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The new titans A survey of the world economy September 16th 2006

China, India and other developing countries are set to give the worldeconomy its biggest boost in the whole of history, says Pam Woodall.What will that mean for today’s rich countries?

in which these economic newcomers area�ecting the developed world. As it hap-pens, their in�uence helps to explain awhole host of puzzling economic develop-ments, such as the record share of pro�ts innational income, sluggish growth in realwages, high oil prices alongside low in�a-tion, low global interest rates and Amer-ica’s vast current-account de�cit.

Emerging countries are looming largerin the world economy by a wide range ofmeasures (see chart 1). Their share ofworld exports has jumped to 43%, from20% in 1970. They consume over half ofthe world’s energy and have accounted forfour-�fths of the growth in oil demand in

A question of de�nitionThe borderline between rich and poor has be-come more �uid. Page 3

Emerging at lastDeveloping economies are having a good run.Page 4

More pain than gainMany workers are missing out on the rewardsof globalisation. Page 6

More of everythingDoes the world have enough resources tomeet the growing needs of the emergingeconomies? Page 9

Weapons of mass disin�ationCompetition from emerging economies hashelped to hold in�ation down. Page 11

Unnatural causes of debtInterest rates are too low. Whose fault isthat? Page 12

A topsy-turvy worldHow long will emerging economies continueto �nance America’s spendthrift habits? Page 14

Playing leapfrogIf today’s rich world does not watch out, itcould become tomorrow’s relatively poorworld. Page 16

The Economist September 16th 2006 A survey of the world economy 1

1

The new titans

LAST year the combined output of emerg-ing economies reached an important

milestone: it accounted for more than halfof total world GDP (measured at purchas-ing-power parity). This means that the richcountries no longer dominate the globaleconomy. The developing countries alsohave a far greater in�uence on the perfor-mance of the rich economies than is gener-ally realised. Emerging economies aredriving global growth and having a big im-pact on developed countries’ in�ation, in-terest rates, wages and pro�ts. As thesenewcomers become more integrated intothe global economy and their incomescatch up with the rich countries, they willprovide the biggest boost to the worldeconomy since the industrial revolution.

Indeed, it is likely to be the biggest stim-ulus in history, because the industrialrevolution fully involved only one-third ofthe world’s population. By contrast, thisnew revolution covers most of the globe,so the economic gains�as well as the ad-justment pains�will be far bigger. As de-veloping countries and the former Sovietblock have embraced market-friendlyeconomic reforms and opened their bor-ders to trade and investment, more coun-tries are industrialising and participatingin the global economy than ever before.This survey will map out the many ways

1Why they matter

Sources: IMF; MSCI; BP

Emerging economies as % of world total, 2005

0 20 40 60 80 100

Population

Foreign-exchange reserves

Energy consumption

GDP at PPP

Exports

GDP at market exchange rates

Stockmarket capitalisation

Also in this section

www.economist.com/audio

An audio interview with the author is at

www.economist.com/surveys

A list of sources can be found online

AcknowledgmentsThis survey has bene�ted from the help of many econo-mists, not all of them mentioned in the text. The sta� atthe IMF, BIS, OECD and the World Bank were particularlygenerous with their time. Special thanks go to Eswar Pra-sad, Jean-Philippe Cotis, Bill White, Matthew Slaughter,Nouriel Roubini, Brad Setser, Bert Ho�man, Jiming Ha, YuYongding and Arthur Kroeber. A forthcoming book by theWorld Bank, �Dancing with Giants: China, India and theGlobal Economy�, is highly recommended.

www.economist.com/globalisation

Past articles on related subjects are at

1

2 A survey of the world economy The Economist September 16th 2006

2 the past �ve years. They also hold 70% ofthe world’s foreign-exchange reserves.

Of course there is more than one re-spectable way of doing the sums. So al-though measured at purchasing-powerparity (which takes account of lowerprices in poorer countries) the emergingeconomies now make up over half ofworld GDP, at market exchange rates theirshare is still less than 30%. But even at mar-ket exchange rates, they accounted for wellover half of the increase in global outputlast year. And this is not just about Chinaand India: those two together made up lessthan one-quarter of the total increase inemerging economies’ GDP last year.

There is also more than one de�nitionof emerging countries, depending on whodoes the de�ning (see box on the nextpage). Perhaps some of these countriesshould be called re-emerging economies,because they are regaining their formereminence. Until the late 19th century,China and India were the world’s two big-gest economies. Before the steam engineand the power loom gave Britain its indus-trial lead, today’s emerging economiesdominated world output. Estimates by An-gus Maddison, an economic historian,suggest that in the 18 centuries up to 1820these economies produced, on average,80% of world GDP (see chart 2). But theywere left behind by Europe’s technologicalrevolution and the �rst wave of globalisa-tion. By 1950 their share had fallen to 40%.

Now they are on the rebound. In thepast �ve years, their annual growth has av-eraged almost 7%, its fastest pace in re-corded history and well above the 2.3%growth in rich economies. The Interna-tional Monetary Fund forecasts that in thenext �ve years emerging economies willgrow at an average of 6.8% a year, whereas

the developed economies will notch uponly 2.7%. If both groups continued in thisway, in 20 years’ time emerging econo-mies would account for two-thirds ofglobal output (at purchasing-power par-ity). Extrapolation is always risky, butthere seems every chance that the relativeweight of the new pretenders will rise.

Faster growth spreading more widelyacross the globe makes a huge di�erence toglobal growth rates. Since 2000, worldGDP per head has grown by an average of3.2% a year, thanks to the acceleration inemerging economies. That would beat the2.9% annual growth during the golden ageof 1950-73, when Europe and Japan wererebuilding their economies after the war;and it would certainly exceed growth dur-ing the industrial revolution. That growth,too, was driven by technological changeand by an explosion in trade and capital�ows, but by today’s standards it was a gla-cial a�air. Between 1870 and 1913 worldGDP per head increased by an average ofonly 1.3% a year. This means that the �rstdecade of the 21st century could see thefastest growth in average world income inthe whole of history.

Financial wobbles this summer actedas a reminder that emerging economiesare more volatile than rich-country ones;yet their long-run prospects look excellent,so long as they continue to move towardsfree and open markets, sound �scal andmonetary policies and better education.Because they start with much less capitalper worker than developed economies,they have huge scope for boosting pro-ductivity by importing Western machin-ery and know-how. Catching up is easierthan being a leader. When America andBritain were industrialising in the 19th cen-tury, they took 50 years to double their realincomes per head; today China is achiev-ing the same feat in nine years.

What’s newEmerging economies as a group have beengrowing faster than developed economiesfor several decades. So why are they nowmaking so much more of a di�erence tothe old rich world? The �rst reason is thatthe gap in growth rates between the oldand the new world has widened (see chart3). But more important, emerging econo-mies have become more integrated intothe global system of production, withtrade and capital �ows accelerating rela-tive to GDP in the past ten years.

China joined the World Trade Orga-nisation only in 2001. It is having a biggerglobal impact than other emerging econo-

mies because of its vast size and its un-usual openness to trade and investmentwith the rest of the world. The sum ofChina’s total exports and importsamounts to around 70% of its GDP, againstonly 25-30% in India or America. By nextyear, China is likely to account for 10% ofworld trade, up from 4% in 2000.

What is also new is that the internet hasmade it possible radically to reorganiseproduction across borders. Thanks to in-formation technology, many once non-tradable services, such as accounting, canbe provided from afar, exposing more sec-tors in the developed world to competitionfrom India and elsewhere.

