Wairarapa Institute of International Affairs: 25 May, 2011.
Keywords: Globalisation & Trade;
It is easy thinking about the future by projecting recent trends. But if the past is a foreign country, so is the future . Tonight I am going to paint a scenario of a world economy which will be very different from anything we have experienced in the past.
It is a globalised world economy, something which has existed for only a couple of centuries, but it differs dramatically from the past because there will be no single economy which will dominate the globalised world, as Britain did in the nineteenth century and America did in the twentieth. Rather it will be a multi-polar world with a number of large economies contesting with one another, but none will be able to dominate the world economy. That poses an enormous challenge for small and relatively isolated economies such as New Zealand; the purpose of this presentation is to get you to think about that future world.
I am going to be talking about the world economy, and will have little to say about the military scene and about the environment. Economists are not military experts – I am certainly not. We tend to assume that military power is related to economic power, although with a lag. In particular a nation can get over-committed militarily, as Britain was for decades after the Second World War – some would say America is today. That will drain the economy. The evidence is that military adventures do not contribute in total to economic performance. While some sectors benefit, most suffer. So military activities may speed up or slow down the new balance of powers rather than fundamentally change the long run. However if there is a nuclear war, say, all bets are off.
There are complex interactions between the environment and the economy. I have not time to deal with them all tonight, but they are there, implicitly or explicitly, in the analysis.
To understand where the world economy is going, it is useful to start 250 years ago. Then there was not really any world economy as we know it. There was a little international trade but that was mainly of extremely valuable goods which could not be locally produced: ‘quinquereme of Nineveh … with a cargo of ivory, and apes and peacocks, sandalwood, cedarwood, and sweet white wine’ or the ‘stately Spanish galleon … with a cargo of diamonds, emeralds, amethysts, topazes, and cinnamon, and gold moidores’. In contrast the work horse of the globalised world was a ‘dirty British coaster … with a cargo of Tyne coal, road-rails, pig-lead, firewood, iron-ware, and cheap tin trays.’ Today’s container ships may be more stately but they carry pedestrian mass products – perhaps for The Warehouse.
We usually attribute this transformation to industrialisation with its factories exploiting new technologies and economies of scale. But there was another crucial factor. The costs of distance – of communicating, transporting, connecting – began falling strongly about two hundred years ago, with better navigation, steamships, railways, containers, cars, telecommunications and so on. That enabled factories to reap the economies of scale, using the lower costs to undercut local production elsewhere.
The economies of scale do not apply just to a single factory, they can apply to an entire conurbation; the larger its manufacturing sector, the lower its unit costs. Economists call that effect ‘economies of agglomeration’. It is thought these economies of industry scale are more important than those of scale in a single factory. They explain why manufacturing clusters in urban centres, rather than spreads evenly throughout a land.
The first manufacturing agglomerations were in Britain. As congestion costs rose and the labour supply ran out, the clustering extended to the European Triangle of Britain, Berlin and Paris, and then south to the Mediterranean states and east as far as Finland. It is still extending east to the ex-satellites of the Soviet Union.
The European cluster also extended west across the Atlantic, for while North America is geographically a long way from Europe, shipping costs were low and falling. What began in the US north-east extended into the mid-west and later to the south and Pacific west.
The American clustering even extended across the Pacific, as Japan industrialised. The forty-year Japanese boom is often seen to be a miracle, but when the economy reached the North Atlantic standard of living in about 1990, it switched to slower growth, as it began outsourcing to lower wage regions, just as the European triangle and the US North-east had outsourced before it; this time it was to South Korea, Taiwan and parts of South East Asia.
This explanation says that the post-war attempts by ex-colonies – here I include New Zealand – to artificially stimulate their manufacturing industries by protecting their domestic markets from imports were going to fail, because they did not have the economies of agglomeration. Instead they – this time I exclude New Zealand – were trapped into low-income agriculture.
Where the economies of agglomeration were strong, manufacturing had high productivity and paid high wages. The rural areas surrounding the cities had high wages in the agricultural and service sectors too. Since the rest of the world could not generate this high productivity, their wage levels were low. Thus the ‘great divergence’ between rich and poor countries
There were some exceptions. Economies with a valuable natural resource – like oil – can have high incomes. And so would agricultural economies that were underpopulated, like New Zealand. However, the vast majority of the world was trapped in low incomes and stagnation; although a handful located close to the industrial centres had the prospect of eventually escaping into medium or high wage economies.
In summary, a quarter of a millennium ago manufacturing was scattered around the globe in proportion to the local population. The falling costs of distance enabled manufacturing to concentrate in a few cities, thereby reaping the economies of agglomeration. Congestion costs prevent all the industries of the world centring in a single city, and so economic activity extends to nearby locations, while the rest of the world – with a few exceptions – is confined to low wage agriculture.
