the 1970s and early 1980s, many countries in Latin America saw
the emergence of a growth pact, a commitment to economic liberalization
opening up the economy to more competition, eliminating monopolies,
and removing the government from the business of private enterprise.
Unfortunately, these efforts to replicate the ideas that had led Western
economies to prosperity were largely unsuccessful.
In the 1980s, Mexico, for example, began to adopt some of the freemarket approaches of the United States, and many believed that this nation
represented the future of the world economy. In the end, however, freemarket reforms in Mexico led to a wave of corruption. Mexico lost a decade
of growth and, with it, the faith of the people in the countrys ability to
achieve economic success. Similar periods of optimism followed by failure
in Argentina and Peru led people to question whether free-market approaches
were appropriate for Latin American economies.
With the exception of Chile, all the economies of Latin America that
supported capitalist economic reform policies found that the result was a lot
of pain with no gain. Opening up to foreign competition, adopting reforms,
and limiting the social safety net provided by the government brought wealth
61
Lecture 21: Latin AmericaMoving Away from Free Markets
to a few, but the majority experienced stagnation and poverty. The result was
a combination of mistrust and anger over political and economic reforms that
had been promulgated from the West,
leading to the return of revolutionary
In broad terms, it appears
ideas. At the end of the 20th century,
Latin America had turned away from
that what really went wrong
the economic policies of the West
in Latin America was simply
and back toward socialism.
that there werent enough
ladders. There werent
Probably the real explanation behind
enough ladders leading
the economic failure of so many
countries in Latin America is that
people out of poverty into
the buy-in weve talked about was
the middle class or into the
simply lost. The fact that the freeopportunities that a good
market approach seems to work
free-market set of incentives
everyone else just doesnt matter.
If theres no growthno success
could provide.
from the policiesthen there will
be no support. What we see in Latin
America now is the idea that redistribution, rather than growth, is the goal.
Latin America is looking for a bottom-up approach that starts with delivering
to the people the resources they need to live better.
What Latin Americas turn to the left teaches us is that values of justice
and fairness, a better life for most, always seem to dominate over particular
ideologies in the long run. Any economic strategywhether its a state-led
approach, a free-market approach, or any othermust ultimately prove its
value in the minds of the people who sustain it.
Important Term
socialism: An economic system in which the state maintains ownership of
the means of production.
Suggested Reading
62
1. Is growth the right goal for all developing economies?
2. How should growth and distributional issues be balanced?
63
Financial Crises and Economic Theory

Lecture 22
That confidence that resulted from this global flow of money into the
United States at an unprecedented rate, at levels that wed never seen
before because of the great growth around the world, led to a huge
over-consumption in the United States that really added to the pain of
this bubble when it was ultimately burst.
G
Lecture 22: Financial Crises and Economic Theory
lobalization seems to be a wonderful idea, but we have to ask: Will

a global economy actually be a safer, smoother economy with more
checks and balances that will deliver us a steady expectation of the
future? To answer that question, we might begin by asking: What are the
benefits of globalization? In financial terms, globalization means opening up
the world to more savers and investors; it also means greater liquiditythe
ability to realize the value of an asset quickly. Another benefit should be
economic growth as a result of connecting resources around the world.
As weve seen with the Asian Tigers, globalization does bring growth, but
with that growth comes intense scrutiny from around the world. Investors
and policymakers react to every economic action or result in a way that
could lead to more crises. If an economy opens up to the worlds inflow
of resources, then its also subject to the outflow, and in that reversal, an
economy can be quickly destabilized.
At the beginning of the 21st century, globalization had already brought us a

