The original Socialist Economic Bulletin was published, in hard copy form only, from 1990-2000. It gained an extremely high reputation for economic analysis and policy on the left, in the Labour Party and, judging by its subscribers, in far wider circles. That Socialist Economic Bulletin pioneered the possibilities created by modern personal computers to bring hard statistical based analysis to economic policy making on the left but it was published before the internet era and relied on paper circulation.
Socialist Economic Bulletin made its reputation by correctly forecasting the disaster that would follow from British membership of the ERM, published articles on women and the economy, was one of the first to draw attention to the sustained rise of the Chinese economy, wrote on world poverty and analysed the much less serious credit crunch of its time, as well as publishing regular analysis of the British economy and the appropriate policies. Socialist Economic Bulletin set a standard of statistical excellence, and therefore ability to analyse economic events, that made it a respected reference point in the discussion on economic policy. It showed the left was able to win the debate on the economy not by dogma or rhetoric but by being factually correct and rigorous. Those who want a short review of the history of Socialist Economic Bulletin can find it on pages 275-278 of Andrew Hosken's book. [1]
The reason for relaunching Socialist Economic Bulletin now is evident. The global financial crisis is the most serious in the world economy since 1929. Many of the trends already analysed in the earlier Socialist Economic Bulletin continue today in a stronger form today. Today the internet makes it both easier to produce, and more rapid to circulate, socialist economic analysis.
Socialist Economic Bulletin will have its own viewpoint. But it is open to all on the left who want to contribute to the formation of economic policy.
[1] Andrew Hoskens, Ken, Arcadia Books London 2008.
The Paulson plan and unrest in US politics
Introductory note
Socialist Economic Bulletin is reproducing three articles on the long term background to the current financial crisis which appeared on the blog Key Trends in the World Economy. This blog is published by John Ross, Ken Livingstone's Director of Economic and Business Policy when the latter was Mayor of London. The views expressed in these articles are, however, the personal ones of John Ross and do not necessarily represent the views of Socialist Economic Bulletin.
* * *The $700 billion Paulson plan passed by the US Congress will have only a marginal effect on the international financial crisis. It will however have a profound effect on US politics – reinforcing the trend to an era of greater US political turbulence.
The reason the Paulson package will have no major effect on the financial crisis is easily grasped – it is simply too small to be decisive. $700 billion may sound a large sum, but it is small compared to the size of the markets it is seeking to stabilise.
To put arithmetic to this, the $700 billion of the Paulson package may be measured against the $393,000 billion in financial contracts outstanding at the end of 2007. Many such contracts, of course, merely offset each other, and while this sum indicates the weight and complexity of these markets it is not a net figure. However, the issue driving the financial situation, the crisis in US housing mortgages, is a net lending market of $12,000 billion. The entire Paulson package is therefore not only small when compared to the scale of US financial markets but equivalent to only a six per cent fall in US house prices - and a further six per cent fall in US house prices is not merely possible but even likely.
It is the falling prices of the assets, such as housing debt, held by financial institutions that is the transmission belt to the present fulcrum on the crisis – the sharply deteriorating situation in the interbank lending market illustrated in Figure 1.
The vertiginous rise in interbank lending rates that may be seen during September reflects the market's anticipation of high levels of risk of further insolvencies by financial institutions. This risk, leading to fears of a run on the banks, in turn produced the new element of destabilisation – the 100 per cent guarantees on bank deposits introduced by the Irish and Greek governments, which itself produces a move of assets into the institutions covered by such guarantees and out of those of other countries. In effect Ireland and Greece are avoiding a run on their own banks by producing a run on other countries banks.
The prospect of the passage of the Paulson package totally failed to reverse the interbank lending crisis, simply because it is far too small. In the short term only the state can temporarily sustain the interbank lending markets – by the middle of last week financial firms were going to the Federal Reserve for $409.5 billion in overnight loans and even this led to no downward movement in one or three month interbank lending rates - as may be seen in Figure 1. In the medium term only factors affecting overall US spending power by consumers, government and corporations, and international developments, have sufficient weight to reverse that situation.
But if the financial effects of the Paulson plan will be marginal it will have a deep effect on US politics. The model by which free markets are supposed to operate is that entrepreneurs fairly bear the consequences of both success and risk – if they take the right decisions they profit, if they take the wrong decisions they suffer losses.
This model is supposed to continue to operate even in cases where, for any reason, there has to be widespread state intervention. The reason the rescue of the Swedish banking system in the 1990s has been widely praised in the media, and by economic experts, is because it stuck to this principle. Depositors were safeguarded, but the shareholders of banks that had made wrong decisions shouldered any losses before risk to the taxpayers money that was used to rescue the banking system – that is, tax payers were protected and shareholders took the risk.
The Paulson package stands this on its head. Bad debts will be purchased from banks by up to $700 billion supplied by tax payers. This will improve the situation for shareholders, as they will be relieved of the bad debts, but it is bad for taxpayers - who will be acquiring the worst performing assets. In other words the Paulson plan is the opposite of the Swedish one; shareholders are being protected and taxpayers are taking the risk.
Despite this fundamental feature, if the US financial system were to turn round in the short term then while the Paulson package would be unjust it would not be very serious in its social and electoral consequences. Up to $700 billion of taxpayers money would be spent on bad debts in the short term but then this sum would be returned to tax payers as the purchased assets recovered to better values.
But this is extremely unlikely to happen. As has been noted in previous posts the essence of the present financial crisis is the revaluation downwards of assets priced in dollars. Therefore US taxpayers will not get their money back. As shareholders in distressed US financial institutions will have benefited in the meantime there will therefore be a shift in resources from US taxpayers to various categories of shareholders of distressed financial institutions. This, needless to say, will be unpopular.
This is why the Paulson package will not stabilise financial markets - but it will help sustain unrest in US politics.
This article first appeared as 'The Paulson plan and unrest in US politics' on Key Trends in the World Economy
Socialist Economic Bulletin is reproducing three articles on the long term background to the current financial crisis which appeared on the blog Key Trends in the World Economy. This blog is published by John Ross, Ken Livingstone's Director of Economic and Business Policy when the latter was Mayor of London. The views expressed in these articles are, however, the personal ones of John Ross and do not necessarily represent the views of Socialist Economic Bulletin.
* * *
The reason the Paulson package will have no major effect on the financial crisis is easily grasped – it is simply too small to be decisive. $700 billion may sound a large sum, but it is small compared to the size of the markets it is seeking to stabilise.
To put arithmetic to this, the $700 billion of the Paulson package may be measured against the $393,000 billion in financial contracts outstanding at the end of 2007. Many such contracts, of course, merely offset each other, and while this sum indicates the weight and complexity of these markets it is not a net figure. However, the issue driving the financial situation, the crisis in US housing mortgages, is a net lending market of $12,000 billion. The entire Paulson package is therefore not only small when compared to the scale of US financial markets but equivalent to only a six per cent fall in US house prices - and a further six per cent fall in US house prices is not merely possible but even likely.
It is the falling prices of the assets, such as housing debt, held by financial institutions that is the transmission belt to the present fulcrum on the crisis – the sharply deteriorating situation in the interbank lending market illustrated in Figure 1.
The vertiginous rise in interbank lending rates that may be seen during September reflects the market's anticipation of high levels of risk of further insolvencies by financial institutions. This risk, leading to fears of a run on the banks, in turn produced the new element of destabilisation – the 100 per cent guarantees on bank deposits introduced by the Irish and Greek governments, which itself produces a move of assets into the institutions covered by such guarantees and out of those of other countries. In effect Ireland and Greece are avoiding a run on their own banks by producing a run on other countries banks.
The prospect of the passage of the Paulson package totally failed to reverse the interbank lending crisis, simply because it is far too small. In the short term only the state can temporarily sustain the interbank lending markets – by the middle of last week financial firms were going to the Federal Reserve for $409.5 billion in overnight loans and even this led to no downward movement in one or three month interbank lending rates - as may be seen in Figure 1. In the medium term only factors affecting overall US spending power by consumers, government and corporations, and international developments, have sufficient weight to reverse that situation.
