Montrose Journal Winter 03

Journal Index Next Article ->



There's nothing new about the key feature of the new globalisation. A sudden discovery somewhere in the world breaks down the barriers of distance and customs. It happened in the 16th century when gold from the New World flooded through Spain. It happened at the beginning of the 19th century when machine-made cotton from Britain swept all before it. It happened again in the middle 19th century as the Great Plains of North America became the wheat fields of the world with the help of the steamship.

So great changes brought about by the world coming together are not new. But there is something new about the globalisation which we are seeing now. For this time the Great Discovery is not a mineral or a machine or a source of food. It is people. And people make it different.

Until the end of the 1980's, the world's two biggest nations played only a minor part in the economic system of the western industrial world. Accounting between them for about 38% of the world's total population, China and India had few of the attributes of the countries which dominate the trade in industrial goods. Key sectors of the modern economy, such as automobile production, were almost entirely missing. The countries were not party to any of the specially open trading arrangements between industrial countries which grew up within GATT (now the WTO.) They had little heritage of industrial production or exporting modern goods to the old industrial nations. In China, the economic system remained stuck within the framework of state-owned, centrally-planned communism. In India, industry relied on protectionism for survival producing goods some of which had changed little since the days of the British Raj.

These two countries were not the only parts of the world excluded (or excluding themselves) from the advanced industrial system. Eastern Europe and the Soviet Union were autarchies, cut off from western technology, capital and markets.

All that has changed. A key break came at the end of the 1990's with the collapse of communism. That brought Eastern Europe back into the orbit of the west and opened up to (mainly) German producers a labour supply prepared to work at far lower wages and with far fewer restrictions than those in the West were used to. It was partly seeing the collapse of the Soviet Union and partly developments in its own country which led China to make a great change in its economy. It moved from trying to build 1930's style communism to a complex mixture of state and private ownership geared to getting fast growth and a more open economy where local producers have to compete. India's change has been later and less obviously dramatic. India was never a communist economy in the first place. But it was an economy which rested on the assumption that Indian producers were less competitive than foreign producers and needed to be protected to survive. That is gradually being dismantled as the country finds more and more things where it can match the world.

How does the entry of these two giants into the world economy change things? After all, the post-war era saw rapid industrialisation in many Asian economies, starting with Japan but spreading rapidly to Korea and happening pretty much at the same time in Singapore, Taiwan and some other countries. The answer is that the population of these countries adds up to less than the population of the US. China alone is 4 times the size. And although there has been a flood of people to the Eastern seaboard of China, where something just under 300 million people live, the available labour pool of low-cost workers remains huge, with its consequent downward pressure on wages. In all the rapidly industrialising countries of the first wave of post-war industrialisation, wages rose quite rapidly. Long before the Japanese car industry established itself as unrivalled master of production, wages in Japan had reached levels above those of declining competitors like Britain. It was superior production technology that made Japanese cars cheaper, not low wage costs.

So far, we have not seen a similar rise in wages in China. Basic production workers earn far more than their rural counterparts in the fields, but there are so many more seeking work, either from country areas or from old industries which are dying, that wages are held down. For more skilled or more qualified workers the dramatic improvements in educational standards are producing more people qualified for the jobs available. So we are not likely to see wages rise enough in the near future to make a big difference. People sometimes talk of China as being under threat from even lower-wage areas, such as Vietnam. Those countries might make their own great leaps forward, but the gap in production costs between China and the old industrial world is so great that it is unlikely they will lose much edge soon. Low costs are one thing; being able to turn them into something economically viable is another. Houses are cheaper in central Patagonia than on Central Park West because not many people want to live in Patagonia and housing is one good which has to be consumed where it is produced.

Transportation costs have fallen dramatically over the years because of more efficient ships and sea transport being far cheaper than using land, so the extra distance from Asian producers to old industrial markets gives a misleading picture. When Japan started selling cars in the US it sold only in California. That was because sea transportation was so cheap that it cost a Japanese producer only one third as much to get a car from Tokyo to Los Angeles by sea as it cost a US manufacturer to get it from Detroit to Los Angeles by rail. The big US firms consoled themselves at the time that this meant Japanese manufacturers would leave the east coast alone.

