Making globalisation work for all Ministry of Foreign Affairs of Denmark Unit for Analytics and International Economics April 2017

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1 Making globalisation work for all Ministry of Foreign Affairs of Denmark Unit for Analytics and International Economics April 2017 Abstract This paper tracks the development of globalisation from 1820 to the present. Three waves of globalisation are identified: The first wave began in the late 18 th century and ended with the interwar period. The second wave started after WWII, and the third wave of globalisation began around 1990 and continues to this day. All three waves have been powered by technological change and increasingly lower economic transaction costs, all have accelerated global economic growth and prosperity, and all have changed the distribution of income and wealth between states and within the nations. The current wave of globalisation may mark a turning point with regards to the distribution of the rewards of globalisation and technological change. This presents a risk of derailing globalisation, preferring short term gain for long-term loss. To prevent this there is a need for domestic public policies to manage the transition period and prepare societies for continuous economic and social change. Among the issues for national policy reforms are: Globalisation and technology How are companies, the labour market and individuals affected by globalisation and technological change, and what are the impact on productivity, growth, jobs and distribution? Will globalisation and technology continue to deliver vast global and individual economic benefits? Is a future with increased globalisation, artificial intelligence and robotics "more of the same" or this time is different? Free trade and protectionism How important is free trade and foreign investments for the growth potential of the global economy and individual companies. What policies can encourage and support companies adaptation to the global and digital economy and their continued competitiveness? And what are the drivers and the potential effects of increased scepticism to-wards globalisation and the spread of protectionism for the advanced economies? Globalisation and inequality What is the trade-off between on the one hand globalisation, technology and economic growth and on the other hand: social stability, national sovereignty and democracy? What policies can increase the benefits of international trade and cross-border investment, and also promote a more inclusive and fairer distribution of gains between countries and citizens, reconciling the long and short term interests? 1

2 MAKING GLOBALISATION WORK FOR ALL A note on globalisation and technology Globalisation has a long history. And globalisation is closely connected to technical progress, comparative advantages and political systems. Three major waves of globalisation can be identified. The first wave began in the late 18 th century and ended with the interwar period. The second wave started after WWII, and the third wave of globalisation began around 1990 and continues to this day. All three waves have been powered by increasingly lower economic transaction costs, all have accelerated global economic growth and prosperity, and all have changed the distribution of income and wealth between states and within the nations. It is difficult to separate the effects of innovation and globalisation, but the combined consequences of the two are shown in the panels below. Before the industrial revolution, economic growth was infinitesimal slow: It took several centuries to double GDP per capita; after the industrial revolution, it became a matter of one or two generations. The data shows an exponential increase in wealth (GDP per capita) in the G7 i from 1820 to 2008 (right hand panel, blue dots). The data also shows that the G7 share of global GDP increased from 22 per cent in 1820 to a highpoint in 1960 of almost 70 per cent (blue dots, left hand panel). This was achieved by only 17 per cent of the world s population. G7 countries compared to the rest of the world: GDP, population and GDP per capita. Data from Baldwin (2016) and Maddison (2013) ii However, starting around 1990, the G7 share of world GDP started to decline and fell to 45 per cent in 2014, while the share of world population decreased to about 11 per cent. The decline of the G7 share of the world economy did not reflect a decline in GDP per capita of the G7, although the rate of increase in wealth was slower than that achieved in the booming 1950s 2

