(What’s Left of) Our Economy: More Evidence of Germany’s Stealth Protectionism

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Angela Merkel, consumers, consumption, developing countries, Financial Times, Germany, Global Imbalances, globalization, imports, Matthew C. Klein, protectionism, savings, taxes, Trade, Trump, value-added taxes, VATs, wage suppression, wages, {What's Left of) Our Economy

President Trump’s charges that the United States has signed terrible trade deals in recent decades, and that foreign economies have been the main beneficiaries, inevitably have triggered a potentially useful debate over which major countries are most open to trade and which are tightly closed. Unfortunately, such arguments won’t actually be useful until “open” and “closed” are properly defined, and a new Financial Times column on Germany’s economic policies nicely illustrates how remote that goal remains.

I’ve previously made the case that accurately measuring protectionism – and thus accurately gauging which countries are contributing adequately to global prosperity and which are free-riding – entails much more than adding up individual trade barriers. Such simple counts also mislead on the equally important question of which countries the United States can reasonably hope to trade with for mutual benefit, and which countries can’t possibly qualify.

And because Germany’s government has both taken trade fire from Mr. Trump and vigorously replied, I’ve used it to illustrate the above points. In a short op-ed for USA Today and a much more detailed RealityChek post, I’ve noted that, as with many other leading foreign economies, the main problem with Germany as a promising trade partner stems at least as much from its overall national economic strategy as from its specific trade practices. That is, countries like Germany, which heavily emphasize growing by saving, producing, and exporting, can’t possibly be good trade matches for countries like the United States, whose priorities have been the diametric opposites.

Of course, those national economic strategies manifest themselves in specific practices and policies. (How else could their focus be established?) But the links to trade flows aren’t always clear. For example, there’s widespread reluctance to acknowledge the trade impact of value-added taxes (VATs), which promote exports and penalize imports. The role played by other German policies, like suppressing wages or skimping on infrastructure spending, has been even less apparent.

What the new Financial Times post adds to the mix is a generally neglected form of wage suppression: Germany’s taxes on low-wage workers – which author Matthew C. Klein describes as “among the highest in the world” since at least the turn of the century.

These taxes inflict an outsized blow on Germany’s imports – and on the the world economy as a whole – in at least two important respects. First, economists tend to agree that the lower an individual’s or household’s income, the higher the share of that income will be spent (as opposed to saved). If they’re right, then these taxes ave been hitting Germany’s overall consumption and import levels especially hard. Therefore, these levies look like notable contributors to the bloated German trade and current account surpluses that are not only detrimental to America, but that could threaten the entire world’s financial stability.

Second, as supporters of pre-Trump U.S. trade policies constantly point out, much of what low-income consumers buy is produced and exported by low-income countries (e.g., apparel or school supplies or furniture). So since high taxes on low-wage workers in Germany prevent them from importing as much from the developing world as they could, third world countries need to focus more on customers in more promising markets – like America’s.

Germany and its leader Angela Merkel lately have been basking in the glow of praise from the political classes in the United States and abroad, which have anointed them as among the new, post-Trump champions of free trade and all its purported benefits. (China’s another alleged globalization champion, but that’s another story.) Its lofty taxes on low-wage workers add to the evidence that these titles are wildly premature.

(What’s Left of) Our Economy: Progress from Progressives on Trade

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America First, developed countries, developing countries, environmental standards, Financial Crisis, GATT, General Agreement on Tariffs and Trade, George W. Bush, Global Imbalances, Global Trade Watch, globalization, Hillary Clinton, Jared Bernstein, labor standards, Lori Wallach, multinational companies, NAFTA, national treatment, non-discrimination, North American Free Trade Agreement, offshoring, progressives, Public Citizen, The American Prospect, TPP, Trade, Trans-Pacific Partnership, World Trade Organization, WTO, {What's Left of) Our Economy

Ever since the debate over NAFTA (the North American Free Trade Agreement) more than twenty years ago turned trade policy into a nationally contentious issue, the American left has provided the overwhelming share of the political money and muscle aimed at creating urgently needed course corrections. So it’s great to see important signs that progressives have finally started touting two ideas that realistically could make a significant difference.