But if the financial effects of the Paulson plan will be marginal it will have a deep effect on US politics. The model by which free markets are supposed to operate is that entrepreneurs fairly bear the consequences of both success and risk – if they take the right decisions they profit, if they take the wrong decisions they suffer losses.
This model is supposed to continue to operate even in cases where, for any reason, there has to be widespread state intervention. The reason the rescue of the Swedish banking system in the 1990s has been widely praised in the media, and by economic experts, is because it stuck to this principle. Depositors were safeguarded, but the shareholders of banks that had made wrong decisions shouldered any losses before risk to the taxpayers money that was used to rescue the banking system – that is, tax payers were protected and shareholders took the risk.
The Paulson package stands this on its head. Bad debts will be purchased from banks by up to $700 billion supplied by tax payers. This will improve the situation for shareholders, as they will be relieved of the bad debts, but it is bad for taxpayers - who will be acquiring the worst performing assets. In other words the Paulson plan is the opposite of the Swedish one; shareholders are being protected and taxpayers are taking the risk.
Despite this fundamental feature, if the US financial system were to turn round in the short term then while the Paulson package would be unjust it would not be very serious in its social and electoral consequences. Up to $700 billion of taxpayers money would be spent on bad debts in the short term but then this sum would be returned to tax payers as the purchased assets recovered to better values.
But this is extremely unlikely to happen. As has been noted in previous posts the essence of the present financial crisis is the revaluation downwards of assets priced in dollars. Therefore US taxpayers will not get their money back. As shareholders in distressed US financial institutions will have benefited in the meantime there will therefore be a shift in resources from US taxpayers to various categories of shareholders of distressed financial institutions. This, needless to say, will be unpopular.
This is why the Paulson package will not stabilise financial markets - but it will help sustain unrest in US politics.
This article first appeared as 'The Paulson plan and unrest in US politics' on Key Trends in the World Economy
Fundamental driving forces of the financial crisis
Introductory note
Socialist Economic Bulletin is reproducing three articles on the long term background to the current financial crisis which appeared on the blog Key Trends in the World Economy. This blog is published by John Ross, Ken Livingstone's Director of Economic and Business Policy when the latter was Mayor of London. The views expressed in these articles are, however, the personal ones of John Ross and do not necessarily represent the views of Socialist Economic Bulletin.
* * *
It is superfluous to note on this blog that the world economy is passing through the most severe financial crisis since 1929.[1] Its results are also beginning to be well understood: the era of increasing deregulation has ended and instead increased, in the US very large scale, state intervention in the economy has begun.[2]
But what type of crisis is this - which greatly affects what its eventual outcome will be?
The most trivially superficial explanation, put forward in tabloid newspapers and demagogic political speeches, is that this is an extremely severe short term convulsion caused by the activities of ‘financial spivs’ and ‘short sellers’– modern embodiments of the ‘gnomes of Zurich’ denounced by British Prime Minister Harold Wilson in the 1960s, Slightly less superficially it is ascribed to subjective, widespread, miscalculation by financial institutions.[3] A related view is that the fundamental factor is psychology.[4] Therefore, there is a widely asserted view that the key issue is ‘confidence' or 'lack of confidence’.
If any of the above were true then, although the present financial convulsion is severe, the adjustments that will follow will eventually be relatively minor. Once current psychology is reversed, that is ‘confidence is restored’, there can be a return to something approximating the previous situation – doubtless with some individual changes.
Such analyses are false. The present financial crisis is not rooted in psychology or subjective mistakes. It is rooted in long term economic trends. Its roots are therefore objective not subjective. Psychology is not driving the objective economic forces but following them.
The unfolding of the financial crisis does, however, show the importance of considering long term trends, and underlying developments, rather than merely considering short term shifts or individual facts taken out of context - as occurs in many newspaper commentaries. Misunderstanding of the preceding period, through failure to consider the overall situation, inevitably led to confusion regarding present events.
The outcomes, and conclusions regarding the real driving forces of the present financial crisis, will be considered at the end of this article. First, however, the decisive data on the situation will be set out.
The most fundamental cause driving the present financial crisis was dealt with in a previous post on this blog - 'Why Asia will continue to grow more rapidly than the US or Europe'. This showed that the US now lags far behind the key Asian economies in the proportion of its economy which is invested - with a consequent continuing decline in the international competitiveness of the US economy.
This trend can be seen in Figure 1 - which is a simplified form of the graph in the previous post. It shows the investment levels (gross domestic fixed capital formation) as a proportion of GDP in the US, China and India. The US invests only 18-20 percent of its GDP whereas India invests over 30 percent and China more than 40 per cent. Similar, if less striking, graphs would show the same pattern for other key Asian economies. The result is China’s economy is growing at 9-11 percent a year, India’s at 7-9 per cent a year, and the US at only 3 percent a year.
Given this US lag in investment, which is a key factor in competitiveness, the US economy, at any given exchange rate, becomes progressively less competitive over time. Consequently, given this decreasing underlying competitiveness, as long as the US does not raise its investment levels to that of other economies the only way for it to remain competitive is to steadily lower its exchange rate – that is to progressively devalue the dollar.
This declining competitiveness of the US economy is illustrated clearly in Figure 2, showing the US balance of payments. That the US runs a large balance of payments deficit is well known, but this graph shows the phases in the unfolding of that process.
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The US balance of payments first began to slide into sharp deficit in the early 1980s - the deficit initially reaching over 3 per cent of GDP by the mid-1980s
There was a short lived recovery in the early 1990s - due to dollar devaluation, recession at the beginning of that decade, and a large one off payment from the Gulf states to finance the first Gulf war.
This short recovery was followed by an even greater US balance of payments deficit after 1991 - which reached a peak of well over 6 per cent of GDP, or over well $700 billion a year, by 2006.
To show this development over a longer period Figure 3 shows net US ‘lending’ to the rest of the world since 1956 – a negative number showing US borrowing from the rest of the world. The deterioration of the competitiveness of the US economy is evident from these trends.
Figure 3
Given that the low US level of investment means the only fundamental mechanism by which it can remain competitive is dollar devaluation therefore Figure 4 shows the long term exchange rate of the dollar against two of the world's three most important non-US currencies, the euro and the yen - comparisons over the same period with the third, the yuan, are not meaningful as until the early 1980s China had an artificially set exchange rate which was not aimed at participation in international trade.
Figure 4
Three clear periods of developments in the US exchange rate are evident.
- From the immediate post-war period to the early 1970s the US maintained fixed exchange rates under the Bretton Woods currency system.
- From 1973 until the mid-1980s, via sharp short term fluctuations, a substantial dollar devaluation took place.
- From the mid 1980s onwards, while there were considerable short term fluctuations, and formally a floating exchange rate system operated, in fact the long term trend of the dollar’s exchange rate was stable.
The worsening US balance of payments situation, already shown in Figure 2, was an inevitable result of the the two circumstances which operated after the mid-1980s. The combination of
a deteriorating competitiveness of the US due to its low investment rate
a stable dollar exchange rate which prevented competitiveness being maintained by devaluation
necessarily meant an increasing movement into deficit of the US balance of payments - precisely as shown in Figure 2. In otherwords the dollar became progressively overvalued compared to the underlying competitiveness of the US economy.
The means whereby this dollar exchange rate remained stable, despite the worsening balance of payments deficit and the fact that the exchange rate was not formally fixed, is shown in Figure 5. Net foreign purchases of US debt instruments, Treasury Bonds and others, rose from around zero per cent of GDP in the early 1980s to 5.6 per cent of GDP in 2007 or $770 billion. The large inflow of investment in US debt instruments counterbalanced the deteriorating current exchange deficit to maintain a stable dollar exchange rate.
Figure 5
It is, however, impossible to cheat underlying economic forces. The history of all economies shows that attempts to artificially maintain a high exchange rate against the pressure of underlying economic forces will eventually fail. In short, at some point, there would inevitably be a dollar devaluation.
