<div><div> <br> <h2>CHAPTER 1</h2> <p><b>How the Modern Economies Got Their Dynamism</b></p> <p>The secret of brilliant productivity will always be discovering new problems and intuiting new theorems, which open the way to new results and connections. Without the creation of new viewpoints, without positing new aims, mathematics would soon exhaust itself in the rigor of logical proofs and begin to stagnate, as it would run out of content. In a way, mathematics has been best served by those who distinguished themselves more by intuitions than by rigorous proofs.</p> <p>FELIX KLEIN, <i>Lectures on Mathematics in the 19th Century</i></p> <br> <p>Part One sees the first modern economies as lying at the core of the modern societies that arose in the West early in the 19th century. Their unprecedented dynamism was mirrored by dynamism in other realms of society as well. The narrative describes how these economies changed not only living and working standards but also the very character of life: dynamism manifests itself in manifold ways. The narrative goes on to examine how and why these history-making economies came about.</p> <p>A modern economy, as that term is used here, means not a present-day economy but rather an economy with a considerable degree of dynamism—that is, the will and the capacity and aspiration to innovate. One may ask, then, what makes a modern economy modern, just as one may ask what makes modern music modern. If a national economy is a complex of economic institutions and a fabric of economic attitudes—an economic culture—what structure of these elements equipped and fueled the modern economies for dynamism? To begin, it is necessary to be clear about the concept of dynamism and its relation to growth, with which it is often confused.</p> <br> <p>Innovation, Dynamism, and Growth</p> <p>An innovation, to repeat, is a new method or new product that becomes a <i>new practice</i> somewhere in the world. The new practice may arise in just one nation, before it spreads, or in a community that cuts across nations. Any such innovation involves both the <i>origination</i> of the new thing—its conception and its development—and the <i>pioneering adoption</i>. Thus innovations depend on a <i>system</i>. Innovative people and companies are just the beginning. To have good prospects for innovation, a society requires people with the expertise and experience to judge well whether to attempt development of a new thing; whether a proposed project is worth financing; and whether, when a new product or method is developed, it is worth trying.</p> <p>Until recent decades, the innovation system was supposed to be the national economy. To innovate, a nation had to do its own development as well as its own adoption. But in a global economy, in which national economies are open to outside developments, the development could take place in one country and the adoption in another. If an innovation, joint or singlehanded, is then adopted by another country, that adoption is not regarded as an innovation—not from a global perspective. Yet selecting foreign products that would have good prospects of acceptance at home might require as much insight as selecting among new conceptions to develop. The distinction between innovation and imitation is basic, but the line between may be fuzzy.</p> <p>We must also understand the concept of an economy's dynamism. It is a compound of the deep-set forces and facilities behind innovation: the drive to change things, the talent for it, and the receptivity to new things, as well as the enabling institutions. Thus dynamism, as it is used here, is the willingness and capacity to innovate, leaving aside current conditions and obstacles. This contrasts with what is usually called vibrancy: an alertness to opportunities, a readiness to act, and the zeal to "get it done" (as Schumpeter puts it). Dynamism determines the normal volume of innovation. Other determinants, such as market conditions, may alter the results. And there can be a drought of new ideas or a gush of them, just as a composer may have a dry or fertile spell. So the pace of actual innovation may exhibit marked swings without any change in dynamism—in the normal tendency to innovate. Post-war Europe saw a sprinkling of innovation in the 1960s —the bikini, the Nouvelle Vague, and the Beatles, for example. By 1980, though, with wealth having recovered to its old level relative to income, innovation had fallen back. It became apparent that the dynamism of Europe had not recovered, even partially, to its healthy level in the interwar years, although that became clear only with mounting evidence.</p> <p>One way to measure this dynamism is to gauge the aforementioned forces and facilities—the inputs producing dynamism. Another approach is to gauge the size of its estimated output: the average annual volume of innovation in recent years—the growth of total GDP not attributable to the growth of capital and labor—after allowance for unusual market conditions and after deducting the "false innovations" copied from other countries. The decadal average income earned by those in the innovation process, if we could observe it, would be a crude measure of that "output." Or we could size up many strands of circumstantial evidence: new firm formation, employee turnover, turnover in the 20 largest companies, turnover of retail stores, and the mean life of a product's universal product code.</p> <p>The economic growth rate of a country is <i>not</i> a useful measure of dynamism. In a global economy driven by one or more economies of high dynamism, an economy with low or even no dynamism may regularly enjoy much the same growth rate as that of the highflying moderns—the same growth rate of productivity, real wages, and other economic indicators. It grows that fast partly by trading with the highflyers but mainly by being vibrant enough to imitate the adoptions of original products in modern economies. Italy provides a nice example: from 1890 to 1913, output per manhour there grew at the same rate as in America—it remained 43 percent lower, neither gaining nor losing ground in the <i>league tables</i> (the rankings of countries by the relative levels of their productivity (e.g., output per hour worked) and real wages), but no economic historian would suggest that Italy's economy had much dynamism at all, let alone the American level.