However, the model I have been using goes on to predict that as the costs of distance fall even further, manufacturing ceases to be concentrated in particular locations and instead reverts to where the population is. If distance costs are low enough, poor countries can get back into manufacturing by their low wages undercutting the superior productivity of the industrial centres.
That is what has been happening, as manufacturing has shifting from the great industrial centres to China; so once again China is one of the largest manufacturers in world – as it was 250 years ago. Today it is the third largest economy in the world in terms of material output (or GDP), although its per capita income is still low by the standards of the rich economies.
Industry has not shifted as rapidly to India as it has to China, although its population is almost as large as China’s, and growing faster. This is partly because it is not as well located as China – its supply links to Japan and America are not as direct across the Pacific.
It also has yet to get its act together. The chief executive of a big Indian industrial export companies told me that the consolidating ports they use – where they send their product to be shipped to end destinations – are Singapore to the east and Dubai to the west. Years of inward-looking import-substituting industrialisation means there is not one in India. When there is, you will find a dynamic manufacturing sector close by.
Despite being a service, information technology is like manufacturing in that cheap cabling means low costs of distance, enabling it to agglomerate into clusters anywhere in the world. India is well hooked into the international cable system, and its IT sector – ranging from call centres to software – is vibrant and growing. China does not have India’s advantage of a people fluent in English and is not doing as well in IT.
As a result of this relocation of economic activity, India and China are each already among the five largest economies in the world. The other three are the United States, Japan and the European Union.
We often overlook Europe because we are so backward looking and see it as a set of independent nations. Politically it may be, but economically it is the world’s largest economy, albeit only fractionally larger than America. Europe is having its troubles; any area trying integrate its economy as fast as its ambition is bound to have difficulties.
There is a severe one at the moment, highlighted by the financial difficulties Greece faces. Because it is locked into the European Monetary Union, Greece does not have enough policy freedom to deal with its fiscal difficulties in a politically sensitive way. Meanwhile the rest of the EU states are too cantankerous to find a solution. But whatever happens to Europe’s financial arrangements, we can expect a Europe integrated in its product and capital markets, increasingly integrated in its regulatory framework, and clumsily integrated in its labour markets.
New Zealand has long neglected the European market. Fifty years ago the current members of the EU took four-fifths of our exports, today they take one-fifth. Yet the dramatic loss of market share has been barely a public concern. It has not as if we have done well generally – our share of world trade has fallen.
The second largest economy in the world is that of the United States. For over 70 years the US has been the hegemonic leader of the world economy; it has its largest military force – the only global one. The relative rise of Japan, China and India and the increasing economic integration of Europe means that the US is gradually losing that hegemony. This is inevitable, given a relocation of industrial activity.
The US will continue to remain a large economy in the world, and will have a weight and power reflecting that size. But its leadership role will be blunted. It is not even obvious that the US dollar will remain as central to the world financial system as it is today. There are respected American economists who say this change hardly matters to the US; it may matter to the world.
The loss of American hegemony poses various problems, not least that the US may not recognise it, and overreach itself, just as when Britain lost its global hegemony 70 odd years ago, it maintained a military presence far in excess of what its economy could bear. Some argue that the US involvement in Iraq has been similarly ruinous. Yet, what happens when the US scales down its military aspirations to be more in line with its economic size? Who will fill the vacuum; how will it be filled?
Perhaps global hegemony is so central to the Americans’ national psyche that some overreaching is inevitable. Certainly there are American intellectuals who are aware of the changing role of the US, but they are not listened to. I thought Obama touched on this reality in his presidential campaign, but the politics of the presidency has given him little room to move. There is the gloomy possibility that America is becoming ungovernable; the congressional deadlock over the budget may be just the beginning. Perhaps it and the rise of the Tea Party reflect an unthinking, barely understood response to declining US hegemonic power, even though the response may accelerate the decline. What prospects are there for the world economy in which one of its largest economies and the issuer of the international currency cannot run a disciplined fiscal stance?
We see only dimly what this multipolar world will be like. One thing is certain; while the US may no longer be the hegemonic player in the world economy, it will not be replaced by another dominant power. Much of the popular literature is about a contest between America and some other country vying for hegemonic dominance – the Soviet Union, Europe, Japan China or whomever. It is a thinking fixated on the past, of a globalised world with a dominant economic power.