The consequences of an overvalued dollar for asset values denominated in dollars are also clear. The values of assets held in overvalued dollars are themselves necessarily overvalued in real international terms. There would, therefore, eventually be a revaluation of such assets downwards to their real, that is lower, values. As that downward revaluation takes place it will erode or destroy the balance sheet of the institutions holding such assets – this is the process which is at present occurring, unleashing the wave of bankruptcy of US financial institutions.
As the dollar devalues, and assets decline towards their real competitive values, two other processes occur.
Foreign holders of dollar assets suffer losses – given that last year alone such inflows, as noted, amounted to $770 billion in US debt instruments any such losses would be large. Japan is estimated to hold $860 billion in US debt instruments, including Treasury Bonds and $75 billion in debt issued previously by the recently nationalised US mortgage institutions Fannie May and Freddie Mac. China is estimated to hold large quantities of US Treasury Bonds and up to $400 billion in Fannie Mae and Freddie Mac debt.
Given the decline in the value of US assets, a political struggle breaks out between different groups in the US population over who will bear the cost of such a fall.
Given the preceeding overvaluation of the dollar it is inevitable that such shifts should take place. In essence the current financial crisis in the US is a classic one of the attempt to maintain an overvalued exchange rate - the type of crisis which affected Mexico in 1982, Russia in 1998, or Argentina in 2001. In each of these cases the inevitable collapse of the attempt to maintain an overvalued currency wrought havoc on the financial institutions of the country concerned. In the case of the US the fact that its economy is on a much larger scale, and plays a pivotal role in the global economy, makes the consequences of such a crisis far more severe.
Why, however, If the crisis is of a rather classical form is there confusion over its driving forces - of the type outlined at the beginning of this article?
The confusion has arisen because a number of commentators in the preceeding period, instead of considering fundamentals and overall trends, took individual facts out of context and created a false ‘narrative’ regarding developments. This perspective was that the US economy was becoming more competitive - to the point where it had created a ‘new economy’. This false perspective was rationalised by looking at a few individual sectors, notably high technology, in which the US is indeed highly competitive. But, as shown in the balance of payments figures, overall the US economy was becoming less, not more, competitive.
The financial crisis is therefore not rooted in psychology nor in short term developments. It is rooted in objective economic processes operating over long periods. The outcome and unfolding of this crisis will, however, be determined by political factors.
The interrelation of these economic and political elements will be looked at in a future post. But the fundamental factors in the situation are clear and flow from the above trends.
If the US were to seek to achieve a level of investment to match its Asian rivals this would, in the short term, due to the huge transfer of resources from consumption to investment that would be required, unleash a wave of popular discontent in the US that would destabilise the political situation - for that reason it is highly unlikely to occur in the short term. The only other way to restore competitiveness in the short term, that is dollar devaluation, would cause radical financial destabilisation as the value of dollar assets declines - destroying the balance sheets of financial institutions holding such assets.Either course will produce strong pressure on the living standards of the US population and therefore have major political impact in the US.
This article was originally published as 'Fundamental driving forces of the financial crisis' on Key Trends in the World Economy
References
[1] For the New York Times: ‘The nation is gripped by the worst financial crisis since the Great Depression.’ For the Wall Street Journal it is ‘Black September' which the papercharacerised simply as 'the worst financial crisis since the 1930s'. The Times characterised the US as suffering from: ‘the cataclysmic fall-out from the country’s worst financial crisis since the Great Depression of the 1930s.’ For the Guardian it was: ‘the most traumatic week on Wall Street since the Great Depression’ For Robert Peston of the BBC: ‘The US Government... admitted that the financial system was on the verge of total meltdown.’
The Wall Street Journal gave a particularly graphic account of the events of 19 September: ‘When government officials surveyed the flailing American financial system this week, they didn't see only a collapsed investment bank or the surrender of a giant insurance firm. They saw the circulatory system of the U.S. economy -- credit markets -- starting to fail.
‘Huddled in his office Wednesday with top advisers, Treasury Secretary Henry Paulson watched his financial-data terminal with alarm as one market after another began go haywire. Investors were fleeing money-market mutual funds, long considered ultra-safe. The market froze for the short-term loans that banks rely on to fund their day-to-day business. Without such mechanisms, the economy would grind to a halt. Companies would be unable to fund their daily operations. Soon, consumers would panic...
‘One day later, Mr. Paulson and Federal Reserve Chairman Ben Bernanke sped to Congress to seek approval for the biggest government intervention in financial markets since the 1930s. In a private meeting with lawmakers, according to a person present, one asked what would happen if the bill failed.
"If it doesn't pass, then heaven help us all," responded Mr. Paulson, according to several people familiar with the matter.’ Similarly: America was “literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally,” Senator Christopher Dodd, Democrat chairman of the Banking, Housing and Urban Affairs Committee reported after the meeting.’
[2] As the Wall Street Journal put it: ‘In Turmoil, Capitalism in U.S. Sets New Course’. More precisely: ‘the biggest financial shock since the Great Depression, is prompting a Republican Treasury secretary and Federal Reserve chairman to devise the most muscular government intervention in the economy since the Great Depression in an effort to prevent the economic devastation of the Great Depression.’
'In March, the Federal Reserve shattered a half-century of tradition in which it had lent money only to banks whose deposits were insured by the government. Declaring circumstances to be "unusual and exigent," as required by a little-used statute, it lent to investment bank Bear Stearns and eventually risked $29 billion of taxpayer money to induce J.P. Morgan Chase to buy Bear. It seemed a very big deal at the time.
‘But in the past two weeks, the U.S. government, keeper of the flame of free markets and private enterprise, has:
‘- nationalized the two engines of the U.S. mortgage industry, Fannie Mae and Freddie Mac, and flooded the mortgage market with taxpayer funds to keep it going;
‘- crafted a deal to seize the nation's largest insurer, American International GroupInc., fired its chief executive and moved to sell it off in pieces.
‘- extended government insurance beyond bank deposits to $3.4 trillion in money-market mutual funds for a year;
‘- banned, for 799 financial stocks, a practice at the heart of stock trading, the short-selling in which investors seek to profit from falling stock prices.
‘- allowed or encouraged the collapse or sale of two of the four remaining, free-standing investment banks, Lehman Brothers and Merrill Lynch;
‘- asked Congress by next week to agree to stick taxpayers with hundreds of billions of dollars of illiquid assets from financial institutions so those institutions can raise capital and resume lending.
‘It was less than a week ago that Mr. Paulson appeared to draw a line at government bailouts, rebuffing Lehman's plea for a Bear Stearns-like rescue and allowing the investment bank to collapse into bankruptcy. "The national commitment to the free market lasted one day," Barney Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, quipped earlier this week. That one day was Monday, Sept. 15. The day before the government rejected Lehman's cry for help; the day after it seized AIG.’
The Financial Times stated the US government: ‘envisage[s] the most extensive peacetime expansion of the role of government in the financial system since the Great Depression and appeared to many to mark the end of an era of Reaganite deregulation.’
[3] The BBC's respected business editor, Robert Peston, for example stated: ‘an entire generation of banking executives had behaved wholly irresponsibly in their lending practices for years’.
[4] Robert Peston, for example, suggesting that what we now have is ‘a stock market that is bereft of reason and is being driven almost purely by hysteria and momentum.’
Why Asia will continue to grow more rapidly than the US and Europe - a historical perspective
Introductory note
Socialist Economic Bulletin is reproducing three articles on the long term background to the current financial crisis which appeared on the blog Key Trends in the World Economy. This blog is published by John Ross, Ken Livingstone's Director of Economic and Business Policy when the latter was Mayor of London. The views expressed in these articles are, however, the personal ones of John Ross and do not necessarily represent the views of Socialist Economic Bulletin.
* * *
Data on long term trends in investment and economic growth
This post deals with the historic trend of investment and economic growth. This may appear a relatively esoteric topic. In fact, however, it has decisive economic and strategic business consequences - in particular for understanding the more rapid growth of the key Asian economies relative to the US and Europe and why this will continue for a prolonged period. Before dealing with these and other more detailed implications, however, the factual data is set out.
