One element explaining the financial crisis is what Hyman Minsky called ‘destabilizing stability’: long periods of stability lead to increasing vulnerability. This chapter argues that similar mechanisms are at work inside economics: long periods of economic progress in the core countries lead to increasingly abstract and irrelevant economic theories (‘terrible simplifications’). This leads to turning points towards more relevant economic theories, referred to as ‘1848 moments’. The chapter further outlines the key variables that need to be re-introduced into economic theory in order to furnish poor countries with the type of productive structures that makes it possible to eliminate poverty.

The United Nations has announced that the number of chronically hungry people on the planet has exceeded the billion mark for the first time. It is extremely unlikely that any of them will ever hold a Swiss 1,000 franc banknote (worth more than 900 dollars), but if they did, they would see the portrait of a man who perceived the essence of the explanation as to why extreme poverty and extreme plenty coexist so naturally on this planet, and of the grim fate of the permanently starving – Swiss historian Jacob Burckhardt (1818–1897). Burckhardt, best known as a historian of the Italian Renaissance, coined the term ‘the terrible simplifiers’ to describe the demagogues who – in his dark vision of what the twentieth century would bring – would play central roles in the future (Dru 2001: 230). Events amply fulfilled Burckhardt's predictions of a cataclysmic twentieth century, of the rule of terrible simplifiers, men whom Burckhardt's colleague at the University of Basel, Friedrich Nietzsche, called power-maniacs (Gewaltmenschen), and John Maynard Keynes referred to in 1936 as ‘madmen in authority’.

A key common element in persistent world poverty and in the financial and (real) economic crisis is the ‘terrible simplification’ – a theoretical overshooting into irrelevant abstractions – that has taken place in economic theory after World War II. As unlikely as it may initially sound, I shall endeavour to explain in this chapter how – in spite of its apparent sophistication – equilibrium economics became ‘mathematized demagoguery’ based on an extremely simplistic world view.

‘Woe to the vanquished’ – a saying of the ancient Romans – came to mind when I attended a conference in the Mongolian Parliament building in March 2000. As the only non-Asian I participated in a forum addressing the severe economic problems of the country. The local newspapers vividly reported that not far away from the snug heat of Parliament, an estimated 2 million animals pasturing on the plains were starving to death in the bitter cold. Permanent desertification threatened the country, and it was clear that this disaster was manmade. What was not reported was the important fact that the 2 million animals dying during the winter of 1999–2000 were only the increase in the animal population over the previous two or three years. The fundamental cause of the disaster was the same type of diminishing returns that has afflicted mankind since biblical times: too much economic pressure on one factor of production, land, the supply of which was fixed. Rooted in this phenomenon, vicious circles of poverty were already well established.

In terms of economic theory, the Mongolian situation takes us back to economics as the ‘dismal science’, to Thomas Malthus (1820), John Stuart Mill (1848) and even Alfred Marshall (1890). In spite of the recurrence and description of these phenomena since the biblical Genesis, the mechanisms at work in Mongolia during the 1990s apparently were not recognized, even when the disaster was a consummated fact. The underlying cause was clearly not global warming, as the Western press reported.

The more I studied Mongolia in the months that followed, the clearer it became that this nation, vanquished in the Cold War, for all practical purposes was being subjected to a Morgenthau Plan (Morgenthau 1945).

Carl Menger, the founder of the Austrian School of Economics, had the ambition that economics should be a ‘map of the forces at work’. Standard textbook economics (‘neo-classical economics’) takes as its starting point a metaphor of ‘equilibrium’ based on the state of the physics profession in the 1880s. This force towards equilibrium is, however, only one of many forces at work. The most fundamental feature of capitalism is change, and this change is only poorly reflected in standard economics. Financial crises are just one of the many things that happen in real life, but cannot happen in standard textbook economics. From the standpoint of Joseph Alois Schumpeter (1883–1950), an Austrian economist and Harvard economics professor who spent much time at Harvard Business School, ‘equilibrium’ is the opposite of economic development. Equilibrium theory therefore fails to reflect many of the mechanisms of industrial and economic dynamics that create economic welfare. This chapter attempts to outline some of these forces.

