Over-Stretching Is Required for Economic Growth

The preceding four chapters are all about how an economy could stagnate, sometimes for an extended period, when it is in Cases 3 and 4. This chapter discusses the opposite case, the drivers of economic growth. Not surprisingly, economic growth is highly relevant to an economy in Case 1 or 2.

Much has been written about economic growth since the days of Thomas Malthus. However, the recent emphasis on productivity and demographics by economists seeking to explain growth has placed the growth debate on the misleading path.

At the most fundamental level, someone must spend more than they earn for an economy to grow. If businesses and households behave prudently and spend only what they earn in each period, the economy may be stable, but it will not grow. For it to expand, some entities must over-stretch themselves—either by borrowing money or drawing down savings.

A business will do so if it finds an attractive investment opportunity that seems to offer returns that are higher than the borrowing costs. Similarly, a household might borrow money or reduce its savings if it finds an item that it feels it cannot live without. It should be noted that business and household borrowings to purchase existing assets do not count here—these transactions only result in a change of ownership and do not add to GDP.

Economic growth, therefore, requires either (1) a continuous supply of attractive investment opportunities capable of persuading companies to borrow money or (2) a continuous flow of new and exciting products that consumers want to buy, even if that means reducing savings or going into debt. Many factors influence the availability of investment opportunities and “must have” products, and demographics and productivity considerations are just two of them.

A government can also over-stretch by borrowing and spending money to increase economic growth. So-called pump-priming via fiscal stimulus is an attempt by the government to over-stretch itself in order to put a weak economy back on a growth path. Government investment in social infrastructure may also give businesses more reasons to over-stretch and thereby spur growth.

But unless the economy is in Case 3 or 4, government over-stretching cannot be relied on for too long because it can crowd out private-sector investments and increase the burden on future taxpayers. As government investments tend to be less efficient than the private-sector equivalent, economic growth often slows when the former start to crowd out the latter.

If attractive investment opportunities and “must-have” products are plentiful, there will be no shortage of private-sector borrowers, and the economy is in Case 1 or 2. When that is the case, policy makers should rely more on monetary policy because it will be highly effective in steering the economy. An overreliance on fiscal policy under such circumstances will only result in the crowding-out of private-sector investments and a general misallocation of resources. In other words, when the economy is in either of those two cases, standard textbook theory regarding the undesirability of fiscal policy and the desirability of monetary policy applies.

Consumer- and Business-Driven Economic Growth

For the economy to continue growing, there must be good reasons for businesses and households to over-stretch themselves on a sustained basis. For consumer-driven growth to continue, the recurrent emergence of new “must-have” products is necessary.

The problem is that it is difficult to forecast when such blockbuster products might emerge, because predicting the inventions and innovations that lead to such products has proved to be notoriously difficult. It is also hard to foresee what will appeal to consumers' rapidly changing tastes. This uncertainty is particularly acute in the developed world, where households already own most of life's necessities.

In contrast, business-driven growth is more robust because companies are always under pressure from shareholders to expand their operations and generate more profits. It is also businesses that create the products that consumers find irresistible. While there is no guarantee that businesses will hit upon such products or find other investment opportunities, they tend to be more dependable drivers of economic growth than fickle consumers.

Positive Fallacy-of-Composition during Golden Era

During the golden era, when businesses are faced with a surfeit of domestic investment opportunities and the purchasing power of consumers is growing rapidly, as is explained in Figure 3.1 in Chapter 3, corporate decisions to over-stretch by investing in capacity- and productivity-enhancing equipment are not difficult to make. That, in turn, often creates a positive fallacy of composition that serves to accelerate economic growth.

Because one person's expenditures are another's income, if all households and businesses “live beyond their means” and begin consuming and investing more, their incomes will increase by an amount equal to the growth in expenditures. For example, if everyone decides to over-stretch by spending 10 percent more than they earn, either by dis-saving or by borrowing money, their incomes will also increase by 10 percent because everyone else will be spending 10 percent more than before.

With incomes up by 10 percent, the initial decision to over-stretch no longer appears especially reckless relative to current incomes—this is what might be called the “paradox of dis-saving.” This positive fallacy of composition with rapidly increasing incomes may lead to an even greater willingness to consume and invest on the part of consumers and businesses. This virtuous growth cycle is observed frequently during the golden era and is another example of one plus one not equaling two in macroeconomics. The growth momentum created by this positive feedback loop is also one reason why economic growth is taken for granted during the golden era.

A vast number of Japanese households in the late 1950s sought to acquire sanshu-no-jingi, or the “three sacred items”—a black-and-white television set, a refrigerator, and a washing machine—even if they had to borrow money to do so. Those purchases added significantly to the Japanese economy's rapid growth during that period. This is the opposite of Keynes's “paradox of thrift”; by collectively living beyond their means, consumers can drive the economy into a virtuous growth cycle. The rapid growth experienced by an economy in a bubble—for example, the surge in Japanese gross domestic product (GDP) before the bubble burst in 1990 (Figure 2.1)—is probably due to this paradox. As long as the paradox is producing positive outcomes, however, most people are happy to go along with it.

For this positive fallacy of composition to continue, there must be sufficient and concurrent growth in savings to draw upon. That is why economies that favor savings will grow faster than those that do not when there are plenty of good reasons for businesses and households to over-stretch themselves. When the economy is in Case 1 or 2, therefore, saving is a virtue, as is noted in Chapter 3.

Two Strategies for Businesses to Follow

While there is no guarantee that there will always be attractive investment opportunities worth borrowing money for, there are basically two growth paths for businesses to follow amid that uncertainty. They can try to develop either new products and services capable of wowing customers (Strategy A) or new ways to supply existing products and services at lower cost (Strategy B).

Strategy A, when successful, will lead to rapid growth not only for the company but also for the economy as a whole by spurring consumer-driven economic growth. If the new product displaces old products, total expenditures in the economy may not increase significantly, apart from the investment required to develop the new product. But chances are high that companies that lost market share to the new entrant will try to regain it by investing in the development and production of near-substitutes. Those investments will add to GDP growth.

On the other hand, this strategy is also risky because predicting profitable inventions and innovations is notoriously difficult, as noted earlier. This strategy may also require access to leading-edge technologies that only a few companies have access to. This strategy is therefore pursued mostly by businesses in the developed world with both the financial strength to take risks and access to the intellectual property rights framework needed to protect newly developed products.

Strategy B, which involves making existing products more cheaply, also provides a powerful motive to borrow and invest for entrepreneurs who believe they have devised a better way to produce existing services and products. Because consumers do not have to over-stretch as much to buy these cheaper products, a company pursuing Strategy B may earn a healthy return on capital by capturing market share quickly.

The emergence of companies offering competitively priced products may also force existing producers to invest more in productivity-enhancing equipment to stay competitive. The resultant over-stretching by rival firms adds to both economic and productivity growth.

Most businesses follow a mixture of Strategy A and Strategy B depending on their product lines. But the main source of growth is likely to be Strategy A in the advanced economies and Strategy B in the emerging economies.

Profit Motive and Productivity

Whether following Strategy A or B, most businesses are constantly on the lookout for ways to increase profitability by enhancing productivity, and they are likely to borrow and invest in machinery and innovations that lead to lower costs and higher profits. Many businesses may also be forced into investing in new equipment to raise productivity just to remain competitive. Those investment expenditures will add to economic growth.

It should be noted, however, that the economy in this case did not grow because of increased productivity. It grew because firms over-stretched themselves in the hope of raising profits when cost-cutting innovations presented themselves. If they did not over-stretch in acquiring the new equipment, their productivity might improve, but the economy would not expand because total expenditures would remain the same. This means the concept of “cash flow management” in post-bubble Japan that is noted in Chapter 2, where companies refuse to borrow money and invest only as much as cash flow will allow, has not been helpful to the country's economic growth.

The preceding discussion also suggests that the profit motive and technological progress in cost-reducing equipment are important drivers of productivity-enhancing investments. Of the two, the importance of the profit motive was amply demonstrated by the persistence of slow economic growth in communist economies where such a motive was absent. Technological progress in cost-cutting equipment, on the other hand, often depends on scientific discoveries and technological innovations that are difficult to forecast, as noted earlier.

Problems with the Concept and Measurement of Productivity

The concept of productivity is also not so straightforward. It has been said for decades that Japan's manufacturing sector is highly productive, but its service sector is not. There is no question that the former is true, but if the latter were also true, Japan should have been flooded with foreign retailers and other service providers that are more productive than their Japanese rivals.

U.S. and European retailers have made numerous attempts over the decades to enter the Japanese market. After all, Japan was the world's second largest consumer market until 2010, when China took away that title. But almost all of these attempts failed, and there is still no meaningful foreign penetration of the Japanese retail market.

The reason for this failure is simple. There is a big difference in the relative factor prices of real estate, energy, and labor between Japan and the West. In Japan, real estate and energy prices are high relative to the cost of labor, whereas the opposite is true in the West. As a result, a typical Japanese retailer will try to use as little real estate and energy as possible relative to workers to maximize profits, whereas a Western retailer will take the opposite tack. Japanese stores therefore tend to be smaller establishments staffed by many employees, while Western stores are generally huge, well-lit establishments staffed by only a few people.

When revenues are divided by the number of workers, Japanese stores are naturally outperformed by Western establishments. But this so-called “labor productivity” figure is meaningless without considering the productivity figures for the floor space and energy used, where Japan comes out looking significantly better than the West.

Western retailers who did not understand this point and operated stores in Japan the same way they did at home lost a great deal of money before eventually having to leave. Any attempt to raise so-called “labor productivity” in Japan is futile unless relative factor prices in the country are the same as in the West.

This also implies that actual labor productivity should be measured per unit of capital—including land. But measuring the amount of capital available to each worker is extremely difficult, if not impossible. There are, however, some anecdotal cross-country comparisons.

A traveling Australian entertainment group has been performing “Thomas the Tank Engine” for children around the world with the same stage props for years. The props are set up in theaters in each country by the same number of young part-time workers. The Australian manager of the group told the author's son, who was one of the part-time workers in Japan, that in any other country, setting up the props takes a minimum of four hours, and often six hours or more. But in Japan, he said, it never takes more than two hours even though different workers are involved each year. This anecdote suggests young Japanese part-time workers may be more productive than their peers elsewhere.

It could be argued that cross-country productivity comparisons should be made based on total factor productivity instead of labor productivity. This is easier said than done, since it may require adding apples and oranges when different factors of production are involved.

One way to get around this problem in comparing retail sector productivity is to examine final selling prices across countries, since retailers with higher total factor productivity should be able to sell products at lower prices.

The Big Mac index compiled by the Economist magazine is useful in this regard because the quality of Big Macs is the same everywhere in the world (see Figure 9.3 in Chapter 9). Although the original objective of the index was to determine the over- and under-valuation of currencies on a purchasing power parity basis, it is interesting to note that in Japan, which has the same per capita GDP as Europe, Big Macs are sold at a much lower price than in Europe, even though Japan imports almost all of its ingredients from abroad. This suggests either that the yen is undervalued, or that the Japanese operation has a much higher total factor productivity than the European operations.

It was not always this way. Prices in Japan used to be much higher than the international norm, and Tokyo was consistently voted the world's most expensive city well into the 1990s. The gap in prices was so bad that there was even a Japanese word, naigai-kakakusa, to describe the huge disparity between domestic and international prices. The gulf was so wide that the author used to buy everything from daily necessities to motor oil in the United States and bring them back to Tokyo in suitcases.

But this all changed when the shock of an incredibly strong yen—the Japanese currency climbed to 79.75 yen/dollar in April 1995¹—finally kicked open the domestic market to imports. The relentless competition among domestic retail establishments that followed made Japan one of the cheapest places to dine and shop in the developed world.

