When borrowers disappear because of an absence of attractive investment opportunities, which was also the cause of the centuries of economic stagnation that preceded the Industrial Revolution, a very different mindset is needed to address the problem. This is because the reasons for this problem vary depending on the stage of economic development, and each requires a different policy response.

Today's developed economies all started out as agrarian societies, and the centuries-long paradox of thrift only ended with the arrival of the Industrial Revolution. The invention of new products and the machines needed to manufacture them produced a huge number of investment opportunities for the first time in history. Private-sector businesses that would not borrow money unless they were certain they could pay it back found numerous promising projects and started borrowing. The financial sector also developed to meet the newfound demand for funds. This process continued as long as there were debt-financed projects sound enough to pay for themselves.

Thus began a virtuous cycle in which investment created more jobs and income, which, in turn, created more savings to finance additional investment. Unlike the government investments in earlier centuries that eventually ran into financing difficulties, private-sector investments could sustain themselves as long as attractive new products were continuously brought to market. With new household appliances, cars, airplanes, and many other products invented and developed in rapid succession, a lack of investment opportunities was seldom a constraint to growth. The end result has been the rapid economic growth observed since the Industrial Revolution.

At the beginning of this revolution, constraints to growth included insufficient social infrastructure (e.g., transportation networks), inadequate savings to fund investments, an illiterate work force, and the slow pace of technological innovation. But some of these constraints were soon transformed into investment opportunities in the form of railways and other utilities. The urbanization of the population alone created massive investment opportunities as rural workers needed accommodation when they migrated to the cities to work in factories.

The growth of investment opportunities also increased corporate demand for borrowings, and from a macroeconomic perspective, savings became a virtue instead of a vice for the first time in history. Economies where people felt responsible for their own futures and saved more began to grow more rapidly than economies where people saved less.

Borrower Availability and the Three Stages of Economic Development

The availability of investment opportunities, however, is never guaranteed. It depends on myriad factors, including the pace of technological innovation and scientific breakthroughs, the ability of businesspeople to identify such opportunities and their willingness to borrow, the cost of labor and other inputs, the availability of reasonably priced financing, the protection of intellectual property rights, and the state of the economy and world trade.

The importance of each factor also depends on a nation's stage of economic development. The pace of innovation and breakthroughs is probably more important for countries already at the forefront of technology, while in emerging economies the availability of financing and the protection of intellectual property rights may be equally important.

When Germany was emerging as an industrial power, for instance, the United Kingdom accused it of copying its products and demanded the use of “Made in Germany” labels to distinguish its products from the British originals. Japan faced similar accusations from Western countries. Today, “Made in Germany” and “Made in Japan” are both highly valued labels because of the effort invested by the Germans and the Japanese in producing quality products.

China was also accused of copying products by both the West and Japan. Yet today, many Chinese businesses are demanding that Beijing implement stronger intellectual property rules because they worry that any product they develop will be quickly imitated by domestic competitors, rendering their research and development efforts worthless. In this way, the ability to copy goes from being a huge positive at one stage of economic development to a major negative later.

To understand how these factors change over time, the concept of pursued economy divides economies into three categories based on the stage of industrialization: urbanizing economies, which have yet to reach the Lewis Turning Point (LTP), maturing economies, which have already passed the LTP, and pursued economies, where the return on capital is lower than in emerging economies. The LTP refers to the point at which urban factories have finally absorbed all surplus rural labor. (In this book, the term LTP is used only because it is a well-known expression for a specific point in a nation's economic development; it is not used to refer to the model of economic growth proposed by Sir Arthur Lewis.)

Stage I of Industrialization: The Urbanization Phase

At the advent of industrialization, most people are living in rural areas. Only the educated elite, who are few in number, have the technical know-how needed to produce and market goods. Families whose ancestors have lived on farms for centuries have no such knowledge. When they migrate to the cities in search of jobs, all they can offer is their labor. Most of the gains during the urbanization phase of industrialization therefore go to the educated few, while the rest of the population simply provides labor for the urban industrialists. And with so many surplus workers in the countryside, worker wages remain depressed for decades until the LTP is reached.

Figure 3.1 illustrates this from the perspective of labor supply and demand. The labor supply curve is almost horizontal (from D to K) until the Lewis turning point (K) is reached because there is an essentially unlimited supply of rural laborers seeking to work in the cities. A business owner in the urbanization phase can attract any number of such laborers simply by paying the going wage (D).

In this graph, capital's share is represented by the area of the triangle formed by the vertical axis on the left, the labor demand curve, and the labor supply curve, while labor's share is represented by the rectangle below the labor supply curve. At labor demand curve D₁, capital's share is the triangle BDG, and labor's share (i.e., total wage income) is the rectangle DEFG. Strictly speaking, BGD is not the profits that accrue to capitalists, as there are other non-labor costs involved in the production and marketing of goods and services. But except for imported inputs and payments to government, this triangle should approximate the share of capitalists as a group since all wage-related expenditures are accounted for by the rectangle DEFG. In terms of income distribution and inequality, what is important is the change in the relative size of the triangle to the rectangle over time, not the exact content of the triangle and the rectangle as long as that remains unchanged. During this phase of industrialization, the capital share BDG may be shared by only a few persons or families, whereas the labor share DEFG may be shared by millions of workers.

Successful businesses continue investing in an attempt to make even more money. That raises the demand for labor, causing the labor demand curve to shift steadily to the right (from D₁ to D₂) even as the labor supply curve remains flat. As the labor demand curve shifts to the right, total wages received by labor increase from the area of the rectangle DEFG at time D₁ to the area of the rectangle DEIH at time D₂ as the length of the rectangle below the labor supply curve grows. However, the growth is linear. The share of capital, meanwhile, is likely to increase at more than a linear rate as the labor demand curve shifts to the right, expanding from the area of the triangle BDG at D₁ to the area of the triangle ADH at D₂.