world economy that had some profound insecurity and instability built into
it. In 2005, Ben Bernanke pointed out that too much of the worlds savings
were finding their way to the United States. As a result of the Asian financial
crisis of the late 1990s, there was a lot of excess saving in Asia, but rather
than deploy it locally, it was being sent to the United States. Thus, the United
States itself didnt need to save. Interest rates in the United States plummeted,
which meant that borrowing was easier, and many people invested in homes
or property. Asset prices were rising rapidly in the United States because
consumers had little need to save, low interest rates, and a strong currency.
The economy was primed for a bubble, and thats exactly what we got.
64
What really happened as a result of the earlier Asian financial crisis was
that the United States became the worlds bank. Money flowed into the
U.S. financial system, and much of it stayed there and was poorly used.
Even though the world had more options than ever before, it chose one that
ultimately led to its undoing, a result that seemed to fly in the face of many
of the benefits of globalization.
In the wake of the U.S. financial crisis, the world economy will rebalance.
The United States will no longer be the recipient of such large inflows,
and the dollar will get weaker. There will also
likely be trade reversals. Further, the strategy
of basing an economy on what a country can Really, financial
sell to the United States will no longer be openness and
completely viable.
globalization mean
that the imperative
One of the things the U.S. crisis teaches us is
for nations is to be
that imbalances are common and, perhaps, even
inevitable. They may be an inherent part of even more adaptive
being financially open. This means that global than before.
and financial openness arent without systemic
risk. This greater freedom doesnt banish the
idea that an economy can be subject to the same types of shocks or even
bigger ones than before. In fact, the more open the world is, then the heavier
and faster can be the swings of positive and negative.
Important Term
liquidity: The ability to quickly realize the value of an asset; the ease with
which an asset may be exchanged for cash.
Suggested Reading
Friedman and Schwartz, A Monetary History of the United States
65
1. How did the United States become the worlds largest borrower nation?
Was this the fault of U.S. economic policy?
2. How must the United States adapt to its financial crisis to prevent it from
Lecture 22: Financial Crises and Economic Theory
happening again? How must China adapt?
66
The Multipolar Economic World

Lecture 23
Managing the cost of credit is also about managing price stability,

ensuring that the world economy doesnt grow too rapidly or too
slowly. Its a bit like the captain of a ship; you have to really manage
the course and the tide and account for weather. Its an art as much
as a science, but this is, in fact, what powerful economies do.
ith globalization and an unprecedented level of financial openness

come new possibilities, but with these also comes a revision of
the script as to which countries are economically powerful. Who
are the major investors and borrowers in the world today, and is it better to
be an exporter or a recipient of savings?
There is power in being a saver. If Im a saver, I have resources to invest and
Im the one who decides where my resources will go. Having savings also
means that Im not subject to rapid reversals of fortune. It would seem that
savers have a key role in deciding which economies will grow and where the
future of the world economy will be. There are some downsides to saving,
however. For instance, saving isnt always voluntary; domestic opportunities
for investment may be weak, and therefore, the only viable option is to
save elsewhere. Further, sending savings around the world means that your
country doesnt have those resources in the short term, which can lead to
economic stagnation.
The central banks of the world help mediate the flows of saving and
investment. In the United States, the Federal Reserve Board is charged
with managing U.S. currency, the reserve currency for the world. About
70 percent of all financial assets in the world are held in U.S. dollars. The
trust other economies have in U.S. currency is perhaps one measure of our
nations position of power in the world. But other banks are lined up to take
over for the Fed in the wake of the economic crisis in the United States.
One of these is the European Central Bank (ECB), which manages the euro,
increasingly seen as a potential successor to the dollar.
67
Lecture 23: The Multipolar Economic World
One reason that the central banks are so important is that they serve as the
worlds thermostats. If the U.S. economy is faltering, then as the central
banker and producer of U.S. currency, the Fed can dial down the interest rate
to help stimulate growth and production. In such situations, its helpful if one
nations policies work in concert with
others, but that cooperation is not
Once we move from a world
always easy to manufacture. Thus,
the world banks work a bit like the
of barter and a world where
United Nations. Some countries have
we can exchange goods
power, but power can shift or groups
directly for other goods [to]
of countries can work together to
a world where we use money
exercise their power to the detriment
and financial currency,
of others.
particularly currencies that
Even powerful economies are subject
some economies produce as
to the influence of the less powerful.
much as they want, then the
Financial hegemony, like that held
dance of the powerful is a bit
by the United States, is no longer
just national. Other economies, even
hard to follow.
poor ones, have a vote in deciding
who is powerful by their choices
in saving and investing. The United States currently holds a seat of power
because of its production of the worlds reserve currency. A transition away
from that situation could be worrisome, but the truth is that most everyone in
the world wants stability. Were destined to see changes in the definition of
whos powerful, but those changes will likely be a consensus of voices from
around the world.
Suggested Reading
68
1. How much power comes with being the worlds largest economy? How
much comes with being the worlds biggest saver?
2. What
determines
world economy?
economic
power
in
flat,
centerless
69
Driving Forces, Emerging Trends

