EC2096 Vle

Economic history in the
20th century
D.E. Baines
EC2096, 2790096
2012
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 200 course offered as part of the University of London
International Programmes in Economics, Management, Finance and the Social Sciences.
This is equivalent to Level 5 within the Framework for Higher Education Qualifications in
England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
D.E. Baines, BSc (Econ), Reader in Economic History, Department of Economic History,
London School of Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the author is unable to enter into any correspondence relating to, or arising
from, the guide. If you have any comments on this subject guide, favourable or unfavourable,
please use the form at the back of this guide.
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University of London 2012
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Contents
Contents
Chapter 1: Course introduction .............................................................................. 1

1.1 What this course is about ........................................................................................ 1
1.2 What is economic history? ....................................................................................... 1
1.3 Learning outcomes .................................................................................................. 2
1.4 What you should be able to do after studying this course ......................................... 2
1.5 Some important concepts ........................................................................................ 2
1.6 The structure of the course ....................................................................................... 8
1.7 A note on the names of countries........................................................................... 10
1.8 The subject guide................................................................................................... 10
1.9 Essential reading ................................................................................................... 11
1.10 Further reading.................................................................................................... 12
1.11 Online study resources ......................................................................................... 13
1.12 The examination .................................................................................................. 14
1.13 Summing up ........................................................................................................ 15
Chapter 2: International trade and economic growth ......................................... 17
What this chapter is about ........................................................................................... 17
Objectives .................................................................................................................. 17
Learning outcomes ...................................................................................................... 17
Essential reading ......................................................................................................... 17
Further reading............................................................................................................ 17
Introduction ................................................................................................................ 18
2.1 Factors that determine economic growth ............................................................... 18
2.2 Modern economic growth .................................................................................... 20
2.3 Industrialisation .................................................................................................... 23
2.4 The spread of modern economic growth ................................................................. 24
A reminder of your learning outcomes.......................................................................... 27
Questions .................................................................................................................... 27
Chapter 3: The development of an international economy by 1900: trade,
capital and labour ................................................................................................ 29
Objectives ................................................................................................................... 29
Learning outcomes ..................................................................................................... 29
Further reading............................................................................................................ 30
Introduction ................................................................................................................ 30
3.1 Characteristics of the international economy ......................................................... 30
3.2 Why did international trade grow so fast? .............................................................. 31
3.3 Overseas investment ............................................................................................. 35
3.4 International migration ......................................................................................... 37
Summary .................................................................................................................... 38
Questions .................................................................................................................... 38
96 Economic history in the 20th century
Chapter 4: Institutions that underpinned the international economy before

the First World War .............................................................................................. 39
Objectives ................................................................................................................... 39
Further reading............................................................................................................ 39
Introduction ................................................................................................................ 40
4.1 Free trade .............................................................................................................. 40
4.2 Multilateral settlements ......................................................................................... 41
4.3 The gold standard .................................................................................................. 42
4.4 Rules for international and domestic policies: some questions............................... 46
4.5 The British economy ............................................................................................... 46
Summary ..................................................................................................................... 48
Questions .................................................................................................................... 49
Chapter 5: The development of modern industry ............................................... 51
What this chapter is about .......................................................................................... 51
Objectives ................................................................................................................... 51
Further reading............................................................................................................ 51
Introduction ................................................................................................................ 52
5.1 The early development of manufacturing ................................................................ 52
5.2 The growing strength of US industry....................................................................... 55
5.3 Germany and catch-up with the USA ................................................................... 59
5.4 UK industry ........................................................................................................... 60
Summary ..................................................................................................................... 60
Questions .................................................................................................................... 61
Chapter 6: Britain trade and empire ................................................................. 63
Objectives ................................................................................................................... 63
Learning outcomes ..................................................................................................... 63
Further reading............................................................................................................ 63
Introduction ................................................................................................................ 64
6.1 The UKs share of world trade ................................................................................ 64
6.2 The pattern of multilateral settlements ................................................................... 64
6.3 UK imports: tariff protection or free trade? ............................................................. 65
6.4 The UK balance of payments surplus ...................................................................... 66
6.5 Long-run issues ..................................................................................................... 67
6.6 The economic costs and benefits of empire ............................................................. 67
6.7 Trade aspects of empire ......................................................................................... 68
Summary ..................................................................................................................... 71
Questions .................................................................................................................... 71
ii
Contents
Chapter 7: The First World War and the international economy .......................... 73
Objectives ................................................................................................................... 73
Essential reading ........................................................................................................ 73
Further reading............................................................................................................ 73
Introduction ................................................................................................................ 74
7.1 War economies and the direct effects of the First World War ................................... 74
7.2 The long-run economic effects of the First World War.............................................. 77
7.3 Long-run trade problems ....................................................................................... 78
7.4 Long-run capital flow problems.............................................................................. 80
7.5 Inflation ............................................................................................................... 81
7.6 The new gold standard .......................................................................................... 82
7.7 Political problems .................................................................................................. 82
Summary ..................................................................................................................... 83
Questions .................................................................................................................... 83
Chapter 8: The world economic and financial crisis, 192933 ............................. 85
Objectives .................................................................................................................. 85
Further reading............................................................................................................ 86
Introduction ................................................................................................................ 86
8.1 What was the long-run context of the crisis? .......................................................... 86
8.2 How serious was the Depression? .......................................................................... 87
8.3 What happened in the USA? .................................................................................. 87
8.4 What happened in Germany?................................................................................. 88
8.5 What happened in primary producing countries? .................................................... 88
8.6 What went wrong for Brazilian coffee producers? ................................................... 89
8.7 How did the Depression spread through the world? ............................................... 90
8.8 How did a banking crisis finish off the gold standard? ........................................... 92
8.9 Had the gold standard made the crisis worse? ....................................................... 93
8.10 How could the crisis have been avoided before 1929? ......................................... 94
8.11 Aftermath ............................................................................................................ 95
8.12 Overview ............................................................................................................. 95
Summary ..................................................................................................................... 95
Questions .................................................................................................................... 96
Chapter 9: Government intervention, recovery and the international
economy in the 1930s .......................................................................................... 97
Objectives ................................................................................................................... 97
Further reading............................................................................................................ 98
Introduction ................................................................................................................ 98
9.1 Crisis and response in the USA .............................................................................. 98
9.2 The effect of American policy on the international economy .................................. 100
9.3 The UK and Germany ........................................................................................... 101
iii
9.4 Trading blocs ....................................................................................................... 102

9.5 Germany again .................................................................................................... 102
Summary ................................................................................................................... 103
A reminder of your learning outcomes........................................................................ 103
Questions .................................................................................................................. 103
Chapter 10: The war economies, 193945 ......................................................... 105
What this chapter is about ........................................................................................ 105
Objectives ................................................................................................................. 105
Learning outcomes ................................................................................................... 105
Essential reading ....................................................................................................... 105
Further reading.......................................................................................................... 105
Introduction .............................................................................................................. 106
10.1 How is a wartime economy different to a peacetime economy? .......................... 106
10.2 The economic situation at the beginning of the war ............................................ 107
10.3 The effects on output ......................................................................................... 108
10.4 Strategy and the wartime economy .................................................................... 109
10.5 The expansion of economic management ........................................................... 111
10.6 Other aspects of wartime economies .................................................................. 111
Summary ................................................................................................................... 113
Questions .................................................................................................................. 113
Chapter 11: International monetary relations since 1944 ................................. 115
What this chapter is about ......................................................................................... 115
Objectives ................................................................................................................. 115
Learning outcomes .................................................................................................... 115
Further reading.......................................................................................................... 116
Introduction .............................................................................................................. 116
11.1 Institutions in the international economy Bretton Woods ................................. 116
11.2 The post-war international economy................................................................... 119
Summary ................................................................................................................... 128
Questions .................................................................................................................. 128
Chapter 12: Economic growth in western Europe since 1950 ........................... 129
Objectives ................................................................................................................. 129
Further reading.......................................................................................................... 129
Introduction .............................................................................................................. 130
12.1 Relative growth rates ........................................................................................ 130
12.2 Reasons for the high growth rates ..................................................................... 130
12.3 The increase in demand ..................................................................................... 132
12.4 Political continuity ............................................................................................. 133
12.5 Policy instruments.............................................................................................. 133
12.6 The historic compromise competition and welfare............................................ 134
12.7 Policy and the growth of the European market ................................................... 135
12.8 Labour market changes...................................................................................... 138
12.9 Convergence .................................................................................................... 139
Summary ................................................................................................................... 140
iv
Contents

Questions .................................................................................................................. 140
Chapter 13: The American economy since 1960: supply-side economics .......... 141
What this chapter is about ........................................................................................ 141
Objectives ................................................................................................................. 141
Learning outcomes ................................................................................................... 141
Introduction .............................................................................................................. 141
13.1 The dominance of the American economy........................................................... 141
13.2 Supply-side economics in theory ........................................................................ 146
13.3 Reaganomics in practice .................................................................................... 147
13.4 What does the Reagan experiment tell us about the relationship between
government intervention and the growth rate?........................................................... 149
Summary ................................................................................................................... 149
Questions .................................................................................................................. 150
Chapter 14: Technology and deindustrialisation ................................................ 151
Objectives ................................................................................................................ 151
Further reading.......................................................................................................... 151
Introduction .............................................................................................................. 152
14.1 Deindustrialisation ............................................................................................. 152
14.2 The relationship between technology and the structure of industries ................... 157
14.3 Japan and the third revolution ........................................................................... 159
Summary .................................................................................................................. 162
Questions .................................................................................................................. 163
Chapter 15: International trade and developing countries in the late
twentieth century ............................................................................................... 165
Objectives ................................................................................................................ 165
Further reading.......................................................................................................... 165
Introduction .............................................................................................................. 166
15.1 World trade patterns .......................................................................................... 166
15.2 Developing economies ....................................................................................... 170
15.3 Can trade be an engine of growth?.................................................................... 174
15.4 Can growth be an engine for trade? .................................................................. 175
Summary ................................................................................................................... 176
Questions .................................................................................................................. 176
Chapter 16: Japan and China .............................................................................. 177
Objectives ................................................................................................................. 177
Reading .................................................................................................................... 177
Introduction .............................................................................................................. 178
v
16.1 China ................................................................................................................ 178

16.2 Japan ................................................................................................................ 183
Summary ................................................................................................................... 187
Questions .................................................................................................................. 187
Chapter 17: The financial crisis of 2008 ............................................................. 189
Objectives ................................................................................................................ 189
Further reading.......................................................................................................... 189
Introduction ............................................................................................................. 189
17.1 Instability in the world economy......................................................................... 190
17.2 The housing market in the USA .......................................................................... 190
17.3 The response ..................................................................................................... 191
17.4 The rest of the world .......................................................................................... 193
17.5 The Euro problem ............................................................................................. 194
17.6 Further considerations about the US economy .................................................... 195
17.7 Some serious problems in the USA ..................................................................... 195
17.8 Relations with the rest of the world.................................................................... 196
Summary ................................................................................................................... 196
Questions .................................................................................................................. 196
Appendix: Sample examination paper ............................................................... 197
vi
Chapter 1: Course Introduction
Chapter 1: Course introduction

1.1 What this course is about
Welcome to this 200 course about economic history, a wide-ranging
subject that you will hopefully find stimulating. Economic history uses
many economic concepts which can help our understanding of economic
changes, including changes that are occurring in the world at the present
time. We hope that you enjoy studying the course.
There are no formal prerequisites to take this course. No previous
knowledge is expected. However, it is assumed that you have a grasp of
economic concepts or at least that you will obtain a grasp as you study. If
you have followed an economics subject in this degree or diploma or are
taking an economics subject at the same time, that will give you sufficient
knowledge of economics for you to follow this subject.
1.2 What is economic history?

The first question to answer is this: what do we mean in this course by
economic history? Here is our definition:
Economic history is the study of history using economic
concepts.
Come back and remind yourself of this definition from time to time. Before
going further, let us look a little closer at this.
Economic history explains how economies have developed. Although
its subject matter is in the past it is rather different from the history
which you may have encountered at school. Economic history is less
concerned with explaining what individuals (kings, prime ministers) did,
which is what political history does. Rather, economic history is more
concerned with large groups of people (industrial workers, farmers)
and with explaining technological change or how business worked, or
with analysing the effects of institutions, such as governments or trade
associations on the economy.
Economic history is also concerned with quantities (tonnes of steel,
kilowatt/hours of electricity or statistical constructions like gross domestic
product or total factor productivity).
But the main difference between political and economic history is that
economic history uses more theory and in particular, economic theory. This
is why economic history is considered to be a part of the social sciences
as opposed to a part of the humanities. Economic history is also different
from economics because economics is more likely to use abstractions (e.g.
assumptions like other things being equal). Abstractions allow economics
to give very powerful explanations but these explanations are not always
easy to apply to the real world.
For example, economic prediction for any period of more than a few
years is very difficult. This is because a whole host of circumstances and
also human behaviour are constantly changing. Economic history is also
different from economics because, like all history, we actually know
what happened next. In other words we can apply the theory to real
circumstances that actually happened.
Of course in economic history we dont know anything like as much about

the past as we do about the present. Also, economic history will never give
us a blueprint to tell us what will happen to the economy in the future
history rarely repeats itself. But what it does teach us is the importance of
understanding the historical context. For example why was it possible for
governments to follow a particular policy in some years and not in other
years?
If you have some knowledge of economic history, you will not only know
how the present world economy was created but you will also have
acquired a tool that will help you understand economics and the other
social sciences.
1.3 Learning outcomes

At the end of this course, and having completed the Essential reading and
activities, you should have learnt:
how economic growth is transferred from one economy to another
how the nature of the international economy affects the transfer of
economic growth
what the benefits to economic growth and international trade of fixed
versus fluctuating exchange rates are
how relatively free capital mobility and controls on capital flows
compare
how the effects of relatively free labour mobility (migration) compare
with the effects of controls on mobility
why the ability of a country to catch up the economic growth of
other countries is affected by the social capabilities (the underlying
conditions) in the country
how technical change affects the economy.
1.4 What you should be able to do after studying this

course
By the end of this course, students should have acquired the following skills:
techniques for using simple economic theory to explain how various
factors led to economic growth
the ability to construct economic reasons for historical events
the ability to identify and select the sort of data that is needed to
do this, and how to assess how much data is needed to make valid
judgements.
1.5 Some important concepts

Economic historians use a range of concepts to analyse the past; many are
taken from economics. You will learn to use these concepts as you work
your way through the course. We summarise the main ones below.
1.5.1 Gross national product

This is a measure of the total output or size of an economy. Gross national
product (GNP) includes all the output of goods (e.g. manufactures), all the
output of resources (e.g. oil), all the output of services (e.g. transport and
universities), plus all exports. It also includes all the money returned to
2
the country from overseas investments. GNP is easier to measure now than
in the past. Nevertheless we have good estimates for most countries from
about 1870.
1.5.2 Gross domestic product

A slightly different measure from GNP, gross domestic product (GDP), has
been commonly used in recent years. GDP only measures the output made
within the country, that is it includes exports but not money made from
overseas investments, like profits from overseas factories. Until recently
GDP and GNP were not very different.
1.5.3 The production function

This is a way of measuring the inputs that go into making goods (goods
that are otherwise known as the outputs). For example a farmer could use
a lot of labour and a little machinery (capital) or he or she could use a lot
of capital and little labour. We will see that in the late nineteenth century
United States farmers used relatively more machinery and relatively less
labour than European farmers. But remember, this does not tell us which
combination was the more efficient, because the cost of labour and the
cost of machinery were different in Europe and the USA.
1.5.4 Total factor productivity

The concept of total factor productivity (TFP) is a way of measuring
efficiency. It calculates the amount of each input (labour, capital and
other resources) that are used and the price of the inputs to the producer.
This shows how well (or how efficiently) the producer (and ultimately
the whole economy) is using the factors at its disposal. There is usually
an unmeasured part which is the residual. This is a rough measure
of changes in technology that is the increase in output which is not
accounted for by more labour, more capital or more resources. Or it may
include the effect on output if the quality of inputs increases. A good
example is the effect of better education on the quality of workers. In
most modern economies, TFP growth is usually more important than the
increase in resources, labour or capital.
1.5.5 Comparative advantage

The concept of comparative advantage is used especially in the theory of
international trade. It can make economic sense for a country to import
products (A) even though it could produce A cheaper itself. This is because
although the country has a cost advantage in producing A, it has an even
greater cost advantage in producing B and importing A. By specialising
in producing B and exporting some of its production of B, the country
can obtain more A (by imports) than it can by trying to produce both A
and B. We may say that the country has a comparative advantage in the
production of B compared with other countries. Similarly, for the other
country (the trading partner), the comparative advantage lies with A and
the disadvantage lies with B.
1.5.5.1 Tariffs
Tariffs prevent countries from following their comparative advantage
in trade. Why? Because tariffs change the price of goods A and B when
these goods are traded. An import tariff means that it may no longer be
worthwhile for a country to specialise in B and export B while importing A.
1.5.6 Gains from trade

If two countries have comparative advantages in the production of
something, then there are gains from trade. World output rises because the
same resources are used to make more goods than if there was no trade. A
good historical example would the gains from the exports of (frozen) beef
from Argentina to the UK in the early twentieth century. The Argentine
meat farmers gained, as did those involved in the trade (like railway
companies). The British consumers gained (because the price of meat
fell). But the other Argentine farmers lost (because the land became more
expensive), American meat farmers lost (because they lost the UK market)
and British meat farmers lost. Note that there is no automatic mechanism
for evening out the gains and losses from trade and these may continue for
some time.
1.5.7 Liquidity trap

A liquidity trap is the situation in a depression where very few people
are willing to risk putting their money into investment. So the economy
stagnates. With liquidity preference people are more likely to hold cash or
government bonds. This usually comes about because the interest rate on
investment is low that is, low relative to the risk involved in investment.
In more normal times there is a premium for investment which
compensates so that people do not put excessive funds into cash. The
solution usually involves (extra) government expenditure, often paid out
of borrowing. But if liquidity preference is high, government expenditure
will not lead to an increase in income level. Liquidity preference will mean
that individuals will save their money rather than spend it.
1.5.8 Human capital

The concept of human capital means the skills embodied in the labour
force. At its simplest level this means the extent of literacy and formal
schooling, but historically many skills are embodied. They are learned on
the job. Most of the skilled workers in Britain before the First World War
leaned their skills at work rather than by formal training, for example.
1.5.9 Entrepreneurs
These are people who take risks to make a profit. They are not the
same as inventors, although they may use inventions. But they have to
see a market, raise finance and organise production. Usually the main
incentive is profit, but governments have often engaged in entrepreneurial
behaviour. Obtaining and using capital is an important part of the risk an
entrepreneur takes.
1.5.10 Catch up and social capability

These are very important concepts in economic history. They are often
used to explain why poorer countries take such a long time to catch up
with the income levels of richer countries. Social capability includes,
among other things, the skill level of the labour force and the nature of
the government. For example if a government cannot guarantee the rule of
law, entrepreneurs will not invest since they have no guarantee that they
will benefit from the investment. You may wonder if this means that only
a democracy had the social capability to increase total factor productivity
and grow richer. The answer is no. There are many examples of rapid
growth in undemocratic countries, for example, the Peoples Republic of
China is one.
1.5.11 Increasing returns to scale

This is a simple concept. It means that the cost of a product is related to
the scale of production. Increasing returns means that if you double the
scale and use double the inputs, you more than double output. As a result
unit costs fall.
Increasing returns occur because the cost of the technology involved
can be spread over a greater amount of output. It is easier to achieve
scale economies in manufacturing as long as the market is large enough.
However, it is important to remember that economies in production
are not the only economies. There can be economies in marketing, for
example, or in purchasing raw materials.
1.5.12 External economies

These are different. In the previous section we were discussing what are
called internal economies those affecting the plant directly. But cost,
and therefore efficiency, is also affected by external economies. One
example is that of a so-called thick labour market where there are many
people with similar skills; another is the existence of particularly good
transport links. External economies are the main reason why industries
tend to cluster together and the main reason for the growth of cities.
This means that to catch up an economy needs more than importing
technology.
1.5.12.1 Negative external economies
An example of a negative external economy is pollution coming from
industry. Pollution raises costs for a firm; for instance, workers are less
healthy and less productive. (This was a particular problem in the USSR
and Eastern Europe in the 1960s and 1970s.) In general though there are
more positive external economies than negative ones.
1.5.13 Principal-agent problems

In the early years of economic development, before modern
communications existed, it was difficult for governments and businesses,
the principals, to monitor the performance of their agents who were
working a long way away. For example, would a Dutch trader be able
to be sure that the captain of the ship he had sent to the Indies was not
stealing from him? The easiest way to deal with this problem was to use
his relatives, who could be disinherited if things went wrong, but this
strategy was obviously limited. The development of modern transport and
communications improved this as it allowed agents to be monitored.
1.5.14 Transactions costs

One way to look at the process of economic development may be seen
as a continuous reduction in the cost of making deals, including making
payments. For instance, the cost of raising government revenue was initially
very high. It cost a lot of money (paying for tax-gatherers) to raise a little.
Nowadays, tax-gatherers cost relatively little money but taxes raise a lot.
So more of government expenditure can be used for beneficial purchases
rather than paying for tax-gathering. In recent years information and
communications technology (ICT) has reduced transaction costs to very
low levels.
Another point to remember is that nowadays, there are large parts of the
service sector whose purpose is to reduce transaction costs (lawyers who
make and enforce contracts, for instance).
5
1.5.15 Tariff and non-tariff barriers

One way to protect a country from imports is to erect a tariff. This is a
charge on goods entering the country. Tariffs are either a fixed payment
per unit, say 1 per bottle of wine, or a proportion of the price, say 30 per
cent. A proportional tariff is called an ad valorem tariff.
A fixed tariff is the same whatever the price of the import. However, an ad
valorem tariff varies according to the price of the import. If wine falls in
price from 3.00 to 1.50, a 30 per cent tariff falls from 0.90 to 0.45.
A fixed tariff of 1 doesnt change.
1.5.16 Non-tariff barriers

These can be more protective. For example, a state railway might have
very unusual technical standards to which its electric trains must conform.
This might aim to stop foreign makers of railway locomotives competing
with local firms. Another example is a refusal to recognise foreign
qualifications to reserve jobs for locally trained people. This might be
to protect local colleges and teachers against foreign competition and
to preserve jobs for locals. It is a barrier to trade in services. Non-tariff
barriers are frequently used when tariff barriers are low or non-existent.
(Both these examples are from the recent history of the EU.)
1.5.17 Opportunity cost

This is the cost of the next best alternative. For instance, say I can employ
a gang of workers at wages of 1,000 per month. If I dont employ them,
say I can lend the money I would have paid on wages to someone else
and receive interest of 10 per month. The opportunity cost of employing
the gang is 1,010 per month. In other words 1,010 is the opportunity
I forgo by employing the gang. Hence I will not employ them unless they
make more than 1,010 per month for me.
1.5.18 Contagion
In a depression there is a fall in income, investment and growth. But the
most damaging effect would be a collapse of a major bank or banks. Since
all banks have large funds with other banks, the collapse of one bank
is likely to lead to the collapse of other banks. The collapse of Lehman
Brothers in 2008 was a major example of this. The US government
allowed Lehman Brothers to go bankrupt but compensated those banks
(or other institutions) who were owed money by Lehman. In other words,
nowadays, contagion makes it very close to essential that the government
will step in. (This usually means that the government will increase money
supply.) In some circumstances the government may nationalise, or partly
nationalise, the banks.
1.5.19 The prisoners dilemma

The prisoners dilemma is commonly encountered in economics. At its
simplest it explains why it is often very difficult to make agreements. This
is because one party may not be able to predict what the other will do.
For example, two farms are alongside a river. The river will flood unless
1,000 is spent on flood control. Both farmers will lose if it floods. The
best way is for both farmers to pay 500. But each knows that if the other
farmer paid 1,000, he or she would get the work for nothing. So each
waits for the other to pay 1,000. In the meantime the river floods, costing
each farmer more than 500. It may be necessary for governments to force
cooperation in the best interests of the parties.
1.5.20 Terms of trade

The calculation of the terms of trade can be complicated, but at their
simplest they show the prices a country obtains for exports compared with
the prices for imports. If the latter is rising compared with the former, it is
said that the terms of trade are moving against the country. This may not
mean that the country is worse off, of course, since that will depend on the
volume of exports and imports. It is also possible to talk of the terms of
trade faced by different producers farmers, for example.
1.5.21 Rational expectations

The idea of rational expectations is very important in modern monetary
economics. Simply put it says that people are able to anticipate what
government policy will be in the future. This makes it very difficult for
government policy to be effective. For example, there may be inflation,
which the government wishes to control. So it increases interest rates. But
if the population anticipates that this is what the government are going to
do, they now spend as much as possible. Also, if they can, they will borrow
at the old interest rate before the rate goes up. This means that inflation
increases. Government finds it harder to control and there will probably
have to be a second interest rate rise, which is also subject to rational
expectations and could be damaging to the economy.
1.5.22 Hedge funds

The rationale of a hedge fund is to lead the market. For instance in a
depression, a hedge fund will sell the local currency with the aim of
forcing a devaluation, then changing the money back again at a profit.
This happened in the Thailand devaluation in the 1997. (Of course, there
are many more sophisticated versions of this.) Hedge funds have become
much more dominant in recent years, possibly because globalisation has
made it easier to finance. Hedge funds usually say that the desired effect
(that is, devaluation) would have happened anyway. But many people
deny this.
1.5.23 Elasticity
Elasticity shows the effect of a change in one variable on another variable.
It has many forms. For example, price elasticity shows how much more of
a commodity will be purchased if the price falls and how much less will
be purchased if the price rises. If, for example, a 10 per cent fall in the
price leads to more than a 10 per cent rise in purchases, demand is said to
be price elastic. An example would be the sales of textiles in a relatively
poor country. If, on the other hand, a 10 per cent fall in the price leads to
less than a 10 per cent rise in purchases, the demand is said to be price
inelastic. An example of this would be the demand for food in a relatively
rich country.
Note what happens to total revenue (price X quantity). When price
increases, total revenue falls if demand is price elastic. In contrast, when
price increases total revenue rises if demand is price inelastic.
Elasticity may also relate to income. If a rise in income of 10 per cent
leads to an increase in sales of more than 10 per cent then demand for
that good is said to be income elastic. An example would be the demand
for health care in rich countries.
1.5.24 Quantitative easing

In a depression, quantitative easing is a way of increasing money supply.
It applies to a country with an independent central bank. The government
sells an additional tranche of government stock which the bank buys. The
government now has a currency which it can use. The central bank does
not market the government stock. Of course, quantitative easing may not
work if the money is saved that is, it does not increase money supply, for
example if liquidity preference is very high.
1.6 The structure of the course

Chapter 1
This is an introduction to the course. If you get lost, this is the one to return to.
Chapter 2
We examine what we call modern economic growth a relatively recent
phenomenon. We see why it started in Europe and how it has spread from
one country to another. This introduces the concept of economic catch up.
Chapter 3
We explain how movements of capital, labour and goods created the
international economy and how trade was related to the growth of world
output. We examine the development of modern industry, including
an explanation of why both assembly-line production and the business
corporation first developed in the USA.
Chapter 4
We look at the main economic institutions of the pre-First World War
period. These were:
free trade
fixed exchange rates
multilateral payments.
We explain why these were characteristics of the period before the First
World War and not after. This introduces you to the idea of contingency
why, for example, fixed exchange rates have often been thought to be
universally desirable, but the condition of the international economy has
not always made it possible to have fixed exchange rates.
Chapter 5
We consider why Britain remained the most important player in the
international economy even though it was no longer the largest economy.
Chapter 6
We examine the economic advantages of colonies to the colonial powers.
We also discuss colonial development and see how far being a colony
inhibited development.
Chapter 7
We examine the long and short-run effects of the First World War on trade
and international finance. This introduces the idea of a war economy and
how it differs from a peacetime economy. Then we look at the mediumrun consequences of the war, in particular the reasons for the poor
performance of the international economy after 1918.
8
Chapter 8
We look at the international economic crisis of 192933. We examine the
spread of the crisis through the world economy, its causes, and why it was
not possible to use (macro) economic policy to contain it. We explain why
the Depression was more serious in some countries than in others, why the
rate of recovery was also different and why national economies recovered
faster from the Depression than the international economy. We also discuss
the changes in economic theory and their influence on economic policy.
Chapter 9
We look at the economic history of the Second World War, particularly the
successes and failures of the main economies. We look once more at the
nature of war economies and the relationship between the economy and
strategy.
Chapter 10
We examine the development of the international monetary system and
of international economic cooperation in the post war years (194552).
We discuss the changes to the Bretton Woods agreements and why
the agreements took a long time to implement. Then we look at the
development of the international monetary system in the later twentieth
century, including the end of fixed exchange rates and the change to the
floating exchange rate system of the late twentieth century. We analyse the
causes and effects of the oil crises.
Chapter 11
We look at the reasons why economic growth was so fast in the major
European economies up to the early 1970s and why growth rates then
fell. We discuss why some economies have grown faster than others. Then
we look at the growth of the European Economic Community. We look at
changes in economic policy in the post-war period, particularly the end of
the Keynesian consensus and the fashion for supply-side economics in the
United States and Britain.
Chapter 12
We consider Japanese industrial performance, particularly the position of
Japan in the world motor industry since the Second World War, showing
how Japanese innovations and industrial organisation contrasted with
American.
Chapter 13
We explain deindustrialisation and why services have become more
important than manufacturing in national economies.
Chapter 14
We show the development of industrial technology from the early factory
system through mass production to the flexible production systems of
today.
Chapter 15
We try to answer the question: is economic growth easier or harder to
transfer to poorer countries in the twenty-first century compared with the
twentieth century? This returns us to the relationship between trade and
development with which we started the module.
9
Chapter 16
We show how China developed into the most important manufacturing
country in the world and how Japan developed extremely fast but in
recent years development has stalled.
Chapter 17
We show the main causes of the recent financial crisis, and how it spread
from one country to another.
1.7 A note on the names of countries

Occasionally we use Britain and the UK as synonyms in the course,
even though the word Britain excludes Ireland. Our apologies if our
attempt to add variety causes offence to some readers.
All of Ireland was part of the UK during the period 18011922.
Since then, only Northern Ireland has been part of the UK. We do
not consider here the economic history of the Irish Republic after
independence in 1922. The economic history of Northern Ireland since
1922 is part of the economic history of the UK and Britain.
We use the word Germany for both the whole country and also for
West Germany (194590). We do not discuss East Germany (194590).
We restrict the name Americans to people who live in the USA. People
who live in other countries on the American continents are named after
their country Canadians, Brazilians, Argentines, etc.
We use the names European Economic Community (EEC), European
Community (EC) and European Union (EU) according to the period
under discussion.
1.8 The subject guide

This subject guide, as its name suggests, is designed to guide you through
the material. You must use it with the suggested readings. The guide is
not intended to replace these readings. If you work your way through
the subject guide and follow the readings, you will be ready to take the
examination. The subject guide has 17 chapters, each of which considers
a large question or series of questions about the development of the
international economy.
1.8.1 How to use the subject guide

1. Read through the text of the chapter.
2. Read those parts of the basic books which are recommended in that
chapter. If you are able to get hold of any of the supplementary
reading, read that too.
3. As you read, think about the questions that are raised in the text. The
Pause and think sections and Activities in the chapter are designed
to help you to understand particularly important questions. But think
about any other questions that suggest themselves to you. Do not be
afraid to use economic concepts and theory with which you may be
familiar as well as insights and concepts from other social sciences.
4. Look at the suggested questions at the end of the chapter and write a
draft of how you might answer them. These questions are similar to
those set in the examination. Remember that writing something down
is the best way of ordering your thoughts and finding out whether you
really understand the issues involved.
10
1.8.2 Try to link the subject guide chapters together as you study
The chapters are designed to introduce you to the most important and the
most interesting parts of the subject. If you follow the guide right through
you will have thought about most of the important parts of the syllabus
and the main features of the development of the international economy.
The chapters are not self-contained and it is a mistake to think of each
chapter as a discrete piece of material, or as an answer to a particular
question that might come up in an examination.
For example, to learn about the reasons why the international economy
deteriorated after the First World War (see Chapter 7), you need to have
read the material on international economic institutions in Chapter 4.
To learn about the causes of the world economic crisis of 192933 (see
Chapter 8), you need to read first Chapter 7. Pay particular attention
to the earlier chapters. They contain material that will help your
understanding of the later part of the subject guide.
1.8.3 You do not need to learn lots of historical facts by heart

for the examination
It is not necessary to remember a great deal of factual information to pass
the examination. It is much more important to use simple economics.
For example, if you are considering why prices of agricultural products
sometimes rose and sometimes fell, it is important to consider the
conditions that determined the supply of and demand for agricultural
products. Of particular importance is the concept of elasticity. You should
be able to use this concept which we introduced above.
Of course you need more than knowledge of economic theory to follow
Economic history. But you do not need to know the details of the historical
record, only the broad outlines. Nor is there any need to remember long
runs of statistics such as car or steel output in different countries or details
of trade and exchange rates.
All you need to know are the broad quantities. For example, you need to
remember that UK annual growth rates in the 195080 period were about
a half of those in the countries of the European Community. During the
1980s and 1990s, UK annual growth rates were more or less the same as
the EU average.
1.9 Essential reading

The textbooks are the books that you will use the most. They cover
different aspects of the subject as described.
The best book to buy is:
Kenwood, A.G. and A.L. Lougheed The growth of the international economy,
18202000: an introductory text. (London: Routledge, 1999) fourth edition
[ISBN 9780415199308].
If you buy only one book, buy this one. It is a simple but comprehensive
account of the development of the international economy. It will not tell
you much about the national economies, however, and you will need to
look at other books to find out about them.
Other important books which you could consider purchasing:
Broadberry, B.N. and K. ORourke (eds) The Cambridge economic history of
modern Europe. Volume 2: 1870 to the present. (Cambridge: Cambridge
University Press, 2010) [ISBN 9780521708395].
11

Eichengreen, B. Globalizing capital. A history of the international monetary
system. (Princeton, NJ: Princeton University Press, 2008 second edition)
[ISBN 9780691139371].
Eichengreen provides an excellent concise analysis of the development of

the main financial institutions since the early nineteenth century (the rise
and fall of the gold standard, the Bretton Woods system etc.).
You should also consider purchasing the following texts:
Kemp, T. The climax of capitalism. (London: Longman, 1990)
[ISBN 0582494230 pbk].
Kemp, T. Industrialisation in the non-Western world. (London: Longman, 1989)
[ISBN 0582021820 pbk].
Stiglitz, J. Freefall: free markets and the sinking of the global economy. (London:
Penguin Books, 2010) [ISBN 9780141045122 pbk].
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.
1.10 Further reading

Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Aldcroft, D.H. The European economy, 19142000. (London: Routledge, 2001)
[ISBN 0415250633 pbk].
Good coverage of changes in the European economies, and the main

changes in the international economy, such as the Depression of the 1930s,
the Bretton Woods system and the creation of the EEC (now EU).
Allinson, G. Japans post war history. (London: Routledge, 1997)
[IBSN 1857287754].
A basic book about Japanese economic development.

Blackford, M.G. The rise of modern business in Great Britain, the United States
and Japan. (Chapel Hill, NC: University of North California Press, 1988)
[ISBN 0807842028 pbk].
Covers the most important aspects of the development of industry and

business in the three countries, including the development of the business
corporation and the rise of mass production.
Feinstein, C.H., P. Temin and G. Toniolo The world economy between the world
wars. (Oxford: Oxford University Press, 2008) second edition
[ISBN 9780195307559 hbk].
A very sophisticated discussion of the inter-war period. Read Kenwood and

Lougheed (above) before you read this book.
Foreman-Peck, J. A history of the world economy: international economic
relations since 1850. (New York: Harvester/Wheatsheaf, 1995) second
edition [ISBN 9780745009353].
12
The Foreman-Peck text is an excellent treatment of the subject. You should

read Kenwood and Lougheed first and move on to this book which is more
difficult and sophisticated than Kenwood and Lougheed.
Jones, E., L. Frost and C. White Coming full circle. An economic history of the
Pacific Rim. (Boulder, CO: Westview Press, 1993)
[ISBN 0813312418 pbk].
Contains important material on Japanese development and other parts of

south-east Asia (the NICs).
Mosk, C. Japanese economic development: markets, norms, structures.
(Abingdon: Routledge, 2008) [ISBN 9780415771580].
Naughton, B. The Chinese economy: transitions and growth. (Cambridge, MA:
MIT Press, 2006) [ISBN 9780262640640 pbk].
Naughton provides an excellent treatment of the Chinese economy.

Krugman, P. The return of depression economics and the crisis of 2008. (London:
Penguin Books, 2008) [ISBN 9781846142390 pbk].
1.11 Online study resources

In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you forget your login details at any point, please email uolia.support@
london.ac.uk quoting your student number.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own
understanding of subject material.
Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
Past examination papers and Examiners commentaries: These provide
advice on how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
13
Recorded lectures: For some courses, where appropriate, the sessions

from previous years Study Weekends have been recorded and made
available.
Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library

The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login:
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
1.12 The examination

Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations for
relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
check the rubric/instructions on the paper you actually sit and follow
those instructions.
The whole assessment for this course is by examination.
The examination is three hours long.
The examination paper will consist of eleven questions of which you
will be asked to answer four.
The paper is divided into two sections. Section A covers the period up
to 1938 and Section B covers the period from 1939 onwards. However,
you will often find that an answer requires you to explain historical
issues and trends that cover periods on both sides of this divide.
The examination is designed to test your basic understanding of the
subject. So the questions will test only what you have learnt about the
broad issues. As mentioned above, you will not be asked to answer
detailed questions about individual countries.
Sample questions are given at the end of each chapter, and you will find
a specimen examination paper in the Appendix at the end of the guide.
14
Remember, it is important to check the VLE for:

up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners commentaries
for the course which give advice on how each question might best be
answered.
1.12.1 A note on examination technique

Here are some important points to remember.
When you sit down to take the examination, make sure that you read
through the whole examination paper before you begin to write.
Make sure that you read the questions carefully.
The Examiners take relevance very seriously. A common mistake, for
example, is for students to see particular words in a question (e.g.
American railroads) and to write about the economic history of
American railroads, when the question asked the student to write about
the effect of the development of American railroads before the First
World War on the British and other economies.
Make sure that you allocate your time correctly. Give equal time to each
question. Examiners cannot give marks for blank pages. If you only
write three answers when you are asked to write four, you have will
have lost many marks.
1.13 Summing up
You do not have to read every word of the textbooks or the additional
readings mentioned in the guide. You may do more work on some chapters
rather than others, as you choose. But it is important for you to remember
that the guide has been designed only to introduce you to a very big
subject.
Remember also that this subject guide is not a set of examination notes. It
does not, on its own, contain sufficient material to enable you
to pass the examination.
Before the examination you will be sent the Examiners commentaries and
past examination papers for this course. It is a valuable resource. Make
sure that you read it carefully.
15
Notes
16
Chapter 2: International trade and economic growth
Chapter 2: International trade and

economic growth
What this chapter is about
We focus on the period 182070 in this chapter. Modern economic growth
began in Europe before this, but industrialisation was delayed until energy
resources could be exploited on an industrial scale. This happened after
1820.
The first industrialised economy was Britain. We explain why this was so
and the process by which growth spread to other European countries and
to the USA.
Objectives
To:
explain the factors that led to modern economic growth
make clear the distinction between growth and industrialisation
show what factors encouraged growth to transfer from the central
economy (Britain) to a peripheral economy, the USA.
Learning outcomes
By the end of this chapter, and having completed the Essential reading,
you should be able to:
explain what is meant by modern economic growth and why it became
a feature of countries over the last 200 years
discuss how this relates to the development of the international
economy
outline the mechanism by which economic growth was transferred
from one economy to another
demonstrate why some countries caught up with more developed
countries earlier than others did
use economic concepts like the gains from trade and comparative
advantage to analyse how the international economy developed.
Essential reading
University Press, 2010) [ISBN 9780521708395] pp.629.
[ISBN 0415199301 pbk] Introduction pp.925 and Chapter 8 pp.12031.
Further reading
[ISBN 0582494230 pbk] pp.18.
17
Introduction
We look at several processes that were under way during the nineteenth
century. There was the establishment of what we call modern economic
growth, meaning a rapid and continuous process of growth per head of the
population. We see how this began in Britain and spread to other European
countries. Next we consider the reasons behind this growth and see how
industrialisation is part of the process.
Then we look at how growth spread to countries on the periphery of the
international economy. We see how the preconditions for modern growth
were present in nineteenth-century USA. As US growth accelerated, trade
expanded on the basis of specialisation and comparative advantage. This led
to gains from the trade in the USA and elsewhere (see 1.5.6).
Finally, we emphasise that growth and its preconditions form the basis for
rising prosperity, while trade expands as a result of growth. Trade, without
these preconditions, does not lead to modern economic growth. This is as
true today as it was in the nineteenth century.
2.1 Factors that determine economic growth

For this section read Kenwood and Lougheed, pp.912; pp.2224.
We live in an age when economic growth is expected. Slow-downs in growth
or recessions are expected to be short-lived. Nobody today would vote
for a government which promised that average income would be lower in
five years time than in this year. A process of what we will call modern
economic growth has gone on for about 200 years. This chapter considers
the causes of that growth. First of all we list the main factors involved.
2.1.1 What are the sources of growth?

technology leading to increasing productivity
learning by doing
exploitation of natural resources
capital inputs (more capital)
labour inputs (more labour).
2.1.2 What makes growth more likely?

favourable institutions
reliable methods of payment
high quality human capital
a large market.
2.1.3 What makes it more likely that economic growth in one country leads to growth in other countries?
favourable international institutions
low barriers to trade
international peace and security.
Pause and think
Why do more resources often lead to modern economic growth? Try to put this in your own
words before reading on.
18
2.1.4 Causes of economic growth

More land or cheaper energy will increase output overall. As we
said when discussing the key concepts in Chapter 1, output also grows by
increasing the amount of labour and/or by increasing the amount of capital
(machinery, stocks of materials, buildings etc.).
In the past, increasing labour inputs often led to growth because in
sectors such as agriculture, output per head was very low. So long as it was
possible to transfer labour to other more productive parts (i.e. industry),
output rose. This source of growth is not now very important in developed
countries since agriculture is only a small proportion of the economy (two
or three per cent of overall output) and output per head is already relatively
high. (Growth by transferring resources from agriculture to industry is
important in present day China and India, for example.)
Capital inputs are another cause of growth. Capital includes buildings,
stocks of materials or machinery. Let us consider the nature of capital for a
minute.
Capital expenditure is something that is paid for today but the
benefit of the spending only occurs tomorrow. In other words, it reduces
consumption in the short run but increases output in the long run. Technical
change is often part of capital inputs, but it does not have to be. In theory,
a better way of doing something might not require investment. Moreover,
technology does not usually affect economic growth by one-off inventions;
for instance, by an inventor who has a brilliant idea in the bath.
Most technology in the present day that increases growth comes from
within the firm, the factory, the farm or even the government. That is,
people learn better ways of doing things on the job. Technical change is
more of a systematic than a heroic process.
Pause and think
How did the invention of the motor car come about?
The first cars came from within the engineering firms of Daimler (Germany)
and Renault (France).
Companies who were already involved in other transport (carriages/
horses/buses) were soon involved.
But the success of the motor car depended on many things. In the
first place, the internal combustion engine was soon copied. But the
development of the industry also depended, for example, on new ways
of refining oil to make petrol, on new metals and on the development of
rubber tyres.
Within ten years of their first appearance, cars were being manufactured
in most industrial countries.
Then mass production revolutionised the way that cars were made and
made them cheap enough so that large numbers of people were able to
buy them (see Chapter 6).
In other words, the invention of the internal combustion engine was
only a part of the development of the industry.
2.1.5 Additional factors affecting growth

Think about the way that modern economic growth was transferred from
one economy to another. Some of the elements listed in 2.1.4 could also
apply to many countries that did not develop very early. Something else
must be important, things that make growth more likely.
19
Pause and think

