Unit 1 Prosperity, inequality, and planetary limits

1.10 Capitalism, causation, and history’s hockey stick

We have seen that the institutions associated with capitalism have the potential to make people better off, through opportunities for specialization and introduction of new technologies, and that capitalism emerged at the same time as, or just before, the continuous technological revolution. But can we conclude that capitalism caused the upward kink in the hockey stick? The emergence in the seventeenth century of a free-thinking cultural environment known as ‘The Enlightenment’ also predated or coincided with the upturn. So was it institutions, or culture, both, or some other set of causes? Economists and historians disagree, as we show in Unit 2.

causal, causality, causation
We can say that a relationship between two variables is causal if we can establish that a change in one variable produces a change in the other. While a correlation is simply an assessment that two things have moved together, causation implies a mechanism accounting for the association, and is therefore a more restrictive concept. See also: natural experiment, correlation.
natural experiment
An empirical study that exploits a difference in the conditions affecting two populations (or two economies), that has occurred for external reasons: for example, differences in laws, policies, or weather. Comparing outcomes for the two populations gives us useful information about the effect of the conditions, provided that the difference in conditions was caused by a random event. But it would not help, for example, in the case of a difference in policy that occurred as a response to something else that might affect the outcome.

We want to make causal statements in economics—to understand why things happen, or to devise ways of changing something so that the economy works better. For example, an economist might claim: ‘If the central bank lowers the interest rate, more people will buy homes and cars.’

But an economy is made up of the interactions of millions of people. We cannot measure and understand them all, and we should be sceptical when anyone claims that something complex (capitalism) ‘causes’ something else (increased living standards, technological improvement, or environmental challenges).

In science, we support the statement that X causes Y by performing experiments in which we change X and measure any associated change in Y. We design the experiments in such a way that we can be confident that the change in Y was caused by the change in X (rather than vice versa, or by some other variable). For most important questions in economics, it is not possible to conduct conventional experiments (although Unit 4 includes some examples where this is done). So how can economists study causation? The following example of a natural experiment shows how what we observe in the world can help us investigate causes and effects.

How economists learn from facts Do institutions matter for growth in income?

In a conventional experiment, the experimenter changes the variable thought to be a cause (X), keeping all the other variables the same as before, and observes the change in Y that is associated with the change in X. In an agricultural experiment, X might be the dosage of fertiliser applied, the things kept the same (or ‘held constant’) might be the amounts of water and light, and Y would be the amount of the crop produced.

By contrast, in what is called a natural experiment, we rely on accidents of history, geography or other differences to ‘perform the experiment’ and to present us with different values of X that can then be associated with differing values of Y, when not much else that could cause changes in Y differs.

A natural experiment is a situation where we use an external event, such as a change in institutions or a natural disaster, to compare the outcomes for economic actors who were affected by this event and those who were not.

The division of Germany at the end of the Second World War into two separate economic systems—centrally planned in the east, capitalist in the west—provided a natural experiment. During this time a political ‘Iron Curtain’, as the British prime minister Winston Churchill described it, divided the country. It separated two populations that until then had shared the same language, culture, and capitalist economy. But for half a century they differed in the institutions governing the economy. This allows us to study the effect of different institutions on the economy.

You can read more examples of natural experiments in the book Natural Experiments of History, written by Jared Diamond, a biologist, and James Robinson, a professor of government.

Using the language of experiments, central planning under Communist Party rule in East Germany is the ‘treatment’ and capitalism in West Germany is the ‘control’ that provides an indication of how the East would have developed had Germany not been divided. The control is also termed the ‘counterfactual’ event: what would have happened if, contrary to the facts of history, East Germany had not been organized as a planned economy between 1948 and 1991.

The validity of this as a natural experiment relies on the comparability of the two parts of Germany before the introduction of different economic systems. In 1936, before the Second World War, living standards in both parts of Germany were the same. Firms in Saxony and Thuringia were world leaders in automobile and aircraft production, chemicals, optical equipment, and precision engineering. During the war, the entire German economy was organized as a war economy: for example, wages and prices and the allocation of labour and resources were under central control.

After the war, Communist central planning replaced the war economy in East Germany, where the Soviet Union was the occupying power. Decisions about how and what to produce did not revert to private individuals, but were taken by government officials. The officials managing plants, offices, mines, and farms did not need to follow the principle of capitalism and produce goods and services that customers would buy at a price above their cost of manufacture. Pre-war private property, markets, and firms virtually disappeared.

