PLSC 270: Capitalism: Success, Crisis, and Reform

Lecture 15

 - Mass Affluence Comes to the Western World


Professor Rae discusses the rise of mass affluence, the joint stock corporation, and advertising/consumer culture in America. Gregory Clark’s theory of the causes of the Industrial Revolution, including England’s “downward social mobility” in the medieval and early modern periods, are explored. According to this theory, the upper classes produced children in greater numbers than in other countries, and there were fewer jobs of high social status. This led to upper-class children working in “lower-class” jobs, infusing lower economic strata with upper class outlooks toward work. Clark also touches on a genetic, Darwinian explanation for England’s Industrial Revolution. Professor Rae also discusses other causal explanations for the Industrial revolution, including exogenous and endogenous growth theories, institutions, and Schumpeter’s theory of creative destruction. The wealth-generating power of the joint stock corporation is also presented.

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Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 15 - Mass Affluence Comes to the Western World

Chapter 1. Introduction and Class Agenda [00:00:00]

Professor Douglas W. Rae: Okay, today the coming of mass affluence to the advanced economies, principally the economies of the west. Jennifer, speaking of informal property rights, I thought you owned a chair right up there? I ‘m just kidding. I’m going to take it in three chunks. We’re going to look at big picture, causal explanations for the rise of mass affluence, and for explanations first of its rise, and second, its rise beginning in Western Europe and North America. Second, I’m going to reintroduce the joint stock corporation into that conversation, and finally we’re going to look at the phenomenon of mass affluence and the advertising culture of mid-twentieth century America. Then on Wednesday we’re going to descend to details, and the challenge for you in preparing for Wednesday is to imagine a country, and imagine that you somehow have been granted a fund amounting to 5% of its gross domestic product, and with that 5% you want to make whatever changes you can imagine, will increase the overall wealth of that country as much as possible. It’s a pragmatic question. It has a causal side to it, but ultimately it’s pragmatic and it is not one size fits all. That is, you’ve got to know something about the country to know something about what needs doing; 5% of the GDP in Ghana will be spent — will be wisely spent very differently than 5% of the GDP in Bolivia or Mexico, or Norway.

Chapter 2. The Capitalist Take-Off [00:02:23]

Okay. So the first of the three topics is capitalist takeoff. The portrait of this corpulent and obviously affluent gent is Sir Richard Arkwright, who was the creator of the most efficient early textile machinery, and who unlike many others about whom Clark talks, actually profited very handsomely from that work. By takeoff in the west, and this goes back to the first day of class, and by Wednesday we’ll go back again to and look at the bubbles moving through space. This still photograph, so to speak, covers a longer time horizon, a 500 year time horizon. It shows an abrupt northward movement in GDP per capita in the U.S., lagging a bit in Japan, lagging further in China, India, and Indonesia. If we just throw all the countries in the world in a pot, we get a picture that looks something like this, where gross GDP is in blue, population in green, and the one divided by the other in gold. What we’re interested in from here to the end of term really is in understanding what lies behind these curves and in thinking about from a given a country’s point of view, or from given class of people in a given country’s point of view, how can we increase the rate at which things gets better? Now before I go further some of you are thinking green thoughts. Wave at me if you’re thinking green thoughts and wondering whether it’s really a good idea; I have so many people with so much money in their pockets. Sasha tell us. We got a microphone here?

Student: I think basically the root of all environmental problems, if you care about the natural environment, is that there are too many people, so you have more people who can consume more. The simple thing to think is that that’s bad news for the earth.

Professor Douglas W. Rae: Okay so you would like to kill off a portion of the world’s population.

Student: Yes.

Professor Douglas W. Rae: Okay very straightforward, good, clear MBA thinking. Given a constant world population, if we had it, would you prefer that that population on average be a little less affluent then it is, or that I seem to want it to be?

Student: I’m not sure that it’s that straightforward because if people — societies don’t have the means to advance technology, even though consumption does go up, you have cleaner technologies that would be developed with greater economic prosperity, so I’m not as clear on that one.

Professor Douglas W. Rae: Okay, not as clear. Now you would acknowledge that as hundreds of millions of people living in places like China and India come into income enough to have a family car or even two, that there’s a challenge there?

Student: Certainly.

Professor Douglas W. Rae: Okay, so let’s keep the natural environment in the background as we talk about this, but let’s for the moment focus on economics, and let’s start with a curve like this. The curve shows low income to the left, high income to the right, and the frequency of each income stratum is indicated vertically, and the red curve is a fairly typical market economy income distribution with a truncated tail on the left, and an elongated tail on the right, with the mean income being much higher than the median because it is pulled to the right by the very high incomes. If this chart were drawn to scale that right hand tail would probably be even more elongated, but wondrously thin out to the right.

