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Saturday, June 12, 2004


This is the 4th of a 8-article mini-series on economic development, the mini-series itself part of longer series --- which seems to stretch back in time all the way to the Battle of Gettysburg, but more likely to the end of April this year --- on the democratic prospects of the Arab Middle East. It takes up where the 3rd article left off: at the point where it explained that convergence theory predicts how the gap between the US as the lead country and rich follower countries like Japan or Germany or even smaller ones like Sweden or Taiwan should, in principle, be closed sometime in the future.

As the article concluded, the prediction has not been borne out.

The US has been the richest country in the world in per capita income since the 1880s, roughly half the time that has expired since the industrial revolution of the late 18th century erupted. Far from the gap in per capita income and productivity being closed, the EU average is now back to where it was in the early 1960s --- about 63% of the US level. Germany and Japan, two countries that had closed the gap to around 90% by the end of the 1980s --- widely touted as late as 1993 to match the US level by the end of the decade, then to go on and surpass it in the next decade --- are themselves not doing much better, comparatively speaking.

Why has convergence theory not worked out, at any rate for the US lead? The previous article didn't delve much into the reasons for catch-up growth not to work in its case. The current article seeks to repair the omission. There are two possible explanations: either convergence theory is wrong, or the US enjoys a superior form of capitalism --- a system of national innovation, plus an unusually mobile and flexible population, that surpasses that of the EU or Pacific Asian countries.

Not surprisingly, the latter explanation is what will be stressed here. In particular, we will try to show that the US has an unusually effective system of national innovation . . . at any rate, compared to its rivals in Europe or Pacific Asia.



Convergence Theory

Convergence theory itself is sound enough . . . at any rate, for developing countries with good institutions, good economic policies, a rule of law, and sufficient human talents to work with modern technologies, all matters set out at length in the first three articles of this buggy mini-series. Even if they start out with only partially effective institutions and a dictatorship, those countries that can sustain long-term development over several generations have managed to reform their institutions, encourage a rule-of-law, and move in almost every instance to solid democratic politics.

  • Similarly --- to clarify some key points set out in the previous two articles --- whatever the initial policies that ignited short-term economic bursts in effectively developed countries, the improved political process led, eventually, to policy-changes that approximated the Washington Consensus of the early 1990s about long-term development: sound money and finances, government spending over the long haul that doesn't endlessly run up national debt, an effective protection of private property that limits bribes, corruption, and defaults on contracts. The protection of intellectual property rights is no less important. So too is a decent social security network. And finally, no country has ever become rich without full integration into the global economy.

  • One other thing too: In shaping their policies, the policymakers in successfully developed countries have to pay increasing attention to how the incentives of various economic agents --- investors, managers, would-be entrepreneurs, workers seeking new training, and tax-payers in general --- are affected by those policies. It's no secret what the best policies would do as far as incentives go. They would encourage entrepreneurship, technological innovation, an efficient allocation of capital investment to the most promising firms and industries, and proper education and work habits that, taken together, cause a shift away from quantitative, investment-led development and toward a more qualitative, technology-driven form of dynamic economic growth.

  • But note right off: even as countries adapt their institutions and policies in these ways, there is still leeway for different institutional outcomes. In particular, as you'll see in Part Three of this article, Anglo-American capitalism is only one successful model. East Asian capitalism and EU Continental welfare-state capitalism are two other successful models. Whether they lead to similar flexibility in adapting to change is, however, another matter --- a point also stressed and clarified in Part Three.

Thanks to these national assets, such countries can launch themselves onto a path of sustained long-term economic growth over generations. In the process, countries like Taiwan, South Korea, Hong Kong, Israel, or Singapore --- all affluent countries now --- have tended in the last generation to converge on the levels of per capita income and productivity enjoyed by the rich industrial countries like Japan, the US, and West Europe. For that matter, though it's to early to judge the outcome, China and India --- both pursuing more market-oriented policies and integration into the global economy --- have been growing the last 15 years or so at rates of GDP three times that of the EU and Japan, and way ahead of the US too . . . all in line, as we'll see in a moment, with what convergence theory predicts.


Nor is that all. The theory's prediction that catch-up growth will also work for the follower countries that are themselves highly developed --- growing faster than the very rich lead country --- has also been sound for about half the time-period, about 240 years, since the industrial revolution was ignited in the late 18th century.

The exception, which the argument in this article tries to account for, is the US . . . the leader country since the 1880s. Time and again, the American lead in productivity and per capita income has been narrowed by faster growing follower countries --- most notably, from 1950 until 1990 or so, by Japan, Germany, and France. Yet time and again, American economic dynamism was eventually reignited and the country pulled ahead once more . . . exactly what it has done over the last 14 years. Right now, comparatively speaking, Japan and the EU countries on an average are back where they were in the early 1960s.

