23 Things They Don't Tell You about Capitalism

by Ha-Joon Chang

  To sum up, the fall in the share of manufacturing in total output in the rich countries is not largely due to the fall in (relative) demand for manufactured goods, as many people think. Nor is it due mainly to the rise of manufactured exports from China and other developing countries, although that has had big impacts on some sectors. It is instead the falling relative prices of the manufactured goods due to faster growth in productivity in the manufacturing sector that is the main driver of the de-industrialization process. Thus, while the citizens of the rich countries may be living in post-industrial societies in terms of their employment, the importance of manufacturing in terms of production in those economies has not been diminished to the extent that we can declare a post-industrial age.

  Should we worry about de-industrialization?

  But if de-industrialization is due to the very dynamism of a country’s manufacturing sector, isn’t it a good thing?

  Not necessarily. The fact that de-industrialization is mainly caused by the comparative dynamism of the manufacturing sector vis-à-vis the service sector does not tell us anything about how well it is doing compared to its counterparts in other countries. If a country’s manufacturing sector has slower productivity growth than its counterparts in other countries, it will become internationally uncompetitive, leading to balance of payments problems in the short run and falling standards of living in the long term. In other words, de-industrialization may be accompanied by either economic success or failure. Countries should not be lulled into a false sense of security by the fact that de-industrialization is due to comparative dynamism of the manufacturing sector, as even a manufacturing sector that is very undynamic by international standards can be (and usually is) more dynamic than the service sector of the same country.

  Whether or not a country’s manufacturing sector is dynamic by international standards, the shrinkage of the relative weight of the manufacturing sector has a negative impact on productivity growth. As the economy becomes dominated by the service sector, where productivity growth is slower, productivity growth for the whole economy will slow down. Unless we believe (as some do) that the countries experiencing de-industrialization are now rich enough not to need more productivity growth, productivity slowdown is something that countries should get worried about – or at least reconcile themselves to.

  De-industrialization also has a negative effect on a country’s balance of payments because services are inherently more difficult to export than manufactured goods. A balance of payments deficit means that the country cannot ‘pay its way’ in the world. Of course, a country can plug the hole through foreign borrowing for a while, but eventually it will have to lower the value of its currency, thereby reducing its ability to import and thus its living standard.

  At the root of the low ‘tradability’ of services lies the fact that, unlike manufactured goods that can be shipped anywhere in the world, most services require their providers and consumers to be in the same location. No one has yet invented ways to provide a haircut or house-cleaning long-distance. Obviously, this problem will be solved if the service provider (the hairdresser or the cleaner in the above examples) can move to the customer’s country, but that in most cases means immigration, which most countries restrict heavily (see Thing 3). Given this, a rising share of services in the economy means that the country, other things being equal, will have lower export earnings. Unless the exports of manufactured goods rise disproportionately, the country won’t be able to pay for the same amount of imports as before. If its de-industrialization is of a negative kind accompanied by weakening international competitiveness, the balance of payments problem could be even more serious, as the manufacturing sector then won’t be able to increase its exports.

  Not all services are equally non-tradable. The knowledge-based services that I mentioned earlier – banking, consulting, engineering, and so on – are highly tradable. For example, in Britain since the 1990s, exports of knowledge-based services have played a crucial role in plugging the balance of payments gap left behind by de-industrialization (and the fall in North Sea oil exports, which had enabled the country – just – to survive the negative balance of payments consequences of de-industrialization during the 1980s).

  However, even in Britain, which is most advanced in the exports of these knowledge-based services, the balance of payments surplus generated by those services is well below 4 per cent of GDP, just enough to cover the country’s manufacturing trade deficits. With the likely strengthening of global financial regulation as a consequence of the 2008 world financial crisis, it is unlikely that Britain can maintain this level of trade surplus in finance and other knowledge-based services in the future. In the case of the US, supposedly another model post-industrial economy, the trade surplus in knowledge-based services is actually less than 1 per cent of GDP – nowhere near enough to make up for its manufacturing trade deficits, which are around 4 per cent of GDP.4 The US has been able to maintain such a large manufacturing trade deficit only because it could borrow heavily from abroad – an ability that can only shrink in the coming years, given the changes in the world economy – and not because the service sector stepped in to fill the gap, as in the British case. Moreover, it is questionable whether the strengths of the US and Britain in the knowledge-based services can be maintained over time. In services such as engineering and design, where insights gained from the production process are crucial, a continuous shrinkage of the industrial base will lead to a decline in the quality of their (service) products and a consequent loss in export earnings.

  If Britain and the US – two countries that are supposed to be the most developed in the knowledge-based services – are unlikely to meet their balance of payments needs in the long run through the exports of these services, it is highly unlikely that other countries can.