The evidence can be found in an article coming up in The American Prospect by Jared Bernstein, former top economist to Vice President Biden, and Lori Wallach of Public Citizen’s Global Trade Watch. To be sure, the article does dwell overlong on proposals that left-of-center figures have been making for decades, and that hold little, if any, promise of turning trade agreements and related policy decisions into engines of domestic growth.

For example, there’s the usual call for truly enforceable labor and environmental standards in trade deals – even though adequately inspecting enormous third world national manufacturing complexes is a logistically impossible task. Worse, the offshoring lobby and its minions in Congress and the Executive Branch have already twice used the tactic of making cosmetic changes along these lines in trade agreements to call progressives’ bluff: during the George W. Bush administration in deals with agreements with Panama and Peru; and in President Obama’s Trans-Pacific Partnership (TPP).

Don’t think Democratic presidential candidate Hillary Clinton doesn’t recognize how successful this ploy has been in persuading fence-sitting Congressional Democrats to fall in line behind new trade deals.

Judging from the Bernstein-Wallach piece, moreover, the American left still believes that no hard choices need be made in trade and broader globalization strategy, and that with their proposed reforms, growing international commerce can become a win-win for first and third world workers alike around the world. As I’ve recently written, positive sum outcomes for developed and developing country workforces are possible – if, for instance, NAFTA was turned into a genuine western hemisphere trade bloc, as its leading founders once suggested they intended.

On a global basis, though, the surplus of developing country workers earning pauper wages (both in absolute terms and in relative terms in sectors like advanced manufacturing and high tech services) ensures that for decades the third world will remain much more important as a low-wage and low-regulation production site than as a source of new consumer demand. And as long as that situation holds, astronomical growth-, job-, and wage-killing trade deficits in the United States will be inevitable. Also inevitable will be the buildup of enormous international economic imbalances like those that set the stage for the last financial crisis.

But the most encouraging aspect of the Bernstein-Wallach article was indeed encouraging: The authors argued that not all prospective U.S. trade partners should be treated equally – because they differ in crucial respects. Ever since the current global trading system began taking shape in the immediate aftermath of World War II, one of its biggest weaknesses – and one posing special problems for a relatively open economy like America’s – has been its insistence (largely at Washington’s behest, to be sure) on the principles of non-discrimination and national treatment.

In other words, regardless of how open or closed they are, or how wealthy or impoverished, the United States needed to deal equally with all countries belonging to the old General Agreement on Tariffs and Trade (GATT) and to the newer World Trade Organization (WTO). During the early post-war decades, these requirements legally forced American leaders to open their markets as much, say, to relatively open Britain as to hermetically sealed Japan, and to treat identically in the American market businesses from wildly varying countries.

When the end of the Cold War encouraged third world population giants like China and Mexico to introduce selected free market reforms and join the global economy, the option of mass production offshoring was created for multinational companies. As a result, these GATT and then WTO principles prompted the U.S. leaders influenced by these companies to expand trade whether or not the target countries could become significant net consumers, and thus create reasonably balanced trade flows and their economic benefits.

Bernstein and Wallach don’t favor discrimination on grounds like these. (That’s not surprising, since this practice would undercut their positive-sum first-third world trade optimism.) But they do urge selecting

“trade partners based on their countries’ records of compliance with the terms of past trade agreements, international labor and environmental standards, and human rights and other criteria. [The article makes clear that records of currency manipulation would be among them.] While no country has a perfect track record, there is a well-understood continuum of compliance, and known bad actors should be barred from the negotiating table until they’ve made proven, effective efforts to begin cleaning up their acts.”

That’s a start – and a potential wedge.

It’s also heartening to see Bernstein and Wallach emphasize “rewarding those who play by the rules” by creating and enforcing meaningful rules of origin in trade deals. As they rightly note, without such provisions, countries that have not signed various trade deals can still benefit from them because multinationals and other companies will be free to import into member countries goods largely made outside the new trade zone. That’s great of course for businesses seeking the great possible sourcing flexibility. But these practices inevitably render meaningless most of the rest of the given agreement.

And most encouraging of all – although the authors don’t mention this – an American trade policy (robustly) incorporating these features would be in violation of WTO rules. Free of a straitjacket that mandates policy uniformity in a highly diverse world, Washington would be free to choose another globalization lodestar – one that makes far more sense for a country with incomparable market power, potential for self-sufficiency, and thus unilateral leverage. A lodestar like “America First.”

