Growth Potential of Korean Economy from Growth Accounting Perspective 1

Growth Potential of Korean Economy from

Growth Accounting Perspective

Jong-il Kim*

This paper seeks to overview the growth potential of Korea economy based
on the empirical results of a cross-country comparison of growth accounting.
According to the empirical results, the sources of the rapid growth of Korea
in the last forty years are mostly to be found in the increase of labor and
capital input a due to the favorable environment such as demographic
transition, social and economic institutions, and government policies. These
factors favorable to the past growth seem to have come to a close and could
change into a burden for future growth. However, the low total factor
productivity growth, which is assumed as the shadow of accumulation-
oriented growth and the precursor of future stagnation can be interpreted as
the natural phenomenon of economy under rapid industrialization and thus
may conrersely indicate the opportunity for efficiency-based growth. Such
indicators as trends of sources of growth, education, and R&D investments
suggest Korea is moving swiftly into efficiency-based growth. However, the
hasty atktudes of Koreans accustormed to high growth could rather invite
stagnation and distortion.

JEL classification : O47, O53

Key Words : Growth Accounting, Total Factor Productivity, Demographic

Transition

*Prefessor, Department of Economics, Dongguk University, Pil-Dong Jung-Gu Seoul Korea

 2 Economic Papers Vol.8 No.1

I. Introduction

Korea has achieved rapid economic growth over the past 40 years. However,
there are concerns that the engine of growth of Korean economy may be running
out of steam as Korea is entering a new stage of economic development. After
economic crisis in the late 1990' s, Korea went through rapid structural change in
the financial system, corporate governance, and labor relations, etc. It
undoubtedly implies that Korea cannot move as aggressively as before in its
pursuit of rapid growth, and suggests that the most critical issue facing the
current Korean economy is whether it can continue to grow at the same pace as
it has in the past. The fate of Latin American countries that have failed to enter
the wealthy nations' club haunts the newspaper headlines whenever there is a
bad news on the Korean economy. Since many countries underwent dramatic
social, political, and economic structural changes on their way to the wealthy
club, it may be instructive to examine the current state of the Korean economy
and what is needed for Korea to become a developed country.
In order to evaluate the necessary conditions for the Korean economy to
sustain stable growth in the future, there is a need to identify the current
economic situation and potential obstacles of the Korean economy. Since the
current economic situation is the cumulative result of several decades of
development, the growth patterns of the past must be understood. Economic
growth is the product of complex interactions among various factors, including
politics, social systems and culture. There are numerous studies discussing
challenges for Korea' s continuous growth even within the various fields
ofeconomics. This paper tries to assess the current situation of Korean economy
by exploring the recent empirical results of cross-country comparisons of
economic growth. 1) It seak to provide an overview on where the Korean
economy is now in terms of factors immediate to economic growth and what can
be implied in terms of its future growth. The methodology utilized in this paper
induding the cross-country comparison of growth accounting can be criticized as
Note : 1) There have been many studies analyzing the sources of Korean economic development. For example, a
series of growth accounting analyses such as Kim and Park(1979), Kim and Hong(1992), Hong and
Kim(1996), Kim, Lee, and Kim(2002) have been undertaken in the KDI by utilizing Denison's
methodology. These studies provide extensive time series estimates of factor and productivity growth of
Korean economy but have difficulty in interpreting since the estimates sensitively depend on the
estimation methodology and data treatment. Therefore, only with the absolute level of estimates we cannot
assess whether the growth rate of total factor productivity, for instance, is high or low. Thus, many studies
have recently applied the identical methodology to comparable data across countries to examine growth of
nations on international comparison. See Young(1995), Collins and Bosworth(1996), Sarel and
Robinson(1997), and Kim(1998).
 Growth Potential of Korean Economy from Growth Accounting Perspective 3

being too simple to cover the complexity of economic growth. However, by

focusing on only quantitative growth factors, such as labor, capital, and
productivity, we can get a more concise overview of Korean economic growth.
National income is determined by a country' s level of production activity, and
thus national income growth is based on the growth of production factors such as
capital and labor, as well as total factor productivity, which reflects the
efficiency of factor utilization. A rapid accumulation of capital has been
identified as one of the factors behind the robust growth of the Korean economy.
While statistics clearly show that Korea' s high savings rate and vigorous
corporate investment were instrumental in fueling Korea' s economic
development, mixed evidence has emerged in regard to the contribution of
productivity growth. Several studies reported that the productivity growth of
East Asia' s newly industrialized countries, including Korea, may have been
much lower than might be expected from their high economic growth. 2)
Krugman(1994), based on this empirical evidence, warned that, due to low
productivity growth, their future economic growth would be limited, a view that
has triggered various debates.3) Regardless of the validity of his prediction,
concerns over the limits to East Asia' s economic growth have come to the
forefront as a result of the recent Asian financial crisis.
This paper looks into the growth potential of the Korean economy by
comparing Korea and other developed countries in terms of the comparable
growth accounting. Since there seems to be a similar pattern of economic
development across countries as can be seen in the change of industrial structure,
the comparison with developed countries will give valuable implications for
future growth. While other studies such as Young(1995) paid much attention to
cross-country comparison of total factor productivity growth rate, this paper
seeks to examine closely two factors that could be especially significant in
explaining Korea' s economic growth, but which so far have been relatively
underestimated: demographic transition and changes in the industrial structure.
These two factors are topics that have long attracted attention in the fields of
developmental economics. They are also relevant variables when considering
Korea' s future economic prospects, as they involve wide-ranging consequences.
Korea' s "compressed" economic growth was accompanied by massive
demographic transition and a basic transformation of the industrial structure.
With rapid demographic transition there was a massive inflow of young workers

