What Does ‘hollowing out Of the Economy’ Mean?

This note was prepared for some colleagues.
 

Keywords: Distributional Economics;  Growth & Innovation;
 

Th phrase ‘hollowing out’ is often used to cover a multitude of poorly thought through ideas which have lots of rhetoric but perhaps not much intellectual content. Here I am going to try to give the notion some analytical rigour to the notion of hollowing out of the economy as far as New Zealand is concerned. (There is also a literature on the hollowing out of the middle class but that is a different phenomenon. See my http://www.eastonbh.ac.nz/?p=817.)
 

Hollowing Out and Offshoring
 

Chapter 15 of my recent book ‘Globalisation and the Wealth of Nations’ discusses hollowing out as a part of policy towards the welfare state. Its basic mechanism is that the process of offshoring – which is an increasingly integral part of globalisation (see chapter 7) – leads to some parts of the labour market being affected more than others. Here is a brief extract form the book:
 

Throughout the rich world in recent decades there has been a steady ‘hollowing out’ of those manufacturing and service activities whose products are traded relatively easily. Despite the costs of distance, lower-paid offshore workers have become increasingly successful at supplying many products.
 

The following schematic figure sets out the problem. It divides the economy into quadrants, separating the tradeable sector (the sector exposed to foreign competition) from the non-tradeable sector (which is not exposed directly to foreign competition), and subdividing both sectors according to whether they are dominated by skilled or unskilled labour.
 

<>  <>Economy
<>Tradeable Sector
<>Non-tradeable Sector
<>Labour Force
<>Skilled
<>  <>  <>Unskilled
<>Hollowed-out Sector
<> 

 

It is the tradeable/unskilled labour force quadrant which appears to be hollowed out by the relocation of manufacturing offshore. There will still be some unskilled jobs in the tradeable sector (such as janitors for high-tech manufacturers), and there will also be unskilled jobs in the non-tradeable sector. But a substantial number of low-skilled jobs will be lost. In this context, ‘skill’ is not some absolute notion. The issue is whether the particular labour skills are available offshore at wage rates low enough to offset the distance costs. If they are, the product will be sourced offshore and local employment will diminish.
 

Thus the consequence of such a hollowing-out is a fall in demand for ‘unskilled’ workers from the sector. Their personal options are to move to other sectors, to upskill themselves to levels which the offshore worker cannot meet (at least, not immediately), to become unemployed, or to take wage cuts sufficient to make them competitive with the low-paid offshore workers. Other than upskilling – which is unrealistic for some workers, even if the facilities exist – none of these options are particularly attractive to those involved.
 

The public policy option might be to protect the industries from the offshore competition by measures such as tariffs and import controls, so that local consumers are forced to purchase the product from the more expensive local producers. The fact is the historic tendency has been for public protection to fall, while natural protection from the costs of distance have been also falling.
 

The bitterly fought case for and against protection is discussed elsewhere in this study. Here we observe that if the rest of the economy purchases high-cost products from a protected sector it is, in effect, transferring income from the general populace to those in the protected sector. Thus hollowing out generates pressures which compromise the social market economy, because it removes from some workers the protection that was part of the historic compromise.
 

(Moreover there was a second pressure on the social market economy. Although the mountain will not come to Mahomet, Mahomet can go to the mountain: if cheap labour cannot be embedded in exports of goods and tradeable services, the labour may be able to export itself to provide services in the non-tradeable sector. And so the chapter goes on to discuss how unskilled immigrants might also be though as hollowing out the economy.)
 

The policy implication might be that we need to shift the labour force into areas which are less likely to be offshored (which is what why we should be concerned about upskilling) and into industries which are less prone to offshoring (which is why we should be concerned about the sunrise industries dependant upon new technologies and creativity), and to modify the welfare state (which I have discussed in a recent paper The Globalisation of the Welfare State to be published next year.)
 

Hollowing Out and the Rising Terms of Trade
 

There is a particular form of Hollowing Out which is currently puzzling New Zealand, and which is not quite covered by Chapter 15. The analytic foundations are in later chapters in the book, but I wont go into them in any detail.
In the earlier part of the book I am observing the effects of technological change which reduce the costs of distance, and make off shoring more effective. In the later part of the book I observe that the theory also suggests that there will be a long term increase in the price of food (and other resource based products) relative to the price of manufactures – the technical term for this is a rise in our ‘terms of trade’. (There is a heuristic description in a ‘Listener’ column at http://www.eastonbh.ac.nz/?p=867.)
 

What this means is that certain activities become more profitable (give a greater return on capital). The obvious example is apparent in the rise in dairy prices, but I expect that in due course meat prices will rise too – and also the price for some of our other important exports (fish would seem to be a certainty). Since those activities are more profitable, their production will expand and that involves drawing resources (let’s focus on the labour resource) from other sectors. As it happens (to a first approximation) the resources have to be drawn from other tradeable sectors, rather than from non-tradeable ones, since we are not going to reduce (much) our consumption of those products we cant import. (Tradeable sectors are those whose products can be imported and exported – one of the points the book makes is this now applies to some services.)
 

That means that the other tradeable sectors – those which dont experience a benefit of higher terms of trade – are going to contract (relatively) as the resources from them get drawn off.
 

Historically the argument was about the sectors where there was the resource draw-off was the import substituting sectors. As a result we have hardly any import substituting industries left. So the draw-off of resources which the expanding industries needs comes from other export sectors (since it cant come from the non-tradeable sectors and it cant come from the nonexistent import substituting sectors).
 

This is a long tortuous argument to get to a conclusion which is now obvious and which is happening. We must expect to cannibalise some export industries to make room for expansions in those export sectors which become more profitable form higher overseas prices. That is what we see when various clothing manufacturers offshore their production processes while – and this is important – maintaining their design work in New Zealand.
 

This is but another example of one of the most routine ways of improving economic performance. Getting out of low productivity industries into high productivity industries is a key element of the economic development strategy, although – wrongly in my opinion – we place little emphasis on that shift at the heart of the development process.
 

To add three more points:
 

1. The hollowing out arises because New Zealand is generally benefiting from rising terms of trade. The market economy mechanism which does this is a rise in the real exchange rate. We are seeing that. Had dairy prices not risen as much as they have, our terms of trade would be lower, and so would our exchange rate. (I note that there is a general acceptance that there are other things driving up the terms of trade including the stage of the New Zealand business cycle, the severe imbalances in the world economy, and also – in my view – a monetary policy framework which is overly crude.)
            One of the effects of a higher real exchange rate is that some of the gains of the higher terms of trade are shared through the economy as a whole in lower prices to all consumers and not just confined to the dairy (or whatever) sector. At the same time some of the other exporting becomes unprofitable, and so they close down – hence the hollowing out.
 

2. While higher terms of trade are beneficial for the economy as a whole (obviously since we are getting better prices for what we produce), there will be some people worse off – at least in the short run. The largest group are those who lose their jobs in the hollowed out industries.
 

3. I have written above what I have understood, but there is much of this process I have not yet understood. Indeed some key questions are not even properly formulated. As a result I am hesitant to come to any policy conclusions about the response to hollowing out, although as best as I understand it, there is nothing in the Economic Transformation Agenda which we would want to abandon had we a better understanding of the hollowing out phenomenon.
            I apologise for not having not more enough progress. My book Globalisation and the Wealth of Nations represents an enormous step forward, some of which is beginning to trickle into policy thinking. (Its all obvious of course, once its been explained – like the theory of relativity.) However, when I asked for further funding to progress the work, I was told there were higher priorities. (Some of the higher priorities seem to me to be quite eccentric.)
 

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