(What’s Left of) Our Economy: Why Trump-ian Trade Policies Needn’t Doom the Third World

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China, David Cay Johnston, developing countries, Donald Trump, James Pethokoukis, Jobs, Kenneth Rogoff, poverty, progressives, protectionism, The Daily Beast, third world, Trade, wages, {What's Left of) Our Economy

A major test of a worthy journalist is whether he covers stories that clash dramatically with his own sympathies and/or those of his biggest fans, and David Cay Johnston’s latest piece – on the immense toll taken on third world economies by corrupt leaders – passes with flying colors. Moreover, Johnston’s work also strongly undermines a major emerging claim during this presidential campaign – that Trump-ian trade policies should be opposed largely because they would his close down a major growth engine for developing countries.

In his May 3 Daily Beast article, Johnston – a Pulitzer Prize-winner during his years at The New York Times – spotlights the work of “investigative economist” Jim Henry, whose research contends that, since 1970, crooked politicians have stolen just over $12 trillion from the third world countries they’ve ruled. As Johnston notes, this humongous figure represents about five cents of each dollar of total global wealth and about two-thirds of America’s current annual economic output. And he rightly observes that “Were all of the flight capital returned and invested smartly it would reduce human misery by raising living standards, especially by reducing child mortality while increasing both health status and life expectancy.”

According to Henry’s findings, almost a third of this stolen wealth has come from five countries – China, Malaysia, Mexico, Russia, Venezuela. The first has certainly made impressive progress reducing poverty largely via trade with the United States and other rich economies, and expanded trade with America in particular clearly has created a modern manufacturing complex – with all its wide-ranging benefits – in northern Mexico.

But if Henry’s work is on target, it means that some $9 trillion has been looted from much poorer regions – notably in sub-Saharan Africa – that have been left far behind as trade and investment have created ever more extensive economic integration between the world’s North and South. The political ramifications for the politics of American trade policy would be profound.

For during this presidential campaign in particular, Donald Trump’s rise to the threshold of the Republican nomination has prompted trade policy supporters to retreat into the argument that, whatever the harm they’ve done to the U.S. middle and working classes, recent trade deals and similar decisions deserve backing because they’ve achieved a major moral goal: reducing third world poverty.

In the words of James Pethokoukis of the conservative American Enterprise Institute, “Even knowing what we now know about the possible impact on U.S. jobs, should Washington have somehow limited trade and overseas investment with China — even at the cost of higher global poverty? Certainly the humanitarian answer is ‘No.'”

And according to Harvard professor Kenneth Rogoff, a former chief economist at the International Monetary Fund, “In the name of reducing U.S. inequality, presidential candidates in both parties would stymie the aspirations of hundreds of millions of desperately poor people in the developing world to join the middle class.”

Moreover, making explicit a point Rogoff left implicit, a writer from liberal website Vox.com used the same argument against Democratic presidential challenger Bernie Sanders: “Limiting trade with low-wage countries as severely as Sanders wants to would hurt the very poorest people on Earth. A lot.

“Free trade is one of the best tools we have for fighting extreme poverty. If Sanders wins, and is serious about implementing his trade agenda…he will impoverish millions of already-poor people.”

In fact, this position has long been an article of faith even among avowed progressives who have been highly critical of current trade policies – to the point of fingering American protectionism as a leading obstacle to third world economic progress.

Henry’s research makes clear that developing countries and their self-styled champions can adopt a poverty fighting strategy that doesn’t require shafting American and other developed country workers – cleaning up their acts. Johnston deserves great credit for reporting on these findings. Any chance that America’s political leaders throughout the spectrum will start paying attention?

(What’s Left of) Our Economy: The IMF (Unwittingly) Trashes the Case for Obama’s Pacific Trade Deal

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Christine LaGarde, developed countries, developing countries, emerging markets, free trade agreements, IMF, International Labor Organization, International Monetary Fund, Obama, Stolper-Samuelson theory, third world, TPP, Trade, Trans-Pacific Partnership, World Bank, {What's Left of) Our Economy

Whatever reputation the French have had for being master logicians has just been shredded by International Monetary Fund (IMF) chief Christine LaGarde.  Her take on emerging markets’ emerging role in the world economy is completely incoherent, and its fatal flaws have big implications for President Obama’s Trans-Pacific Partnership (TPP) and U.S. trade policy as a whole.