2) Kim and Lau(1994), Young(1995), and Collins and Bosworth(1996) reported that the total factor productivity
growth in the East Asian newly industrialized countries was not so high as might be expected.
3) For the total factor productivity controversy, see Rodrik(1997).
 4 Economic Papers Vol.8 No.1

and economic growth successfully provided these young workers with new job
opportunities. The rapid conversion of the industrial structure, from agriculture
to manufacturing, led to large-scale investment demands. This process created a
virtuous cycle of growth, which in turn led to rapid development. However,
various indices now indicate that this virtuous cycle of rapid growth could play a
negative role in the future. However, Korea is moving toward efficiency-based
growth, which is a natural transition from the historical perspective of economic
development. Thus policy attention should be oriented to qualitative growth
rather than quantitative growth which still captures the minds of Korean people
and policy makers.
Section II summarizes the characteristics of Korean economic growth in terms
of sources of growth compared with other developed countries. Section III and
IV examine the growth prospects of two major factors of growth, labor and
capital. Section V looks into the total factor productivity growth in depth.
Section VI will extract the growth prospects of the Korean economy based on
the analyses of Sections III to V. Section VII concludes the paper with comments
on what should be done for future growth.

II. Korean Economy' s Sources of Rapid Growth

National income is a measure of the production activities of a nation' s people,

and its growth depends on increases in the quantity of production factors and
productivity gains. According to the theory of economic growth, national
income growth can be divided into that induced by production factor growth and
that by productivity increases. If we make some assumptions on the production
function, we can quantitatively estimate the contributions of each source of
economic growth, making what is commonly referred to as a growth accounting
analysis. Table 1 reports the results of growth accounting analysis in explaining
the growth of the newly industrialized economies of East Asia between 1966 and
1990, as compared to the growth of the G-5 developed countries from 1947 to
1973. The two groups achieved the most rapid growth in history over these two
periods. In particular, the East Asian countries, including Korea, enjoyed
remarkably high economic growth rates, accompanied by a rapid expansion of
production factor inputs. When the economic growth of East Asian countries is
compared to that of developed countries, several notable characteristics can be
identified in regard to the emerging industrial economies of East Asia, including
 Growth Potential of Korean Economy from Growth Accounting Perspective 5

Table 1 Cross-Country Comparison of Sources of Growth

Korea.
First, in most countries, capital accumulation contributed to more than 40
percent of economic growth, thus exhibiting critical importance. The high rate of
capital accumulation in East Asian countries has been particularly impressive.
Second, unlike the developed countries, East Asian countries experienced a
large increase of labor input. In most European developed countries, labor input
almost stayed constant. Korea shows as high as 6.4% per annum increases of
labor input over as long as a 25-year period. This high increase of labor input in
Korea consists of the high population growth and favorable demographic
transition, the rise in labor force participation rate, and decline in
unemployment. Among them, demographic transition contributed most to the
increase in working labor. Third, total factor productivity growth, which reflects
improvement in production efficiency, has accounted for less than 30 percent of
economic growth in most East Asian countries, indicating that their productivity
 6 Economic Papers Vol.8 No.1

growth has been lower than that of developed countries. In the case of Korea,
total factor productivity increased by 1.2 percent annually, which is much lower
than that of developed countries during the period of their highest growth. The
relevance of these statistical results has fueled the discussions over the limits to
economic growth in East Asia.
Among the above three characteristics of economic growth, the growth in
labor input has been relatively less noticed than the two aforementioned factors.4)
Labor input has not attracted much attention because from a theoretical
perspective, economic growth analysis is focused mainly on capital
accumulation and productivity gains. Moreover, from a practical sense as well,
labor input has always been overshadowed by an explosive expansion of capital.
However, a close examination of Table 1 shows that, in the case of Korea, the
rate of increase of labor input has been quite high as in the case of capital input.

III. Labor Input Growth

According to Table 1, Korea recorded an annual increase of labor input of 6.4

percent on average. This annual rate of increase means that labor input
approximately doubled over a 12-year period, and thus labor input expanded
four-fold from 1966 to 1990. Instances of such rapid labor input increases over
such a brief time period are rare indeed. This figure includes changes in the
composition of labor input in terms of gender, age, education level, and
industrial sector and employment patterns. If these factors are excluded, the
simple quantitative increase would amount to a 5-percent annual rate.5) Then,
what were the factors behind this high rate of labor input increase And how
much did labor input contribute to economic growth?

The quantitative aspects of labor input can be calculated based on total labor
hours. Total labor hours can be decomposed as the following formula:

Total labor hours

= (total labor hours / total employment) (total employment / total labor

4) While most studies paid attention to capital accumulation, Bloom and Williamson(1998) emphasized the role of
demographic transition in the rapid growth of East Asia.
5) According to Young(1995), the source for the figures for Korea in Table 1, the compositional change accounts
for 1 percent per annum increase of labor input.
 Growth Potential of Korean Economy from Growth Accounting Perspective 7

force) (total labor force / working age population) (working age

population / total population) (total population)
= average labor hours (1.0-unemployment rate) labor force participation
rate (1.0-dependency ratio) total population.

Based on this formula, Table 2 decomposes Korea' s quantitative labor input

growth into the changes in average labor hours, employment, labor force
participation rate, dependency ratio, and total population. The most significant
contribution to the quantitative increase in labor input results from the increase
in total population, which is a typical phenomenon of most developing countries.
What is unique about the case of Korea is the sharp increase in the share of its
working age group to the total population as shown in the fourth column of the
Table 2. Over 30 years, from the 1960s to the 1990s, the rising share of the
working age population continued to account for more than 1 percentage point
of labor input growth. The dramatic decline in the dependency ratio resulted
from a rapid demographic transition, that is, a transition from a high birth-high
mortality to a low birth-low mortality phase.
Most developed countries have shifted from a high birth-high mortality to a
low birth-low mortality phase over the past 200 years. In particular, this
demographic trend has been attributed to the advance of medical technology,
which lowered the mortality rate, especially in regard to infant mortality. When a
society shifts from a high birth-high mortality phase to a high birth-low
mortality, the infant population will surge dramatically.