</p> <p>An economy with low dynamism might for a time show a faster growth rate than a modern economy does with its high dynamism. A transient elevation of the growth rate could result from any of a number of structural shifts in the economy, such as an increase in vibrancy or an increase in dynamism from low to not-as-low. While the economy is moving up to a higher place in the league tables—a partial "catch-up" to the modern economies—it will be growing at the normal, global, rate plus a transient, which fades away as the destination nears. But even a growth rate that is the world's highest should not suggest that the economy has just acquired high dynamism, let alone the highest. Sweden provides a good example. It held the world cup for the championship growth rate of productivity from 1890 to 1913. It started a raft of new companies, several of which endured and became famous. But it did not appear to acquire the high dynamism of America or, say, Germany. In ensuing decades its growth rate dropped below that of America and not one new firm has entered the top 10 on the stock exchange after 1922 even to this day. Japan's high growth from 1950 to 1990 is another example. Many observers inferred high dynamism, but this streak of growth reflected not the advent of state-of-the-art modernity throughout Japan—no such transformation occurred—but rather the chance to import or imitate practices pioneered for decades by the modern economies. The world-record growth in China since 1978 is the latest example: while the world sees world-class dynamism, the Chinese discuss how to <i>acquire</i> the dynamism for indigenous innovation, without which they will be hard pressed to continue their fast growth.</p> <p>So a nation's "dynamism" is not a new word for a nation's productivity growth. Its own dynamism is not necessary for its growth if the rest of the world has dynamism—vibrancy is enough; and it is not sufficient if the nation is so small that its dynamism cannot go far. Dynamism over an appreciable part of the world leads to global growth, barring bad luck. The modern economies, with their high dynamism, are the engines of the growth of the global economy—today, as in the 19th century.</p> <p>So, although the growth rate of productivity in an economy—say, output per manhour—over a month or even a year is no indicator of its own dynamism, we might think that the <i>level</i> of its productivity relative to the levels abroad would be an indicator. It is true, with few exceptions, if any, that the economies with productivity levels at <i>or</i> very close to the top level owe that position to a high level of dynamism. Yet a low position of a country's productivity level may reflect low dynamism or low vibrancy or both. So the relative level of productivity is not an altogether safe indicator of an economy's dynamism.</p> <p>To gauge more deeply an economy's dynamism, we have to look under the hood to see what there is in the structure of an economy that might strongly nourish or inhibit dynamism.</p> <br> <p>Inner Workings of the Historical Modern Economies</p> <p>Schumpeter's near-classical theory, with its concept of punctuated equilibrium, blocked all thoughts of a modern economy—an economy generating economic knowledge through its own talent and insight into the business of innovating. The dominance of this theory has had consequences: to this day, policymakers and commentators do not distinguish between modern economies, less modern ones, and nonmodern ones. They see all national economies, even exemplars of modernity, as essentially machines for producing products and doing so more or less efficiently at that—though some have natural handicaps or costly policies.</p> <p>But if we just look, we can see the distinctive stuff that modern economies are made of: It is <i>ideas</i>. The visible "goods and services" of the national income statistics are mostly embodiments of past ideas. The modern economy is primarily engaged in activity aimed at innovation. These activities are stages in a process:</p> <p>• conception of new products or methods</p> <p>• preparation of proposals to develop some of them</p> <p>• selection of some development proposals for financing</p> <p>• development of the chosen products or methods</p> <p>• marketing of the new products or methods</p> <p>• evaluation and possible tryout by end-users</p> <p>• significant adoption of some new products and methods</p> <p>• revision of new products after tryout or early adoption</p> <br> <p>In an economy of substantial size, there are gains in expertise from a Smithian division of labor, and innovational activity is no exception: some participants work full-time in a team conceiving and designing a new products, some work in a financial company picking new companies to fund, some work with a start-up entrepreneur developing a new product, some are employees specializing in evaluating new methods, others specialize in marketing, and so forth. No less important, in an economy of dynamism, some portion of most participants' time is spent looking at current practice with the expectation that a new idea will occur for a better way to do things or a better thing to produce. This patchwork of activity is the <i>ideas sector</i>. In an economy high in dynamism, the idea-driven activity might amount to a tenth of total manhours worked. However, the work of investing in new ideas and new practices—though it may crowd out work in some familiar lines of investment activity—may spark a boundless amount of investment activity aimed at producing facilities to make the new products. The result is a strongly positive effect on employment. (Innovative activity in particular and investment activity in general are far more labor intensive, hence less capital intensive, than the production of consumer goods: food production, for example, uses much capital, such as wire fences, and much energy; energy production also uses much capital, such as derricks, dams, and windmills.)