What might these extra causes of growth be?
The first element that makes growth more likely is the presence of
favourable institutions, in particular, the rule of law. As we note above,
entrepreneurs will not invest (that is reduce current consumption in the
expectation of more income in the future) if they think that their contracts
will not be honoured or if they think that the government is likely to
confiscate their property.
As well as the rule of law, the economy needs reasonably stable
financial institutions. Deposits in banks have to be safe. There has to be
an easy way to make payments and, most important of all, an easy way
to borrow money. A good financial system transfers savings from one
part of the economy so that it can be invested in another. But it is not
easy to develop stable financial institutions, especially if there is no rule
of law.
The level of education among the population is also an important
element. Remember, however, that practical knowledge gained from
experience was probably more important in the past than book
learning. Nowadays technology is so advanced that formal education
has become much more important.
Finally, if an economy has access to a large market, entrepreneurs can
produce on a larger scale. This market could be an export market in
another country of course.
Pause and think
The above elements are important for all successful economies. Can you also identify an
additional set of elements which are important internationally?
2.1.6 What makes it easier for economic growth in one country

to be transferred to another country?
Trade is one element, because it allows the follower country to import
modern products, for example machinery.
Similarly, it is a big advantage if the follower country can import
capital: if it can borrow from a more developed economy where savings
are higher.
This means that relatively free trade and relatively free movement
of capital helps the transfer of growth from one economy to another.
There are exceptions to this which we explore below. In some periods
international institutions, such as rules about exchange rates or
international agreements, have made the transfer of growth more likely
than in other periods.
For instance, a good international environment makes the transfer of
economic growth more likely. And obviously wars reduce international
trade and payments, so wars are bad for the transfer of growth.
2.2 Modern economic growth

We introduced this term earlier in this chapter. It is used to distinguish
the rapid and, most importantly, continuous economic growth that
characterised the world economy in our period from the much slower and
more erratic growth that characterised earlier times.
20
There have been periods of economic growth in different parts of the

world for all of recorded history. It was erratic, however, and there have
been periods of stagnation and decline as well. (Sometimes the stagnation
was because output could not keep up with population growth.) In China,
for example, growth virtually stopped for about two hundred years. But in
the last 60 or so years modern economic growth has become established
there.
This continuous economic growth began in Europe then spread to the USA
and countries where Europeans had settled overseas, such as Argentina,
Canada and Australia. Only in the twentieth century did it spread to Japan
and China, and, as we know, there are still many parts of the world where
growth is not continuous. Parts of Africa, for example, have a lower per
capita income than ten years ago.
2.2.1. The emergence of modern economic growth in Europe

There were several reasons why western Europe was at the forefront
of economic growth some two hundred years ago. Three of the most
important were higher agricultural productivity, demographics and
marriage, and the development of the nation state. We look at these next.
2.2.2 Agricultural productivity

Pause and think
What were the effects of higher agricultural productivity on other parts of the economy
industry, for example?
Food production was essential, of course. Fewer resources were needed
to produce food, so more resources (particularly labour) could be used
to produce other goods clothing, tools, buildings, for example. As we
see later in this chapter, agricultural technology in Europe developed to
allow labour to shift from farming to industry without resulting in reduced
agricultural production. To use an economic concept, the opportunity cost
of working outside agriculture was lower in western Europe than in most
other parts of the world.
Two other factors explain why Europe was the first region to experience
modern economic growth.
2.2.3 Demographics and marriage in Europe

The number of people supported by a particular area of land was relatively
smaller than in other parts of the world. In other words, there was a bigger
gap in western Europe compared with elsewhere between the maximum
number of people that could be supported by a given amount of land and
those that actually were supported by it.
The reason was that people married at a later age in western Europe than
elsewhere so that fewer children were born per married couple. In turn
this meant that fewer children were born and there was less pressure on
the land. This was a major reason why the agricultural population was
relatively smaller and the non-agricultural population relatively larger.
2.2.4 The nation state

The second main reason for the early development of modern economic
growth in western Europe was the early development of the competitive
nation state before other parts of the world. Precursors of the European
nation state were the city-states that emerged in Italy during the
Renaissance period.
21
By the early part of the nineteenth century, there were already many
European nation states. Chief among these were Britain, France, the
Netherlands, Denmark, Sweden, Spain and Portugal.
By 1914, Italy, Germany, Norway, Belgium and Greece had joined the list.
The rest of Europe became organised into nation states after 1918.
Not all features of the nation state were beneficial to economic growth
(the destruction created by wars is one example), however, nation states
did offer three advantages:
The governments were more trustworthy.
Property rights and contracts were easier to enforce, and more likely to
be enforced.
Bankers and traders found it easier to accumulate capital.
Pause and think
Consider the following situation and questions:
You enter a contract with another business person. You need to know that the contract
would be honoured. In other words, that your property rights in the contract would be
protected.
If your trading partner does not fulfil his or her obligations, how can you be confident
that the legal process will help you gain redress?
How does this point relate to the nation state?
An entrepreneur is more likely to enter contracts, for example, to
introduce new technology or begin trading voyages when the state is a
helpful and benign influence. He or she needs to be confident that the
state itself will not arbitrarily confiscate property.
In other words the cost of making transactions in western European
countries was lower than in most of the rest of the world, where the state
(if it existed) was different. (1.5.14 tells you what transactions costs are.)
Consider a non-nation state. In 1820 there were a number of non-nation
states in Europe (Turkey, Austria and Russia). Elsewhere there was the
Chinese Empire and Japan, which was cut off from the world, plus the
various colonies of the imperial powers.
Pause and think
Why do you think that these states were less encouraging to economic growth? After all,
they all had codes of law.
Although they protected property rights with legal codes, these could
be changed according to the rulers pleasure.
If an empire was multinational, some nationalities were often treated
better than others.
As a result, property rights were less reliable and lending money (e.g.
putting it in the bank) was less attractive.
In contrast, in Britain and the USA the business community had, by 1820,
become an important part of government. This made it less likely that the
government would act in an arbitrary way.
22
2.3 Industrialisation
By 1820 modern economic growth in western Europe was established,
though in most countries it was still rather slow say about 1 per cent per
head per year. By about 1900, it was faster, but still less than 2 per cent
per head per year. This acceleration came about through the spread of
industry a process known as industrialisation.
Pause and think
The first signs of modern economic growth can be found in Europe much earlier than
1900. Why, then, did the process of industrialisation take so long to become established?
The reason why industrialisation came late was that until the late
eighteenth century, economies could not produce large amounts of energy.
Most energy came from waterpower, animal or human power. The wind
provided a cheaper source of power for ocean transport.
Pause and think
Watermills and windmills have been used for hundreds of years. Why werent they used to
power industrialisation?
These were not able to generate sufficient energy for industrialisation.
Modern economic growth is rapid and continuous. It requires new
sources of energy. The problem was that exploiting most existing energy
sources needed labour. That meant competition for labour with farms and
therefore endangered the production of food.
In economic terms, the amount of energy available was a constraint on
development.
The breakthrough came with an increase in agricultural productivity,
thanks to a number of innovations made much earlier. Higher agricultural
production allowed labour and other resources to be diverted into other
sectors of the economy without reducing food production. In addition, the
production of coal after about 1780 in Britain and later in Belgium, France
and parts of Germany, enabled modern growth to spread and accelerate.
Once the energy problem was solved, major changes in engineering and
in transport (e.g. the railway and steam shipping) were possible. These
transformed the international economy. In the period 18201850, Britain,
followed by Belgium and parts of Germany and France, experienced very
high growth rates in iron production, engineering, coal and textiles.
The acceleration in growth rates is frequently called, the Industrial
Revolution. Growth was fastest in textiles, production of which became
mechanised, in iron and in engineering. However, growth was much more
widely based. Non-mechanised industries could expand by taking on more
labour and agricultural productivity measured both by returns to labour
and returns to land increased although not by as much as in industry.
2.3.1 Summing up
Modern economic growth began in western European nation states
during the period 17801820.
We now know that a characteristic of modern growth is that it becomes
permanent and continuous.
Growth rates were modest by present day standards (around 1 per
cent). Nevertheless, we can now see that a major historic change
occurred.
23
In the subsequent period of 182050 the process of industrialisation

began, based on coal and steam power. Growth rates began to
accelerate (to between one and two per cent).
In this section we have used some of the concepts, which were mentioned
in Chapter 1. In particular, we have been discussing productivity growth.
Initially, the main source of growth was structural change.
This means that labour and capital moved from one part of the
economy to parts where they were more productive.
The classic example was labour moving from agriculture to industry.
Adding an extra person to a farm did not produce as much as adding
an extra person to a factory (or to employment in services). This means
that their labour productivity rose if they moved to a city.
As the energy problem was solved, leading to industrialisation, capital
was used to build factories or install machinery. This means that capital
productivity rose as well.
Transport development was also very important. Better, cheaper
transport allowed manufactured goods, which were also now cheaper,
to reach the farmers and food in sufficient quantities to reach the cities.
Finally there was the increased size of the market, leading to higher
demand and making an increase in the scale of industrial production
possible. Note that agriculture was still not mechanised in Europe as
late as 1900.
2.4 The spread of modern economic growth

We see above why modern economic growth began in western Europe
before 1820 and why industrialisation followed after 1820. Next we look
at how the growth spread from one country to another.
Pause and think
Why might the spread of growth from one country to another have happened?
We use the term centre and periphery in economic history to help
explain this. Modern economic growth spread from western Europe, (the
centre) to other parts of the world (the periphery) in two main ways.
By conscious copying. For example, once the railways had been
developed in Britain they were quickly copied in other countries. They
did not have to be reinvented.
Through trade. The most important way that growth was transferred
was through trade. Britain was the most important trading country
before 1914 because it had been the first to industrialise. Later starters
could import capital and consumer goods from Britain in exchange for
primary products (raw materials and foodstuffs).
We can use a famous nineteenth century example, the relationship
between Britain and the USA.
In the early nineteenth century Britain and the United States were each
others best customers.
Britain exported industrial products to the USA in return for cotton
and timber (unfortunately, since cotton was produced by slaves, cotton
exports prolonged the life of slavery in the USA).
24
But United States exports were not enough to pay for US imports. In
other words, the USA had a balance of payments deficit (we look at the
balance of payments in Chapter 4).
Britain lent money to the USA which financed the deficit. Note that,
in order to encourage this flow of credit, US interest rates had to be
higher than British interest rates.
The relationship between, what we call, a central country like Britain, and
a peripheral country, which the USA was at the time, raises several points.
2.4.1 Catch up
Once one (central) country industrialised, the position of many other
economies was transformed. It became easier for them to develop that
is to catch up. But we know that in the nineteenth century, only a few
countries managed to catch up. This is because of the need for social
capability in a peripheral economy that tries to catch up with the centre.
The peripheral economy has to be able to take advantage of the
connection with the more developed economy. This means having similar
institutions to those in the central country. Such institutions include a
benign government, the enforcement of contracts, a comparable level
of literacy and some useful raw materials. Without these, trade with the
centre does not lead to modern economic growth. In an extreme case,
trade leads to a plantation economy and/or colonial exploitation.
In other words, the nature of the peripheral economy was, in the
nineteenth century, the determinant of whether trade led to modern
growth.
For example, Americans were rich, well educated and had a strong
government well before the USA industrialised. They had the right
institutions and could not return to being an economic colony of Britain.
Some smaller, weaker countries did become economic colonies, however.
2.4.2 Use of other countries resources

Britain, the first industrial country, gained access to the abundant (and
therefore cheap) resources of other continents, especially the resources
of the USA in the beginning. This allowed Britain to specialise in those
products in which it had a comparative advantage, which increased
its income. These were products which Britain produced relatively
more cheaply than other countries. This meant that Britain exported
manufactures and services. Eventually, Britain was able to import most of
its foodstuffs, leading to a still higher level of specialisation.
2.4.3 Trade as a consequence of industrialisation

This is an important point. The growth of trade in the nineteenth century
was a consequence of industrialisation not a cause of it. This is because
industrialisation meant specialisation in industrial goods. This led to
a demand for imported primary products. Remember this important
relationship. You can find it re-stated at the end of the course (see Chapter
15).
2.4.4 Trade and policy

The development of the relationship between the first industrial country
and the rest of the world had important implications for policy. In
particular, it was in Britains interest to adopt free trade.
25
Pause and think

Why was free trade in Britains interest?
Britain industrialised first and was the worlds cheapest producer of a
large range of industrial products.
Free trade increased imports of food and raw materials into Britain.
This gave other countries more money with which to purchase British
exports.
For instance, if countries did not have an iron industry, they could
import railways from Britain. In the long run this might not be politically
acceptable. Take the example of US railways. In the 1850s the USA
imported iron rails from Britain to build its railway system. Since the US
iron industry was relatively underdeveloped, importing from Britain meant
that the USA was able to develop a railway system earlier than otherwise.
But Americans did not want to be dependent on British imports. They
wanted to manufacture rails for themselves. Hence, in the 1860s, the
American government raised tariffs on a range of (British) imports. This
allowed American manufacturers to compete with the cheaper British
products. Eventually, they became even cheaper producers than British
manufacturers, to the benefit of the American economy.
This is an example of an infant industry tariff allowing import
substitution. This pattern applied to other industrialising countries. In the
early stages of industrialisation, countries purchased cheap capital goods
imports, but later raised tariffs to allow import substitution.
Pause and think
Under what circumstances does it make sense to introduce tariffs on cheaper
manufactured imports?
Think about the long-run consequences. Is it probable that the goods could
eventually be produced more cheaply at home? And even if they were, is
there another product in which the country has a comparative advantage?
2.4.5 Factor proportions and comparative advantage

Pause and think
Why were Britain and the USA initially such important trading partners?
The reason why Britain and the USA were initially such important trading
partners is because the economies were complementary:
The USA had very large resources of land and raw materials. What
it lacked was capital and labour. Because resources were abundant,
labour and capital were scarce, by definition, and therefore more
expensive.
Britain had relatively abundant labour and because it industrialised
first, relatively abundant capital. This meant that the return to labour
(wages) was higher in the USA than in Britain, and the return to
capital (interest rates) was also higher in the USA. On the other hand,
land and new materials were relatively scarce in Britain, and relatively
expensive.
Labour (emigrants) and capital (investment) moved from Britain to
the USA and those goods that used a lot of natural resources (i.e. were
resource-intensive), such as timber and cotton, were traded from the
26
USA to Britain. The two countries specialised in those areas where they
had a comparative advantage.
A reminder of your learning outcomes

Having completed this chapter, and the Essential reading, you should be
able to:
explain what is meant by modern economic growth and why it became
a feature of countries over the last 200 years
discuss how this relates to the development of the international
economy
outline the mechanism by which economic growth was transferred
from one economy to another
demonstrate why some countries caught up with more developed
countries earlier than others did
use economic concepts like the gains from trade and comparative
advantage to analyse how the international economy developed.
Questions
1. Why did Britain introduce free trade in the mid-nineteenth century?
2. How did energy production constrain the rate of economic growth
before industrialisation?
3. Were there any features of the nation state in western Europe that
made economic growth easier?
27
Notes
28
Chapter 3: The development of an international economy by 1900: trade, capital and labour
Chapter 3: The development of an

international economy by 1900: trade,
capital and labour
A number of factors helped the development of the international economy
during the period 18701914. In particular:
a rapid growth in international trade
migration of labour
international capital flows
helpful economic institutions such as the gold standard (we deal with
the gold standard in Chapter 4.)
peace and security in international affairs which encouraged the
development of the international economy.
In this chapter we look at the first three of these factors.
Objectives
To explain:
why trade grew so rapidly
what role labour migration played
what stimulated capital flows.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
explain why international trade grew so rapidly
analyse the reasons for the high levels of both international investment
and international migration in the period before 1914
apply the idea of comparative advantage to these movements
explain the effect of migration on different economies
account for the relatively low barriers to the mobility of factors of
production in the international economy 18701914.
Essential reading
University Press, 2010) [ISBN 9780521708395] pp.137 and pp.6571.
[ISBN 0415199301 pbk]. Read Chapters 1, 2 and 3 and in particular the
following pages which relate to the sections below: pp.1224, pp.3443,
pp.4460, pp.6777.
29
Further reading
Foreman-Peck, J. A history of the world economy: international economic relations
since 1850. (New York: Harvester/Wheatsheaf, 1995) second edition [ISBN
0745009352 pbk] pp.3149, pp.5464, pp.97101, pp.12026, pp.1336,
pp.14053.
Introduction
During the period from 1870 to 1914 world trade grew by about a third
per head per ten years. World output (GDP) grew by only seven per cent
per person per decade, slower than trade but still impressive. The world
did not see such rapid growth in trade again until 194573.
Growth of trade and output were already under way in the 1820s. In this
chapter we examine why the increase took place. The chapter has four
main sections:
characteristics of the international economy
international trade
overseas investment
international migration.
A problem for us is that we have the benefit of hindsight. It seems almost
inevitable today that the international economy would have grown in that
period. Population was growing, new production processes were coming on
stream and, in particular, there was great development of steam transport.
But it was not inevitable that the international economy would grow.
In this and subsequent chapters, we see how beneficial conditions
encouraged the international economy to grow. Several relate to one
country, the UK. The UK was the first industrial economy and it could have
turned inward towards domestic production. It did not do so.
Instead, the UK became the dominant trading nation, with a large empire
which lasted well into the twentieth century. The UK also played a major
part in running the worlds monetary payments and credit. At the same
time the UK put up no barriers to trade, or any hindrances to the outflow
of labour or capital. It is worth remembering that the international
economy could have stagnated if different policies had been adopted.
In the twentieth century, the UKs share of world exports and its share
of world overseas investment declined. This meant that its influence in
the international economy also declined. Once that happened, it was
important for the smooth functioning of the international economy that
new institutions were created to take over the role which the UK had once
had. As we see in Chapters 8, 12 and 13, this proved difficult.
In this chapter we look at the period 18701914, when UK influence was
at its height.
3.1 Characteristics of the international economy

Chapter 1 in Kenwood and Lougheed sets out how they view the causes of
the expansion of the international economy in the period before 1914.
The main characteristics of the international economy between 1870 and
1914 were the relatively free movement of:
goods
labour
capital.
30
There were fewer restrictions than at any period in history except perhaps
in very recent years.
3.1.1 Goods
Countries did have tariffs, but they rarely discriminated the level of
tariffs faced by one countrys exports was usually the same as the level
faced by other countries. If a discriminatory tariff is used it means that
imports might not come from the cheapest overseas producer. This reduces
income.
3.1.2 Labour
There were no restrictions on international migration by people of
European origins. On the other hand, there were serious restrictions on
non-white emigration, even within the British Empire.
3.1.3 Capital
There were no restrictions, such as exchange controls, on international
capital movements.
All the major world currencies were freely convertible into each other at
fixed rates. The reasons why there was monetary stability are discussed in
Chapter 4. In this chapter we concentrate on the three factors above.
3.2 Why did international trade grow so fast?

Pause and think
There is a relationship at the national level between international trade (imports and
exports) and the domestic economy. Does economic growth at home lead to expanding
trade, or does expanding trade lead to economic growth?
This is a good question to think about. We must distinguish between cause
and effect. The real reason for the growth of the international economy
was not the relatively free movement of goods, labour and capital. It was
the other way round. Fast growth convinced countries that the best policy
was to allow relatively free trade. So growth led trade.
Growth even led trade in countries like Australia and Canada whose
economies grew because of massive export growth of wool and wheat,
respectively. Exports from these countries grew because:
demand in the industrial countries grew
the industrial countries provided the essential technology and capital to
build the railways and ships to carry the exports.
Australia and Canada became very successful economies, but there are
countries that became successful exporters of important products but did
not achieve sustained economic growth. Examples include Jamaica and
sugar, Bolivia and tin and Nigeria and oil. Simply put, this was because
these countries had insufficient social capability (see 1.5.10).
So success in trade does not guarantee economic growth and higher
incomes. Similarly, countries can grow without trade being very important.
The USA is a prime example. US trade has been a minor cause of American
economic growth throughout the twentieth century, for example.
There were several reasons why the period before the First World War
(18701914) was particularly favourable to the growth of international
trade.
31
3.2.1 Peace
Between the end of the Franco-Prussian War in 1871 and the outbreak of
the First World War in 1914 there were no wars between any of the great
powers (Britain, France, USA, Russia and Germany).
3.2.2 Transport costs

Transport costs declined at a faster rate than in any previous period. The
development of railways enabled goods to be moved overland at low cost.
Previously, goods could only be moved cheaply by water, which is why
all the major cities of the pre-industrial world were either ports or on
navigable rivers.
The development of steam shipping created an international market in all
the main commodities. This was because steam ships were not dependent
on the weather, but could go anywhere that goods were cheap and sell
them anywhere that goods were expensive. This made the prices of, for
example, cotton, wheat, rubber and tin the same across the world except
for transport costs.
Pause and think
Can you think of goods which did not have the same price worldwide?
For goods to have the same price worldwide they have to be
homogeneous, like wheat. Transports costs still remained high for some
goods that is those that could be damaged in transit.
3.2.3 Travel and communication

Other developments were the telegraph, marine cables and postal
services. The effect was massively to increase the amount of information
available to businessmen and traders, that is information about the
market in particular commodities. These costs of doing business are called
transactions costs (see 1.5.14).
In preindustrial societies, there was little certainty about
economic transactions (e.g. about markets, the weather, safety,
the creditworthiness of clients). More useful information reduces
uncertainty.
Less uncertainty allows an increase in the number of transactions. If
you think about it, this is virtually the same as increasing economic
growth. Resources that were used to make transactions can now be
used to create more goods.
There is also a link between falling transport costs and lower transactions
costs. Over time, the speed of obtaining information depended less on the
wind and the speed of horses and more on the steamship and telegraph
cable.
3.2.4 The international market in commodities

So far we have talked about goods. From now on we reserve this label
for manufactured goods. We use the word commodities and primary
products for basic raw materials the products of mines, forests, fishing
and agriculture.
Pause and think
How did lower transport costs affect international trade in commodities?
32
The combined effects of the fall in transport costs and the increase
in information was to create an international market in the basic
commodities. Take wheat as an example.
Let us assume that there was a very good harvest in Argentina and a
poorer one in the USA.
The price of wheat would be lower in Buenos Aires than the price in,
say, Chicago.
At the same time, the information about the Argentine harvest would
be available in, say, London. Ships would go to Buenos Aires to buy
wheat at a low price.
In this way, the harvest in Argentina affected the price in the USA.
Ultimately, the price of wheat anywhere in the world was the same
except for transport costs, which for bulk commodities like wheat
were low. Futures markets subsequently developed, allowing people
to trade in basic commodities worldwide before the crops were even
harvested.
Activity
Which of the following goods and commodities are commonly traded internationally
today and which are not? Can you think why?
cement
bricks
steel sheets
potatoes
tropical root crop foods like cassava.
Cement and bricks have a low value-to-weight ratio and are seldom worth
trading internationally. Steel sheets are traded as long as they are of high
quality (and value) to make it worthwhile. Potatoes are easily stored and
graded so do get traded. Cassava is heavier and more uneven, so it is more
difficult to trade. In short, it depends on the value, the weight, and the
ease with which the product may be bought and sold. Then, if one country
has an advantage in its production trade develops. Otherwise it doesnt.
Note that a country only needs to have a comparative advantage to
make trade worthwhile (see 1.5.5).
3.2.5 Specialisation
One of the main gains from trade is a consequence of specialisation.
Consider what happened in UK, in the period from 1870 to 1914.
Food imports increased because of the development of virgin lands,
first in the western part of the USA and then in other countries, such as
Canada. Note that this would not have been possible without transport
development, particularly the railway.
In turn, agriculture in the UK declined because it became cheaper for
basic food to be imported rather than produced at home.
Of course, if the British government had decided to protect British farmers,
there would have been fewer imports. But the UK did not protect food
imports (see Chapter 5).
Imports meant that basic food costs in the UK fell by half in thirty years
(18701900). Since, at the time, British people, on average, spent about
half of their income on food, this had a significant effect on the standard
33
of living. Also the British economy could concentrate on more productive

sectors, in which they had a comparative advantage for example, the
export of manufactures.
Pause and think
How do you think that the agricultural sector responded to this new competition from
abroad? Try to answer using the concept of comparative advantage (see 1.5.5)
If this question gives you difficulties, have a look at Kenwood and
Lougheed, 75. They explain how farmers in the UK and Denmark moved
out of grain and cattle farming for meat, into areas where they had a
comparative advantage, notably pig rearing and dairy farming. A century
later Denmark is still well known for bacon and cheese production.
The answer to this question forms an example common to many situations.
There was increased competition from abroad, the loss of comparative
advantage and the search for a new product where the local producers
still had a comparative advantage. The effect was that different countries
specialised, to some extent.
3.2.6 The supply of primary products

In the late nineteenth century, those parts of the world with very low
population densities, and where the resources had previously been little
exploited, were entering the international economy; areas such as the west
of the United States, most of Australia, Argentina and parts of Siberia.
These regions of recent settlement, as they are called, experienced
constant returns to scale in agriculture and primary production. Constant
returns to scale means that the output per hectare did not fall as total
output increased (see 1.5.11).
Activity
Imagine three families each having farms of 25 hectares in nineteenth-century Kansas.
A government land grant enables them each to increase to 50 hectares (25+25). Each
family uses double the inputs (labour, cattle, machinery etc.) Each family obtains the
following results:
The first family gets 200 per cent of the previous output.
The second family gets 50 per cent more output.
The third family gets 100 per cent more output.
Now describe the returns to scale of each farm. Try this before reading on.
The first family obtains increasing returns, the second decreasing returns
and the third constant returns to scale.
But what if there was no extra land available?
Then 50 per cent more output, or a worse result, is the only conceivable
outcome. In other words, where land is scarce there are diminishing
returns to land.
But in the regions of recent settlement, technology and transport liberated
agriculture from diminishing returns to land that is where adding more
labour and capital could not lead to an equivalent increase in output
because the amount of land could not be increased.
In the regions of recent settlement, the amount of land could be increased
and any increase in labour and capital applied to the land would lead to a
large increase in the output of food.
34
This is why the massive rise of population in the industrial countries and
increased demand for commodities did not lead to rising food prices.
Activity
Draw a supply and demand diagram for the world supply of food. The diagram should
show:
a demand curve that shifts to the right as population increased
a supply curve that shifts to the right as new areas come into production in new areas
an equilibrium price for food.
Finally, comment on the diagram:
Is the price of food falling?
Under what conditions would it fall?
Think about the increase in supply compared with demand, and if you know a bit more
economics think about the elasticity of demand. We know that world food prices fell c.
18701900. What are the implications for the diagram?
Bear in mind that food prices did begin to rise after 1900, once the best
land in the regions of recent settlement was taken up and farmed.
3.3 Overseas investment

Economic conditions in the later nineteenth century were exceptionally
favourable for international investment. The countries that had already
industrialised were generating capital from the profits of industry. The UK,
the first country to industrialise, was the biggest capital-exporting country;
40 per cent of the 10 billion of outstanding foreign investment in 1913
was still British-owned.
Pause and think
How could the UK afford to invest such an enormous amount overseas?
Where did the money come from?
The UK could only invest overseas because it had a surplus of exports of
goods and services. Consider how the balance of payments is made up. On
one side are exports of goods and services. On the other side are imports
of goods and services. Obviously, the balance of payments must balance.
For example:
If a country is importing more than it exports, it must have paid for the
imports. In other words, to acquire the foreign currency to pay for the
imports it must be importing capital, that is borrowing.
If a country is lending overseas, as the UK was in the nineteenth
century, it must have been earning the foreign currency with which
to make the investment. To do this, the UK must have exported more
goods and services than it imported. It must have had an export
surplus.
The main demand for foreign investment was from the so-called regions
of recent settlement, such as the USA, Canada, Argentina and Australia.
These were countries which had only recently been settled by Europeans;
the native population was relatively small. Inward investment was mainly
used for infrastructure such as railways and docks.
35
Pause and think

Why was it profitable for investors in the UK (and other countries) to invest in the regions
of recent settlement?
Think about the return to new investment (capital) in these countries and
in the UK. Because they were relatively underpopulated, countries such
as Canada, Argentina and Australia and, until about 1900, the USA had
little capital but a lot of resources. In fact, if they had a lot of resources,
they would have relatively little capital, by definition. This meant that the
productivity of capital was high and the return to capital was high.
Pause and think
What else was needed, besides a favourable resources-to-capital ratio, to make
investment in the regions of recent settlement profitable?
Demand for the products that the resources helped to create was also
required. This is an important point. Investment in these countries was
only profitable as long as there was a demand for the products associated
with the investment, such as a railroad that carried the products.
An example may help. British investment in railways in Argentina:
allowed Argentine beef to reach the coast, so exports of beef rose
gave the Argentine borrower the money to repay the loan, from sales of
beef in the UK
made it profitable for the UK lender to lend the money in the first
place, as this repayment with interest justified the investment.
3.3.1. Technology transfer

Foreign investment also led to technology transfer (sometimes called
technical transfer). This allowed regions of recent settlement to copy
and learn from more developed countries. This is how many countries
acquired railways, for example. Instead of having to produce their own
rail and locomotives, the new countries could use what had already been
developed by industrial countries like the UK and France.
Another type of technical transfer happened later in the period. After 1900
companies were beginning to make direct investments abroad, for example
in manufacturing.
Pause and think
What impeded technical transfer?
In 1900, technical transfer was not as easy as it is today. One reason is
that at the time many skills were embodied in the workers who made the
products. Local labour often did not have enough skills, enough human
capital, to work the new machines.
This is an example of how a lack of social capability can impede catching
up with a more developed country. This was one reason why technical
transfer often occurred alongside international migration.
36
3.4 International migration

Just as the fall in transport costs and the development of information
mechanisms allowed an international market in goods to develop, it also
allowed the partial development of an international labour market. It
became possible for people, particularly from Europe, to increase their
income by emigration to the regions of recent settlement, of which the
most important, by far, was the USA. (Non-European emigrants were
not always welcomed, however; many countries banned non-white
immigration.)
The flow of emigrants from Europe was a response to the relative labour
shortages of the regions of recent settlement and the relative labour
surplus in Europe. In the regions of recent settlement, resources were
relatively abundant and labour was relatively scarce.
Pause and think
Who gains and who loses from such migration?
Is it all cost for the country of origin and all gain for the recipient country?
Write down a balance sheet for the two countries involved.
Simple international trade theory suggests that the migration of labour
increases income in both countries. For the factors you should have in your
balance of costs and benefits see Kenwood and Lougheed, pp.5456. If
you want to try something a bit harder, ask yourself what the difference
is if the emigrants return to Europe? About a third returned during the
18701914 period.
You should be able to see that, in a sense, overseas investment, trade
and migration are substitutes. For example, capital investment could
provide jobs in Europe. If the investment went to the USA, for example, it
would increase jobs there and, other things being equal, which is a large
assumption, of course, migration to the USA would increase.
The reason that workers went from Europe to the USA and other countries
was that they increased their standard of living by doing so. In other
words, returns to labour were higher in the USA and other countries of
recent settlement.
In the long run, it was likely that migration from Europe to the USA would
fall. This was because the differential between European and American
wages would fall, as the relative scarcity of labour in America fell, and
the relative abundance of labour in Europe fell. This is eventually what
happened, but it did not happen very fast because returns to capital
were also higher in the USA than in Europe. So capital continued to flow
towards the USA, relatively increasing labour demand there and relatively
reducing it in Europe, which meant that wages were not equalised and
migration continued.
Pause and think
Were some immigrants more useful to an economy than others?
Many of the international migrants had valuable skills but the great
majority were unskilled.
Pause and think
Did this mean the unskilled were of little use?
37
No. A high proportion were young adults. They entered the new countries at the
peak of their productive and consuming power. In other words, the cost of their
upbringing had been paid in the country from which they came. They were a free
gift of human capital from Europe.
Summary
In this chapter we cover a lot of ground. Even so, we do not have space to
expand and discuss some important and interesting issues. You should make sure
you complete the reading before moving on.
We have argued that there is a two-way relationship between the growth of
individual countries and the growth of the international economy.
In some countries trade based on exporting raw material led to a lot of
economic growth. In other countries to much less.
European countries, especially the UK, experienced growth at home that led
to an expansion of exports and created a demand for imports.
Many of the capital flows in the period were reliant on the UK export surplus.
This recycling of export earnings was a vital part of the development of the
Labour migration had costs and benefits in both the country the emigrants left
and the one in which they arrived. It was only an unambiguous benefit to the
latter.

Having completed this chapter, and the Essential reading and activities, you
should be able to:
explain why international trade grew so rapidly
analyse the reasons for the high levels of both international investment and
international migration in the period before 1914
apply the idea of comparative advantage to these movements
explain the effect of migration on different economies
account for the relatively low barriers to the mobility of factors of production
in the international economy 18701914.
Questions
1. Assess the relationship between the spread of agriculture into previously
uncultivated land and the growth of industry in the UK and other European
countries before 1914.
2. Examine the effect of transport development in the creation of an
international market in the basic commodities in the early twentieth century.
3. Why was the level of international investment high in the early twentieth
century?
38
Chapter 4: Institutions that underpinned the international economy before the First World War
Chapter 4: Institutions that underpinned

the international economy before the
First World War
In this chapter we explain why international monetary relations were
stable in the late nineteenth and early twentieth centuries. Why, for
example, most exchange rates were fixed and why most currencies
were convertible into each other. In later periods it proved difficult, and
sometimes impossible, to fix exchange rates as rigidly as they were fixed
during the period from 1870 to 1914.
This chapter introduces the idea of contingency why it was possible
for exchange rates to be fixed in the period before the First World War.
Also why, at the time, bankers, traders and governments were almost
universally in favour of fixed exchange rates.
Objectives
To explain:
the implications of fixed exchange rates in the historical context
how the gold standard worked in practice.
Learning outcomes
explain why businessmen and governments were determined to
maintain fixed exchange rates
outline what it was that allowed fixed exchange rates (i.e. the gold
standard) to be maintained
discuss whether the gold standard worked because central banks
followed a set of rules or for some other reason
explain how the flow of capital made it easier for the gold standard to
work, and give examples.
Essential reading
system. (Princeton, NJ: Princeton University Press, 2008) second edition
[ISBN 9780691139371] pp.1542.
[ISBN 0415199301 pbk] Chapters 6 and 7, pp.91119.
Further reading
edition [ISBN 0745009352 pbk] pp.16174. (This section is rather more
difficult than that in Kenwood and Lougheed.)
39
Introduction
The international economy in the period from 1870 to 1914 was
characterised by three institutions. (An institution is defined here as
something manmade for a purpose.) Laws, rules and organisations are
all examples of institutions. As we see in this chapter, there are three
institutions which were closely linked together:
free trade
multilateral settlements
fixed exchange rates.
4.1 Free trade

Although free trade was not practised by all countries, the most important
trading economy, the UK, had virtually no restrictions on imports at all in
the period from 1870 to 1914. We have already seen why free trade was
important for the UK. It was also important for the smooth working of the
There is a detailed examination of the rise and fall of free trade in
Kenwood and Lougheed, Chapter 4. The chapter includes a discussion
of commercial policy, but you will not be examined on the details of
commercial policy.
Free trade became the norm between 1850 and 1880 (see Chapter 2).
Later industrialising countries, like the USA and France, wanted to import
technology and capital goods from Britain, hence free trade made sense.
But eventually these countries sought to replace imports of manufactures
with domestic production. Hence, they introduced infant industry tariffs.
These tariffs never reached the levels of 191939. After 1870 some
industrial countries introduced tariffs on food imports in order to protect
their own agriculture.
Activity
What determines whether or not a country introduces tariffs on food imports?
How does this affect the standard of living?
Make a case using the concept of comparative advantage (1.5.5). Do this before
reading on.
You could make the following points to answer the questions above:
Imported cheap food would mean major changes in the countryside, for
example, a large number of farmers might have to give up farming and
move to the cities.
This would be an advantage if the country had a comparative
advantage in manufactured exports and disadvantage in farming.
On the other hand, there might be political and military reasons to
protect agriculture.
Cheap food imports hold down the cost of living for industrial workers.
This exerts downwards pressure on wage rates and costs. Other things
being equal, this makes manufacturing exports more competitive.
The free trade stance of the UK was very important because it gave other
countries free access to the UK market. The UK remained the worlds
largest importer until 1939.
40
In the main, UK exporters were able to maintain their sales in the face
of tariffs and foreign competition. This was, partly, because the world
market was growing fast, and partly because UK exporters were very good
at finding new products and new markets. (UK exports still continued to
grow, although the UKs share of total world exports was falling as other
countries began to compete.)
4.2 Multilateral settlements

Consider imports. These have to be paid for, so the level of imports
depends on a flow of payments from overseas. If exports and imports in
each country had to balance with each other so-called bilateral trade
the level of trade is limited. We can see the effect of multilateral
settlements in a simple diagram. Look at Kenwood and Lougheed, 94
(including the diagrams), or look at Figure 4.1 which is simpler.
A
Owes 50
Owes 70
B
Owes 20
Figure 4.1 Multilateral settlements
Country A imports 50 more units from B than it exports to B. Hence it

owes 50 units in funds.
Country B imports 20 more units from C than it exports to C. Hence it
owes 20 units in funds.
Country C imports 70 more units from to A than it exports to A. Hence
it owes 70 units in funds.
To settle the account, the three countries need 140 units of currency. (50
plus 20 plus 70). If they could not obtain the currency, they could each
only import the same amount as they exported. So, As imports would be
50 fewer, Bs 20 fewer and Cs 70 fewer. These are what are called bilateral
settlements that is just between a pair of countries.
Pause and think
What would have happened if the settlements were multilateral?
Can you work out what C must pay A and B pay C?
Note how just two payments settle all accounts between A, B and C.
If the settlements were multilateral the countries currencies would have to
be convertible into each other. The entire account could be settled by one
payment of 20 units from C to A; and one payment of 30 units from C to
B. Only 50 units of foreign currency are needed. In other words, a smaller
amount of currency finances the same amount of trade.
Pause and think
What condition must be satisfied for multilateral payments to work?
This is important to remember, so dont read on too quickly!
41
All the countries must be willing to accept Cs currency. B would have to

accept Cs currency which was paying debts owed by A.
Fixed exchange rates were thought to be an essential component of the
international economy in the years before the First World War. It was
thought that multilateral trade depended on certainty about exchange
rates.
Pause and think
Why did people believe that multilateral trade depended on certainty about exchange
rates?
For trade to be multilateral, as in the example above, traders had to accept
paper, usually, a so-called bill of exchange, from a foreign buyer. The
trader would then use the bill to purchase something in a third country. So
traders needed to be certain about the future exchange rate. You can find a
more complicated example in Chapter 6 of Kenwood and Lougheed.
Another area where fixed exchange rates were important was in overseas
investment. Fixed exchange rates removed the exchange rate risk faced
by investors who bought overseas stocks and shares. We may assume,
therefore, that there would have been less overseas investment if exchange
rates had fluctuated.
4.3 The gold standard

The so-called gold standard was the mechanism for ensuring that
exchange rates remained fixed. Remember, it was only a means to an end,
not an end in itself. When a country decided to go on to the gold standard,
it had to:
Fix its currency in terms of gold (e.g. one franc equals x grammes of
gold).
Allow its paper currency to be convertible into gold, at face value, if
people requested it. In practice, only large amounts of gold could be
exchanged in most countries.
Ensure that the amount of paper money in circulation was related to
the reserves of gold held by the central bank.
Kenwood and Lougheed cover this in their Chapter 7. Read the chapter in
conjunction with these notes.
4.3.1 The price-specie-flow mechanism

The main threat to the above occurred when there was a balance of
payments deficit. (Exports were less than imports.) If a country had a
persistent balance of payments deficit, the demand for its currency abroad
was lower than its demand for foreign currency at home. In time, the
country would lose so much gold and foreign exchange that it would have
to devalue its currency and allow the exchange rate to fall, thus leaving
the gold standard and breaking up the system.
There was a mechanism within the gold standard that was supposed to
prevent a persistent balance of payments deficit occurring. This is usually
called the price-specie-flow mechanism. Specie is an old word meaning
monetary gold. The price-specie-flow mechanism is explained below.
But first, note an important point. It was not the mechanism itself that
ensured exchange rate stability because it was not an automatic
mechanism. Rather, it was a rule, which told central banks what to do if
42
they chose to. The point is that the central banks were usually willing to
subject themselves to the discipline of the price-specie-flow mechanism.
We will explain why this was later.
SHORT-RUN PROBLEM
A
BoP Surplus
BoP Deficit
Gold IN
Gold OUT
l
O
I
Money Supply
Money Supply
Prices
Prices
BoP Equilibrium
Rules of the game
Rules of the game
Figure 4.2: The price-specie-flow mechanism
The price-specie-flow mechanism operated as follows:

Think about a world with two countries, A and B.
Country A has an excess of exports, country B an excess of imports.
To pay for the import surplus, country B would be losing foreign
currency or gold.
This means that, under gold standard rules, the money supply in
country B falls. This reduces prices. This means that country Bs exports
become cheaper and some domestic goods become cheaper than
imported goods.
Hence, exports (X) from B are raised, imports (M) to B fall and the
balance of payments (BoP) deficit is closed.
At the same time, country A gains gold, which means that its money
supply increases and prices rise.
In consequence, exports fall and imports rise. Country As balance of
payments surplus disappears.
Balance of payments equilibrium in A is restored.
Note three points:
There are no changes in exchange rates, which is the intention.
In this simple example, there is no change in output, only in prices.
The adjustment was painless; no one lost their job, no companies went
bankrupt, no factories closed.
Pause and think
Read Kenwood and Lougheed, p.111. Work through their example now.
43
4.3.1.1 The rules of the game

Central banks (like the Banque de France or the Bank of England) usually
intervened to speed up the process. They were applying what has come to
be called the rules of the game.
The rules of the game are shown in Figure 4.2. They were an unwritten
set of guidelines that central bankers were supposed to follow. If the
central bank of country B followed these rules, it would increase the
interest rate at the central bank when it observed that country B was
losing gold, In turn, this would increase interest rates across the whole
economy. This would lead to a fall in investment and output would fall.
The fall in output would cause a fall in prices, which would increase
exports and decrease imports, as above.
At the same time, the central bank of country A would observe that it was
gaining gold. If it followed the rules, it would reduce interest rates which
would increase investment and output. Prices would rise, imports would
rise and exports would fall.
Pause and think
What was the monetary variable that played the part of an adjustment mechanism under
(a) the price-specie-flow and (b) the rules of the game?
If you answered (a) the money supply and (b) interest rates, read on.
Otherwise look back over the last few paragraphs and in the readings to
see where you went wrong.
Activity
The rules of the game gave national economies more pain than the price-specie-flow
mechanism. See if you can explain why. Take a few minutes over this, and then read on.
When answering the question above you might have said something like
this:
A rise in interest rates in the deficit country affects output and
employment but the effects might not be too great if the rise in interest
rates is temporary. Conversely, a fall in interest rates in the surplus country
may have an inflationary effect and this can be damaging.
4.3.2 Why was the gold standard a success?

