(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.