A Multipolar World Economy?

Paper for NZIIA Seminar “New Zealand and the BRIC Group”, 24 November 2009

It may be useful to first read New Developments in Trade and Trade Theory.

Keywords: Globalisation & Trade;

I begin with a question; its answer eventually leads to an extraordinary scenario for the future of the world. ‘What two countries had the largest manufacturing sectors 200 years ago?’ To avoid it being a trick question, your answer may use today’s national boundaries.

The short answer is that the two countries were China and India, which between them had over half the world’s manufacturing. Of course the industries were primitive compared with today’s, but that was true everywhere.

Manufacturing Output (World Total Share: Percent),

	1750	1800	1860	1913	1938
Britain	1.9	4.3	19.9	13.6	) ) ) 92.8 ) )
Other Europe	21.3	25.8	33.3	43.0
US & Canada	0.1	0.8	7.5	32.9
Japan	3.8	3.5	2.6	2.7
China	32.8	33.3	19.7	3.6	3.1
India	24.5	19.7	8.6	1.4	2.4
Other	15.6	12.6	8.4	2.8	1.7

Source: B. H. Easton (2007), Globalisation and the Wealth of Nations, p.180.

Yet a mere 60 years later they had lost their dominance and were down to about a quarter of the world’s manufacturing with over half supplied by Europe including Britain. Just fifty years later, at the time of the First World War, China and India’s share was under 5 percent, Europe still provided half, with the United States (and Canada) providing about another third.

What is striking is that before the age of globalisation, manufacturing was distributed according to population. But as the world economy integrated, manufacturing concentrated in a few regions. My interest today is not why manufacturing ended up in the North Atlantic economies – something economic histories detail. The critical fact, here, is that in a relatively short period the manufacturing sector shifted from one based on where the population was, to a much greater locational concentration. Up to the era of globalisation population attracted manufacturing; after it manufacturing attracted more manufacturing

I am now going to describe an economic model which explains that shift. Not in detail, because the mathematics is a bit demanding – you can find the details and extensions in my book Globalisation and the Wealth of Nations and the mathematics in The Spatial Economy, Cities, Regions and International Trade, by Mashito Fujita, Paul Krugman, and Tony Venables. You will observe that one of the latter authors was awarded an economics prize in honour of Alfred Nobel last year, an indication that the model I am using is pretty well established, if not in New Zealand.

I am not using the model just because it gives a good explanation for the past. It also has intriguing predictions for the future, suggesting the same forces which concentrated industry in the past two centuries, eventually lead to a return to a world economy of manufacturing occurring where the population is concentrated – to a recovery of India’s and China’s place in the industrial world.

The model is based upon two economic processes. The first is the falling costs of distance. The second is the economies of scale which exist in manufacturing, so that as production increases in a factory or localised industry the average cost of production falls. The two coming together leads to a concentration of manufacturing.

Economies of scale are of little use if high transport costs mean that the factory has only a small market. As distance costs fall, the business can sell more and reap the economies of scale. Because these scale effects apply to industries as well as industrial plants, businesses cluster together, reducing their costs, reinforcing the concentration, especially as labour is attracted to the industrial centres.

Those who miss out on the industrial concentration – we know with hindsight it included China and India – are forced to remain in farming. But farming experiences diminishing returns – the more workers on the land the lower their average productivity. So the farm labour experiences low wages, and countries without a concentrations of industry are relatively poor. Ironically the successful manufacturers draw labour off the land, so the reverse happens there and farming in those countries ends up with high productivity.

Add in stories about capital formation, technological innovation, and service industries which reflect affluence and population; one has a portrait of the last 200 years of the world economy, especially if we extend farming to all resource industries and note that falling costs of distances – such as by telecommunications – makes some services tradeable like manufacturing.

The model considers what happens as costs of distance continue to fall. One possibility is that a region will move out of low income farming into high income manufacturing. That is what happened to the US in the late nineteenth century and to Japan throughout the twentieth. We sometimes forget that a century ago Japan was among the poorest countries in the world.

More subtly, the region of industrial concentration spreads out as congestion costs rise in the heartland. So the industrial revolution which began in Britain now extends to Finland and Spain; industry in the United States moved out from the north east to the south and west; Japan offshored industry to Korea and Taiwan.

Intriguingly, the model I have been using predicts a dramatic change when costs of distance fall far enough. At some point agricultural nations are able to use their low wages to undercut the products manufactured in the rich countries despite their higher industrial productivity. The poor agricultural nations become manufacturers too, and the cumulative causation from the industrial economies of scale and shifting workers out of farming into manufacturing now favours them. The model predicts the world will eventually to the pre-globalisation pattern of manufacturing (and tradable services) located where the population is.

Since about half the world’s population is in India and China, that is where manufacturing is going to relocate. Or rather, that is where it is relocating, for the trends the model predicts have been happening for about two decades.

