Barbara Alexander, Charles River Associates

This article outlines the history of the National Recovery Administration, one of the most important and controversial agencies in Roosevelt’s New Deal. It discusses the agency’s “codes of fair competition” under which antitrust law exemptions could be granted in exchange for adoption of minimum wages, problems some industries encountered in their subsequent attempts to fix prices under the codes, and the macroeconomic effects of the program.

The early New Deal suspension of antitrust law under the National Recovery Administration (NRA) is surely one of the oddest episodes in American economic history. In its two-year life, the NRA oversaw the development of so-called “codes of fair competition” covering the larger part of the business landscape.¹ The NRA generally is thought to have represented a political exchange whereby business gave up some of its rights over employees in exchange for permission to form cartels.² Typically, labor is taken to have gotten the better part of the bargain; the union movement having extended its new powers after the Supreme Court abolished the NRA in 1935, while the business community faced a newly aggressive FTC by the end of the 1930s. While this characterization may be true in broad outline, close examination of the NRA reveals that matters may be somewhat more complicated than is suggested by the interpretation of the program as a win for labor contrasted with a missed opportunity for business.

Recent evaluations of the NRA have wended their way back to themes sounded during the early nineteen thirties, in particular, interrelationships between the so-called “trade practice” or cartelization provisions of the program and the grant of enhanced bargaining power to trade unions.³ On the microeconomic side, allowing unions to bargain for industry-wide wages may have facilitated cartelization in some industries. Meanwhile, macroeconomists have suggested that the Act and its progeny, especially labor measures such as the National Labor Relations Act may bear more responsibility for the length and severity of the Great Depression than has been recognized heretofore. ⁴ If this thesis holds up to closer scrutiny, the era may come to be seen as a primary example of the potential macroeconomic costs of shifts in political and economic power.

Kickoff Campaign and Blanket Codes

The NRA began operations in a burst of “ballyhoo” during the summer of 1933. ⁵ The agency was formed upon passage of the National Industrial Recovery Act (NIRA) in mid-June. A kick-off campaign of parades and press events succeeded in getting over 2 million employers to sign a preliminary “blanket code” known as the “President’s Re-Employment Agreement.” Signatories of the PRA pledged to pay minimum wages ranging from around $12 to $15 per 40-hour week, depending on size of town. Some 16 million workers were covered, out of a non-farm labor force of some 25 million. “Share-the-work” provisions called for limits of 35 to 40 hours per week for most employees. ⁶

NRA Codes

Over the next year and a half, the blanket code was superseded by over 500 codes negotiated for individual industries. The NIRA provided that: “Upon the application to the President by one or more trade or industrial associations or groups, the President may approve a code or codes of fair competition for the trade or industry.” ⁷ The carrot held out to induce participation was enticing: “any code … and any action complying with the provisions thereof . . . shall be exempt from the provisions of the antitrust laws of the United States.” ⁸ Representatives of trade associations overran Washington, and by the time the NRA was abolished, hundreds of codes covering over three-quarters of private, non-farm employment had been approved.⁹ Code signatories were supposed to be allowed to use the NRA “Blue Eagle” as a symbol that “we do our part” only as long as they remained in compliance with code provisions.¹⁰

Disputes Arise

Almost 80 percent of the codes had provisions that were directed at establishment of price floors.¹¹ The Act did not specifically authorize businesses to fix prices, and indeed it specified that ” . . .codes are not designed to promote monopolies.” ¹² However, it is an understatement to say that there was never any consensus among firms, industries and NRA officials as to precisely what was to be allowed as part of an acceptable code. Arguments about exactly what the NIRA allowed, and how the NRA should implement the Act began during its drafting and continued unabated throughout its life. The arguments extended from the level of general principles to the smallest details of policy, unsurprising given the complete dependence of appropriate regulatory design on precise regulatory objectives, which here were embroiled in dispute from start to finish.

To choose just one out of many examples of such disputes: There was a debate within the NRA as to whether “code authorities” (industry governing bodies) should be allowed to use industry-wide or “representative” cost data to define a price floor based on “lowest reasonable cost.” Most economists would understand this type of rule as a device that would facilitate monopoly pricing. However, a charitable interpretation of the views of administration proponents is that they had some sort of “soft competition” in mind. That is, they wished to develop and allow the use of mechanisms that would extend to more fragmented industries a type of peaceful coexistence more commonly associated with oligopoly. Those NRA supporters of the representative-cost-based price floor imagined that a range of prices would emerge if such a floor were to be set, whereas detractors believed that “the minimum would become the maximum,” that is, the floor would simply be a cartel price, constraining competition across all firms in an industry.¹³

Price Floors

While a rule allowing emergency price floors based on “lowest reasonable cost” was eventually approved, there was no coherent NRA program behind it.¹⁴ Indeed, the NRA and code authorities often operated at cross-purposes. At the same time that some officials of the NRA arguably took actions to promote softened competition, some in industry tried to implement measures more likely to support hard-core cartels, even when they thereby reduced the chance of soft competition should collusion fail. For example, with the partial support of the NRA, many code authorities moved to standardize products, shutting off product differentiation as an arena of potential rivalry, in spite of its role as one of the strongest mechanisms that might soften price competition.¹⁵ Of course if one is looking to run a naked price-fixing scheme, it is helpful to eliminate product differentiation as an avenue for cost-raising, profit-eroding rivalry. An industry push for standardization can thus be seen as a way of supporting hard-core cartelization, while less enthusiasm on the part of some administration officials may have reflected an understanding, however intuitive, that socially more desirable soft competition required that avenues for product differentiation be left open.

National Recovery Review Board

According to some critical observers then and later, the codes did lead to an unsurprising sort of “golden age” of cartelization. The National Recovery Review Board, led by an outraged Clarence Darrow (of Scopes “monkey trial” fame) concluded in May of 1934 that “in certain industries monopolistic practices existed.” ¹⁶ While there are legitimate examples of every variety of cartelization occurring under the NRA, many contemporaneous and subsequent assessments of Darrow’s work dismiss the Board’s “analysis” as hopelessly biased. Thus although its conclusions are interesting as a matter of political economy, it is far from clear that the Board carried out any dispassionate inventory of conditions across industries, much less a real weighing of evidence.¹⁷

Compliance Crisis

In contrast to Darrow’s perspective, other commentators focus on the “compliance crisis” that erupted within a few months of passage of the NIRA.¹⁸ Many industries were faced with “chiselers” who refused to respect code pricing rules. Firms that attempted to uphold code prices in the face of defection lost both market share and respect for the NRA.

NRA state compliance offices had recorded over 30,000 “trade practice” complaints by early 1935.¹⁹ However, the compliance program was characterized by “a marked timidity on the part of NRA enforcement officials.” ²⁰ This timidity was fatal to the program, since monopoly pricing can easily be more damaging than is the most bare-knuckled competition to a firm that attempts it without parallel action from its competitors. NRA hesitancy came about as a result of doubts about whether a vigorous enforcement effort would withstand constitutional challenge, a not-unrelated lack of support from the Department of Justice, public antipathy for enforcement actions aimed at forcing sellers to charge higher prices, and unabating internal NRA disputes about the advisability of the price-fixing core of the trade practice program.²¹ Consequently, by mid-1934, firms disinclined to respect code pricing rules were ignoring them. By that point then, contrary to the initial expectations of many code signatories, the new antitrust regime represented only permission to form voluntary cartelization agreements, not the advent of government-enforced cartels. Even there, participants had to be discreet, so as not to run afoul of the antimonopoly language of the Act.

It is still far from clear how much market power was conferred by the NRA’s loosening of antitrust constraints. Of course, modern observers of the alternating successes and failures of cartels such as OPEC will not be surprised that the NRA program led to mixed results. In the absence of government enforcement, the program simply amounted to de facto legalization of self-enforcing cartels. With respect to the ease of collusion, economic theory is clear only on the point that self-enforceability is an open question; self-interest may lead to either breakdown of agreements or success at sustaining them.

Conflicts between Large and Small Firms

Some part of the difficulties encountered by NRA cartels may have had roots in a progressive mandate to offer special protection to the “little guy.” The NIRA had specified that acceptable codes of fair competition must not “eliminate or oppress small enterprises,” ²² and that “any organization availing itself of the benefits of this title shall be truly representative of the trade or industry . . . Any organization violating … shall cease to be entitled to the benefits of this title.” ²³ Majority rule provisions were exceedingly common in codes, and were most likely a reflection of this statutory mandate. The concern for small enterprise had strong progressive roots.²⁴ Justice Brandeis’s well-known antipathy for large-scale enterprise and concentration of economic power reflected a widespread and long-standing debate about the legitimate goals of the American experiment.

In addition to evaluating monopolization under the codes, the Darrow board had been charged with assessing the impact of the NRA on small business. Its conclusion was that “in certain industries small enterprises were oppressed.” Again however, as with his review of monopolization, Darrow may have seen only what he was predisposed to see. A number of NRA “code histories” detail conflicts within industries in which small, higher-cost producers sought to use majority rule provisions to support pricing at levels above those desired by larger, lower-cost producers. In the absence of effective enforcement from the government, such prices were doomed to break down, triggering repeated price wars in some industries.²⁵

By 1935, there was understandable bitterness about what many businesses viewed as the lost promise of the NRA. Undoubtedly, the bitterness was exacerbated by the fact that the NRA wanted higher wages while failing to deliver the tools needed for effective cartelization. However, it is not entirely clear that everyone in the business community felt that the labor provisions of the Act were undesirable.²⁶

Labor and Employment Issues

By their nature, market economies give rise to surplus-eroding rivalry among those who would be better off collectively if they could only act in concert. NRA codes of fair competition, specifying agreements on pricing and terms of employment, arose from a perceived confluence of interests among representatives of “business,” “labor,” and “the public” in muting that rivalry. Many proponents of the NIRA held that competitive pressures on business had led to downward pressure on wages, which in turn caused low consumption, leading to greater pressure on business, and so on. Allowing workers to organize and bargain collectively, while their employers pledged to one another not to sell below cost, was identified as a way to arrest harmful deflationary forces. Knowledge that one’s rivals would also be forced to pay “code wages” had some potential for aiding cartel survival. Thus the rationale for NRA wage supports at the microeconomic level potentially dovetailed with the macroeconomic theory by which higher wages were held to support higher consumption and, in turn, higher prices.

Labor provisions of the NIRA appeared in Section 7: “. . . employees shall have the right to organize and bargain collectively through representatives of their own choosing … employers shall comply with the maximum hours of labor, minimum rates of pay, and other conditions of employment…” ²⁷ Each “code of fair competition” had to include labor provisions acceptable to the National Recovery Administration, developed during a process of negotiations, hearings, and review. Thus in order to obtain the shield against antitrust prosecution for their “trade practices” offered by an approved code, significant concessions to workers had to be made.

The NRA is generally judged to have been a success for labor and a miserable failure for business. However, evaluation is complicated to the extent that labor could not have achieved gains with respect to collective bargaining rights over wages and working conditions, had those rights not been more or less willingly granted by employers operating under the belief that stabilization of labor costs would facilitate cartelization. The labor provisions may have indeed helped some industries as well as helping workers, and for firms in such industries, the NRA cannot have been judged a failure. Moreover, while some businesses may have found the Act beneficial, because labor cost stability or freedom to negotiate with rivals enhanced their ability to cooperate on price, it is not entirely obvious that workers as a class gained as much as is sometimes contended.

The NRA did help solidify new and important norms regarding child labor, maximum hours, and other conditions of employment; it will never be known if the same progress could have been made had not industry been more or less hornswoggled into giving ground, using the antitrust laws as bait. Whatever the long-term effects of the NRA on worker welfare, the short-term gains for labor associated with higher wages were questionable. While those workers who managed to stay employed throughout the nineteen thirties benefited from higher wages, to the extent that workers were also consumers, and often unemployed consumers at that, or even potential entrepreneurs, they may have been better off without the NRA.

The issue is far from settled. Ben Bernanke and Martin Parkinson examine the economic growth that occurred during the New Deal in spite of higher wages and suggest “part of the answer may be that the higher wages ‘paid for themselves’ through increased productivity of labor. Probably more important, though, is the observation that with imperfectly competitive product markets, output depends on aggregate demand as well as the real wage. Maybe Herbert Hoover and Henry Ford were right: Higher real wages may have paid for themselves in the broader sense that their positive effect on aggregate demand compensated for their tendency to raise cost.” ²⁸ However, Christina Romer establishes a close connection between NRA programs and the failure of wages and prices to adjust to high unemployment levels. In her view, “By preventing the large negative deviations of output from trend in the mid-1930s from exerting deflationary pressure, [the NRA] prevented the economy’s self-correction mechanism from working.” ²⁹

Aftermath of Supreme Court’s Ruling in Schecter Case

The Supreme Court struck down the NRA on May 27, 1935; the case was a dispute over violations of labor provisions of the “Live Poultry Code” allegedly perpetrated by the Schecter Poultry Corporation. The Court held the code to be invalid on grounds of “attempted delegation of legislative power and the attempted regulation of intrastate transactions which affect interstate commerce only indirectly.” ³⁰ There were to be no more grand bargains between business and labor under the New Deal.

Riven by divergent agendas rooted in industry- and firm-specific technology and demand, “business” was never able to speak with even the tenuous degree of unity achieved by workers. Following the abortive attempt to get the government to enforce cartels, firms and industries went their own ways, using a variety of strategies to enhance their situations. A number of sectors did succeed in getting passage of “little NRAs” with mechanisms tailored to mute competition in their particular circumstances. These mechanisms included the Robinson-Patman Act, aimed at strengthening traditional retailers against the ability of chain stores to buy at lower prices, the Guffey Acts, in which high cost bituminous coal operators and coal miners sought protection from the competition of lower cost operators, and the Motor Carrier Act in which high cost incumbent truckers obtained protection against new entrants.³¹

On-going macroeconomic analysis suggests that the general public interest may have been poorly served by the experiment of the NRA. Like many macroeconomic theories, the validity of the underconsumption scenario that was put forth in support of the program depended on the strength and timing of the operation of its various mechanisms. Increasingly it appears that the NRA set off inflationary forces thought by some to be desirable at the time, but that in fact had depressing effects on demand for labor and on output. Pure monopolistic deadweight losses probably were less important than higher wage costs (although there has not been any close examination of inefficiencies that may have resulted from the NRA’s attempt to protect small higher-cost producers). The strength of any mitigating effects on aggregate demand remains to be established.

¹ Leverett Lyon, P. Homan, L. Lorwin, G. Terborgh, C. Dearing, L. Marshall, The National Recovery Administration: An Analysis and Appraisal, Washington: Brooking Institution, 1935, p. 313, footnote 9.

² See, for example, Charles Frederick Roos, NRA Economic Planning, Colorado Springs: Cowles Commission, 1935, p. 343.

³See, for example, Colin Gordon, New Deals: Business, Labor, and Politics in America, 1920-1935, New York: Cambridge University Press, 1993, especially chapter 5.

⁴Christina D. Romer, “Why Did Prices Rise in the 1930s?” Journal of Economic History 59, no. 1 (1999): 167-199; Michael Weinstein, Recovery and Redistribution under the NIRA, Amsterdam: North Holland, 1980, and Harold L. Cole and Lee E. Ohanian, “New Deal Policies and the Persistence of the Great Depression,” Working Paper 597, Federal Reserve Bank of Minneapolis, February 2001. But also see “Unemployment, Inflation and Wages in the American Depression: Are There Lessons for Europe?” Ben Bernanke and Martin Parkinson, American Economic Review: Papers and Proceedings 79, no. 2 (1989): 210-214.

⁵ See, for example, Donald Brand, Corporatism and the Rule of Law: A Study of the National Recovery Administration, Ithaca: Cornell University Press, 1988, p. 94.

⁶ See, for example, Roos, op. cit., pp. 77, 92.

⁷ Section 3(a) of The National Industrial Recovery Act, reprinted at p. 478 of Roos, op. Cit.

⁸ Section 5 of The National Industrial Recovery Act, reprinted at p. 483 of Roos, op. cit. Note though, that the legal status of actions taken during the NRA era was never clear; Roos points out that “…President Roosevelt signed an executive order on January 20, 1934, providing that any complainant of monopolistic practices … could press it before the Federal Trade Commission or request the assistance of the Department of Justice. And, on the same date, Donald Richberg issued a supplementary statement which said that the provisions of the anti-trust laws were still in effect and that the NRA would not tolerate monopolistic practices.” (Roos, op. cit. p. 376.)

⁹ Lyon, op. cit., p. 307, cited at p. 52 in Lee and Ohanian, op cit.

¹⁰ Roos, op. cit., p. 75; and Blackwell Smith, My Imprint on the Sands of Time: The Life of a New Dealer, Vantage Press, New York, p. 109.

¹¹ Lyon, op. cit., p. 570.

¹² Section 3 (a)(2) of The National Industrial Recovery Act, op. Cit.

¹³ Roos, op. cit., at pp. 254-259. Charles Roos comments that “Leon Henderson and Blackwell Smith, in particular, became intrigued with a notion that competition could be set up within limits and that in this way wide price variations tending to demoralize an industry could be prevented.”

¹⁴ Lyon, et al., op. cit., p. 605.

