What are the key constraints on investment and growth across today’s advanced economies? I examine two recent original contributions to this debate. Balance sheet recessions and the pursued economy are compared with the idea of a global savings glut driven by excessive inequality and a dysfunctional global financial system.
I recently finished reading Richard Koo’s fascinating 2022 book Pursued Economy which is full of novel and stimulating ideas. In particular, he describes the growth constraints facing the rich countries, those at or near the technology frontier, what he calls ‘pursued economies’. As with his previous works, the arguments are set out with great clarity, if a little repetitively, but maybe this helps the reader absorb his main points. The book is essentially an updated and extended rewrite of his 2018 The Other Half of Macroeconomics, but is no worse for that. My review of that book can be found here.
This post is not another book review. Rather I want to compare some of Koo’s arguments with those of Michael Pettis and his co-author of Trade Wars Are Class Wars, Matthew Klein. Pettis has penned three earlier books, including The Great Rebalancing, which in part covers similar themes, but the former is his most recent. I will start with Koo’s ideas, before moving onto Pettis/Klein, and then compare the implications for policymakers.
The pursued economy
In short, the pursued economy (PE) is one which is considered to be ‘advanced’ or rich, with high levels of GDP per capita and productivity. It has significant numbers of firms producing close to the global technology frontier. It is ‘pursued’ in the sense that poorer, emerging or developing economies (DEEs) are growing faster and catching up with it. DEEs have lower wage and other costs, and are able to attract flows of foreign direct investment (FDI) from multinational corporations established in the richest countries, due to the prospect of higher returns. Thus investment is drawn from PEs to the pursuing DEEs. This leads to job losses in the PEs, particularly in manufacturing. These jobs tend to be relatively low skilled but well-paid. Thus wages for a significant section of the working and middle class stagnate or fall, leading to higher income inequality.
Koo argues that if PEs do not respond appropriately to the negative economic impacts of being pursued, then they face stagnant growth prospects and persistent inequality, with all that implies for social division and political instability. With investment prospects being brighter in the DEEs, the PEs face a loss of investment opportunities and the threat of losing advanced country status if these trends persist. While the DEEs can catch up by copying already existing technologies while benefiting from lower wages, the PEs need to become more innovative, and focus on advancing the technology frontier itself. Only in this way can they generate new productive investment opportunities, transform accumulating private savings into investment, and continue to be economically successful.
The global savings glut
Pettis and Klein (henceforth PK) argue differently. For them, it is inequality and the maldistribution of income which act as the key constraint on long-run growth in today’s world, for many advanced and emerging economies. Together with the dysfunctional structure of the global trade and financial system, these have led to a ‘savings glut’, an excessive desire to save on the part of wealthy elites, and its flipside, underconsumption. Wealthier households tend to save a larger proportion of their income than poorer ones, so that rising inequality leads to higher desired savings. Since the value of GDP or total production in a closed economy, such as the world as a whole, is equal to consumption plus savings, higher desired savings leads to lower consumption. If these higher savings are invested productively, then the lower consumption can be traded for higher future consumption as the economy grows faster and becomes more productive over time. This is fine if investment is constrained by scarce and therefore more costly savings, a supply-side issue. But if productive investment is instead constrained by demand in the form of consumption, then lower consumption will reduce the need for firms producing consumer goods and services to invest in new capacity. Investment will weaken, leading to slower growth in output and productivity.
For PK, a source of the savings glut is clearest in economies such as China and Germany, which have for many years produced far more than they can consume domestically. Household income and wages as a share of GDP have been held down through a variety of policy and institutional distortions, leading to production that is greater than domestic demand (consumption plus investment). This is symptomatic in their tendency towards large trade and current account deficits, with exports substantially exceeding imports. Their weak domestic demand has therefore been absorbed by the rest of the world, sustaining their economic growth to some degree. But the size of their economies is such that this outcome has become increasingly unsustainable, both economically and hence politically. Countries with large trade and current account deficits, such as the US, have been absorbing the excess savings, and production, of the surplus countries. The US finds itself in this position due to its large, sophisticated and relatively well regulated capital markets.
Of course the US also suffers from high levels of inequality. But due to it being willing and able to absorb excess global savings, this has maintained a strong global demand for dollars. The resulting stronger dollar exchange rate has led to a loss of competitiveness for domestic firms on foreign markets, particularly in manufacturing, and hence job losses and lower wages in that sector of the economy. The ‘exorbitant privilege’ of the dollar is only so for wealthy business and financial elites. It is actually an exorbitant burden for ordinary households who have experienced the downsides of a a persistently strong dollar.
