ZHU Min: Warmly, warmly welcome to everyone… We are honored and privileged to have invited professor Michael Spence… Now, we are in such dramatically changing world. It is a very dramatic time today. I think we have a lot of things we can talk. Recently you wrote about a classical economics theory - Lewis turning point. Globally, because labor supply reached to its peak, so the whole world is at Lewis turning point. In the sense, we don't have any cheap labor supply anymore. We don't have anything as sensibly production capacity as well. So in that sense, the growth will slow down. And we move into the new phase, which you call the “regime change”, right? We have to improve our productivities to bring to the new growth stage. Can you explain your theory more to us?

You emphasized “global”. I recall China reached its Lewis turning point around 2010, because the labor of supply peak at the time and we observed, indeed, a growth slow down exactly that year. We are also going to have a whole population growth approach to zero now, which will impact the growth once again. I think this is a very important piece of work, and for the whole world. Please explain a little more to us.

Spence: Thank you, Min and thank you for having me… Those of you in China are very familiar with this concept. The growth at the early stages of very high growth is very substantially supported by bringing under-utilized productive resources and mainly labor into the modern economy where they join export sector initially and then eventually of a large growing domestic economy. A lot of the productivity gains come from just moving people from low productivity environments, on average, into the higher productivity ones. That process works beautifully until you start to exhaust the supply of under-utilized labor, which is what the Lewis model was all about and why it's been such an important part of the framework for thinking about the growth dynamics in China.

Once you reach that point, it doesn't happen instantly as all of you and your colleagues know. But you start to lose the force of that particular growth dynamic. Then the growth dynamic that takes over is much more broad based productivity gains across the entire economy. And China is an excellent example of having made that transition well. And there is some growth slowdown associated with that. But it's not dramatic. Chinese growth rates have been impressive for a long period of time.

With my hypothesis, - this requires more serious work with data and so on - but when you look at the global economy as a whole, two things strike me immediately. First, we went from demand constrained growth for a decade after the great financial crisis, all of a sudden very quickly into supply constrained growth. Some of this is associated with imbalances and congestion in the global supply chains, and some of it residual covid overhangs and blockages. But fundamentally, I think we shift it so that our growth will be constrained by the extent to which we can increase productivity and broke the supply side.

Then if you look at the big picture, what's happened over 30 years, is that we don't have that much surplus labor left. There are questions about the speed of the scalability of what we have. But we also have a much bigger global economy with millions, tens of millions of new middle class consumers. So when you go back and look at that 30-year front, the process we had essentially a kind of deflationary force operating because we kept bringing certainly under-utilized productive capacity into the global economy. So anytime there was some sense of supply side constraints, they were relaxed immediately, at least in the credible side of the economy.

So my hypothesis is that, that period is largely over. The vast majority of people in what used to be called developing countries and now are called emerging economies or middle class consumers. So the demand side has grown enormously in the supply side capacity to keep up that flow of low cost supply of goods and services, which are now tradable, is nowhere near what it was at the peak of that period.

So my hypothesis is, this is a kind of regime change. We're going to live in a global economy that’s aging and has less surplus labor and under-utilized capacity to bring on. We will have growth that depends on productivity gains. I think the best chance for that at the moment among the several, would be digital transformation. We're gonna have inflationary pressures that we haven't seen for a long, long time. And I think, this is important. We may want to talk further about it. This is what I'm talking about now, and some other things that are going on in the inflation story, these are not transitory at all. This is a kind of secular shift.

ZHU Min: Let me clarify first. You mean it’s “global”. So you don't think there are unlimited labor supply, for example, in India or Africa, that we can bring them into the global system. You don't think so?

Spence: No, I think we can. But then the question is: is it gonna happen fast enough? At the scale that would reproduce the effect of the major Asian economy, east Asian economies, especially China on the global economy. Now this is a judgment call. I could turn out to be wrong on this. But if you were placing bets, would you bet that there would be a sudden surge of productive capacity coming out of Africa? Of the type that you saw in China? Maybe. I mean it would be nice, it would be good for their growth story. But I guess I don't see it happening.

India has a somewhat by some standard idiosyncratic set of growth patterns. So India is a potential source of incremental productive capacity. But to me, it looks like they're taking a kind of different route. But we could spend more time on that.

ZHU Min: Right. That's very interesting because when China reaches its Lewis turning point, the cheap labor support driven growth model is almost gone unless you can find other surplus labor to fill the gap, or unless the production capacities.

