I have a new article in Shanghai Daily analysing China's attempt to develop high value added production. It shows that China is rightly emphasising technology. But an equally key issue, that of high quality design, is not receiving the attention which is required. The article looks at the examples of Apple, Intel and Samsung and their lessons.
Preparing for a panel discussion with Paul Krugman at Jiao Tong University in Shanghai led to reflection on how different the parameters of practical policy making are from those of academic economics. The questions asked and point of approach are frequently divergent
In policy making all theoretical and other arguments have to be aligned and concentrated around one settling one decisive issue - ‘what should be done’. That is, what is involved is a synthetic decision – assembling issues, and giving them their specific weights, around one point. In academic discussion exploration of distinctions and points can be pursued without settling the decisive practical question of what difference it makes to what should be done.
This particular reflection was reinforced by re-reading, to prepare the debate, Paul Krugman’s well known 1995 paper, ‘The Myth of Asia’s Miracle’. This analysis, arguments from which are still frequently used today, drew heavily on two quantitative papers by Alwyn Young on growth in the four Asian Tigers/Newly Industrialised Economies (NICs) of South Korea, Singapore, Taiwan and Hong Kong.[1]
In analysing the Asian Tiger economies Young/Krugman were attempting to deal with a theoretical/analytical issue. Was the rapid rate of growth of the South East Asian Tigers based on, or substantially contributed to, by a particularly high rate of growth of productivity – whether of labour, capital, or total factor productivity? Or to what degree was it based on quantitative growth of factors of production – i.e. accumulation of labour and capital?
It should be noted that the quantitative results of Young’s work has come under criticism - notably from Chang-Tai Hsieh. However, for the moment, leave statistical criticism aside and assume, for the sake of argument, that Young’s quantitative conclusions were correct – although, to be clear, this is done as a hypothesis and is not an acceptance of Young’s calculations per se. Then what follows?
Writing in 1995 Young noted that for the period 1960-85 the four Asian Tigers constituted four out of the five countries with the fastest growth of GDP per capita in the world - the fifth, Botswana, was an economy sufficiently small that no general conclusions would be drawn from it. However, after subtracting growth due to the increase in labour input (including increased participation in the workforce, higher educational achievement etc) and the rate of additions and improvements to capital, Young concluded that the growth of total factor productivity in the Asian Tiger economies was not remarkable. Summarising his article, Young wrote that he:
‘presents estimates of “total factor productivity” in the sample economies... the ranks of Taiwan and South Korea [among economies placed in descending order of growth of total factor productivity] are now reduced to 21st and 24th, respectively. While this remains a strong performance, it is no longer dramatically differentiated from that of the rest of the world economy. Fully 81 of the 118 sample economies lie within one standard deviation… of Taiwan and South Korea. Surprisingly, economies such as Bangladesh, Uganda, Iceland and Norway are now seen to have outperformed Korea and Taiwan, whose productivity growth is only 0.5% greater than that of a renowned laggard, the United Kingdom. Singapore, where participation and investment rates have risen faster than any of the NICs, is reduced to a rank of 63rd in the world economy.’
So, therefore, Young finds the growth of productivity in the NICs was average or slightly above average and their rapid growth was not primarily due to extraordinary growth in total factor productivity but was due to large scale quantitative inputs of capital and labour. To which the appropriate answer, from the point of view of economic growth, is: ‘yes, that is quite adequate, even very encouraging. For it shows that if it is possible to combine average productivity growth with very large quantitative inputs, then the economy’s rate of growth will be far higher than the average and very rapid in absolute terms – enough to industrialise a country in a single generation (which is what the NICs achieved).’
The point is a simple arithmetic one. The effectiveness of the contribution of investment, for example, to economic growth depends on the combination of its quantity and how efficiently the economy utilises it. This blog has noted on numerous occasions that there is a fundamental logical error in judging an economy’s growth potential by economic approaches which concentrate only on the efficiency of the use of investment rather than also analysing the quantity of investment. The quantitative relation of the relative scale of investment and the relative efficiency of investment is the critical one. If, for example, economy A utilises investment 20% more efficiently from the point of view of generating growth than economy B, but nevertheless economy B invests 50% more as a proportion of GDP, then economy B will grow more rapidly than A despite the fact that economy A uses its investment more efficiently.[2]
Young/Krugman demonstrate that the rate of productivity growth of the Asian Tiger economies is not below average, but only average, as a result of which these economies quantitative advantage in growth of inputs of investment and labour ensures much more rapid growth that economies with higher rates of total factor productivity growth but much lower rates of input growth.
This is why, for example, criticisms that countries such as South Korea, during their phases of rapid growth, allegedly allocated capital inefficiently compared to more ‘liberal’ economies such as Britain or the United States entirely miss the point. An economy such as South Korea invested so much more as a proportion of GDP, almost double the rate of the US, that unless, from the point of view of growth, its' efficiency of investment was only half that of the US the South Korean economy would still have grown more rapidly than the US.
Put in properly formulated economic terms the quantitative level of macro-economic allocation of resources to investment may be more important from the point of view of economic growth than the marginal efficiency of investment. Put crudely, when it comes to investment and growth, 'quantity' may simply be more important than 'quality'. That, for example, would by itself be enough to vindicate the present very high rates of investment in India and China.
Whether it has proved in practice a more viable growth strategy to have an average rate of growth of productivity, combined with very high quantitative inputs of investment and labour, or whether it is more effective to aim at the highest rate of growth of total factor productivity, with much smaller quantitative inputs of investment and labour, may be illustrated rather graphically by showing the rank order of countries produced by Young’s calculation.
Young found that the top five countries in terms of growth of total factor productivity, after he has carried out his adjustments, were as set out in Table 1.
Table 1
In short, if highest possible growth in total factor productivity is the variable that should be targeted, then Egypt, Pakistan, Congo and Malta, together with Botswana, should be taken as the most successful economies in the world – the economic models to be emulated.
If, however, the key criteria of success is increase in GDP per capita, achieved, according to Young’s calculation, by the Asian Tiger economies combining average rate of growth in total factor productivity with massive quantitative inputs of investment and labour, then in contrast Table 2 shows the world ranking of economies.
Table 2
Which economic variable is in practice decisive in determining real economic outcomes may be shown graphically by taking the case of by far the worst performing case of total factor productivity according to Young/Krugman’s account – Singapore.
Singapore, poorly performing in terms of total factor productivity, has today, in Parity Purchasing Power terms, the 5th highest GDP per capita in the world – a level 9% higher than the United States. Egypt, which is better performing in terms of growth of total factor productivity, ranks 101st in the world with a GDP per capita only 13% that of the United States. While the second ranking, from the point of view of total factor productivity growth, Pakistan ranks 130th in the world with a GDP per capital 6% that of the US.
In short, taking for arguments sake Young and Krugman's calculations as entirely correct, then the route to actual economic success, in terms of economic growth and a high living standard, lay in the average rate of increase of total factor productivity, combined with massive quantitative inputs of capital and labour, of Singapore rather than in the high total factor productivity, combined with far lower quantitative growth of inputs, of Egypt, Congo and Pakistan. Or, put in deliberately shocking terms, 'quantity' (growth of factor inputs) was much more successful in determining growth in GDP per capita than 'quality' (growth in total factor productivity)!
It is, of course, possible to have a rate of growth of total factor productivity that is so low (potentially a negative number) that even the greatest increases in quantitative inputs cannot produce viable growth – the USSR in its final period represents such a case. But the case of the Asian Tiger economies showed that provided close to average increases in total factor productivity can be achieved then quantitative increases were the decisive ones. Put formally, the evidence is that provided an average, or near to average, rate of total factor productivity growth can be achieved then ensuring very large quantitative inputs proved a more viable growth strategy than aiming to maximise efficiency – i.e. total factor productivity growth.This is simply the arithmetical outcome of multiplying the rate of growth of factor productivity by the rate of growth of inputs. The criteria which must decide the strategy chosen is therefore that which maximises the rate of growth of GDP per capita, not the abstract theoretical one of maximising rate of growth of factor productivity.
Turning to India and China this has an immediate practical consequence. It means that even if it were to be assumed, for the sake of argument, that the efficiency of their use of investment were average, or even somewhat below average, then they might well be right to concentrate on massive inputs – to take the Singapore route. That, in turn, evidently raises the question of whether investment in India and China actually is inefficient – which goes beyond the scope of the present article, but will be returned to in a future article. But it should be noted from the above that even if, for the sake of argument, it were assumed that Krugman and Young’s quantitative premises are correct then this does not constitute a valid argument, from the point of view of the key variable of maximising the rate of growth of per capita GDP, against the effectiveness of the growth model followed by either the South East Asian Tiger economies or current policies pursued by India or China.