No country is big enough in a multipolar world to lead unilaterally; the others can gang up on it. That can mean deadlock, as has happened over the Doha Trade negotiations, or is likely to happen over a world regime on carbon emissions; and it may happen as they try to sort out the world financial regime. While we know a lot about how to think systematically about a world in which there is one dominant player, and a bit about a world in which there are two major contestants. once there are a number of large players the analysis has no simple insight. That is the world regime we are entering.
In expecting there to be four or five large economic players in the future world economy, I am not including such countries as Brazil, Russia and South Africa. Each is less than half the size of the smallest of the big five, and is unlikely to catch up. The new world regime will have a second tier of countries: those three, one or two from the Middle East, possibly Australia may have a significant role. But the list is limited and it certainly does not include New Zealand.
Three of the big five – those not in the North Atlantic – are Asian. It is the largest continent and it has some of the largest populations. I shant say much about Japan. It is the smallest of the five as measured by GDP – India seems to have just passed it – but it is rich like the North Atlantic economies. It also has very large foreign reserves, although they can be easily squandered, as Britain did during the Great War. The international future of Japan may be as the centre of group of East Asian economies who do not want to get too close to China.
China is currently the growing economic power. It is easy to project the recent past way into the future and conclude that one day the Chinese economy will be huge – larger than any other. I am cautious, for at least five reasons.
First, unique in the developing world, China has an aging population, with population dynamics even more problematic than most rich countries’; theirs can be moderated by immigration in a way that China’s cannot. How quickly will China’s aging population become an uncomfortable burden? There is some evidence that there are already labour shortages which are leading to higher wages which may make some exporting unprofitable.
China’s second problem is that it has serious environmental challenges (as has India) including water shortages, water pollution and dirty air, which may retard or divert its development path.
Its third problem is governance. China is not what we would call a democracy, but its development is creating a middle class who are likely to be increasingly uncomfortable with current political arrangements. Their demands may not be exactly the same as those of Western middle classes, but they will be more like them than they are currently experiencing. The Chinese leadership has been struggling with these tensions since Tiananmen Square – with some success. But incumbents regimes tend to be conservative, and may not respond sufficiently to the growing aspirations of the population without upheaval. One of the geniuses of the West is that it institutionalised the turmoil into regular elections which allows it to throw out backward incumbents, incentivising those in power to be responsive. Even more important is freedom of expression and the elimination of corruption – governments are falling in India, where it is also endemic, because voters are fed up.
The fourth problem China faces is really the world’s. It is such a big economy that its growth will create feedbacks which stifle it and disrupt the world’s economic arrangements. The enormous Chinese foreign savings which fuelled the US financial boom and the resulting Global Financial Crisis is an example. Importing countries cannot absorb China’s exports if they continue to grow at their current rate; China has the possibility of switching to greater domestic consumption – which would also assuage some of the demand of the middle class. That wont avoid, though, China’s competitiveness being undermined by its inefficient gargantuan appetite for oil and raw materials driving up their prices. And what happens internally when China gets to the point that Japan did in about 1990, and the growth rate slows down to the world average?
The fifth danger is the Chinese banking system. We dont know enough about it to be able to assess how just robust it is, but the sniff test suggests that many of its banks have unsatisfactory balance sheets, that the system is fragile and with the wrong shock it could crash. That may be why the Chinese government has been unwilling to float the renminbi because reducing capital controls could expose the vulnerability of their banks’ balance sheets. Some time in the not too distant future the Chinese banking system may get into serious difficulties, perhaps like the South Korean banking system which collapsed in 1998; although given its vast foreign exchange reserves a Chinese banking crisis would be probably be resolved differently.
So we cannot assume that the Chinese economy will continue to expand as rapidly as it has. It may even experience a period of financial or social turmoil, or both. The Chinese motor may not drag the world out of the Great Recession.
There is a sort of racist view that the Chinese leadership comes from a very old civilisation and is going to wait the West out and ultimately dominate it. Sure, their leadership may be inscrutable but that is because it is a collective which deliberates in secret and does not have to account to its public. The evidence is that the leadership is well aware of the complexity of the tasks it faces, knows that it is inexperienced, and responds cautiously.
India is just as old a civilisation, but its geography has been much less conducive to a centralising power. Other than cricket, New Zealanders dont have a lot to do with India. It is just out of flying range – but will be inside within a few years – and we export seven times as much to China, although the gap will diminish after we sign a free trade agreement with India at the end of the year. Yet India is the fourth largest economy in the world, and it is growing rapidly. It hasnt an aging population; its population will overtake China’s in about 2030.