Growth Exacerbates Income Inequality in Pre-LTP Urbanization Stage

During this phase, income inequality, symbolized by the gap between rich and poor, widens sharply as capitalists' share of income (the triangle) often increases faster than labor's share (the rectangle). One reason why a handful of families and business groups in Europe a century ago and the zaibatsu in Japan prior to World War II were able to accumulate such massive wealth is that they faced an essentially flat labor supply curve (wealth accumulation in North America and Oceania was not quite as extreme because these economies were characterized by a shortage of labor). Some in post-1978 China became extremely rich for the same reason.

Because capitalists during this period are profiting handsomely, they continue to reinvest profits in a bid to make even more money. With depressed wages leaving workers unable to save much, most investment must be self-financed by the capitalist class—in other words, capitalists' investments are limited by their savings. Sustained high investment rates mean domestic capital accumulation and urbanization also proceed rapidly. This is the take-off period for a nation's economic growth.

Until the economy reaches the LTP, however, low wages mean most people still lead hard lives, even though the move from the depressed countryside to the cities may improve their situations modestly. For many workers this was no easy transition, with 14-hour factory workdays not at all uncommon until the end of the 19th century. According to the Organisation for Economic Co-operation and Development (OECD), the annual working time in Western countries averaged around 2,950 hours in 1870, or double the current level of 1,450 hours.¹ Business owners, however, were able to accumulate tremendous wealth during this period.

Stage II of Industrialization: The Post-LTP Maturing Economy

As business owners continue to generate profits and expand investment, the economy eventually reaches the LTP. Once that happens, urbanization is largely finished and the total wages of labor—which had grown only linearly until then—start to increase much faster because any additional demand for labor pushes wages higher along the upward-sloping labor supply curve (from K to P in Figure 3.1).

Even if labor demand increases only modestly, from J to M in Figure 3.1, total wages accruing to labor will rise dramatically, from the area of rectangle DEJK to the area of rectangle CEML. This means labor's share of output is likely to expand relative to capital's share. It is at this point that the income inequality problem begins to correct itself. But businesses will continue to invest as long as they are achieving good returns, leading to further tightness in the labor market.

A significant portion of the U.S. and European populations still lived in rural areas until World War I, as shown in Figure 3.2. Even in the United States, where—unlike in Europe—workers were always in short supply, nearly half the population was living on farms as late as the 1930s. Continued industrialization as well as the mobilizations for two world wars then pushed these economies beyond the LTP, and the standard of living for the average worker began to improve dramatically.

Once the economy reaches the LTP and wages start growing rapidly along the upward-sloping labor supply curve, workers begin to utilize their newfound bargaining power. The numerous strikes experienced by many Western countries from the 1950s to the 1970s reflect this development.

Capitalists initially respond to labor movements by hiring union busters and strike busters. But as workers grow increasingly scarce and expensive, the capitalists must back down and begin accepting some of labor's demands if they want to keep their factories running. After 20 years or so of such struggles, both employers and employees begin to understand what can be reasonably expected from the other side, and that leads to a new political order. The current arrangement in the West and Japan, which is dominated by center-left and center-right political parties, is largely an outgrowth of this learning process.

Put differently, countries where center-left and center-right political parties dominate are characterized by an understanding among politicians and voters that they are in an interdependent system—which is what a macroeconomy is. Meanwhile, countries where this learning process is fading or never existed may swing from one political extreme to the other, which is detrimental to both society and the economy.

Explosion of Borrowing for Capacity- and Productivity-Enhancing Investments

As labor's share increases, consumption's share of GDP will increase at the expense of investment. At the same time, the explosive growth in the purchasing power of ordinary citizens means most businesses are able to boost profits simply by expanding existing productive capacity. Both consumption and investment increase rapidly as a result.

From that point onward, the economy begins to “normalize” in the sense in which the term is used today. Inequality also diminishes as workers' share of output increases relative to that of capital. In the United States, that led to the so-called Golden Sixties where everyone benefited from economic growth. With incomes rising and inequality falling, this post-LTP maturing phase is referred to as the “golden era” of economic growth in this book.

This trend toward reduced inequality receives further impetus from the fact that the economy in this phase is typically driven by the manufacturing sector. Manufacturing jobs do not require high levels of (expensive) education, so when this sector is leading job creation, wages are bid up from the lowest level of society. Wage increases starting at the bottom will naturally lift wages at higher levels as well, benefiting everyone in society.

Higher wages and the resulting explosive growth in the purchasing power of ordinary workers prompts businesses to invest for two reasons. First, they seek to enhance worker productivity so they can pay those steadily rising wages. Second, they want to expand capacity to address workers' growing purchasing power. Both productivity- and capacity-enhancing investments increase demand for borrowings that add to economic growth. That keeps the economy squarely in Case 1 and 2, with demand for borrowings often outstripping savings and resulting in higher interest rates.

With rapid improvements in the living standards of most workers, the post-LTP golden era is characterized by broadly distributed benefits from economic growth. In this phase, business investment often increases worker productivity without any improvement in worker skills. Even those with limited skills are able to make a good living, especially if they belong to a strong union. Rapid growth in tax receipts during this period also allows the government to offer a continuously expanding range of public services. That, in turn, further reduces the sense of inequality among the population. This golden era lasted into the 1970s in the West.

When Western manufacturers were leading the world, the West was also in an export-led globalization phase as it exported consumer and capital goods to the rest of the world. American cars and German cameras were the global standard to which other countries aspired.

Stage III of Industrialization: The Pursued Economy

But the golden era does not last forever. At some point, wages reach the level Q in Figure 3.1, where it becomes profitable for domestic manufacturers to shift production overseas. As businesses must add in the cost of all risk factors when considering whether to relocate production overseas, Q is that “high enough” domestic wage level at which it makes sense for businesses to relocate after taking into account all the risk factors. This means the actual wage foreign workers receive will be far less than Q.

