governance and innovation (routledge studies in global competition)

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Governance and Innovation

This book focuses on the relationships between rules of decision-making

and economic development, concentrating on the similarities and differences

between old and modern modes of governance in both business and politics.

Maria Brouwer uses concepts such as uncertainty and expectations to analyze

political and corporate governance models from an economic theoretical

perspective.

Governance and Innovation analyzes the emergence of organizations and

institutions conducive to commerce and growth and the relationship withpolitical organization in both past and present in order to improve our

understanding of economic development. The author shows how maritime

trade spawned many organizational innovations in the past that still feature

in modern innovative enterprise, and highlights how political governance

can stimulate or hinder innovation, taking issue with existing legislation on

bankruptcy and corporate governance. The effects of political governance

on innovation are modeled to analyze how competition for novelty enhances

the value of human capital.This book will be of great use to students and researchers engaged in

political and corporate governance, leadership and entrepreneurship, as well

as policy-makers interested in economic development.

Maria Brouwer is Professor in Economics at the University of Amsterdam.

Routledge Studies in Global CompetitionEdited by John Cantwell, Rutgers, the State University of New Jersey, USA,

and David Mowery, University of California, Berkeley, USA

1 Japanese Firms in Europe

Edited by Frederique Sachwald

2 Technological Innovation,

Multinational Corporations and

New International

Competitiveness

The case of intermediate

countries

Edited by Jose Molero

3 Global Competition and the

Labour Market

Nigel Driffield

4 The Source of Capital Goods

Innovation

The role of user firms inJapan and Korea

Kong-Rae Lee

5 Climates of Global Competition

Maria Bengtsson

6 Multinational Enterprises and

Technological Spillovers

Tommaso Perez

7 Governance of International

Strategic Alliances

Technology and transaction

costs

Joanne E. Oxley

8 Strategy in Emerging

Markets

Telecommunications

establishments in Europe

Anders Pehrsson

9 Going Multinational

The Korean experience of

direct investment

Edited by

Frederique Sachwald

10 Multinational Firms and

Impacts on Employment,Trade and Technology

New perspectives for a

new century

Edited by Robert E. Lipsey

and Jean-Louis Mucchielli

11 Multinational Firms

The global-local dilemma

Edited by John H. Dunning

and Jean-Louis Mucchielli

12 MIT and the Rise of

Entrepreneurial Science

Henry Etzkowitz

13 Technological Resources

and the Logic of Corporate

Diversification

Brian Silverman

14 The Economics of Innovation,

New Technologies and Structural

Change

Cristiano Antonelli

15 European Union Direct

Investment in China

Characteristics, challenges andperspectives

Daniel Van Den Bulcke,

Haiyan Zhang and

Maria do Ceu Esteves

16 Biotechnology in Comparative

Perspective

Edited by Gerhard Fuchs

17 Technological Change and

Economic PerformanceAlbert L. Link and

Donald S. Siegel

18 Multinational Corporations

and European Regional Systems

of Innovation

John Cantwell and

Simona Iammarino

19 Knowledge and Innovation in

Regional Industry

An entrepreneurial coalition

Roel Rutten

20 Local Industrial Clusters

Existence, emergence and

evolutionThomas Brenner

21 The Emerging IndustrialStructure of the Wider

Europe

Edited by Francis McGowen,

Slavo Radosevic and

Nick Von Tunzelmann

22 Entrepreneurship

A new perspective

Thomas Grebel

23 Evaluating Public Research

Institutions

The U.S. Advanced Technology

Programs Intramural ResearchInitiative

Albert N. Link and John T. Scott

24 Location and Competition

Edited by Steven Brakman and

Harry Garretsen

25 Entrepreneurship and

Dynamics in the KnowledgeEconomy

Edited by Charlie Karlsson,

Borje Johansson and

Roger R. Stough

26 Evolution and Design of

Institutions

Edited by Christian Schubert

and Georg von Wangenheim

27 The Changing Economic

Geography of Globalization

Reinventing space

Edited by Giovanna Vertova

28 Economics of the Firm

Analysis, evolution and history

Edited by Michael Dietrich

29 Innovation, Technology and

Hypercompetition

Hans Gottinger

30 Mergers and Acquisitions in Asia

A global perspective

Roger Y. W. Tang and

Ali M. Metwalli

31 Competitiveness of New

Industries

Institutional framework and

learning in InformationTechnology in Japan, the U.S

and Germany

Edited Cornelia Storz and

Andreas Moerke

32 Entry and Post-Entry

Performance of Newborn

FirmsMarco Vivarelli

33 Changes in Regional Firm

Founding Activities

A theoretical explanation and

empirical evidence

Dirk Fornahl

34 Risk Appraisal and Venture

Capital in High Technology

New Ventures

Gavin C. Reid and

Julia A. Smith

35 Competing for Knowledge

Creating, connecting andgrowing

Robert Huggins and

Hiro Izushi

36 Corporate Governance, Finance

and the Technological

Advantage of Nations

Andrew Tylecote and

Francesca Visintin

37 Dynamic Capabilities between

Firm Organisation and Local

Systems of Production

Edited by Riccardo Leoncini

and Sandro Montresor

38 Localised Technological Change

Towards the economics of

complexity

Cristiano Antonelli

39 Knowledge Economies

Innovation, organization and

locationWilfred Dolfsma

40 Governance and Innovation

A historical view

Maria Brouwer

41 Public Policy for Regional

DevelopmentEdited by

Jorge Martinez-Vazquez

and Francois Vaillancourt

Governance and InnovationA historical view

Maria Brouwer

First published 2008by Routledge2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN

Simultaneously published in the USA and Canadaby Routledge270 Madison Avenue, New York, NY 10016

Routledge is an imprint of the Taylor & Francis Group, an informa business

# 2008 Maria Brouwer

All rights reserved. No part of this book may be reprinted or reproducedor utilised in any for m or by any electronic, mechanical, or other means,now known or hereafter invented, including photocopying and recording,or in any infor mation storage or retrieval system, without perm ission inwriting from the publishers.

British Library Cataloguing in Publication DataA catalogue record for this book is available from the British Library

Library of Congress Cataloging in Publication DataBrouwer, Maria.Governance and innovation / Maria Brouwer.p. cm.

Includes bibliographical references and index.1. Organizational change. 2. Economic development. 3. Institutional

economics. 4. Political stability. I. Title.HD58.8.B758 2008

658.40 063dc22 2007037741

ISBN13 978-0-415-43705-9 (hbk)ISBN13 978-0-203-92951-3 (ebk)

This edition published in the Taylor & Francis e-Library, 2008.

To purchase your own copy of this or any of Taylor & Francis or Routledgescollection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.

ISBN 0-203-92951-9 Master e-book ISBN

Contents

List of tables viii

Preface and acknowledgments ix

Prologue xi

1 Governance and prosperity 1

2 Entrepreneurship and economic development 20

3 Organizations and uncertainty: the management ofperceptions: from medieval Italy to Silicon Valley 44

4 Entrepreneurship and the state 61

5 Valuation and authority in failing firms: the role of

reorganization in US and European bankruptcy law 81

6 Performance pay and uncertainty in entrepreneurial andbureaucratic firms 100

7 Executive pay and tenure: founding fathers, mercenaries and

revolutionaries 120

8 Decision agents in corporate and political democracies:

Venice, Florence and the Low Countries 141

9 Democracy and dictatorship: the politics of innovation 161

10 Waning and emerging empires 185

Notes 216

References 218

Index 229

Tables

4.1 Financial development measured by stock market

capitalization over GDP and the number of listed companies

per million people, 191390 77

5.1 Outside finance as a percentage of GNP for five countries 84

5.2 Creditors rights in five countries 85

7.1 Comparison of compensation structures of Dutch CEOs of

AEX listed companies in 2004 and of US CEOs of S&P

500 in 2002 1297.2 Tenure data for founder/family CEOs 130

7.3 Tenure data for non-family CEOs 131

7.4 Average tenure of departed non-family CEOs, 19742005 131

Preface and acknowledgments

This book is the product of a journey that took me to several places and

allowed me to meet many people. My stay in Amsterdam as a young stu-

dent of economics was enlivened by meeting several people who guided me

on my way. Tiny Fekkes-Peters, Suze Aleven, Madge Kalff-de Vries-Robbe,

Phia de Vries Robbe-Polak and Jeanette de Vries Robbe were several of the

noteworthy people I met then.

