Pancasila Economics: Historical Perspectives

Independence with a Socialist Touch

Pancasila, Indonesia's guiding philosophy established in 1945, outlines five core principles. These principles serve as a compass for the nation's core values, not an economic blueprint. Enshrined in the constitution's preamble are:

A belief in the One and Only God, just and civilised humanity, the unity of Indonesia, and democratic life led by wisdom of thoughts in deliberation amongst representatives of the people, and achieving social justice for all the people of Indonesia.


These articles suggest a tilt towards a state-driven economy, with the government wielding greater influence than the market. The emphasis on "family system" in economic organization hints at a preference for collective decision-making. Similarly, the language barring control of strategic sectors from private hands and references to "togetherness," "efficiency with justice," and "self-sufficiency" all suggest a certain wariness of market-driven individualism.

In essence, while the constitution avoids ideologically charged terms like socialism or capitalism, a closer look reveals a document with a more socialist flavor. This socialist preference is not uncommon among former colonies, as explained by the concept of the colonial dialectic.

Explaining Socialist Post-Independence Tendencies: The Colonial Dialectic

The concept of the colonial dialectic sheds light on why many newly independent nations leaned towards socialism. Logical reasoning based on dialectic is a construct with deep socialist roots. Unlike early utopian socialists like Henri de Saint-Simon, who argued on normative and idealistic grounds, so-called scientific socialists like Karl Marx tied "scientific" to adherence to the ancient Greek dialectic found in Plato, Socrates, and Aristotle.

The basic idea of dialectic consists of three stages: thesis, antithesis, and synthesis. In the Marxist framework, these stages can be illustrated as follows: (1) bourgeois capital exploits proletarian labor (thesis), (2) proletarian labor revolts (antithesis), and (3) communism resolves the inevitable class conflict inherent to capitalism (synthesis).

The socialist kind of “science,” of course, stands in contrast to the modern scientific method, which emphasizes rigorous hypothesis testing and falsification, as championed by Karl Popper in the 20th century.
The colonial dialectic follows a similar pattern as Marx’s original analysis of class struggle. Just substitute bourgeois capitalists with colonial rulers and proletarian workers with the colonized subjects. With a touch more nuance, the colonial dialectic suggests that in the first stage, the colonial ruler divides the colonized society. Commercial, intellectual, and political elites often benefited from colonial rule by gaining access to new opportunities, such as trade access to foreign markets, educational opportunities in the colonizing country, and political empowerment. The losers were typically the landless peasants and workers.

The second stage witnesses a counterrevolution fueled by the widening gap between the beneficiaries of colonialism and those left behind. For those left behind, the military, particularly its lower ranks, offered one of the few career paths. These lower ranks provided fertile ground for organizing and networking, making them receptive to revolutionary ideas, despite the colonizer's efforts to demand loyalty. When the colonial ruler weakens due to external events like wars, new political leaders seize the moment with the backing of the military. These leaders then usher in the third stage of the colonial dialectic, for which socialist and communist ideas seem to pave the way.

The Historical Appeal of Socialism

The rise of socialism finds its roots in the tumultuous throes of the Industrial Revolution, which swept across 18th century England and reverberated throughout Europe. This era of unprecedented industrial growth undoubtedly brought hardship to specific sectors of the workforce. Hand weavers, for instance, found themselves replaced by the relentless efficiency of mechanized looms. Yet, amidst the upheaval, certain professions, like those in construction or service industries catering to the burgeoning industrialist class, experienced relative prosperity.

Economic growth, by its very nature, creates winners and losers. As a nation's wealth swells, it is inevitable for the gains of the privileged few to outweigh the losses of the many. However, a critical juncture arises when the number of beneficiaries pales in comparison to the vast throng of those left behind. This widening gap breeds rampant income inequality, a fertile ground for social ills like poverty, crime, and disease.

Karl Marx offered a seemingly straightforward explanation: the capitalist class, the bourgeoisie, ruthlessly exploits the working class, the proletariat. In his view, capitalists were villains who needed purging from the economic landscape. He envisioned a complete societal overhaul, where a benevolent elite, a socialist ruling class, would manage the entire economy under a centralized plan. This essentially nationalized system transformed the entire economic engine into a single, vast enterprise, devoid of the practical experience and expertise found in the traditional business world.