But it is shops as well as ships that have made transport cheaper. The availability of sources of cheap production has shifted power from producer to retailer. And retailers such as Wal-Mart have used the opportunity this gives them to produce transport and distribution systems of great efficiency and complexity. Like most things in the economy, there is an element of accident in all this.

Back at a time when US brands like RCA and Zenith dominated the television market there, Sears decided to sell an own-brand television and asked US manufacturers to produce it. They all refused and Sears was forced to turn to Japan, which used the American 525 line system and whose manufacturers had been trying unsuccessfully to break into the US. The success of this order led to a flood of others and started the process by which Japanese brands themselves became established. By the early 1970's a leading British retailer realised that attitudes had changed so much that it changed its own brand label from Prinz (designed to make it sound like a high-quality German camera) to a name aimed at making it sound Japanese.

There is a difference between this early phase of Asian gains in US and European markets and what is going on now. Japanese (and Korean) producers focused on goods with a declining marginal cost curve. That is to say, goods where once a dominating position had produced really big volumes of sales, the costs of producing one extra car or TV were so low that it was difficult for new entrants to break in to the market. That justified exceptionally low start up costs and long periods in which exports produced little or no profit.

China can produce pretty much any simple thing, where labour cost dominates transport, cheaper than any US or European plant - and cheaper than almost all of the newly industrialised countries as well. The rule that if it costs less than $5 it will have "Made in China" stamped on it is not quite true but it is close. The result is that China has a huge surplus on its trade with the USA, which it ploughs back into US government assets. Note that overall China's trade is much closer to balance because it imports huge amounts of goods for both producers and consumers. Capital equipment still flows from Japan, while the products which that equipment produces often sell on world markets with Japanese brand names.

'This time the Great Discovery is people. And people make it different.'

No one should underestimate how much of the rise in living standards in the west has benefited from cheaper goods imported from the newly industrialised countries. In total, western economies are massive net beneficiaries from access to cheaper goods. The rise in living standards in the countries being drawn into the world system makes increasingly important markets as well. But the winners and losers in the advanced countries are not all the same, just as in the 19th century town dwellers in Britain welcomed the cheaper food from America which caused desolation to the agricultural economy.

There has been much focus of late on some of the macro-economic causes and consequences of China's large trade surplus with the old industrial countries. Is it caused by having too weak an exchange rate? Does the fact that the Renminbi is pegged to the dollar remove the Chinese authorities ability to control domestic monetary policy in China? Is the long-term build up of currency reserves as a side-effect of maintaining a stable currency either sustainable or desirable?

My own view is that a greater degree of flexibility for the Chinese currency would make sense for both China and the rest of the world. But there's no getting away from the fact that any plausible move in exchange rates would barely dent China's huge competitive advantage in the fields where it is strong. So macro policy, especially exchange rate policy, can only do so much.

And in any case it fails to understand that we are dealing here with a much bigger phenomenon. As is shown by the latest arrival on the scene. India.

In the western world, the emergence of China, like the rise of Japan before it, has often been seen in terms of its sectoral impact on the economy. Cars and TV's can be packed onto a ship and moved across the ocean; services can't. And so those who worked in services have had the benefits of cheaper goods, while those who work in manufacturing have seen their wages cut and their industries contract - or even close down altogether. We used to say that the US and Europe made up most of the "industrialised countries." But "industrialised" no longer properly defines economies where more than three in four now work in services.

According to the so-called Gini quotient, which measures income distribution and disparity in countries, the World Bank now indicates that China and the United States have reached about the same level, which is about 40. On the scale, a 1 is about where everyone in a country is economically equal, and 100 is where one person has all the money. Other countries, like Brazil, Guatemala, and South Africa are up at around 60. Most European countries are down in the 20-30 range. That is an interesting indicator of the growing income disparity in China. There is also data that urban disposable income grew in 2002 at about 14 percent, whereas rural disposable income only grew in 2002 at about four percent. The Chinese leadership understands that they are going to have to work on this income distribution problem in a way that avoids social instability.
Source: The Gini quotient

To understand what is happening now it is perhaps instructive to go back to the Alpine valleys of Switzerland nearly 150 years ago. Isolated and with bad transport links to everywhere, the inhabitants had already learned to seek high value per kilo in what they produced, building the Swiss watch industry to use the long winter. But that was only a solution for some of the people. Lush pasture fed the cows whose bells tinkled across the valley; and they produced copious quantities of lush milk. But Switzerland is a small country, milk is plentiful everywhere within a reasonable distance and it goes off quickly. One solution was to condense it and put it in tins as a Mr. Nestle did, but that required the product to be cheap enough to compete with fresh milk produced nearer the markets. So after much research they came up with a breakthrough and Presto! milk chocolate was invented.

