The resurgence of “Chindia” is the big economic story of our time. In 1820 China and India together accounted for almost 50% of world output. In 1950 that figure was less than 10%. Today it is about 20%, and by 2025 it is projected to be almost 35%.
The recent recovery of China and India followed the implementation of comprehensive economic reform programmes, starting in China in 1978 and in India in 1991. From 1990 to 2008, real income per head, a measure of the physical quantity of production, grew by 4.7% a year on average in India, and by 9% in China. To put these numbers into context, the comparable figure for the UK was 2.4%, and that was a high-end performance amongst our peer group of industrialised countries.
Together, China and India contain over a third of the world’s population, so their development is lifting hundreds of millions of people out of abject poverty. Their vast populations also mean that, in terms of economic output, they will come to dominate the global economy. In August this year, for example, China overtook Japan to become the world’s second-largest economy behind the US.
A common element in both the Chinese and the Indian reforms was the liberalisation of foreign trade and integration into the global economy. For example, China’s share of total world exports rose from 1% in the early 1990s to 7% in 2005 – and in some sectors, such as clothing, textiles and consumer electronics, China is now the world’s leading exporter.
What does academic economics have to say about the consequences of these developments for Britain? The key insight is that international trade increases the real national incomes of all trading partners: the overall size of the economic pie grows. Indeed, the market economy can be thought of as a mechanism that harnesses the profit motive to ensure that maximum economic value is squeezed out of the available resources.
International trade creates benefits by decoupling production and consumption. It allows countries to specialise in the production of the goods that their resource endowments make them most suited to producing. Thus, we expect developing countries to export labour-intensive and low-skill products to the world market, whereas developed countries will tend to export goods whose production requires significant inputs of skilled labour, technology and capital.
However, there are downsides to trade integration. In particular, the gains from trade can be very unevenly distributed. Because international trade creates gains through economic restructuring – some industries expand, others shrink – it makes intuitive sense that there will be losers as well as winners. Think, for example, of the contrast within Western countries between middle class consumers, who are able to enjoy cheap Chinese electronics imports, and assembly line workers whose firms are at the hard end of that import competition.
Economics confirms this intuition. Types of labour that are heavily used in import-competing sectors will lose out from trade integration, while those whose main employment is in expanding export sectors will benefit. Drawing the threads together, Britain, as a developed country, should export high-tech goods in exchange for low-skill imports, and low-skilled workers will lose out in this process compared to their skilled counterparts.
What does the empirical evidence tell us? There is no doubt that the skill premium – usually measured as the ratio of graduate to non-graduate earnings – has risen sharply in developed countries since the early 1970s. However, traditionally, economists have tended to doubt the importance of globalisation in this process.The usual culprit was technological change: changes in production processes, such as computerisation, that led firms to switch their labour demands towards high-skilled workers.
More recently, however, the surge in imports from developing countries like China has led to a reassessment of the importance to labour market outcomes of trade flows. The usefulness of the trade/technology distinction has also been questioned. For example, Western firms might invest in R&D to move up the technology ladder and escape import competition.
The policy challenge for Britain and other developed countries is to ensure that we benefit from globalisation without destroying the overall economic gain. For this reason, the vast majority of economists would oppose policies of tariffs and protectionism. The price of such policies – the squandering of the gains from trade – is just too great.
Why take distribution of income seriously? Developments in the world economy are no one’s fault, so it seems unfair that low-skilled workers, who are already relatively deprived, should be singled out to bear the costs. Moreover, hard-headed politics also suggests that distribution matters. Nothing in the economic theory says that the winners from trade integration must be in a majority. If the losers are sufficiently numerous, a protectionist backlash will threaten to destroy the gains from trade. The lesson is clear: to put policies of free trade on a firm footing, we need to ensure that the benefits are widely shared.
To misquote the reformers of Eastern European communism, our task must be to build capitalism with a human face. Education and training policies should become life-long, and they should be geared towards enabling labour market entrants and displaced workers to take advantage of job opportunities in growing sectors. At the same time, in-work benefits like the Tax Credits system, should be used to top up the market earnings of adversely affected workers. Of course, these policies need to be carefully co-ordinated: one creates an incentive to move jobs, the other to stay. However, the broad outlines to follow are clear.