Productivity explosions

What from a long-term perspective may look as relatively smooth curves of economic development are in reality the result of explosive productivity changes in a small number of industries. Figure 24.1 shows an early such ‘productivity explosion’ from a breakthrough innovation: that of cotton spinning in the late 1700s, when annual labour productivity rose by more than 25 per cent annually for a brief period.

At the time the common sense of economics was for nations to attempt to get industries behaving like this inside their borders. Productivity explosions create a system of triple rents: profits are high, wages rise and the government tax-base grows. In its essence colonialism was a system that prohibited such production activities – industry in general – from being carried out in the colonies. At the time of this early productivity explosion, this prohibition of manufacturing was a main motive for the United States’ independence in 1776.

Recently we have experienced a similar productivity explosion in the computer industry. Moore’s Law tells us that, since the late 1970s, the capacity of the computer chips doubles roughly every 18 months, creating an upward curve like the one of the cotton industry in the 1700s.

Also the activities, even technologically pedestrian ones, that are near the productivity explosion may achieve triple rents. The task of cutting and preparing cables for the computer industry grew up geographically close to the computer industry itself when

This chapter attempts to explain the drastic fall in income experienced by Saami reindeer herders in Northern Norway between 1976 and 2000, in spite of increasing government subsidies. Saami herders maintain a legal monopoly as suppliers of reindeer meat, a traditional luxury product in Norway.

Introduction

The Saami are one of more than 20 indigenous groups across the Northern Eurasian continent that have traditionally made reindeer herding one of the bases of their livelihood. As an ethnic group, they live throughout the Northern parts of Norway, Finland, Sweden and Russia, a territory known traditionally as Lapponia or Sápmi. Their exact number varies from source to source, depending among other things on national criteria used to determine ethnicity, but official sources place the total population of Saami in the area somewhere between 30,000 and 70,000, with about 2,000 Saami living in Russia. In Finland, Norway and Sweden “Saami parliaments” have created parallel indigenous political structures that function as advisory bodies to their respective national governments. Only a minority of the Saami practice reindeer herding, and conflicts of interest over land rights, access to natural resources and political rights often create tensions between the reindeer herders and other Saami groups. Reindeer herders are thus a minority within the Saami minority, and many herders have chosen neither to register in the Saami census nor take an active part in Saami political life.

The purpose of this chapter is to outline the economics and the structural conditions for entrepreneurship of indigenous Saami reindeer herding in Norway today, as well as the historical and political forces that have shaped the present situation. Saami reindeer herders possess a legal monopoly on the production of reindeer meat, traditionally considered a culinary luxury in Norway. As monopoly providers of a highly priced commodity, the Saami reindeer herders have a unique economic position among the indigenous peoples of the Arctic. Nevertheless, despite this monopoly position, at the end of the millennium the reindeer herding communities of Northern Norway found themselves in a devastating economic crisis and had to be saved through emergency subsidies by the Norwegian government.

In The Great Transformation Karl Polanyi (1886–1964) argued that ‘for a century the dynamics of modern society was governed by a double movement: the market expanded continuously but this movement was met by a countermovement checking the expansion in definite directions. Vital though such a countermovement was for the protection of society, in the last analysis it was incomparable with the self-regulation of the market, and thus with the market system itself.’ In the eyes of Polanyi, the forces promoting laissez-faire have been met by a countermovement attempting to protect society and the common weal. As Fred Block puts it: ‘What we think of as market societies or “capitalism” is the product of both of these movements; it is an uneasy and fluid hybrid that reflects the shifting balance of power between these contending forces.’

The last financial crisis – starting in 2008 – seems to have created less and weaker ‘countermovements’ than did the crisis starting in 1929. This chapter looks into these differences, and argues that the main explanation may be somewhat vaguely summarized by referring to a completely different Zeitgeist in economic theory and social attitudes then and now. In order to be more concrete and to provide an illustration of the difference in Zeitgeist, we contrast the personal experience, attitudes and values held by two men in power at the peak of the crises: Marriner Eccles – head of the Federal Reserve from 1934 to 1948 – and Mario Draghi – who will be at the helm of the European Central Bank from 1 November 2011 until 31 October 2019.