For decades, Washington has told Americans that the U.S. economy urgently needs new trade deals mainly because without them, the nation and its workers would be shut out of all the huge, rapidly expanding third world economies that would surely be the globe’s most powerful growth engine for the indefinite future. Moreover, both Democratic and Republican presidents and Congresses have followed through, as new U.S. trade deals since Mexico’s addition to the North American Free Trade Agreement (NAFTA) have focused tightly on developing countries.

Mr. Obama and other TPP supporters have used the same justification for the Pacific Rim trade agreement, repeating over and over again the mantra that “more than 95 percent of our potential customers live outside our borders….” Obviously, they haven’t been thinking mainly of developed markets like Europe and Japan.

On the level of both individuals and national economies, these claims have always been bogus. As I’ve shown, according to major international organizations like the World Bank and the International Labor Organization, the vast majority of third world populations still earn far too little to buy goods made in wealthier countries like the United States on anything close to a regular basis. Moreover, as my book The Race to the Bottom documented exhaustively, most major developing countries – ranging from Mexico to China and its low-income Asian neighbors – have achieved most of their growth by selling to America and the high-income world. Even the commodity producers that have profited by supplying China have remained dependent on U.S. and other developed markets indirectly, since they have been such important final customers for China’s output.

In a Tuesday speech in Paris, LaGarde echoed recent observations that developing countries are in the process of turning into global growth laggards from global growth leaders. As made clear above, their claim to that former status was dubious at best, but LaGarde’s outlook was also noteworthy for its profound pessimism. She not only warned that emerging economies that borrowed heavily in dollars were vulnerable to monetary tightening moves from the Federal Reserve. She also declared that “emerging and developing countries are now confronted with a new reality. Growth rates are down, and cyclical and structural forces have undermined the traditional growth paradigm.”

Indeed, LaGarde pointed to IMF research projecting that “the emerging world will converge to advanced economy income levels at less than two-thirds the pace we had predicted just a decade ago. This is cause for concern.” (What she failed to mention is that this convergence could also result in part from incomes in the developed world sinking closer to third world standards, as the Stolper-Samuelson theory of international trade’s impact first stipulated.) For good measure, LaGarde reminded her audience that “Clearly, emerging markets are benefiting from the fact that many central banks in many advanced economies still have a very easy policy stance.” In other words, historically easy credit in the wealthier countries had kept third world exports and growth much greater than they would have been otherwise.

Yet even though she made the case that emerging market economies’ prospects were deteriorating and had relied critically on the developed countries even after the financial crisis, LaGarde also mysteriously contended that the emerging world “contributed more than 80 percent of global growth since” the global economy seemed on the verge of collapse and that, consequently, “The economic health of the emerging world is of first-order importance for the advanced economies.”

And in the strangest statement of all, she proceeded to insist that the wealthy countries now need to deal with this situation by propping up emerging market performance with “a stronger global financial safety net” for these economies that expands their access to the swap lines of the richer countries’ central banks.

A respectable case can be made that emerging markets have always been the keys to future global growth. Equally respectable cases can be made for the propositions that they have been the main global growth drivers since the financial crisis; that they have never been the keys to global growth; that they will remain central to the wealthier countries’ well-being; that they are headed to a much gloomier “new normal;” and that they need new aid from the developed countries to avoid major future woes. But no case can be made for all these contentions at the same time – unless reason and logic are abandoned entirely.

Moreover, since the claim behind which LaGarde is putting her money is the one that’s downgrading the third world’s economic importance substantially, and the one conforming with past and future realities, it should be clear that the term “emerging markets” is likeliest to be an oxymoron going forward. As a result, although the United States and other wealthier countries could legitimately decide to lend them a hand for moral and humanitarian reasons, the argument from self-interest is looking ever more far-fetched. And tying America’s fortunes even more tightly to global economic losers via new trade deals like the TPP? That looks downright masochistic.

(What’s Left of) Our Economy: Why the Latest World Trade Failure Should be Celebrated

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agriculture, Alan Greenspan, bubbles, China, Congress, developed countries, developing countries, Doha Round, Federal Reserve, Financial Crisis, George W. Bush, Global Imbalances, Information Technology Agreement, ITA, Obama, offshoring, poverty, Robert Zoellick, September 11, terrorism, TPP, Trade, trade law, Trans-Pacific Partnership, World Trade Organization, WTO, {What's Left of) Our Economy

Trade policymakers have just uncharacteristically – and perhaps unwittingly – given the world economy an important holiday gift: a virtual decision to kill the so-called Doha Development Round of world trade liberalization talks.