Table 2 Decomposition of Labor Input Growth (annual average growth, percent)

However, the birth rate, unlike the mortality rate, tends to trend downward in
response to changes in the social and cultural environment. Following such
 8 Economic Papers Vol.8 No.1

periods of rapid growth in total population, over time, a society gradually shifts
to a low birth-low mortality phase, during which time population growth levels
off, which in turn results in a decline in the share of the economically active
population. Most developed countries have experienced such demographic
changes gradually over long periods of time, whereas in Korea, the timeframe
between the decrease in the mortality rate and the decline in the birth rate
occurred within a period of only 20 years. Such a compressed time frame of
population transition is virtually unheard of in the history of the world.
Therefore, since the 1960s, Korea has experienced expansion of its working
age population, based on the changes in demographic trends, as well as total
population growth. This indicates that the economy was able to enjoy rapid
growth provided plentiful jobs were available for young workers. The
continuous downward trend of the unemployment rate since the 1960s
demonstrates that the demand for labor had outpaced the rapidly expanding
supply of labor. Therefore, during this period, the rapid growth of the Korean
economy was based on the fact that jobs were being continuously created for the
fast-growing labor supply.

As for how this increase in labor input contributes to the growth of per capita
national income, the following formula can be used:

Per capita GDP

= (total GDP / total labor hours) (total labor hours / total employment)
(total employment / total labor force) (total labor force / working age
population) (working age population / total population)
= labor productivity average labor hours (1.0-unemployment rate)
labor force participation rate (1.0-dependency ratio)

According to this formula, per capita GDP growth results from increases in
labor productivity, average labor hours, and the labor force participation rate, or
when there are decreases in the unemployment rate and dependency ratio. Total
population growth could increase labor input, but it might also have a negative
impact on per capita GDP because it simultaneously increases the denominator.
Table 3 shows that the quantitative increase in labor input that occurred during
the 1960s through the 1980s was significant in that it accounted for about 30
percent of the growth in per capita GDP. Since Korea had more workers per
capita as a result of an increasing pool of young workers, per capita GDP grew
by one percent per annum up to the 1980s. The very existence of the large pool
 Growth Potential of Korean Economy from Growth Accounting Perspective 9

of young generation entering labor market has significant implications for rapid
growth, as the young workers are equipped with more education and ready to
learn by doing. Based on the impact of young educated workers steadily entering
the labor market, and their subsequent on-the-job training, it can reasonably be
concluded that the changes in demographic trends have indeed played an
essential role in enhancing labor productivity.6) In sum, the rapid demographic
transition could have contributed to labor productivity growth as well as
quantitative increase in labor input.

Table 3 Decomposition of Per Capita GDP Growth (annual average growth, percent)

As national income increases, the opportunity cost of giving birth begins to

trend upward, which in turn serves to dampen birth rates. A decrease in the
number of children who require childcare increases both the demand and supply
for female workers. In particular, in a country like Korea, where there is less
social opposition to abortion, the downturn in the birth rate has been accelerated,
along with the growth of national income leading to an even more rapid decrease
in the birth rate. As such, in the case of Korea, there has been a strong
correlation between economic growth and declining birth rates, which has
supported the achievement of robust growth within a virtuous cycle.7)
However, in the 1990s, the contributions of quantitative labor input increases
became inconsequential as the share of the economically active age population
also leveled off. The contribution of demographic change as implied by the
fourth column of Table 2 sharply dropped from more than 1 percentage point to
6) Moreover, the decrease in the birth rate may have a positive effect on labor productivity as parents pay more
attention to education with fewer children. Thus low birth brings about high human capital growth. See
Rosenzweig(1990).
7) Bloom and Williamson(1998), and Bloom, Canning, and Melany(1999) found that demographic transition has a
significant effect on economic growth based on cross-country regression analysis
 10 Economic Papers Vol.8 No.1

0.3 percentage point in the 1990s. In addition, average labor hours began to
decrease in the 1980s and most factors of quantitative labor input growth show
downward trends. The future demographic change indicates that the labor pool
will age rapidly hereafter, while the past high dependency ratio of children will
soon be replaced by a high dependency ratio of the elderly. Thus, we can expect
that the high labor input growth of the previous generation and its positive
impact on growth will turn into a rapidly aging population and a negative burden
in the next generation.
Therefore, the improvement in labor productivity has recently assumed a more
significant role in boosting income growth. In the 1990s, labor productivity
growth accounted for 97 percent of per capita GDP growth. Undoubtedly, labor
productivity gains provided the most significant contributions to the remarkable
upsurge in per capita income growth, which recorded annual increases of 6
percent on average over the past 40 years. The labor productivity growth is
attributable to the increase in capital per worker and overall productive

Figure 1 The Dependency Ratio of Korea

60 1.2

50 1
Dependency population per work
Dependency ratio (percent)

40 0.8

30 0.6

20 0.4

10 0.2

0 0
75

80

85

90

95

00

05

10

15

20

25

30
70
60

65

19

19

19

19

19

20

20

20

20

20

20

20
19
19

19

Young dependency ratio

Old dependency ratio

Total dependent population per worker

 Growth Potential of Korean Economy from Growth Accounting Perspective 11

efficiency, so-called total factor productivity. The total factor productivity may
increase due to numerous causes such as technological progress, better resource
reallocation, and human capital accumulation and so on. In terms of labor input,
education and the training of needed skills are also fundamental factors to be
considered in efforts to improve labor productivity. In the following sections,
capital accumulation and total factor productivity growth, the two sources of
labor productivity growth will be discussed.