The writings of Marriner Eccles show us a man whose point of reference was the poverty and lack of freedom his father suffered in the slums of Glasgow. Eccles’ goal was – at the depth of the crisis of the 1930s – to achieve economic security for his fellow Americans with a minimum loss of freedom.

The Problem: Marshall Plans & Morgenthau Plans

During the 1990s, a majority of the world's nations experienced falling real wages. In many cases real wages declined both rapidly and considerably; a human crisis of large proportions is evolving in some former communist countries, while in most Latin American countries, real wages peaked sometime in the late 1970s or early 1980s, and since then have fallen. The term ‘state’ is hardly applicable to several African countries, and this problem of ‘failed states’ is growing. In these nations many institutions, such as educational systems, that used to be handled by the nation state have broken down, and different areas of what used to comprise a nation are ruled over by different warlords. This is a type of political structure that a few years ago was thought of as belonging to a mediaeval past. If there is something called ‘progress’ and ‘modernization’, globalization has – particularly for many small and medium-size nations – brought with it the opposite: many are experiencing ‘retrogression’ and ‘primitivization’. Poverty and disease increase sharply in Sub Saharan Africa, and a creeping ‘Africanization’ in parts of Latin America can be detected.

These events profoundly challenge the present world economic order and the standard textbook economics on which this order rests. This is because the increasingly globalized economy seems to produce opposite effects of what standard economic theory predicts. Instead of a convergence of world income (towards factor-price equalization), we find that a group of rich nations show a tendency to converge, while another convergence group of poor countries gathers at the bottom of the scale. Mainstream logic is that the more backward a nation, the easier it will be to catch up to some imaginary ‘frontier’. In effect, what is actually happening is very different: Nations specialize. Some nations specialize in producing continuous flows of innovations that raise their real wages (‘innovation rents’), whereas other nations specialize either in economic activities where there is very little or no technological change (maquila-type activities), or where technological change takes the form of process innovations (in which technical change is taken out in the form of lower prices to the consumer rather than in higher wages to the workers, who are typically unskilled – particularly in the area of raw material production).

The objective of this chapter is to show how economic policies based on completely different principles – one described as ‘emulation’ and the other as ‘comparative advantage’ – have been strategically employed in order to achieve economic development when nations have made the transition from poor to wealthy. It also briefly describes key aspects of the process by which Europe, through emulation, developed from a collection of fiefdoms ruled by warlords into city-states and later to nation-states. It is argued that the timing of the strategic shift from emulation to comparative advantage is of utmost importance to a nation. Making this policy shift too early will hamper development much as a late shift will do. It is argued that these principles, although sometimes under different names, were well known and employed by European nations from the seventeenth century onwards – in the United States all the way to the end of the nineteenth century – and that the Marshall Plan implemented in 1947, owed its success to putting the principle of emulation chronologically ahead of comparative advantage.

The Oxford English Dictionary defines emulation as ‘the endeavor to equal or surpass others in any achievement or quality’; also ‘the desire or ambition to equal or to excel.’ In eighteenth-century political and economic discourse, emulation was essentially a positive and active effort, to be contrasted with envy or jealousy (Hont, 2005). In modern terms emulation finds its approximate counterparts in the terminology of US economist Moses Abramovitz, whose ideas of ‘catching-up’, ‘forging ahead’ and ‘falling behind’ resonate with the same understanding of dynamic competition. In his 1693 work English economist Josiah Child made the emulative nature of English catching-up very clear: ‘If we intend to have the Trade of the World, we must imitate the Dutch, who make the worst as well as the best of all manufactures, that we may be in a capacity of serving all Markets, and all Humors.’

By focusing on barter alone, leaving out the dynamics of innovation and competition, Ricardian trade theory neglects a core element inherent to capitalism. There is no forging ahead, nor is there any falling behind, in Ricardian economics, nor in any other type of economics based on metaphors of equilibrium. In a Schumpeterian framework,