Faster growth that lifts the living stan-dards of hundreds of millions of people inpoor countries should be a cause for cele-bration. Instead, many bosses, workersand politicians in the rich world are quak-ing in their boots as output and jobs shift tolow-wage economies in Asia or eastern Eu-rope. Yet on balance, rich countries shouldgain from poorer ones getting richer. Thesuccess of the emerging economies willboost both global demand and supply.

Rising exports give developing coun-tries more money to spend on importsfrom richer ones. And although their aver-age incomes are still low, their middleclasses are expanding fast, creating a vastnew market. Over the next decade, almosta billion new consumers will enter theglobal marketplace as household incomesrise above the threshold at which peoplegenerally begin to spend on non-essentialgoods. Emerging economies have alreadybecome important markets for rich-world�rms: over half of the combined exports ofAmerica, the euro area and Japan go tothese poorer economies. The rich econo-mies’ trade with developing countries is

3Speeding ahead

Source: IMF *Forecast

GDP, % increase on year earlier

1985 90 95 2000 06*0

2

4

6

8

7

5

3

1

Developedeconomies

Emerging economies

2Re-emerging

Sources: OECD, Angus Maddison; IMF

*At purchasing-power parity †The Economist forecasts

Share of global GDP*, %

1000 1500 1820 1913 1950 2005 2025†0

20

40

60

80

100

Emerging economies

Developed economies

1


2

other developing countries into the worldtrading system is causing the biggest shiftin relative prices and incomes (of labour,capital, commodities, goods and assets) forat least a century, and this, in turn, is lead-ing to a big redistribution of income. Forexample, whereas prices of the labour-in-tensive goods that China and others ex-

port are falling, prices of the goods they im-port, notably oil, are rising.

In particular, the new ascendancy ofthe emerging economies has changed therelative returns to labour and capital. Be-cause these economies’ global integrationhas made labour more abundant, workersin developed countries have lost some oftheir bargaining power, which has putdownward pressure on real wages. Work-ers’ share of national income in thosecountries has fallen to its lowest level fordecades, whereas the share of pro�ts hassurged. It seems that Western workers arenot getting their full share of the fruits ofglobalisation. This is true not just for thelowest-skilled ones but increasingly alsofor more highly quali�ed ones in, say, ac-countancy and computer programming.

If wages continue to disappoint, therecould be a backlash from workers and de-mands for protection from low-cost com-petition. But countries that try to protectjobs and wages through import barriers orrestrictions on o�shoring will only hastentheir relative decline. The challenge forgovernments in advanced economies is to�nd ways to spread the bene�ts of global-isation more fairly without reducing thesize of those gains.

The high share of pro�ts and low shareof wages in national income are not theonly numbers that have strayed a longway from their historical average. Analarming number of economic variablesare currently way out of line with whatconventional economic models wouldpredict. America’s current-account de�citis at a record high, yet the dollar has re-

growing twice as fast as their trade withone another.

The future boost to demand will belarge. But more important in the long termwill be the stimulus to the world economyfrom what economists call a �positive sup-ply shock�. As China, India and the formerSoviet Union have embraced market cap-italism, the global labour force has, in ef-fect, doubled. The world’s potential outputis also being lifted by rapid productivitygains in developing countries as they try tocatch up with the West.

This increased vitality in emerg-ing economies is raising globalgrowth, not substituting foroutput elsewhere. The new-comers boost real incomes inthe rich world by supplyingcheaper goods, such as mi-crowave ovens and comput-ers, by allowing multinat-ional �rms to reap biggereconomies of scale, and byspurring productivitygrowth through increasedcompetition. They will thushelp to lift growth in worldGDP just when the rich world’sgreying populations would other-wise cause it to slow. Developedcountries will do better from being part ofthis fast-growing world than from trying tocling on to a bigger share of a slow-grow-ing one.

Stronger growth in emerging econo-mies will make developed countries as awhole better o�, but not everybody willbe a winner. The integration of China and

WHAT determines whether an econ-omy is �developed� or �develop-

ing�? Economies used to be categorised asdeveloped if they were members of theOrganisation for Economic Co-operationand Development (OECD), the so-called�rich-man’s club�. But today the OECD issomething of a mixed bag. It includespoorer countries such as Mexico and Po-land, yet excludes places such as HongKong, Singapore and the UAE, whichhave GDPs per person similar to Italy’s.

To add to the confusion, di�erent orga-

nisations use di�erent de�nitions. For in-stance, JPMorgan Chase and the UnitedNations count Hong Kong, Singapore,South Korea and Taiwan as emergingeconomies. Morgan Stanley Capital Inter-national includes South Korea and Tai-wan in its emerging-market index, butkeeps Hong Kong and Singapore in itsdeveloped-markets index. The IMF

schizophrenically counts all four as�developing� in its International Finan-cial Statistics but as �advanced econo-mies� in its World Economic Outlook.

This survey will use the pre-1994OECD membership as its de�nition of thedeveloped world, and lump the rest�in-cluding Mexico, Poland, Hong Kong andso on�together as emerging economies.This is because its main objective is to as-sess the impact of the faster-growing de-veloping world on the old rich world. Theterms developing, third and poor worldwill be used interchangeably to refer toemerging economies, even though manyof them are well on their way to joiningthe developed world.

The borderline between rich andpoor has become more �uidA question of de�nition

1


2

IN 1994 this newspaper launched a newemerging-market indicators page to

mark �a fundamental and remarkablyrapid change in the balance of the worldeconomy�. Emerging economies werethen growing twice as fast as the rich ones,and their stockmarkets were surging. Butthe timing of the launch was awful. It cameat the start of a dismal decade for emergingeconomies, with crises in Mexico at theend of 1994, Asia in 1997, Russia in 1998,Brazil in 1999, Turkey in 2000, Argentina in2001 and Venezuela in 2002. By 2002 theMSCI emerging-market share-price indexhad lost almost 60% of its 1994 value. Lastyear it regained that peak. But is the currenteconomic boom any more sustainable?

The 25% drop in emerging stockmarketsduring May and June of this year was awarning. Having tripled over the previousthree years, share prices, fuelled by exces-sive global liquidity, had got ahead ofthemselves and a correction was overdue.

Emerging at last

Developing economies are having a good run

However, the economies themselves lookin better shape than for decades. Over thepast �ve years GDP per head in the emerg-ing economies has grown by an annual av-erage of 5.6%, compared with only 1.9% inthe developed world. In the preceding 20years GDP per head in poor countries hadbeen growing by an average of 2.5%, littlemore than in rich economies.

Deep and crisp and evenIn the past, as some economies sprinted,others stumbled. Today rapid growth ismore evenly spread. This year, for the thirdyear running, all of the 32 biggest emergingeconomies tracked weekly by The Econo-mist are showing positive growth. In everyprevious year since the 1970s at least oneemerging economy, often several, su�ereda recession, if not a severe �nancial crisis.

Even Africa’s prospects look brighterthan they have done for many years. In thelast quarter of the 20th century real in-

mained relatively strong. Global interestrates are still historically low, despitestrong growth and heavy government bor-rowing. Oil prices have tripled since 2002,yet global growth remains robust and in-�ation, though rising, is still relatively low.House prices, however, have been soaringin many countries.

Puzzling it outThis survey will argue that all of these puz-zles can be explained by the growing im-pact of emerging economies. For instance,low bond yields and the dollar’s refusal toplunge are partly due to the way thesecountries have been piling up foreign re-serves. Likewise, higher oil prices havemostly been caused by strong demandfrom developing countries rather than byan interruption of supply, so they havedone less harm to global growth than inthe past. And their impact on in�ation hasbeen o�set by falling prices of goods ex-ported by emerging economies. This hasalso made it easier for central banks toachieve their in�ation goals with muchlower interest rates than in the past.