¹⁵ Smith, Assistant Counsel of the NRA (per Roos, op cit., p. 254), has the following to say about standardization: One of the more controversial subjects, which we didn’t get into too deeply, except to draw guidelines, was standardization.” Smith goes on to discuss the obvious need to standardize rail track gauges, plumbing fittings, and the like, but concludes, “Industry on the whole wanted more standardization than we could go with.” (Blackwell Smith, op. cit., pp. 106-7.) One must not go overboard looking for coherence among the various positions espoused by NRA administrators; along these lines it is worth remembering Smith’s statement some 60 years later: “Business’s reaction to my policy [Smith was speaking generally here of his collective proposals] to some extent was hostile. They wished that the codes were not as strict as I wanted them to be. Also, there was criticism from the liberal/labor side to the effect that the codes were more in favor of business than they should have been. I said, ‘We are guided by a squealometer. We tune policy until the squeals are the same pitch from both sides.'” (Smith, op. cit. p. 108.)

¹⁶ Quoted at p 378 of Roos, op. Cit.

¹⁷ Brand, op. cit. at pp. 159-60 cites in agreement extremely critical conclusions by Roos (op. cit. at p. 409) and Arthur Schlesinger, The Age of Roosevelt: The Coming of the New Deal, Boston: Houghton Mifflin, 1959, p. 133.

¹⁸ Roos acknowledges a breakdown by spring of 1934: “By March, 1934 something was urgently needed to encourage industry to observe code provisions; business support for the NRA had decreased materially and serious compliance difficulties had arisen.” (Roos, op. cit., at p. 318.) Brand dates the start of the compliance crisis much earlier, in the fall of 1933. (Brand, op. cit., p. 103.)

¹⁹ Lyon, op. cit., p. 264.

²⁰ Lyon, op. cit., p. 268.

²¹ Lyon, op. cit., pp. 268-272. See also Peter H. Irons, The New Deal Lawyers, Princeton: Princeton University Press, 1982.

²² Section 3(a)(2) of The National Industrial Recovery Act, op. Cit.

²³ Section 6(b) of The National Industrial Recovery Act, op. Cit.

²⁴ Brand, op. Cit.

²⁵ Barbara Alexander and Gary D. Libecap, “The Effect of Cost Heterogeneity in the Success and Failure of the New Deal’s Agricultural and Industrial Programs,” Explorations in Economic History, 37 (2000), pp. 370-400.

²⁶ Gordon, op. Cit.

²⁷ Section 7 of the National Industrial Recovery Act, reprinted at pp. 484-5 of Roos, op. Cit.

²⁸ Bernanke and Parkinson, op. cit., p. 214.

²⁹ Romer, op. cit., p. 197.

³⁰ Supreme Court of the United States, Nos. 854 and 864, October term, 1934, (decision issued May 27, 1935). Reprinted in Roos, op. cit., p. 580.

³¹ Ellis W. Hawley, The New Deal and the Problem of Monopoly: A Study in Economic Ambivalence, 1966, Princeton: Princeton University Press, p. 249; Irons, op. cit., pp. 105-106, 248.

Citation: Alexander, Barbara. “National Recovery Administration”. EH.Net Encyclopedia, edited by Robert Whaples. August 14, 2001. URL http://eh.net/encyclopedia/the-national-recovery-administration/

Lennart Schön, Lund University

This article presents an overview of Swedish economic growth performance internationally and statistically and an account of major trends in Swedish economic development during the nineteenth and twentieth centuries.¹

Modern economic growth in Sweden took off in the middle of the nineteenth century and in international comparative terms Sweden has been rather successful during the past 150 years. This is largely thanks to the transformation of the economy and society from agrarian to industrial. Sweden is a small economy that has been open to foreign influences and highly dependent upon the world economy. Thus, successive structural changes have put their imprint upon modern economic growth.

Swedish Growth in International Perspective

The century-long period from the 1870s to the 1970s comprises the most successful part of Swedish industrialization and growth. On a per capita basis the Japanese economy performed equally well (see Table 1). The neighboring Scandinavian countries also grew rapidly but at a somewhat slower rate than Sweden. Growth in the rest of industrial Europe and in the U.S. was clearly outpaced. Growth in the entire world economy, as measured by Maddison, was even slower.

Table 1 Annual Economic Growth Rates per Capita in Industrial Nations and the World Economy, 1871-2005

Note: Rest of Nordic countries = Denmark, Finland and Norway. Rest of Western Europe = Austria, Belgium, Britain, France, Germany, Italy, the Netherlands, and Switzerland.

Source: Maddison (2006); Krantz/Schön (forthcoming 2007); World Bank, World Development Indicator 2000; Groningen Growth and Development Centre, www.ggdc.com.

The Swedish advance in a global perspective is illustrated in Figure 1. In the mid-nineteenth century the Swedish average income level was close to the average global level (as measured by Maddison). In a European perspective Sweden was a rather poor country. By the 1970s, however, the Swedish income level was more than three times higher than the global average and among the highest in Europe.

Figure 1
Swedish GDP per Capita in Relation to World GDP per Capita, 1870-2004
(Nine year moving averages)

Sources: Maddison (2006); Krantz/Schön (forthcoming 2007).

Note. The annual variation in world production between Maddison’s benchmarks 1870, 1913 and 1950 is estimated from his supply of annual country series.

To some extent this was a catch-up story. Sweden was able to take advantage of technological and organizational advances made in Western Europe and North America. Furthermore, Scandinavian countries with resource bases such as Sweden and Finland had been rather disadvantaged as long as agriculture was the main source of income. The shift to industry expanded the resource base and industrial development – directed both to a growing domestic market but even more to a widening world market – became the main lever of growth from the late nineteenth century.

Catch-up is not the whole story, though. In many industrial areas Swedish companies took a position at the technological frontier from an early point in time. Thus, in certain sectors there was also forging ahead,² quickening the pace of structural change in the industrializing economy. Furthermore, during a century of fairly rapid growth new conditions have arisen that have required profound adaptation and a renewal of entrepreneurial activity as well as of economic policies.

The slow down in Swedish growth from the 1970s may be considered in this perspective. While in most other countries growth from the 1970s fell only in relation to growth rates in the golden post-war ages, Swedish growth fell clearly below the historical long run growth trend. It also fell to a very low level internationally. The 1970s certainly meant the end to a number of successful growth trajectories in the industrial society. At the same time new growth forces appeared with the electronic revolution, as well as with the advance of a more service based economy. It may be the case that this structural change hit the Swedish economy harder than most other economies, at least of the industrial capitalist economies. Sweden was forced into a transformation of its industrial economy and of its political economy in the 1970s and the 1980s that was more profound than in most other Western economies.

A Statistical Overview, 1800-2000

Swedish economic development since 1800 may be divided into six periods with different growth trends, as well as different composition of growth forces.

Table 2 Annual Growth Rates in per Capita Production, Total Investments, Foreign Trade and Population in Sweden, 1800-2000

Source: Krantz/Schön (forthcoming 2007).

In the first decades of the nineteenth century the agricultural sector dominated and growth was slow in all aspects but in population. Still there was per capita growth, but to some extent this was a recovery from the low levels during the Napoleonic Wars. The acceleration during the next period around the mid-nineteenth century is marked in all aspects. Investments and foreign trade became very dynamic ingredients with the onset of industrialization. They were to remain so during the following periods as well. Up to the 1970s per capita growth rates increased for each successive period. In an international perspective it is most notable that per capita growth rates increased also in the interwar period, despite the slow down in foreign trade. The interwar period is crucial for the long run relative success of Swedish economic growth. The decisive culmination in the post-war period with high growth rates in investments and in foreign trade stands out as well, as the deceleration in all aspects in the late twentieth century.

An analysis in a traditional growth accounting framework gives a long term pattern with certain periodic similarities (see Table 3). Thus, total factor productivity growth has increased over time up to the 1970s, only to decrease to its long run level in the last decades. This deceleration in productivity growth may be looked upon either as a failure of the “Swedish Model” to accommodate new growth forces or as another case of the “productivity paradox” in lieu of the information technology revolution.³

Table 3 Total Factor Productivity (TFP) Growth and Relative Contribution of Capital, Labor and TFP to GDP Growth in Sweden, 1840-2000

Source: See Table 2.

In terms of contribution to overall growth, TFP has increased its share for every period. The TFP share was low in the 1840s but there was a very marked increase with the onset of modern industrialization from the 1870s. In relative terms TFP reached its highest level so far from the 1970s, thus indicating an increasing role of human capital, technology and knowledge in economic growth. The role of capital accumulation was markedly more pronounced in early industrialization with the build-up of a modern infrastructure and with urbanization, but still capital did retain much of its importance during the twentieth century. Thus its contribution to growth during the post-war Golden Ages was significant with very high levels of material investments. At the same time TFP growth culminated with positive structural shifts, as well as increased knowledge intensity complementary to the investments. Labor has in quantitative terms progressively reduced its role in economic growth. One should observe, however, the relatively large importance of labor in Swedish economic growth during the interwar period. This was largely due to demographic factors and to the employment situation that will be further commented upon.

In the first decades of the nineteenth century, growth was still led by the primary production of agriculture, accompanied by services and transport. Secondary production in manufacturing and building was, on the contrary, very stagnant. From the 1840s the industrial sector accelerated, increasingly supported by transport and communications, as well as by private services. The sectoral shift from agriculture to industry became more pronounced at the turn of the twentieth century when industry and transportation boomed, while agricultural growth decelerated into subsequent stagnation. In the post-war period the volume of services, both private and public, increased strongly, although still not outpacing industry. From the 1970s the focus shifted to private services and to transport and communications, indicating fundamental new prerequisites of growth.

Table 4 Growth Rates of Industrial Sectors, 1800-2000

Source: See Table 2.

Note: Private services are exclusive of dwelling services.

Growth and Transformation in the Agricultural Society of the Early Nineteenth Century

During the first half of the nineteenth century the agricultural sector and the rural society dominated the Swedish economy. Thus, more than three-quarters of the population were occupied in agriculture while roughly 90 percent lived in the countryside. Many non-agrarian activities such as the iron industry, the saw mill industry and many crafts as well as domestic, religious and military services were performed in rural areas. Although growth was slow, a number of structural and institutional changes occurred that paved the way for future modernization.

Most important was the transformation of agriculture. From the late eighteenth century commercialization of the primary sector intensified. Particularly during the Napoleonic Wars, the domestic market for food stuffs widened. The population increase in combination with the temporary decrease in imports stimulated enclosures and reclamation of land, the introduction of new crops and new methods and above all it stimulated a greater degree of market orientation. In the decades after the war the traditional Swedish trade deficit in grain even shifted to a trade surplus with an increasing exportation of oats, primarily to Britain.

Concomitant with the agricultural transformation were a number of infrastructural and institutional changes. Domestic transportation costs were reduced through investments in canals and roads. Trade of agricultural goods was liberalized, reducing transaction costs and integrating the domestic market even further. Trading companies became more effective in attracting agricultural surpluses for more distant markets. In support of the agricultural sector new means of information were introduced by, for example, agricultural societies that published periodicals on innovative methods and on market trends. Mortgage societies were established to supply agriculture with long term capital for investments that in turn intensified the commercialization of production.

All these elements meant a profound institutional change in the sense that the price mechanism became much more effective in directing human behavior. Furthermore, a greater interest in information and in the main instrument of information, namely literacy, was infused. Traditionally, popular literacy had been upheld by the church, mainly devoted to knowledge of the primary Lutheran texts. In the new economic environment, literacy was secularized and transformed into a more functional literacy marked by the advent of schools for public education in the 1840s.

The Breakthrough of Modern Economic Growth in the Mid-nineteenth Century

In the decades around the middle of the nineteenth century new dynamic forces appeared that accelerated growth. Most notably foreign trade expanded by leaps and bounds in the 1850s and 1860s. With new export sectors, industrial investments increased. Furthermore, railways became the most prominent component of a new infrastructure and with this construction a new component in Swedish growth was introduced, heavy capital imports.

The upswing in industrial growth in Western Europe during the 1850s, in combination with demand induced through the Crimean War, led to a particularly strong expansion in Swedish exports with sharp price increases for three staple goods – bar iron, wood and oats. The charcoal-based Swedish bar iron had been the traditional export good and had completely dominated Swedish exports until mid-nineteenth century. Bar iron met, however, increasingly strong competition from British and continental iron and steel industries and Swedish exports had stagnated in the first half of the nineteenth century. The upswing in international demand, following the diffusion of industrialization and railway construction, gave an impetus to the modernization of Swedish steel production in the following decades.

The saw mill industry was a really new export industry that grew dramatically in the 1850s and 1860s. Up until this time, the vast forests in Sweden had been regarded mainly as a fuel resource for the iron industry and for household heating and local residential construction. With sharp price increases on the Western European market from the 1840s and 1850s, the resources of the sparsely populated northern part of Sweden suddenly became valuable. A formidable explosion of saw mill construction at the mouths of the rivers along the northern coastline followed. Within a few decades Swedish merchants, as well as Norwegian, German, British and Dutch merchants, became saw mill owners running large-scale capitalist enterprises at the fringe of the European civilization.

Less dramatic but equally important was the sudden expansion of Swedish oat exports. The market for oats appeared mainly in Britain, where short-distance transportation in rapidly growing urban centers increased the fleet of horses. Swedish oats became an important energy resource during the decades around the mid-nineteenth century. In Sweden this had a special significance since oats could be cultivated on rather barren and marginal soils and Sweden was richly endowed with such soils. Thus, the market for oats with strongly increasing prices stimulated further the commercialization of agriculture and the diffusion of new methods. It was furthermore so since oats for the market were a substitute for local flax production – also thriving on barren soils – while domestic linen was increasingly supplanted by factory-produced cotton goods.

The Swedish economy was able to respond to the impetus from Western Europe during these decades, to diffuse the new influences in the economy and to integrate them in its development very successfully. The barriers to change seem to have been weak. This is partly explained by the prior transformation of agriculture and the evolution of market institutions in the rural economy. People reacted to the price mechanism. New social classes of commercial peasants, capitalists and wage laborers had emerged in an era of domestic market expansion, with increased regional specialization, and population increase.

The composition of export goods also contributed to the diffusion of participation and to the diffusion of export income. Iron, wood and oats meant both a regional and a social distribution. The value of prior marginal resources such as soils in the south and forests in the north was inflated. The technology was simple and labor intensive in industry, forestry, agriculture and transportation. The demand for unskilled labor increased strongly that was to put an imprint upon Swedish wage development in the second half of the nineteenth century. Commercial houses and industrial companies made profits but export income was distributed to many segments of the population.

The integration of the Swedish economy was further enforced through initiatives taken by the State. The parliament decision in the 1850s to construct the railway trunk lines meant, first, a more direct involvement by the State in the development of a modern infrastructure and, second, new principles of finance since the State had to rely upon capital imports. At the same time markets for goods, labor and capital were liberalized and integration both within Sweden and with the world market deepened. The Swedish adoption of the Gold Standard in 1873 put a final stamp on this institutional development.

A Second Industrial Revolution around 1900

In the late nineteenth century, particularly in the 1880s, international competition became fiercer for agriculture and early industrial branches. The integration of world markets led to falling prices and stagnation in the demand for Swedish staple goods such as iron, sawn wood and oats. Profits were squeezed and expansion thwarted. On the other hand there arose new markets. Increasing wages intensified mechanization both in agriculture and in industry. The demand increased for more sophisticated machinery equipment. At the same time consumer demand shifted towards better foodstuff – such as milk, butter and meat – and towards more fabricated industrial goods.

The decades around the turn of the twentieth century meant a profound structural change in the composition of Swedish industrial expansion that was crucial for long term growth. New and more sophisticated enterprises were founded and expanded particularly from the 1890s, in the upswing after the Baring Crisis.

The new enterprises were closely related to the so called Second Industrial Revolution in which scientific knowledge and more complex engineering skills were main components. The electrical motor became especially important in Sweden. A new development block was created around this innovation that combined engineering skills in companies such as ASEA (later ABB) with a large demand in energy-intensive processes and with the large supply of hydropower in Sweden.⁴ Financing the rapid development of this large block engaged commercial banks, knitting closer ties between financial capital and industry. The State, once again, engaged itself in infrastructural development in support of electrification, still resorting to heavy capital imports.

A number of innovative industries were founded in this period – all related to increased demand for mechanization and engineering skills. Companies such as AGA, ASEA, Ericsson, Separator (AlfaLaval) and SKF have been labeled “enterprises of genius” and all are represented with renowned inventors and innovators. This was, of course, not an entirely Swedish phenomenon. These branches developed simultaneously on the Continent, particularly in nearby Germany and in the U.S. Knowledge and innovative stimulus was diffused among these economies. The question is rather why this new development became so strong in Sweden so that new industries within a relatively short period of time were able to supplant old resource-based industries as main driving forces of industrialization.

Traditions of engineering skills were certainly important, developed in old heavy industrial branches such as iron and steel industries and stimulated further by State initiatives such as railway construction or, more directly, the founding of the Royal Institute of Technology. But apart from that the economic development in the second half of the nineteenth century fundamentally changed relative factor prices and the profitability of allocation of resources in different lines of production.

The relative increase in the wages of unskilled labor had been stimulated by the composition of early exports in Sweden. This was much reinforced by two components in the further development – emigration and capital imports.

Within approximately the same period, 1850-1910, the Swedish economy received a huge amount of capital mainly from Germany and France, while delivering an equally huge amount of labor to primarily the U.S. Thus, Swedish relative factor prices changed dramatically. Swedish interest rates remained at rather high levels compared to leading European countries until 1910, due to a continuous large demand for capital in Sweden, but relative wages rose persistently (see Table 5). As in the rest of Scandinavia, wage increases were much stronger than GDP growth in Sweden indicating a shift in income distribution in favor of labor, particularly in favor of unskilled labor, during this period of increased world market integration.

Table 5 Annual Increase in Real Wages of Unskilled Labor and Annual GDP Growth per Capita, 1870-1910

Sources: Wages from Williamson (1995); GDP growth see Table 1.