Figure 1 shows the percentage of fixed investment (gross fixed capital formation) in GDP for a series of major countries over the longest periods of time for which data is available. [1]
Figure 1
The pattern is clear and striking. By far the strongest trend is for the proportion of GDP devoted to fixed investment (gross domestic fixed capital formation) to rise with time. This in turn, as will be shown, is associated with progressively rising rates of economic growth.
Considering countries in the chronological order in which a new peak in the proportion of GDP devoted to gross fixed domestic capital formation appeared the following is the historical pattern.
- Commencing with the period immediately antedating the industrial revolution, the proportion of GDP devoted to fixed investment in England and Wales, at the end of the 17th century, was 5-7 per cent. [2] This rose slightly, although current estimates are that it did not rise greatly, during the 19th century - peaking at over ten percent of UK GDP prior to World War I.
This level of investment was sufficient to launch the first industrialisation of any country but at a rate of growth which, while unprecedented at the time, was extremely slow by contemporary international standards - about two per cent a year. With such a growth rate it takes 35 years for an economy to double in size and 70 years to quadruple.
- Turning to the latter part of the 19th century, the proportion of US GDP devoted to fixed investment had risen to considerably exceed that for the UK – reaching a level of 18-20 per cent of GDP by the last decades of the century.
A sharp fall in the proportion of the US economy devoted to fixed investment commenced in the late 19th century, and was particularly pronounced during the period between World War I and World War II – being associated with the great depression of the inter-war period. After World War II the US resumed its pattern of 18-20 per cent of GDP being devoted to gross fixed capital formation. This generated an average growth rate of 3.5 per cent a year. With such a growth rate an economy doubles in size every 20 years and quadruples in size every 40 years. It was on the basis of this historical level of investment, and growth rate, that the US overtook Britain to become the world’s greatest economic power.
- In the period following World War II Germany achieved a level of fixed investment exceeding 25 per cent of GDP – peaking at 26.6 per cent in 1964. This period 1951-64 was that of the post-war German ‘economic miracle’ with average growth of 6.8 per cent a year - with such a growth rate an economy doubles in size every 11 years and quadruples in 22 years.
- Starting at the beginning of the 1960s Japan achieved a level of gross domestic fixed capital formation of more than 30 per cent of GDP. This reached a peak in the early 1970s, at 35 per cent of GDP, before later sharply falling. During that period the average annual rate of growth of the Japanese economy was 8.6 per cent. With such a growth rate an economy doubles in size in eight and half years and quadruples in size in 17 years.
- From the 1970s onwards, South Korea similarly achieved a level of fixed investment of 30 per cent of GDP. During the 1980s this rose above 35 per cent of GDP. The other East Asian ‘Tiger’ economies – Singapore, Hong Kong and Taiwan – showed a similar pattern. South Korea’s economy confirmed the relation between fixed investment and economic growth illustrated by Japan by growing in this period by an average 8.3 per cent a year. At such a growth rate an economy doubles in size in nine years and quadruples in 18.
Such growth rates in Asia showed that something unprecedented in human history was now possible – that it was possible to industrialise an economy, and achieve a ‘first world’ level of development, in a single generation.
- From the early 1990s onwards China achieved sustained rates of fixed investment of 35 per cent of GDP with, from the beginning of the 21st century, this rising to more than 40 per cent of GDP – a level never before winessed in human history. The result was average 9.8 per cent a year economic growth over a sustained period – also the most rapid sustained economic growth ever seen in human history. On that basis an economy doubles in size every seven and a half years and quadruples in size in 15 years.
- To complete the chronological picture, the proportion of GDP devoted to fixed investment for two countries recently undergoing rapid economic growth, India and Vietnam, is shown. The proportion of Indian GDP devoted to fixed investment has not reached the Chinese level but has become high – reaching 34 per cent of GDP in 2007. On this basis, in the last five years, India has achieved an average growth rate of 8.8 per cent a year. At that rate of growth India’s economy doubles in size in slightly over eight years and quadruples in sixteen and a half years.
In Vietnam the proportion of GDP devoted to fixed investment rose from 13 per cent in 1990 to 25 per cent in 1995 to 37 per cent in 2007. Economic growth has accelerated rapidly, rising to an average of 7.9 per cent a year in the five years up to 2007. At that rate of growth Vietnam’s economy doubles in slightly under 9 years and quadruples in size in 18 years.
Considering these trends, such a high level of investment is a necessary condition for rapid economic growth. No substantial country without comparable high levels of fixed investment has achieved such rapid rates of growth on a sustained basis. [3] But it is not a sufficient condition: the high level of investment is also linked to the scale of production, that is the size of the market being produced for. In a modern economy only large scale production can be efficient in the decisive sectors of production, requiring an orientation to the international market – this is particularly evident with such high levels of investment.
No purely national market, not even the US or China, is sufficiently large to maintain the most efficient level of production. As many others have frequently correctly stressed, high levels of investment must therefore be accompanied by an export orientation. [4] It is this high level of investment, accompanied by an export orientation, which was responsible for the rapid economic growth of South Korea, China, India and Vietnam.
Implications of different investment levels
There are a number of clear consequences of these factual trends (it must be stressed that this data, of course, deals only with long and medium term trends and is not a guide to short term fluctuations). Among the most important of these implictions are:
- It provides a clear historical framework for understanding the present rapid growth of (primarily Asian) economies and why they will continue to grow far more rapidly than the US and Europe.
- China’s economy will continue to outperform India’s and the gap between the two will grow - and not shrink as some have suggested.
- There is no serious historical evidence for the thesis sometimes presented that China is oversaving/overinvesting. China therefore should seek to maintain, and not cut, its current savings and investment levels.
- Current US/UK economic policy, with its overwhelming emphasis on microeconomic efficiency of resource allocation, fails to address the most important economic issues and therefore will be unsuccessful – which will deepen the tendency for the key Asian economies to grow more rapidly than the US and Europe. The also provides a background to current issues in the credit crunch.
Taking these issues in more detail:
First, these trends place in wider historical context the present rapid growth of a number of (primarily Asian) economies. The latter represent the latest high point in the trend for higher and higher proportions of GDP to be devoted to fixed investment. Consideration of such trends therefore provides a clear theoretical underpinning for the evident current empirical fact that not only is Asia growing substantially more rapidly than the US and Europe but that it will continue to do so. The investment rates in the key Asian economies are not aberrantly high but merely the latest point in an historical trend.
Seen in long term historical perspective it is US and European savings and investment rates that are too low, not Asian savings and investment rates that are too high.
Second, given these historic trends, it is clear that on the basis of current macroeconomic trends China’s economy will continue to expand more rapidly than India's and that China will increase its economic lead over the latter.
This naturally does not mean anything other than that India is an extraordinarily important market. India’s economy is, at a realistic exchange rate, in Parity Purchasing Power (PPP) terms, the fourth largest economy in the world after the US, China and Japan.[6] India's economic growth, running at around at 8-9 per cent a year, is the second largest for any major economy in the world after China. However, China’s economy is already approximately two and a half times the size of India’s in PPP terms and is continuing to grow at one to two per cent a year more rapidly than India – this combination ensuring that the gap between China and India is widening and not narrowing. There is also no evidence from consideration of historical data that the factors invoked to claim that India’s economy will grow more rapidly than China’s, for example different demographic profiles, are crucial. The historical evidence is that it is the proportion of the economy devoted to gross fixed capital formation that is decisive. The fact that, until the present, the Chinese economy continues to devote a significantly higher proportion of the economy to fixed investment than India – 43 per cent compared to 34 per cent to take the latest available years, indicates that unless India catches up with China in terms of this area China will grow more rapidly than India.
