The world in 2017

It’s generally agreed that we face an unusually uncertain outlook this year: elections in France and Germany, the path for the UK’s leaving of the European Union and above all, how will President Trump act? Underneath the political fog there are some fundamental forces that I think are worth thinking about, as a basis for understanding why there is so much uncertainty and how the politicians’ decisions might be framed.

The three tectonic plates of the global system seem to me to be: i) the continuing shift of economic power to Asia; ii) the change in how advanced economies operate; and iii) the advance of climate change. There are doubtless others, but as an economist I’m drawn to these as having the most weight on political decisions.

The economic shift to Asia

The move in relative economic power away from the “west” (including Japan) towards Asia (not just China, but India and south east Asia) is no longer something that is going to happen; it is already here and likely to continue for many years to come. At a very high level it represents a slow re-balancing of economic power back in line with population, after an historically unusual few centuries when economic power was concentrated in a relatively small population in Europe and the countries it created (the US, Canada, Australia). India and China, the former large and relatively wealthy civilisations, were eclipsed but are now catching up.

The catch up is a result of two things. First, national decisions, mainly governments no longer acting to hold back economic development. Deng Xiaoping kick-started the Chinese economy, not by a high level decision to accelerate growth, but by no longer opposing the actions of local farmers seeking to use market forces to trade their surplus produce. The miracle has continued by a combination of the government getting out of the way of the Chinese people’s attempts to become better off (bottom up) and a (mostly) very effective programme of state investment in infrastructure (top down).

The speed of the Chinese economic transformation is still not fully understood but it could only have happened with the second factor, the existence of a an open global economy into which China could fit. This was firstly about trade but it is now increasingly about the flow of ideas. These represent two aspects of globalisation. China could probably have grown much faster in the 1960s if Mao had let it, but it would have been harder for the world economy to absorb China at that point. Other economies did of course grow very fast from that period (most notably Taiwan, Hong Kong, Singapore and South Korea). But they are much smaller than mainland China.

The second aspect of globalisation that will be critical for China’s continuing economic development is the flow of ideas, made cheaper and faster by the spread of the Internet (and the vast increase in English language speaking). It is very hard now to keep a secret. The knowledge that something can be done is sufficient to stimulate researchers in other countries to find a way to do it. China, already now losing low cost assembly jobs to cheaper locations such as Vietnam, has to build the next stage of its development on the knowledge economy (see below). While investing heavily in its own research and education, it continues to benefit from the massive installed base of research and innovation in the west.

The absorption of the world’s largest population into the world economy was unlikely to be smooth. Adding several hundred million people to the global economy represents a big increase in resources on a scale never seen before. Unsurprisingly it caused some disruption, chiefly in the economies that bought China’s surging exports, made competitive by low labour costs. A narrow view of economics (partial equilibrium) tells us that a sudden increase in the supply of a resource is likely to drive down the price of that resource, at least compared with what it would otherwise have been. That has been the experience of many people, especially in parts of the US which have lost jobs to Chinese competition. But a wider economic perspective (general equilibrium) tells us that the new labour brings new production and there is no necessity for the overall effect to be negative. Globalisation of trade has indeed brought a net increase in economic output, even in the US. But the benefits have been unevenly distributed. In particular, the losers in richer countries have not been compensated for their losses and have in many cases not found new jobs of equivalent pay or status. It is scant comfort to them to know that the rest of the American workforce benefits from all of those cheap toys, furniture and smartphone assembly.

The rise of the innovation economy

The second trend in the world economy has reinforced the problem of the displaced workers in the US. It is that the growth of productivity in advanced economies is increasingly driven by knowledge, making education ever more important. Manufacturing used to be the source of well paid jobs but that sector has been largely automated. Advanced manufacturing remains an important sector of the economy in countries such as the US, France and UK but it doesn’t employ that many people and now probably never will. Germany is unusual in having a larger manufacturing share of employment but even there the trend is towards productivity growth leading to flat or falling employment growth.

