Capitalism in Korea: A Model for the New Millennium

Op-ed in the series "Insight into Korea," sponsored by the Korea Herald

July 24, 2007

Korean economic performance over the last four decades has been nothing short of spectacular. During this period the country experienced only two years of negative growth-1980 in the wake of the second oil shock and the assassination of President Park Chung-hee and 1998 in the midst of the Asian financial crisis. Between the initiation of a wide-ranging economic reform program by Park in 1963 and the financial crisis in 1997, purchasing power-adjusted per capita income growth averaged more than six percent annually, and per capita income stood at more than eight times its level when reforms began. At the start of that period the country's income level was lower than that of Bolivia and Mozambique; by the end it was higher than that of Greece and Portugal.

Problems began to arise as the country approached the international technological frontier and opportunities for easy technological catch-up began to erode. The disappearance of straightforward paths for industrial upgrading based on imitating the prior trajectories of more advanced economies put a heightened premium on the ability of corporate managements and their financiers to discern emerging profit opportunities. The crisis of 1997-98 proved that the old state-led development strategy was inadequate, but in the intervening decade, devising a model for the new millennium has presented Korea with a considerable challenge.

Economists normally locate the long-run sources of growth in the availability of the basic inputs to production such as labor and capital, together with productivity growth. In the case of Korea, during its high growth period it benefited from a rapid expansion of the labor force and a relatively low number of dependents per worker, combined with a significant increase in the educational level of the workforce. However, looking forward, those favorable demographic factors may go into reverse: Korea will face a rapidly aging population and a growing legion of nonworking dependents. Under current trends, within the next decade Korea's dependency ratio will begin rising, and by 2030 population size will begin to decline, falling below its current level by 2040.

Nothing is certain and changes in underlying behavior could frustrate these projections. Yet if these forecasts prove broadly correct, they imply increases in health and pension burdens which will in turn necessitate adjustments in Korean policies and practices, such as increasing the retirement age, improving the efficiency of delivery of health care and retirement services, and using female labor, especially educated women, more efficiently. These developments will undoubtedly impact Korean family life. Korea, which among the members of the Organization for Economic Cooperation and Development (OECD), the club of rich industrial democracies, has some of the most restrictive immigration policies, may have to reconsider those as well in response to changing demographics. Korea's demographic bonus could turn into a demographic onus.

Korean investment has not returned to levels existing prior to the 1997-98 crisis, though in this respect Korea is not alone: Investment in other crisis affected Asian economies has never fully recovered either. This pattern may reflect overinvestment during the 1990s boom, secularly falling profitability as capital is accumulated, and political developments over the past decade. The rise of progressive political forces following the financial crisis, their contentious relationship with the corporate sector, and greater willingness to side with the unions in labor disputes may have contributed to a reduction in business confidence and a consequent attenuation by the business sector to engage in irreversible commitments, which, after all, is what investment represents. Labor market regulations, which make it difficult to fire permanent workers once they are hired, further reinforces caution with respect to expansions of capacity which may be effectively irreversible in the payroll dimension as well. Direct foreign investment flows into Korea are relatively sluggish; in a recent United Nations survey, Korea placed 114th out of 141 countries with respect to foreign investment flows, and outward investment is rising. The undeniable impression is that Korea is losing its luster as a location for production.

Under such circumstances, squeezing the maximum productivity out of labor and capital inputs is essential to maintain growth. Korea faces important competitive challenges posed by the country's intermediate position between its neighbors, low-wage China and high-technology Japan. A pproaching the technological frontier, Korea faces significant challenges in stimulating productivity growth. It is tempting to think of spurring productivity increases in terms of technological upgrading, and indeed, Korea's technological progress, particularly in information technology, has been phenomenal. But increasing productivity involves more than just technological change; indeed, technology, narrowly defined, may not even be among the most important drivers. Financial sector reform, for example, could have a considerable impact on the availability of capital to underwrite the commercialization of innovative activity. Changes in labor market regulations could have an equivalent impact with respect to the efficient utilization of labor.

One can conceptualize the process of productivity advance as encouraging innovation in emerging sectors or activities, while at the same time terminating practices that discourage productivity increases in existing activities. Where Korea falls badly behind is in the heavily regulated service sector, and it is here that the greatest opportunities for productivity increase lie.

In terms of productivity, the Korean service sector lags the industrial sector, and this divergence is far larger in Korea than it is in most other OECD countries. In fact, estimates by the International Monetary Fund indicate that while total factor productivity growth, a concept that measures productivity increase taking the application of both labor and capital into account, has been rising at a rate of 3-4 percent a year outside the service sector over the last quarter century, productivity in the service sector has actually declined. According to these calculations, Koreans are actually getting less output in the service sector, once inputs of labor are taken into account, than they were in the 1970s. Whatever the specifics, considerable evidence suggests that Korea faces a real problem with respect to service sector productivity-and the importance of this problem is growing. China's rise means that manufacturing is likely to play a smaller role in the Korean economy in the future, a trend that will be reinforced domestically by the growth of Korea's elderly population who tend to consume relatively more services than the population as a whole.