This chapter argues that the international financial crisis is just the last in a series of economic calamities produced by a type of theory that converted the economics profession from a study of real-world phenomena into what in the end became mathematized ideology. While the crises themselves started by halving real wages in many countries in the economic periphery, in Latin America in the late 1970s, their origins are found in economic theory in the 1950s when empirical reality became academically unfashionable. About half way in the destructive path of this theoretical tsunami – from its origins in the world periphery in the 1970s until today's financial meltdowns – we find the destruction of the productive capacity of the Second World, the former Soviet Union. Now the chickens are coming home to roost: wealth and welfare destruction is increasingly hitting the First World itself: Europe and the United States. This chapter argues that it is necessary to see these developments as one continuous process over more than three decades of applying neo-classical economics and neo-liberal economic policies that destroyed, rather than created, real wages and wealth. A reconstruction of widespread welfare will need to be based on the understanding that what unleashed the juggernaut of welfare destruction was not ‘market failure’; it was ‘theory failure’. Being a résumé of a larger research project, the chapter includes references to more detailed studies of these processes of ‘destructive destruction’.

Introduction

Two institutions established soon after World War II provided the conditions for a 30-year period of unprecedented increase in human welfare: The 1947 Marshall Plan, in the end re-industrializing not only Europe but creating a cordon sanitaire of wealthy nations around the communist bloc from Norway via Southern Europe to Japan, and the 1948 Havana Charter which established the rules of international trade that made this industrialization plan possible.

Both institutions were based on a key insight from Secretary of State George Marshall's 1947 Harvard Speech announcing his plan: that civilization had always been built on a particular type of economic structure.

Schumpeter once said that ‘the upper strata of society are like hotels which are … always full of people, but people who are forever changing’ (Schumpeter 1934: 156). It is tempting to use the same metaphor on nations. Taking a long view, many nations have in sequence joined the upper strata hotel: Britain, the United States, Germany, Japan and others. Once there, however, they have tended to stay. The country occupying the best suites has changed, but all who ever moved into the hotel, still – compared to the Third World – ‘constitute “the rich”, a class … who are removed from life's battles’, to continue quoting Schumpeter on this issue (Schumpeter 1934: 156). These countries, however, are the home of only a minority of the world population.

The last 10 years have brought about a changing perspective on how economic growth actually happens. This improved understanding, however, has mainly evolved around the countries which are already living in Schumpeter's upper strata hotel – the Triad of Europe, Japan and the United States. In this chapter I shall mentally leave this hotel, and see the world from the Third World point of view. Unfortunately, the focus on the upper strata is somewhat in the spirit of the master himself. Schumpeter's own aristocratic manners, habits and tastes were not exactly compatible with viewing the world from the point of view of the ‘losers’ or laggards.

There is a second, and, less obvious, reason for studying the problems of the Third World. Understanding underdevelopment in the Third World can contribute effectively to a better understanding of the growth process in the industrialized countries. The economic problems of the industrialized world give weak and unclear symptoms, much in the same way that early stages of an illness produce general and unspecific symptoms: a fever or a headache. As the illness advances – as the patient gets sicker – stronger and more specific symptoms appear, making a diagnosis possible. My contention is that the study of the economically very sick nations can significantly contribute to the understanding of the developed world, for example the European Community running a slight fever.

Introduction

As a result of the inability of mainstream economics to tackle prominent problems of the global economy, some of its basic assumptions are increasingly being questioned. In this context, the standard emphasis on methodological individualism is gradually being eased in favour of studying the institutional structures necessary for economic development: The social, cultural and political norms and habits economists had come to take for granted. This ‘institutionalist’ approach is most often traced back to the work of Thorstein Veblen in the late nineteenth and early twentieth century. My chapter shows how an acute awareness of the importance of institutions, and more specifically of a certain kind of institutions, in fact has been explicitly present in the history of economic thought and policy at least since the Renaissance. Therefore, in addition to the ‘new’ institutional economics of Douglass North (1991) and the ‘old’ institutional economics of Veblen and Commons, there existed an ‘ancient’ tradition of institutional economics which, among other things, informed the policies responsible for the European economic miracle in the early modern period.

In light of this ‘ancient’ institutionalism, I wish to explore its relevance for economic development. Whereas today's literature tends to discuss institutions independent of the type of productive structure they support, both the ‘ancient’ and the ‘old’ institutional schools saw institutions as an integral part of a particular production system. Different technological systems, or modes of production, were seen as requiring different institutions, and an institution per se could not change the technological system. Whereas institutions like property rights and universal suffrage today often are seen as promoting economic development, I wish to show that the arrows of causality historically have been considered going in both directions. In fact, the institution of insurance came about after the need for it developed out of risky long-distance trade, and modern democracies, in any meaningful sense, were the fruits of literate urban artisan and working classes rather than of feudalism.