For the moment, though, put the US exception on the backburner. Look instead at . . .


. . . More Illustrations of Convergence Theory's Basic Soundness

We've already mentioned some examples on this count. Consider some others.

Think of Japan --- its per capita income about 35% of the US's in 1950 after post-war reconstruction was over, only to close the gap rapidly to around 90% by 1990. South Korea, to clarify its impressive growth record, was once so poor that in 1959 the World Bank's report on its economy claimed that it would be an economic basket-case forever, utterly dependent on foreign aid. Three decades later, its 50 million people exported cars, trucks, TVs, DRAM memory chips, pc's, and a range of advanced consumer electronics; its steel industry was and remains one of the most efficient in the world; the same is true of its shipbuilding industry. In per capita income, it is roughly at the level of affluence enjoyed by Portugal and Greece in the EU: all three about $18,000 in purchasing power parity terms (PPP).

For that matter, the record of convergence in the European Union is clear here too.

Ireland, once the poorest country in West Europe, now is the richest in the EU except for tiny Luxembourg (250,000 people vs. 4 million Irish): while the EU average per capita income for the 15 West European members at the start of 2004 was about $26,000, Ireland's was an astonishing $32,000. (The US level, as a point of comparison, is around $39,000.) Stated differently, Ireland when it joined the EU in 1973 had a per capita income that was only 62% of the EU average; even Greece when it joined in 1981 was better off comparatively, its level around 64% of the EU average at the time. Today, Ireland's is 21% higher, an astonishing economic performance. And though Greece's per capita income isn't much higher percentage wise, that of Spain, another poor country when it joined the EU in the mid-1980s, has leapt ahead of the richer northern Europeans in its rate of growth since then and can now boast of a per capita income around 90% of the EU average. Spain's is at around 90% of the EU average.

Note that the new EU members in East Europe --- Poland, the Czech Republic, Hungary, the Baltic States, Slovenia, and Slovakia --- have per capita incomes that average around 45% of the EU's. In that respect, they are worse off than Ireland or the poorer Mediterranean countries that joined the EU in the 1970s and 1980s. Even so, if they continue to reform their economic institutions, convergence catch-up growth should work for them as well. Above all, they will likely enjoy big inflows of capital and technology as West European firms relocate there to take advantage of their disciplined, far cheaper wages and far lower taxes. In the process, they would no less likely benefit from faster growth of their GDP and per capita income.

All of which prompts a pivotal question:


What Explains Convergence Catch-Up Growth? Or Why Do Follower Countries Grow Faster
Than the Lead Countries

There are several convergence processes that account for catch-up growth, again always for the countries whose people have enough skills to work with modern technologies and --- no less important --- whose institutions and policies are sufficiently efficient or reformed to launch their economies onto a path of sustained long-term economic development.

(i.) Bold Innovation Is Costly, Risky, and Often Disruptive. Much of the Investment Won't Pan Out, and Eventually Follower Countries Can Import the Lead Country's Breakthrough Technologies At Bargain Rates

The lead country is almost always at the technological frontier, with the most dynamic of the follower countries not far behind. Given the higher wages of its work force, it has to invest at hefty levels in R&D and try to continually innovate if it's to sustain its lead in productivity and per capita. By contrast, follower countries with good institutions, policies, and human talents can rely on technological transfers (imports) and then diffuse the innovations made by the leader to their economies in less costly ways.

How so?

Well, much of that R&D and initial investments made by the lead country's firms to bring its leading-edge technologies to the market will be wasted.

In particular, lots of promising R&D expenditures --- at times even in a production-stage --- never really pan out. Even when radical innovations do lead to brand-new products that are profitable in the market-place, whole new industries probably need to be established before that happens: think of electrification, autos, airplanes, radio, TV, movies, airlines, computers, the Internet, E-Commerce, and so on. That takes time. Time is costly. Most established big firms, moreover, aren't effective vehicles for such radical undertakings. They have too many vested interests in the status quo: to invest in entirely new products, their managers will risk disrupting their existing line of products. Suppose, though, they go ahead and make the investments. In that case, the managers have to contend with another problem: resistance from their existing work forces at all levels. Lots of workers won't be able to be re-trained; many will be superfluous and have to be laid off or fired; among those who stay on, morale may sag anyway. In the EU and Japan nowadays, it's worth noting, such labor practices are virtually impossible --- for both social and legal reasons.