All this will require some radical newthinking about economic policy. Govern-ments may need to harness the tax and

bene�t system to compensate some work-ers who lose from globalisation.

Monetary policy also needs to be re-vamped. Central bankers like to take thecredit for the defeat of in�ation, but emerg-ing economies have given them a big help-ing hand, both by pushing down the pricesof many goods and by restraining wages indeveloped countries. This has allowedcentral banks to hold interest rates at his-torically low levels. But they have misun-derstood the monetary-policy implica-tions of a positive supply shock. Bykeeping interest rates too low, they have al-lowed a build-up of excess liquidity whichhas �owed into the prices of assets such ashomes, rather than into traditional in�a-tion. They have encouraged too much bor-rowing and too little saving. In Americathe overall result has been to widen thecurrent-account de�cit.

The central banks’ mistake has beencompounded by the emerging economies’refusal to allow their exchange rates to rise,piling up foreign-exchange reserves in-stead. Bizarrely, by �nancing America’sde�cit, poor countries are subsidising theworld’s richest consumers. The openingup of emerging economies has thus notonly provided a supply of cheap labour to

the world, it has also o�ered an increasedsupply of cheap capital. But this surveywill argue that the developing countrieswill not be prepared to go on �nancingAmerica’s massive current-account de�citfor much longer.

At some point, therefore, America’s costof capital could rise sharply. There is a riskthat the American economy will face asharp �nancial shock and a recession, oran extended period of sluggish growth.This will slow growth in the rest of theworld economy. But America is less im-portant as a locomotive for global growththan it used to be, thanks to the greater vig-our of emerging economies. America’s to-tal imports from the rest of the world lastyear amounted to only 4% of world GDP.The greater risk to the world economy isthat a recession and falling house priceswould add to Americans’ existing con-cerns about stagnant real wages, creatingmore support for protectionism. Thatwould be bad both for the old rich coun-tries and the new emerging stars.

But regardless of how the developedworld responds to the emerging giants,their economic power will go on growing.The rich world has yet to feel the full heatfrom this new revolution. 7


2 come per person in the world’s poorest re-gion stagnated, but so far this decade Af-rica has put on a spurt, with GDP growthabove 5% for three consecutive years,thanks largely to higher commodity prices.

Developing countries have also bene-�ted from America’s consumer-spendingbinge, which has sucked in imports; andfrom historically low global interest rates,which have lowered debt-service costs.But favourable external factors playedonly a minor part in the revival of emerg-ing economies. Much more importantly,their underlying economic health has im-proved. Structural reforms and soundermacroeconomic policies have made themmore able to sustain robust growth and towithstand adverse shocks. In�ation hasbeen tamed and many countries havetrimmed their budget de�cits; indeed, onaverage they are running much smallerde�cits than the rich world.

Emerging economies are also much lessdependent on foreign capital than theywere a decade ago, leaving them less vul-nerable to the whims of investors. As agroup, they are in their eighth year of cur-rent-account surplus, having been in de�-cit for most of the previous 20. Their aver-age ratio of foreign debt to exports hastumbled from 174% in 1998 to an estimated75% this year. Foreign-exchange reserveshave swollen to nine months’ importcover, compared with only �ve months’just before the Asian crisis in 1997. Andmost emerging economies no longer �xtheir currencies at the grossly overvaluedrates that contributed to past �nancial cri-ses. If anything, the currencies of Chinaand some other Asian countries are nowundervalued.

Over the past few years all regions have

enjoyed brisker growth, but some are inbetter shape than others. Emerging Euro-pean economies have the least healthy ex-ternal balances. Hungary and Turkey havecurrent-account de�cits of 7-8% of GDP.When investors dumped emerging-mar-ket assets in May and June of this year,these countries were hit hardest.

Emerging economies still face many po-tential risks, from banking crises to unrestin response to widening income inequal-ity. Some could be badly hurt by a slumpin demand in America or China and a con-sequent fall in commodity prices. StephenRoach of Morgan Stanley argues that theweakness of emerging economies is nolonger their dependence on external �-nance, as in the 1990s, but their depen-dence on external demand.

Just like America during its take-o� inthe late 19th century, emerging economiestend to be subject to economic ups anddowns. But what matters most for theirlong-term prospects are their economicpolicies. They need to take advantage ofthe present period of strong growth topush ahead with reforms. Governmentsthat still have large budget de�cits, notablyin central and eastern Europe, must wieldthe axe. Others, such as China, need toclean up their banking systems. Almost ev-erywhere, governments can do more tofree up markets and reduce their own med-dling. In Asia, that includes allowinggreater exchange-rate �exibility.

Rich economies can grow only by in-venting new technology or managementmethods. Poor countries, in theory, should�nd it easy to grow faster because they canboost their productivity by adopting inno-vations from richer ones. In the past, suchopportunities were all too often squan-

42040 visionWorld’s ten biggest economies, United States=100

Sources: IMF; Goldman Sachs *Market exchange rates

GDP (market exchange rates) 2005 GDP (PPP) 2005 GDP* forecast 2040

0 20 40 60 80 100

United States

Japan

Germany

China

Britain

France

Italy

Canada

Spain

Brazil

0 20 40 60 80 100

United States

China

Japan

India

Germany

Britain

France

Italy

Brazil

Russia

0 20 40 60 80 100

China

United States

India

Japan

Mexico

Russia

Brazil

Germany

Britain

France

dered through bad policies. But if struc-tural reforms continue, there is huge futurepotential for growth.

Alwyn Young, an American economist,caused a stir in the mid-1990s (just beforethe East Asian crisis) by suggesting thatEast Asia’s growth miracle was a myth. Hecalculated that most of the region’s fastergrowth was due to increased inputs of la-bour and capital rather than to total factorproductivity growth (the e�ciency withwhich inputs of both capital and labourare used). Paul Krugman, another Ameri-can economist, summed up Mr Young’sdiscovery thus: �The miracle turns out tohave been based on perspiration ratherthan inspiration.�

In fact, Mr Young underestimated thegrowth in total factor productivity in theAsian tiger countries, which had actuallybeen considerably faster than in rich econ-omies. Moreover, developing economiesdo not need inspiration to catch up. In theearly stages of development, it is enoughto maintain high rates of investment andcopy techniques that have proved success-ful elsewhere. Asia worked its �miracle� bycreating the right conditions for high in-vestment: a high saving rate, open marketsand a good education system.

Today, China’s critics similarly arguethat its growth has been driven largely bywasteful investment and cannot be sus-tained. In fact, total factor productivitygrowth in China has been even faster thanin the rest of Asia. Over the past quarter-century it has averaged 3% a year, account-ing for roughly the same amount of GDP

growth as capital investment. (Over thesame period, America’s total factor pro-ductivity grew by an annual average ofonly 1%.) Growth will slow as China’s capi-tal-to-output ratio rises toward rich-coun-try levels and its excess labour dries up,but the country should still have a couplemore decades of rapid growth in it.

A race that all can winPeople love to argue about whether Chinaor India will win the economic race, yetboth can prosper together. China scoreshigher than India on many of the key in-gredients of growth: it is more open totrade and investment, has a better recordof macroeconomic stability and has putmore e�ort into education and infrastruc-ture. It is perhaps 10-15 years ahead of In-dia in its economic reforms. However, inthe long run India might pull ahead be-cause its population will continue to growlong after China’s has levelled o�. Fore-casters say that by 2030 it is likely to have 1

1


2 more people than China. Brazil, Russia, India and China are the

four biggest emerging economies, groupedtogether under the acronym BRICs,created by Goldman Sachs in 2001. Thesefour economies account for two-�fths ofthe total GDP of all emerging economies.China and India are generally seen as thetwo giants among them. This is true in pur-chasing-power-parity terms, but in currentdollars Brazil and Russia both producemore than India. At market exchange rates,only China and Brazil rank among theworld’s top ten economies, but in purchas-ing-power terms all four BRICs make it.