Well the phenomenon of takeoff is the upward shift in that distribution. It may change shape a little, bit it’s not mainly that it’s changing shape; it’s that its mean is drifting upward and to the right. If we think about two distributions, two or three generations removed from one another in a given society, let’s say the United States 1920 and the United States today, it will often be the case that the difference is so dramatic that the material condition of people living in the top tenth then will be about like the top half today. And you keep that up for ten generations or so, and you have something like this, where the top decile in, let’s say, 1800, is living in material conditions that would be equivalent to perhaps the ninth decile today. Not the very bottom, but people living relatively near the bottom. This is particularly true if you take into account not just income, but what it is that income can buy in the way of medical care, comfort and lodging, quality of diet, and so forth. There’s an enormous explosive change in the background here. That change is our subject.

Now how you feel about that change is more complicated and we often hear that money doesn’t buy happiness. The people who say that have evidence of a kind. None of them volunteer to become poor, and there is something that money buys that people want, and we’ll return to that from time to time. But imagine now that there are — just think about an economy with two people in it, A’s income or wealth is measured vertically, B’s is measured horizontally, and you’re Mr. A. Which of these two outcomes would you prefer on — by one way of thinking you’re maximizing your own income, you’d like to be there. If on the other hand, what you’re doing is staying ahead of the Joneses, you’d like to be there. More generally, if you’re just trying to maximize your own household income, you will have indifference curves like these horizontal ones and just seek to climb as high as possible, and you’ll be perfectly content if others climb at the same rate, or even a higher rate. On the other hand, you may be calculating the ratio of your household to other households that you choose to compare yourself with and the indifference curve will then become rays from the origin like that, and you will be trying to swing your position from bottom right to upper left. One function is just maximize one variable and the other is maximize the ratio of two variables, and most people are — tend to mix these two things. The — their contentment with their material position is partly relative and partly absolute; absolute here, relative there. If you think about the employees of a firm, the way they’re compensated is — raises both concerns. Suppose everybody in a law firm is making between $150,000 and $200,000, and along comes Jim Alexander, ace corporate lawyer —

Jim Alexander: Never.

Professor Douglas W. Rae: Never, I know. I’m abusing you. Never, and — all right Leslie Hough, ace corporate lawyer, and we really need her and we’ve got to pay her $800,000 and we make the offer and she takes it. There will be a — if this fact becomes public within the firm, which is quite likely, everybody else will in some measure feel impoverished by it. She’s making four times what I’m making; surely she’s not four times better than me, so the relative and the absolute are always at play. Now let’s look through Clark’s explanations — and I spent almost all of yesterday reviewing Clark, and he’s kind of all over the place. There’s some of everything in this book, but let’s pick out some of his main explanations for economic takeoff, and for the fact that the takeoff occurred first and most dramatically in western countries, and among western countries, first in the United Kingdom. His — there’s a recurring theme, it’s in the beginning, the middle, and the end of the book, about his speculative interpretation of wills from England in late medieval and early modern — and right into modern times. The phenomenon he finds is a fountain of wellborn children who cannot replicate their parents place in society. The empirics on this are pretty strong. That well to do families, by and large, had more than two surviving children reaching — more than two children reaching adulthood, and indeed, the survival rate among well to do children was quite a lot higher than the survival rate among other children. If you read all the way to the end of the book you discover that if you compare this with Asian societies such as Japan and China, the effect is stronger in England.

From this he adduces several consequences, the most obvious of which is that many of these wellborn children will be downward mobiles. The will marry beneath their class, they will take up occupations or roles beneath their parents’ class, and Clark is — he’s trying to say two things at once. One is that the culture — the universalization of culture from the top could in some measure be promoted by this downward mobility; that children raised with high expectations and upbringing may be cultural carriers which would infuse lower economic strata with a more energetic, more performance-oriented outlook. For that there’s no evidence in this story, it’s just a speculation. The other speculation, for which there is also no specific evidence, is a Darwinian genetics story in which — and here Clark is — this is dangerous territory in the way of politics. He seems to believe that the genes carried at the top of the income curve may be better genes than those elsewhere in the income curve, and that the downward — forced downward mobility of progeny from that top level gene pool might upgrade the whole society in a genetic sense. Anybody want to comment on that thought? Yes.

