The British economy is perplexing economists. The economy as a whole is growing but we as individuals don’t seem to be any better off. Unemployment tumbles but pay stays rooted to the spot. This is called the “productivity puzzle”. Added to this puzzle is the phenomenon of “re-shoring”: the reversal of offshoring, the process by which manufacturing and services were migrated abroad, typically to China or India. David Cameron, the Prime Minister, made a speech promoting it last week. It is worth stepping back to think through just what is going on.
After all, when offshoring was popular, in the years of the Labour government from 1997 to 2010, it was hailed as a good thing in the long term, worth a little disruption in the short run. It meant that prices for goods and services were kept down, and therefore our collective living standards improved. Looking at the components of retail price inflation in the 2000s told quite a startling story: prices of manufactured goods were actually falling. Locally produced services could advance in price by 4% or so, and the Bank of England could still meet its 2% inflation target. That 4% reflected the advance in average pay – so advancing living standards were largely explained by lower priced imports. Offshoring was a very important part of this phenomenon.
And this conformed very neatly to the elementary economic theory of Comparative Advantage, first explained by 18th century economist David Ricardo, and part of any first-year economics course. This says that the benefits of trade arise from differences in opportunity cost, or comparative advantage, and not actual cost, or absolute efficiency. The Chinese had a comparative advantage in basic manufacturing; Britain had a comparative advantage in high-end services. So, even if British workers were more efficient than Chinese ones in basic manufacturing, it still made sense for Britons to import from China – and both countries drew benefits. Trade between the developed and developing world follows the predictions of Ricardo’s theory very closely. And supporters of globalisation, like the Labour big beast Peter Mandelson, pointed this out endlessly.
But economists rarely follow through the logic of Comparative Advantage. If two identical economies have identical opportunity costs for different goods, there are no gains from trade (not on the basis of this theory, anyway). Trade arises from differences in the shape of economies. Since developed and developing economies are very different, big gains from trade are to be expected. But what happens as the developing economy starts to catch up with, and resemble the developed one? The gains from trade reduce. I have taken the trouble to work this out with a crude model of a developed and developing economy. The catch up process is marked by an appreciation of the developing country’s exchange rate, so that it converges with purchasing power parity. The interesting thing is where the loss in gains from trade falls. The developing economy becomes more productive and efficient, so its losses from reduced trade are made up for by gains in productivity. But for the developed economy, there is no corresponding level of compensation; the gains from trade disappear and the economy is worse off as a result.
And this is exactly what seems to be happening now. China and (in a rather different way) India are catching up; their exchange rates appreciate relative to ours. Their wages rise faster than ours. The gains from trade disappear, and it is the developed countries (us) that pay the price. Re-shoring is simply part of this process. The great gains from globalisation prove to be quite temporary, in this respect at least.
But as China and India catch up with the West and Japan, won’t other developing countries take their place, just as China and India took the place of South Korea and Taiwan? Vietnam, Indonesia and African economies stand ready. But these emergent economies are as interested in dealing with China’s and India’s vast economies as they are with the developed world’s. The world is rebalancing and the old economies of the west cannot expect to stay in the driving seat.
So, what’s the bottom line? I think re-shoring is one of the factors that explains Britain’s productivity puzzle. We had outsourced lower productivity jobs abroad, and they are returning. It is good news for employment, and will help balance the country’s trade. It will make the British economy more sustainable. But it will not make us feel any better off.