The first signs of a serious threat to Western economic growth appeared when businesses in the United States and Europe encountered Japanese competition in the 1970s. Initially this was blamed on the wage gap between Japan and the Western economies. But the wage gap had always existed. The real reason was that Japanese businesses were approaching and, in some cases, surpassing the technological and marketing sophistication of the West while at the same time benefiting from lower wage costs.

Many in the West were shocked to find that Japanese cars required so little maintenance and so few repairs. The Germans may have invented the automobile, and the Americans may have established the process by which it could be manufactured cheaply, but it was the Japanese who developed cars that did not break down. The arrival of the Nikon F camera in the 1960s also came as a huge shock to the German camera industry because it was so much more rugged, adaptable, easy to use and serviceable than German Leicas and Exaktas, and professional photographers around the world quickly switched to the Japanese brand. For the first time since the Industrial Revolution, the West found itself being pursued by a formidable competitor from the East.

Once a country is being chased by a technologically savvy competitor, often with a younger and less expensive labor force, it has entered the third or “pursued” stage of economic development. In this phase, it becomes far more challenging for businesses to find attractive investment opportunities at home—it often makes more sense to buy directly from the “chaser” or to invest in that country themselves. In other words, the return on capital is higher abroad than at home. Businesses in pursued economies are still investing to meet shareholder demands to maximize profits, but not necessarily in their home countries. Many businesses are also forced to invest overseas when their competitors start producing abroad.

Many U.S. and European companies in the 1970s happily added Japanese products to their product lines or sold them through their dealerships. These products carried proud American or European brand names but were actually made in Japan. General Motors was buying cars from Toyota; Ford, from Mazda; and Chrysler, from Mitsubishi. Ford acquired a large ownership stake in Mazda, and Chrysler did the same with Mitsubishi. In the “German” camera industry, Leicas were increasingly made with Minolta components—if not produced entirely by the Japanese company—and cameras with such venerable names such as Exakta and Contax were made entirely in Japan.

Once this phase of development is reached, businesses no longer have the same incentive to invest in productivity- or capacity-enhancing equipment at home because there is now a viable alternative—investing in or buying directly from lower-cost production facilities abroad. With constant pressure from shareholders to improve the return on capital, firms are forced to shift investments to locations offering higher returns on capital.

Once this stage is reached, investment in productivity-enhancing equipment at home slows significantly, resulting in lower productivity gains. According to U.S. Bureau of Labor Statistics data compiled by Stanley Fischer at the Fed,² productivity growth in the nonfarm business sector averaged 3.0 percent from 1952 to 1973 before falling to 2.1 percent between 1974 and 2007 and dropping further to 1.2 percent between 2008 and 2015. These numbers not only confirm the trend previously noted, but also suggest that worker productivity in the future will depend increasingly on the efforts of individual workers to improve their skills instead of on corporate investment in productivity-enhancing equipment.

In a pursued economy, where outsourcing to foreign production sites becomes a viable alternative, the labor supply curve as perceived by businesses becomes largely horizontal at wage level Q in Figure 3.1. Any increase in labor demand from this point onward will be satisfied with foreign labor. For example, if the labor demand curve is at D₄, total workers employed will be ET in Figure 3.1, of which NT workers will be employed abroad. Real wage growth will therefore be minimal from this point onward, except for workers with abilities that are not easily replicated abroad.

It should be noted that Q depends not just on domestic wage inflation but also on foreign productivity gains. For example, if Japanese products in the 1970s had not been so competitive, Q for the West would have been much higher. Q also depends on changes in the global labor supply. When China joined the world economy after opening up to the world in 1978, the Q for many countries probably declined. When Mexico joined North American Free Trade Agreement (NAFTA) in 1992 and when China became a member of the World Trade Organization (WTO) in 2001, the Q for many advanced countries probably fell again.

With domestic investment opportunities shrinking, economic growth also slows in the pursued countries, which are now in an import-led globalization phase as capital seeks higher returns abroad and inexpensive imports flood the domestic market. With an ever-increasing number of emerging countries joining the ranks of the chasers, constant downward pressure on Q helps keep the price level from rising.

In addition, the loss of investment opportunities at home means a fall in business demand for borrowings. The household sector, however, will continue to save for an uncertain future as it has always done.

That combination of continued household savings and sharply reduced corporate borrowings pushes the economy toward Case 3, where the private sector begins running a financial surplus. The surge in inexpensive imports and slower growth of wages at home ease the upward pressure on prices, while lower inflation rates and reduced demand for borrowings weigh on interest rates.

In the phenomenon known as the Great Moderation of the 1990s, both inflation rates and interest rates came down significantly. Although this is often attributed to central banks' success in taming inflation, the dominant cause was more likely advanced countries' entry into the pursued phase of development.

Japan's Ascent Forced Changes in the West

Japan's emergence in the 1970s shook the U.S. and European industrial establishments. As manufacturing workers lost their jobs, ugly trade frictions ensued between Japan and the West. This marked the first time that Western countries that had already passed their LTPs had been chased by a country with much lower wages.

Zenith, Magnavox, and many other well-known U.S. companies folded under the onslaught of Japanese competition, and household names such as General Electric (GE) and Radio Corporation of America (RCA) stopped producing most household products. The West German camera industry, the world's undisputed leader until around 1965, had all but disappeared by 1975. While Western companies at the forefront of technology continued to do well, the disappearance of many well-paying manufacturing jobs led to worsening income inequality in these countries.

Initially there was tremendous confusion in the West over what to do about the Japanese threat. As the Japanese took over one industry after another, industry and labor leaders sought protection via higher tariffs and nontariff barriers. France, for example, ruled that all Japanese videocassette recorders (VCRs) must clear customs in the remote countryside village of Poitiers, which not surprisingly had few customs officers, to discourage their entry into the country. This was done even though there were no French manufacturers of VCRs. Others argued for exchange rate realignments that were realized in the Plaza Accord of September 1985, which halved the dollar's value against the yen (from 240 to 120 yen to the dollar) by the end of 1987.