A more nuanced understanding of the social hardships during the Industrial Revolution can be gleaned through the lens of economics and historical data analysis. This era witnessed a mass exodus from rural areas to burgeoning cities. Regardless of automation replacing workers, this influx of labor dramatically outpaced demand, driving wages down in a relentless race to the bottom. Workers, desperate for mere survival, found themselves undercutting each other's wages, a desperate struggle that even included the unthinkable practice of child labor under undeniably horrific conditions.

With the benefit of hindsight, it is easy to condemn capitalists who employed workers and children under such inhumane circumstances. But what were the viable alternatives? Could a capitalist employer truly act with benevolence amidst these cutthroat market conditions? The answer is likely no. Raising wages might cripple businesses, leading to even greater unemployment and further misery. By offering these jobs, however limited and appalling they may seem, these employers arguably prevented a complete societal collapse.

Social economists proposed a different solution to the plight of the working class. Their answer was not the abolishment of markets and the embrace of socialism, but the implementation of sound economic policies. These policies focused on social welfare programs and a robust safety net. Banning child labor entirely would be a cornerstone of this approach. Additionally, targeted programs for struggling families could offer a lifeline. Limiting working hours would introduce another layer of protection. The objective is not the eradication of the competitive market system, but their advancement with regulations that safeguard against the emergence of unacceptable practices like child labor. For social economists, rules and regulations are not meant to abolish markets, but to make them just and humane.

Germany in the 1880s serves as a historical case study of such policy responses. A newly unified nation, Germany was grappling with rapid industrialization, mirroring the earlier struggles of England. This period witnessed a surge in worker hardship and, consequently, a rise in socialist movements. Furthermore, a significant portion of the German workforce emigrated to the United States, seeking a brighter future. This exodus, while alleviating some social pressures, also threatened Germany's industrial ambitions. In response to these challenges, Chancellor Otto von Bismarck spearheaded social reforms, including accident and health insurance and a pension system. These initiatives marked the birth of Germany's unique social market economy, a system that aimed to balance market freedom with equitable social development.

In Russia, however, a socialist revolution could not be prevented. Russia, under the thumb of a Tsarist autocracy, lagged behind the development of continental Europe. This underdevelopment left the nation vulnerable to the Bolshevik Revolution of 1917. The resistance to this socialist uprising proved insufficient, and Russia became the world's first real-world experiment in socialism. Despite the horrific brutality that accompanied the establishment of this new regime, including the devastating famine orchestrated by Joseph Stalin in Ukraine – the so-called Holodomor, which killed millions of Ukrainians – the Soviet Union did manage to achieve rapid industrialization in the early 20th century. This industrial might culminated in the Red Army's pivotal role in defeating Nazi Germany during World War II. The image of Soviet tanks rolling through the vanquished streets of Berlin cemented the image of a seemingly successful socialist model in the eyes of many, especially those emerging from the throes of the colonial dialectic's second stage.

Capitalism in crisis in the interwar period

At the same time, capitalism was in crisis after the stock market crash of 1929. The stock market crash of 1929 provides important lessons about the dynamics of financial crises. The U.S. economy emerged largely unscathed from World War I. With the restoration of world peace, consumer confidence returned, and with it consumer spending, which had been held back during the war years. The spending spree caused stock prices to rise rapidly in the 1920s. Consumers bought not only goods and services, but also corporate stocks, which seemed to have no limits. As citizens' wealth increased with rising stock prices, many citizens began to pledge these stocks in order to borrow more money for additional stock purchases. Seemingly, all it took to finance consumption and get rich was to buy corporate stock. But the sky was not the limit, and the stock market finally crashed in 1929.

What happened? Financial crises follow a similar pattern. They typically start with an exogenous event, such as the end of a war, or a new product hype, such as the tulip mania of 1634-1637, or a sudden export boom that drives up domestic demand for real estate. The prices of the in-demand goods rise and, more importantly, so do the stock values of the companies that produce them. Banks are happy to accept the stocks as collateral and make loans to finance the production of these in-demand goods and services. Unfortunately, as more and more of the originally in-demand goods are produced, supply eventually catches up with demand and even overshoots it, causing prices to fall again. As the prices of the formerly overpriced goods fall, so do the profits of the companies that produce them, and ultimately their stock values.

This is where the problems begin. As stock prices fall and many investors no longer see certain products as overpriced as they once did, they begin to sell their shares to cash in their profits. But if many investors have the same idea, and herding behavior is not uncommon in financial markets, stock prices can fall faster than investors can sell them, leaving many of them with more debt than their collateral is worth. The banks then come after their debtors, demanding either more collateral or early repayment, neither of which the debtors can provide.

