Re-shoring: good news that does not make us feel better

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.

Globalisation is at a turning point

After a period of relative silence the idea of “globalisation” is re-entering political commentary.  But almost none of the commentators seem have seem to have grasped its dynamics – and that its pressure on developed economies is easing rapidly to both good and bad effect.

Maybe it’s Davos.  But globalisation has been coming up a lot lately.  It is the subject of this week’s Bagehot Column in the Economist, which claims that its effect lie behind a lot of the political debate in Britain.  An FT article drew attention to recent speeches by President Obama and French Presidential hopeful Francois Hollande apparently attacking its effects. And the IPPR launched a heavy (108 page) report on The Third Age of Globalisation, recommending that Britain in particular develops a proper industrial strategy.

I have already worried about how much political debate centres on abstract nouns, in particular “capitalism” and “neoliberalism” (a favourite on the left).  “Globalisation” has to be added to this list.  It is much better for the debate to move to the concrete (income and wealth distribution, for example).  But there is value in trying to unpick the concept a bit.  And what arises from this, at least in my view, is that the globalisation process is changing in way that few commentators recognise.

“Globalisation” is used as a collective word to refer to three inter-related phenomena in particular: international trade, cross-border investment, and international finance.  These three have worked together in the last couple of decades (the IPPR’s “third age”) to transform the world economy, with developing economies being at the heart of it.  It is associated with positive outcomes: the rise of so many developing economies, and negative – the increase in inequality in developed and developing nations alike.  But to understand how this process will evolve it is best to consider the trade aspect, from which all the rest flows.

The central phenomenon had been the growth of trade between less developed economies and more developed developed ones, with the former taking over the manufacture of many consumer goods, and also many services too.  Economists find this type of trade particularly easy to understand: it is a straightforward application of the principle of comparative advantage, first described some 200 years ago by David Ricardo.

Comparative advantage is one of those ideas that tend to separate “proper” economists from those that just try to follow economics from newspapers.  I think many of the latterle think it is similar to the much more familiar idea of competitive advantage – but it is quite different.  Basically it says that benefits in trade between two economies arise when there are differences between them in the opportunity costs of producing different goods.  So if one economy can produce 10 tons of wheat to one of beef, and another 5 tons, there are benefits in trade which each economy specialising in the good where it has comparative advantage.  In this case the first economy has a comparative advantage in beef and the second in wheat.  It makes no difference how efficient each economy is in producing either good.  And a comparative advantage in one good means a disadvantage in another – unlike competitive advantage (which applies to individual businesses rather than to whole economies) where one party can dominate the other.

So this theory predicts that there will be trade between economies that are different to each other – which is why the trade between developed and developing economies is to easy to explain.  Economists struggle in using the theory to explain trade between similar, developed economies – but that’s another story, and it is a different type of trade.

Developing countries have emerged with a comparative advantage in low and middle tech manufacturing.  Developing countries typically have the balancing comparative advantages in higher-end goods and services, raw materials (where they have endowments) and agriculture.  Of course what we notice is the very low wages in developing countries, which make us think that the whole business is unfair.  But it is a sideshow, and very easy to explain using basic economics.  Wage rates are low because the developing economy as a whole is massively unproductive.  The manufacturing plants may be relatively efficient, but other industry, and especially agriculture, is so unproductive that it drags wages down for the whole labour market.  If factories paid higher wages, nobody would man the farms and people would starve (to greatly oversimplify things).  It takes some getting used to the idea that developed countries have a comparative advantage in agriculture, when so much of a developing country’s resources are tied up in the sector – but that is what is going on.  Full free trade in agriculture would put most developing world farmers out of business – except where tropical conditions gave them an advantage (bananas, perhaps).

And here’s the point.  As the developing economy advances this picture changes.  More and more people come off the land, and agriculture becomes more productive.  Wages across the economy rise, and the developing economy slowly comes to resemble a developed one.  The gains from trade disappear.  Trade continues but it is on much more equal terms and much more about the competitive advantage of particular businesses than about the circumstances of a whole economy.

And this is exactly what has happened.  In the 1990s the globalisation trend was mainly about the so-called “tiger” economies, of Taiwan, South Korea, Hong Kong, Thailand, and so on.  I remember Tory ministers wandering around saying how this country was under existential threat unless workers’ pay and conditions were cut so that we the country would be competitive.  But eventually a South Korean firm decided to build a factory here because it was cheaper producing goods here than at home.  South Korea had caught up.  But as the Tigers caught up and went to the next phase, China and India entered the picture, and gave the process a boost.  The two most populous countries in the world were bound to have a massive effect and the whole process accelerated.

But these countries are catching up.  This is especially clear in China, where rising wages have become a big issue.  This week’s Economist has a very interesting briefing on the subject.  The same processes are visible in the rather more chaotic India too.  In both cases the attention is shifting to raising the standard of living for the domestic population, rather than international competitiveness.  The worm has turned.

And on to the next wave?  There are plenty of less developed economies in the queue: Vietnam, Bangladesh, Pakistan, and various countries in Africa.  But none have the size and weight of the big two.  And it’s not just a matter of supply: the developed world is becoming that much bigger as new countries enter it – so impact of these poorer countries entering the market will be spread more widely; they will be busy exporting to India and China.

So the basic driving force behind the globalisation trend of the last 20 years is grinding to a halt.  What effect does that have on us in the developed countries?  The good news is that the pressure to offshore will ease, producing a bit more stability on our work landscape.  The bad news is that the gains on trade will vanish.  This has been an important part of the general rise in living standards in the last couple of decades, which we have been relying on to produce forward momentum to a greater extent than many realise.  Another reason why the “new normal” is slower growth.

So the developed countries will stay grumpy, but more from the slowdown of globalisation than from its continued rise.  But the big question is whether the trends to inequality will reverse.  On that score things are much less clear.