As stated at the beginning of this article, in economics quantity in some cases may simply be more important than quality.
Notes
[1] The argument of all three papers by young and Krugman was that the rapid growth of the NICs was based on quantitative accumulation of inputs of labour and capital and not on any productivity growth that was remarkable by international standards. The same analysis was then applied to China in Young’s 2003 paper ‘Gold into Base Metals: Productivity Growth in the People’ Republic of China during the Reform Period’.
[2] Ideally, of course, a combination of the maximum level of efficiency of investment from the point of view of economic growth and the maximum level of inputs would be achieved. However, while this is optimal in a purely abstract theoretical model in practice it may be necessary to chose between the two. An evident case of this is heavily state influenced financial systems aimed to maximise savings, as for example existed in Japan and South Korea during periods of rapid growth, versus those which are aimed to maximise the efficiency of use of savings. General discussion of this point, however, goes beyond the scope of this article.
This blog has analysed on several occasions that the current decline in financial markets, including share prices, has continued for 17 months to match in rapidity that after 1929 – i.e. the most severe recorded.
As may be seen from Figure 1 the rise in share prices on Wall Street in the trading week 9-13 March week did not break out of this declining trend. The shift so far has simply moved the rate of descent closer to the declining trendline that has been operating since October 2007 following several weeks of more precipitate than average falls.
As may be seen from the comparison in Figure 2 the rate of descent of the Dow Jones Industrial Average since October 2007 continues to be as rapid as in 1929 - i.e. it greatly exceeds in speed any other major share decline, apart from 1929, seen since the beginning of the 20th century.
Considering the relation between the financial decline and the productive economy, an article on this blog earlier this month also noted that, for the major industrialised economies, the annualised rate of decline in exports in the last three months has actually been more rapid than in 1929.
The latest statistical data released by the Organisation for Economic Co-operation and Development (OECD) for world trade up to December 2008, with data for more recent months in a few cases, allows the calculation of a picture for a wider range of countries that confirms this trend in striking fashion.
Due to the extremely rapid shift in the situation three indicators have been calculated for exports – the actual year on year decline to December 2008, the actual decline in exports since the peak month for each country or area last year, and the change during the three months to December 2008 on an annualised basis.
In order to give a historical scale of comparison the decline of US exports, in current prices, was 22.5% in 1929-30, 32.7% in 1930-31, 32.4% in 1931-32 and 4.0% in 1932-33 after which partial export recovery commenced - i.e. the most rapid annual rate of decline of US exports in the Great Depression, and the most rapid on record to date, was 32.7% in 1930-31. By 1933 US exports had fallen 66.2% below their 1929 level.
Considering first the OECD area as a whole, and the situation in the European region, the data is set out in Table 1. As can be seen for the OECD region as a whole exports have already declined by over 30% since their peak in April 2008 - essentially equaling the rates of decline of the worst year of the 1930s. The annualised rate of decline in three months up to December 2008 was an astonishing 64%.
For the major G7 economies the decline was only slightly less severe - with a decline of 26.9% since the peak in July and an annualised rate of decline of 57.8% in the three months to December 2008.
Within the Euro area the annualised rate of decline for the three months to December 2008 was 50.4% and for the OECD European region, which includes some East European states, the annualised rate of decline was 67.0%.
It may therefore be clearly said that in the field of trade, as in that of financial markets, the current decline is full comparable in speed of descent to the onset of the Great Depression. The difference, so far, is not in the speed of fall but in its duration. The decline in exports after 1929 continued for four years whereas so far the current decline has been occurring for a year.
Table 1
Turning to individual countries, Table 2 shows the figures for the largest OECD economies - the G7. As may be seen all have seen declines in exports of over 25% since their peak levels last year and in the three months to December 2008 all witnessed annualised rates of decline of more than 50%.
In short, the precipitate decline in world trade, at 1930s rates of descent, is not confined to smaller economies but fully affects the largest ones.
Table 2
Table 3 shows the rates of decline of exports for the non-G7 European OECD states. As may be seen with the exception of two small economies, Luxemburg and Ireland, which have done better than others, all OECD European countries have seen actual export declines of at least 25% and annualised rates of decline of 50% or more.
It is possible that the rate of decline for Spain, an incredible 99.7% annualised rate in the three months to December 2008, is a statistical freak or error but the annualised rates of decline for Sweden, Poland, and Norway are almost as severe - respectively, 79.1%, 82,8%, and 83.1%. Such rates may rightly be characterised not as decline but of collapse of exports in at least the short term.
Table 3
Turning to non-European economies, the data is set out in Table 4. Again, with the exception of the small economies of Iceland and New Zealand, the highly publicised decline of Chinese exports by 22.3% since their peak last year year, and at an annualised rate of 53.0% in the three months to December, are themselves actually significantly smaller than for other countries. Mexico and South Korea have already seen actual declines of exports of over 30% and South Africa and Turkey have seen falls of over 40%. The annualised rates of decline of exports for South Korea, Brazil, Indonesia, South Africa, and Turkey - at 70.7%, 72.4%, 78.2%, 82.1%, and 90.1% respectively - are clearly catastrophic.
Table 4
Countries for which OECD data is available for January confirm continuation of the same trend – as shown in Table 5. The chief difference is that with the extra month the actual declines in exports, as opposed to only the annualised rates of fall, have become more serious.
The actual falls recorded from the maximum levels of exports are 29.8% for Switzerland, 41.1% for South Africa, 41.4% for Sweden, 46.3% for Norway and 47.5% for Turkey. There is nothing in this pattern which indicates results for other countries are likely to show an improved tendency.
Summarising the above data, of the 34 countries studied 14 had annualised rates of decline of exports of more than 70% and 20 had rates of decline of more than 60%. The widely publicised reports of declines of exports in the last three months of last year such as the annualised 51.9% for Japan, 53.0% for China, or 54.0% for the US, which attracted much publicity, are actually modest compared to the falls in most countries.
While the annualised rates of decline show the extremely striking implosion of world trade during the last three months of 2008 an annualised rate, naturally, indicates an, in this case extremely severe, tendency. What is equally disturbing is the factual falls in exports recorded from the maximum levels last year. Seven countries registered actual falls in exports of more than 40% and 19 of more than 30%.
It should be noted that trade today plays a more significant role in the world economy than at the onset of the 1929 crisis. Exports in an economy with relatively low exposure to trade such as the US now account for 12% of US GDP compared to 7% in 1929 - the figures for most countries are of course much higher. The result of any continuation of such rapid rates of decline of trade therefore, all other things being equal, would be more severe than in 1929.
The transmission mechanisms of the financial crisis into the productive economy are also made clear by such trends. As has been noted previously, initially in the present crisis there was a disjunction between the decline in financial markets, which was of 1929 magnitude, and the situation of the productive economy - which was of a severe but not equivalent decline. As such a disjunction is highly unlikely to continue either financial markets would recover, having overshot on the downside, or the trends and statistics in the productive economy would be shown to have been a lagging indicator and they would adjust downwards to the tendencies indicated in financial markets.
The extraordinarily powerful falls in world exports shown in the latest figures for all major economies indicate that the decline in trade is operating as a key mechanism by which the crisis revealed in financial markets is beginning to affect the productive economy. It may now be said that in two areas of the world economy, financial markets and trade, rates of decline are fully comparable to 1929 scale. How powerful the transmission mechanisms from the international sector are into domestic economies must clearly be carefully studied. The duration of the crisis is also critical - the so far unique severity of 1929 was not only due to the rapidity of the fall but by its duration. The decline in US trade and GDP in the 1930s continued for four years whereas the current decline in financial markets has lasted 17 months, the decline in trade slightly under one year, and the fall in GDP approximately six months.
Nevertheless quite sufficient data are now in to say with certainty that in the last three months of 2008 a convulsion in world trade occurred. The extreme rapidity of the fall in world trade, as with the situation in financial markets, confirms that the benchmark for present analyses must be not only post-World War II recessions but also 1929 itself.
Notes to Tables - peak month for exports in 2008
1. Peak January 2008
2. Peak March 2008
3. Peak April 2008
4. Peak May 2008
5. Peak June 2008
6. Peak July 2008
7. Peak August 2008
8. Peak September 2008
The rise of Asia, in particular China, in world export markets is well known. The aim of this post is, however, to provide a more systematic overall examination of trends in world visible exports - i.e. exports of goods and not including trade in services (to avoid excessive repetition all references to exports below are to be taken to be referring to visible exports unless otherwise specified).
