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The Developmental State: Short-Run Growth and Long-Run Stagnation?

An analysis of the post-war economic miracles in South Korea and Japan

Prof. Lynette Ong

April 28, 2010

Introduction

The so-called “Asian Tigers” are often cited as models for developing nations around the world. Characterized by high rates of economic growth, these success stories have generated many different interpretations of what exactly allowed for these achievements. Broadly speaking, Singapore, Taiwan, South Korea and Japan are all economically successful countries that grew rapidly from the end of World War II till at least 1980. While it is undeniable that certain quantitative measures of economic success such as GDP grew at astonishing rates over this time period, the exact methods employed by these “East Asian Developmental States” and the resulting effects are varied and often misunderstood. Introductory courses in macroeconomics state will state that these countries succeeded because they employed export driven economies and were open to trade as opposed to employing import substitution; yet a historian might point out that 300 to 600 items were banned as exports in Korea in the 1960’s. What exactly defines a developmental state is difficult to quantify as both methods and results vary across all four Asian Tigers. This paper seeks to describe and define at least one type of developmental state by examining the cases of the Republic of Korea and Japan.

Broadly speaking, developmental states are characterized by strong, at least semi-authoritarian governments that regularly intervene in the economy. The effect of such intervention in an economy is a much debated topic within economics. Korea and Japan favoured certain industries over others and, while they undoubtedly some made errors (a few famous ones being MITI’s attempt to merge Nissan and Toyota and their attempt to block Sony from importing certain western technologies), the end result was overwhelmingly positive. I do not intend to argue that developmental states can allocate resources better than a market can; instead I suggest that effects of such a regime have a superior effect on raw economic growth but not economic development when compared with a market economy in the short run (in the context of nations, meaning one or two decades). In the long run (in the case of Japan about forty years), however, both economic growth and development will stagnate in absence of significant reform.

On a macro level, I suggest that such a regime creates two conflicting forces; firstly, there is the obvious “expansion effect” which leads to economic growth and, secondly, there is the “corruption effect” that constrains economic growth and halts social and political progress. This paper will analyse each of these force and explain why the former outweighed the latter in Korea and Japan from the end of WWII up to at least 1980. It will then examine Japan’s “lost decades” and show that much of it is a direct legacy of Japanese developmental policies.

Case Qualification

The number of countries categorized as “developmental states” continues to grow, first in Southeast Asia with Thailand and Indonesia and more recently with the addition of China since 2001, it is becoming clear that there are multiple ways to achieve rapid economic growth. Even amongst the 4 original tigers, both policy and result varies greatly. Japan and Korea, in additional to being geographically close, have significant overlap historically (with Japan’s colonization of Korea) and employed many of the same policies and strategies to promote growth. In fact, Korea directly important many technologies and managerial practices from Japan; furthermore, both the Korean and Japanese economies are dominated by large, diversified conglomerates that received significant support from the Korean and Japanese governments. Though this paper will analyse both the similarities and differences between the two models, it is not incorrect to state that Korea and Japan are similar types of developmental states.

The Expansion Effect

One significant contributor to success of the Korean and Japanese economies is the success of big business (the chaebol in Korea and the keiretsu in Japan). The closeness between such business and policy makers has been criticized by many as a form of corruption and market intervention which, under classical economics, should lead to suboptimal resource allocation and thus stunt growth. The situation in Korea and Japan, however, was much different. I suggest that government intervention was effective for two reasons: firstly, the way that winners were picked was economically sound (whether this was intentional on the part of the regimes is debatable) and, secondly, that the corrupt methods used for assigning credit and loans to these big businesses actually had positive effects on economic growth.

In his review of East Asia’s economic success, Robert Wade outlines how the Korean government prioritized export industries; Korean heavy industries such as steel, semiconductors and automotives clearly produced with an eye for exports as there was little domestic demand for such goods. The situation in Japan was similar about a decade earlier when, Prime Minister Ikeda’s policy of heavy industrialization lead to 83% of all Japan Development Bank went into shipbuilding, steel, electric power and coal during the mid 1950’s. We can see clearly that from (insert stat) those export-oriented ventures were highly successful in the world market and quickly became primary outputs for Korea. As Wade points out, according to neo-classical economic theory, success in the export market is a good proxy for finding optimal resource allocation. These policies that promoted specific industries raised controversy at the time since economists saw little in the way of comparative advantage for Korea; nevertheless, the fact that they were successful shows sound economic choices. If Korea had left resource allocation to the market, suboptimal choices may have been made as at least some firms would have focused on Korea’s protected, domestic markets. To reconcile with economics, in a trade-barrier free world, this would not happen as imported goods would be cheaper and better than the domestic ones, but under import protection this does not occur. The obvious hole in this system is the lack of production for domestic consumption, thus leaving the average Korean citizen devoid of quality, well priced consumer goods. This is supported by evidence, again presented by Wade, that shows that quality of life in Korea did not rise nearly as much as per-capita GDP. Thus, one can tentatively conclude that Korea developed at the expense of its population.

