Economists use models to simplify concepts and explanations. In the elaborate world in which we live, this helps to penetrate on the key issues at hand. Last week, Paul Krugman, the Nobel Prize winning economist in his column in the New York Times, used the W. Arthur Lewis model of the economy to explain the situation now confronting China.
“China’s problem today.” China’s economy today is held back by lack of domestic demand so that, its manufacturing sector which has been geared mainly to meet the world’s demand, is having growing pains: there is not enough home-grown demand to perk up the economy. Remember that in its heyday, China’s economy was growing at around 10 percent per year.
On the strength of world demand for its manufactures based on its inexpensive labor, China has had a highly investment driven growth for three decades. But since 2008, the world economy has stalled and recovery has not happened evenly. Europe is still in recession and Japan has experienced economic stagnation for a prolonged decade.
So, facing a weak world economy, China’s manufacturing sector has hit a double wall. There is not enough domestic consumption to make up for the loss of world demand. This in part explains the stalling economic growth rate of China.
“The labor surplus model.” Here’s how Krugman explained the labor surplus and growth story of China:
“The story that makes the most sense to me … rests on an old insight by the economist W. Arthur Lewis, who argued that countries in the early stages of economic development typically have a small modern sector alongside a large traditional sector containing huge amounts of “surplus labor” — underemployed peasants making at best a marginal contribution to overall economic output.
“The existence of this surplus labor, in turn, has two effects. First, for a while such countries can invest heavily in new factories, construction, and so on without running into diminishing returns, because they can keep drawing in new labor from the countryside. Second, competition from this reserve army of surplus labor keeps wages low even as the economy grows richer.”
(And, turning then to the problem that China currently faces – of a very high rate of investment and a relatively low level of domestic consumption – Krugman continues:)
“Indeed, the main thing holding down Chinese consumption seems to be that Chinese families never see much of the income being generated by the country’s economic growth. Some of that income flows to a politically connected elite; but much of it simply stays bottled up in businesses, many of them state-owned enterprises.”
“The abundance of other factors.” What Krugman just described in the first part of the quote is not only China’s but that of East Asia’s growth model in their early development histories. The second part of the quote is about a side-story to the China model that distinguishes it from the other countries.
The labor surplus story of development describes the growth story of East Asian countries. Each story however is uniquely differentiated from the other with the entry of cultural, historical, political and economic factors. Economic policy that responded to these unique factors has been crucial to their successes.
But one element that is common to all these growth stories is their access to world’s economic markets. Only their appropriate choice of economic policies made it possible to gain access not only to export markets but also to capital.
This also meant gaining access to world class technology and innovations, often through the vehicle of foreign direct investments or from the growing sophistication of the country’s domestic firms that learned to penetrate world trade and commerce. In addition, maturing governments undertake timely and appropriate adjustments in policy to make it possible to meet new and challenging problems.
This type of economic openness among these countries enabled them to overcome the deficiencies of domestic economic factors that impeded investments. The growth of domestic investments meant expansion of industries that raised the capacity to employ domestic labor.
When the demand for labor becomes great enough relative to the abundant supply – the surplus labor is wiped out. Wages and incomes at home rise as more domestic growth is experienced because the demand for labor outstrips the labor supply that had been made scarce by then.
“The East Asian countries.” During the last century until the present, the economic rise of Asian countries has been one of the important world changing events of our times. As I have said, the labor surplus story is one way of perceiving how these countries have risen.
Japan’s early steady growth in Asia during the 20th century was the spectacular early growth case in East Asia. This steady economic rise was broken by its misstep in getting involved in a war that reduced her to ruins and defeat by 1945, but Japan rebuilt itself (initially with US aid) even more in rapid fashion after the war. By the time of its sponsorship of the Tokyo Olympics in 1960, it had achieved its rise to the top tier among economic powers.
South Korea and Taiwan were the miracle growth stories of the 1960s to the 1970s. After a short period of inward looking development these countries turned around and found their salvation through production for markets abroad. They learned that by exporting their goods for the world market, they could grow ahead by leaps and bounds faster. They strongly encouraged foreign direct investments during this early growth period.
Thailand’s story of high labor surplus being slowly erased by rising progress continues to this day. But its high growth period that helped to reduce that labor surplus significantly was during the 1970s to the 1980s.
Vietnam and Indonesia are contemporary stories still unfolding. Their recent economic policies have indicated substantial achievements in bringing a large part of their labor force into gainful employment through their more open economic policies.
Hong Kong and Singapore have for decades been permanently linked with the world economy through trade. When they embarked in industry, they further supplemented this openness of their economy. Their access to world capital has been a critical aspect of their economies.
Malaysia’s rich natural resources and its openness to the world economy has always been a major element in her economic success story. However, Malaysia has been a sparsely populated country and did not fit the labor surplus story.
(Next: Philippine labor surplus story.)