Higher inequality has therefore, paradoxically, not led to higher savings and investment in the US. Rather it has led to structurally weaker economic growth than would otherwise be the case. Growth has itself become dependent on rising debt, shared between the public and private sectors, or between government on the one hand, and households and firms on the other. The alternative, lower debt, path is one of even slower growth and higher unemployment. Some of this debt has in recent decades fuelled asset-price bubbles, in stocks, housing, and all the associated financial products, rather than sustainable productive investment. Thus a global savings glut has led to lower productive investment and even lower savings in the US. The UK, which also has a large and sophisticated financial sector, has suffered from similar problems.
Policy implications
For Koo, the policy response for the PEs is to strengthen innovation through an original combination of demand-side public investment stimulus, and supply-side reform. In the presence of unutilised private savings, the government should borrow to invest in public investment projects, carefully vetted by an independent skilled commission, which is needed to ensure that the social return, or that for the economy as a whole, is greater than the total cost.
On the supply-side, reform should also aim to increase private returns on new investment opportunities for firms. This involves tax cuts, deregulation, and the promotion of a liberal education system which encourages independent, innovative thinking, particularly its applications to commerce. There is also a need for increased government-sponsored research and development and innovation. He argues that the US has already done some of this, while the European Union and Japan have not been so successful overall. In all cases there is more to be done.
PK’s arguments imply a rather different direction for policymakers, though with the same ends in mind: to restore prosperity to the advanced economies, and much of the rest of the world, which should reduce the appeal of authoritarian and populist forces and help to safeguard and promote healthy democratic societies.
Their analysis points to the need to reduce inequalities of income and wealth within countries in order to reduce the global savings glut and boost household income and wages for ordinary workers. This would lead to faster and more sustainable growth in consumption, and therefore in productive investment, and reduce the tendency towards periodic financial bubbles and instability, and the excessive accumulation of debt, across the world economy.
PK call for structural policies which redistribute income and wealth to ordinary households, not least in China, as much as in Japan and Germany, which are three of the major economies needing to rebalance and boost domestic demand arising from spending on consumption relative to domestic production. This need not mean simply taxing the wealthy and increasing the generosity of the welfare state, though this could be part of the solution. It could mean encouraging faster wage growth more directly by reforming and encouraging collective bargaining, a stronger real exchange rate, changes in corporate governance which reduce corporate retained earnings relative to investment, or cuts in consumption taxes.
Persistent trade and current account imbalances and the economic, social and political conflict which can arise from their disruptive consequences are for them the result of ‘class wars’, illustrated by rising domestic inequality in many countries, backed by its beneficiaries among the business and financial elites. But in its current form, the global trade and financial system incentivises countries and their governments to try and achieve international ‘competitiveness’ by suppressing wage growth so that it lags productivity growth. While this reduces costs, increases profits, and can enable firms producing for export to cut prices, this cannot be a sustainable strategy for a number of large economies in a global system of free trade. Wages are a major cost for firms, but they are also the dominant source of income and expenditure for workers and ordinary households. Thus wages which persistently lag productivity growth across the major economies weaken global demand. As already described, they generate patterns of slower growth with higher unemployment in some countries, and higher debt and more frequent financial crises and greater economic instability in others. Weak wage growth also reduces the incentives for firms to compete by investing in new more productive technologies. Instead there is a tendency for them to directly lower wage costs and degrade the terms and conditions of employment, undermining the well-being of the workforce and potentially reducing worker productivity as a consequence.
Like PK, Koo also makes a case for the stronger regulation of global capital flows, which for him dominate and distort trade flows, and undermine monetary policy effectiveness and exchange rate adjustment. These lead to persistent trade imbalances, and a backlash against free trade itself, due to the disruptive nature of such outcomes on jobs and wages for the mass of ordinary workers.
Differences on debt
Koo and PK differ somewhat when it comes to their views on financial bubbles and debt. PK’s views on their causes have already been described. Inequality, the resulting savings glut and the global financial system together play the major role. For Koo, there is a tendency for slow-growing, pursued economies with unutilised savings to generate bubbles when interest rates fall to low levels and savings are invested in existing financial assets rather than in new capital due to a lack of opportunities for productive investment. When debt-fuelled financial bubbles collapse, leaving firms and households saving or paying down debt instead of borrowing to invest and consume, in spite of very low interest rates, an economy faces what is known as a Balance Sheet Recession (BSR), one of Koo’s signature intellectual contributions. This then calls for the only actor sufficiently large and able to borrow and spend the otherwise unutilised savings, the government, to run persistent deficits and prevent economic collapse.