Korea and Japan picked these “winners” and rewarded them with subsidies and loans. In both cases, most of these loans were non-arms-length transactions; in Korea, the government owned the banks and gave loans on the basis of political connection and concurrence with government goals while in Japan, the keiretsu owned their own banks. The result is once again incredible positive effects for these big businesses.

There are two sides to investment: the supply side (domestic savings and foreign capital) and the demand side (firms raising capital). Culturally, Asian countries generally have much higher savings rates than European or North American countries, and this was accentuated by high interest rate policies in Korea and Japan. Normally, high interest rates reduce economic growth by making both consumption and investment more difficult, but in a country where most people are net lenders, consumption benefits from high interest rates and the way credit was being assigned by the Korean government and the keiretsu owned Japanese banks essentially negated the effects of making it more difficult for firms to raise capital. This situation is purely a political construction even in Japan where banks were technically private enterprises because the Bank of Japan lent extensively to the commercial banks, giving them broad control of lending activities. Furthermore, borrowing from a non-arms-length party essentially removes all costs of financial distress making it optimal for these firms to leverage at ridiculous ratios; the average debt to equity ratio of a chaebol between 1961 and 1984 ranges from 92 to 488. By 1996, some firms had ratios well into the thousands. The Nobel Prize winning Modigliani-Miller theory states that, in the presence of taxes, financing a firm through at higher debt to equity ratios will increase its value because interest expense is tax deductable and thus the government takes a smaller portion of a firms profit (tax regimes in Korea and Japan were highly effective from the 1960’s onwards, especially under Park in Korea), however, in an ordinary, western-style economy, the costs of financial distress typically keep debt-to-equity ratios in check. In the absence of such costs, however, it makes sense for firms to over-leverage, even when rates of return on the investment exceed the rate promised to domestic savers or foreign investors, because the resulting loss would be absorbed by the bank. This kind of setup is only possible in systems like those existing in Korea and Japan. In Korea, this loss would be financed through government revenue sources such as taxes, while in Japan, the bank would be supported (at least temporarily) by other sections of the conglomerate.

Another factor that was greatly beneficial to the economic development of Japan and Korea was their high labour productivity to wage ratios. This unusual condition was not a naturally occurring phenomenon, and was created only though a set of policy choices and social engineering on the part of the Park regime in Korea and the LDP in Japan. The key question to be answered here is how did the chaebol and keiretsu get labour to work so effectively for such low wages? Once again, I return to my point that these developmental states grew at the expense of their populations (at least in the short-run). Essentially, the Korean and Japanese governments were able to convince their labour forces to sacrifice for the greater good of the economy. Here the methods differ between the two countries but the results are the same.

Firstly, one should consider the relatively high rates of education in post WWII Japan and Korea. Pre-war Japan was already fairly developed in its own right and Korea benefited from higher education rates as a colonial legacy. Furthermore, these productive workers were willing to work long hours for low wages thus making investment incredibly profitable.

Atul Kohli points out that, for example, in Korea during the 1970’s, young women aged 14 to 24 would work over 70 hours a week for half the pay of a male worker (which, itself, was already low). This was a product of two factors: union crushing, which is not unique to the Korean developmental state, through police and intelligence and an intelligence agency called the KCIA, and nationalistic propaganda, which is. The Park regime was able to somehow convince workers that Korea’s economic development was a matter of national security. That the labour force was convinced that working hard and not complaining about working conditions or wage is a necessary sacrifice because of the presence of North Korea suggests that there was an incredibly effective propaganda campaign.

In Japan, standard of living did not rise at the same rate as GDP per-capita throughout the 1960’s and 1970’s (the same case as Korea). Though the regime was quite as hard-authoritarian as Korea under Rhee or Park, there was nevertheless plenty of opportunity for the Japanese government to suppress labour movements, mostly through corporatism which limited the ability of labour unions to form without registration. The other major factor that allowed for such a high productivity to wage ratio is Japanese industrial and labour practices within industry. Lifetime contracts effectively reduce worker incentive to bargain against their employer because their livelihood is directly tied to the success of their employer. Japanese firms are also known for using human resource policies that would seem outrageous to a western businessman that are designed to foster company spirit. In America, the Wal-Mart cheer is policy worthy of study; in Japan, company cheers are only the beginning of spirit-building labour policies. These practices would later be adopted in Korea under the direction of Park (who was himself Japanese educated). These policies combined with strong public-private cooperation allowed Japan to set social goals without flirting with communism and thus delayed the onset of the innovation crisis experienced by command economies like the Soviet Union.

