June 21, 2013

Production as Privilege: Mercantilism

The Production as Privilege series of posts here has been examining the ways that production connects to the distribution of wealth, through a series of "conceptual tools". Some of the tools are in the basic econ101 toolkit, others are a bit less conventional. Still others, like mercantilism, have been at the core of economic debate for centuries.

Conceptual Tool #12: Mercantilism

For hundreds of years before Adam Smith bestowed his great wisdom upon the land, Mercantilism was the order of the day. In a nutshell, mercantilism was a national policy that believed selling products abroad and running a positive balance of trade was the route to national wealth. If they bought more from you than you bought from them, you got rich and they got poor, because they gave you all their gold. (Gold was better than wine or cheese because it was more fungible and stored value better. Also it glittered.)

However, the mercantilist logic holds only so far as there is a fixed amount of goods and money, and fixed exchange rate prices. Wikipedia has a good summary of the flaws: more modern logic emphasizes the fact that you can consume what you produce (or more accurately, what you get in exchange for what you produce or convince people to lend to you for what you might produce in the future) and that exchange rates will equalize so as to ensure that one country cannot simply take all of another country's money or stuff. This logic is not impeccable either, but it does do a better job of according with the current reality.

What traditional mercantilism gets slightly more correct is the importance of competitiveness, and if you look at the list of typical mercantilist policies at the top of the Wikipedia page, many of them look uncannily up-to-date: export subsidies, promoting manufacturing with research or direct subsidies, limiting wages, maximizing the use of domestic resources, restricting domestic consumption with non-tariff barriers to trade.

Why are we (and moreso other countries like China or Germany) following the recommendations of a "discredited" economic ideology? And what does this have to do with distribution of wealth between countries or within countries?


Partly it is a matter of confusing definition, as we might expect from a term that has been around for a few centuries. It can be helpful to think of mercantilism as not simply as competition for export share, but more generally as deliberate state intervention to bolster a nation's economy. Dani Rodrik contrasts mercantilism not with unrestricted trade (the simple traditional dichotomy) but with a broader economic liberalism--he frames mercantilism as a question of overall government tinvolvement in and direction of the economy, rather than simply applying tariffs with the intent of getting more gold.

From now on, for the sake of clarity, I will refer to "get all the gold", zero-sum mercantilism as "balance of payments mercantilism", and mercantilism grounded in any state action as "state action mercantilism." Balance of payments mercantilism is typically a goal or at least an effect of state action mercantilism, but they are theoretically distinct because state action mercantilism is not inherently about improving trade balances, it is about improving domestic production. State action mercantilism is also roughly synonymous to "state capitalism".

Rodrik also makes the point that capitalism (in the sense of having capital directed by investors) is still feasible under state action mercantilism--we don't need to wholly socialize investment for mercantilism to exist. State action mercantilism can thrive with private capital, as government can still regulate and nudge that private capital in deliberate ways.

Rodrik's definition of state action mercantilism is a bit broad but provides a useful perspective because it helps reveal the assumptions at the heart of mercantilist and free trade/liberal economic ideologies. In Rodrik's view, state action mercantilism assumes that markets can be deliberately improved while liberalism assumes that government is best establishing well-functioning markets and then getting out of the way. Really, this argument is about where to draw the line about government action in the economic sphere and what kind of government action is necessary and desirable.

Any argument about the extent of government action should be about the efficacy of that action, in both the short and the long term. The major debates about state action mercantilism in the past decades have been about the efficacy of the government encouraging certain industries: that is, is government better at anticipating profitable investment than the market?

Obviously the market has a lot of advantages: thousands of highly trained analysts and people with great incentives to make sure their money gets as high a return as possible. But the government has potential advantages of its own: size, time frame, social accountability, and the ability to shape the rules of the game.

Size: The size of the government means that it can direct investment on a scale that private investors have a difficult time doing. And in investment, scale matters. A company may not be profitable without local supplier firms, or industries may not be profitable without whole clusters of complementary industries. Scale is important, and it has gotten progressively more important in the last 200 years.