The most fundamental, twenty year, tendency is shown in Figure 1. This is the well known consistent trend, since the late-1980s, for a major rise in the share of developing countries in world exports - and the decline of the share of already industrialised countries.
Having spent the last week attending the Mayor of Shanghai's International Business Leaders Advisory Council, giving a talk to and discussing with Shanghai financial and government officials, and then going on to Beijing to discuss with more business and government figures, it is possible to form a fairly clear view of how the international financial crisis appears in China. It presents a rather different aspect to that as seen in Europe or the US.
Direct financial turmoil is not a key feature in China. China's banks had almost no exposure to now heavily discounted, or worthless, sub-prime mortgage or similar financial products. While in Hong Kong there is some concern over the direct financial fallout, no mainland Chinese bank has suffered significant losses in this field. The immediate issue for China is the effect on its productive economy and on the renminbi’s exchange rate. But underlying these is a still more fundamental issue – maintenance of China’s savings and investment rates.
Indeed. seen from China, the international financial crisis might be posed from a different angle. It may be viewed as the 'third great Asian financial crisis' – the first being that of Japan and the yen in 1973-90, and the second that of the South East Asian debt and currency crisis of 1997. To emerge successfully will require from China an enormous response and a new stage of its economic development.
Key Trends in Globalisation has noted that the fundamental determinant of the much higher rates of growth of a number of Asian economies, compared to the US or Europe, is their far higher investment rates. Therefore for the US and Europe to regain competitiveness with Asia one of two things has to happen. The US and Europe have to raise their investment rates up to Asian levels, or the Asian economies have to lower their investment rates down to US and European ones.
These two courses have very different implications for world economic growth. If the US and Europe raise their investment levels towards Asian ones then Asia will essentially maintain its present economic growth rate and that of the US and Europe will increase – i.e. world economic growth will accelerate. If, however, Asian investment levels are reduced towards US and European levels then the growth rate of the Asian economies will also fall, while economic growth in the US and Europe will not increase – i.e. world economic growth will decline. It is, therefore, far preferable that the US and Europe increase their investment rates rather than that those in Asia fall.
Nevertheless, in successive economic crises of the last thirty years, the outcome was the opposite of the preferable one – the US and Europe did not increase their investment rates, indeed those in Europe fell, but the investment rates of a number of Asian economies declined.
To illustrate this process in more detail, Figure 1 shows the level of fixed investment as a percentage of GDP for the US, Germany and France. As may be seen, the US fixed investment level has been essentially constant for the last half century at around 20 per cent of GDP – itself a continuation of a very long term trend in US investment rates. The German and French levels were somewhat higher than that for the US for the period up to the early 1970s, at around 25 per cent of GDP, and then fell to levels comparable to the US. Such investment levels generate rates of growth of 1.5-3.5 per cent a year.
Figure 1
If these US and European trends are compared to the situation in Asia there is a clear contrast. Asian economies have achieved far higher levels of investment, reaching over 40 per cent of GDP, and far higher rates of growth – in some case approaching or achieving double digit rates. However, the effect of both the post-1973 crisis in Japan, and the 1997 crisis in South East Asia, was to reduce these investment rates and with them also rates of growth of growth of GDP.
Considering this trend in a number of Asian countries in greater detail, Figure 2 shows the proportion of GDP accounted for by gross fixed capital formation in Japan. Japan’s fixed investment level peaked at 36.4 per cent of GDP in 1973. At this time, averaging the preceding five years, the annual average rate of growth of Japan’s GDP growth was 9.3 per cent.
Figure 2
The economic events which commenced in 1973, and which were accompanied by the first ‘oil shock', greatly affected Japan. The proportion of GDP devoted to gross domestic fixed capital formation declined to 27.5 per cent by 1986, and Japan’s average annual rate of growth of GDP, over the preceding five years, fell by two thirds to 3.1 per cent. By 1986 the Japanese economy, which had been expanding almost three times as fast as the US in the early 1970s, was growing more slowly than the US – in comparison in 1986 the average annual growth rate of US GDP over the preceding five years was 3.5 per cent.
Japan’s investment rate then temporarily rose under the impact of the hyper lax monetary regime during the ‘bubble’ economy in the late 1980s – a consequence of Japanese financial policies introduced to aid US economic stability following the 1987 Wall Street stock market crash. Following the bursting of Japan's financial bubble in 1990, the investment rate fell again and by 2002 gross domestic fixed capital formation had declined to 25.8 per cent of GDP while Japan’s five yearly annual growth rate of GDP had declined to 0.2 per cent.
Summarising these processes, under the successive impacts of the oil price increase and the monetary effects in Japan of the measures it chose to take to respond to the 1987 Wall Street crash, the proportion of the Japanese economy devoted to fixed investment fell by 10.6 per cent of GDP, and Japan’s annual growth rate decelerated from 9.3 per cent to 0.2 per cent - a 98 per cent decline.
If Japan post-1973 was the first great Asian economic/financial crisis, the second was the debt and currency crisis of the South East Asian economies in 1997. The similarity of the outcome to the earlier crisis in Japan’s is striking.
Figure 3 therefore shows South Korea’s rate of gross domestic fixed capital formation. This rose progressively to 39.0 per cent of GDP in 1991. By that year the average annual rate of growth of South Korea’s GDP over the preceding five years was 9.4 per cent.
By 1996, the last year before the currency crisis, South Korea was still investing 37.5 per cent of GDP and its five yearly annual average rate of growth of GDP was 7.3 per cent.
Following the 1997 debt and currency crisis, however, the proportion of South Korea’s GDP devoted to fixed investment fell sharply, to only 28.8 per cent of GDP in 2007, and its five yearly annual average growth rate of GDP declined by almost half to 4.4 per cent.
Figure 3
Figure 4 shows the similar process in Thailand. By 1996 the proportion of Thailand’s GDP devoted to fixed investment was 41.1 per cent of GDP – although this level was clearly unsustainable as it far exceeded the domestic savings available to finance it, resulting in a balance of payments deficit of 8.2 per cent of GDP. Thailand’s five yearly average annual rate of GDP growth was 8.1 per cent.
Following the currency crisis, by 2007 the proportion of Thailand’s GDP devoted to gross domestic fixed capital formation had declined to 26.8 per cent and the five yearly average annual rate of GDP growth had fallen to 5.6 per cent.
Figure 4
Figure 5 shows the similar process in Malaysia. By 1996, the last year before the debt/currency crisis, Malaysia’s gross domestic fixed capital formation was 42.5 per cent of GDP - although again this was being unsustainably financed by a balance of payments deficit. Malaysia’s five yearly annual average rate of growth of GDP was 9.6 per cent.
By 2007, ten years after the currency crisis, the proportion of Malaysia’s economy devoted to fixed investment had fallen to 21.7 per cent and the five yearly average annual rate of growth had dropped to 6.0 per cent.
Figure 5
Therefore, although the mechanisms of the crises were different, the outcomes in Japan in 1973-90, and South East Asia in 1997, were essentially the same - the proportion of the economy devoted to investment fell drastically and therefore so did the growth rate.
The impact of these two previous Asian economic crises, therefore, clearly illustrates the challenge facing China. China’s level of investment is significantly higher than Japan’s in 1973 – China's fixed investment rate is over 40 per cent of GDP compared to Japan's 30-35 per cent at that time. China's annual average annual rate of growth for the last five years is over ten per cent compared to Japan's nine per cent in 1973. In a number of South East Asian states, on the eve of the 1997 crisis, their very high investment rates were unsustainable, as they far exceeded domestic savings levels and were financed through extremely high balance of payments deficits. In contrast China’s savings level, running at over 50 per cent of GDP at nominal exchange rates, is even higher than its level of investment – see Figure 6. China, therefore, does not fact the international financial constraints facing South East Asia in 1997. There is, therefore, nothing inherently financially unsustainable in China’s very high investment rates. It has more than adequate domestic savings to finance its current investment levels and, therefore, approximately its present growth rate.
Figure 6
But it is the international context that has changed significantly and poses the economic challenge. With many economies moving into recession, and virtually all slowing, China's export growth will become significantly harder - even more so as simultaneously the renminbi is becoming a ‘hard’ currency.
As illustrated in Figure 7, the renminbi's exchange rate moved up against the dollar prior to the outbreak of the international financial crisis and it has remained constant against the dollar since its onset. As, however, the dollar has moved up against almost all currencies, except the yen, this means that the renminbi has undergone an upward revaluation against almost all other currencies.
