From Globalization to Localization?

There seems to be no stopping the powerful forces of globalization. Not only has the world just completed four years of the strongest global growth since the early 1970s, but in 2006, cross-border trade as a share of world GDP pierced the 30% threshold for the first time ever.

The latter represents almost three times the portion prevailing during the last global boom over 30 years ago. What a great testament to the stunning successes of globalization!

On another level, however, there are increasingly disquieting signs. That’s because of a striking asymmetry in the benefits of globalization. While living standards have improved in many segments of the developing world, a new set of pressures is bearing down on the rich countries of the developed world.

Most notably, an extraordinary squeeze on labor incomes has occurred in the industrial world — an outcome that challenges the fundamental premises of the so-called “win-win” models of globalization.

Ricardian comparative advantage tells us that the first win goes to low-wage workers in developing economies who enter the global economy — initially through their involvement in export production — and eventually as a new class of consumers.

The second win is presumed to benefit the rich nations of the developed world — where consumers can expand their standard of living by buying low-cost, high-quality goods from poor countries and where workers can ultimately gain from being involved in the production of more sophisticated products exported to increasingly prosperous developing economies.

It is a great theory — but it’s not working as advertised. The first win is hard to dispute. China has led the way, with more than a quadrupling of its per capita GDP since the early 1990s.

Other developing countries have lagged the Chinese experience but have still made considerable progress in boosting living standards. India’s standard of living, for example, has more than doubled during the past 15 years.

Moreover, according to IMF statistics, per capita GDP in Eastern and Central Europe is likely to have expanded at a 3.6% average annual rate in the decade ending 2007 — a dramatic acceleration from the 0.3% pace of the prior ten-year period.

In the Middle East, a 2.7% trend in the growth of per capita output in the decade ending 2007 would be nearly double the 1.5% pace of the previous ten years.

Developing Asia stands out from the rest of the pack, with a 6.2% average annual increase in per capita GDP estimated over the 1998 to 2007 period — little changed from the vigorous 6.3% trend over the 1988-97 interval.

Moreover, the first win hasn’t just gone to labor. Four years of extraordinary returns for emerging market stocks and bonds underscore impressive returns to capital, as well. The problem lies with the second win — the supposed benefits accruing to the rich countries of the developed world.

That’s where the going has gotten especially tough. Following the example of the United States, in recent years, the benefits of the second win in major industrialized countries have accrued primarily to the owners of capital — at the expense of the providers of labor.

At work is a powerful asymmetry in the impacts of globalization on the world’s major industrial economies — namely, record highs in the returns accruing to capital and record lows in the rewards going to labor.

The global labor arbitrage has put unrelenting pressure on employment and real wages in the high-cost developed world — resulting in a compression of the labor income share down to a record low of 53.7% of industrial world national income in mid-2006.

With labor costs easily accounting for the largest portion of business expenses, this has proved to be a veritable bonanza for the return to capital — pushing the profits share of national income in the major countries of the industrial world to historical highs of 15.6% in the second quarter of 2006. This asymmetry in the second win is not without very important consequences.

In days of yore — when labor and its organized unions actually had bargaining power — the current squeeze on labor income in the developed world would have undoubtedly resulted in some form of a “worker backlash.”

In today’s increasingly globalized world, however, workers have no such power. Declining union membership throughout the major economies of the industrial world underscores the loss of labor’s bargaining power in an era of globalization.

Union members as a proportion of employed wage and salary workers has fallen dramatically since the early 1970s. Sharp declines are evident in the United States, Europe, Japan and the United Kingdom — with a modest drop in Canada being the only real outlier.

The United States stands out with a unionized sector that is less than half the size of that evident elsewhere in the major developed economies.

The political response in the United States deserves special attention. Most importantly, it has not arisen out of thin air. Rather, there are important macro-analytic reasons behind this backlash.

Unlike in Europe and Japan, where relatively stagnant real wages have matched up quite closely with weak or declining productivity, in the United States, real compensation has been going nowhere in a rising productivity climate.

Over the five-year period from 2001 through 2005, real compensation per hour in the non-farm business sector expanded at just a 1.4% average annual rate — less than half the 3.1% pace of trend productivity over this same period.

While we have been taught that, over time, workers are rewarded in accordance with their marginal product, that most assuredly has not been the case during the United States’ newfound productivity renaissance.

Moreover, recent research has pointed up the inequity of the so-called productivity dividend that has accrued to U.S. workers. These issues were not lost in the 2006 mid-term elections in the United States. Nor is the United States alone in tilting to the pro-labor left.

Italy’s Prodi is pro-labor, and in Spain, Zapatero is certainly more sympathetic to the plight of labor than Aznar was.

Meanwhile, in Germany, Merkel has tilted increasingly toward labor after she nearly lost the election running on a pro-market reform agenda.

Similarly, the Abe government in Japan has teamed up with the center-right in support of the “second chance society” — attempting to make certain that the victims in the rough-and-tumble arena of global competition are given the opportunity to come back.

And in Australia, Kevin Rudd, the opposition leader, seems set to center his platform on the struggle of the average worker.

I fully realize it is heresy to challenge the greatest mega-trend of our lifetime. So let me state categorically that I am not heralding the demise of globalization. What I suspect is that a partial backtracking is probably now at hand, as the collective interests of globalization succumb to the self-interests of “localization.”

An era of localization will undoubtedly have some very different characteristics from trends of the recent past. The most obvious: Wages could go up and corporate profits could come under pressure.

But it also seems reasonable to expect increased regulatory scrutiny of excess returns on capital — focusing, in particular, on the perceptions of excess returns in financial markets (i.e., hedge funds and private equity) as well as on the inequities of rewards at the upper end of the income distribution (i.e., tax cuts for wealthy citizens and the excesses of executive compensation).

Moreover, localization taken to its extreme could also spell heightened risks of protectionism — especially if the global economy slows and unemployment starts to rise at some point in the 2007-08 period.

Under those circumstances, localization could ultimately give rise to accelerating inflation, higher interest rates, greater volatility in financial markets and a potentially vicious unwinding of an over-extended credit cycle.

And, of course, the protectionist ramifications of localization could prove equally challenging for the beneficiaries of globalization’s first win: Dynamic new companies in the developing world and the employment growth they generate.

Don’t confuse prognosis with advocacy. Many of these potential developments, especially a drift toward protectionism, are without any redeeming merit, in my view. But this is what happens when trends go to extremes. In free-market systems, the pendulum of economic power then invariably swings the other way.

An era of localization will undoubtedly have more frictions than the unfettered strain of capitalism and globalization that has been so dominant over the past decade.

The big question, in my view, pertains mainly to degree — how far the pendulum swings from globalization to localization. The answer rests with the body politic. The repercussions lie in economics and financial markets.