IV. Capital Accumulation

The previous section confirmed the instrumental role of labor productivity

increases in achieving economic growth. Labor productivity increases could
have resulted in considerable part from rapid capital accumulation. Accordingly,
the question is: What enabled this rapid capital accumulation to occur? Since
economic growth is a complex process with all the economic variables changing
altogether, it is not easy to pinpoint the cause of capital accumulation and even
impossible to define the causality. However, the government' s development
policy could be regarded as one of the major factors which induced high saving
and investment in Korea. The immediate target of most industrialization policy
has been in large part triggering capital investment as Gerschenkron(1962)
characterized the history of latecomers in industrialization. In particular, the
economic development policy launched by the Park Chung Hee regime in the
1970s, which focused on the promotion of Korea' s heavy-chemical industry
sector, stands out as a representative example of government intervention
leading to a rapid transformation of the industrial structure.8) The heavy and
chemical industry drive under the government' s strong initiative to mobilize
resources for capital accumulation seems to have achieved this goal. There are
various researchers who have contended that the domestic heavy-chemical
industry could have been developed under a more market-friendly process, and
even without such government intervention. While there have been differing
opinions about this policy' s positive or negative consequences, there can be no
denial that, despite resultant distortions in the distribution of resources and
creation of structural deficiencies, the high investment rate induced by the
government' s policy was a contributing factor, until recently, to Korea' s rapid
8) Kim and Watanabe(1987) argued that Korean experience is the most typical example of Gerschenkronian
economic development.
 12 Economic Papers Vol.8 No.1

economic growth.
Effective investment in the heavy-chemical industry sector requires the
development of production facilities that can capitalize on economies of scale. In
the case of Korea, due to its relatively small-scale domestic market, from the
early stages of its industrialization process, efforts were focused on the
promotion of export activities. In contrast to an import-substitution strategy, an
export-oriented policy is able to reduce market distortions by establishing
standards that can assess government support measures in relation to export
results, while also exposing domestic enterprises to international competition in
markets abroad and continuously bolstering production efficiency. In this case,
such expansion of potential markets serves to maximize economies of scale and
reduce price distortions while improving the flexibility of nominal exchange
rates. While other developing countries have promoted their own heavy-
chemical industries based on an import-substitution approach, Korea' s heavy-
chemical industry development policy not only sought to realize import
substitution and protection of its infant industries, but also to promote exports.
Countries like Korea have to rely on the import of resources and capital goods
from abroad to secure the inputs needed to facilitate industrialization. Moreover,
with its general lack of natural resources, Korea was forced to rely on exports to
earn hard currency.9) As was examined earlier, large numbers of young workers
entered the labor market as a result of changes in demographic trends. Despite a
lack of other resources, expansion of the available manpower pool was a major
contributing factor to export growth during the early stages of economic
development, especially in labor-intensive industries.10) Therefore, it was natural
for Korea to promote exports as a means of generating revenue for these labor-
intensive industries. Increases in the supply of young workers strengthened the
competitiveness of labor-intensive industries and resulted in the creation of a
virtuous cycle for promoting export-led economic growth.
In addition, the labor market' s ability to accommodate the entry of young
workers also contributed to an upward trend in the savings rate. In the case of
Korea, after the Korean War experience in the 1950s, income levels during its
economic reconstruction period were much lower than those of other developing
countries, as was the domestic savings ratio, which stood at less than 10 percent
in the 1960s. However, as the economy began to grow, the savings ratio rose
19) Rodrik(1994b) reported that the returns to Korea and Taiwan from exports were not so high as other developing
countries but exports were the only way to get hard currency.
10) According to Fukuta and Toya(1999), Korea' s capital-labor ratio in the early industrialization period was
exceptionally low compared with other countries, and this also contributed to rapid capital accumulation with
increase in labor intensive exports.
 Growth Potential of Korean Economy from Growth Accounting Perspective 13

sharply, reaching a level of 25 percent by the 1970s. It then continued to

increase, climbing to 40 percent by the early 1990s. This sustained upsurge in
the savings ratio can also be attributed to changes in demographic trends. The
rapid changes in demographic trends led to a dramatic increase in the share of
young workers in the total population. According to typical life-cycle patterns,
people tend to save more during the time when they are economically active and
then draw on these savings after retirement. Therefore, people' s savings rate
would remain high up through the time they reach middle age or an even more
advanced age. For Korea, its economically active age group expanded rapidly

Figure 2 Saving Ratios in Korea

45 15

40
10

Foreign net borrowing/GDP(%)

35
Total domestic saving/GDP(%)

30 5

25
0
20

15 -5

10
-10
5

0 -15
69

72

75

78

81

84

87

90

93

96

99

02
66
60

63

19

19

19

19

19

19

19

19

19

19

19

20
19
19

19

Domestic saving ratio Foreign saving ratio

after the 1960s, thus contributing to the steep rise in the savings ratio.
Unlike developed countries, Korea' s social welfare programs, such as its
pension, unemployment insurance, and medical insurance systems, were not
introduced until the late 1980s. Therefore, individuals themselves had to prepare
for any future uncertainty and their post-retirement life. This situation
contributed to the high savings rate as well. Furthermore, Korea' s housing loans
and mortgage system remain relatively undeveloped, meaning that people had to
save money over a number of years in order to purchase a house. The high cost
 14 Economic Papers Vol.8 No.1

of education also motivated families to save money. The financial system also
forced saving. In the 1970s, the government controlled real interest rates at
negative levels resulting in forced savings, while suppressing the development of
retail banking services and consumer credit. Instead, the government introduced
the postal deposit service to facilitate saving. Therefore, under such financial
constraints, households were effectively compelled to moderate their
consumption habits. Korea' s social system and culture, including such aspects as
the changes in demographic trends, social welfare system, financial system, and
wage payment system, all contributed to a low-consumption and high-savings
society.
To summarize, the rapid increase in capital accumulation resulted from a
virtuous cycle of continuous investment related to the government' s
development policy, strengthened competition through exports, high-quality
labor, expansion of employment opportunities, and rising savings ratio
coinciding with income growth. Consequently, the economic growth of the past
was the product of various factors that created an economic environment that
was conducive to capital investment. However, the causes mentioned for high
saving and investment are rapidly disappearing. First of all, there is no scope of
such government intervention as in the former development policy under
liberalized financial markets and a globalized economic environment.
Particularly, after the economic crisis, banks have tended to promote consumer
credit. Also, the aging population, the expansion of the social welfare system,
and the easy availability of consumer credit will lower the saving ratio to the
level of developed countries. Thus, the prospect of labor and capital input
increase indicates the declining growth potential of Korean economy. That is,
first, Korea cannot sustain rapid growth as before, and second, quantitative
expansion of economy may not guarantee sustained income growth without
improvement of productive efficiency.