Goldman’s economists predict that ifgovernments stick to policies that supportgrowth, by 2040 China will be the world’sbiggest economy at market exchange rates.By then there will be �ve emerging econo-mies in the top ten: the four BRICs plusMexico (see chart 4, previous page). To-gether, they will be bigger in dollar termsthan the G7 economies.

These forecasts assume, realistically,that growth in the BRICs will slow signi�-cantly by the end of the period. About one-third of the projected increase in the dollarvalue of the BRICs’ GDPs comes from realcurrency appreciation rather than real

growth. As countries’ relative productivityrises, their exchange rates should movecloser to purchasing-power parity.

However impressive, the forecasts stillleave income per head in the BRICs wellbelow those in developed countries. In2040 the average American will still bethree to four times richer than the averageChinese. Faster growth will not automati-cally end third-world poverty; that de-pends on how the fruits of growth areshared. But faster growth will make thisgoal more achievable. And as they movetowards it, these economies will leave anever larger footprint on the globe. 7

RICH countries have democratic govern-ments, so continued support for glob-

alisation will depend on how prosperousthe average worker feels. Yet workers’share of the cake in rich countries is nowthe smallest it has been for at least three de-cades (see chart 5). In many countries aver-age real wages are �at or even falling.

Meanwhile, capitalists have rarely hadit so good. In America, Japan and the euroarea, pro�ts as a share of GDP are at or nearall-time highs (see chart 6, next page). Cor-porate America has increased its share ofnational income from 7% in mid-2001 to13% this year.

Like so many other current economicpuzzles, the redistribution of income fromlabour to capital can be largely explainedby the entry of China, India and otheremerging economies into world markets.Globalisation has lifted pro�ts relative towages in several ways. First, o�shoring tolow-wage countries has reduced �rms’costs. Second, employers’ ability to shiftproduction, whether or not they take ad-vantage of it, has curbed the bargainingpower of workers in rich countries. In Ger-many, for example, several big �rms havenegotiated pay cuts with their workers toavoid moving production to central Eu-rope. And third, increased immigrationhas depressed wages in sectors such as ca-tering, farming and construction.

Most of the fears about emerging econ-omies focus on jobs being lost to low-costforeign competitors. But the real threat is towages, not jobs. In the long run, trade ando�shoring should have little e�ect on total

employment in rich countries; rather, theywill change its composition. So long as la-bour markets are �exible, job losses inmanufacturing should eventually be o�setby new jobs elsewhere. But trade withemerging economies can have a big im-pact on both average and relative wages.

Over long periods of time, real wagestend to track average productivity growth.But so far this decade, workers’ real pay inmany developed economies has increasedmore slowly than labour productivity. Thereal weekly wage of a typical Americanworker in the middle of the income distri-bution has fallen by 4% since the start ofthe recovery in 2001. Over the same periodlabour productivity has risen by 15%. Evenafter allowing for health and pensionbene�ts, total compensation has risen byonly 1.5% in real terms. Real wages in Ger-many and Japan have also been �at or fall-

ing. Thus the usual argument in favour ofglobalisation�that it will make most work-ers better o�, with only a few low-skilledones losing out�has not so far been borneout by the facts. Most workers are beingsqueezed.

If GDP per person is growing fairlybriskly, why are most workers missing outon real pay rises? Partly because a biggershare is going to pro�ts, and partly becausehigh earners have pocketed a huge slice ofthe gains in income, causing inequality towiden. America’s top 1% of earners nowreceive 16% of all income, up from 8% in1980. Wage inequality in Europe and Japanhas also increased, but not by as much.

A decade ago, the consensus amongeconomists was that increasing wage in-equality was caused mainly not by tradebut by information technology, which hasraised the demand for skilled workers rela-tive to unskilled ones. Today, a growingnumber of economists agree that trade isplaying a bigger role. It is hard to separatethe impact of globalisation and IT on rela-tive wages because they both reduce thedemand for low-skilled workers. But nowthat the majority of workers are losing out,the �nger of blame points at globalisation.

It’s all comparativeTraditional trade theory, based on theideas of David Ricardo, a 19th-centuryeconomist, argues that economies gainfrom trade by specialising in productswhere they have a comparative advantage.Developed economies have lots of skilledworkers, whereas emerging economies

More pain than gain

Many workers are missing out on the rewards of globalisation

5The bill from the China shop

Source: Bank for International Settlements

*Weighted average based on 2000 GDP and PPP exchange rates†2005 and Q1 2006 The Economist estimates

Wages as % of national income, G10 countries*

1975 80 85 9590 2000

59

60

61

62

63

58

06

†

1


2 have lots of low-skilled ones, so accordingto the theory advanced countries will spe-cialise in capital-intensive products requir-ing skilled labour and emerging econo-mies in low-tech products. Competitionfrom cheaper imports will reduce thewages of unskilled workers in developedeconomies, but workers as a whole will bebetter o�.

Yet, according to the evidence above,the average worker does not seem to be en-joying his fair share of the fruits of econ-omic prosperity. Richard Freeman, aneconomist at Harvard University, points toseveral reasons why the traditional theorymay need modifying. The �rst is that thesheer size of the emerging giants’ labourforces has shifted the global capital-labourratio (which determines the relative re-wards of capital and workers) massivelyagainst workers as a group. The entry ofChina, India and the former Soviet Unioninto market capitalism has, in e�ect, dou-bled the world supply of workers, from 1.5billion to 3 billion. These new entrantsbrought little capital with them, so theglobal capital-labour ratio droppedsharply. According to economic theory,this should reduce the relative price of la-bour and raise the global return to capital�which is exactly what has happened.

Over time, competition should reducepro�t margins and distribute bene�ts backto consumers and workers in the form oflower prices. But downward pressure onwages in rich countries could continue fora long time. China still has perhaps 200munderemployed rural workers who couldmove to factories over the next two de-cades, so wages for low-skilled workers arerising more slowly than productivity, re-ducing China’s unit labour costs.

A second reason why the traditionaltrade model needs modifying has to dowith a rise in emerging countries’ skill lev-els. It used to be thought that only richcountries had educated workforces able toproduce skill-intensive goods, but poorcountries have invested heavily in educa-tion in recent years, allowing them to startcompeting in more sophisticated markets.Every year, 1.2m engineers and scientistsgraduate from Chinese and Indian univer-sities, as many as in America, the Euro-pean Union and Japan combined andthree times the number ten years ago (seechart 7). In 1970 America accounted for30% of all university enrolments world-wide; now its share is down to around 12%.

The McKinsey Global Institute esti-mates that only one-tenth of engineeringgraduates in China and one-quarter in In-

dia would meet the standards expected bybig American �rms. But this will improveover time. A report by the World Bank alsopoints out that a large share of engineeringgraduates in China and India become civiland electrical engineers, needed for theboom in domestic construction. There arenot enough engineers and scientists to pro-duce high-tech goods across the board. Butit remains true that there has been a big in-crease in the global supply of educated aswell as unskilled workers.