Relative profitability fell in traditional industries, which exploited rich natural resources and cheap labor, while more sophisticated industries were favored. But the causality runs both ways. Had this structural shift with the growth of new and more profitable industries not occurred, the Swedish economy would not have been able to sustain the wage increase.⁵

Accelerated Growth in the War-stricken Period, 1910-1950

The most notable feature of long term Swedish growth is the acceleration in growth rates during the period 1910-1950, which in Europe at large was full of problems and catastrophes.⁶ Thus, Swedish per capita production grew at 2.2 percent annually while growth in the rest of Scandinavia was somewhat below 2 percent and in the rest of Europe hovered at 1 percent. The Swedish acceleration was based mainly on three pillars.

First, the structure created at the end of the nineteenth century was very viable, with considerable long term growth potential. It consisted of new industries and new infrastructures that involved industrialists and financial capitalists, as well as public sector support. It also involved industries meeting a relatively strong demand in war times, as well as in the interwar period, both domestically and abroad.

Second, the First World War meant an immense financial bonus to the Swedish market. A huge export surplus at inflated prices during the war led to the domestication of the Swedish national debt. This in turn further capitalized the Swedish financial market, lowering interest rates and ameliorating sequential innovative activity in industry. A domestic money market arose that provided the State with new instruments for economic policy that were to become important for the implementation of the new social democratic “Keynesian” policies of the 1930s.

Third, demographic development favored the Swedish economy in this period. The share of the economically active age group 15-64 grew substantially. This was due partly to the fact that prior emigration had sized down cohorts that now would have become old age pensioners. Comparatively low mortality of young people during the 1910s, as well as an end to mass emigration further enhanced the share of the active population. Both the labor market and domestic demand was stimulated in particular during the 1930s when the household forming age group of 25-30 years increased.

The augmented labor supply would have increased unemployment had it not been combined with the richer supply of capital and innovative industrial development that met elastic demand both domestically and in Europe.

Thus, a richer supply of both capital and labor stimulated the domestic market in a period when international market integration deteriorated. Above all it stimulated the development of mass production of consumption goods based upon the innovations of the Second Industrial Revolution. Significant new enterprises that emanated from the interwar period were very much related to the new logic of the industrial society, such as Volvo, SAAB, Electrolux, Tetra Pak and IKEA.

The Golden Age of Growth, 1950-1975

The Swedish economy was clearly part of the European Golden Age of growth, although Swedish acceleration from the 1950s was less pronounced than in the rest of Western Europe, which to a much larger extent had been plagued by wars and crises.⁷ The Swedish post-war period was characterized primarily by two phenomena – the full fruition of development blocks based upon the great innovations of the late nineteenth century (the electrical motor and the combustion engine) and the cementation of the “Swedish Model” for the welfare state. These two phenomena were highly complementary.

The Swedish Model had basically two components. One was a greater public responsibility for social security and for the creation and preservation of human capital. This led to a rapid increase in the supply of public services in the realms of education, health and children’s day care as well as to increases in social security programs and in public savings for transfers to pensioners program. The consequence was high taxation. The other component was a regulation of labor and capital markets. This was the most ingenious part of the model, constructed to sustain growth in the industrial society and to increase equality in combination with the social security program and taxation.

The labor market program was the result of negotiations between trade unions and the employers’ organization. It was labeled “solidaristic wage policy” with two elements. One was to achieve equal wages for equal work, regardless of individual companies’ ability to pay. The other element was to raise the wage level in low paid areas and thus to compress the wage distribution. The aim of the program was actually to increase the speed in the structural rationalization of industries and to eliminate less productive companies and branches. Labor should be transferred to the most productive export-oriented sectors. At the same time income should be distributed more equally. A drawback of the solidaristic wage policy from an egalitarian point of view was that profits soared in the productive sectors since wage increases were held back. However, capital market regulations hindered the ability of high profits to be converted into very high incomes for shareholders. Profits were taxed very low if they were converted into further investments within the company (the timing in the use of the funds was controlled by the State in its stabilization policy) but taxed heavily if distributed to share holders. The result was that investments within existing profitable companies were supported and actually subsidized while the mobility of capital dwindled and the activity at the stock market fell.

As long as the export sectors grew, the program worked well.⁸ Companies founded in the late nineteenth century and in the interwar period developed into successful multinationals in engineering with machinery, auto industries and shipbuilding, as well as in resource-based industries of steel and paper. The expansion of the export sector was the main force behind the high growth rates and the productivity increases but the sector was strongly supported by public investments or publicly subsidized investments in infrastructure and residential construction.

Hence, during the Golden Age of growth the development blocks around electrification and motorization matured in a broad modernization of the society, where mass consumption and mass production was supported by social programs, by investment programs and by labor market policy.

Crisis and Restructuring from the 1970s

In the 1970s and early 1980s a number of industries – such as steel works, pulp and paper, shipbuilding, and mechanical engineering – ran into crisis. New global competition, changing consumer behavior and profound innovative renewal, especially in microelectronics, made some of the industrial pillars of the Swedish Model crumble. At the same time the disadvantages of the old model became more apparent. It put obstacles to flexibility and to entrepreneurial initiatives and it reduced individual incentives for mobility. Thus, while the Swedish Model did foster rationalization of existing industries well adapted to the post-war period, it did not support more profound transformation of the economy.

One should not exaggerate the obstacles to transformation, though. The Swedish economy was still very open in the market for goods and many services, and the pressure to transform increased rapidly. During the 1980s a far-reaching structural change within industry as well as in economic policy took place, engaging both private and public actors. Shipbuilding was almost completely discontinued, pulp industries were integrated into modernized paper works, the steel industry was concentrated and specialized, and the mechanical engineering was digitalized. New and more knowledge-intensive growth industries appeared in the 1980s, such as IT-based telecommunication, pharmaceutical industries, and biotechnology, as well as new service industries.

During the 1980s some of the constituent components of the Swedish model were weakened or eliminated. Centralized negotiations and solidaristic wage policy disappeared. Regulations in the capital market were dismantled under the pressure of increasing international capital flows simultaneously with a forceful revival of the stock market. The expansion of public sector services came to an end and the taxation system was reformed with a reduction of marginal tax rates. Thus, Swedish economic policy and welfare system became more adapted to the main European level that facilitated the Swedish application of membership and final entrance into the European Union in 1995.

It is also clear that the period from the 1970s to the early twenty-first century comprise two growth trends, before and after 1990 respectively. During the 1970s and 1980s, growth in Sweden was very slow and marked by the great structural problems that the Swedish economy had to cope with. The slow growth prior to 1990 does not signify stagnation in a real sense, but rather the transformation of industrial structures and the reformulation of economic policy, which did not immediately result in a speed up of growth but rather in imbalances and bottle necks that took years to eliminate. From the 1990s up to 2005 Swedish growth accelerated quite forcefully in comparison with most Western economies.⁹ Thus, the 1980s may be considered as a Swedish case of “the productivity paradox,” with innovative renewal but with a delayed acceleration of productivity and growth from the 1990s – although a delayed productivity effect of more profound transformation and radical innovative behavior is not paradoxical.

Table 6 Annual Growth Rates per Capita, 1971-2005

Sources: See Table 1.

The recent acceleration in growth may also indicate that some of the basic traits from early industrialization still pertain to the Swedish economy – an international attitude in a small open economy fosters transformation and adaptation of human skills to new circumstances as a major force behind long term growth.

References

Abramovitz, Moses. “Catching Up, Forging Ahead and Falling Behind.” Journal of Economic History 46, no. 2 (1986): 385-406.

Dahmén, Erik. “Development Blocks in Industrial Economics.” Scandinavian Economic History Review 36 (1988): 3-14.

David, Paul A. “The Dynamo and the Computer: An Historical Perspective on the Modern Productivity Paradox.” American Economic Review 80, no. 2 (1980): 355-61.

Eichengreen, Barry. “Institutions and Economic Growth: Europe after World War II.” In Economic Growth in Europe since 1945, edited by Nicholas Crafts and Gianni Toniolo. New York: Cambridge University Press, 1996.

Krantz, Olle and Lennart Schön. Swedish Historical National Accounts, 1800-2000. Lund: Almqvist and Wiksell International (forthcoming, 2007).

Maddison, Angus. The World Economy, Volumes 1 and 2. Paris: OECD (2006).

Schön, Lennart. “Development Blocks and Transformation Pressure in a Macro-Economic Perspective: A Model of Long-Cyclical Change.” Skandinaviska Enskilda Banken Quarterly Review 20, no. 3-4 (1991): 67-76.

Schön, Lennart. “External and Internal Factors in Swedish Industrialization.” Scandinavian Economic History Review 45, no. 3 (1997): 209-223.

Schön, Lennart. En modern svensk ekonomisk historia: Tillväxt och omvandling under två sekel (A Modern Swedish Economic History: Growth and Transformation in Two Centuries). Stockholm: SNS (2000).

Schön, Lennart. “Total Factor Productivity in Swedish Manufacturing in the Period 1870-2000.” In Exploring Economic Growth: Essays in Measurement and Analysis: A Festschrift for Riitta Hjerppe on Her Sixtieth Birthday, edited by S. Heikkinen and J.L. van Zanden. Amsterdam: Aksant, 2004.

Schön, Lennart. “Swedish Industrialization 1870-1930 and the Heckscher-Ohlin Theory.” In Eli Heckscher, International Trade, and Economic History, edited by Ronald Findlay et al. Cambridge, MA: MIT Press (2006).

Svennilson, Ingvar. Growth and Stagnation in the European Economy. Geneva: United Nations Economic Commission for Europe, 1954.

Temin, Peter. “The Golden Age of European Growth Reconsidered.” European Review of Economic History 6, no. 1 (2002): 3-22.

Williamson, Jeffrey G. “The Evolution of Global Labor Markets since 1830: Background Evidence and Hypotheses.” Explorations in Economic History 32, no. 2 (1995): 141-96.

Citation: Schön, Lennart. “Sweden – Economic Growth and Structural Change, 1800-2000”. EH.Net Encyclopedia, edited by Robert Whaples. February 10, 2008. URL http://eh.net/encyclopedia/sweden-economic-growth-and-structural-change-1800-2000/

Barbara Alexander, Charles River Associates

This article outlines the history of the National Recovery Administration, one of the most important and controversial agencies in Roosevelt’s New Deal. It discusses the agency’s “codes of fair competition” under which antitrust law exemptions could be granted in exchange for adoption of minimum wages, problems some industries encountered in their subsequent attempts to fix prices under the codes, and the macroeconomic effects of the program.

The early New Deal suspension of antitrust law under the National Recovery Administration (NRA) is surely one of the oddest episodes in American economic history. In its two-year life, the NRA oversaw the development of so-called “codes of fair competition” covering the larger part of the business landscape.¹ The NRA generally is thought to have represented a political exchange whereby business gave up some of its rights over employees in exchange for permission to form cartels.² Typically, labor is taken to have gotten the better part of the bargain; the union movement having extended its new powers after the Supreme Court abolished the NRA in 1935, while the business community faced a newly aggressive FTC by the end of the 1930s. While this characterization may be true in broad outline, close examination of the NRA reveals that matters may be somewhat more complicated than is suggested by the interpretation of the program as a win for labor contrasted with a missed opportunity for business.

Recent evaluations of the NRA have wended their way back to themes sounded during the early nineteen thirties, in particular, interrelationships between the so-called “trade practice” or cartelization provisions of the program and the grant of enhanced bargaining power to trade unions.³ On the microeconomic side, allowing unions to bargain for industry-wide wages may have facilitated cartelization in some industries. Meanwhile, macroeconomists have suggested that the Act and its progeny, especially labor measures such as the National Labor Relations Act may bear more responsibility for the length and severity of the Great Depression than has been recognized heretofore.⁴ If this thesis holds up to closer scrutiny, the era may come to be seen as a primary example of the potential macroeconomic costs of shifts in political and economic power.

Kickoff Campaign and Blanket Codes

The NRA began operations in a burst of “ballyhoo” during the summer of 1933.⁵ The agency was formed upon passage of the National Industrial Recovery Act (NIRA) in mid-June. A kick-off campaign of parades and press events succeeded in getting over 2 million employers to sign a preliminary “blanket code” known as the “President’s Re-Employment Agreement.” Signatories of the PRA pledged to pay minimum wages ranging from around $12 to $15 per 40-hour week, depending on size of town. Some 16 million workers were covered, out of a non-farm labor force of some 25 million. “Share-the-work” provisions called for limits of 35 to 40 hours per week for most employees.⁶

NRA Codes

Over the next year and a half, the blanket code was superseded by over 500 codes negotiated for individual industries. The NIRA provided that: “Upon the application to the President by one or more trade or industrial associations or groups, the President may approve a code or codes of fair competition for the trade or industry.”⁷ The carrot held out to induce participation was enticing: “any code … and any action complying with the provisions thereof . . . shall be exempt from the provisions of the antitrust laws of the United States.”⁸ Representatives of trade associations overran Washington, and by the time the NRA was abolished, hundreds of codes covering over three-quarters of private, non-farm employment had been approved.⁹ Code signatories were supposed to be allowed to use the NRA “Blue Eagle” as a symbol that “we do our part” only as long as they remained in compliance with code provisions.¹⁰

Disputes Arise

Almost 80 percent of the codes had provisions that were directed at establishment of price floors.¹¹ The Act did not specifically authorize businesses to fix prices, and indeed it specified that ” . . .codes are not designed to promote monopolies.”¹² However, it is an understatement to say that there was never any consensus among firms, industries and NRA officials as to precisely what was to be allowed as part of an acceptable code. Arguments about exactly what the NIRA allowed, and how the NRA should implement the Act began during its drafting and continued unabated throughout its life. The arguments extended from the level of general principles to the smallest details of policy, unsurprising given the complete dependence of appropriate regulatory design on precise regulatory objectives, which here were embroiled in dispute from start to finish.

To choose just one out of many examples of such disputes: There was a debate within the NRA as to whether “code authorities” (industry governing bodies) should be allowed to use industry-wide or “representative” cost data to define a price floor based on “lowest reasonable cost.” Most economists would understand this type of rule as a device that would facilitate monopoly pricing. However, a charitable interpretation of the views of administration proponents is that they had some sort of “soft competition” in mind. That is, they wished to develop and allow the use of mechanisms that would extend to more fragmented industries a type of peaceful coexistence more commonly associated with oligopoly. Those NRA supporters of the representative-cost-based price floor imagined that a range of prices would emerge if such a floor were to be set, whereas detractors believed that “the minimum would become the maximum,” that is, the floor would simply be a cartel price, constraining competition across all firms in an industry.¹³

Price Floors

While a rule allowing emergency price floors based on “lowest reasonable cost” was eventually approved, there was no coherent NRA program behind it.¹⁴ Indeed, the NRA and code authorities often operated at cross-purposes. At the same time that some officials of the NRA arguably took actions to promote softened competition, some in industry tried to implement measures more likely to support hard-core cartels, even when they thereby reduced the chance of soft competition should collusion fail. For example, with the partial support of the NRA, many code authorities moved to standardize products, shutting off product differentiation as an arena of potential rivalry, in spite of its role as one of the strongest mechanisms that might soften price competition.¹⁵ Of course if one is looking to run a naked price-fixing scheme, it is helpful to eliminate product differentiation as an avenue for cost-raising, profit-eroding rivalry. An industry push for standardization can thus be seen as a way of supporting hard-core cartelization, while less enthusiasm on the part of some administration officials may have reflected an understanding, however intuitive, that socially more desirable soft competition required that avenues for product differentiation be left open.

National Recovery Review Board

According to some critical observers then and later, the codes did lead to an unsurprising sort of “golden age” of cartelization. The National Recovery Review Board, led by an outraged Clarence Darrow (of Scopes “monkey trial” fame) concluded in May of 1934 that “in certain industries monopolistic practices existed.”¹⁶ While there are legitimate examples of every variety of cartelization occurring under the NRA, many contemporaneous and subsequent assessments of Darrow’s work dismiss the Board’s “analysis” as hopelessly biased. Thus although its conclusions are interesting as a matter of political economy, it is far from clear that the Board carried out any dispassionate inventory of conditions across industries, much less a real weighing of evidence.¹⁷

Compliance Crisis

In contrast to Darrow’s perspective, other commentators focus on the “compliance crisis” that erupted within a few months of passage of the NIRA.¹⁸ Many industries were faced with “chiselers” who refused to respect code pricing rules. Firms that attempted to uphold code prices in the face of defection lost both market share and respect for the NRA.

NRA state compliance offices had recorded over 30,000 “trade practice” complaints by early 1935.¹⁹ However, the compliance program was characterized by “a marked timidity on the part of NRA enforcement officials.”²⁰ This timidity was fatal to the program, since monopoly pricing can easily be more damaging than is the most bare-knuckled competition to a firm that attempts it without parallel action from its competitors. NRA hesitancy came about as a result of doubts about whether a vigorous enforcement effort would withstand constitutional challenge, a not-unrelated lack of support from the Department of Justice, public antipathy for enforcement actions aimed at forcing sellers to charge higher prices, and unabating internal NRA disputes about the advisability of the price-fixing core of the trade practice program.²¹ Consequently, by mid-1934, firms disinclined to respect code pricing rules were ignoring them. By that point then, contrary to the initial expectations of many code signatories, the new antitrust regime represented only permission to form voluntary cartelization agreements, not the advent of government-enforced cartels. Even there, participants had to be discreet, so as not to run afoul of the antimonopoly language of the Act.