V. Total Factor Productivity Growth

The fact that the rate of Korea' s total factor productivity growth is lower than
that of other developed countries, as shown in Table 1, indicates that Korea' s
growth resulted more from quantitative accumulation rather than qualitative
efficiency. From the viewpoint of a neo-classical growth model, this implies that
growth may eventually stagnate as a result of the diminishing returns of
 Growth Potential of Korean Economy from Growth Accounting Perspective 15

production factors. In particular, when we consider the situation that Korea still
has to catch up with the technological development of developed countries, and
its industrial structure has noticeably closed the gap with its Western
counterparts, this low total factor productivity growth is somewhat of a surprise.
Thus, there were many studies discussing the controversy of low total factor
productivity growth in East Asia. Sarel and Robinson(1997), Rodrik(1997),
Hsieh(1997), and Nelson and Pack(1999) suggest that there could be a
measurement error due to restrictive assumptions of growth accounting
methodology and incorrect measurement of inputs, particularly capital stock.
However, there is no denying that factor growth accounts for a larger proportion
of growth than efficiency improvement. Furthermore, according to comparision
of East Asia with developed countries based on the identical methodology and
data treatment such as Young(1995) and Collins and Bosworth(1996), the
estimates of total factor productivity growth are not so high in Korea as other
developed countries.
If this should prove to be the case, how can we explain the relatively low total
factor productivity growth of Korea? One of the reasons might be the decrease in
productivity caused by the inefficiency of government policy initiatives. There
are several studies reporting the empirical evidence that industries supported by
the industrial policy underperform other industries without support. 11) Most
studies compared the total factor productivity growth across industries and tried
to find whether there were signifnicant differences between industries with and
without support of industrial policies. However, these empirical findings do not
seem very conclusive. First of all, while dynamic efficiency of industrial
transition is a major target of industrial policy, these studies use relatively short
period data, which are too short to detect the industrial shift. Second, as Beason
and Weinstein(1996) reported in the case of Japan, some industrial policies were
not for picking winners but for saving losers. It is also true of Korea that large
financial incentives against market signal have been diverted to declining sectors
such as agriculture. Therefore, we cannot test the effectiveness of industrial
policy in general just by comparing the performance of industries without
specifying the purpose of specific interventions. Third, as Rodrik(1994)
comments on the methodology of the World Bank(1993), one cannot test the
success of industrial policy by comparing its performance on targeted industries
vis--vis other industries but should be concerned with the performance of
industries in the absence of intervention.

11) See World Bank(1993), J. Lee(1995), and B. Lee(1998).

 16 Economic Papers Vol.8 No.1

However, if we take into consideration that the heavy-chemical industry has

played a critical role since the early 1980s as an engine of economic growth, it is
difficult to assess which of the two influences was more prevalent: the distortion
of the distribution of resources or the benefits arising from the dynamic
transformation of the industrial structure. In particular, a comparison of the
growth rates of the manufacturing industry' s total factor productivity before and
after the 1980s reveals that the heavy-chemical industry' s rate of growth in total
factor productivity increased after the 1980s. 12) Thus, in terms of industrial
transition, we cannot conclude that the heavy and chemical industry drive in the
1970s failed just based on the low total factor productivity growth of the 1970s.
Of course, there is no denying that the government' s control of commercial
banks and their support for selected industries, as well as the rise of the
Chaebeol that resulted from this government-directed assistance, led to the
creation of structural deficiencies. These shortcomings included excessive debt
levels, a lack of proper corporate governance, in regard to management
transparency and accountability, and distortion of the functions of financial
institutions, which became targets of restructuring in the aftermath of Korea' s
financial crisis. However, until the late 1980s, these structural weaknesses were
regarded as positive factors that contributed greatly to Korea' s economic
development.
A different interpretation of low total factor productivity growth is possible
when the situation is assessed based on changes in the industrial structure. Over
the past two centuries, economic development has involved a transition from
primary industry, centering on agriculture, to secondary industries, such as
manufacturing activities. Moreover, the manufacturing industry has evolved as
well, starting from simple labor-intensive processes to capital-intensive sectors,
and more recently a technology-intensive structure. This transformation of the
industrial structure was also accompanied by changes in growth patterns,
involving a shift from factor accumulation to efficiency gains.
Characteristics of the early stages of industrialization typically include market
expansion and urbanization leading to large-scale investment in social overhead
capital. This pattern of growth also included development of light industry
manufacturing that employed unskilled labor. As the industrialization process
advanced, the heavy-chemical industry, in which capital and technology were
applied to production, became the center of economic growth. In addition, the
investment of intangible capital, such as education for skilled manpower, and

12) See Hong and Kim(1996), B. Lee(1998), and Kim(1998).