Japan now has over 4,000 so-called 100-yen shops offering everything from quality household wares to stationary items from around the world for 100 yen (about $.80) each. Many of these stores are selling goods at the lowest prices seen anywhere in the world. The fact that they are often sitting on some of the most expensive real estate in the world suggests that total factor productivity is high. Since these shops have appeared, no one in Japan talks about naigai-kakakusa anymore.

Profitability and Physical Productivity

Another problem with productivity is that it is often confused with profitability. In the mid-1980s, many Japanese companies borrowed and invested heavily in the latest equipment and factories to make themselves even more competitive. The exchange rate at the time was 240 yen to the dollar. But when those factories came on line in the late 1980s, the exchange rate had fallen to 120 yen to the dollar, reflecting a stronger yen. The companies that had made these investments were badly hurt, and economic growth slowed.

Japanese companies enjoyed higher physical productivity with their newer equipment and factories, but capacity utilization and profitability were far lower. When the exchange rate went to 80 yen to the dollar in the mid-1990s, many of these companies were referred to as “zombies” because of their earlier over-stretching, even though their physical productivity was still second to none.

Many observers who argue that Japanese GDP growth declined because of reduced productivity growth are mistaking profitability for productivity. It is the decline in profitable investment opportunities due to the strong yen that has weighed on investment (i.e., over-stretching) and GDP growth. Investment also declined after the bubble burst in 1990 because so many companies faced balance sheet problems, and productivity growth slowed because there was less investment.

As is noted in Chapter 4, productivity growth has recently slowed in almost all advanced countries because they have become pursued economies, with lower returns on capital than are available in emerging markets. With shareholders clamoring for higher returns on capital, it has become difficult for companies in these countries to justify investing in less profitable projects at home. That, in turn, has lowered both economic and productivity growth in the advanced nations.

Higher Productivity Does Not Necessarily Lead to Higher Wages in Pursued Economies

Even if businesses invest in productivity-enhancing equipment at home in a pursued era, such investments do not increase the wages or purchasing power of workers the way they did during the golden era. U.S. President Joe Biden noted during his 2020 election campaign that U.S. productivity had risen 70 percent between 1979 and 2018 while wages had grown only 12 percent in real terms. This decoupling of wages and productivity growth has much to do with the fact that the United States and other advanced economies are now in the pursued era.

The Western economies until the 1980s, and Japan until the 1990s, were in a golden era where attractive domestic investment opportunities were plentiful but the supply of labor was limited. That led to annual increases in wages as the expanding economy moved along the upward-sloping labor supply curve from K to P in Figure 3.1. This wage growth was also the key driver of domestic demand because it increased workers' purchasing power.

Businesses facing rising wages as well as greater demand for their products expanded investment both to boost productivity (to remain competitive) and to expand capacity (to meet additional demand). Wage growth and productivity growth therefore moved together, with the former driving the latter.

For the last 30 years, however, businesses in advanced countries have realized that the return on capital is higher in low-wage emerging markets than in their high-wage home markets, and they have shifted their investment destinations accordingly. Instead of paying higher wages at home, they simply moved production abroad. That has resulted in the loss of millions of manufacturing jobs at home and slower economic growth. The loose domestic labor market conditions that resulted removed the key reason for wages to rise. Consequently, companies are no longer forced to enhance productivity to pay ever-increasing wages.

If businesses invest at home in the pursued era, they do so to improve profitability. Even if wages are not rising, there is no reason not to invest in equipment that lowers costs and boosts profitability. The resultant improvements in productivity do not translate into higher wages because wages themselves are determined by the labor market, where conditions are much looser than during the golden era.

During the golden era, labor productivity and wages moved in tandem because it was the rising wages that forced companies to enhance worker productivity. During the pursued era, the benefits of improved productivity brought about by corporate investments go to those who made the investments, not to the workers.

Will Higher Minimum Wage Boost Productivity?

Some have argued that the government should then raise the minimum wage to boost labor productivity. Although rising wages will force some companies to make more productivity-enhancing investments, higher unemployment could also result if the wages are rising because of government decree and not because of tighter labor market conditions.

An attempt to raise the minimum wage in a pursued economy also risks shifting even more investment to emerging economies by further depressing the domestic return on capital. Unlike their predecessors in the golden era, many businesses in the pursued era have production facilities located around the world. That means proposals to raise the minimum wage should be approached carefully inasmuch as they have the potential to further reduce already low domestic returns on capital and create more unemployment.

The point is that businesses do not engage in productivity- or capacity-enhancing investments if they see no money in it. Productivity growth is the result of businesses responding to the emergence of cost-cutting investment opportunities that increase their return on capital. When such opportunities present themselves in the form of technological progress and are acted on by businesses that over-stretch themselves, both economic and productivity growth will accelerate.

Whether that growth benefits labor depends on the tightness of the labor market. That, in turn, is often determined by whether the economy is in the golden era or the pursued era. In the golden era, the macroeconomic tide originating from a surfeit of domestic investment opportunities prompts businesses to expand, increasing demand for labor in a tight labor market, thereby raising all wages. In the pursued era, when returns on capital are higher abroad than at home, there is unlikely to be a macroeconomic tide that lifts all wages. Instead, individual workers must enhance their own productivity by learning new skills if they want to increase their income. Businesses will continue to invest more to boost productivity, but the resultant increase in productivity does not often lead to higher wages in a much looser labor market of the pursued era.

Export-Driven Economic Growth Faces Fewer Hurdles

For many industries in the developed world, significantly cheaper labor costs in the emerging economies eliminate the option of pursuing Strategy B at home. Barring revolutionary discoveries or innovations that drastically improve domestic productivity, it simply does not make sense for them to continue with Strategy B. That is why they became pursued economies in the first place, and why so many companies in these countries are forced to pursue the more difficult Strategy A.

For businesses located in the emerging world, on the other hand, wage levels often make the pursuit of Strategy B highly attractive. For instance, wages in Japan and China were far lower than those in the West when the two countries first entered the global market in the 1950s and 1980s, respectively. All manufacturers had to do was to produce quality products cheaply (which, of course, is not easy), and the products would basically sell themselves in overseas markets.

These less-expensive products sold themselves because there was no need for consumers in importing nations to over-stretch when buying them. On the contrary, consumers in the importing nations were saving money by switching to lower-priced imports, which is the opposite of over-stretching. From the perspective of exporting countries, foreign consumers were doing the over-stretching that helped their exports and economies to grow, but individual consumers in importing countries saw themselves as under-stretching by shifting their purchases to cheaper imports. (The inherent contradiction here is discussed further in Chapter 9, which looks at global trade.)

That means that even if the products themselves are not new and do not “wow” consumers, exporting companies and countries can grow rapidly as long as their products can be priced competitively in overseas markets. Japan and all the other countries that successfully achieved export-led economic growth in the postwar period started out with Strategy B.

Even though most businesses pursue a combination of Strategy A and B depending on the product line, most companies in pursued countries are forced into the riskier and more difficult Strategy A, resulting in slower growth for the economy. Businesses in emerging markets, on the other hand, are either in the pre–Lewis Turning Point (LTP) urbanization era or the post-LTP golden era and tend to pursue the easier, less risky Strategy B, which leads to faster economic growth.

Import-Substitution Model Seldom Sustainable

The emphasis on over-stretching to explain economic growth also helps to explain why the export-driven model of economic growth has been more successful than the import-substitution model pursued by some countries. In the latter case, the captive market provided by protectionist government policies initially boosts the profitability of businesses benefiting from the protection. That prompts them to increase investment at home, accelerating economic growth. But someone in the economy must continuously over-stretch themselves for this growth model to remain viable.

For that to happen, businesses must continuously come up with new and exciting products to wow domestic consumers, something that has proved difficult for underdeveloped local industries requiring government protection. The limited size of the domestic market also leads to correspondingly high production costs, making these products less attractive to consumers. In addition, their high cost limits their appeal to foreign consumers, making it difficult for businesses to pursue Strategy B. In other words, this growth model effectively asks businesses in developing countries to pursue the more difficult Strategy A.

That is why after a promising initial boost to growth, this model has never remained viable for long in any country—although it has been tried by many countries in Latin America and elsewhere in the 1950s and 1960s.

Transparency Is the Greatest Attraction of U.S. Market

The export-driven model of growth does have one requirement that the import-substitution model never had to worry about: access to foreign markets. Before 1945, access to foreign markets was limited for most countries because all nations had erected numerous barriers to trade. Indeed, revenue from tariffs had been a major source of government income for centuries. With many foreign markets effectively closed, most countries had no choice but to pursue the import-substitution model of growth. That, in turn, placed substantial constraints on global economic growth.

All that changed after World War II when the United States introduced a free-trade regime under General Agreement on Tariffs and Trade (GATT), as is noted in Chapter 4. Even though the concept and practice of free trade had been observed from time to time in the past, the U.S. decision to open its vast domestic market—which accounted for nearly 30 percent of global GDP at the time—was a game-changer.

Japan, realizing the far-reaching implications of the U.S. policy change, placed its best and brightest in exporting industries and started growing rapidly. The Japanese success was soon followed by Taiwan, South Korea, and others. Wartime technological breakthroughs helped, of course, but without free trade it would be difficult to explain the rapid economic growth of countries such as West Germany and Japan, which depended heavily on the U.S. market.

The end of the Cold War in 1990 then allowed Communist and former Communist countries to join the free trade bandwagon. China, with its low labor costs, benefited most. Capitalizing on the U.S.-built free trade regime, China raised its per capita GDP from a paltry $300 in 1978 to over $10,000 in 2019 for 1.4 billion people, representing the greatest burst of economic growth in history. Indeed, all countries that have relied on exports to achieve economic growth after 1945 have done so by tapping into the U.S. market.

The Importance of Recognizing the Source of Over-Stretching

The importance placed on the U.S. market by the Japanese came as a cultural shock to the author when he moved from the Federal Reserve Bank of New York to Nomura Research Institute (NRI) in Tokyo in 1984. When forecasting GDP growth, it was typical in the United States to start the exercise by estimating personal consumption, which is the biggest component of U.S. GDP. From there, projections of other, smaller components of GDP such as fixed capital investment and net exports were added to come up with a final figure.

In Japan, which was already the second largest economy in the world, the forecasting exercise at NRI, the oldest, largest, and most influential private think-tank in the country at the time, started with an elaborate forecast of the U.S. economy. Projections for Western Europe were then added to come up with a forecast of Japan's exports. Exports were followed by fixed capital investment, and forecasts of personal consumption and other items came after that. This was in spite of the fact that personal consumption was the biggest single component of Japan's GDP and was far larger than exports.

The Japanese knew that exports were the key driver of growth, and that it was foreigners who were doing the crucial over-stretching. They knew from experience that if exports slumped, other components of GDP would also stagnate. They understood that as far as growth is concerned, where the over-stretching is happening is more important than the size of the sector itself. Even if exports are not the biggest sector, if that is where most of the over-stretching is taking place, then that is where the focus should lie when forecasting overall economic growth.

Even today, the United States remains a crucial market for both developed and developing countries, including Japan, Europe, and China. This is due not only to the size of the U.S. market, but also to its great transparency and the absence of nontariff trade barriers. From a business standpoint, transparency is often as important as—if not more important than—the size of the market itself.

For instance, the nominal GDP of the 27 European Union nations was equal to 73.1 percent of U.S. GDP in 2020, and in the mid-1990s Japanese GDP approached 70 percent of U.S. output. In 2020, China's nominal GDP was 71.2 percent of the U.S. figure.² However, the companies and countries that would suffer from being shut out of U.S. market far outnumber those that would be hurt by being kept out of the other three markets.

The reason is that the other three markets are less transparent than the United States and therefore require much greater efforts by foreign exporters. The return on capital for marketing efforts in these three markets is therefore lower than in the United States. As a result, many companies do not even try to penetrate the other three markets.