Student: I mean, genetically speaking it’s just sort of silly, because traits don’t pass directly. You aren’t a clone of your parents, or even just a 50/50 combo. In terms of carrying skills downward though, I mean that makes a lot of sense. If you’re well educated and you bring that down you might educate your children, values, etc.

Professor Douglas W. Rae: That’s precisely my own view, but does anybody want to defend Clark here?

Student: Well it could be more of a bell curve situation, if you know what I mean. The people on the higher end of the income ladder have, over time, been privy to better situations and better selection pressures leading to the evolution of skills like analytical thinking, intelligence skills that are necessary for the professions that are characteristic of the higher classes.

Professor Douglas W. Rae: Let’s have a vote here. How many people think it’s likely that there is some validity to — let’s start with the cultural story and then go to the genetic story. How many people find the cultural story broadly plausible? The opposite — implausible? Okay, and how many find the genetics story broadly plausible? Fewer, but a substantial number. And how many find it implausible? Okay, I have no idea, and Clark provides not one shred of evidence with which we could test this. My own guess is that a few hundred years is a pretty short time for carrying out the kind of selection process he has in mind. It’s also the case that the association between parental — let’s call it IQ. The twin studies actually do confirm this — where identical twins are born to Mr. and Mrs. Smith and raised by Mr. and Mrs. Jones, in IQ and several other variables, the association between the identical will be greater than between them and the siblings belonging to the new family, so genetics is not wholly out of the picture. On the other hand, from a pragmatic point of view, which is where we’re going with all this, the idea of — well what was Eugenics? Does anybody — are any of you in a history course, picked up Eugenics? Anyone?

Student: Eugenics is an idea that in some form has existed since ancient times, but really picked up in the late nineteenth century, and then especially under the Third Reich, where it was essentially believed that people at the top tended to have better genes, or in the case of the Third Reich, a specific racial group, and therefore you want to maximize the number of people with certain desirable traits for reproducing, and minimize the ability of people with undesirable traits to reproduce, resulting in a better, stronger, smarter, in the case of the Nazis, blonder, race.

Professor Douglas W. Rae: Okay, that’s the gist of it. The heart of it, which was most influential, had to do with trying to prevent people who were mentally retarded from reproducing, and a lot of that happened. The vulgar prejudices that lay behind much of it, it was — much of it was conducted by something called The Vineland Institute, located near Princeton, New Jersey; no guilt by association there. The Vineland Institute published data showing that all the immigrant groups streaming into the U.S. in the early twentieth century were inferior to WASPS mentally, and they were very tough on the Jews. The Jews are just not bright at all, and they did this by administering English language questionnaires to immigrants just after they got here. The pragmatics of culture are something that’s a lot easier to deal with, and which fits more readily into the humanistic framework that we share.

After “the fountain,” which really doesn’t fit into any of his categories, Clark has three broad categories. One is exogenous growth theories — exogenous meaning economic growth caused by something that is — that has its origin outside of the market economy. One of these ideas, which I think he’s right about, he doesn’t run with it very far, but the emergence of the nation’s state system, the rule of law, the existence of well formalized property rights, all that stuff is pretty powerful, and the western world was the initial focal point of the Westphalian nation state system. Clark is at pains to show that that by itself isn’t enough an explanation. In general, no one should expect one story to explain the evolution of capitalist wealth. This is way too complex a story — way to complex a phenomenon for simple theories to carry the day.

A special case of that would be wealth-maximizing law as illustrated a week ago in Ghen v. Rich or in U.S. v. Cosby, or any of hundreds of legal precedence. Clark also briefly, toward the end of the book, takes up the work of a guy named Kenneth Pomeranz, and Pomeranz has a book called The Great Divergence which asks the question, why did the — well he begins with the proposition that from a social and economic point of view, China and Japan, both look a lot like Europe in about 1800. There’s lots to quibble with in that generalization but it’s not crazy. Then he says, “Well, Europe takes off well over a century ahead of those Asian countries,” and he wants to know why. His thesis is it has to do with natural resources. In particular, that large population centers like the cities of England were located close to large energy resources such as the coal mining areas of the Midlands in the United Kingdom.

Also of almost equal importance for Pomeranz, access to vast agricultural land in the form of North America, and that about 1800 was the time when the exploitation of the largely empty continent in the United States was feeding resources into Western Europe. There’s some plausibility in those ideas. Then Clark talks about multiple equilibrium theories, and the idea here is — think of time passing that way, and standard of living or productivity going this way. The idea is that a country could climb this small hill and get stuck here, and then there would be some exogenous shock, some huge event outside the economic system, which would allow it to pass from that equilibrium to a new equilibrium on top of the taller hill.