The result? Usually, to bring revolutionary products to the market-place successfully, start-up firms created by bold, risk-taking entrepreneurs and funded by venture capitalists will be needed. Thus 75% of the US Fortune Five Hundred Companies in 1999 didn't even exist in 1975. In Germany and Japan, by contrast, the equivalent ranks of top corporate firms scarcely altered over the same period.


Nor is this all. For radical innovators, there are other risks to contend with.
Start with a recurring problem. Specifically, even if the new products pan out, it may take lots of time for customer-firms or end-consumers to learn how to use them effectively --- think of computers, which were invested in heavily for a decade by American companies and agencies before they enhanced productivity for them. The longer the delay, the less likely customers or end-consumers will update their equipment. For many firms and agencies, for instance, investments in ICT technologies (information and computer technologies) may actually have led to declining productivity the first few years, until the learning-curves within those firms and agencies began to rise steeply. And computers are hardly unique in this respect. It took decades for the airline industry to take off and become productive --- roughly, 40-50 years after the Wright brothers first flight. A good three decades after the light-bulb was invented by Edison, half the homes in America still weren't electrified.

Still, continue to focus on the computer chip, and the breakthroughs in the information and communications technologies of the last 25 years.

American companies, it's estimated, spent hundreds of billions of dollars on ICT R&D --- much of it leading to a dead-end --- before the breakthrough products were produced and firms and agencies here learned to work with them effectively. The Internet itself, developed by the Pentagon in the 1960s, never became commercially viable until the World Wide Web was perfected in the early 1990s, followed by graphic-oriented browsers like Netscape and IE. Even then, e-commerce --- which is now doing around $1 trillion in business and likely to soar by multiples in the future --- lagged until about 1999.

By that date --- the end of the 1990s --- one British study found that all these commercially viable breakthrough technologies in ICT could be bought for about 15-20% of the original US R&D expenditures by foreign countries with good firms, managers, and other human skills: either through multinational investment by American companies in their countries or by licensing the US technololgies or by working around the patents that covered them (reverse engineering, a Japanese specialty).


The moral? It's two-fold:

  • Vigorous follower countries with good institutions and policies can narrow the lead with the front-running country by means of fairly low-cost technological transfer and diffusion throughout their economies, then take advantage of their lower wage levels and even --- a Japanese and German specialty --- improve on the quality of the products. Even if they spend as much on R&D as the leader country, most of it is focused on adapting the latter's innovations to local circumstances, then diffusing the new technologies to the relevant industries, plus any beneficial spillovers that might follow to the rest of the economy. In the process, their R&D spending is much more focused, and there is limited wastage.

  • Oppositely, though, the closer follower countries have moved to the technological frontier with the US, the less they can wait for innovations to standarize and be transferred to them. They have to begin competing directly with the front-runner in order to compete effectively. That means spending more on innovation itself. And innovation, as we've pointed out, is more costly and risk-laden.

Note though. Whether the various institutional arrangements, policies, and vested interests that have grown up and hardened around the economic status quo in follower countries that have shown themselves able to move close to the technological frontier have enough flexibility to adapt their economic structures and practices to bold innovation --- with all the social and economic dislocations that the switch entails --- is another matter. The fate of Germany and Japan since the late 1980s is instructive here. Their forms of capitalism --- much more heavily state-dominated --- were well adapted to high levels of capital investment and technological transfers from abroad. Call it good adaptation and imitation. Most of the time, German and Japanese firms would go beyond that and improve on the quality of the goods in the industries where these new technologies were employed, even as they found ways to enhance, incrementally, the production processes they used.

Innovation, however, is much harder --- not just harder, but riskier and costly: disruptive to the economic and political status quo too.

The result? At all levels of their economic and political systems --- including culture-laden resistance to change, reinforced by a host of government regulations and other policies --- German and Japanese firms and policymakers found that the switch-over to a growth strategy of bold, nimble-footed innovation has been hemmed in by swarms of tenacious obstacles that defend the existing status quo: political, financial, social, and attitudinal. . . all matters that will be clarified in Parts Three and Four in this and the next article, especially compared to the far more flexible form of US capitalism.


(ii.) In Long-Wave Cycles of Innovation, Standardization Will Eventually Set In and Technological
Transfers to Others Accelerate

In particular --- to continue the previous line of analysis --- once the initial breakthrough technologies become standardized, the lead country's advantages will be cut noticeably as the technologies are transferred abroad and diffused among efficient follower countries. Those with good engineering skills and disciplined work forces will likely find it possible to out-compete the lead country in their home markets and third-country markets: in particular, using newer factories and machines, they can incrementally reduce the costs of production and --- not always, but often --- improve on the quality of the end product. Sooner or later, then --- unless the firms in the lead country at the technological frontier can find ways to innovate whole new industries --- its own market will see a huge influx of exports from the follower countries in the formerly cutting-edge industries.