A third �aw in the traditional trademodel, says Mr Freeman, is its assumptionthat rich countries would make high-techproducts and developing economies low-tech ones. In fact, rich countries no longerhave a monopoly on high-tech capital andknow-how. The OECD says that in 2004China overtook America as the world’sleading exporter of information-technol-ogy goods. This exaggerates China’s moveup the ladder: laptop computers, mobilephones and DVD players are no longer cut-ting-edge technology, and they are typi-cally only assembled in China by foreign�rms, with most of their high-value com-

ponents being imported. Even so, thefaster spread of technology to poor coun-tries is weakening the rich world’s compar-ative advantage in high-tech sectors. Asemerging economies start to export high-tech goods and services, this reduces theprices of such products in world markets,and hence the wages of skilled workers inthe developed world.

White-collar bluesIt is no longer just dirty blue-collar jobs inmanufacturing that are being sucked o�-shore but also white-collar service jobs,which used to be considered safe from for-eign competition. Telecoms charges havetumbled, allowing workers in far-�ung lo-cations to be connected cheaply to custom-ers in the developed world. This has madeit possible to o�shore services that wereonce non-tradable. Morgan Stanley’s MrRoach has been drawing attention to thefact that the �global labour arbitrage� ismoving rapidly to the better kinds of jobs.It is no longer just basic data processingand call centres that are being outsourcedto low-wage countries, but also softwareprogramming, medical diagnostics, engi-neering design, law, accounting, �nanceand business consulting. These can nowbe delivered electronically from anywherein the world, exposing skilled white-collarworkers to greater competition.

The standard retort to such argumentsis that outsourcing abroad is too small tomatter much. So far fewer than 1m Ameri-can service-sector jobs have been lost too�shoring. Forrester Research forecaststhat by 2015 a total of 3.4m jobs in serviceswill have moved abroad, but that is tinycompared with the 30m jobs destroyedand created in America every year. Thetrouble is that such studies allow only forthe sorts of jobs that are already being o�-shored, when in reality the proportion ofjobs that can be moved will rise as IT ad-vances and education improves in emerg-ing economies.

Alan Blinder, an economist at Prince-ton University, believes that most econo-mists are underestimating the disruptivee�ects of o�shoring, and that in future twoto three times as many service jobs will besusceptible to o�shoring as in manufactur-ing. This would imply that at least 30% ofall jobs might be at risk. In practice thenumber of jobs o�shored to China or In-dia is likely to remain fairly modest. Evenso, the mere threat that they could beshifted will depress wages.

Moreover, says Mr Blinder, educationo�ers no protection. Highly skilled ac-

6The triumph of capitalism

Source: UBS

G7 corporate profits as % of GDP

1980 85 90 95 2000 06

11

12

13

14

15

16

7Body count

Source: Morgan Stanley

University students graduating inscience and engineering, ’000

0 100 200 300 400 500 600 700

United States

EuropeanUnion

Japan

China

India

1990-91 2002-04

2 countants, radiologists or computer pro-grammers now have to compete with elec-tronically delivered competition fromabroad, whereas humble taxi drivers, jani-tors and crane operators remain safe fromo�shoring. This may help to explain whythe real median wage of American gradu-ates has fallen by 6% since 2000, a biggerdecline than in average wages.

In the 1980s and early 1990s, the paygap between low-paid, low-skilled work-ers and high-paid, high-skilled workerswidened signi�cantly. But since then, ac-cording to a study by David Autor, Law-rence Katz and Melissa Kearney, in Amer-ica, Britain and Germany workers at thebottom as well as at the top have done bet-ter than those in the middle-income group.O�ce cleaning cannot be done by workersin India. It is the easily standardised skilledjobs in the middle, such as accounting, thatare now being squeezed hardest. A studyby Bradford Jensen and Lori Kletzer, at theInstitute for International Economics inWashington, DC, con�rms that workers intradable services that are exposed to for-eign competition tend to be more skilledthan workers in non-tradable services andtradable manufacturing industries.

Ride on, RicardoNone of this makes a case for protection-ism. O�shoring, like trade, is bene�cial todeveloped economies as a whole. The in-creased mobility of capital and technologydoes not invalidate the theory of compara-tive advantage, as some commentators liketo argue. China and India cannot have acomparative advantage in everything; theywill export some things and import others.Emerging economies’ comparative advan-tage will largely remain in labour-inten-sive industries. A country’s trading patternis determined by its relative capital inten-sity compared with other economies.Emerging economies still have relativelylittle capital, so they are unlikely to be-come signi�cant capital-intensive export-ers until their capital-to-labour ratiocatches up. That will take time. Developedeconomies will retain their comparativeadvantage in knowledge-intensive activi-ties because they have relatively moreskilled labour, but that advantage will beeroded more quickly in future.

The developed economies as a wholewill still bene�t hugely from trade withemerging economies. Increased compe-tition and greater economies of scale willboost the growth in productivity and out-put. Consumers will enjoy lower pricesand a greater variety of products, and

shareholders will enjoy higher returns oncapital. Although workers will continue tosee their pay squeezed, they can still gainas consumers or as shareholders, either di-rectly or through their pensions. The snagis that richer people own more shares, sothe increased return on capital tends to re-inforce income inequality.

In recent years the stagnation of realwages in America has been masked bysurging house prices, which make familiesfeel better o�. If the housing market stum-bles and the growth in pay remains feeble,there will be increased calls for the intro-duction of import barriers, restrictions onoverseas investment and higher taxes onpro�ts. But in a globalised economy, suchmeasures would be worse than useless.Firms would simply move their head of-�ces to friendlier countries.

The fact that many workers seem to beexcluded from the spoils of globalisation isa big challenge to orthodox economics.Many of its practitioners refuse to comeclean about the costs to workers of tradewith emerging economies for fear of hand-ing ammunition to protectionists. At thesame time, protectionists exaggerate thosecosts and ignore the bene�ts. It is time for amore honest debate about trade.

Heading o� the political backlashA study by the Institute for InternationalEconomics estimates that globalisation isbene�ting America’s economy by $1 tril-lion a year, equivalent to $9,000 a year forevery family. But in practice the averagefamily has not seen such a gain becausemuch of it has gone to those at the top orinto pro�ts. This explains the lack of sup-port for globalisation from ordinary peo-

ple. Unless a solution is found to sluggishreal wages and rising inequality, there is aserious risk of a protectionist backlash.Rather than block change, governmentsneed to ease the pain it in�icts in variousways: with a temporary social safety-netfor those who lose their jobs; better educa-tion to equip workers for tomorrow’s jobs;and more �exible labour markets to en-courage the creation of new jobs.

More controversially, governmentsmay need to redistribute the bene�ts ofglobalisation more fairly through the taxand bene�ts system. Studies suggest thatcountries with more generous social wel-fare policies are less likely to support pro-tectionism. For instance, one reason whyopposition to o�shoring in Europe is lessvocal than in America is that Europeanhealth-care systems tend to be indepen-dent of employment, whereas in Americalosing your job means losing your healthinsurance too. In a riskier labour market,there may be a stronger case for health careto be �nanced by the state rather than by�rms. Tax redistribution does not mean areturn to taxing high earners at 70-80%,which would blunt economic incentives.Instead, scrapping tax breaks such as thosegiven to home-buyers could make the taxsystem more progressive.

It is often argued that generous social-insurance and redistribution policies areinconsistent with globalisation because inan open world governments cannot raisetaxes and spending in isolation. But if realwages continue to stagnate and no com-pensation is forthcoming, political sup-port for globalisation may fade and thevast gains from the biggest economic stim-ulus in world history will be lost. 7


1


THE average income of the 5.5 billionpeople on this planet who live in

emerging economies has been growing ata cracking pace: an annual rate of over 5%in recent years. As people grow richer,they want more cars and householdappliances as well as better homesand roads. This, in turn, means a hugeincrease in the demand for energyand raw materials.