My professional career started at Nijenrode Business School and from

there to the University of Amsterdam with notable colleagues such as Robde Lange and Derk Haank. My intellectual journey introduced me to

Schumpeters writings on innovation, which resulted in a doctoral thesis and

a book. After this, my interest in entrepreneurship took me to Boston on a

study trip sponsored by Bert van Twaalfhoven, a Dutch entrepreneur. The

visit to several venture capital firms during the Boston trip opened my eyes

to the importance of finance for entrepreneurship. Several of my articles on

entrepreneurship were published in Small Business Economics and I thank

the editors Zoltan Acs and David Audretsch for their guidance. I also thankAlbert Link, editor of the Journal of Technology Transfer, for his help in

publishing my work.

My interest in issues of management and strategy took me to Haarlem

Business School and Nijmegen School of Management where I taught

executive courses on Corporate Strategy and Organization Theory, and I

am grateful to all my students for the interesting discussions we had.

I would also like to thank the organizers of various Schumpeter Society

conferences where I presented parts of the work: Stan Metcalfe (2000), BobLanzillotti (2002); Franco Malerba (2004) and Jean-Luc Gaffard (2006).

Also thanks to EUNIP, Copenhagen Business School and the University of

Antwerp for participation in their interesting conferences. Three papers that

appear in this book were previously published in journals. Weber,

Schumpeter and Knight on Entrepreneurship and Economic Development

was published in The Journal of Evolutionary Economics (2002) 12: 83105.

Managing Uncertainty through Profit Sharing Contracts from medieval

Italy to Silicon Valley appeared in the Journal of Management and Govern-ance (2005) 9: 23755, and Reorganization in US and European Bankruptcy

Law, appeared in the European Journal of Law and Economics (2006) 22: 520.

Thanks to Springer Publishers for their permission to republish these arti-

cles and editors Stan Metcalfe, Anna Grandori and Juergen Backhaus for

their support.I also want to thank my students at the University of Amsterdam and

especially Linda de Jong, Roderick Verkleij and Freek van Waveren whose

theses contributed to Chapter 7 of the book. Yolande Vroons of the Uni-

versity of Amsterdam helped me prepare the manuscript. I also want to thank

Routledge (Taylor & Francis) editors Terry Clague and Thomas Sutton for

their support and assistance.

Maria Brouwer, July 2007, Amsterdam

x Preface and acknowledgments

Prologue

The US government under President George W. Bush made the promotion

of democracy and freedom a keystone of its foreign policy. However, there

was less freedom in Venezuela, Russia and Thailand in 2006, according to a

Freedom House report. Moreover, the performance of democratic countries

was dismal in several instances. Nigeria, a formal democracy with an ailing

economy, in spite of its rich oil resources is a case in point. Newsweek

commentator Fareed Zakaria commented, The basic problem facing the

developing world to-day is not an absence of democracy but an absence ofgovernance. This is what American foreign policy should be focused on

(Zakaria, Jan. 29, 2007). Democracy thus is not enough on its own to create

stable government that pursues peace and prosperity. This fact was also

known by the people of the republic of Siena, who in 1297 commissioned

Ambrogio Lorenzetti to paint frescoes depicting the Allegory and Effects of

Good and Bad Government on the walls of the Palazzo Pubblico. Good

government was depicted as featuring an impartial judiciary endowed with

wisdom and a city populated by virtuous citizens. Trade prospers under goodgovernment and the people are dancing in the streets. Bad government, by

contrast, features crime, disease and a crumbling city.

In the same vein, Ronald Reagan, in his farewell address of 1989, drew a

picture of a shining city on a hill teeming with people of all kinds, living in

harmony and peace; a city with free ports that hummed with commerce and

creativity that was open to anyone with the will and heart to get there. The

pictures of good government have not changed much in 700 years. Pros-

perity, peace and justice characterize good government. Both the Sieneseand Reagan depicted good government by its results and not by its inten-

tions. The question arises, how are these beneficial results created?

The concept of governance refers to the allocation and exercise of

authority (Zingales, 2000). Governance systems determine who is entitled to

make decisions. Governance also indicates who is held responsible for the

outcome of decisions and how this affects decision-makers.

Governance encompasses both institutions and organizations. Institutions

are the rules of the game as recorded in laws and regulations. Examples ofinstitutions are contract law, family law, property law, money and finance.

Economists agree that good institutions are essential for economic devel-

opment (La Porta et al., 1999). Upholding private property rights; the legal

enforcement of contracts, an independent judiciary and a non-corrupt

executive government branch promote economic growth. The same appliesto an advanced financial and monetary system. Organizations are the play-

ers who play the game set by the rules.

Democracy and autocracy are two political governance systems that

differ with respect to how rules are made and decision-makers are selected.

Democratic executives are elected for limited office terms at modest remu-

nerations. They have to stick to the rules set by elected law-makers. Auto-

cratic decision-makers, by contrast, obtain power by force or inheritance

and have life tenure. They can change the rules without popular approvaland use the countrys wealth for their own purposes. Democracy involves an

open discussion of policies, whereas autocracy lacks open discussion.

Leaders in both politics and business develop and execute strategies to

achieve their goals. Executives only want to take risks, if expected profits

outweigh losses. Commanders in chief, who win a war, can either seize the

country or return home with a fixed pension. Successful business leaders

can get a share of profits or a fixed salary. Modest remuneration should be

paired with small losses in the case of failure. Executives in democracies andcorporations do not have to give up their wealth or their life if their strate-

gies fail. The stakes for failed autocratic leaders are usually higher.

Democracies can elect a president with great authority or leave decision-

making to a collective. Both democracy and autocracy can thus involve a

single decision-maker. The same applies to the corporate world. Some cor-

porations have a CEO, who is also chairman of the board, whereas others

spread authority and responsibility over a larger group. Hence, both poli-

tical and corporate governance show a rich variety of governance modes.Nations and corporations give up (some of) their authority, if they join

an alliance or are acquired by another firm or nation. Historically, regional

political entities were often subject to a higher imperial power. History

records the existence of many empires from Mesopotamia to the British

Empire and Germanys Third Reich. Corporations also outgrew their home

countries and expanded across national boundaries.

Present instabilities of both political and corporate governance have

spurred comparative and historical research on institutions and leadership.The law and finance literature points to the importance of good for growth

institutions and well-developed capital markets. The democracy and dicta-

torship literature wants to explain the evolution of government models

(Acemoglu and Robinson, 2006, 2007). Historians like Niall Ferguson have

investigated the characteristics of former and present empires. This book

will add to this literature by studying the relations between individual moti-

vation and the performance of organizations. Political and economic change

is fueled by individuals who want to improve their station in life and that oftheir family. Initiative in the business world is often labeled entrepreneurship

xii Prologue

and is closely related to new business formation. Some societies promote

entrepreneurship, while others forbid it. Freedom for political action also

differs considerably among nations. Democracy features freedom of poli-

tical organization, whereas dictatorship forbids it. But, freedom in the poli-tical and the economic realm do not need on a par. Democracies can curtail

the freedom of business formation and curb international trade, whereas

dictatorships can open their economies and allow the incorporation of new

business.

Outline of the book

Chapter 1 discusses the literature on globalization; democracy, empire andinstitutional innovation. Economic theory has developed the persona of the

entrepreneur as the main economic change agent. The meaning of the

term, however, has undergone some changes, as is recorded in Chapter 2,

which discusses entrepreneurship in the works of Max Weber, Joseph

Schumpeter and Frank Knight. Webers original work on medieval maritime

enterprises distinguished between the financier as the principal and the

leader of the venture as his agent. However, decision-making was not

restricted to the principal as the captain had to use his own judgment insituations of contingency. Chapter 3 discusses Webers treatise in the light of

modern principal-agent theory. Chapter 4 expands the analysis of maritime

ventures to the Dutch and English Indian trading companies and discusses

the role of the government in European entrepreneurship.

Risk-sharing contracts and limited liability arose in the medieval city-

states and spread to the rest of Europe. Limited liability is essential to

modern bankruptcy law. Chapter 5 discusses changes in bankruptcy law in

the US and some European countries.Chapter 6 investigates the use of incentive pay in small and large firms.

Incentive pay is a feature of entrepreneurial firms that are subject to large

uncertainty. Large incumbents can better diversify their risks and practice

fixed pay. Promotion can be used to stimulate employee motivation, but will

not work, if the outcome is known beforehand and if it is independent of

performance.

