The book mentioned in the title of this article is The Other Half of Macroeconomics and the Fate of Globalization written by economist Richard C. Koo (Gu Chao Ming) and published in 2018.
I first came across Koo’s book in March 2020 when I chanced upon a review of it in Mandarin, written by investor Li Lu. I can read Mandarin and I found myself agreeing to the ideas from the book that Li shared, so much so that I made a self-directed attempt at translating the review into English. But I only began reading the actual book near the start of this year and finished it about a month ago. There was even more richness in the book’s ideas about how economies should operate than what was shared in Li’s already-wonderful review.
Earlier this month, the US government, under the Trump administration, made sweeping changes to the global trading system by introducing the Reciprocal Tariff Policy, which raised tariffs, sometimes significantly so, for many of the US’s trading partners. Major driving forces behind the Reciprocal Tariff Policy ostensibly include the US’s sustained trade deficits (particularly with China) and a desire by the Trump administration to bring manufacturing jobs back to the country.
As I contemplated the Trump administration’s actions, and the Chinese government’s reactions, I realised Koo’s book explained why all these issues happened. So I’m writing my own notes and takeaways from the book for easy reference in the future and I would like to share them in this article in the hopes that they could be useful for you. I will be borrowing from my translation of Li’s Mandarin review in this article. Below the horizontal line, all content in grey font are excerpts from my translation while all italicised content are excerpts from the book.
The three stages of economic development a country goes through
There are six important ideas that Koo discussed in his book. One of them is the concept that a country goes through three distinct stages of economic development over time.
The first stage of development would be a country that is industrialising and has yet to reach the Lewis Turning Point (LTP). The LTP is the “point at which urban factories have finally absorbed all the surplus rural labour.” When a country starts industrialising, people are mostly living in rural areas and there are only a very few educated elite who have the knowhow to kickstart industrialisation. There is also a surplus of labour. As a result, the educated elite – the industrialists – hold the power and “most of the gains during the initial stage of industrialisation therefore go to the educated few.” The first stage of economic development is also when income inequality widens – the gains from industrialisation continue to accumulate in the hands of the elite as they reinvest profits into their businesses because there continues to be a surplus of labour.
The second stage of development happens when an industrialising economy reaches the LTP. At this point, labour “gains the bargaining power to demand higher wages for the first time in history, which reduces the share of output accruing to business owners.” But business owners are happy to continue reinvesting their profits as they are still “achieving good returns, leading to further tightness in the labour market.” This dynamic leads to an economy’s “golden era”:
“As labor’s share increases, consumption’s share of GDP will increase at the expense of investment. At the same time, the explosive increase in the purchasing power of ordinary citizens means that most businesses are able to increase profits simply by expanding existing productive capacity. Consequently, both consumption and investment will increase rapidly…
…Inequality also diminishes as workers’ share of output increases relative to that of capital…
…With incomes rising and inequality falling, this post-LTP maturing phase may be called the golden era of economic growth…
…Higher wages force businesses to look harder for profitable investment opportunities. On the other hand, the explosive increase in the purchasing power of ordinary workers who are paid ever-higher wages creates major investment opportunities. This prompts businesses to invest for two reasons. First, they seek to increase worker productivity so that they can pay ever-higher wages. Second, they want to expand capacity to address workers’ increasing purchasing power. Both productivity- and capacity-enhancing investments increase demand for labor and capital that add to economic growth. In this phase, business investment increases workers’ productivity even if their skill level remains unchanged…
…With rapid improvements in the living standards of most workers, the post-LTP maturing phase is characterised by broadly distributed benefits from economic growth.”
The golden era has its problems too. This is because this period is when “workers begin to utilise their newfound bargaining power” such as by organising strikes. But business owners and labour tend to be able to work out their differences.
The third stage of development is what Koo calls a “post-LTP pursued economy.” When a country is in the golden era, at some point ever-growing wages creates inroads for foreign competitors – and the country starts being chased by the foreign competitors that have lower wages. This is when businesses in the country find it very challenging to “find attractive investment opportunities at home because it often makes more sense for them to buy directly from the “chaser” or to invest in that country themselves.” This is also when “the return on capital is higher abroad than at home.” During the pursued stage, “real wage growth will be minimal” and “economic growth also slows.” Although a pursued country can continue to grow economically, a major problem is that inequality once again rears its ugly head:
“Japan’s emergence in the 1970s shook the U.S. and European industrial establishments. As manufacturing workers lost their jobs, ugly trade frictions ensued between Japan and the West. This marked the first time that Western countries that had already passed their LTPs had been chased by a country with much lower wages…
…While Western companies at the forefront of technology continued to do well, the disappearance of many well-paying manufacturing jobs led to worsening income inequality in these countries…
…Some of the pain Western workers felt was naturally offset by the fact that, as consumers, they benefited from cheaper imports from Asia, which is one characteristic of import-led globalisation. Businesses with advanced technology continued to do well, but it was no longer the case that everyone in society was benefiting from economic growth. Those whose jobs could be transferred to lower-cost locations abroad saw their living standards stagnate or even fall.”
Koo wrote that Western economies – the USA and Europe – entered their golden eras around the 1950s and became pursued starting in the 1970s by Japan. During the golden era of the West, “it was in an export-led globalisation phase as it exported consumer and capital goods to the world.” But as the West started getting pursued, they entered “an import-led globalisation phase as capital seeks higher returns abroad and imports flood the domestic market.”