Lecture 24
We must have theories and ideas about the way the world works that
account for this lack of realism and what were able to reproduce in our
theories, through our math, however sophisticated. The stories must be
adjusted over time. The more we learn, the more we learn that we need
to learn, adapt, and constantly revise.
O
Lecture 24: Driving Forces, Emerging Trends
ur conversations about economics often center on isms and

ideologies, but all these schools of thought are really focused on
how to get what we want. Theyre a means to an end, and that end is
growth, possibility, opportunity. Once we push past these schools of thought,
we see economics as the quest to solve a tough problem: How can we allocate
the scarce resources in the world in a way that makes people better off over
time and doesnt impinge on their freedoms or ambitions? The key here is to
get people to behave productively and cooperatively.
The actors in the story of growth and economic well-being are human beings,
who are difficult to understand as individuals, let alone in large groups.
And as weve seen, economics is unable to test its theories in scientific
experiments. Even if it could, people in the same circumstances sometimes
behave differently. We know that people respond to incentives, but any major
decision entails numerous, sometimes conflicting incentives. We also know
that its complicated to make decisions in a world where our choices have
lots of dimensions and only some of them can come true.
Thus, economic theories are really more like ancient parables with a modern
touch of econometrics and statistical theories. Weve learned a lot from
history, but our laws are often general and entail exceptions. The point,
however, is not to develop profound laws but to find the growth, equality,
justice, and opportunity that we all long for. Free-market capitalism, for
instance, seems to be a good set of ideas about how to run an economy, but
even it has flaws. The more we look at free markets, the more we understand
just how many assumptionssome realistic and some notare layered in.
70
Throughout this course, weve seen economies that worked well for a period
of timethe Western miracle stories, the Asian miracle stories, the new
Tiger stories. But they have proven incapable of being perfectly copied and
adapted to other economies at other points in time. Weve even seen that
sometimes the same solutions fail in the same country. The explanations
can be traced to the complexity of
bringing people together in a world
thats constantly changing and to the [T]he theories, the
complexity of individuals themselves.
schools of thought, and
In the end, what seems to matter is a
complex combination of incentives
for productivity, but also critical
to productivity is the advance of
technology. Without the rapid advance
of science and technology, the
Industrial Revolution would never
have begun. Interestingly enough, the
development of scientific ideas requires
incentives, too.
the isms and ideologies

we use are rougher
stories. Theyre not exactly
scientific theories; theyre
something broader. By
design, they have to be
because people are just
that complicated, and
theyre the protagonists.
Theyre the key to the

What we owe most to ourselves and
our children is the enduring appetite entirety of the story.
to question our theories, our schools of
thought and isms. Not questioning our
own ideas can lead us so far astray that we can have decades where large,
intellectually rich, and profoundly capable countries stagnate and suffer.
Virtually nothing is more important than developing ideas and thinking
critically about them time and time again.
Important Term
capitalism: A free-market economic system characterized by private
ownership of property and goods.
71
Suggested Reading
1. What is the best way to get people to behave productively and work
together in a 21st-century global economy?
2. What would you do to produce growth and raise living standards in

low-income countries?
3. What would you do to maintain growth and raise living standards in