Chapter 7 discusses recent changes within the corporate world, involving

CEO compensation and tenure. CEO tenure has been considerably shor-tened, while remuneration has increased. These developments can be

explained by the increased responsibility of CEOs for performance, more

than was common in the past.

Chapter 8 discusses the political evolution of the Italian city republics

and the Low Countries in the late Middle Ages. Florence and Venice

developed new governance models that ranged from direct democracy to

guild democracy and dictatorship. The call for a strong man prompted

Florence to push democracy aside at several points in its history. The samehappened in the Low Countries, where military leadership prevailed. This

Prologue xiii

was not the case in Venice, where responsibility for military ventures was

shared among appointed generals and elected executives.

Chapter 9 discusses some appropriation models and their relationship to

innovation. Autocrats can appropriate a surplus by monopolizing markets,paying people less than their market worth or by innovation. Innovation

thrives on competition and is hardly reconcilable with autocratic allocation.

Chapter 10 discusses the evolution of past and present empires. It dis-

cusses the relationship between empire and democracy and raises the ques-

tion whether empire is still a viable governance model in our days.

xiv Prologue

1 Governance and prosperity

Institutional innovation

Institutions, as the rules of the game, structure human interaction. Institu-

tions need to be distinguished from organizations, who are the players ofthe game. Institutional change emerges out of the interaction between

organizations and institutions (North, 1990: 70). The type of organizations

that emerge in certain periods and places is largely determined by rules and

regulations (ibid.: 5). Institutional change also occurs when people break

the rules in crime or by regime change. The type of institutional change

thus depends on the type of organizations that come to the fore in a legal or

illegal manner.

Organizations like the trading companies emerged in medieval Italy tofinance maritime ventures. Liability problems arose that could not be solved

by existing laws. New concepts like limited liability emerged out of discus-

sions on how to solve the problems in a manner that satisfied all parties.

Representative democracy emerged in city-states to curtail the authority and

liability of political decision-makers. New organizations that undermine

peace and prosperity are war gangs and exploitative autocracies.

North argues that institutions exist to reduce the uncertainties involved in

human interaction (ibid.: 25). People will abide by rules, if they know if theyare applied judiciously. Certainty in this area facilitates human interaction,

but uncertainty can also have positive effects. Certainty about the coming of

disaster will paralyze people, whereas uncertainty will prompt them to

change the odds in their favor. Likewise, people will stay passive, if they fear

the outcome of their actions, but will jump at new possibilities if they expect

gains to outweigh costs. Traditional societies inflicted grave consequences

on those violating tradition, which kept society stable though stagnant.

Modern societies diverge from tradition and create room for initiative. Non-traditional organizations like cities and corporations have developed new

codes of conduct that encourage experimentation and innovation.

North argues that institutional change is driven by transaction costs. The

gains from trade that generations of economists have modeled are reduced

by the costs of exchange. Transaction costs involve the costs of writing

contracts, but also the problems of moral hazard. Parties to a contract want

to maximize their own objectives regardless of how these affect others.

Employees want to shirk; suppliers want to provide lousy products; employers

want to exploit employees and sellers want to monopolize markets. Moralhazard increases the risk premium to transactions and curbs investment (ibid.:

33). But uncertainty due to moral hazard needs to be distinguished from

uncertainty that springs from uncontrollable forces like competition. We do

not want sports teams to control the outcome of a game; likewise we do not

want companies to control the market. Ventures may fail beyond the fault

of the parties involved; markets may clear at prices below costs; competitors

may appear on the scene causing the demise of a company. Competition

makes the outcome of investments uncertain but this type of uncertaintybolsters the trust in the fairness of the game, whereas uncertainty due to

moral hazard can spoil the whole game. Investment is ultimately based on

the expectation that parties to a contract will put in an effort to meet their

obligations. Otherwise, we have to create a command economy, in which each

person fulfills prescribed activities under close supervision. Such arrangements

will hardly turn out to be profitable. Moreover, they will stifle innovation,

which is based on investments in novelty. Innovation requires a discourse on

how to improve things. Ideas will only carry weight, if people are deemedloyal to the organization. Organizations have developed several ways to cope

with moral hazard. Novices had to swear an oath before they entered a

monastic order. Guild members had to go through a period of training before

becoming master. Modern business corporations have developed new ways

of control, such as behavioral codes, performance pay, corporate training and

rituals to cement a common corporate culture. Investment and trade thus

assume that organizations find ways to curb moral hazard. This applies with

the greatest force to organizations that surpass national boundaries. How-ever, some eras were more conducive to international trade and investments

than others.

The ebb and flow of globalization

Globalization involves a process of expanding world trade and increasing

the mobility of production factors. Investors nowadays move their capital

around the globe at lightning speed; people leave their hometowns to moveto domestic or foreign cities to flee poverty and political turmoil.

Some people abhor globalization because of the alleged exploitation of

people and the environmental damage it would cause. It is argued that glo-

balization widens income differences both within and between nations (Hardt

and Negri, 2000). Large multinational corporations would replace indigen-

ous industries. Local communities would lose their cultural identity and

submerge in Western mass culture. Others contend that globalization creates

opportunities for the many who have been excluded from prosperity up tillnow and consider it the ultimate vehicle of emancipation.


Globalization is also assumed to affect politics. Nation-states are assumed

to wither away and a new empire would emerge that obeys the dictates of

the large multinationals and pushes democracy aside (Forrester, 2000).

Others argue that small ethnic enclaves and city-states are arising in theaftermath of the collapse of the Soviet Union (Kaplan, 2000). The political

effects of globalization are thus not undisputed. Some see nations disappearing

due to emerging empire, whereas others foresee political fragmentation due

to waning empire.

History shows periods of rise and fall of long-distance trade. Trade was

more extensive in ancient Greek and Roman times than in the early and high

Middle Ages (4001000 AD). Trade peaked in the nineteenth century and

declined after World War I to rise again after World War II. The 1913 level oftrade was only restored in 1973 (Krugman, 1995). Historically, trade surged,

when cities grew, whereas the decline of cities coincided with a decline of (long-

distance) trade. This applies to the cities that arose in the river valleys of

Sumeria, Mesopotamia and Egypt. Maritime civilizations such as those of

Phoenicia and Greece endorsed the rise of autonomous city-states. Greek city-

states obtained autonomy after the Mycenaean Kingdom fell apart. Trade

flourished in Athens of Antiquity and Athenian colonies were established

along the Mediterranean coast. Some Greek city-states spawned democraticgovernment, such as fifth-century BC Athens. Not all Greek city-states, how-

ever, furthered commerce and democracy. Corinth was ruled by a small

aristocracy; Sparta by two kings and five ephors. Trade played a minor role

in the economies of both Corinth and Sparta (McNeill, 1963: 202). However,

Athenian democracy was not stable; Athens repeatedly altered the rules of

the political game. Tyrants overthrew democratic government and installed

autocratic rule. Oligarchs threatened Athenian democracy in 411 and 404 BC

in an attempt to reduce progressive taxation. Inter-city warfare also under-mined city-states. Athens was beaten in the Peloponnesian War after Sparta

had concluded an alliance with her enemies (431 BC). Military defeat brought

the end of Athenian glory. Many colonies chose Spartas side and the ones that

had supported Athens were overrun by Spartas allies. The feelings of solidarity

that had characterized Greek city culture disappeared in the wake of defeat.

Thucydides recorded how Athenian society was divided into camps of friends

and enemies. Sophists and other Greek philosophers put Athenian leadership

under heavy scrutiny after the defeat. Plato (427347 BC) wanted to cureAthenian society by abolishing all economic and social change. Everybody

in his Republic carried out his hereditary duties as slave, soldier or aristocrat.

The slaves labored, the soldiers fought and the aristocrats ruled. Freedom of

speech was limited. Platos idea of social and cultural ossification to ward

off change was not novel and was practiced by many later civilizations that

preferred stability to innovation. Greek cities lost their independence in the

Hellenistic period. The freedom of the cities of Antiquity was swept away

by a bureaucratically organized world (Weber, 1978: 335). Overseas tradedeclined and the countryside gained political weight.