Emerging economies already accountfor over half of the world’s total energyconsumption. Since 2000 they have beenresponsible for 85% of the increase inworld energy demand. China alone ac-counted for one-third of the increase inworld oil consumption. The developingworld’s demand for industrial raw materi-als is also rising rapidly. China’s share ofworld metal consumption has jumpedfrom less than 10% to around 25% over thepast decade. In the three years to 2005 thecountry accounted for 50% of the increasein world consumption of copper and alu-minium, almost all the growth in nickeland tin and more than the entire rise in de-mand for zinc and lead (which means therest of the world consumed less of them).

Some of the extra demand in China re-�ects a shift in production from other partsof the globe, but most of it is a net boost toglobal demand. Since 2000 world energyconsumption has been increasing at an an-nual average of 2.6%, twice as fast as in theprevious decade. Yet China and otheremerging economies have only just begunto make an impact on commodity markets.

Given the size of their populations, theiruse of raw materials is still modest. For in-stance, China uses only one-third as muchcopper per person as does America. Its oilconsumption per person is only one-thir-teenth that of America (see chart 8).

China’s current demand for raw ma-terials per person is roughly at the stage ofJapan’s and South Korea’s during their re-spective economic take-o�. If China fol-lows a similar path to South Korea’s as itsincome rises, then its total oil consump-tion could increase tenfold in absoluteterms over the next three decades, and yetit would still be using 30% less oil per per-son than the United States does today.

Currently about 90% of China’s energyis produced at home, but in future thecountry will need to import much more ofit. A study by Deutsche Bank predicts thatits oil imports will jump from 91m tonnesto 1,860m tonnes by 2020. The bank alsoreckons that copper imports will rise from3m tonnes to 20m tonnes. No wonderChina is forging close trade links with com-modity producers in Africa, the MiddleEast, Australia and Latin America.

Rising demand in emerging economieshas caused oil and commodity prices tosurge in recent years. The prices of both oil

and metals have roughly tripled since2002. This has been good for commodityproducers, most of which are developingeconomies. The past few years have seenthe sharpest rise in commodity prices inmodern history, with metal prices in realterms gaining twice as much as in thebooms of the 1970s and 1980s.

Previous commodity booms have al-ways been followed by slumps. Indeed,the long-term trend in commodity priceshas been �rmly downwards. Even withthe recent rise, prices in real terms are lessthan half of what they were in themid-19th century (see chart 9). The shift indeveloped countries’ output from metal-bashing industries to services has curbeddemand, as have technological advancesthat have provided substitutes, such as �-bre optics instead of copper wire. Bettertechnology has also improved rates ofmineral extraction, increasing supply.

Di�erent this time?However, some analysts claim that theworld is now in the middle of a �super-cy-cle�, fuelled by soaring demand in emerg-ing economies, which will keep priceshigh for the foreseeable future. Demandfrom emerging economies continues togrow strongly and supply remains tight, sothe equilibrium price of raw materialsdoes appear to have increased. But otherexperts argue that this is a speculative bub-ble and prices are unsustainable. Accord-ing to Simon Hayley, an economist at Capi-tal Economics, many analysts make the

More of everything

Does the world have enough resources to meet the growing needs of the emerging economies?

8The poor sip, the rich guzzle

Sources: IMF; BP; UN

Oil consumption and GDP per person, 2005

GDP per person, PPP$’000

Oil c

onsu

mpt

ion

per p

erso

n, b

arre

ls

0

10

20

30

0 10 20 30 40 50

Brazil

Canada

China

FranceGermany

India

Italy

JapanSouth Korea

MexicoRussia

Britain

UnitedStates

9A raw tale

Source: The Economist *Adjusted by US GDP deflator

The Economist industrial commodity-price indexReal* terms, 1845-50=100

1845 80 1900 20 40 60 80 20060

20

40

60

80

100

120

140


2 mistake of extrapolating from the recentrate of growth in demand and underesti-mating the potential for increasing supply.

Farm output can be increased mostquickly; stepping up oil production takesthe longest. Higher oil prices will encour-age more investment and production, butit can take up to seven years for new pro-jects to come on stream. Meanwhile,higher prices help to curb demand by en-couraging a switch to alternative fuels andchanges in consumer behaviour, such asbuying more fuel-e�cient cars. CapitalEconomics expects the oil price to fall to$50 a barrel by the end of 2007 from its cur-rent level of $70, but other analysts expectit to stay above $60 for several years. Andstrong demand with little or no spare ca-pacity means a high risk of price spikes ifsupply is disrupted.

Prices of commodities other than oilare more likely to fall because supply anddemand are more responsive to price. Re-serves of metals are vast. According to MrHayley, total deposits of copper (inferredfrom geological evidence) would last 107years and of iron ore 151 years at currentrates of consumption. These deposits maynot all be pro�table to extract with currenttechnology, but high prices will encouragetechnological advances. A study by MartinSommer, an economist at the IMF, �ndsthat copper prices are currently almostthree times above the cost of the least e�-cient producers, a much higher ratio thanat the peak of the 1980s boom.

The problem is that years of low priceshave caused underinvestment, and pro-ducers have been caught out by the jumpin demand. But in the long term capacityshould catch up and prices will fall. Globalspending on exploration for non-ferrousmetals rose to $5 billion in 2005, from $1.9billion in 2002. High prices are also en-couraging users to look for alternatives.

Commodity bulls argue that China hasreached the most commodity-intensivestage of its development: industrialisation,urbanisation and infrastructure all use lotsof raw materials. If China’s growth re-mained as commodity- and energy-inten-sive as at present, supply would struggle tocatch up and there could indeed be furtherupward pressure on prices. However, thecountry’s investment boom cannot con-tinue at its current pace. The governmentaims to shift the balance of growth fromexports and investment towards privateconsumption, which implies slowergrowth in the demand for raw materials.The Chinese leadership has also an-nounced a target of a 20% cut in energy use

per unit of GDP by 2010. The risk is that new supplies of com-

modities will come on stream just asglobal demand starts to slow, causingprices to drop sharply. The commodityboom may anyway have been exagger-ated by speculation as new investors piledinto the market. However, an analysis bythe IMF suggests that speculative invest-ment has had much less e�ect on metalprices than it has on oil prices.

Mr Sommer’s study, using a model thatestimates both future demand and futuresupply, forecasts that by 2010 prices of

copper and aluminium in real terms willfall by 53% and 29% respectively as supplyincreases. This is broadly in line withprices in the futures market, which signal a44% average fall in metal prices in realterms over the next �ve years, whereas oilfutures are close to the current spot price.

Such a drop would still leave metalprices well above their level at the start ofthis decade, in contrast to previous boomsafter which price rises were always fully re-versed. This is because global demand islikely to continue to grow much faster thanit has done in the past. Even if the growthin China’s demand for commodities slowsin future, it will remain faster than in richeconomies. Because of the country’s in-creasing weight in the world economy,this will keep up global demand.

Moreover, as China’s demand for rawmaterials slows, India’s is likely to take o�.India currently consumes only one-eighthas much copper and one-third as much en-ergy per person as does China. India’s ex-port growth has been led by business andIT services, which use fewer raw materials.But India needs to expand its manufactur-ing to create more jobs, and to improve itsdreadful infrastructure. UBS reckons thatIndia’s raw-material demand will triple

over the next ten years as capital expendi-ture and infrastructure spending increase.