  Post-industrial fantasies

  Believing de-industrialization to be the result of the change of our engine of growth from manufacturing to services, some have argued that developing countries can largely skip industrialization and move directly to the service economy. Especially with the rise of service offshoring, this view has become very popular among some observers of India. Forget all those polluting industries, they say, why not go from agriculture to services directly? If China is the workshop of the world, the argument goes, India should try to become the ‘office of the world’.

  However, it is a fantasy to think that a poor country can develop mainly on the basis of the service sector. As pointed out earlier, the manufacturing sector has an inherently faster productivity growth than the service sector. To be sure, there are some service industries that have rapid productivity growth potential, notably the knowledge-based services that I mentioned above. However, these are service activities that mainly serve manufacturing firms, so it is very difficult to develop those industries without first developing a strong manufacturing base. If you base your development largely on services from early on, your longterm productivity growth rate is going to be much slower than when you base it on manufacturing.

  Moreover, we have already seen that, given that services are much less tradable, countries specializing in services are likely to face much more serious balance of payments problems than countries that specialize in manufacturing. This is bad enough for a developed country, where balance of payments problems will lower standards of living in the long run. However, it is seriously detrimental for a developing country. The point is that, in order to develop, a developing country has to import superior technologies from abroad (either in the form of machines or in the form of technology licensing). Therefore, when it has a balance of payments problem, its very ability to upgrade and thus develop its economy by deploying superior technologies is hampered.

  As I say these negative things about economic development strategies based on services, some of you may say: what about countries like Switzerland and Singapore? Haven’t they developed on the basis of services?

  However, these economies are not what they a
re reported to be either. They are in fact manufacturing success stories. For example, many people think that Switzerland lives off the stolen money deposited in its banks by Third World dictators or by selling cowbells and cuckoo clocks to Japanese and American tourists, but it is actually one of the most industrialized economies in the world. We don’t see many Swiss manufactured products around because the country is small (around 7 million people), which makes the total amount of Swiss manufactured goods rather small, and because its producers specialize in producer goods, such as machinery and industrial chemicals, rather than consumer goods that are more visible. But in per capita terms, Switzerland has the highest industrial output in the world (it could come second after Japan, depending on the year and the data you look at). Singapore is also one of the five most industrialized economies in the world (once again, measured in terms of manufacturing value-added per head). Finland and Sweden make up the rest of the top five. Indeed, except for a few places such as the Seychelles that has a very small population and exceptional resources for tourism (85,000 people with around $9,000 per capita income), no country has so far achieved even a decent (not to speak of high) living standard by relying on services and none will do so in the future.

  To sum up, even the rich countries have not become unequivocally post-industrial. While most people in those countries do not work in factories any more, the manufacturing sector’s importance in their production systems has not fallen very much, once we take into account the relative price effects. But even if de-industrialization is not necessarily a symptom of industrial decline (although it often is), it has negative effects for long-term productivity growth and the balance of payments, both of which need reckoning. The myth that we now live in a post-industrial age has made many governments ignore the negative consequences of de-industrialization.

  As for the developing countries, it is a fantasy to think that they can skip industrialization and build prosperity on the basis of service industries. Most services have slow productivity growth and most of those services that have high productivity growth are services that cannot be developed without a strong manufacturing sector. Low tradability of services means that a developing country specializing in services will face a bigger balance of payments problem, which for a developing country means a reduction in its ability to upgrade its economy. Post-industrial fantasies are bad enough for the rich countries, but they are positively dangerous for developing countries.

  Thing 10

  The US does not have the highest

  living standard in the world

  What they tell you

  Despite its recent economic problems, the US still enjoys the highest standard of living in the world. At market exchange rates, there are several countries that have a higher per capita income than the US. However, if we consider the fact that the same dollar (or whatever common currency we choose) can buy more goods and services in the US than in other rich countries, the US turns out to have the highest living standard in the world, barring the mini-city-state of Luxemburg. This is why other countries seek to emulate the US, illustrating the superiority of the free-market system, which the US most closely (if not perfectly) represents.

  What they don’t tell you

  The average US citizen does have greater command over goods and services than his counterpart in any other country in the world except Luxemburg. However, given the country’s high inequality, this average is less accurate in representing how people live than the averages for other countries with a more equal income distribution. Higher inequality is also behind the poorer health indicators and worse crime statistics of the US. Moreover, the same dollar buys more things in the US than in most other rich countries mainly because it has cheaper services than in other comparable countries, thanks to higher immigration and poorer employment conditions. Furthermore, Americans work considerably longer than Europeans. Per hour worked, their command over goods and services is smaller than that of several European countries. While we can debate which is a better lifestyle – more material goods with less leisure time (as in the US) or fewer material goods with more leisure time (as in Europe) – this suggests that the US does not have an unambiguously higher living standard than comparable countries.