Good jobs come from high productivity sectors and these are now largely in technology-intensive areas or those driven by innovation: healthcare, software, communications and entertainment. The globalisation of ideas has accelerated growth in these sectors but there is a paradoxical result. These sectors are concentrated geographically and depend on local, face to face contact. Enrico Moretti’s 2012 book “The New Geography of Jobs” beautifully captures this effect, describing the enormous differences between US cities which have these innovation sectors and those which don’t. We in Cambridge, UK, are very lucky to live in one of the most flourishing of the city clusters where high productivity growth now happens. Most of these clusters lie near universities but that is not enough to create one. Indeed, it’s rare to find one of these clusters which has been created by deliberate policy. Most have arisen by chance from a combination of government decisions (especially military spending), universities and sometime sheer luck (the decision by Bill Gates and Paul Allen to relocate their fledgling Microsoft from Albuquerque, New Mexico to Seattle in 1979, which has transformed the local economy).

A key finding of Moretti’s research is that the pay of all workers, even less skilled, is higher in these innovation cities than elsewhere. The services that the well-paid people spend buy (hair cuts, massages, artisan bread and coffee) are immune to the globalisation of trade because they can only be supplied locally. Services make up most of the US economy now but they need a high productivity, high paid core of workers to drive the incomes of everyone else. That role used to be played by manufacturing but now it’s the innovation sectors which do it.

The problem with this new type of capitalism is that it’s ruthlessly hard on those without education or who are in the wrong cities, through no fault of their own. Many move to the successful cities but high property prices (often worsened by supply restrictions imposed by those lucky enough to already live there) are a barrier. The combination of international trade globalisation and the new knowledge economy has created despair in many western cities which feel they are being left behind by the modern economy.

This forms part of the wider concern about the failure of modern capitalist economies to build a hope for the future among the great majority of their citizens (see here). It is hard to disentangle temporary macroeconomic problems from the effects of the debt boom and bust that lay behind the financial crisis, the apparent deceleration in productivity growth and the effects of trade globalisation. But the combination, when added to the tensions from the partial-globalisation of people movements, is proving poisonous to rich country politics.

There is an intense and engaging debate in the world of economics blogs about these problems and what can be done. Economists have known about these problems for several years. I’ve been lecturing about the problems of the US middle class income stagnation on the Cambridge Advanced Leadership Programme for at least five years. But we missed the politics, or at least we didn’t recognise the political logic of our economic arguments. People are fed up. But I regret to say that, apart from much more investment in education and in greater payments for job retraining and for labour mobility, the policy suggestions fall short of the challenge. Innovation clusters have a powerful logic that makes me doubtful about attempts to artificially create new ones.

The economic dislocation in the US is being reinforced by status concerns – the Easternisation of the world is not just about economic power but increasingly about political and eventually military and even cultural power. Many people in the US (and eventually in Europe, temporarily distracted by what I fear is the beginning of the end of the EU) are facing the uncomfortable fact that they are no longer as central to the world as they used to be and this is only going to get worse.

Climate change

While not an economic trend, climate change is caused by the increased greenhouse gas emissions that have arisen from economic growth. Global emissions have been flat recently and there is some cause for optimism in that China’s use of coal is probably at a peak and global oil use may not be far off a peak too. But the odds are that emissions will continue to rise far beyond the level required to stabilise global temperatures at safe (probably – we don’t know for sure) levels. I’m not optimistic about government policies here, as there is a powerful collective action problem that no amount of conferences is likely to solve. There are some encouraging trends from renewable energy technologies but these will not stop the rise in coal burning for power stations in India, which has every reason to expect other countries to pay the costs of it adopting cleaner but more expensive energy.

Conclusion

It’s likely to be a bumpy ride in 2017. The solutions to our problems are likely to come from a mixture of technological innovation, which remains abundant, and wise leadership, which is always in short supply. Those of us lucky to live in the knowledge economy owe it to everyone else to share our ideas, listen and be humble.

Further reading

A short summary of the key ideas in Moretti’s book is here. But I recommend the whole book.

Gideon Rachman’s excellent book Easternisation captures the economics and politics of the shift in power towards Asia.

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