3 and 1960s. Rather, the declining share was due to growth outside the G7 being faster than inside the G7 since 1990 (red dots, right hand panel). Globalisation, technology and international trade play a big part in explaining this development, along with political and economic change in China, India, the former Soviet Union and other parts of the world. It is a story of scientific discoveries, technological advances, improved health and better living conditions spreading throughout the world on the basis of international trade, investments and sharing of knowledge. Three waves of globalisation The first wave of globalisation Writing in 1817, David Ricardo first formulated the theory of relative comparative advantage in his book On the Principles of Political Economy and Taxation, laying down the theoretical groundwork for the mutual benefits of trade. He was writing at a time of exceptional bursts of scientific discoveries and technological innovation. Building on James Watt s improvement of the steam engine in 1781, Blenkinsop had made the first practical steam locomotive in The same year the first sea-going steamboat went from Leeds to Yarmouth, and in 1819 the first steamship crossed the Atlantic, heralding a huge drop in the costs and risks of long distance transportation. The decline in costs of moving goods by ship and rail made it possible to separate the physical site of production from the place of consumption. That separation was the precondition for large industrial and urban clusters to evolve, bringing with them unprecedented innovation, productivity gains, and scientific discoveries. Before 1800, the sum of exports and imports never exceeded 10 per cent of world GDP. This changed over the course of the 19 th century, when technological advances triggered a period of fast growth in world trade. Before WWI world trade peaked in 1913 with 29 per cent of world GDP. 70% 60% 50% 40% 30% 20% 10% 0% World trade over 5 centuries ( ). Per cent of world GDP Klasing and Milionis (2014) Penn World Tables Version 8.1 Upper bound (Estavadeordal, Frantz and Taylor, 2003) Lower bound (Estavadeordal, Frantz and Taylor, 2003) Esteban Ortiz-Ospina and Max Roser (2016) International Trade iii 3

4 This first period of globalisation validated Ricardo s theory of comparative advantage: It was obvious that every country would benefit by specialising in what they could do best and most efficiently, and engage in trade afterwards. For the advanced European economies, that meant specialising in high value-added production underpinned by modern technology. For most other countries it meant specialising in labour intensive production with lower remuneration, but through international trade, these countries would still reap much higher rewards than if left to themselves. As Ricardo had shown, Britain should specialise in cloth and Portugal in wine, and both countries would gain. Specialisation and international trade meant higher GDP growth and real wages for all parties. The second wave of globalisation Trade collapsed during the two world wars and in the interwar period due to international conflict, economic crisis and the rise of nationalism. After WWII, trade started growing again, reaching about 40 per cent of global production in 1990 and more than 50 per cent today. The rate of increase was even higher than in the first wave on globalisation due to declining costs of sea and air transportation, combined with the establishment of new international rule-based frameworks in the form of the UN, IMF, WTO (GATT), OECD and more to regulate international relations with regard to people, finance and trade. Technology continued to develop in the Western world and led to even larger differences in comparative advantage between countries on the frontier of innovation and productivity (the USA) and those not so advanced (Europe and the rest of the world). Also, on the back of lower transportation costs, intra-industry trade increased substantially as countries were able to specialise in intermediate goods. Increasing specialisation and trade led to vast increases in real wages, especially for those whose productivity was augmented by modern technology. The third wave of globalisation The third wave of globalisation began around 1990 with the revolution in communications and data processing, and the economic opening of China, India, Russia and other countries expanding the global workforce by more than a billion people. Consequently, since 1990 more countries and more people benefit from technology, trade and global value chains (GVC), but due to the catching-up process, the G7 now to a lesser extent than the rest of the world. The Internet, which had been around since the 1960s, became much more user friendly with the invention of the World Wide Web in In 1995, the Internet had about 16 million users or 0.4 pct. of the global population. 10 years later, in 2005, that had increased to 1 billion or 16 pct. of the global population. Another 10 years later, in 2016, the Internet had 3.7 billion users or 50 pct. of the global population iv. The same period witnessed an exponential increase in computing power and a sharp drop in the costs of communication and data processing. The ICT revolution profoundly changed the nature of globalisation. Whilst the first phase of globalisation was anchored on lower costs of transportation of goods and enabled a separation of the site of production from the place of consumption, and the second phase was founded on increased intra-industry specialisation and even lower transportation costs, the third phase is 4