The four states of an economy
Another important idea from Koo’s book is the concept that an economy has four distinct states, which are summarised in Table 1 below:
“An economy is always in one of four possible states depending on the presence or absence of lenders (savers) and borrowers (investors). They are as follows: (1) both lenders and borrowers are present in sufficient numbers, (2) there are borrowers but not enough lenders even at high interest rates, (3) there are lenders but not enough borrowers even at low interest rates, and (4) both lenders and borrowers are absent.”
Koo’s idea that an economy has four distinct states is important because mainstream economic-thought does not cater for the disappearance of borrowers:
“Of the four, only Cases 1 and 2 are discussed in traditional economics, which implicitly assumes there are always enough borrowers as long as real interest rates are low enough.”
There are two key reasons why an economy would be in Cases 3 and 4, i.e. when borrowers disappear. The first is when private-sector businesses are unable to find attractive investment opportunities (this is related to economies that are in the third-stage of development discussed earlier in this article, when attractive domestic investment opportunities become scarce):
“The first is one in which private‐sector businesses cannot find investment opportunities that will pay for themselves. The private sector will only borrow money if it believes it can pay back the debt with interest. And there is no guarantee that such opportunities will always be available. Indeed, the emergence of such opportunities depends very much on scientific discoveries and technological innovations, both of which are highly irregular and difficult to predict.
In open economies, businesses may also find that overseas investment opportunities are more attractive than those available at home. If the return on capital is higher in emerging markets, for example, pressure from shareholders will force businesses to invest more abroad while reducing borrowings and investments at home. In modern globalized economies, this pressure from shareholders to invest where the return on capital is highest may play a greater role than any technological breakthroughs, or lack thereof, in the decision as to whether to borrow and invest at home.”
The second reason for the disappearance of borrowers is named by Koo as a “balance sheet recession” which is described as such:
“In the second set of circumstances, private‐sector borrowers have sustained huge losses and are forced to rebuild savings or pay down debt to restore their financial health. Such a situation may arise following the collapse of a nationwide asset price bubble in which a substantial part of the private sector participated with borrowed money. The collapse of the bubble leaves borrowers with huge liabilities but no assets to show for the debt. Facing a huge debt overhang, these borrowers have no choice but to pay down debt or increase savings in order to restore their balance sheets, regardless of the level of interest rates.
Even when the economy is doing well, there will always be businesses that experience financial difficulties or go bankrupt because of poor business decisions. But the number of such businesses explodes after a nationwide asset bubble bursts.
For businesses, negative equity or insolvency implies the potential loss of access to all forms of financing, including trade credit. In the worst case, all transactions must be settled in cash, since no supplier or creditor wants to extend credit to an entity that may seek bankruptcy protection at any time. Many banks and other depository institutions are also prohibited by government regulations from extending or rolling over loans to insolvent borrowers in order to safeguard depositors’ money. For households, negative equity means savings they thought they had for retirement or a rainy day are no longer there. Both businesses and households will respond to these life‐threatening conditions by focusing on restoring their financial health—regardless of the level of interest rates—until their survival is no longer at stake.”
A balance sheet recession can be a huge problem for a country’s economy if it is unresolved as it can lead to a rapidly shrinking economy as a manifestation of the “fallacy of composition” problem:
“One person’s expenditure is another person’s income…
…The interaction between thinking and reacting households and businesses create a situation where one plus one does not necessarily equal two. For example, if A decides to buy less from B in order to set aside more savings for an uncertain future, B will have less income to buy things from A. That will lower A’s income, which in turn will reduce the amount A can save.
This interaction between expenditure and income also means that, at the national level, if one group is saving money, another group must be doing the opposite – “dis-saving” – to keep the economy running. In most cases, this dis-saving takes the form of borrowing by businesses that seek to expand their operations. If everyone is saving and no one is dis-saving on borrowing, all of those savings will leak out of the economy’s income stream, resulting in less income for all.
For example, if a person with an income of $1,000 decides to spend $900 and save $100, the $900 that is spent becomes someone else’s income and continues circulating in the economy. The $100 that is saved is typically deposited with a financial institution such as a bank, which then lends it to someone else who can make use of it. When that person borrows and spends the $100, total expenditures in the economy amount to $900 plus $100, which is equal to the original $1,000, and the economy moves forward…
…If there are no borrowers for $100 in savings in the above example, even at zero interest rates, total expenditures in the economy will drop to $900, while the saved $100 remains unborrowed in financial institutions or under mattresses. The economy has effectively shrunk by 10 percent, from $1,000 to $900. That $900 now becomes someone else’s income. If that person decides to save 10 percent, and there are still no borrowers, only $810 will be spent, causing the economy to contract to $810. This cycle will repeat, and the economy will shrink to $730, if borrowers remain on the sidelines. This process of contraction is called a “deflationary spiral.”…
…Keynes had a name for this state of affairs, in which everyone wants to save but is unable to do so because no one is borrowing. He called it the paradox of thrift. It is a paradox because if everyone tries to save, the net result is that no one can save.
The phenomenon of right behaviour at the individual level leading to a bad result collectively is known as the “fallacy of composition.””