Governance and prosperity 3

The example of Athens illustrates how city-states rose and fell due to

internal and external causes. The same applied to old imperial civilizations,

whose existence was threatened by recurrent barbaric invasions and cultural

ossification. The need for river regulation and an irrigation policy in theNear East and in Egypt, and to a lesser degree also in China, caused the

development of royal bureaucracies (ibid.: 1261). The bureaucracy was charged

with construction tasks and with the organization of the army. The Meso-

potamian King Hammurabi, whose empire extended from the Mediterra-

nean to the Bay of Bengal, founded the first royal bureaucracy and codified

existing law (the famous Hammurabi Code). His royal judges, tax collectors

and garrison commanders were sent all over the empire and he commu-

nicated with them by way of written reports. The development of a writtenlanguage and of codified law greatly facilitated trade. Merchants could

reckon on a universal judicial system and on royal military protection. The

market mechanism arose as a new coordinating device distinct from com-

mand, but this period of economic and cultural bloom was brief. Stagnation

set in round 1500 BC, when officials were required to undergo long periods

of training, which could scarcely fail to produce in each successful pupil a

thoroughly conventional mind. Schools became jealous corporations,

guarding both professional standards and professional privileges with animpartial rigor. Science especially mathematics which had flourished

under Hammurabi, came to a standstill. (McNeill, 1963: 601).

Sailors from Phoenicia ventured as far as Britain and the Atlantic coast

of Africa. However, Babylonian culture was deeply conservative and the

cultural bloom of Hammurabis days was never restored (ibid.: 136). Lit-

erature was only available in old styles of writing. Simplified scripts were

developed for commercial purposes but were not used by the ruling elite.

The Mesopotamian valley civilization reached its end, when nomadic tribesinvaded the empire, which then broke up into many smaller states. Imperial

rule was re-established, when local warlords submitted to a successful

leader. Hammurabis laws were re-established and trade revived.

The Persian Empire succumbed to barbarian attacks in 200 AD. Nomadic

tribes also overran India and China on several occasions; most notable

were the raids by Genghis Khan. The same applies to Ancient Rome, whose

decline was hastened by Hun invasions. Nomadic steppe peoples dis-

tinguished themselves from civilized societies by their lack of investments ininfrastructural works, such as temples and palaces. However, nomadic

societies were capable of military and organizational innovation. Warriors

were not highly esteemed in oriental literate civilization, but military pro-

wess was considered the main virtue of a man in the nomadic war

bands. Many civilizations could not overcome the steppe peoples, once they

had organized themselves in a confederation of tribes. A charismatic leader

such as Genghis Khan could overcome tribal differences and organize

people under his leadership. The horse-mounted nomads constituted arather egalitarian society during periods of war. This changed, when they


settled down in the conquered territories and changed to more permanent

organizations.

Both city-states and imperial bureaucracies established institutions con-

ducive to trade. This does not apply to feudalism. Feudalism was firstintroduced by the Parthans in 400 BC, who established military aristocracies

to supervise provinces. Aristocratic titles were first granted to the most

courageous and successful warriors, but became hereditary later on. A pea-

sant village provided sufficient income to a lord, who in turn defended

his subjects against nomad attacks. Feudal organization was not conducive

to long-distance trade due to contributions in kind made by its subjects.

Feudal military organization was better equipped to ward off foreign inva-

sions and suppress domestic rebellion than a bureaucracy. Feudal lords wereeager to expand their territory. However, feudal strife would weaken stabi-

lity and create tensions between emperor and local rulers. Mercenary and

slave armies were sometimes used to counterbalance local feudal military

power. Religious authority was also invoked to strengthen central authority.

Another device to overcome the inherent tension between centralization and

decentralization was to move the aristocracy to the capital for at least part

of the year.

The feudal model was adopted by the Byzantine, Carolingian, Arab andOttoman Empires. The military success of Islam was due to the confederate

tribal factor, which remained important in the first centuries of Moslem

rule. Islam rewarded its warriors in a feudal manner and adopted feudal

organization and ethics (Weber, 1978: 6246). Several Moslem empires or

caliphates existed. The last was the Abbasid Caliphate located in Baghdad

which lasted from 750 till 1258, when it fell due to Mongol and Turkish

invasions. The Moslem world then fragmented into many local lordships.

The period of political fragmentation ended, when the Ottoman Empireespoused Islam. The exploitation of feudal fiefs constituted the most prof-

itable enterprise in the Ottoman Empire and the locus of power resided in

the countryside. Only a few towns in Anatolia and Iran approached the

autonomy of the free towns of Europe during the same age (McNeill, 1963:

496). Central power was supported by a slave army of converted Christian

boys from the Balkan, the Janissaries.

Trade flourished in the Roman Republic, but the Empire replaced trade

privileges by the distribution of land to the military. Land ownershipbecame hereditary in imperial Rome and tributes to the state took the form

of either compulsory contributions or compulsory labor. The entire grain

harvest was distributed to the cities according to their needs; surpassing the

market mechanism.

Trade revived in the late medieval and Renaissance period, when city-

states such as Venice, Florence, Antwerp and Amsterdam prospered due to

overseas trade. European globalization developed by fits and starts after

1500. The Italian city-states were succeeded by Holland and Britain as themain maritime powers, which in turn were superseded by rising powers


like the United States, whose growth surpassed that of Great Britain in the

nineteenth century.

International trade peaked in the nineteenth century and declined after

1913, when protectionism and mercantilism recurred. Capital also flowedfreely between the continents in the nineteenth century and World War I

constituted a watershed in this respect. The recent wave of globalization

thus does not constitute a new phenomenon. Each new wave of globaliza-

tion has occurred when new organizations emerge that thrive on trade.

Both political fragmentation and integration can spur trade. The decline

and fall of the Mycenean Empire and the Roman Holy Empire gave rise to

city-states that reinvigorated trade. The British Empire promoted trade in the

nineteenth century. The question whether either a strong empire such as theBritish Empire or a weak empire such as the Holy Roman Empire promotes

trade and growth has not been answered unequivocally. The answer varies

according to time and place, depending on the new organizations it spawns.

The end of history?

The collapse of the Soviet Union in 1989 inspired some people to predict

the end of the ideological quest for dominance. Liberal democracy hadbecome the uncontested government of choice of millions of people around

the globe, preferred to monarchy, communism and fascism (Fukuyama,

1992). People were to be organized in nation-states, whose relations were

peaceful and based on the principle of mutual recognition. Autocratic

regimes based on ideologies like communism and fascism had proved to be

unsuited to cope with the exigencies of post-industrial society. Hence, there

is no alternative to liberal democracy and capitalism in our times. Democ-

racy expresses the equality of all citizens and therewith calls for the end ofdominance both within and between nations, in Fukuyamas view. The

desire for recognition and prestige had driven people into bloody battles for

domination in the past, making masters out of victors and enslaving the

conquered. This Hegelian interpretation of history leaves no other distinc-

tion between people than that of victor and victim. However, the French

and American Revolutions created opportunities for all people to become

equal citizens in a democracy. Liberal democracy replaced the irrational

desire to be recognized as greater than others with a rational desire to berecognized as equal (ibid.: xx). With equal and reciprocal recognition the

reasons for tyranny and imperialism would end too, as nobody wanted to

impose their will on others. Without the desire for superiority, history

would witness its last man: a person without ambition. The end of history

would thus entail the end of progress.

Fukuyamas Hegelian analysis of peoples motives is somewhat limited, in

my opinion. The same applies to his analysis of democracy. I want to argue

that although liberal democracy is based on the ex ante political equality ofindividuals, this does not need to imply that each person has equal authority.


Some people rise to leadership, whereas others lack decision-making power.

Some people gain wealth, whereas others do not. Fukuyama limits recog-

nition to the military powerful, whose superiority is recognized by weaker

people, but such recognition is shallow, as it is involuntary. Recognition, in aliberal sense, refers to political and corporate leaders that are chosen. Demo-

cratic political leaders are chosen by the many, whereas entrepreneurs are

initially chosen by a few investors. Investors in art and business gain, if they

discern value before others do. Such recognition is the main source of

capitalist profits. It requires that investors hold different views on the value

of a certain person or project. We could argue that recognition is the essential

ingredient of capitalism, which created a new peaceful game creating win-

ners and losers, but benefiting all.Investment decisions are tested by the market, which can prove them

wrong. An investor can refuse to invest in a certain venture, but is proved

wrong, if other investors turn it into a success. Employers can refuse to hire

certain workers, but will pull their hair out, if they become the star of their

competitors. Economic theory points out that homogenous labor receives

equal rewards but human capital is heterogeneous from the perspective of a

business organization that wants to select those individuals that fit its

organization best. Education is only an imperfect predictor of the value ofhuman capital for a certain organization. Business firms, therefore, turn to

unorthodox ways to select their favorite employees as Google did, when it

developed an algorithm to select its employees, instead of relying on inter-

views and educational achievements. Liberal democracy is thus all about

diversity and not the bland, homogenous soup of Fukuyamas description.