Think of Japanese cars, TVs, and VCRs or South Korean ship-building and DRAM chips in US markets, or German luxury automobiles and machine tools.

To compete, the US --- we'll focus on it as the lead country --- will find that many of its bigger firms will accelerate the relocation of much of their production abroad to take advantage of cheaper labor. That will help to slow down the advantages in GDP growth and maybe exports of advanced goods now enjoyed by the more skillfully endowed follower countries, but it won't stave off their fast-growing advances on its lead.


(iii.) The Problems of Diminishing Returns Confront the Lead Countries First. Also Higher Wage Costs
in Standardized Industries Might Matter Too

Above all, at some point where technological innovation has slowed down to mere incremental improvements, the lead country with its higher wages and bigger cumulative capital stock will find that diminishing returns will set in faster in its economy than in that of its competitors. By contrast, the dynamic follower countries generally have a smaller stock of capital and the returns on their investments bring in more profits.

These disadvantages to the lead country --- again, think of the US in the late 1970s and 1980s ----- won't change until new breakthrough technologies of a radically restructuring sort occur again . . . always assuming that the lead country is the pioneer innovator again. The trouble is, innovative breakthroughs are hard to come by.

Consider the evidence. Since the industrial revolution of the late 18th century, radically restructuring breakthroughs in technology --- which change the way we work and live in dramatic fashion --- have erupted in clustered waves every 50 or 60 years. They also directly influence the global distribution of power, favoring the innovator countries. In the first four waves --- the latter ending in the 1970s --- the slow-down in radical innovations occurred generally in the third or fourth decade. By then, innovation would slack off, and standardization of production occur in the new industries that the breakthrough technologies had spawned. It's at this point that the advantages of relative backwardness come into play for the more dynamic follower countries. They are able to build more modern factories, concentrate on incremental improvements in the production process, and cut costs thanks to both those steady improvements and lower wage-costs. In many instances, too, they have been able to improve on the quality of the end products.

On all these grounds then --- greater investment opportunities and cheaper and more up-to-date ways to obtain lead technologies once they are standardized --- those follower countries with lower per capita incomes and wage-costs should experience higher rates of growth in GDP and productivity and hence close the gap over time with the rich country. And through the first four waves of revolutionary innovations, that was the case during the period of standardization --- both for poor developing countries converging on the club of rich countries, and within the club convergence by follower countries on the lead country.

The gap, quickly note once more, might not ever be fully closed. For Britain, the rich pioneer country of the 18th century industrial revolution, it was not only closed, it lost its lead first to the US and later to some other former follower countries. The US, as we've said several times already, is the exception. If anything, in the current fifth wave of ICT and biotech cutting-edge technologies, it is increasing its lead at a speed that defies convergence theory.

Ponder now another advantage of comparative backwardness:


(iv.) Exporting Abroad,

Follower countries, remember, can sooner or later count on exporting their increasingly high-tech products to the larger, more prosperous market of the lead country or other rich countries of the second-tier . . . even as they exploit their lower wages and newer factories to outperform the leaders in export sales to third-country markets. Again, think of big Japanese advances in both the US and foreign markets in automobiles, DRAM memory-chips, consumer electronics, motorcycles, and computer peripherals since the late 1970s.

Nor is that all.

Interestingly, the large wealthy countries in the EU or in East Asia --- notably Germany, Japan, South Korea, or Taiwan --- have all ignited and then sustained their fast pace of economic growth down to 1990 by export-led growth into the US market. Since 1990, both Germany and Japan have continued to run large trade surpluses with the US, and the Pacific Asian countries recovered from the currency and financial shock of 1997-98 by a huge surge of exports into the US economy. Indifferent generally to its current account --- trade in goods and services --- the deficit in that account, balanced by capital inflows from abroad, doubled in size between 1997 and 1998.

Ever since, Japan, China, and the other Pacific Asian countries dependent on the US market have sold more than a trillion dollars worth of their national currencies in order to buy dollars and keep the exchange rate of the dollar high. The result: last year, these Pacific Asian countries had accumulated over $1.6 trillion worth of dollars as reserves. For them, it's a bargain. Cheaper national currencies in dollar terms keep the export machine whirring away into the US market; they are also able to invest their dollars in US stock and bond markets or buy US firms or real estate. For the US, it's a bargain too. Thanks to the steady inflow of foreign capital, US policymakers have been able to rely on to keep interest rates in our economy lower than they would otherwise be, and generate first a consumer-led, then investment-led growth boom out of the 2001 recession.