We know that the gold standard was a success. By the late nineteenth
century all the major currencies (pounds, dollars, marks, French, Belgian
and Swiss francs and guilders) were tied to gold and, unlike in the late
twentieth century, their exchange rates remained fixed. No major economy
had to devalue its currency.
Pause and think
Was the stability because of the rules of the gold standard (the price-specie-flow
mechanism plus the rules of the game) or was it because of something else? Look in
Kenwood and Lougheed, 11518, for ideas. Once you have formed an opinion, read on.
So far we have only talked about the gold standard and the international
economy. But the gold standard had important advantages in domestic
economies as well. The main reason was the relation with government
finance.
44
Pause and think

Can you think how the gold standard and government finance were related?
(Remember about the danger of inflation.)
A government borrows money on different terms to a private institution
because a government can repay the loan by creating more money.
Such government borrowing can create inflation.
Someone who lends money to the government can lose if inflation
erodes the real value of the loan that is it was repaid in devalued
currency. In the jargon, if this was unexpected, it is called a monetary
surprise.
If the currency were tied to gold, a country would lose gold if it had
inflation. Technically, if the inflation rate was higher than that in the
other countries. Losing gold would lead to monetary contraction.
As long as a country remained on gold, lenders were guaranteed that the
government would honour its debts and there would be no monetary
surprises. Lenders could lend without fear of inflation. This is why
the gold standard has been described as a good housekeeping seal of
approval.
The seal of approval was especially important for the peripheral
countries. Greece and Argentina, for example, sometimes had balance of
payments problems that forced them to leave the gold standard. But when
they needed international loans, they returned to the gold standard, which
made their commitment to repaying the loans more credible.
The seal of approval even out-lasted wars. It was not expected that
countries would stay on the gold standard during wartime because the
government would have to borrow to finance the war. But once the war
was over, it was expected that the country would return to the gold
standard as soon as possible. In other words, the government was not
expected to honour its debts in wartime, but eventually the government
would go back to gold, which would eliminate inflation and hence, honour
the commitments made before the war. As we see in Chapter 7, this led to
problems after the First World War.
4.3.3 Further considerations relating to gold standard

We can think of the implications for domestic policy of the gold
standard in a different way. The gold standard effectively limited what a
government could spend over and above what they could raise in taxes.
We may see this from a simple example.
Assume for a moment that a government wished to increase
expenditure significantly, and without increasing taxation for some
socially desirable purpose, for example pensions, state housing
provision. (That is, they intended to borrow to meet the expenditure.)
If this borrowing was on a large scale, the mechanisms that we
described above would mean that the country would lose gold. The
central bank would then have to tell the government that it had to
choose one of two courses: either (a) stay on the gold standard or (b)
abandon the socially desirable expenditure
Before 1914 governments always chose (b). That is, they thought that the
exchange rate (staying on the gold standard) was more important than
social expenditure. Remember, governments of that period were under
little political pressure to increase social expenditure. In other words, since
45
there was little pressure on governments to spend (government spending

of only 10 per cent of GNP was normal, including all defence expenditure)
it was easy for them to commit the economy to the gold standard.
But after the First World War, governments were faced with increasing
demands to increase expenditure, partly because there was more pressure
from the electorate. Government expenditure was commonly 25 per cent
of GNP in this period. This made it much more difficult to stay on the gold
standard (see Chapter 7).
4.4 Rules for international and domestic policies: some

questions
Pause and think
You should pause here until you are quite clear about your answers to the next three
questions. The answers affect your understanding of other periods in the history of the
Do you think that it has ever been possible to establish a set of rules both for
international and domestic policies which, if all countries followed them, would lead
to stability?
Historically, have countries followed rules only when it was in their interests to do
so?1
Think about the situation in your own country at the moment. What would be
the advantages of fixing the exchange rate forever, and what would be the
disadvantages?
4.5 The British economy

First consider the table below and then read on.
GB Capital exports
CURRENT PAYMENTS
GB
CURRENT
A/C
SURPLUS
USA &
OTHERS
CURRENT A/C
DEFICIT
K FLOW
Figure 4.3 The pattern of British capital exports c.18751914
Pause and think

Were there some other factors which made the gold standard last so long?
What about the British economy?
What about the British balance of payments?
Think about how these played a part in providing financial stability for the international
economy.
46
We explore another
attempt to set up
a set of rules, the
1944 Bretton Woods
conference, in Chapter
11.
The position of the UK economy was very important. The UK was the
largest exporter of both goods and services and the greatest provider of
overseas investment; 40 per cent of the total, as late as 1914. The UK had
a balance of payments surplus; exports of goods and services exceeded
imports, and earnings from foreign investment exceeded new investment.
Pause and think
Do you think that if the largest trading country always had a surplus, the gold
standard could not have worked properly?
In what direction was gold and foreign exchange moving? What was the effect on
central bank reserves in the other countries?
How was it possible for the world to live with the UK surplus?
The point was the British surplus was continuously recycled. Look at
Figure 4.3 again. The UK had a permanent balance of payments surplus.
Therefore other countries, such as, in the late nineteenth century, the USA,
must have had permanent deficits.
Under the gold standard, a deficit country had to choose between
leaving the gold standard, as mentioned above, or accepting higher
interest rates and lower output.
The US growth rate would have had to be lower. But in reality, the
USA could always finance its deficit (i.e. pay for its excess of imports)
because it was always possible to borrow from the UK.
The UK was a free-trade country. The UK imported the bulk of its food and
raw materials. This meant that if a country borrowed from the UK, it was
relatively easy to obtain sterling to pay the interest by exporting to the UK.
In other words, in effect, the world was using a sterling standard, rather
than a gold standard.
Pause and think
Can you think of a later example where large balance of payments surpluses needed to
be recycled?
4.5.1 Confidence in sterling

Obviously if they were to use sterling, international traders and bankers
needed to have confidence that there was no possibility of its devaluation.
Sterling was as good as gold for three reasons.
First, the pound had been tied to gold for far longer than in any other
country; from 1717, with the exception of the Napoleonic War period.
Secondly, the British economy had a consistent payments surplus,
which meant that demand for sterling was consistently higher than
demand for foreign currency. This means that if the pound had been
floating, it would have floated upwards.
Thirdly, sterlings stability was ensured by Bank of England policy. The
most important objective of the Bank of England and the government
was to maintain the value of sterling. Monetary policy was extremely
conservative; the Bank would always act to curb inflation, for example.
Hence, the UK had the seal of approval. In the last quarter of the
nineteenth century the British price level was falling, and in the years
up to the First World War, it was rising at only 1 per cent each year.
There were no fears about the value of sterling before the First World
War.
47
It is not surprising that most countries held their foreign exchange reserves
in sterling rather than gold.
4.5.2 Joining the gold standard at the right time

A major reason why the gold standard worked was that countries did not
fix their currencies to gold until after the exchange rate had been stable
for some time. For example, Germany joined the gold standard in 1874,
the United States in 1879, Japan and Russia in 1897. All these countries
had a strong balance of payments for some years before they joined the
gold standard.
In other words, they started after their economies had adjusted to a
fixed exchange rate. They did not fix their exchange rate and then hope
that their economy would adjust to it. We can say that their exchange
rates had converged to a sustainable level. We return to the concept of
convergence in later chapters, where we consider the tendency of some
countries GNP and/for growth rates to equalise.
4.5.3 Crises and the gold standard

What we do not know is what would have happened to the gold standard
if there had been a serious financial crisis in one of the large economies,
say Germany. There is no guarantee that the gold standard would have
survived such a crisis.
The gold standard was suspended during the First World War (see Chapter
7). After the war it was difficult to re-establish the gold standard, and
when there was a massive financial crisis in Europe in the early 1930s,
the gold standard collapsed (see Chapter 8). The point to note is this.
Since there were no serious crises in Europe, the gold standard remained
unchallenged up until the First World War.
Summary
As we said at the beginning of this chapter, the gold standard worked
because:
There was strong trade growth which made it easier for countries to
fix their exchange rates. Trade growth made it easier to earn foreign
currency.
One country, the UK, had a persistent trade surplus. But this was not a
problem for other countries because the UK recycled the surplus.
There was a strong central currency, which was universally expected to
remain strong.
The gold standard could have been threatened if governments had
borrowed substantially, since this would have led to inflation. But
governments did not wish to borrow heavily.

Having completed this chapter, and the Essential reading and activities,
explain why businessmen and governments were determined to
maintain fixed exchange rates
outline what it was that allowed fixed exchange rates (i.e. the gold
standard) to be maintained
48
discuss whether the gold standard worked because central banks

followed a set of rules or for some other reason
explain how the flow of capital made it easier for the gold standard to
work, and give examples.
Pause and think
Consider the two questions below. You may want to return to them again later in your
studies.
Before 1914 what would have happened to the international economy if the UK had
stopped recycling its surpluses?
After 1918 what did happen to the international economy when the UK was no
longer able to earn large surpluses?
Questions
1. Why were exchange rates fixed before the First World War?
2. Explain the reasons for the stability of the international monetary
system before the First World War.
49
Notes
50
Chapter 5: The development of modern industry
Chapter 5: The development of modern

industry
In this chapter we examine why manufacturing grew so fast in the early
twentieth century and why American manufacturing developed in a
different way to the UK. Also we consider assembly-line production and
new organisational structures in industry. Both of these were American
developments.
Objectives
To:
show the nature of the modern business corporation and how it
developed in the twentieth century
explain how and why American industrial development took a different
character to either the UK or continental European models.
Learning outcomes
activity, you should be able to:
explain how far UK manufacturing became a model for other countries
explain why mass production first started in the USA
suggest and evaluate reasons why the US industrial structure changed
show how US industry differed from UK industry before the First World
War.
Essential reading
[ISBN 9780691139371] pp.1542.
[ISBN 0415199301 pbk] pp.7891, pp.12031.
Further reading
[ISBN 0807842028 pbk] pp.5163, pp.724, pp.958.
[ISBN 0582494230 pbk] pp.1219, pp.2530, pp.3841.
51
Introduction
In this chapter we see why the manufacturing sector expanded in the
late nineteenth and early twentieth centuries. We explain why American
manufacturing was not a copy of UK manufacturing, and why the
development of assembly-line production occurred first in the USA and
not in the UK or continental Europe. In the chapter, we also discuss
the development of new organisational structures in industry, another
American phenomenon of the period.
5.1 The early development of manufacturing

The UK was the first country to industrialise but did not maintain its lead.
Around 1870 the UK had the most industry and the second highest GDP
per head in the world (Australia had the highest). By 1914 the USA and
Germany surpassed Britain in terms of industrial output.
The biggest industrial power was the United States which as early as 1913
produced more than a third of world industrial output (Table 5.1). This
raises an important point. The fact that the UK was the first industrial
country did not predict that it would remain the most important. So if we
are interested in the UKs comparative economic decline in the twentieth
century, it would be important to look at the way the UK industrialised.
5.1.1 The characteristics of the UK economy in the late

nineteenth century
We must compare the characteristics of the UK economy in the early years
of industrialisation with the characteristics of other countries.
1870
1914
UK
32
14
USA
23
36
Germany
13
16
Other countries
32
34
Table 5.1 Percentage of world manufacturing production in 1870 and 1914
Pause and think

Which economic questions come out of Table 5.1? There are some interesting ones. Note
down one or two that occur to you before you read on.
Two questions come to mind:
Why did the USA and Germany grow faster than the UK after 1870?
What differences did policies make did they make the UKs relative
decline, and the USA and Germanys relative rise, faster or slower?
Britains GDP growth rate was much higher than it was before it
industrialised. However, its growth rate was lower than in other industrial
countries until the 1980s. This was primarily because Total Factor
Productivity (TFP) growth was low (see 1.5.4). The USA had a much
more favourable resource base than the UK, which was a big advantage.
Nevertheless, the TFP calculations suggest that Britain was doing less well
than might have been expected.
5.1.2 Social development

Current development economists use what is called a Human
Development Index (HDI). The HDI measures the quality of life, using
variables like life expectancy at birth and literacy (see Tables 5.2 and 5.3).
There are problems in using this sort of evidence, but although the UK
52
had a much higher per capita income than either the USA or Germany in
1870, its HDI index, although higher, was not proportionally as high as
the difference in income. The disappointing social development (HDI) in
Britain partly explains the US, and later German, catch up.
Life expectancy at birth
0.33
Education index +
Adult literacy +
Gross number in schools
0.33
GDP (Expressed in logs to take account of higher values)
0.33
Value of Human Development Index
100
Table 5.2 The derivation of the Human Development Index
UK
USA
Germany
GDP per
capita
$3,263
$2,457
$1,913
Life
expectancy
48 yrs
44 yrs
36 yrs
Literacy
rate
64%
75%
80%
HDI
index
0.53
0.45
0.39
Table 5.3 Some components of the Human Development Index in 18701
Activity
HDI measures education, among other things. Why might deficient education have led to
slower growth in Britain?
Three possible effects are:
Workers whose literacy and numeracy skills are weak are likely to be
less flexible and slower to learn new skills.
The GDP in 1870 is

expressed in terms of
1990 US dollars per
head of population.
This means that the
GDP in 1870 is broadly
comparable to the
purchasing power of
GDP in 1990.
The type of education might have been important. In Britain there

was less secondary and tertiary (university) education in science and
technology than in Germany and the USA. Secondary and tertiary
education in the UK was more likely to be in the humanities and aimed
at an elite who took jobs in the colonial service or the professions.
The main route to industrial training in the UK was by apprenticeship.
This was fine as long as UK industry was changing relatively slowly (as
in the nineteenth century). But in the twentieth century, it made the
acquisition of new skills more difficult since the younger workers were
taught by older workers with older skills.
Note that these reasons became more applicable in the twentieth century.
This is because industry became much more technically and scientifically
based.
5.1.3 Government trade policy

Economic policy in the UK was markedly different to policy in other
countries. The government did not intervene very much in the economy
before the First World War. In other countries there was more intervention.
In the UK there was no policy to aid particular industries, and also there
were no tariffs to protect industries that were just starting, so-called infant
industries. The reason was that the UK regarded itself as a trading country
for which tariffs were inappropriate.
53
5.1.4 The size of the agricultural sector

The main difference between the UK and the other industrial countries
was in the proportion of the labour force in agriculture (15 per cent in the
UK in 1870, compared with about 50 per cent in most other rich countries.
See Table 5.4).
UK
USA
Germany
France
GDP per capita

$3,263
$2,457
$1,913
$1,858
% in agriculture
15
50
50
49
Table 5.4 Income levels and structure of employment in 18702 ($1990)
Pause and think

Note that in Table 5.4 there seems to be an inverse relationship between GDP per capita
and the proportion of it in agriculture. If you are interested, have a look at similar data for
countries today and see if such an inverse relationship holds.
Compared with continental Europe, but not with the USA, agriculture
became capitalist in Britain much earlier. As early as 1800 most British
farms were quite large. They were worked by wage earners not peasants.
This had important implications for profits and investment.
Shifting labour from agriculture to industry is an important source of
economic growth. The problem was that in the UK this process had been
more or less completed by 1870 (see Table 5.4).
The UK could not continue to grow by transferring labour from agriculture
to industry; it could not be done twice. Continued growth could only come
by increasing productivity within industry and services, for example by the
development of high-technology industries for which the UK was not as
well equipped as the USA or Germany.
Of course the UK remained ahead in the export of manufactures. But this
was not because UK industry was more productive than in other countries,
but because the UK was the first industrial country and because the
government followed policies that maximised trade, such as free trade.
This explains the large part of the UK economy that was devoted to
textiles, far greater than in other countries. Textiles were not a high tech
product, so dominance in textile exports did not predict that the UK would
still dominate trade in industrial products in the twentieth century. In fact,
by 1913, Germany was close to catching up with UK manufactured exports
(see Chapter 6).
Pause and think
If country A has lower labour productivity in exports relative to a competing country B,
how can country A remain competitive?
Country A can remain competitive by paying lower wages than country
B, which will offset the lower productivity. So, other things being equal,
we would expect to see UK wages in the export industries that competed
with the USA and Germany (this was not all British exports, of course) to
decline relative to wages in those countries.
54
The GDP in 1870 is

expressed in terms of
1990 US dollars per
head of population.
This means that the
GDP in 1870 is broadly
comparable to the
purchasing power of
GDP in 1990.
Pause and think

In the last chapter we said that food prices in the UK fell after 1870 because of cheap
imports from the regions of recent setlement. How would this have affected the position
of British workers whose wages were held down by foreign competition?
Lower food prices helped offset lower money wages. Food was an
important part of consumption. Hence, real wages (money wages divided
by prices) could still rise even if money wages stayed constant.
5.2 The growing strength of US industry

A number of factors explain the growing strength of American industry
after 1870. We concentrate on five:
new ways of organising firms
the size of the domestic market
new industrial structures
managerial capitalism
the use of new technology.
5.2.1 New ways of organising firms

As early as 1850 a few American industries had been different to those
in the UK. These industries were part of what was called the American
System of Manufactures.
The early American entrepreneurs had to solve the problem of a shortage
of skilled labour. They partially solved this problem by reducing the
amount of craft skills needed by subdividing tasks.
Each person made one part, of say, a clock and they used labour-saving
machinery as much as possible.
The parts were then fitted together.
Because the entrepreneurs were also short of capital, the quality of the
machines used in the early factories in the USA was very poor.
American consumer products, like clocks, were cheaper than their UK
equivalents. However, in the middle of the nineteenth century, they
were of much poorer quality than UK goods, which were made and
assembled by skilled labour.
These methods only applied to a limited range of industries: guns,
clocks, and furniture. The real beginnings of mass production came much
later, towards the end of the nineteenth century. Then several American
industries were using the assembly line to produce goods. This gave
very large economies of scale (see 1.5.11).
The essence of the assembly line was a strict division of labour. Instead of
a worker carrying out a series of tasks on, say, a workbench, each worker
on the assembly line carried out only one task. The product then moved
along the assembly line to the next worker who performed a different task
but still only one task. This had two advantages:
Each worker had the use of a large amount of capital equipment, which
increased his (or very rarely her) output.
55
Because they had only one task, each worker could become very
proficient at it. Nor did the workers have to spend time looking for
parts, tools etc. Hence there was an increase in output per worker
(labour productivity rose). Moreover, because each worker only had to
learn one task, it was easy to train them, which reduced the demand
for highly skilled labour, which was very expensive in the USA.
Mass production first started in industries where there was already a
continuous process, for example: paint making, sugar and food processing.
A famous early example was meat packing (canned food), which started in
Chicago.
This demonstrates that mass production was used long before its most
famous example: the Ford Car plant, which was built to manufacture
the Model T Ford in the early twentieth century. It was the most famous
example of the work of Frederick Taylor who was the key figure in the
development of mass production. (See below.)
5.2.1.1 Fords assembly line
The Model T Ford car is a classic example of a mass-produced consumer
product. Fords idea was to minimise costs by producing a very large
number of identical products, even in colour, which was black. What Ford
realised was that the same product would be bought for different reasons.
Many cars were bought by farmers and small-town businessmen, for
example.
The Model T Ford car could be both a consumer product (to take you and
your family on a picnic) and a factor of production (to take a sack of
potatoes to market). This meant that the cars could all be the same. In
turn, this allowed Ford to produce the high volume necessary to minimise
costs.
Figure 5.1 Model T production, before and after the assembly line, 1914
The introduction of the assembly line to the Ford plant in Detroit increased
labour productivity by about twelve times. But it was not easy to get the
assembly line to work. It took Henry Ford three years after he started
to produce the Model T to perfect his assembly lines. There were three
variables which had to be optimised:
the layout of the plant
the speed at which the line moved
the speed at which the workers worked.
The subdivision of production required a very high degree of management
control. Tasks had to be identified, incentives paid and quality maintained.
Time and motion studies, called scientific management, were common
56
in Ford plants. This was partly the work of Frederick Taylor and his
assistants. Taylor had been instrumental in optimising the layout of
mass production plants for many years. There was also another result
of his work. Before the onset of mass production, it had been difficult to
show those workers who worked hard and those who did not. But mass
production made it easy to see who was a good worker and who was not.
The less good workers were dismissed immediately.
5.2.2 The size of the domestic market

Demand was extremely important to American industry. By 1900 the
American population was already double the size of that in the UK, and
individual consumption levels were 50 per cent higher than in the UK.
That means that the consumer market in the USA was three times the
size it was in the UK. Obviously, the ability to mass-produce products
depends on the existence of a large market for those products, especially
in decreasing cost industries. In economic jargon, the lowest point of the
average cost curve only occurs at high levels of production.
5.2.3 A new industrial structure

In the nineteenth century the USA had a large number of firms which
were all in competition with each other, but by the early twentieth
century a new industrial structure had developed. Firms in the USA were
large and instead of perfect competition, either a very small number of
trusts (a big financial monopoly) controlled a whole industry, or firms
made agreements with each other which restricted or even eliminated
competition. In contrast, the old competitive structure was still common in
the UK.
A small number of firms controlling an industry is an oligopoly,
agreements between such firms are called cartel agreements. Remember
that the USA had tariffs on industrial imports. This made anti-competitive
agreements easier to make.
Pause and think
Why should tariffs make it easier to obtain agreement on competition rules within a
country?
Tariffs push up prices. As Kenwood and Lougheed point out, US tariffs
on manufactures in 1900 were at levels of up to 50 per cent. This was
a high degree of protection. In a competitive market where there is
tariff protection, local firms expand production to fill the gap left by
now-expensive imports. But it is in the interests of the local companies
to restrict output, so that prices will be high. The winners from a tariff
are the local firms, their shareholders and, possibly, their workers. The
losers are foreign producers and domestic consumers. There are many
contemporary examples of this. For example, President Reagan allowed
a (temporary) tariff on steel imports into the USA. The winners were the
US steel industry. The losers were all users of steel, that is, the automobile
industry.
On the other hand, a tariff makes it easier to get local firms to agree to
behave in a competitive manner not to restrict production and raise
prices. There is no guarantee that they will behave in this way, however,
once the tariff is in place.
57
5.2.4 Managerial capitalism

The new industrial structure that emerged in the USA required managerial
innovations.
When there were a large number of small and highly competitive firms,
management was not very difficult. If the firm was performing well it
made profits; if it performed badly it made losses. We could say that
firms were regulated by the market.
Large uncompetitive firms cannot be regulated by the market. Think
about the economics of the firm. At its simplest, a competitive firm is
faced with a perfectly elastic demand curve, but an oligopolistic firm is
faced by a downward-sloping demand curve.
The new structure required that managers examine the internal
organisation of the firm and make the firm as efficient as possible.
In the 182080 period, the people who owned firms were also the people
who controlled them, often, members of one family firm. It is not true,
however, that Britain was dominated by family control and the USA
by managerial capitalism. British industry was quite dynamic. There
was more family control of companies in Britain, but only because the
American companies had on average been set up more recently than
British companies. As a consequence, the stock market was less important
in Britain than in the USA.
However, the stockholders did not control the firm. The big US corporations
were run by managers who controlled the business and made decisions.
This is what managerial capitalism means. The change in the way the
firms were managed led, in many firms, to a change in objectives. Profit
might not be the main objective. Increasing the size of the firm might be
more important.
Pause and think
How do shareholders nowadays encourage managers to put profits first?
There are a number of ways of encouraging this. One popular method is to
make managers salaries partly dependent on profits. This can be done by
offering bonuses or giving managers the option to purchase shares at an
advantageous price.
5.2.5 Cheaper inputs

Managerial capitalism was not the only reason for the growth of American
industry. The price of inputs fell. For example, in the late nineteenth
century in Europe, machine tools were made in-house, by skilled workers,
not on the production line.
However, in the USA large firms, mass-production methods and
professional management led to specialist large machine tool companies.
This meant lower prices for equipment. Similarly electricity was cheaper in
the USA.
5.2.6 New technology

Finally, production lines and large-scale plants needed new technology.
The USA led in this respect as well. The production line could not have
operated without electric power, for example.
58
5.3 Germany and catch-up with the USA

Why couldnt these changes be replicated in Europe, in particular in
Germany?
In some ways, the German economy was more like the US economy than
was the UK economy.
There were large vertically integrated3 firms. Germany was the
dominant producer of chemicals, for example.
Germany had created a highly skilled labour force.
Germany was also investing in education and research laboratories
just like the USA, but unlike Britain.
In theory, Germany should have been able to catch up with the USA.
But even at the beginning of the twenty-first century, German industrial
productivity was still below that of the USA.
Vertically intergrated
means that the raw
materials, the research
and the marketing
as well as the actual
production all come
from within the same
firm.
Pause and think

Why do you think that it took so long for Germany to catch up?
Two reasons have been suggested:
The USA had an abundance of resources.
The USA had a larger domestic market.
The first argument is related to the abundance of resources in the USA
compared with Europe. Nowadays, the location of raw materials is not
very important. In the main, they are not a major cost for industry and,
most importantly, the cost of transport by large ships and pipelines is low.
This was not true in the nineteenth and early twentieth century.
As a result of their abundant resources US companies had lower prices for
inputs such as iron ore, coal, timber, oil and agricultural products. This
gave US industry an absolute advantage. The resource question is one
reason German industry could not achieve the same levels of productivity
as American industry at the time.
The second argument is that the USA had a well-developed market for
consumer goods. We have already seen that the market was larger and the
consumers richer than in either the UK or Germany.
The USA was the first mass-consumer society. By the late 1920s, most,
though not all, Americans were able to spend something on leisure and on
new mass-produced consumer durables, which had become much cheaper.
As early as 1914 Kelloggs cornflakes, Levi jeans and numerous other
brands had become familiar to US consumers. Advertising also became
important, as did the cinema, as a guide to the good life. By the late
1920s, 80 per cent of households in the USA had consumer durables
such as radios and refrigerators. The majority of families had cars. This
was far above the level in any other country. One reason it was possible
was because of consumer credit. Most families in the USA could acquire
consumer durables if they were prepared to go into debt.
59
5.4 UK industry
We have seen that the UK economy was different. One consequence was
that firms in the UK operated on a much smaller scale than American
firms. Most British industries had far more firms than the same industries
in the USA.
Pause and think
Why did British industries have so many more firms than the equivalent ones in the USA?
It is easy to say the UK family-owned businesses would not give control to
managers, like in the USA. But this would be a travesty. Many companies
did give control to managers. And some US firms refused to do so. They
remained in family control. But remember the context. UK markets were
more segmented than American markets, partly because exports were
more important to UK industry than to the USA. So, on average, the firms
were smaller in the UK. The USA also had a large, protected domestic
market, quite homogeneous in tastes, which allowed greater economies of
scale. Remember also, the UK was considerable poorer than the USA in the
early twentieth century,
There is another point. We also know that the UK had more skilled
workers than the USA and they were paid less. Consequently, it was
cheaper for UK firms to use skilled workers to make small-scale, highquality, niche products as opposed to large-scale, mass-produced goods.
Summary
Mass production began in the USA. It was associated with changes in
finance, management and in the organisation of the firm. It was aided
by tariff protection. British industry did not have the same structure, had
no import protection, and in some respects the UK had an inappropriate
educational system.
Germany had a strong industrial structure and appropriate education, yet
still it did not match levels of productivity in the USA. This was because
the US resource environment and the size of the market were much more
favourable to large-scale production. Consequently, Germany found it
impossible to catch up in this period.

Having completed this chapter, and the Essential reading and activity, you
should be able to:
explain how far UK manufacturing became a model for other countries
explain why mass production first started in the USA
suggest and evaluate reasons why the US industrial structure changed
show how US industry differed from UK industry before the First World
War.
60
Questions
1. How far was the development of the UK economy in the nineteenth
century unique? Was the UK economy well placed to achieve high
productivity growth in the twentieth century?
2. Does an increase in bureaucracy in giant non-competitive companies
lead to more or less efficiency?
3. What happened to American industry when it was faced with new
technology in the late twentieth century? Were American companies
flexible enough to cope, for example, with Japanese competition?
61
Notes
62
Chapter 6: Britain trade and empire

This chapter completes our survey of the international economy in the
years from 1870 to 1914. Two topics are covered.
First we examine the gains from trade in the years before the First World
War, using the UK as an example. The UK remained important in the
international economy before the First World War, even though it was no
longer the largest economy.
Second we consider the significance of imperialism. In particular we ask:
was the development of poorer economies held back because of their
colonial status?
Objectives
To:
round off our discussion of the pre-1914 international economy
explain the continuing importance of British trade
consider the effects of imperialism and Empire on the international
economy.
Learning outcomes
explain how the UK remained the most important country in the
international economy
discuss why economic imperialism was more characteristic of the other
industrial countries than it was of the UK
discuss whether the colonies were disadvantaged compared with
independent countries
outline why the UK remained a free-trading economy rather than
a tariff-protected one, and say why this was beneficial to the
Essential reading
[ISBN 0415199301 pbk] pp.133147.
Further reading
edition [ISBN 0745009352 pbk] pp.1317 and pp.90113.
[ISBN 0582494230 pbk] pp.199202.
63
Introduction
This chapter examines gains from trade in the years before the First World
War, using mainly the example of the UK. We saw in Chapter 5 that the UK
economy was overtaken by the USA and Germany during the period from
1870 to 1914. Nevertheless, the UK remained the most important trading
country.
6.1 The UKs share of world trade

Table 6.1 shows the share of the world trade in manufactures from the
four most important exporting countries before and after the First World
War.
USA
GER
UK
FRA
1899
12%
22%
33%
14%
1913
13%
27%
30%
12%
1929
21%
21%
23%
11%
Table 6.1 World export of manufactures
Pause and think

What does the table show you?
The UK accounted for 30 per cent of world manufactured exports in 1913
and was still the worlds biggest exporter of manufactures in 1929 as it
had been throughout the nineteenth century. No other country has been
as important in international trade for such a long time. For comparison,
Japan was the worlds largest exporter of manufactures in the 1990s yet
only accounted for 13 per cent of world trade in manufactures.
Pause and think
In 1913, the UK produced only 14 per cent of world industrial output compared with
Germany, which produced 16 per cent, and the USA, which produced 36 per cent. How
then did the UK maintain such a strong export performance and protect its overseas
markets from German and US competition?
6.2 The pattern of multilateral settlements

Look at the diagram below. This is a very simplified version of the diagram
in Kenwood and Lougheed, 99, also found in Alford, 40. It shows the
international pattern of settlements in 1910. Settlements means the net
flow of money paid or received after the net flow of imports and exports.
In other words, say a country exports 15 million worth of goods and
imports 10 million of goods. The settlement for that period is +5
million.
If we make simplifying assumptions (no manufactured exports from
developing countries and no primary product exports from industrial
countries) we can reduce world trade at this time to three groups of
countries:
the UK
the other European countries plus the USA
the primary producing countries. The most important of these were
Russia, Argentina, India and Canada.
64
UK
PPS
USA/W Europe
Goods and services
Money
Figure 6.1 The world pattern of settlements c. 1910
Pause and think

Can you see three important relationships illustrated in Figure 6.1?
The UK had an export surplus with the primary producing countries.
UK exports of manufactures, shipping and financial services and
interest on previous investment were greater than UK imports of food
and raw materials.
The other industrial countries had an export surplus with the UK. Their
exports of manufactures to the UK were more than UK exports to them.
The primary producing countries had an export surplus with the other
industrial countries, mainly of food and raw materials.
Stated the other way round, the primary producing countries had a deficit
with the UK, the UK had a deficit with other industrial countries, and the
other industrial countries had a deficit with primary producing countries.
6.3 UK imports: tariff protection or free trade?

There was a great deal of pressure in the early twentieth century for
the UK to abandon its free trade policy and, instead, introduce tariffs.
Remember, the UK was the only major industrial economy that still
operated a free trade policy, so other countries could sell more freely to it
than it could sell to them.
Pause and think
What would have been the consequences for the international economy if Britain had
introduced tariffs?
Look at Figure 6.1 and try and think this through.
If there had been tariffs in the UK other industrial countries would
have exported less to it. After all, that would have been the point of the
tariffs in the first place. So exports to Britain would have fallen.
These countries would have earned less foreign exchange from their
exports to the UK.
These foreign exchange earnings were used to buy imports from the
primary producing countries. So as exports to the UK fell, the other
industrial countries would have imported less from the primary
producing countries (see Figure 6.1).
In turn, the primary producing countries would have exported less, so
their foreign exchange earnings would have fallen.
This may be put another way. Some of the exports of UK goods to India,
for instance textiles, were effectively paid for by German exports to the
UK; these in turn were paid for by Indian exports to Germany.
65
Pause and think

What would have happened to UK exports to India if it had imposed tariffs on German
imports?
If the UK had imposed tariffs on German imports into the UK the Germans
would have bought less from India, in turn this would have given India
less foreign exchange and UK exports to India would have fallen.
6.4 The UK balance of payments surplus

Before the First World War, the UK was a net importer of goods, but a
net exporter of services. In addition, there were large profits on previous
overseas investments. So, before the war, the UK was always in surplus. As
we saw in Chapter 4, if one country has a big surplus this causes problems
for the international economy unless that country does two things.
Pause and think
What are these two things a country must do to avoid a large surplus, causing problems
for the international economy?
Either the country has to lend abroad or offer greater access to its local
market. Otherwise there will be a shortage of liquidity (foreign currency)
in the world economy and a shortage of development funds. In the early
twentieth century period the UK export surplus was recycled that is
exported overseas.
Pause and think
How could the UK import more goods than it exported yet still have a balance of
payments surplus on current account?
The current account is made up of trade and payments from services and
from profits from previous investments (invisibles). Britain had a surplus
of exports over imports of invisibles and this surplus was larger than the
deficit of imports over exports of visible trade.
Pause and think
Why did the UK have such a large inflow of financial receipts from the rest of the world?
As we have seen, the UK was investing abroad during the whole period
from 1820 to 1914. The inflow of profits (plus services) kept the current
account in surplus.
Activity
What do you think happened later, after 1918, when the UK surplus fell? Try to trace
through the logic following the end of the British surplus.
There were major dislocations in the international economy during the
First World War.
Britain lost many overseas markets.
This meant that it did not have a large surplus so its lending fell.
The only country with a large surplus was now the USA, but the US
economy was very different to the UK economy.
These developments led to serious dislocations in the international
economy (see Chapter 7).
66
6.5 Long-run issues

The position of Britain depended on exports of manufactures to primary
producing countries. This meant that there was no great demand for
high-tech goods and the UK did not produce much of these before 1914.
But, after the war, the markets for traditional British exports to primary
producing countries fell. This was partly because of import substitution in
the importing countries. Also it was partly because other countries such as
the USA and Japan, took over this trade (see Chapter 7).
Pause and think
Was the UK wrong to rely on traditional exports?
Should the government have taken measures to encourage the development of hightech industries in Britain before 1914?
To change the economy so that the UK produced more high-tech goods
would have required tariffs. Britain would then have looked more like
the German economy, which, as we have seen, did develop sophisticated
industries behind tariffs. The key question is which path would have
maximised GNP? As you decide on your position, keep the following points
in mind.
Did the concentration on traditional trade and services make the
UK population richer or poorer than would have a different sort of
economy?
Remember, free trade allowed the UK to purchase everything it wanted
in the cheapest markets.
If there were benefits of tariffs, they would come in the long run. The
benefits of free trade came in the short run.
Pause and think
How would the British have known that they needed to change the structure of the
economy?
How are such decisions made in a free-enterprise economy?
The simple answer is that it was difficult for people at the time to see
that there was something wrong with the UK economy. A free-enterprise
economy changes through price and profit signals. If the economy is
concentrating on the wrong industries, they will be unprofitable. Profits
are the signals that tell the entrepreneurs that they need to invest in new
industries. But the UK export industries were doing quite well before the
First World War. They were not unprofitable. Hence, there was no political
demand for tariffs to help create new industries.
The big problem for the UK economy came only after the war. So for an
entrepreneur to know that he was investing in the wrong industry, he
would have to know what the effect of the First World War was going to be.
6.6 The economic costs and benefits of empire

The period up to the First World War was the peak of the European
empires, of which by far the most economically important was the British
Empire. The colonies were markets for European manufactures and
provided primary products in exchange. This meant they were part of an
international division of labour. With the exception of the regions of recent
settlement (e.g. Canada, Australia, New Zealand) few of the colonies
developed very fast before the First World War or for a long time after.
67
Pause and think

Did this international division of labour restrict the growth of the colonies?
Certain economic costs of being colonised are frequently mentioned and
these are listed below. There are also important non-economic costs, such
as the loss of liberty, but these are not considered here.
Distorted trade pattern: The colony might be made to purchase
imports only from the colonial power and made to sell exports only to
the colonial power, possibly at higher prices for imports and/or lower
prices for exports than could be obtained elsewhere.
Loss of ownership of land and other resources.
A financial burden: The colonies were often taxed to pay for
military occupation. Police, colonial administration and other
expenditures were often of little use to the colonised people.
Enforced labour: This was on farms, in mines, in other countries as
migrant labour. This was often made necessary by new taxes.
Frequently mentioned benefits of being colonised include the following:
rule of law
release from a servile social system
better education and for the lucky few, travel abroad
capital and new investment, increasing incomes and employment
agricultural development leading to better food security and raw
materials for new industries
new exports allowing output to rise
new consumer products, better transport and other infrastructure.
6.7 Trade aspects of empire

Most of the growth in colonies was identified as trade-led. This often
meant the creation of plantations and mines which were tied to trade but
which did little for the general development of the country. Sometimes the
new investment was so isolated from the rest of the country that it became
an export enclave of resources, output and money that was cut off from
the rest of the country. The rubber industry in Malaya (Malaysia) is an
example. Rubber plantations employed immigrant Tamils (from India)
serviced by immigrant Chinese. Malay GNP rose but very little accrued to
the native Malays. The effect of the enclave on the rest of the economy
usually depended on how much tax revenue it generated that could be
spent elsewhere.
Plantations did increase income in the colonies, of course, but this raised
another problem. European manufactured imports were cheaper than local
handicrafts, which led to the collapse of the local handicraft industry.
The most famous historical example of this is the effect of UK textile
imports on domestic Indian cotton textile production. This situation
may be contrasted with that of the less developed countries that were
not colonies. The best examples of these were in Latin America, where
most countries had been Spanish or Portuguese colonies but had
become independent in the early nineteenth century. These countries
had introduced tariffs against some European imports, which colonies
could not do, and by the later nineteenth century, some, including Brazil,
Argentina and Chile, had much more diversified economies. They had
68
a large export sector, but they also had more industry. There is some
evidence, therefore, that being a colony may have held back development.
Now try the next activity.
Activity
See if you can write answers to these two questions.
Was the fact that they were colonies the main reason for the slow development of
these countries?
Would India have been much richer in, say 1914, if it had been independent, for
example?
Think about the conditions that led to economic growth in Europe (see
Chapter 2). Do you think that many of these countries had the social
capability to develop, whether they were independent or not? In other
words, colonialism held back these colonies only if it retarded their social
capability.
The second question is much more difficult. Interestingly, many Indian
historians, in the main, no longer think that Indias colonial status to 1947
was the cause of its problems. This may be because the Indian economy
since 1947 has been very successful, with high growth rates. A large
proportion of the Indian population are still poor but India was very poor
in, say, 1900. It was also much poorer than Britain was in, say, 1820.
Development can be a long, slow process.
6.7.1 Did British colonies suffer a trade cost?

Colonial trade was not as important for other colonial powers as it was for
the UK. Germany, France, the Netherlands, Belgium, Spain and Portugal all
had overseas empires but only the UK had a large trade with its colonies.
Most of the other imperial powers restricted their limited colonial trade to
the mother country.
For the UK, empire trade was important, even though the UK always
sold much more outside the Empire than inside. And remember also that
important Empire markets included rich countries such as Canada and
Australia. Trade with many of the tropical colonies was very limited.
Pause and think
Do you think that the UK government used its political influence in its colonies to reserve
the markets for UK exports?
The short answer is no. British colonies were free to purchase goods from
any country, unlike the colonies of other countries.
Pause and think
If there were no compulsion for the colonies to buy UK goods, why did they buy British?
The first answer to the question above is because the UK was the worlds
cheapest producer of the main goods that primary producing countries,
including the colonies, wanted to import. Given a choice, the colonies
would still buy mainly UK goods.
Second, part of the UK success in the primary producing countries was
because of the UKs early start in industrialisation. For example, both the
Indian and the Argentine railways were British designed and equipped
and employed British technicians. Hence, they were likely to continue to
reorder British equipment. This is an example of path dependency.
69
Third, free trade worked against new competitors becoming established

in the colonies themselves. The main potential threat to exports from the
UK came from import substitution rather than from foreign competition.
The UK insisted on free trade (e.g. in India), so that made it very difficult
for the colony to develop industries in competition with UK imports.
(Particularly Indian production of textiles.) The insistence of the UK that
their colonies remained as free trading countries has been called the
imperialism of free trade.
Pause and think
Was the lack of tariffs the only, or even main, reason why the colonised countries did
not develop very fast? Did free trade hurt them?
When do you think India began import substitution in cotton textiles?
The answer to the first question is probably yes. New industries were
unable to get started against the unhindered competition of wellestablished UK imports. The second answer is that during the First World
War British shipping had to be concentrated in the North Atlantic so that
UK textile exports to India could not be transported. In effect, the shipping
shortage had the same effect as a tariff, which the Indian textile industry
had wanted for some time, but had not been able to obtain.
In this chapter we have suggested that the answer to the question about
the economic importance of empires is rather complicated. There is
another point to remember, however. Most less developed countries
could not have been independent countries at that period of history.
Other European countries, for instance France, Germany, the Netherlands
and Portugal, as well as the USA, did restrict trade. Imports into their
territories were reserved for the mother country, which meant that the
UK could not export to them.
Pause and think
Can you think why Britain ran a free-trade Empire and other countries did not?
If, say, France had allowed people in Indo-China, present-day Vietnam,
Cambodia and Laos, to import from any country they wished, people
would have purchased from the UK, which was the cheapest producer. As
long as countries, colonies or not, practised free trade, the UK would be
able to export to them.
But even if countries had not been part of the British Empire they would
probably not have been independent, but colonies of another country, in
which case the UK would not have been allowed to trade with them. Very
few countries managed to avoid becoming colonies between 1820 and
1914 Abyssinia (now Ethiopia), Persia (now Iran), Siam (now Thailand)
and Morocco (which was finally colonised in the 1920s).
Pause and think
What would the UK government have done if there had been a danger of losing the
colonial markets?
This is what happened in the 1930s. The British government response was
to negotiate trade agreements leading to Imperial Preference within the
British Empire. The 1930s was a period when world trade was seriously
depressed, reducing British markets in other countries.
70
Summary
In this chapter we have suggested that the pattern of British trade
maximised income in the short run. Changing the British economy to
include more high-tech industry, would have involved short-term welfare
losses. We have also suggested that the UK did not exploit its colonies,
in the sense that they forced them to purchase British products. This
was not because of ideology, but because, given the choice, the colonies
would have purchased British manufactures anyway. They did not need to
be compelled to do so. Colonies of other countries could not buy British
manufactures. Hence, British colonies had an advantage and it was
important that they were in the British Empire and not another empire.

explain how the UK remained the most important country in the
discuss why economic imperialism was more characteristic of the other
industrial countries than it was of the UK
discuss whether the colonies were disadvantaged compared with
independent countries
outline why the UK remained a free-trading economy rather than
a tariff-protected one, and say why this was beneficial to the
Questions
1. How was it possible for the UK to remain the most important country in
the international economy before the First World War? How important
was the British Empire to Britains pre-eminence in trade?
2. Assess the benefits to (a) the UK and (b) the international economy of
the UKs policy of free trade before the First World War.
3. What were the main economic advantages and disadvantages of
colonial status in the early twentieth century?
71
Notes
72
Chapter 7: The First World War and the international economy
Chapter 7: The First World War and the

The first part of the chapter is about the direct effects of the First World
War on trade, international finance and the internal finance of the main
countries.
The second part is about the medium-run consequences of the war,
particularly the poor performance of the international economy after
1918. We look at:
changes in international trading patterns and capital flow
the effects of the war on the primary producing countries
how the war affected exchange rate stability and what post-war
political problems were created.
Objectives
To:
demonstrate how the war affected economic and financial systems
analyse the effects of war on different types of country
evaluate the long-term economic problems caused by the war.
Learning outcomes
explain how the war was financed and the long-run economic problems
this led to
make an argument about why there was a high level of international
debt and why it proved so difficult to eradicate
give reasons why fixed exchange rates were difficult to establish.
Essential reading
University Press, 2010) [ISBN 9780521708395] pp.1349 and pp.14356.
[ISBN 0415199301 pbk] pp.17092.
Further reading
[ISBN 0415250633 pbk] pp.830 and pp.4654.
[ISBN 9780195307559 hbk] pp.2438.
73
Introduction
The First World War began in August 1914 between France, the UK,
Russia, Belgium and Serbia (the allies) and Germany and AustriaHungary (the central powers). Other countries became involved Italy,
Romania and Portugal joined the allies and Bulgaria and Turkey joined
the central powers. In 1917 the USA finally joined the Allies, and Russia
collapsed into revolution.
It was called a world war because fighting had spread to the colonies;
countries such as India, Australia, New Zealand, Canada and the French
colonies contributed large numbers of troops. Japan was also involved,
although only to a limited extent.
The war was the first total war. It involved, in some way, most of the
population of the main protagonists. Technical change (e.g. the invention
of the machine gun, the submarine and heavy artillery) meant that it was
difficult to achieve a quick result. There were also very heavy casualties
about 10 million military deaths and possibly another 10 million from the
diseases and hunger that accompanied the war. At the end of the war there
was also a worldwide influenza pandemic which probably killed 50 million
people.
The war had a number of economic effects. The scale and duration of the
war meant that governments had to learn how to shift resources from
peacetime to wartime use, how to manage the finance and pay for the war.
Governments had to take control of some parts of the economy. The first
part of the chapter looks at these challenges.
7.1 War economies and the direct effects of the

First World War
We look at five economic aspects of the war:
inflation
government intervention
supply problems
trade and import substitution
borrowing.
7.1.1 Inflation
In wartime an economy creates more purchasing power than goods.
Pause and think
What does the increase in purchasing power, but not in goods, lead to?
In economic terminology we say there is usually an inflationary gap.
This is because workers are paid to produce armaments which are not
consumed by the workers themselves. If the inflationary gap is not closed
it leads to a rise in prices. During the First World War, governments had
neither the will nor the knowledge to close this gap so most countries
experienced rapid inflation. Now try the next activity.
Activity
Why did many governments print money even though it created inflation? Why didnt
they increase taxes instead? See if you can evaluate the two options before you read on.
74
The priority was to raise money as quickly as possible.