Japan was the “first advanced country to experience a private-sector shift to debt minimization for balance sheet reasons since the Great Depression.” Japan’s real estate bubble burst in 1990, where real estate prices fell by 87%, “devastating the balance sheets of businesses and financial institutions across the country” and leading to a disappearance of borrowers:
“Demand for funds shrank rapidly when the bubble finally burst in 1990. Noting that the economy was also slowing sharply, the BOJ took interest rates down from 8 percent at the height of the bubble to almost zero by 1995. But demand for funds not only failed to recover but actually turned negative that year. Negative demand for funds means that Japan’s entire corporate sector was paying down debt at a time of zero interest rates, a world that no economics department in university or business school had ever envisioned. The borrowers not only stopped borrowing but began moving in the opposite direction by paying down debt and continued doing so for a full ten years, until around 2005…
…While in a textbook economy the household sector saves and the corporate sector borrows, both sectors became net-savers in post-1999 Japan, with the corporate sector becoming the largest saver in the country from 2002 onward in spite of zero interest rates.”
The Western economies experienced their own balance sheet recessions starting in 2008 with the bursting of housing bubbles in that year. When the “bubbles collapsed on both sides of the Atlantic in 2008, the balance sheets of millions of households and many financial institutions were devastated.” Borrowers also disappeared; the “private sectors in virtually all major advanced nations have been increasing savings or paying down debt since 2008 in spite of record low interest rates.” For example, “the U.S. private sector saved 4.1 percent of GDP at near-zero interest rates in the four quarters through Q1 2017” and the “Eurozone’s overall private sector is saving 4.6 percent of GDP in spite of negative interest rates.”
Prior to the Japanese episode, the most recent example was the Great Depression:
“Until 2008, the economics profession considered a contractionary equilibrium (the $500 economy) brought about by a lack of borrowers to be an exceptionally rare occurrence – the only recent example was the Great Depression, which was triggered by the stock market crash in October 1929 and during which the U.S. lost 46 percent of nominal GNP. Although Japan fell into a similar predicament when its asset price bubble burst in 1990, its lessons were almost completely ignored by the economics professional until the Lehman shock of 2008.”
The appropriate macroeconomic policies
The third important idea from Koo’s book is that depending on which stage (pre-LTP, golden era, or pursued) and which state (Case 1, Case 2, Case 3, or Case 4) a country’s economy is in, there are different macroeconomic policies that would be appropriate.
First, it’s important to differentiate the two policies governments can wield, namely, monetary policy and fiscal policy:
“The government also has two types of policy, known as monetary and fiscal policy, that it can use to help stabilise the economy by matching private-sector savings and borrowings. Themore frequently used is monetary policy, which involves raising or lowering interest rates to assist the matching process. Since an excess of borrowers is usually associated with a strong economy, a higher policy rate might be appropriate to prevent overheating and inflation. Similarly, a shortage of borrowers is usually associated with a weak economy, in which case a lower policy rate might be needed to avert a recession or deflation.
With fiscal policy, the government itself borrows and spends money on such projects as highways, airports, and other social infrastructure. While monetary policy decisions can be made very quickly by the central bank governor and his or her associates, fiscal policy tends to be very cumbersome in a peacetime democracy because elected representatives must come to an agreement on how much to borrow and where to spend the money. Because of the political nature of these decisions and the time it takes to implement them, most recent economic fluctuations were dealt with by central banks using monetary policy.”
Fiscal policy is more important than monetary policy when a country’s economy is in the pre-LTP stage, but the relative importance of the two types of policies switches once the economy enters the golden era; fiscal policy once again becomes the more important type of policy when the economy is in the pursued stage:
“In the early phases of industrialisation, economic growth will rely heavily on manufacturing, exports, and the formation of capital etc. At this juncture, the government’s fiscal policies can play a huge role. Through fiscal policies, the government can gather scarce resources and invest them into basic infrastructure, resources, and export-related services etc. These help emerging countries to industrialise rapidly. Nearly every country that was in this stage of development saw their governments implement policies that promote active governmental support.
In the second stage of development, the twin engines of economic growth are rising wages and consumer spending. The economy is already in a state of full employment, so an increase in wages in any sector or field will inevitably lead to higher wages in other areas. Rising wages lead to higher spending and savings, and companies will use these savings to invest in productivity to improve output. In turn, profits will grow, leading to companies having an even stronger ability to raise wages to attract labour. All these combine to create a positive feedback loop of economic growth. Such growth comes mainly from internal sources in the domestic economy. Entrepreneurs, personal and household investing behaviour, and consumer spending patterns are the decisive players in promoting economic growth, since they are able to nimbly grasp business opportunities in the shifting economic landscape. Monetary policies are the most effective tool in this phase, compared to fiscal policies, for a few reasons. First, fiscal policies and private-sector investing both tap on a finite pool of savings. Second, conflicts could arise between the private sector’s investing activities and the government’s if poorly thought-out fiscal policies are implemented, leading to unnecessary competition for resources and opportunities.
When an economy reaches the third stage of development (the stage where it’s being chased), fiscal policy regains its importance. At this stage, domestic savings are high, but the private sector is unwilling to invest domestically because the investing environment has deteriorated – domestic opportunities have dwindled, and investors can get better returns from investing overseas. The government should step in at this juncture, like what Japan did, and invest heavily in infrastructure, education, basic research and more. The returns are not high. But the government-led investments can make up for the lack of private-sector investments and the lack of consumer-spending because of excessive savings. In this way, the government can protect employment in society and prevent the formation of a vicious cycle of a decline in GDP. In contrast, monetary policy is largely ineffective in the third stage.”
It’s worth noting that an economy that is in the pre-LTP stage is likely to be in Case 4, where borrowers and lenders are both absent. Meanwhile, an economy that is in the Golden Era is likely to be in Case 1 (where both borrowers and lenders are present in abundance) and in Case 2 (where borrowers are present, but lenders are absent) during a run-of-the-mill recession, although a Case 1 Golden Era economy can also quickly be in Case 3 or Case 4. Once an economy is in the pursued stage, it is likely to be in Case 3 (where borrowers are absent but lenders are present) because of a lack of domestic investment opportunities or a balance sheet recession, or Case 4 (where borrowers and lenders are both absent) because of a balance sheet recession.