This outcome of the latest meeting of the World Trade Organization (WTO) in Nairobi won’t make an active contribution to solving global economic problems. But it greatly reduces the odds that additional multilateral trade expansion will keep worsening the kinds of international economic imbalances that helped trigger the last financial crisis and keep threatening to set the stage for a new meltdown.

The Doha round (named after the capitol of Qatar, where it was launched) was a product of the September 11 terror attacks, but was whoppingly misconceived both strategically and economically. Though intended to spur the prosperity needed in developing countries ostensibly needed to reduce terrorism’s appeal, its founders – notably President George W. Bush’s administration trade chief Robert Zoellick – seemed unaware that dangerous extremism had never taken hold in most world regions where poverty was most desperate, e.g., rural India and rural China. Moreover, the round’s explicit aim of channeling most of its trade liberalization benefits to developing countries completely violated the core principles of genuinely free trade.

But those mistakes and their impact paled next to the damage likely from a treaty reflecting the Doha goals – ever greater global financial instability stemming from trade flows that fostered the offshoring of production, and therefore income-earning opportunities, to countries that would still long remain too poor to consume adequately, and away from the rich-country populations (especially America’s) whose purchasing power was still crucial for adequate global growth.

By the time the Doha talks were inaugurated, in 2001, years of NAFTA-style, offshoring-centric U.S. trade liberalization decisions capped by China’s admission into the WTO had already recklessly placed the U.S. and world economies on a completely unstable course. The Bush administration and the Federal Reserve under Alan Greenspan further greased the skids for crisis with two decisive moves. The former filled the resulting American income and growth shortfall with renewed, and record, federal budget deficits. The latter even more powerfully fueled consumption with prolonged (then) record low peacetime interest rates. For half a decade, the United States experienced an unprecedented burst of debt-led, bubble-ized growth. And then the entire global economy nearly collapsed.

Success at Doha was always bound to magnify world trade imbalances further and ensure even more badly lopsided growth by requiring the United States and other developed countries to open their markets much wider and faster than low-income countries. Particularly important were measures practically certain to gut the U.S. trade laws that shielded America’s domestic economy from foreign predatory trade practices like export subsidization and dumping. In fact, the inequities were so egregious that even America’s staunchly pro-trade liberalization agricultural sector, which has long wielded outsized influence in Congress, balked; its reservations began the Doha hold-up that eventually brought its demise.

Unfortunately, another recent international trade policy decision is likely to add to dangerously distorted global growth – the new Information Technology Agreement reached under WTO auspices, which eliminates tariffs on many tech products but does nothing about the non-tariff barriers and predatory commercial practices used so heavily by so many U.S. trade rivals. New financial pressures may also be fueled if Congress passes the Trans-Pacific Partnership (TPP) trade deal pursued so avidly by President Obama. As I’ve often explained, this agreement’s text does target non-tariff barriers, but creates no mechanisms even remotely capable of actually curbing their use. Therefore, it’s all but certain to create the trade deficit-boosting, finance destabilizing effects of the previous American trade agreements on which it’s modeled.

All the same, TPP ratification this year looks doubtful, given election-year opposition by major Republicans in Congress. Doha’s death would represent a second “do no harm” decision in a single year – certainly not enough progress on the trade policy front, but considerably better than nothing.

(What’s Left of) Our Economy: Open Borders, the Goose, and the Golden Eggs

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Bernie Sanders, bubbles, central banks, developed countries, developing countries, Ezra Klein, Financial Crisis, free trade deals, Great Recession, Immigration, imports, incomes, investment, Jobs, New Economy, Open Borders, recovery, Sharing Economy, third world, Trade, Trans-Pacific Partnership, Vox.com, wages, {What's Left of) Our Economy

Since Ezra Klein is still young, he has time to learn what a bad idea it is to try being clever on unfamiliar subjects. Nonetheless, as made painfully clear in a new interview with Democratic presidential hopeful Bernie Sanders, the media wunderkind and Vox.com founder would be well advised to learn this lesson sooner rather than later, at least when it comes to how the global economy works.