 Growth Potential of Korean Economy from Growth Accounting Perspective 17

technological development became ever more important. This accumulation of

intangible capital is directly reflected in the increases of total factor productivity.
As a result, the economy began to shift away from an accumulation-oriented
focus and increasingly move toward an emphasis on efficiency-centered growth.
According to a recent empirical analysis, even developed countries such as the
United States and Japan benefited more from capital accumulation during the
early stages of industrialization than from improvement in productivity.13)

Table 4 Trends of Employment Structure by Country

13) Abramovitz(1993) reported that the total factor productivity growth of the US up to the 1890s was much lower
than that in the next century. Hayami and Ogasawara(1999) also provide evidence that Japan also experienced
low total factor productivity growth before 1920 during the early period of industrialization. For a detailed
analysis, see Kim(2002).
 18 Economic Papers Vol.8 No.1

This kind of transition in industrial structure, from primary to secondary and

then tertiary service industries, has been experienced by most developed
countries as we can see from the trends of employment structure in the Table 4.
In the U.K., where the industrial revolution began, secondary industries already
accounted for a 30 percent share of the overall industrial structure in the 1820s.
In the United States, more than 25 percent of the labor force was employed in
secondary industries by the 1880s, thus indicating that the early stages of
industrialization had been underway well before this period. In the early stages
of industrialization, capital accumulation accelerates amid an expansion of
employment in the manufacturing industry. Thereafter, improvement of
productivity becomes the top priority, as the industry moves toward a
technology-intensive structure centered on the electronics, automobile and
chemical industry sectors. While Japan was mainly engaged in primary
industries in the 1880s, the share of its secondary industries reached more than
20 percent by the 1920s, and then 30 percent by 1945.
On the other hand, the share of secondary industries in Korea in the early
1960s, during the early stages of its economic development, was only 10
percent. Therefore, the pattern of economic growth in Korea in the 1960s is
similar to that of the early industrialization period of developed countries when
capital accumulation played an essential role. Moreover, it is only natural that
increases in total factor productivity do not play a critical role during a country' s
early stages of economic development. Therefore, it is important to point out
that low total factor productivity growth itself does not mean that the Korean
economy was particularly inefficient or that it will experience stagnation in
coming years.
Korea' s industrialization process, centered on the promotion of its heavy-
chemical industry, advanced at a rapid pace throughout the 1970s. Thereafter,
the focus of the industrial structure shifted to the accumulation of intangible
capital, such as education and technological progress. Since industrial structure
cannot be shifted overnight, physical capital accumulation, given Korea' s
latecomer status, continued to play an important role. Meanwhile, efficiency
became a critical aspect of economic growth during this period as well.
This point is even more apparent based on data regarding investment in
education and technology investment. As is well known, education served as a
cornerstone of Korea' s rapid economic development. In the 1960s, in the early
stages of growth, Korea' s primary school attendance exceeded 90 percent, which
was extremely high for a developing country. Moreover, while school attendance
at the middle- and high-school level was very low as compared to developed
 Growth Potential of Korean Economy from Growth Accounting Perspective 19

countries during the 1960s, this level increased dramatically in the 1970s. The
Korean culture that stressed education could have led to increased demands for
further education with income growth. Together with this increased demand for
middle- and high-school education, where necessary labor skills could be
learned, there was, as a result of changes in the industrial structure, an expanding
need for middle- and high-school-educated manpower. Remarkably, secondary
school attendance reached more than 80 percent by the 1980s, while university
attendance rose to almost 40 percent in the 1990s, due to a sudden jump in the
number of universities. While there were other factors behind this zeal for
education, the fact that the 1970s marked a turning point for investment in
secondary education indicates that the quality of human resources became an
important factor of production during this period.
Increases in per capita investment in technological development were nominal
until the mid-1970s, rose gradually thereafter, and then surged sharply from the
early 1980s. With the government' s support, investment in research and
development expanded robustly after the 1980s, especially among private sector
conglomerates. This indicated that economic growth could not be continued
without investment in technology once the industrial structure became

Figure 3 Trends of Enrolment Rate by Education Level

120

100

80
percent

60

40

20

0
40

45

48

55

60

66

70

75

80

85

90

95

00
35
25

30

19

19

19

19

19

19

19

19

19

19

19

19

20
19
19

19

Primary Middle High University

 20 Economic Papers Vol.8 No.1

technology-oriented, moving away from simple imitation. Based on these

circumstances, it can be concluded that the growth patterns prior to and after the
1980s differed greatly. In particular, it can be confirmed that a late-comer
industrialized country, such as Korea, was able to experience rapid transformation
of its industrialized structure because of its compressed growth process.

Figure 4 Per Capita R&D Expenditure of Korea

80.00

70.00

60.00
1985 constant price US dollar

50.00

40.00

30.00

20.00

10.00

0
69

71

73

75

77

79

81

83

85

87

89

91
67
63

65

19

19

19

19

19

19

19

19

19

19

19

19
19
19

19

The trends of school attendance and technology investment indicate that the
Korean economy also saw a rapid increase in accumulated intangibles as well as
physical capital. Since a certain period of time is required before intangible
capital can be reflected in production efficiency, the low rate of increase in total
factor productivity means that it is possible that total factor productivity will
continue to increase and that continuous growth based on productivity
improvement can be realized in the future.14) Therefore, we can conclude that the
low total factor productivity growth itself does not imply Korea' s economic
14) The empirical evidences reported by many growth accounting analyses such as Hong and Kim(1996) and
Kim(1998) indicate that total factor productivity growth showed an upward trend in the 1980s compared with
that in the 1970s.
 Growth Potential of Korean Economy from Growth Accounting Perspective 21

growth will stagnate. Instead Korea can grow further under the improvement of
productivity although the room for quantitative input growth has become
smaller. The following section will identify the prospects for Korea' s future
growth based on the discussion so far.