When a country’s economy is in Case 1 or Case 2, monetary policy is more important:
“Case 1 requires a minimum of policy intervention – such as slight adjustments to interest rates – to match savers and borrowers and keep the economy going. Case 1, therefore, is associated with ordinary interest rates and can be considered the ideal textbook case.
The causes of Case 2 (insufficient lenders) can be traced to both macro and financial factors. The most common macro factor is when the central bank tightens monetary policy to rein in inflation. The tighter credit conditions that result certainly leave lenders less willing to lend. Once inflation is under control, however, the central bank typically eases monetary policy, and the economy returns to Case 1. A country may also be too poor or underdeveloped to save. If the paradox of thrift leaves a country too poor to save, the situation would be classified as Case 3 or 4 because it is actually attributable to a lack of borrowers.
Financial factors weighing on lenders may also push the economy into Case 2. One such factor is an excess of non-performing loans (NPLs) in the banking system, which depresses banks’ capital ratios and prevents them from lending. This is what is typically called a “credit crunch.” Over-regulation of financial institutions by the authorities can also lead to a credit crunch. When many banks encounter NPL problems at the same time, mutual distrust may lead not only to a credit crunch, but also to a dysfunctional interbank market, a state of affairs typically referred to as a “financial crisis.”…
…Non-developmental causes of a shortage of lenders all have well-known remedies… For example, the government can inject capital into the banks to restore their ability to lend, or it can relax regulations preventing financial institutions from serving as financial intermediaries.
In the case of a dysfunctional interbank market, the central bank can act as lender of last resort to ensure the clearing system continues to operate. It can also relax monetary policy. The conventional emphasis on monetary policy and concerns over the crowding-out effect of fiscal policy are justified in Cases 1 and 2 where there are borrowers but (for a variety of reasons in Case 2) not enough lenders.””
When a country’s economy is in Case 3 or Case 4, fiscal policy is more important because monetary policy does not work when borrowers disappear, although the appropriate type of fiscal policy can also differ:
“It should be noted that in the immediate aftermath of a bubble collapse, the economy is usually in Case 4, characterized by a disappearance of both lenders and borrowers. The lenders stop lending because they provided money to borrowers who participated in the bubble and are now facing technical or real insolvency. Banks themselves may be facing severe solvency problems when many of their borrowers are unable to service their debts…
…In a financial crisis, therefore, the central bank must act as lender of last resort to ensure that the settlement system continues to function…
…Once the bubble bursts and households and businesses are left facing debt overhangs, no amount of monetary easing by the central bank will persuade them to resume borrowing until their balance sheets are fully repaired…
…When private-sector borrowers disappear and monetary policy stops working, the correct way to prevent a deflationary spiral is for the government to borrow and spend the excess savings of the private sector…
…In other words, the government should mobilize fiscal policy and serve as borrower of last resort when the economy is in Case 3 or 4.
If the government borrows and spends the $100 left unborrowed by the private sector, total expenditures will amount to $900 plus $100, or $1,000, and the economy will move on. This way, the private sector will have the income it needs to pay down debt or rebuild savings…
…It has been argued that the fiscal stimulus is essential when the economy is in Case 3 or 4. But there are two kinds of fiscal stimulus: government spending and tax cuts. If the economy is in a balance sheet recession, the correct form of fiscal stimulus is government spending. If the economy is suffering from a lack of domestic investment opportunities, the proper response would be a combination of tax cuts and deregulation to encourage innovation and risk taking… augmented by government spending…
…The close relationship observed prior to 2008 between central-bank-supplied liquidity, known as the monetary base, and growth in money supply and private-sector credit broke down completely after the bubbles burst and the private sector began minimizing debt. Here money supply refers to the sum of all bank accounts plus bills and coins circulating in the economy, and credit means the amount of money lent to the private sector by financial institutions…
…In this textbook world, a 10 percent increase in central bank liquidity would increase both the money supply and credit by 10 percent. This means there were enough borrowers in the private sector to borrow all the funds supplied by the central bank, and the economies were tin Case 1…
…But after the bubble burst, which forced the private sector to minimize debt in order to repair its balance sheet, no amount of central bank accommodation was able to increase private-sector borrowings. The U.S. Federal Reserve, for example, expanded the monetary base by 349 percent after Lehman Brothers went under. But the money supply grew by only 76 percent and credit by only 27 percent. A 27 percent increase in private-sector credit over a period of nearly nine years represents an average annual increase of only 2.75 percent, which is next to nothing.”
Fiscal stimulus equates to government-spending, which increases public debt. Koo suggests that (1) when an economy is in Case 3 or Case 4, rising and/or high public debt is not necessarily a problem, and (2) the limits of public debt should be determined by the bond market:
“Debt is simply the flip side of savings. Somebody has to be saving for debt to grow, and it is bound to increase as long as someone in the economy continues to save. Moreover, if someone is saving but debt levels fail to grow (i.e., if no one borrows and spends the saved funds), the economy will fall into the $1000 – $900 – $810 – $730 deflationary spiral….
…Growth in debt (excluding debt financed by the central bank) is merely a reflection of the fact that the private sector has continued to save.
