Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  A second problem with favoring producers in developing countries is that households get a raw deal, and so consumption tends to be low. For starters, wages tend to be low because the many workers in low-productivity agriculture constitute a reserve army, waiting to take up factory jobs at low wages, and keep industrial wages from rising rapidly. But over time governments can also interfere in the wage-setting process, favoring manufacturers over workers so as to keep firms competitive and profitable. Also, the favored firms may pay low prices for government-controlled natural resources such as energy and minerals. Governments make up the shortfall in their revenue by taxing households more, even while the firms charge high prices for the goods they sell to those same households in the cartelized domestic markets.19 To add insult to injury, banks offer low government-set deposit rates for household savings, thus cutting further into household income, even while making subsidized loans to businesses.

  In sum, the need to create strong firms may lead the state to favor the producer and the financier at the expense of the citizens. As a result, consumption is unnaturally constrained in such economies. The India of my youth was not dissimilar to the Korea that my Korean friends still remember, where wages were low, work hours long, and consumption frowned on. Indeed, many of them recollect how dim Seoul was at night, because bright neon lights advertising consumer goods were prohibited. Midnight curfews both ensured security and prevented young workers from wasting their energy on an unproductive night life. So a second problem of managed capitalism is that because consumption is repressed, firms are deprived of large domestic markets.

  Export-Led Growth and Managed Capitalism

  One way to both discipline inefficient firms and expand the market for goods is to encourage the country’s large firms to export. Not only are firms forced to make attractive cost-competitive products that can win market share internationally, but the larger international markets offer them the possibility of scale economies. Moreover, because they are no longer constrained by the size of the domestic market, they can pick the products for which they have the greatest comparative advantage.

  Often, the starter sector in developing countries is easy-to-make but laborintensive consumer goods like garments and textiles. Having consolidated the protected textile sector as described earlier, the Taiwanese government started putting in place incentives to export. By 1961, Taiwanese textile exports had become a big enough threat that the United States imposed quotas on them—a sure sign that Taiwan’s textile industry had come of age.

  Once industry learned the basics of production in textiles, it started moving up the technological ladder to produce more complicated goods. As late as 1970, textiles were still Korea’s leading export, followed by plywood and, curiously, wigs, whereas its major exports today include cars, chips (silicon, not potato), and cell phones.20 Today, it is China, Vietnam, and Cambodia that compete to export textiles.

  Developing-country governments tried to enhance incentives even further by offering greater benefits to firms that managed to increase exports. For instance, because foreign exchange was scarce in the early days of growth, imports were severely restricted. Successful exporters were, however, given licenses to import, and the prospect of making money by selling these licenses gave them strong incentives to expand their foreign market share. In situations where foreign countries imposed import quotas, or where raw materials were scarce, the government also allocated a greater share of these to the more successful exporters. So both indirectly and directly, the efficient were encouraged.

  The export-led growth strategy does not mean that government reduces its support to industry. Indeed, exports may initially require more support if domestic firms are to be competitive globally. Some countries have provided a general subsidy by maintaining an undervalued exchange rate or holding down wages by suppressing or co-opting unions; such strategies are more easily followed by authoritarian governments. Others have provided a specific targeted subsidy by underpricing key raw material or energy inputs to exporters or by directly providing cash rebates for exports or for importing manufacturing equipment intended to produce exports.

  What is clear is that a necessary concomitant to the strategy of government intervention to create strong domestic firms is to push them to prove their mettle by exporting. Managed capitalism has proved enormously successful in its immediate objective of getting countries out of poverty. It is not, however, an easy strategy to implement.

  Missing the Turn

  Managed capitalism initially requires a producer bias that is not easy to sustain in populist democracies. Then the government, despite coddling firms in their early years, has to turn and push them toward exports. For small nations like Taiwan, limited domestic markets made the second step virtually a necessity. But for countries with large domestic markets like Brazil, that second transformation was long delayed.

  One country that flubbed this move was India. Under its first prime minister, Jawaharlal Nehru, India did strive to build organizational capacity. Although Nehru reserved industries like steel and heavy machinery for the state sector, he never actively suppressed the private sector. Instead, a system of licensing—the infamous “license-permit raj”—was put in place, ostensibly to use the country’s savings carefully. This meant guiding investment away from industries that bureaucrats thought were making unnecessary consumer goods (even durable ones such as cars), and instead into areas that could lay the basis for future growth, such as heavy machinery. The result, however, was that incumbents, typically firms owned by established families that were well enough connected to procure license early, were protected from competition. Barriers were also erected against foreign competition in order to provide a nurturing environment to India’s infant industries until they matured and became competitive.

  The protection India offered these industries, however, became an excuse for the companies to become “Peter Pans”—companies that never grew up. Car manufacturing is a case in point. Over nearly four decades, only five different models of the Ambassador car were produced, and the sole differences between them seemed to be the headlights and the shape of the grill. After growing rapidly just after independence, the Indian economy got stuck at a per capita real growth rate of about 1 percent—dubbed the “Hindu” rate of growth.