Governments tried raising taxes but it is difficult and slow whereas
inflationary finance is quick and easy.
But prices might rise faster than wages causing real wages and
therefore real incomes to fall, in turn causing discontent.
Some countries imposed rationing and price controls on food.
Other countries (e.g. Germany and Russia) were unable to prevent real
wages falling, with disastrous political circumstances.
7.1.2 Government intervention

In the early stages of the war, 191415, most governments did not want to
intervene in the economy because they thought that the war would soon
be over. This was because they did not appreciate the defensive power
of modern weapons. Nor were governments sure that they could borrow
indefinitely. They decided that the best short-run policy was to intervene
as little as possible in the economy, so as not to undermine the free-enterprise
system once the war was over. This was to be called business as usual.
Pause and think
What difference do you think it would make to government policy-making if a war were
expected to last:
a few months
four years?
The economic needs of a short war can be met using temporary measures.
Supplies can be switched from current production or from stocks. A long
war needs new investment in factories to maintain output and to replace
those called into the armed forces. Hence a long war needs planning.
7.1.3 Supply problems

During the war all countries experienced shortages of nearly everything,
including armaments. Food was in short supply in many countries. The
price of food and other essentials rose, in some countries leading to
civilian unrest. In order to prioritise the supply of essentials, governments
were forced to intervene. Eventually most governments controlled (not
always very efficiently) large parts of the economy, including all trade and
shipping, railways, civilian consumption and the production of armaments.
Pause and think
Why cant war supply problems be resolved by the market mechanism of price changes?
There are major structural changes that must be met in wartime due to
huge increases in the demand for certain products. Supply cannot adjust
quickly so leaving it to market forces would mean that prices would
fluctuate wildly, causing problems.
At the end of the war the USA and the western allies relinquished control
of their economies as quickly as they could. The defeated central powers
were in a chaotic state of revolution and disintegration; government
intervention simply fell apart.
75
7.1.4 Trade during the war

The war broke up pre-1914 trade patterns. Try the next activity.
Activity
How was Latin America affected by the First World War?
Think about this for a few minutes. Remember, before 1914 Latin America was an
important market for UK exports. Once you have formed an opinion, read on.
During the war the UK was unable to export to Latin America because
British resources were needed for the war effort and shipping was not
available for exporting.
Some countries were able to replace UK imports with domestic
production import substitution.
The United States was not a belligerent nation until 1917 and was able
to take over many of Britains Latin American markets.
Similarly Japan, whose economy was not fully committed to war, was
able to increase its exports to south-east Asia at the expense of Britain.
Unless Britain could regain these markets after the war, the UK
economy would face serious problems.
German trade was also seriously disrupted during the war. Germany was
the second most important producer of high-tech goods after the USA,
but it could not sell outside Europe because of a UK blockade and could
not sell to France, Italy or Russia because they were enemies. In contrast,
the USA was the biggest beneficiary of the war.
Pause and think
Why did the USA benefit the most from the war?
The USA entered the war late. Her economy could continue to produce
peacetime goods, which were in demand.
The USA was well-placed to produce and sell wartime goods on a large
scale because it had developed mass production before other countries
(see Chapter 6). France and the UK, for example, placed huge orders
for armaments in the USA.
The supply of food and raw materials in the USA was very elastic so it
was easy to increase output.
A major development during the war was the growth of import
substitution in many countries. Some countries, which had imported
manufactures before the war, were cut off from their European suppliers.
They began to make them for themselves. India is a good example. India
was a major importer of UK textiles, but turned to domestic production.
UK exports to India were permanently reduced.
7.1.5 Borrowing
As we note above, borrowing was the most important way that
governments financed the war. Governments borrowed from abroad and at
home. Lets look at each source separately.
7.1.5.1 International borrowing
Governments needed money to pay for armaments and borrowed from
their allies. The French borrowed from the UK and the UK borrowed from
the USA. The allies were in the better position than the central powers
thanks to their access to the USA money market.
76
The USA was by far the biggest lender. Before the First World War the USA
always borrowed more than it lent abroad. The war changed the USA from
a net debtor to a net creditor for the first time. This had important postwar consequences, as we see later.
Pause and think
Think back to Chapter 6. Did the USA in the war have a balance of payments deficit or
surplus on current account?
The USA had a payments surplus because US exports expanded relative to
US imports. The surplus was recycled by US lending to the allies.
Pause and think
What were the implications for the international economy after the war, if and when the
debts to the USA were to be repaid?
To repay debts to the USA, the UK and France would need to earn export
surpluses after the war. Since it was difficult to do this (we come to that
later) this presented a critical problem after 1918.
7.1.5.2 Domestic borrowing
We know that governments found it impossible to finance their
huge wartime expenditures from taxation. Instead, all governments
borrowed from their own citizens.
Some of this borrowing was funded governments floated war bonds.
These bonds were bought by the population. Repayment was scheduled
for a long time after the war was over. Thus, the bonds were a way of
taking cash from the public and using it for war expenditure.
Many governments were left with the problem of paying the interest on
their large national debt after the war.
A great deal of government borrowing was non-funded. That is, it was
financed by literally printing money. Governments bought goods with
bills, which they printed. The suppliers who accepted the notes took
them to the bank. The banks issued banknotes in return for the bills (it
is called discounting). Obviously the money supply increased, leading
to rapid inflation in most countries.
7.2 The long-run economic effects of the First World War

The way the war was financed had long-run effects.
Pause and think
We have said enough for you to have a good idea what the long-run effects were. Write
down how you think the war affected international monetary and trade flows. Think also
how you would have suggested they could (or could not) be overcome.
We look at these effects below. International debts were difficult to repay.
Trade was slow to recover, which was a major reason why the debts were
difficult to repay. Linked to this was the desire to return to fixed exchange
rates (the gold standard).
77
7.3 Long-run trade problems

7.3.1 Tariffs
An important barrier to trade recovery after 1918 was the high level
of tariffs on imports. Tariffs rates were, on average, 40 per cent higher
in Europe in 1918 than pre-1914. Almost all countries increased tariffs
during and after the war for two main reasons:
The countries which started import substitution during the war wanted
to protect the infant industries that had been created. We noted the
Latin American example earlier. These countries wanted to protect their
new industries from the renewal of competition after the war from
traditional European exporters.
There were a number of newly independent countries, mainly in
eastern and central Europe.
There had been important political changes of which the most important
was the break-up of the Austro-Hungarian Empire into mutually
antagonistic successor states (e.g. Czechoslovakia, Yugoslavia, Austria
and Hungary). The AustroHungarian Empire had been a large free-trade
community.
The new states were determined to protect industries and agriculture for
their own populations, so they put up tariffs to stop imports. This was
often disastrous. Protection reduced economies of scale which increased
prices and made their populations worse off. For example, before 1914,
Czech industry exported all over the Austria-Hungarian Empire. After the
war, these exports were seriously reduced.
Other independent countries emerged from the revolution in Russia
(Finland, Estonia, Lithuania, Latvia, Poland and a few more, albeit
briefly). These also had a taste for tariffs. Also, the successor state to Russia,
the USSR, was in political and economic disarray (a civil war and foreign
intervention lasted from 1918 until 1921). The Ottoman Empire also broke up
and revolution and political change occurred in Turkey and the Middle East.
Pause and think
What did this upheaval mean for countries like France, Britain and Germany, trying as they
were to re-establish their export industries?
They lost markets and their exports declined. In order to avoid balance of
payments crises, they also restricted imports.
7.3.2 Trade patterns changed

It soon became apparent that the changes in the pattern of trade were
permanent. They were not just the temporary effect of wartime conditions.
Before 1914 the pattern was as we have seen in Chapter 6:
Britain was the key country.
Britain had a deficit with the USA and the other European countries.
Britain had a surplus with primary producing countries.
In the new (post-1918) pattern:
The USA was the key country.
The USA had a surplus with European countries (including the UK).
The USA had a small deficit with primary producers.
Europe (including the UK) had a surplus with primary producers.
78
Pause and think

What did the replacement of the UK by the USA as the key country mean?
What problems did it pose for the international economy?
7.3.3 Problems
The USA was not only the worlds largest industrial country but also
the worlds largest primary producer. As we have seen, US total factor
productivity (TFP) was higher than European TFP. Most US industrial and
primary products were now the cheapest in the world.
Pause and think
What did this mean in trade terms?
The USA needed few imports and was a large exporter (it had a trade
surplus). In addition, US economic policy favoured the domestic economy.
Exports only represented six per cent of GDP, the domestic economy the
other 94 per cent. This meant that the USA could have high tariffs with
little impact on the domestic economy from higher prices.
7.3.4 The result a dollar gap

The US trade surplus meant that there was a dollar gap in the 1920s.
Other countries bought American exports, but because the USA
imported relatively little it was difficult for other countries to obtain
dollars.
The dollar gap added to the already difficult trading conditions
mentioned above, and world trade in the 1920s (and 1930s) grew
more slowly than world output.
This in turn put a brake on the growth of international specialisation,
which had been important to the growth of world income before 1914.
This problem was not solved until after the Second World War, when
trade again grew faster than income.
Pause and think
What could the USA have done to end the dollar gap and stop it being a problem for the
rest of the world?
The USA could have reduced tariffs, which would have increased imports.
It could also have recycled the trade surplus by lending. Lending dollars
abroad (as the UK had done in the period 18701914) would have
allowed the other countries to buy more imports. The USA did lend
abroad, but (unlike the UK, 18701914) its lending formed only half the
US trade surplus. The UK did manage to earn a small trade surplus after
1918 but not enough to make up for the lack of US recycling. Therefore
half the US surplus accumulated as gold in Fort Knox and foreign
exchange reserves.
Pause and think
What did the USAs large trade surplus mean for the rest of the world?
It meant taking international spending power out of circulation (called
reducing international liquidity). This in turn reduced the demand for
goods on the international market. It also reduced the reserves of central
banks around the world.
79
Pause and think

What was the effect on the plans to restore fixed exchange rates based on gold?
The dollar became stronger and European currencies weaker. There
was pressure on exchange rates. Countries had gone off gold during the
war. After the war, it became difficult to maintain fixed exchange rates
and, therefore, to go back to the gold standard. But, by the early 1930s,
virtually every country had done so.
With hindsight we now know that there was no need to go back to the
gold standard. But this was not obvious at the time.
Pause and think
How could the dollar gap have been closed?
To close the dollar gap US exports would have had to fall compared with
European exports. To do this the USA would have to remove all tariffs.
But, in the 1920s, US productivity was growing faster than that of Europe,
hence the dollar would have to appreciate relative to the European
currencies. If this did not reduce the trade imbalance between Europe and
the USA, American companies would have to invest in Europe to replace
imports from the USA.
Stated like this, it is obvious that the American people (and electorate)
would have rejected such measures.
7.4 Long-run capital flow problems

In addition to the trade problems there were serious problems affecting
capital flows.
7.4.1 The debt problem

The debt problem was obviously linked with the trade pattern. The USA
was the worlds biggest creditor, but, as we saw above, it had a trade
surplus.
Pause and think
How could countries repay their debts to the USA?
The only way to repay debt in the long run was with a trade surplus.
The position of the USA in the international economy made a trade
surplus very difficult to achieve.
Countries could borrow to repay earlier loans of course (remember
that the USA was lending some of its trade surplus). But this simply
postponed the final payment.
Defeated countries such as Germany did not have foreign debt because
they had been unable to borrow from the USA or Britain during the war.
This was regarded as unfair by the victors, especially France. They made
it a condition of the 1918 Armistice that the defeated countries had to
pay reparations. These were payments to compensate the victorious
countries for the damage done to them. Germany had occupied Belgium
and a large part of the French industrial areas during the four years of war.
Reparations were seen by France and the UK as a way of repaying their
war debts, primarily to the USA.
80
Pause and think

Why did the system of reparations not work out?
Because the German economy was run down by the war, its ability to
export was limited.
Insufficient exports made it difficult for Germany to pay the reparations.
Germany had lost a large part of its economy, including 38 per cent of its
steel capacity and 26 per cent of its coal output to other countries in the
post-war settlement.
The government proved unable to control spending, and inflation began.
At the same time, Germany needed imports to enable reconstruction to
occur. Germany had to borrow heavily. Part of the short term solution was
for the US banks to make short-term loans to Germany which were used
to pay reparations (e.g. to the UK) which were then used to repay some of
the war loans from the USA. With the reparations, this made Germany the
worlds largest debtor. The USA was the largest creditor of course.
In this way, the trade problem made it impossible to solve the debt problem.
In the next chapter, we will see that there was in fact no solution to this.
What happened instead was a major financial crisis. This led to changes
in the international economy. One result was that Germany refused to pay
reparations and a large part of the other war debts were never repaid.
Pause and think
Note above that Germany took new loans from the USA to make debt repayments. These
new loans were often short term. What was the danger to the international economy if the
debts were covered by short-term loans?
The danger became apparent in the 1920s. The new American loans were
deposited in European, especially German, banks. When the loans were
recalled by the USA, from 1928 onwards, the German banks collapsed.
7.5 Inflation
As we have discovered, most governments used inflationary finance during
the war. This inflation carried over into the post-war period because of the
need for economic reconstruction and the war pensions that had to be paid
to widows and disabled soldiers. Political changes in many countries meant
that welfare had become a more pressing issue than it had been before the
war.
As we have seen, governments abandoned the gold standard during the war.
But after the war it was generally agreed that countries should go back to
the gold standard as soon as they were able. This was partly because they
found it difficult to visualise a world with floating exchange rates (which
was the alternative) and partly because they wanted the good housekeeping
seal of approval which we talked about in Chapter 4.
But in the short run it was impossible for most countries to fix their
exchange rates. As we saw above, many countries had serious balance
of payments problems after the war. And most countries, other than the
USA, had various rates of inflation. If they fixed their currency in gold,
they would lose all their reserves. It was impossible to go back to the gold
standard immediately.
81
For most countries to fix their exchange rate, it would be necessary to

stop inflation. This would mean deflating the economy in order to cut
government expenditure and borrowing, and to restrict the growth of
credit. This would stop inflation but it would also cause great economic
hardship so soon after the war. Hence countries did not immediately
return to the gold standard. Instead they allowed their currencies to float.
Some countries in eastern and central Europe experienced runaway
inflation. The country most affected was Germany. Peoples expectations
were that inflation would continue. Goods bought tomorrow were
expected to cost more than goods bought today. People spent their money
as quickly as possible, preferring to hold goods (that were going up in
value) rather than money (which was going down in value). Money soon
lost all its value and people resorted to barter (i.e. the government lost
control of the money supply).
Runaway inflation rates were eventually stabilised with the aid of foreign
loans. These allowed governments to balance their budget without
printing more currency.
7.6 The new gold standard

Most countries did eventually fix their exchange rates. This was because
governments and the business community could not contemplate a world
with floating exchange rates. (Chapter 4 explains why this was.) A new
gold standard was established from 1925 onwards. But the post-war gold
standard did not work well for a number of important reasons. Two we
have seen above trade growth was slow and the USA was not recycling
half of its trade surplus, leaving the world short of dollars.
Pause and think
Why was it difficult to fix exchange rates even when the inflationary rates were over?
Because the rates of inflation during and after the war had differed, the
price levels in different countries were no longer in line. The new fixed
exchange rates were not always the appropriate ones. For example the
pound was overvalued from 1925 and the French franc was undervalued
from 1926.
Pause and think
What was the effect of an overvalued pound on UK exports and imports and therefore
on the balance of payments?
British exports would be lower and imports higher. Alternatively, exports
and imports could be the same, but in this case it would mean that prices
and incomes would have to be reduced by deflationary policies which
increased unemployment.
7.7 Political problems

The scale of the war meant that there were important political problems.
To take some examples:
The western countries would not trade with the USSR because their
investments had been confiscated in the revolution.
The French were unwilling to help Germany because they were
determined to keep Germany weak, to avoid another invasion.
82
The most important country, the United States, withdrew from

participation in international politics.
These and other political problems meant that it was difficult to negotiate
a way out of economic issues, like the trade, debt and exchange rate
problems.
When the international economy came under stress from falling stock
markets, falling output and incomes and bank failures between 1929 and
1931, it made the collapse of the international economy inevitable.
Summary
The international economy worked poorly after 1918 because:
The war changed trade patterns and reduced the earnings of the
European exporters.
Political problems associated with the rise of nationalism reduced
European export earnings further.
Many countries incurred large international debts.
These international debts were difficult to repay because the USA had
a large trade surplus but was not recycling all of the surplus, as the UK
had done before 1914.
In turn, this affected exchange rates and made it difficult for the
reimposed gold standard to work properly.
The USA had become the dominant economy but was unwilling to act
as the leader of the international economy.
The USA was not willing to negotiate to solve these problems.
The inability to solve the trade problem, and hence the debt problem,
made it inevitable that there would be a major international crisis. This
occurred in 1931.

explain how the war was financed and the long-run economic problems
this led to
make an argument about why there was a high level of international
debt and why it proved so difficult to eradicate
give reasons why fixed exchange rates were difficult to establish.
Questions
1. How far was the First World War a turning point in the international
economy?
2. Why did the international economy work less well after the First World
War than it had before?
3. Compare the position of the UK in the international economy before
the First World War with that of the USA after the First World War.
83
Notes
84
Chapter 8: The world economic and financial crisis, 192933
Chapter 8: The world economic and

financial crisis, 192933
The chapter explains:
the causes of the economic crisis of the early 1930s
how the crisis spread though the world economy
why the crisis could not be contained
why the centres of the crisis were in the USA, Germany and primary
producers.
We also examine the causes of the international banking crisis and the
crisis in world agriculture. Finally, we place the events of 192933 in the
long-run perspective of the growth of the international economy.
Objectives
To:
interpret the events of the 1930s in an international context
explain how the Depression had both national and international aspects
see what lessons were learned as a result of countries failures in the
1930s.
Learning outcomes
describe the nature of the 1931 financial crisis
give reasons why the United States economy caused such problems for
the post-1918 international economy
explain why the world economic crisis was unavoidable, given the postwar settlement
explain why the world crisis was a turning point in the development of
the international economy.
Essential reading
[ISBN 9780691139371] pp.7083.
[ISBN 0415199301 pbk] pp.193210 and pp.21114.
85
Further reading
[ISBN 0415250633 pbk] pp.6667.
[ISBN 9780195307559 hbk] pp.93104.
edition [ISBN 0745009352 pbk] pp.98201, pp.2046, pp.21528 and
pp.2324.
[ISBN 0582494230 pbk] pp.6473.
Introduction
In Chapter 7 we saw how the First World War permanently altered
the system of trade and payments that had fuelled the growth of the
international economy since 1870. In particular, the UK could no longer
play a key role in providing stability and aiding growth in the rest of the
world. The USA, which was now the dominant economy, was unwilling to
take up this role.
Between 1918 and 1926, a major breakdown in the financial system was
narrowly avoided. German reparations were rescheduled, the inflations
were contained and most countries had returned to gold by 1926. But the
system was weak and some exchange rates were unsustainable.
Moreover, nationalism was much more important than it had been in
1914. When the crisis spread round the world from Germany, the USA
and the primary producing countries in 1929, there was no international
mechanism to contain it. Recovery, when it came in the 1930s, was based
on national economies, not international trade. The Second World War
came at the end of this period. When peace returned, governments turned
to international institutions again, as they had before 1914.
In this course, there are many questions. The topic is complicated so do
not go through the chapter too quickly. Dont forget the readings. You
will also find that there are close links between Chapters 7, 8 and 9, so
remember to look backwards and forwards.
8.1 What was the long-run context of the crisis?

Although it was not seen at the time, the world economic crisis of the early
1930s was an important turning point in the history of the international
economy. It divides into two periods:
a period when the international economy had fixed exchange rates and
multilateral settlements
a period when the international economy had managed currencies and
bilateral trade.
We know that the international economy did not work as well in the
1920s as it did before the First World War, but in the 1920s, governments,
bankers and most business people were still trying to recreate the
economic conditions of the pre-war period, when the international
economy did seem to work well.
86
Pause and think

What were the three main problems that caused the poor performance of the
international economy? (See Chapter 7.)
Trade, debt and exchange rates were the main problems in the 1920s.
Inflation was also a problem, but it was important for the international
economy insofar as it affected exchange rates.
In contrast, in the 1930s, virtually no government was trying to recreate
the pre-1914 situation. Recovery from the Depression came, not via
trade but via the national economies of countries, often through active
government intervention in the economy. World output recovered strongly.
But in 1939 world trade was still below its 1929 level. (This situation was
unique in recorded history, except in time of war.)
8.2 How serious was the Depression?

The countries most affected were the USA and Germany. GDP in Germany
and the USA fell by about 30 per cent between 1929 and 1933. Industrial
output fell by about 50 per cent. Unemployment was 25 to 33 per cent of
the labour force.
The Depression affected every country in the world, not just the main
industrial countries. The only possible exception was the USSR, which was
isolated from the international economy. The USSR had its own internal
economic and social problems.
There were three places where the Depression started. The rest of
the world fell into depression through the effect of these centres on
international trade and payments.
the industrial part of the United States
Germany
major primary producing countries (Canada, Australia, Argentina and
the USA again).
(We discuss the reasons for the start of the Depression in the USA in
Chapter 9.)
8.3 What happened in the USA?

As we note above, the USA suffered a fall in GDP from 1929 to 1933. The
problem, however, was not that the economy initially turned down. Every
capitalist economy has downturns. The problem was that there was no
upturn. Income in the USA kept falling continuously from 1929 until 1933.
Pause and think
What stopped the US economy recovering in 1930 after the fall in 1929?
Three factors prevented a recovery:
There was serious overproduction in agriculture in the USA leading to
an agricultural debt crisis.
There were major banking crises.
Monetary policy in the USA almost certainly made the Depression more
serious (see Chapter 9).
87
8.4 What happened in Germany?

The German economy also fell into depression in 1929. As in the USA,
the Depression was made more serious by what happened afterwards.
In this case, government policy made the Depression more severe. The
German government cut expenditure and increased taxes. It felt it had no
alternative since it was not allowed to borrow further by the terms of the
loans it had negotiated at the time of the hyperinflation in 1923. In any
case, if the government could not borrow because of the experience of
inflation, it meant that people had no faith in the German governments
ability to repay its debts.
Pause and think
Why is it a problem if a government cannot borrow during a depression?
As output and income fall, tax receipts decline.
The government needs to borrow to bridge the gap in its finances.
If the government doesnt borrow to bridge the gap it must reduce its
expenditure, e.g. cut welfare payments when people need them most.
Note that printing money is technically non-funded borrowing (see
Chapter 7). During the First World War countries used non-funded
borrowing a lot. This was forbidden to the Germans under the 1923
agreement.
In effect, the German government in 1931 was bankrupt. Its only policy
was to cut expenditure (i.e. to deflate). Yet it still had to make reparation
payments in foreign currency. The only way was to cut government
expenditure and further deflate the economy, so that exports would rise
and imports fall.
Pause and think
What were the weaknesses of this policy?
Since the rest of the world had falling incomes, the chances of increasing
exports were slim. The only realistic outcome was that Germany would
be so impoverished that imports would decline enough to leave an export
surplus to make reparation payments.
But there was a serious political risk. The more serious the depression,
the more likely it was that the Nazis would be elected. And the Nazis had
promised to cancel reparations, which put them at an electoral advantage.
The German economy had become dependent on short-term loans from
the USA. The loans began to be recalled in 1928 (so that they could be
spent on the Wall Street boom). When the US economy fell into depression
in 1929, more loans were recalled, causing the German banking system to
collapse and making the Depression far more serious.
8.5 What happened in primary producing countries?

These countries were experiencing a world wide agricultural crisis. This
pre-dated the industrial depression that started in 1929. During the First
World War and immediately after, the prices of primary products rose,
peaking in 1920. The war and the start of post-war reconstruction meant
that there was strong demand, but supply was restricted because transport
was disrupted.
88
In the 1920s, this was reversed. Demand increased slowly while supply
increased very fast. As a result prices fell.
The ratio of the price of primary products to the price of industrial
products is called the terms of trade (see 1.5.20). We can say that the
terms of trade moved against primary producers after 1921.
Pause and think
Why did the terms of trade move against primary producers after 1921?
There were two main reasons why primary prices fell:
Technical changes, such as the tractor and artificial fertilisers, meant
that the supply of primary products was rising faster than demand. For
example, tractors allowed more land to be cultivated because, unlike
horses, they did not require land for their feed. Instead cattle could be
grazed or the land ploughed up. And tractors were faster than horses
and used less labour. Hence the introduction of tractors increased
agricultural output and acreage also increased.
The demand for food was not rising as fast as supply. In the jargon,
demand for food was income-inelastic people spent little of any
additional income on food. We use this concept again in Chapter 15.
Initially, the falls in primary product prices in the 1920s were not as great
as they might have been. This was because stockpiles (the amount that
wasnt sold) were rising (see the example of Brazilian coffee below).
But the banking crisis in Europe and the USA meant that the loans used
to finance stock holding were recalled. Hence stocks had to be sold
(liquidated) which led to a collapse in world prices.
Pause and think
Catastrophic falls in the prices of primary products occurred throughout the 1930s. The
income of the primary producing countries fell severely.
What do you think this did to capital flows to and from primary producers?
The primary producers were forced to restrict imports from the
industrial countries and often to default on their (very large) loans
from those countries.
This meant that exports from the industrial countries fell.
This resulted in reduced income in the industrial countries.
The loans were not government loans. Nor were they, in the main, bank
loans. They fell on individuals, which reduced individual income.
8.6 What went wrong for Brazilian coffee producers?

In the 1920s, the Brazilian government (actually, the So Paulo provincial
government) started a scheme to restrict the output of coffee. Since at
that time Brazil produced most of the worlds coffee, this had the effect
of increasing the price to (mainly American) consumers and increasing
Brazilian income.
But because the price of coffee increased, it was now possible for highercost countries like Costa Rica to enter the international coffee market. This
caused a problem, because stocks of commodities may only be held off the
market if credit is available. The main source of credit was the USA. Stocks
built up, financed by American loans. But when the USA had a major
banking crisis between 1929 and 1931, the loans were recalled. The stocks
had to be liquidated as quickly as possible and the price collapsed.
89
Pause and think

What are the conditions which would make a commodity control scheme work? (Think
about the Oil Crisis in 1973.)
All the main producers must join in the scheme and new producers
must also join.
Demand must be inelastic, so that restricting production would lead to
an increase in total revenue.
Stocks must be under the control of the scheme.
There must be no artificial products or other substitutes for customers
to turn to.
As you can see, this makes it difficult for a commodity scheme to last very
long!
8.7 How did the Depression spread through the world?

Pause and think
How did the Depression that began in the USA, Germany and the primary producers
spread to all other countries?
8.7.1 Through falling trade

As export earnings from country A fell, that countrys ability to purchase
imports from country B also fell. Hence, country Bs exports fell reducing
that countrys output. Falling exports often led to balance of payments
problems in that country.
Pause and think
What was the effect of a balance of trade deficit?
If exports fall relative to imports a balance of payments deficit on current
account emerges. In the 1930s:
This led to a fear that the currency would be devalued.
This often led to capital flight. No one wanted to be caught holding
the currency when it fell in value. As people sold the currency, the
effect was seriously deflationary. It could lead to bank collapses as bank
assets were withdrawn, for example.
This was a partly a consequence of the gold standard to which the
world had returned in the 1920s. Ultimately, it led to the gold standard
being abandoned, largely in 19313.
8.7.2 Incorrect responses by governments

The Depression of the 1930s presented governments with a new set of
problems. In the 1930s, most had the wrong policies on tariffs, on taxation
and spending and the wrong policy on interest rates. They learned better
responses a long time later.
Pause and think
What would you have done in a depression?
Would you have raised or lowered tariffs?
Would you have had a deficit or surplus budget?
Would you have tried to push interest rates up or push them down?
90
8.7.2.1 Tariffs
In 1930 the USA increased its tariffs substantially. (The famous Smoot
Hawley tariff.) This lead to almost immediate retaliation. When faced with
falling export earnings, countries raised their tariffs on imports. Naturally
this reduced another countrys exports and so spread the Depression.
The point was that the tariffs were often much higher than necessary;
governments overreacted.
Pause and think
In what circumstances would a country have gained from putting up tariffs on imports?
A single country could benefit as long as it had resources that could be
moved into import substitute areas. It must not be too reliant on imported
inputs, otherwise the tariff raises costs.
8.7.2.2 Deflation
The initial policy response of every government was to deflate the
economy in order to cut government spending. Balanced budgets were
considered to be a key objective, even in a depression. So when demand
fell because of a fall in exports, governments reduced demand, instead of
the correct response increasing it. This deepened the crisis.
Pause and think
Governments sometimes argued at the time that they had to behave like prudent
housekeepers, that is match their income (taxes) to their expenditure. We look at this in
Chapter 9. Can you see the weakness of the argument during the Depression?
Governments did not realise that cutting expenditure in an economy with
a circular flow of income also cuts income and therefore tax receipts. The
more they cut, the more income fell and the more their tax receipts fell. It
was fortunate that many governments failed to cut expenditure as much as
they planned.
This was the only acceptable policy supported by the economic theory of the
time. Theory began to change in the 1930s as Keynes influence, Takahashi
in Japan and that of some other economists, grew (see Chapter 9).
8.7.2.3 Interest rates were kept high
In the early years of the Depression interest rates were kept high to
persuade people to hold the currency (fear of capital flight). Since prices
were falling, this meant that real interest rates were rising. The cost of
borrowing rose and businesses, which had borrowed to invest, found that
their costs increased just as demand was falling. This led to the collapse of
businesses.
Activity
Imagine it is 1931, the Depression is serious and you are a government economic advisor.
1. You are in an industrial country. The government asks you two questions.
a. Can you think of any policies that we should follow?
b. Do you think our country alone can get itself out of the Depression or is
international cooperation essential? What do you say?
2. Imagine you are advisor to a primary producing country. Explain to them why the fall
in world prices in recent months has been much greater in food and raw materials
than in industrial products.
91
3. You are advisor in an industrial country. The Minister of Agriculture wants to introduce
tariffs on imported food so that local farmers can be protected. He asks you if it will
that have any negative effects on the countrys recovery from the Depression.
Answer these questions using the readings as well as this subject guide
for help. Once you have completed your answers, compare them to the
possible responses below:
1. a. You can recommend an expansionary monetary policy which will
lower interest rates. But this cannot be introduced with fixed
exchange rates. You can also recommend a deficit budget, unless
the country relies on exports. It would probably have worked in the
USA, but not as well in the UK.
b. If there is no international agreement (and in 1931 there isnt)
national policies without international cooperation will only work
if the country is largely isolated from the (depressed) international
economy. If this country expands demand alone, it will suffer a
balance of payments deficit followed by a currency crisis.
2. When the demand for industrial goods goes down, supply can be
reduced by closing factories and reducing employment. Therefore
supply contracts as well as demand and prices do not fall too much.
On the other hand, when demand for agricultural products goes down,
supply does not fall so quickly or easily land continues to be farmed.
This means prices must fall a lot further.
3. Tariffs will raise the cost of food and therefore lower the real wages
of workers. This will have a deflationary effect. If there are no tariffs
and food is freely imported, food prices will be lower, real wages will
be higher and workers will have more money to spend on industrial
goods.
8.8 How did a banking crisis finish off the gold

standard?
Pause and think
What is a banking crisis?
Think for a moment before reading on.
A banking crisis is a shortage of liquidity. Banks lose their liquid funds
because they cannot borrow as much as they are paying out. Since
liquidity (credit) is essential to business, a bank crisis is very damaging.
This is the sequence of the 1931 international banking crisis:
The central European banks were in difficulties because their
economies were in depression. Businesses could not repay their
borrowings.
These banks had borrowed heavily from American banks. Remember
the debt structure, which we have discussed.
These loans were short-term, because they were risky and people
would not lend long-term.
From 1931, there was a major banking crisis in the USA.
To cover their losses in the USA, foreign banks started to withdraw
funds in Europe, especially from Germany.
92
People sold their holdings of European currencies and withdrew funds

from banks.
Many European banks collapsed.
Governments introduced exchange control to stop further runs on the
banks. Bankers who had money frozen in one country would withdraw
money from another, thus spreading the international banking crisis.
People sold their holdings of sterling (i.e. sterling deposits in UK banks
were withdrawn). This meant that UK banks might collapse
The link between sterling and gold was cut. Sterling was devalued. This
stopped the withdrawal of sterling. (The devaluation made sterling
attractive to buy, rather than sell.)
Other countries (e.g. Sweden) who traded a lot with the UK, and who
held their reserves in sterling, also devalued.
This was the end of the gold standard (1931).
Pause and think
Why did other countries follow Britain and sterling out of the gold standard?
If a country traded a lot with the UK and the pound was devalued, the
cost of its exports to the UK would rise, so that it would sell less, possibly
leading to a balance of payments crisis. Similarly if the central bank of
the country held its reserves in sterling, the value of its reserves would be
devalued. Note that the possibility of either of these occurring would lead
people to sell the currency, thus making its devaluation inevitable.
Once countries were off gold:
Their currencies were no longer valued at a fixed rate of exchange with
gold.
Currency could not be exchanged for gold at a central bank.
There was no longer a link between the countrys gold reserves and its
money supply.
8.9 Had the gold standard made the crisis worse?

The answer is yes.
Pause and think
Why did the gold standard make the crisis worse?
Why were fixed exchange rates counterproductive in the Depression?
Think what happens in a financial crisis. People who hold a particular
currency might expect the currency to be devalued sooner or later. As
long as the exchange rate is fixed they have no reason to hold on to the
currency. Better to sell it before it goes down! This, as we have seen, leads
to runs on the currency.
In order to defend a fixed exchange rate and stay on the gold standard,
policy must be deflationary, which reduces output. To check your
understanding of this point, try the next activity.
93
Activity
1. Imagine it is 1931 and you are again an economic advisor in an industrial country.
Your central bank chairman has decided to stay on the gold standard. Explain to him
why you must therefore advise the government to pursue a deflationary policy, which
will reduce output.
2. Now the contrary position. This time your central bank chairman says the country is
leaving the gold standard. What, he asks you, does that mean for economic policy?
1. With a deflationary policy the country will have less output and
employment and there will be downward pressure on wages. This
economic pain is expected to reduce prices and costs. In turn, this
should increase exports and reduce imports, thus eliminating a balance
of payments deficit.
2. Here the government has more room to manoeuvre in monetary and
fiscal policies. An expansion of domestic demand is possible, increasing
output and employment. When this leads to a balance of payments
deficit, the exchange rate can be allowed to fall.
8.10 How could the crisis have been avoided before

1929?
This section is an example of a counterfactual, something used by
economic historians. A counterfactual is an alternative situation. It shows
what might have happened.
Pause and think
How would you have avoided the crisis?
Take a moment to look back over the chapter and the readings.
It is important to remember that the crisis had several causes. This meant
that there was no simple way of avoiding it. But it is likely that, to avoid
the crisis, the following were required:
The worlds currencies needed to be realigned. Most important, the
dollar had to be revalued upwards. Remember the fact that the US
trade surplus was not fully recycled led to the dollar gap.
The dollar gap problem meant that the USA had to remove its tariffs.
Europe needed American investment and technology. Otherwise
European goods would continue to be more expensive than US
goods. This meant that the USA would not increase its imports of
manufactured goods from Europe. The result of new investment and
technology in Europe from the USA would have been to raise European
productivity to US levels.
Finally, all war debts and reparations had to be cancelled.
In the real world of the 1920s none of these solutions were politically
possible. Therefore, there was no way that the world economic crisis could
have been avoided.
Interestingly, all the things mentioned above did happen after the Second
World War.
94
8.11 Aftermath
The world depression led to serious problems for ordinary people,
for example mass unemployment. In turn, this led to the election of
governments that were committed to intervene in the economy to improve
conditions. We look at this in Chapter 9.
Some countries were less depressed or were recovering faster. The UK
economy reached its 1929 output in 1934, Germany in 1936, the USA only
in 1939 and France not until after 1945. Those countries that recovered
fast, the UK and Germany, needed to insulate themselves from other, stilldepressed countries. Consequently they avoided links through trade and
exchange rates with countries that were still depressed.
Pause and think
What did the last point imply as regards the recovery of trade?
It meant that output (GDP) rose faster than international trade. Note this
was the opposite of the situation before 1914. In that period, as we saw,
trade increased faster than GDP.
8.12 Overview
To complete the chapter, here is a synopsis of the changes that occurred
in the international economy. We put them in the context of change
throughout the period we have dealt with so far in the course.
A synopsis of the development of the international economy, 18201945
c.182070: There was a great deal of variety, including changing
exchange rates. There were examples of both bilateral and multilateral
trade.
c.18701914: Fixed exchange rates. Multilateral settlements.
1914c.1919: Crisis 1 the First World War.
c.191931: Return to fixed exchange rates but serious problems.
c.1931: Crisis 2 serious banking crisis.
c.193139: Interventionist governments. End of fixed exchange rates.
Bilateral trade.
193945: Crisis 3 the Second World War.
Summary
The world economic crisis of the early 1930s was caused by the structural
problems of the international economy of the 1920s. These problems were
caused by the changes initiated by the First World War. Governments in
the 1920s failed to understand that the world economy was in serious
crisis, or if they did, they were unwilling to change their policies. Hence,
the world economic crisis was inevitable. In the later 1930s, countries did
recover from the crisis but recovery was based on domestic recovery, not
on international trade and finance.
95

describe the nature of the 1931 financial crisis
give reasons why the United States economy caused such problems for
the post-1918 international economy
explain why the world economic crisis was unavoidable, given the postwar settlement
explain why the world crisis was a turning point in the development of
Questions
1. Explain the main causes of the Depression in the international economy
in the early 1930s.
2. How far was the world economic crisis of the early 1930s inevitable?
3. How far did the existence of the gold standard make the world
economic crisis worse?
96
Chapter 9: Government intervention, recovery and the international economy in the 1930s
Chapter 9: Government intervention,

recovery and the international economy
in the 1930s
In Chapter 8 we looked at how the post-war recovery of the international
economy in the 1920s collapsed and led to the Depression of the 1930s.
In this chapter we discover why the rate of recovery from the Depression
varied from country to country. We look at Britain, the USA and Germany in
particular. Issues discussed include:
why national economies recovered faster from the Depression than
international trade did
the effects of interventionist government policies (including rearmament)
changes in economic theory and its influence on government policy.
Objectives
To:
explain the course of the Depression in selected countries
show the links between national events and policies and the international
economy
evaluate the extent to which Keynesian economics could have improved
the situation and how far it was tried by governments.
Learning outcomes
outline why international trade in the 1930s failed to recover from the
Depression although world output did recover
explain why multilateral trade ceased in the 1930s and trade became
bilateral
discuss why government intervention in national economies in the 1930s
reduced the level of international trade in the short run.
Essential reading
Broadberry, B.N. and K. ORourke (eds) The Cambridge economic history of modern
Europe. Volume 2: 1870 to the present. (Cambridge: Cambridge University
Press, 2010) [ISBN 9780521708395] pp.21924.
Eichengreen, B. Globalizing capital. A history of the international monetary system.
(Princeton, NJ: Princeton University Press, 2008) second edition
[ISBN 9780691139371] pp.8390.
[ISBN 0582494230 pbk] pp.759 and pp.8992.
97
Further reading
[ISBN 0415250633 pbk] pp.8093.
[ISBN 9780195307559 hbk] pp.13559.
edition [ISBN 0745009352 pbk] pp.2014 and 22832.
[ISBN 0415199301 pbk] pp.197210.
Introduction
In Chapter 7 we looked at how the countries affected by the First World
War recovered, but how the recovery was beset with problems. In Chapter
8 we continued the historical analysis and examined the breakdown of the
financial system and the onset of the Depression. In this chapter we look at
the 1930s from the different perspectives of the USA, the UK and Germany.
9.1 Crisis and response in the USA

The problems of the US economy were crucial to the onset of the
international Depression and the recovery. Policy in the USA had never had
an international dimension. After 1945, however, the USA did not isolate
itself from the international economy. In the next section we consider how
the US economy affected other countries.
9.1.1. The seriousness of the American Depression was

unprecedented
Between 1929 and 1933:
Real output fell by 30 per cent.
Real consumption fell by 20 per cent.
Real investment fell by about 90 per cent.
Output fell for three and a half years.
Agriculture was serious depressed, and remained so until the Second
World War.
Pause and think
Could the severity of the Depression in the USA have been predicted from the stock
market crash of 1929?
The Depression was much more serious than we would expect from the
problems of the American economy in 1929. In other words, something
made the Depression more serious after it had started. The most likely
explanation is government policy.
Economists in the 1930s and since have argued about the causes of the
Depression and also whether US policy could have prevented it, or, once it
began, reversed the decline. Two of the most popular approaches are:
a monetary explanation
a Keynesian explanation.
98
Evidence for the monetarist explanation can be found in the three bank
crises between 1929 and 1933. This was largely the policy of the Federal
Reserve Bank (the FED) in 1931. The FED allowed real interest rates to
rise; the monetarists say they should have fallen.
Keynesian explanations, named after the UK economist John Maynard
Keynes, depend on the strength of demand; consumer incomes, investment
etc.
According to this view, the reason for the Depression was that there
was a fall in investment, which was caused by an autonomous fall in
consumption. An implication of the Keynesian view is that there is no
automatic reason for demand to rise. For example, falling prices and
falling interest rates would not necessarily increase investment, as the
monetarists believe. Remember, however, that both explanations could be
true, they are not substitutes for each other.
9.1.2 Why did it take so long to recover?