Now the banks are in trouble because they are sitting on a lot of bad debt, which alarms those who had their savings in the banks. These savers are now rushing to the banks in a bank run to withdraw their deposits, which the banks cannot provide because they have lent the savers' savings to investors who cannot repay the loans. Now the banks have to close and the financial crisis is complete.

In addition to investor greed and the rapid expansion of credit in the 1920s that fueled the stock market bubble and an overshooting catch-up process on the supply side that caused prices to fall again, another and perhaps more important aspect contributed to falling prices: The Gold Standard. Like many other countries at the time, the United States operated under a monetary system in which a dollar could only be issued if it was backed by a certain amount of gold.

In simple terms, the price level of an economy depends on the ratio of money chasing goods and services to the actual amount of goods and services produced. If this ratio rises, with more money chasing fewer goods, there will be inflation. Likewise, if the ratio falls and less money chases more goods, there will be deflation. The latter is exactly what happened in the U.S. in the 1920s. The gold standard prevented the money supply from keeping up with the real sector, causing deflation. New gold reserves simply could not be discovered as quickly as would have been necessary to allow the money supply to keep pace with the rapid expansion of economic output.

Once a country enters deflation, it is very difficult to get out. As consumers see prices fall, they hold back on major purchases in anticipation of even lower prices. It becomes a self-fulfilling prophecy. Because consumers expect prices to fall, they do not make purchases, which means that demand falls and prices fall as expected. While the gold standard was originally designed to instill confidence in the monetary system, in practice it has proven to be a highly ineffective tool of monetary policy. Looking at the stock market crash of 1929, the role of rapid monetary expansion first and deflation later can be summarized as follows: Rapid credit expansion in the early 1920s, when gold was still abundantly available, fueled the bubble, but it was the gold standard and deflation that burst it in 1929.

The crisis of capitalism between World War I and World War II was exacerbated by the nationalist policies that followed the stock market crash of 1929. The period from 1870 to 1914 is commonly known as the first wave of globalization. Technological advances in transportation and the independence of many Latin American states in the early 19th century facilitated global trade between North and South. Similarly, the United States slowly emerged as the new global political and economic superpower and became a major mediator in the post-World War I peace efforts in Europe.

After World War I, the 1918 Treaty of Versailles required Germany to pay reparations in cash and natural resources, primarily to France, Belgium, Great Britain, and Italy. Under reparations, Germany was unable to collect taxes to finance public spending, so it resorted to printing money. The price mechanism eventually spun out of control, and the German economy collapsed in 1923 under unprecedented hyperinflation. At this point, the United States helped negotiate lower reparations payments for Germany under the so-called Dawes Plan, and allowed Germany to gain access to loans from the United States by issuing government bonds in the United States. As a result, the German economy recovered significantly in the second half of the 1920s.

The period following the stock market crash of 1929 is known as the Great Depression. During the Great Depression, countries retreated from free trade and adopted beggar-thy-neighbor policies. The United States imposed massive import tariffs in the hope that domestic production would replace imports and create jobs. Similarly, the United States abandoned the gold standard and tried to devalue the U.S. dollar in the hope that this would stimulate more exports and export-related employment. The problem was that other countries were just as "smart". As a result, no country created more jobs, but all countries ended up losing their comparative advantage and facing higher inflation than would have been the case had they adhered to free trade and non-manipulative exchange rate policies.

Of course, if one country imposes a tariff on another that retaliates with a tariff, all that happens in each country is that jobs are taken away from what it used to export to replace the goods it used to import. But since free trade allows countries to specialize in what they do best, these specialization gains from free trade are now lost. Similarly, if two countries want to devalue their currency at the same time, which is typically done by increasing the money supply, relative prices do not change, so neither country gains an exchange rate advantage over the other, but both countries end up with more inflation. Competitive tariff and currency devaluation wars, which were designed as beggar-thy-neighbor policies, i.e., ideally to help one country become better off at the expense of another, have failed miserably. The retreat from free trade and multinationalism to protectionism and nationalism significantly delayed recovery from the 1929 crash.

In short, at the time of Indonesia's independence, capitalism was still associated with colonial exploitation, Russia's socialist path seemed to promise a path to rapid industrial development, and capitalism itself was in deep crisis. These factors help explain why most formerly colonized countries, including Indonesia, favored a constitution with a more socialist flavor, even though the word socialism does not appear in Indonesia's constitution.