I refer to the work of Michael Pettis quite often on this blog. He strikes me as a highly original thinker, combining macroeconomics, finance, development, political economy and economic history in a way which provides a deep understanding of world economic events.
He recently posted here about what he sees as the two main models of economic development which nations have used to transform their economies at certain times in history: the high wages model, and the high savings model.
Models of development can be described as a set of policies and institutions which aim to develop the economy and achieve sustained rises in productivity and output via industrialisation and the advancement of technology.
For Pettis, both models aim to raise wages and productivity, but they are distinct from one another in how they drive the investment which makes this possible.
The high wages model
The high wages model is associated with the American School of Political Economy which was influential in the US during the 19th century. The policy of accepting and sustaining growth in average real wages across the economy creates a growing domestic market for goods consumed by the working classes. Strong growth in consumption should stimulate investment.
This demand effect is complemented by supply-side effects: relatively high wages encourage firms to invest in upgrading the technology used in production, since they are less able to compete by cutting wages to any great extent.
In addition, high wages and the growing domestic demand they create can boost productivity via the resultant opportunities to exploit economies of scale in production. This can potentially give rise to a virtuous circle of rising demand, supply and capacity, and productivity.
To accommodate and sustain the high wages economy, the government needs to carry out its own investment in infrastructure, education, training and research and development. Such policies should help create the environment in which firms would wish to invest in order to raise productivity, so that wages can continue rising along with profits and output.
The high savings model
The high savings model also aims to raise wages and productivity, but it does so by constraining consumption and raising the savings share of income in the economy, increasing the supply and reducing the cost of capital. This is complemented by policies which encourage those savings to flow into investment, particularly in infrastructure and manufacturing capacity.
Policies which increase the savings share have historically included a repressed financial system, a weak exchange rate, low wages and taxes on household income or consumption. All of these lower the share of household income and, by implication, the share of consumption, in GDP.
In this case, higher wages are the outcome of the high savings and investment, rather than the driver of the investment.
Examples of the high savings model include Japan in the post-war period and China in the last few decades since it began its reform programme in the late 1970s.
Historically, as mentioned by Pettis, the high savings model has been associated with more rapid growth in the short and medium term, and a period of ‘catching-up’ with income levels in the most advanced countries. But it seems to create larger economic imbalances than the high wages model. These prove hard to resolve in the longer term, since their resolution has meant challenging those groups in society that have benefited the most from the policy status quo.
These imbalances typically involve an excess supply of savings relative to investment needs, once those needs have been met at a certain level of development. If national savings are greater than investment this necessitates that the country run a current account surplus in order to sustain demand, and will thus end up exporting the surplus abroad.
The Japanese economy grew rapidly from the 1950s until the 1970s. In the 1980s academics, business leaders and policymakers in the US feared that this would result in Japan overtaking them economically.
But it never happened. The Japanese economy underwent a financial crash in the early 1990s and has struggled to grow since then, experiencing two or more ‘lost decades’ as it has slowly rebalanced.
China has been growing rapidly since the reform period, but Pettis argues that it is now struggling to enact a new set of reforms which are required to rebalance the economy away from extraordinarily high rates of savings and investment, towards consumption.
It also needs to reduce the growth in corporate debt that has emerged since the financial crisis in 2008. Much of this debt has been fueling unproductive investment, so that debt is growing faster than debt-servicing capacity. The current rate of economic growth is still rapid, but is probably unsustainable: without the growth in debt, growth would be much lower.
The Chinese government seems to realize all this, and while rebalancing the economy away from unproductive investment and towards consumption has started, there is some way to go.
From development models to wage-led vs profit-led growth
This distinction between high wages and high savings models of development tallies quite well with an influential strand of research in heterodox economics, more specifically in post-Keynesian and Marxist theory.
This is the debate over whether economic growth is wage-led or profit-led. Although it draws on the work of early post-Keynesians such as Michal Kalecki, Joan Robinson, Nicholas Kaldor, and Luigi Pasinetti, the seminal paper is by Bhaduri and Marglin.
Economic growth is wage-led if a rising wage share in national income boosts aggregate demand via increased consumption more than it reduces demand via lower investment from a reduced profit share (the necessary flip side of a rising wage share). Since firms finance much of their investment internally, a falling profit share will reduce the funds available for investment.
By contrast, an economy is profit-led if a rising wage share leads to a slower rate of growth due to weaker investment from the lower profit share.
Certain policy implications follow: if an economy is wage-led, boosting the wage share will boost growth; if it is profit-led, boosting the profit share (and reducing the wage share) will boost growth.
Many Marxist economists argue that growth is generally profit-led, meaning that there will be conflict between capitalists and workers over the distribution of income between profits and wages. Capitalists want profits, and therefore investment and growth, to be as high as possible, while workers want wages to be as high as possible, but if workers win the struggle, this will lower profits and growth.
Post-Keynesians have argued that growth can be either wage or profit-led, and which of the two applies should be decided empirically. If it is wage-led, there is more scope for cooperation between capitalists and workers over the distribution of income.
Having said that, in the profit-led story, there is still scope for cooperation between capitalists and workers, if the former can make the case that lower wages in the short term mean higher profits, investment, growth and productivity, and therefore potentially higher wages in the longer term, so that workers will gain if they can be patient.
All this seems pretty similar to Pettis’ distinction between high wages and high savings models of growth. These models are applied in his post to development processes, although they can be applied more generally to growth among advanced countries too.
The high savings model is quite similar to the profit-led growth model. After all, profits are corporate savings, which can be invested in new production capacity and, if productive, will help drive growth.
Savings as a whole can be attained by firms, households, governments, and from abroad, so the high savings model contains a broader notion of what constitutes the difference between national production and consumption (the difference being equal to national savings).
There is a difference between Pettis and the post-Keynesians/Marxists. Pettis draws on the historical record to suggest that the high wages model of growth is more sustainable over the longer run, even if it produces slower growth in the short and medium run.
This is because it tends to produce smaller imbalances between consumption and investment than the high savings model and may need less radical reforms in order for growth to continue. Such processes take place over many years, so it is important to understand the history of development successes and failures.
One problem with the high wages model is that if productivity growth does not keep up with the growth in wages, then firms competing internationally can become uncompetitive, should they be unable to reduce prices relative to their competitors abroad. They might lose market share or relocate to countries with lower labour costs, where profits will be higher.
Wage growth in excess of productivity growth could also squeeze profits, reducing the funds available for investment, as well as the incentive to invest if lower profits are expected to continue.
As long as productivity growth is sustained, and wages grow at a similar pace, the high wages model should be successful. But the bargaining power of workers vis-à-vis capitalists in the labour market is necessarily affected by various policies and institutions, such as regulations, the strength of trade unions, and the rate of unemployment. These will vary within and between countries, and will affect the success of a high wages policy.
The high savings model has produced a number of ‘growth miracles’, periods of rapid growth and catch-up with advanced nations, including Japan, South Korea, Brazil and most recently China, but these have all come to an end, with China beginning to negotiate the transition in recent years. History shows that the passage from middle-income to advanced country status has required significant reform which has proved hard to achieve politically.
All growth models can therefore generate imbalances and other problems which require changes in policy or politics in order for the relevant country to continue to develop. The role of the state in economic change thus remains vital. Under capitalism, there will be a need to manage conflict between social groups and to create the conditions for productivity growth and technical progress. Appeals to return to a bygone era of laissez-faire and the nightwatchman state remain a utopian delusion.