A study by Ting Gao, Cameron Odgersand Jiming Ha, at China International Cap-ital Corporation, forecasts that annualgrowth in China’s demand for copper willslow from an average of 14% over the past15 years to 9% between 2006 and 2020,whereas India’s will accelerate from 7% to20% over the same period. Even if demandin the rest of the world continued to growat the same pace as before, this would liftthe annual rate of growth in global de-mand for copper from 3.5% between 1990and 2005 to 5.3% over the next 15 years. Forother commodities, too, the growth inglobal demand is forecast to speed up,even as growth in China slows down. Theauthors conclude that commodity priceswill remain historically high.

Over the next few decades, one of themain determinants of increased oil de-mand will be higher car ownership inemerging economies. At present there areonly two cars for every 100 people inChina, against 50 in America. GoldmanSachs forecasts that China’s car ownershipwill rise to 29 per 100 by 2040. The totalnumber of cars in China and India com-bined could rise from around 30m today to750m by 2040 (see chart 10)�more than allthe cars on the world’s roads today. Evenso, car-ownership rates in those two coun-tries would still be only half those inAmerica today.

Keep it greenMany people worry more about the envi-ronmental damage resulting from emerg-ing countries’ rising energy demand thanthey do about rising prices. Rapid industri-alisation has already caused an alarmingincrease in emissions of greenhouse gasesand air pollution. China has 16 of theworld’s 20 most air-polluted cities. Amer-ica is still the world’s largest spewer of car-bon emissions, but China is expected toovertake it within a decade or so. A reportby Zmarak Shalizi, an economist at theWorld Bank, forecasts that on current poli-cies carbon emissions in China and Indiawill more than double by 2020�thoughthat would still leave China’s carbon emis-sions per person at only one-third of thecurrent level in America.

The world does not have the resourcesfor another 5 billion or so people to behavethe way that Americans do today. It maynot be about to run out of energy and com-modities, but higher prices will certainlyforce big changes in lifestyles. The era ofcheap raw materials is over. 7

10Future traffic jams

Source: Goldman Sachs

Forecasts of car ownership, m

2000 05 10 15 20 25 30 35 40

0

100

200

300

400

500

India

China

UnitedStates

29

21

55

Per 100peoplein 2040

1


INFLATION worldwide has been unusu-ally subdued in recent years. Although in

developed economies, notably America, ithas been creeping up over the past year, itis still well below what most economicmodels would have predicted given stronggrowth, rising oil prices and easy mone-tary conditions. This is partly the result ofbetter monetary policy, which has low-ered in�ationary expectations. But possi-bly a more important explanation is thatglobalisation has made central banks’ jobof holding down in�ation much easier.

Monetary pedants will argue that in thelong run in�ation is determined by mone-tary policy. Globalisation can a�ect onlyrelative prices. Thus China is pushing upcommodity prices, but pulling down thecost of labour-intensive manufacturedgoods (see chart 11). If central bankers aimfor a particular in�ation target, then fallingprices of consumer durables will be o�setby rising prices elsewhere, leaving the in-�ation rate unchanged.

However, globalisation can make suchtargets easier to achieve, at lower interestrates than would otherwise be neces-sary. This can happen in several ways.Most obviously, the opening upof China, India and the formerSoviet block has exerteddownward pressure onin�ation by increas-ing competitionfrom these lower-

cost producers. The average price of Amer-ican imports from emerging Asia has fallenby over 25% since the mid-1990s.

The increase in the global labour forcehas also curbed workers’ bargainingpower, and hence wage costs. More gener-ally, the expansion in global supplybrought about by the emerging economies

has reduced price pressures at any givenrate of growth and so reduced the

cost of �ghting in�ation. And byhelping to tame in�ation,

globalisation may also havebolstered the credibility of

central banks, thus re-ducing in�ationary

expectations. Lastbut not least, globali-

sation has reduced the sensitivity of in�a-tion to changes in the amount of domesticeconomic slack.

A study by Claudio Borio and AndrewFilardo, two economists at the Bank for In-ternational Settlements, con�rms that in-�ation rates in developed economies havebecome less sensitive to the domestic out-put gap (the di�erence between actual andpotential GDP), whereas global economicconditions have become more important.In a closed economy, when productionoutpaces potential output, in�ation rises.In an open economy, an increase in de-mand can be met by imports, so it has lessof an e�ect on in�ation.

This makes a nonsense of traditionalclosed-economy models used to forecastin�ation, which assume that �rms setprices by adding a mark-up over unit costs,with the size of the margin depending onthe amount of slack in the domestic econ-omy. It also explains why in�ation is stillrelatively low even though domestic ca-pacity utilisation has been rising rapidlyand unemployment has been falling inmost developed economies: at a globallevel there is still ample economic slack.

In�ated claims?Some economists question the link betweenglobalisation and lower in�ation. For exam-ple, a study in the IMF’s April 2006 WorldEconomic Outlook concludes that the de-cline in real import prices caused by global-isation has had little lasting e�ect on in�a-tion rates. But this ignores the potentiallylarger indirect e�ects of increased interna-tional competition. Cheaper goods fromChina do not just reduce the prices of im-ports, but the prices of all goods sold in com-peting domestic markets. And competitionfrom emerging economies holds down in-�ation not just in traded goods but also innon-traded ones, by restraining wages.

Don Kohn, vice-chairman of America’sFederal Reserve, has also argued that theentry of China and India into the globaltrading system has probably had only amild disin�ationary e�ect. By running cur-rent-account surpluses, these economiesare currently adding more to global supplythan to demand, so their net e�ect on therest of the world is disin�ationary. But Mr

Weapons of mass disin�ation

Competition from emerging economies has helped to hold in�ation down

11Relatively speaking

Source: Bank for International Settlements*Excluding food and energy

G7 price changes, 2000-05, %

10 0 10 20 30 40+–

Imported consumergoods

Core goods*

Goods

Services

Commodities

Houses

1


2 Kohn points out that if their exchange ratesrise and domestic demand increases,eliminating current-account surpluses,these e�ects could be reversed.

Still, even if emerging economies as agroup were to run a current-account de�-cit, the increasing integration into theworld economy of lower-cost producerswould still continue to hold down wagesand prices in a growing number of indus-tries. So long as goods remain muchcheaper in emerging economies, the risingmarket share of these countries will helpto reduce in�ation in the developed world.International trade in services is also likelyto accelerate. The IMF calculates that iftrade integration in business services wereto reach the current levels in manufactur-

ing, prices for these services would fall by20% relative to average producer prices.

None of this means that globalisationhas killed o� in�ation. Indeed, the rise inAmerica’s in�ation rate over the past year,to over 4%, should have rung alarm bellsmuch sooner. Central banks need to re-main vigilant. Mr Kohn is right to point outthat capacity constraints and hence in�a-tionary pressures will eventually makethemselves felt in the world economy, justas they always have done at national level.

Some commentators think that this isnow beginning to happen. In recentmonths there has been a �urry of reportssuggesting that China is running out ofcheap labour, and that wages and exportprices are rising. China, it is argued, is nowexporting in�ation, not de�ation. Suchconcerns are hugely overblown. It is truethat several cities have increased theirminimum wage by an average of 20% thisyear, but many manufacturers were al-ready paying above the minimum.

There have also been reports of labourshortages in China, but mainly for manag-ers and skilled workers. The rapid pace ofaverage wage growth is due to productiv-ity gains rather than labour shortages. Av-erage urban wages have been rising bymore than 10% a year over the past decade,but productivity in manufacturing hasbeen growing faster still, so unit labourcosts have fallen. According to the BankCredit Analyst they have continued to slidethis year (see chart 12). China’s productiv-ity gains partly re�ect a shift in the mix of

its exports towards higher-value goods. Inthese new sectors the country is now driv-ing global prices down, but the shift tomore expensive products misleadinglymakes it look as if export prices havestopped falling.