That's not the only example of finding a way to export something in the guise of something else. Norway has enormous capacity for hydro power but little use for it in its remote areas. And so we have aluminium, the production of which eats up enormous amounts of electricity. So we come to the unexpected consequence of the electronic revolution of the past decade. For this has given India a way to export labour as services without any physical transportation of goods at all. 

Hartford Connecticut used to call itself the insurance capital of the world and 50 years ago enormous amounts of paper used to make their way there to be processed as premium payments or as claims. Computerisation took its toll of many of the jobs there quite early, but for many there remained much work dealing with the outside world. This required a capacity to speak English well above that of any computer, a reliable postal system to communicate quickly and reasonably priced phone and data connections. All of these effectively limited sourcing to the US for US insurance companies.

Now along comes India, with a very large population with extremely high proficiency in English, an education system producing graduates of exceptionally high attainment levels in subjects which employers want and, the final piece in the jigsaw, access to an international phone system where costs of international calls have collapsed to levels little above those for a short distance call in the US.

Any service which can be delivered over the phone or internet can now operate in India as easily as Indiana for a US or UK consumer. The most often quoted example is the rise of call centres, themselves a new phenomenon which were hailed as the source of jobs for the future to replace those lost in manufacturing.

Like the production line jobs which have gone, these are not traditionally the sort of jobs which graduates would expect to take. But people in India with a degree will do them for far less than those they replace in the market they serve. They will even learn an American regional accent and avidly follow the fortunes of a baseball team to give a sense of familiarity to the clients.

As a growing number of large organisations are beginning to realise, there is no reason why this should only work for low-end jobs. India is the world's second software giant after the US. Many organisations have tried moving a part of their software work out of the UK, for example. In most cases the quality available in India is so much higher that they very soon want to move all of it.

So the old demarcation line between manufacturing exposed to newly-industrialising countries, and service sectors de facto protected, is breaking down. What new lines might be drawn?

An obvious one, and one which will hold is that if something MUST be done in a particular place then it WILL be done there. You can buy a computer on the internet, but someone has to deliver it physically to your home. You can only sweep the streets of Birmingham if you are in Birmingham.

But invention can change more of this than we think. Ten years ago, if you wanted new software for your computer you had to buy disks which were delivered by post or sold in a shop. Now you just download from the web.

Another demarcation line is what is provided by government. Most governments are more open to political pressure to keep jobs than most private companies are. But here is where the market comes into play. If governments do not use the much cheaper sourcing available to them, the relative price of the services they provide will rise. Voters will want to switch to cheaper private alternatives. And so the scope of things which are provided by the government will narrow.

Because all of this change is really about something very simple. Price. Over the past 15 years the supply of labour has increased dramatically in a huge step; the amount of capital available grows steadily but has not had that leap. Thus the relative prices at which these goods trade and the relative prices within the labour market have changed. It is not new that a change in the ratio of capital and labour changes the relative prices they can command. The Black Death killed people but left capital intact. And so for a long period after real wages were higher. For those who survived.

'Because all of this change is really about something very simple. Price.'

Consider a company with two employees, one a production line worker and one a manager making decisions about products, marketing and future action of all kinds. The company can sack the production worker and buy its product from overseas; but it can't sack the manager without ceasing to exist as an entity. Thus the relative power of the two is changed. Over time, either the company will move production to China or the manager will succeed in getting the production worker to take lower pay per unit of output.

But both of them have to reckon with the fact that the investors who put capital into the company can switch their capital out of it altogether to a company somewhere else in the world which takes advantage of the lower costs there. So the rate of return has to be higher.

Much of modern politics in the west is about how the political process interacts with this set of decisions. And we are only just beginning to see how big a set of changes we face.

David Blake is an executive director of Goldman Sachs and a former economics editor of The Times of London. He is writing in a personal capacity.
Journal Index Next Article ->
Home |  Advisory Board |  Case Studies |  Journal |  Contact   © 2003-2017 Montrose Associates. All rights reserved.