Figure 7
China’s exporters, therefore, face a double squeeze. First, the markets in the economies into which they are exporting are either contracting or growing far more slowly. Second, the renminbi’s exchange rate is rising. This combination squeezes China’s exporters while simultaneously cheapening imports. China's balance of payments surplus may, therefore, decrease from its current level – the last available data being for 2007 showing a surplus of $372 billion.
However, statistically, the balance of payments is necessarily equal to the difference between domestic savings and investment - China’s balance of payments surplus reflecting that its savings level is even higher than its investment level. If China’s balance of payments surplus declines this can therefore only be achieved by its investment level moving up towards its savings level or its savings level declining towards its investment level, or a combination of the two.
Which of these two occurs will have a huge influence on both the Chinese and the world economies. As already noted, in the case of both Japan and the South East Asian economies, faced with crisis, investment levels fell. Their economies consequently drastically decelerated – negatively influencing the rate of growth of the world economy. A major deceleration of China’s economy, particularly under conditions of recession in other major economies, would have very negative consequences for international growth.
The health of the world economy, therefore, requires that if China’s balance of payments surplus is to shrink this should be by moving its domestic investment rate up towards its savings rate, not by its savings level falling towards its investment rate.
Domestic economic requirements China push in the same direction. The exchange rate of the renminbi has not merely moved upwards but will remain higher due to the underlying strength of China’s economy. A clear lesson of the current crisis is that any primary use of China’s financial resources not for domestic investment but fundamentally to attempt to maintain a low exchange rate of the renminbi will not work as a strategy – even in cases where the renminbi is stabilised against the dollar it moves up against other currencies.
China will, therefore, have to learn to compete at a higher exchange rate. This requires that its whole economic mechanism become more efficient, which can only be achieved through investment. China will cease to compete as a pure low wage economy – Vietnam and other economies now occupy the place China did twenty years ago. High levels of investment are therefore vital if China's economy is to compete in this new context.
Put in other terms, China's traditional strategy has been to keep its currency's exchange rate down to the level of productivity of its economy. In the future China will have to raise the level of productivity of its economy up to its appreciating exchange rate - requiring gigantic further investment in its productive base.
Consequently the cyclical requirements of economic management, that is ‘Keynesian’ anti-recessionary measures, coincide with the structural requirements of a high investment level. So far the Chinese government is heading in the right direction in announcing successive waves of infrastructure and other investment – railways, roads, housing. The fact that China has a large state owned economic sector allows it to take far more direct ‘Keynesian’ measure to sustain investment than are available in the US or Europe.
Nevertheless the scales of the programme’s which are required are gigantic. If, to take a hypothetical example, China’s balance of payments surplus were to fall by half under the impact of pressure on exporters and cheaper imports due to the higher exchange rate, while its savings level remained the same, this would required $175-$200 billion extra a year investment in China’s domestic economy. While there is no financial constraint on this, due to the high savings rate, the task of physically gearing up the economy for such a scale of extra-investment programmes is gigantic.
Naturally this particular example is arbitrary, and China’s balance of payments surplus may not fall to this degree, but it shows the scale of economic forces and shifts which are involved.
At the same time China faces new economic challenges it has not experienced previously. The fact that China is acquiring a 'harder' currency will undoubtedly lead to central banks of other countries wishing to hold the renminbi as part of their foreign exchange reserves – an issue China has not faced on a significant scale before.
Simultaneously China will come under pressure to use its financial resources for measures other than investment in its domestic economy. The US has announced that it is arranging dollar swaps for four economies that it considers systemically crucial – Brazil, Mexico, Singapore, and South Korea. But there will be a whole series of much weaker economies in deep trouble and it will undoubtedly be proposed that China should finance these, probably via intermediaries such as the IMF, rather than investing its resources in its domestic economy. When China attends the international economic summit in Washington on 15 November the US will also almost certainly propose that China accelerate a programme of buying US Treasury bonds.
So far China is rightly adopting the approach that 'the most important task for us now is to manage our own affairs well', as vice-premier Wang Qishan put it. But pressure put on China to change that stance, and divert resources away from its key goals, will increase. In other words many other people also have their eye on the funds which China could invest in its domestic economy.
With all these pressures, together with domestic programmes of improving social welfare and attempts to improve conditions in rural areas taking place simultaneously, not to mention other issues to manage, Chinese economic policy makers are going to be kept extremely busy in the coming months.
However, as noted, while there are many specific issues to tackle they are all within the framework of one decisive strategic choice. If China responds in the same way that Japan did in 1973-90, and South East Asia did in 1997, that is by reducing its savings and its investment levels, this will be bad not only for the Chinese economy but for the world economy. If, however, China is able to maintain its savings and investment levels through the present ‘third’ Asian currency crisis, which is a crucial aspect of how the international financial crisis appears from its perspective, not only will that be good for the world economy but it will be one of the greatest pieces of macro-economic management, not to speak of practical management of huge investment programmes, ever seen.
China since 1979 has achieved one of the greatest economic miracles in history. Confronted with the third great Asian financial crisis China again faces a gigantic challenge to its macro-economic management. How successfully it confronts that will have profound consequences not only for its own but for the entire world economy.
Data on long term trends in investment and economic growth
This post deals with the historic trend of investment and economic growth. This may appear a relatively esoteric topic. In fact, however, it has decisive economic and strategic business consequences - in particular for understanding the more rapid growth of the key Asian economies relative to the US and Europe and why this will continue for a prolonged period. Before dealing with these and other more detailed implications, however, the factual data is set out.
Figure 1 shows the percentage of fixed investment (gross fixed capital formation) in GDP for a series of major countries over the longest periods of time for which data is available. [1]
Figure 1
The pattern is clear and striking. By far the strongest trend is for the proportion of GDP devoted to fixed investment (gross domestic fixed capital formation) to rise with time. This in turn, as will be shown, is associated with progressively rising rates of economic growth.
Considering countries in the chronological order in which a new peak in the proportion of GDP devoted to gross fixed domestic capital formation appeared the following is the historical pattern.
· Commencing with the period immediately antedating the industrial revolution, the proportion of GDP devoted to fixed investment in England and Wales, at the end of the 17th century, was 5-7 per cent. [2] This rose slightly, although current estimates are that it did not rise greatly, during the 19th century - peaking at over ten percent of UK GDP prior to World War I.
This level of investment was sufficient to launch the first industrialisation of any country but at a rate of growth which, while unprecedented at the time, was extremely slow by contemporary international standards - about two per cent a year. With such a growth rate it takes 35 years for an economy to double in size and 70 years to quadruple.
· Turning to the latter part of the 19th century, the proportion of US GDP devoted to fixed investment had risen to considerably exceed that for the UK – reaching a level of 18-20 per cent of GDP by the last decades of the century.
A sharp fall in the proportion of the US economy devoted to fixed investment commenced in the late 19th century, and was particularly pronounced during the period between World War I and World War II – being associated with the great depression of the inter-war period. After World War II the US resumed its pattern of 18-20 per cent of GDP being devoted to gross fixed capital formation. This generated an average growth rate of 3.5 per cent a year. With such a growth rate an economy doubles in size every 20 years and quadruples in size every 40 years. It was on the basis of this historical level of investment, and growth rate, that the US overtook Britain to become the world’s greatest economic power.
· In the period following World War II Germany achieved a level of fixed investment exceeding 25 per cent of GDP – peaking at 26.6 per cent in 1964. This period 1951-64 was that of the post-war German ‘economic miracle’ with average growth of 6.8 per cent a year - with such a growth rate an economy doubles in size every 11 years and quadruples in 22 years.
· Starting at the beginning of the 1960s Japan achieved a level of gross domestic fixed capital formation of more than 30 per cent of GDP. This reached a peak in the early 1970s, at 35 per cent of GDP, before later sharply falling. During that period the average annual rate of growth of the Japanese economy was 8.6 per cent. With such a growth rate an economy doubles in size in eight and half years and quadruples in size in 17 years.
· From the 1970s onwards, South Korea similarly achieved a level of fixed investment of 30 per cent of GDP. During the 1980s this rose above 35 per cent of GDP. The other East Asian ‘Tiger’ economies – Singapore, Hong Kong and Taiwan – showed a similar pattern. South Korea’s economy confirmed the relation between fixed investment and economic growth illustrated by Japan by growing in this period by an average 8.3 per cent a year. At such a growth rate an economy doubles in size in nine years and quadruples in 18.