Time horizon: While some investors are focused on longer-term value, the liquidity of most investment means that many more investors are focused on shorter-term value. Governments can have a slightly longer time horizon. Although elected officials can serve for as little as two years, that is still far longer than quarterly returns. Moreover, presidents can serve for up to 8 and senators for many more than that. Civil servants, as well, may work their entire careers in government and thus have incentives to promote longer-term economic success. Government can be extremely short-sighted as well, of course. The point is that the right combination of incentives is possible.

Social accountability: While individual investors are only responsible to themselves and their clients, governments can in theory be accountable to their citizens. This means that governments have to worry about how the whole economy works as a system, instead of just individual parts.

Rule-changing ability: Finally, governments have the ability to change the rules of the economy in ways that few individual actors can. By creating subsidies, by taxing, by regulating certain procedures, or through a million other methods, the government shapes what is profitable. Perhaps the most fundamental way that the government can change the rules is by changing the price of labor by changing the share of profit that workers are willing or able to receive. Changes in the price of labor can have fundamentally powerful effects on competitiveness.

So is the question of mercantilism simply a question of when these government advantages win out against highly-informed-but-far-from-ideal private direction of capital? This is one way to see it. The argument has been made from a number of different perspectives over the years, however. One of the most interesting positions was from Frederick List.


Friedrich List is a lesser-known political economist from 19th-century Germany who also lived and worked in Pennsylvania. He was influenced, oddly enough, in part by the economic ideas of Alexander Hamilton. Although Hamilton is not primarily remembered for his contributions to economic policy, his 1791 Report on Manufactures as Secretary of the Treasury helped set the course of the US economy over the next two centuries. Report on Manufactures essentially laid out the state action mercantilist strategy the USA followed more or less until the 1970s.

List made many of the same mercantilist arguments as Hamilton in his treatise, National System of Political Economy. Like Rodrik, he contrasts mercantilism with liberalism and broader ideas of free trade. But he does it in an interesting way, arguing that most classical (and now neoclassical) economic theory suffers from fallacies of composition. That is, economic theory failed to recognize that a whole could be something other than the sum of its parts. Arguing from historical examples, List saw that nation-states had without fail been critically powerful players in national economic development.

List further argues that most economic progress has been made through deliberate state policy to promote not simply a nation's economic strength but more specifically a strong, productive manufacturing base. This requires an understanding of both specific national context and also an ability to understand the nation as a system and affect all the moving parts. Those moving parts are not always well aligned:
Nor does the individual merely by understanding his own interests best, and by striving to further them, if left to his own devices, always further the interests of the community. (134)
How you define sound economic policy and correctly aligned incentives, in other words, may vary depending on whether you understand that society is made up of groups. This is because those groups may establish and change collective behavior. One common way this is done is through laws. List argues that, as we already have a state-facilitated market system based on laws, further state intervention can be easily rationalized on utilitarian grounds:
In a thousand cases the power of the state is compelled to impose restrictions on private industry. [...And the state has no right to do so, as long as the actions of private industry] remain harmless and useful; that which, however, is harmless and useful in itself, in general commerce with the world, can become dangerous and injurious in national internal commerce, and vice versa.
The group determination of laws is an example of the rule-changing ability referenced above. However, the point about individual versus collective incentives is different. Countries, because of their aggregated scale, have actual different incentives than individuals and, if properly safeguarded against, these incentives can strongly enhance collective welfare.

As an example, in recent post I made the point that competitors' own actions can shape the availability of what they are competing for. That is, competitors may be competing for pieces of the pie, but the pie may expand or contract based on the actions of the competitors. This is because the fungibility of money converts many different types of competition into competition for value, and we produce value in order to exchange it for other value. This is not a trivial point, it is the crux of Adam Smith's (and all modern free trade supporters') argument against balance of payments mercantilism (see here) and for the productive power of self-interest.