Still others said the West should study Japan's success and learn from it, which led to a Western infatuation with so-called “Japanese management” techniques. Many well-known business schools in the United States actively recruited Japanese students so they could discuss Japanese management practices in the classroom. Some even argued that eating fish—and sushi in particular—would help to make Western managers as smart as the Japanese. All in all, Western nations' confidence that they were the world's most technically advanced economies was shattered.

Some of the pain felt by Western workers was offset by the fact that, as consumers, they benefited from cheaper imports from Asia, which is one characteristic of import-led globalization. During the golden era, rising wages and rising prices were the norm. During the pursued era, stagnant wages and stagnant prices become the norm.

Businesses with advanced technology and individuals with advanced degrees continued to do well, but it was no longer the case that everyone in society was benefiting from economic growth. Those whose jobs could be transferred to lower-cost locations abroad saw their living standards stagnate or even fall.

Inequality Worsens in the Pursued Era

Figure 3.4 shows the real income of the lowest quintile of U.S. families from 1947 to 2020. Even in this group, incomes grew rapidly in the post-LTP golden era that lasted until around 1970. But income growth subsequently stagnated as the country entered the post-LTP pursued phase. Figure 3.5, which illustrates the income growth of other quintiles relative to the lowest 20 percent, demonstrates that the ratios remain remarkably stable until 1970 but diverge thereafter.

Figure 3.6 shows annualized income growth by income quintile in the post-LTP golden era from 1947 to 1970 and the post-LTP pursued phase from 1970 to 2020. It shows that the bottom 60 percent actually enjoyed slightly faster income growth than those at the top before 1970, indicating a reduction in income inequality. This was indeed a golden era for the U.S. economy, with everyone growing richer and enjoying the fruits of economic growth.

But the situation changed drastically once Japan started chasing the United States. Figure 3.4 shows that income growth for the lowest quintile has been stagnant ever since. Figures 3.5 and 3.6 illustrate that income growth for other groups was only slightly better—except for the top 5 percent, which continued to experience significant income gains even after 1970. This group probably includes those who were at the forefront of innovation and those who were able to take advantage of Japan's emergence.

Figure 3.6 demonstrates that income growth for different income quintiles was quite similar during the golden era, but began to diverge significantly once the United States became a pursued economy. Income growth for the top 5 percent dropped from 2.50 percent per year during the golden era to just 1.48 percent during the pursued phase, but that was still 3.36 times the rate of growth for the lowest 20 percent.

Similar developments were observed in Europe. Figure 3.7 illustrates real wages in six European countries. With the possible exception of the United Kingdom, all of these countries experienced rapid wage growth until the 1970s followed by significantly slower growth thereafter.

Three Stages of Japanese Industrialization

Japan reached the LTP in the mid-1960s, when the mass migration of rural graduates to urban factories and offices, known in Japanese as shudan shushoku, finally came to an end. Investment opportunities in Japan were plentiful during this period because the hard work needed to develop new products and processes had already been done in the West. All Japan had to do was make those products better and less expensive, a task the Japanese system was well suited for. Rapid urbanization and the need to rebuild cities devastated by U.S. bombing during World War II also offered an abundance of low-hanging investment opportunities.

Indeed, the main constraint on Japanese growth at the time was savings—there was simply not enough savings to meet the investment demand from Japanese businesses. Japan found itself in an extreme variant of Case 1 where the number of borrowers completely overwhelmed the number of lenders. As a result, inflation and interest rates in those years were quite high, leading the government to ration savings to high-priority industries. The government and the Bank of Japan (BOJ) also implemented numerous measures to encourage Japanese households to save.

Once Japan reached the LTP in the mid-1960s, the number of labor disputes skyrocketed, as shown in Figure 3.8, and Japanese wages started to increase sharply (Figure 3.9). In other words, Japan was entering the post-LTP golden era that the West had experienced 40 years earlier.

Japan was fortunate in that it was not being pursued at the time, enabling it to focus on catching up with the West. No one was chasing it because most emerging countries at the time had embraced the so-called import-substitution model of economic development. Why this model was eventually scuttled in favor of the export-led model pioneered by Japan is explained in Chapter 5.

Japanese wages were rising rapidly, but Japanese companies invested heavily at home to boost workforce productivity. The nation's golden era of strong growth and prosperity could continue as long as productivity rose faster than wages. With the quality of its exports appreciated by consumers around the world, Japan was very much in an export-led globalization phase.

Labor's share of output rose along with wages, and Japan came to be known as the country of the middle class, with more than 90 percent of the population identifying itself as such. The Japanese were proud of the fact that their country had almost no inequality. Some even quipped in those days that Japan was how Communism was supposed to work.

The happy days for Japan lasted until the mid-1990s, when Taiwan, South Korea, and China emerged as serious competitors. By then, Japanese wages were high enough to attract pursuers, and the country entered its pursued phase. Japanese wages stopped growing in 1997 and then stagnated or fell, as shown in Figure 3.9.

Although the three Asian countries were also chasing the West, the shock to Japan was greater because this was the first time the country had been pursued since it opened itself up to the world in the 1868 Meiji Restoration. All of Japan's institutions, from education to employment, had been optimized for catching up with the West, not fending off competitors from the East. Meanwhile, the Europeans and Americans who had experienced the Japanese onslaught 25 years earlier had already recalibrated their economies and were therefore less affected by China's emergence.

Today, the Japanese are worried about income inequality as highly paid manufacturing jobs have migrated to lower-cost countries. They are also concerned about the emergence of the so-called working poor, people who were once employed in manufacturing but have now been forced to take low-end service jobs. Some estimate that as many as 20 million out of a total population of 130 million are now living in poverty.³ Their suffering, however, has been eased somewhat by a flood of inexpensive imports that has substantially reduced the cost of living. This means Japan has entered an import-led globalization phase and is reliving the West's experience when it was being chased by Japan.