Such growth rates in Asia showed that something unprecedented in human history was now possible – that it was possible to industrialise an economy, and achieve a ‘first world’ level of development, in a single generation.
· From the early 1990s onwards China achieved sustained rates of fixed investment of 35 per cent of GDP with, from the beginning of the 21st century, this rising to more than 40 per cent of GDP – a level never before winessed in human history. The result was average 9.8 per cent a year economic growth over a sustained period – also the most rapid sustained economic growth ever seen in human history. On that basis an economy doubles in size every seven and a half years and quadruples in size in 15 years.
· To complete the chronological picture, the proportion of GDP devoted to fixed investment for two countries recently undergoing rapid economic growth, India and Vietnam, is shown.
The proportion of Indian GDP devoted to fixed investment has not reached the Chinese level but has become high – reaching 34 per cent of GDP in 2007. On this basis, in the last five years, India has achieved an average growth rate of 8.8 per cent a year. At that rate of growth India’s economy doubles in size in slightly over eight years and quadruples in sixteen and a half years.
In Vietnam the proportion of GDP devoted to fixed investment rose from 13 per cent in 1990 to 25 per cent in 1995 to 37 per cent in 2007. Economic growth has accelerated rapidly, rising to an average of 7.9 per cent a year in the five years up to 2007. At that rate of growth Vietnam’s economy doubles in slightly under 9 years and quadruples in size in 18 years.
Considering these trends, such a high level of investment is a necessary condition for rapid economic growth. No substantial country without comparable high levels of fixed investment has achieved such rapid rates of growth on a sustained basis. [3] But it is not a sufficient condition: the high level of investment is also linked to the scale of production, that is the size of the market being produced for. In a modern economy only large scale production can be efficient in the decisive sectors of production, requiring an orientation to the international market – this is particularly evident with such high levels of investment.
No purely national market, not even the US or China, is sufficiently large to maintain the most efficient level of production. As many others have frequently correctly stressed, high levels of investment must therefore be accompanied by an export orientation. [4] It is this high level of investment, accompanied by an export orientation, which was responsible for the rapid economic growth of South Korea, China, India and Vietnam.
Implications of different investment levels
There are a number of clear consequences of these factual trends (it must be stressed that this data, of course, deals only with long and medium term trends and is not a guide to short term fluctuations). Among the most important of these implictions are:
· It provides a clear historical framework for understanding the present rapid growth of (primarily Asian) economies and why they will continue to grow far more rapidly than the US and Europe.
· China’s economy will continue to outperform India’s and the gap between the two will grow - and not shrink as some have suggested.
· There is no serious historical evidence for the thesis sometimes presented that China is oversaving/overinvesting. China therefore should seek to maintain, and not cut, its current savings and investment levels.
· Current US/UK economic policy, with its overwhelming emphasis on microeconomic efficiency of resource allocation, fails to address the most important economic issues and therefore will be unsuccessful – which will deepen the tendency for the key Asian economies to grow more rapidly than the US and Europe. The also provides a background to current issues in the credit crunch.
Taking these issues in more detail:
First, these trends place in wider historical context the present rapid growth of a number of (primarily Asian) economies. The latter represent the latest high point in the trend for higher and higher proportions of GDP to be devoted to fixed investment. Consideration of such trends therefore provides a clear theoretical underpinning for the evident current empirical fact that not only is Asia growing substantially more rapidly than the US and Europe but that it will continue to do so. The investment rates in the key Asian economies are not aberrantly high but merely the latest point in an historical trend.
Seen in long term historical perspective it is US and European savings and investment rates that are too low, not Asian savings and investment rates that are too high.
Second, given these historic trends, it is clear that on the basis of current macroeconomic trends China’s economy will continue to expand more rapidly than India's and that China will increase its economic lead over the latter.
This naturally does not mean anything other than that India is an extraordinarily important market. India’s economy is, at a realistic exchange rate, in Parity Purchasing Power (PPP) terms, the fourth largest economy in the world after the US, China and Japan.[6] India's economic growth, running at around at 8-9 per cent a year, is the second largest for any major economy in the world after China. However, China’s economy is already approximately two and a half times the size of India’s in PPP terms and is continuing to grow at one to two per cent a year more rapidly than India – this combination ensuring that the gap between China and India is widening and not narrowing.
There is also no evidence from consideration of historical data that the factors invoked to claim that India’s economy will grow more rapidly than China’s, for example different demographic profiles, are crucial. The historical evidence is that it is the proportion of the economy devoted to gross fixed capital formation that is decisive. The fact that, until the present, the Chinese economy continues to devote a significantly higher proportion of the economy to fixed investment than India – 43 per cent compared to 34 per cent to take the latest available years, indicates that unless India catches up with China in terms of this area China will grow more rapidly than India.
Third, there is no evidence from this historical trend data for the argument that China is facing a basic crisis of oversaving/overinvestment, and therefore that China needs to lower its total savings level (i.e. savings including private, public and corporate saving) and to increase consumption - as some commentators, including the Financial Times chief economics commentator Martin Wolf, have stated. [5]
It is evident that China’s level of investment and saving is far higher than that of the US or UK. However the historical data make clear that China’s is simply the latest stage in the long term trend for an increasing proportion of GDP to be devoted to gross fixed capital formation. Given this rising historical trend it is entirely likely that in the future another country, or China itself, will have a higher proportion of GDP devoted to saving/investment than China today - yielding a higher rate of growth.
While, of course, short term fluctuations and adjustments may be required there is no historical evidence that China's savings and investment rate is excessively high - it is merely the latest stage in a long term international historical trend. Reduction of China’s investment and savings rate would lead to slowdown not only of China’s economy but also, because of its locomotive role in the world economy, a slowdown in the global economy. China should therefore be seeking to maintain, not reduce, its current high investment and savings levels.
Fourth, there is no evidence from the historical data that the 'quality of entrepreneurship' plays any crucial role in economic development. Or more precisely, and what is another way of saying the same thing, the quality of entrepreneurship and managerial effectiveness appears to be randomly distributed and therefore cannot explain differences in economic growth rates. There are no cases where, due to the 'quality of entrepreneurship', countries have experienced rapid growth without high levels of gross domestic fixed capital formation in GDP.
Fifth, present US/UK government economic policy, by according overwhelming centrality to dealing with microeconomic efficiency, is addressing relatively minor issues in terms of international competitiveness compared to that of dealing with inadequate saving and investment rates. The economic priorities of a number of rapidly growing Asian economies will therefore clearly be more effective than that of the US and UK.
Put in other terms, the implications for governments’ economic policies of the long term trends outlined here is that in a balance between seeking microeconomic efficiency in the allocation of resources, and seeking a high level of savings and investment, the high level of savings and investment is more important that the emphasis on microeconomic efficiency from the point of view of creating economic growth.
There is an entirely reasonable supposition that the microeconomic allocation of investment in South Korea or China, given the use of subsidised loans, cross forms of ownership in different branches of industry, higher capital/output ratios etc, is less microeconomically efficient than in the UK or the US. However the rate of growth of the South Korean or Chinese economies is much more rapid, over a sustained period, than that of the UK or US.
Quantitatively the greater microeconomic efficiencies in allocation of resources in the US or UK, to generate an equal rate of growth, would have to compensate for their lower savings and investment ratios and there is no evidence that it does so. It is the higher savings and investment rates in Asian economies that predominate over greater microeconomic efficiency. Therefore any quality of microeconomic priorities in the US and UK will be overwhelmed by the quantity of investment in the rapidly growing economies of Asia.
Ideally, of course, both high microeconomic efficiency and high savings/investment levels should be sought. However there is evidence that the two are contradictory. For example the policies pursued in the US and UK have been accompanied by massive declines of savings rates which have undermined the competitiveness of the economy – leading into present sharp financial problems. It is therefore likely that current US and UK economic policy will be unsuccessful, and these economies will remain under financial pressure created by lack of competitiveness for a prolonged period. The credit crunch is a one periodic form of the manifestation of this loss of competitiveness by the US and UK.
Conclusions
The following clear conclusion may be drawn from this data:
There is a clear historical trend for the proportion of the economy devoted to gross domestic fixed capital formation to rise. This is the key determinant of rising rates of economic growth.