For PK this is simply transferring debt from the private to the public sector, as has occurred in Japan since its years of stagnation began in the 1990s. While this may have stalled total economic meltdown, it has not led to a refounding of growth and prosperity there. Koo’s argument does not account for the deeper causes of Japan’s travails, which PK and others have convincingly argued is the failure to change its economic development model from the high savings/high investment form which served it so well in its postwar ‘catching-up’ phase to one based more on higher wages and consumption. In short, it has been suffering from a longstanding savings glut! Again, PK see the glut and associated lack of investment opportunities as a problem of weak growth in wages, household income and consumption. Koo argues that the problem is a long BSR and the failure to transition from being a pursuing economy to one that is successfully pursued, or from catching up to forging ahead technologically. The diagnosis is similar, but the policy prescriptions differ.
In conclusion
Richard Koo and Michael Pettis/Matthew Klein have set out differing theses on the nature of the constraints on productive investment and more sustainable growth across the capitalist world, and their policy prescriptions differ accordingly. PK lay the blame at policies which have encouraged inequality, maldistribution, and underconsumption, coupled with and abetted by a dysfunctional liberalised global financial system. For Koo it is the pursued economies which have failed to reform sufficiently to promote innovation, while neglecting expansionary fiscal policies in this new phase of their development. There is some overlap between the two approaches but much that is different. PK’s argument still allows room for governments to increase necessary public investment in research, infrastructure, education and skills, but unlike Koo the crux of their case is the inadequacy of global demand in the form of underconsumption.
There is “a world to win” out there for ordinary workers, to coin a phrase penned by Karl Marx in the Communist Manifesto. However this world remains a capitalist one, albeit one with the potential for greater, more sustainable and more widely-shared prosperity. Policymakers and elites, as much as workers, need to make some major changes to achieve this. Overall I am more persuaded by the reforms advocated by PK, which in part draw on a more systemic analysis of the global economy. Koo’s contributions remain original, interesting and worthy of study, but for me they neglect the deeper, fundamental economic problems caused by excessive inequality itself, including the conditions which underpin financial crises.
The Political Economy of Development 
PK seem to be telling Germany, China, and Japan that they have a cure for their high-tech, low-unemployment ailment, which is to have larger welfare states and higher wages so they can be more like the countries with the decaying manufacturing sectors. China is dominating the battery production industry, and batteries seem likely to be key components in cars, motorcycles, phones, and even small boats and watercraft. China seems to be among the biggest shipbuilders, auto exporters, electronics manufacturers, and semiconductor manufacturers. Koo rightly recognizes that it’s the US, France, UK who are in a lot of trouble. The financial papers have been telling me my whole life that Japan’s economy sucks, while I watched it stand out as the only country competitive with the US in producing cultural exports like video games and animated TV, and introduce the hybrid car to the US via Toyota and Honda. It is so weird to look at Europe, at least before the Ukraine invasion, and point out Germany as the economic laggard. PK are asking net exporters to be charitable, while RK is recognizing that net exporters don’t want to be in the situation net importers are in, and that net importers don’t want to be in their own situation, either, so they’ll need to make R&D investments and pray that something comes of it
Doesn’t it seem like PK are asking high-tech, low-unemployment net exporter countries to solve the problems of the rest of us by joining us in reducing their manufacturing sectors’ competitiveness, while RK is encouraging us to try to invest IRA/CHIPS-style because it’s unlikely that our geopolitical and economic rivals will bail us out?
Thanks for your comment. There is a relative component to this kind of competitiveness, according to PK, so China’s industrial policy has been in the form of massive transfers of income from the household sector to support manufacturing for export, infrastructure and real estate, which worked well for some time, but has now run its course. But it means that China dominates global manufacturing production, more than it would if its economy were more balanced, and production/supply didn’t exceed domestic demand/consumption by so much. This is now China’s problem as much as the ROW, and all the imbalances are tied together in their uneven impact across the world, since one country’s trade surplus is another’s deficit.
So yes, China/Germany and other major surplus countries need reduce their ‘competitiveness’, but their economies would benefit since higher wage costs and a more generous social wage would boost household income and consumption. At this stage it becomes political since elites would lose out relatively while lower/middle classes would benefit as inequality falls.
Reducing inequality would also, according to PK, reduce the extent to which economic growth is dependent on rising debt, from the US to China. So the benefits could be far-reaching.
I am not sure that RK’s arguments are entirely synonymous with Bidenomics. He says that pursued economies need more active and intelligent fiscal policy to help sustain demand, and supply-side tax cuts/deregulation to incentivise entrepreneurial investment. PK on the other hand want to see policies that redistribute and predistribute income/wealth to reduce inequality in a context of a reformed global financial system, without which all the imbalances and the consequent rising debt will be harder to reduce/resolve.