Similar concerns are being voiced in post-2005 Taiwan and South Korea as they experience the same migration of factories to China and other even lower-cost locations in Southeast Asia. These two countries passed their LTPs around 1985 and entered a golden era that lasted perhaps until 2005. The frequency of Korean labor disputes also shot up during this period (Figure 3.10) as workers gained bargaining power for the first time and won large wage concessions. In Taiwan, wages climbed sharply during the post-LTP golden era but peaked around 2005 and stagnated thereafter (Figure 3.11). Except in the area of semiconductor manufacturing, both countries are now feeling the pinch as China steadily takes over the industries that were responsible for so much of their past growth.

Free Trade Accelerated Globalization while Rendering War Obsolete

This process of chasing and being chased, otherwise known as globalization, can trace its beginnings to the U.S. introduction of a free-trade regime after World War II. Before then, a variety of barriers to trade hindered economic growth. Most countries in those days imposed high tariffs on imported products both to raise revenues and to protect domestic industries. But if workers constituted the main source of consumption demand in the pre-LTP urbanizing world, they could not have provided enough demand for all the goods produced because their share of income was so low, while capitalists typically had a higher marginal propensity to save. As a result, aggregate supply often exceeded aggregate demand.

To overcome this constraint, European powers turned to colonialism and imperialism in a bid to acquire both sources of raw materials and captive markets where they could sell the goods they produced. Indeed, it was believed for centuries that national economies could not grow without territorial expansion. That belief led to centuries of wars and killings.

When World War II ended, the victorious Americans introduced a free-trade regime known as the General Agreement on Tariffs and Trade (GATT) that essentially allowed any country with competitive products to sell to any other country. As a reluctant participant in two world wars, the Americans wanted to build a system in which countries sharing democratic values could prosper without the need to expand their territories. The United States was also motivated by the need to fend off the Soviet threat by rapidly rebuilding Western Europe and Japan.

Although the concept and practice of free trade were not new, the U.S. decision to open its vast domestic market, which accounted for nearly 30 percent of global GDP at the end of World War II, to the (free) world was a game-changer. The resultant free-trade regime allowed not only Japan and West Germany but also many other countries to prosper without the need to expand their territories. Indeed, it is difficult to find a country that grew rapidly in the post-1945 world that did not benefit from the U.S. market.

The advent of a U.S.-led free trade framework rendered obsolete the whole notion that territorial expansion was a necessary condition for economic growth and prosperity. After World War II, the victorious allies found themselves busy fighting indigenous independence movements in their colonies at enormous expense. Meanwhile, Japan and West Germany—which had lost all of their overseas and some of their domestic territories—quickly grew to become the world's second- and third-largest economies. In other words, postwar Japan and West Germany proved that economic growth requires markets and investment opportunities, not territories. Economic growth will accelerate if markets can be accessed without the expense of acquiring and managing overseas territories.

The relative infrequency of wars after 1945 is often attributed to the Cold War and the deterrence doctrine of mutually assured destruction (“MAD”), but the drastic reduction in conflict between countries that had been fighting since history began is also due to the fact that territorial expansion was no longer viewed as a necessary condition for economic prosperity. Colonies actually became more of a liability than an asset for economic growth under the free-trade regime.

Today, thanks to the fabulous track record of the U.S.-led adoption of free trade, almost no one in the (advanced) world sees territorial expansion as a prerequisite for economic prosperity. This monumental change in mindset, at least in the advanced countries, should qualify as one of the greatest chapters in the history of human progress. It is unfortunate that this new mindset is not yet shared by the leaders of both China and Russia.

In Asia, it was the Japanese who discovered in the 1950s that their economy could still grow and prosper by producing high-quality products for the U.S. market. They then put their best and brightest to the task while leaving complicated diplomatic and national security issues to be decided by the Americans. Indeed, many high-end products made in Japan during the 1950s and 1960s, such as TEAC audio gear, were sold only in the United States because Japanese consumers were still too poor to afford them.

Japan's spectacular success then prompted Taiwan, South Korea, and eventually the rest of Asia to follow the same export-oriented growth formula in a process dubbed the “flying geese” pattern of industrialization. These countries' golden eras became synonymous with export-led globalization. In the 1990s, even Mexico, one of the emerging countries that had pursued the import-substitution model of economic growth, decided to join the globalization bandwagon by signing NAFTA.

China Now in Post-LTP Golden Era of Industrialization

The biggest beneficiary of the U.S.-led free-trade regime was China, which succeeded in transforming a dirt-poor agrarian society of over a billion people into the world's second-largest economy in just 30 years. The three decades after Deng Xiaoping opened the Chinese economy in 1978 probably qualify as the fastest, greatest economic growth story ever, as per capita GDP for over a billion people increased from a little over $300 to more than $10,000 in 2019. China wasted no time integrating itself with the global economy and attracted huge quantities of foreign direct investment, first from Hong Kong and Taiwan, but soon from all the advanced countries.

Those investments came because the U.S.-led free-trade system allowed businesses—both Chinese and foreign—to sell their products anywhere in the world. Even though China was nowhere near democracy when it opened itself to the outside world, many in the United States believed that the nation would become a freer and more open society before long. And that hope was not without justification: millions of bright Chinese students were studying in Western universities, and millions more tourists were traveling around the world as the country became more prosperous. This stood in sharp contrast to the totally closed systems of the Soviet Union and Eastern Europe, where contact with foreigners was strictly controlled. That contrast convinced many Americans that China would soon open up its political system as well. The fact that many Americans held this idealistic hope was what allowed China to enter the WTO in 2001.

The entrance to WTO and the resulting access to global markets prompted businesses from around the world to build factories in China. Chinese economic growth skyrocketed, with exports accounting for as much as 35 percent of GDP at the peak. Were it not for the markets provided under the U.S.-led free-trade regime, it probably would have taken China many more decades to achieve the growth it did.