It is still far from clear how much market power was conferred by the NRA’s loosening of antitrust constraints. Of course, modern observers of the alternating successes and failures of cartels such as OPEC will not be surprised that the NRA program led to mixed results. In the absence of government enforcement, the program simply amounted to de facto legalization of self-enforcing cartels. With respect to the ease of collusion, economic theory is clear only on the point that self-enforceability is an open question; self-interest may lead to either breakdown of agreements or success at sustaining them.

Conflicts between Large and Small Firms

Some part of the difficulties encountered by NRA cartels may have had roots in a progressive mandate to offer special protection to the “little guy.” The NIRA had specified that acceptable codes of fair competition must not “eliminate or oppress small enterprises,”²² and that “any organization availing itself of the benefits of this title shall be truly representative of the trade or industry . . . Any organization violating … shall cease to be entitled to the benefits of this title.”²³ Majority rule provisions were exceedingly common in codes, and were most likely a reflection of this statutory mandate. The concern for small enterprise had strong progressive roots.²⁴ Justice Brandeis’s well-known antipathy for large-scale enterprise and concentration of economic power reflected a widespread and long-standing debate about the legitimate goals of the American experiment.

In addition to evaluating monopolization under the codes, the Darrow board had been charged with assessing the impact of the NRA on small business. Its conclusion was that “in certain industries small enterprises were oppressed.” Again however, as with his review of monopolization, Darrow may have seen only what he was predisposed to see. A number of NRA “code histories” detail conflicts within industries in which small, higher-cost producers sought to use majority rule provisions to support pricing at levels above those desired by larger, lower-cost producers. In the absence of effective enforcement from the government, such prices were doomed to break down, triggering repeated price wars in some industries.²⁵

By 1935, there was understandable bitterness about what many businesses viewed as the lost promise of the NRA. Undoubtedly, the bitterness was exacerbated by the fact that the NRA wanted higher wages while failing to deliver the tools needed for effective cartelization. However, it is not entirely clear that everyone in the business community felt that the labor provisions of the Act were undesirable.²⁶

Labor and Employment Issues

By their nature, market economies give rise to surplus-eroding rivalry among those who would be better off collectively if they could only act in concert. NRA codes of fair competition, specifying agreements on pricing and terms of employment, arose from a perceived confluence of interests among representatives of “business,” “labor,” and “the public” in muting that rivalry. Many proponents of the NIRA held that competitive pressures on business had led to downward pressure on wages, which in turn caused low consumption, leading to greater pressure on business, and so on. Allowing workers to organize and bargain collectively, while their employers pledged to one another not to sell below cost, was identified as a way to arrest harmful deflationary forces. Knowledge that one’s rivals would also be forced to pay “code wages” had some potential for aiding cartel survival. Thus the rationale for NRA wage supports at the microeconomic level potentially dovetailed with the macroeconomic theory by which higher wages were held to support higher consumption and, in turn, higher prices.

Labor provisions of the NIRA appeared in Section 7: “. . . employees shall have the right to organize and bargain collectively through representatives of their own choosing … employers shall comply with the maximum hours of labor, minimum rates of pay, and other conditions of employment…” ²⁷ Each “code of fair competition” had to include labor provisions acceptable to the National Recovery Administration, developed during a process of negotiations, hearings, and review. Thus in order to obtain the shield against antitrust prosecution for their “trade practices” offered by an approved code, significant concessions to workers had to be made.

The NRA is generally judged to have been a success for labor and a miserable failure for business. However, evaluation is complicated to the extent that labor could not have achieved gains with respect to collective bargaining rights over wages and working conditions, had those rights not been more or less willingly granted by employers operating under the belief that stabilization of labor costs would facilitate cartelization. The labor provisions may have indeed helped some industries as well as helping workers, and for firms in such industries, the NRA cannot have been judged a failure. Moreover, while some businesses may have found the Act beneficial, because labor cost stability or freedom to negotiate with rivals enhanced their ability to cooperate on price, it is not entirely obvious that workers as a class gained as much as is sometimes contended.

The NRA did help solidify new and important norms regarding child labor, maximum hours, and other conditions of employment; it will never be known if the same progress could have been made had not industry been more or less hornswoggled into giving ground, using the antitrust laws as bait. Whatever the long-term effects of the NRA on worker welfare, the short-term gains for labor associated with higher wages were questionable. While those workers who managed to stay employed throughout the nineteen thirties benefited from higher wages, to the extent that workers were also consumers, and often unemployed consumers at that, or even potential entrepreneurs, they may have been better off without the NRA.

The issue is far from settled. Ben Bernanke and Martin Parkinson examine the economic growth that occurred during the New Deal in spite of higher wages and suggest “part of the answer may be that the higher wages ‘paid for themselves’ through increased productivity of labor. Probably more important, though, is the observation that with imperfectly competitive product markets, output depends on aggregate demand as well as the real wage. Maybe Herbert Hoover and Henry Ford were right: Higher real wages may have paid for themselves in the broader sense that their positive effect on aggregate demand compensated for their tendency to raise cost.”²⁸ However, Christina Romer establishes a close connection between NRA programs and the failure of wages and prices to adjust to high unemployment levels. In her view, “By preventing the large negative deviations of output from trend in the mid-1930s from exerting deflationary pressure, [the NRA] prevented the economy’s self-correction mechanism from working.” ²⁹

Aftermath of Supreme Court’s Ruling in Schecter Case

The Supreme Court struck down the NRA on May 27, 1935; the case was a dispute over violations of labor provisions of the “Live Poultry Code” allegedly perpetrated by the Schecter Poultry Corporation. The Court held the code to be invalid on grounds of “attempted delegation of legislative power and the attempted regulation of intrastate transactions which affect interstate commerce only indirectly.”³⁰ There were to be no more grand bargains between business and labor under the New Deal.

Riven by divergent agendas rooted in industry- and firm-specific technology and demand, “business” was never able to speak with even the tenuous degree of unity achieved by workers. Following the abortive attempt to get the government to enforce cartels, firms and industries went their own ways, using a variety of strategies to enhance their situations. A number of sectors did succeed in getting passage of “little NRAs” with mechanisms tailored to mute competition in their particular circumstances. These mechanisms included the Robinson-Patman Act, aimed at strengthening traditional retailers against the ability of chain stores to buy at lower prices, the Guffey Acts, in which high cost bituminous coal operators and coal miners sought protection from the competition of lower cost operators, and the Motor Carrier Act in which high cost incumbent truckers obtained protection against new entrants.³¹

On-going macroeconomic analysis suggests that the general public interest may have been poorly served by the experiment of the NRA. Like many macroeconomic theories, the validity of the underconsumption scenario that was put forth in support of the program depended on the strength and timing of the operation of its various mechanisms. Increasingly it appears that the NRA set off inflationary forces thought by some to be desirable at the time, but that in fact had depressing effects on demand for labor and on output. Pure monopolistic deadweight losses probably were less important than higher wage costs (although there has not been any close examination of inefficiencies that may have resulted from the NRA’s attempt to protect small higher-cost producers). The strength of any mitigating effects on aggregate demand remains to be established.

¹ Leverett Lyon, P. Homan, L. Lorwin, G. Terborgh, C. Dearing, L. Marshall, The National Recovery Administration: An Analysis and Appraisal, Washington: Brooking Institution, 1935, p. 313, footnote 9.

² See, for example, Charles Frederick Roos, NRA Economic Planning, Colorado Springs: Cowles Commission, 1935, p. 343.

³See, for example, Colin Gordon, New Deals: Business, Labor, and Politics in America, 1920-1935, New York: Cambridge University Press, 1993, especially chapter 5.

⁴Christina D. Romer, “Why Did Prices Rise in the 1930s?” Journal of Economic History 59, no. 1 (1999): 167-199; Michael Weinstein, Recovery and Redistribution under the NIRA, Amsterdam: North Holland, 1980, and Harold L. Cole and Lee E. Ohanian, “New Deal Policies and the Persistence of the Great Depression,” Working Paper 597, Federal Reserve Bank of Minneapolis, February 2001. But also see “Unemployment, Inflation and Wages in the American Depression: Are There Lessons for Europe?” Ben Bernanke and Martin Parkinson, American Economic Review: Papers and Proceedings 79, no. 2 (1989): 210-214.

⁵ See, for example, Donald Brand, Corporatism and the Rule of Law: A Study of the National Recovery Administration, Ithaca: Cornell University Press, 1988, p. 94.

⁶ See, for example, Roos, op. cit., pp. 77, 92.

⁷ Section 3(a) of The National Industrial Recovery Act, reprinted at p. 478 of Roos, op. Cit.

⁸ Section 5 of The National Industrial Recovery Act, reprinted at p. 483 of Roos, op. cit. Note though, that the legal status of actions taken during the NRA era was never clear; Roos points out that “…President Roosevelt signed an executive order on January 20, 1934, providing that any complainant of monopolistic practices … could press it before the Federal Trade Commission or request the assistance of the Department of Justice. And, on the same date, Donald Richberg issued a supplementary statement which said that the provisions of the anti-trust laws were still in effect and that the NRA would not tolerate monopolistic practices.” (Roos, op. cit. p. 376.)

⁹ Lyon, op. cit., p. 307, cited at p. 52 in Lee and Ohanian, op cit.

¹⁰ Roos, op. cit., p. 75; and Blackwell Smith, My Imprint on the Sands of Time: The Life of a New Dealer, Vantage Press, New York, p. 109.

¹¹ Lyon, op. cit., p. 570.

¹² Section 3 (a)(2) of The National Industrial Recovery Act, op. Cit.

¹³ Roos, op. cit., at pp. 254-259. Charles Roos comments that “Leon Henderson and Blackwell Smith, in particular, became intrigued with a notion that competition could be set up within limits and that in this way wide price variations tending to demoralize an industry could be prevented.”

¹⁴ Lyon, et al., op. cit., p. 605.

¹⁵ Smith, Assistant Counsel of the NRA (per Roos, op cit., p. 254), has the following to say about standardization: One of the more controversial subjects, which we didn’t get into too deeply, except to draw guidelines, was standardization.” Smith goes on to discuss the obvious need to standardize rail track gauges, plumbing fittings, and the like, but concludes, “Industry on the whole wanted more standardization than we could go with.” (Blackwell Smith, op. cit., pp. 106-7.) One must not go overboard looking for coherence among the various positions espoused by NRA administrators; along these lines it is worth remembering Smith’s statement some 60 years later: “Business’s reaction to my policy [Smith was speaking generally here of his collective proposals] to some extent was hostile. They wished that the codes were not as strict as I wanted them to be. Also, there was criticism from the liberal/labor side to the effect that the codes were more in favor of business than they should have been. I said, ‘We are guided by a squealometer. We tune policy until the squeals are the same pitch from both sides.'” (Smith, op. cit. p. 108.)

¹⁶ Quoted at p 378 of Roos, op. Cit.

¹⁷ Brand, op. cit. at pp. 159-60 cites in agreement extremely critical conclusions by Roos (op. cit. at p. 409) and Arthur Schlesinger, The Age of Roosevelt: The Coming of the New Deal, Boston: Houghton Mifflin, 1959, p. 133.

¹⁸ Roos acknowledges a breakdown by spring of 1934: “By March, 1934 something was urgently needed to encourage industry to observe code provisions; business support for the NRA had decreased materially and serious compliance difficulties had arisen.” (Roos, op. cit., at p. 318.) Brand dates the start of the compliance crisis much earlier, in the fall of 1933. (Brand, op. cit., p. 103.)

¹⁹ Lyon, op. cit., p. 264.

²⁰ Lyon, op. cit., p. 268.

²¹ Lyon, op. cit., pp. 268-272. See also Peter H. Irons, The New Deal Lawyers, Princeton: Princeton University Press, 1982.

²² Section 3(a)(2) of The National Industrial Recovery Act, op. Cit.

²³ Section 6(b) of The National Industrial Recovery Act, op. Cit.

²⁴ Brand, op. Cit.

²⁵ Barbara Alexander and Gary D. Libecap, “The Effect of Cost Heterogeneity in the Success and Failure of the New Deal’s Agricultural and Industrial Programs,” Explorations in Economic History, 37 (2000), pp. 370-400.

²⁶ Gordon, op. Cit.

²⁷ Section 7 of the National Industrial Recovery Act, reprinted at pp. 484-5 of Roos, op. Cit.

²⁸ Bernanke and Parkinson, op. cit., p. 214.

²⁹ Romer, op. cit., p. 197.

³⁰ Supreme Court of the United States, Nos. 854 and 864, October term, 1934, (decision issued May 27, 1935). Reprinted in Roos, op. cit., p. 580.

³¹ Ellis W. Hawley, The New Deal and the Problem of Monopoly: A Study in Economic Ambivalence, 1966, Princeton: Princeton University Press, p.

Citation: Alexander, Barbara. “National Recovery Administration”. EH.Net Encyclopedia, edited by Robert Whaples. August 14, 2001. URL http://eh.net/encyclopedia/the-national-recovery-administration/

Carl Mosk, University of Victoria

Japan achieved sustained growth in per capita income between the 1880s and 1970 through industrialization. Moving along an income growth trajectory through expansion of manufacturing is hardly unique. Indeed Western Europe, Canada, Australia and the United States all attained high levels of income per capita by shifting from agrarian-based production to manufacturing and technologically sophisticated service sector activity.

Still, there are four distinctive features of Japan’s development through industrialization that merit discussion:

The proto-industrial base

Japan’s agricultural productivity was high enough to sustain substantial craft (proto-industrial) production in both rural and urban areas of the country prior to industrialization.

Investment-led growth

Domestic investment in industry and infrastructure was the driving force behind growth in Japanese output. Both private and public sectors invested in infrastructure, national and local governments serving as coordinating agents for infrastructure build-up.

• Investment in manufacturing capacity was largely left to the private sector.
• Rising domestic savings made increasing capital accumulation possible.
• Japanese growth was investment-led, not export-led.

Total factor productivity growth — achieving more output per unit of input — was rapid.

On the supply side, total factor productivity growth was extremely important. Scale economies — the reduction in per unit costs due to increased levels of output — contributed to total factor productivity growth. Scale economies existed due to geographic concentration, to growth of the national economy, and to growth in the output of individual companies. In addition, companies moved down the “learning curve,” reducing unit costs as their cumulative output rose and demand for their product soared.

The social capacity for importing and adapting foreign technology improved and this contributed to total factor productivity growth:

• At the household level, investing in education of children improved social capability.
• At the firm level, creating internalized labor markets that bound firms to workers and workers to firms, thereby giving workers a strong incentive to flexibly adapt to new technology, improved social capability.
• At the government level, industrial policy that reduced the cost to private firms of securing foreign technology enhanced social capacity.

Shifting out of low-productivity agriculture into high productivity manufacturing, mining, and construction contributed to total factor productivity growth.

Dualism

Sharply segmented labor and capital markets emerged in Japan after the 1910s. The capital intensive sector enjoying high ratios of capital to labor paid relatively high wages, and the labor intensive sector paid relatively low wages.

Dualism contributed to income inequality and therefore to domestic social unrest. After 1945 a series of public policy reforms addressed inequality and erased much of the social bitterness around dualism that ravaged Japan prior to World War II.

The remainder of this article will expand on a number of the themes mentioned above. The appendix reviews quantitative evidence concerning these points. The conclusion of the article lists references that provide a wealth of detailed evidence supporting the points above, which this article can only begin to explore.

The Legacy of Autarky and the Proto-Industrial Economy: Achievements of Tokugawa Japan (1600-1868)

Why Japan?

Given the relatively poor record of countries outside the European cultural area — few achieving the kind of “catch-up” growth Japan managed between 1880 and 1970 – the question naturally arises: why Japan? After all, when the United States forcibly “opened Japan” in the 1850s and Japan was forced to cede extra-territorial rights to a number of Western nations as had China earlier in the 1840s, many Westerners and Japanese alike thought Japan’s prospects seemed dim indeed.

Tokugawa achievements: urbanization, road networks, rice cultivation, craft production

In answering this question, Mosk (2001), Minami (1994) and Ohkawa and Rosovsky (1973) emphasize the achievements of Tokugawa Japan (1600-1868) during a long period of “closed country” autarky between the mid-seventeenth century and the 1850s: a high level of urbanization; well developed road networks; the channeling of river water flow with embankments and the extensive elaboration of irrigation ditches that supported and encouraged the refinement of rice cultivation based upon improving seed varieties, fertilizers and planting methods especially in the Southwest with its relatively long growing season; the development of proto-industrial (craft) production by merchant houses in the major cities like Osaka and Edo (now called Tokyo) and its diffusion to rural areas after 1700; and the promotion of education and population control among both the military elite (the samurai) and the well-to-do peasantry in the eighteenth and early nineteenth centuries.

Tokugawa political economy: daimyo and shogun

These developments were inseparable from the political economy of Japan. The system of confederation government introduced at the end of the fifteenth century placed certain powers in the hands of feudal warlords, daimyo, and certain powers in the hands of the shogun, the most powerful of the warlords. Each daimyo — and the shogun — was assigned a geographic region, a domain, being given taxation authority over the peasants residing in the villages of the domain. Intercourse with foreign powers was monopolized by the shogun, thereby preventing daimyo from cementing alliances with other countries in an effort to overthrow the central government. The samurai military retainers of the daimyo were forced to abandon rice farming and reside in the castle town headquarters of their daimyo overlord. In exchange, samurai received rice stipends from the rice taxes collected from the villages of their domain. By removing samurai from the countryside — by demilitarizing rural areas — conflicts over local water rights were largely made a thing of the past. As a result irrigation ditches were extended throughout the valleys, and riverbanks were shored up with stone embankments, facilitating transport and preventing flooding.

