In 1979, W. Arthur Lewis received the Nobel Prize in economics for his analysis of growth dynamics in developing countries. Deservedly so: His conceptual framework has proved invaluable in understanding and guiding structural change across a range of emerging economies.
The basic idea that Lewis emphasized is that developing countries initially grow by expanding their export sectors, which absorb the surplus labor in traditional sectors like agriculture. As incomes and purchasing power rise, domestic sectors expand along with the tradable sectors. Productivity and incomes in the largely urban, labor-intensive manufacturing sectors tend to be 3-4 times higher than in the traditional sectors, so average incomes rise as more people go to work in the expanding export sector. But, as Lewis noted, this also means that wage growth in the export sector will remain depressed as long as there is surplus labor elsewhere.
Because labor availability is not a constraint, the key factor with respect to growth is the level of capital investment, which is needed even in labor-intensive sectors. The returns on such investment depend on competitive conditions in the global economy.
These dynamics can produce startlingly high growth rates that sometimes continue for years, even decades. But there is a limit: when the supply of surplus labor is exhausted, the economy reaches the so-called Lewis turning point. Typically, this will happen before a country has climbed out of the lower-middle-income range. China, for example, reached its Lewis turning point 10-15 years ago, which brought about a major shift in the country’s growth dynamics.
At the Lewis turning point, the opportunity cost of shifting more labor from traditional to modernizing sectors is no longer negligible. Wages start to increase across the whole economy, which means that if growth is to continue, it must be driven not by shifting labor from low- to higher-productivity sectors, but by productivity increases within sectors. Because this transition often fails, the Lewis turning point is when many developing economies fall into the middle-income trap.
Lewis’s growth model is worth revisiting because something similar is happening today. When the global economy started to open and become more integrated several decades ago, massive amounts of previously disconnected and inaccessible labor and productive capacity in emerging economies shifted to the manufacturing and export sectors, producing dramatic results. Manufacturing activity relocated from developed countries, and emerging economies’ exports grew faster than the global economy.
Owing to the sheer scale of relatively low-cost labor in emerging economies (especially China), wage growth in advanced economies’ tradable sectors was subdued, even when the activity did not shift to emerging economies. Labor’s bargaining power was reduced in developed economies, and the negative pressure on middle- and low-income wages spilled over to non-tradable sectors as displaced labor in manufacturing shifted to non-tradable sectors.
But that process is largely over. Many emerging economies have become middle-income countries, and the global economy no longer has any more large reservoirs of accessible low-cost labor to fuel the earlier dynamic. Of course, there remain pools of underutilized labor and potential productive capacity, for example in Africa. But it is unlikely that these workers will enter productive export sectors fast enough and at sufficient scale to prolong the pre-turning point dynamics.
The Lewis turning point will have profound consequences for the global economy. The forces that have been depressing wages and inflation over the past 40 years are receding. A wide range of emerging and developed economies are growing older, reinforcing the trend, and the COVID-19 pandemic has further reduced the labor supply in many sectors, possibly on a permanent basis. Under these conditions, the four-decade decline in labor incomes as a share of national income is likely to be reversed – though automation and other rapidly advancing labor-saving technologies may counteract this process to some extent.
In short, now that several decades of developing-country growth have exhausted much of the world’s unused productive capacity, global growth is increasingly constrained not by demand but by supply and productivity dynamics. This is not a transitory shift.
One clear consequence of this process is that inflationary forces have shifted fundamentally. After vanishing or flattening for an extended period, the Phillips curve (which describes an inverse relationship between inflation and unemployment) is probably back, permanently. Interest rates will rise along with inflationary pressures, which are already forcing major central banks to withdraw liquidity from capital markets.
A highly indebted global economy (the legacy of years of low interest rates) will go through a period of turbulence as debt levels are reset for a “new normal” interest-rate environment. Portfolio asset allocations will be adjusted accordingly, and the extended honeymoon during which risk assets outperformed the economy will end.
It is anyone’s guess how abruptly this will happen. Specific outcomes are impossible to forecast precisely. The global economy’s encounter with the Lewis turning point will be a period of considerable uncertainty, which is to be expected with any tectonic shift.
Many parts of the global economy will experience a fundamental regime change. Several decades of growth in emerging economies have driven a massive increase in middle-income consumers and overall purchasing power, while simultaneously removing the world’s ultra-low-cost productive capacity.
Of course, there may still be periods of demand-constrained growth, following crises like the pandemic or future climate-driven shocks. But the underlying pattern will be one of supply- and productivity-constrained growth, because the remaining reservoirs of underutilized productive capacity simply are not large enough to accommodate growing global demand.
Lewis’s work was not primarily focused on the global economy, except to the extent that international markets provide the technology and demand needed to fuel early-stage export-led growth in developing countries. Nonetheless, his insight that growth patterns shift dramatically depending on whether there are accessible untapped productive resources (especially labor) is as relevant as ever.
Applied to the transitions now underway in the global economy, Lewis’s insights imply major changes in growth patterns, the structure of economies, the configuration of global supply chains, and the relative prices of pretty much everything – from goods, services, and labor to commodities and various asset classes. Equally important, they indicate that this transition will be irreversible.
Navigating the global version of the Lewis turning point will be tricky. Understanding the underlying structural changes is the necessary place to start.
EBR 10th Year • Feb 2022 • No. 104