If debt is growing faster than actual savings, it simply means there is double counting somewhere, i.e., somebody has borrowed the money but instead of using it himself, he lent it to someone else, possibly with a different maturity structure (maturity transfer) or interest rates (fixed to floating or vice versa). With the prevalence of carry trades and structured financial products involving multiple counterparties, debt numbers may grow rapidly on the surface, but the actual debt can never be greater than the actual savings.
Furthermore, the level of debt anyone can carry also depends on the level of interest rates and the quality of projects financed with the debt. If the projects earn enough to pay back both borrowing costs and principal, then no one should care about the debt load, no matter how large, because it does not represent a future burden on anyone. Similarly, no matter how great the national debt, if the funds are invested in public works projects capable of generating returns high enough to pay back both interest and principal, the projects will be self-financing and will not increase the burden on future taxpayers…
…Whether or not fiscal policy has reached its limits should be decided by the bond market, not by some economist using arbitrarily chosen criteria.
During the golden era, when the private sector has strong demand for funds to finance productivity- and capacity-enhancing investments, fiscal stimulus will have a minimal if not negative impact on the economy because of the crowding-out effect. The bond market during this era correctly assigns very low prices (high yields) to government bonds, indicating that such stimulus is not welcome.
During the pursued era or during balance sheet recessions, however, private-sector demand for funds is minimal if not negative. At such times, fiscal stimulus is not only essential, but it has maximum positive impact on the economy because there is no danger of crowding out. During this period, the bond market correctly sets very high prices (low yields) for government bonds, indicating they are welcome…
…Ultra-low bond yields in economies in Cases 3 and 4 are also a signal to the government to look for public works projects capable of producing a social rate of return in excess of those rates. If such projects can be found, fiscal stimulus centered on them will ultimately place no added burden on future taxpayers.”
The experience of the economies of the US, the UK, Japan, and Europe in the aftermath of the housing bubble bursting in 2008 which thrust them into balance sheet recessions is instructive on the importance of fiscal policy in combating balance sheet recessions:
“In November 2008, just two months after Lehman Brothers went under, the G20 countries agreed at an emergency meeting in Washington to implement fiscal stimulus. That decision kept the world economy from falling into a deflationary spiral. But in 2010, the fiscal orthodoxy of those who did not understand balance sheet recessions reasserted itself at the Toronto G20 meeting, where members agreed to cut deficits in half even though private-sector balance sheets were nowhere near a healthy state. The result was a sudden loss of forward momentum for the global economy that prolonged the recession unnecessarily in many parts of the world. After 2010, those countries that understood the danger of balance sheet recessions did well, while those that did not fell by the wayside…
…Bernanke and Yellen both understood this, and they used the expression “fiscal cliff” to warn Congress about the danger posed by fiscal consolidation, which the Republicans and many orthodox economists supported. The extent of Bernanke’s concerns about fiscal consolidation can be gleaned from a press conference on April 25, 2012, when he was asked what the Fed would do if Congress pushed the U.S. economy off the fiscal cliff. He responded, “There is . . . absolutely no chance that the Federal Reserve could or would have any ability whatsoever to offset that effect on the economy.”10 Bernanke clearly understood that the Fed’s monetary policy not only cannot offset the negative impact of fiscal consolidation, but would also lose its effectiveness if the government refused to act as borrower of last resort.
Even though the U.S. came frighteningly close to falling off the fiscal cliff on a number of occasions, including government shutdowns, sequesters, and debt‐ceiling debates, it ultimately managed to avoid that outcome thanks to the efforts of officials at the Fed and the Obama administration. And that is why the U.S. economy is doing so much better than Europe, where virtually every country did fall off the fiscal cliff…
…The warnings about the fiscal cliff set the Fed apart from its counterparts in Japan, the UK, and Europe. In the UK, then-BOE Governor Mervyn King publicly supported David Cameron’s rather draconian austerity measures, arguing that his bank’s QE policy would provide necessary support for the British economy. At the time, the UK private sector was saving a full 9 percent of GDP when interest rates were at their lowest levels in 300 years. That judgement led to the disastrous performance of the UK economy during the first two years of the Cameron administration…
…BOJ Governor Haruhiko Kuroda also argued strongly in favor of hiking the consumption tax rate, believing a Japanese economy supported by his quantitative easing regime would be strong enough to withstand the shock of fiscal consolidation. This was in spite of the fact that Japanese private sector was saving 6.2 percent of GDP at a time of zero interest rates. The tax hike, which was carried out in April 2014, threw the Japanese economy back into recession…
…ECB President Mario Draghi has admonished member governments to meet the austerity target imposed by the Stability and Growth Pact at every press conference, even though his own inflation forecasts have been revised downwards almost every time they are updated. He seems to be completely oblivious to the danger posed by fiscal austerity when the Eurozone private sector has been saving an average of 5 percent of GDP since 2008 despite zero or even negative interest rates.”
Koo also noted that when Japan’s real estate bubble burst in 1990, the government was “quick to administer fiscal stimulus to stop the implosion” and that “the economy responded positively each time fiscal stimulus was implemented, but lost momentum each time the stimulus was removed.” The Japanese government was under enormous pressure to cut fiscal stimulus in the aftermath of the bubble, but the government did not completely cave, and the Japanese economy managed to fare better than it would otherwise:
“The orthodox fiscal hawks who dominated the press and academia also tried to stop fiscal stimulus at every step of the way, arguing that large deficits would soon lead to skyrocketing interest rates and a fiscal crisis. These hawks forced politicians to cut stimulus as soon as the economy showed signs of life, prompting another downturn. The resulting on-again, off-again fiscal stimulus did not imbue the public with confidence in the government’s handling of the economy. Fortunately, the LDP [Liberal Democratic Party] had enough pork-barrel politicians to keep a minimum level of stimulus needed in place, and as a result, Japanese GDP never once fell below its bubble peak. Nor did the Japanese unemployment rate ever exceed 5.5 percent.
