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Supply Shock and Awe

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Feb 14, 2005
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Southern SD
Supply Shock and Awe
By Fredrik Segerfeldt 02 Feb 2006

Economists usually argue vehemently in favor of globalization. International trade, they contend, fosters specialization and division of labor. Each country leverages its comparative advantage, which in the longer run leads to marked welfare gains. Jobs will be lost, to be sure, but only at a general level; each country engaged in international trade wins in the end. Or so the theory goes. Yet now a new narrative is snagging audiences. It suggests that globalization is in fact detrimental to the rank-and-file workers of rich countries.

I am referring to the labor supply shock, eloquently noted and described by Richard Freeman, economics professor at Harvard University. He has estimated that the entry into the world economy by the former Soviet bloc, China and India in a very short period of time has doubled the workforce of the international economy. Previously, about one 1.5 billion people were involved in globalized production. Now, we are roughly three billion. But the amount of capital hasn't kept up with this development. Granted, the 1.5 billion people added to the global supply of labor had jobs also prior to their countries' integration into the world economy, but they did not compete internationally. Their countries were either communist and/or too underdeveloped to play any significant role in the global economy.

The supply shock has become the latest catchword in the debate on globalization, jobs and incomes. Freeman avers that the doubling of the global workforce will put enormous downward pressure on wages in industrialized countries, not least when it comes to untrained workers. Intuitively, he seems to be onto something. When the relative supply of one factor of production goes up, its relative price will go down. Huge amounts of labor compete to attract the world's investment capital. Anecdotal evidence about lower wages, or extended working hours with frozen wages—not least as regards manufacturing in continental Europe—suggests that Freeman has made an important observation. With anti-globalizers backed by renowned intellectuals, protectionism and economic nationalism could garner support. Why should the general public in rich countries support a development that worsens living standards?

Well, for two reasons. Freeman is mistaken; and a standard of living is determined not only by wages but also by prices. Let's break it down.

The workforce has already doubled in size. China, India and Central and Eastern Europe have followed an upward trajectory for over 15 years. And this puts to one side the avalanche of media coverage documenting Asia's rise in recent years. Suffice it to say that 400 of the Fortune 500 corporations have central functions in mainland China and that a majority of all DVD players, digital cameras and footwear is produced in China, that Slovakia is the world's largest manufacturer of cars per capita and that India's IT industry has grown from $8 billion in 2000 to $28 billion in 2005. And, during the same period, wages in rich countries have continued to grow. If Freeman were right, we would already be worse off. But we're not.

This is for two reasons. First, high growth and rising incomes in poor countries have increased demand for goods and services produced in rich countries, creating jobs and income. But perhaps more importantly, Freeman's thesis presupposes a static production apparatus in rich countries; that people will continue to do the same jobs they have always done; that businesses will not change. That's not the case. Sweden is a textbook example. In 1960, 40 percent of all employment was attributable to manufacturing, compared to only 17 percent today. Or take the United States, where nine of the 50 largest companies did not exist 35 years ago. People have moved on to new jobs in other sectors of the economy, as manufacturing and other jobs were lost to poorer and cheaper countries. An economy needs to be dynamic—to constantly ascend the global value chain—to secure as prominent a position as possible in the value-added production arena. This will move average income higher than in other countries.

But suppose Freeman is right about wages: will this necessarily mean that our standard of living will fall? No, of course not. The impressive manufacturing machine in China and other countries has squeezed consumer goods prices. Restrictive nominal wage rises, or even cuts in nominal wages, will not necessarily lead to a negative real wage trend. On the contrary. Not only have prices on consumer electronics and food gone down, low inflation has opened the door to low interest rates, benefiting low-income households.

The keys to success in today's increasingly globalized world are flexible and mobile labor, support for structural change and an embrace of internationalization. Europe, unfortunately, is headed in the opposite direction. I suppose that is why resentment is higher than it should be, and why Freeman's doomsday prophecy is more likely to be fulfilled here than anywhere else in the world.

The author is a director at the Swedish think tank Timbro.

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