Lecture 24: Driving Forces, Emerging Trends
high-income countries?
72
Glossary
absolute advantage: A concept originated by Adam Smith. If one economy

can produce more of a product than another using the same amount of
resources, the higher producer is said to have an absolute advantage over
the lower producer. In this situation, it is beneficial for the two producers to
engage in trade of the products that give them an absolute advantage.
average worker productivity: Calculated by dividing total economic output
(GDP) by the number of employed workers in an economy.
balance of payments: An accounting system that measures the flows of
resources from one economy into another and aggregates them across the
world. Provides a summary of an individual nations economic relationship
with the rest of the world.
bubble: Rapid expansion of an economy, followed by an often-dramatic
contraction.
capital account: One component of the balance of payments; provides
information about financial flows in an economy.
capitalism: A free-market economic system characterized by private
ownership of property and goods.
command economy: An economy in which the central government makes
all relevant economic decisions.
comparative advantage: An extension of Adam Smiths concept of absolute
advantage, developed by David Ricardo. The idea that even in a situation
of absolute advantage, trade is still beneficial between two economies if the
lower-producing economy specializes in some aspect of production.
corruption: The abuse of power for private gain.
73
current account: One component of the balance of payments; provides

information about the flow of goods and services in an economy.
deflation: A situation of falling prices for goods and services.
free market: A system in which business is conducted according to the laws
of supply and demand, without government intervention. Participants in free
markets reap all the benefits and incur all the costs of their actions.
gray market: Trade that falls outside of normal distribution channels. Graymarket trade can often be found in developing economies, where sellers
with no connection to the original manufacturer offer for sale such items as
electronics and DVDs at discounted prices.
gross domestic product (GDP): A measure of a nations economic activity;
the total value of all goods and services produced in an economy in a given
year.
hegemony: Economic or other influence exerted by a dominant nation.
hyperinflation: Inflation that grows at a very high rate in a short time
period.
inflation: A situation of rising prices for goods and services.
law of demand: With all other factors equal, the demand for a product will
decrease as its price increases.
law of one price: The idea that one product should never have two particular
prices in one market.
Glossary
leverage: The use of credit to enhance an investors ability to make additional

investments.
liquidity: The ability to quickly realize the value of an asset; the ease with
which an asset may be exchanged for cash.
74
macroeconomics: A branch of economics concerned with the study of

economic systems as a whole.
microeconomics: A branch of economics concerned with the study of
individual aspects of an economy, such as firms or prices.
misery index: A measure developed in the 1970s to describe a poor economic
state. Calculated by adding the unemployment rate to the inflation rate.
monetarism: School of thought in which the money supply is believed to
have a significant influence on economic factors, such as inflation rates.
opportunity cost: The cost of an alternative that must be eliminated in
making a decision. The classic example is the money a student would have
earned had he or she chosen to work rather than attend college.
per capita GDP: GDP divided by the total population of a country.
recession: A period of reduced activity in an economy.
scale production: The ability to produce on a large as opposed to an
individual scale; realized with the advent of the Industrial Revolution.
socialism: An economic system in which the state maintains ownership of
the means of production.
tariffs: Duties on imports. Raising tariffs is a strategy used to diminish or
prevent trade.
theory of the second best: Explains the state of flux that results when one
option must be eliminated in a decision-making situation. Eliminating one
option may mean that other variables in the decision are changed.
Washington Consensus: A now-controversial set of economic policy
recommendations compiled from the World Bank, the U.S. Treasury, and
other international financial institutions by John Williamson in 1990 and
directed toward developing economies in crisis.
75
Bibliography
Bastiat, Frederic. Economic Fallacies. La Vergne, TN: Simon Publications,

2001. A classic collection of writings on all manner of questions about
political economy, protectionism, government intervention in free markets,
and the virtues of good commerce.
Bhagwati, Jagdish. In Defense of Globalization. New York: Oxford
University Press, 2004. The doyen of modern free traders offers convincing
evidence of globalizations virtues and impact on poverty alleviation.
De Soto, Hernando. The Mystery of Capital: Why Capitalism Triumphs in the
West and Fails Everywhere Else. New York: Basic Books, 2000. The Mystery
of Capital offers a rare glimpse into a deliberate economic experiment that
reveals some of the preconditions for capitalism to take root.
Diamond, Jared. Guns, Germs and Steel: The Fates of Human Societies.
New York: W.W. Norton and Company, 1997. Diamond offers insight into
the roles of technological advance, globalization, and luck in shaping the
modern world.
Bibliography
Easterly, William Russell. The Elusive Quest for Growth: Economists