Liberal democracy can only achieve higher per capita growth, if its inno-

vative powers exceed that of other governance systems. Innovation involves

the introduction of novelty in economic life, whose value exceeds that offormer ways of doing things. Successful innovation generates profits for

investors and value for consumers. Liberal democracy has to be better at

discovering the best people with the best ideas to out-compete other gov-

ernance systems. Market competition forces firms to look for yet undetected

human capital. The discrepancy between ex ante valuation and ex post

realization generates profits and losses. Economic competition makes social

positions volatile and therefore differs from feudal and bureaucratic gov-

ernance, where a persons fate was largely determined at birth. Only a fewindividuals could improve their position by joining the military or entering

the royal palace. There were wars and battles, victories and defeats, but the

greater part of the population remained unaffected by these changes. They

tilled the land according to time-honored traditions, on subsistence incomes.

Surpluses accrued to local and far-off rulers; shortages caused famines.

Traditional societies largely lacked incentives for innovation and can be

described more as a population of last men than our modern post-industrial

society. Liberal democracy that offers incentives to individuals to improvetheir lives can better be described as a society of first men and women.


Fukuyamas analysis rests on the premise that the best political system

wins the contest, which ends the game. He argues that fascism was defeated

together with Hitler, after which fascism lost its appeal and legitimacy. The

collapse of the Soviet Union points to the economic defeat of communism.However, Fukuyamas argument entails that democracy could also lose its

appeal and be superseded by a new ideology or a militarily superior power.

His argument of the end of history thus depends crucially on both the eco-

nomic and military superiority of liberal capitalism. Arguably, capitalism

won the race for production figures during the years of the Cold War, but

has not yet won the hearts and minds of everyone.

The stability of democracy

Francis Fukuyama predicted the end of history and the permanent success

of liberal democracy. However, democracy has proven to be a rather

unstable form of government. This applies to antiquity but also to modern

democracies. History does not seem to support the hypothesis that democ-

racy entails the end of history. The French Revolution did not mark the

beginning of the end of history for France, but brought Napoleon and his

drive for imperial power. The American Revolution did not prevent theoccurrence of the American Civil War. The road to the end of history also

made many detours in the twentieth century, when many European nations

fell prey to autocratic regimes of both the Right and the Left. Fascism was

based on the denial of the equality of all men and assumed the existence of

a master race. Communism was based on the equality of all men, but some

were more equal than others. Political leaders wanted to replace the vagaries

of the market by state control of the economy and incomes. Consequently,

peoples lives were put in the hands of a single authority, which turned outto be more interested in finding hidden enemies than hidden talent.

The relationship between democracy and prosperity is also puzzling.

Democracy was found to be positively related to per capita income (Lipset,

1959). The relationship between democratization and economic growth,

however, is less obvious (Acemoglu et al., 2005). The positive relationship

between democracy and income can be explained by the fact that, histori-

cally, democracy was the preferred governance model of commercial socie-

ties. Democratic government first arose in commercial city-states such asAthens, Venice, Genoa, Florence and the cities of the Low Countries. These

governments were ruled by wealthy merchants, who wanted to preserve the

rules of the game and protect property rights.

The twentieth century featured many rapid movements from democracy

to dictatorship and back in many countries. Many newly established

democracies were unstable and fell prey to coups and revolutions. The his-

tory of Argentina is a case in point. Democracy was set up in Argentina in

1912, but a military coup led to the Peron era and a military regime. NoLatin American democracy was stable in the twentieth century. The same


applies to many Sub-Saharan democracies that emerged in the wake of

decolonization. The development path of these newly founded democracies

differs from British experience, whose democracy once installed was

never threatened. Continental Europe, however, saw democracy alternatewith dictatorship during the twentieth century in most continental European

countries.

We can argue that democracy provided new instruments for resolving

disputes; such as the majority vote and consensus-building instead of using

physical force. Yet, political disputes, which cannot be repressed, as in

autocratic regimes, can destabilize democracy. Such disputes are not always

resolved by parliamentary discussions, as the many regime changes in

democracies in the past centuries testify. Hence, democracy carries the seedsof its own destruction in military coups and revolutions. Moreover, democ-

racy can be abolished by democratic means. Democratically elected leaders

can extend their tenure by decree. Such processes of aggrandizement could

be witnessed in Germany, the Philippines, Zimbabwe and a host of other

countries.

Democracy is called stable, if it is not defeated by a foreign power or

overthrown from within. The instability of democracy seems to follow

naturally from the ever shifting balance of power between a rich oligarchyand a less well-endowed mass. Acemoglu and Robinson modeled coups as

attempts by minorities (elites) to impose their will on the majority. Elites are

always outvoted in democracies, since peoples opinions are derived from

their economic position (Acemoglu and Robinson, 2006: 211). The poor

would always outnumber the rich in societies without a middle class. The

logic of the median voter, therefore, impels the masses to support revolu-

tions that expropriate the rich and elites to support coups. Change of gov-

ernment would spell the end of the old game and the start of a new one ona clean slate!

The analysis of Acemoglu and Robinson, which is based on the distribu-

tion of the national produce according to either majority rule or military

force, is not representative of liberal democracy, in my opinion. That is

because the market as an allocation and distribution mechanism is largely

absent in their models. Acemoglu and Robinsons models are based on the

assumption that distribution is determined by politics, i.e. the tax rate. The

fear of the wrath of the masses forces ruling elites in dictatorships to dis-tribute some of the national product to the poor in order to keep them from

overthrowing the government by revolution. Hence, the revolution con-

straint would stop the ruling elite from complete expropriation. Moreover, a

revolution would diminish the national product due to the destruction of

assets (ibid.: 121). Acemoglu and Robinson model revolutions as a collec-

tive action problem; some will undertake revolutionary activities for the

benefit of the many. Hence, revolutionaries are scarce due to the public

good character of revolutions and the inherent free rider problems (ibid.:123). Yet this seems to ignore the fact that many revolutionary leaders


assume political leadership after they succeed in overthrowing the incum-

bent government. Lenin, Mao and Fidel Castro became leaders for life.

Moreover, many former revolutionaries were not rewarded, but were

eliminated as they posed a threat to single political leadership. Revolutionsand coups need to offer glittering prizes to the few who succeed in grasp-

ing power in a post-revolutionary society. A failed politician in a democracy

loses his job, but not his wealth or his life. However, failed attempts at

absolute rule carry great risks of losing both property and life. We could,

therefore, argue that revolution does not suffer from a free rider but from a

high risk problem.

Democracy introduced the concept of limited liability into the political

realm. Dictatorship, by contrast, raised both the rewards and the risks ofpolitical entrepreneurship. Dynastic rule can stabilize autocracy. Stable

democracy, by contrast, does not depend on individuals, but on institutions.

Democracy versus oligarchy

Alexis de Tocqueville, who wrote a perceptive analysis of early American

democracy, also identified democracy with equality. US incomes were rather

equal at the time of his visit to the US in 183132. We can argue that theUS economy at the time consisted of small enterprises, which did not allow

great differences of wealth and income. Anyway, De Tocqueville was struck

by the equality of condition that he found there. Another of his observa-

tions involved the degree of organization by voluntary associations in both

politics and business. He perceived the US as a society without an elite, and

therefore characteristically different from oligarchy. He foresaw that equal-

ity would also be Europes future. De Tocqueville, who was born into a

French aristocratic family that survived the French Revolution, comparesUS democracy to oligarchy, which had prevailed in France during the 700

years before the Revolution. The French territory came to be ruled by a

small number of families with hereditary succession. Equality increased in

this feudal context by the opportunities for advancement opened by the

Church and commerce. Consequently, military prowess became less impor-

tant over time; education paid off and the value of nobility depreciated (De

Tocqueville, 2001: 267). The Crusades limited the number of nobles and

their possessions. Eventually, all privileges were abandoned and royal powerincreased. His analysis describes how oligarchy gave way to single rule in

France. The French Revolution toppled this structure and installed democ-

racy, which was, however, of an unstable nature. He attributed the several

regime changes that occurred in post-revolutionary France to be flowing

from two different tendencies, which arose in the French Revolution. The

first was favorable to liberty, as it loosened the absolute power of the mon-

arch. The second was favorable to despotism as it did away with provincial

institutions and installed centralized administration (ibid.: 71). The rem-nants of feudalism that were present in France before the Revolution gave at


least some people a voice. They could hold a dissenting opinion, since their

possessions and hereditary title made them largely independent of royal

power. Only independent people can hold an opinion of their own in De

Tocquevilles analysis. Their independence derives from the fact that theycannot lose their title and possessions. The question, however, arises whe-

ther these magistrates were also responsible for their opinions. Moreover,

De Tocqueville does not answer the question how many divergent opinions

can lead to one decision. This might have been superfluous in French oli-

garchic government, if oligarchs had jurisdiction in their own estate. It

seems, however, doubtful whether such decentralized government could curb

the evils of arbitrary power. People could only escape arbitrary power by

moving to another jurisdiction.De Tocqueville argues that a centralized democracy can entrust all decision

power to a single person, chosen by the people. He predicts that representa-

tive government will fall prey to what he calls the tyranny of the majority.