Evidently trying to be clever, Klein tried to trip up the Vermont Senator by asking him how he could reconcile his avowed democratic socialism – and its presumed concern about global poverty – with his opposition to “sharply raising the level of immigration we permit, even up to a level of open borders….” Added Klein, “It would make a lot of the global poor richer, wouldn’t it?”

Sanders’ response was good. But he could have really humiliated Klein by reminding him that unlimited immigration would not only slash American living standards, but that it would ultimately backfire on developing countries as well. The reason is the same as that which argues, from a global perspective, against dropping all barriers to imports from the third world, and it springs from a reality as unmistakable as it is apparently unknown to Klein: American consumption is the goose that lays the developing countries’ golden eggs. To paraphrase that immortal adage, it’s “where the money is.”

Yet just as the United States ultimately can’t responsibly finance the consumption of enough third world imports to spur developing country progress unless its own economy remains truly healthy, it can’t ultimately provide opportunity for third world immigrants without maintaining genuine prosperity. And as Klein and other chattering class advocates of much freer immigration and trade policies should understand – but clearly don’t – the financial crisis demonstrated the heavy costs for everyone of forgetting this truth.

As I’ve written, thanks in large measure to more than a decade of U.S. job- and wage-killing trade deals focused tightly on developing countries, a critical mass of American workers lost the incomes they needed to support acceptable living standards by living within their means. Rather than change course on trade policy, the bipartisan Washington powers-that-be decided to enable the working and middle classes to at least run in place economically by borrowing, instead of earning. The economic meltdown and Great Recession that inevitably ensued inflicted damage worldwide.

Just as important, the historically feeble recovery that’s followed has claimed its share of third world victims, too. Slower American growth has helped crimp imports from China and the rest of Asia, thus sapping the vigor of these export-dependent countries. (Although, as this recent post shows, this phenomenon is easily exaggerated.)  The continuing U.S. malaise has also undermined employment opportunities for current and prospective immigrants from Mexico and the rest of Latin America. Meanwhile, because many global investors have become more risk averse since the last decade’s bubbles burst, and because Wall Street regulations have (necessarily) tightened up some, much international capital has forsaken developing country market and fled to the safety of the United States.

Do Klein and his ilk really believe that admitting a flood of overwhelmingly low-wage, low-skill immigrants will turn this situation around and help anyone, at least for any serious length of time? The only possible justification is a belief, contrary to the evidence and common sense, that the newcomers could rise up the U.S. income ladder as quickly as previous immigrant cohorts. The same question applies to boosting American imports from developing countries – which other supposed experts have touted as a prime reason for supporting President Obama’s Pacific Rim trade deal. Moreover, as I’ve just reported, import- and offshoring-friendly American trade policies could also start victimizing recent immigrants – and choking off opportunities for their successors.

In a perfect world, of course, inhabitants from poor countries could move to wealthier countries any time they wished, and they and the native-born populations would all live happily ever after. Alternatively, in a perfect world, third world populations could supercharge their incomes by providing their first world counterparts with an indefinitely growing supply of increasingly advanced products. Americans (and in principle, Europeans and Japanese) would all support themselves by finding themselves jobs in the New Economy, or the Newer Economy, or the Sharing Economy, or whatever fantasy economic utopians conjure up. Or maybe central banks could keep trying to shatter ever-soaring records for money-printing,

In that perfect world, however, we wouldn’t need economics, or economics. And we certainly wouldn’t need economic journalists like Ezra Klein.

(What’s Left of) Our Economy: A Flawed Basis for “Over-Priced” China Hopes

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advanced manufacturing, Boston Consulting Group, China, developing countries, economic development, labor, labor-intensive manufacturing, Lewis Point, manufacturing, manufacturing renaissance, Obama, productivity, W. Arthur Lewis, wages, {What's Left of) Our Economy

Quick – how many of you have heard of the Lewis point? Not a clue? Don’t worry – you’re not alone. Even most supposedly serious economic analysts seem unacquainted with it. At the same time, it’s difficult to talk realistically about patterns of Chinese and U.S. industrial competitiveness without keeping it in mind, along with its significant weaknesses, and the release of a new report about China’s labor force is a great occasion to examine its significance.

