The Macroeconomics of a North Korean Collapse

While I was weekend with some of my friends from K this past weekend in Chicago (post about that pending), we had an interesting conversation about North Korea. It started with this article that I read about an ongoing crystal meth epidemic in the hermit kingdom itself. My friend Adam, who's an East Asian Civilization major, was surprised by this downslide in social stability in North Korea. This led to us talking about the possibility (inevitability?) of a regime collapse in the North and how South Korea and China would respond. We all speculated about what impact the flood of North Korean refugees would have on the neighboring countries. One thing that I forgot to mention is what macroeconomics has to say about those refugees.

Let's say that the Korean peninsula becomes reunified. The first thing an economist would note is that South Korea is much more productive than North Korea. By this, we don't mean that North Koreans are lazy, just that their workers don't have the same level of capital - things like machines, roads, and knowledge - to produce goods and services. In economics, workers are paid by their marginal productivity, or how much extra stuff is made by having one more worker (this is of course a simplification, but there are good reasons to think this is approximately true. Watch this video for more info). The productivity of a worker is determined by the capital per worker. If you have a lot of workers, you're going to need a lot of capital to keep them employed productively. Clearly, South Korea has a lot more capital per worker than North Korea, as evidenced by their higher GDP per capita.

So what's going to happen when the Koreas merge? Well, South Korea is going to have a lot more workers but not much more capital. Because the number of workers has grown significantly while the amount of capital has not, we can expect wages to fall for South Korean workers. But it's not all bad! North Koreans will get to take advantage of all that great South Korean capital, so their wages will likely go up.

Plus, this is only the short term we're talking about. You see, in the long run (which has a notoriously vague definition) capital doesn't just stay at some constant level. Much as workers are paid by their marginal productivity, the owners of capital are paid by the marginal productivity of their capital. What determines the marginal productivity of capital? How many workers there are! A factory is much more useful if it can be fully manned than if there's only one person to work it. Thus, when all those North Koreans flood south, we can expect the marginal productivity of capital to shoot upwards. This means owning capital becomes quite profitable, so we can expect entrepreneurs to invest in new factories and machines. It would also behoove the government to beef up its spending on roads and education to accommodate its larger workforce. Eventually, we can expect to get back to the same capital per worker we had before, bringing wages for everyone back to their old high.

Unfortunately, this increase in investment doesn't come free. The government and entrepreneurs will have to borrow in order to finance their investments, and that means someone will have to save instead of spend. Either the citizens of Korea will have to tighten their belts for awhile or the country will have to borrow from foreigners. Either way, it won't be fun for a bit. But, once that great long run comes around, everyone will be happy once again (assuming, as Keynes quipped, they're not dead).

Overall, I'd say this economic analysis is positive for Korean reunification. North Koreans should be able to attain the prosperity enjoyed by their southern brethren, and although there will be a brief period of falling wages for the South Koreans, they should be able to build back up to their old lifestyle. Plus, this model makes some simplifications that ignore some potential benefits of a united Korea. First of all, there's trade. North Korea and South Korea have limited economic interaction, and as we know from comparative advantage, trade can make everyone better off! The extra workers may allow for more specialization and efficiency. Plus, I've been ignoring technology this whole time, which affects the marginal productivity of both labor and capital. There's a good reason to believe that technology is positively impacted by population size. Thus, we can expect the incoming North Koreans to spur innovation, helping make Korea richer than ever before. The possibilities for how North Koreans could become more productive by becoming integrated into the global economy are numerous. One possibility that enters my mind is that Japan could use some North Korean immigrants to fill the holes in its workforce left by its rapidly aging population.

This sort of speculation is one of my favorite parts of economics. The models applied here involve breathtaking simplifications - assuming all workers and capital are the same, for one - and yet it gives us some pretty actionable predictions about a very complex and specific topic. I don't think the falling wages, rising return to capital, and long term return to the old capital per worker are immediately obvious to anyone who thinks about North Korean refugees flooding into South Korea. Best of all, I think we can be pretty confident that this is roughly how the story would (will?) play out. And if it doesn't, we can look for what went wrong to make these models non-applicable. We also have some policy recommendations from this model's prediction - more investment and saving if the refugees arrive. To be clear, I'd be highly skeptical of any specific prediction like wages will fall by X based on these models. But, this kind of an analysis can certainly point to more specific promising areas of research. I'm sure there are people smarter than me who are already thinking beyond the scope of this model on the economic impact of Korean reunification.

I know East and West Germany went through a very similar process with the fall of the Berlin Wall, so I'd be curious to learn more about how that played out economically. I'd say that the sooner North Korea collapses the better. There will surely be some unrest in the short term as wages fall and capital is built up, but the welfare gains for the impoverished North Koreans will be huge, and even those living outside of Kim Jong Un's control could benefit.