What is oddly missing from most discussions of the "mercantilist fallacy", however, is the idea of incentives. The size of the pie depends on the incentives of the producers--balance of payments mercantilism was initially successful in England and the Netherlands because it incentivized the state to commission and support corporations with incentives to be competitive. But economists eventually ditched balance of payments mercantilism in part because these ideas placed an arbitrary limit on the size of the pie--they failed to recognize that properly incentivized production is bounded only by technology, resources, and organization. Competition is not for resources some set quantity of gold but for the ability to accrue rents from favorable transactions and spend them on plentiful goods.

Let's return to List for a moment. List argues strongly against free trade between nations because, he argues, free trade can destroy the productive capacity of a country. In theory this make sense: if you have moderately good technology and can produce cars for $1000, but somebody else has really good technology and can produce cars for $500, then under free trade only the country with really good technology is going to produce cars. This is fine if we are talking about wine, and you can just switch to producing beer, and sell beer in exchange for wine. But if we are talking about complex industries with dense networks of suppliers and the coordination of specialized technical knowledge (cars need steel and chemicals and computers and hundreds of different parts, etc...), then free trade looks far more dangerous.

And in reality, countries that have successfully grown their economies have mostly used state action mercantilist policies. To be sure, it is not always successful--the general failure of export-led (and state-directed) industrialization was a major catalyst for the neoliberal revolution (Washington Consensus) in development policy. But the examples of successful development mostly involve deliberate state action including picking industries and nurturing them to competitiveness.

More to the point, successful economic policy has involved getting the incentives right. Successful development stories like South Korea show us that state action mercantilism can be successful if the increase the size of the pie domestically--aka the value that is being created in the country over the long term.


What does all this have to do with the distribution of wealth and income? Under fully liberalized trade with flexible exchange rates, the income distribution between two countries should depend wholly on each country's productivity. As we saw, however, productivity depends on having the right incentives for producers, and it can be understandably hard to achieve such a system if the incentives for producers are entirely set by foreign countries--either intentionally through foreign mercantilism or unintentionally through the "natural" workings of the market (this is another main point of List's). Particularly in a world with widely varying levels of productivity between states, state action mercantilism is thus an important tool states can use to "catch up" and even the distribution of wealth.

State action mercantilism, at its core, is a deliberate reshaping of the market that diverts and redirects capital or consumption flows. Mercantilist reshaping can change the current distribution of wealth, but more importantly it can preserve or increase a country's long term productive capacity by stimulating beneficial competition.

But as liberalism argues, reshaping markets not always a good thing. Using state power in markets is dangerous because when you manipulate the behavior of buyers and sellers you lose track of what an un-manipulated market would prefer, and you can inadvertently crush suppliers and demanders that might otherwise happily connect. Worse, deliberate errors (corruption, cronyism, rentierism) are all too easy to come by as state power is turned toward private interests. State power establishes markets but it can also undermine them if the right incentives are not kept in view.

In effect, reshaping markets is what private interests try to do anyway, whether it is through legal means (inventing a new product, changing consumer demand through advertising, or just bringing down prices by selling more of a product) or illegal ones as mentioned in the previous paragraph. Reshaping markets--changing the options that buyers and sellers have, changing their preferences, changing the ways that buyers and sellers interact--is how businesses make profits. States need to be able to establish firm limits on how firms are able to reshape markets and keep the playing field fair if markets are to have any kind of equitable distribution.

But even a "fair", well-functioning market may not end up with a suitable distribution of wealth (if businesses have increasing returns to scale, for example). The state's advantages--size, time horizon, social accountability, and rule-changing ability--put it in a good position to address these further equity concerns. We already do things like provide public education, which is an enormous force for equity. With a broader understanding of how the state creates markets we can hopefully find new ways to make markets fairer--and recognize when markets are simply not the best solution. We must keep List's dictum in mind, that private interests are not always the interests of the group.