Adventures and Misadventures in the Tropics. Cambridge, MA: MIT Press,
2001. Easterlys gift lies in elucidating the challenges of defining good
economic practice in a world that doesnt often work as theory suggests. The
book offers a window into how economic policies and ideologies have fared
in actuality over the past 50 years.
Faulkner, Robert, and Susan Shell, eds. America at Risk: Threats to Liberal
Self-Government in an Age of Uncertainty. Ann Arbor, MI: University of
Michigan Press, 2009. This collection of essays considers the many ways that
the United States is adapting and must continue to adapt to the challenges of
modernity in a global economy.
76
Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United

States: 18671960. Princeton, NJ: Princeton University Press, 1971. No
other book can claim to have done a more complete job of explaining the
monetary causes of the initiation and propagation of the Great Depression.
It is also the defining book for monetarist thought and a prescient guide to
contemporary concerns over banking and the role of financial markets in
modern economies.
Friedman, Thomas. The World Is Flat: A Brief History of the 21st
Century. New York: Farrar, Strauss and Giroux, 2005. Friedman offers a
wonderful look into the anxieties and opportunities of a modern global and
technologically advanced economy.
Gambetta, Diego. The Sicilian Mafia: The Business of Private Protection.
Boston: Harvard University Press, 1993. Understanding the Sicilian Mafia in
part offers an understanding of the vital needs of commercial enterprises in
any economy. Gambettas framing of the Mafia as primarily an organization
that produces, sells, and at times, consumes protection from others yields
insights into the critical institutions of capitalism.
Grossman, Gene M., and Elhanan Helpman. Innovation and Growth in
the Global Economy. Cambridge, MA: MIT Press, 1993. Grossman and
Helpman offer this lucid and technically sophisticated look at how global
economies integrate to foster technological innovation, the essential seed of
continuous growth worldwide.
Helpman, Elhanan. The Mystery of Economic Growth. Boston: Harvard
University Press, 2004. One of the modern masters of international
economics ponders the fundamental questions of growth and explains why
so many of the answers remain a mystery.
Keynes, John Maynard. The Economic Consequences of the Peace. New
York: Penguin Books, 1990. Keyness hard look at the aftermath of World
War II and the problems it created for the global economy is as powerful
now as it was almost a century ago.
77
. The General Theory of Employment, Interest and Money. New

York: Prometheus Books, 1997. Keyness magnum opus and the book that
defines the great divide in modern economic thought between believers in
the purity of markets and those that support some level of intentional policy.
Modern macroeconomics, its terminology, and concepts did not exist prior
to Keynes.
Kindleberger, Charles P. The World in Depression. Berkeley, CA: University
of California Press, 1973. This book offers a fantastic, detailed account of the
global impact of the Great Depression and how it challenged and challenges
our understanding of the economy.
Krugman, Paul. The Return of Depression Economics. New York: W.W.
Norton and Company, 2000. Nobel Prize winner Krugman revitalizes some
of Keyness better insights through an examination of how economies have
continued to steer off course decades after the Great Depression.
Landes, David S. Revolution in Time: Clocks and the Making of the Modern
World. Boston: Harvard University Press, 1993. Landes offers a powerful and
deep examination into the role of technology in changing human behavior
and shaping it toward an obsession with productivity.
Naim, Moises. Illicit: How Smugglers, Traffickers, and Copycats Are
Hijacking the Global Economy. New York: Anchor Books, 2005. Naim offers
a terrific and startling account of the challenges of making productivity the
most profitable route to financial success.
Bibliography
Prahalad, C. K. The Fortune at the Bottom of the Pyramid: Eradicating