But a capitalist economy re-emerged in West Germany as a result of decisions by the occupying powers (the UK, US, and France). Following currency reform in 1948, which abolished wartime price controls and introduced a new currency, rapid growth occurred.

The East German Communist Party forecast in 1958 that material wellbeing there would exceed that of West Germany by 1961. The failure of this prediction was one of the reasons the Berlin Wall separating East from West Germany was built in 1961. By the time the Wall fell in 1989, and East Germany abandoned central planning, its GDP per capita was less than half of that of capitalist West Germany. Figure 1.16 shows the different paths taken by these and two other economies from 1950.

In this line chart, the horizontal axis shows years from 1950 to 1989. The vertical axis shows GDP per capita in 1990 dollars and ranges between 2,000 and 18,000. In West Germany, GDP per capita increased almost linearly from 4,000 dollars in 1950 to 18,000 dollars in 1989. In Japan, it increased from 2,000 dollars in 1950 to 4,000 in 1960. It then grew at a faster rate to 18,000 dollars in 1989. In Spain, GDP grew from 2,000 dollars in 1950 to 8,000 dollars in 1973. It then grew at a slower pace to 12,000 dollars in 1989. In East Germany, it increased almost linearly from 2,500 dollars in 1950 to just above 8,000 dollars in 1989.
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Figure 1.16 The two Germanies: planning and capitalism (1950–89).

The Conference Board. 2015. Total Economy Database. Angus Maddison. 2001. ‘The World Economy: A Millennial Perspective’. Development Centre Studies. Paris: OECD.

Figure 1.16 shows that West Germany started from a more favourable position in 1950 than East Germany. In 1936, before the war began, the two parts of Germany had virtually identical living standards; both had achieved successful industrialization. East Germany’s relative weakness in 1950 was not mainly because of differences in capital equipment or skills, but because its industrial structure was more disrupted by splitting the country than was the case in West Germany.1

But other capitalist economies that had even lower per capita incomes in 1950, grew much faster. By 1989, the Japanese economy, which had also suffered war damage, had—with its own combination of private property, markets, and firms, along with strong government coordination—caught up to West Germany. By 1989, Spain, which until 1975 like East Germany was ruled by a dictatorship, had closed part of the gap. Growth accelerated after the market reforms introduced in 1959.2

We cannot conclude from the German natural experiment that capitalism always promotes rapid economic growth, while central planning is a recipe for relative stagnation. What we can infer is more limited: during the second half of the twentieth century, the divergence of economic institutions mattered for the material living standards of the German people. For a longer run view of comparative performance under central planning (the Soviet Union and Latin American countries), see Figure 1.19 in Section 1.12.

 

Question 1.9 Choose the correct answer(s)

Figure 1.16 shows a graph of GDP per capita for West and East Germany, Japan, and Spain between 1950 and 1990. Read the following statements and choose the correct option(s).

  • Having a much lower starting point in 1950 was the main reason for East Germany’s poor performance compared to West Germany.
  • The fact that Japan and West Germany have the highest GDP per capita in 1990 implies that they found the optimal economic system.
  • Spain was able to grow at a higher growth rate than Germany between 1950 and 1990.
  • The difference in East and West Germany’s performance proves that capitalism always promotes rapid economic growth while central planning is a recipe for stagnation.
  • Japan had an even lower starting point than East Germany and yet was able to catch up with West Germany by 1990.
  • Different economic systems can be successful. The Japanese economy had its own particular combination of private property, markets, and firms, along with a strong government coordinating role, which was different to the West German system.
  • The growth rate of an economy’s GDP per capita can be inferred from the steepness of its curve (when plotted using a ratio (‘log’) scale). The fact that the slope of Spain’s curve is greater than that of either West or East Germany from 1950 to 1990 indicates that it grew at a faster rate.
  • In economics one cannot use only one piece of evidence to ‘prove’ a theory. What we can infer here is that during the second half of the twentieth century, the divergence of economic institutions mattered for the livelihoods of the German people.
  1. Hartmut Berghoff and Uta Andrea Balbier. 2013. ‘From Centrally Planned Economy to Capitalist Avant-Garde? The Creation, Collapse, and Transformation of a Socialist Economy’. In The East German Economy, 1945–2010: Falling Behind or Catching Up? Cambridge: Cambridge University Press. 

  2. Leandro Prados de la Escosura, Joan R. Rosés and Isabel Sanz-Villarroya. 2011. ‘Economic Reforms and Growth in Franco’s Spain’, Journal of Iberian and Latin American Economic History, Vol. 30 No. 1, pp. 45–89.