The world demographic transition is such a story, and not a crazy story at all. The notion that the falling death rate created by better public health, probably more than any single factor, by clean water, and elementary vaccinations, but clean water probably above all else, and the eventual adjustment of the birthrate to that so that you go from high birthrate, high death rate, short lives, to low birthrate, low death rate, long lives. That by itself is a — is I think without question a powerful element in the story wherever a nation state society has gone from poor to rich.

Then the endogenous growth theories, and these are — the idea here is that something happens inside the economy that creates a dynamic change, and that dynamic change leads to mass affluence. I think there’s a lot in this idea which of course is not Clark’s. Clark is merely cataloguing other people’s ideas. The — does anybody recognize either of these two handsome gentlemen? I’d prefer the haircut on the left. This is Joseph Schumpeter, and this is F.A. Hayek. Each of them had an idea of about market societies that has to be central to our thinking. In Schumpeter’s case it was creative destruction, and I’m told by the teaching fellows that most of you knew that quite well on the mid-term. Creative destruction is a way of reshuffling the deck economically at short intervals, so that, looking back at this story, so that sitting still on this hill, is difficult for any given firm and arguably impossible for society at large once you’re into a capitalist market economy.

One way to diagram that is — this diagram we have, the capital invested in a given kind of product or production, rising from left to right, and the productivity of that capital rising from bottom to top, and each of these curves is a production function representing a technology and a way of organizing people and handling information. The idea would be that change occurs in the sequence 1, 2, 3, 4, 5, 6 here where there’s a process of climbing to the right as we go to more capital-intensive production, more capital per worker, and then while Tal is doing that, Jennifer is saying, “Well no, we should reorganize this entirely. We should use a different technology, a different method of attracting investments, a different method of compensating employees,” and she shifts to the lower end of three and then that gets carried to here, and then a similar shift to the blue production function and then up that, and so a kind of zigzag story of change where people compete not within one production function but between production functions and a chaotic pattern of creative destruction occurs. What makes it creative is that it is ultimately an upward movement in productivity.

A version of that story is in Clark but he doesn’t really think in the dynamic way that Schumpeter and Hayek, and others do. Hayek’s story is the one about the creative potential of a free society, which I think you had a memo to write about, and the notion there is that social learning will accrue. That the society at large will have a higher learning rate than any individual within it, and that as each of us goes about her or his work, we are spewing off insights for others. Both when we succeed and when we fail. When we succeed people will copy our ideas. When we fail people will know an idea not to try, and that over time society actually smartens up. If you look at the first chapter in the assignment for today in Clark, he has all the factors of growth, as he conceives them, in a very simplified model, and the residual — the residual, which accounts for about half the variance, it’s most natural interpretation is it is social learning. It isn’t the specific capital embodied in a given workers education, or in the factory plant and equipment with which that worker is supplied by an employer, but in the less tangible forms of social knowledge which the society is generating. And Hayek’s idea, then, is that over time social learning makes the whole system smarter, taken as a whole, and that learning to navigate unfamiliar information, which arguably, would be something you’re all doing right now, becomes not only an advantage to the individual but to the society at large.

Chapter 3. The Joint Stock Corporation [00:33:17]

Well the most glaring omission in Clark, in talking about the surge of wealth in the west, is the joint stock corporation. The joint stock corporation goes back of course many centuries, but the kind of joint stock corporation which has become dominant in the world, goes back only to about the middle of the 1800s. In the UK it’s dated to The Corporation Act of 1862, in the U.S. I think you’d probably say somewhere in the 1840s it becomes important. You can find legal traces of it much earlier in both cases, but it gets to be a big deal in the middle years of the nineteenth century. As we saw with the reading from Alfred Chandler, the rise of the large-scale railroad in the U.S. provoked the creation of the equity and bond markets in New York, and the feverish development of joint stock corporations in virtually every field of endeavor thereafter.

These slides — I’m going to show a series of proprietary slides constructed by Ibbotson Associates. Ibbotson Associates is named for Roger Ibbotson at The School of Management here. Ibbotson became filthy rich by being the first one to systematically compile, analyze, and sell long trend data about stocks and bonds. It’s only because he likes to teach that he bothers to continue. The time scale here is 1925 to more or less the present. The earnings of various classes of assets are — I’ve traced here, beginning in this case with treasury bills issued by the government, and as safe as the government is. Then municipal bonds, government bonds of other kinds, corporate bonds, so this would be debt taken on by a corporation and it might be — they might be junk bonds if the corporation is a little risky and they might be blue chip bonds if not. Then this is — the blue curve is an amalgam of stock returns, and in every case we start with $1 in 1925 and keep investing the money — the way these charts are generated is we assume that every dollar of dividend is plowed back, and that we don’t pay any taxes. This would sort of be Yale that we’re charting. You and I wouldn’t quite have the same tax privilege Yale has, and the most striking thing there is — what’s the most striking thing about that chart? First of all there is some magic in compound interest, right? You can just leave your money to grow, it really does eventually do that. How about the blue curve versus the others? Pretty startling — we’ve got to get somebody else — yes Tal.