Third, there is no evidence from this historical trend data for the argument that China is facing a basic crisis of oversaving/overinvestment, and therefore that China needs to lower its total savings level (i.e. savings including private, public and corporate saving) and to increase consumption - as some commentators, including the Financial Times chief economics commentator Martin Wolf, have stated. [5]
It is evident that China’s level of investment and saving is far higher than that of the US or UK. However the historical data make clear that China’s is simply the latest stage in the long term trend for an increasing proportion of GDP to be devoted to gross fixed capital formation. Given this rising historical trend it is entirely likely that in the future another country, or China itself, will have a higher proportion of GDP devoted to saving/investment than China today - yielding a higher rate of growth.
While, of course, short term fluctuations and adjustments may be required there is no historical evidence that China's savings and investment rate is excessively high - it is merely the latest stage in a long term international historical trend. Reduction of China’s investment and savings rate would lead to slowdown not only of China’s economy but also, because of its locomotive role in the world economy, a slowdown in the global economy. China should therefore be seeking to maintain, not reduce, its current high investment and savings levels.
Fourth, there is no evidence from the historical data that the 'quality of entrepreneurship' plays any crucial role in economic development. Or more precisely, and what is another way of saying the same thing, the quality of entrepreneurship and managerial effectiveness appears to be randomly distributed and therefore cannot explain differences in economic growth rates. There are no cases where, due to the 'quality of entrepreneurship', countries have experienced rapid growth without high levels of gross domestic fixed capital formation in GDP.
Fifth, present US/UK government economic policy, by according overwhelming centrality to dealing with microeconomic efficiency, is addressing relatively minor issues in terms of international competitiveness compared to that of dealing with inadequate saving and investment rates. The economic priorities of a number of rapidly growing Asian economies will therefore clearly be more effective than that of the US and UK.
Put in other terms, the implications for governments’ economic policies of the long term trends outlined here is that in a balance between seeking microeconomic efficiency in the allocation of resources, and seeking a high level of savings and investment, the high level of savings and investment is more important that the emphasis on microeconomic efficiency from the point of view of creating economic growth.
There is an entirely reasonable supposition that the microeconomic allocation of investment in South Korea or China, given the use of subsidised loans, cross forms of ownership in different branches of industry, higher capital/output ratios etc, is less microeconomically efficient than in the UK or the US. However the rate of growth of the South Korean or Chinese economies is much more rapid, over a sustained period, than that of the UK or US.
Quantitatively the greater microeconomic efficiencies in allocation of resources in the US or UK, to generate an equal rate of growth, would have to compensate for their lower savings and investment ratios and there is no evidence that it does so. It is the higher savings and investment rates in Asian economies that predominate over greater microeconomic efficiency. Therefore any quality of microeconomic priorities in the US and UK will be overwhelmed by the quantity of investment in the rapidly growing economies of Asia.
Ideally, of course, both high microeconomic efficiency and high savings/investment levels should be sought. However there is evidence that the two are contradictory. For example the policies pursued in the US and UK have been accompanied by massive declines of savings rates which have undermined the competitiveness of the economy – leading into present sharp financial problems. It is therefore likely that current US and UK economic policy will be unsuccessful, and these economies will remain under financial pressure created by lack of competitiveness for a prolonged period. The credit crunch is a one periodic form of the manifestation of this loss of competitiveness by the US and UK.
Conclusions
The following clear conclusion may be drawn from this data:
There is a clear historical trend for the proportion of the economy devoted to gross domestic fixed capital formation to rise. This is the key determinant of rising rates of economic growth.
Five key historic stages in the rise in this proportion of the economy devoted to fixed investment may be identified: the achievement of a 5-7 per cent investment rate in Britain in the 18th century permitting the launching of the industrial revolution; an 18-20 per cent of GDP fixed investment rate from the latter part of the 19th century, achieved by a number of countries led by the US, which permitted the United States to replace the UK as the world's leading economic power; a 25 per cent of GDP fixed investment rate in Germany in the immediate post-World War II period which accompanied the German 'economic miracle'; a more than 30 per cent of GDP rate of fixed investment achieved in Japan, and then the other East Asian 'Tiger' economies, from the mid-1960s which permitted growth rates of more than 8 per cent a year; a more than 35 per cent of GDP fixed investment rate in China from the 1990s onwards which has permitted sustained growth rates approaching 10 per cent a year.
On the basis of this differential in investment rates a number of the key Asian economies will continue to outperform the US and Europe in terms of economic growth for a prolonged period.
China will continue to increase its economic lead over India - although the latter will experience rapid economic growth.
There is no historical evidence China is oversaving or overinvesting and it should seek to strategically maintain, and not cut, its present investment and saving rates.
Current US and UK economic policy addresses secondary issues and therefore is unlikely to be successful.
This article originally appeared as 'Why Asia will continue to grow more rapidly than the US and Europe - a historical perspective' on Key Trends in the World Economy
References
[1] The figure for England for 1688 is that in Angus Maddison, The World Economy, OECD Paris 2006 p395. UK figures after 1688 and up to 1947 are calculated from One Hundred Years of Economic Statistics, The Economist, London 1989 p74. Figures from 1948 are calculated from International Monetary Fund, International Financial Statistics (August 2008) Minor adjustments have been made to chain the earlier statistics to be consistent with the IMF data – in no case does this make any significant difference to the pattern shown. The data for fixed investment for the earlier period used by The Economist One Hundred Years of Economic Statistics are based on calculations in C H Feinstein and Pollard Studies in Capital Formation in the United Kingdon 1750-1820, Oxford University Press, Oxford 1988. Other commentators have suggested that Feinstein and Pollard's figures are somewhat too high - see for example. N F R Crafts British Economic Growth during the Industrial Revolution, Clarendon, Oxford 1986 p73. None of these revisions and differences however is of sufficient magnitude to alter the fundamental pattern shown here.
US figures prior to 1948 are calculated from One Hundred Years of Economic Statistics, The Economist, London 1989 p74. Figures from 1948 are calculated from International Monetary Fund, International Financial Statistics (August 2008) Data for the earlier period give only private fixed capital formation whereas that after 1948 is for total fixed capital formation – i.e. including government fixed capital formation. There are no reliable estimates of government fixed capital formation in the earlier period and therefore data for the earlier period have been adjusted upward by the difference between the two in 1948 – which is slightly over two per cent of GDP. This has the effect of revising upwards slightly the percentage of GDP allocated to fixed investment in the earlier period but the difference is too small to affect the overall pattern.
Figures for Germany prior to 1960 are calculated from One Hundred Years of Economic Statistics, The Economist, London 1989 p202. Figures from 1960 are calculated from International Monetary Fund, International Financial Statistics (August 2008). There is however no significant statistical difference between the two.
Figures for Japan, South Korea, China, India and Vietnam calculated from International Monetary Fund, International Financial Statistics.
[2] Phyllis Deane and W A Cole in British Economic Growth 1688-1959, Cambridge University Press, Cambridge 1980 p2 being closer to the lower figure while further studies have tended to revise the figure upwards slightly. The higher estimates for the earlier period have been taken here so as to avoid any suggestion of exaggerating the degree to which the proportion of GDP devoted to Gross Domestic Fixed Capital Formation has risen. The precise figure used here is that calculated by Maddison in Angus Maddison, The World Economy, OECD Paris 2006 p395. The higher figure, as can be seen, makes no difference to the overall trend.
[3] The only exceptions are the extremely small states, with populations of less than two million, of Equatorial Guinea and Botswana - which are so small their economic conditions can be essentially wholly determined by external factors.
[4] A particularly coherent theoretical explanation of this may be found in N Lardy Foreign Trade and Economic Reform in China, Cambridge University Press, Cambridge 1993.
[5] See for example Beijing should dip into China’s corporate bank and China should risk bolder trials. Similar views are expressed in The Growth Report: Strategies For Sustained Growth And Inclusive Development
[6] For a convenient survey of the latest calculations in this field see http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP.
Big is Flexible - New Patterns in World Investment
Introduction
Ken Livingstone MP
The latest figures on the emerging pattern of global investment present a massive challenge to the next government. The likely future we can extrapolate from these figures will come as a shock to many, particularly those who subscribe to the theory of post-fordism which became fashionable in the 1980s. According to this thesis, the era of mass assembly line output, pioneered by the Model T Ford, was superseded. New forms, based on ‘flexible batch production,’ were playing the leading role in the economy.