Businesses in the West and elsewhere that were able to take advantage of China's low-cost, hard-working labor force found almost unlimited investment opportunities and operated like the capitalists in their own countries' pre-LTP urbanization eras. Those investments added massively to China's economic growth and transformed the country into “the world's factory.”

But those investments also exacerbated inequality in the advanced countries in the same way that inequality had increased during their own pre-LTP urbanizing eras. This happened in part because foreign businesses expanding rapidly in China were likely to invest less at home, which served to depress domestic economic and productivity growth. Indeed, slow productivity growth in the advanced economies is the flipside of the rapid productivity and income growth in China and other emerging markets that was made possible by investment from developed nation businesses. Workers in Asia and the West who had to compete with Chinese workers have therefore seen their wages stagnate or even fall.

Those in the advanced economies who still wonder where the golden era enthusiasm for fixed capital investment has gone need only get a window seat on a flight from Hong Kong to Beijing (or vice versa) on a nice day. They will see below them an endless landscape of factories stretching out in all directions. Many of those plants were first started with foreign capital because when Deng Xiaoping opened up the economy in 1978, there were no capitalists left in China: they had all been killed or driven into exile by the Communist revolution in 1949.

In the beginning, only foreign capital, mainly from Taiwan and Hong Kong, was available to jump-start China's industrialization. Indeed, it was these businessmen in the 1980s who taught the Communist Chinese how to run a market-based economy. And capitalists from Taiwan and Hong Kong came in only because they realized they could sell whatever they produced in China to the rest of the world. After their pioneering efforts, they were joined by others from the West and Japan who realized that the return on capital in China was far higher than what was available at home—if the goods produced there could be sold around the world.

China is also subject to the same laws of urbanization, industrialization, and globalization as other countries. It actually passed the LTP around 2012 and is now experiencing sharp growth in wages. That means the country is now in its post-LTP golden era. However, because the Chinese government is wary of strikes, labor disputes, or other public disturbances of any kind, it is trying to preempt such conflict by administering significant wage increases each year, with local governments issuing directives forcing businesses to raise wages. In some regions, wages were rising at double-digit annual rates as the authorities sought to prevent labor disputes. It remains to be seen whether such top-down actions can substitute for a process in which employers and employees learn through confrontation what can reasonably be expected from the other party.

The higher wages that have resulted in China are now leading both Chinese and foreign businesses to move factories to lower-wage countries such as Vietnam and Bangladesh. In effect, the laws of globalization and free trade that benefited China when it was the lowest-cost producer are now posing challenges.

That means the easy part of China's economic growth story is now over. If the country hopes to maintain economic growth in the face of rising wages, it needs to improve the domestic business environment so that businesses will continue to invest at home at a time when they are discovering that the return on capital is higher abroad, at least for certain industries. The challenges facing Chinese policy makers, including the nation's shrinking workforce and its confrontation with the United States, is addressed further in Chapter 5, which discusses growth.

The Happiness of Nations

The preceding discussion regarding the stages of economic development is summarized in Figure 3.12. Here, the bold arrows indicate the direction of pursuit.

Countries appear to be reaching their “golden eras” sooner owing to accelerated globalization, which has been made possible by free trade and rapid advances in information technology. However, the length of the golden era appears to be shortening as more countries join the globalization bandwagon. For example, the golden era for the United States and Western Europe probably lasted for about 40 years until the mid-1970s, while Japan's ended after around 30 years in the mid-1990s. The golden era for Asian Tigers like Taiwan and Korea was about 20 years long, coming to an end around 2005. It will be interesting to see how long China's golden era lasts, with policy makers already worried about poor demographics and the middle-income trap, which are discussed in Chapter 5.

If a nation's happiness can be measured by (1) how quickly inequality is receding and (2) how fast the economy is growing, then the post-LTP golden era would qualify as the period when a nation is at its happiest. During this period, strong demand for workers from a rapidly expanding manufacturing sector forces all other sectors to offer comparable wages to retain workers. Because manufacturing jobs do not require advanced education, when manufacturing is driving job creation, it raises the wages of even the least skilled, thereby positively affecting wages in all other sectors. In this sense, manufacturing is a great social equalizer: when manufacturing industries are prospering, people without advanced (and expensive) education can still earn a decent living. With everyone benefiting from economic growth, people are hopeful for the future, and inequality shrinks rapidly.

U.S. manufacturing employment peaked in 1979 at 19.6 million, with the bulk of the growth taking place from 1946 (12.7 million) to 1969 (18.8 million). This timeframe coincides with the period of shrinking income inequality in the United States, as noted earlier. Manufacturing employment has now fallen to 12.6 million, or just 8.4 percent of total nonfarm employment. The corresponding figure in 1946 was 32 percent.

Insufficient Attention to Trade Deficits and Loss of Manufacturing Jobs

Many economists continue to argue that those manufacturing jobs disappeared not because of outsourcing to foreign countries but because of automation. And it is true that more goods—such as automobiles—are now produced with fewer workers in advanced countries. But that is often the case because many intermediate products are now made abroad. This reliance on suppliers from abroad was amply demonstrated during the pandemic when supply-chain disruptions reduced production everywhere. If automated factories in the United States are so efficient, stores in the country should be carrying more goods made in the United States, and the United States should not be running such large trade deficits for the last four decades. The U.S. trade deficit reached more than $900 billion for the first time in 2021 (Figure 9.1).

Nor is the automation argument consistent with allegations, made by Japanese visiting the factories of U.S. companies, that it was a lack of investment in automation due to the short-sightedness of U.S. management that led to the manufacturing decline. The decline was so severe that the country had next to zero ability to manufacture the ventilators, masks, and various other items needed to fight the COVID-19 pandemic.