Five key historic stages in the rise in this proportion of the economy devoted to fixed investment may be identified: the achievement of a 5-7 per cent investment rate in Britain in the 18th century permitting the launching of the industrial revolution; an 18-20 per cent of GDP fixed investment rate from the latter part of the 19th century, achieved by a number of countries led by the US, which permitted the United States to replace the UK as the world's leading economic power; a 25 per cent of GDP fixed investment rate in Germany in the immediate post-World War II period which accompanied the German 'economic miracle'; a more than 30 per cent of GDP rate of fixed investment achieved in Japan, and then the other East Asian 'Tiger' economies, from the mid-1960s which permitted growth rates of more than 8 per cent a year; a more than 35 per cent of GDP fixed investment rate in China from the 1990s onwards which has permitted sustained growth rates approaching 10 per cent a year.
On the basis of this differential in investment rates a number of the key Asian economies will continue to outperform the US and Europe in terms of economic growth for a prolonged period.
China will continue to increase its economic lead over India - although the latter will experience rapid economic growth.
There is no historical evidence China is oversaving or overinvesting and it should seek to strategically maintain, and not cut, its present investment and saving rates.
Current US and UK economic policy addresses secondary issues and therefore is unlikely to be successful.
Note on future postings
A companion blog Key Trends in the World Economy has therefore been established to deal with a wider range of economic issues. Notification of links to posts on Key Trends in the World Economy will be given on the current blog. But the full posts will not be reproduced here in order to maintain accessibility.
References - for detailed references see continuation of article
Introduction
The latest figures on the emerging pattern of global investment present a massive challenge to the next [UK] government. The likely future we can extrapolate from these figures will come as a shock to many, particularly those who subscribe to the theory of 'post-fordism' which became fashionable in the 1980s. According to this thesis, the era of mass assembly line output, pioneered by the Model T Ford, was superseded. New forms, based on ‘flexible batch production’, were playing the leading role in the economy.
A series of interrelated concepts were advanced linked to this — that a tendency towards small(er) scale production had replaced the huge units of output of ‘Fordism’, that service industries were replacing manufacturing, that a ‘segmentation’ of markets had/was taking place etc.. In a typical formulation of the period: ‘The new terrain is that of high technology, of small firms, computers and information technology’. This concept led, in terms of rhetoric, to various views that the large scale economy of the manufacturing period was bypassed and instead ‘small is beautiful.’
This thesis was based on ripping individual aspects of the situation out of context, exaggerating them, and using this to destroy any quantified, precise or balanced consideration of reality, and thereby obscuring the real tendencies of development.
The real economic trends were, and are, the exact opposite of ‘small is beautiful.’ In the context of the issues discussed here, they might be termed ‘big is flexible.’
The most advanced sectors of modern production are, indeed, characterised by extraordinary flexibility — compared to the standardisation caricatured in Henry Ford’s famous ‘you can have it any colour provided its black.’ But this emphasis on the outward forms of flexibifity, segmentation, and individualisation obscures the underlying economic reality. The necessary precondition, and foundation, for the flexibility of ‘post-Fordist’ production is an historically unprecedented level of investment and associated scale of production.
This trend is evident not merely in direct investment within industry — i.e. the technology which makes possible flexible manufacturing, but in the processes necessary to co-ordinate extremely large scale production — telecommunications systems, transport, computerisation of stock control etc. These, in turn, require radical expansion of the educational system — the creation, on a new and unprecedented scale, of skilled labour which is the indispensable precondition for operating this new, more capital intensive, production.
The enormous concentrations of capital which make flexible production possible have a number of aspects. One, analysed by in 'Fundamental Economic Implications of a Single European Currency', is that the necessary scale of production, of the most advanced industries, can only be carried out, on an efficient basis, on a scale which exceeds the nation state. It is this which is the ultimate root of globalisation — and why all attempts to pull production back into the scale of nation state are purely utopian.
This article concentrates on a second aspect — that of the scale of investment required for modern production. This is considered from both an ‘extensive’ and an ‘intensive’ point of view. The ‘extensive’ is the spread of successively higher ratios of investment to GDP into the most successful contemporary economies. The ‘intensive’ is the penetration of high levels of investment into the new service sectors in the most advanced economies. This combination makes clear that what is being seen is not a retreat to the ‘small’ but a new upward twist in the role of large scale investment within the economy.
The implications of this for the U.K. are evident. Britain historically suffered from an inadequate level of investment — a phenomenon illustrated again here. But under 18 years of Tory government this chronic historic problem has become acute — with investment having now fallen to its lowest share of GDP for forty years. The material analysed below shows that far from the rise of the service sector leading to a lessening of the requirements for investment, it will raise them still further — together with the demand for an educated labour force capable of operating this investment.
The last 18 years of Conservative government have not corrected (he historical distortions of the U.K. economy, but deepened them still further. An emphasis on investment by the next Labour government is the essential precondition for tackling any of the problems which face the British economy.
Ken Livingstone MP
* * *
The historical rise in the proportion of the economy devoted to fixed investment is one of the most well established of long term economic processes. It will be illustrated below in considering the overall trend of fixed capital formation from the industrial revolution to the present. Current conjunctural trends, the development of very rapid economic growth in South East Asia, and the transformations within the service sectors of the most advanced economies, may then be clearly understood against this backdrop.1
The industrial revolution
While estimates for investment for early historical periods are extremely difficult to make, it is clear that at the time of the industrial revolution in the U.K., at the end of the 18th century, less than 10% of the U.K.’s GDP was allocated to fixed capital formation. To give an historical contrast, by the 1990s rates of investment had reached, in extreme cases, 35-40% of GDP. A rate of fixed capital formation of 30% of GDP, or above, is typical for Japan and the East Asian Newly Industrialising Countries (NICs) (Figure 1).
Sharp increases in investment
It is also clear from historical data that increases in the rate of investment do not occur gradually, but in (relatively) short periods that are frequently reflected in shifts in international economic leadership — i.e. such upward shifts in investment are ‘revolutionary’ rather than ‘evolutionary’.
Since the industrial revolution four such waves of sharp increases in the proportion of GDP allocated to investment have taken place — with, arguably, a fifth occurring at present. Using as titles the countries which provided the ‘leading edge’ of such periods of increased investment, these may be termed the ‘UK period’, the ‘US period’, the ‘West German period’, and the ‘Japanese period’. The fifth may be termed the ‘Chinese/South East Asian period’ — although it remains to be seen if this is a new higher phase, or a generalisation of the preceding Japanese one.
These periods will be considered in chronological order.
The UK rate of investment
Historical studies indicate that, following the industrial revolution, the U.K.’s domestic fixed capital formation was less than 10% of GDP and that no fundamental increase in the proportion of UK GDP devoted to fixed capital formation took place during the following century. While the U.K.’s savings rate became substantially higher than this level of domestic investment, the capital created was invested abroad. By the eve of World War I, U.K. annual overseas investment was larger than investment in its domestic economy — this tendency to substitute investment abroad for investment at home being one of the chief historical features of the U.K. economy, and substantially accounting for its weak character compared to its rivals. By 1885 UK fixed domestic capital formation was still only seven per cent of GDP.2
Only after World War II did U.K. domestic investment substantially rise as a proportion of GDP, and even then it remained lower than its rivals — while, simultaneously, its rate of investment abroad remained higher, in proportionate terms, than its competitors.
The US rate of investment
While the UK level of domestic investment remained fixed at under 10% for over a century, the U.S., by the period following the end of the civil war, had qualitatively surpassed this rate — to achieve an historically unprecedented level of capital formation of 15-20% of GDP. This rate of fixed capital formation, being double that of the UK, accompanied the establishment of the US as the world’s leading economy — replacing Britain in the period from the nineteenth century until the end of World War II. Furthermore, the U.S. did not become a substantial investor abroad until after the two world wars, and even then its accumulation of foreign investment remained proportionately lower than that of the U.K.
It is clear that the US has not succeeded in seriously raising this rate of investment since the period in which it was established. The post World War II US economy saw fixed capital formation still averaging 15-20% of GDP.
The West Germany rate of investment
Data for German rates of investment prior to World War II are, unfortunately, not available. There is no evidence they surpassed US rates. However, by the early 1950s, West Germany had achieved a new historical peak of fixed investment of 20-25% of GDP — for the first time achieving a level clearly exceeding that of the U.S..
This level of investment, due to the competitive power/example of the West German economy, became generalised throughout Europe during the period of post-war boom from the 1950s-70s — with the exception of the U.K, in which the rate of investment remained lower. This pattern of investment, at a ‘West German level,’ underlay the process of economic convergence in Western Europe in this period. The failure of the U.K. to achieve this level of investment explained why it fell behind its European rivals, and was, and is, unable to participate in their process of convergence.