A series of interrelated concepts were advanced linked to this — that a tendency towards small(er) scale production had replaced the huge units of output of ‘Fordism,’ that service industries were replacing manufacturing, that a ‘segmentation’ of markets had/was taking place etc.. In a typical formulation of the period: ‘The new terrain is that of high technology, of small firms, computers and information technology’. This concept led, in terms of rhetoric, to various views that the large scale economy of the manufacturing period was bypassed and instead ‘small is beautiful.’This thesis was based on ripping individual aspects of the situation out of context, exaggerating them, and using this to destroy any quantified, precise or balanced consideration of reality, and thereby obscuring the real tendencies of development.
The real economic trends were, and are, the exact opposite of ‘small is beautiful.’ In the context of the issues discussed here, they might be termed ‘big is flexible.’The most advanced sectors of modern production are, indeed, characterised by extraordinary flexibility — compared to the standardisation caricatured in Henry Ford’s famous ‘you can have it any colour provided its black.’ But this emphasis on the outward forms of flexibifity, segmentation, and individualisation obscures the underlying economic reality. The necessary precondition, and foundation, for the flexibility of ‘post-Fordist’ production is an historically unprecedented level of investment and associated scale of production.
This trend is evident not merely in direct investment within industry — i.e. the technology which makes possible flexible manufacturing, but in the processes necessary to co-ordinate extremely large scale production — telecommunications systems, transport, computerisation of stock control etc. These, in turn, require radical expansion of the educational system — the creation, on a new and unprecedented scale, of skilled labour which is the indispensable precondition for operating this new, more capital intensive, production.The enormous concentrations of capital which make flexible production possible have a number of aspects. One, analysed by Socialist Economic Bulletin (SEB) in Fundamental Economic Implications of a Single European Currency, is that the necessary scale of production, of the most advanced industries, can only be carried out, on an efficient basis, on a scale which exceeds the nation state. It is this which is the ultimate root of globalisation — and why all attempts to pull production back into the scale of nation state are purely utopian.
This issue of SEB concentrates on a second aspect — that of the scale of investment required for modern production. This is considered from both an ‘extensive’ and an ‘intensive’ point of view. The ‘extensive’ is the spread of successively higher ratios of investment to GDP into the most successful contemporary economies. The ‘intensive’ is the penetration of high levels of investment into the new service sectors in the most advanced economies. This combination makes clear that what is being seen is not a retreat to the ‘small’ but a new upward twist in the role of large scale investment within the economy.The implications of this for the U.K. are evident. Britain historically suffered from an inadequate level of investment — a phenomenon illustrated again here. But under 18 years of Tory government this chronic historic problem has become acute — with investment having now fallen to its lowest share of GDP for forty years. The material analysed below shows that far from the rise of the service sector leading to a lessening of the requirements for investment, it will raise them still further — together with the demand for an educated labour force capable of operating this investment.
The last 18 years of Conservative government have not corrected (he historical distortions of the U.K. economy, but deepened them still further. An emphasis on investment by the next Labour government is the essential precondition for tackling any of the problems which face the British economy.Ken Livingstone MP
* * *
The historical rise in the proportion of the economy devoted to fixed investment is one of the most well established of long term economic processes. It will be illustrated below in considering the overall trend of fixed capital formation from the industrial revolution to the present. Current conjunctural trends, the development of very rapid economic growth in South East Asia, and the transformations within the service sectors of the most advanced economies, may then be clearly understood against this backdrop.1
The industrial revolutionWhile estimates for investment for early historical periods are extremely difficult to make, it is clear that at the time of the industrial revolution in the U.K., at the end of the 18th century, less than 10% of the U.K.’s GDP was allocated to fixed capital formation. To give an historical contrast, by the 1990s rates of investment had reached, in extreme cases, 35-40% of GDP. A rate of fixed capital formation of 30% of GDP, or above, is typical for Japan and the East Asian Newly Industrialising Countries (NICs) (Figure 1).
Sharp increases in investment
It is also clear from historical data that increases in the rate of investment do not occur gradually, but in (relatively) short periods that are frequently reflected in shifts in international economic leadership — i.e. such upward shifts in investment are ‘revolutionary’ rather than ‘evolutionary’.Since the industrial revolution four such waves of sharp increases in the proportion of GDP allocated to investment have taken place — with, arguably, a fifth occurring at present. Using as titles the countries which provided the ‘leading edge’ of such periods of increased investment, these may be termed the ‘UK period’, the ‘US period’, the ‘West German period’, and the ‘Japanese period’. The fifth may be termed the ‘Chinese/South East Asian period’ — although it remains to be seen if this is a new higher phase, or a generalisation of the preceding Japanese one.
These periods will be considered in chronological order.
The UK rate of investmentHistorical studies indicate that, following the industrial revolution, the U.K.’s domestic fixed capital formation was less than 10% of GDP and that no fundamental increase in the proportion of UK GDP devoted to fixed capital formation took place during the following century. While the U.K.’s savings rate became substantially higher than this level of domestic investment, the capital created was invested abroad. By the eve of World War I, U.K. annual overseas investment was larger than investment in its domestic economy — this tendency to substitute investment abroad for investment at home being one of the chief historical features of the U.K. economy, and substantially accounting for its weak character compared to its rivals. By 1885 UK fixed domestic capital formation was still only seven per cent of GDP.2
Only after World War II did U.K. domestic investment substantially rise as a proportion of GDP, and even then it remained lower than its rivals — while, simultaneously, its rate of investment abroad remained higher, in proportionate terms, than its competitors.The US rate of investment
While the UK level of domestic investment remained fixed at under 10% for over a century, the U.S., by the period following the end of the civil war, had qualitatively surpassed this rate — to achieve an historically unprecedented level of capital formation of 15-20% of GDP. This rate of fixed capital formation, being double that of the UK, accompanied the establishment of the US as the world’s leading economy — replacing Britain in the period from the nineteenth century until the end of World War II. Furthermore, the U.S. did not become a substantial investor abroad until after the two world wars, and even then its accumulation of foreign investment remained proportionately lower than that of the U.K.It is clear that the US has not succeeded in seriously raising this rate of investment since the period in which it was established. The post World War II US economy saw fixed capital formation still averaging 15-20% of GDP.
The West Germany rate of investmentData for German rates of investment prior to World War II are, unfortunately, not available. There is no evidence they surpassed US rates. However, by the early 1950s, West Germany had achieved a new historical peak of fixed investment of 20-25% of GDP — for the first time achieving a level clearly exceeding that of the U.S..
This level of investment, due to the competitive power/example of the West German economy, became generalised throughout Europe during the period of post-war boom from the 1950s-70s — with the exception of the U.K, in which the rate of investment remained lower. This pattern of investment, at a ‘West German level,’ underlay the process of economic convergence in Western Europe in this period. The failure of the U.K. to achieve this level of investment explained why it fell behind its European rivals, and was, and is, unable to participate in their process of convergence.On the international field, this new historically higher rate of fixed capital formation was accompanied by Western Europe achieving a more rapid rate of economic growth, and productivity increase, than the United States in the period from the 1950s to the early 1970s.
The Japanese rate of investmentFrom 1960 onwards Japan, which had commenced its post-war economic growth with levels of investment comparable to those of West Germany, achieved a new historical peak in investment rates — reaching levels of gross fixed capital formation of 30% of GDP and, at its peak, 35% of GDP. Such a rate of investment had, historically, only been previously seen once before — during Stalin’s period of rapid industrialisation of the USSR in the 1930s.
Japan’s rate of fixed capital formation has now been sustained for a quarter of a century indicating a new historical level in the proportion of GDP devoted to fixed investment.The international accompaniments of this ‘Japanese’ rate of investment are well known. During the 1960s and 1970s Japan achieved rates of growth exceeding that of not only the U.S. but also Western Europe.