But today look around, it is not easy. It may have some potential, but it's not easy. So to support global growth and particularly on the productivity growth, it looks like we need two things. One thing is for the middle income countries, we need to shift to the productivity based growth. For the other remain in the low income and also developing countries, we need to find whether we will be able to bring the technologies, bring in the capacities to absorb the remaining labor force so that's become two issues. But for the middle income countries, for example, China, how can those countries move into productivity based growth model?

Spence: Well I think there's a long winded answer to that. But the answer is essentially what is going on in China. China has become a major source of technological innovation in multiple sectors. It is a major investor in human capital to support the deployment of those technologies. There is a kind of global explosion of entrepreneurial activity, particularly in the digital area. China is an extremely important prominent part of that. I mean if you measure this by the production of unicorn. So it is private companies with a valuation of $1 billion or more. The largest source of that is the US still, the second largest source by considerable margin is China. So the aggregated impact of all of that activity, I think, goes very well for productivity growth and over a wide range of sectors, including domestic service sectors.

I'm not trying to dismiss the challenges that I know you and your colleagues talk about like debt overhangs, real estate things, global tensions and so on. But I think the fundamentals of a very dynamic economy that will produce productivity gains that will enable a transition to a high income economy in the relatively near future are pretty much in place. You can find other countries where the digital transformation is underway, but the mass of investment in things that drive productivity in the long run, particularly human capital, is nowhere near what China has been able to achieve. So I'm pretty optimistic about that. I think those are the fundamentals.

ZHU Min: I think that's great. Thank you. But with your experience and also with your theory and your framework, when an economy moving away from the cheap labor driven growth model to a productivity based driven growth model, does that mean the growth rate will slow down?

Spence: Yes.

ZHU Min: For example, moving from manufacture to service is not easy, because service productivity is obviously lower than manufacturers as well.

Spence: On Average, that’s right.

ZHU Min: When they close to frontier of the whole world, to improve the productivity become more challenging. Think about 40 years ago, we were way and way from productivity frontier, right? That’s quite a job.

Spence: You are much closer now. I think you are right. I mean there are two things that happened and they are both important. China is at the frontier in some sectors already, including a number of digital part. The way I think about it, is if you look at the advanced countries and ask how fast do they grow on average, because they're basically growing on the model we're talking about, right? You don't get long term growth if you don't have productivity growth unless the labor forces are increasing, right? But let's discount that for the moment. And that those numbers run in an even optimistic version 3% range. So China is still well above that.

But you're converging in growth rate to what is sustainable for advanced countries. And if you look at the data, it's not like a steady flow. You get surges of productivity growth when you have a big, big, powerful general purpose technology, like some of the digital ones, and then it levels off and then you get another surge. So it's not a kind of steady flow. But on average, when you average it out over decade type periods, you get a pattern like that.

Right now, in the world, you see a declining pattern of productivity. And there's a big important question coming up, which is whether we have enough of the kind of technological tools to reverse that pattern. People have different opinions about that. And I'm an optimist. I think once the digital technologies are widely deployed, they have the potential to produce another productivity surge. But that remains to be seen and that will of course occur in China as well. I mean because of China's prominence in building and deploying and adapting and adopting these technologies.

Pandemic has produced a surge because we had to rely on the digital technologies in order to. So bottom line is you're right. You get a slowdown in part, because the structure changes and you're building lower productivity sectors on average. And you're slowing down because you're getting near the frontier and you're starting to grow at rates that are characteristic of advanced countries.

ZHU Min: So when you move to productivity based growth, as you mentioned, I think it is important to invest in technology, you firmly believe the technology will nurture the future productivity, I think that’s the key issue, invest in the infrastructure or the new infrastructure and also invest in people – human capital. Anything else?

Spence: It is color commentary. I mean I mentioned before this global outbreak of explosion of entrepreneurial activities. This has been essentially, but there's a more complicated version of the story. But the simple part of the story is the mobile internet has expanded to the about 6.5 billion people around the world, and it is that underpins the platform – I am using the word loosely - I don’t mean the platform as in Alibaba or JD.com, but it’s the platform on which this kind of surge of digital innovation in serving consumers and goods and services is occurring. That’s a particularly important element of the infrastructure. But that's just color commentary.

I guess what I'm saying is you can’t build too many bridges and not enough digital capacity or vice versa. So the balance matters. But it's still infrastructure.

Infrastructure and markets. Let me say, the Indian story is really interesting in this respect. India was lagging in the mobile internet for two reasons. One the supply side was fragmented. And while you know where there were several million Indians on the internet, and the streaming data costs were way too high. And because of the Reliance Jio investments, they went from some of the highest data rates to some of the lowest data rates in a matter of five years. And it's produced explosive growth in the mobile internet users and that again has created a platform on which their digital innovation system is starting to grow. And it’s beginning to look a little bit like China.