He here touches on the heart of the governance problem; the effects of

leaving decision-making to one or a few persons. Both nobles and kings

were infallible in the oligarchic system; if something went wrong; it was

blamed on the advisers. De Tocqueville suggests that the democratic leader

cannot fail either, because he represents majority opinion (which in his viewis crafted by the press). Nobody would want to deviate from majority opi-

nion in a democracy at the expense of total isolation. De Tocqueville sees

two antidotes to this tyranny of the majority. The first involves the decen-

tralization of government, which leaves some decisions to local government.

This would open up possibilities for people to choose their own jurisdiction.

People can thus vote with their feet, if democracy allows freedom of move-

ment. Another mechanism for institutional improvement involves the way

the US judiciary operates. De Tocqueville describes how US judges candiverge from general principles by declaring that a decision along these lines

in a certain case would violate the Constitution (ibid.: 73). Hence, an indi-

vidual judge can rejuvenate the law by offering a new interpretation.

De Tocqueville was most struck by the abundance of associations he

found in the US. He points primarily to political associations, which in

contrast to Europe were largely peaceful; they wanted to convince and not

to fight (ibid.: 100). Freedom of association extended to the economic

realm, where people were free to found their own businesses.Freedom of association heightened motivation, in his view, because

people could choose their own organization, which unleashed the energy of

multitudes. De Tocqueville considers freedom of association the main com-

parative advantage of democracy. The disadvantages lie in the realm of

culture and quality. His aristocratic background led him to presume that art

that is made for the masses must be of a lower quality than art produced for

elites. He applied the same analysis to science. The detached scientist of

former days, who was more interested in general principles than in practicalsolutions, would not thrive in a democratic society, in contrast to oligarchic


society. His assumption that a hereditary elite would always feature the best

and brightest seems beyond the mark. However, his idea that people whose

position is secure are more inclined to speak their mind freely contains some

truth. However, their opinions are uncontested in the absence of competition.

The end of empire?

Both Fukuyama and De Tocqueville saw democracy as the government of

the future. Niall Ferguson, however, advocates a return of empire. He

argues that the end of history will not come, since the struggle for mastery

is both perennial and universal (Ferguson, 2004: xxii). He advocates empire

as the governance model of choice, since history shows that the absence of aworld power leads to the darkness of anarchy. Ferguson discerns a period of

a-polarity that prevailed between 843 and 1095 AD, when the two halves of

the Roman Empire Rome and Byzantium had passed the height of their

power and imperial power in the Abbasid Caliphate and imperial China was

on a steep decline. He describes this period as one in which people were

inward-looking instead of outward-looking. The a-polar period constituted

the antithesis of globalization. The world was broken up into disconnected,

introverted civilizations, which were susceptible to raids on urban centers byless civilized people such as the Vikings (ibid.: xxvi).

However, not all empires are considered beneficial. Ferguson distin-

guishes between liberal and illiberal empires; the former promotes trade,

while the latter curbs trade. Liberal empires establish and enforce the rules

of the capitalist game on territories under their jurisdiction. International

trade requires that both parties agree on the rules of the game. This can be

accomplished, if both nations adopt one set of rules, or when nations

mutually recognize each others rules. Institutions can also be imposed onpeople by an imperial power. Foreign investment is hampered, when nations

are expected to change the rules and declare former obligations null and

void. Twentieth-century empires defaulted on their debts and introduced

new laws that expropriated people. Drastic institutional renewal also occurs

in democracies that redistribute wealth. Expected, institutional instability

hampers economic growth, as it adds a risk premium to investments. The

British Empire was able to eradicate the risk premium on foreign invest-

ments by removing the risk of default. Bond yield figures for Indian bondswere below 4 percent in between 1870 and 1914 (ibid.: 191). Empire was a

better guarantee than adherence to the gold standard, which did not pre-

vent countries from defaulting on their debt. Argentina defaulted in 1888

93 and Brazil both in 1880 and 1914. Consequently, Argentine bond yields

were more than 200 basis points higher than Indian yields in the pre-World

War I period. Hence, the British Empire boosted investment.

A large number of developing nations defaulted on their debts after 1945.

Consequently, investments in poor countries have decreased to a muchlower level than was the case before 1914 (ibid.: 189). New institutions such


as the World Bank and the International Monetary Fund (IMF) could not

change this trend.

Liberal and illiberal empires differ with respect to their attitude towards

trade, but most empires were multi-ethnic. Some empires made governmentthe reserve of an ethnic master class; other empires allowed subjects of

various origins to move up the ranks of military and government bureau-

cracies. Non-Romans could reach high positions in Ancient Rome. But the

possibilities for upward social mobility of subject people were far from

perfect in most empires. Access to the elite was largely determined by birth.

Some bureaucratic empires used learning as a method of ascent; China and

Byzantium are cases in point. Feudal empires used military prowess, but

entry into the ruling elite was restricted and the vast majority lacked anypossibility of social improvement.

Another question involves the extent to which liberal empire improved

the living standards of people under their rule. The figures of nineteenth-

century British rule are not unequivocally positive. Indian per capita income

more or less stagnated under imperial rule; it grew by only 0.12 percent per

annum between 1820 and 1950 (ibid.: 194). This differed considerably from

the growth in the British Dominions (Canada, Australia) and the United

States. Moreover, growth in the Dominions also largely surpassed that ofGreat Britain. Indias meager growth occurred in spite of large capital

exports to India to build railroads and other infra-structural works. True,

India did better under British rule than China at the time and Indias eco-

nomic performance deteriorated after becoming independent (ibid.: 175).

The same rather bleak performance of British imperialism appeared in

Egypt, whose years under British rule (18821956) were characterized by

stagnant per capita incomes (ibid.: 222). This also happened in spite of large

capital exports from Britain to Egypt. The primary reason for Britishinvolvement with Egypt was the protection of British investments and of

safe passage for British ships through the Suez Canal. The British had

heavily invested in Egyptian government bonds, which would lose their

value if the country was unable to repay its debts. Ferguson argues that

Britain acted in the same way as the IMF does today with bad debtor

nations; they reorganize the debt and put good policies in place. But Britain

could bolster their policies by naval force, unlike the IMF.

The economic successes of nineteenth-century British imperialism werethus underwhelming. This differed from the performance of nations that

had just become independent, such as the Latin American countries, which

gained independence at the beginning of the nineteenth century. These grew

as rapidly as the US in 18701913. Independence or promotion to com-

monwealth status, which signaled the achievement of maturity as a nation,

spurred economic growth. We can argue that the British, Dutch, French,

Spanish and Portuguese Empires had outstayed their economic welcome.

Nationalist groups in both India and Egypt expressed their desire for inde-pendence in an increasingly forceful manner. But many nations, after gaining


independence, choose economic isolation instead of pursuing trade. More-

over, they are subject to coups and subsequent regime changes, which deter

foreign investment. The dismal performance of many independent nations

seems to indicate that imperial rule is preferable. Ferguson considers thepresent predicament of many nations as a failure of de-colonization. Many

new nations were not up to the job of nation- and institution-building and

instead fell prey to ethnic clashes and corrupt government, which trans-

ferred a large share of international aid monies to foreign bank accounts

(ibid.: 180).

The consequence of political instability was that capital flows have been

diverted from the poorest nations to developed countries and emerging

countries in Asia, like India and China. Britain invested four times as muchin Africa in 1913 than in 2000. But Britain invested even more in indepen-

dent countries in the Americas than in Africa and Asia in 1913 (Ferguson,

2003: 244).

