Avoiding Protectionism

The Economist is running a series this week on what the emergence of China, India and other developing countries means for developed countries. This article in the series examines the problems arising from globalization, the potential causes of those problems, and how to avoid a resurgence of protectionism in response:

More pain than gain, The Economist: Rich countries have democratic governments, so continued support for globalisation will depend on how prosperous the average worker feels. Yet workers' share of the cake in rich countries is now the smallest it has been for at least three decades (see chart 5). In many countries average real wages are flat or even falling.

Meanwhile, capitalists have rarely had it so good. In America, Japan and the euro area, profits as a share of GDP are at or near all-time highs (see chart 6). ...

[T]he redistribution of income from labour to capital can be largely explained by the entry of China, India and other emerging economies into world markets. Globalisation has lifted profits relative to wages in several ways. First, offshoring to low-wage countries has reduced firms' costs. Second, employers' ability to shift production, whether or not they take advantage of it, has curbed the bargaining power of workers in rich countries. ... And third, increased immigration has depressed wages in sectors such as catering, farming and construction. ...

Most of the fears about emerging economies focus on jobs being lost to low-cost foreign competitors. But the real threat is to wages, not jobs. ... So long as labour markets are flexible, job losses in manufacturing should eventually be offset by new jobs elsewhere. But trade with emerging economies can have a big impact on both average and relative wages. ...

Thus the usual argument in favour of globalisation—that it will make most workers better off, with only a few low-skilled ones losing out—has not so far been borne out by the facts. Most workers are being squeezed.

If GDP per person is growing fairly briskly, why are most workers missing out on real pay rises? Partly because a bigger share is going to profits, and partly because high earners have pocketed a huge slice of the gains in income, causing inequality to widen. ...

It's all comparative

Traditional trade theory, based on the ideas of David Ricardo, ... argues that economies gain from trade by specialising in products where they have a comparative advantage. Developed economies have lots of skilled workers, whereas emerging economies have lots of low-skilled ones, so according to the theory advanced countries will specialise in capital-intensive products requiring skilled labour and emerging economies in low-tech products. Competition from cheaper imports will reduce the wages of unskilled workers in developed economies, but workers as a whole will be better off.

Yet, ... the average worker does not seem to be enjoying his fair share of the fruits of economic prosperity. Richard Freeman, an economist at Harvard University, points to several reasons why the traditional theory may need modifying.

The first is that the sheer size of the emerging giants' labour forces has shifted the global capital-labour ratio (which determines the relative rewards of capital and workers) massively against workers as a group. .... According to economic theory, this should reduce the relative price of labour and raise the global return to capital—which is exactly what has happened.

Over time, competition should reduce profit margins and distribute benefits back to consumers and workers in the form of lower prices. But downward pressure on wages in rich countries could continue for a long time....

A second reason why the traditional trade model needs modifying has to do with a rise in emerging countries' skill levels. It used to be thought that only rich countries had educated workforces able to produce skill-intensive goods, but poor countries have invested heavily in education in recent years, allowing them to start competing in more sophisticated markets ... (see chart 7). In 1970 America accounted for 30% of all university enrolments worldwide; now its share is down to around 12%. ...

A third flaw in the traditional trade model, says Mr Freeman, is its assumption that rich countries would make high-tech products and developing economies low-tech ones. In fact, rich countries no longer have a monopoly on high-tech capital and know-how. ... As emerging economies start to export high-tech goods and services, this reduces the prices of such products in world markets, and hence the wages of skilled workers in the developed world.

White-collar blues

It is no longer just dirty blue-collar jobs in manufacturing that are being sucked offshore but also white-collar service jobs, which used to be considered safe from foreign competition. Telecoms charges have tumbled... This has made it possible to offshore services that were once non-tradable. ...

The standard retort to such arguments is that outsourcing abroad is too small to matter much. So far fewer than 1m American service-sector jobs have been lost to offshoring. ...[But] Alan Blinder, an economist at Princeton University, believes that most economists are underestimating the disruptive effects of offshoring, and that in future two to three times as many service jobs will be susceptible to offshoring as in manufacturing. This would imply that at least 30% of all jobs might be at risk. ...

Moreover, says Mr Blinder, education offers no protection. Highly skilled accountants, radiologists or computer programmers now have to compete with electronically delivered competition from abroad, whereas humble taxi drivers, janitors and crane operators remain safe from offshoring. This may help to explain why the real median wage of American graduates has fallen by 6% since 2000, a bigger decline than in average wages...

Ride on, Ricardo

None of this makes a case for protectionism. Offshoring, like trade, is beneficial to developed economies as a whole. ... China and India cannot have a comparative advantage in everything; they will export some things and import others. ... Emerging economies still have relatively little capital, so they are unlikely to become significant capital-intensive exporters until their capital-to-labour ratio catches up. That will take time. Developed economies will retain their comparative advantage in knowledge-intensive activities because they have relatively more skilled labour, but that advantage will be eroded more quickly in future.

The developed economies as a whole will still benefit hugely from trade with emerging economies. Increased competition and greater economies of scale will boost the growth in productivity and output. Consumers will enjoy lower prices and a greater variety of products, and shareholders will enjoy higher returns on capital. Although workers will continue to see their pay squeezed, they can still gain as consumers or as shareholders...

In recent years the stagnation of real wages in America has been masked by surging house prices, which make families feel better off. If the housing market stumbles and the growth in pay remains feeble, there will be increased calls for the introduction of import barriers... But in a globalised economy, such measures would be worse than useless. Firms would simply move their head offices to friendlier countries. ...

Heading off the political backlash

...[G]lobalisation is benefiting America's economy... But in practice the average family has not seen such a gain because much of it has gone to those at the top or into profits. This explains the lack of support for globalisation from ordinary people. Unless a solution is found to sluggish real wages and rising inequality, there is a serious risk of a protectionist backlash. Rather than block change, governments need to ease the pain it inflicts in various ways: with a temporary social safety-net for those who lose their jobs; better education to equip workers for tomorrow's jobs; and more flexible labour markets to encourage the creation of new jobs.

More controversially, governments may need to redistribute the benefits of globalisation more fairly through the tax and benefits system. Studies suggest that countries with more generous social welfare policies are less likely to support protectionism. ... In a riskier labour market, there may be a stronger case for health care to be financed by the state rather than by firms. ...

It is often argued that generous social-insurance and redistribution policies are inconsistent with globalisation because in an open world governments cannot raise taxes and spending in isolation. But if real wages continue to stagnate and no compensation is forthcoming, political support for globalisation may fade and the vast gains from the biggest economic stimulus in world history will be lost.