The US economy was suffering several long-run problems that made
recovery difficult.
Many markets for consumer durables were saturated.
There was serious farm distress. This was caused by low prices and
made worse by the serious indebtedness of the farmers.
The banking system was weak and the Stock Market had crashed,
leading to a fall in confidence.
The international economy was also seriously depressed, as we have
seen.
Roosevelt became president in 1933 and promised a New Deal. The
Federal government would intervene directly in the economy to increase
output, raise prices and reduce unemployment. This degree of intervention
was unprecedented in peacetime.
9.1.3 How far was the New Deal based on new economic theory?
J.M. Keynes changed the way that governments looked at intervention.
Before Keynes people believed that markets always cleared and that
the economy was in equilibrium at full employment. For example, they
believed that unemployment was caused because wages were too high
for everyone to be employed. If wages fell, unemployment would fall.
According to this view government intervention would make the market
work badly. Hence intervention was difficult to justify.
Keynes showed that the economy could be in equilibrium at less than full
employment.
Pause and think
What does Keynes theory imply for adherents of free-market economics?
This meant that employment could never recover through the market
mechanism (see above). This is a prima facie argument that government
intervention was necessary for recovery from the Depression. The correct
policy in a depression was for the government to increase expenditure
(e.g. on unemployment benefits or public works) so that demand
increased.
The whole idea of economic management came from these insights.
Keynesian ideas were very important in many countries after the Second
World War.
99
There was one major problem with the New Deal of 1933. There was no
worked out policy of fiscal deficits. This was not surprising since Keynes
himself did not fully work out this part of his economic model until 1936!
The US government did increase expenditure substantially, but most of it
was paid for by increases in taxation. The deficits were very modest. In the
main, the New Deal was not an early example of economic management.
9.1.4 Other objectives of US government economic policy

We must remember that recovery from the Depression was only one
policy among many. It was essential for the federal government to help
agriculture by increasing agricultural prices. It was also essential to
provide relief for the large number of unemployed. In 1933 the USA had
no social security. The New Deal had to provide a minimum social security
net, which it did.
9.1.5 How successful was the New Deal in getting the USA out
of the Depression?
In the main, the New Deal was not successful. It did not lead to rapid
recovery. Income per capita was no higher in 1939 than in 1929. Recovery
and growth in the US economy came later through rearmament.
Pause and think
We have mentioned one reason why the impact of the New Deal on the Depression was
disappointing the US Federal Government put up taxes at the same time as it put up
expenditure. This lessened the stimulus to aggregate demand. Another reason was that
the government (and its economic advisors) misunderstood the relationship between
prices output.
Can you think how prices and output were related?
The New Deal government in the USA believed that the fall in prices
caused the fall in output. Hence their policy was to increase output by
increasing prices. In fact, it was the other way round; the fall in prices was
caused by the fall in output. Therefore a fall in prices would not increase
output (see Figure 9.1).
They thought:
prices caused output
so, prices would lead to output
But, in reality:
output caused prices
so, prices would not lead to output
Figure 9.1. New Deal economic policy
9.2 The effect of American policy on the international

economy
Pause and think
The American government considered the American Depression in isolation. The
government never considered that it had any responsibility to help the international
economy to recover. Do you think that the governments view was correct? Was it in fact
the case that the United States had to recover before the international economy could
recover?
100
There is a very important point here. If a government during the

Depression was actively trying to create growth in its national economy
it would have to isolate the economy from the rest of the world.
Activity
Follow through the sequence below and think about what might have happened if the
USA or the UK had run a fiscal deficit during the 1930s instead of covering expenditure
by raising taxes, as they both did.
Think about three hypothetical countries, all equally depressed.
The government of one country opens up a fiscal deficit. In other words, government
spending is higher than taxation.
That country begins to grow fast. That would mean that its demand for imports
would rise but not its demand for exports. (Because the other two countries were still
depressed.)
If there were no remedial action, that country would suffer a balance of payments crisis.
This would mean that the government would have to reduce expenditure (i.e. it would
have to deflate the economy and the recovery would stop).
Or it could isolate the country from the rest of the world, by even more tariffs and/or
exchange control. This would mean that both exports and import would be seriously
affected.
A governments ability to create growth is constrained by its connection
with the rest of the world economy. It is not surprising that the
interventionist governments of the 1930s used various means to insulate
their economies. As we would expect, the degree of insulation depended
on the extent that the government was creating growth.
9.3 The UK and Germany

In the UK, where government intervention was mild, the main insulation
policy was to allow the pound to depreciate, which in the jargon is called
a dirty float. The advantage to the UK economy was that if the pound
was low but stable, interest rates could be low which helped recovery. In
addition, the UK introduced general tariffs, which was a major break with
the previous 60 years during which it had been largely following a policy
of free trade.
In Germany, where the government was running an economy with many
controls, the mark was made unconvertible. This meant that all trade
could be controlled through the supply of marks. The effect was to reduce
German trade because, in general, the German government only allowed
trade that helped rearmament.
But more important, German trade became bilateral. This was because
someone who exported to Germany would be paid in inconvertible marks
they could not use the marks to buy goods from a third country. Hence
they would only trade with Germany if they wanted to buy something
from Germany. So trade with Germany was bilateral. In fact in some cases
trade with Germany was straight barter, with no money changing hands. For
example Germany exchanged machinery for cotton from Latin America.
What happened to German trade was just the extreme version of what
happened in virtually every countrys trade in the 1930s. There was
virtually no trade that did not require some sort of permission. The UK, for
example, would only purchase bacon from Denmark if Denmark agreed to
take more UK exports.
101
9.4 Trading blocs

The world broke up into trading blocs. The reason why a country joined a
particular trading bloc was because it used the blocs common currency for
trade. The countries that traded most with each other were:
Those countries that left the gold standard late, such as France,
Switzerland and the Netherlands.
Those countries that left the gold standard early and devalued, such
as the UK and Scandinavian countries. This group included British
Colonies and Dominions, almost all trading in sterling. Canada was the
exception since the USA was Canadas main trading partner.
Those countries whose currencies had been massively devalued,
notably Japan and the East Asian countries.
Those countries with exchange control such as Germany and eastern
European countries.
Pause and think
Why did these trading blocs listed above develop?
Remember that to trade it was necessary to make treaties (deals).
The French, for example, could try to make a deal to import goods
from the UK.
Obviously the UK government would be happy to do this.
The French government would not be happy because the UK would not
agree to buy from France.
The reason the UK would not agree to buy from France was that it
could buy the goods more cheaply from somewhere else. (The franc
had not devalued; the pound had.)
The easiest country for the French to make a deal with would be one
whose price level was similar to the French price level, for example
Switzerland.
The point is that because fixed exchange rates (the gold standard) had
collapsed, multilateral trade also collapsed.
9.5 Germany again

Political and military considerations became more important in
international trade. Germany had an additional reason to make bilateral
treaties with eastern European countries, to acquire strategic raw
materials.
Hitler was elected when the Depression in Germany was at its worst.
Before being elected, he had already forced reparations to be reduced;
now they were cancelled altogether. This allowed Germany to abandon its
deflationary policy, which was making their depression even deeper (see
Chapter 8).
Pause and think
Why did cancelling reparations have such a positive effect on the German economy?
Without reparation payments, the German government was able to expand
demand because they had more foreign exchange for the additional
imports which expanded with the increase in demand. Once this foreign
102
exchange was used up, the government used strict exchange control to
avoid the increase in demand leading to a balance of payments crisis.
The German government also started a massive work creation scheme,
designed to eradicate unemployment. By 1936 rearmament had started in
earnest. Government deficits paid for armaments. Since Germany, by then,
had full employment, inflation was a danger. This was suppressed through
restrictions on consumption and trade.
Pause and think
How far did German policies allow the economy to recover from the Depression?
German GNP in 1939 was 50 per cent higher than in 1929. Recovery in
statistical terms had occurred. But the main products of the economy were
armaments and capital goods. Guns before butter, as it was put at the
time. Consumption was less than in 1929. This leads to the question of
whether the German recovery could be considered to be economic growth.
We continue the discussion of guns before butter in Chapter 10 where we
look at wartime economies.
Summary
The economic depression of the 1930s led to major changes in the role of
government in the economy, changes which still affect economies today.
The effect of national recovery policies in the 1930s was to reduce the
importance of trade and to change the international economy, from which
it only recovered after the Second World War.

should be able to:
outline why international trade in the 1930s failed to recover from the
Depression although world output did recover
explain why multilateral trade ceased in the 1930s and trade became
bilateral
discuss why government intervention in national economies in the
1930s reduced the level of international trade in the short run.
Questions
1. Explain why international trade grew slowly in the 1930s.
2. How far was it necessary for countries to turn away from international
trade in the 1930s in order to recover from the Depression?
3. How successful was government intervention to the recovery of
economies from the Depression of the early 1930s? You may confine
your answer to one country if you wish.
103
Notes
104
Chapter 10: The war economies, 193945

In Chapter 7 we discussed the First World War. In this chapter we look at
the Second World War (193945). There are two differences between the
two wars to keep in mind.
First, the context. In 1914, Britain, the Empire, the gold standard and
international capital flows were all factors working in favour of an
expansion of the international economy. In 1939, the international
economy was growing slowly and international finance was often
restricted to bilateral flows. Labour migration, especially to the USA, had
been limited since the early 1920s.
Secondly by 1939 governments realised much more clearly than their
predecessors had in 1914 that the government must plan and organise
a wartime economy. Incidentally, one result of this for the economic
historian is that there are many more economic statistics available for the
Second than for the First World War.
Objectives
To show:
explain the market does not work in wartime
how the market in wartime is always controlled by government policy
that a government may have different objectives in wartime than in
peacetime
the importance of output (i.e. GDP) in war as well as in peace
the problems associated with the transition from a wartime to a
peacetime economy.
Learning outcomes
explain why planning was necessary to maximise output in wartime
explain why strategic objectives may affect the efficiency of the
economy in wartime
suggest possible reasons why some countries were able to devote
proportionally more resources to the war effort than others
discuss what the main constraints on output in a war economy can be.
Essential reading
Further reading
[ISBN 0415250633 pbk] pp.97114.
[ISBN 0582494230 pbk] pp.93103 and pp.1068.
105
Introduction
In this chapter we examine the relative scarcity of capital and labour
in wartime. We discuss the successes and failures of war economies,
particularly governments management of war economies.
Next, we show the important choices that governments had to make
and how these were related to the military strategy that the country was
pursuing.
We examine how much trade is possible and desirable in wartime.
Examples are taken from the experience of the USA, the UK, Germany and
the USSR, during the Second World War.
10.1 How is a wartime economy different to a

peacetime economy?
War makes an enormous difference to how a government runs the
economy, what goods are produced and how efficiently resources are used.
Activity
Write down the goods produced during a modern war and compare the list with the
products made in peacetime.
The same goods are made during peace and war but think about the quantities that
are required. What are the differences therefore between a wartime and a peacetime
economy?
Are the objectives of a government the same in peace and war?
Finally, why do governments intervene in the economy more in wartime? In particular,
why doesnt a government in a capitalist economy simply allow the market to allocate
labour and capital?
Once you have tried to answer these questions, read on.
The choice that must be made in wartime is often expressed as a contrast
between guns (armaments) and butter (consumer goods). See if you can
explain this choice, then read on.
In wartime the economy needs armaments.
People, however, want (need) consumer goods.
What would happen if the government simply wrote out orders for
large numbers of guns, etc.?
Prices rise because the armaments manufacturers order more materials
and recruit more labour. So demand for labour and materials would rise.
But this would not reduce demand for consumer goods. The wages paid
to the armaments workers actually increases demand for consumer goods.
This means that in the market for consumer goods, there is a supply
constraint, but less demand constraint. Consequently consumer prices rise;
there is inflation.
Pause and think
Why wont market forces alone sort this out and bring inflation to a halt?
The market will not sort this out, or at least not in any reasonable period
of time. So, if the government needs to increase armaments production, it
has to restrict consumption.
106
Of course people have to eat, so consumption of essential items, like basic

food, must somehow be maintained. But this raises a further problem. If
consumer items are restricted, their price will rise, making it impossible for
poorer people to purchase them. Thus basic needs (food, water, domestic
electricity) can only be guaranteed by some form of rationing, where the
government controls supply.
Summing up
In wartime a government intervenes in the economy because if it did not:
Non-essential goods would continue to be manufactured, wasting
scarce resources.
All prices would rise, but not equally.
In other words, in wartime the price system will not allocate resources
efficiently.
Pause and think
If the government is going to purchase tanks and guns from business, what prices does it
pay? Think about this before reading on.
We know that looking for a market price will not help, because the market
will not work in wartime. A government could offer to purchase, say
aircraft, from the private sector. This would presumably mean that the
government would have to offer a higher price than previously. But it has
no way of knowing if that is an efficient price.
The aircraft manufacturer may be paying too much or too little for his
inputs. The government has, in effect, to decide how many resources,
labour and capital investment to allocate to aircraft production.
Pause and think
One of the features of a war economy is that labour is usually the scarcest factor relative
to others. Why is this so? Decide your answer before reading on.
Capital was not the scarcest factor in the Second World War as it
usually is in peacetime. This was because large economies of scale
were possible for most wartime goods. Economies of scale mean that
as output rises the cost per unit of output falls. For example, if there
was a large amount of underused capital, as on a railway, more trains
could be run without much more investment in equipment. Moreover,
machine tools and other capital goods could themselves be mass
produced.
The scarcest resource must have been labour. The industrial labour
force could not easily be increased, particularly when, as in the 1939
45 period, the armed forces took a large proportion of the pre-war
labour force (20 per cent in the UK). Once full employment had been
achieved, the only source of additional labour in most countries was
married women. There was also a major redeployment of women from
consumer industry and services to war factories in most countries.
10.2 The economic situation at the beginning of the war

Our discussion above regarding labour scarcity assumes full employment.
As long as there were unused resources in the economy, there were no
serious constraints on war production until full employment was reached.
We have seen that most economies were seriously depressed in the 1930s.
107
It was possible, therefore, in the short run, to have both guns and butter
but only in the short run. For example, although Hitler was elected in
Germany in 1933, the Nazi economy did not introduce maximum controls
until 1937. This was when the economy reached full employment.
The position of the United States was quite different. The American
economy was still very depressed in 1939. Output per person was no
higher in 1939 than in 1929. It was, therefore, initially very easy to
increase output. Rearmament started after the fall of France in 1940 and
the USA fully entered the war in late 1941.
In other words, initially, supply constraints were less in the USA than in
other countries.
Now consider another aspect of the wartime economy.
Pause and think
We have mentioned technology and mass production. What do you think were the
main problems of mass-producing weapons? Only read on when you have decided your
answer.
In wartime, output is maximised with long runs of identical products. This
is particularly true of armaments. In the Second World War, the benefits of
mass production were enormous.
There was a problem, however. If maximum economies were to be
obtained, a decision would have to be taken about which armaments to
produce. It took a long time to bring a weapon, such as a fighter aircraft,
from design to mass production several years in fact.
The main constraint was in production engineering. Just as it took Ford
four years completely to set up the Model T production line, it took a long
time to set up a weapon-production line.
The problem was that if the decision to mass produce, say an aircraft,
was made too early, it would be obsolete by the time large numbers
were available. On the other hand, if the government waited until the
most advanced technology was developed, the aircraft might not reach
production until it was too late. All countries made mistakes in weapons
policy, but the largest economies, especially the USA, could afford to make
more mistakes than others.
Germany, for example, continued to produce the Messerschmitt 109 fighter
plane up to the end of the war in 1945. Even though the Focke-Wulf 190,
which came into service in 1941 was a far superior aircraft, twice as many
Messerschmitts were built. This was because planning mistakes led to
engineering problems and a shortage of skilled labour.
10.3 The effects on output

Two effects are worth considering. First there is the diversion of output
from consumer goods to wartime goods. Second, there were the effects of
the war on economic growth. We look at each in turn next.
10.3.1 The proportion of the economy making war goods

Table 10.1 below shows that the proportion of the economy of the main
belligerents directly devoted to the war effort varied from country to
country.
108
UK
55%
USA
40%
Germany
40%
USSR
40%
Table 10.1 Percentage of GNP in armed forces/armaments
Pause and think

Why was it possible for the UK to devote 55 per cent of its GNP to the war effort when
the USSR only devoted 40 per cent?
There are several reasons:
First, both the Soviet Union and Germany had to devote a large
proportion of their GNP to agriculture because it was inefficient so
agriculture needed a large proportion of the available labour supply.
Germany had an additional problem, in that it did not fully mobilise
until late in the war.
The main reason that the share of GNP in the war effort was so high was
that, unlike Germany, the UK could trade. The case of America is rather
different.
Because the US economy was so large it could produce large quantities
of armaments without switching all possible resources into armaments,
which was the case in the UK. The USA is estimated to have accounted
for 40 per cent of world output. With such capacity, the US economy
could produce all the armaments needed without a serious drop in the
production of consumption goods.
10.3.2 Growth rates during the war

During the war, GNP in the USA grew by 70 per cent, in the UK by 15 per
cent and in the USSR by 8 per cent. (GNP fell in Germany and Japan, of
course.) There are two points to remember, however.
The USA was still in Depression at the beginning of the war.
The USSR lost 33 per cent of its output in the German invasion in
1941.
Pause and think
What were the implications for consumption levels in these countries?
Consumption fell most in the USSR, then Japan and then Germany. It did
not fall in the USA. It fell in the UK, but thanks to strict rationing and price
controls, not for the poorest people.
10.4 Strategy and the wartime economy

We turn now to strategy decisions made about how to fight the war. For
example, one strategic decision is whether to have more ships or more
aircraft. Considerable planning was necessary if maximum output was to
be achieved.
10.4.1 The UK strategy

For example, the UK strategy was to fight a long war. This was possible
because of Britains island position and the knowledge that the USA would
either be an ally or neutral, not an enemy. This meant that the UK could
assume that trade would be possible with the USA, as well with Canada,
India, Australia, Malaya etc. The Empire countries did not have the
resources of the USA, but they made a vital contribution.
109
10.4.2 The German strategy

When we look at Germany, we see, surprisingly, that the proportion of
resources devoted to the war effort was lower than in Britain. This cannot
be wholly explained by Britains greater ability to trade.
In 1938, Germany was using about 25 per cent of its GNP for war
purposes, compared with only 10 per cent in the UK. But once the war
started, the UK economy expanded faster. We may see this in Table 10.2,
which is about British and German aircraft output. Aircraft were an
essential weapon in the war, and the ability to produce aircraft is a key
indicator of the efficiency of the economy. Remember that the German
economy (with Austria) was 33 per cent larger than the British in 1939.
UK
Germany
1940
15
10
1941
20
11
1942
24
14
1943
26
25
1944
27
40
Table 10.2 Aircraft production, 194044 (000s)
Pause and think

What does the table illustrate?
Despite the larger size of the German economy, the UK out-produced
Germany in aircraft before 1944, by which time the Germans were on the
way to losing the war. Note that these figures are production, not use.
American aircraft used by Britain are excluded.
The reasons for the apparent inability of the German economy to devote a
higher proportion of GNP to the war effort are still controversial.
According to one view, the Nazis were unwilling to ask their population
to make the sacrifices necessary to fight a long war. They had no option
but to try to win quickly. This policy had to be revised after the failure
to defeat the USSR in 194142.
Alternatively, some experts think that Germany was attempting to fight
a long war, but in the early years its planning was inefficient.
Incidentally, there is an important historical point here. The easy German
victories of 194041 tell us very little about the efficiency of the economy.
10.4.3 The USSR strategy

The USSR, of course did not have the luxury of time. It was faced with
invasion by a very powerful enemy. The situation was made worse because
Stalin had purged the armed forces of most of the competent officers just
before the war. The Soviet Union had no option but to maximise output in
the short run, even if this policy was inefficient in the long run.
For example the USSR mass produced the aircraft and tanks that they had
in production in 1941 (three tank types and six aircraft types). It was luck
that the tanks and aircraft turned out to be good products. You may wish
to return to the section in 10.2 on production engineering to understand
this point.
10.4.2 UK strategy again

We have seen in Chapter 2 and elsewhere that trade usually maximises
output. This should be true in wartime, as well. But was trade possible in
wartime? Let us look at the British example.
Germany and its allies could not trade outside Europe whereas the UK
could trade with the USA and many other countries. This meant that even
110
in wartime the UK could use the international division of labour. There

were two trade problems for the UK, however.
10.4.2.1 How to pay for imports
The UK had large overseas investments, which could be sold. But when
these ran out, the gains from trade were limited. This is because the cost
of manufacturing exports in the UK became too high compared with
making armaments, which had to have priority. This is why Lend Lease,
which was a series of loans from the USA, was so important. Lend Lease,
which started in 1941 (before the USA entered the war), was a series of
gifts (technically, loans) from the US government to allied governments,
which were used to pay for imports from the USA. The main recipient was
the UK followed by the USSR. Lend Lease to the UK increased the amount
of armaments available to the armed forces by 17 per cent.
10.4.2.2 Transport costs
These were very high in wartime because ships were sunk. Although the
cost of production of goods was lower in the USA, the delivered cost in
the UK could be higher and outweigh the greater production costs of
manufacturing the goods in the UK. Therefore, the British government
replaced a great deal of food imports, by guaranteeing the price of food.
To incentivise farmers, the food guarantees were continued in the post-war
period.
10.5 The expansion of economic management

The war also saw the rapid development of economic management to a
much greater extent than before. For example, an inflationary gap was
identified in both the British and American economies.
Pause and think
Why would there be inflation in wartime? If you are not sure, look back at 10.1.
It was possible to identify an inflationary gap in the UK and USA because
by 1940, both countries had properly worked-out national income
accounts. In other words, because of important deployments in theoretical
and practical economics in the late 1930s, it was now possible to measure
the size of the important variables in the macro economy.
For example, inflation had to be suppressed by increasing taxation and
savings. Much of the saving was forced. The government took the savings
directly from pay packets. National income accounting made it possible to
calculate how large the increase in taxation would have to be.
As we have seen, in the UK this led to the suppression of consumption,
which in turn required rationing to preserve a degree of equity.
10.6 Other aspects of wartime economies

There are many other aspects of wartime economies you will find
examples in the readings given at the beginning of the chapter. Here we
look at the following:
The war led to an increase in welfare in the UK.
The increase in welfare was partly due to the elimination of
unemployment.
111
The war led to major changes in the international economy and the
political settlement.
Post-war reconstruction presented new problems.
The USA ended the war as the dominant economy in the world.
Pause and think
What have you already learnt about the five aspects above?
Answer this before reading on.
10.6.1 Why did welfare improve in wartime?

In Britain and, initially in Germany, there was an increase in social welfare
during the war. There are many explanations for the growth of social
welfare but a key one is related to the concept of total war. (Welfare did
not increase in the USSR, of course.)
Victory ultimately depended on the output of the economy. This meant
that the output of civilian workers was just as important to the war effort
as the output of members of the armed forces. It was just as important
(that is, just as efficient) to look after the welfare of civilians, as it was to
look after the welfare of the military, plus civilian labour was relatively
scarce.
Pause and think
Did full employment make it easier for governments to offer a higher degree of welfare
than in the pre-war period when unemployment was high?
Unemployment was an important reason for poverty in the pre-war period.
War led to full employment and the main beneficiaries were the poorest
people.
10.6.2 Political changes

There were also political changes which had important economic effects.
For example, the USSR and most of Eastern Europe were cut off from full
participation in the international economy. Also, several colonial empires
began to collapse.
10.6.3 Reconstruction
The war caused massive destruction in Europe and the Far East. In
particular, capital equipment had to be replaced. Japan and Germany
had been heavily bombed for example, and even countries less heavily
bombed, like the UK, ended the war with worn out factories and transport
systems.
The only undamaged economy of any size was the USA. The USA made 50
per cent of world manufactures in 1945. Clearly the majority of the capital
needed for reconstruction could only come from the USA. However, the
damaged economies did not have the capacity to export to pay for imports
from the USA.
There were two possible solutions:
War-damaged economies could recover by devoting the few resources
they had to investment. This would mean that consumption would
have to remain low. In other words, it would take many years of
privation before countries could recover from the war.
112
The only alternative was that these countries were given loans to help
recovery. The loans would have to come from the USA.
We explore these problem and the decisions taken in 1944 and after in
Chapter 11.
10.6.4 The position of the USA in the international economy

The USA was the only major economy that was undamaged by the war.
The war had strengthened the US economy. For example, technical
change had been rapid during the war, for instance in aircraft
production, which naturally favoured the technically most advanced
economy at the time.
Most importantly, the strength of the American economy after the war
and the weakness of the rest of the world (including the necessity of
loans for post-war reconstruction) had important political effects. The
USA would be able to recreate the international economy after the war
largely as it wished.
(We look at these issues in Chapter 11.)
Summary
The Second World War required that governments intervene in the
economy to an unprecedented extent. Depending on circumstances, some
economies were able to devote proportionally more resources to the war
effort than others.
After the war, there was a serious reconstruction problem and only
international loans from the USA could save governments from continuing
to impose severe restrictions on consumption.

should be able to:
explain why planning was necessary to maximise output in wartime
explain why strategic objectives may affect the efficiency of the
economy in wartime
suggest possible reasons why some countries were able to devote
proportionally more resources to the war effort than others
discuss what the main constraints on output in a war economy can be.
Questions
1. How does a wartime economy differ from a peacetime economy? You
may restrict your answer to any one country during the Second World
War if you wish.
2. Account for the successes of economic management during the Second
World War in any country that you choose.
113
Notes
114
Chapter 11: International monetary relations since 1944
Chapter 11: International monetary

relations since 1944
The end of the First World War in 1918 left a legacy of problems for the
international economy that proved impossible to solve. The failures of
the 1920s and 1930s convinced people that new steps had to be taken to
create a set of international rules that would offer stability. In this chapter,
we look at these steps.
Objectives
To:
explain that international institutions are contingent on the
circumstances of the time
make clear why the post-war international monetary arrangements
could not be implemented at the time
show why the fixed rate regime (Bretton Woods system) collapsed and
was replaced by flexible exchange rates
discuss how the move to flexible exchange rates affected national
economies
explain the methods used to contain major economic crises, such as the
oil crises of 1973 and 1979.
The effect of the recent crisis (from 2007) will be discussed in Chapter 17.
Learning outcomes
discuss whether it was the Bretton Woods rules or something else that
made the international economy work so much better after 1945 than
before 1939
explain the importance of political considerations in the development
of international economic structures
explain how a country (and its currency) may remain dominant in the
international economy without being economically the most efficient
explain how an important shock to the international economy, such as
an oil crisis, can be contained.
Essential reading
[ISBN 9780691139371] pp.12633, pp.15764, pp.21925 and pp.22832.
[ISBN 0415199301 pbk] pp.23746 and pp.26978.
115
Further reading
[ISBN 0415250633 pbk] pp.11421, 2048.
Foreman-Peck, J. A history of the world economy: international economic relations
since 1850. (New York: Harvester/Wheatsheaf, 1995) second edition
[ISBN 0745009352 pbk] pp.23957, pp.30511 and pp.3358.
Introduction
In this chapter we investigate international monetary arrangements and
the changes that occurred before and after 1973. We discuss the reasons
why the Bretton Woods agreements took the shape that they did. Then we
explain why the Bretton Woods agreements were unsuitable for the postwar recovery and why different monetary arrangements had to be made
which were not envisaged at the end of the war. We also look at the effects
of Marshall Aid on the recovery of Europe.
Next we explain why the dollar declined in the 1960s and why this led to
the end of fixed exchange rates and the introduction of floating currencies.
Finally, we look at the oil crises of 1973 and 1979 and how the effects of
the crises were controlled.
11.1 Institutions in the international economy

Bretton Woods
We return to a question we posed in Chapter 6. Why did the international
economy sometimes function well and at other times function badly?
Did the success of the international economy depend on creating a
set of international rules which meant that the international economy
would prosper as long as countries followed those rules?
Or were these so-called rules only what was possible at the time? That
is, the economic and political realities were what really counted.
And were these rules abandoned when their usefulness had passed?
11.1.1 The Bretton Woods conference

There was an international conference of all the allied powers at
Bretton Woods, New Hampshire, USA in 1944. This conference was
unprecedented. The war was still continuing, although by 1944 it was
clear to most people that Germany and Japan would be defeated. The
purpose of the conference was to plan what the international economy
would look like in the post-war period. Countries were determined to
create a post-war settlement that would avoid the problems of the interwar period:
a major collapse of the international economy
the rise of Fascism
another world war.
The conference led directly to the creation of the most important financial
and economic institutions of the post-war international economy:
The International Monetary Fund (the IMF), whose role was to
manage international currencies and to ensure that exchange rates, as
far as possible, remained fixed.
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The General Agreement on Tariffs and Trade (the GATT), whose role
was to ensure that barriers to trade were as low as possible, so that the
amount of international trade was as great as possible.
The International Bank for reconstruction and development (the

World Bank), whose role was to give aid to help, first, in the
reconstruction of Europe and secondly, in the long-term financial
support of developing economies.
11.1.2 The objectives at Bretton Woods

All the countries present at the conference agreed on several objectives.
In other words, this is what all countries thought that the international
economy should look like in the future. The objectives were:
Fixed exchange rates and why they were thought desirable was
discussed in Chapter 4.
Convertibility of one currency into another. The dollar would be
convertible into gold, and all currencies would be convertible into
dollars. Again, this would allow trade to be multilateral as we discussed
in Chapter 4.
A reserve fund that countries could draw on. Because of the point
above, if a country had balance of payments difficulties because its
imports exceeded its exports, the convertibility of its currency would
be threatened or it might have to devalue. If it could not borrow,
convertibility and fixed exchange rates would be threatened. The only
way to avoid this would be with a loan. Hence there had to be a fund
on which countries could draw and the reserve fund provided this.
No trade discrimination meant that although countries could have
tariffs, they could not have different tariffs against different countries.
For instance, tariffs on US imports into Britain could not be higher than
tariffs on imports into Britain from France or Australia.
Pause and think
Look over the discussion of the 1930s in Chapter 9. How did these 1944 objectives differ
from those of countries in the 1930s?
Make sure you can see that these objectives were almost the exact opposite
of what countries were doing during the 1930s.
11.1.3 Most countries had additional objectives at Bretton Woods

Most countries, led by the UK, had additional objectives. The reason was
that their trade position was so weak. As we pointed out in Chapter 10:
Most countries apart from the USA had suffered serious physical
damage to their economies during the war.
The damage meant that these countries needed imports to make
reconstruction possible.
The damage also meant that they were not able to produce many
exports.
It was inevitable that they would have balance of payments deficits.
This meant that they needed access to foreign credit to cover the gap
between exports and imports. If they had no credit their post-war
reconstruction would be delayed, which would have serious political
consequences.
Pause and think
Where could countries who needed credit to fund their post-war reconstruction obtain
such credit? Certainly not from each other, they were impoverished and indebted by war.
What about the IMF? Think this through before reading on.
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The IMF was a fund and the amount a country could draw on was related to
the amount it had put in. With the exception of the USA, this was not much.
The Europeans wanted an institution that would allow them to draw funds
from the IMF without being limited by the original contributions. In other
words, they wanted to obtain overdraft facilities, to use the British term
for borrowing from banks.
The problem for the European countries, for example, was that if they
could not obtain credit, it would be necessary to deflate their economies.
Both imports and consumption would have to be seriously limited. This
was politically very difficult, particularly in countries such as the UK,
which had won the war and had a new government which was committed
to social expenditure programmes.
Activity
Imagine that you are the finance minister of a war-damaged west European country
between 1945 and 1950 such as Belgium. Explain why your country would have to
deflate unless it could obtain foreign credit.
In your answer, remember the following:
Your country can produce few saleable exports.
Imports are required to rebuild the economy and meet consumer demand.
Without credit, investment can only be at the expense of other expenditure.
Most countries were also unwilling to accept that there would be no trade
discrimination in the post-war international economy. The reasons were
similar to the reasons that they wanted access to international loans.
Pause and think
Why did countries want trade discrimination?
Make sure you can follow the logic of the argument below.
The USA was the most powerful economy, with a dominant trade
position.
This meant that a so-called dollar gap was inevitable.
People would always want dollars in order to buy US goods so there
would be a shortage of dollars.
It would be necessary to buy as much as possible from non-dollar
sources. So, those holding dollars could not use them without
permission from the central bank.
This meant that it would be necessary to discriminate against the
dollar. Technically, under IMF rules, to declare the dollar a scarce
currency. This would allow the government to take dollars owned by
exporters, and use them only for essential imports. So the purpose of
the trade was to obtain dollars.
Trade with other (European) countries would be on a barter basis, that
is it would be bilateral. (The value of exported goods would equal the
value of the imported goods.)
These two additional objectives, to gain access to foreign loans from a
revised version of the IMF and to discriminate against dollar exports, were
very sensible. Without them, recovery from the war for most countries
would have been difficult and slow. But the two extra objectives were not
included in the Bretton Woods agreements, which stuck to fixed exchange
rates, a limited fund, convertibility and no discrimination.
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11.1.4 Why did the post-war settlement not automatically lead

to recovery?
The objective of Bretton Woods was to set out what the international
economy should look like in the post-war world. But the International
Monetary Fund and the other institutions did not provide the means by
which the international economy could be reconstructed after the war.
The Bretton Woods agreements were statements of what the international
economy should look like, not how stability could be created. The next
point is that the economic dominance of the United States was a major
problem.
Pause and think
Why was the economic dominance of the USA a major problem?
The assets of an unrestricted international bank to provide the loans that
Europeans needed to cover their large balance of payments deficits would
have to come, almost exclusively, from the United States. In other words,
the international bank would be a channel for US loans. From 1944 to
1945, American loans of this size were politically impossible in the USA.
Another problem was the American insistence that there was to be no
discrimination against the dollar. Like the UK in the nineteenth century,
the USA wanted free access to world markets. American insistence that
there was no discrimination in trade, and none against the dollar, would
maximise American exports.
As we shall see, eventually the Americans realised they could not insist on
these conditions.
11.2 The post-war international economy

We may conveniently divide the period since 1945 into several subperiods. Each period was distinct and presented new challenges for
the international community. But a unifying theme is the success of the
international economy after 1945, especially when compared with the
period before the war. In terms of growth and development, the post-1945
period re-established the pattern we observe in the 18701914 period (see
Chapters 36). The old system was based on the UK, gold and free trade.
The new system was initially based on international institutions, the dollar
and less free trade. As we see in the next part of this chapter, the success
had less to do with the Bretton Woods agreements than with other factors.
11.2.1 The problem period: 194549

The strength of the new system was not immediately apparent. People
could see that the institutions established at Bretton Woods were
inadequate. Just as in the 1920s (see Chapter 8).
A serious dollar gap appeared. After 1945:
There was high demand for American exports, but little that other
countries could sell to the USA in return.
Governments, particularly those in Europe, were forced to discriminate
against the dollar, and to discriminate against American goods.
They exercised exchange controls which prevented their nationals from
obtaining dollars and therefore from importing American products
unless the products were absolutely necessary.
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It was sometimes possible to use the dollars earned by one country by

exporting to the USA to pay for American imports to another country. The
British pound sterling was linked to the countries of the sterling area.
Members, including most British Commonwealth countries, held their
reserves in sterling and agreed to impose similar exchange controls against
imports of US goods. This meant, for example, that most dollars earned by
Australians had to be converted into sterling.
Hence Australia had to use its dollar earnings to purchase goods from
within the sterling area (e.g. from the UK) not from America. For example,
Australia, at the time, imported British cars and not American cars.
The shortage of dollars meant that a return to currency convertibility was
impossible. There was a disastrous episode in 1947 when the Americans
insisted that the pound sterling was returned to convertibility. Within a
few weeks, the UK had lost most of its reserves that is, as we could have
predicted, people converted their pounds immediately into dollars. Try the
next activity.
Activity
Say it is now 1947. What factors do you consider when choosing to hold pounds or
dollars?
Why would a country discriminate if it could not obtain large loans?
If it were not allowed to discriminate (because of rules being enforced) what other
methods could it use to reduce a large balance of payments deficit?
11.2.2 The international economy begins to work, 194958

Conditions changed dramatically after 1949 and the international
economy began to recover:
The dollar gap was closed.
Fixed exchange rates were finally established.
But this was not because of the Bretton Woods institutions agreed in
1944, like the IMF.
The reasons for the changes were as follows.
In the first place, the Communist threat, initially in Europe, plus
the start of the Cold War, changed the thinking of the American
government. It also affected the American electorate.
The US government made a political decision to confront the Soviet
Union and to support threatened countries.
This meant that it was necessary to help non-Communist economies
grow as fast as possible. Growth would make it less likely that the
populations of western Europe would support the Communists. At that
time both France and Italy had strong Communist parties.
The problem was that this was incompatible with the Bretton Woods
institutions.
If the European countries grew more rapidly, their imports would
increase faster than their exports leaving balance of payments deficits.
This would mean that the governments would have to deflate the
economies to correct the deficit that is increase taxes and lower
expenditure.
But that would make it harder to meet the Communist threat. The only
alternative was loans to allow imports to grow so that the balance of
payments constraint was reduced.
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But, as we have seen, the Bretton Woods agreements had no provision

for large loans.
The solution was the European Recovery Programme or Marshall Aid
as it was called after its Director, the American General Marshall, which
started in 1949. Under Marshall Aid, the USA gave large grants in dollars
(plus a few loans on extremely generous terms) to European countries.
Marshall Aid lasted for four years, and allowed the European economies
to import more than they exported, increasing the growth rate. Moreover,
European governments could still control imports, so Marshall Aid dollars
were used to pay for capital not consumption goods.
11.2.3 The effect of Marshall Aid

The direct effect of Marshall Aid was not particularly large. The average
payment to each European country was one to two per cent of its GDP a
year over the four years the payments were made. A typical investment
rate at the time was more than 10 per cent of GDP each year. Therefore
Marshall Aid itself was not large enough to transform the growth of the
European economies.
Marshall Aid benefited the European economies in a completely different
way, however. Since the end of the war, the European governments had
kept tight controls on trade, because of the currency problems, especially
the dollar gap.
The problem was that the controls were on trade between European
countries as well as between Europe and the USA. In other words, because
of the shortage of dollars, each European country was trying to be as selfsufficient as possible.
The USA made Marshall Aid conditional upon reducing barriers to
trade; particularly the most restrictive barriers which were quotas (see
Chapter 2). Freer trade allowed each country to pursue its comparative
advantage. Remind yourself of the benefits of this outcome (see 1.5.5).
Trade between European countries was also facilitated by the European
Payments Union (EPU). The EPU was a fund created from Marshall Aid in
1948. It worked through monthly accounting. Each month, those countries
with trade surpluses (and therefore, foreign exchange balances) allowed
the countries with deficits to draw on these balances. This meant that
deficit countries could import without finding the foreign exchange. The
surplus countries were compensated from the fund. By 1958, there was no
need for the fund and it was wound up.
The result of these measures was a large growth in trade between
European countries, which in turn led to a large growth in their income.
The income growth from trade liberalisation was much greater than the
direct effects of Marshall Aid.
This is an important point. In the next chapter we see how the European
Coal and Steel Community (ECSC) had a similar beneficial effect on
trade. Note in passing how economic historians interpret events. We
look at the actual outcomes (here, more trade) rather than the planned
outcome (here, the flow of capital from the USA).
Pause and think
Quotas allow only a fixed volume of imports as opposed to tariffs which increase the
price to the consumer. Which are more restrictive, quotas or tariffs?
The answer is quotas. Think about a tariff. Both the exporter and the
importer could absorb some of the price increase from a tariff to hold
prices down.
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Marshall Aid finished in 1952, but the flow of American funds to other
countries continued. For example the Cold War between the West and
the Soviet Union meant that the USA kept military forces overseas and
spent abroad large sums on the military. In turn this meant that dollars
were spent in foreign countries. The key event was the Korean War which
both increased American spending overseas and American imports and
effectively ended the dollar shortage.
There was also an increase in direct investment by Americans overseas.
The reason was that the General Agreement on Tariffs and Trade (GATT)
had not worked. Free trade had not come about and all the major
economies still had tariffs. This meant, for example, that large American
corporations were unable to export cars to Europe. Hence they used
factories in European countries and manufactured the cars within the tariff
barriers that is in Europe.
Pause and think
Make sure that you understand that American loans were equivalent to an increase in
American imports. If you find the concept difficult, think about who buys the goods and
services and who supplies them.
Why would, say, a French company exchange francs for dollars in 1948?
Where did those dollars come from?
The Cold War and American overseas investment both helped to maintain
the flow of dollars to other countries. As a result, European countries
quickly recovered and the dollar gap closed in the 1950s. This was quite
different to the situation in the 1920s (see Chapter 7).
11.2.4 Dollar problems and the international economy, 195871

Before the early 1960s, the United States had a trade surplus, which was
recycled through capital exports. But, in the early 1960s, the American
economy developed a deficit on capital account. This arose because
American overseas lending was not 100 per cent covered by American
(net) exports of goods. This meant that the USA had to borrow. Try the
next Activity.
Activity
Work through these hypothetical figures to help you understand the changing position of
the USA in the international economy during the period.
1. Say in the 1950s that US exports were 10 and imports were six. What was the deficit
on capital account required to balance these net exports?
2. Say in the 1960s, US exports expanded to 12 and imports to nine. What happened if
net capital flow abroad rose to eight?
3. How could balance be obtained? Six theoretical possibilities are listed below, though
the Bretton Woods agreements ruled out several. We look into these more closely
later in this chapter.
4. Say in the late 1960s, US exports stay at 12 and imports rise to 17. The net capital
outflow is still 8 but what is the excess of dollars?
1. Four.
2. An excess of dollars flowing out of the USA of eight minus three equals
five.
3. a. The exchange rate of the dollar is lowered, US exports increase and
imports fall by a net of five. However, this would have meant ending
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the fixed exchange rate for the dollar that underpinned Bretton
Woods. The same applies to the other option, a rise in the exchange
rates of the yen and the mark.
c. Other countries increase their dollar reserves by five.
d. People and companies in other countries build up dollar holdings by
five.
e. The USA introduces import controls to reduce imports by five.
f. The USA introduces capital controls to reduce the capital outflow by
five.
g. The USA deflates the economy and as a result net exports increase
by five.
4. The excess of dollars rises to five plus eight equals thirteen.
The possibility that the USA might have a deficit had not been anticipated
in the post-war settlement. But American foreign policy made it likely that a
deficit would eventually appear.
The increase in direct investment overseas by American companies made
a deficit even more likely. The appearance of the American capital deficit
meant that bonds, denominated in dollars were taken up by the overseas
central banks. This increased the central bank reserves. In theory the central
banks could have used the increase to finance more spending. But they
would not do this, largely because of a fear of inflation. This meant that by
holding US bonds the European central banks were in effect lending money
to the Americans. This was bound to weaken the dollar in the long run (see
below).
Fixed exchange rates had been established by the early 1950s. But this was
a bit of an illusion. Convertibility was the most difficult aspect of the postwar settlement to establish. Many European currencies were not 100 per
cent convertible until the 1960s, for example. And countries still had some
controls on currency used for capital movements (but not on currency used
for trade).
When the controls were lifted, it was not possible to avoid devaluations. This
was contrary to the original Bretton Woods agreements, under which fixed
exchange rates were taken for granted and IMF loans would only be made to
cover temporary balance of payments deficits.
But if a countrys export performance was weak it might be necessary to
devalue. Not devaluing would be more damaging than doing so.
Pause and think
Consider an economy with a fixed exchange rate that is too high. This means that the
economy cannot operate at full employment, for example. What other effects would it have?
Eventually devaluations would have to be allowed, as with the British pound
in 1967, and the French franc several times. The German mark had to be
revalued.
Fixed exchange rates remained an objective but it was going to be more
difficult to achieve them.
11.2.5 The late 1960s: the US trade deficit

The American trade deficit, which started in the late 1960s, had never been
anticipated. The reasons are complex, but simply put: several American
industries had been technologically overtaken, American manufactured
exports were falling and, more seriously, low cost imports, especially from
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Germany and Japan were increasing faster than American exports. Finally,
the Vietnam war led to inflation in the USA.
Hence Germany and Japan had trade surpluses and the USA, a trade
deficit. The USA was losing gold reserves to cover the deficit. (Remember
that the US dollar was convertible into gold, unlike other currencies.)
Faced with the weakness of the dollar and the consequent gold losses, the
American government could follow one of several options:
Do nothing. This would mean that the USA would continue to lose
gold. The problem was that although US gold stocks were very large
they would eventually run out, which would destroy the convertibility
of the dollar.
Deflate the economy. This would reduce income in the USA and,
hence, reduce US imports. The problem, of course, was whether
deflation was politically acceptable that is if the electorate would
allow the government to reduce the standard of living.
Control capital flows which they did. The problem with this
solution to the deficit was that the IMF system was designed to ensure
convertibility. By the 1960s, countries were not allowed to have
exchange controls on their current accounts. Moreover, the GATT rules
did not allow countries to increase tariffs. Obviously, the USA, which
had, in effect, forced other countries to follow these rules, was hardly
in a position to break them.
Devalue the dollar. This was also impossible under the IMF system
which was designed to ensure fixed exchange rates. The dollar was the
key currency, against which all the other exchange rates were set. The
dollar could not be devalued without changing the whole system. If a
devaluation of the dollar was allowed, it would be an admission that
the post-war international economic system had failed.
Pause and think
If the USA was boxed in and unable to devalue the dollar, what alternatives can you think
of which would have restored stability to the international economy?
The final way out was, rather than devaluing the dollar, to persuade the
surplus countries to revalue. But this was easier said than done since
it would mean that the exports of the surplus countries, such as Germany
and Japan would fall.
In other words it was easier for the surplus countries to adjust their
economies if there was an exchange rate problem. However the fact that
exchange rates were fixed meant that it was the deficit countries that had
to adjust and not the surplus countries. This was because, under fixed
exchange rates, a deficit country that did not adjust would eventually run
out of reserves.
This problem had been anticipated, but when the USA had designed the
system in 1944, it was not anticipated that the USA would itself be a
deficit country one day.
The IMF system was making it difficult for the USA to solve the weakness
of the dollar.
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11.2.6 The end of the Bretton Woods system, 19713

In the end, the system could not survive the transformation of the mark
and yen from weak currencies into long-run strong currencies and the
dollar into a long-run weak currency. The link between the dollar
and gold was removed in August 1971. The dollar fell in value,
particularly against the mark and the yen. At the same time, US import
duties were increased. This was the equivalent of revaluing the strong
currencies.
Pause and think
Consider the paragraph above. Would introducing tariffs have had the same effect on the
US balance of payments, and on the dollar, as the devaluation?
The changes in US policy in 1971 were not meant to be permanent. The
objective was to bring other countries to the conference table. This led to
the famous Smithsonian agreements (made at the Smithsonian Institution
in Washington), which attempted to patch things up. But the Smithsonian
agreements were not enough to save the Bretton Woods system. The dollar
was devalued for a second time in 1973, and then floated was allowed to
find its own level. This marked the end of the Bretton Woods system.
Note that when we say the Bretton Woods system collapsed in 1973, we
do not refer to the IMF or the World Bank. These institutions continued to
flourish. Also the GATT was eventually transformed into the World Trade
Organisation (WTO), which also continues. What collapsed was the system
of fixed exchange rates against the dollar.
11.2.7 The first oil crisis, 1973