The question, whether the world needs a new liberal empire could thus be

answered in the negative, if we look at nineteenth-century data. The ques-

tion only gains relevance, if we compare it to twentieth-century perfor-

mances of independent nations. Ferguson has selected a successor to British

imperialism; he considers the United States the best candidate for the job(Ferguson, 2004: 301). The US, however, has no imperial ambitions. It is an

empire in denial that does not want to occupy nations. However, Ferguson

argues that the few successes of US attempts at nation-building after 1945,

i.e. Germany, Japan and South Korea, involved lengthy occupations and

large military deployments. We could argue that the three countries men-

tioned above crafted development models of their own. The three countries

opened themselves up to trade, but kept foreign direct investment largely at

bay. This differed from the nineteenth-century development model, whichthrived on foreign investment. The late twentieth century saw a revival of

foreign direct investment, when India, China and other emerging economies

countries were opened up to foreign direct investment.

Ethnicity as an organization principle

The break-up of twentieth-century empires triggered the formation of

independent nation-states and the rise of new empires such as Nazi Ger-many, the Soviet Union and Japan. We could argue that the twentieth cen-

tury saw the fruits of nineteenth-century liberalism go sour. The promise of

independence and equality that looked so shining in 1913 was smothered in

wars and revolutions that entailed the rise of murderous dictatorships. The

twentieth-century empires were short-lived in contrast to former ages, when

empires lasted for hundreds of years. Both Byzantium and the Holy Roman

Empire existed for more than thousand years. The Ottoman and the Habs-

burg and Roman empires existed for more than 300 years. The Dutch,British, Spanish and Portuguese maritime empires also existed for hundreds


of years (Ferguson, 2006: lxiv). The Soviet Union lasted less than 70 years;

Hitlers millennial empire only seven years (193845).

The twentieth century also witnessed the birth of nation-states based on

ethnic identity, which signified a departure from multi-ethic empire. Fergu-son ascribes the rise of ethnic nation-states after 1900 to the backlash to

assimilation that emerged at the end of the nineteenth century, when people

came to sort themselves according to ethnicity. Ethnicity is defined as a

combination of language, custom and ritual inculcated in the home, the

school and the temple (ibid.: xlvii). This definition makes ethnicity similar

to culture. However, a culture that is determined at birth and not by choice.

Ethnicity as an organizational principle is diametrically opposed to organi-

zation based on voluntary association. Ethnicity can influence organizationsin several ways. Organizations can give people of various ethnic origins equal

rights, which can result in an equal distribution of leadership positions among

ethnic groups within organizations. Organizations can also prefer one ethnic

group to others, which results in a subordinate position of some ethnic groups,

as prevailed in many empires. Ethnic preference can also lead organizations

to exclude people of different ethnic origin. Exclusion can also take differ-

ent forms. Ethnic groups can build their own organizations within larger

political entities. Both government policies and a preference for within-groupmarriages (endogamy) contributed to the model of ethnic self-organization

that prevailed in many societies. This model was discernible in the US,

where ethnic communities had their own business enterprises, churches, schools

and neighborhoods. Self-organization and segregation were also common in

Europe, where Jews, Armenians and other minorities lived in their own quar-

ters. This dates back to old city-states such as Venice and Constantinople,

where ethnic communities lived segregated lives; sometimes voluntarily, some-

times involuntary. The model of ethnic self-organization has some draw-backs, as it locks people into their indigenous culture. Ethnic communities

are basically involuntary associations, as they organize people according to

inalterable characteristics and, therefore, lack free entry and exit. The closed

character of ethnic organizations made them prone to crime, as in the Mafia.

Another model of ethnic exclusion came to the fore around 1900, when

ethnic groups wanted to establish their own nation-states.

Ethnic groups like the Greeks, Italians, Germans and Romanians estab-

lished their own nation-states at the beginning of the twentieth century.Others, like the Armenians and the Jews, aspired to do so. Ethnic differ-

ences, which had played a part in empires, were exacerbated in the new

nation-states. Minorities which were predominantly occupied in commerce

lost the rights of self-organization that had prevailed in empires, where they

could live by their own (family) laws.

The principle of self-determination introduced by the American President

Wilson at the Peace Conference of Versailles at the end of World War I

involved nation-building based on ethnicity. The treaty concluded at Ver-sailles ceded part of German imperial territory to Denmark, Poland, Belgium


and France. The treaty also involved the foundation of Czechoslovakia,

Poland, Hungary and Yugoslavia as nation-states. Danzig became a free

city under the protection of the League of Nations. Poland expanded its

territory beyond that of the treaty by wars against Russia, Ukraine, Lithua-nia and other countries. However, these new nation-states had sizable ethnic

minorities, particularly Germans and Jews. Self-determination thus had its

limits. It obviously did not apply to the United States, which was a multi-

ethnic society. It also did not apply to minority groups within nations. It

also did not apply to the Soviet Union. The expectations of self-determi-

nation held by the various ethnic groups within the new Soviet Union were

brutally suppressed by Stalin. He dismissed the idea of a federal Union of

Soviet republics and established a one-party dictatorship over an area thatcomprised almost the whole former Tsarist empire (ibid.: 1578). A new

multi-ethnic empire emerged out of the ruins of the civil war, epidemics and

famine that raged from 1918 till 1922 and which cost about 6 million Russian

lives.

Ferguson argues that the main problem with the newly founded Eur-

opean nation-states was the contradiction between self-determination and

the existence of minorities. Majorities were tempted to claim to be the sole

proprietor of the nation and its assets (ibid.: 166). Discrimination gainedimportance as the role of the state increased in the 1920s and a national

ethnic culture was imposed on minorities, which lost their own schools,

theatres and universities. A policy of self-organization was thus no longer

tolerated within the new nation-states. The most threatened minority were

the Jews, who often lost their jobs in schools and universities in the new

Eastern European nation-states. This differed from the widespread tendency

towards cultural assimilation and intermarriage that had prevailed in

Europe before the emergence of the new states. This applied particularly tointermarriages between Jews and gentiles, which had risen to large propor-

tions before the 1930s. The number of mixed marriages in the German

Reich had risen to 20 percent of all marriages involving a Jewish partner in

1914 (ibid.: 28). The Danish and Italian rates were comparable. Legal obsta-

cles to marriage between Jews and gentiles were removed in most Western

European countries and the US in the nineteenth century. Jews differed

from other minorities by their prominent role in business and the profes-

sions in Western Europe and the US. Anti-Semitic parties arose con-comitantly with the legal equality of Jews in Germany at the end of the

nineteenth century, although their popular appeal was limited at the time.

Ferguson argues that the formal equality of minorities in nineteenth-century

Europe triggered a discriminatory response, which culminated in twentieth-

century policies of racial discrimination. This extended also to the Turkish

state that emerged out of the former Ottoman Empire, which persecuted

Armenians and expelled its Greek population.

Twentieth-century nation-building differed from its nineteenth-centurycounterpart, when new nations experienced a huge influx of both people


and capital. The population of the Americas became ethnically mixed due

to the immigration of people from Europe, Africa and Asia. However,

ethnic cleansing was the corollary of nation-states based on ethnicity. Mass

migration ensued after the foundation of nation-states in Turkey andGreece. The same happened later in the twentieth century after the break-up

of Yugoslavia and the foundation of Israel. These new nations differed from

their nineteenth-century counterparts by their emphasis on ethnicity as a

basis of nation-building in contrast to the ethnic heterogeneity that had

characterized nations that arose in earlier times.

The idea of ethnic homogenous nation-states raises two problems. The

first involves the inferior position of minorities who lack the opportunity to

create their own state. The second problem involves the wars that nationsbased on ethnicity want to fight to expand their territory and subjugate

other peoples. Both Nazi Germany and the Japanese empire were expansive

empires that wanted to vindicate their racial superiority by subjugating and/

or annihilating peoples they considered inferior.

The Cold War and after

The defeat of the German, Italian and Japanese empires in World War IIspawned the birth of a new host of nation-states. The same occurred in the

Southern hemisphere, where new nation-states emerged out of collapsing

European colonial empires. The bi-polar world of the Cold War divided

nations into either friends or foes. The Soviet Union fought its ideological

wars in the new nation-states largely by proxy. The direct intervention in

Afghanistan constituted a rare exception to this rule as it preferred to

spread its ideological message largely by supporting liberation movements

abroad. The United States army fought several wars to protect their inter-ests and their allies. The Korean War was a draw and the Vietnam War a

defeat. The only war they won, the Cold War, was won without open mili-

tary conflict between the two superpowers. The Cold War was won by

manifest success and not by military force or persuasion.