The Lewis point – named after the prominent development economist Sir W. Arthur Lewis – is the hypothetical stage of a country’s economic evolution at which its supply of excess labor shrinks enough to start pushing wages up. As a result, it’s the dominant theory in economics explaining how low-income third world countries with major labor surpluses nowadays can plausibly hope to become much higher income countries.

I’ve always been somewhat skeptical of the Lewis notion, mainly because the labor surpluses in developing countries have been so vast, and incomes so incredibly low. Indeed, my book The Race to the Bottom cited third world labor gluts as features of the global economy with such staying power that they would be instrumental in ensuring that world trade flows would long remain lopsided to the detriment of workers in developed countries, and global financial stability.

More recently, the Lewis point has shaped much recent thinking about global manufacturing’s future, and especially about the outlook for the United States and China – even though few of these thinkers have mentioned Lewis’ ideas. In particular, U.S. manufacturing cheerleaders like President Obama and the Boston Consulting Group have predicted that lots of industrial activity will move from China to the United States largely because labor shortages there are already driving wages too high to justify its current levels of production. In other words, the Lewis theory looks like it’s playing out right now in the PRC.

As I’ve written exhaustively, these claims of rising Chinese wages are full of serious problems. (The new China labor report claims to have spotted another one.) One rising-China-wages problem I haven’t discussed, however, stems from a big flaw in the Lewis point theory that would weaken it even if one could document the kinds of Lewis-ian wage hikes that the cheerleaders claim to be seeing. Lewis’ ideas arguably make sense outside sectors of an economy exposed to international trade, like services. But since trade is crucial to developing countries’ growth – because, by definition their domestic markets lack the wealth needed to create anything like the employment opportunities they need – relevance to trade should make or break the Lewish theorem. And here’s why it doesn’t seem able to hold long enough to matter.

In developing countries making their way in a world with robust trade – and full of surplus labor – overly generous pay in the labor-intensive industries in which economic development naturally starts will indeed reduce the competitiveness of their manufacturing. But events don’t then simply come to a screeching halt. One of three manufacturing-related developments – or some combination of them – can be expected next, at least if the rest of economics has any validity. (Of course, as with all economics theorizing, these scenarios depend at least in part on other factors holding more or less constant.)

Possibility one is that so much competitiveness is lost that jobs in those globally exposed sectors dry up, surplus labor starts to emerge once more, and wages start sagging again. Possibility two is that employers do what they do everywhere else in the world to cope with scarce labor – they automate, or become more efficient in other ways, and either replace labor with capital and technology, or raise their productivity, or do both. And possibility three is that these countries use capital and technology to move into more advanced industries.

China specifically seems to be climbing the technology ladder quite rapidly, as evidenced by its production of ever more advanced manufactures. But the nation still hosts a large labor-intensive manufacturing sector, and its struggles appear to be in part behind China’s growth slowdown.

It’s true that, in principle, because low-income countries are poor, their businesses might lack the access to capital and technology to take these steps. In practice, though, many foreign investors have been happy to help out, and many third world governments (notably in Asia) access the capital from their own populations through economic policies that promote saving and discourage consumption. Intellectual property theft, or forced technology transfers, have aided many (mainly Asian) countries, too.

It’s also true that not all national business establishments in globally exposed sectors will be smart enough to make these adjustments, or fast enough to re-attract from more promising sectors whatever workers they need. But at least some will, and they’ll become the new manufacturing winners until others start coping as or more successfully, or come up with superior alternative approaches.

Incidentally, these Lewis point shortcomings also explain why hopes for significant wage increases in U.S.-based manufacturing (which, to their credit, the manufacturing cheerleaders like President Obama have not predicted) appear misplaced. Although it’s difficult to know the tipping points in various manufacturing sectors, no one can reasonably doubt that they exist. If they’re ever passed strongly enough and long enough (a development that looks pretty far-fetched for now), offshoring to much lower wage countries will start looking just as attractive as in the past. Moreover, as made clear by China’s inroads into advanced manufacturing, the productivity gains that will be needed to offset these wage increases will need to be genuinely historic – a sobering thought at a time when manufacturing’s productivity growth has been slowing.