The Chinese/South East Asian rate of investmentSince the beginning of the 1980s a rate of investment exceeding that of Japan has been achieved by China, and a number of the South East Asian NICs. Their levels of fixed capital formation have reached levels of 35-40% of GDP (Figure 2). If this is maintained it will, of course, represent a new higher period of rate of investment. However, this level has, so far, been sustained only for a relatively short period — a decade. It is, therefore, necessary to reserve judgement as to whether a new ‘plateau’ of investment, exceeding that of Japan, has been achieved or whether they will slip back to the Japanese level.
The consequences of such rates of investment are, however, clear. The four ‘Asian Tigers’ — South Korea, Hong Kong, Singapore and Taiwan — have been transformed from underdeveloped countries to advanced industrial states in a single generation. China is undergoing the most rapid sustained growth seen by any large underdeveloped country in history.
Successive rises in the rate fixed capital formationSummarising the above data the four, possible five, historically characteristic periods of rates of fixed investment can clearly be seen. These were:
• the UK rate, from the industrial revolution to the late nineteenth century, with levels of fixed capital formation of 5-10% of GDP;• the post-civil war level US with investment at 15-20% of GDP:
• the post-World War II West German level of fixed capital formation of 20-25% of GD?;• the post-1960 Japanese level of investment of 30% of GDP;
• a possible Chinese/South East Asian level of investment of 35% of GDP.‘Leaps’ in the rate of investment
It is evident that, at least in the modern period, such characteristic increases in the rate of fixed capital formation do not take place gradually but in relatively sudden spurts. The West German level of investment was achieved in ten years between the end of World War II and 1955; the Japanese level of investment was achieved in a rapid surge between 1950 and 1960; the Chinese/South East Asian rate of investment was achieved in the ten year period after 1980.‘Extensive’ increases of rates of investment
It is, furthermore, evident that once a ‘leading country’ of a given period has achieved the new higher proportion of GOP devoted to fixed capital formation this rate is ‘sticky’ — i.e. it is hard to achieve a higher rate. Once the UK had achieved the level of fixed capital formation of the industrial revolution its level of domestic investment rose only slightly over the next 150 years — a substantial increase only occurring in the post-World War II period. After the US had achieved its post-civil war level of investment this did not significantly increase in the next 130 years. West Germany did not succeed in rising above its post-World War II peak of investment. Such ‘stickiness’ of the rate of investment evidently reflects the fact that the relations between social groups, established by a given investment rate, would require major political upheaval to modify that level of investment.The result of such ‘stickiness’ is the ‘extensive’ spread of increases in the rate of investment. In each case the new, higher, level of fixed capital formation was accompanied by a shift in the geographical locus of the most rapid economic growth. This ‘leading edge’ of investment and growth rates passed successively from the UK to the United States in the late nineteenth century and the first half of the twentieth; to Western Europe, immediately after World War II; to Japan from the 1960s; and to China and the East Asian NICs from the 1980s onwards. A spiralling outwards from the first industrial countries occurred.
The rise of the ‘service economy’The rise of, first, the Japanese and now the EastlSouth East Asian economies is, of course, a commonplace observation of modern economics — although its place in the systematic successive increases in rates of investment is not so widely appreciated. But what is involved in the second characteristic process taking place within the already advanced economies themselves — that of the rise of the service sector?
It is in this field, in particular, that the idea of ‘smallness’ is thrown up. The level of investment in a ‘Fordist’ car plant is evident in its sheer physical size. Does, therefore, the rise of the service economy represent a retreat to a new, lower, level of investment? To illustrate the actual processes, Tables 1, 2 and 3 [at the end of this article] show, for those sectors for which data exists, the percentage of value added that is constituted by consumption of fixed capital in the U.S., Japan and Germany — i.e. in the most advanced economies. Consumption of capital, as a percentage of value added, is the most appropriate measure of the capital intensity of production.A number of features stand out in this data which are not connected to the rise of the ‘service economy’ — in particular the extremely capital intensive character of the extractive industries (oil, gas, coal, mining in general etc.), and agriculture (which in all three economies has a higher capital intensity than the average for the economy as a whole). But the most striking feature, for present purposes, is that in all three economies the level of capital intensity in manufacturing is lower than the average for the economy as a whole — i.e. manufacturing does not represent a peak level of investment, from which a decline then takes place. Other things being equal a shift out of manufacturing would be associated with a rise in the level of capital intensity, not a fall.
Distinctions within the service sectorThe process involved in this striking fact that manufacturing represents a sector of lower than average, not higher than average, capital intensity may be seen clearly by examining the service sectors in Tables 1 to 3. Certain service sectors have a low, common, capital intensity in all three economies — indicating that these are sectors that, at least at the present stage of economic development, are less capital intensive than manufacturing. These are notably the wholesale and retail distribution system and provision of government services. But considering the U.S. economy, that is the most advanced in the world, a whole series of service sectors have capital intensities significantly above the average — and substantially above those for manufacturing. These include communications and telecommunications, hotels, recreational and cultural services, finance, non- dwelling real estate and transport.
These named service sectors are, however, precisely the core of the expanding areas that form the base of the modern ‘service economy.’ That is, the movement of the U.S. economy out of manufacturing, and into services, is not a shift into sectors with a lower capital intensity than manufacturing, but into those with a higher capital intensity.Some of the reasons for this trend are evident. These U.S. service sectors, which are the most advanced in the world, have undergone a massive process of computerisation in almost all areas. This process of computerisation has interlinked with that of telecommunications — the necessary precondition of efficient organisation of very large scale, including ‘globalised,’ production. Whole service sectors, such as finance, transport, and hotels, are now entirely dependent on such systems.3 These trends, together with others, result in a situation, as illustrated by the data, whereby the capital intensity of these service sectors actually exceeds that of manufacturing.
The process of rising capital intensity, in the most advanced service sectors, can be seen clearly by making a comparison of service sectors where capital intensity in the U.S differs sharply from the other economies noted — particularly for Germany, for which more comprehensive data is available than for Japan. In Germany, sectors such as communications and transport have high capital intensities — as in the U.S. But sectors such as financial institutions and restaurants and hotels do not — as is also the case for the U.K., Norway, Sweden, Finland, Austria and New Zealand for which OECD data are available.4 The higher level of capital intensity of these sectors in the U.S. is, evidently, linked to their more advanced development.Increasing scale of production
A feature accompanying this rising capital intensity in the service sector is its increasing scale of production — the bringing of the service sector under the sway of large scale concentrations of capital. The process of creation of such concentrations in banking, entertainment, music, sport, broadcasting etc., is now on a scale equaling that in manufacturing. It was accurately described in Business Week:‘Almost without warning, the U.S. has entered a new era of bigness... Chase-Chemical, Disney- ABC, Time Warner-Turner - these are just the tip of an economy wide move toward combination and consolidation.
‘Today’s deals are not the financially driven hostile takeovers and leveraged buyouts that dominated the 1980s. No raiders are carrying out bags of cash this time around. Now it’s the corporate leaders of America... Their goal: to acquire the size and resources to compete at home and abroad, to invest in new technology and new products, to control distribution channels and guarantee access to markets. “We are moving toward a period of the megacorporate state in which there will be a few global firms within particular economic sectors,” says Steven Nagourney, chief investment strategist for Lehman Brothers Inc.’s private client group.‘That’s certainly true in the media industry, where the race to lock up key distribution channels such as television, and cable networks just got more frenzied. Market dominance is also driving such mergers in the drug industry, Merck’s & Co.’s purchase of Medco Containment Services Inc. ‘As your competitors get bigger, you’re almost forced to get bigger to stay equal’, says Norman S. Selby, Head of McKinsey & Co.’s pharmaceutical practice. ‘It’s a continual game of catch-up’.
‘Other deals are driven by a need to bulk up as U.S. companies take on global competitors. The Chemical-Chase merger produces a bank that’s No 1 in the U.S. but only 21st in the world, by assets. And the combination of Upjohn Co. and Sweden’s Pharmacia, announced on Aug. 20, will create a titan that only ranks about ninth in sales among drugmakers worldwide.‘Besides adding sheer size, acquisitions can provide an instant presence in foreign markets. Scott Paper Co. was acquired by Kimberly-Clark Corp., in large part, because Scott had strengths in Europe that Kimberly lacked....