It is therefore not entirely clear that the Masaai are poor and stuck in subsistence agriculture because they lack property rights. Perhaps, I would argue, they lack property rights because they are poor and stuck in subsistence agriculture.

After receiving the National Bank of Sweden's 1973 ‘Nobel’ Prize in economics – shared with development economist Gunnar Myrdal – Friedrich von Hayek (1899–1992) held an unusual dinner speech where he quite explicitly criticized the prestigious prize he had just received: ‘…if I had been consulted whether to establish a Nobel Prize in economics, I should have decidedly advised against it. One reason was that I feared that such a prize … would tend to accentuate the swings of scientific fashion.’ Hayek believed that economics was different than other sciences, and his 1973 speech shows a degree of humility towards the complexities of economics which, in my view, differs profoundly from today's professional attitudes.

An insight from a 1952 book by Hayek strengthens the argument: ‘Never will man penetrate deeper into error than when he is continuing on a road which has led him to great success.’ In other words: when being right and successful, Mankind will ‘overshoot’ into error.

The origins of what colleague Mark Thoma refers to as the ‘Great Disconnect’ between professional economics and the public sphere can be better understood by taking a closer look at Hayek's propositions. Observing the economics profession over time, it indeed appears to be subject to cycles of fashion as Hayek suggests: apparent theoretical success overshoots the scientific fashion into error and irrelevance

Other economists have contributed, from different angles, to describing this ‘overshooting’ phenomenon. Norwegian-American economist Thorstein Veblen (1857–1929) suggests that knowledge exists on two different levels. Highly abstract and esoteric knowledge, like that of high priests, carries much prestige, but is – in practice – often fairly useless. On the other hand there is exoteric knowledge – useful knowledge – based on facts and experience that carries little prestige. Using Veblen's terminology, we can argue that Hayek's overshooting of scientific fashion corresponds to Veblen's idea that irrelevant education may contaminate healthy instincts of useful and exoteric knowledge.

In this chapter I shall provide examples of historical instances where esoteric knowledge has created crises, and how these crises were only solved by resurrecting alternative, sometimes near-defunct, paradigms of knowledge.

‘Smith and Ricardo were our best allies in the cold war against central planning – but that battle is over and won, and we are now facing other challenges where other prophets will better serve Society's needs.’

‘Neo-classical economics fundamentally lacks a theory of economic development beyond seeing it as a process of adding capital to labour.’

‘The “Green Movement” has done us all a great favour by pointing to the severity of the problems of environment and sustainability. But, although they are not aware of it, their solutions to these problems are framed in the static and barter-centred theories of Smith, Malthus and Ricardo.’

‘All levels of knowledge carry with them their own limits to ecological sustainability. For this reason, the habit of making predictions holding the level of knowledge constant produces curious and overly pessimistic results.’

The work of the 1997 Bergo Commission is based on today's standard economic theory, the economics of Adam Smith and David Ricardo. The theories of Smith and Ricardo were our best allies in the cold war against central planning but that battle is over and won, and we are now facing other challenges in areas which these authors ignored. We shall argue in this chapter that today's mainstream economic theory – because of its basic structure – contains important ‘blind spots’ when it comes to the role of knowledge, technology and energy for the welfare of nations. We further argue that the monopoly of this type of economic theory, based on the ‘dismal science’ of Adam Smith, Thomas Malthus and David Ricardo, is a fundamental source of inspiration for the techno- and eco-pessimism which dominated the Zeitgeist of the late 1990s. The same production functions predicting diminishing returns which gave birth to Malthus’ dismal predictions of disaster, are still at the very core of the tool-box of today's standard economic theory.

We here suggest an alternative tradition in economic theory which can help us find our place in the knowledge-based society of the future. Where Smith and Ricardo focused on barter and exchange, other economists have focused on knowledge, production and the harnessing of energy, and produced theories which in our opinion will better serve us as guides for today's challenges.