ZHU Min: So the entrepreneurship is also very important. Building the policy framework, building the business environment to support entrepreneurship and innovation of a business model is also important to support productivity growth. I think this is a very important point.

So to conclude this part of the discussion, this is a really fascinating. It's a big picture. As you mentioned, moving from demand constrained growth model to supply constrained growth model, it means we need more structure reform at the policy levels and we need the supply side policy and reform as well. Right?

Spence: Yes, no question.

ZHU Min: Not just like the new, near or whatever Keynesianism to support aggregated demand. I think that's a absolutely important point. I think the good news in China we started the supply side reform a few years ago. We realized this change is also important. In your talk, you also mentioned when you exhaust the unlimited labor force, the wage will increase which will bring in the inflation pressure. Can you explain that little more?

Spence: Yeah, so this is the thing that Sir Author Lewis worried about. He thought the early stage growth model was just fine in terms of producing growth. But as long as you have a large pool of people who have not made the transition to the kind of urban modern economy, which is a multi-decade process, then the mere fact that there holds the wage growth down. So you're getting productivity growth in the economy, but wages and income aren’t keeping up with it for a period of time. And then at the Lewis turning point, you started to get more broad based increases in wages because there is much competition standing there in the wings.

Lewis worried about that because he thought you get growth with most of the returns for growth going to the owners of capital, and not the labor. Even though you were generating a lot of employment. But he also thought that was not a permanent condition. If you translate that to the modern context, this is one aspect of why we're gonna see a reversal in the pattern of declining shares of income in national income which is labor income.

It's not the only factor. I mean, at least in the west, there is a sort of growing body of evidence that isn't really completely understood, which suggests that labor market behavior on the supply side by people, individuals and families is starting to change. There's names for this like “the great resignation”. We have way more turnover than we used to. People are retiring earlier than we expected, and so on.

There's other factors that we're gonna have to learn about overtime, but the bottom line is yes, I think that labor share it's gonna rise because of the market conditions. Labor power will increase relative to where it's been. At least in the developed countries, labor lost a lot of power because there was always the option of going and producing it somewhere else, if they made too much noise. So I think that pattern is also reducing. And probably at least it paints a different picture, with the respective to inflation.

You know this very well from your work in banking and at the IMF and so on. We've gone through probably almost three decades, at least in the developed countries, inflation basically hasn't shown since it’s over. We really haven't had any significant inflationary pressure even with what looked like relatively tight labor markets and so on. Now I think that's about to change.

ZHU Min: So low inflation is over. Fundamentally because of wage will increase. I think you made a very interesting point. I mean the point is, it's not good or bad, because wage increase will bring more middle income, or bring in more aggregated demand. The only thing is we are just getting into the new regime as in your picture. So you have to understand it's different from previous pictures. We will move on.

Spence: I think you will see this in China. I mean, you are pretty near the peak of the population. And the population pyramid looks pretty aging like the rest of it.  There's gonna be a lot of demand for those younger workers.

ZHU Min: You really dig into a deep and fundamental issue, say, the global economy fundamental it's shifting. I think that's very important. On top of that, we have all those volatilities, Ukraine crisis or the others. Are you concerned about inflation will go further? Do you think we will get to the stagnation situations in the next few years?

Spence: Min, I don't think it's the most likely outcome, but it's definitely a risk. so Let me maybe take Europe and the and North America separately. So in Europe, the European central bank has not yet forecasting a recession. I think, they are hoping they can avoid it. They are not gonna slam on the brakes in terms of monetary policy. My own view is that's a bit of optimistic. And we might very well have a recession in conjunction with relatively high inflation because we had high inflation before. Now we have a huge boost in inflation associated with energy prices globally. But there are prominently affecting Europe where we import the vast majority of the fossil fuels we use.

And if you look at the inflation figures now, the majority of major European countries are up in 6% or over. Now, this could subside quickly, but I don't think there's any real evidence that that's likely. You'll see a similar pattern in the United States but it's more muted as the energy prices are having a slightly lower effect.

So I think the best guess is, to the future, on this is that central banks, who are kind of behind the curve and getting on top of inflation, are going to try to find a middle ground. They're gonna try not to slam on the brakes, which would produce a kind of stagflation scenario. But they can't sit there and let inflation get out of control and inflation expectations get embedded.