The sustained growth of proto-industrialization in urban Japan, and its widespread diffusion to villages after 1700 was also inseparable from the productivity growth in paddy rice production and the growing of industrial crops like tea, fruit, mulberry plant growing (that sustained the raising of silk cocoons) and cotton. Indeed, Smith (1988) has given pride of place to these “domestic sources” of Japan’s future industrial success.

Readiness to emulate the West

As a result of these domestic advances, Japan was well positioned to take up the Western challenge. It harnessed its infrastructure, its high level of literacy, and its proto-industrial distribution networks to the task of emulating Western organizational forms and Western techniques in energy production, first and foremost enlisting inorganic energy sources like coal and the other fossil fuels to generate steam power. Having intensively developed the organic economy depending upon natural energy flows like wind, water and fire, Japanese were quite prepared to master inorganic production after the Black Ships of the Americans forced Japan to jettison its long-standing autarky.

From Balanced to Dualistic Growth, 1887-1938: Infrastructure and Manufacturing Expand

Fukoku Kyohei

After the Tokugawa government collapsed in 1868, a new Meiji government committed to the twin policies of fukoku kyohei (wealthy country/strong military) took up the challenge of renegotiating its treaties with the Western powers. It created infrastructure that facilitated industrialization. It built a modern navy and army that could keep the Western powers at bay and establish a protective buffer zone in North East Asia that eventually formed the basis for a burgeoning Japanese empire in Asia and the Pacific.

Central government reforms in education, finance and transportation

Jettisoning the confederation style government of the Tokugawa era, the new leaders of the new Meiji government fashioned a unitary state with powerful ministries consolidating authority in the capital, Tokyo. The freshly minted Ministry of Education promoted compulsory primary schooling for the masses and elite university education aimed at deepening engineering and scientific knowledge. The Ministry of Finance created the Bank of Japan in 1882, laying the foundations for a private banking system backed up a lender of last resort. The government began building a steam railroad trunk line girding the four major islands, encouraging private companies to participate in the project. In particular, the national government committed itself to constructing a Tokaido line connecting the Tokyo/Yokohama region to the Osaka/Kobe conurbation along the Pacific coastline of the main island of Honshu, and to creating deepwater harbors at Yokohama and Kobe that could accommodate deep-hulled steamships.

Not surprisingly, the merchants in Osaka, the merchant capital of Tokugawa Japan, already well versed in proto-industrial production, turned to harnessing steam and coal, investing heavily in integrated spinning and weaving steam-driven textile mills during the 1880s.

Diffusion of best-practice agriculture

At the same time, the abolition of the three hundred or so feudal fiefs that were the backbone of confederation style-Tokugawa rule and their consolidation into politically weak prefectures, under a strong national government that virtually monopolized taxation authority, gave a strong push to the diffusion of best practice agricultural technique. The nationwide diffusion of seed varieties developed in the Southwest fiefs of Tokugawa Japan spearheaded a substantial improvement in agricultural productivity especially in the Northeast. Simultaneously, expansion of agriculture using traditional Japanese technology agriculture and manufacturing using imported Western technology resulted.

Balanced growth

Growth at the close of the nineteenth century was balanced in the sense that traditional and modern technology using sectors grew at roughly equal rates, and labor — especially young girls recruited out of farm households to labor in the steam using textile mills — flowed back and forth between rural and urban Japan at wages that were roughly equal in industrial and agricultural pursuits.

Geographic economies of scale in the Tokaido belt

Concentration of industrial production first in Osaka and subsequently throughout the Tokaido belt fostered powerful geographic scale economies (the ability to reduce per unit costs as output levels increase), reducing the costs of securing energy, raw materials and access to global markets for enterprises located in the great harbor metropolises stretching from the massive Osaka/Kobe complex northward to the teeming Tokyo/Yokohama conurbation. Between 1904 and 1911, electrification mainly due to the proliferation of intercity electrical railroads created economies of scale in the nascent industrial belt facing outward onto the Pacific. The consolidation of two huge hydroelectric power grids during the 1920s — one servicing Tokyo/Yokohama, the other Osaka and Kobe — further solidified the comparative advantage of the Tokaido industrial belt in factory production. Finally, the widening and paving during the 1920s of roads that could handle buses and trucks was also pioneered by the great metropolises of the Tokaido, which further bolstered their relative advantage in per capita infrastructure.

Organizational economies of scale — zaibatsu

In addition to geographic scale economies, organizational scale economies also became increasingly important in the late nineteenth centuries. The formation of the zaibatsu (“financial cliques”), which gradually evolved into diversified industrial combines tied together through central holding companies, is a case in point. By the 1910s these had evolved into highly diversified combines, binding together enterprises in banking and insurance, trading companies, mining concerns, textiles, iron and steel plants, and machinery manufactures. By channeling profits from older industries into new lines of activity like electrical machinery manufacturing, the zaibatsu form of organization generated scale economies in finance, trade and manufacturing, drastically reducing information-gathering and transactions costs. By attracting relatively scare managerial and entrepreneurial talent, the zaibatsu format economized on human resources.

Electrification

The push into electrical machinery production during the 1920s had a revolutionary impact on manufacturing. Effective exploitation of steam power required the use of large central steam engines simultaneously driving a large number of machines — power looms and mules in a spinning/weaving plant for instance – throughout a factory. Small enterprises did not mechanize in the steam era. But with electrification the “unit drive” system of mechanization spread. Each machine could be powered up independently of one another. Mechanization spread rapidly to the smallest factory.

Emergence of the dualistic economy

With the drive into heavy industries — chemicals, iron and steel, machinery — the demand for skilled labor that would flexibly respond to rapid changes in technique soared. Large firms in these industries began offering premium wages and guarantees of employment in good times and bad as a way of motivating and holding onto valuable workers. A dualistic economy emerged during the 1910s. Small firms, light industry and agriculture offered relatively low wages. Large enterprises in the heavy industries offered much more favorable remuneration, extending paternalistic benefits like company housing and company welfare programs to their “internal labor markets.” As a result a widening gulf opened up between the great metropolitan centers of the Tokaido and rural Japan. Income per head was far higher in the great industrial centers than in the hinterland.

Clashing urban/rural and landlord/tenant interests

The economic strains of emergent dualism were amplified by the slowing down of technological progress in the agricultural sector, which had exhaustively reaped the benefits due to regional diffusion from the Southwest to the Northeast of best practice Tokugawa rice cultivation. Landlords — around 45% of the cultivable rice paddy land in Japan was held in some form of tenancy at the beginning of the twentieth century — who had played a crucial role in promoting the diffusion of traditional best practice techniques now lost interest in rural affairs and turned their attention to industrial activities. Tenants also found their interests disregarded by the national authorities in Tokyo, who were increasingly focused on supplying cheap foodstuffs to the burgeoning industrial belt by promoting agricultural production within the empire that it was assembling through military victories. Japan secured Taiwan from China in 1895, and formally brought Korea under its imperial rule in 1910 upon the heels of its successful war against Russia in 1904-05. Tenant unions reacted to this callous disrespect of their needs through violence. Landlord/tenant disputes broke out in the early 1920s, and continued to plague Japan politically throughout the 1930s, calls for land reform and bureaucratic proposals for reform being rejected by a Diet (Japan’s legislature) politically dominated by landlords.

Japan’s military expansion

Japan’s thrust to imperial expansion was inflamed by the growing instability of the geopolitical and international trade regime of the later 1920s and early 1930s. The relative decline of the United Kingdom as an economic power doomed a gold standard regime tied to the British pound. The United States was becoming a potential contender to the United Kingdom as the backer of a gold standard regime but its long history of high tariffs and isolationism deterred it from taking over leadership in promoting global trade openness. Germany and the Soviet Union were increasingly becoming industrial and military giants on the Eurasian land mass committed to ideologies hostile to the liberal democracy championed by the United Kingdom and the United States. It was against this international backdrop that Japan began aggressively staking out its claim to being the dominant military power in East Asia and the Pacific, thereby bringing it into conflict with the United States and the United Kingdom in the Asian and Pacific theaters after the world slipped into global warfare in 1939.

Reform and Reconstruction in a New International Economic Order, Japan after World War II

Postwar occupation: economic and institutional restructuring

Surrendering to the United States and its allies in 1945, Japan’s economy and infrastructure was revamped under the S.C.A.P (Supreme Commander of the Allied Powers) Occupation lasting through 1951. As Nakamura (1995) points out, a variety of Occupation-sponsored reforms transformed the institutional environment conditioning economic performance in Japan. The major zaibatsu were liquidated by the Holding Company Liquidation Commission set up under the Occupation (they were revamped as keiretsu corporate groups mainly tied together through cross-shareholding of stock in the aftermath of the Occupation); land reform wiped out landlordism and gave a strong push to agricultural productivity through mechanization of rice cultivation; and collective bargaining, largely illegal under the Peace Preservation Act that was used to suppress union organizing during the interwar period, was given the imprimatur of constitutional legality. Finally, education was opened up, partly through making middle school compulsory, partly through the creation of national universities in each of Japan’s forty-six prefectures.

Improvement in the social capability for economic growth

In short, from a domestic point of view, the social capability for importing and adapting foreign technology was improved with the reforms in education and the fillip to competition given by the dissolution of the zaibatsu. Resolving tension between rural and urban Japan through land reform and the establishment of a rice price support program — that guaranteed farmers incomes comparable to blue collar industrial workers — also contributed to the social capacity to absorb foreign technology by suppressing the political divisions between metropolitan and hinterland Japan that plagued the nation during the interwar years.

Japan and the postwar international order

The revamped international economic order contributed to the social capability of importing and adapting foreign technology. The instability of the 1920s and 1930s was replaced with a relatively predictable bipolar world in which the United States and the Soviet Union opposed each other in both geopolitical and ideological arenas. The United States became an architect of multilateral architecture designed to encourage trade through its sponsorship of the United Nations, the World Bank, the International Monetary Fund and the General Agreement on Tariffs and Trade (the predecessor to the World Trade Organization). Under the logic of building military alliances to contain Eurasian Communism, the United States brought Japan under its “nuclear umbrella” with a bilateral security treaty. American companies were encouraged to license technology to Japanese companies in the new international environment. Japan redirected its trade away from the areas that had been incorporated into the Japanese Empire before 1945, and towards the huge and expanding American market.

Miracle Growth: Soaring Domestic Investment and Export Growth, 1953-1970

Its infrastructure revitalized through the Occupation period reforms, its capacity to import and export enhanced by the new international economic order, and its access to American technology bolstered through its security pact with the United States, Japan experienced the dramatic “Miracle Growth” between 1953 and the early 1970s whose sources have been cogently analyzed by Denison and Chung (1976). Especially striking in the Miracle Growth period was the remarkable increase in the rate of domestic fixed capital formation, the rise in the investment proportion being matched by a rising savings rate whose secular increase — especially that of private household savings – has been well documented and analyzed by Horioka (1991). While Japan continued to close the gap in income per capita between itself and the United States after the early 1970s, most scholars believe that large Japanese manufacturing enterprises had by and large become internationally competitive by the early 1970s. In this sense it can be said that Japan had completed its nine decade long convergence to international competitiveness through industrialization by the early 1970s.

MITI

There is little doubt that the social capacity to import and adapt foreign technology was vastly improved in the aftermath of the Pacific War. Creating social consensus with Land Reform and agricultural subsidies reduced political divisiveness, extending compulsory education and breaking up the zaibatsu had a positive impact. Fashioning the Ministry of International Trade and Industry (M.I.T.I.) that took responsibility for overseeing industrial policy is also viewed as facilitating Japan’s social capability. There is no doubt that M.I.T.I. drove down the cost of securing foreign technology. By intervening between Japanese firms and foreign companies, it acted as a single buyer of technology, playing off competing American and European enterprises in order to reduce the royalties Japanese concerns had to pay on technology licenses. By keeping domestic patent periods short, M.I.T.I. encouraged rapid diffusion of technology. And in some cases — the experience of International Business Machines (I.B.M.), enjoying a virtual monopoly in global mainframe computer markets during the 1950s and early 1960s, is a classical case — M.I.T.I. made it a condition of entry into the Japanese market (through the creation of a subsidiary Japan I.B.M. in the case of I.B.M.) that foreign companies share many of their technological secrets with potential Japanese competitors.

How important industrial policy was for Miracle Growth remains controversial, however. The view of Johnson (1982), who hails industrial policy as a pillar of the Japanese Development State (government promoting economic growth through state policies) has been criticized and revised by subsequent scholars. The book by Uriu (1996) is a case in point.

Internal labor markets, just-in-time inventory and quality control circles

Furthering the internalization of labor markets — the premium wages and long-term employment guarantees largely restricted to white collar workers were extended to blue collar workers with the legalization of unions and collective bargaining after 1945 — also raised the social capability of adapting foreign technology. Internalizing labor created a highly flexible labor force in post-1950 Japan. As a result, Japanese workers embraced many of the key ideas of Just-in-Time inventory control and Quality Control circles in assembly industries, learning how to do rapid machine setups as part and parcel of an effort to produce components “just-in-time” and without defect. Ironically, the concepts of just-in-time and quality control were originally developed in the United States, just-in-time methods being pioneered by supermarkets and quality control by efficiency experts like W. Edwards Deming. Yet it was in Japan that these concepts were relentlessly pursued to revolutionize assembly line industries during the 1950s and 1960s.

Ultimate causes of the Japanese economic “miracle”

Miracle Growth was the completion of a protracted historical process involving enhancing human capital, massive accumulation of physical capital including infrastructure and private manufacturing capacity, the importation and adaptation of foreign technology, and the creation of scale economies, which took decades and decades to realize. Dubbed a miracle, it is best seen as the reaping of a bountiful harvest whose seeds were painstakingly planted in the six decades between 1880 and 1938. In the course of the nine decades between the 1880s and 1970, Japan amassed and lost a sprawling empire, reorienting its trade and geopolitical stance through the twists and turns of history. While the ultimate sources of growth can be ferreted out through some form of statistical accounting, the specific way these sources were marshaled in practice is inseparable from the history of Japan itself and of the global environment within which it has realized its industrial destiny.

Appendix: Sources of Growth Accounting and Quantitative Aspects of Japan’s Modern Economic Development

One of the attractions of studying Japan’s post-1880 economic development is the abundance of quantitative data documenting Japan’s growth. Estimates of Japanese income and output by sector, capital stock and labor force extend back to the 1880s, a period when Japanese income per capita was low. Consequently statistical probing of Japan’s long-run growth from relative poverty to abundance is possible.

The remainder of this appendix is devoted to introducing the reader to the vast literature on quantitative analysis of Japan’s economic development from the 1880s until 1970, a nine decade period during which Japanese income per capita converged towards income per capita levels in Western Europe. As the reader will see, this discussion confirms the importance of factors discussed at the outset of this article.

Our initial touchstone is the excellent “sources of growth” accounting analysis carried out by Denison and Chung (1976) on Japan’s growth between 1953 and 1971. Attributing growth in national income in growth of inputs, the factors of production — capital and labor — and growth in output per unit of the two inputs combined (total factor productivity) along the following lines:

G(Y) = { a G(K) + [1-a] G(L) } + G (A)

where G(Y) is the (annual) growth of national output, g(K) is the growth rate of capital services, G(L) is the growth rate of labor services, a is capital’s share in national income (the share of income accruing to owners of capital), and G(A) is the growth of total factor productivity, is a standard approach used to approximate the sources of growth of income.

Using a variant of this type of decomposition that takes into account improvements in the quality of capital and labor, estimates of scale economies and adjustments for structural change (shifting labor out of agriculture helps explain why total factor productivity grows), Denison and Chung (1976) generate a useful set of estimates for Japan’s Miracle Growth era.

Operating with this “sources of growth” approach and proceeding under a variety of plausible assumptions, Denison and Chung (1976) estimate that of Japan’s average annual real national income growth of 8.77 % over 1953-71, input growth accounted for 3.95% (accounting for 45% of total growth) and growth in output per unit of input contributed 4.82% (accounting for 55% of total growth). To be sure, the precise assumptions and techniques they use can be criticized. The precise numerical results they arrive at can be argued over. Still, their general point — that Japan’s growth was the result of improvements in the quality of factor inputs — health and education for workers, for instance — and improvements in the way these inputs are utilized in production — due to technological and organizational change, reallocation of resources from agriculture to non-agriculture, and scale economies, is defensible.

With this in mind consider Table 1.

Table 1: Industrialization and Economic Growth in Japan, 1880-1970:
Selected Quantitative Characteristics

Panel A: Income and Structure of National Output

Panel B: Domestic and External Sources of Aggregate Supply and Demand Growth: Manufacturing and Mining (Ma), Gross Domestic Fixed Capital Formation (GDFCF), and Trade (TR)

Panel C: Infrastructure and Human Development

Notes: [a] Maddison (2000) provides estimates of real income that take into account the purchasing power of national currencies.

[b] Ohkawa (1979) gives estimates for the “N” sector that is defined as manufacturing and mining (Ma) plus construction plus facilitating industry (transport, communications and utilities). It should be noted that the concept of an “N” sector is not standard in the field of economics.

[c] The estimates of trade are obtained by adding merchandise imports to merchandise exports. Trade openness is estimated by taking the ratio of total (merchandise) trade to national output, the latter defined as Gross Domestic Product (G.D.P.). The trade figures include trade with Japan’s empire (Korea, Taiwan, Manchuria, etc.); the income figures for Japan exclude income generated in the empire.