These problems emerged in part because the free trade regime lost its rebalancing mechanism when the free movement of capital was introduced on top of free trade in 1980 without careful consideration. How that led to the loss of U.S. manufacturing and the anti-globalization backlash of Donald Trump's “America First” movement and even Joe Biden's “Buy American” program is discussed in Chapter 9.

Income inequality begins to worsen once manufacturers start migrating to lower-cost countries because only those with advanced education and skills can keep up with the changes and continue to do well. The increase in their incomes, however, seldom trickles down to boost the wages of those without advanced education on the lower rungs of society.

Manufacturers also have a far greater need to borrow for capital expenditures than companies in most other industries, which is crucial in keeping the macroeconomy in Case 1 and 2. The loss of manufacturing, therefore, is one of the key drivers of advanced countries' shift to Case 3. Manufacturing is also where the greatest productivity gains can be expected. The shrinkage of the U.S. manufacturing sector is therefore consistent with the productivity growth numbers from Stanley Fischer previously noted.

The West was at its happiest before Japan started chasing it in the 1970s because its manufacturing industry led the rest of the world. It was a French person who said before the Berlin Wall came down that the world would be a much nicer place if there were no Soviet Union and no Japan.

The Japanese were at their happiest when their manufacturing sector was chasing the West, but nobody was chasing them. Those happy days ended when the Asian Tigers and China began pursuing Japan in the mid-1990s. The Tigers then enjoyed their own golden era for about 20 years until China started chasing them.

Conceptual Origins of “Post-Industrial Society” and Pursued Phase

The concept of the pursued phase introduced here and the concept of the “post-industrial society,” popularized by authors such as Daniel Bell, both refer to the same period in history. When the latter concept was unveiled in the 1970s, people were excited about the prospect of societies becoming cleaner and more humane as knowledge-based industries became increasingly dominant in the economy. This was in contrast to the age of industrialization, which forced people to work long hours in oily, dirty factories.

Today, most advanced countries enjoy cleaner air with fewer factories operating inside their borders. But for a large part of the population, the rosy, humane scenario promised by the proponents of post-industrial society never materialized. Instead, many feel far less secure and hopeful today than in the earlier era. Some have become angry and desperate enough to vote for populists and extremists.

The overly optimistic post-industrialization scenarios never came to pass because those scenarios require a world in which knowledge-based industries are expanding so fast and paying so well that they draw workers away from the manufacturing sector. Manufacturers will then be forced to leave the country because they cannot compete for workers when knowledge-based businesses are offering such high wages.

What actually happened, however, was that advanced countries were forced into de-industrialization because emerging economies started offering higher returns on capital than those that are available at home. Although knowledge-based businesses have been expanding in most societies, they need workers who are highly educated, unlike the workers who manufacturers employed. More importantly, loan demand from knowledge-based industries has clearly been insufficient to offset the loss of borrowings from manufacturers that are needed to absorb private savings and keep the economy in Case 1 or 2. This issue is discussed further in the next chapter with Figure 4.1.

Society has suffered from slower growth and widening income inequality because corporate borrowings have fallen relative to savings, and only those with special abilities or advanced degrees have done well in knowledge-based, de-industrializing economies. Since slower growth and rising inequality are not positive developments, the author coined the term “pursued economies” to convey the sense of urgency with which the problem of inferior domestic returns on capital must be addressed. How to deal with the challenges faced by pursued economies is discussed in Chapters 4 and 5.

The Rise and Fall of Communism

The preceding description of how inequality increases and decreases before and after the LTP also explains why so many people have found Communism appealing at certain points in history. Karl Marx and Friedrich Engels, who lived in pre-LTP urbanizing Europe, were appalled by the horrendous inequality around them and the miserable working and living conditions of ordinary people. As previously noted, it was not uncommon for people to work 16 hours a day in dark, dirty, and dangerous industrial environments while capitalists rapidly grew rich. Any intellectual with a heart would have found it difficult to turn a blind eye to the social and economic inequality of the time.

Marx responded by proposing the concept of Communism, which called for capital to be owned and shared by the laborers. He argued that if capital were owned by the workers, the exploitation of labor would end, and workers would enjoy a greater share of the output. Many “exploited” workers who had been working long hours in dreadful conditions embraced the new theory enthusiastically because it appeared to offer the hope of a better life with little to lose. In that sense, the birth of Communism may itself have been a historical imperative of sorts.

Marx and Engels' greatest mistake, however, was to assume the extreme inequality they witnessed (points G and H in Figure 3.1) would continue forever without a Communist revolution. In reality, it marked just one inevitable step on the path toward industrialization. If capitalists are earning large profits in the pre-LTP urbanizing period, they are likely to continue investing in the business in the hope of making even more money. It is that drive for more profits that eventually pushes the economy to reach and pass the LTP, when a totally different labor-market dynamic kicks in.

As soon as the economy reaches the LTP and wages start rising along the positively sloped labor supply curve (from K to P in Figure 3.1), the appeal of Communism wanes as workers begin to realize they can get what they want within the existing framework. The early years of the golden era, however, are typically characterized by frequent strikes and labor disputes as workers start to utilize their newfound bargaining power for the first time. The scenes of workers marching under Red Communist banners in the 1960s and 1970s in many countries gave the impression that a Communist takeover was imminent. But their success in winning higher wages ended up undermining the movement's appeal.

After 15 or 20 years of such struggles, employers and employees alike begin to understand what can be reasonably expected from the other side, and a new political order is established based on that understanding. The result is the prevalence of center-right and center-left political parties seen in advanced countries today.

Although this political arrangement served advanced countries well in their post-LTP golden eras, it remains to be seen whether it is the most appropriate arrangement under the very different labor market dynamic of the pursued phase. The rise of far-right and populist political parties in the West that are opposed to free trade and globalization is already presenting a major challenge to the established political order. These political issues are discussed further in Chapters 5 and 9.

