South Korea’s Neo-Mercantilist Growth Engine Has Stalled – Mihai Macovei (02/07/2020)

Capital accumulation and productivity growth are the outcome of free market investment and not of government spending. This is well known to Austrian school economists. Rothbard1 argued that only the free market can ensure an efficient allocation of factors of production whereas government sponsored investment is “either malinvestment or not investment at all, but simply waste assets.” Mises2 explained how restricting market competition shifts production to places with less favorable conditions, resulting in lower labor productivity and standards of living. Nevertheless, this point still needs to be understood by countries such as South Korea, whose growth model driven by state-led and export-oriented industrialization appears to have reached its limits.

Remarkable Success Story of Growth at First Sight

Korea grew from one of the poorest economies in the 1960s into an advanced economy while avoiding the middle-income trap.Its GDP per capita in PPP (purchasing power parity) almost reached the OECD (Organisation for Economic Co-operation and Development) average in 2018 after having been less than one-sixth in 1970 (Graph 1). Rapid growth rates of between 7 and 10 percent for several decades until the mid-1990s were propelled by very high investment which peaked at 40 percent of GDP in 1990 and has averaged around 32 percent of GDP since then (Graph 2).


Rapid industrialization and deep integration in the global value chains helped Korea become the world’s fifth-largest exporter of manufactured goods in 2017. It is most striking that behind this seeming outstanding success lies an active industrial policy. Government support for large business groups, known as chaebols, via subsidies and trade and investment barriers turned the likes of Samsung, Hyundai, LG, Kia, and Daewoo (now defunct) into global champions. But as Ryan McMaken points out, there are a lot of “unseen” missed economic opportunities behind Korea’s government-corporate “cooperation,” which means that centralized decision-making and government favoritism to big businesses obviously come at a price.

Growth Slumping While Productivity and Consumption Lag Behind

Growth typically decelerates when countries grow richer. Yet Korea’s decline in real GDP growth has been very abrupt—from about 7–8 percent in the 1980s and 1990s to below 3 percent currently. Its potential output has also slumped, driven by slowing capital accumulation and total factor productivity despite the very high investment rates. Most importantly, labor productivity has lagged significantly behind the rapid GDP growth. In 2018 Korea’s real GDP per capita was one-third lower than that of the top half of OECD countries, while labor productivity was 46 percent below that of the same sample (Graph 3). The difference is compensated by longer working hours—Koreans work 15 percent more than the OECD average and 30 percent more than the EU average.


In exchange for the long working hours, Koreans must content themselves with lower wages and private consumption levels relative to GDP performance. From 1990–2018, the Korean GDP per capita in PPP more than doubled from 43 to 94 percent of the OECD average, while the average wage in purchasing power parity grew much slower, from 59 to 85 percent of the OECD average. This is consistent with the weaker labor productivity growth, but also reflects the monopsonic power of chaebols, very rigid labor market conditions, and an inefficient wage model favoring length of service over performance, which keeps wages depressed in exchange for job security. At 53 percent of GDP, the share of labor compensation is among the lowest in the OECD group. Similarly, households’ net disposable income has steadily dropped, reaching around 50 percent of GDP in 2018 compared to US and euro area levels of about 75 and 60 percent of GDP.

In addition to compressed wages, high import tariffs and limited competition among domestic companies has hurt private consumption, which fell to a quite low 48 percent of GDP in 2018 (Graph 4). As household incomes lagged behind GDP growth, consumption and housing purchases were increasingly supported by credit. Household debt peaked at about 92 percent of GDP in 2019, one of the highest among developed economies.

Revealing an Inefficient Resource Allocation

According to the mainstream growth recipe, Korea should be a top-class student with its very high investment ratio, extremely long working hours, and first-rate R&D (research and development) spending (4.6 percent of GDP in 2017). It has obviously excelled in the quantitative utilization of both capital and labor. But the sheer size of resource utilization is not enough to deliver sustainable growth without their efficient combination. Only free markets can ensure an efficient allocation of factors of production to their most productive uses. Unfortunately, in Korea’s case, labor and product markets are heavily regulated and cannot perform their resource optimization task.