The oil crisis led to major changes in the international economy. There
were major changes in trade patterns, and in the pattern of capital
movements. Major adjustments were necessary in the economies in both
developed and less developed countries.
The effect of the oil crisis on prices was particularly severe because of the
fall in the dollar (oil was priced in dollars). This meant that many traders
had moved into commodities to hedge against a dollar fall. As we would
have predicted, demand for commodities rose and prices rose by 200 to
300 per cent. The oil price itself rose by 400 per cent.
11.2.7.1 The recycling problem
Figure 11.1 shows the main features of the crisis.
The recycling problem: petrodollars
$
OPEC
USA/UK assets (35%)
Euro $ (42%)
Deficit countries
IMF (10%)
$
Figure 11.1
The increase in the price of oil meant large flows of dollars into the OPEC
countries because oil was priced in dollars. (OPEC is the Organisation of
125
Petroleum Exporting Countries). But the OPEC countries were not able
to absorb all the dollars that they were earning. Hence they lent them to
other countries or international institutions.
About 35 per cent of OPEC earnings went into assets in the UK and USA
(property, shares and bonds), about 42 per cent went to the Eurodollar
market (which was located in London) and about 10 per cent went into
IMF funds. In this way the dollars that had been paid to OPEC were
recycled.
Pause and think
What was the effect on the world distribution of income? Compare the effects on:
an OPEC member country
a developing country exporting agricultural products and importing oil.
11.2.7.2 The switching problem
The price of imports of oil had risen. The switching problem was basically
the way the extra cost of oil imports was absorbed, or if it was not
absorbed, how the cost was switched. In the importing countries the extra
cost was paid (absorbed) through a large increase in their debt.
Developed countries such as Germany and Japan paid for the oil in dollars
then borrowed the dollars back from the OPEC countries. This increased
their debts but these debts were eventually repaid without it being
necessary to significantly reduce living standards in those countries.
The less developed countries also had to borrow to finance oil imports.
But these countries could not increase exports to repay the loans, as
the developed countries had been able to do. Hence, debt continued to
increase. By 1982 the debt had reached crisis proportions. It was possible
that some less developed countries would default on their debts, which
would threaten the stability of some of the commercial banks which had
lent to them.
Eventually, the creditors the World Bank, and the commercial banks
imposed large deflationary packages on these less developed countries
in the 1980s. These were called Structural Adjustment Packages and
included rescheduling loan repayments. The aim was to reduce imports
and make it easier for them to repay their debts. However, imports were
reduced by depressing the already low living standards in these countries.
11.2.7.3 Stagflation
The oil crisis was partly responsible for a major change in the internal
economies of developed countries. The increase in the oil price fed
through into the price of most products, causing inflation. At the same
time rising energy costs led to reduced output and more unemployment.
This considerably worsened a problem which had first appeared in the
1960s the coexistence of both unemployment and inflation, stagflation,
as this phenomenon was called. This was made more serious by incorrect
policy responses to the oil crisis. These issues are dealt with in Chapter 13.
11.2.8 A new currency and payments regime
126
After 1973, currencies were floated. As we have already seen it had been
thought that a strong international economy depended on the certainty
of fixed exchange rates. When currencies floated in the later 1970s,
there were large variations in their value. This was called the volatility
problem. It had been thought that the volatility of exchange rates when
currencies floated would lead to chaos, but this did not occur.
Businesspeople seemed to be able to adjust to the volatility of exchange

rate changes very easily. They were helped by the growth of forward
currency markets, where it was possible to trade in currencies in
advance, which reduced uncertainty. This is how they worked:
If a Japanese person decided to purchase something in the future
for $10 million, he or she could also contract to buy the dollars at a
particular exchange rate.
If the dollar fell, he or she would pay at the same rate in yen.
If the yen fell, he or she would still have $10 million to buy the
product.
11.2.8.1 Did floating exchange rates give domestic policy freedom?
It was expected that floating rates would remove the constraints on the
internal policies of governments. In other words, governments would
increase expenditure (net of taxes) and avoid a balance of payments crisis
by letting the currency float down (see Chapter 4 for the same argument).
But this did not happen.
Pause and think
Why didnt governments avoid the balance of payments crisis?
The major economies were not isolated from each other.
If one government increased borrowing, for example, it would lead to a
rise in (real) interest rates.
A rise in interest rates would lead to a rise in the exchange rate,
which would have effects on the economy and which were probably
undesirable. As we will see in Chapter 13, this is an important issue in
monetary economics.
11.2.8.2 The strength of Japan and the weakness of the US economy
By the early 1990s, Japan was the worlds largest creditor. The worlds
largest debtor continued to be the USA. In other words, Japan was
financing the US trade deficit, and this continued to be the case into the
1990s. There were important consequences for the international economy.
However, this has changed in more recent years. Japanese economic
performance has been poor and the worlds largest creditor is now China.
These issues are discussed in Chapter 16.
11.2.8.3 The 1987 Crash
As always in the international economy, trade surpluses needed to be
recycled. In the case of the Japanese surplus, Japanese banks purchased a
major part of US government bonds. As a result, the USA continually had
to persuade foreigners, especially the Japanese, to buy its bonds to remain
solvent.
In addition, Japanese banks were purchasing large amounts of American
stocks (what the British call shares). But in 1987 Japanese banks stopped
increasing their purchases of stocks on the US stock exchange. This led
to a collapse on Wall Street. Note that Japanese stock purchases did not
reduce, they merely stopped increasing.
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11.2.8.4 A final point

The USA was able to maintain a large trade deficit only so long as its
bonds were easy to place on the world money market. That is, easy to
place at low interest rates. Up until the early 1990s this was easy for the
USA to do because the dollar was still such an important trading currency.
But if at some future date world trade began to be denominated in Chinese
currency, for example, it would be much less easy for the USA to persuade
other countries to hold its debt. In turn, the USA would have to reduce its
trade deficit, which would mean a considerable fall in American income.
This has not happened yet, however.
Summary
In 1944, attempts were made to create a set of institutions to ensure that
the problems of the 1930s would not reccur in the post-war international
economy. These institutions did not work well and had to be modified
in the light of circumstances, particularly the problems of reconstruction
from the effects of the Second World War in Europe.
But the international economy did recover and in the 1950s and 1960s
there was unprecedented economic growth, as we will see in Chapter 12.
Then a new and unforseen problem appeared.
This was the relative weakness of the American economy and of the dollar.
Changes in the structure of the international economy were inevitable as a
result and particularly after the oil crisis of 1973. By then, fixed exchange
rates had gone and the international economy entered a new phase.

discuss whether it was the Bretton Woods rules or something else that
made the international economy work so much better after 1945 than
before 1939
explain the importance of political considerations in the development
of international economic structures
explain how a country (and its currency) may remain dominant in the
international economy without being economically the most efficient
explain how an important shock to the international economy, such as
an oil crisis, can be contained.
Questions
1. How far were the Bretton Woods agreements the reason for the
recovery of the international economy after the Second World War?
2. What were the effects of the change from a dollar shortage to a dollar
glut on the international economy in the second half of the twentieth
century?
3. What was the effect of the 1973 oil crisis on the less developed
countries?
128
Chapter 12: Economic growth in western Europe since 1950
Chapter 12: Economic growth in western

Europe since 1950
In this chapter we find out how the western European economies achieved
golden growth in the 1950s and 1960s. Then why the golden age ended
in the 1970s. We see how this growth was closely related to the growth of
Objectives
To:
explain why rapid growth occurred in the 1950s and 1960s
explain why growth slowed down in the 1970s
outline what this growth and slowdown meant for the international
economy.
Learning outcomes
explain why growth rates in western Europe after the Second World
War were relatively high
discuss the importance of labour market behaviour in growth rates
give reasons why technology favoured the shift to very large integrated
markets in the late twentieth century
show how changes in the relative growth rates may be explained by the
idea of convergence.
Essential reading
Further reading
[ISBN 0415250633 pbk] pp.12862, pp.16872 and pp.1806.
[ISBN 0807842028 pbk] pp.1417.
129
Introduction
We start with a discussion of the changes in the share of American,
Japanese and western European manufactures in the international
economy since the Second World War. We then concentrate on explaining
two features of the growth of the western European economies in the
period:
why post-war growth in western Europe was exceptionally fast
compared with all other periods
why growth rates fell in the 1970s.
Remember an important lesson from Chapter 11. It wasnt the rules of the
Bretton Woods agreements that led to a flourishing international economy.
Rather, success came for other reasons. In economic history we must be
careful to find the real causes of events.
12.1 Relative growth rates

By 1950 output in most countries had reached its pre-war level. In other
words, this part of the world had largely recovered from the war.
UK
USA
Germany
France
Italy
Japan
195060
2.2
1.6
6.5
3.5
5.3
7.0
196070
2.2
2.6
3.3
5.0
4.7
10.0
197080
1.8
1.7
2.6
3.0
3.3
3.6
198090
2.4
1.8
2.3
2.1
2.3
4.0
19902000
1.9
1.4
1.2
1.4
1.1
1.2
200008
1.9
2.0
1.6
2.0
1.3
0.8
Table 12.1 Real GNP growth per capita (percentage)
Activity
Look back at Chapters 2 and 3.
What were typical growth rates for those countries, which had achieved modern
economic growth in the nineteenth century?
How do the nineteenth-century rates compare with those shown in Table 12.1?
What other economic information would you want before assessing how far living
standards were raised in the countries shown in Table 12.1?
After 1950 per capita growth rates were high. The growth rates are much
higher than any previous period, so much so in fact that the 1950s and
1960s have been called a golden age.
Table 12.1 also shows that the growth rates of the continental European
countries were faster in the 1950s and 1960s than in the 1970s and
1980s. The reasons for the high growth rates must also have been truly
exceptional and would not be repeated.
12.2 Reasons for the high growth rates

Pause and think
What do you think the reasons were? Write these down before moving on.
Some of the main reasons for the rapid growth are discussed below.
130
12.2.1 The recovery of trade in the post-war period allowed

technology to be transferred from the USA
The USA had had the most advanced technology in the world for most of
the twentieth century. This lead had actually increased in the inter-war
period. This was because of the decline in trade in the 1930s and because
the growth of economic nationalism cut Europe off from this technology.
When trade revived after the Second World War, as we saw in Chapter 11,
the economic links between the USA and Europe were strengthened. This
allowed the European countries to close the technological gap with the
USA and this in turn increased the growth rate.
12.2.2 European social capability had increased

The acquisition of American technology was a classic case of catch up,
which we talked about in Chapter 2. A key concept which we discussed
was social capability the ability to import a superior technology
depended on the educational and skill level of the labour force, and a
responsible government, among other things.
In the early twentieth century US literacy, skills and educational levels
were, in the main, superior to those in Europe. An important reason was
that a smaller proportion of the population of most European countries
went to schools compared to the proportion of Americans.
Around 1900, however, European social capability was much closer to
that of the USA.
This was catch up growth. We can see this because western European
countries with the lowest income in 1950, Portugal and Spain, had
the highest subsequent growth. Countries with the highest incomes in
1950, Britain and Sweden, had the slowest growth. As a result, income
differentials between west European countries narrowed (in economic
jargon, the economies converged).
The transfer of American technology to western Europe was quicker than
to other regions of the world. The technology was relatively cheap because
US machine tools were mass produced. Also, high levels of human capital
in Europe made it easy to absorb technical change. This did not apply to
less developed countries which still had low levels of human capital.
12.2.3 Labour force growth

The industrial labour force grew much faster, in most European countries
after the war, than it had in the pre-war period. The most important
reason was the decline of the agricultural populations.
Pause and think
Why did agricultural populations decline?
In 1945 agriculture was still relatively inefficient and in most countries it
absorbed a large proportion of the working population (Table 12.2.). This
was partly because, in many countries, agriculture had been protected
from imports. After 1945, technical change in agriculture, such as tractors
and fertilisers, meant that productivity could grow fast. This released
labour for industry.
1950
1970
West Germany
25
9
Italy
41
19
France
29
14
UK
6
3
Table 12.2 Percentage of the labour force in agriculture, 1950 and 1970
131
In addition, there was migration into western Europe:

Migrants came from central and eastern Europe, for example
immigrants from the East added seven million people to the West
German labour force between 1945 and 1971.
Southern Europeans migrated to northern European countries (Italy to
Germany, Portugal to France and from Turkey to Germany).
The old colonial powers had immigration from their former colonies
(Algerians came to France, West Indians to the Netherlands and West
Indians, Indians and Pakistanis to the UK, for example.)
Pause and think
Do you think that the supply of new labour led the growth?
Or do you think that the demand for goods stimulated the demand for labour?
What do you think was the driving force of growth?
We can look at this question historically. There was a large and relatively
poor agricultural population in all European countries long before the late
1940s and 1950s. So if the driving force was labour supply, why did it
not happen before? Obviously this suggests that something must have
been special about the period after 1950.
Now think about this. In the period that labour supply to industry was
growing very fast, so was investment in labour-saving technology. Why
would companies have bothered to do this? If factories were taking on
labour for no other reason than that wages were very low, would they also
have invested in machinery that saved labour? Wouldnt they have had
more workers and fewer machines?
We may conclude that the movement out of agriculture was not supply
driven, but was because the demand for industrial goods was
rising fast, which, in turn increased the demand for labour.
Pause and think
The labour force did not grow as fast in the UK as in continental Europe because the
agricultural labour force was already small (Table 12.2). This meant that labour costs in
1950 were relatively high in Britain.
12.3 The increase in demand

Pause and think
If growth was driven by demand, why was demand increasing in western Europe in the
1950s and 1960s?
We know that the international economy was working better than it had
before. Trade was increasing. We saw in Chapter 11 how the dollar gap
was closed. Specifically, Germany had not been able fully to participate in
the international economy in the inter-war period. In the 1920s, German
growth had been held back by the debt problem and by the failure to
achieve a post-war economic settlement. And in the 1930s, German trade
had been held back by the development of a war economy.
After the war Marshall Aid and the European Payments Union made
it possible, in fact essential, for trade barriers to be reduced to allow
rapid trade growth within Europe. This led first to the European
Coal and Steel Community (ECSC), which was set up in 1950. The ECSC
ensured free trade in coal, iron ore and steel between West Germany, Italy,
132
Belgium, the Netherlands, Luxembourg and France. Most importantly, the

ECSC led directly to the European Economic Community (EEC) which was
agreed by the Treaty of Rome in 1957 and came into force in 1958. The
EEC created a Common Market (with no internal tariff barriers).
Therefore we may conclude that:
Rapid growth was demand-led.
This rapid growth resulted from increased trade within western
Europe, especially with a restored Germany now the main European
trading nation.
The development of new international institutions followed rather than
led the trade expansion.
Pause and think
Which came first, the move for economic unity in western Europe (the founding of the
EEC) or the growth in trade?
Once the move to political unity was made, this made the expansion of
trade easier.
12.4 Political continuity

Two factors created a favourable political climate for rapid growth. First,
people with a Fascist or Nazi past were marginalised. Second, centreright
governments were the norm in western European countries.
The defeat of Fascism led to the election of Christian Democrat (centre
right) governments in most western European countries. There was a
policy of deNazification (a similar policy was followed in Japan) which
purged the governments of the worst elements of the Fascist governments,
thus giving legitimacy to the political process.
The post-war governments were not as ideological as pre-war governments
had been, and in fact there was a considerable consensus between the
main European political parties. This was a much more favourable
environment for business and consequently investment was encouraged.
12.5 Policy instruments

Some post-war European governments in the golden age did intervene in
the economies, but with the exception of the UK, they did not, in the main,
follow the writings of J.M. Keynes (see Chapter 9). In the 1930s, Keynes
advocated demand management, using budgetary policy to maintain full
employment.
Pause and think
Why were governments in the 1950s not very interested in demand management?
With rapid demand-led growth, governments didnt need to intervene.
There was no need for governments to budget for a deficit to increase
demand through government spending. Business expectations, leading to
a high rate of investment, were uniformly high. (British growth was less,
hence the need for more intervention.)
Why, you may ask, was this investment profitable? Obviously, there must
have been a high rate of investment for growth to be high. This meant that
business profits, from which the investment came, must also have been
high. But we know that at the same time there was a high demand for
labour.
133
Pause and think

Why did the high demand for labour not lead to wage increases that would reduce profits
and hence investment? Try the next activity.
Activity
You are a trade union negotiator in 1950s Germany. What strategy would you use to gain
higher wages? Would you
try to get higher wages at the expense of profits
or
cooperate with the employers and allow profits to rise in the hope that they will
reward the workers with higher wages at a later date?
This is an example of the Prisoners dilemma.
The workers wanted to increase their incomes as much as possible.
The employers wanted to pay less so that their profits would be high
which would allow them to increase investment.
This would increase productivity in the future which would increase
workers incomes.
The workers best strategy was to defer their wage demands so that
profits could increase.
The problem was that there was nothing to make the employers keep
their side of the bargain, what we call a commitment mechanism.
The employers could promise to reinvest the profits, but in the end they
could give them out as dividends to shareholders.
It would have been a mistake for workers to mitigate their wage
demands.
It was best for the economy that wage demands were limited, but the
workers would only agree to do so if they were sure that the profits
would be reinvested.
This is where the governments came in. They made it clear that they
wanted compromise. In some countries workers were put on the board
of companies. This made it easier to make the deals and the prisoners
dilemma was avoided.
12.6 The historic compromise competition and welfare

Western European governments were important in another area. For a
variety of reasons, workers had been protected from foreign competition
in most European countries for some time. After 1958 the establishment
of the EEC meant that their protection had gone, leaving workers at the
mercy of international forces over which they had no control.
Pause and think
Why would workers, voting in elections, vote to remove tariff protection?
Eventually, all western European countries introduced welfare
schemes that would protect the workers in cases of unemployment or
redundancy, as well as many other social benefits. This removed the fear
of unemployment, for example. It was relatively easy to pay for these
benefits in the 1950s and 1960s because there was high growth and full
employment. But in the 1970s and later, the situation was rather different,
as we will see.
134
A major reason why there was full employment was that the reduction
in trade barriers within the EEC expanded demand which, in turn, led
to more output. This was because trade creation was more important
than trade diversion. Think about the effect of a common market with
a common external tariff. One effect would be to divert imports which
had previously come from a lower cost producer outside the common
market to a higher cost producer within it. This would reduce income. The
other effect is that the larger common market increases demand within
it so that trade specialisation increases. This would increase income. In
the 1958 common market, trade creation was more important than trade
diversion, so incomes rose.
12.7 Policy and the growth of the European market

Growth in western Europe was so fast that, by the early 1990s, the
European Union (EU), as the EEC was re-named, was the worlds largest
market. It had been a free trade area since the 1970s. By the 1990s, there
were virtually no internal restrictions on the free movement of goods,
capital and labour. The EU was well on the way to becoming a single
economy, which, by the turn of the century, with only a few exceptions,
would have a single currency.
The main driving forces towards a single, EU economy were as follows.
12.7.1 Reduction in transaction costs and the move towards

flexible production
Pause and think
Check that you understand the term Transactions costs (see 1.5.14). Then ask yourself:
What does it mean to reduce transactions costs?
One way of looking at the whole process of economic growth and
development is as a reduction in the costs of doing business, or trading, if
you like.
By the end of the twentieth century reduced transactions costs proved
a more important factor in the globalisation of business companies
manufacturing and selling on a worldwide basis than economies of scale
in production.
The production methods developed with the aid of computers in the 1980s
did not need large economies of scale to produce goods cheaply. This
was very different to production methods developed in the 1880s. New
methods include flexible production (discussed in Chapter 14).
As a result it is no longer necessary to have very long runs of identical
products. In turn, market size was a less important constraint on
production costs than hitherto.
12.7.2 A single currency

The development of communications, particularly computer link ups,
meant that the biggest advantages would occur in the biggest most
integrated economies. An implication was, of course, that the EU should
have a single currency, like the USA. Trading and investing with a single
currency and therefore without exchange uncertainty reduces transactions
costs.
For this reason, large corporations supported the establishment of the euro
as the single currency. The euro was introduced in January 2002.
135
12.7.3 An end to non-tariff barriers

To establish a truly single market and free trade within the EU required
political agreement to eliminate not only tariffs but also hidden barriers to
trade. These are called non-tariff barriers (see 1.5.5). The easiest way
to reduce non-tariff barriers is through supra-national agreements (EU
rules) from Brussels.
12.7.4 Common political goals

We cannot ignore the importance of national politics in the desire for a
single economy. One of the main motivations of the original EEC was a
path-breaking attempt to bring the economies of France and Germany
together so that another war between them would be impossible. Both
German and French politicians benefited from this.
France could be more important politically with the support of the
German economy, the largest in Europe.
German politicians could benefit because Germany would regain
international political respectability.
Of course, not all politicians took this view. Many in Britain, for example,
were in favour of a common market but not a single economy, fearing the
domination of France and Germany. This was a major reason why Britain
did not join the EEC until 1973.
12.7.5 Relative growth rates

Research shows that the most important predictor of the growth rate of
economies in the post-war period has been the growth of manufactured
exports.
This does not necessarily mean that export growth caused economic
growth. It means that what made exports grow fast also made the
economy grow fast.
Pause and think
What factors are important in gaining success in export markets for manufactured goods?
Three factors are:
producing manufactured goods of high quality
selling them at low prices
marketing the goods well.
Table 12.3 shows the share of world manufactured exports from each of
the major economies
UK
USA
Germany
France
Italy
Japan
China
all seven
countries
1960
13
18
15
62
1970
15
16
62
1980
10
55
1990
11
14
14
57
1997
13
11
10
50
2010
11
12
12
54
Table 12.3 Percentage share of world trade in manufactures
136
Pause and think

Consider Table 12.3. What does it show regarding the USA and UK?
12.7.5.1 The UK
The share of Britain in trade in manufactures fell to 4 per cent by 2010.
This sounds small. However, the share is virtually the same as in France
and Italy, both economies of a similar size. Moreover, Britain has a much
larger share of world trade in services than any European country.
12.7.5.2 The USA
The US share has also fallen. In fact by 2010 the US share of manufactured
exports was surprisingly small. The US economy was about seven times
as large as the British economy, but its exports of manufactures were only
three times that of the British.
This underlines the importance of both services, such as the exports of
Disney, CNN and Microsoft, and primary products in American exports.
These US exports are very successful but they are not generally included in
the historical record. The indicator used most often for success or failure in
trade is often simply the productivity growth in manufactured exports.
If this indicator is a good indicator for all exports, including services and
primary products, then US export performance has been relatively poor.
And if this continues to be true, the USA may suffer difficulties in the
future (see deindustrialisation in Chapter 14).
12.7.5.3 Germany, China and Japan
Germany and China were the two most important exporters of
manufactured goods in 2010. The USA was a little behind. The main loser
has been Japan, which had 10 per cent of world trade in 1997 but only
6 per cent in 2010. In the case of Japan, there was a major financial and
economic crisis in the late 1990s. We discuss this in Chapter 15.
12.7.5.4 The rest of the world
There is an important comparison to be made with the early twentieth
century. The seven countries shown in Table 12.3 are the most important
exporters of manufactures. Yet their combined share in 2010 was only 54
per cent. In 1913, nearly a half of world manufactured exports came from
two countries, Britain and Germany. In other words, many more countries
have become significant exporters of manufactures, countries such as
South Korea, Turkey and Brazil.
A further contrast concerns the products being traded. By the late
twentieth century, manufactures had become the most important item in
international trade by value. In 1913, primary products were the most
important item of international trade and manufactured exports were
limited to a very small number of countries. The change in the structure
of trade had important implications for developing countries (see Chapter
15).
137
12.7.5.5 The downturn in European growth rates

Growth rates fell in all the western European economies in the 1970s. The
main reason is obvious. The scope for catch up growth had gone. By the
1970s, western European technology was almost as advanced as American
technology.
Moreover, European social capability, including skills and education, was
at the US level. So the unique set of circumstances which had driven the
golden age had gone.
12.8 Labour market changes

There was also a change in the labour market in the later 1960s.
Labour had been relatively docile in most western European countries
until the late 1960s. This was partly, as we have seen, because the labour
supply was expanding, and partly because of the wage moderation/high
investment agreements of the 1950s and 1960s (see 12.6 on The historic
compromise).
By the late 1960s, the rapid growth in the labour force had ceased. Most
western European countries had very full employment. There were many
unfilled vacancies, a sign of labour shortages.
Pause and think
What do you think full employment and labour shortages meant for the relative power of
capital and labour?
There was an increase in labour militancy in most countries. At one
point in 1968, for example, two-thirds of the French labour force was
on strike.
There were also political changes. The improvements in welfare,
education etc. had the effect, which was expected, of increasing job
security in manufacturing industry. The other effect, however, was that
the labour market became less flexible. This did not matter
when growth was fast, as in the 1950s and 1960s, but it was a problem
when, for a variety of reasons, the economies growth slowed down in
the 1970s.
For the above reasons and others, it became possible in the 1970s
for economies to have both inflation and unemployment. This is the
phenomenon of stagflation, which made management of the economy
so difficult (see Chapter 13).
The combined effect of these factors was a large fall in business
profits. This in turn led to a fall in investment and slower growth.
Falling growth rates led to many changes in the labour market.
Pause and think
What do you think the changes in the labour market, resulting from the falling growth
rates, might have been?
There was an increase in youth unemployment in most western
European countries. The income and benefits of young workers
increased in the 1960s, and became a larger proportion of adult wages.
Young workers had to be given almost the same conditions of work as
adult workers.
138
The need for young workers to receive virtually the same conditions
as adults had the effect of protecting adult jobs since it prevented
adult wages from being undercut. But, at the same time, it made it less
attractive to employ young workers. Their wages were high relative to
their productivity. Hence youth unemployment increased.
The increase in job security in European countries for the existing
full-time adult workers and young workers led to the growth of
secondary labour markets. Fewer full-time workers and young
workers were recruited. Far more part-time workers, who were
mainly women and immigrants, were recruited. Such workers were
rarely unionised, were paid lower wages and fewer benefits than the
established workers. This phenomenon occurred in every European
country in the 1960s but particularly in the UK.
Pause and think
What are the arguments in favour of and against paying young workers the going wage
for adults?
12.9 Convergence
In 1957 there were considerable differences in per capita income between
the original six countries of the EEC, notably between Italy and Germany.
By the 1990s these differences were quite small.
Pause and think
What was the mechanism for this convergence?
Labour had moved from low to high-income countries, for instance
from Italy to Germany.
Investment was moving to countries where labour was cheaper, for
instance from Germany to Britain.
As a result, real income differences between the EU countries (with the
exception of Spain, Portugal and Greece, which only joined the EU in
the 1980s) are within probably plus or minus 10 per cent of the average
income. A spectacular example was Ireland. Ireland was relatively poor
but the country had growth rates of five to 10 per cent per annum in the
1980s. By 2000 Irish income per head exceeded the EU average.
Pause and think
Convergence has had an important political consequence. Can you think what it is?
Opposition to further European integration has decreased. Also the
attractiveness of joining the EU has become obvious to other countries.
The process of enlargement of the EU into central and eastern Europe has
been marked by local enthusiasm, particularly from business and political
leaders.
Note that the UK growth rate, which had been relatively low in the 1970s,
changed in the 1980s to the European average (or even slightly above).
This may be related to the Thatcher experiment. In the 1980s, the power
of the trade unions was weakened, taxes on high incomes reduced and an
enterprise culture fostered. This included lower personal taxes and fewer
constraints on accumulating personal wealth.
139
We must remember, however, that two factors were behind the better
economic performance of the UK:
changes in government policy
convergence within the more integrated west European economy.
Summary
Economic growth in western Europe in the 1950s and 1960s was
unprecedented. The growth was caused by catch up and the improvement
in the performance of the international economy. In turn, this led to
further integration of the economies and to further growth. In the 1970s
growth slowed, partly due to changes in the labour market. But the
convergence of the European economies continued.

should be able to:
explain why growth rates in western Europe after the Second World
War were relatively high
discuss the importance of labour market behaviour in growth rates
give reasons why technology favoured the shift to very large integrated
markets in the late twentieth century
show how changes in the relative growth rates may be explained by the
idea of convergence.
Questions
1. Why were growth rates in western European economies relatively high
in the 1950s and 1960s?
2. Why did growth rates in the western European economies fall in the
1970s?
3. Explain the economic benefits of the creation of a common market in
western Europe. Were the expected benefits achieved?
140
Chapter 13: The American economy since 1960: supply-side economics
Chapter 13: The American economy since

1960: supply-side economics
In this chapter we will explore the performance of the United States in
the international economy, in particular since the early 1960s, and the
successes and failures of economic management.
We discuss the effects of the Vietnam war, the end of the consensus and
an appraisal of the theory and practice of monetarism during the Reagan
presidency.
Objectives
To:
explain why economic management in the USA became more difficult
in the 1960s
explain supply-side economics and show the reasons why it did not
work as expected
argue that the poor performance of the dominant world economy leads
to problems for other countries.
Learning outcomes
list and explain the objectives of economic policy
give reasons why economic management became more difficult in the
1970s
analyse why supply-side economics in the USA did not work
list and explain the international implications of the poor performance
of the largest economy.
Essential reading
Kemp, T. The climax of capitalism. (London: Longman, 1990) [ISBN
0582494230 pbk] pp.12734, pp.1437, pp.17788 and pp.20411.
Introduction
We have seen how the US economy dominated the post-war international
economy during the 1940s and 1950s. This dominance started to change
in the 1960s.
13.1 The dominance of the American economy

In 1945 the USA was by far the most important economy in the world. The
American share of world industrial output (50 per cent) and world exports
was the highest ever. Because of this success there was little need for an
interventionist economic policy. Budgets in the 1950s were balanced.
Demand was high, leading to full employment.
141
13.1.1 The two wars

In the 1960s, United States politicians often said that the country was
involved in two wars.
the war in Vietnam
the war against poverty.
The campaign against poverty in the USA in the 1960s, under President
Johnson, was the most successful attack on policy in that country to date.
There was a large increase in welfare, and higher taxes on higher incomes.
It proved impossible, however, to finance both the Vietnam war and the
attack on poverty, and the latter was abandoned. Even so, the budget
moved into deficit.
13.1.2 Unemployment
A new problem in the 1960s was the rise in unemployment to what in
the USA was considered to be a high level (6 per cent). At this time,
unemployment was considered to be a structural problem and nothing to
do with the overall demand for labour in the economy.
For example surveys showed that unemployment rates among young
black men and women were several times as high as the national average.
Black men and women were less well educated than whites. Hence,
unemployment policy was aimed at increasing their skill levels. This
meant that unemployment policicy was aimed at individuals, as opposed
to demand management.
13.1.3 Growth
A second problem was that since the 1940s, the growth rate of the
American economy had been very low. The 1960s decade had higher
growth but it was against a trend of falling growth rates and the 1960s
were seen as an aberration. In other words, the US economy seemed to
have peaked in the 1940s.
Moreover, budget deficits were increasing and inflation was increasing in
the USA. In other words, economic management did not seem to
be working. However, the failure of economic management was passed
off, not as a problem of government policy, but as a problem of industry.
Firms were individually blamed by the US government for increasing their
prices.
Pause and think
Why was this view unfair?
13.1.4 Stagflation
We noted briefly in Chapter 11 that the problems of the 1960s were
followed by a new combination of problems in the 1970s and 1980s.
Prices were rising.
Output was falling.
Unemployment was rising.
This was a new combination of problems and the economic models
available could not explain it.
In the standard Keynesian model, which was developed in the 1930s
and was in the toolbox of all government economists in the 1960s,
unemployment and inflation were substitutes. This meant that, in theory,
142
if a government intervened to reduce unemployment (e.g. through a

budget deficit), prices would rise, and vice versa.
Hence, a government could choose the level of unemployment and
inflation at which the economy could operate.
The unemployment/inflation trade off was particularly important because
a government had only a few policy instruments (the means to
achieve its policy objectives). Try the next activity.
Activity
Look at the objectives and instruments below. Go through how you think a 1960s
government would have reacted to:
a. a depression
b. a period of normal inflation.
Then imagine that the problem was stagflation. Can you see how the policy responses to
(a) and (b) made the situation worse?
The objectives of macro-economic policy were:
full employment
growth
balance of payments equilibrium
price stability.
The instruments were:
government spending and taxes
interest rates
tariffs
exchange rates.
% INFLATION
Now look at Figure 13.1.
Y
Year 2
Year 1
% UNEMPLOYMENT
Figure 13.1 Inflation and unemployment
143
Figure 13.1 is a schematic way of showing the reasons why the trade off
between unemployment and inflation had gone and, hence, the dilemma
faced by government policy under stagflation:
In the first year, the economy has Y per cent inflation and X per cent
unemployment.
In the second year, the workers expect that prices will continue to rise
by Y per cent.
Workers are able to demand wages to compensate them for the
expected inflation (see below).
Any government policy to reduce inflation will lead not to X per cent
unemployment but to even more unemployment (Z per cent).
13.1.5 The causes of stagflation

There were several causes of stagflation in the USA. In the first place,
international commodity prices rose. This was because traders lost faith
in the future value of the dollar (see Chapter 11). Traders moved into
commodities and prices rose. This posed a problem for the US government
because commodities were priced in dollars. This meant that the USA
could not afford to devalue the dollar because it had very large commodity
exports. So if it devalued, its export earnings would fall. There were also
several domestic causes, including a poor US harvest in 1972.
Secondly, the oil crisis of 1973 led to a 400 per cent increase in energy
prices. And, as we will see, the policy response of the American
government to the rise in oil prices was incorrect, as it was in other
countries (see below).
Moreover, when the American government was faced with pressure
to solve the problems of rising prices and wages they responded by
passing legislation to index wages. Employers had to pay cost of living
adjustments (COLAs) to increase wages to match price increases. COLAs
meant that the expectations that prices would rise were now confirmed
since rising prices would always be followed by increased wages.
Pause and think
What would the correct government policy have been following the oil price rise?
Figures 13.2 and 13.3 provide a diagrammatic framework for analysing
stagflation during the time of the oil crisis and the effect of different policy
responses.
S2
S1
P2
P1
D1
O2 O1
Figure 13.2 The supply and demand for oil in 1973
144
The oil crisis was a supply problem. This is shown in Figure 13.2
where the supply curve moves from S1 to S2 while the demand curve D1
remains fixed. The supply curve was also affected by more than the oil
price (e.g. COLAs).
The American government was faced with two choices. The correct
policy would have been to reduce expenditure and demand. This would
have reduced inflation, but the problem was that it would have further
increased unemployment. This is shown in Figure 13.3 Option A. If the
supply curve had moved from S1 to S2, the most effective policy would
have been for the American government to reduce demand that is to
move D1 to D2.
The American government chose to try and reduce inflation without
reducing demand. But they failed to control inflation. This meant that
the high price of fuel was causing shortages, which was reducing output.
To deal with this the government then increased demand from D1 to D2.
The effect of this was to cause much more inflation, but not much more
output. This is shown in Figure 13.3 Option B.
The key point to understand is this: stagflation meant that conventional
economic management would not work.
Option B
Option A
S2
S2
S1
S1
P2
P2
P1
P1
D1
D2
D1
D2
O2
O1
O1 O2
Figure 13.3 Policy responses to the oil crisis
The second oil crisis of 1979 (which was caused by the IranIraq War)
was much better handled by governments because most understood the
stagflation problem. Monetary policy was tightened (so real interest rates
rose) and most governments were careful not to allow expenditure to rise.
Hence there was little inflation, which in turn led to low wage demands.
The failure of government policy in the 1970s, in this and similar
episodes, led to the discussion of different cures for stagflation, including
monetarism. Milton Friedman (a Professor at the University of Chicago)
argued that:
Governments must take a long-run view.
Government intervention made the economy unstable. There would
only be stability if there was no government intervention.
An important reason was that people always anticipate government
policy. (As in the case of the COLAs which changed peoples
expectations about future inflation.)
145
This is an example of what is called rational expectations. The effect

of rational expectations is shown above in Figure 13.2 (see also 1.5.21).
In other words, Friedman argued that government policy was redundant.
His prescription was that money supply must be controlled and must only
be allowed to increase at a rate that will give the desired growth in GDP,
but no faster. Try the next activity.
Activity
Look at the diagrams above and imagine the effect of restricting the money supply during
stagflation when there was rising prices, falling output and rising unemployment.
Consider how monetarist medicine would affect each of the characteristics of
stagflation.
13.1.6 The problem of the election cycle

Monetarism was difficult to implement. There was a political problem.
Restricting money supply growth would reduce inflation. However,
because interest rates would increase, it turned out that the policy also
increased unemployment. Hence, if the government restricted money
supply, it might begin to work (and unemployment begin to rise) just
before an election.
There was also a policy conflict in the USA between the Federal
Government, which had to take account of unemployment, and the
Federal Reserve, or FED, (the central bank) which had to take account of
inflation.
In fact, money supply was kept under very tight control throughout the
1980s. This cured inflation but at the cost of high unemployment. The FED
had won the policy battle.
Pause and think
What would have happened if the government had won and not the FED?
In other words monetarism was not painless. It was not possible to reduce
inflation without increasing unemployment.
13.2 Supply-side economics in theory

The second policy of the 1980s was called Reaganomics, after
President Reagan. In the UK it was also personalised as Thatcherism and
in New Zealand as Rogernomics.
Reaganomics was aimed at the supply side, whereas the old economic
management had worked by manipulating demand. The fundamental
objective was to increase output by increasing incentives. This would be
achieved by reducing taxation.
Pause and think
Which approach is likely to sound more attractive to voters freeing the supply side by
reducing taxation or restricting demand through monetarist or Keynesian deflationary
measures?
146
taxes are cut and:

effort increases
savings increase
productivity rises
investment increases
output rises
output rises
prices fall*
unemployment falls*
(* = assumes neutral monetary policy)

Figure 13.4 The expected effect of supply-side policies
The proponents of Reaganomics argued that:

The welfare state discourages incentive for both rich and poor.
Taxes to finance the welfare state, paid by rich people, were a
disincentive, so that they worked less and the economy suffered.
Welfare benefits for the poor also meant that they worked less
(voluntary unemployment would rise) and the economy would suffer.
For the poor, of course, welfare benefits were a part of their income. So if,
as the proponents of Reaganomics argued, welfare benefits were cut, this
would reduce their income. It was the equivalent of increasing taxation.
In other words, Reaganomics advocated reducing the taxes on rich people
and increasing it on poor people.
Study Figure 13.4 above and follow the relationships. Note that the fall in
taxation affected output in two ways:
by encouraging people to work harder and more productively
by increasing savings and investment.
13.2.1 The assumptions of Reaganomics

Let us review the main assumptions of Reaganomics.
The welfare state reduces the incentive to work. Therefore poor people
work less because of benefits and rich people work less because of high
taxation needed to pay for the benefits.
People are sensitive to marginal tax rates, therefore, reducing taxation
on rich people makes them work harder.
Most unemployment is voluntary. People can choose between
unemployment (leisure) and work. Therefore lower taxes and less
welfare benefits will solve unemployment.
13.3 Reaganomics in practice

The main problems were as follows:
It proved impossible to reduce taxes on middle and lower incomes.
Falling taxation only benefited the rich.
The tax cuts on high incomes did not increase savings and investment.
Most of the increase in disposable income was spent on leisure and
other forms of consumption. This meant that as taxes fell, effective
demand rose.
This led to an entirely unforseen result. Growth in the USA, in the
1980s, was coming from the demand side, not from the supply side.
(See Figure 13.4.)
147
Activity
Consider some of the assumptions of Reaganomics. For example:
Would a super-rich person work harder if marginal tax rates fell?
Do successful rich people, like business managers, only work for money?
Is it possible for such people to work harder than they do?
Predictions
Outcomes
Productivity increases
Productivity falls
Savings increase
Savings fall
Investment increases
Investment falls
Prices fall
Prices fall (*)
Unemployment falls
Unemployment falls (**)
(*) from tight monetary policy

(**) thanks to a rise in defence expenditure
Figure 13.5 Expectations and outcomes of Reaganomics in the 1980s
If you work through Figure 13.5 you can see that the objectives were
achieved, but not because of supply-side economics.
There were also some undesirable side effects:
The balance of payments deficit rose.
The budget deficit rose (because taxes fell).
The growth rate was low (because savings and investment were low).
And, (as Reaganomics intended) there was more income inequality.
Poverty increased. Welfare declined.
13.3.1 International implications

The problems of the US economy, and the failure to solve them in the
1980s had implications for the international economy. The US trade
deficits were covered by capital flows from the UK, Canada and, most
importantly, Japan. The budget deficit was also partly financed by
Japanese banks. They took up Federal Government debt. In recent years
this role had increasingly been performed by China. (We discuss the rise of
Chinese trade and payments in Chapter 16.) Hence:
American interest rates had to be higher than they would have been.
A temporary fall in the daily flow of Japanese funds into the USA (not
their withdrawal) started the collapse of the American stock
market in 1987. This forced the Federal Reserve to increase money
supply to save US banks from collapse.
The USA had not solved its growth problem. For example, average
family income in the USA fell from 1978 to the late 1980s. This also
indicated that the poverty problem was not solved.
148
13.4 What does the Reagan experiment tell us about the

relationship between government intervention and the
growth rate?
In the 1980s:
Markets were freer than in the past.
There was less government intervention.
Growth rates in the 1980s were expected to be higher than in periods
when there was more government intervention.
Growth in the USA in the free market 1980s was actually less than
it had been in the interventionist decades of the 1940s, 1950s and
1960s.
Growth in the American economy in the 1980s was less than in
countries that had more welfare and more government intervention.
(Germany/Japan).
13.4.1 Did the US economy become more competitive?

It is possible that the reason why the American economy behaved rather
poorly in the late twentieth century compared with other countries was
because the international economy had become more competitive. The
American economy performed better in the 1950s and 1960s when the
international economy was less competitive.
Pause and think
Was the source of the American growth problem internal or external?
There was a major crisis in 2007. The causes and consequences are
discussed in Chapter 17.
Summary
In the 1950s and 1960s it was believed that government intervention in
the economy could guarantee full employment and economic growth.
This was not the case in the 1970s, which lead to the implementation of
different economic policies monetarism and Reaganomics.
Economic performance improved in the 1980s, but not necessarily because
economic policies were the correct ones.

list and explain the objectives of economic policy
give reasons why economic management became more difficult in the
1970s
analyse why supply-side economics in the USA did not work
list and explain the international implications of the poor performance
of the largest economy.
149
Questions
1. Why did Keynesian demand management become difficult in many
countries in the 1970s?
2. For what reasons were supply-side policies introduced in the USA in the
1980s? Were the policies successful?
3. How did the poor performance of the American economy after the
1960s affect the international economy?
150
Chapter 14: Technology and deindustrialisation
Chapter 14: Technology and

deindustrialisation
In the last chapter we looked at the problems that affected the US
economy and the policy measures that were undertaken. Here we
identify what was seen as a long-run problem for the USA and the UK
deindustrialisation. In this chapter, we consider what this means and why,
in the 1980s and early 1990s, the major industrial economic lost their
world lead in manufacturing.
Objectives
To:
explain why the share of industry in developed countries has declined
show the main long-run changes in manufacturing technology
explain the main contribution of Japanese industry to world
technology.
Learning outcomes
explain why the relative share of services in the output of the major
economies increased
discuss whether the increase in the share of services was a source of
problems in economies
describe the major differences between flexible production methods
and mass production methods in industry
explain why it was possible in the late twentieth century to have
products that were both cheap and of high quality, and why it was not
in any other period.
Essential reading
Kemp, T. Industrialisation in the non-Western world. (London: Longman, 1989)
[ISBN 0582021820 pbk] pp.200203 and pp.21218.
Further reading
[ISBN 0807842028 pbk] pp.12738 and pp.14868.
edition [ISBN 0745009352 pbk] pp.2627.
151
Introduction
In this chapter we will show the changes in the demand for industrial
goods and services in the second half of the twentieth century. We look
closely at the concept of deindustrialisation why the share of industry in
the output of the major industrial economies fell compared with the share
of services.
We will also discuss a related issue long-run changes in technology:
from craft production to the early factory system
from early factory system to mass production
from mass production to flexible production.
And we will use the automobile industry, in particular, the rise of the
Japanese automobile industry as our example.
14.1 Deindustrialisation
We begin with the evidence for deindustrialisation. (Table 14.1)
Shares in total employment by sector (%)
UK
USA
Japan
1870
Agriculture
Manufacturing
Services
21
34
26
50
17
25
85
4
10
1913
Agriculture
Manufacturing
Services
12
32
42
32
22
37
61
20
20
1955
Agriculture
Manufacturing
Services
5
36
47
10
29
53
39
18
37
1980
Agriculture
Manufacturing
Services
3
26
62
3
22
66
10
25
55
1997
Agriculture
Manufacturing
Services
1
24
64
3
23
70
5
32
59
Agriculture
Manufacture
19
15
26
Services
79
83
69
2010 (Japan 2009)
(Excludes employment in mining, construction and utilities.)