The difficulty of breaking into the Japanese market, for example, was amply demonstrated until quite recently by the existence of many so-called export-only manufacturers in Japan. These companies existed because they could earn a much higher return on capital by concentrating their marketing efforts in more transparent overseas markets—and particularly the U.S. market—instead of trying to crack the more difficult domestic market. This transparency is also why many governments—including those of Japan, China, and Europe—were so eager to conclude a “deal” with former President Donald Trump when he was pushing a protectionist “America First” agenda.

The Middle-Income Trap and Difficulty of Transitioning from Strategy B to Strategy A

Advanced countries at the receiving end of emerging economies' export drive have largely exhausted low-hanging investment (i.e., over-stretching) opportunities at home, and their economic growth has slowed, even though business executives are paid a great deal to identify profitable investment opportunities. The West was shocked when Japan emerged as a fierce competitor in the 1970s, pushing many well-known manufacturers out of business and forcing remaining companies to focus on the more difficult Strategy A.

Japan then experienced a similar shock when the Asian Tigers began chasing it in the 1990s, as did the Asian Tigers themselves when Chinese competition appeared in the 2000s. Today, the Chinese are worried that many of their industries and jobs will migrate to Vietnam and other lower-wage countries, even though China's per capita GDP is still significantly lower than that of the advanced economies.

Wages in successful emerging economies will eventually approach the levels of the developed world. However, only countries that leveraged know-how and capital acquired during the pursuit of Strategy B to develop superior products that are necessary for Strategy A have succeeded in breaking into the ranks of developed nations. Those that fail to accumulate the necessary know-how and capital might initially achieve a certain amount of export-driven economic growth, but investment slows once domestic wages rise to a level that makes Strategy B unprofitable. Growth in these countries then stagnates as they find themselves in the so-called middle-income trap.

The middle-income trap refers to the slowdown in economic growth that occurs when rising domestic wages cause a country to lose its status as a low-cost producer. When that point is reached, domestic and foreign companies start moving factories to emerging economies with even lower wage costs. That causes investment and growth to decline unless explicit reforms are undertaken to increase the return on capital, thereby prompting both domestic and foreign companies to continue expanding their investment in the country.

Indeed, only a handful of countries outside the West have managed to escape this trap and achieve advanced-economy status. This short list contains Japan, Taiwan, South Korea, and Singapore, while the number of countries struggling to escape from the trap continues to increase with globalization. As more and more developing countries adopt the export-led growth model and enter the global supply chain, many middle-income countries are facing challenges—in the form of this “trap”—that are similar to those faced by pursued countries.

Demographics and Corporate Investment Decisions

Where do demographics, a favorite subject of economists, fit in this framework? In today's globalized market, domestic demographics should have increasingly less influence on corporate investment decisions—except when a firm has difficulty finding workers or its business is closely tied to the fortunes of a certain geographic region. In all other cases, it should be global demographics that matter for businesses operating in a globalized market.

Amid this diminished influence, an increase in the population will certainly be viewed by businesses as a good reason to expect consumer-led growth if those new additions to the population are able to find jobs and earn income. For those jobs to materialize, however, businesses themselves must feel that demand for their products will increase in the future.

A growing population is certainly one reason for businesses to believe that demand for their products and services will increase. However, few businesses are likely to rely solely on this factor when making investment decisions unless they are a monopoly, or something close to it. Instead, they will probably pay more attention to what their research and development departments are doing relative to competitors at home and abroad. They will also be watching factors that drive short- and medium-term fluctuations in demand, such as the COVID-19 pandemic. In other words, demographic trends are one factor in businesses' investment decisions, but usually not the dominant one.

Demographics may, however, have an outsized psychological influence on investment decisions if growth turns negative. If businesses are unable to find enough employees for their factories, that is a legitimate reason to move the plants overseas. But too often, businesses—even those that are globally active—may use a shrinking population as an excuse to do nothing. The author has encountered many global portfolio investors who skipped Japan altogether because “soon there won't be any Japanese left.” This is in spite of the fact that Japan remains the third largest economy in the world, and its companies still dominate many fields requiring cutting-edge technologies.

Even in those countries where the population is growing rapidly, if new entrants to the labor market are unable to find gainful employment—perhaps because of insufficient education or opportunity—the expanding population will only worsen poverty without adding much to economic growth. If poverty undermines social stability, businesses may be even less inclined to invest, and the country's economic growth will stagnate further. Many developing countries today are suffering from this kind of population explosion and the resulting social unrest.

When war-torn Japan faced this problem of too many people chasing too few jobs and social services in the 1950s, the government actively encouraged emigration of its people to destinations in South America so that those who remained had a chance to advance themselves economically. Many governments in the emerging economies of South and Southeast Asia today are also encouraging their workers to go abroad to reduce overcrowding at home. Some of these governments are even counting on those workers' overseas remittances to bolster their foreign currency reserves.

The fact that such de-population policies have had a positive impact on economic growth in certain developing countries suggests there may be an optimal rate of population growth that varies with the stage of economic development. In other words, both excessively high and excessively low population growth (relative to the optimal rate) can be detrimental to economic growth. Ultimately, the economic growth that relies on population growth is neither desirable nor sustainable because the planet simply cannot take unlimited expansion in human population.

Demographics as Endogenous to Economic Development

Demographic trends are also dependent on the stage of economic development. Before the Industrial Revolution, when most people lived on farms, families tended to have more children because the infant mortality rate was high, and children were expected to work on the family farm. There were also religious pressures in many parts of the world not to limit the number of children.

Once the economy enters the urbanizing industrial age, families tend to have fewer children, but rapidly increasing incomes—especially during the post-LTP golden era—and a fall in the infant mortality rate due to better public health often cause the population to expand, sometimes dramatically. Some of the emerging economies currently exporting workers are facing just this sort of population explosion.

Once the economy enters the pursued phase and becomes a post-industrial “knowledge-based society,” the birth rate falls even further. This happens not only because more women join the workforce, but also because parents realize that only children who receive a good education are likely to do well in such a society. This last point is most prominent in the education-obsessed East Asia, where birth rates have dropped sharply as families decided to have fewer children so that the children they do have can receive a quality education.

This trend has been amply demonstrated by the sustained decline in China's birth rate to the second lowest in the world after South Korea even after the government ended its one-child policy. It suggests that demographic trends are to a large degree endogenous to the stage of economic growth.

The Three-Pronged Reforms Needed for a Pursued Economy to Stay Ahead

In the pursued economies, where there are no more low-hanging investment opportunities and populations are aging, policy makers pushing for growth should concentrate their structural reform efforts on at least three areas. First, they should seek supply-side reforms such as deregulation and tax cuts that are designed to increase the return on capital at home. Second, they should encourage labor market flexibility so that businesses can take evasive action to fend off pursuers. Third, they should revamp the educational system to address both the increased human-capital requirements and the greater inequality that are specific to pursued economies.

These three challenges are unique to countries in the pursued phase, and these three policies are necessary for pursued countries to remain advanced economies. Policy makers must also pay more attention to trade deficits to safeguard free trade, as is explained in Chapter 9, and refrain from relying excessively on monetary policy, as is discussed in Chapter 4.

How the United States Answered Japan's Challenge

On all three fronts of structural reform, it is instructive to start with the real-world experiences of the United States in fending off Japan. This is the story of a pursued country that lost its high-tech leadership and then regained it two decades later. When the United States began losing industries left and right to Japanese competition in the mid-1970s, as is described in Chapter 3, it pursued a two-pronged approach in which it tried to keep Japanese imports from coming in too fast while simultaneously shoring up the competitiveness of domestic industries.

The United States utilized every means available to prevent Japanese imports from flooding the market while pushing for market-opening measures in Japan. These included dumping accusations, the Super 301 clause, various “gentlemen's agreements,” currency devaluation via the Plaza Accord of 1985, and an attempt to revamp the Japanese economy via the Structural Impediments Initiative of 1989. The author was directly involved in the U.S.-Japan trade frictions at that time and can say without qualification that the struggle was neither easy nor pleasant (some of the author's experiences are discussed in detail in Chapter 9).

Meanwhile, “Japanese management” was all the rage at U.S. business schools in the 1980s and 1990s. Harvard University professor Ezra Vogel's Japan as Number One: Lessons for America, published in 1979, was widely read by people on both sides of the Pacific. The business schools also recruited many Japanese students so they could discuss Japanese management styles in their classrooms. The challenge from a seemingly unstoppable Japan, coupled with the U.S. defeat in the Vietnam War, sent national confidence to an all-time low, while consumption of sushi went up sharply.

Reaganomics and Learning How to Run Faster

The United States was fortunate, however, that the supply-side reforms of President Ronald Reagan—who cut taxes and deregulated the economy drastically starting in the early 1980s—addressed the first of the three challenges of pursued economies by raising the return on capital at home. These policies encouraged innovators and entrepreneurs to generate new ideas and products, especially in the area of information technology.

Reaganomics itself was a response to the stagflation of the 1970s, which was characterized by frequent strikes, high inflation rates, substandard manufacturing quality, and mediocrity all around. It was a reaction against organized labor, which was still trying to extend gains made during the post-LTP golden era without realizing that the United States had already entered the pursued phase in the 1970s with the arrival of Japanese competition. The fact that the United States was losing so many industries and good jobs to Japan also created a sense of urgency that a break from the past was urgently needed.

People with ideas and drive began to take notice when President Reagan lowered taxes and deregulated the economy. These people then began pushing the technological envelope in many directions, eventually enabling the United States to regain the lead it had lost to the Japanese in many high-tech areas. Few Americans in the 1980s thought the nation would ever win back high-tech leadership from Japanese companies like Sony, Panasonic, and Toshiba, yet today, even the Tokyo offices of Japanese companies are full of products from such U.S. brands as Apple, Dell, and Microsoft.

In retrospect, “Japanese management” looked invincible in the 1980s, in part, because Japan was in a golden era with numerous positive feedback loops, whereas the United States was already in the pursued era. Today, few people extol the virtues of Japanese management because Japanese companies, now in the pursued era, are grappling with the same problems that confronted U.S. companies three decades ago. Some of them have already gone bankrupt or have been taken over by companies from pursuing countries. Indeed, the author came up with the concept of pursued economies after noticing that Japanese companies today face problems similar to those that U.S. companies struggled with three decades ago. This also implies that both management and labor must change as the economy moves from one era to the next.

The Need for Labor Market Flexibility in Pursued Economies

Reagan also addressed the second policy challenge of pursued economies by pushing hard for a more flexible labor market. This was symbolized by his decision to fire the civilian air-traffic controllers who had gone on strike in defiance of federal regulations and replace them with military controllers. This bold action, widely supported by the public, finally broke the back of the labor unions that were still trying to extend gains made during the golden era.

Once the country enters the pursued phase, the whole economy must become more flexible to enable its businesses to take evasive action to fend off pursuers. Foreign competitors may suddenly show up from anywhere, often with a vastly different cost structure. When faced with such competition, businesses must downsize or abandon product lines that are no longer profitable and shift resources to areas that remain profitable.

These tough decisions—which must be made without delay—make it difficult for firms to maintain seniority-based wages and lifetime employment because both effectively turn labor into a fixed cost and undermine management's ability to take evasive action. Attaining this flexibility is a new challenge that is unique to the pursued era.

In contrast, during the golden era, when a country is a global leader or is chasing someone without being chased by anyone else, there is typically no need for evasive action. With a promising road ahead and no one visible in the rear-view mirror, businesses take a forward-looking approach and focus on finding good employees and retaining them for the long term. Seniority-based wages and lifetime employment are therefore typical features of the golden era—especially at successful companies—since such measures help maintain a stable and reliable workforce. In the United States, IBM and other top companies had lifetime employment systems during the golden era.

Reagan's deregulation, tax cuts, and anti-union actions enhanced the ability of U.S. businesses to fend off competitors from behind. Even though those measures hurt labor and aggravated income inequality in some quarters, chances are high that without them the post-1990 U.S. resurgence would have been much weaker or faltered altogether. After trying everything from protectionism and currency devaluation to studying Japanese management techniques, the United States concluded that when a country is being pursued from behind, the only real solution is to run faster—that is, to continuously generate new ideas, products, and designs that encourage consumers and businesses to over-stretch.