(v.) Higher Savings and Investment Ratios

As a rule, poorer countries that are able to sustain long-term development and engage in catch-up growth save more of their GDP percentage-wise than rich countries. The gulf here can be marked. This is especially the case of Japan and Pacific Asia compared to the US.

One reason for the gulf in savings ratios: rich countries have tax-financed social security. That's a disincentive to save as much of a family income for old age in Europe or North America compared with China or India or Thailand. Additionally, rich countries have advanced credit facilities for stimulating consumption at high levels. Thus house ownership is much higher in rich countries, and houses or apartments can be bought on a mortgage basis, the down payment usually no more than 10-15%. Such policies hardly exist in poor countries.

Instead, by a variety of government policies and regulations, most of the more successfully developing countries in Asia have preferred to allocate more of national saving to investment rather than consumption. One widely used policy is to restrict the access of consumers and households to bank loans, either for mortgages or other durable goods like cars or TVs. Another is to limit the development of large discount chains: in the upshot, faced with higher prices on most consumptions goods, households have to save even more of their incomes to purchase them. As a third policy, subsidies and advantageous depreciation rates in the tax code encourage large corporate firms to invest more than they otherwise might.

Nor is that all. Some countries have reinforced the impact of these policies by preventing foreign banks, brokerage houses, and insurance companies from operating in their home markets, while simultaneously impeding the ability of their own citizens to invest abroad. Once again, consequently, average households have had to save even more of their income in order to get even a minimal interest-rate payment on them . . . this, whether they are saving for retirement or to purchase a car or residence.

Until well into the 1990s, Japan --- the second largest economy in the world --- continued to apply the whole range of these anti-consumption policies. Only very slowly, as the economic crisis in the country intensified, have they begun to modify.



Consider this part, if you want, something of a digression --- albeit an important one, which figures daily in the US media and is bound to be underscored in the coming presidential election: should we worry about the US trade deficit? Enter the trio of clarifications by way of an answer.

Clarification One

Why don't prosperous follower countries reduce their reliance on export-led and shift more to domestic-led growth by stimulating more consumption in their home markets?

The answer: sooner or later many of them probably will . . . at any rate if their home market is large and it becomes prosperous enough. That doesn't mean they will switch entirely from export-led to domestic-led GDP growth. As before, Germany and Japan and all the rest of Pacific Asia continue to rely chiefly on the former --- a pattern deeply rooted in their institutions and policies, reinforced by neo-mercantilist sentiments diffused throughout their media and public opinion that trade surpluses and accumulating dollars reserves are desirable, a sign of vigorous national competitiveness. What's more, to ensure that their trade surpluses have continued, Asian governments have manipulated the dollar price of their currencies on a massive scale. Since 1998, as we noted, they have even spent well over a trillion dollars worth of their currencies since 1998 to buy dollars and keep the exchange rate of their currencies artificially low. That has kept the export-spigot bursting to the US market, and they then invest almost all of their cumulative $1.6 trillion in their Central Bank reserves in the US bond and stock markets.

In this manner, the US experiences a steady inflow of foreign investment in the capital account of our balance of payments. The counterpart in our balance of payments is that the current account --- trade in good and services --- will automatically be in deficit. The causal mechanism here can be easily grasped. The larger the capital inflows from abroad, the higher the dollar's price in exchange rate markets, and the larger the resulting US current account deficit. By contrast, the smaller the inflows, the lower the dollar's exchange rate, and the smaller the deficit on current account.

Recently, for a good decade, the inflows of foreign capital have been ever higher. One result: on a per capita basis, the US now absorbs about 3 to 4 times more manufacturing exports from Asia in dollar terms than do West Europeans or the Japanese (from the rest of Asia).


Clarification Two:

Are growing American trade deficits worrying? No, not really. The ongoing trade surpluses of Asian countries, Germany, and several other EU countries --- whose counterpart is our large trade deficit --- reflect voluntary, mutually satisfying market transactions on all sides.

Specifically, foreign governments are happy to rely on export led growth into the prosperous, booming US market. They also have a secure US financial market for investing their huge dollar reserves . . . including, if their firms want, to buy US firms or relocate some of their production here, a pattern that marks Japanese and European multinational investment for almost two decades now. Thanks to it, the US is the biggest recipient of foreign direct investment --- multinational activity --- in the world.