[d] The Human Development Index is a composite variable formed by adding together indices for educational attainment, for health (using life expectancy that is inversely related to the level of the infant mortality rate, the IMR), and for real per capita income. For a detailed discussion of this index see United Nations Development Programme (2000).

[e] Electrical generation is measured in million kilowatts generated and supplied. For 1970, the figures on NHK subscribers are for television subscribers. The symbol n.a. = not available.

Sources: The figures in this table are taken from various pages and tables in Japan Statistical Association (1987), Maddison (2000), Minami (1994), and Ohkawa (1979).

Flowing from this table are a number of points that bear lessons of the Denison and Chung (1976) decomposition. One cluster of points bears upon the timing of Japan’s income per capita growth and the relationship of manufacturing expansion to income growth. Another highlights improvements in the quality of the labor input. Yet another points to the overriding importance of domestic investment in manufacturing and the lesser significance of trade demand. A fourth group suggests that infrastructure has been important to economic growth and industrial expansion in Japan, as exemplified by the figures on electricity generating capacity and the mass diffusion of communications in the form of radio and television broadcasting.

Several parts of Table 1 point to industrialization, defined as an increase in the proportion of output (and labor force) attributable to manufacturing and mining, as the driving force in explaining Japan’s income per capita growth. Notable in Panels A and B of the table is that the gap between Japanese and American income per capita closed most decisively during the 1910s, the 1930s, and the 1960s, precisely the periods when manufacturing expansion was the most vigorous.

Equally noteworthy of the spurts of the 1910s, 1930s and the 1960s is the overriding importance of gross domestic fixed capital formation, that is investment, for growth in demand. By contrast, trade seems much less important to growth in demand during these critical decades, a point emphasized by both Minami (1994) and by Ohkawa and Rosovsky (1973). The notion that Japanese growth was “export led” during the nine decades between 1880 and 1970 when Japan caught up technologically with the leading Western nations is not defensible. Rather, domestic capital investment seems to be the driving force behind aggregate demand expansion. The periods of especially intense capital formation were also the periods when manufacturing production soared. Capital formation in manufacturing, or in infrastructure supporting manufacturing expansion, is the main agent pushing long-run income per capita growth.

Why? As Ohkawa and Rosovsky (1973) argue, spurts in manufacturing capital formation were associated with the import and adaptation of foreign technology, especially from the United States These investment spurts were also associated with shifts of labor force out of agriculture and into manufacturing, construction and facilitating sectors where labor productivity was far higher than it was in labor-intensive farming centered around labor-intensive rice cultivation. The logic of productivity gain due to more efficient allocation of labor resources is apparent from the right hand column of Panel A in Table 1.

Finally, Panel C of Table 1 suggests that infrastructure investment that facilitated health and educational attainment (combined public and private expenditure on sanitation, schools and research laboratories), and public/private investment in physical infrastructure including dams and hydroelectric power grids helped fuel the expansion of manufacturing by improving human capital and by reducing the costs of transportation, communications and energy supply faced by private factories. Mosk (2001) argues that investments in human-capital-enhancing (medicine, public health and education), financial (banking) and physical infrastructure (harbors, roads, power grids, railroads and communications) laid the groundwork for industrial expansions. Indeed, the “social capability for importing and adapting foreign technology” emphasized by Ohkawa and Rosovsky (1973) can be largely explained by an infrastructure-driven growth hypothesis like that given by Mosk (2001).

In sum, Denison and Chung (1976) argue that a combination of input factor improvement and growth in output per combined factor inputs account for Japan’s most rapid spurt of economic growth. Table 1 suggests that labor quality improved because health was enhanced and educational attainment increased; that investment in manufacturing was important not only because it increased capital stock itself but also because it reduced dependence on agriculture and went hand in glove with improvements in knowledge; and that the social capacity to absorb and adapt Western technology that fueled improvements in knowledge was associated with infrastructure investment.

References

Denison, Edward and William Chung. “Economic Growth and Its Sources.” In Asia’s Next Giant: How the Japanese Economy Works, edited by Hugh Patrick and Henry Rosovsky, 63-151. Washington, DC: Brookings Institution, 1976.

Horioka, Charles Y. “Future Trends in Japan’s Savings Rate and the Implications Thereof for Japan’s External Imbalance.” Japan and the World Economy 3 (1991): 307-330.

Japan Statistical Association. Historical Statistics of Japan [Five Volumes]. Tokyo: Japan Statistical Association, 1987.

Johnson, Chalmers. MITI and the Japanese Miracle: The Growth of Industrial Policy, 1925-1975. Stanford: Stanford University Press, 1982.

Maddison, Angus. Monitoring the World Economy, 1820-1992. Paris: Organization for Economic Co-operation and Development, 2000.

Minami, Ryoshin. Economic Development of Japan: A Quantitative Study. [Second edition]. Houndmills, Basingstoke, Hampshire: Macmillan Press, 1994.

Mitchell, Brian. International Historical Statistics: Africa and Asia. New York: New York University Press, 1982.

Mosk, Carl. Japanese Industrial History: Technology, Urbanization, and Economic Growth. Armonk, New York: M.E. Sharpe, 2001.

Nakamura, Takafusa. The Postwar Japanese Economy: Its Development and Structure, 1937-1994. Tokyo: University of Tokyo Press, 1995.

Ohkawa, Kazushi. “Production Structure.” In Patterns of Japanese Economic Development: A Quantitative Appraisal, edited by Kazushi Ohkawa and Miyohei Shinohara with Larry Meissner, 34-58. New Haven: Yale University Press, 1979.

Ohkawa, Kazushi and Henry Rosovsky. Japanese Economic Growth: Trend Acceleration in the Twentieth Century. Stanford, CA: Stanford University Press, 1973.

Smith, Thomas. Native Sources of Japanese Industrialization, 1750-1920. Berkeley: University of California Press, 1988.

Uriu, Robert. Troubled Industries: Confronting Economic Challenge in Japan. Ithaca: Cornell University Press, 1996.

United Nations Development Programme. Human Development Report, 2000. New York: Oxford University Press, 2000.

M. Umer Chapra, Islamic Research and Training Institute

Islamic economics has been having a revival over the last few decades. However, it is still in a preliminary stage of development. In contrast with this, conventional economics has become a well-developed and sophisticated discipline after going through a long and rigorous process of development over more than a century. Is a new discipline in economics needed? If so, what is Islamic economics, how does it differ from conventional economics, and what contributions has it made over the centuries? This article tries to briefly answer these questions.

It is universally recognized that resources are scarce compared with the claims on them. However, it is also simultaneously recognized by practically all civilizations that the well-being of all human beings needs to be ensured. Given the scarcity of resources, the well-being of all may remain an unrealized dream if the scarce resources are not utilized efficiently and equitably. For this purpose, every society needs to develop an effective strategy, which is consciously or unconsciously conditioned by its worldview. If the worldview is flawed, the strategy may not be able to help the society actualize the well-being of all. Prevailing worldviews may be classified for the sake of ease into two board theoretical constructs (1) secular and materialist, and (2) spiritual and humanitarian.

The Role of the Worldview

Secular and materialist worldviews attach maximum importance to the material aspect of human well-being and tend generally to ignore the importance of the spiritual aspect. They often argue that maximum material well-being can be best realized if individuals are given unhindered freedom to pursue their self-interest and to maximize their want satisfaction in keeping with their own tastes and preferences.[1] In their extreme form they do not recognize any role for Divine guidance in human life and place full trust in the ability of human beings to chalk out a proper strategy with the help of their reason. In such a worldview there is little role for values or government intervention in the efficient and equitable allocation and distribution of resources. When asked about how social interest would be served when everyone has unlimited freedom to pursue his/her self-interest, the reply is that market forces will themselves ensure this because competition will keep self-interest under check.

In contrast with this, religious worldviews give attention to both the material as well as the spiritual aspects of human well-being. They do not necessarily reject the role of reason in human development. They, however, recognize the limitations of reason and wish to complement it by revelation. They do not also reject the need for individual freedom or the role that the serving of self-interest can play in human development They, however, emphasize that both freedom and the pursuit of self-interest need to be toned down by moral values and good governance to ensure that everyone’s well-being is realized and that social harmony and family integrity are not hurt in the process of everyone serving his/her self-interest.

Material and Spiritual Needs

Even though none of the major worldviews prevailing around the world is totally materialist and hedonist, there are, nevertheless, significant differences among them in terms of the emphasis they place on material or spiritual goals and the role of moral values and government intervention in ordering human affairs. While material goals concentrate primarily on goods and services that contribute to physical comfort and well-being, spiritual goals include nearness to God, peace of mind, inner happiness, honesty, justice, mutual care and cooperation, family and social harmony, and the absence of crime and anomie. These may not be quantifiable, but are, nevertheless, crucial for realizing human well-being. Resources being limited, excessive emphasis on the material ingredients of well-being may lead to a neglect of spiritual ingredients. The greater the difference in emphasis, the greater may be the difference in the economic disciplines of these societies. Feyerabend (1993) frankly recognized this in the introduction to the Chinese edition of his thought-provoking book, Against Method, by stating that “First world science is only one science among many; by claiming to be more it ceases to be an instrument of research and turns into a (political) pressure group” (p.3, parentheses are in the original).

The Enlightenment Worldview and Conventional Economics

There is a great deal that is common between the worldviews of most major religions, particularly those of Judaism, Christianity and Islam. This is because, according to Islam, there is a continuity and similarity in the value systems of all Revealed religions to the extent to which the Message has not been lost or distorted over the ages. The Qur’an clearly states that: “Nothing has been said to you [Muhammad] that was not said to the Messengers before you” (Al-Qur’an, 41:43). If conventional economics had continued to develop in the image of the Judeo-Christian worldview, as it did before the Enlightenment Movement of the seventeenth and eighteenth centuries, there may not have been any significant difference between conventional and Islamic economics. However, after the Enlightenment Movement, all intellectual disciplines in Europe became influenced by its secular, value-neutral, materialist and social-Darwinist worldview, even though this did not succeed fully. All economists did not necessarily become materialist or social-Darwinist in their individual lives and many of them continued to be attached to their religious worldviews. Koopmans (1969) has rightly observed that “scratch an economist and you will find a moralist underneath.” Therefore, while theoretically conventional economics adopted the secular and value neutral orientation of the Enlightenment worldview and failed to recognize the role of value judgments and good governance in the efficient and equitable allocation and distribution of resources, in practice this did not take place fully. The pre-Enlightenment tradition never disappeared completely (see Baeck, 1994, p. 11).

There is no doubt that, in spite of its secular and materialist worldview, the market system led to a long period of prosperity in the Western market-oriented economies. However, this unprecedented prosperity did not lead to the elimination of poverty or the fulfillment of everyone’s needs in conformity with the Judeo-Christian value system even in the wealthiest countries. Inequalities of income and wealth have also continued to persist and there has also been a substantial degree of economic instability and unemployment which have added to the miseries of the poor. This indicates that both efficiency and equity have remained elusive in spite of rapid development and phenomenal rise in wealth.

Consequently there has been persistent criticism of economics by a number of well-meaning scholars, including Thomas Carlyle (Past and Present, 1843), John Ruskin (Unto this Last, 1862) and Charles Dickens (Hard Times, 1854-55) in England, and Henry George (Progress and Poverty, 1879) in America. They ridiculed the dominant doctrine of laissez-faire with its emphasis on self-interest. Thomas Carlyle called economics a “dismal science” and rejected the idea that free and uncontrolled private interests will work in harmony and further the public welfare (see Jay and Jay, 1986). Henry George condemned the resulting contrast between wealth and poverty and wrote: “So long as all the increased wealth which modern progress brings goes but to build great fortunes, to increase luxury and make sharper the contrast between the House of Have and the House of Want, progress is not real and cannot be permanent” (1955, p. 10).

In addition to failing to fulfill the basic needs of a large number of people and increasing inequalities of income and wealth, modern economic development has been associated with the disintegration of the family and a failure to bring peace of mind and inner happiness (Easterlin 2001, 1995 and 1974; Oswald, 1997; Blanchflower and Oswald, 2000; Diener and Oshi, 2000; and Kenny, 1999). Due to these problems and others the laissez-faire approach lost ground, particularly after the Great Depression of the 1930s as a result of the Keynesian revolution and the socialist onslaught. However, most observers have concluded that government intervention alone cannot by itself remove all socio-economic ills. It is also necessary to motivate individuals to do what is right and abstain from doing what is wrong. This is where the moral uplift of society can be helpful. Without it, more and more difficult and costly regulations are needed. Nobel-laureate Amartya Sen has, therefore, rightly argued that “the distancing of economics from ethics has impoverished welfare economics and also weakened the basis of a good deal of descriptive and predictive economics” and that economics “can be made more productive by paying greater and more explicit attention to ethical considerations that shaped human behaviour and judgment” (1987, pp. 78-79). Hausman and McPherson also conclude in their survey article “Economics and Contemporary Moral Philosophy” that “An economy that is engaged actively and self-critically with the moral aspects of its subject matter cannot help but be more interesting, more illuminating and, ultimately, more useful than the one that tries not to be” (1993, p. 723).

Islamic Economics – and How It Differs from Conventional Economics

While conventional economics is now in the process of returning to its pre-Enlightenment roots, Islamic economics never got entangled in a secular and materialist worldview. It is based on a religious worldview which strikes at the roots of secularism and value neutrality. To ensure the true well-being of all individuals, irrespective of their sex, age, race, religion or wealth, Islamic economics does not seek to abolish private property, as was done by communism, nor does it prevent individuals from serving their self-interest. It recognizes the role of the market in the efficient allocation of resources, but does not find competition to be sufficient to safeguard social interest. It tries to promote human brotherhood, socio-economic justice and the well-being of all through an integrated role of moral values, market mechanism, families, society, and ‘good governance.’ This is because of the great emphasis in Islam on human brotherhood and socio-economic justice.

The Integrated Role of the Market, Families, Society, and Government

The market is not the only institution where people interact in human society. They also interact in the family, the society and the government and their interaction in all these institutions is closely interrelated. There is no doubt that the serving of self-interest does help raise efficiency in the market place. However, if self-interest is overemphasized and there are no moral restraints on individual behavior, other institutions may not work effectively – families may disintegrate, the society may be uncaring, and the government may be corrupt, partisan, and self-centered. Mutual sacrifice is necessary for keeping the families glued together. Since the human being is the most important input of not only the market, but also of the family, the society and the government, and the family is the source of this input, nothing may work if families disintegrate and are unable to provide loving care to children. This is likely to happen if both the husband and wife try to serve just their own self-interest and are not attuned to the making of sacrifices that the proper care and upbringing of children demands. Lack of willingness to make such sacrifice can lead to a decline in the quality of the human input to all other institutions, including the market, the society and the government. It may also lead to a fall in fertility rates below the replacement level, making it difficult for society not only to sustain its development but also its social security system.

The Role of Moral Values

While conventional economics generally considers the behavior and tastes and preferences of individuals as given, Islamic economics does not do so. It places great emphasis on individual and social reform through moral uplift. This is the purpose for which all God’s messengers, including Abraham, Moses, Jesus, and Muhammad, came to this world. Moral uplift aims at the change in human behavior, tastes and preferences and, thereby, it complements the price mechanism in promoting general well-being. Before even entering the market place and being exposed to the price filter, consumers are expected to pass their claims through the moral filter. This will help filter out conspicuous consumption and all wasteful and unnecessary claims on resources. The price mechanism can then take over and reduce the claims on resources even further to lead to the market equilibrium. The two filters can together make it possible to have optimum economy in the use of resources, which is necessary to satisfy the material as well as spiritual needs of all human beings, to reduce the concentration of wealth in a few hands, and to raise savings, which are needed to promote greater investment and employment. Without complementing the market system with morally-based value judgments, we may end up perpetuating inequities in spite of our good intentions through what Solo calls inaction, non-choice and drifting (Solo, 1981, p. 38)

From the above discussion, one may easily notice the similarities and differences between the two disciplines. While the subject matter of both is the allocation and distribution of resources and both emphasize the fulfillment of material needs, there is an equal emphasis in Islamic economics on the fulfillment of spiritual needs. While both recognize the important role of market mechanism in the allocation and distribution of resources, Islamic economics argues that the market may not by itself be able to fulfill even the material needs of all human beings. This is because it can promote excessive use of scarce resources by the rich at the expense of the poor if there is undue emphasis on the serving of self-interest. Sacrifice is involved in fulfilling our obligations towards others and excessive emphasis on the serving of self-interest does not have the potential of motivating people to make the needed sacrifice. This, however, raises the crucial question of why a rational person would sacrifice his self-interest for the sake of others?

The Importance of the Hereafter

This is where the concepts of the innate goodness of human beings and of the Hereafter come in – concepts which conventional economics ignores but on which Islam and other major religions place a great deal of emphasis. Because of their innate goodness, human beings do not necessarily always try to serve their self-interest. They are also altruistic and are willing to make sacrifices for the well-being of others. In addition, the concept of the Hereafter does not confine self-interest to just this world. It rather extends it beyond this world to life after death. We may be able to serve our self-interest in this world by being selfish, dishonest, uncaring, and negligent of our obligations towards our families, other human beings, animals, and the environment. However, we cannot serve our self-interest in the Hereafter except by fulfilling all these obligations.

Thus, the serving of self-interest receives a long-run perspective in Islam and other religions by taking into account both this world and the next. This serves to provide a motivating mechanism for sacrifice for the well-being of others that conventional economics fails to provide. The innate goodness of human beings along with the long-run perspective given to self-interest has the potential of inducing a person to be not only efficient but also equitable and caring. Consequently, the three crucial concepts of conventional economics – rational economic man, positivism, and laissez-faire – were not able to gain intellectual blessing in their conventional economics sense from any of the outstanding scholars who represent the mainstream of Islamic thought.