I wouldn't want their job. I mean that's a pretty tough job. That's pretty tough thing to pull off. So they may be forced to produce a pretty big economic slowdown because of the inflationary pressures. Then whether we call that stagflation, which to me has a kind of longer term connotation or just a kind of major draught of the type that Volcker delivered when we really did have embedded inflation, at least in the United States.

ZHU Min: The key is, as you just mentioned, central banks are behind the curve, right, and fear where they hesitated to much, or they always say, it is transitory. Although I think that you would always disagree, as in earlier days, it is not transitory. It is permanent, as we all saw that.

I think everybody are concerned if the Fed will take very strong action in US. Because in Europe it is 6%. In Europe is 8-9% now. And the strong use of the shrink of the balance sheet and temporary plus interest rate increases to curve the inflation which will cause the growth to dramatically slow down. I think that's a real concern.

But on the other end, I think because the central bank is behind the curves. It is very difficult for them to take actions, because this Ukraine crisis has created another new situation, right? The military expenditure is increasing, the security and expensive expenditures increasing, and the food prices increasing, energy prices increasing. And the companies think about re-setting basis on the security, also on the stability, not on the maximized the profit and lower the cost, per say as we experienced in the past.

I am just wondering how fast or strong the central bank can go because there's zero fiscal space after the covid. I mean, the US, for example, has a 15% of budget deficits in the past 2 years more than that, and everybody says it’s at its peak. So the only thing you can do is to print money. So between the tight and easing monetary policy, I think the central bank is really having a tough job to do. But my sense is that it probably will continue to sort of kick the can around the role and keep the liquidity because everyone needs the money. In that sense, inflation will remain pretty high. I don't think inflation will be coming down.

Spence: I agree with you. I'm glad you mentioned that last point, which is, there's various dimensions of security. But one of the things I think we're gonna see pretty much everywhere is diversification, by countries and by companies.

And the reason for it, is that we live in a different world. When you and I were younger and I was a lot younger, we lived in a global economy that very rarely shut down, right? Sometimes we have a supply shock and the violent price movements, but basically you didn't get in any pass forward to today.

We've got climate shocks of increasing frequency and severity, global tensions interfering with the openness of markets, we've got now this conflict and the pandemic, which is a major shock. I don't think most people think that's the only one we will ever have.

So we have rising risk with respect to supply and demand chain, and they are uncorrelated. When we teach our students finance, as you do in Tsinghua, we tell them that when you have rising uncorrelated risk, the proper response is the diversification. Relative to the world of lower risk that's gonna be expensive and have to do with inflationary pressures exactly what you said.

ZHU Min: This has also raised another interesting issue because diversification means increasing cost on the corporate side, right? So corporate said really have a big three in the categories of cost increase, labor cost increase, material cost increase and diversification cost increase. So they will either push the price increase or squeeze the profit margin. So which on the very fundamental base, the productivity can slow down and the growth will further slow down by your theory.

Spence: Yeah, I think there is some productivity growth potential, as I said before. But in the short run, yes, absolutely right. So far, limited evidence that I have been able to pick up suggested that most corporations have the ability to perhaps pass on the price increases. Some of them aren’t passing them all on. I have friends - mutual friends with you - in the supply chain world who say that the some of the major players are absorbing some of the cost right now. So inflation, looked that from the point of view, final prices is actually higher on the cost side that what is showing up in the marketplace for the final product. But that's just more inflation, right? But in the long run, they'll pass it on.

ZHU Min: Right. But the risks are pretty high, and particularly with the volatilities. But these are all in the real sectors. But when we move to the financial sector, you also teach finance in both Milan and NYU. Do you expect to see a big financial market adjustment? Given, anytime I see the real economy in financial market, I see the real economy is changing and adjusting, but in a rather slow pace, because more or less is moving ok in a sense. But the three costs increase but it takes time. But financial assets increase dramatically because quantitative easing monetary policy, and the interest is close to zero. And net return in many assets is close to zero. Do you see financial market will experience big adjustments in the near term, because of inflation pressures and because of monetary policy change and because of geo political risk?

Spence: I do. I mean I don't know how to calibrate it, but it will feel very different from the kind of liquidity feel, central bank dependent asset pricing, that we've seen in the past, I just don't see that continuing. And generally, I think when you have a period of inflationary, higher inflation, there is a tendency for the asset markets to underperform relative to their long term averages, and less liquidity. I think we'll see less liquidity events. When you look around the world, the thing you mentioned before, which is higher sovereign debt levels in lots of places that's gonna produce distress of a variety of kinds. Your colleagues in Washington at the IMF are gonna be in the center of trying to deal with some debt restructuring and whatnot, in a range of economies that been forced to get themselves into trouble, I guess, because of the pandemic.