The Corruption Effect

Economists often blame the asset bubble of 1991 as the primary cause of the Japanese “lost decades” and blame failed Japanese monetary and fiscal policy since then for the continuity of the recession. I contest that, however, while Japanese macroeconomic policy over the past two decades is not necessarily airtight, the primary reason Japan is unable to return to strong economic growth is because of the legacies of the developmental state. It should be noted that I am not suggesting that Japanese macroeconomic policy since 1991 has been correct (or even largely correct); rather, I contest that such policies were made unavoidable by the political, economic and social system created by Japanese developmentalism. I also suggest that Korea may soon follow suit which, if I am correct, may show a common trend amongst Asian developmental states.

To understand why Japan is unable to fix is economic woes, we should first look at what some of the direct causes of stagnation are. One of these is the continued support of what “Zombie Firms”. Perhaps the most important issue is the lasting credit crunch during which banks refuse to lend (a sharp contrast to the 1950’s and 1960’s). Lastly, continued economic protectionism in a number of areas such as agriculture and many consumer goods continues to harm consumers and hamper economic recovery. These issues are not difficult to spot within the Japanese economy and all of them have clear academic solutions. So why has Japan failed to reform? Here I take a look at Leonard J. Shoppa’s article, Japan the Reluctant Reformer, and attempt to show how the points he raises are legacies of the developmental state.

The support of so-called “Zombie Firms” is maintaining inefficient resource allocation and promoting deflation. Shoppa points out that Japanese banks often give loans to failing businesses and do not demand much in the way of restructuring. The result is more bad debts for the Bank, leading to more government stimulus and bank recapitalization. Such practice has pushed the Japanese national debt to over $5.6 trillion dollars or 130% of GDP by 2001. A casual observer might pin this on poor business decisions by banks or on the government’s willingness to bailout such institutions; I argue that this is not a result of any incompetency on the part of current administrators of bank executives, but rather a conditioned response created by developmental legacy.

Considering the nature of the Japanese economy with the keiretsu in centre, it should be no surprise that banks are still lending to the corporations that own them. Japanese industrial policy during the post-war period involved several key policies that led to economic growth; firstly, they significantly relaxed the anti-trust laws imposed by the Supreme Commander of the Allied Powers (SCAP) at the end of the war and, secondly, they allowed banks to be owned by corporations. I contrast the latter policy to, for example, Canadian law which ensures diverse ownership of all chartered banks. Furthermore, there was a high level of cooperation between the keiretsu and the Japanese government, which Chalmers Johnson credits to “selective access to governmental or government-guaranteed finance … government-supervised investment coordination…” and a number of other interventionist measures that I would argue border on organizational corruption. Such a system removes the costs of financial distress and allows a plentiful supply of cheap capital which, as I discussed in my section on expansionary effects, leads to phenomenal short-term growth. This practice can, however, also lead to excessive risk taking and suboptimal investment. In the short-run, this manageable because government guarantees and slimmer banking profits can absorb some of this bad debt, but after forty years of this practice, the burden will eventually become unbearable. To this point, Shoppa points out that Japanese banks wrote off twice the value of their capital base between 1991 and 2001. The Bank of Japan follows by bailing out these banks leading to a ballooning national debt and no real incentive for banks (or firms) to change policy. The fear of and ability to fail is very important in a market economy, and this has essentially been removed by Japanese developmental policies. A similar situation exists in Korea, but the magnitude of the bad debt problem is not near the level of Japan’s (though we have yet to see the lasting effects of the 2008 financial crisis on Korean banks).

That I suggest that Japanese banks have poor lending policies does not mean that I believe they are being too loose with their money; in fact, quite the opposite is true. Capital flow to small businesses, including tech start-ups has slowed to a trickle. The key problem is that capital is not being allocated to the optimal investments. We have seen Japanese banks continue to give bad loans and now I will attempt to show why they are not making potentially profitable loans.