That was a fantastic achievement in view of the fact that the Japanese private sector was saving an average of 8 percent of GDP from 1995 to 2005, and the Japanese lost three times as much wealth (as a share of GDP) as Americans did during the Great Depression, when nominal GNP fell 46 percent.”
The reason for US backlash against globalisation & the conflict between free-trade and free-capital
The fourth and fifth important ideas from Koo’s book are connected and they are respectively, (a) the possible reasons behind the backlash against globalisation that is seen from the current US government under the Trump administration, and (b) the possible conflict between free trade and free-movement of capital. Again, Koo’s book was published in 2018, so it was discussing Donald Trump’s first term as President. But the ideas appear to me to be very applicable to today’s context.
Koo advanced that the Western economies’ entrance into the third stage of economic development – pursued stage – is a reason for the backlash against globalisation:
“One reason for the frustration and social backlash witnessed in the advanced countries is that these countries are experiencing the post-Lewis Turning Point (LTP) pursued phase for the first time in history…
…Many were caught offguard, having assumed that the golden era that they enjoyed into the 1970s would last forever. It comes as no surprise that those who have seen no improvement in their living standards for many years but still remember the golden age, when everyone was hopeful and living standards were steadily improving, would long for the “good old days.”…
…In the U.S. too, the Trump phenomenon, which has depended largely on the support of blue-collar white males, suggests that people are longing for the life they enjoyed during the golden era, when U.S. manufacturing was the undisputed leader of the world.
Participants in this social backlash in many of the pursued economies view globalization as the source of all evil and are trying to slow down the free movement of both goods and people. Donald Trump and others like him are openly hostile toward immigration while arguing in favour of protectionism and the scuttling of agreements such as the TPP that seek even freer trade.”
Koo described the mainstream view that free trade creates overall gains for trading partners, but cautioned that the view has a flawed assumption, in that imports and exports will be largely balanced as free trade grows, and it is that wrong assumption that also contributed to the backlash against globalisation:
“Economists have traditionally argued that while free trade creates both winners and losers within the same country, it offers significant overall welfare gains for both trading partners because the gains of the winners are greater than the losses of the losers. In other words, there should be more winners than losers from free trade…
…This conclusion, however, is based on one key assumption: that imports and exports will be largely balanced as free trade expands. When – as in the U.S. during the past 30 years – that assumption does not hold and a nation continues to run massive trade deficits, free trade may produce far more losers than theory would suggest. With the U.S. running a trade deficit of almost [US]$740bn a year, or about four percent of GDP, there were apparently enough losers from free trade to put the protectionist Donald Trump into the White House. The fact that Hillary Clinton was also nominated to be the Democratic Party’s candidate for president in the arena full of banners saying “No to TPP” indicates that the social backlash has grown very large indeed.”
Koo clarified that free trade is important and has its benefits, but the way free trade has taken place since World War II is hugely problematic because of (1) the way free trade is structured, and (2) the free movement of capital that is happening in parallel:
“Outright protectionism is likely to benefit the working class in the short term only. In the long run, history has repeatedly shown that protected industries always fall behind on competitiveness and technological advances, which means the economy will stagnate and be overtaken by more dynamic competitors…
…This does not mean that free trade as practiced since 1945 and globalism in general have no problems. They both have major issues, but these can be addressed if properly understood. A correct understanding is important here because even though increasing imports is the most visible feature of an economy in a pursued phase, trade deficits and the plight of workers displaced by imports have been made far worse by the free movement of capital since 1980…
…Once the U.S. opened up its massive markets to the world after 1945 and the GATT-based [General Agreement on Tariffs and Trade] system of free trade was adopted, nations belonging to this system found that it was possible to achieve economic growth without territorial expansion as long as they could produce competitive products. The first countries to recognize this were the vanquished nations of Japan and West Germany, which then decided to devote their best people to developing globally competitive products…
…By the end of the 1970s, however, the West began losing its ability to compete with Japanese firms as the latter overtook the U.S. and European rivals in many sectors, including home appliances, shipbuilding, steel, and automobiles. This led to stagnant income growth and disappearing job opportunities for Western workers.
When Japan joined the GATT in 1963, it still had many tariff and non-tariff trade barriers. In other words, while Western nations had been steadily reducing their own trade barriers, they were suddenly confronted with an upstart from Asia that still had many barriers in place. But as long as Japan’s maximum tariff rates were falling as negotiated and the remaining barriers applied to all GATT members equally, GATT members who had opened their markets earlier could do little under the agreement’s framework to force Japan to open its market (the same problem resurfaced when China joined the WTO 38 years later)…
…When U.S.-Japan trade frictions began to flare up in the 1970s, however, exchange rates still responded correctly to trade imbalances. In other words, when Japanese exports to the U.S. outstripped U.S. exports to Japan, there were more Japanese exporters selling dollars and buying yen to pay employees and suppliers in Japan than there were U.S. exporters selling yen and buying dollars to pay employees and suppliers in the U.S.