  The roads are not paved with gold

  Between 1880 and 1914, nearly 3 million Italians migrated to the US. When they arrived, many of them were bitterly disappointed. Their new home was not the paradise they had thought it would be. It is said that many of them wrote back home, saying ‘not only are the roads not paved with gold, they are not paved at all; in fact, we are the ones who are supposed to pave them’.

  Those Italian immigrants were not alone in thinking that the US is where dreams come true. The US became the richest country in the world only around 1900, but even in the early days of its existence, it had a strong hold on the imagination of poor people elsewhere. In the early nineteenth century, US per capita income was still only around the European average and something like 50 per cent lower than that of Britain and the Netherlands. But poor Europeans still wanted to move there because the country had an almost unlimited supply of land (well, if you were willing to push out a few native Americans) and an acute labour shortage, which meant wages three or four times higher than those in Europe (see Thing 7). Most importantly, the lack of feudal legacy meant that the country had much higher social mobility than the Old World countries, as celebrated in the idea of the American dream.

  It is not just prospective immigrants who are attracted to the US. Especially in the last few decades, businessmen and policy-makers around the world have wanted, and often tried, to emulate the US economic model. Its free enterprise system, according to admirers of the US model, lets people compete without limits and rewards the winners without restrictions imposed by the government or by misguided egalitarian culture. The system therefore creates exceptionally strong incentives for entrepreneurship and innovation. Its free labour market, with easy hiring and firing, allows its enterprises to be agile and thus more competitive, as they can redeploy their workers more quickly than their competitors, in response to changing market conditions. With entrepreneurs richly rewarded and workers having to adapt quickly, the system does create high inequality. However, its proponents argue, even the ‘losers’ in this game willingly accept such outcomes because, given the country’s high social mobility, their own children could be the next Thomas Edison, J. P. Morgan or Bill Gates. With such incentives to work hard and exercise ingenuity, no wonder the country has been the richest in the world for the last century.

  Americans just live better . . .

  Actually, this is not quite true. The US is not the richest country in the world any more. Now several European countries have higher per capita incomes. The World Bank data tell us that the per capita income of the US in 2007 was $46,040. There were seven countries with higher per capita income in US dollar terms – starting with Norway ($76,450) at the top, through Luxemburg, Switzerland, Denmark, Iceland, Ireland and ending with Sweden ($46,060). Discounting the two mini-states of Iceland (311,000 people) and Luxemburg (480,000 people), this makes the US only the sixth richest country in the world.

  But, some of you may say, that cannot be right. When you go to the US, you just see that people there live better than the Norwegians or the Swiss do.

  One reason why we get that impression is that the US is much more unequal than the European countries and therefore looks more prosperous to foreign visitors than it really is – foreign visitors to any country rarely get to see the deprived parts, of which the US has many more than Europe. But even ignoring this inequality factor, there is a good reason why most people think that the US has a higher living standard than European countries.

  You may have paid 35 Swiss francs, or $35, for a 5-mile (or 8-km) taxi ride in Geneva, when a similar ride in Boston would have cost you around $15. In Oslo, you may have paid 550 kroner, or $100, for a dinner that could not possibly have been more than $50, or 275 kroner, in St Loui
s. The reverse would have been the case if you had changed your dollars into Thai baht or Mexican pesos on your holidays. Having your sixth back massage of the week or ordering the third margarita before dinner, you would have felt as if your $100 had been stretched into $200, or even $300 (or was that the alcohol?). If market exchange rates accurately reflected differences in living standards between countries, these kinds of things should not happen.

  Why are there such huge differences between the things that you can buy in different countries with what should be the same sums of money? Such differences exist basically because market exchange rates are largely determined by the supply and demand for internationally traded goods and services (although in the short run currency speculation can influence market exchange rates), while what a sum of money can buy in a particular country is determined by the prices of all goods and services, and not just those that are internationally traded.

  The most important among the non-traded things are person-to-person labour services, such as driving taxis and serving meals in restaurants. Trade in such services requires international migration, but that is severely limited by immigration control, so the prices of such labour services end up being hugely different across countries (see Things 3 and 9). In other words, things such as taxi rides and meals are expensive in countries such as Switzerland and Norway because they have expensive workers. They are cheap in countries with cheap workers, such as Mexico and Thailand. When it comes to internationally traded things such as TVs or mobile phones, their prices are basically the same in all countries, rich and poor.