Restricted competition on product markets and the government picking winners have always been intrinsic features of Korea’s growth model. The protectionist toolbox has comprised both trade and investment barriers and subsidies. In contrast to its excellent overall ranking in the 2019 Global Competitiveness Index (thirteenth out of 141 countries), Korea ranked only the ninety-first in terms of trade openness for tariffs and seventy-seventh for nontariff barriers. Similarly, its stock of inward foreign direct investment (FDI) was a meager 14 percent of GDP in 2018, compared to 55 percent of GDP for the EU and 36 percent of GDP for the US. With an outward FDI stock of about 22 percent of GDP, Korea has been a net exporter of direct investment. On-budget subsidies for economic activities are almost double the OECD average.

When the chaebol system overstretched and its inefficiencies became too obvious, especially after the 1997 financial crisis, the government pushed for its downsizing and leveling the playing field versus small to medium-sized enterprises (SMEs). As vested interests made market liberalization almost impossible, government support was instead gradually extended to SMEs via credit and other financial subsidies, lower taxation, preferential access to public procurement, and exclusive rights to operate in certain business lines. As a result, both chaebols and SMEs are now operating in segmented and rigorously protected markets while Korea’s product market regulations remain the fourth strictest among the OECD nations.

Labor market regulations are very rigid too, which led to an inefficient dual labor market over time. Korea only ranked close to one hundredth in the 2019 Global Competitiveness Index in terms of labor market flexibility, redundancy costs, and ease of hiring and firing. The labor market is strongly segmented, with a large share of irregular jobs to make up for the tight regulations. Nonregular workers represent about one-third of total employment compared to 11 percent in OECD economies, and earn only 66 percent of regular workers’ wages on average. Well-paid regular jobs in large companies are scarce relative to unattractive jobs in SMEs and services, which suffer from labor shortages. Together with educational mismatches this contributes to a fairly low youth employment rate.

Shift in Growth Strategy Goes in the Wrong Direction

As often is the case with government action, Korea tried to address the symptoms rather than the root causes of its problems of inefficient growth and depressed consumption. In 2017, the newly elected president Moon Jae-in announced a shift towards domestic income–led growth, primarily by redistributing incomes and boosting consumption. The government increased substantially the minimum wage by a cumulated 30 percent during 2018–19, reduced statutory working hours from 68 to 52 hours per week, and promised an increase in public employment of about 40 percent.

It goes without saying that these measures made things worse, especially as theyoverlapped with a significant decline in external demand following the US-China trade war.Employment growth decelerated notably, driven by job losses in manufacturing and SMEs, and new jobs were created primarily in the public sector and more precarious part-time positions. Despite income redistribution measures, private consumption growth decelerated further in 2019 while private investment declined for six quarters in a row, weakened by FDI outflows and company relocations. All in all, Korea’s real GDP growth declined from 3.2 percent in 2017 to an estimated 2 percent in 2019. On top of that, income-boosting measures have been costly: the budget balance is projected to deteriorate from a surplus of 2.6 percent of GDP in 2018 to a deficit of 1.4 percent in 2020.

A Sensible Way Forward

What Korea needs to achieve a sustainable revival of its potential growth is an efficient allocation of factors of production by free markets, unencumbered by government protection of either dominant chaebols or SMEs. Only this can ensure genuine capital accumulation and higher labor productivity to underpin market-set wages that do not undermine cost competitiveness. As production is only a means for consumption, freedom to choose the preferred consumption schedules would provide Koreans with a better standard of living and work incentives.

The case of Korea justifies in full Mises’s assertion that government interference with businesses makes people poorer and less satisfied. In Mises’s own words: 

government doesn’t have the power to encourage one branch of production except by curtailing other branches….It may subsidize openly or disguise the subsidy in enacting tariffs….What alone counts is the fact that people are forced to forego some satisfactions which they value more highly and are compensated only by satisfactions which they value less (Human Action, p. 737).


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