ZHU Min: The sovereign debt issues in the past few years, almost 10 years now, particularly since 2008 global financial crisis. The public debts are piled up, increasing dramatically. But in its payments, actually, rather a slowdown, in terms of share of GDP, because zero interest in the policy, right? If the real interest rates change and your nominal interest rates were changed. Do you see a bit that's debt crisis happening or it’s coming?

Spence: I'm not really sure. I mean the way you get out of the debt overhang and you and I both know is with nominal growth, right? So you get nominal growth from some real growth inflation. So maybe a period of inflation which is otherwise not terribly desirable, will actually help reduce the kind of real liability of some of these sovereign debt overhang. I don't know how to calibrate that at the moment because there's sort of pluses and minuses.

ZHU Min: Your theory bases on the Lewis turning point, actually have a huge implication on globalization. Do you think globalization will slow down? From different angles, Trump was anti-globalization, whether or not there was serious support of his political positions. If the whole world is turning into the new regime, what’s its impact on globalization?

Spence: I don’t think the shift is necessarily a negative with respect to globalization. I mean, it depends on what you called the globalization. I think diversity will feel a little bit like the globalization in some dimensions. But just having supply constraints be more binding and feel more binding than they have in the past, I don't think it points us to be de-globalization.

When I think of the de-globalization, I think of downside risks of really intercepting and disrupting global flows of technology. For example, in meeting the sustainability crisis, one absolute prerequisite is that technology, wherever it's developed, flows freely and openly to wherever it's needed, which is everywhere in the world. Right?

So the worrying parts of de-globalization, I think, are associated with tensions and policy shifts that really disrupt global flows. The patterns will change for sure. I mean they already have, Min. If you go back you know four decades, the purchasing power in the developing world wasn't all that high. Right? So trade consistent of commodity flows into developing countries and goods flows out. Well that's no longer true. Right? I mean there's a huge amount of purchasing power in the emerging economies now, so some trade is internal. I mean China absorbs a fair amount of what it produces because it's such an enormous economy now. That's a completely different pattern, than way back when.

So just the evolution of the global economy is as emerging economies grow and achieve their growth and development objectives will produce changes in patterns. And they're not worrying. I mean they take some navigational skills. Maybe one of the big changes is this reduction in the relative size of under-utilized productive capacity relative to demand, we were talking about before. But still, you can still have a relatively open global economy at the major players are determined to keep it open.

So I think when there's risks there, regardless of which side they come from, I mean the risks are policies that are a reflection of some kind of deep under appreciation of the importance of the global economy in terms of prosperity for everybody. So I think just the determined effort to make sure that we don't go down the road of having sort of economies functioning in silos or the sphere of influence is a kind of pretty high priority for the major economies in the world to lead, major countries in the world to lead.

ZHU Min: This is a fascinating conversation. We talked 30 minutes. We ran over times already as usual. This is absolutely amazing. Every time when I talk to you is a joy because you always bring in this is very deep fundamental thoughts with us. It is really, really nice. I mean today you bring us a very big picture, the regime shift. The whole world experiences Lewis turning point shifting that we're moving from cheap labor driven growth model to more productivity driven growth model now, which we're moving from demand constrained growth to supply constrained growth. So the policy also need a shift to more supply side structure reform and also structure reform as well. I think that's a very, very important point.

Also during the process and obviously the inflation pressure will be high. So the management process will not be easy. And the management of the smooth transitions also will not be easy. But this transformation, is not necessarily against globalization. But it's also just say at this process we need the more global corporation, global leaders working together, and make sure the whole world will move into a new regime, still maintaining strong productivity growth and a growth, so that will be good for the whole world. And the current political interruptions are no good and we particularly need to be careful on the inflation risk and the central bank's marginal policy risk as well. I think this is really fascinating, thank you thank you once again. Do you have any last words you would like to add?

Spence: I think that good people and a whole variety of countries who understand the importance of this, will be influential in the long run. I think China has voiced this in its leading policy makers, have voiced their commitment to some modified adapted version of multilateralism. I'm hoping the United States takes the same view, although there's some risk there. We are polarized and there is a subset of our policy making apparatus, that doesn’t seem to be focused primarily on that. But Min, I try to remain conscious and optimistic.

ZHU Min: That good. This beautifully ends this conversation. Once again, thank you, Michael. Thank you so much for bringing your insight and share your thought with us…So let's hold together our hands, big hands for professor Michael Spence. Thank you, Michael very much.

Spence: Thank you, Min. Thank you for having me.