VI. Prospects for Future Growth

To overview the prospects for future growth, we compute the relative

productivity level of Korea to see how much room is left to catch up with
developed countries. First of all, I will compare the labor productivity level of
countries. According to Table 5, the labor productivity of Korea is far behind
that of developed countries as we may expect from the per capita GDP
differences among countries. To find out further the sources of labor productivity
difference, we decompose the labor productivity difference into the capital input
and total factor productivity difference based on the Cobb-Douglas aggregate
production function. Following Collins and Bosworth(1996), we simply assume
that the production elasticity of capital input is 0.35 identically across countries.
As for the labor productivity level, Korea' s total factor productivity is far behind
other Asian Tigers as well as developed countries. Korea' s total factor
productivity level is about 50 percent of that of the US.
Thus the rough comparison of labor productivity across countries indicates
that Korea still has much room to catch up in terms of input quantity and
productive efficiency. Then, can a country like Korea maintain high growth as in
the past? In terms of its development pattern, the Korean economy appears to
mirror the experiences of developed countries. Therefore, the relatively low
increases in total factor productivity would seem to indicate that growth has not
reached its limit. Here, Japan' s experience may provide some clues.
Following World War II, Japan was able to maintain national income growth at
an annual rate of about 10 percent until the 1970s; however, this pace noticeably
slowed thereafter. While there is no comprehensive explanation for this
phenomenon, changes in the industrial structure as a result of economic growth
were no doubt a key factor. These changes in the industrial structure can be
detected by reviewing the share of employment of individual sectors. In 1950,
just after the end World War II, the share of workers engaged in primary
industries stood at almost 50 percent. As such, compared to other developed
countries, Japan possessed an abundance of manpower in rural areas. As this
 22 Economic Papers Vol.8 No.1

Table 5 Relative Productivity Level by Country

unutilized labor force from primary industries was absorbed into the
manufacturing industry, a foundation was laid for a period of high growth. But
after the mid-1970s, the share of employment of secondary industries gradually
 Growth Potential of Korean Economy from Growth Accounting Perspective 23

trended downward. This indicates that overall expansion of the manufacturing

industry, which was the primary engine of Japan' s economic growth, had
abruptly reached a plateau. Consequently, Japan' s rapid economic growth came
to a halt as well.

Figure 5 Economic Growth of G5 Countries

12

10

6
percent

0
62

65

68

71

74

77

80

83

83

86

89

92

95
59
53

56

19

19

19

19

19

19

19

19

19

19

19

19

19
19
19

19

-2

U.S.A Japan France Germany U.K

Table 6 summarizes changes in the employment structure of other East Asian

countries. As was the case with Japan, these countries all recently began to
experience a decline in the employment share of their secondary industries. This
means that the four East Asian tigers have already entered a mature stage of
industrialization. In terms of the share of workers engaged in Korea' s secondary
industries, after reaching 35.5 percent in 1991, this figure then decreased to 27.7
percent in 1999, showing a much sharper decline than that of other countries.
The table also reveals that the share of Korea' s labor force employed in
secondary industries is lower than that of other countries.
The fact that the share of workers engaged in secondary industries began to
decrease since 1992 indicates that the high growth period based on increased
 24 Economic Papers Vol.8 No.1

Table 6 Employment Structure Trends of East Asian Countries

quantitative inputs had come to an end. Despite changes in the growth outlook,
domestic businesses invested excessively in the 1990s, taking advantage of the
rapid liberalization of the financial market. Nevertheless, investment efficiency
plummeted dramatically. It was the longstanding deficiencies of past financial
and corporate structure that encouraged such overly aggressive investment. In
this sense, the recent financial crisis provided clear evidence that the Korean
economy had entered a new environment in which the economic practices of the
past high-growth era were no longer applicable.
The limitations to quantitative input-based growth can also be verified from
other indices. As Table 2 indicates, quantitative increases in labor input are no
longer possible. In terms of the industrial structure, it is difficult to find new
sources of labor input. The changes in demographic trends and demands for
improved labor conditions also served to curtail expansion of the manpower
 Growth Potential of Korean Economy from Growth Accounting Perspective 25

supply. In terms of the changes in demographic trends, there was only a 20-year
period between the time when the birth rate started to decline and the point when
the mortality rate began to improve. Therefore, Korean society will age
especially rapidly amid a downward trend in labor input. In addition, the aging
of the population will mean increased demands for welfare expenditures while
savings will also tend to diminish, including private sector savings. In fact, the
entire social environment, including the population' s composition, the social
welfare system, and the financial system, is changing in a manner that
encourages a downward trend in the savings ratio. In sum, economic growth
through the quantitative input of production factors, such as capital and labor,
will no longer be possible.
However, such changes will come about gradually and are not insurmountable
barriers to economic growth. The aging of the population will not come to the
forefront until around 2020. Moreover, although the savings ratio has decreased
to 30 percent recently, this is still higher than that of other developed countries.
Thus, while the period of high growth rates may have passed its peak, the
Korean economy is entering the same efficiency-centered stage that other
developed countries have experienced. Korea' s average education and training
period increased from less than 5 years in the 1960s to 11 years in 1999,
surpassing the level of all other developed countries except the United States.
Although this is a quantitative comparison, while qualitative aspects, such as the
number of teachers per student, education expenditures per student and
instructional content, might be less developed than that of developed countries, it
is unusual for a lower-income nation like Korea to surpass developed countries,
in terms of quantitative measures of education. Koreans still complain strongly
about the shortcomings of their education system, but education will
undoubtedly have a positive effect on future growth.
Furthermore, investment in technological development has been trending
upward, as is the case with education spending. Korea' s share of investment in
research and development amounted to only some 0.2 percent of GDP in the
1960s, but this figure had increased to 2.5 percent by the 1990s, comparable to
the level of developed countries. Nevertheless, Korea' s accumulated reserves of
developed technologies still remain far lower than that of developed countries.
If this trend continues, the Korean economy will move toward a technology-
intensive industrial structure similar to that of developed countries. However, as
in the case of Japan, growth rates will gradually slow down as the employment
share of the service industry increases. In this regard, the previous growth rates
of 7 to 10 percent will become a thing of the past. Nor are they desirable. The
 26 Economic Papers Vol.8 No.1