(What’s Left of) Our Economy: Why Productivity Gains Won’t Save American Jobs, Either

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developing countries, factors of production, Global Imbalances, globalization, inequality, Jobs, multinational corporations, productivity, {What's Left of) Our Economy

The heated debate in the economics world about whether expanded trade and investment has worsened income inequality in wealthy countries like the United States often obscures the equally heated debate over globalization’s effects on developing countries. Many left-of-center critics of current U.S. policies in particular charge that current the current world trade regime has worsened the rich-poor gap within low-income economies and left entire third world countries behind.

The Economist magazine deserves credit for bringing this neglected debate to the mainstream media, and spotlighting new work from Nobelist Eric Maskin of Princeton University and Michael Kremer of Harvard University presenting a new explanation for this development, and for how it does or doesn’t fit into conventional trade theory. (Their paper itself, can be read here.) But actually, their findings tear a much bigger rent in the theoretical basis for the current version of globalization to an even greater extent than The Economist, most trade policy critics, and even the authors recognize.

As the magazine notes, worsening income inequality within developing countries and for much of the third world as a whole matters not only because it indicates that current world trade policies are exacting a major (and possibly needless) human toll, but because the prevailing economic wisdom tells us that exactly the opposite is supposed to happen.

Maskin and Kremer speculate that what’s been missed by the founding fathers of trade theory was how the explosion of global commerce was likely to foster what the authors call international worker “matching.” Today’s wide open global economy, they contend, enables higher-income economies to access relatively high-skill workers in developing countries by investing in new factories and labs their multinational companies build offshore. Therefore, they create unprecedented economic opportunities for those skilled workers while leaving their less-skilled compatriots up the creek.

As is clear to anyone who closely follows the globalization debate, Maskin and Kremer leave out another significant impact of this worker matching – how it harms relatively lower-skill workers in high income countries by plunging them into competition with much less expensive third world counterparts.

If they did discuss this unmistakable result of current U.S. trade policies and their foreign counterparts, they might have recognized how this relatively new form of worker matching strongly undercuts the uber claim of mainstream theory that trade liberalization is ultimately a winner for the entire world. First world corporate investment in high-value facilities and jobs in third world countries means nothing less than that productivity itself – assumed by mainstream economics to be what’s called a fixed factor of production – is actually mobile. Efficiency-creating knowhow can be transferred across borders as easily as goods and capital.

Not that this is exactly news. My book The Race to the Bottom and many other studies have extensively documented how it’s become routine for multinational corporations to engage in capital- and technology-intensive work in developing countries as well as in labor-intensive work.

One crucial implication of this finding is debunking the (still) widely accepted claim that liberalized trade threatens mainly low-skilled and poorly educated countries, and that this competitive heat should actually be welcomed because it encourages wealthier economies to get those disadvantaged portions of their populations up to speed, and move them into higher value industries and jobs. If this higher value work can be sent to much lower-cost countries just as easily as less advanced work, then reeducation and retraining claims become much less convincing.

But as the work of Maskin and Kremer underscores, high-value offshoring to low-income countries entails not just the export of industrial machinery and laboratory equipment. It also entails the export of technical expertise and corporate culture – of all the intangibles that produce corporate — and supposedly national competitive — success. As a result, it also entails the export of all of the social and cultural values and experiences – or at least their fruits – that over time have contributed to these intangible assets. In other words, it entails the export of productivity.

Supporters of the globalization status quo seem to assume that productivity can’t be exported, at least not readily. Indeed, despite the proliferation of high value offshoring, they seem confident that both its historically developed ingredients and its operational end product will remain uniquely American advantages, especially if government policies remain fundamentally supportive, and avoid creating unnecessary obstacles. But in their work on skill matching, Maskin and Kremer strongly (if inadvertently), suggest that even if public policy remains perfect, this confidence is misplaced.

But in addition to undercutting the theoretical case for current globalization policies, the factor mobility of productivity also undercuts the macroeconomic case. It greatly strengthens the idea that high-income countries – especially the United States – keep sending valuable production and employment to countries whose wages will long remain too low (largely because of their enormous populations) to permit them to consume and import remotely what they can produce and export. As long as these practices continue unabated, the U.S. and other high income governments will keep being tempted to fill the resulting income gaps for most of their people with cheap credit – and keep running the risk of reflating dangerous domestic and worldwide bubbles.

I’d feel a lot more confident that policymakers will promptly put this crucial two-and-two together if this challenge didn’t keep eluding prominent economists like Maskin and Kremer.