Ferguson notes the fierce hostility against liberal development models in

both the West and the East at the time of the Cold War. Japan, China,

North Korea, Vietnam and Cambodia all adopted non-liberal models of

economic development in the twentieth century. The Soviet model of soci-alism plus one-party rule was more popular among new nations in the 1960s

and 1970s than the American model of capitalism and democracy (Ferguson,

2006: 613). In a one-party system, the first winner takes all; socialism enabled

the rulers to appropriate all the assets they wanted to seize. The US response

was to support right-wing dictators in Guatemala, Argentina, Brazil, Uruguay

and Chile who were as lethal to their enemies as the communist dictatorships.

The US also backed Pol Pot in his war with Vietnam; Saddam Hussein in

his war with Iran and the Mujahedin in Afghanistan. This were all movesin the game of chess played between the Soviet Union and the United States


in far-away theatres, which undermined the credibility of the US as an

advocate of liberalism and democracy. Moreover, many US allies turned

into US enemies. Saddam Hussein and the Mujahedin illustrate this princi-

ple most clearly. Those alliances were not based on shared political pre-ferences, but on the existence of a temporary common enemy.

The attraction of communist ideology has waned after the collapse of the

Soviet Union and its end as a sponsor state, but religion has taken its place.

Khomeini, who established the Islamic Republic in Iran in 1979, wanted to

purify Iranian society and challenge the United States. Al Qaeda established

itself first in Sudan and then in Afghanistan and Iraq to fulfill its mission of

removing the US from Saudi Arabia and the Middle East by overthrowing

Arab governments sympathetic to the US and by destroying the state ofIsrael (Ferguson, 2004: 120). The establishment of a Moslem empire akin to

the Abbasid caliphate may loom as a future goal, but is impeded by a lack

of military power and sectarian strife among Moslems. The Islamist move-

ment is not so much based on notions of racial, but of moral superiority.

Western civilization is depicted as decadent and its influence should be

completely removed from Moslem societies. Islamism also expands by proxy

and supports adherents both in and outside the Middle East. Terrorism

not explicit warfare is their preferred mode of combat. They also avoidelections. Terrorism had for long been the favorite mode of combat of lib-

eration movements in Russia, Ireland, and Bengali in their struggle against

imperial rule (ibid.: 121). The US attempt to bring democracy to Iraq ran

counter to the sectarian and ethnic fragmentation that followed in the wake

of the disappeared dictatorship.

The installation of democracy tends to unleash centrifugal forces as it

allows people to grasp political power for their own group by all possible

means. The situation in the Middle East bears some resemblance to thewars of religion that ravaged Europe in the sixteenth century after the

downfall of the Holy Roman Empire. The new nation-states that arose had

state religions and either expelled religious minorities, or made them second-

class citizens.

History shows that the collapse of empire provokes new forms of inte-

gration. The two opposite movements of fragmentation and integration are

discernible in the twentieth century, but also in earlier times. Ferguson regrets

the collapse of liberal empire and the descent into the hell of hatred that wascharacteristic of the twentieth century. However, it is questionable whether

empire offers the best integrative device. Empire gave rise to feelings of super-

iority, which provoked resentment. These feelings of superiority that the

English expressed towards their colonies were not limited to people of dif-

ferent ethnicity, but were also expressed towards the inhabitants of the New

World. The colonists were treated as a mixed rabble of Scotch, Irish and for-

eign vagabonds, descendants of convicts and ungrateful rebels by the Eng-

lish (Ferguson, 2003: 91). However, British notions of superiority were provedfalse by the rapid growth of the (former) colonies of white settlement.


Moreover, a rentier empire like the British one, does not suit the United

States. First, the US has a rapidly growing economy, in contrast to late

nineteenth-century Britain, which was in relative decline. Second, the US is

a net importer of human capital in contrast to the nineteenth century, whenpeople left Britain in droves to build a new life in the (former) colonies of

white settlement. The flight of capital and people indicates that opportunities

outside the British Isles were considered more attractive than inside the

country. The reverse applies to the United States, which attracts both money

and people like a magnet. The countries of the European Union also attract

many immigrants. But immigrant communities with high levels of unem-

ployment pose a threat to the stability of European societies. The US seems

to have largely overcome racial segregation by offering people opportunitiesin its buoyant economy. The US has become an ethnically mixed nation

where the descendants of the Pilgrim Fathers constitute a minority, without

losing its character through successful Americanization of newcomers. The

people of the United States have one of the highest per capita incomes in

the world. Their wealth is largely based on human resources and innova-

tions in technology, organization and legislation.


2 Entrepreneurship and economicdevelopment

Introduction

Economic growth is considered a normal phenomenon in developed econo-

mies. However, economic stagnation has been the norm for long periods ofhistory. Per capita income in Western Europe was stagnant or even regressed in

the first millennium (Maddison, 2001) and was below that of Africa, Asia and

Japan in the year 1000. Many African, Eastern European and Latin American

economies in our times have experienced zero growth or even decline.

Economic growth occurs when more production factors such as capital,

labor and natural resources are put to economic use (extensive growth) and

when factor productivity increases (intensive growth). Economic theory has

produced several explanations for productivity growth. Investments in bothphysical and human capital figure prominently as explanations in neo-classical

growth theory. However, neo-classical theory can only partially explain the

productivity growth of the past centuries. The best explanation for the rest is

technological progress that made both capital and labor more productive. The

question of what triggers technological progress is, therefore, important. Tech-

nological progress is associated with advances in knowledge and their dif-

fusion. Both the generation and diffusion of new knowledge depend on how

new ideas are generated and adopted. Scientific knowledge spreads in awave-like fashion; a new idea is adopted by only a few in the beginning and

then by more people. However, societies have not always been receptive to

new knowledge. The adoption of novelty requires a positive attitude towards

new ideas, which can discard past knowledge and brush aside tradition. The

adoption of new knowledge could also entail a power shift, if old leaders are

dethroned and replaced by new ones. Progress assumes that existing ideas and

ways of doing things can be improved. Entrepreneurial theories of economic

development assume that economic development is shaped by individualswho start new organizations. Capitalism is special since it channels ambition

towards the economic arena instead of the military where it was located in

feudal times.

Theories of entrepreneurship span a long period, at least from Cantillons

time up to the present. Many scholars have contributed to the literature on

the subject. They all wanted to unravel the way in which entrepreneurial

initiative has contributed to economic development (Hebert and Link, 1982).

This chapter analyzes the contributions of three leading social scientists:

Max Weber, Joseph Alois Schumpeter and Frank Hyneman Knight. Schump-eter defined the entrepreneur as the individual, who founds a new firm that

has a comparative advantage vis-a-vis incumbent firms. The definition of

entrepreneurship as new firm formation also applies to Weber and Knight.

All three authors wrote their theories during the first two decades of the

twentieth century and were well aware of each others writings. Their work

constitutes a fascinating debate on the motives and effects of entrepreneur-

ship. Their theories explain why new ventures emerge and how they are

financed. Weber held the view that Calvinist parsimony would finance invest-ment, whereas both Schumpeter and Knight considered external finance to

be the main source of entrepreneurial investment.

Entrepreneurship had only been a sideshow in economic theory after World

War II. Neo-classical economics had pushed the entrepreneur out of the

economic model, leaving no room for enterprise and initiative but only for

passive calculation (Baumol, 1968). Entrepreneurship escapes neo-classical

modeling by definition due to its relationship to novelty and change. The

lack of interest in entrepreneurship in the second half of the past centurycan be attributed to the widespread idea that entrepreneurship would

become more and more obsolete as capitalism developed. Weber con-

tributed to this idea by emphasizing that economic life would become ever

more rational. Large bureaucracies would take over as the predominant

organizational form of capitalism. Schumpeter also became convinced that

large firms would become the main vehicles for innovation and economic

progress. He predicted that market societies would evolve from competitive

to trust capitalism, which in time would give way to socialism. Schumpeteralso contended that the demise of capitalism would be hastened by an

increase of rationality in all realms of life. People would no longer tolerate

the irr

governance and innovation (routledge studies in global competition)

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