5 anchored on lower costs of communication and sharing of knowledge. This enables a complete separation of the constituent parts of traditional production. In this third phase, production processes are split up across countries and regions and give rise to GVC. Also, the improvements in ICT and the developments in artificial intelligence enable the hitherto non-tradeable services sector to become part of the global economy and GVCs, with potential implications for the ever more service-intensive G7 economies. The sharing of knowledge through better communications enables modern technology to augment productivity in all parts of the world, thereby fast changing the metric of comparative advantage, from which past globalisation had grown. This has profound consequences for the distribution of the wealth between states, and for the distribution within nations. In the words of Nobel laureate Paul A. Samuelson v : Historically, U.S. workers used to have kind of a de facto monopoly access to the superlative capitals and knowhows (scientific, engineering and managerial) of the United States. ( ). However, after World War II, this U.S. know-how and capital began to spread faster away from the United States. That meant that in a real sense foreign educable masses - first in Western Europe, then throughout the Pacific Rim - could and did genuinely provide the same kind of competitive pressures on U.S. lower middle class wage earnings that mass migration would have threatened to do. Post-2000 outsourcing is just what ought to have been predictable as far back as And in accordance with basic economic law, this will only grow in the future period. The process described by Samuelson is often referred to as catching up. The key factor is spreading of modern technology and best practices from the most advanced economies to the less advanced. The process allows the laggards to leapfrog stages of technological development, saving time and money, to arrive at a much more advanced stage with much higher productivity. From 1945 to 1990 it was mostly Europe, Japan and South East Asia that benefitted from this process in some sectors even taking the lead in technological achievement. Globalisation and inequality There is no doubt that globalisation, trade and technological change have immensely increased global prosperity, reduced absolute poverty and improved health conditions generally. The World Bank estimates vi that since 1990, nearly 1.1 billion people have lifted themselves out of extreme poverty. Also, data since the 1990s show a substantial narrowing in inequality worldwide. Like Richard Baldwin, the World Bank notes that this is the first such reduction since the industrial revolution, and that it occurred during a period of increasing global integration. From 1820 to the 1990s, global inequality steadily rose. Then, the Gini index fell to 62.5 in 2013, most markedly beginning in 2008, when the Gini was

6 World Bank illustrations of global inequality vii Note: The blue line (measured on the right axis) shows the level of the global Gini index. The numbers in the bars refer to the relative contributions (in percent) of within and between inequalities to total global inequality. The World Bank describes this unprecedented decline in global inequality since 1990 as the result of two opposing trends: Convergence in average household incomes between countries that was spurred by rising incomes in populous countries such as China and India. In contrast, within-country inequality, the other component of global inequality, took on a greater role in global inequality (explaining a third of the total variation) It is often assumed that as an economy develops, often led by trade and technology, market forces first increase and then decrease economic inequality. The theory was first advanced by Simon Kuznets in the 1950s and 1960s and suggests that as a country undergoes industrialisation, initially labour is abundant and labour costs are low, while rewards to investors are high. The resulting increase in inequality will slowly diminish as labour acquires higher skills and becomes scarcer and political forces strengthen to advance social redistribution through taxes and social expenditure. The resulting Kuznets curve shows an inverted U with inequality first rising and then declining over time. It is very difficult to evaluate a theory with so many moving parts as the Kuznets curve. In a study of the rapid economic development of the East Asian countries, Joseph Stiglitz showed that the theory did not apply and attributes this to prudent economic and social policies viii. But on the other hand, the rising inequality in China and other developing or emerging economies seems to speak in favour of the theory so the question remains; whether the Kuznets curve does in fact apply under certain conditions, and could perhaps reappear during a time of fast innovation and automation that decreases the demand for labour and augments the rewards for capital investments? The Elephant curve by Lakner and Milanovic ix is often cited to demonstrate how globalisation has been detrimental to the middle classes of the advanced economies. The curve shows the change in the global income distribution from 1988 to It appears that the lowest dec- 6