The willingness of banks to lend has a lot to do with their degree of risk aversion and risk perception. For example, the financial crisis of 2008 brought lending to a standstill worldwide because financial institutions were unwilling to invest in anything because everything was considered very risky at the time. Standard macroeconomic theory will suggest that expansionary monetary policy can encourage banks to lend again by decreasing their cost of capital; however, there are limits to this policy because when interest rates approach zero, and economy will head into what Keynes called a “liquidity trap”. This trap occurs because creditors see that there is no reason for interest rates to go anywhere but up in the near future, so lending now is suboptimal to lending later. I argue that investor sentiment is not the primary reason for the Japanese credit crunch, but instead subscribe to Benjamin Powell’s argument that the large amount of bad debt on the books is to blame. Banks would use new capital to improve their balance sheets instead of issuing new loans where they are needed, but their financial position never improves because they continue to make bad loans to well connected “Zombie Firms” such as those in the construction industry, which is a legacy of developmental policies from the 1960’s and 1970’s when the Japanese government encouraged massive public works projects. Public works are no longer needed to the extent that they are conducted in Japan because Japanese infrastructure is already very advanced and thus continuing investment is far from optimal.

Protectionism and highly regulatory policies still exist in Japan today, leading to uncompetitive small business and ineffective service industries. Inefficiencies arising from such policies are easy to see as they lead to things like higher food prices, ridiculous labour costs and insurance commission gouging amongst others. Such policies may have been helpful to short term growth in the past since they helped protect fledgling industries and aided corporate profits, but now they are beginning to work against this highly developed economy and are constraining further growth. Steven K. Vogel and Leonard J. Shoppa write on how the Japanese public is well educated on these matters, but still fail to support reform wholeheartedly. I argue that the reason there is a lack of support for reform is another legacy of the developmental state. Industries that are hurt by protectionism, say for example, exporters having higher costs because their intermediate goods are protected, are also the beneficiaries of other regulations (in this case, perhaps subsidies or government promotion). Even if the entire system would be better off is all regulations were removed, it is difficult to start the process because removing certain regulations will advantage one party over another in the short-term. Since managers are notoriously short-sighted, it is easy see why it is difficult to get businesses to support liberalization and deregulation in general. What might not be so obvious is why firms do not lobby for the removal of specific regulations that would give them short-run advantages (as would likely be the case in a western economy like the United States). I credit this to the Japanese business practices involving cooperation (which is consistent with Johnson’s model for Japan as introduced in his final chapter of MITI and the Japanese Miracle). Firms do not want to be seen as directly lobbying against another member of their own supply chain. As such, manufacturers will not lobby for policy that disfavours labour unions or firms in intermediate goods. It is very difficult to find individual policies that are Pareto improvements to an economy, thus explaining the low rate of reform within Japan.

Weighing the Factors

What I have yet to address in this essay is why the expansionary effects of the developmental state worked for more than forty years in Japan before collapsing and into recession, and why Korea has yet to fall into an extended recession. Why didn’t the corruption effect sink the developmental state sooner? To answer this question I refer to David C. Kang’s article Bad Loans to Good Friends: Money Politics and the Developmental State in South Korea.

According to Kang, when the both the state and business are powerful, the destructiveness of corruption is reduced because neither side can do anything particularly horrible to the other party for fear of repercussions. True, trillions of Won were skimmed by the government in “voluntary” donations and much credit was extended on the basis political connection. I have already discussed why the latter is beneficial (at least in the short-run) for the economy; as for the former, the scope of the skimming was held in check by this “mutual hostage” and what was skimmed was spent domestically. Though this transfers consumption power towards the politically connected, it does not affect overall economic growth indicators like GDP. Though I have Korea as an example here, a similar situation exists in Japan where the LDP and their bureaucratic organizations like the MITI wielded a great deal of power, and the keiretsu were a concentrated group of business interest. Japan, in fact, had even less corruption in terms of skimming than in Korea which is a credit to the regime (at least on a comparative basis).

What both Korea and Japan had in common that would eventually bring the developmental state to a halt is large numbers of bad loans to overleveraged, enormous firms that the government cannot afford to let fail. They also had overly complex systems of political and business relationships that make reform extremely difficult. These contractionary effects take time to come into play. Bad debts can be absorbed to a point and a few write-offs are not fatal to a bank unless a large number of them happen at the same time, as was the case in 1991 for Japan. The inability to reform is not a paralysing factor unless reform is made necessary by recession.

Will Korea go the way of Japan? Perhaps; Korean GDP growth has gone from an impressive 10% in 2000 to only 2.2% in 2009 (though this is still significantly better than Japan and is not by any means low compared to other industrialized countries). If there ever was a time to cause a ballooning of bad debt, fall of 2008 was definitely it. Korean politics are as messy as ever, and state power has only fallen since democratization in 1987, leading more and more towards Kang’s “rent seeking” scenario. The case of Korea over the next ten years could prove to be a sad one in terms of economic growth, in which case will be able to see a familiar scenario.