Rational Economic Man

While there is hardly anyone opposed to the need for rationality in human behavior, there are differences of opinion in defining rationality (Sen, 1987, pp. 11-14). However, once rationality has been defined in terms of overall individual as well as social well-being, then rational behavior could only be that which helps us realize this goal. Conventional economics does not define rationality in this way. It equates rationality with the serving of self-interest through the maximization of wealth and want satisfaction, The drive of self-interest is considered to be the “moral equivalent of the force of gravity in nature” (Myers, 1983, p. 4). Within this framework society is conceptualized as a mere collection of individuals united through ties of self-interest.

The concept of ‘rational economic man’ in this social-Darwinist, utilitarian, and material sense of serving self–interest could not find a foothold in Islamic economics. ‘Rationality’ in Islamic economics does not get confined to the serving of one’s self-interest in this world alone; it also gets extended to the Hereafter through the faithful compliance with moral values that help rein self-interest to promote social interest. Al-Mawardi (d. 1058) considered it necessary, like all other Muslim scholars, to rein individual tastes and preferences through moral values (1955, pp. 118-20). Ibn Khaldun (d.1406) emphasized that moral orientation helps remove mutual rivalry and envy, strengthens social solidarity, and creates an inclination towards righteousness (n.d., p.158).

Positivism

Similarly, positivism in the conventional economics sense of being “entirely neutral between ends” (Robbins, 1935, p. 240) or “independent of any particular ethical position or normative judgment” (Friedman, 1953) did not find a place in Muslim intellectual thinking. Since all resources at the disposal of human beings are a trust from God, and human beings are accountable before Him, there is no other option but to use them in keeping with the terms of trust. These terms are defined by beliefs and moral values. Human brotherhood, one of the central objectives of Islam, would be a meaningless jargon if it were not reinforced by justice in the allocation and distribution of resources.

Pareto Optimum

Without justice, it would be difficult to realize even development. Muslim scholars have emphasized this throughout history. Development Economics has also started emphasizing its importance, more so in the last few decades.[2] Abu Yusuf (d. 798) argued that: “Rendering justice to those wronged and eradicating injustice, raises tax revenue, accelerates development of the country, and brings blessings in addition to reward in the Hereafter” (1933/34, p. 111: see also pp. 3-17). Al-Mawardi argued that comprehensive justice “inculcates mutual love and affection, obedience to the law, development of the country, expansion of wealth, growth of progeny, and security of the sovereign” (1955, p. 27). Ibn Taymiyyah (d. 1328) emphasized that “justice towards everything and everyone is an imperative for everyone, and injustice is prohibited to everything and everyone. Injustice is absolutely not permissible irrespective of whether it is to a Muslim or a non-Muslim or even to an unjust person” (1961-63, Vol. 18, p. 166).

Justice and the well-being of all may be difficult to realize without a sacrifice on the part of the well-to-do. The concept of Pareto optimum does not, therefore, fit into the paradigm of Islamic economics. This is because Pareto optimum does not recognize any solution as optimum if it requires a sacrifice on the part of a few (rich) for raising the well-being of the many (poor). Such a position is in clear conflict with moral values, the raison d’être of which is the well-being of all. Hence, this concept did not arise in Islamic economics. In fact, Islam makes it a religious obligation of Muslims to make a sacrifice for the poor and the needy, by paying Zakat at the rate of 2.5 percent of their net worth. This is in addition to the taxes that they pay to the governments as in other countries.

The Role of State

Moral values may not be effective if they are not observed by all. They need to be enforced. It is the duty of the state to restrain all socially harmful behavior[3] including injustice, fraud, cheating, transgression against other people’s person, honor and property, and the non-fulfillment of contracts and other obligations through proper upbringing, incentives and deterrents, appropriate regulations, and an effective and impartial judiciary. The Qur’an can only provide norms. It cannot by itself enforce them. The state has to ensure this. That is why the Prophet Muhammad said: “God restrains through the sovereign more than what He restrains through the Qur’an” (cited by al-Mawardi, 1955, p. 121). This emphasis on the role of the state has been reflected in the writings of all leading Muslim scholars throughout history.[4] Al-Mawardi emphasized that an effective government (Sultan Qahir) is indispensable for preventing injustice and wrongdoing (1960, p. 5). Say’s Law could not, therefore, become a meaningful proposition in Islamic economics.

How far is the state expected to go in the fulfillment of its role? What is it that the state is expected to do? This has been spelled out by a number of scholars in the literature on what has come to be termed as “Mirrors for Princes.”[5] None of them visualized regimentation or the owning and operating of a substantial part of the economy by the state. Several classical Muslim scholars, including al-Dimashqi (d. after 1175) and Ibn Khaldun, clearly expressed their disapproval of the state becoming directly involved in the economy (Al-Dimashqi, 1977, pp. 12 and 61; Ibn Khaldun, pp. 281-83). According to Ibn Khaldun, the state should not acquire the character of a monolithic or despotic state resorting to a high degree of regimentation (ibid., p. 188). It should not feel that, because it has authority, it can do anything it likes (ibid, p. 306). It should be welfare-oriented, moderate in its spending, respect the property rights of the people, and avoid onerous taxation (ibid, p. 296). This implies that what these scholars visualized as the role of government is what has now been generally referred to as ‘good governance’.

Some of the Contributions Made by Islamic Economics

The above discussion should not lead one to an impression that the two disciplines are entirely different. One of the reasons for this is that the subject matter of both disciplines is the same, allocation and distribution of scarce resources. Another reason is that all conventional economists have never been value neutral. They have made value judgments in conformity with their beliefs. As indicated earlier, even the paradigm of conventional economics has been changing – the role of good governance has now become well recognized and the injection of a moral dimension has also become emphasized by a number of prominent economists. Moreover, Islamic economists have benefited a great deal from the tools of analysis developed by neoclassical, Keynesian, social, humanistic and institutional economics as well as other social sciences, and will continue to do so in the future.

The Fallacy of the ‘Great Gap’ Theory

A number of economic concepts developed in Islamic economics long before they did in conventional economics. These cover a number of areas including interdisciplinary approach; property rights; division of labor and specialization; the importance of saving and investment for development; the role that both demand and supply play in the determination of prices and the factors that influence demand and supply; the roles of money, exchange, and the market mechanism; characteristics of money, counterfeiting, currency debasement, and Gresham’s law; the development of checks, letters of credit and banking; labor supply and population; the role of the state, justice, peace, and stability in development; and principles of taxation.I t is not possible to provide comprehensive coverage of all the contributions Muslim scholars have made to economics. Only some of their contributions will be highlighted below to remove the concept of the “Great Gap” of “over 500 years” that exists in the history of conventional economic thought as a result of the incorrect conclusion by Joseph Schumpeter in History of Economic Analysis (1954), that the intervening period between the Greeks and the Scholastics was sterile and unproductive.[6] This concept has become well embedded in the conventional economics literature as may be seen from the reference to this even by the Nobel-laureate, Douglass North, in his December 1993 Nobel lecture (1994, p. 365). Consequently, as Todd Lowry has rightly observed, “the character and sophistication of Arabian writings has been ignored” (See his ‘Foreword’ in Ghazanfar, 2003, p. xi).

The reality, however, is that the Muslim civilization, which benefited greatly from the Chinese, Indian, Sassanian and Byzantine civilizations, itself made rich contributions to intellectual activity, including socio-economic thought, during the ‘Great Gap’ period, and thereby played a part in kindling the flame of the European Enlightenment Movement. Even the Scholastics themselves were greatly influenced by the contributions made by Muslim scholars. The names of Ibn Sina (Avicenna, d. 1037), Ibn Rushd (Averroes, d. 1198) and Maimonides (d. 1204, a Jewish philosopher, scientist, and physician who flourished in Muslim Spain) appear on almost every page of the thirteenth-century summa (treatises written by scholastic philosophers) (Pifer, 1978, p. 356).

Multidisciplinary Approach for Development

One of the most important contributions of Islamic economics, in addition to the above paradigm discussion, was the adoption of a multidisciplinary dynamic approach. Muslim scholars did not focus their attention primarily on economic variables. They considered overall human well-being to be the end product of interaction over a long period of time between a number of economic, moral, social, political, demographic and historical factors in such a way that none of them is able to make an optimum contribution without the support of the others. Justice occupied a pivotal place in this whole framework because of its crucial importance in the Islamic worldview There was an acute realization that justice is indispensable for development and that, in the absence of justice, there will be decline and disintegration.

The contributions made by different scholars over the centuries seem to have reached their consummation in Ibn Khaldun’s Maquddimah, which literally means ‘introduction,’ and constitutes the first volume of a seven-volume history, briefly called Kitab al-‘Ibar or the Book of Lessons [of History].[7] Ibn Khaldun lived at a time (1332-1406) when the Muslim civilization was in the process of decline. He wished to see a reversal of this tide, and, as a social scientist, he was well aware that such a reversal could not be envisaged without first drawing lessons (‘ibar) from history to determine the factors that had led the Muslim civilization to bloom out of humble beginnings and to decline thereafter. He was, therefore, not interested in knowing just what happened. He wanted to know the how and why of what happened. He wanted to introduce a cause and effect relationship into the discussion of historical phenomena. The Muqaddimah is the result of this desire. It tries to derive the principles that govern the rise and fall of a ruling dynasty, state (dawlah) or civilization (‘umran).

Since the centre of Ibn Khaldun’s analysis is the human being, he sees the rise and fall of dynasties or civilizations to be closely dependent on the well-being or misery of the people. The well-being of the people is in turn not dependent just on economic variables, as conventional economics has emphasized until recently, but also on the closely interrelated role of moral, psychological, social, economic, political, demographic and historical factors. One of these factors acts as the trigger mechanism. The others may, or may not, react in the same way. If the others do not react in the same direction, then the decay in one sector may not spread to the others and either the decaying sector may be reformed or the decline of the civilization may be much slower. If, however, the other sectors react in the same direction as the trigger mechanism, the decay will gain momentum through an interrelated chain reaction such that it becomes difficult over time to identify the cause from the effect. He, thus, seems to have had a clear vision of how all the different factors operate in an interrelated and dynamic manner over a long period to promote the development or decline of a society.

He did not, thus, adopt the neoclassical economist’s simplification of confining himself to primarily short-term static analysis of only markets by assuming unrealistically that all other factors remain constant. Even in the short-run, everything may be in a state of flux through a chain reaction to the various changes constantly taking place in human society, even though these may be so small as to be imperceptible. Therefore, even though economists may adopt the ceteris paribus assumption for ease of analysis, Ibn Khaldun’s multidisciplinary dynamics can be more helpful in formulating socio-economic policies that help improve the overall performance of a society. Neoclassical economics is unable to do this because, as North has rightly asked, “How can one prescribe policies when one does not understand how economies develop?” He, therefore, considers neoclassical economics to be “an inappropriate tool to analyze and prescribe policies that will induce development” (North, 1994, p. 549).

However, this is not all that Islamic economics has done. Muslim scholars, including Abu Yusuf (d. 798), al-Mawardi (d. 1058), Ibn Hazm (d. 1064), al-Sarakhsi (d. 1090), al-Tusi (d. 1093), al-Ghazali (d. 1111), al-Dimashqi (d. after 1175), Ibn Rushd (d. 1187), Ibn Taymiyyah (d.1328), Ibn al-Ukhuwwah (d. 1329), Ibn al-Qayyim (d. 1350), al-Shatibi (d. 1388), Ibn Khaldun (d. 1406), al-Maqrizi (d. 1442), al-Dawwani (d. 1501), and Shah Waliyullah (d. 1762) made a number of valuable contributions to economic theory. Their insight into some economic concepts was so deep that a number of the theories propounded by them could undoubtedly be considered the forerunners of some more sophisticated modern formulations of these theories.[8]

Division of Labor, Specialization, Trade, Exchange and Money and Banking

A number of scholars emphasized the necessity of division of labor for economic development long before this happened in conventional economics. For example, al-Sarakhsi (d. 1090) said: “the farmer needs the work of the weaver to get clothing for himself, and the weaver needs the work of the farmer to get his food and the cotton from which the cloth is made …, and thus everyone of them helps the other by his work…” (1978, Vol. 30, p. 264). Al-Dimashqi, writing about a century later, elaborates further by saying: “No individual can, because of the shortness of his life span, burden himself with all industries. If he does, he may not be able to master the skills of all of them from the first to the last. Industries are all interdependent. Construction needs the carpenter and the carpenter needs the ironsmith and the ironsmith needs the miner, and all these industries need premises. People are, therefore, necessitated by force of circumstances to be clustered in cities to help each other in fulfilling their mutual needs” (1977, p. 20-21).

Ibn Khaldun ruled out the feasibility or desirability of self-sufficiency, and emphasized the need for division of labor and specialization by indicating that: “It is well-known and well-established that individual human beings are not by themselves capable of satisfying all their individual economic needs. They must all cooperate for this purpose. The needs that can be satisfied by a group of them through mutual cooperation are many times greater than what individuals are capable of satisfying by themselves” (p. 360). In this respect he was perhaps the forerunner of the theory of comparative advantage, the credit for which is generally given in conventional economics to David Ricardo who formulated it in 1817.

The discussion of division of labor and specialization, in turn, led to an emphasis on trade and exchange, the existence of well-regulated and properly functioning markets through their effective regulation and supervision (hisbah), and money as a stable and reliable measure, medium of exchange and store of value. However, because of bimetallism (gold and silver coins circulating together) which then prevailed, and the different supply and demand conditions that the two metals faced, the rate of exchange between the two full-bodied coins fluctuated. This was further complicated by debasement of currencies by governments in the later centuries to tide over their fiscal problems. This had, according to Ibn Taymiyyah (d. 1328) (1961-63, Vol. 29, p. 649), and later on al-Maqrizi (d. 1442) and al-Asadi (d. 1450), the effect of bad coins driving good coins out of circulation (al-Misri, 1981, pp. 54 and 66), a phenomenon which was recognized and referred to in the West in the sixteenth century as Gresham’s Law. Since debasement of currencies is in sheer violation of the Islamic emphasis on honesty and integrity in all measures of value, fraudulent practices in the issue of coins in the fourteenth century and afterwards elicited a great deal of literature on monetary theory and policy. The Muslims, according to Baeck, should, therefore, be considered forerunners and critical incubators of the debasement literature of the fourteenth and fifteenth centuries (Baeck, 1994, p. 114).

To finance their expanding domestic and international trade, the Muslim world also developed a financial system, which was able to mobilize the “entire reservoir of monetary resources of the mediaeval Islamic world” for financing agriculture, crafts, manufacturing and long-distance trade (Udovitch, 1970, pp. 180 and 261). Financiers were known as sarrafs. By the time of Abbasid Caliph al-Muqtadir (908-32), they had started performing most of the basic functions of modern banks (Fischel, 1992). They had their markets, something akin to the Wall Street in New York and Lombard Street in London, and fulfilled all the banking needs of commerce, agriculture and industry (Duri, 1986, p. 898). This promoted the use of checks (sakk) and letters of credit (hawala). The English word check comes from the Arabic term sakk.

Demand and Supply

A number of Muslim scholars seem to have clearly understood the role of both demand and supply in the determination of prices. For example, Ibn Taymiyyah (d. 1328) wrote: “The rise or fall of prices may not necessarily be due to injustice by some people. They may also be due to the shortage of output or the import of commodities in demand. If the demand for a commodity increases and the supply of what is demanded declines, the price rises. If, however, the demand falls and the supply increases, the price falls” (1961-3, Vol. 8, p. 523).

Even before Ibn Taymiyyah, al-Jahiz (d. 869) wrote nearly five centuries earlier that: “Anything available in the market is cheap because of its availability [supply] and dear by its lack of availability if there is need [demand] for it” (1983, p. 13), and that “anything the supply of which increases, becomes cheap except intelligence, which becomes dearer when it increases” (ibid., p. 13).

Ibn Khaldun went even further by emphasizing that both an increase in demand or a fall in supply leads to a rise in prices, while a decline in demand or a rise in supply contributes to a fall in prices (pp. 393 and 396). He believed that while continuation of ‘excessively low’ prices hurts the craftsmen and traders and drives them out of the market, the continuation of ‘excessively high’ prices hurts the consumers. ‘Moderate’ prices in between the two extremes were, therefore, desirable, because they would not only allow the traders a socially-acceptable level of return but also lead to the clearance of the markets by promoting sales and thereby generating a given turnover and prosperity (ibid, p. 398). Nevertheless, low prices were desirable for necessities because they provide relief to the poor who constitute the majority of the population (ibid, p. 398). If one were to use modem terminology, one could say that Ibn Khaldun found a stable price level with a relatively low cost of living to be preferable, from the point of view of both growth and equity in comparison with bouts of inflation and deflation. The former hurts equity while the latter reduces incentive and efficiency. Low prices for necessities should not, however, be attained through the fixing of prices by the state; this destroys the incentive for production (ibid, pp. 279-83).

The factors which determined demand were, according to Ibn Khaldun, income, price level, the size of the population, government spending, the habits and customs of the people, and the general development and prosperity of the society (ibid, pp.398-404). The factors which determined supply were demand (ibid, pp. 400 and 403), order and stability (pp. 306-08), the relative rate of profit (ibid, pp. 395 and 398), the extent of human effort (p. 381), the size of the labor force as well as their knowledge and skill (pp. 363 and 399-400), peace and security (pp. 394-95 and 396), and the technical background and development of the whole society (pp. 399-403). All these constituted important elements of his theory of production. If the price falls and leads to a loss, capital is eroded, the incentive to supply declines, leading to a recession. Trade and crafts also consequently suffer (p. 398).