Supply-Side Reforms Need Time to Produce Results

Although the U.S. success in regaining the high-tech lead from Japan was a spectacular achievement, it took nearly 15 years. Reagan's concepts were implemented in the early 1980s, but it was not until Bill Clinton became president that those ideas bore fruit. The U.S. economy continued to struggle during Reagan's two terms and the single term of George H.W. Bush, who had served as vice president under Reagan.

The senior Bush achieved a number of monumental diplomatic successes, including the end of the Cold War, the collapse of the Soviet Union, and victory in the first Gulf War. Yet he lost his reelection campaign to a young governor from Arkansas named Bill Clinton whose only campaign slogan was, “It's the economy, stupid!” Bush's election loss suggests the economy was still far from satisfactory in the eyes of most Americans 12 years after Reaganomics was launched.

Once Clinton took over, however, the U.S. economy began to pick up—even though few today can remember any of his administration's economic policies. Things were going so well that the federal government was running budget surpluses by Clinton's second term. The conclusion to be drawn here is that while supply-side reforms are essential in a pursued economy, it can take many years for such measures to produce macroeconomic results that the public can recognize and appreciate.

The time needed for structural reforms to produce enough domestic investment opportunities for businesses to over-stretch themselves means the government must operate as “over-stretcher of last resort” in the meantime if the economy is in Case 3 or 4. There is simply no substitute for fiscal stimulus in the short run when the private sector is unable to find sufficient domestic investment opportunities to absorb all the savings generated in the economy.

Structural reform is not a panacea, either. Many economists argued for structural reforms instead of fiscal stimulus in post-1990 Japan and in the post-2008 Eurozone. But both economies suddenly lost steam not because of structural problems, but because they were suffering from post-bubble balance sheet problems. And only a government acting as borrower and spender of last resort can help an economy in a balance sheet recession, as is explained in Chapter 2.

The Challenge of Finding and Encouraging Innovators

With regard to the third challenge—having the right kind of educational system to match human capital requirements in pursued economies—the United States was fortunate to have had a long tradition of liberal arts education that encouraged students to think independently and challenge the status quo. Such thinkers are essential to creating the new products and services that are needed by businesses pursuing Strategy A in advanced countries.

The problem is that not everyone in a society can come up with new ideas or products, and it is not always the same group. It also takes an enormous amount of effort and perseverance to bring new products to market. But without innovators and entrepreneurs willing to persevere, the economy will stagnate or worse. The most important human-capital consideration for countries being pursued, therefore, is how to maximize the number of people capable of generating new ideas and businesses and how to incentivize them to focus on their creative efforts.

Only a limited number of people in any society are able to come up with such ideas. They are often found outside the mainstream because those in the mainstream have few incentives to think differently, and only those with an independent perspective can create something new. Some may also show little interest in educational achievement in the ordinary sense of the word. For those who want to create something new, learning about what was discovered in the past often seems a waste of time. Indeed, many successful start-ups have been founded by college dropouts.

Many innovators and potential entrepreneurs may infuriate and alienate the establishment with their “crazy” ideas. If sufficiently discouraged by the orthodoxy, they may withdraw altogether from their creative activities. Finding these people and encouraging them to focus on their creative pursuits is therefore no easy task.

In this regard, the West's tradition of liberal arts education has served it well. In particular, the notion that students must think for themselves and substantiate their thinking with logic and evidence instead of just absorbing and regurgitating what they have been taught is crucial in training people who can think differently and independently.

At some top universities in the United States, students who simply repeat what their professor said may only receive a “B” grade; an “A” requires that they go beyond the lectures and add something of their own. This training encourages them to challenge the status quo, which is the only way to come up with the new ideas and products that are essential for businesses pursuing Strategy A.

Liberal arts education has a long tradition in the West. It started with the Renaissance and the Enlightenment, when the value of the human intellect was finally recognized after being suppressed for centuries by the Catholic Church. This long struggle to free the intellect from church authorities was not an easy one, and many brilliant thinkers were burned at the stake. Societies that went through this long and bloody struggle therefore tend to cherish the liberal arts tradition.

Societies that did not experience such struggles, however, may have to guard against the tendency of the educational hierarchy to worship “authorities” to the detriment of independent thinkers. Once such a hierarchy is established, it becomes difficult for new thinkers to gain an audience, especially when their ideas challenge the orthodoxy. The implication here is that citizens' creativity may not be fully utilized in societies where the educational establishment and other authorities continue to act like the Catholic Inquisitors of the past.

One problem, however, is that a true liberal arts education is expensive. It requires first-rate teachers to guide and motivate students, and those persons with such abilities are usually in strong demand elsewhere. Tuition at some of the top U.S. universities has reached almost obscene levels as a result. Furthermore, the ability to think independently does not guarantee that students will immediately find work upon graduation. As such, this type of education is usually reserved for those who can afford it, which exacerbates the already worsening income inequality in pursued economies as is noted in Chapter 3.

The Need for the Right Kind of Education

In contrast, the cookbook approach to education, where students simply absorb what teachers tell them, is cheaper and more practical in the sense that students at least leave school knowing how to cook. The vast majority of the population is exposed only to this type of education, where there is limited room to express creative ideas or challenge established concepts. Creative minds may be buried and forgotten in such establishments, like the proverbial diamonds in the rough.

In pursued economies, teachers in all schools should be asked to keep an eye out for students who seem likely to come up with something new and interesting. Once found, those students should be encouraged to pursue their creative passions.

The United States always had an excellent system of liberal arts education that encouraged students to challenge the status quo. It was therefore able to maintain the lead in scientific breakthroughs and new product development even as it fell behind the Japanese and others in manufacturing those new products at competitive prices.

In contrast, many countries in catch-up mode adopted a cookbook-style approach to education, which can prepare the maximum number of people for industrial employment in the shortest possible time. When a country is in catch-up mode and pursuing Strategy B, this type of system often appears sufficient because the hard work of inventing and developing something new is already being done by someone else in the developed world.

However, these countries will have to come up with new products and services themselves once they exhaust the low-hanging investment opportunities stemming from urbanization and industrialization. The question then is whether they can modify their educational systems to produce the independent and innovative thinkers and entrepreneurs needed for Strategy A in the pursued era. This can be a major challenge if society has discouraged people from thinking outside the box for too long since both teachers and students may be unable to cope with the new task of producing independent thinkers.

Although people in most societies can recall the names of famous native innovators and entrepreneurs, the issue for national policy makers is whether there are enough people like this to pull the entire economy forward. All the advanced countries are now in the pursued era, and they all need more innovators. Policy makers must therefore work harder to create an environment that will allow innovators to flourish. Countries with large populations may also need more innovators.

The Increased Importance of Education in the Pursued Era

Education also has a bigger payoff in the pursued era because a worker's income depends more on individual abilities than in the golden era, when it was often determined by macroeconomic factors such as GDP growth and by institutional factors such as union membership.

Moreover, businesses in the pursued era will not be investing as much in productivity-enhancing equipment to increase worker productivity as they did in the golden era. Even if they did, those investments would not benefit the workers as they had during the golden era. This means workers must take responsibility for educating themselves and expanding their skill sets if they want to improve their living standards.

The fact that workers are on their own in the pursued era also means inequality will worsen compared with the manufacturing-led golden era if workers do not improve their own skills. This makes education one of the few areas in which policy makers can address the pursued era's inherent tendency to exacerbate inequality.

This inequality problem, both real and perceived, has grown to the point where everything has become more difficult, including the reforms needed to overcome the challenges faced by the pursued economies. The difficulty has arisen in part because low or nonexistent wage growth for a large part of the population in pursued economies has made the average person less tolerant and forgiving compared with the golden era, when everyone was enjoying rising wages.

Ensuring equal access to a quality education is one area where policy makers can help reduce inequality in the pursued era. Given the high social and political costs of inequality in the advanced countries today, addressing this issue with improved educational access and quality makes good economic sense.

Unfortunately, this is one area where President Ronald Reagan failed miserably. Although his supply-side and labor-market reforms were essential for a pursued economy, he swung to the other extreme on education by drastically cutting federal spending. As Peter Temin of the Massachusetts Institute of Technology pointed out, this is one of the key reasons why inequality and the social divide in the United States have become such a big problem three decades later.³ If Reagan had understood that improving education is one of the three necessary policy initiatives for pursued economies, the U.S. social divide would be much smaller than it is.

Donald Trump made the same mistake. Although his supply-side reforms and efforts to help domestic manufacturers instead of Wall Street financiers were laudable, he also cut the federal budget for education. This worsened the nation's already serious inequality problems and made it more difficult to implement the policy changes needed to overcome the challenges of a pursued economy.

The Challenge of Keeping Students in School

Education is also far more important in the de-industrializing pursued era than in the manufacturing-led golden era because most good jobs in the former are in “knowledge-based” sectors requiring higher levels of education. In some countries, including the United States, the challenge in terms of education starts with the need to keep students in school long enough to learn something useful. Former Fed Chair Janet Yellen noted in a speech on June 21, 2016, that the median U.S. income is $85,000 for Asian-Americans, $67,000 for whites, and $40,000 for African Americans.⁴ And this order is consistent with the number of years they spent in school.

From the author's own experience with both the Japanese and American educational systems, this gap is due, at least in part, to the fact that many, if not most, Asian youth are brainwashed to the extent that the option of not studying no longer exists in their minds. The default option is to spend most of their waking hours studying.

When the author attended a Japanese elementary school as a boy, his school happened to have no classes on Saturdays, when nearly all other schools in the country did. When the author left the house on Saturday mornings, he was frequently stopped by adults asking him why he was not in school, as though he were some kind of delinquent. And each time he had to explain that his school had no classes on Saturdays. This shows just how much social pressure there was on every child in Japan to be in school studying five and a half days a week.

When the author moved to the United States at the age of 13 and enrolled in a public junior high school, he was shocked to find that many students there had no intention of studying at all. It came as a surprise because the idea that a 13-year-old could get away with not studying was unthinkable for someone from East Asia. And he envied these students because they seemed to enjoy their teenage lives much more than he did.

Fifty-five years later, some of those who neglected their studies might regret their decisions. But 55 years ago, in the midst of the “Golden Sixties,” many of them probably thought they could make a decent living without studying so hard. At the time, the United States was in its golden era, and it was quite possible for someone without an advanced degree to buy a three-bedroom house and a car with a V-8 engine, automatic transmission, and power steering.

Many of them saw their parents, who also lacked advanced degrees, still doing relatively well and assumed that the good life was within easy reach. Little did they know that the well-paying manufacturing jobs that generated rising wages for their parents would be lost to pursuing economies and that their lack of education would prevent them from moving higher up on the jobs ladder.

In retrospect, it could be said that the good life experienced during the golden era, when everyone benefited from economic growth, created a false sense of security for many who came to believe it would continue forever. Thus they were caught totally off guard when the United States entered the pursued phase.

Had they grown up in a country where they could see what happens to workers when a country enters the pursued phase, they probably would have been more diligent students. But there was no example for them to follow in the United States and Western Europe because they were the first ones in history to experience this phase of economic development. In a sense, those who did not apply themselves to their studies constitute a lost generation, since it is now too late for many of them to go back to school. These frustrated people blame their plight on visible targets such as immigrants and imports. Many of them also supported Donald Trump's “America First” policies. Their inclination to support extreme-right agendas, however, does not change the fact that they themselves lack the skills today's businesses need. Although their frustrations are understandable and some social safety net must be provided, at the end of the day people must realize that they need to acquire skills that are in demand since the clock cannot be turned back.