There are a numerous predictions and challenges from this model. I have not time to look at them all, even important ones like how will rich economies response to this shift? Today I look at just two critical developments pertinent to this seminar.

The first is that we may expect a reversal of the long term fall in the terms of trade for foodstuffs (and other resources). As poor countries shift labour out of farming, their foodstuff production declines, while the higher incomes factory workers eat more food. With the supply shortage the price of food goes up, while the prices of manufactures now made with cheaper labour go down.

This pattern of rising relative prices for food has been happening for the last two decades coinciding with the shift of manufacturing to the poor economies. That is important for New Zealand’s prospects but it also says something about Brazil’s and Russia’s. Neither has a large enough population to be a great centre of manufacturing.

No doubt Russia could eventually join the European industrial centre as congestion further spreads out manufacturing. But first the growth will be in the emerging economies of East-central Europe, the Balkans and, even possibly, North Africa.

Brazil might hope to benefit from the US industrial centre spreading out. But the first beneficiary should be Mexico with the North America Free Trade Agreement as a facilitator. Mexico’s hopes of attracting US industry were cruelly dashed, when America leapt over the neighbouring country, and sourced instead from China.

Where Brazil and Russia fit into the world economy is a larger version of the same role as New Zealand. We and they (and Australia) have large resources relative to our populations so we are resource providers. Whether that will give us the sort of standard of living we aspire to is a matter which belongs to another venue. It is some comfort that unlike in the twentieth century the terms of trade for our exports may well favour us in the twenty-first.

The second development is that if manufacturing becomes based upon population, no country has a monopoly of the population, so no country is going to have a monopoly of economic power, There will be no hegemonic economic leader in the third century of globalisation as there was in the first two.

It is hard to get one’s head around this. American airport stores are stacked with books whose theme is that another economy is contesting for America’s economic supremacy: Brazil, Europe, Japan, Russia have all been fashionable – the current focus is China. But each book assumes that there will be a hegemon so the immediate future is a contest between the current holder and the next challenger.

What the books dont contemplate is that there are a number of challengers and the outcome will not be a single leader but an ongoing contest for leadership between four or five large economies – America, the European Union, China, Japan and (probably) India – which together make up two thirds of the world’s production. I am guessing that Brazil and Russia are too small to be top tier.

Share of World GDI (measured in the same – PPP – prices)

	1956	1981	2006
United States	25.8%	21.2%	19.6%
European Union*	28.8%	26.1%	19.0%
China	5.4%	5.4%	16.8%
India	3.9%	3.3%	6.1%
Japan	3.7%	7.9%	6.1%
Brazil	1.7%	3.0%	2.4%
Russia**	6.5%	5.1%	2.4%
Rest of World	24.2%	28.0%	27.7%
TOTAL	100%	100%	100%

Source: Maddison Data Base (European Union* & Russia** figures for 1956, 1981 are on 2006 boundaries). Note that the shares would be different if exchange rates were used.

How this contest will work out is deeply problematic. Much of the contesting will be political, but even there economic theory provides some guidance. We know a lot about competitive markets with many small firms, we know a lot about markets dominated by a monopoly; we even know a bit about markets dominated by a duopoly. But behaviour in a market with five major players is so very complex it is extremely difficult to make predictions.

Is that the world we are going into? Well no, we are already in it. The outcome of the Uruguay Round ultimately involved a settlement between America and Europe. That has not been possible in the Doha Round because, while China and Japan remain quiescent, India and Brazil, in association with other economies, have enough leverage to influence the outcome – or rather because they have enough leverage there has been no outcome.

Again the end of a single global leader is a far more complex issue than we have time to pursue today. I want to draw attention to but two issues.

The first is that it is going to be very difficult for the current hegemon to adapt to the loss of power. I observed Britain in the 1960s and the 1970s – even today – struggling with the fact it was no longer the economic hegemon it had been before the First World War, a fact obscured in the inter-war period by America’s insularism. It will be even more difficult for Americans suffering the same fate, because the world they understand is being replaced by a quite different, multipolar, one. The friends of America are going to have to put a lot of effort supporting it through the transition; pretending it is not happening is not support.

But, second, the multipolar world presents a challenge to New Zealand. In the past our international relations – economic, diplomatic and security – have depended upon a patron which was the hegemon. First it was Britain, then America together with the American acolyte Australia as a sub-patron.

How do we act when there is no hegemon? Do we stay with one of the big five or do we try go with all five or some of them? Sometimes a coalition of smaller states may matter, as Brazil is demonstrating in the Doha round. This issue of functioning in a multipolar world is going to puzzle New Zealand’s foreign policy for many years to come. We will not be alone, but given our unusual geographical isolation and odd economic structure we will have to find a unique solution to living in a world very different from that which we are used to. .