Since foreign exchange market participants in those days consisted mostly of exporters and importers, excess demand for yen versus the dollar caused the yen to strengthen against the dollar. That, in turn, made Japanese products less competitive in the U.S. As a result, trade frictions between the U.S. and Japan were prevented from growing any worse than they did because the dollar fell from ¥360 in mid-1971 to less than ¥200 in 1978 in response to widening Japanese trade surpluses with the U.S..
But this arrangement, in which the foreign exchange market acted as a trade equalizer, broke down with financial liberalization, which began in the U.S. with the Monetary Control Act of 1980…
…These changes prompted huge capital outflows from Japan as local investors sought higher-yielding U.S. Treasury securities. Since Japanese investors needed dollars to buy Treasuries, their demand for dollars in the currency market outstripped the supply of dollars from Japanese exporters and pushed the yen back to ¥280 against the dollar. This rekindled the two countries’ trade problems, because few U.S. manufacturers were competitive vis-a-vis the Japanese at that exchange rate.
When calls for protectionism engulfed Washington, President Ronald Reagan, a strong supporter of free trade, responded with the September 1985 Plaza Accord, which took the dollar from ¥240 in 1985 down to ¥120 just two years later. The dollar then rose to ¥160 in 1990 but subsequently fell as low as ¥79.75 in April 1995, largely ending the trade-related hostilities that had plagued the two nations’ relationship for nearly two decades…
…Capital transactions made possible by the liberalization of cross-border capital flows also began to dominate the currency market. Consequently, capital inflows to the U.S. have led to continued strength of the dollar – and stagnant or declining incomes for U.S. workers – even as U.S. trade deficits continue to mount. In other words, the foreign exchange market lost its traditional function as an automatic stabilizer for trade balances, and the resulting demands for protectionism in deficit countries are now at least as great as they were before the Plaza Accord in 1985.”
Specifically with regards to the belligerent relationship the US has with China today, Koo suggested that it was because of flaws in the free trade framework of the World Trade Organisation (WTO):
“…a key contradiction in the WTO framework: the fact that China levies high tariffs on imports from all WTO nations is no reason why the U.S.—which runs a huge trade deficit with China—should have to settle for lower tariffs on imports from China.
This problem arose because the developed‐world members of the WTO had already lowered tariffs among themselves before developing countries such as China, with their significantly lower wages and higher tariffs, were allowed to join. When they joined, developing countries could argue that they were still underdeveloped and needed higher tariffs to allow infant domestic industries to grow and to keep their trade deficits under control. Although that was a valid argument for developing countries at the time and their maximum tariff rates have come down as negotiated, the effective rates remained higher than those of advanced countries long after those countries became competitive enough to run trade surpluses with the developed world…
…Because the WTO system is based on the principle of multilateralism, with rules applied equally to all member nations, this framework provides no way of addressing bilateral imbalances between the U.S. and China. It is therefore not surprising that the Trump administration has decided to pursue bilateral, not multilateral, trade negotiations.
In retrospect, what the WTO should have done is to impose a macroeconomic condition stating that new members must lower their tariff and non‐tariff barriers to advanced‐country norms after they start to run significant trade surpluses with the latter. Here the term “significant” might be defined to mean running a trade surplus averaging more than, say, two percent of GDP for three years. If a country fails to reduce its tariffs to the advanced‐nation norm within say five years after reaching that threshold, the rest of the WTO community should then be allowed to raise tariffs on products from that country to the same level that country charges on its imports. The point is that if the country is competitive enough to run trade surpluses vis‐à‐vis advanced countries, then it should be treated as one.
If this requirement had existed when Japan joined the GATT in 1963 or when China joined the WTO in 2001, subsequent trade frictions would have been far more manageable. Under the above rules, Japan would have had to lower its tariffs starting in 1976, and China would have had to lower its tariffs from the day it joined the WTO in 2000! Such a requirement would also have enhanced the WTO’s reputation as an organization that supports not only free trade but also fair trade.”
Koo also noted that the term globalisation actually has two components, namely, free trade and free movement of capital, and that the former is important for countries to continue maintaining because of the benefits it brings, while the latter system needs improvement:
“The term “globalization” as used today actually has two components: free trade and the free movement of capital.
Of the two, it was argued in previous chapters that the system of free trade introduced by the U.S. after 1947 led to unprecedented global peace and prosperity. Although free trade produces winners and losers and providing a helping hand to the losers is a major issue in the pursued economies, the degree of improvement in real living standards since 1945 has been nothing short of spectacular in both pursued and pursuing countries…
…The same cannot be said for the free movement of capital, the second component of globalization. Manufacturing workers and executives in the pursued economies feel so insecure not only because imports are surging but also because exchange rates driven by portfolio capital flows of questionable value are no longer acting to equilibrate trade.
To better understand this problem, let us take a step back and consider a world in which only two countries – the U.S. and Japan – are engaged in trade, and each country buys $100 in goods from the other. The next year, both countries will have the $100 earned from exporting to its trading partner, enabling it to buy another $100 in goods from that country. The two nations’ trade accounts are in balance, and the trade relationship is sustainable.
But if the U.S. buys $100 from Japan, and Japan only buys $50 from the U.S., Japan will have $100 to use the next year, but the U.S. will have only $50, and Japanese exports to the U.S. will fall to $50 as a result. Earning only $50 from the U.S., the Japanese may have to reduce their purchases from the U.S. the following year. This sort of negative feedback loop may push trade into a “contractionary equilibrium.”
When exchange rates are added to the equation, the Japanese manufacturer that exported $100 in goods to the U.S. must sell those dollars on the currency market to buy the yen it needs to pay domestic suppliers and employees. However, the only entity that will sell it those yen is the U.S. manufacturer that exported $50 in goods to Japan.