Ironically, countries that adopted Communism before reaching their LTPs, such as pre-1978 China and pre-1986 Vietnam, ended up stagnating at very low income levels because the profit motive needed to promote investment and push the economy beyond the LTP was lost. Even in countries where industrialization was forced through, many of the resulting industries turned out to be less than viable because they did not have to face the discipline imposed by the need to earn profits in a competitive marketplace. Most of these enterprises therefore folded, with no buyers for their products, when their Communist governments collapsed.

Interestingly, the economy also ends up stagnating when labor becomes too powerful and expensive before the country reaches the LTP, for both economic and political reasons. First, the economy stops growing and becomes stuck in the pre-LTP urbanizing phase because the protected workers are too expensive for businesses to expand production. Second, unionized and privileged workers end up creating a two-tier labor market with a permanent underclass that is denied meaningful employment because the economy is not growing fast enough. This leads to political alienation and divisions that slow the economy even further, as has been seen in some Latin American countries since the 1950s.

LTP and Inclusive Social Order

The preceding discussion suggests that many inclusive social and political reforms are possible only after a country passes the LTP. Even in the advanced countries, the majority of inclusive reforms, such as the U.S. civil rights movement, took place in the post-LTP era. That means sequencing matters, and those in emerging countries seeking more inclusive social and political order might want to push their economies beyond the LTP first if they want to avoid the pitfalls previously noted.

Although the preceding discussion suggests that all countries pass through the same development process, there has also been general progress toward more agreeable working conditions in all countries. For instance, European workers were working as long as 16 hours a day in the pre-LTP urbanizing phase, whereas post-1978 Chinese workers were working only a little more than 8 hours a day even before the country reached its LTP. That suggests the progress made elsewhere in the world is reflected in working conditions in at least some of the emerging economies today.

The Real Source of Thomas Piketty's Inequality

Income inequality has become one of the hottest, most controversial issues in economics, not only in the developed world but also in China and elsewhere. Many are growing increasingly uncomfortable with the divide between the haves and the have-nots, especially after Thomas Piketty's book, Capital in the 21st Century, sparked a fresh debate on the optimal distribution of wealth, an issue that had been largely overlooked by the economics profession.

The author cannot claim to have understood the full implications of Piketty's enormous contributions, but the analysis presented here, which is based on how economies develop over time, contradicts one of the key historical points he makes. Namely, he claims that the extreme inequality that existed prior to World War I was corrected by the wealth destruction of two world wars and the Great Depression. He then goes on to argue that the retreat of progressive taxation in the developed world starting in the late 1970s ended up creating a level of inequality that approaches that seen prior to World War I.

Although he has ample data to back his assertions, his pre–World War I results might also be due to the fact that those countries were all in the pre-LTP urbanization phase, which is characterized by a rapid increase in inequality. Similarly, his post–World War I findings might be attributable to the West's entering the post-LTP golden era, where everyone enjoys the fruits of economic growth and inequality shrinks. Piketty attributes this to the destruction of wealth brought about by two world wars and the introduction of progressive income taxes, but this period was also characterized by an end to rapid urbanization in most of these countries. Furthermore, the four decades through 1970 marked a golden era for Western economies as their manufacturing sectors led the world and were being chased by no one.

Finally, Piketty's post-1970 results may be due to the fact that Western economies entered their pursued phase when Japan and other countries began chasing them. For Western capitalists able to utilize Asian resources, this was a golden money-making opportunity quite similar to what they had enjoyed during the pre-LTP urbanization era. But it was not a welcome development for Western factory workers, who found themselves competing with cheaper imports from Asia.

This also suggests that the favorable income distributions observed by Piketty in the West before 1970 and in Japan until 1990 were transitory phenomena. These countries enjoyed growing incomes and shrinking inequality not because they had the right kind of tax regime but because they were in the golden era, when manufacturing prospered. And it prospered because the global economic environment was such that these countries either were ahead of everyone else or were chasing others but were not themselves being pursued. In other words, the return on capital was highest at home.

Just because such a desirable state of affairs was observed once does not mean it can be maintained or replicated. Any attempt to preserve that equality in the face of fierce international competition would have required massive and continuous investment in both human and physical capital, something that most countries are not ready to implement.

It is not even certain whether such investment constitutes the best use of resources since businesses may still find that the return on capital is higher elsewhere. To the extent that businesses are under pressure from shareholders to invest in countries offering the highest returns, forcing them to invest at home is no easy task. That means a more extreme form of protectionism than what was proposed by Donald Trump may be needed to keep cheaper foreign goods out and force businesses to invest at home. What is certain, however, is that a completely different mindset is required to secure economic growth in the pursued countries.

Now that most advanced countries are in the pursued phase, the key question for policy makers should be how to increase investment and borrowings, both public and private, to absorb all the savings generated by the private sector and allow the economy to grow again. Unfortunately, very little of the policy debate in advanced countries is couched in these terms. And there have been almost no macroeconomic studies on the policy implications of capital earning higher returns abroad than at home. Instead, almost all macroeconomic theory and policy debate is based on the golden era assumption that attractive domestic investment opportunities are always available.

For example, central banks in the advanced countries had been trying to increase the rate of inflation to 2 percent during the post-2008 balance sheet recession because that was the optimal rate for attaining maximum long-term growth during the golden era. But at the time, most businesses had factories only at home.

In today's pursued era, companies have production facilities all over the world. When domestic inflation rates outstrip those abroad because the central bank is aggressively easing monetary policy, many companies will shift production to their foreign plants to remain competitive, resulting in less employment and investment at home. This is the opposite of what the 2-percent inflation target is supposed to achieve. Unfortunately, economics has failed to reflect these and many other fundamental changes that have taken place over the last three decades.

Economic policy debate in advanced countries is still conducted as though they are still in the golden era because the foundations of macroeconomics were laid in the 1950s when the West was in the golden era. And because it was a beautiful era (apart from air quality), politicians and economists alike long for its return. But they will not be able to improve people's lives until they fully appreciate the current economic reality in a global context. These points are discussed in greater detail in the next two chapters.