For our part, US consumers get cheaper and maybe better quality goods than we otherwise would; and at the same time, the capital inflows from Asia or parts of the EU that finance our trade deficits with them keep interest rates lower here than they otherwise would. One outcome? Something highly desirable: both investment and the consumption of durable goods like cars and houses are stimulated here to higher levels, entailing faster GDP growth. As another outcome ---- contrary to neo-mercantilist thinking --- American workers find more and more jobs created . . . including, if they've lost employment in import-competing industries (or to outsourcing abroad), alternative jobs that favor better educated workers. Simultaneously, the more foreign multinationals use their dollars to relocate production here, the more they employ American workers and stimulate more competition within the US home market.

In the export-led economies of Japan and Germany, by contrast, job creation has badly lagged the last generation. Neo-mercantilism --- the theory that export-led growth and trade surpluses are always desirable --- may have helped their long-term development in the past. If so, it stopped doing that two decades or more ago.


Clarification Three: Can The US Continue To Run Trade Deficits Forever?

Probably not, though Britain did for well over a century --- from about 1850 to the middle of the last century. At some point, though, a few countries with increasingly large dollar reserves may be reluctant to continue running up their investments in the US economy. In that case, the governments of Japan, China, and other Pacific Asia countries heavily dependent on export-led growth would likely stop buying as many dollars as before in order to keep their own currencies relatively cheap in dollar terms. Additionally, they and some governments in the EU and elsewhere might decide also sell off part of their dollar-denominated bonds and stocks --- held as part of their Central Bank official foreign reserves --- and invest them elsewhere.

In both instances, the price of the dollar in exchange-rate markets would then fall.

Would that be bad?

For the US, no, not really --- unless a falling dollar was precipitous and set off inflation, something that didn't happen in the late 1980s when that was the case. In a five year period, the dollar fell by over 50% against the Japanese Yen and the German Mark, plus a few other important currencies, yet inflation itself continued to decline in the US, not accelerate. If anything, the current US and global environment is more immune to inflation than in the 1980s.

Otherwise, aside from this hypothetical danger, a falling dollar would bring only benefits to the US --- above all, by stimulating more US exports abroad to the rest of the world. That happened in the late 1980s: as the dollar fell brusquely, American exports rose by over 50%, and by 1990 the US current account deficit disappeared. There's another benefit that can also be expected here: to the extent that protectionist pressures have been generated in certain import-competing industries, those pressures would be relieved . . . a trend that also marked the US economy by 1990 as well. All this would be desirable for us.


So much for the US. What about other countries whose currencies would rise against the dollar?

A falling dollar would more likely bring more costs than benefits to them. In fact, only one benefit stands out, a hypothetical one. Specifically, it would occur if --- instead of relying on export-led growth --- some large foreign countries or a region like the EU eurozone switched to domestic-led growth. But note: such a switch could occur only if --- as is now the case with France, Germany, Italy, and Spain as the euro has soared against the dollar the last two years --- their governments carried out a slew of essential market-oriented reforms of their institutions and policies. Their governments have loudly proclaimed the need to do so.

But it's one thing to proclaim the need, and another to follow through successfully. The obstacles loom large.

Most of all, whenever any reforms that reduce welfare payments or close down uncompetitive enteprises have been pushed by EU governments outside Scandinavia and Holland, social conflicts and electoral backlashes have invariably surged. The same is true when the reforms include privatizing high-cost nationalized industries. On all these scores, the evidence of tenacious resistance continues to pile up. Three months ago, the Spanish conservative government lost an election after carrying out a fair number of impressive economic reforms, and the current conservative French government has recently had to backtrack blatantly from its tepid reform program --- again for electoral reasons. Italian reform has also been stymied. When, three years ago, the conservative coalition led by Silvio Berlusconi asked a law professor in Rome to rewrite the labor laws and allow firms more freedom to lay-off unproductive workers, the professor was assassinated. Terrorists in Italy --- probably anti-globalizers --- sought earlier this year to kill the heads of the EU Commission, the Eurobank, and its chief police official. Even Swedish ministers have been assassinated or assaulted; the same has been true of Dutch politicians. Traditionally, both countries pride themselves on their civility and lack of political violence.

That leaves Germany. The left-wing coalition there is undertaking some reforms too, so far showing more spunk than the French Right; but that doesn't mean it will succeed. Up to now, the chief fall-out has been that the Schroeder-led coalition stands at an all-time low in German public opinion. Gerhardt Schroeder himself, the Chancellor, has has had to step down as the leader of the Social Democratic Party, whose rank-and-file is rife with discontent and acerbic criticisms. Meanwhile, a new national election is likely in two years time. Should Schroeder's standing in public opinion continue to fall, don't be surprised if the election has to come much sooner.


What about the Asian countries?