Table 14.1 Evidence of deindustrialisation
152
Activity
Table 14.1 presents a number of intriguing features. Look through the table and find
answers to the following questions:
Did the agricultural labour force fall in all countries?
Was employment in services generally high or low, and was this rising or falling over
time?
Did manufacturing employment rise or fall relative to services?
By the late twentieth century which sector was the greatest employer in all
economies?
Was the shift to services greater in the USA and UK than in Japan?
How far are the data in Table 14.1 affected by differences in productivity in the
different sectors of the economy?
It is possible that the fall in manufacturing employment reflects the fact
that fewer people have been needed in industry compared with services
that is productivity in manufactures grew faster than in services.
Pause and think
Is it likely that productivity in manufactures grew faster than in services?
Actually, the answer is yes. It is easier to use capital to raise productivity in
manufacturing. Many service industries are labour intensive, so we would
expect labour productivity to rise faster in services.
Ask yourself now: what are the implications of these changes in
employment for:
growth rates?
unemployment?
international trade?
The causes of deindustrialisation have been explained in three main ways:
industrial failure
trade specialisation
structural change.
Later we introduce a fourth idea that perhaps the distinction between
manufacturing and services has become blurred.
14.1.1 The industrial failure idea

It has often been stated that the British and American economies failed
in the post-war period. In the 1950s, both countries had an export surplus
of manufactures equivalent to 10 per cent of GDP. By the 1970s, both
countries were net importers of manufactures. This trend has been seen as
evidence for their failure.
British and American industry and governments were usually blamed. It
was said that:
Firms were uncompetitive.
Unions were too powerful (in the 1970s).
Managements were inefficient (in the 1980s).
Government interference hurt industry.
153
You can see that these criticisms are similar to those which led to
Reaganomics in the USA and Thatcherism in the UK in the 1980s (see
Chapter 13).
One problem was that the solution to industrial inefficiency led to a
further relative decline of the industrial sector. In the UK, for example, the
competitiveness of industry was far higher in 1990 than it was in 1979.
But industry was also relatively smaller. Competitiveness had risen because
the less efficient firms had disappeared, leaving only the most efficient
firms, which were leaner and fitter.
Pause and think
How valid were the criticisms in the bullet list of the older industrial economies?
Something that you might consider is that in the 1970s, Germany, Japan, France and
Italy, the faster growing economies, were, in general, more bureaucratic than the UK and
the USA. In addition, most of these countries had more powerful unions than the UK
and the USA. Perhaps the critics of the UK and USA were missing the real reasons for
deindustrialisation?
14.1.2 The trade specialisation idea

This is a completely different argument that does not imply that the
deindustrialisation of the older industrial countries is a problem. The
argument is about comparative advantage. The older industrial
countries are higher cost producers than the new countries (e.g. in southeast Asia) in industry, but are lower cost in services. It made sense for
them to import manufactures and export services.
The difference could be explained by the price of inputs for example
labour costs or by efficiency. Lower labour costs were an important
reason that export prices for manufactures were lower in south-east Asia,
for example, but in more recent years, relative efficiency is probably more
important. But the low cost of exported services in the UK and the USA,
for example, must be because of higher relative efficiency.
The multinationals invested heavily in manufacturing plants in many parts
of the world where wages were low, for example, Japanese investment in
south-east Asia, US investment in Latin America.
Pause and think
Is the trade specialisation idea a demand-side or a supply-side argument?
The trade specialisation idea is a supply-side argument. It is
possible, however, that changes in demand have also affected
deindustrialisation. As incomes continue to rise in countries that are
already rich, people do not want to spend much more on manufactures
but much more on services. (They do not want a third car but they want to
spend more on health care or take more overseas holidays.)
14.1.3 The structural change idea
154
This argument says that services will always grow relative to manufactures
because of productivity differences. Historically, it has normally been much
easier to increase productivity in industry than in services. (Although
there also many examples where productivity can increase in services,
for example roads, railways, utilities and financial services.) This means
that as manufacturing output rose, fewer people were needed to make
the same output. Hence manufacturing employment declined relative to
service employment. But output of manufactures did not. This is shown in
Table 14.2
Manufacturing
Marketed services
Non-marketed services
France
Germany
Japan
UK
USA
3.7
1.5
1.9
2.9
2.7
1.4
4.6
2.5
1.9
3.3
1.9
0.4
2.1
1.1
-0.3
Source: IMF
Table 14.2 Percentage growth in output per hour by sector, 197395
France
Germany
Japan
UK
USA
2.0
0.9
1.4
1.2
1.2
Table 14.3 Percentage growth in employment in man hours, 2006
France
Germany
Japan
UK
USA
1503
1523
1758
1483
1610
Table 14.4 Hours worked per annum in manufacturing, 2006
Table 14.2 confirms that in the late twentieth century, the growth in
output per hour in manufacturing was higher than it was in services
that is labour productivity growth was higher. The table also shows
that productivity growth in non-traded services, which are largely those
provided by governments, such as education or health appear low
compared with marketed services. This could be misleading, however. The
output of government services is not always sold, and therefore, because
it has no price it cannot be counted as output. In this case, the output is
usually measured by the input. This means, for example, that the output of
a state university is largely counted as the salaries of its staff and is almost
certainly understated (see below).
Table 14.4 shows that there are considerable variations in the number of
hours worked per year in manufacturing. France, for example, had more
holidays (more time off per worker) but produced more per unit of labour
than the USA and Japan.
Activity
Estimate how much it would cost you to buy a television, video recorder, stereo,
refrigerator, cooking stove and small second-hand car in your country.
Assuming that the products last approximately seven years, what does your total for
the point above represent as a percentage of annual average income in your country?
How much does a university place cost in your country? (How much does the
government pay and how much the individual?)
What proportion of average income is this?
Comparing your answers, what does this say about the relationship between the cost
of manufacturing and service products?
My rough calculation for the UK cost of the consumer goods would be
about 7,500, which would mean an average UK family paying 4 per cent
of their annual income to acquire them.
In 2012, it is estimated that the UK Government will charge 9000 per
year in fees at most British universities. This will cover most, but not the
entire, fee. In addition, a student will need about 10,000 for living costs
etc. This is 65 per cent of the average wage for the three (or four) years of
a first degree. Fortunately, the cost can be spread over a long time frame,
but the debt will then increase.
This example shows that as income rises in developed countries, relatively
less is spent on manufactures because they are so cheap, and relatively
more on services because they are more expensive. It is possible
155
that in constant rather than current prices, the output of

manufactures may not have fallen at all.
The activity above demonstrates that deindustrialisation occurs because
manufacturing has become very productive and manufactured products
very cheap. This includes the cost of capital goods like machinery and
computers.
14.1.4 Is the distinction too blurred to make sense?

Pause and think
What is included in the terms manufacturing and services?
We must be careful when we divide output into manufacturing and
services. In modern industrial economies, relatively few people actually
make things that is work on the production line.
In the automobile industry, for example, more people are involved in
design, marketing and management than are on the shop floor, although
all these people are employed in manufacturing. But a manager in an
automobile factory has a similar job to a manager in an airline, although
we consider the former to be employed in manufacturing and the latter in
services. In fact, we almost certainly underestimate the effect of services
on GNP.
14.1.5 The must have argument for manufacturing

Many people still argue that manufacturing is more important for an
economy than services. Try the next activity.
Activity
Think about any country. Do you think that manufacturing gives this economy a
dynamism that services cannot? Does it matter if labour moves from manufacturing
to financial services and retailing?
Most services are part private, part public. For example, think of health, education,
transport and security. Is there a difference between the productivity of public and
private services? Could productivity be raised by privatising services?
Do you think that manufacturing is technologically more dynamic than services? Put
another way, is the potential for increasing value added greater in manufacturing
than in services? (Value added is the improvement in the quality of products and
in their value.) If this were true, those countries where services have become more
important would have become, on average, less competitive.
The answer to the last question depends on which services are included
and what we consider to be technology. Obviously baggage handling and
waiting at tables have low productivity (although they are still important
jobs) but computer consultants have high productivity. A study in the USA
showed that some people working in services, like baggage handling,
produced only a half as much as the average worker in manufacturing. On
the other hand, workers in services like computer consultancy produced
three times as much. In other words, highly productive services are more
important than manufacturing.
Pause and think
Do you consider public services to be less efficient than privately run services? If so, try to
think why you believe this.
156
The question of whether public services are less productive than private
ones is not easy to answer. Crudely, the argument is that because
government output is not traded (sold) there is no criterion against which
to judge efficiency. Government services are therefore often considered to
be over-staffed and inefficient.
The problem is that we observe only the inputs that go into government
services (e.g. the cost of the labour working in a hospital) not the output
(e.g. a higher standard of health for the population as a whole).
But the output of a public service could be very large. For example, the
additional output created by a university degree may not be easy to
measure, but all countries think that a highly educated labour force is
essential for economic growth. (Although the private return is higher, of
course, which is why the British and other governments expect individuals
to pay.)
Nor is it true that all government services are not traded. (A governmentowned airline sells its output, for example.) Much of the output of
government is sold in competitive markets.
We conclude that there is no evidence that economies which have a
high proportion of their output in services were (or are) necessarily less
efficient than economies with a smaller proportion in services.
Pause and think
Could a country export only services and import all its manufactured goods?
Currently the market for traded services in the world is limited. Services
are only one third of world exports of goods and services combined. In
fact, it is probably more difficult for countries to increase their exports of
services than of manufactures. This means that an economy that is highly
dependent on exporting services has to be very productive in order to
compete. It is probably easier to compete in the export of manufactures.
14.2 The relationship between technology and the

structure of industries
We turn to the long-run history of technology and how recent technical
changes have affected trade. We start by considering the nature of
industrial change before the twentieth century. Look back at Chapter 2,
where we introduced this topic.
14.2.1 Craft industry

Before industrialisation the main inputs of industry were skilled workers.
Little capital was used (i.e. there were few machines). The outputs of
craft industry were of high quality but their cost was high. There was also
a great deal of variety between products.
Examples of craft industry products include hand made watches and
shoes.
14.2.2 The earliest factories

The main inputs were:
energy (e.g. water wheels, steam engines)
capital (e.g. for machinery and buildings).
There was also a division of labour (e.g. between skilled and unskilled
workers).
157
The outputs of the early factories were:

much cheaper than before
lower quality than craft products.
Examples include cheap cotton cloth and hand tools.
So the most important effect of the early factories c.180050 (the
Industrial Revolution) was to enable goods to be produced more cheaply
but at the cost of lower quality.
14.2.3 Mass production

We discussed the so-called second industrial revolution the introduction
of mass production and managerial capitalism that started in the USA in
Chapter 6. We will not repeat that material here so you should look at it
again. The main inputs in mass-production industry were as follows.
There was much more capital per worker. In other words, there was a
rise in the capital/output ratio.
There was a high division of labour.
The outputs of mass production were a large number of identical
products.
The products were very low cost.
The quality was fairly low.
Examples of mass-production outputs include early motor cars and sewing
machines.
So the effect of mass-production industrial plants, first, in the USA, was
to make cheap goods of low quality and little variety. As we explained in
Chapter 6, mass production led to important management problems, a
consequence of having to make the production line work. We can see this
in the example of the early development of Ford motor cars.
Model T production started with the cars on fixed stands. The workers
worked at the stands. By 1914 there was a moving production line and
the workers position was fixed. But this was not the end of the story. In
fact there were three stages in the development of the Ford engine
production line:
fixed stands/fixed labour, c.190813: it took eight hours
before a worker repeated the same operation
fixed stands/moving labour, 1913: it took two minutes before
a worker repeated the same operation
moving line/fixed labour, 1914: it took one minute before a
worker repeated the same operation
between 1915 and 1920: further cost falls were made by trial and error.
Note the differences in productivity at each stage.
Pause and think
Why did productivity at each stage vary so much?
158
14.3 Japan and the third revolution

In the so-called third industrial revolution new industrial processes were
introduced from the 1970s, in Japan and Europe. These processes eroded
the American lead in industry. The main inputs of the third industrial
revolution were:
so-called lean production (using very small stocks of components)
flexible capital (the same machine makes several products)
flexible labour (the same worker does many tasks).
The outputs were:
products of very high quality
of a great variety of types
produced at low cost.
Examples include modern cars and consumer electronics.
So the effect of the new, late twentieth century processes was to produce
cheap goods of higher quality than using old mass-production techniques,
and also without the penalty of standardisation. For the first time, the
consumer could have low cost, high quality and variety at the
same time.
We can see this in the example of making Toyota cars. Toyota are the
largest motor manufacturer in the world, and are also generally thought to
be one of the most efficient. In the 1980s Toyota carried out a study of the
worlds car producers. The results are summarised in Figure 14.1.
TOYOTA STUDIES 1980s
LABOUR
PRODUCTIVITY
J
US
JUS
E
NIC
QUALITY
Figure 14.1 Quality and productivity in world car production in the 1980s
Activity
Study Figure 14.1 which shows the relationship between labour productivity and quality.
It includes car plants in Japan, the USA, Europe and the NICs (newly industrialised countries)
and also Japanese-owned plants in the USA (JUS in the diagram). The further out on the Y
axis, the higher is productivity. The further on the X axis, the higher is the quality.
Write down the main points that the diagram illustrates (seven are listed below). Try this
before reading on.
159
Make sure that you can see that the diagram shows the following:
Japanese plants at that time had the highest productivity and were high
quality.
US plants had high productivity (but less than Japan) but lower quality.
European plants had high quality (the same as Japan) but lower
productivity.
Plants in the NICs (the New Industrial Countries in south and east
Asia) have lower quality and lower productivity.
The US plants achieved high productivity at the expense of quality.
The European plants achieved high quality at the expense of
productivity.
Japanese plants achieved high quality and productivity.
Pause and think
Could Toyotas high performance be due to cultural factors?
Could Japanese workers and managers have some special cultural feature that makes
them perform well?
The productivity differences were not because the Japanese workers were
different to non-Japanese workers. We may see this from the performance
of Japanese-owned and American-owned plants in USA, both of which had
American workers. The Japanese-owned plants had higher quality than the
American-owned plants but the same productivity as the American-owned
plants.
The conclusion of the Toyota study was that Japanese plants had achieved
high productivity and high quality because their production methods were
more flexible than American ones.
This was a consequence of the particular problems of the Japanese motor
industry in its early years. Japan did not have a mass-produced consumer
car industry until the 1950s. The market was too small and the economy
had been destroyed in the Second World War. In other words there was a
desperate shortage of capital.
Not long after the war, Toyota engineers returned from the USA with
some second-hand American machinery. But because Toyota had very
little capital it could not use the inflexible high volume machines, made
for American mass-production methods. It took the company ten years to
work out how to use the machines flexibly. This led to what is called total
quality control. (In total quality control the workers are individually
responsible for the quality of the product.) The companies introduced just
in time production because they did not have the capital to hold large
stocks of materials (see below).
Pause and think
The Japanese car companies must have been maximising the use of particular resources
by introducing total quality control. Which resources were they?
14.3.1 The essence of Japanese technology

flexibility
total quality control
just in time production.
160
By the early 1970s Japanese imports were making inroads into the US
domestic market.
The American car producers knew that by the 1970s the large Japanese
car plants had higher productivity than American car plants.
American car producers misread the signals and thought that the
reason for Japanese success was automation.
This led American companies to introduce robots in car assembly. So
they built highly automated plants just to make a single model.
Even with robotic car assembly labour productivity was still lower than
in Japan.
Another problem was that the new integrated plants were very
inflexible. If the model they were building turned out to sell badly, it
was very expensive to change the plant and produce a different one.
AUTOMATION AUTOS 1980s
LABOUR
PRODUCTIVITY
JAPAN
USA
NIC
EUROPE
AUTOMATION
Figure 14.2 Automation and productivity in world car production in the 1980s
Study the diagram. (NIC stands for newly industrialising countries.) The
further along the X axis a country is, the greater the degree of automation;
the further along the Y axis, the greater the productivity. The diagram
shows that the Americans had less automation and less productivity
than Japan. European producers had high automation but not very high
productivity. The point was that there was no direct relationship between
automation and labour productivity.
14.3.2 Manufacturability
The Toyota study of the 1980s discovered another difference between
Japanese and other cars. They asked all the car companies which car was
the easiest to manufacture. Nearly all producers in the world said that
Japanese car design made it easier to assemble the cars. It was
thought that half of the Japanese cost advantage was because of better
design and about a half was because of better factory organisation.
Pause and think
How did Japanese plants manage to achieve both low cost and high quality?
161
Japanese companies achieved both flexibility and quality by innovative

production methods which were different to those in the USA, although by
the 1990s, they were extensively copied in the USA and Europe.
Total quality control: Individual workers in Japan had the authority
to stop the line if there was a fault in the cars. In the USA, only a
supervisor could do this. So the American lines were rarely stopped and
errors were corrected at the end, which was expensive. This meant that
American workers, unlike Japanese workers felt no responsibility for
the quality of the products. American products had more faults and it
cost more to rectify them.
Flexibility: In the 1980s it took a typical US mass-production plant a
whole day to change settings (i.e. to effect a model change, say from
two-door to four-door cars). This stopped the line for a whole day. The
Japanese plants had technology which allowed settings to be changed
in minutes.
Just in time: In the 1980s, General Motors needed to hold two weeks
stock of components to ensure that the production line was never short
of components. In Japan, Toyota held only two hours worth of stocks
and they never ran out. In Toyotas US plant, they held more stocks,
but still only for two days. Both companies relied on outside suppliers
of components, but Toyota had organised their suppliers much more
efficiently than had General Motors.
Pause and think
Ask yourself, how does the size of stocks affect profitability? Your answer should use the
concept of opportunity cost (see 1.5.17).
14.3. Falling economies of scale

An important general point, which applies to most manufacturing industry
in the late twentieth century, is that for many products the economies of
scale had changed. The output necessary to produce at minimum cost
(in first year economics, the lowest point on the average cost curve) in the
late twentieth century was much lower than it had been before.
There are still some advantages from a very large plant, but these are
outweighed by other effects, including flexibility and innovations. Hence
by the late twentieth century, there were many examples of small and
medium size companies (not only in Japan) where huge increases in
productivity had occurred, and where the products were cheap, high
quality and varied. Good examples may be found among Italian clothing
firms.
Summary
Massive changes in the productivity of industry and the quality of
products reduced the inputs needed to produce high quality products.
There is now much less of a trade off between quality and cost.
Consumers in developed countries have a whole range of good quality
products at low prices and still have money left over.
Transport costs are now much lower than previously.
Since the consumer in the developed country is not going to spend
more on food (as opposed to on restaurants) they spend it on services.
162
Hence additional resources have been used in services, many of which

(like restaurants) have lower productivity than industry.
Moreover, in the late twentieth century, a very large amount of
consumer expenditure, either directly or via the government consists of
expenditure on health and education, for example.
To return to the beginning, these changes in industry are driving the
process of deindustrialisation which, in general, is a sign
of success, not failure.

explain why the relative share of services in the output of the major
economies increased
discuss whether the increase in the share of services was a source of
problems in economies
describe the major differences between flexible production methods
and mass production methods in industry
explain why it was possible in the late twentieth century to have
products that were both cheap and of high quality, and why it was not
in any other period.
Questions
1. Why was deindustrialisation a major concern of the large industrial
economies in the late twentieth century? Was the alarm justified?
2. Account for the success of the Japanese motor industry and the relative
failure of the American motor industry in the later twentieth century.
3. Examine the main differences between best practice mass-production
methods of the mid-twentieth century and flexible manufacturing
methods of the late twentieth century.
163
Notes
164
Chapter 15: International trade and developing countries in the late twentieth century
Chapter 15: International trade and

developing countries in the late
twentieth century
This chapter is important. We draw lessons from the work done in the
course and form conclusions about the nature of the relationship between
trade and growth since 1820.
Objectives
To:
identify those developing economies which have been successful
examine the relation between developed and developing countries
look at some simple models of economic development
understand those factors which make development more likely.
Learning outcomes
give the main reasons why first one country, then another dominated
the international economy
explain why it took less time for Japan to catch up the USAs position
in the international economy than it had for the USA to catch up the
UKs position
account for the rise of the Chinese economy (see Chapter 16)
explain whether the circumstances of the international economy were
more favourable to the poorest countries in the past than they are
today
describe and analyse some of the main ways that poor countries have
developed in the past.
Essential reading
[ISBN 0415199301 pbk] pp.25366 and pp.31726.
Further reading
edition [ISBN 0745009352 pbk] pp.2704, pp.31519, pp.3249, pp.3323
and pp.3446.
Pacific Rim. (Boulder, CO: Westview Press, 1993) [ISBN 0813312418 pbk]
pp.11215 and pp.15663.
165
Introduction
In this chapter we consider whether or not economic conditions were more
conducive to the economic development of the poorer countries in the late
twentieth century than in the early twentieth century.
We discuss the effects on the less developed countries of changes in
international economic relations and in the economies of the richer
countries.
There is also an appraisal of the relationship between trade and growth
in historical perspective which will include a brief description of the
contrasting growth paths followed by developing countries.
15.1 World trade patterns

Let us look briefly at how the general world trade pattern has changed.
UK
= services
= primary producers
c. 1890
= manufacturers
USA
PP
USA
c. 1950
UK
PP
J
c. 1990
USA
PP
C
c. 2010
PP
USA
Figure 15.1 Patterns of trade, 18902010

Study the diagrams. They show:
The position of the UK in 1890 as the major exporter of manufactures
and services, the main importer of primary products and as an importer
of manufactures. As a result of this pattern, there was no sterling gap.
The position of the USA in 1950 as the major exporter of both primary
products and manufactures and a relatively unimportant importer. As a
result of this pattern, there was a dollar gap.
The position of Japan (J) in 1990 as a major exporter of manufactures
and an importer of services and primary products.
166
The position of China (C) in 2010 as a major exporter of manufactures

and with relatively few imports.
Pause and think
Make sure that you can redraw Figure 15.1. Use it to explain the reasons for the success
in the international economy of the UK, the USA and Japan, respectively. Table 15.1
will help you. The table is very crude but hopefully it should remind you and help to
summarise some of the important material from the earlier chapters.
When?
Typical products
Reasons?
UK
18001914
textiles/ships
early start/human capital
USA
19141970
cars/machinery
resources/management/research
Japan
19701995
cars/electronics
management/research
China
1995
manufactures
low wages/management
Table 15.1 What determined success in the international economy?
The first column shows the period when the country was the most
important one in the international economy. The second column gives
example important products that helped the country to be the most
important exporter and the third column gives a simple reason why the
countrys exports were able to dominate. Try the next activity.
Activity
As we said, Table 15.1 is very crude and very simplified. Try adding industries and reasons
for their success to the table.
Next we consider in more detail the cases of Britain, the USA and Japan.
15.1.1 Britain
Pause and think
What was Britains success in the pre-1914 period based upon? Use Figure 15.1 and
Table 15.1 to answer the question.
The British success was based upon a combination of technology and
human capital and by the economys marketing expertise.
In textiles for example, the British used a technology, which maximised the
supply of highly skilled textile workers, which they had, in abundance.
The skills were not learnt by formal training but by learning on the job.
This meant that the early start was important for UK trade. The longer
industry had been developing in the UK, the greater the supply of human
capital. The same argument may be applied to its marketing success. This
is another example of path dependency (see 6.7.1 in Chapter 6).
The other advantage of an early start, which we discussed in Chapter 2, was
that the first industrial country gained access, through trade with the New
World, to a source of raw materials and foodstuffs and a market for exports.
15.1.2 The USA

Pause and think
Why, in your opinion, did the USA succeed in the period 191470? Write down your
answer.
167
United States industry operated on a much larger scale than industry in

the UK. And mass production first started in the USA. When the American
plants became very large in the early twentieth century, they produced
manufactures at a much lower cost than any other country was able to do.
But the reasons for the very low cost of American industry may have been
misunderstood. It may not have been because industry was more efficient
in the sense that total factor productivity (TFP) was higher.
It is interesting, for example, that it took a long time for American industry
to produce goods more cheaply than British industry. This was even true
when US industry was larger scale. Think about the concept of efficiency
(TFP). British industry might have been better at using the available
resources than US industry.
The labour force in the mass-production industries were not highly skilled.
The purpose of mass production, as we have seen, was to reduce the
amount of skilled labour that was needed.
The big advantage that US industry had may have come, not from the
skills of its labour force, but from the very low cost of inputs. American
industries were very resource intensive, for example the motor industry
was able to use huge amounts of steel, petroleum and electricity which
were much cheaper than anywhere else in the world. Moreover, the US
economy was the worlds largest free-trade area.
Pause and think
Why do you think the USA lost a lot of its advantage in the late twentieth century?
Answer before reading on.
The cost of producing, transporting and handling raw materials has fallen
dramatically in the late twentieth century. World commodity markets have
become globalised. And now most of the world has very low tariffs on raw
materials. In other words the USA is not the only large free-trade area.
Other very large free-trade areas exist. This means that the possession of
very cheap resources no longer confers an advantage as it did for the USA
in the early twentieth century. Remember, when we consider Japan, that
Japan has no natural resources to speak of. It simply imports them.
15.1.3 Japan
The reasons for the increasing importance of the Japanese economy are
different to the reasons for the USA when it was the dominant economy.
Japanese industry is highly technological and produces very high quality
products. Therefore its success depends on a high level of skills plus
research and development programmes.
Research in Japan occurs within large business corporations, unlike in
the UK and the USA where it is more likely to come from universities
and research units. It was Japanese not American industry that created
reprogrammable machines which were different to the American massproduction machines of an earlier period.
Pause and think
The UK dominated the international economy for over 100 years.
The USA dominated it for not much more than 50 years.
Japan dominated it for not much more than 20 years.
In each case the catch-up time was less. Why has the catch-up period got shorter each
time?
168
The reason for the catch-up period reducing is, of course, that the world
economy has become much more integrated. Direct foreign investment is
much commoner than in the past. (In a recent publication, the World Bank
estimated that, on average, 56 per cent of each countrys share capital and
government stock was held overseas.)
Globalisation has had an important effect for developing countries. It
is now possible, for example, to purchase turnkey plants which come
complete and ready to operate (the Brazilian steel industry has done this).
In the nineteenth century technical transfer depended on the transfer
of skills, which were difficult to acquire outside the already developed
economies. Hence it was difficult for other countries to catch-up with the
UK because they did not have the UKs stock of human capital.
15.1.3.1 Japan and the international economy
Pause and think
Japanese exports were large through the 1980s compared with Japanese imports. Did
this create a yen gap?
It is important to remember that:
Exchange rates were flexible in the 1980s. Hence the yen rose 100 per
cent against the dollar in the 1980s.
The yens rise increased the price of Japanese exports, and perhaps
more importantly, reduced the price of Japanese imports.
There was a big rise in imports into Japan in the 1980s. About half of
the imports were manufactures.
Pause and think
Where do you think Japanese imports in the 1980s came from?
The rise in the yen had encouraged Japanese corporations to invest in
overseas production, particularly in south-east Asia.
Many of the industrial products were exported from south-east Asia
to Japan (car parts, car assembly, computer assembly, and consumer
durables).
Pause and think
Does the evidence above suggest that Japan is ceasing to be a major industrial economy?
In the 1980s, Japanese industrial imports were relatively lowtechnology products. Examples included washing machines and
televisions. Japan did not import high value-added products, only
exported them.
The composition of Japanese industrial exports has changed.
Increasingly, Japan exports industrial technology rather than products.
This was similar to the British position in the international economy
before the First World War, with one crucial difference. The UK was
importing high-tech products at that time; Japan in the late twentieth
century was not.
Pause and think
Why has Japans importance in the international economy diminished?
169
Interestingly, in recent years, a major weakness has appeared in the

Japanese economy. The Japanese financial system has not proved adequate
for the needs of the second largest economy in the world. In particular:
The financial system has not proved to be very competitive. There are
many stories of cronyism, including an uncompetitive relationship
between the banks, corporations and the government.
The uncompetitive financial system led to a loss of confidence in the
Japanese economy, leading to very low rates of saving.
In the early twenty-first century interest rates were very low (e.g. 0.5
per cent per year) but that has not lead to a revival of investment so
that the country has been in recession for some years.
The recession means that the predictions of the early 1990s, that Japan
would become the most important player in the international economy
have had to be revised downwards. Despite its financial problems,
the United States continues to be the most important player in the
15.1.4 China
Although China is technically a socialist country, a series of reforms from
about 1995 onwards made it capitalist. It has now become the dominant
producer of industrial goods. Because the country is still quite poor, GNP
per capita is about $4700 a year. Import demand does not equal the
demand for exports. There is a large luxury trade in China high quality
motor cars, fashion items, etc. But the majority of the population does not
buy them. On the other hand, demand for raw materials is very large,
because the country is still at the stage of developing major industries.
(For example, the Australian economy is becoming increasingly dependent
on Chinese demand for iron ore and coal.)
Hence, because on average China is poor and because savings are very
high, it has a balance of trade surplus. This is partly invested abroad,
in, for example, African raw materials and partly it helps pay for other
countries trade deficits. So, for example, about 15 per cent of the USA
trade deficit is financed by China. One effect of this is to stop the Renminbi
rising, which is good for Chinas exports.
Both Japan and China will be discussed in greater detail in Chapter 16.
15.2 Developing economies

We turn now to the developing countries. An important change for these
countries has been the effect of deindustrialisation on international trade
in the late twentieth century.
The relationship between their development and the international
economy is crucial, as it was for so many economies in the past.
Pause and think
How far do you think that less developed countries can grow through exporting to rich
countries?
As we know, before the First World War, exporting primary products was
very profitable and this was the way the economies of many countries
started to grow. But, it may not be easy for present day developing
economies to grow in the same way. Consider this and form your own
opinion before reading on.
170
One piece of evidence to think about it this over recent decades, primary
products has been a decreasing proportion of international trade.
15.2.1 The example of Britain

We will use Britain as an (admittedly extreme) example. Consider Table
15.2. Remember the UK is the most extreme case, but the principles apply
to all countries.
1951
16%
1953
11%
1980s
2%
2010
4%
Table 15.2 UK net imports, food and raw materials (as a percentage of GNP)
Since the Second World War UK raw material imports have declined
relatively and absolutely. The UK can import all the primary products
it needs at very low cost only 4 per cent of GDP in 2010. Obviously,
this does not provide a large market for primary products from the less
developed countries. (This is much lower proportionately than UK imports
in 1914.)
Activity
You should try to work out why this happened yourself before reading further. The things
to think about are deindustrialisation, changing demand, price levels and agricultural
protection. Another factor special to Britain was the exploitation of oil from the North Sea
during the 1980s; this affects Table 15.2.
The reasons for the change in imports were:
Deindustrialisation: We discussed this in Chapter 14. In developed
countries productivity in industry increased very fast, which meant that
the price of industrial goods fell. People could purchase large quantities
of consumer goods at low prices. Since many people could buy all
the consumer goods they needed, they spent more of their increased
income on services, and the share of manufactures in output fell. But
services needed fewer raw materials. So, as income rose, the demand
for raw materials fell.
Engels Law: This observation, made by Marxs collaborator
Freidrich Engels is that, as income rises, the proportion of household
income spent on basic necessities declines. As a result, the demand
for food increases at a slower rate than the demand for manufactured
goods and services.
Pause and think
Try to put the argument above in terms of the income elasticity of demand for food.
With the exception of oil, the price of food and raw materials has
been low since the Korean war, when prices were high. This is because of
technology and competition between producers.
Pause and think
Technology and competition between producers might lead us to expect an increase in
demand. Why was there was little increase in demand using the concept of price elasticity
of demand?
171
North Sea oil: This was the reason why UK imports were so low in
the 1980s. A fraction of it provided most of the countrys energy needs.
The rest was exported. At its peak, North Sea oil comprised five per
cent of UK GDP.
Agricultural protection. All industrial countries support agriculture
and protect their farmers against imports. The USA is currently
the worst offender. The UK as part of the EU follows the Common
Agricultural Policy (CAP). Under the CAP, European farmers are partly
protected. European consumers pay more for European products than
they would if they imported them from outside the EU. For a long time,
UK farmers were investing heavily in protected agricultural products
leading to amazing increases in productivity.
wheat
barley
land
+64%
+166%
output
+350%
+442%
Table 15.3 UK agriculture, 194582
milk (litres per cow/year)

eggs per hen
120
145
240
248
Table 15.4 UK milk and eggs production, 194582
The table shows that after a period of less than thirty years, the average
cow in the UK produced double the milk and the average hen twice as
many eggs. Output of wheat rose by 3.5 times, through an increase in the
area sown and a two times increase in yield per hectare.
Pause and think
Is protecting agriculture the correct policy for a country like the UK?
What are the effects of the UK agriculture protection policy on the poorest countries?
Which country would benefit most if there were no tariffs in the UK?
Would the UK be a poor country if it removed its tariffs?
15.2.2 The UK trade position with the less developed countries

(LDCs)
In the 1980s and 1990s the UK was a net exporter of services and of raw
materials (oil). This meant that as UK incomes rose, any increase in (net)
imports was likely to be in manufactures.
Hence if less developed countries were to grow through exports to the
UK and to the other industrial countries, LDCs had to increase exports of
manufactures, not exports of food and raw materials.
15.2.3 Implications of late twentieth-century trade patterns for LDCs

We have already pointed out that the share of primary products in
international trade has fallen. By the late twentieth century, most trade
was in manufactures and manufactures moved in both directions.
Therefore there was limited scope for less developed countries to increase
their exports of primary products.
Pause and think
Does the fact that manufactures dominate trade make it more difficult for LDCs to
develop now than at the beginning of the century, when most of international trade was
in primary products? What is the relation between trade growth and income growth?
172
We may think of several possible ways that LDCs could develop:

Peasant exports could increase. The peasants could farm more
efficiently and export more of their (agricultural) output. This would
pay for imports of capital goods for development. Burma (now called
Myanmar) tried to do this by getting the peasants to grow more rice.
The problem was that the rice exports were used to finance imports of
capital goods, not consumer goods and this meant that the peasants
could see no benefit from their increased production. Hence the
peasants had little incentive to be more efficient.
As an alternative to the situation in the first point, the agricultural
or raw material exports could come from plantations
or mines. In this case the local workers would be paid a wage.
Exports of primary products would increase, but the problem is that
the plantations/mines would be under overseas ownership. When a
high proportion of profits goes overseas, they are not available for
development. However, in recent years governments of LDCs have been
able to tax plantations much more effectively than they could in the
past. This means that the benefits from plantations are greater than
they were before. When these countries were colonies they were often
unable to tax foreign-owned firms.
A more radical way in which an LDC developed is the USSR model,
also followed for sometime by mainland China. Originally, the USSR
was a primary producing economy. The government invested heavily
in heavy industry and neglected agriculture. Industrial output rose but
the standard of living fell. The country was modernised, however. The
problems with the USSR as a model for LDCs are two-fold.
Pause and think
What are the two problems of the USSR as a model for LDCs?
First, the social cost was very high. Many peasants died in the 1930s, when
their food was taken away to feed the cities. Subsequently, no LDCs, except
China, seem to be willing to pay the price paid by the USSR population.
Second, in more recent years the USSR economy has fallen apart, and
as a result, not surprisingly, the USSR model has lost its appeal. Growth
without consumer incentives, without an increase in the standard of
living of ordinary people, is an unattractive choice. (Now Russia is
fundamentally capitalist.)
Let us return to the linkages between trade and growth. In recent years,
development economists have changed their thinking. They now think of
trade not as the driving force of development but as a vent for surplus.
What happened was that before 1914 export enclaves became established
using surplus or near-surplus land and labour in tropical colonies.
However, the lack of social and political structure outside the enclave
prevented the export industry from helping the rest of the economy. This
explains why, for example, Jamaica is still a poor country despite 300
years of exporting sugar.
The vent for surplus approach makes us aware that changes in the social
and political structure of the country are necessary before the benefits
of export trade will spill over into the whole country. When it does, for
instance, a peasant society can change into an exporter of manufactures,
as happened in Japan in the nineteenth century.
173
15.3 Can trade be an engine of growth?

Did countries in the past become rich on the basis of trade? In the jargon,
is it true that trade was an engine of growth in the nineteenth century
and not in the twentieth century?
The next activity poses probably the most important question of the whole
course. Take your time in answering it and think through your reading in
this course before you do.
Activity
What evidence is there that trade led to economic growth in various countries? Make
notes and write down your opinion before reading further.
Once you think you have decided what the answer is, read on.
We have seen, of course, that exports of primary products were the key
reason for the initial development of countries like the USA, Canada and
Australia. But there may have been a special reason for their success which
we will discuss later in the chapter.
Remember that the demand for primary products was high in the
nineteenth century. Since the late twentieth century, prices of primary
products have been low compared with industrial prices. We say the terms
of trade are against countries exporting primary goods and importing
industrial goods. Such countries now receive fewer industrial goods for
each unit of primary exports compared with what they got in the recent
past. This makes development and growth more difficult to finance.
Activity
The terms of trade argument downgrades the value of aid to LDCs. What is the point of
aid if it increases the supply of primary exports from LDCs? Try to make the case against
aid that increases the supply of primaries. Then read on.
The extra supply of primary products will meet an inelastic demand.
The result of this will be lower prices.
The beneficiary of the aid is the rich importing country not the poor
exporting country.
This problem would not arise if rich countries agreed to buy more primary
products from poor countries at high prices. This is what the slogan trade
not aid refers to. But both the EU and the USA maintain high tariffs
against food imports the most important primary products.
The argument is that LDCs would benefit if rich countries agreed to
purchase the LDCs exports at higher prices, rather than if the LDCs were
given financial aid. In fact because increasing trade for LDCs can seem so
difficult, the governments of some LDCs have neglected trade as a way of
developing the economy.
Pause and think
The discussion above seems to suggest that trade was once an engine for growth but is
no longer available to LDCs today. In fact this rests on an incorrect view of history. Trade
was rarely an engine of growth. Why? Try to answer before reading on.
174
The late nineteenth and early twentieth centuries were not uniquely
favourable to international trade in primary products.
Primary product prices were not high relative to the prices of
manufactures. In other words the terms of trade were not much more
favourable than today.
The reason why the industrial countries bought large amounts of
primary products in the nineteenth century was because they were
cheap, i.e. because the terms of trade were against primary products.
Pause and think
Would an LDC develop faster if the price of its exports was high or low?
If the prices of primary products are high, industrial countries will develop
substitutes such as plastics to replace metal, and synthetics to replace
rubber and cotton. In any case it is not the price alone that matters to
LDCs but the total revenue from exports (price times quantity). In the
nineteenth century, countries bought large quantities of primary products
because they were cheap.
Therefore low prices on their own are not a reason to avoid exporting
primary products. But that leaves the basic question unanswered can
trade be an engine of growth? To answer this let us look at the other
possibility: can growth be an engine for trade?
15.4 Can growth be an engine for trade?

We argue that it can, and that this is the correct way to interpret the
history of trade and growth in primary producing countries:
Think about the historical record. The successful primary producing
exporters in the early twentieth century (e.g. Canada, Australia) were
not less developed countries as we think of them today, although
they were not developed since their economies relied on primary
products. The reason for their success was because they had a very high
ratio of resources (particularly good quality land) to population. Hence
primary product exports were large. (Price times quantity was high.) It
did not matter that they depended on primary product exports as long
as they could sell large quantities of them at reasonable, not necessarily
high, prices. (We discussed what happened to these countries after the
First World War in Chapter 8.)
The LDCs that have been successful in recent years have been, in
the main, small countries. They have also been countries with welleducated populations and strong governments; not typical, late
twentieth century LDCs. (In other words, their social capability was
high.) Nor have they grown through exports of primary products.
A good example is South Korea, which grew through manufactured
exports. At the end of the Korean war in 1953, (South) Korean GDP per
capita was about 40 per cent of that of Portugal and Greece. By 2000 it
was the same.
We may, however, be entering a new phase of economic development
the development of large less developed economies, such as China,
India and Brazil.
175
In other words, what matters is not finding markets for export crops. What
matters is having the foundations for growth that can then take advantage
of world markets through trade.
In the main, the large LDCs have grown faster than the developed
countries since the Second World War. Countries like India have grown
as fast as the industrial countries, though rapid population growth
makes the per capita growth rate less. It is simply that the big LDCs
were very poor in 1945. So it will take them a long time for their
income to catch up with the rich countries.
As we saw in Chapter 11, the oil crises were a particular problem for
the LDCs, most of which are oil importers. The crises left many LDCs
with huge debts.
Summary
Conditions affecting LDCs, with the significant exception of the oil crises,
are not very different than they were in the early twentieth century. The
key to their development is not, in the main, exporting primary products.
Rather it is establishing the right social and political conditions to allow
growth to begin. Trade will then follow.

give the main reasons why first one country, then another dominated
the international economy
explain why it took less time for Japan to catch up the USAs position
in the international economy than it had for the USA to catch up the
UKs position
explain whether the circumstances of the international economy were
more favourable to the poorest countries in the past than they are
today
describe and analyse some of the main ways that poor countries have
developed in the past.
Questions
1. Was the international economy of the early twentieth century more
favourable to trade in primary products than the late twentieth
century?
2. Why did manufactures become the most important components of
international trade in the later twentieth century?
176
Chapter 16: Japan and China

Japan was a poor country at the beginning of the twentieth century.
This chapter shows how Japan began to approach US levels of GDP per
head, only to fall away in the mid 1990s. China remains relatively poor,
but is beginning to dominate international trade in many important
commodities, just as the developed countries are abandoning trade in
those commodities.
Objectives
To:
show how first Japan and then China industrialised very fast and how
they became important players in the international economy
show how the communist regime in China was unable to deliver
economic growth and was replaced by a system which was largely
capitalist in nature including (in effect) private ownership of land and
industry.
Learning outcomes
explain the main features of growth in these countries
discover why countries that were very poor, for example, China, grew
very fast in the last 60 years
explain the significance of the relative fall of the Japanese economy in
recent years
show how socialism was replaced by capitalism
explain why growth was different in some periods than in others.
Reading
China
Pacific Rim. (Boulder, CO: Westview Press, 1993) [ISBN 0813312418
pbk] pp.12230.
Naughton, B. The Chinese economy: transitions and growth. (Cambridge, MA:
MIT Press, 2006) [ISBN 9780262640640 pbk]pp.210, pp.338, pp.6982,
pp.87101, pp.11434, pp.14050, pp.1567, pp.16472, pp.2104,
pp.27582, pp.37886 and pp.3918.
Japan
Pacific Rim. (Boulder, CO: Westview Press, 1993) [ISBN 0813312418
pbk] pp.10721.
Mosk, C. Japanese economic development: markets, norms, structures. (Abingdon:
Routledge, 2008) [ISBN 9780415771580] pp.2318, pp.26359, pp.26472,
pp.278282, pp.3058, pp.3126, pp.32131 and pp.33752.
177
Introduction
Both Japan and China were devastated by the effects of the Second World
War. Japan was richer and continued its development of capitalism. But
there were several features that were unique to Japanese society.
China initially pursued a policy of strict socialism, which only had a
modest growth rate. Hence the strict socialism had to be replaced by
largely free markets and private ownership of industry. This has led to very
high rates of economic growth.
16.1 China
China has achieved an average growth rate of 10 per cent from 1978 (per
capita, 8.5 per cent). Because of the world depression the average growth
rate is now a bit lower but still 8 per cent or so. At these rates China
will overtake US GDP, per capita, round about 2050. Of course, we dont
know whether this will actually occur. For example, it was predicted that,
per capita, Japanese growth would exceed US GDP by 2005, but, in fact
Japanese GDP was only 80 per cent of US GDP in 2005.
The important features of the Chinese economy are:
Initially, China was very poor.
China is moving away from a socialist economy and moving towards
many features of a market economy.
China is in the middle of an industrial revolution, with profound
changes to its economy and society.
16.1.1 The background

Japan invaded China in 1937 and by 1945 had conquered a large part of
the country. However, Japan was defeated by the USA in 1945. This left
the nationalists in China but they were defeated by the communists. The
nationalists fled to Taiwan. By 1949, the communists controlled all of
China, with the exception of Hong Kong, which was a British colony. The
communists established the Peoples Republic of China in 1949.
16.1.2 Chinese income

As late as 1978, Chinese average income was only $674 (in 2000
purchasing power.) In other words, Chinese income per capita was much
the same as a less developed country, for example, India. By 2003 Chinese
income had reached $4726 (in constant price 2000 dollars). This was
substantially more than India. What was different to India was that in
1978, 44 per cent of Chinese output was produced in industry. This, of
course, was very large for a less developed country. From the beginning,
in 1949, industrialisation was prioritised. The government owned all the
large factories, transport, foreign trade, banking, etc. The large proportion
in industry also showed that agriculture was being neglected at the time.
On the other hand, the urban population was extremely small. It was only
18 per cent of the total population. This was a much lower level than a
typical low income, less developed country at the time.
In the 1950s, there was a deliberate attempt to control the movement
from the countryside to the cities. This was the reason for the relatively
small population of Chinese cities compared with other countries. This was
to prevent desperately poor farmers who could make more money in the
cities from moving. The urban population of China only rose from 11 per
cent in 1949 to 19 per cent in 1980. (Shanghai only rose 10.4 million to
178
11.8 million and Beijing only rose 6.7 million to 9.1 million in this period.)
In roughly the same period (195082), the urban growth in most of the
less developed countries grew about 200 per cent. Most significantly, the
government controlled the export of food (that is, from the countryside)
to the cities. This was at low prices, which obviously befitted the cities, but
meant that the farmers could not benefit directly from industrialisation.
In other words, the farmers did not receive high prices from the urban
population.
Pause and think
What was the governments objective? Why restrict ruralurban movement?
Perhaps the government realised that if there were no controls, the
number of migrants would be very large. This is what happened in most
less developed countries. Urban wages, in the period, were very low. But
rural wages were much lower.
16.1.3 The rural sector

Farming, which was the dominant occupation, of course, was partly
socialised in the 1950s and 1960s. Farms were collectivised. But there
were serious problems, one of which was an incentive problem. The
price of agricultural products was not the most important criteria of the
rural wage. Many workers were paid in points and did not know their
wages until the harvest was gathered. Nor did the large units increase
productivity, because there were few economies of scale in Chinese
agriculture. This was partly because of the nature of rice production and
partly because the government prioritised deliveries to the urban sector.
This had the effect of forcing the collective farms to concentrate on grain
(wheat) output. The problem was that concentrating on grain output
meant that its output probably cost more than the other crops (that is,
the output of grain at the margin probably cost more to produce than its
price). Hence, the output of agricultural products in 195383 was less
than 1 per cent per head of the population. Output grew by 3 per cent, but
the population of China grew by more than 2 per cent a year in the 1950s.
Not surprisingly, Mao Zedong was dissatisfied with progress, particularly in
agriculture. In the Great Leap Forward, from mid 1957 to 1960, the size
of the average commune was increased. Agriculture became (increasingly)
collectivised. And a large number of very simple technologies (iron and
steel, for example) were introduced into the countryside. But this also led
to a big problem, which was a drain of resources from agriculture, often
into backyard steel factories. And the farmers had to work for no material
rewards. At the same time the amount that farmers had to deliver (that
is, give) to the state was increased. In other words, China ignored the
experience of the Soviet Union, where the collectivisation of agriculture
had led to mass deaths in the 1930s in famines. Similarly, in China there
was a huge increase in mortality, probably about 2025 million excess
deaths.
Obviously, the Great Leap Forward was a mistake. Mao Zedongs reaction
to the crises was the Cultural Revolution. He used the revolutionary
spirit of large numbers of younger people to attack reactionaries. For
example, school teachers, foreigners and managers of collective farms
were attacked. About 40 million people in 196676, the undesirables,
were sent to the countryside. Most of those who went to the countryside
subsequently returned to the cities. It is not clear whether there was any
benefit to the economy, however.
179
Pause and think

Do you think the Cultural Revolution was politically motivated?
It is difficult to think of an economic advantage of the Cultural Revolution.
There was no need for urban workers to move to the countryside, although
it did show them how hard agricultural life was. But at the same time the
Cultural Revolution took a large number of people who were important
workers and moved them to parts of the country where their work was
marginal.
Reform could not come until the death of Mao Zedong. This occurred in
1976. Almost immediately, the economy began to improve. Agriculture
was de-collectivised, which meant that peasants were given access to the
land. This was not the same as private ownership but it didnt seem to
matter. Agriculture output rose 8 per cent in each of three years 197983.
It only rose 3 per cent in the period 195376. Per capita growth rose from
4.1 per cent in the period 195278, to 8.5 per cent in 19782005.
16.1.4 How was the growth achieved?