The High Price of Asian Educational Achievement

Many Asian-Americans, on the other hand, are the offspring of recent immigrants or are first-generation immigrants themselves. For centuries, China (starting in 598 A.D.) had an imperial examination system that assured upward social mobility for the educated. In Japan, Korea, and Taiwan, the focus on education was such that the largest building in most villages, towns, and cities a century ago was often the public school rather than city hall or mansions for the well-to-do.

With so much emphasis on education, the cultural imprinting to study hard still affects many of their offspring in the United States and elsewhere. Because of this cultural straitjacket on the issue of educational achievement, even the dimmest Asian student ends up studying and acquiring some useful skills. They may not be the most creative or articulate within their respective fields, and aspirations and talents that fell outside the confines of formal education may have been suppressed to the detriment of their self-actualization and true happiness, but at least they earn a decent paycheck.

Indeed, an Organisation for Economic Co-operation and Development (OECD) survey of “life satisfaction” among 15-year-olds in 2015 indicated that Japan ranked 42 out of 47 countries, followed by South Korea, Taiwan, Macau, Hong Kong, and Turkey.⁵ In other words, the youth in these countries are having a miserable time. Meanwhile, the same East Asian countries all placed in the top 10 in the latest OECD scientific literacy tests. These results suggest the cultural differences regarding education that the author experienced 50 years ago still hold today—that is, educational achievement in Asia comes at a high cost. But those who study manage to earn a decent living, which pushes up the average income for the group.

For the other two groups, which do not have such a pervasive cultural straitjacket, much depends on the family or environment in which the child is raised. This is because it takes 15 years or more to realize the payoff from education. At a time when it is said that American corporate executives can only see as far as the next quarterly earnings report, it is a tall order for a child to commit to education when the economic payoff of such effort is 12, 16, or even 20 years away. Most students will therefore need a great deal of outside support to continue their long educational journey.

Those from families and communities with a strong commitment to education will naturally go further than those who do not enjoy such support. Even in households where parents are often absent or too busy to help, being a “nerd” is not so painful if the student is surrounded by hard-working classmates. But studying can be very hard for youths who do not receive support and encouragement to stay in school when others like them seem to be having so much fun outside school.

It is these youth who need help, because their eventual inability to contribute to the economy will be a loss to the entire society. They must also be made aware that they are now effectively competing with youth in the emerging world who are studying and working hard to achieve the living standards of those in the developed world.

An advanced degree is not for everyone, of course, but all students need to know what they are good at and what they enjoy doing so they can make appropriate choices given their personal circumstances. The emphasis on personal strengths and circumstances is important because workers in the pursued phase are really on their own, and the chances are high that they will not do well in a field they do not enjoy.

This means counselors advising students at regular intervals might have just as big an impact on the student's (and society's) final educational outcome as teachers and parents. In addition to supporting students who need outside encouragement to further their education, these counselors can help students discover what they are good at and what they enjoy doing so they can be directed to areas where they are likely to succeed. If possible, these counselors should also be trained to spot independent thinkers and encourage them to pursue their ideas further.

The Importance of a Proper Tax and Regulatory Environment

To maximize people's creative potential, countries in the pursued phase must also revamp their tax and regulatory regimes. It must be emphasized that to create something out of nothing and bring it to market often requires so much effort that “any rational person will give up,” in the words of Steve Jobs. In a similar vein, Thomas Edison famously claimed an invention is 1 percent inspiration and 99 percent perspiration.

Although some people are so driven that they require no external support, most find outside encouragement important during the long, risky, and difficult journey of producing something the world has never seen before. Financial, regulatory, and tax regimes should therefore do everything possible to encourage such individuals and businesses to pursue their pioneering efforts.

Thomas Piketty cited the retreat of progressive tax rates as the cause of widening inequality in the post-1970 developed world.⁶ But the United States, which led the reduction in tax rates, has regained its high-tech leadership while Europe and Japan, which did not go as far as the United States, have stagnated. This comparison suggests that tax and regulatory changes might have to be drastic enough for people to take notice.

The United States is considered one of the most unequal countries in the developed world, with the top few percent owning a large share of the nation's assets. But those at the very top are mostly founders of new companies (Figure 5.1) who have transformed the way people live and work around the world. Except for Warren Buffett, who made his money investing in the stock market, all of them became rich by taking risks and bringing something completely new and useful to the world.

There are some further down the list who made money in largely zero-sum financial or real estate investments or through established companies and inheritance. But in no other country is the list of the wealthiest people dominated by those who have created transformative technologies. The fact that seven of the top eight in the United States are self-made individuals with transformative ideas suggests that inequality has different implications in the United States than in other countries, where the top ranks are dominated by more traditional and established types of wealth.

Figure 5.1 suggests that the gradualist approach preferred by the traditional societies of Europe and Japan may not work well when a drastic push in innovation is required as the economy enters the pursued era. This outcome also suggests that a tax regime that was reasonable when a country was not being pursued may no longer be appropriate when it is.

The Importance of Interpreting Inequality Statistics Correctly

One should also be careful when interpreting data on inequality, which are often presented as though we still live in an agricultural society. The key asset in an agricultural society is land. When data for such societies say the top 10 percent of the population owns 60 percent of the wealth, it is safe to assume that the other 90 percent is either crowded into slums in the remaining 40 percent of the country or is relegated to the status of sharecroppers with no hope for economic advancement.

Today, however, the wealth possessed by the richest individuals in the United States consists chiefly of shares in the companies they founded. For example, 91 percent of Jeff Bezos' wealth consists of shares in his own companies. The ratio is 97 percent for Mark Zuckerberg and 85 percent for Elon Musk. The shares in those companies are valued by the market and the public, not by an expropriation decree issued by a monarchy or a dictator. In other words, it is wealth that is created instead of being taken or stolen from others.

An increase in the wealth of these individuals therefore does not entail a decrease in the wealth of others, although that is what is often implied by those presenting such data. Moreover, most people in the advanced countries can lead dignified lives even if they are not especially rich.

In those agricultural societies where land ownership is largely in the hands of a privileged few, land reforms that give ownership rights to former sharecroppers often result in vast improvements in productivity and economic well-being. Similar expropriation policies in advanced countries today, on the other hand, might discourage risk-taking and over-stretching to such a degree that the economies would implode.

There are also certain risks that only wealthy individuals can take. Institutional investors and banks must comply with a host of governance rules designed to prevent the public's money from being exposed to excessive risk. But those rules make it difficult for such institutions to invest in start-ups, where failure rates are high but new ideas are often incubated and hatched.

It is said, for example, that only one in eight start-ups succeed. In other words, investors in this space typically experience seven failures before seeing a single success. Fund managers in banks or pension funds cannot post such a high failure rate and hope to keep their jobs. A rich individual who is accountable only to him- or herself, on the other hand, can allocate a certain amount of his wealth to such investments and wait out the seven failures to reach the one winning bet.

The United States also has an ecosystem of highly successful individuals who help nurture start-ups as venture capitalists. That has allowed the nation to stay ahead of other countries in many areas. While this system tends to make the rich even richer, it actually creates wealth instead of taking it away from someone else.

It is therefore time to treat inequality statistics in the advanced countries with a little more caution. They are not equivalent to land ownership data in agricultural societies.

Better Distribution of Medical Care or More New Medicine?

Another frequently raised inequality issue in the United States is the high cost of medical care. This is important because most Americans, who are brought up in the pioneering spirit of self-reliance, really do not want to talk about inequality as long as they are earning a living wage and have a dignified life.

Their rugged sense of self-reliance, however, could be shattered overnight with a catastrophic medical bill. Indeed, a huge share of personal bankruptcies filed in the United States is due to this cause. Even for those who are lucky enough to be healthy and have good health insurance, the fear that they might lose one or both at any time is undermining their faith in the system.

There is a huge room for improvement in the U.S. medical industry, especially in comparison to those available in Japan and some other countries. For example, an appendicitis operation in the United States can easily cost 20,000 dollars when the same operation in Japan can be done for only 3,000 dollars.⁷ Although Japanese doctors frequently complain that they are not paid enough, this one-to-seven difference in cost is adding to the sense of inequality and insecurity among many people in the United States. In other words, if an average American faced Japanese medical bills, his or her sense of inequality would be far less.

At the same time, it is said that almost all new drugs that are brought to the market in the world today are developed in the United States. This is because the United States does not impose a cap on drug prices the way it is imposed in very many other countries, including Japan. As a result, drug companies can recoup the enormous cost of developing a new drug only in the United States. This is indeed one of the reasons why the medical cost in the United States is so high.

If the United States imposed a cap just like the one in Japan, chances are high that the research and development on new drugs will come to a standstill, which it almost did when Hillary Clinton tried to devise a national health insurance with a cap on drug prices when her husband was the President of the United States. Some would argue that such a stoppage in medical research would be against the interest of humanity.

This American preference on growth and progress instead of on redistribution served the country well during its golden era because its strong manufacturing-led growth improved the life of everybody and reduced inequality, as is noted earlier. The question is whether the same trade-off is appropriate in a pursued economy where inequality is destined to rise with highly undesirable social consequences.

The Importance of Entrepreneurs in Over-Stretching

A country may have great workers, engineers, accountants, and lawyers, but it is the entrepreneur who brings them together in an enterprise to produce goods and services. Of all the economic resources in a country, entrepreneurial talent is probably the most valuable for economic growth because without it very little over-stretching takes place. This can be seen from the fact that economies of communist countries that assigned zero value to entrepreneurship all ended up stagnating for decades. The communist disdain for entrepreneurs can be gleaned from the fact that Karl Marx extolled workers to simply overthrow the capitalists and run the factories themselves.

Workers, at least in the short run, may be able to operate the factories because they are the ones actually doing the job. But it is unrealistic to expect them to come up with new products to fend off competitors or to secure financing to put those new products into production, to say nothing of the need to maintain and expand marketing efforts both at home and abroad. After all, these undertakings require extensive knowledge of technology, finance, management, and marketing.

They also require stressful risk-taking at every step of the decision-making process. And many, if not most people, are happy to stay out of such stressful settings if they can help it. But without the ability to address all the issues required to bring new products to market, there is no reason for firms to over-stretch. It is no coincidence that most factories in communist Eastern Europe, Russia, China, and elsewhere ended up producing the same old (and obsolete) items for decades—after all, there was no profit motive to justify taking risks to develop new products and expand the business. By attaching zero value to entrepreneurship and not rewarding risk-taking, Communist countries denied themselves access to such resources and ended up stagnating for decades.

Most capitalists, on the other hand, became capitalists by proving themselves willing and able to address the issues noted above to build a successful business. Since pursued economies always need new drivers of growth, it is vitally important that their governments provide as much opportunities as possible for those who are willing to put up the effort to start something new.

The Renewed Attraction of Socialism and Difficulty of Achieving Public Consensus

Unfortunately for many countries, economic and educational reforms previously mentioned are often derided as “favoring the rich” or “elitist” and rejected out of hand by those with a golden-era mindset. When an economy is in a golden era with a surfeit of investment opportunities, the rejection of such policies may not lead to a noticeable economic slowdown. But in a pursued economy that needs to outrun its chasers, the inability to fully utilize the innovative and entrepreneurial potential of its people can have devastating consequences. The nation's future growth may well depend on how quickly it can achieve a social consensus on developing growth-friendly infrastructure, such as a liberal arts education system and innovator-friendly financial, regulatory, and tax regimes to maximize the population's innovative capacity.

This may require a new consensus in which those who are unable to think outside the box understand and appreciate the fact that their well-being depends on those who can. Indeed, in the pursued phase the entire society must understand that such thinkers are essential to generating the new investment opportunities at home that will keep the economy out of prolonged stagnation.

This is far from easy, however. As Piketty noted, inequality in the West began increasing in the 1970s and has reached alarming levels in some countries. This increasingly unequal distribution of income is dividing society between the haves and the have-nots and is making it difficult to reach a social consensus of any kind. But without social consensus, the reforms needed to meet the challenges of a pursued economy will not be possible.