Well, don't look forward to a switch to domestic-led growth any time soon. If anything, the reliance on export-led growth seems so entwined in their economic structures that a rising currency would mainly have detrimental effects, little else. None of them, not even Japan --- never mind China --- show enthusiasm for carrying out enough reforms of their policies and institutions to wean themselves off export-led growth. And as long as they rely on it --- which means, among other things, that they keep domestic consumption limited compared to what it could be --- they will want to invest the higher levels of domestic savings that result from this policy abroad . . . in the US mainly, but possibly in the euro-area as well.

And now back to our main concern in this article:



Apparently Not.

Consider closely the evidence here. The US has been the richest country with the highest levels of per capita income and productivity for about 125 years now, roughly half the time, as we noted earlier, that has elapsed since the industrial revolution of the late 18th century. There's no evidence that the gap in per capita income and productivity will be closed soon by any other country in the next few decades --- certainly not Japan or Germany, once touted as late as the start of the 1990s as the likeliest to catch-up with the US by the end of the decade, then go on to surpass it in per capita income in this decade. The reality? Since 1991, both Germany and Japan have racked up the worst record of any industrial countries since the Great Depression of the 1930s. By 1989 or so, their per capita income in purchasing power terms was close to 90% of the US's. Today, thanks to a vigorous US burst of technological creativity and new productivity gains, their per capita income is below 70% of the US's --- roughly where it was back in the mid-1960s.

What follows is an effort to explain the causes of the US lead --- institutional and policy-oriented --- that have defied the logic of convergence catch-up growth.


Different Kinds of Capitalism and National Innovation Systems

The main causes of the American lead --- to foreshadow the argument in Part Three --- add up to a different sort of capitalism than that found on the EU Continent or in Japan and the rest of Pacific Asia . . . that, plus the apparently superior system of national innovation that American capitalism has spawned over the centuries. Don't worry about the meaning of national innovation; it will be clarified later on. Briefly though, consider what the three kinds of prevailing institutional capitalism amount to.


(i.) The EU Welfare-State Form of Capitalism.

On the continent of West Europe, all the EU countries there --- 13 in number at the start of 2004 --- have developed over time an advanced regulatory- and welfare-state form of capitalism predominates, marked by high levels of taxation and transfer payments (social security and welfare) extensive regulations of labor markets --- including major restrictions on laying off existing labor --- numerous restrictions on large discount stores and hours of operation, and various forms of a generous system of health and retirement. For the most part too --- despite the boosts to long-term unemployment among youth and others outside the job market --- high minimum wages are enforced by statute or regulation. As for capital allocation, the EU welfare-state countries have relied historically far more on bank loans and banker-corporate relations than on impersonal stock markets.

Finally, with two or three exceptions, all of the Continental EU welfare-states rely on export-led growth as a preferred way of sustaining growth in GDP and employment.


(ii.) The Japanese and Wider East Asian Form of Capitalism

Though high levels of taxes and government transfer-payments are avoided in the model of capitalism pioneered by Japan, then emulated closely by South Korea and to a somewhat lesser extent in Taiwan and Singapore, it stands out as system that entails a large state role of governmental-guidance: tariffs and quotas to limit imports, a lavish use of subsidies, industrial targeting, and a host of regulations across-the-board. The elites of the civil service in all four countries have been uncommonly powerful in determining much of economic activity. Only France in West Europe is controlled to the same degree by a small group of elite civil servants.

There are some differences across these Asian countries worth singling out.

In Japan and South Korea, the governments have deliberately encouraged the growth of huge cartel-like corporations; those in export markets have traditionally enjoyed a variety of targeted subsidies and encouragement to R&D spending. Until recently, foreign multinationals were strictly limited in their ability to set up and do business there. A variety of techniques were used in place of multinational investment as a means of technological transfer: licensing, reverse-engineering to build around foreign patents, or the purchase of industrial firms abroad. In Taiwan and Singapore, energetic family-owned firms flourish more, and multinational implantation and the transfer of technology that way have been far more encouraged. As in Japan and South Korea, capital allocation has been almost entirely limited to bank-credit; even today, stock markets remains fairly circumscribed, though Japan --- to escape the stagnation of the last 13 years --- has recently begun to liberalize its financial institutions. All four countries have relied heavily on export-led growth, especially to the US. More recently, they have also been vigorously exporting to China.

Traditionally, all four countries have emphasized social stability and control, including a swarm of techniques to discipline labor. Only in the last decade have Taiwan and South Korea democratized. Singapore remains an authoritarian system. Japan, though democratic since its independence was restored in 1949, has been governed ever since except for a brief period of 9 months by the Conservative Right --- specifically, from 1954 on, by the Liberal Democratic Party.