‘Companies are taking advantage of deregulation to make ever- larger combinations. New rules lifting barriers on interstate banking set to take effect in September, for example, will ignite a new round of cross-country mergers. And the proposed elimination of the Interstate Commerce Commission, which reviews railroad mergers, may spark more combinations among real carriers. One possibility: a Norfolk Southern Corp., takeover of Contrail Inc.‘The passage of the telecom deregulation bill, expected this year and next, may be the signal for some of the biggest mergers of all time, especially if the old Bell system starts reassembling itself. ‘It’s not unreasonable to see several (regional Bell operating companies) merging over the next several years’, says Daniel Rein gold, vice-president at Merrill Lynch & Co. The most likely candidates: Bell Atlantic Corp. and Nynex Corp., which already jointly run a cellular service...
‘Inevitably, some once-mighty players will be trampled in the stampede for market dominance. Apple Computer Inc., with only about 10% share of the personal- computer market, may find that software developers opt to concentrate their efforts on the much larger Windows market.’As Business Week noted, even in ‘classical’ service sectors:
‘Entertainment — just about everyone is trying to dominate this very hot U.S. export. Reason: vertical integration is supposed to yield clout in the Information Age. Result: Disney, Seagram and Westinghouse are all doing huge deals. Now, Time Warner is wooing Turner Broadcasting. Financial services — the goal here is to squeeze out costs and earn economies of scale. That’s a big reason behind Chemical’s $10 billion merger with Chase and First Union’s $5.4 billion acquisition of First Fidelity Bancorp.’5The Wall Street Journal noted precisely the same trend driving the process of mergers which now extends well into the service sector:
‘The deals come tumbling out, one upon another. Chase/Chemical. Sandoz/Ciba-Geigy. Bell Atlantic/Nynex. British Telecom! MCI. Boeing/McDonnell Douglas. Morgan Stanley/Dean Witter.‘It is a merger boom the likes of which the business world hasn’t seen since 1960s, when assembling conglomerates out of dozens of smaller companies was the rage. Except that it isn’t really like those eras. It is bigger, for one thing. And the forces behind it are different.
‘First, a few figures. The volume of mergers and acquisitions done world-wide last year added up to $1 trillion. That included 10,000 transactions in the U.S. alone, worth more than $650 billion — nearly twice the dollar volume and the number of deals for the peak year of the 1980s.‘Many have been huge: Six last year topped $10 billion. Indeed, one-fifth of last year’s total dollar volume was squeezed into just 10 mega-mergers. The year saw more than 100 billion-dollar-plus transactions, a record...
‘This year there is no letup: 26 billion-dollar announcements so far and already a few giant ones, such as Morgan Stanley/Dean Witter and Banc One /First USA. It is the fastest pace since the current merger boom began...‘Some of the causes aren’t far to seek... Above all, a globalizing economy in which companies often find they must become big to compete, either by acquiring or by being acquired. “There are all kinds of related factors, but the fundamental determinant of the overall level of activity is the expansion of the global economy,” says Scott Lindsey, co-head of mergers at Credit Suisse First Boston Corp.
‘As these elements suggest, the mergers of today are overwhelmingly being done for strategic business reasons. Thus, this merger boom differs from that of the 1980s, when some buyers were financial types simply angling for undervalued assets that could resell, and also from the conglomerate era that began in the early 1960s...‘At its most fundamental level, today’s merger wave is about efficiency and market clout. Look at the union last year of Chemical Bank and Chase Manhattan. Where there had been two banks, with two. chairman, two corporate-loan departments, roughly 600 branches and over 75,000 employees, there is today just one bank. One chairman. One loan department. Eventually 100 branches will be shuttered, and 12,000 jobs will be eliminated...
‘A common theme in modern mergers is sheer size. Size is advantageous in many ways. Tyco international in Exeter, New Hampshire, by buying a packaging maker called Carlisle Plastics and wrapping it into its own Armin plastics, has doubled the volume of its purchases of low- density polyethylene film and gained new clout with suppliers. Banc One, by buying credit-card issuer First USA and its U.S. portfolio of 16 million card holders, gains a national platform in a key business.‘And British Telecommunications’ $21 billion purchase of ‘MCI can now aggressively pursue a local strategy without worrying about near-term earnings impact,’ notes Salomon Brothers analyst Jack Grubman...
‘Size also matters in trying to capture as much business as possible from a given client. Companies like to offer customers “end- to-end solutions”. So Duke Power bought gas-pipeline giant PanEnergy, creating one the biggest energy suppliers in the U.S. Citing Duke’s contract to manage First Union’s energy needs over its entire 12-state network. Duke Chairman William Grigg says:“Customers want companies to manage their whole energy requirements.”
‘Mergers are happening even in technology, historically an industry devoted to creating new products and services in-house. Cisco Systems, whose stock has been one of the great performers of the 1990s, last year spent a speck of it for a little-known company called Granite Systems Inc. Granite had no revenue, only a great idea: a promising switching technology, a crucial piece of the puzzle for networking companies. Like Duke, Cisco wanted to be better able to provide end-to-end solutions. And it wanted to do so fast.‘For Cisco, with a $40 billion stock-market value, ‘to pay $200 million and potentially ride the next wave is a trivial insurance policy if it works,’ says Charlie Federman of Broadview Associates, a technology-oriented investment bank. “Time-to-market is absolutely critical, and you can’t be one or two months late.”..
‘The Clinton administration and the Republican Congress enacted the Telecommunications Act of 1996, opening up the long- distance phone business and the TV and radio markets, That helped spawn some of the biggest combinations ever, such as the $22 billion pending Nynex-Bell Atlantic merger and WorldCom’s $14 billion acquisition of MFS Communications. Westinghouse’s purchase of Infinity Broadcasting, combining Nos. 1 and 2 in the radio business, couldn’t have happened without the same legislation.’6This scale of concentration of capital, now spreading far into the service sector, is simply a counterpart of the increased capital intensity of production — reflected in the figures for the most advanced service sectors.
SummaryConsidered from a fundamental point of view three of the most striking features of the new world economy — globalisation, the explosive growth of the Asian economies, and the rise of the service economy — are merely different manifestations of the same process — the continuing sharp rise in the proportion of the economy devoted to investment, and the scale of production which results from this. In its outward form flexible production appears small and precise — involving ability to produce smaller runs of differentiated products and utilising physically smaller units of production as parts of large concentrations of capital. But this physical aspect is merely the outward form. The underlying reality which makes such ‘flexible production’ possible, its precondition, is levels of investment, and a scale of production, on an unprecedented level.
The implications for the U.K. are evident. The fact that Britain’s is a mature economy, which must rest on the most advanced spheres of manufacturing and on services, does not obviate its need for investment — or lessen the crippling effects of its historical inadequacy in this field. It merely gives this problem unprecedented acuteness.
1. An earlier analysis of part of this material was given in ‘Behind the Threat of a Global Credit Crunch’, May 1991. This article both updates these international trends and considers the situation within the service sector of the advanced economies.
2. All historical figures, unless otherwise stated, are from One Hundred Years of Economic Statistics, Economisy publications, London 1989. Where more recent data is available from the OECD this has been used.3. This process of cornputerisation of transportation has affected no simply obvious areas, such as civil aviation, but also lies behind the revival of the U.S. railway system. For an excellent analysis of this see Barnaby Feder, ‘What drives U.S. rail rebirth,’ International Herald Tribune 2 November 1996.
4. The only exception to this is the hotel and restaurant sector in Sweden, the capital intensity of which is above that of the Swedish economy as a whole.5. Michael Mandel, Christopher Farrell, Catherine Yank, ‘Land of the Giants,’ Business Week 11 September 1995.
6. Steven Lipin, ‘Corporations Dreams Converge on One Idea: Its ‘lime to Do a Deal.’ Wall Street Journal 26 February 1997.
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