</p> <p>How do these modern economies <i>work</i>—those of the 19th and the 20th century too? We may begin at an almost physiological level, rather like Henry Gray's <i>Anatomy</i> (1862). We see in these modern economies multiple lines of innovative activity. These are parallel efforts, which represent the competition of ideas. In an economy of appreciable size, new commercial ideas are hatched every day, mostly inside enterprises. Development of such ideas will generally require enterprises with the right expertise. Among the projects with an eager entrepreneur, not all will find financial backing. Capital flows only to those projects judged by an entrepreneur and a financial backer to have good prospects of development and marketing. Among the projects carried forward, not all will manage to embody the idea in a product that would be cheap enough to be marketable. Among the new products brought to the market, sales or orders will come in only for those judged by end-users—managers or consumers—to be worth the risk of a pioneering adoption. Only a small proportion will show signs of wide enough adoption to continue production or to warrant stepping up production to break-even or profitable levels. This <i>selection mechanism</i> may leave one idea standing where there were thousands to begin with. (A study by McKinsey estimated that, from 10,000 business ideas, 1,000 firms are founded, 100 receive venture capital, 20 go on to raise capital in an initial public offering of shares, and 2 become market leaders.)</p> <p>We can picture the corresponding competition going on in a socialist economy: the "enterprises" are state-owned, and the backing comes from a state development bank. We can also picture the corresponding competition in a corporatist economy: the enterprises, though under private ownership, are state-controlled, and their finances are allocated by state-controlled banks. However, the modern economies of the storied past possessed neither one of these structures. The modern economies of the past two centuries—primarily those of Britain, America, Germany, and France—were, and to varying degrees still are, specimens of <i>modern</i> capitalism.</p> <p>In these real-life modern economies—and in any modern-capitalist economy—decisions to provide capital for the first steps toward innovation are made predominantly by investors, financiers, and share buyers drawing on their own private wealth or by managers of financial companies under private ownership. The collected investments and loans of these "capitalists," some of them with very small wealth, determine which directions, among those presented, the economy will embark on. Decisions to take the initiative of planning and seeking finance for development of a new idea are made predominantly by producers—managers by trade—starting a private venture or acting within established private enterprises. To distinguish producers of such undertakings from producers of established products, the former are called <i>entrepreneurs</i>. Typically, the entrepreneurs also bring some capital to the new undertaking. Both a project's entrepreneur and its investors stand to gain whatever pecuniary returns the project might bring and suffer the loss should the returns be negative. Of course, these returns are not determined in isolation: such projects compete against others, driving down the private returns and driving up rents to land and wages to labor. The pecuniary return is not unimportant to an investor with a large stake or to an entrepreneur—their livelihoods and standard of living may be at stake. An entrepreneur may need the prospect of winnings to obtain the moral support of family members.</p> <p>The prospect of profit, which entrepreneurs and investors share after paying creditors, is not the only prospective return factored into the decision to start a new undertaking. Both entrepreneurs and large-stake investors favor projects that excite their imagination and enlist their energies. They may also want to play a part in the development of the community or the nation. (Some entrepreneurs and financiers create enterprises primarily for the satisfaction of producing a social benefit—on top of whatever pecuniary return may be expected. These "social entrepreneurs" may coexist alongside the classic entrepreneurs, whether or not they are financed by the state. To the extent that this parallel system has dynamism, it helps make modern economies modern.)</p> <p>It is unfortunate that most discussions, except for trivial distinctions like that between ships and factories, do not distinguish modern capitalism from <i>mercantile</i> capitalism (also known as early capitalism or commercial society). Modern capitalism built on early capitalism, of course. The latter solidified property rights; won acceptance of interest, profit, and wealth-building; and taught the social value of individual responsibility. Mercantile capitalism also gave birth (in Venice and Augsburg) to banks that lent to or entered into business. But modern capitalism is as different from mercantile capitalism as innovators are different from merchants. The mercantile economy was about the distribution of products to consumers. (To exaggerate slightly, men and women scooped up nature's crops and took the excess supplies to market to exchange them for excess supplies of other crops.) Modern capitalism introduced innovation into capitalism. Entrepreneurs soon put merchants in the shade. As new practices welled up, many guilds founded in medieval times could not enforce standards. The state could not issue charters fast enough to meet the exploding demand. </div></div><br/> <i>(Continues...)</i> <!-- Copyright Notice --> <blockquote><hr noshade size='1'><font size='-2'>Excerpted from <b>MASS FLOURISHING</b> by <b>EDMUND PHELPS</b>. Copyright © 2013 Edmund S. Phelps. Excerpted by permission of PRINCETON UNIVERSITY PRESS. <br/>All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.<br/>Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.</font><hr noshade size='1'></blockquote>