On the international field, this new historically higher rate of fixed capital formation was accompanied by Western Europe achieving a more rapid rate of economic growth, and productivity increase, than the United States in the period from the 1950s to the early 1970s.
The Japanese rate of investment
From 1960 onwards Japan, which had commenced its post-war economic growth with levels of investment comparable to those of West Germany, achieved a new historical peak in investment rates — reaching levels of gross fixed capital formation of 30% of GDP and, at its peak, 35% of GDP. Such a rate of investment had, historically, only been previously seen once before — during Stalin’s period of rapid industrialisation of the USSR in the 1930s.
Japan’s rate of fixed capital formation has now been sustained for a quarter of a century indicating a new historical level in the proportion of GDP devoted to fixed investment.
The international accompaniments of this ‘Japanese’ rate of investment are well known. During the 1960s and 1970s Japan achieved rates of growth exceeding that of not only the U.S. but also Western Europe.
The Chinese/South East Asian rate of investment
Since the beginning of the 1980s a rate of investment exceeding that of Japan has been achieved by China, and a number of the South East Asian NICs. Their levels of fixed capital formation have reached levels of 35-40% of GDP (Figure 2). If this is maintained it will, of course, represent a new higher period of rate of investment. However, this level has, so far, been sustained only for a relatively short period — a decade. It is, therefore, necessary to reserve judgement as to whether a new ‘plateau’ of investment, exceeding that of Japan, has been achieved or whether they will slip back to the Japanese level.
The consequences of such rates of investment are, however, clear. The four ‘Asian Tigers’ — South Korea, Hong Kong, Singapore and Taiwan — have been transformed from underdeveloped countries to advanced industrial states in a single generation. China is undergoing the most rapid sustained growth seen by any large underdeveloped country in history.
Successive rises in the rate fixed capital formation
Summarising the above data the four, possible five, historically characteristic periods of rates of fixed investment can clearly be seen. These were:
• the UK rate, from the industrial revolution to the late nineteenth century, with levels of fixed capital formation of 5-10% of GDP;
• the post-civil war level US with investment at 15-20% of GDP:
• the post-World War II West German level of fixed capital formation of 20-25% of GD?;
• the post-1960 Japanese level of investment of 30% of GDP;
• a possible Chinese/South East Asian level of investment of 35% of GDP.
‘Leaps’ in the rate of investment
It is evident that, at least in the modern period, such characteristic increases in the rate of fixed capital formation do not take place gradually but in relatively sudden spurts. The West German level of investment was achieved in ten years between the end of World War II and 1955; the Japanese level of investment was achieved in a rapid surge between 1950 and 1960; the Chinese/South East Asian rate of investment was achieved in the ten year period after 1980.
‘Extensive’ increases of rates of investment
It is, furthermore, evident that once a ‘leading country’ of a given period has achieved the new higher proportion of GOP devoted to fixed capital formation this rate is ‘sticky’ — i.e. it is hard to achieve a higher rate. Once the UK had achieved the level of fixed capital formation of the industrial revolution its level of domestic investment rose only slightly over the next 150 years — a substantial increase only occurring in the post-World War II period. After the US had achieved its post-civil war level of investment this did not significantly increase in the next 130 years. West Germany did not succeed in rising above its post-World War II peak of investment. Such ‘stickiness’ of the rate of investment evidently reflects the fact that the relations between social groups, established by a given investment rate, would require major political upheaval to modify that level of investment.
The result of such ‘stickiness’ is the ‘extensive’ spread of increases in the rate of investment. In each case the new, higher, level of fixed capital formation was accompanied by a shift in the geographical locus of the most rapid economic growth. This ‘leading edge’ of investment and growth rates passed successively from the UK to the United States in the late nineteenth century and the first half of the twentieth; to Western Europe, immediately after World War II; to Japan from the 1960s; and to China and the East Asian NICs from the 1980s onwards. A spiralling outwards from the first industrial countries occurred.
The rise of the ‘service economy’
The rise of, first, the Japanese and now the EastlSouth East Asian economies is, of course, a commonplace observation of modern economics — although its place in the systematic successive increases in rates of investment is not so widely appreciated. But what is involved in the second characteristic process taking place within the already advanced economies themselves — that of the rise of the service sector?
It is in this field, in particular, that the idea of ‘smallness’ is thrown up. The level of investment in a ‘Fordist’ car plant is evident in its sheer physical size. Does, therefore, the rise of the service economy represent a retreat to a new, lower, level of investment? To illustrate the actual processes, Tables 1, 2 and 3 [at the end of this article] show, for those sectors for which data exists, the percentage of value added that is constituted by consumption of fixed capital in the U.S., Japan and Germany — i.e. in the most advanced economies. Consumption of capital, as a percentage of value added, is the most appropriate measure of the capital intensity of production.
A number of features stand out in this data which are not connected to the rise of the ‘service economy’ — in particular the extremely capital intensive character of the extractive industries (oil, gas, coal, mining in general etc.), and agriculture (which in all three economies has a higher capital intensity than the average for the economy as a whole). But the most striking feature, for present purposes, is that in all three economies the level of capital intensity in manufacturing is lower than the average for the economy as a whole — i.e. manufacturing does not represent a peak level of investment, from which a decline then takes place. Other things being equal a shift out of manufacturing would be associated with a rise in the level of capital intensity, not a fall.
Distinctions within the service sector
The process involved in this striking fact that manufacturing represents a sector of lower than average, not higher than average, capital intensity may be seen clearly by examining the service sectors in Tables 1 to 3. Certain service sectors have a low, common, capital intensity in all three economies — indicating that these are sectors that, at least at the present stage of economic development, are less capital intensive than manufacturing. These are notably the wholesale and retail distribution system and provision of government services. But considering the U.S. economy, that is the most advanced in the world, a whole series of service sectors have capital intensities significantly above the average — and substantially above those for manufacturing. These include communications and telecommunications, hotels, recreational and cultural services, finance, non- dwelling real estate and transport.
These named service sectors are, however, precisely the core of the expanding areas that form the base of the modern ‘service economy.’ That is, the movement of the U.S. economy out of manufacturing, and into services, is not a shift into sectors with a lower capital intensity than manufacturing, but into those with a higher capital intensity.
Some of the reasons for this trend are evident. These U.S. service sectors, which are the most advanced in the world, have undergone a massive process of computerisation in almost all areas. This process of computerisation has interlinked with that of telecommunications — the necessary precondition of efficient organisation of very large scale, including ‘globalised,’ production. Whole service sectors, such as finance, transport, and hotels, are now entirely dependent on such systems.3 These trends, together with others, result in a situation, as illustrated by the data, whereby the capital intensity of these service sectors actually exceeds that of manufacturing.
The process of rising capital intensity, in the most advanced service sectors, can be seen clearly by making a comparison of service sectors where capital intensity in the U.S differs sharply from the other economies noted — particularly for Germany, for which more comprehensive data is available than for Japan. In Germany, sectors such as communications and transport have high capital intensities — as in the U.S. But sectors such as financial institutions and restaurants and hotels do not — as is also the case for the U.K., Norway, Sweden, Finland, Austria and New Zealand for which OECD data are available.4 The higher level of capital intensity of these sectors in the U.S. is, evidently, linked to their more advanced development.
Increasing scale of production
A feature accompanying this rising capital intensity in the service sector is its increasing scale of production — the bringing of the service sector under the sway of large scale concentrations of capital. The process of creation of such concentrations in banking, entertainment, music, sport, broadcasting etc., is now on a scale equaling that in manufacturing. It was accurately described in Business Week:
‘Almost without warning, the U.S. has entered a new era of bigness... Chase-Chemical, Disney- ABC, Time Warner-Turner - these are just the tip of an economy wide move toward combination and consolidation.
‘Today’s deals are not the financially driven hostile takeovers and leveraged buyouts that dominated the 1980s. No raiders are carrying out bags of cash this time around. Now it’s the corporate leaders of America... Their goal: to acquire the size and resources to compete at home and abroad, to invest in new technology and new products, to control distribution channels and guarantee access to markets. “We are moving toward a period of the megacorporate state in which there will be a few global firms within particular economic sectors,” says Steven Nagourney, chief investment strategist for Lehman Brothers Inc.’s private client group.
‘That’s certainly true in the media industry, where the race to lock up key distribution channels such as television, and cable networks just got more frenzied. Market dominance is also driving such mergers in the drug industry, Merck’s & Co.’s purchase of Medco Containment Services Inc. ‘As your competitors get bigger, you’re almost forced to get bigger to stay equal’, says Norman S. Selby, Head of McKinsey & Co.’s pharmaceutical practice. ‘It’s a continual game of catch-up’.