This is highly significant because the role of both demand and supply in the determination of value was not well understood in the West until the late nineteenth and the early twentieth centuries. Pre-classical English economists like William Petty (1623-87), Richard Cantillon (1680-1734), James Steuart (1712-80), and even Adam Smith (1723-90), the founder of the Classical School, generally stressed only the role of the cost of production, and particularly of labor, in the determination of value. The first use in English writings of the notions of both demand and supply was perhaps in 1767 (Thweatt, 1983). Nevertheless, it was not until the second decade of the nineteenth century that the role of both demand and supply in the determination of market prices began to be fully appreciated (Groenewegen, 1973). While Ibn Khaldun had been way ahead of conventional economists, he probably did not have any idea of demand and supply schedules, elasticities of demand and supply and most important of all, equilibrium price, which plays a crucial role in modern economic discussions.

Public Finance

Taxation

Long before Adam Smith (d. 1790), who is famous, among other things, for his canons of taxation (equality, certainty, convenience of payment, and economy in collection) (see Smith, 1937, pp. 777-79), the development of these canons can be traced in the writings of pre-Islamic as well as Muslim scholars, particularly the need for the tax system to be just and not oppressive. Caliphs Umar (d. 644), Ali (d. 661) and Umar ibn Abd al-Aziz (d. 720), stressed that taxes should be collected with justice and leniency and should not be beyond the ability of the people to bear. Tax collectors should not under any circumstances deprive the people of the necessities of life (Abu Yusuf, 1933/34, pp. 14, 16 and 86). Abu Yusuf, adviser to Caliph Harun al-Rashid (786-809), argued that a just tax system would lead not only to an increase in revenues but also to the development of the country (Abu Yusuf, 1933/34, p. 111; see also pp. 14, 16, 60, 85, 105-19 and 125). Al-Mawardi also argued that the tax system should do justice to both the taxpayer and the treasury – “taking more was iniquitous with respect to the rights of the people, while taking less was unfair with respect to the right of the public treasury” (1960, p. 209; see also pp. 142-56 and 215).[9]

Ibn Khaldun stressed the principles of taxation very forcefully in the Muqaddimah. He quoted from a letter written by Tahir ibn al-Husayn, Caliph al-Ma’mun’s general, advising his son, ‘Abdullah ibn Tahir, Governor of al-Raqqah (Syria): “So distribute [taxes] among all people making them general, not exempting anyone because of his nobility or wealth and not exempting even your own officials or courtiers or followers. And do not levy on anyone a tax which is beyond his capacity to pay” (p. 308).[10] In this particular passage, he stressed the principles of equity and neutrality, while in other places he also stressed the principles of convenience and productivity.

The effect of taxation on incentives and productivity was so clearly visualized by Ibn Khaldun that he seems to have grasped the concept of optimum taxation. He anticipated the gist of the Laffer Curve, nearly six hundred years before Arthur Laffer, in two full chapters of the Muqaddimah.[11] At the end of the first chapter, he concluded that “the most important factor making for business prosperity is to lighten as much as possible the burden of taxation on businessmen, in order to encourage enterprise by ensuring greater profits [after taxes]” (p. 280). This he explained by stating that “when taxes and imposts are light, the people have the incentive to be more active. Business therefore expands, bringing greater satisfaction to the people because of low taxes …, and tax revenues also rise, being the sum total of all assessments” (p. 279). He went on to say that as time passes the needs of the state increase and rates of taxation rise to increase the yield. If this rise is gradual people become accustomed to it, but ultimately there is an adverse impact on incentives. Business activity is discouraged and declines, and so does the yield of taxation (pp. 280-81). A prosperous economy at the beginning of the dynasty, thus, yields higher tax revenue from lower tax rates while a depressed economy at the end of the dynasty, yields smaller tax revenue from higher rates (p. 279). He explained the reasons for this by stating: “Know that acting unjustly with respect to people’s wealth, reduces their will to earn and acquire wealth … and if the will to earn goes, they stop working. The greater the oppression, the greater the effect on their effort to earn … and, if people abstain from earning and stop working, the markets will stagnate and the condition of people will worsen” (pp. 286-87); tax revenues will also decline (p. 362). He, therefore, advocated justice in taxation (p. 308).

Public Expenditure

For Ibn Khaldun the state was also an important factor of production. By its spending it promotes production and by its taxation it discourages production (pp. 279-81). Since the government constitutes the greatest market for goods and services, and is a major source of all development (pp. 286 and 403), a decrease in its spending leads to not only a slackening of business activity and a decline in profits but also a decline in tax revenue (p. 286). The more the government spends, the better it may be for the economy (p. 286).[12] Higher spending enables the government to do the things that are needed to support the population and to ensure law and order and political stability (pp. 306 and 308). Without order and political stability, the producers have no incentive to produce. He stated that “the only reason [for the accelerated development of cities] is that the government is near them and pours its money into them, like the water [of a river] that makes green everything around it, and irrigates the soil adjacent to it, while in the distance everything remains dry” (p. 369).

Ibn Khaldun also analyzed the effect of government expenditure on the economy and is, in this respect, a forerunner of Keynes. He stated: “A decrease in government spending leads to a decline in tax revenues. The reason for this is that the state represents the greatest market for the world and the source of civilization. If the ruler hoards tax revenues, or if these are lost, and he does not spend them as they should be, the amount available with his courtiers and supporters would decrease, as would also the amount that reaches through them to their employees and dependents [the multiplier effect]. Their total spending would, therefore, decline. Since they constitute a significant part of the population and their spending constitutes a substantial part of the market, business will slacken and the profits of businessmen will decline, leading also to a decline in tax revenues … Wealth tends to circulate between the people and the ruler, from him to them and from them to him. Therefore, if the ruler withholds it from spending, the people would become deprived of it” (p. 286).

Economic Mismanagement and Famine

Ibn Khaldun established the causal link between bad government and high grain prices by indicating that in the later stage of the dynasty, when public administration becomes corrupt and inefficient, and resorts to coercion and oppressive taxation, incentive is adversely affected and the farmers refrain from cultivating the land. Grain production and reserves fail to keep pace with the rising population. The absence of reserves causes supply shortages in the event of a famine and leads to price escalation (pp. 301-02).

Al-Maqrizi (d. 1442) who, as muhtasib (market supervisor), had intimate knowledge of the economic conditions during his times, applied Ibn Khaldun’s analysis in his book (1956) to determine the reasons for the economic crisis of Egypt during the period 1403-06. He identified that the political administration had become very weak and corrupt during the Circassian period. Public officials were appointed on the basis of bribery rather than ability.[13] To recover the bribes, officials resorted to oppressive taxation. The incentive to work and produce was adversely affected and output declined. The crisis was further intensified by debasement of the currency through the excessive issue of copper fulus, or fiat money, to cover state budgetary deficits. All these factors joined hands with the famine to lead to a high degree of inflation, misery of the poor, and impoverishment of the country.

Hence, al-Maqrizi laid bare the socio-political determinants of the prevailing ‘system crisis’ by taking into account a number of variables like corruption, bad government policies, and weak administration. All of these together played a role in worsening the impact of the famine, which could otherwise have been handled effectively without a significant adverse impact on the population. This is clearly a forerunner of Sen’s entitlement theory, which holds the economic mismanagement of illegitimate governments to be responsible for the poor people’s misery during famines and other natural disasters (Sen, 1981). What al-Maqrizi wrote of the Circassian Mamluks was also true of the later Ottoman period (See Meyer, 1989).

Stages of Development

Ibn Khaldun stated the stages of development through which every society passes, moving from the primitive Bedouin stage to the rise of village, towns and urban centers with an effective government, development of agriculture, industry and sciences, and the impact of values and environment on this development ( Muqaddimah, pp. 35, 41-44, 87-95, 120-48, 172-76). Walliyullah[14] (d. 1762) later analyzed the development of society through four different stages from primitive existence to a well-developed community with khilafah (morally-based welfare state), which tries to ensure the spiritual as well as material well-being of the people. Like Ibn Khaldun, he considered political authority to be indispensable for human well-being. To be able to serve as a source of well-being for all and not of burden and decay, it must have the characteristics of the khilafah. He applied this analysis in various writings to the conditions prevailing during his life-time. He found that the luxurious life style of the rulers, along with their exhausting military campaigns, the increasing corruption and inefficiency of the civil service, and huge stipends to a vast retinue of unproductive courtiers, led them to the imposition of oppressive taxes on farmers, traders and craftsmen, who constituted the main productive section of the population. These people had, therefore, lost interest in their occupations, output had slowed down, state financial resources had declined, and the country had become impoverished (Waliyullah, 1992, Vol. I, pp. 119-52). Thus, in step with Ibn Khaldun and other Muslim scholars, al-Maqrizi and Waliyullah combined moral, political, social and economic factors to explain the economic phenomena of their times and the rise and fall of their societies.

Muslim Intellectual Decline

Unfortunately, the rich theoretical contribution made by Muslim scholars up until Ibn Khaldun did not get fertilized and irrigated by later scholars to lead to the development of Islamic economics, except by a few isolated scholars like al-Maqrizi, al-Dawwani (d. 1501), and Waliyullah. Their contributions were, however, only in specific areas and did not lead to a further development of Ibn Khaldun’s model of socio-economic and political dynamics. Islamic economics did not, therefore, develop as a separate intellectual discipline in conformity with the Islamic paradigm along the theoretical foundations and method laid down by Ibn Khaldun and his predecessors. It continued to remain an integral part of the social and moral philosophy of Islam.

One may ask here why the rich intellectual contributions made by Muslim scholars did not continue after Ibn Khaldun. The reason may be that, as indicated earlier, Ibn Khaldun lived at a time when the political and socio-economic decline of the Muslim world was underway.[15] He was perhaps “the sole point of light in his quarter of the firmament” (Toynbee, 1935, Vol. 3, p. 321). According to Ibn Khaldun himself, sciences progress only when a society is itself progressing (p. 434). This theory is clearly upheld by Muslim history. Sciences progressed rapidly in the Muslim world for four centuries from the middle of the eighth century to the middle of the twelfth century and continued to do so at a substantially decelerated pace for at least two more centuries, tapering off gradually thereafter (Sarton 1927, Vol. 1 and Book 1 of Vol. 2). Once in a while there did appear a brilliant star on an otherwise unexciting firmament. Economics was no exception. It also continued to be in a state of limbo in the Muslim world. No worthwhile contributions were made after Ibn Khaldun.

The trigger mechanism for this decline was, according to Ibn Khaldun, the failure of political authority to provide good governance. Political illegitimacy, which started after the end of khilafah in 661 gradually led to increased corruption and the use of state resources for private benefit at the neglect of education and other nation-building functions of the state. This gradually triggered the decline of all other sectors of the society and economy.[16]

The rapidly rising Western civilization took over the torch of knowledge from the declining Muslim world and has kept it burning with even greater brightness. All sciences, including the social sciences, have made phenomenal progress. Conventional economics became a separate academic discipline after the publication of Alfred Marshall’s great treatise, Principles of Economics, in 1890 (Schumpeter, 1954, p.21),[17] and has continued to develop since then at a remarkable speed. With such a great achievement to its credit, there is no psychological need to allow the ‘Great Gap’ thesis to persist. It would help promote better understanding of Muslim civilization in the West if textbooks started giving credit to Muslim scholars. They were “the torchbearers of ancient learning during the medieval period” and “it was from them that the Renaissance was sparked and the Enlightenment kindled” (Todd Lowry in his ‘Foreword’ in Ghazanfar, 2003, p. xi). Watt has been frank enough to admit that, “the influence of Islam on Western Christendom is greater than is usually realized” and that, “an important task for Western Europeans, as we move into the era of the one world, is … to acknowledge fully our debt to the Arab and Islamic world” (Watt, 1972, p. 84).

Conventional economics, however, took a wrong turn after the Enlightenment Movement by stripping itself of the moral basis of society emphasized by Aristotelian and Judeo-Christian philosophies. This deprived it of the role that moral values and good governance can play in helping society raise both efficiency and equity in the allocation and distribution of scarce resources needed for promoting the well-being of all. However, this has been changing. The role of good governance has already been recognized and that of moral values is gradually penetrating the economics orthodoxy. Islamic economics is also reviving now after the independence of Muslim countries from foreign domination. It is likely that the two disciplines will converge and become one after a period of time. This will be in keeping with the teachings of the Qur’an, which clearly states that mankind was created as one but became divided as a result of their differences and transgression against each other (10:19, 2:213 and 3: 19). This reunification [globalization, as it is new called], if reinforced by justice and mutual care, should help promote peaceful coexistence and enable mankind to realize the well-being of all, a goal the realization of which we are all anxiously looking forward to.

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[1] This is the liberal version of the secular and materialist worldviews. There is also the totalitarian version which does not have faith in the individuals’ ability to manage private property in a way that would ensure social well-being. Hence its prescription is to curb individual freedom and to transfer all means of production and decision making to a totalitarian state. Since this form of the secular and materialist worldview failed to realize human well-being and has been overthrown practically everywhere, it is not discussed in this paper.

[2] The literature on economic development is full of assertions that improvement in income distribution is in direct conflict with economic growth. For a summary of these views, see Cline, 1973, Chapter 2. This has, however, changed and there is hardly any development economist now who argues that injustice can help promote development.

[3] North has used the term ‘nasty’ for all such behavior. See the chapter “Ideology and Free Rider,” in North, 1981.

[4] Some of these scholars include Abu Yusuf (d. 798), al-Mawardi (d. 1058), Abu Ya’la (d. 1065), Nazam al-Mulk (d.1092), al-Ghazali (d. 1111), Ibn Taymiyyah (d. 1328), Ibn Khaldun (d. 1406), Shah Walliyullah (d. 1762), Jamaluddin al-Afghani (d. 1897), Muhammad ‘Abduh (d. 1905), Muhammad Iqbal (d. 1938), Hasan al-Banna (d. 1949), Sayyid Mawdudi (d. 1979), and Baqir al-Sadr (d. 1980).

[5] Some of these authors include al-Katib (d. 749), Ibn al-Muqaffa (d. 756) al-Nu‘man (d. 974), al-Mawardi (d. 1058), Kai Ka’us (d. 1082), Nizam al-Mulk (d. 1092), al-Ghazali (d. 1111), al-Turtushi (d. 1127). (For details, see Essid, 1995, pp.19-41.)

[6] For the fallacy of the Great Gap thesis, see Mirakhor (1987) and Ghazanfar (2003), particularly the “Foreword” by Todd Lowry and the “Introduction” by Ghazanfar.

[7] The full name of the book (given in the bibliography) may be freely translated as “The Book of Lessons and the Record of Cause and Effect in the History of Arabs, Persians and Berbers and their Powerful Contemporaries.” Several different editions of the Muqaddimah are now available in Arabic. The one I have used is that published in Cairo by al-Maktabah al-Tijarriyah al-Kubra without any indication of the year of publication. It has the advantage of showing all vowel marks, which makes the reading relatively easier. The Muqaddimah was translated into English in three volumes by Franz Rosenthal. Its first edition was published in 1958 and the second edition in 1967. Selections from the Muqaddimah by Charles Issawi were published in 1950 under the title, An Arab Philosophy of History: Selections from the Prolegomena of Ibn Khaldun of Tunis (1332-1406).

A considerable volume of literature is now available on Ibn Khaldun. This includes Spengler, 1964; Boulakia, 1971; Mirakhor, 1987; and Chapra, 2000.

[8] For some of these contributions, see Spengler, 1964; DeSmogyi, 1965; Mirakhor, 1987; Siddiqi, 1992; Essid, 1995; Islahi, 1996; Chapra, 2000; and Ghazanfar, 2003.

[9] For a more detailed discussion of taxation by various Muslim scholars, see the section on “Literature on Mirrors for Princes” in Essid, 1995, pp. 19-41.

[10] This letter is a significant development over the letter of Abu Yusuf to Caliph Harun al-Rashid (1933/34, pp. 3-17). It is more comprehensive and covers a larger number of topics.

[11] These are “On tax revenues and the reason for their being low and high” (pp. 279-80) and “Injustice ruins development” (pp. 286-410).

[12] Bear in mind the fact that this was stated at the time when commodity money, which it is not possible for the government to ‘create,’ was used, and fiduciary money, had not become the rule of the day.

[13] This was during the Slave (Mamluk) Dynasty in Egypt, which is divided into two periods. The first period was that of the Bahri (or Turkish) Mamluks (1250-1382), who have generally received praise in the chronicles of their contemporaries. The second period was that of the Burji Mamluks (Circassians, 1382-1517). This period was beset by a series of severe economic crises. (For details see Allouche, 1994.)

[14] Shah Walliyullah al-Dihlawi, popularly known as Walliyullah, was born in 1703, four years before the death of the Mughal Emperor, Aurangzeb (1658-1707). Aurangzeb’s rule, spanning a period of forty-nine years, was followed by a great deal of political instability – ten different changes in rulers during Walliyullah’s life-span of 59 years – leading ultimately to the weakening and decline of the Mughal Empire.

[15] For a brief account of the general decline and disintegration of the Muslim world during the fourteenth century, see Muhsin Mahdi, 1964, pp. 17-26.

[16] For a discussion of the causes of Muslim decline, see Chapra, 2000, pp. 173-252.

[17] According to Blaug (1985), economics became an academic discipline in the 1880s (p. 3).

Citation: Chapra, M. “Islamic Economics: What It Is and How It Developed”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/islamic-economics-what-it-is-and-how-it-developed/