  Like Korea or Taiwan, India should have made the switch toward exports and a more open economy in the early 1960s. But because the protected Indian domestic market was large, at least relative to that of the typical late developer, firms were perfectly happy exploiting their home base despite government attempts to encourage exports. This is not to say that government efforts to change were particularly strenuous, especially given that protected firms were an important source of revenue to the ruling party for fighting elections. Democracy at this stage may well have seemed a source of weakness: leaders like Park Chung Hee in Korea and Lee Kuan Yew in Singapore did not have to worry about such niceties. As a result, India stayed closed, poor, and uncompetitive long after the economies of countries like Korea, which were at similar levels of per capita income in the early 1960s, had taken off.

  What Happens When the Exporters Get Rich: Germany and Japan

  Not every country has been able to succeed with an export-led growth strategy. Moreover, this strategy also has weaknesses that may become clear only gradually, as countries grow rich. To understand these weaknesses, we should take a closer look at Germany and Japan. Neither was really poor after World War II—their people were educated, these countries had the blueprints to create the necessary organizations, and some of their institutional infrastructure survived—but both had devastated, bombed-out economies, with their capital stock substantially destroyed, large firms and combines broken up or suppressed by the occupation authorities, and households too downtrodden to be an important source of consumption. Exports were the obvious answer to their problems.

  With a large number of workers still in agriculture, and with labor organizations docile, postwa
r wages initially did not keep pace with the extraordinary rate of productivity growth (a measure of the growth in efficiency with which inputs are used and thus a measure of the profit margins that can be distributed to workers through higher wages). As a result, corporations were able to generate substantial profits for a while.

  In both countries, the mature banking sector took on part of the role that was played by the government in the countries discussed earlier. Close cooperation between firms and universal banks in Germany, cemented by share holdings by firms and banks in one another, led to domestic cartels and diminished domestic competition, allowing corporations to focus their energies on competing in foreign markets. Similarly, in Japan, the ties between firms and banks in the bank-centered networks called keiretsus, which were overseen by the powerful Ministry of Finance and the Ministry of International Trade and Industry (MITI), resulted in a canonical version of managed capitalism.

  Once the excess labor in agriculture was fully drawn in to the manufacturing sector, however, wages inexorably increased to keep pace with productivity growth in the efficient export sector. By 1975, hourly wage rates in manufacturing in Germany had caught up with those in the United States, and Japan caught up in the early 1990s. Low wages therefore no longer offered a competitive advantage for the exporters. More problematic, once the initial phase of catch-up was over and Germany and Japan approached the levels of capital per worker that existed in advanced economies such as the United States, the growth rate of investment slowed considerably, and so did imports of capital goods. With the postwar households conditioned to limit consumption, and successive governments intent on disciplined macroeconomic policies, both Germany and Japan started running large trade surpluses. These initially helped them repay foreign borrowing but eventually resulted in increasing pressure on the currency to appreciate.21

  To stay competitive, both countries had to move up the value chain of production and to the frontiers of innovation, making more and more high-tech, skill-intensive products. More important, they also had to improve productivity steadily. They certainly managed to do this in the sectors that exported or competed with imports, the so-called tradable sector. But problems eventually emerged in the domestic nontradable sector, in areas like construction, retail, and hotels, where foreign competition was often naturally absent and sometimes deliberately kept out. Although the extent of government intervention to support exporters was naturally disciplined by international competition—after all, regardless of how much the government helps, if you produce a shoddy product at too high a cost, you will lose export market share—there were no such constraints in the nontradable sector. Productivity growth eventually lagged because the market forces that would force the inefficient to shrink or close were suppressed.

  Japan has fared worse than Germany in this respect. As a part of the European Union (EU), Germany is subject to the EU’s rules on fostering domestic competition—though because it has substantial power in the union, it plays a big role in watering them down. Japan has not found any equivalent external discipline in Asia. As a result, the close relationship between government and incumbents has been particularly detrimental to efficiency in the domestic-oriented production sector.

  Many a visitor to Japan is surprised at the sight of elevator ladies in hotels—women whose job it is to usher guests into the next available elevator, even though bright lights and buzzers clearly indicate, to anyone who can hear or see, which elevator is next. Perhaps these women had a function when elevators were a new invention, when spotting the next elevator was a challenge, and elderly guests had to be coaxed to get in. That the job has not been done away with over the years, or transformed to retain its essential functions (greeting visitors) while allowing the women to do some useful work, suggests an uncompetitive service sector.