‘Other deals are driven by a need to bulk up as U.S. companies take on global competitors. The Chemical-Chase merger produces a bank that’s No 1 in the U.S. but only 21st in the world, by assets. And the combination of Upjohn Co. and Sweden’s Pharmacia, announced on Aug. 20, will create a titan that only ranks about ninth in sales among drugmakers worldwide.
‘Besides adding sheer size, acquisitions can provide an instant presence in foreign markets. Scott Paper Co. was acquired by Kimberly-Clark Corp., in large part, because Scott had strengths in Europe that Kimberly lacked....
‘Companies are taking advantage of deregulation to make ever- larger combinations. New rules lifting barriers on interstate banking set to take effect in September, for example, will ignite a new round of cross-country mergers. And the proposed elimination of the Interstate Commerce Commission, which reviews railroad mergers, may spark more combinations among real carriers. One possibility: a Norfolk Southern Corp., takeover of Contrail Inc.
‘The passage of the telecom deregulation bill, expected this year and next, may be the signal for some of the biggest mergers of all time, especially if the old Bell system starts reassembling itself. ‘It’s not unreasonable to see several (regional Bell operating companies) merging over the next several years’, says Daniel Rein gold, vice-president at Merrill Lynch & Co. The most likely candidates: Bell Atlantic Corp. and Nynex Corp., which already jointly run a cellular service...
‘Inevitably, some once-mighty players will be trampled in the stampede for market dominance. Apple Computer Inc., with only about 10% share of the personal- computer market, may find that software developers opt to concentrate their efforts on the much larger Windows market.’
As Business Week noted, even in ‘classical’ service sectors:
‘Entertainment — just about everyone is trying to dominate this very hot U.S. export. Reason: vertical integration is supposed to yield clout in the Information Age. Result: Disney, Seagram and Westinghouse are all doing huge deals. Now, Time Warner is wooing Turner Broadcasting. Financial services — the goal here is to squeeze out costs and earn economies of scale. That’s a big reason behind Chemical’s $10 billion merger with Chase and First Union’s $5.4 billion acquisition of First Fidelity Bancorp.’5
The Wall Street Journal noted precisely the same trend driving the process of mergers which now extends well into the service sector:
‘The deals come tumbling out, one upon another. Chase/Chemical. Sandoz/Ciba-Geigy. Bell Atlantic/Nynex. British Telecom! MCI. Boeing/McDonnell Douglas. Morgan Stanley/Dean Witter.
‘It is a merger boom the likes of which the business world hasn’t seen since 1960s, when assembling conglomerates out of dozens of smaller companies was the rage. Except that it isn’t really like those eras. It is bigger, for one thing. And the forces behind it are different.
‘First, a few figures. The volume of mergers and acquisitions done world-wide last year added up to $1 trillion. That included 10,000 transactions in the U.S. alone, worth more than $650 billion — nearly twice the dollar volume and the number of deals for the peak year of the 1980s.
‘Many have been huge: Six last year topped $10 billion. Indeed, one-fifth of last year’s total dollar volume was squeezed into just 10 mega-mergers. The year saw more than 100 billion-dollar-plus transactions, a record...
‘This year there is no letup: 26 billion-dollar announcements so far and already a few giant ones, such as Morgan Stanley/Dean Witter and Banc One /First USA. It is the fastest pace since the current merger boom began...
‘Some of the causes aren’t far to seek... Above all, a globalizing economy in which companies often find they must become big to compete, either by acquiring or by being acquired. “There are all kinds of related factors, but the fundamental determinant of the overall level of activity is the expansion of the global economy,” says Scott Lindsey, co-head of mergers at Credit Suisse First Boston Corp.
‘As these elements suggest, the mergers of today are overwhelmingly being done for strategic business reasons. Thus, this merger boom differs from that of the 1980s, when some buyers were financial types simply angling for undervalued assets that could resell, and also from the conglomerate era that began in the early 1960s...
‘At its most fundamental level, today’s merger wave is about efficiency and market clout. Look at the union last year of Chemical Bank and Chase Manhattan. Where there had been two banks, with two. chairman, two corporate-loan departments, roughly 600 branches and over 75,000 employees, there is today just one bank. One chairman. One loan department. Eventually 100 branches will be shuttered, and 12,000 jobs will be eliminated...
‘A common theme in modern mergers is sheer size. Size is advantageous in many ways. Tyco international in Exeter, New Hampshire, by buying a packaging maker called Carlisle Plastics and wrapping it into its own Armin plastics, has doubled the volume of its purchases of low- density polyethylene film and gained new clout with suppliers. Banc One, by buying credit-card issuer First USA and its U.S. portfolio of 16 million card holders, gains a national platform in a key business.
‘And British Telecommunications’ $21 billion purchase of ‘MCI can now aggressively pursue a local strategy without worrying about near-term earnings impact,’ notes Salomon Brothers analyst Jack Grubman...
‘Size also matters in trying to capture as much business as possible from a given client. Companies like to offer customers “end- to-end solutions”. So Duke Power bought gas-pipeline giant PanEnergy, creating one the biggest energy suppliers in the U.S. Citing Duke’s contract to manage First Union’s energy needs over its entire 12-state network. Duke Chairman William Grigg says:
“Customers want companies to manage their whole energy requirements.”
‘Mergers are happening even in technology, historically an industry devoted to creating new products and services in-house. Cisco Systems, whose stock has been one of the great performers of the 1990s, last year spent a speck of it for a little-known company called Granite Systems Inc. Granite had no revenue, only a great idea: a promising switching technology, a crucial piece of the puzzle for networking companies. Like Duke, Cisco wanted to be better able to provide end-to-end solutions. And it wanted to do so fast.
‘For Cisco, with a $40 billion stock-market value, ‘to pay $200 million and potentially ride the next wave is a trivial insurance policy if it works,’ says Charlie Federman of Broadview Associates, a technology-oriented investment bank. “Time-to-market is absolutely critical, and you can’t be one or two months late.”..
‘The Clinton administration and the Republican Congress enacted the Telecommunications Act of 1996, opening up the long- distance phone business and the TV and radio markets, That helped spawn some of the biggest combinations ever, such as the $22 billion pending Nynex-Bell Atlantic merger and WorldCom’s $14 billion acquisition of MFS Communications. Westinghouse’s purchase of Infinity Broadcasting, combining Nos. 1 and 2 in the radio business, couldn’t have happened without the same legislation.’6
This scale of concentration of capital, now spreading far into the service sector, is simply a counterpart of the increased capital intensity of production — reflected in the figures for the most advanced service sectors.
Summary
Considered from a fundamental point of view three of the most striking features of the new world economy — globalisation, the explosive growth of the Asian economies, and the rise of the service economy — are merely different manifestations of the same process — the continuing sharp rise in the proportion of the economy devoted to investment, and the scale of production which results from this. In its outward form flexible production appears small and precise — involving ability to produce smaller runs of differentiated products and utilising physically smaller units of production as parts of large concentrations of capital. But this physical aspect is merely the outward form. The underlying reality which makes such ‘flexible production’ possible, its precondition, is levels of investment, and a scale of production, on an unprecedented level.
The implications for the U.K. are evident. The fact that Britain’s is a mature economy, which must rest on the most advanced spheres of manufacturing and on services, does not obviate its need for investment — or lessen the crippling effects of its historical inadequacy in this field. It merely gives this problem unprecedented acuteness.
Notes
1. An earlier analysis of part of this material was given in ‘Behind the Threat of a Global Credit Crunch’, May 1991. This article both updates these international trends and considers the situation within the service sector of the advanced economies.
2. All historical figures, unless otherwise stated, are from One Hundred Years of Economic Statistics, Economisy publications, London 1989. Where more recent data is available from the OECD this has been used.
3. This process of cornputerisation of transportation has affected no simply obvious areas, such as civil aviation, but also lies behind the revival of the U.S. railway system. For an excellent analysis of this see Barnaby Feder, ‘What drives U.S. rail rebirth,’ International Herald Tribune 2 November 1996.
4. The only exception to this is the hotel and restaurant sector in Sweden, the capital intensity of which is above that of the Swedish economy as a whole.
5. Michael Mandel, Christopher Farrell, Catherine Yank, ‘Land of the Giants,’ Business Week 11 September 1995.
6. Steven Lipin, ‘Corporations Dreams Converge on One Idea: Its ‘lime to Do a Deal.’ Wall Street Journal 26 February 1997.