It has also been reported that among young people in the United States today, the word socialism does not have the same bad connotations it had among the generations that fought the cold war. For example, the January 17, 2020, Wall Street Journal wrote that “Fifty percent of adults under 38 told the Harris Poll last year that they would ‘prefer living in a socialist country.' That outlook recurs in many more surveys and far surpasses figures from even the radical heydays of the '60s and '70s.”⁸ This 50 percent probably feels that with a heavy student loan burden, high housing costs, and prohibitive medical bills, the present system is working only for the old and the rich, and that the deck is stacked against them.

The continued popularity among the young of leftist politicians such as Bernie Sanders and Elizabeth Warren also reflects this dissatisfaction. That means some rebalancing of priorities in the United States is imminent because the weight of these younger voters will only grow in the future. However, that rebalancing must be in the right direction if it is to benefit the public.

This is because the pursued era imposes new constraints and dynamics on the economy that did not exist during the golden era. In particular, the return on capital must be raised in order to create more investment and jobs at home. That means lower, not higher, taxes on those who are making investment decisions. This is the opposite of the traditional leftist agenda pursued by the two politicians previously noted. It is indeed ironic that the young people who are complaining about inequality and espousing socialism are also the most avid users of devices and services pioneered by those sitting atop the list of America's richest.

Making Established Political Parties Relevant Again in the Pursued Era

In traditional politics, conservatives push for supply-side reforms such as a balanced budget, lower taxes, and deregulation (i.e., small government), while progressives push for greater expenditures on social programs such as education (i.e., big government). In the golden era, when reasons for businesses to over-stretch were plentiful and the economy was growing rapidly, the lack of supply-side reforms did not appear to slow down the economy in any meaningful way. In other words, this political choice was a matter of preference.

In the pursued era, however, both supply-side reforms and additional spending on education are needed to support economic growth and maintain social unity. In other words, reduced education budgets and a lack of supply-side reforms will weigh noticeably on economic growth in the pursued phase.

Some of this can already be inferred from the vibrancy of the U.S. economy, where supply-side and labor market reforms have been implemented, relative to the less-than-impressive growth rates of Japan and Europe, where such reforms have been more gradual. At the same time, the U.S. neglect of education has led to much worse social polarization and political deadlock than in Europe or Japan. Although the neglect of education during the last four decades in the United States will take decades to correct, access to quality education is where the battle to contain inequality must be fought because workers in the pursued era are really “on their own” and must continue to educate themselves.

More specifically, both conservatives and progressives must adjust their stances to meet the challenges of a pursued economy. For example, the Biden Administration talks a great deal about the importance of creating good union jobs as it seeks to regain the support of blue-collar workers who voted for Trump in 2016. Labor unions had a role to play during the golden era, when the economy was moving along the upward-sloping labor supply curve in Figure 3.1. But in the pursued era, when the global labor supply curve is basically flat at wage level Q, not only do the unions lack the leverage needed to increase wages, but focusing on their demands could also reduce both labor market flexibility and the return on capital at home. Both of these factors will encourage even more firms to relocate production to emerging economies.

The same golden-era legacy problem also afflicts conservatives in America. Until Trump hijacked the Republican Party, it had long been advocating for small government and a balanced budget. The drive to balance the budget had an important role to play during the golden era, when there was a real danger of government borrowing crowding out private-sector investments. But it is extremely problematic in the pursued era, when the private sector as a whole is often a huge net saver even with zero interest rates, meaning the government must serve as borrower of last resort to keep the economy from spiraling downward. This need is even greater when the pursued economy is also in a balance sheet recession.

On a more positive note, progressives' emphasis on infrastructure spending and improving education is essential both to stabilize the macroeconomy and to counter the tendency for inequality to increase in the pursued era. Similarly, conservatives' focus on lower tax rates and deregulation at the microeconomic level is essential during the pursued era because such measures will increase domestic returns on capital and thereby ensure that more investment takes place at home.

That said, a thorough vetting of infrastructure projects is needed to ensure that they are self-financing so that such spending can be sustained over the long run. On education, schools must encourage independent thinking in the liberal arts tradition while directing students to what they are good at so they stay longer in school to learn something useful.

In short, both conservatives and progressives have to readjust their traditional stances to remain relevant in the pursued era. For those who devoted their entire lives to balancing budgets or expanding the power of labor unions, this is a big challenge. But center-right and center-left parties must reinvent themselves to meet the challenges of a pursued economy if they hope to prevent left- and right-wing extremists peddling nonworkable solutions from gaining influence.

Advanced Economies Are Fighting Two Wars

To make matters worse, most advanced economies fell into a balance sheet recession when their housing bubbles burst in 2008. This exacerbated the shortage of borrowers that began toward the end of the 20th century, when these countries entered their pursued phases. The balance sheet recession was followed by the devastating COVID-19 pandemic recession of 2020. Because fiscal stimulus was needed to fight both recessions, these countries are now saddled with a huge public debt.

When faced with such a large public debt, the natural tendency of economists and policy makers with a golden-era mindset is to raise taxes wherever possible to reduce the debt while ignoring the bond market's pleas—expressed in the form of exceptionally low bond yields—not to do so. But such wanton tax hikes may discourage businesses from investing aggressively in innovation, thus prolonging the period of subpar economic growth.

That means economies currently emerging from balance sheet and pandemic recessions need to resist the temptation to raise taxes and thereby thwart innovation and over-stretching. They need to resist that temptation if the economy is to gain the escape velocity needed to fend off pursuers. This is particularly important in Japan, where public debt levels are high and an orthodox (i.e., golden-era) mindset still dominates the bureaucracy, academia, and the media.

Most advanced countries today are fighting two wars: one because they are in balance sheet recessions and another because they are being pursued by increasingly sophisticated emerging economies offering attractive returns on capital. They have also been battered, like all other countries, by the COVID-19 pandemic. This means the escape velocity needed for their economies to regain forward momentum is exceptionally high. The leaders of these countries must therefore realize that tremendous effort will be needed to reach that velocity.

Of all the pursued economies, the United States probably comes closest to having achieved a consensus on the need for a growth-friendly tax regime, which is why it attracts innovators from around the world. But with the rich growing ever richer while the remaining 80 percent of the population has seen little income growth for the last 20 years, the temptation to undo what was achieved in the past is growing stronger. The social backlash includes a drive to raise taxes on the wealthy from the left and to block immigration from the right. The anger of the 80 percent was also behind the support Donald Trump and Bernie Sanders received during the 2016 and 2020 presidential campaigns.

The political challenge for pursued countries, therefore, is how to persuade voters to maintain and improve the innovator-friendly tax regimes needed for economic growth when the public debt is so large and inequality so pronounced, with the vast majority of the population experiencing no real income growth for many years.

A Case Study in Bad Taxation: Japan's Inheritance Tax

If a pursued country with an aging or declining population is to sustain economic growth, which is the case for many advanced countries today, it must maximize the productivity of its working-age population, and especially those who are able to create new products and transform them into viable businesses. This is because new, well-paying jobs are likely to come only from new businesses when a country is being pursued. If the country keeps on doing what it has always done, it will be overtaken by emerging economies with younger populations and lower wage costs. Each country in the pursued phase must therefore ask itself whether its tax and regulatory regimes are maximizing the productivity of the people capable of developing new products and services.

In Japan, it has been said that many of the successful people who took risks and worked hard to build and expand businesses are now spending much of their time worrying about inheritance and gift tax liabilities. It is quite sad to see so many capable people with excellent track records talking about such a backward topic when they could be spending their time expanding their businesses and chasing their dreams.

They are worried because the top rates for inheritance and gift tax in Japan are 55 percent and 65 percent, respectively, and the tax-free ceiling was lowered in 2015 to just $300,000 (at an exchange rate of $1 = ¥100). The tax rate starts at 10 percent for assets worth less than $100,000, but climbs rapidly to 40 percent at $1 million. In contrast, the U.S. tax liability on inheritance does not kick in until the amount reaches $11 million, and countries such as Australia have no inheritance tax at all.

The concerns of successful Japanese can be gleaned from the fact that the country's bookstores today are full of books about this tax and how to minimize it. It is also common knowledge that a key reason for the boom in Japan's real estate market is that property offers a way to reduce inheritance tax obligations. The boom underscores just how distorted Japan's allocation of resources is. After all, this is a country where the population is shrinking, and unoccupied homes are a major social problem.

This represents a tremendous waste of human and physical resources that Japan, with its shrinking population, can ill-afford—far too many capable people with a successful track record are distracted by this tax. Individuals who should be expanding their businesses or developing induced pluripotent stem (iPS) cells are instead wasting time and mental focus on managing rental properties, which is something that anyone could do, simply because of the inheritance tax.

As Steve Jobs's remark indicates, few people in any society are able to build a successful business because ordinary people simply cannot withstand the stress. Academics and bureaucrats do not create jobs. Only those with vision who can withstand the stress of building and expanding a business are able to create jobs. As Japan is already suffering from one of the lowest rates of new business formation of any advanced country, the country desperately needs such people.

A shrinking population also means productivity must be raised to maintain the existing level of economic activity. This means resources must be allocated as efficiently as possible to enhance productivity. But in Japan the opposite is happening, and the economy has stagnated as a result.

Taiwan Slashed Inheritance Tax and Gift Tax Rates to 10 Percent

What should be done about this issue? Taiwan's recent experience may offer some clues. The administration of President Ma Ying-jeou implemented bold tax cuts in 2008, slashing the top inheritance and gift tax rates to 10 percent.

Like Japan, Taiwan is being chased by the emerging economies of China and Southeast Asia, and its working-age population began to shrink in 2015. With no language barrier between Taiwan and China, the challenges facing economic policy makers in Taiwan are substantial, which is precisely why they implemented the bold tax cuts noted above.

The Taiwanese authorities initially assumed the lower rates would reduce tax revenues substantially, but in the event, tax receipts did not fall at all (Figure 5.2). Moreover, funds that had been fleeing Taiwan for decades because of concerns about the tax and military tensions with Communist China began to return, providing a major support for the Taiwanese economy in the immediate aftermath of the Lehman Brothers' collapse.

Tax revenues did not fall because people who had been spending time and resources to reduce their tax burden decided that at 10 percent it was no longer worth the effort. They decided to pay the 10 percent so they could use their time and resources more productively elsewhere. And because tax revenues did not fall, the lower tax rate did not reduce the funds available for the less fortunate.

From the perspective of the broader economy, the fact that the tax cuts eliminated distortions in the allocation of resources was far more important than any change in tax revenues. All the time and resources that had been devoted to avoiding taxes were now being channeled into more productive pursuits.

If Japan were to lower its highest inheritance and gift tax rates to 10 percent, a great deal of financial and human resources that are either fleeing overseas or going to all the wrong places would come back to where they belong. Such a cut would also encourage the intergenerational transfer of assets in a country where wealth is concentrated in the hands of senior citizens, who typically have a lower propensity to consume. Most importantly, the tremendous distortions in resource allocation that have resulted from efforts to avoid the inheritance tax would disappear as people decide that such efforts are simply not worth their time at a tax rate of 10 percent. While it is difficult to say whether inheritance and gift tax revenues would increase or decrease relative to the current figure of around 2 trillion yen if a 10-percent rate were introduced, even a small decrease would be worth it if the change freed up increasingly precious entrepreneurial resources for forward-looking projects.

The Global Implications of Taiwanese Tax Cut

The revenue-neutral result of Taiwan's drastic cut in inheritance and gift tax rates in 2008 was a pleasant surprise for the local tax authorities. But its implications are far greater because this example proved it is possible to lower tax rates drastically to improve resource allocation in the economy without suffering from reduced tax revenues. This implies that similar possibilities may exist in other countries with different tax regimes if the tax authorities in those countries would carefully recalibrate their tax rates to achieve Taiwan-like results.