  Indeed, when an upstart haircutting firm in Japan recently started opening salons rapidly and undercutting existing barber shops by offering quick, cheap haircuts, a nationwide association of barbershops took note.22 It called for more regulation, protesting that it was unhygienic to cut hair without a shampoo beforehand, and had an ordinance passed requiring all barbershops to have expensive shampooing facilities. This immediately slowed the upstart and hit directly at its low-price strategy.

  More generally, as rising wages in the productive export sector pulled up wages elsewhere in the economy, high wages (relative to productivity) and the resulting high prices of nontraded goods such as haircuts, restaurant meals, and hotel rooms reduced domestic demand for them. So the export-oriented miracle economies started looking oddly misshapen, much like someone who exercises only the limbs on one side of the body: a superefficient manufacturing sector existed side by side with a moribund services sector; a focus on foreign demand persisted even while domestic demand lay dormant.

  The Fault Line: The Case of Japan

  Japan’s and Germany’s dependence on exports for growth did not matter much in the early years, when they were small relative to the rest of the world. But as they became the second and third largest economies in the world, it put a substantially greater burden on other countries to create excess demand.

  What is particularly alarming for the future of countries following this path is that Japan did try to change, but without success. In the Plaza Accord of 1985, Japan agreed, under U.S. pressure, to allow its exchange rate to appreciate against the dollar. As Japanese exports came under pressure, the Bank of Japan cut interest rates sharply. According to a high-ranking Bank of Japan official: “We intended first to boost both the stock and property markets. Supported by this safety net—rising markets—export-oriented industries were supposed to reshape themselves so they could adapt to a domestically-led economy. This step then was supposed to bring about enormous growth of assets over every economic sector. This wealth-effect would in turn touch off personal consumption and residential investment, followed by an increase of investment in plant and equipment. In the end, loosened monetary policy would boost real economic growth.”23

  What the loose monetary policy instead triggered was a massive stock market and real estate bubble that led to the widely circulated, although exaggerated, claim that the land on which the Imperial Palace stood in Tokyo was worth more than the state of California. Corporate investment did pick up. But instead of reorienting themselves toward manufacturing for domestic demand, Japanese firms started investing much more in East Asian countries where labor costs were substantially cheaper, again with the intent of exporting. Construction and consumption in Japan did boom, but these were temporary spikes. When the alarmed central bank started raising rates in the early 1990s, the collapse in stock and real estate prices led to an economic meltdown whose effects are still being felt.

  So, far from automatically becoming more balanced in their growth as they become rich, export-led economies have found it extremely hard to boost their growth on their own, because the typical channels through which they can increase final consumption tend to atrophy during the period of emphasis on exports. As banks grow used to protected markets and instructions on whom to lend to, they have little capacity to lend carefully when given the freedom to do so. Also, given the strong ties between the government and producers, it is far more convenient for the government to channel spending through domestic producers that are influential but not necessarily efficient. In Japan, more government spending generally results in more bridges and roads to nowhere as the powerful construction lobby secures stimulus funds. Even as Japan has been covered with stimulus-induced concrete, the economy has remained moribund.

  As a result, not only are countries like Japan unable to help the global economy recover from a slump, but they are themselves dependent on outside stimulus to pull them out of it. This is a serious fault line. Indeed, an important source of Japan’s malaise in the early 1990s was that the United States did not pull out all the customary stops in combating the 1990–91 U.S. recession, and thus did not provide the demand that historically had helped Japa
n out of its downturns. It was not until the early 2000s, after a number of failed Japanese attempts to pull itself out of its decade-long slump, that the massive U.S. stimulus in response to the dot-com bust helped Japan export its way out of trouble yet again.24

  There is no natural, smooth, and painless movement away from export dependence to becoming a balanced economy. Even ignoring the clout of the export sector, which would like to preserve its benefits, the costs of changing emphasis are substantial, and the tools the government has for redressing past distortions are limited. For instance, wages in the domestic sector are often too high relative to productivity in those sectors. To allow greater differentiation of wages, as will be necessary to allow the service sector to flourish, existing service-sector workers must suffer a steep drop in incomes. They have strong incentives to fight against such change. Moreover, foreign entry into the service sector could boost productivity. But years of protection and overregulation are hard to overcome, and strong incumbent interests, like those of the Japanese barbers, will fight against competition and entry.

  Similarly, consumers have been trained to be cautious about spending, and retail finance is not well developed. Japanese households, unlike those in the United States, do not readily borrow to spend. It is hard for older people to forget the experiences of postwar deprivation and insecurity or the subsequent period of growth when saving was considered patriotic, and it is the older generations who have more spending power and still determine the overall pattern of consumption. For a while, younger consumers in Japan were thought to offer the answer. But after years of depressing economic outcomes, they too seem to be retreating into their shells, perhaps further depressed by the enormous public debt and underfunded pension schemes they will have to shoulder.25 Economic reform in Japan requires tremendous political will, a commodity in short supply when the status quo is perfectly comfortable and the pace of relative decline gentle.