Technological upgrading could increase service sector productivity, but the lack of use of cutting edge technology appears to be less of the cause than a symptom of the sector's woes, which are more closely associated with institutional policies and practices which impede competition, particularly by facilitating barriers to entry by new competitors and stifling the potential impetus to competition generated by the growth of existing small- and medium-sized enterprises (SMEs).

Fortunately, financial sector development is a current government priority and could both increase productivity in that important sector, as well as encourage increased aggregate saving and investment, increase the allocative efficiency of investment, improve access to capital to SMEs, and, by extension, stimulate the degree of competition in the economy more generally. What is likely to prove difficult is balancing the need to increase the degree of financial integration between Korean corporations and their foreign counterparts with the sensitivity of Korea, located between the large economies of China and Japan, to impede this process to preserve national corporate autonomy. In the future, the development of large sovereign wealth funds is likely to enhance the salience of these concerns, raising the specter of foreign government affiliated entities taking over Korean firms. Recent comments by Korean government officials and proposed legislation in the National Assembly suggest that concerns about rising xenophobia with respect to foreign ownership of Korean assets are not misplaced.

Such developments are particularly unfortunate in the context of the perennial challenges posed by Korea's industrial structure which is dominated by a small number of large chaebol, or family-dominated conglomerates. Foreign corporate competitors and private investors are one potential source of market discipline, which can be imposed on the chaebol without resorting to direct regulation, and a potentially positive and constructive force. The foreigners and the emerging good governance movement represented by organizations such as the Center for Good Corporate Governance and the Korea Corporate Governance Fund are natural allies in promoting more fair and transparent practices in the Korean corporate sector.

Beyond the financial sector, the nature of Korean labor market regulation has long encouraged segmentation where there is a small cadre of relatively secure and legally protected employees, who are mainly employed by chaebol or public enterprises, and a much larger group of part-timers and workers employed by SMEs, who labor under far less secure conditions. The result is a dualistic system which is rigid in some respects and flexible in others, and confers considerable protection to some workers, but few safeguards to others, and encourages confrontational behavior by Korea's unions. When Korea was confronted with the specter of mass unemployment during the 1997-98 crisis, it was forced to expand the existing social safety net, yet the provision of social insurance still lags comparators in the OECD. The crisis likewise encouraged reform of some of Korea's most debilitating labor practices. Looking forward Korea could gain from further diminishing the degree of labor market dualism and segmentation, continuing to rein in highly restrictive regulations (with respect to issues such as hiring and firing, for example) which hamper Korea in international competition, while building on recently passed legislation protecting the interests of nonregular workers and encouraging the smooth deployment of labor to its most productive uses.

Beyond these generic improvements in the functioning of capital and labor markets, there is scope for more narrow reforms to the innovation system. As Korea approaches the technological frontier, there are fewer opportunities for imitation and reverse engineering, while at the same time foreign firms are likely to be increasingly reluctant to transfer technology to potential Korean competitors. The OECD has identified a number of areas of potential improvement. Korea's innovative activities are concentrated in a limited number of sectors, and research and development activity in services is low. Considerable scope exists for improving the integration of innovative activities occurring in the universities and other public sector institutions and the private sector within Korea, as well as the degree of cross-border integration between researchers in Korea and those located elsewhere. As in the case of financial and labor market reforms, the government of Korea is making efforts in this direction, though more remains to be done.

A final challenge confronting Korea is growing income and wealth inequality. Again, Korea is not alone in this regard: technological change and globalization have resulted in increased inequality in many countries, and Korea is far, far from the worst. Yet the rise of inequality has been particularly pronounced in Korea, and unsurprisingly it is an enormously sensitive issue. As Korea grapples with inequality going forward, the key issue is to use public policy in a constructive way, by addressing lingering dualism in the labor market, for example. The risk is that inadequate or ineffective public policies in the face of the widening gap could provoke a political reaction that could damage the fundamental drivers of Korean success. This concern is made more acute by the imperative to maximize productivity growth created by Korea's looming demographic challenge and the predicament created by its economic and geographic placement between Japan and China.

These are daunting challenges, indeed. Yet two generations ago few would have predicted Korea's stunning rise. One can only hope that the strengths that the country has exhibited in achieving its extraordinary past accomplishments will be equally evident as it addresses its future challenges.