This also suggests there is a huge potential for tax specialists in all countries to look for similar unexplored possibilities in their own tax regimes. And the key here is that for people to change their behavior, the tax cuts must be large enough to be noticed.

When the West was in its golden era through the 1970s and had no competitors, and when Japan was in its own golden era, chasing the West but facing no competitors of its own, the entire population benefited from economic growth. Given the surfeit of investment opportunities that characterizes the golden era, efficiency losses from the income redistribution function of taxation were not large enough to derail businesses' desire to over-stretch. The fact that golden-era economies were inflationary despite growth-discouraging tax rates and higher interest rates shows just how abundant domestic investment opportunities were.

But now that Japan and the West are being pursued, they will find themselves in a serious predicament if they maintain the golden-era approach to taxation and regulation. The fact that these economies had all suffered from years of near-zero inflation rates despite astronomical monetary easing and zero or negative interest rates indicates just how limited real domestic investment opportunities are.

Tax and regulatory distortions can be found in all countries, even though the source of the distortions may differ considerably. The ultimate goal of regulatory and tax reforms in pursued economies, therefore, should be to minimize the time people spend on tax avoidance and to maximize the time they spend on activities they are good at.

How to Reorganize Society for the Pursued Phase Is an Open Question

How a society should best reorganize itself for the pursued phase has yet to be decided. There are many questions that need to be answered. What are the appropriate labor practices when so many workers are unhappy with wages that have stagnated for the last two decades? What is the best kind of educational system when a traditional liberal arts education is so costly? How should society encourage innovators without appearing unfair to those who are not blessed with similar abilities? How should society help those who were caught off-guard and are now too old to go back to school? And finally, how should society prepare young people to cope with this unprecedented new environment? All of these represent massive challenges for society and the political system.

There is also a mounting social backlash against measures to encourage innovators and increase labor market flexibility. Even in Taiwan, the top inheritance tax rate was rolled back to 20 percent from the original 10 percent by the new government of President Tsai Ing-wen in 2017. Such setbacks indicate how difficult it is for social institutions to change to match the needs of the new pursued era.

Many authorities, economists among them, are also patiently waiting for a return of the golden era by clinging to a 2-percent inflation target even though the underlying economic realities have changed dramatically since then (this issue is discussed further in Chapter 6). But the delay in implementing the necessary reforms only shortens the distance between the pursued and the pursuing, eliminating the advantages the former had over the latter.

For many traditional societies in Europe and Japan, some sort of shake-up may also be needed to open fields to outside-the-box thinkers. In Japan, decades of economic stagnation and the diminished appeal of established companies are prompting college graduates to consider starting businesses for the first time in many decades. This is a welcome development in a country where tradition and authority still carry a great deal of weight. Some younger engineers in Japanese firms, for example, find it difficult to challenge the achievements of older engineers in the company because such actions can be viewed as a sign of disrespect. Such seniority-based rigidity has discouraged innovation in the country in no small way.

Some European designers are also migrating to the United States and Australia to free themselves from traditional constraints on how and where they can express their creative talents. Tradition-bound societies therefore desperately need new businesses that are open to new ideas and innovations.

If the domestic environment is not producing enough innovators, the government may want to consider importing creative thinkers and innovators from abroad. The immigrant-friendly United States is full of foreign-born innovators competing with each other and with native innovators in universities and the business world.

Generous tax treatment of stock options for innovating companies may also be useful. Since these incentives do not cost the government anything until the private-sector risk-taker actually succeeds, they are cost-effective as well.

If the tax and regulatory incentives are not sufficient, the government itself might have to function as innovator of last resort to develop new technologies or open up new fields of research. This is not such a far-fetched idea either. As Richard Duncan pointed out in his The Money Revolution, the U.S. government was by far the biggest investor in research and development (R&D) in the country from 1953 to 1979. In the decade that followed the Sputnik shock of 1957, it invested twice as much in R&D as the business sector did. Today the government’s investment is just one-third of those investments made by the businesses. Such targeted spending on research by the government is likely to encourage the private sector to follow by launching new businesses that might not have existed unless the government had taken the lead.

Preparing Emerging Economies for the Future

What can emerging economies learn from the experiences of advanced countries today? For those that have yet to enter the middle-income trap, policies essential for growth include providing necessary infrastructure, eradicating corruption, improving education and public health, and adopting a disciplined monetary policy to keep borrowing costs within reasonable limits. These policies must be implemented while pursuing the easier Strategy B so that when wages become high enough to attract competition from other emerging economies, the country will have accumulated sufficient physical and human capital to switch to Strategy A.

Authorities should also operate on the assumption that the rapid growth in tax revenues typical of the golden era will diminish going forward. Projects that must be financed with taxes should therefore be implemented while the economy is still in the golden era. They should also take note of the never-ending rollbacks of the pension-eligible retirement age in nearly all developed countries. These rollbacks prove that the original pension schemes, introduced during these nations' golden eras, were based on overoptimistic assumptions about growth and demographics.

They should also modify and refine their education systems so as not to discourage out-of-the-box thinkers. Even though such people may seem to be of limited value when a country is pursuing other economies, they will become the key drivers of growth when it enters the pursued stage. A nationwide system of liberal arts education should be introduced to encourage students to think independently so that they can one day challenge the status quo and come up with new ideas and products.

Emerging countries that are now enjoying the post-LTP golden era will eventually reach the pursued phase with all its challenges. With so many emerging economies joining the globalization bandwagon, those changes may arrive sooner rather than later. Some of the new entrants to globalization will lower the wage level Q for pursued economies, as China probably did when it entered the WTO. That means institutional arrangements such as tax codes and regulations should never be viewed as permanent and may have to be modified as the economy moves from one stage to the next.

On the other hand, historical buildings and neighborhoods with cultural value should not be torn down in the name of modernization. The more rapidly a country develops, the more important this cultural heritage becomes because people in a rapidly changing environment need to be able to put down psychological roots. They need psychological homes where they can reaffirm who they are and whence they came. Historical neighborhoods and monuments also attract foreign tourists, which can help the country earn foreign exchange.

In this sphere, emerging countries should learn from Europe, which attracts a huge number of foreign tourists every year because it kept its beautiful architectural heritage largely intact. Even though Europe's high-tech industries have fallen behind those of America and Asia in some areas, the tourism industry continues to draw millions of American and Asian visitors annually. Income from these nations' architectural heritage was also more stable and reliable, at least until the COVID-19 pandemic, than income from the volatile and extremely competitive high-tech sector.

Emerging countries should also be aware that there is a social backlash against free trade in the developed world originating from both the “lost generation” noted earlier and the disappearance of a mechanism for balancing trade, something that is discussed in greater detail in Chapter 9. The emergence of the “America First” Trump administration and the “Buy American” Biden administration is likely to make it more difficult for emerging countries to access markets in the United States and other advanced economies unless they themselves open their markets to goods from pursued countries.

That means they will have to accept more changes to their own economies, such as higher exchange rates and lower tariffs on imports from advanced countries. And for nations pursuing an export-led growth model based on Strategy B, these changes will have to be made soon if they want to continue enjoying access to the markets of pursued economies.

China's Challenges: Decoupling, Demographics, and Middle-Income Trap

China, the greatest economic growth story of the last four decades, offers a good real-life example of some of the points previously made, as both the middle-income trap and worsening demographics are pressing issues. With a per capita GDP of slightly over $10,000, the country currently finds itself in the middle of the trap (Figure 5.3), while its working-age population began shrinking in 2012 (Figure 5.4). The latest census data, from 2020, imply that the total population may start to contract as early as 2022. Chinese economists are therefore worried the country will lose its growth momentum due to adverse demographics before it fully emerges from the trap and joins the ranks of developed economies.

As noted earlier, two necessary conditions must be satisfied for the export-led model of economic growth to succeed. One is the ability to make competitive products, and the other is access to foreign markets where those products can be sold. There is no question that the Chinese have made huge strides toward meeting the first requirement. Today, the country can make almost everything at high quality and competitive prices.

But as for the second requirement, Chinese policy makers seem to be taking access to foreign markets for granted. This is probably because they have been in the U.S.-led free trade system for over four decades, and it has become second nature to them. Many of them may not be aware of how bad the protectionism was globally before 1945. However, economists in the country need to pay more attention to the question of who will be buying the Chinese products. After all, it is those people who will be doing the over-stretching needed for China's economy to continue growing.

Deng Xiaoping's Decisions Led to the Greatest Economic Growth in Human History

Deng Xiaoping, who spearheaded China's market-opening economic reforms in 1978, understood the importance of securing markets for Chinese-made products. He also had a front-row seat for the bitter U.S.-Japan trade frictions that were unfolding as he opened the Chinese economy to the world in the 1980s. He worried that if Japan and the United States, who were military allies and shared similar values such as democracy and human rights, could get into such an ugly fight, the prospects for U.S.-China trade could not be very bright given the differences in values between the two countries.

To avoid that outcome, he opened the Chinese economy fully to foreign direct investment so that foreign companies investing in China would have a stake in the success of the local economy, something that Japan had utterly failed to do. He also resolved 12 out of 14 ongoing territorial disputes⁹ so that his country would be seen as a safe and peaceful member of the world community. He did so because the U.S.-led free trade system is not fully open to countries with territorial ambitions, something that was underscored when Russia's occupation of the Crimean Peninsula in 2014 and invasion of Ukraine in 2022 were met with economic sanctions.

History has shown that Deng Xiaoping's decision to open the economy and end territorial disputes enabled China's economy to grow faster than any nation in history. The Chinese people certainly studied and worked hard to gain the ability to produce competitive products, but it was the political decisions made by Deng Xiaoping that gave his nation access to the markets for those products.

Deng also opened up Chinese society, which resulted in millions of Chinese students going abroad to study at Western universities. They were soon followed by millions more who went abroad as tourists. This was in huge contrast to the totally closed communist societies of Eastern Europe and the U.S.S.R. These differences gave hope to many in the United States that China would soon open its political system as well. The American hope that China would become truly free and open prompted the United States to invite China into the World Trade Organization (WTO), which led to the greatest burst of economic growth in history.

Chinese U-Turn under Xi

When Xi Jinping took control of China in 2013, he not only reasserted authoritarian rule at home, but also reopened many territorial disputes with China's neighbors, backing those claims with both military and economic threats. This change in the nation's stance torpedoed the American hope that China would soon be like them and also clashed with the reason the United States, a reluctant participant in both world wars, had introduced free trade in the first place: to allow countries with similar values to prosper without the need for territorial expansion and the war that often results.

The resulting confrontation with the United States prompted China's leadership to rely more on domestic demand for economic growth, something that has been dubbed the “great domestic” or “dual” economic cycle. It also led to talk of decoupling in both Washington and Beijing.

With 1.4 billion people, there is no question that China has a huge domestic market. The Chinese are also known for their willingness to study and work hard and their entrepreneurial mindset. These positive qualities have led many to conclude that China's economic growth is unstoppable, and that it is just a matter of time before the country overtakes the United States to become the world's largest economy. While that is certainly possible, the analytical framework introduced here suggests it may be difficult for these positives to overcome the negatives coming from the slowdown in exports as tensions with the West increase.

Up to now, China's growth depended heavily on its ability to export at competitive prices. At the height of the export boom in 2006, exports accounted for nearly 35 percent of Chinese GDP. The figure is still around 18 percent today. As long as exports were competitively priced, foreign consumers did the over-stretching for China (even though they themselves thought they were under-stretching), and exports grew rapidly.

With exports effectively selling themselves, Chinese manufacturers kept on expanding via domestic investment, which made huge contributions to employment and economic growth. In other words, the country was in a golden era, and its companies found numerous reasons to over-stretch while pursuing Strategy B. That was possible because they were exporting to people who were richer than themselves.