With $100 of dollar selling and only $50 worth of yen selling, the dollar’s value versus the yen will be cut in half. This is how a surplus country’s exchange rate is pushed higher to equilibrate trade…
…If Japanese life insurers, pension funds, or other investors who need dollars to invest in the U.S. Treasury bonds sold yen and bought the remaining $50 the Japanese exporters wanted to sell, there would then be a total of $100 in dollar-buying demand for the $100 the Japanese exporter seeks to sell, and exchange rates would not change. If Japanese investors continued buying $50-worth of dollar investments each year, exchange rates would not change, in spite of the sustained $50 trade imbalances.
Although the above arrangement may continue for a long time, the Japanese investors would effectively be lending money to the U.S. This means that at some point the money would have to be paid back.
Unless the U.S. sells goods to Japan, there will be no U.S. exporters to provide the Japanese investors with the yen they need when they sell their U.S. Treasury bonds to pay yen obligations to Japanese pensioners and life insurance policyholders. Unless Japan is willing to continue lending to the U.S. in perpetuity, therefore, the underlying 100:50 trade imbalance will manifest itself when the lending stops.
At that point, the value of the yen will increase, resulting in large foreign exchange losses for Japanese pensioners and life insurance policyholders. Hence this scenario is also unsustainable in the long run. The U.S., too, would prefer a healthy relationship in which it sells goods to Japan and uses the proceeds to purchase goods from Japan to an unhealthy one in which it funds its purchases via constant borrowings…
…When financial markets are liberalized, capital moves to equalize the expected return in all markets. To the extent that countries with strong domestic demand tend to have higher interest rates than those with weak demand, money will flow from the latter to the former. Such flows will strengthen the currency of the former and weaken the currency of the latter. They may also add to already strong investment activity in the former by keeping interest rates lower than they would be otherwise, while depressing already weak investment activity in the latter by pushing interest rates higher than they would be otherwise.
To the extent that countries with strong domestic demand tend to run trade deficits and those with weak domestic demand run trade surpluses, these capital flows will exacerbate trade imbalances between the two by pushing the deficit country’s currency higher and pushing the surplus country’s currency lower. In other words, these flows are not only not in the best interests of individual countries, but are also detrimental to the attainment of balanced trade between countries. The widening imbalances then increase calls for protectionism in deficit countries.”
Prior to the liberalization of capital flows in the 1980s, “trade was free, but capital flows were regulated, so the foreign exchange market was driven largely by trade-related transactions.” This also meant that currency transactions could play the role they were meant to in terms of driving balanced trade:
“The currencies of trade surplus nations therefore tended to strengthen, and those of trade deficit nations to weaken. That encouraged surplus countries to import more and deficit countries to export more. In other words, the currency market acted as a natural stabilizer of trade between nations.”
As a sign of how free movement of capital has distorted the currency market, Koo noted that when the book was published “only about five percent of foreign exchange transactions involve trade, while the remaining 95 percent are attributable to capital flows.”
The problems with China’s economy
The sixth and last important idea from Koo’s book is a discussion of the factors that affect China’s economic growth, and why the country’s growth rate has slowed in recent years from the scorching pace seen in the 1990s and 200s. One issue, described by Koo, is that China no longer has a demographic tailwind to drive rapid economic growth, and is now facing a “middle-income trap” after passing the LTP around 2012:
“China actually passed the LTP around 2012 and is now experiencing sharp increases in wages. This means the country is now in its golden era, or post‐LTP maturing phase. However, because the Chinese government is wary of strikes, labor disputes, or other public disturbances of any kind, it is trying to pre‐empt such conflict by administering significant wage increases each year, with businesses required to raise wages under directives issued by local governments. In some regions, wages had risen at double‐ digit rates in a bid to prevent labor disputes. It remains to be seen whether such top‐down actions can substitute for a process in which employers and employees learn through confrontation what can reasonably be expected from the other party.
Just as China was passing the LTP, its working‐age population—defined as those aged 15 to 594—started shrinking in 2012. From a demographic perspective, it is highly unusual for the entire labor supply curve to begin shifting to the left just as a country reaches the LTP. Japan, Taiwan, and South Korea all enjoyed about 30 years of workforce growth after reaching their LTPs. The huge demographic bonus China enjoyed until 2012 is not only exhausted, but has now reversed… That means China that will not be able to maintain the rapid pace of economic growth seen in the past, and in fact growth has already slowed sharply.
Higher wages in China are now leading both Chinese and foreign businesses to move factories to lower-wage countries such as Vietnam and Bangladesh, prompting fears that China will become stuck in the so-called “middle-income trap”. This trap arises from the fact that once a country loses its distinction as the lowest-cost producer, many factories may leave for lower-cost destinations, resulting in less investment and less growth. In effect, the laws of globalization and free trade that benefited China when it was the lowest-cost producer are now posing real challenges for the country.”
Koo proposed ideas for China to reinvigorate China’s growth, such as investing in productivity-enhancing measures for domestic workers.
Another important factor affecting China’s economic growth involves the appropriate type of policy the government should implement to govern the economy. Since the country had passed the LTP more than a decade ago, and is in its golden era, fiscal policy – the act of the government directing the economy – is no longer the effective way to govern the economy. But is the government relinquishing control? To complicate matters, there are early signs now that China may already be in the pursued stage, in which case, fiscal policy will be important again. It remains to be seen what would be the most appropriate way for the government to lead China’s economy.
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