high growth rates that occurred during the years immediately preceding the
financial crisis resulted from excessive investment levels, which ironically
contributed to the emergence of the financial crisis.
However, Korea will have to proceed along a difficult path in order to catch up
with the national income level of developed countries. The fact that the
employment share of manufacturing industry is lower than that of other
countries will have a negative impact on economic growth. The employment
share of Korea' s manufacturing industry is significantly lower than that of
Japan, Taiwan, and Singapore. While the reasons for this phenomenon require
further analysis, it may be related to the social and cultural disdain for
manufacturing or a lack of student enrollment in science and engineering majors.
Furthermore, the Chaebol-centered growth structure is also a likely culprit due
to its inability to create as many jobs in manufacturing as sounder industrial
structures. This is in stark contrast to the experiences of Taiwan or Singapore,
which concentrated on the development of small and medium-sized enterprises.
Meanwhile, current globalization trends are said to diminish the role of growth
in regard to job creation. If this is true, then Korea stands to lose additional jobs
because of its Chaebol-centered imbalance.
Compared to other industries, Korea' s manufacturing sector has achieved
outstanding results in terms of capital accumulation, job creation, and
productivity enhancement. These achievements are impressive even when
compared with the performances of developed countries. On the other hand, the
labor productivity of Korea' s service sector, despite employment growth, still
lags far behind that of developed countries, a phenomenon which became
especially apparent in the aftermath of the 1997-98 financial crisis. Labor
productivity in manufacturing industry has recorded improvement because of the

Table 7 Growth Rates of Labor Productivity in Korean Industries

 Growth Potential of Korean Economy from Growth Accounting Perspective 27

expanded contributions of value added production while the level of

employment has declined rapidly. However, in the service sector, productivity
has not been able to keep pace with the growth in employment. To sustain
economic growth, employment will have to expand in the manufacturing
industry, or additional jobs with higher productivity will have to be created in
the service sector. Otherwise, the declining pace of economic growth will bring
about a polarization of employment as well as industrial structure, thereby
worsening the inequality of income distribution.
The manufacturing industry will rapidly reach an advanced level, thanks in
part to a deepening of the globalization process and the emergence of China.
When this occurs, it' s job creation capacity will be further diminished.
Meanwhile, the creation of service industry jobs with high labor productivity is
no easy task. Of particular note, while it is possible for manufacturing to
enhance productivity through tangible processes, such as the introduction of
advanced capital goods and technologies, the service industry must rely on
intangible processes by removing obstacles that are shaped by social and cultural
influences, as well as related regulations and systems.
Korea' s recent problems, such as its slumping rate of investment and high
youth unemployment, may well be mid-term business-cycle phenomena, rooted
in the excessive investment of the pre-financial crisis period. However, the low
employment share of the manufacturing industry and the lagging productivity of
the service sector also imply that these mid-term business-cycle problems could
become structural shortcomings. In addition, the sweeping social and economic
reforms that have occurred since the financial crisis, the confrontational nature
of labor-management relations, and a general weakening of the government' s
authority as democracy takes firmer root have all served to heighten the
uncertainty about future growth. This combination of factors has led all
economic players to develop a notably pessimistic outlook on the future. Such
pessimism can lead to self-fulfilling, deeply entrenched economic stagnation;
moreover, an absence of capable political leadership during such difficult times
can contribute to a lack of social consensus and coordination of conflicting
views.
 28 Economic Papers Vol.8 No.1

VII. Conclusions

Korea' s economic growth resembles a model that conforms with the theory of
benefits from latecomer-development advocated by Gerschenkron. However, in
his book, Gerschenkron cites the example of Russia' s economic failings to
explain the problems faced by latecomer industrialized countries. Gerschenkron
contends that Russia excessively focused its efforts on capital accumulation, thus
contributing to market distortions and economic instability, and finally resulting
in extended stagnation. Along this line, the empirical evidence provided in this
paper indicates that Korea can no longer achieve sustained growth based on its
past growth patterns, while misguided economic management could bring about
a serious shock, similar to what occurred during the financial crisis.
Furthermore, the same factors that enabled rapid economic growth in the past
could now represent barriers to future growth. Similarly, the previous system,
including such elements as government-led development policy and financial
resource allocation, may have played a positive role in facilitating input
accumulation-based growth. However, this is no longer a viable approach. In
fact, the previous system had been a target of reform since the early 1990s, even
before the outbreak of the financial crisis. However, it was only in the aftermath
of the financial crisis that restructuring efforts began to be undertaken in earnest.
Today, it remains quite uncertain as to where this restructuring process will lead
the Korean economy. At this point, there is a need for a comprehensive master
plan to assure that necessary reforms are systematically implemented and
capable political leadership to oversee this process. In a break with its past,
Korea is currently undergoing a period of rapid advancement of democratization
as well. Still, the mechanisms needed to create a public consensus within this
democratized society have yet to be fully established, while politics continues to
be influenced by special-interest groups, such as big business and labor unions.
All groups in Korea, regardless of their ideological inclination or economic
interests, seem to be naturally predisposed to growth-oriented policies.
Meanwhile, a majority of the Korean people has subconsciously become
accustomed to rapid economic growth as well, so that any sign of a slowdown
can make them fretful. Consequently, government economic policy tends to
cling to the growth-oriented and myopic ways of the past.
Nevertheless, the Korean economy has been able to achieve growth and
expansion of national income over the past several decades, with the industrial
structure and related systems being adjusted accordingly. Korea still has a long
 Growth Potential of Korean Economy from Growth Accounting Perspective 29

way to go before it can catch up with developed countries in terms of capital

accumulation and technology development. Therefore, if Korea can successfully
reform its past accumulation-centered, growth-oriented system and adapt to a
new environment, continuous growth will be possible. In particular, as was the
case in the past and still is today, the maintenance of an economic system in
which jobs can be created alongside high productivity will be the key to assuring
sustained economic growth.
The old Korean saying that a fast-heating pan cools quickly could be thought
of as a warning that the rapid growth of the past could lead to a period of
extended stagnancy. Although Korea proceeded along a similar path as other
developed countries, the difference may be that this transformation has come
about much more quickly in Korea. Although this may be an additional burden
for the Korean economy, it also represents an opportunity. However, unless
Korea can overcome this challenge in an effective manner, the successes of the
past may rapidly dissipate.
 30 Economic Papers Vol.8 No.1

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