One problem was that agriculture in China was very productive. China
was less wealthy than India in the 1950s, but rice and wheat yields were
much more than in India. We also saw that agriculture was growing hardly
more than population growth. But this depended on a huge increase in
the population. So the size of the agricultural population was, in affect,
a constraint on industrial growth. As we have seen, agriculture had been
collectivised. But by 1977 this had clearly failed. The answer was to decollectivise agriculture and to allow private enterprise to grow.
16.1.5 Chinese approach to transition

People could be allowed to create income for themselves. So price controls
were seriously reduced. By the early 1980s, a significant number of firms
were operating at market prices. And, as we saw, collectivised agriculture
had failed. So in 19812 a programme called the household responsibility
system became the dominant structure. By that time, more than 90 per
cent of peasants had returned to household farming. This led to a huge
increase in grain output. And the farm labour force actually decreased
for the first time. In addition, there was also a rise in mechanical power in
the countryside, comprised of small tractors and pumps (for irrigation).
This was because the agricultural workers actually worked very hard but
also took more leisure. So the labour force could do other things. This
was the beginning of the Townships and Village Enterprises (TVE locally
run factories) which, by 1983, had become nearly universal. They have
been an overall success. The bureaucrats, initially, were against TVEs but
they were allowed to flourish, even when they were competing with the
existing state-owned enterprises. They were particularly important in the
period up to 1996, when 130 million worked in them. (Since then, they
have grown only marginally.) Eventually, the private sector increased,
often in the form of TVE and state-owned enterprises buyouts. Hence, the
number of private enterprises increased markedly. By 2004, the private
sector employed almost twice as many employees as the state-owned
enterprise 55 million compared with 30 million (this doesnt count
foreign owned firms).
180
16.1.6 Investment rates

China has very high investment rates. By the end of the 1970s, gross
capital formation (GCF) was 40 per cent per year. It fell slightly in the
1980s, but GCF is now up to 40 per cent again. These rates are not unique.
Several Asian counties had comparable investment rates, for example,
Japan in 19703, and Thailand and Malaysia had GCF of some 40 per
cent. But the latter were running balance of payments deficits. China,
of course, is in current account surplus. This means that China has the
highest GCF for such a long period. Moreover, GCF in China is 100 per
cent created in China, plus about 4 per cent foreign investments.
An important reason why GCF is so high in China is partly because poor
people (the great majority of the population) have a very limited demand
for goods. But at the same time, they have to invest in social security
in order to compensate for when they are unable to work. (There are
fundamentally no pensions in China and hospitals have to be paid for.)
Clearly the high rate of capital formation has a lot to do with Chinas
phenomenal growth rates. It has allowed China to accumulate a modern
railway system, modern docks (seven of the worlds ten largest docks are
in China) and crucially a modern consumer goods industry. This means
that output growth in some years is close to 10 per cent per year. At the
same time the rural sector is only about 15 per cent of GDP. And most of
that goes to the traditional rural industries.
It is possible that the statistics are misleading, however. The rapid growth
may need final adjustment, which would still leave a growth rate of at
least 7 per cent for the whole period 19782005. But even so, Chinas
growth is unprecedented. Some Asian countries have achieved very high
growth rates, but not for such a long time. And other Asian countries have
had lower growth since the crisis of 1996, although rich people demand
very high quality goods many of which are imported. The Chinese
growth is still dependent on foreign trade. Eventually, China will develop
a mass consumer market. This means that trade will relatively decline and
the consumer market will become more important.
GDP per year Population per year
GDP per capita per year
19521978
6.0
1.9
4.1
19782005
9.6
1.1
8.5
Table 16.1 Growth of per capita GDP (annual averages)
Taken from Naughton, p.140.
16.1.7 Urbanrural differences.

Rural incomes have not kept up with those in industry. Hence, from 1985,
the distribution of income has become wider. China has moved from one
of the most egalitarian societies (because virtually everyone was poor)
to one of the least egalitarian societies. The most important reason is the
urban/rural gap. Even now, there are strict controls of mobility they
were much stronger in the past. Until the mid-1990s, it was difficult for
rural people to move to the cities. And, as we said, the cities did not grow
very much, particularly compared with other countries. Grain rationing
was in effect a tax on farmers, particularly after the Great Leap Forward
when migration to the cities was discouraged (195075). In fact, large
numbers of urban workers moved to the countryside.
181
The benefits to urban workers include job security, health care and
education for their children. Urban workers also gained access to low cost
housing from their employers on favourable terms. Rural workers, on the
other hand, pay more for health services about 90 per cent of health care
expenses, even though their income is lower than urban workers. This
means that there are large differences between urban and rural workers
about three times, in effect.
And it is difficult for rural residents to change their place of work
permanently, even if the rural resident was married to an urban resident.
Only those with permanent residence permits have the right to live in
the city. This has been liberalised since 1980, but not completely. It is still
virtually impossible for a rural worker to live in Shanghai or Beijing, for
instance. But movement to the cities was commonplace in virtually all the
countries at a similar level of development. So a basic problem emerges.
How is China going to cater for large numbers of rural workers who want
jobs in the city? Will they be able to forbid it?
16.1.8 Population growth

The 1970s saw very large reductions in fertility. And this has continued
up to the present day. Birth rates fell from about 40 per 1000 in the late
sixties, when population growth was about 30 per 1000 per year to about
12 per 1000 in the early twenty-first century. Total fertility rates have
become negative. In the long run, this means that population will decline,
other things remaining equal. The demography of Korea, Hong Kong and
Taiwan has a similar fall in fertility. But the reasons are not as drastic as in
China.
The famous one child policy was started in 1984, of course. Restricting
married couples to having only one child was not universally accepted.
And in some areas because of corruption some parents were able to
have a second child, particularly if the first born was a girl. The policy
also did not apply to the ethnic minorities. But we can see that, in the
main, the policy was remarkably successful. But there was a problem. The
Chinese preference for sons means that some girls were aborted, leading
to a deficit of women in other words there will be a shortage of women
for the surplus sons to marry.
16.1.9 Trade
In 2005, exports were around 34 per cent of GDP. Membership of the
World Trade Organisation (WTO), from 1991, has had a major effect on
trade. In the early 1990s, Chinese trade was about 15 per cent of GDP.
By 20045 it had grown to nearly 30 per cent and then to 34 per cent
in 2005. Most major trading countries blame the Renminbi, which is
normally assumed to be an undervalued currency. But, say, a devaluation
of the Renminbi by some 10 per cent would have an effect on trade, but
Chinese trade would still be very important. The Chinese were able to join
the World Trade Organisation in 2001. This was because of a further set of
market reforms, which in turn led to a further acceleration in the growth
rate.
16.1.9.1 Exports and imports
Initially, China exported products largely based on natural resources. After
1985 Chinas trade grew rapidly. But increasingly the raw material trade
was replaced by manufacturing products. These were labour intensive.
When China became a member of the World Trade Organisation in 2002,
this mean that a high proportion of imports could enter the Chinese
182
market. As a consequence, there was large growth in both exports and

imports. Compared with 1985, exports had changed by 2003. Electronic
and electrical machinery were now 50 per cent of exports by value.
Imports by value comprised crude materials, iron ore, fertilised food
grains and products employing much skill in manufacture. In other
words, Chinese trade is currently importing more sophisticated industrial
materials, and exporting less sophisticated industrial materials. This will
change, of course.
16.2 Japan
There is some more material about Japanese industry in Chapter 14 and
foreign trade in Chapter 15.
16.2.1 Growth models

It is very difficult to fit pre-war Japan into any sort of growth model. Japan
was the first rice economy to develop, but even in the mid-nineteenth
century there were many reasons why it was not a standard rice economy.
On the other hand, China was a rice economy until well after the Second
World War. Japan had an important (small scale) industrial sector, for
example, for many years. It was the growth of this sector which provided
the means to move out of agriculture after the Second World War.
One characteristic of rice farming is that the whole family has to be
supported. In other words, it is the average product of agriculture which
matters, not, as in western agriculture, the marginal product. On the
other hand, Japanese agriculture was developing from the later years
of the nineteenth century and possibly even before that. The Japanese
farmer was very skilled, but their skills were only in agriculture. There is
a controversy about when agriculture began to develop but later in the
nineteenth century agricultural output was growing at about 2 per cent
per year, much higher than the increase in population, which was modest
in Japan. Much of the growth was in better rice production new strains
of rice. But they were all labour intensive, of course. There was also a
very large growth in the silk industry, itself agricultural, and again, labour
intensive. Then in the post Second World War period, there was more
employment in industry. In agriculture, there was much deeper ploughing
and modifications to the irrigation system. This led to ruralurban
migration.
16.2.2 The Second World War

The Second World War was a disaster for Japan. There were huge wartime
losses 1.7 million solders and at least 700 thousand civilians died.
A large part of the cities (40 per cent) were gutted and destroyed by
American bombing. (The attack on Tokyo probably cost 100,000 lives
more than in Hiroshima, the city most affected by the atomic bomb.) After
the war poverty was widespread. Real income in Japan in 1946 was about
50 per cent of the income in the 1930s and that wasnt very high.
16.2.3 Tenancy
Most farmers were tenants before the Second World War owing rent to
landlords. But, after the war, the USA (who was the occupying power) had
legislated against tenancy. So landlordism was destroyed. By 1950, only 12
per cent of peasant workers were tenants. As the economy was developing
very rapidly, the surplus labour could leave the farm. Hence, a large
number of farmers moved into (small scale) industry. The better educated
urban workers moved into modern industry.
183
16.2.4 Japanese growth rate, 195073

Initially, the Americans tried to limit Japanese growth to that of the
countries which Japan occupied in the war Malaysia, the Philippines,
Indonesia etc. But the outbreak of the Korean War in 1949 changed that,
as Japan was adjacent to Korea and became the safe base. Growth rates
were very fast. This meant that Japan could participate in the golden age
of growth (see Chapter 12).
Japanese growth was enormous. The growth rate from 195073 was about
8 per cent. This is comparable to the growth rate of China in more recent
decades. Gross investment averaged 29 per cent, 195568. By 1973, the
end of the golden age in Europe and the USA, Japanese GDP was about
two-thirds of the US GDP ($11,000/16,600). At the same time GDP in the
USSR was not much more than one third of the US (6,000/16,600) and
GDP in China was only about seven per cent of US GDP (1186/16,000).
The implication was that Japanese per capita GDP would overtake the
US round about the end of the twentieth century. But this did not occur,
which is explained below. Labour productivity increased about 11 per cent
in this period, 195073. But after 1973 the growth rate dropped to less
than 4 per cent. Then it dropped again. In the nineties the growth rate
was negative for a few years and since then it has been about 2 per cent or
less. (See below.)
Japan first developed the smokestack industries in the 1930s, but after the
war to a much greater extent. Labour costs were, initially, far lower than
in Europe and the USA. As these smokestack industries expanded the low
productivity industries (textiles, for example), which had been central to
the economy in the 1920s and 1930s, moved out to other Asian countries.
By the 1990s, the USA and Japan combined were producing about 40 per
cent of world manufacturing output. But that has diminished since the mid
1990s.
16.2.5 Zaibatsu (the money/industry conglomerates)

The zaibatsu (Yasuda, Mitsui, Sumitomo, Mitsubishi) were basically
trading companies, but after the First Word War they all diversified into
heavy industry. The zaibatsu were increasingly predominant in the interwar period. In the 1930s, the aircraft and other strategic products became
more important. After the Second World War, the USA was determined
to reduce the power of the zaibatsu. In one sense they did this, but the
zaibatsu introduced the keiretsu, that is, smaller firms that existed on
the back of the major companies. These were dependent on the banking
structure of the zaibatsu and the zaibatsu did not need to go to the market
for share capital. The current conglomerates are Mitsui, Sumitomo and
Mitsubishi, and the new (1930s) ones of Dai-Chi Kangyo, Sanwa, and Fuji.
16.2.6 Is Japan culturally different from the west?

Is Japanese success the result of culture? Are the Japanese different to
inhabitants of the west. For example, are the Japanese more likely to
follow the prescriptions of MITI (see below)? Economic historians have,
in general, discounted this explanation. It is true that the Japanese are
thrifty in the main. And, famously, the Chief Executive Officers have taken
a much smaller percentage of the income of the shop floor workers than
in the USA or Britain. This is usually said to help industrial relations. This
characteristic is not as important as in the past, but there is a still a large
difference between the salary structures of the United States or European
companies. Furthermore, the Japanese tend to work for the same firms
for most of their life or working for an associate company earning so184
called seniority wages, with the oldest person having the highest income
in the company. But this has declined in recent years. Moreover, seniority
wages were very useful when the labour force was so young in the 1950s
and 1960s. But in the present day, the Japanese have an extremely old
population with the increasing problems of an older labour force.
But there are problems with a view that the Japanese are culturally
different. Confucianism (the majority Japanese belief) has not been a
very good predictor of economic growth. For example, the Japanese
performance has been rather poor in more recent years, and does not look
likely to overtake the USA in income per capita. Of course, Japan started
out with the labour costs of a developing country. Now it has the labour
costs of a higher productivity country.
16.2.7 The MITI

The Ministry of International Trade and Development (MITI) was the
first to identify the areas of the economy to be promoted. This was
easier to achieve in Japan because the keiretsu were dependent on the
erstwhile zaibatsu for funding. The MITI had no legal sanctions, but veiled
threats were made, so that in some cases a particular firm would have to
increase production, and another particular firm would have to give up
production of that product. For example, there was a MITI programme to
manufacture domestic computer chips (invented in the USA, of course)
in 1976. By 1983, Japan had 70 per cent of the world market. And one
of the four companies producing chips in the 1960s was told to give up
manufacturing chips. But the MITI has not always guessed correctly. For
example, Japan was still producing mainframe computers when the USA
had moved into personal computers.
MITIs position was probably helped by the large number of businessmen
in the government. Retired businessmen were often to be found in
government for example, in 195989, they held 50 per cent of Cabinet
posts. Business men often retired at 50, on modest salaries by American
standards, which accounts for the number of businessmen in the
government.
16.2.8 Japanese foreign trade

Japan imports food and close to 100 per cent of coal, oil, gas, iron ore
and many metal and low value goods. From 1950 until 1973, imports
were strictly controlled. On average, imports attract a tariff of 20 per
cent by value. In more recent years, the Japanese are buying a range
of manufactured goods produced in other Asian countries, textiles and
refrigerators, for example. But developed countries (the USA and Europe),
found it difficult to penetrate the Japanese market, except in services.
The key here is that domestic demand in Japan is much more important
than imports. Put another way, the Japanese producers can achieve large
economies of scale utilising only the domestic market. This cuts down
imports and makes exports very competitive.
Initially, the yen exchange rate was set at $1 Y360; this made Japanese
exports very cheap in the USA initially the big market. But in 1971, as
part of the Smithsonian agreement, it fell to Y308. Eventually, the Plaza
accord of 1985 produced a reasonable yen rate. And eventually the yen
floated. So after 1985 the yen rose, leading to an increase in Japanese
imports.
185
16.2.9 The stock market boom

At the end of the twentieth century there was a boom on the stock market,
followed by a collapse from which Japan has yet to recover. It was said
that the value of the imperial palace, should it ever come on the market,
increased by 70 per cent in 1988 and 80 per cent in 1989. By this time, the
royal palace was equivalent to the whole of the real estate in California. In
the beginning of 1990, the market capitalisation of Japan was more than
the USA, which had more than two times the GPD. But in 1992, there was
an enormous collapse. The Tokyo stock exchange fell by 65 per cent. There
was negative growth in 1992 and 1993. Even in 1994, the growth rate
was only 1 per cent. Household savings were nearly 11 per cent in 1990.
By 2004 they had fallen to 2.4 per cent. The government set interest rates
at about zero per cent. This was a long time before the current worldwide
depression. At the time of writing, Japanese growth is still affected by
what happened in 1992. All the talk of when Japan would overtake the
USA has disappeared.
16.2.9.1 The causes of the stock market boom
Remember that Japanese firms dont usually go to the market. Japanese
banks lent money with no regard for risk. Put simply, the Japanese
population were ignoring the risk, because they thought that, ultimately,
the risk was guaranteed by the government. Hence, there was a huge
increase in Japanese shares followed by a very big collapse. Eventually,
interest rates fell to zero. By 1996 Japan was running a deficit of 4.3 per
cent of GDP. So the government, as we would expect, increased taxation.
But the real problem is that people dont want to spend enough. In
other words, there is a liquidity trap in Japan (see 1.5.7). This is partly
connected to the demographics. Japan has one of the oldest populations
in the world, because, in the post war period there was a high growth rate
of population. But this was followed by a period of very low growth in
population. This means that Japan has a low rate of consumption and a
relatively high rate of saving. Moreover, Japan has very low immigration,
which, had it occurred, would counter-balance the large number of retired
people. There was a chink of light, because the USA was importing large
quantities of goods from Japan. But the present collapse of the USA
economy has reduced this considerably. And increasingly these goods
come from China, not Japan although China does import a large number
of goods from Japan.
16.2.10 A note on social conditions in Japan

On average the Japanese do not take as many holidays compared with
the USA, and particularly western Europe.
The amount of open space in Tokyo is very little compared with
western Europe and the USA.
Japanese children work extremely hard. A typical school year is 243
days compared with 210 a year in western Europe and the USA.
The number of people per house is large that is, the Japanese have
smaller houses than in the USA or Europe.
186
Summary
China was a desperately poor country at the end of the Second World
War. The government tried to produce a socialist state but this failed.
From about 1976, agricultural productivity grew faster. Industry became
capitalist, and this led to enormous growth in construction and overseas
trade.
Japan was the first Asian country to industrialise, particularly after the
Second World War. Progress was so fast that some people thought that
Japan would exceed US GDP per capita by about 2010. However, in early
1992, Japan suffered a collapse from which it has not fully recovered.

able to:
explain the main features of growth in these countries
discover why countries that were very poor, for example, China, grew
very fast in the last 60 years
explain the significance of the relative fall of the Japanese economy in
recent years
show how socialism was replaced by capitalism
explain why growth was different in some periods than in others.
Questions
1. Why has China become more capitalist and less socialist?
2. Account for the success of foreign trade in China.
3. Why has the Japanese growth rate been no more than 2 per cent in the
last 15 years compared with 4 per cent in the period after 1973?
187
Notes
188
Chapter 17: The financial crisis of 2008

This chapter will help you to understand the problems for the world
economy caused by the recent collapse in global markets. We look at
how the banks in the USA and elsewhere were important reasons for that
collapse and the measures that are being put in place to help to solve the
problems caused.
Objectives
To:
understand how the US economy affected the rest of the world
understand how incorrect polices made the situation more serious.
Learning outcomes
explain how the problem of the US economy spread so quickly around
the world
discuss the main problem of the securitisation of assets
describe how far the main policies were appropriate
identify the problems of the US housing market.
Essential reading
Stiglitz, J. Freefall: free markets and the sinking of the global economy. (London:
Penguin Books, 2010) [ISBN 9780141045122 pbk] pp.5066, pp.7786,
pp.10920, pp.13646, pp.16972, pp.18692, pp.198200, pp.30915,
pp.3258 and pp.3359.
Further reading
Krugman, P. The return of depression economics and the crisis of 2008. (London:
Penguin Books, 2008) [ISBN 9781846142390 pbk] pp.928, pp.5676,
pp.96100, pp.1205, pp.16580, pp.1856 and p.189.
Introduction
The financial crisis came as a shock to many people. But it neednt have.
In the first place, much of the world had had similar experiences Japan,
Indonesia, Malaysia, South Korea and Argentina, for example. However, it
was thought that the countries of the west would be immune to a slump
and a serious fall in their GNP. The prevailing theory was the Washington
consensus, which held that a slump was impossible.
189
17.1 Instability in the world economy

As we saw in Chapter 16, there was a huge increase in Japanese shares,
followed by a collapse. This led to a situation where people didnt want
to spend money. In other words, there was a liquidity trap. The Japanese
central bank tried to inject some stimulus into the economy from the
1990s onwards but it didnt work. Interest rates fell to zero. Japanese
growth was less than 2 per cent compared with more than 4 per cent in
the 1980s and 8 per cent in the 1960s.
In Thailand, there was a big boom in the early 1990s. Growth was
impressive. The baht/dollar exchange was stable leading to a big
increase in foreign investment, but increasingly in dubious projects. But
in 1997, the baht sank 50 per cent, far more than was needed to restore
equilibrium. In other words there was a loss of confidence in the Thai
economy. This was partly caused by hedge funds, who were betting that
the baht would fall. The markets were also worried about contagion
that is, the effect on other projects, some in other countries. So it was
not surprising that there were big falls in the Korean and Malaysian
exchange rate in 1997. Of course, all these economies had problems, such
as excessive building of private hotels, but as Krugman (2008) explains, it
was really a financial panic and not very well handled.
There was a different problem in Argentina. The government decided that
the value of an Argentine peso would be one dollar. This was an antiinflation device. But in 2002, the value of an Argentine peso fell from $1
dollar to 30 cents. Real GDP fell 11 per cent in one year. The total fall was
18 per cent from 1998 to 2002 a huge contraction. The problem was that
many Argentine businesses had debts in dollars. Argentina recovered, but
only paid 30 cents on the dollar for foreign investment. And there were
other examples of weaknesses in the international economy.
The Washington consensus was particularly powerful in the USA and, to a
lesser extent, in Britain. According to this view, the money market worked
almost perfectly in the long run. A bank should always be able to borrow
as much as it needed to. Of course, the interest rate mattered but there
was always was an appropriate rate of interest which compensated the
bank for the possibility of default.
17.2 The housing market in the USA
190
There was too much money going into real estate debt. This financed a
housing bubble, of course, but also a consumption binge. House ownership
in the USA increased very rapidly. Normally, a 20 per cent deposit was
required to buy a house. This was thought to go back to Franklin Roosevelt
in the 1930s. But around 2000 the banks or their agents started to
sell mortgages to people who had little financial resources. And these
mortgages were often 100 per cent that is, there was no deposit. But
in the long run, many people were unable to afford the repayment. The
banks made their money in several ways, but, for example, there was a big
increase in mortgage fees (the fees for negotiating the mortgage). Many
of the purchasers walked away from their property if they were unable to
buy them. The original bank, however, had already sold on the mortgage
to other banks. Some of these mortgages were good ones that is, they
would repay the bank but these were bundled up with poor mortgages. If
the house was given up it didnt matter as the bank would sell on a rising
market, but in 2007, the market turned down. The banks were left holding
quantities of worthless houses. Some of these banks were rather remote.
There were quite a few in Germany, for example.
Of course, the problem that the banks faced meant that too much money
was going into real estate. But the banks all bet that there was no real
estate bubble and that real estate prices would not fall. Of course, the
problem was systematic risk. All the banks tried to sell loans at the same
time, so prices fell everywhere at the same time. Foreclosure notices in
the USA were already 1.3 million in 2007. In 2008 they were 2.3 million.
Moodys thought that 3.6 homes million would default and 2.6 million
households would lose their homes in 2009.
The problem is that the big banks became too big to fail. The banks knew
that the effects of bank failures would lead to devastating losses in the
real economy. Projects could not be completed, leading to unemployment,
ordinary citizens would lose their savings, pensioners income would be
lost etc. Hence, many of the banks assumed that the government would
step in to save them.
One problem was securitisation. These were a collection of mortgage
obligations (collateralised mortgage obligations) which were sold on to
other banks. In the second quarter of 2008, there were $10.24 trillion
outstanding. That is almost ten months of the annual US income. But it
was very difficult to apportion the risks that the banks were running. This
is a classic problem of imperfect information. The market did a very bad
job of being risk averse that is, they did not know how to apportion risk.
The bank itself always knows more than its customers big or small. This
would include the government. Hence, the government had little option
but to aid the banks.
In addition, a lot of the banks had been working off balance sheet, so
that shareholders could not tell what they were doing. The staff of the
banks were paid with stock options. This was one of the easiest ways to
move potential losses off balance sheet while recording profitable fees.
What should have happened is that the banks should have moved to real
incentive pay in other words, pay should reflect the actual performance
of the bank. For example, Lehman Brothers had a net worth of $26 billion
shortly before its collapse. But the hole in its balance sheet was getting
close to $200 billion.
17.3 The response

Krugman (2008) uses a babysitting model to explain the process of a
depression. In Washington, there is a babysitting group, just like in other
cities. The members are offered babysitting services and in return offer to
do babysitting. In theory, this means that there is trade off between the
amount supplied and the amount demanded. But the Washington group
accumulated more babysitting coupons and less actual babysitting. That
is, they were increasing their demand for cash (coupons) relative to their
demand for actual babysitting. Put another way, the babysitting group
was suffering from deficient demand. So a scheme was proposed to make
everyone go out and use the babysitting service, twice a month. But this
didnt work. Eventually, the number of coupons was increased. This led to
an increase in the number of people who would go out, so the amount of
babysitting increased and the number of coupons rose. Translated to the
whole of an economy, the solution to a depression is to print money so the
amount demanded equalled the amount supplied.
The first tranche of the US government bailout was $700 billion. (This
came from borrowing, of course.) Under normal circumstances a
government is able to create money. And remember that US GDP is about
14 thousand billion. But there didnt seem to be a way of increasing the
191
banks lending. Treasury bills what it costs to lend to the government

and what it costs for banks to lend to each other increased in price. This
means that the banks were not willing to lend to each other at the same
rate that they had done in the past. The problem was that banks were
frightened about acquiring assets that proved to be worthless. This was
because each bank did not know the value of assets held by the other
banks. Remember, this was a characteristic of the previous period when
banks were working off the book. And Fannie Mae and Freddie Mac (the
intuitions whose job it was to underwrite mortgages) were also bankrupt.
They were nationalised; this means that the taxpayer was, in effect, paying
the cost of their bankruptcy. But, in 2008, Lehman Brothers were allowed
to fail. And we saw their workers lose their jobs instantly.
Pause and think
Why did the federal government step in to help Fannie Mae and Freddie Mac and AIG
(American International Group) and not Lehman Brothers?
Was it because Lehman Brothers was beyond hope? Most of the banks
would have to be bailed out. Was it connected to the fact that stock was all
uninsured? Many banks thought that they had bought insurance, so their
behaviour tended to be more risky. Unfortunately, this type of insurance
was unregulated.
To summarise, the banks behaviour was very dubious. For example:
Securitisation was not necessarily bad, but it has to be carefully
managed. Securitisation means that the bankers shared the risk with
others. The banks seemed to do this in a very cavalier way. Some assets
(for example, mortgages or pension funds) were virtually worthless,
but were still sold on. As we said, the big banks had privileged
information commonly known as insider information.
The US bankruptcy code could aid the banks. Chapter 1 of the code
allowed businesses to continue to operate while bankrupt. So the big
losers were the shareholders. Some lost everything. This was connected
with the idea that the major banks were too big to fail. Hence, the
only source of money was the taxpayer.
Initially, the government thought that a loan to the financial sector
would be sufficient. However, almost immediately there was a large
increase in unemployment, a huge fall in automobile sales. There was
a 20 per cent fall in business, 20058, and a 4 per cent fall in GDP in
2008.
Nor has government policy been consistent. Fannie Mae shareholders lost
everything but the bondholders were fully protected. Washington Mutual
(a large insurance company) shareholders and bondholders lost almost
everything. Then the government safety net extended to investment
banks, and then to AIG, an insurance firm. Stiglitz says that the AIG
bailout (which was an 80 per cent share going to the government) came
about without going to Congress. There was no congressional oversight
or judicial review. In retrospect, the bailout cost $180 billion. The FED
had tried to keep the whole thing secret. The biggest beneficiary, other
than AIG itself, was Goldman Sachs. The Goldman Sachs risky derivative
positions were paid at 100 cents on the dollar.
192
Pause and think

Why was Goldman Sachs privileged in this way? Was Goldman Sachs too big to fail?
The problem was that very few people were able to contemplate a
systematic crash where all the assets lost money simultaneously. By
2002, the big investment banks operated a leverage of 97 per cent. (That
is, they only held 3 per cent in cash or government securities.) Yet in 2004
the SEC (Securities and Exchange Commission) suggested that the banks
operated a leverage of 40 per cent. This was ignored.
17.4 The rest of the world

It was originally thought that the US depression could be decoupled
from Europe. Many people failed to realise how interdependent the
banking system had become. But the US crash almost immediately spread
to Europe and other countries. Only India and China were relatively
unaffected. The growth rate in China fell by about 2 per cent (from about
10 per cent to 8 per cent). This was a problem for the Chinese, but in
2010 growth had returned to its previous level. In the USA and Europe the
growth rate, which was about 2 per cent, contracted in 2008.
The fundamental problem was that governments had so many calls on
their funds. They had to provide unemployment insurance, the money
used to bail out the banks, failing business etc. In addition, the local
authorities (in the USA, the individual states) are themselves very
dependent on government grants. But since taxes had fallen, borrowing
from abroad would have to rise. Money could be borrowed, by a process
called, in Britain, quantitative easing. In this process the central bank
would purchase government stock. This would increase the amount of
liquidity in the economy. But it is not clear whether quantitative easing
will work. Because there may be a liquidity trap in the economy, as people
will not spend, so lower prices do not lead to an increase in spending. And
governments cannot resort to quantitative easing indefinitely, because the
price of government stock would rise. So there would be inflation in the
long run. But there is also the problem of money owed to foreigners. Then
it has to be repaid in foreign currency. In 2009, for example, the UK had a
deficit of 11.5 per cent; most of the other European countries had a similar
level. Note that the rules of the Euro (the common currency in most of
Europe) were that deficits could not exceed 3 per cent of GDP. Obviously,
this ruling went by the board.
Two of the European economies initially most affected were Iceland and
Ireland. Iceland had a population of a little over 300,000 and average
income was about $40,000. Financial services were very important. They
had three banks which took on deposits and bought assets of $176 billion.
This was eleven times Icelands current GPD. Following the collapse of
Lehman Brothers, Iceland turned to the IMF for help. Any bank was
allowed to operate in Iceland. And Britain and the Netherlands had the
biggest deposits. In Britain, for example, many local authorities (cities)
had placed their money in Icelandic banks, because they offered higher
interest rates than British banks. Britain resorted to terrorist legislation
to force the Icelandic banks to settle. Although the Icelandic population
refused to agree to settle immediately, the repayment schedule meant that
the Icelandic population had to suffer a fall of 10 per cent in output.
193
17.5 The Euro problem

A key problem of the Euro is that there is no Euro-wide government. In
the USA, for example, a federal income tax will immediately affect all the
states. But in the EU, there is no mechanism to do this is. There are no
bonds supported by the European Central Bank, for example. There are
rules, such as that each country can only borrow 3 per cent of their GNP,
except for emergencies. But these rules were often evaded. At the moment
of writing the biggest problems for the EU are (in order): Ireland, Greece,
Portugal, Italy and Spain. All these countries use Euros. Britain, of course,
does not. Britain has devalued by about 25 per cent against the Euro.
The Greeks borrowed heavily in 2008, although in fact they had been
borrowing for some time before that, but the extent of their borrowing
was concealed, even from the European Central Bank. The fundamental
problem is that rich Greeks pay hardly any tax. Hence, the government
has to borrow to meets its obligations. When the Greeks approached the
market for additional loans in 2008, the banks sold the existing bonds
short, betting that the bonds would fall in price. They could do this
because they were able to negotiate credit default swaps, which made it
even more difficult for the Greeks to approach the market.
We have now reached the stage that when Greece cannot repay the
current loans they can only be repaid though a Greek austerity package.
But, at the time of writing, it is not clear that the Greek government is able
to deliver an austerity package. The general population has said no.
This places the Germans (and the French) in a difficult position. They
dont want to extend another loan unless they will get it back in the future,
but, at the time of writing, it looks as if the Greeks will not repay it. Hence
Germany, the biggest economy in the EU, has a problem. It will have to
extend another loan to Greece because the Greek state is bankrupt. If
it does not, Greece might default and go back to using drachmas. The
problem is that other countries would probably leave the Euro too (Italy,
Spain). And the Euro would break up.
The European Central Bank thinks that the cost of defaults is six times
the cost of extending the loan to the Greeks. But, fundamentally, most of
the German population does not care about the Euro as long as Germany
itself remains prosperous, which is very likely. No-one knows what will
happen, of course, but it is likely that in the long run the Euro experiment
will break up. It is possibly that Spain, Portugal, Italy and Greece will have
separate (and lower value currencies) compared with Germany, France
and the Netherlands.
Britain suffered a fall of 6 per cent in its GNP, from 20078. However, the
British government achieved a better deal than the US government. One
bank in Britain was 100 per cent nationalised in 2007. And some banks
were forced to amalgamate with weaker banks. But the real problem
came in 13 October 2008. The banks were losing money so fast that many
of them were very close to closing. The government had no choice but
to announce a 500 billion loan ($800 billion) to the banks, including
50 billion in cash. This was the equivalent of 20,000, per tax payer.
Not surprisingly, this calmed the markets. (In fact, the government is not
expected to lose any money on the loan in the long run.)
Not very long ago, the Royal Bank of Scotland was a relatively modest
bank in Edinburgh. By 2007, it was trying to become the largest bank
in the world and may well have succeeded. It was aggressively buying
a series of banks in Britain, the USA and on the continent of Europe. A
194
large Dutch bank with undisclosed liabilities was their undoing. By 2009,
the government owned 68 per cent of RBS. British banks are still in the
doldrums. They wont be as affected as the French and German banks by
the problems of the Euro because Britain is not in the eurozone. But
the banks are still not lending to small businesses and the rate of new
house building is at its lowest peacetime rate since the 1920s. In 2010,
the Labour government was replaced by a coalition of Conservatives and
Liberal-Democrats. They immediately embarked on a policy of cutting
government spending and raising taxes. This policy is more restrictive than
any policy of all the major countries and the IMF. It is designed to reduce
the government deficit from 11.2 per cent of GDP to 4 per cent, which was
the pre-2007 rate, in four years. Many, included the IMF, think that it is too
harsh. Only time will tell.
17.6 Further considerations about the US economy

Adverse selection. Banks were not prepared to lend money among
themselves, because they didnt know which were good assets and
which were not. (Think about the mortgages.) But the government
bailouts ensure that the banks dont bear the full consequences of their
errors. On the other hand, various financiers, like Warren Buffet, were
doing very well.
Moral hazard. The government gave the bulk of the money to the big
institutions. For example, the AIG bailout. The problem was that many
institutions had bought credit default swaps (insurance policies). And
in the end, only a tiny fraction of the money from the government to
AIG helped the smaller companies. Most went to AIG itself. It would
have been better if the government had bailed out institutions directly.
Of course, the problem is that if they made bad investments in the past
the US government would bail them out
Incorrect targeting. In the FED bailout of AIG, $13 billion of this
money was given to Goldman Sachs. This enabled Goldman Sachs to
shift toxic assets from the bank to the government. As we have seen,
there was a deliberate attempt to circumvent Congress in this bailout,
because otherwise the electorate would not stand for it. So this meant
that the government became the bearer of risk of last resort. Of course,
many members of the FED are themselves bankers particularly those
in New York.
17.7 Some serious problems in the USA

17.7.1 US government mismanagement
The US federal deficit was 35 per cent in 2000, already very high. By
2009 it was 60 per cent. (Although many other countries had bigger debt
burdens by 2009 Britains was 100 per cent.) Initially, the economy has
to deal with the financial market. But there are no plans to seriously cut
government expenditure. In 2008 the median household income was 4
per cent less than it was in 2000. We know that the US government is
desperately short of money to pay salaries, welfare payments etc. And
states (who are not allowed to run deficits) will run out of expenditure
and will have to cut payments to their employees. It is also true that
Americans work longer hours than 30 years ago and, compared with
Europeans, work far more. Some of this is because European productivity
(in some areas of the EU) is higher than US productivity.
195
17.7.2 Health insurance

There are some serious problems in the US economy energy and health
care, for example. The Obama Health Insurance Act was crippled before
it began. 15 per cent of the US population have no health insurance.
Moreover, the cost of health care is very large close to 15 per cent of
GNP. But in France the cost is something like 9 per cent, and there are no
obvious differences in health care in the two countries. (Remember the
greater the cost of the contribution to GDP would imply that it would be
better to spend the money on something else.)
17.8 Relations with the rest of the world.

China at the moment has $2.4 trillion assets, of which $1.5 trillion is in
dollars. This imbalance cannot go on indefinitely. At the moment it suits
the Chinese and the USA for China to have a surplus and the USA to
have a deficit. As we know the problem in China is that people do not
consume enough of their output. This leads to a very high rate of saving.
But this cannot continue in the long run, since the Chinese will continue
to consume more and more of their output. China is set to become the
worlds largest merchandise exporter and, eventually, the biggest producer
of manufactures. (China already has more automobile production than
any other country.) There is a combination of factors that have helped
the Chinese achieve this output. Cheap labour, falling transport costs and
improved telecommunications are obvious candidates. So the question
becomes what is the US comparative advantage? Obviously, education is
one. Unless this problem is solved, however, the USA will have to reduce
its deficit, which has implications for living standards in the USA.
Summary
The world depression started in the US housing market, quickly spreading
to US banks, other financial institutions and overseas. In many countries,
some banks collapsed and others were taken over by government.
The main cause was the profligate lending policy of banks, leading to
enormous debts on government account. At the time of writing, for
example, the USA is still experiencing the effects of the depression and the
Euro is still suffering problems. But in Asia, for example, there is a much
higher growth rate.

able to:
explain how the problem of the US economy spread so quickly around
the world
discuss the main problem of the securitisation of assets
describe how far the main policies were appropriate
identify the problems of the US housing market.
Questions
1. Why was the housing market in the USA at the forefront of the
depression of 2008?
2. What has been the effect on the Euro on the international depression
starting in 2008?
196
Appendix: Sample examination paper
Appendix: Sample examination paper

Important note: This Sample examination paper reflects the
examination and assessment arrangements for this course in the academic
year 20102011. The format and structure of the examination may have
changed since the publication of this subject guide. You can find the most
recent examination papers on the VLE where all changes to the format of
the examination are posted.
Candidates should answer four of the following twelve questions: one
from Section A, one from Section B and two further questions from either
section. All questions carry equal marks.
Time: 3 hours
Section A
Answer one question from this section and not more than a further
two questions. (You are reminded that four questions in total are to be
attempted with at least one question from Section B.)
1.
Why was the level of transatlantic migration so high in the early

twentieth century?
2.
Why were fixed exchange rates thought to be desirable in the early

twentieth century?
3.
What were the main economic consequences of the First World War?
4.
Why did large scale industrial production techniques develop first in

the USA?
5.
Discuss the reasons for the seriousness of the Depression of the early
1930s in any two the following countries: USA, Germany, France or
the UK.
6.
Why did the international economy fail to recover after the Depression
of the early 1930s when most national economies did recover?
Section B
Answer one question from this section and not more than a further
two questions. (You are reminded that four questions in total are to be
attempted with at least one question from Section A.)
7.
Discuss the effect of economic management on the conduct of the

Second World War in any belligerent country you choose.
8.
What was the nature of the dollar gap in Europe immediately after the
Second World War? How was the gap closed?
9.
Why was the rate of economic growth in western Europe between

1950 and 1973 much faster than in any peace time period before or
since?
10. Account for the fluctuating fortunes of the major car industries in the
second half of the twentieth century.
11. Should the so-called deindustrialisation of the developed economies
in the late twentieth century be considered a problem?
12. How far have changes in the international economy in the later
twentieth century been to the advantage or disadvantage of the less
developed countries?
197
Notes
198

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What were the main causes of the world depression starting in 2008?

What were the main causes of the world depression starting in 2008?

How did the depression affect different countries and regions?

How did the depression affect different countries and regions?

Economic history in the

University of London International Programmes

Chapter 1: Course introduction .............................................................................. 1

96 Economic history in the 20th century

Chapter 4: Institutions that underpinned the international economy before

96 Economic history in the 20th century

9.4 Trading blocs ....................................................................................................... 102

A reminder of your learning outcomes........................................................................ 140

96 Economic history in the 20th century

16.1 China ................................................................................................................ 178

Chapter 1: Course Introduction

Chapter 1: Course introduction

1.2 What is economic history?

96 Economic history in the 20th century

Of course in economic history we dont know anything like as much about

1.3 Learning outcomes

1.4 What you should be able to do after studying this

1.5 Some important concepts

1.5.1 Gross national product

Chapter 1: Course Introduction

1.5.2 Gross domestic product

1.5.3 The production function

1.5.4 Total factor productivity

1.5.5 Comparative advantage

96 Economic history in the 20th century

1.5.6 Gains from trade

1.5.7 Liquidity trap

1.5.8 Human capital

1.5.10 Catch up and social capability

Chapter 1: Course Introduction

1.5.11 Increasing returns to scale

1.5.12 External economies

1.5.13 Principal-agent problems

1.5.14 Transactions costs

96 Economic history in the 20th century

1.5.15 Tariff and non-tariff barriers

1.5.16 Non-tariff barriers

1.5.17 Opportunity cost

1.5.19 The prisoners dilemma

Chapter 1: Course Introduction

1.5.20 Terms of trade

1.5.21 Rational expectations

1.5.22 Hedge funds

96 Economic history in the 20th century

1.5.24 Quantitative easing

1.6 The structure of the course

Chapter 1: Course Introduction

96 Economic history in the 20th century

1.7 A note on the names of countries

1.8 The subject guide

1.8.1 How to use the subject guide

Chapter 1: Course Introduction

1.8.3 You do not need to learn lots of historical facts by heart

1.9 Essential reading

96 Economic history in the 20th century