Student: There seems to be a rather large equity premium. What I mean by that is that there seems to be excess returns if you put your money in stocks versus any of the other categories, treasuries, corporate bonds. I mean, you’re obviously taking on more risk in stocks versus the other categories, certainly more than treasury bills, but you could possibly argue that the difference in risk doesn’t seem as great as a difference in returns over the long run.

Professor Douglas W. Rae: Okay. What’s the — the equity premium is the punch line here, well said. What’s the standard way one might manage the risk of a portfolio?

Student: You could diversify.

Professor Douglas W. Rae: Okay, so we wouldn’t put all our money in mining stocks or in — even in Apple, which is right now one of the most expensive stocks in the universe, but the equity premium is huge. Look here what happens — this is 1925, the Depression is here, the great crash is here, these people got jolted. Of course the temptation when that happens to you is to imagine that it’s going to go right to the middle of the earth, and therefore to sell at this point, which lots and lots of people did, and of course the effect was to ruin their wealth.

Let’s take another set of these. We let inflation go unnoticed in that one and here we’ll show inflation by the red curve, and then the T-Bills, government bonds, large company stocks, small company stocks and you get a huge premium there. Now the — back to the question of the accumulation of mass affluence; the power of large enterprise to generate enormous wealth over long periods; this is a seventy-five, eighty, eighty-five year period we’re looking at, but patient — money patiently invested in joint stock corporations is a solid strategy for the accumulation of wealth within a given household or institutional portfolio. It’s not anywhere near the sexiest or the fastest way, but it is one of the most solid ways, and the only conclusion I want to get out of this is that in talking about economic takeoff and the sustained growth in mass affluence, companies, joint stock companies with limited liability, are a big part of that.

Chapter 4. Culture of Consumption [00:40:56]

Third and last. With — remember the variable here is gross domestic product per capita. Part of that has to do with the propensity to consume. In the Posner book about what went wrong with the mortgage markets, Keynes, Lord Keynes is mentioned, and Keynesian economics, which are directed to the question of stabilizing mass demand for products so that the economy keeps going around and around, is an important element. Well the joint stock corporation was, from its birth, really good at selling. The move, which would be called forward integration, were not just going to make cigarettes, we’re going to sell cigarettes. We’re not just going to make soap; we’re going to sell soap. We’re not just going to make cars; we’re going to sell them. That forward integration — I’m going to without comment now just show you 20 slides from the middle decades of the twentieth century and then we’ll stop briefly and segue to next — our next meeting. Some of these are a little pernicious. This one is not.

The — a repeated trope is using products to solve marital problems, and the large glove compartment on this Mercury will solve the marital problem between these two. When my grandfather died and I was seventeen, I inherited a Mercury from him, it lasted one year before I crashed it. “Quiet substance” — a series of Palmolive’s here. They all have to do with men and women. Women are the sales target. Does Palmolive soap exist still? Does anybody still use it? That’s pretty nasty stuff right? This is rouge not soap now. You get the gist of it. In the consumer culture that’s embodied in these, and which is powerfully represented all around us, we live in a very consumption oriented culture, is arguably a misleadingly favorable aspect of wealth. That is, an awful lot — if you think about those ads and how silly it seems, with seventy years hindsight, that using Palmolive soap will save your marriage — I often guess that it didn’t save a single marriage — that whole angle of kind of the Hucksterish aspect of a capitalist society, can give one pause.

Now I’d like you to come to class Wednesday having thought a little about a country and what 5% of its GDP would amount to in dollars, and if you need to look that up you can Google it. The easiest Google is CIA Factbook, but the World Bank will give you the data too. The World Bank or the WTO, there are all kinds of organizations that produce these data. Pick a country and think about 5% and think about how you would deploy the 5% if you wanted to maximize the expected wealth of that society over, let’s say, a twenty-year future. The reading is the more policy oriented part of de Soto, and it should in some ways guide and support your thinking, although you surely want to think well beyond de Soto’s framework. So I’ll see you on Wednesday.

[end of transcript]

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