Poverty through Profits. Philadelphia: Wharton School Publishing, 2006.
By reimagining the poor, Prahalad invites a new discussion of the roles of
business and globalization in the alleviation of poverty worldwide.
Rajan, Raghuram, and Luigi Zingales. Saving Capitalism from the
Capitalists: Unleashing the Power of Financial Markets to Create Wealth
and Spread Opportunity. New York: Crown Business, 2003. Rajan and
Zingales synthesize much of their great work, explaining the role and value
78
of the financial sector to any economy. The book also describes the ways in
which the possibilities of capitalism are destroyed by common failings.
Sachs, Jeffrey D. The End of Poverty: Economic Possibilities for Our Time.
New York: Penguin Books, 2005. Perhaps no economist has been more
influential to the course of economic policy making and poverty alleviation
around the world than Jeffrey Sachs. This book discusses the varied
approaches that are necessary to rid the world of profound poverty and
defends the proposition that doing so is possible in the near future.
Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations.
New York: Collier Press, 1909. The most important work in the history of
economic thought. Smith touches on virtually every subject that defines the
scope of modern economics. This is an essential text for everyone.
Yergin, Daniel, and Joseph Stanislaw. The Commanding Heights. New York:
Touchstone, 1998. This is the definitive catalog of economic thinking and
ideological battles of the 20th century.
79

Why Economies Rise or Fall (Guidebook)

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Why Economies Rise or Fall

Professor Peter Rodriguez

Copyright The Teaching Company, 2010

Printed in the United States of America

Peter Rodriguez, Ph.D.

rofessor Peter Rodriguez is Associate Dean

Despite his many activities outside of the classroom, Professor Rodriguez

Why Economies Rise or Fall

he fundamental basis for all economic theory and policy is to improve

and whether growth can persist. The issues of instantaneity and a

From Free Markets to State Economies

Governments arent really the protagonists in the story. People

e hear about different and often-complicated economic policies

Lecture 1: From Free Markets to State Economies

A Brief History of Economic Growth

How fast is fast for an economy to grow? Angus Maddison, an economic

Lecture 2: A Brief History of Economic Growth

In comparing early economic winnersthe

Economic Growth and Human Behavior

eve already seen that economic policies or schools of thought

Lecture 3: Economic Growth and Human Behavior

The fundamental sources of economic

free market: A system in which business is conducted according to the laws

Lecture 3: Economic Growth and Human Behavior

1. Have you ever changed your behavior in direct response to a change in

The Birth of the Western Free Market

When you and I think about Industrial Revolution, we imagine

he idea of a growing economy, a world where successive generations

Lecture 3: Economic Growth and Human Behavior

American Economic Strategies

Lecture 5: American Economic Strategies

bring people back to work. Companies failed,

The United States wouldnt be challenged

Lecture 5: American Economic Strategies

nations ability to grow?

America and EuropeDivergent Approaches

One of the most significant outcomes of this divergence in path at

Lecture 6: America and EuropeDivergent Approaches

performance, however, reinforced much of our thinking about what it takes

2. Is growth the paramount goal of economic policy? How should it be

State-Led Theories of Economic Growth

Growth is really all about economic productivityfull stop. Thats it. If

n Lecture 2, we asked the question: How fast is fast when it comes to

2. Was the Japanese miracle evidence of a different economic model

The Secrets of Rapid Growth in Tiger Economies

o far, weve looked at the growth of countries that were already

Lecture 8: The Secrets of Rapid Growth in Tiger Economies

Lessons and Limits of Japans Economic Model

Lecture 9: Lessons and Limits of Japans Economic Model

Whenever an economy is recovering from a huge asset decline, such as a

2. What lessons do we learn about economic growth from Japans meteoric

Lecture 9: Lessons and Limits of Japans Economic Model

rise and precipitous fall?

From Closed to Open Economies

ntil the time of the Industrial Revolution, economic power

Lecture 10: From Closed to Open Economies

How Can We Manage Global Growth?

ithout question, the world economy is much more connected than

and the capital and financial account,

All the markets around

We can see the degree to which we are

Lecture 11: How Can We Manage Global Growth?

Bastiat, Economic Fallacies.

2. How does financial market integration affect daily life?