There are many ways India differs from China. It is poorer – a third of the world’s poor live in India – less literate, more ethnically and religiously diverse, more politically decentralised and less politically repressive; it has even more problems with its neighbours and it is 70 percent rural, whereas China is only 50 percent. In my recent visit sponsored by the Asia New Zealand Foundation I left both excited by its diversity and promise and frustrated by its paradoxes and failures.
Again dont expect a smooth growth path. Capitalist economic development is like a wobbly bike; it needs to go forward to stay upright, sometimes it falls over, but eventually it gets there. The Chinese will learn that lesson too, although its bike may not be wobbly enough. It is good at replicating simple production processes developed offshore, but it may not be able to develop the cluster of advanced technology firms which lifts the economy into the top bracket of high incomes. Because it is more decentralised – more chaotic – India may; one might cite Infosys, one of the largest IT firms in the world based in Bangalore, as an example of an Indian success which the Chinese may not be able to replicate. (The caveat is that cycles need roads; the Indian infrastructure is far inferior to that I found in China.)
How should New Zealand engage with this evolving world? First, we need to be realistic about our role. It is very marginal. We may have particular responsibilities in Polynesia and Antarctica but they are hardly world priorities. Were New Zealand to sink beneath the sea the United States would send an aircraft carrier to the location; it would drop a wreath and – sail home.
Our economic role has been an extension of the North Atlantic economy, providing it with the food and other raw materials which enabled it to release its farm labour into high productivity manufacturing. We have been able to do this and generate high incomes because there has not been a lot of us. New Zealand is about the same area as Britain, but has one twentieth of the population.
New Zealand is likely to remain a food and fibre exporter supplemented by tourism and a few other things. I doubt we shall become a major world class exporter of manufactures. Certainly we should put effort into making Auckland and Christchurch global cities, exploiting economies of agglomeration, but our ambitions should not overreach.
Prices for food and fibre (and energy) are probably going to rise faster than those for manufacturing. During the industrial concentration phase of globalisation, the surplus labour in poor countries depressed their wages and the price of food and raw materials. As distance costs fall further, and the globalising world moves into the second phase where industry moves back to the centres of population, the poor workers flow out of low productivity agriculture, while increasing their demand for food. Food prices rise, as has been happening in recent years as a result of Asian industrialisation. Of course there will be hiccoughs.
We need to avoid becoming as over-specialised as we were up to 1966, when nine-tenths of our exports were processed grass and two-thirds went to Britain. We should not just be a commodity exporter, but seek to process the food and fibre in sophisticated ways. We should not place too great a reliance on China but have a variety of export destinations. That is why we need free trade deals with India and Europe.
The need for free trade agreements reminds us that trading is not simply about private initiatives; it takes place in a public context. One of our competitive worries about the Australian-US FTA was that if some hitch occurred – perhaps a foul-up at a port – the Australians would get preferential treatment because that is in the agreement.
The issue becomes even more intense during multilateral trade negotiations. We felt our interests were being ignored during the Uruguay Round. We pointed out to the US State Department that the ANZUS Treaty – which was in force then – required mutual support over all security matters including economic threats. The US then helped us to get the negotiations to take greater attention to our trade concerns.
So even if you take the extreme position that our international stance should be confined only to trade and economic matters – ignoring security, human rights, foreign aid and everything else – New Zealand would still have to have political relations with other countries. How to do this in the multipolar world?
When there was a hegemon we treated it as a patron; that was not hard because so many of us came from Britain and spoke a language distantly related to American English. Do we continue to tuck in behind America as our patron even as its power diminishes? Or perhaps go back to Europe? Do we switch over to China, which is likely to become our biggest export market? Perhaps Japan, which may offer a more diversified Asian connection? Can we ignore India given its size and our cricket ties? Where does Australia fit in?
We need to connect with all of them. That is easier to say than to implement, but you will see an ongoing but subtle transformation of New Zealand foreign policy from depending on a single patron to a more sophisticated relationship with each of the big five and Australia.
That means more trade agreements. Multilateralism like the Doha Round has ground to a halt – in part because America is no longer dominant enough to guide the world to a conclusion. We will make bilateral deals like the FTA with India; we should seek one with the European Union. Plurilateral deals, involving a number of countries – the TPP is an example – are attractive. Although all deals will make some of us worse off, hopefully more will be better off. Of course we should never do a deal where there is no net gain to New Zealand.
Had I the time I could explore future economic relations in greater detail. But it would not be a complete vision, for our trade policy has to articulate with the rest of our foreign policy, where I have little expertise. However tonight has been sufficient to have set out an analytic framework to understand the future evolution of the global economy, to convince you that the multipolar world will be very different from anything that has preceded it, and to suggest it presents an enormous challenge to tiny New Zealand. To meet the challenge we must first think about it.