When the U.S.-China trade war began in 2018, the Chinese Ministry of Commerce claimed that 59 percent of the products subject to Trump's tariffs were actually made by foreign firms in China.¹⁰ In other words, a significant share of Chinese production and employment was still being provided by foreign businesses. This comes as no surprise given that when Deng Xiaoping opened up the Chinese economy in 1978, there was not a single capitalist left in China, and all capital, technology, and management know-how had to be provided by foreign firms. These foreign firms also supplied overseas markets for the products they made in China.

Decoupling from Western markets means Chinese companies will be selling to those who are not so rich, both at home and abroad. As Figure 5.5 shows, “Western” economies (including Japan) account for 56.8 percent of global GDP, while Russia, Africa, and other areas amount to just 25.3 percent (China itself stands at 17.9 percent).

Moreover, per capita GDP in the Western economies is 4.5 times that in non-Western countries. Decoupling would thus imply the loss of many of China's richest customers, leaving behind only the poorer ones. Given that China's own per capita GDP has only recently passed the $10,000 mark, this could sharply reduce the size of the markets in which Chinese companies can sell their products. China's market is of course important to the West, but with the latter's 56.8 percent share of global GDP far exceeding China's 17.9 percent share, it is clear which would suffer more. China's market is also far less transparent than those of the West.

The Domestic Over-Stretching Required after Decoupling

For the Chinese economy to grow in such an environment, domestic businesses and consumers will have to do the over-stretching themselves. For that to happen, companies will need to continuously come up with new and exciting products capable of wowing consumers. In other words, they must pursue Strategy A despite having fewer—and significantly less wealthy—customers. This makes their situation similar to countries pursuing an import-substitution model of economic growth, as noted earlier.

China has many companies capable of coming up with exciting new products. But the key question for policy makers is whether there are enough of them to support an economy of 1.4 billion people and propel it forward. In spite of China's spectacular economic growth over the last 40 years, 600 million people still subsist on a monthly income of RMB 1,000 ($157) or less, and 900 million earn RMB 2,000 or less. As such, the country could still use foreign markets and Strategy B to provide gainful employment for these 900 million people and thereby improve their living standards.

For Chinese companies to develop new products, the government will also have to ensure protection for intellectual property rights—without it, companies will not feel safe in pouring resources into research and development. Since Strategy A is also inherently more risky than Strategy B, the financial system will have to be revamped to ensure greater access to risk capital for these companies. In effect, the Chinese government will have to implement the very sorts of policies the U.S. government has been demanding for years.

While those policy reforms may actually happen, the new environment—with fewer and less wealthy consumers—will be far more challenging than what Chinese companies have grown accustomed to. Economic growth is therefore likely to slow as decoupling progresses. The fact that few countries in the postwar era have had to shift to the more difficult Strategy A when their per capita GDP was still low, and that none of them succeeded in achieving sustained economic growth, suggests that China faces a big challenge.

Moreover, when foreign companies with factories in China begin scaling back their operations in response to lower wages elsewhere (i.e., the middle-income trap) or face higher overseas tariffs on products made in China, someone else will have to take their place to maintain output and employment. Although there are a growing number of capable Chinese companies that can both produce at home and market their products abroad, the issue is the same: Are there enough of them to provide gainful employment for the populace after foreign firms leave?

The Xi administration is also trying to reestablish the predominant role of the Chinese Communist Party (CCP) in society by forcing both domestic and foreign businesses to establish CCP cells inside companies. Such a policy may lower the perceived return on capital by reducing the management’s freedom to act and thereby reduce the incentives for businesses, both foreign and domestic, to continue investing in the country.

The government is also enacting new laws and regulations, including the new export control laws promulgated in December 2020, that make China an increasingly less attractive destination for production, especially for foreign companies. Although this may be in retaliation to similar moves in the West, it is the opposite of what a country in the middle-income trap should be doing. Instead, the country should be making a conscious effort to increase the domestic return on capital so that both foreign and domestic companies will continue to invest there. Policy makers in China should remind themselves that it is China, not the West, that is facing the middle-income trap.

The Chinese private sector's response to these new regulations has been muted, but they could still have devastating economic consequences. An entrepreneur who might have pursued five new business initiatives each year in the absence of government intervention might now proceed with only two. The missing three cannot be observed since they exist only in the mind of the entrepreneur, but the economy will suffer from a drastic reduction in entrepreneurial over-stretch. Indeed, decoupling could prematurely end China's golden era.

In the short run, the government can always over-stretch to keep the economy from contracting, and the Chinese government appears to be doing so (Figure 5.6). But unless those public works have high enough social rates of return to be self-financing, the burden of financing both the growing budget deficit and the cost of maintaining new projects will eventually force the government to reduce fiscal stimulus. Chinese economic growth could then slow once those fiscal support measures are rescinded unless Chinese companies are successful in continuously coming up with new and exciting products.

As previously noted, China's working-age population—defined as those aged 15 to 59¹¹—started shrinking in 2012 just as China was passing the LTP. 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, as shown in Figure 5.4. That means it will not be able to maintain the rapid pace of economic growth seen in the past and, in fact, growth has already slowed sharply.

If the Japanese example is any guide, the decline in total population that is expected to start as early as 2022 will weigh on that portion of economic growth that was made possible by population growth. If China fails to emerge from the middle-income trap before the forward economic momentum from demographic factors is lost, it may—as an aging country with rising social burdens—have difficulty achieving a per capita GDP of $20,000, which seems to be the goal President Xi has set for 2035 (Figure 5.3).

Decoupling does not mean that all of China's trade with the West will disappear overnight. Even in the 1960s, at the peak of the Cold War between the United States and the Soviet Union, the United States and the United Kingdom were importing large numbers of single-lens-reflex cameras from East Germany and using them in public school photography classes. This was because East German cameras were far cheaper than competing products from West Germany and Japan. But that was not enough to make East Germany a prosperous nation.

With help from fiscal policy, the Chinese economy is likely to continue growing for the next few years barring actual military conflict. However, decoupling from the West when the population is aging and domestic wages have already reached a level signaling the middle-income trap could lead to a substantial reduction in growth rates.

In that sense, China has little time to waste—and little room for policy error—if it wants to reach the standard of living noted above by 2035. Like the Japanese economists whose domestic forecasts first looked to the United States, Chinese policy makers must understand who has been doing the over-stretching up to now and who will be doing it in the future if they hope to sustain economic growth after decoupling.

The Economic Destiny of Human Progress

In 5,000 years of civilization, humanity has made tremendous progress in according respect to individuals regardless of their background, creed, skin color, sex, or sexual orientation. Although the process is far from complete and there are some areas where progress has been reversed, the world is far ahead of where it was just 100 years ago. Much of this progress has taken place after countries entered their post-LTP golden eras, indicating that inclusive social reforms have certain economic preconditions.

What, then, is the economic destiny of human progress? What is the end game for all the chasing and being chased illustrated in Figure 3.12?

The economic destiny of human progress would seem to be a world in which the opportunity for economic advancement is available equally to everyone on the planet regardless of where they were born or raised. It is a world in which people born in Somalia or Bangladesh will have the same opportunity to advance themselves economically as people born in the United States or Germany. Today, unfortunately, the world remains far from that destination.

A person born in Somalia today would have to study and work exceptionally hard to attain the economic well-being of even less-diligent people born in the United States or Germany. During the golden age of the United States in the 1950s and 1960s, even those with minimal skills could afford a nice house, a big car, and a standard of living that was unthinkable for people on other continents. It is this geographic inequality that is being corrected by the process of industrialization and globalization previously described.

During the last three decades, this process of globalization received a huge boost from developments in the information technology (IT) industry that have dramatically lowered the cost of communication. As a result, any job that can be performed outside an office can now be performed anywhere in the world, something that was conclusively proven during the COVID-19 lockdowns. IT has also lowered the stock advantage advanced countries used to enjoy vis-à-vis emerging nations. For example, it was not too long ago that the quality of a university was judged by the number of books in its library. Today, most of the material needed for research in many fields is available on the internet. And this material is accessible from anywhere in the world with an internet connection.

These IT developments lowered the cost of starting or expanding businesses in both emerging and advanced economies. For those willing to put up with the stress of starting and expanding a business, the global marketplace is only an internet connection away, and there are far more business opportunities today than at any time in history.

This also means the easy days are over for those in the advanced countries who do not study or work hard. Their real wages are likely to stagnate or fall if they do not upgrade their skill sets to match and stay ahead of current demand. If governments in pursued countries rely on protectionism to preserve jobs for those with limited skills, the countries themselves may lose their advanced economy status as their industries lose the ability to compete with the rest of the world.

Conclusion

For an economy to grow, someone must over-stretch by spending more than they earn, either by borrowing money or drawing down savings. For consumers to over-stretch, they must be presented with irresistible, “must-have” products. For businesses to over-stretch, they must find attractive investment opportunities worth borrowing money for. The availability of such opportunities depends on, among other things, the stage of economic development and on hard-to-predict technological innovations that lead to new products (Strategy A) or new ways to make existing products more efficiently (Strategy B).

Most emerging economies that have achieved economic growth have followed the export-led Strategy B because they are at the stage of economic development where wages are low and the pursuit of this strategy offers good returns on capital. With consumers in importing countries doing the over-stretching, Strategy B—if the country can offer lower wage costs—is much easier than Strategy A and will allow emerging economies to grow faster than their more advanced counterparts.

For these emerging economies, the developed world's experience suggests they should never assume that the good times, when exports effectively sell themselves, will last forever. They should prepare for the day when they have to switch to Strategy A by consciously upgrading both human and physical capital. As the concept of the middle-income trap suggests, the rapid spread of globalization is also forcing many emerging economies to confront challenges similar to those faced by pursued economies.

Meanwhile, policy makers in the pursued countries must overcome at least three challenges. First, they must recognize that there is a shortage of domestic investment opportunities and that a conscious effort must be made to increase the domestic return on capital with supply-side reforms. Second, they must improve labor market flexibility so that companies can take evasive action to fend off chasers from behind. Third, they must recognize that education is far more important in the post-industrial pursued era than in the manufacturing-led golden era.

In the golden-era political landscape, conservatives pushed for balanced budgets and small government based on the neoliberal tradition along with supply-side reforms such as tax cuts and deregulation. Progressives, on the other hand, pushed for workers' rights, including the right to unionize as well as increased expenditures on infrastructure and social programs such as education.

In the pursued era, the private sector is often a net saver even at zero interest rates because businesses are hard-pressed to find attractive domestic investment opportunities. This means the government must be prepared to operate as borrower of last resort at the macroeconomic level to keep the economy going. Balanced budgets and small government are not appropriate until private sector borrowers are back.

At the microeconomic level, however, economic growth and good jobs will not be forthcoming without businesses investing more at home. This means governments must implement the supply-side reforms such as deregulation and tax cuts to increase the return on capital that are the hallmarks of small government. The government must also address the inherent tendency of inequality to worsen in the pursued era by ensuring that everyone has equal access to quality education.

Political parties must adjust their stances to remain relevant in this new environment. Conservatives will have to drop their insistence on balanced budgets when the private sector is a net saver, and progressives will have to abandon their focus on organized labor and their opposition to supply-side reforms if they hope to attract investment. Making the labor market more flexible also means a better social safety net will have to be provided for workers who might need it.

The tax regime must also be revamped to maximize the creative potential of the population without losing sight of the revenue flow. That will require a carefully calibrated tax structure, meaning that decisions about tax rates should be more a question of technical calibration than a political issue.

Both supply-side and educational reforms take a long time to bear fruit. In the meantime, the government might have to serve as “over-stretcher of last resort” with self-financing public works projects if the private sector remains a net saver. Fortunately, finding such projects should be easier when the private sector is a net saver because government bond yields will fall to very low levels. Such fiscal support must stay in place until another private-sector investment boom arrives.

All of this suggests that economic management in the pursued era is far more demanding than in the golden era. Although some people are longing for the return of the golden era and others are flirting with socialism, none of them will be able to deliver economic growth until they recognize the reality of pursued economies in a global context.