At least we’ve been here before—and we have a chance to avoid the philosophical traps we fell into after the last calamity that did so much harm to our economic system. But so far, there have been strikingly similar reactions to the crashes of 1929 and 2008. In both cases, when stocks registered some of their largest percentage declines on record, highly leveraged firms and individuals who had placed large bets using complex financial securities that few understood lost everything. The failure of gigantic financial firms spread panic. Complaints about the greedy and reckless rich escalated; a shift toward protectionism and government interventionism appeared inevitable even where free markets once reigned supreme. Authoritarian populists abroad mocked the U.S. system. The catastrophe seemed to threaten democratic capitalism everywhere.
The difference is today we know that after a long and scary Great Depression, democratic capitalism did survive. And the U.S. economy returned to exactly the same long-run trend path it was on before the Depression.
We also know that, for another important part of the world, democratic capitalism did not hold up so well. In many ways, that failure stemmed from a misguided overreaction on the part of a new, influential field of economics that was highly skeptical of capitalism, was deeply traumatized by economic calamity, and considered much of the world “underdeveloped.” Born in the aftermath of the Depression, “development economics” grew on a foundation of bizarre misconceptions and dangerous assumptions.
This approach to poor-country development, promulgated by the economists who took up its cause in the 1950s, had four unfortunate lasting consequences, the effects of which we’re still reckoning with today in the midst of the latest big crash.
First, seeing Depression-style unemployment in every part of the world led these economists to assume that poor countries simply had too many people who were literally producing nothing. A U.N. report in 1951, produced by a group of economists, including future Nobel laureate Arthur Lewis, estimated that fully half of the farming population of Egypt produced nothing. The insulting assumption that poor people had “zero” productivity led these economists to think that individual freedoms for the poor should not be the foundation for wealth creation, as they had been during the Industrial Revolution, when the state had played a secondary, supportive role. And because governments seemed to successfully take on a larger role during the Depression, development economists assumed that granting extensive powers to the state was the surest path to progress. A 1947 U.N. report on development gave equivalent approval to state action in democratic capitalist countries like Chile, enslaved Soviet satellites like Poland, African colonies of the British and French, and apartheid South Africa, ignoring the vast differences in individual liberty between these places.
Second, these thinkers lost faith in bottom-up economic development that was “spontaneous, as in the classical capitalist pattern” (as a later history put it), preferring instead development “consciously achieved through state planning.” After all, the Five-Year Plans of the 1930s Soviet Union had avoided the Depression, at an appalling but then ignored cost in lives and human rights. This thinking was so universal that Gunnar Myrdal (who would later win a Nobel Prize in economics) claimed in 1956: “Special advisors to underdeveloped countries who have taken the time and trouble to acquaint themselves with the problem . . . all recommend central planning as the first condition of progress.”
Third, these economists grew to believe that the most important factor in reducing poverty was the amount of money invested in the tools to do so. After all, if there were simply too many people, they reasoned, the binding constraint on growth must be the lack of physical equipment. As a result, this line of economic philosophy would forever stress the volume of investment over the efficiency of using those resources; would be stubbornly indifferent as to whether it was the state or individuals who made the investments; would always stress the total amount of aid required to finance investment as the crucial ingredient in escaping poverty; and would ignore the role of a dynamic financial system in allocating investment resources to those private uses where they would get the highest return.
Fourth, the collapse of international trade during the Depression made development economists skeptical about trade as an engine of growth. So in Africa, for example, they pushed for heavy taxes on export crops like cocoa to finance domestic industrialization. In Latin America, Raúl Prebisch pushed import-substituting industrialization instead of export-led growth. This strategy was supposed to help developing countries in Africa and Latin America escape a presumed “poverty trap.” But the only “trap” it kept them out of was the greatest global trade boom in history following World War II, which fueled record growth in Asia, Europe, and the United States.