And China?

Despite the monopoly of power in China enjoyed by the Communist Party, the thrust of its developmental strategy since the reform era began in the post-Mao period after 1978 has been to emulate South Korea's state-guided capitalism . . . especially during the 45 years of military rule in that country. The aim seems to be to reduce the inherited Maoist state-sector more and more, above all by paring down drastically the number of state-owned enterprises --- both giants and smaller firms in the industrial sectors, as well as in banking --- and developing a corporatist-like system of authoritarian capitalism. In such a corporatist system, the state is removed from direct daily interference in the economy and operates more in the background --- as in South Korea from the 1950s until recently --- by controlling the commanding heights of the economy in indirect ways. Two such ways stand out. The Chinese government would allocate most capital investment through the Central Bank's authority over the private banking system. Simultaneously, it would retain further influence with the giant corporate firms by instituting a host of subsidies, tariffs and quotas, and regulations that discipline labor and favor giant export-led corporate firms.

That, to repeat, is the Chinese Communist Party's aim. Whether it will be realized is another matter.

Right now, the outcome is doubtful. After all, whatever else can be said about the East Asian capitalisms in Japan, Taiwan, Singapore, and South Korea, they have had more market-oriented institutions from the outset; and none of the latter three in their authoritarian phase ever had anything resembling the Chinese Communist Party --- a huge centralized monopoly party 60 million strong, organized hierarchically and shadowing every form of the state bureaucracy and ministries. Nor, despite the large state role in the economy, did they have state-owned enterprises that, even today in China, still employ 60-70 million people, none of them profitable and all of them absorbing huge amounts of the high savings in the country that are funneled to them by state-owned banks.

Something else too: fairly early on, these other East Asian countries began shifting toward a technology-led form of long-term economic development --- call it qualitative growth, as opposed to sustaining simply high levels of capital investment. Can China do this? Maybe, but unlike those other Asian countries, the country now lacks the managers, engineers, and marketing specialists to carry out such a shift. Will that change over time? It can't be ruled out. Still, the built-in conflict between the logic of decentralized markets on one side, and on the other a CP monopoly of power --- and all the privileges, prestige, and money that positions in the party bring --- seems inescapable in China and may never be easily resolved.

The more so because --- for reasons that lie beyond the scope of this article --- the CP has followed a sequence of easy-to-hard market-oriented reforms since 1978. In dozens of different ways, all the hard reforms loom menacingly in the future.


(iii.) The US Model of Free Markets --- An Anglo-American Form of Capitalism

Along with Britain, Ireland, Australia, and New Zealand --- to an extent, Canada too --- the US has evolved a form of capitalism that limits the role of government compared to the other two systems and enhances the play of free markets and competition. Taxes are far lower than in the EU welfare-state form of regulatory capitalism; so too are transfer payments --- both welfare and state-pension schemes. In all these English-speaking countries except Canada --- ruled the last four decades except for a brief period in the 1980s by a Quebec-dominated Liberal Party that has moved Canada more toward the EU Continental Welfare-State model ---- deregulation has been the watchword of the day for two decades or more.

Industrial targeting, even in the Continental EU sense, is generally avoided, and capital allocation for investment purposes depends heavily on the stock market rather than bank-credit. For a similar reason, the kinds of cozy relationships between big banks and big corporations --- a hallmark of both the East Asian and EU welfare-state capitalisms --- have no counterparts in the Anglo-American model.

As all these examples show, there is a powerful belief --- part of national culture --- in the value of free market competition, both among national firms and with foreign firms. All the English-speaking democracies have, accordingly, encouraged high levels of foreign multinational activity in their economies. In no small part, Britain's and Australia's lethargic economies down to the start of the 1980s have been reignited in dynamism by not just lower taxes and deregulation, but by continued influx of foreign multinational capital. Ireland is renown for encouraging foreign business to operate in its economy. As for New Zealand, its economy has grown vigorously again ever since its people decided to scrap its overweening welfare-state system in the late 1980s.

All this granted, there are some specific characteristics of the US even in this Anglo-American group --- never mind compared with the other two forms of dominant capitalism in the world --- that explain its matchless economic dynamism. Together, they add up to an uncommon system of national innovation, and interacting with the other institutional and cultural strengths of the US, they have made it the richest country in the world for the last 125 years and currently underpin its status as the world's sole great power.

In the process, its these unique strengths that explain why convergence catch-up growth among vigorous follower countries has never operated to close the gap with the US in their levels of productivity and per capita income.



The argument will be continued in the next article in this mini-series on economic development.