7 iles of the global population have had no increase in income, the middle deciles of the global population have had a high increase in income, the deciles between 80 and 90 per cent (which are the middle classes of the advanced economies) have had no increase in income, while the top decile has enjoyed a very large increase in income from While the Elephant curve is accurate with regards to the increase in income for the middle deciles of the global population, primarily due to the economic growth in China, and correct with regards the 1 per cent of top income earners, it is not accurate with regards to the change in income for middle classes of the advanced economies (the deciles). As shown by Caroline Freund x of the Peterson Institute, other factors, especially the economic slowdown in Japan and the former Soviet Union and its satellites, are responsible for the lack of increase in income of middle classes of the advanced economies. On the contrary, Freund concludes that most incomes grew by 30 to 50 per cent and gains were broadly shared in the period Turning to more recent times in the aftermath of the 2008 financial crisis inequality seems to have increased in the advanced economies. In a study of 25 advanced economies, McKinsey Global Institute xi found that per cent of households, the equivalent of 540 to 580 million people, were in segments of the income distribution whose real market incomes were flat or had fallen in 2014, compared to This compared with less than 2 per cent, or fewer than ten million people, who experienced this phenomenon between 1993 and The stagnation or decline of market incomes does not necessarily translate into a decline in disposable income. McKinsey notes that in Sweden, market incomes fell or were flat for 20 per cent of the households, while disposable income advanced for almost everyone. Likewise in the United States, government taxes and transfers turned a decline in market incomes for 81 per cent of income segments into an increase in disposable income for nearly all households. McKinsey points to several reasons for the decline in market income. The 2008 financial crisis and the slow-growth recovery are a fundamental cause of this phenomenon. In addition, McKinsey points to shrinking households, a smaller share of GDP going to wages, and increased automation in the workplace that weakens the demand for low-skilled labour. McKinsey notes that these factors will likely continue to exert pressure in the future. Making globalisation work for all In a long-term, inter-generational perspective globalisation has already worked for all or almost all. Compared to 1820 or 1913 or 1990 living and working conditions, health, education etc. have improved immensely for a large majority of people in the world in spite of an increase in global inequality. In addition, since 1990 absolute poverty has declined, global inequality has decreased and GDP per capita has risen in almost every country in the world. But in a short term perspective and from an individual point of view globalisation has not worked for all. That is because globalisation works in tandem with technological change, and while both create new wealth and prosperity, both also tend to disrupt the status quo of busi- 7

8 nesses, jobs, societies and international relations. In the short run this can be very stressful to individuals and societies. To prevent derailing the process, risking long-term loss for short term gain, there is a need for domestic public policies to manage the transition period and prepare societies for continuous economic and social change. Among the issues for national policy reforms are: Globalisation and technology How are companies, the labour market and individuals affected by globalisation and technological change, and what are the impact on productivity, growth, jobs and distribution? Will globalisation and technology continue to deliver vast global and individual economic benefits? Is a future with increased globalisation, artificial intelligence and robotics "more of the same" or this time is different? Free trade and protectionism How important is free trade and foreign investments for the growth potential of the global economy and individual companies. What policies can encourage and support companies adaptation to the global and digital economy and their continued competitiveness? And what are the drivers and the potential effects of increased scepticism towards globalisation and the spread of protectionism for the advanced economies? Globalisation and inequality What is the trade-off between on the one hand globalisation, technology and economic growth and on the other hand: social stability, national sovereignty and democracy? What policies can increase the benefits of international trade and cross-border investment, and also promote a more inclusive and fairer distribution of gains between countries and citizens, reconciling the long and short term interests? i Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States. ii Richard Baldwin: The Great Convergence. Harvard U.P and: The Maddison Project, version. iii Esteban Ortiz-Ospina and Max Roser: International Trade. In Our World in Data iv Internet World Stats. v Poul A. Samuelson: Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization. Journal of Economic Perspectives. Volume 18, Number 3. Summer Pages vi The World Bank. Taking on Inequality: Poverty and Shared Prosperity vii The World Bank (2016) viii Joseph E. Stiglitz: Some Lessons from the East Asian Miracle. World Bank Res Observer (1996) 11 (2): ix Christoph Lakner and Branko Milanović: Global Income Distribution: From the Fall of the Berlin Wall to the Great Recession. The World Bank Economic Review Advance Access published August 12, x Caroline Freund (PIIE). Deconstructing Branko Milanovic s Elephant Chart : November 30, xi McKinsey Global Institute: Poorer than their parents? July