Arthur Kroeber of Dragonomics, a Beij-ing-based economic-research �rm, dis-misses the worries about China exportingin�ation. Chinese export prices did pick upin 2004-05, but they are now falling again.American import prices from Asia are alsostill falling. Moreover, he says, it is hard tosee how China can be exporting in�ationwhen it has overcapacity, thanks to exces-sive investment.

In any case, focusing on China’s exportprices alone tells only part of the story. AsChina increasingly penetrates world mar-kets and provides competition for moreworkers in the developed world, thedownward pressure on their wages willpersist. It could take two more decades be-fore China’s surplus rural labour is fullyabsorbed by industry.

In a way, the debate about whetherglobalisation has reduced in�ation missesthe point. The real question is whether theopening up of the emerging economieshas allowed central banks in rich countriesto hold interest rates much lower whilestill meeting their in�ation goals. This sur-vey argues that it has, raising two ques-tions. First, have low interest rates had un-desirable side-e�ects? And second, whatwill happen when the cost of borrowingeventually returns to normal levels? 7

12Down escalator

Sources: Bank Credit Analyst; Thomson Datastream

Prices and costs, Jan 1996=100

1996 98 2000 02 04 06

40

50

60

70

80

90

100

110

US import prices from developing Asia

Chinese export prices

Chinese unit labour costs in manufacturing

GLOBALISATION may have helped tohold down in�ation, but it has also

raised some new dilemmas for centralbanks. Most notably, should they cut inter-est rates to stop in�ation falling belowtheir usual target in response to a boost toglobal supply�which is how they woulddeal with falling in�ation caused by aslump in demand�or should they accept alower rate of in�ation? Most central banksaim for an in�ation rate of close to 2%, inthe belief that too little in�ation can be asharmful as too much of it.

Real interest rates in the past few yearshave remained lower for longer than atany other time during the past half-cen-

tury. Despite recent tightening by centralbanks, average real short-term rates andbond yields in the developed economiesare still well below normal levels (seechart 13). Most commentators have con-cluded that a new era of cheaper moneyhas arrived.

Yet globalisation might have been ex-pected to raise, not lower, the world’s natu-ral rate of interest (ie, the rate that is consis-tent with long-run price stability and alsoensures that saving equals investment). Intheory, the long-term real equilibrium in-terest rate should be equal to the marginalreturn on capital. And the opening up ofemerging economies has increased the ra-

Unnatural causes of debt

Interest rates are too low. Whose fault is that?

13Cheap money

Sources: IMF; Thomson Datastream

*Adjusted by consumer-price inflation

G7, real* interest rates, %

1990 95 2000 061

0

1

2

3

4

5

+

–

Ten-year bond yields

Short-term interest rates

1


2 tio of global labour to capital, raising thereturn on capital, so real interest ratesshould rise, not fall.

Another way to look at this is that realinterest rates should be roughly the sameas the trend rate of GDP growth (a proxyfor the return on capital). If greater globaleconomic and �nancial integration leadsto a more e�cient use of labour and capi-tal, economic growth will be faster, whichagain means that real interest rates shouldrise. So why have they been so low?

Analysts have put forward two mainexplanations for the low level of real bondyields in recent years. The �rst is that highsaving (in relation to investment) by Asianeconomies and Middle East oil exportershas caused a global saving glut, pushingdown yields. These economies are run-ning large current-account surpluses, andmuch of that money has been piled up ino�cial reserves, particularly in AmericanTreasury securities, as central banks haveintervened in the foreign-exchange marketto prevent their currencies from rising.

Of gluts and �oodsVarious estimates suggest that such for-eign-exchange intervention reducedAmerican yields by less than one percent-age point in 2004-05. But Nouriel Roubiniand Brad Setser of Roubini Global Eco-nomics reckon that the impact could belarger. Most studies ignore the fact thatwithout o�cial intervention by foreigncentral banks the dollar would be lowerand hence American in�ation higher,which would push bond yields higher.And if central banks were not buying dol-lars to prop up the currency, many privateinvestors might hold fewer greenbacks,which again would push up yields. Add-ing up these and other factors, Messrs Rou-bini and Setser reckon that American Trea-sury bond yields would have been twopercentage points higher in recent years ifcentral banks in emerging economies hadnot bought dollar reserve assets.

A second explanation for low bondyields is that excess liquidity has pushedup the prices of all assets, including bonds.Over the past few years, the global moneysupply has grown at its fastest pace sincethe 1980s. This excess liquidity has notpushed up conventional in�ation (thankslargely to cheap Chinese goods), but hasfed into a series of asset-price bubblesaround the world.

Both developed and emerging econo-mies have contributed to this �ood of li-quidity. Central banks in rich countrieshave held interest rates abnormally low to

o�set disin�ationary pressures fromemerging economies. At the same time, toprevent their currencies rising, emergingeconomies have also held interest rateslow and engaged in heavy foreign-ex-change intervention, which has in�atedtheir money supplies.

Both of these explanations for low in-terest rates�the saving glut and the excessliquidity�involve emerging economies;either through their impact on developedeconomies’ in�ation and hence monetarypolicy, or through their foreign-exchangeintervention. In that sense, global mone-tary conditions are increasingly being in-�uenced by policies in Beijing as much asin Washington, DC. Over the past year,emerging economies have accounted forfour-�fths of the growth in the world’smonetary base.

Have central banks in developed econ-omies been right to pursue lax monetarypolicies? For borrowers, low interest ratesare an unmitigated blessing, but for econo-mies as a whole the gap between interestrates and the long-run return on capitalhas created some serious economic and �-nancial imbalances. Thanks to cheapmoney, American households are savingtoo little and borrowing and spending toomuch. At the same time bubbly houseprices have soared to record levels in rela-tion to incomes.

Bill White, chief economist at the Bank

for International Settlements, suggeststhat central banks’ in�ation targets may betoo high, given the big boost to global ca-pacity from China’s and India’s re-emer-gence. If a negative supply shock (fromhigher oil prices, say) were to cause in�a-tion to rise, most central banks would donothing about it as long as it did not in-crease in�ationary expectations and leadto second-round e�ects on other prices.The logic is that central banks should ig-nore price changes that they cannot con-trol. To be consistent, says Mr White, cen-tral banks should also have tolerated thein�ation-lowering impact of a positivesupply shock from the emerging econo-mies, allowing cheaper goods and wagesto reduce in�ation. Instead, in 2001-03 cen-tral banks prevented in�ation from fallingby pushing interest rates much lower thanthey would otherwise have been.

Ben Bernanke, the chairman of Amer-ica’s Federal Reserve, would argue thatwhen the Fed slashed interest rates to 1% in2003, it was trying to prevent harmful de-�ation. However, de�ation need not bewhat it was in the 1930s, a vicious circle ofde�cient demand, falling prices and risingreal debt. Historically, most de�ationshave been benign, caused by technologi-cal innovation or the opening up of econo-mies (ie, positive supply shocks), and wereaccompanied by robust growth. Duringthe rapid globalisation of the late 19th cen-tury, �at or falling average prices wenthand in hand with strong growth in out-put. Today’s world has much more in com-mon with that period than with the 1930s.

Too much, too soonWith hindsight, the de�ation that the Fedwas fretting about in 2003 was largely be-nign, caused by cheaper goods from Chinaand by the IT revolution. But the Fed wasso determined to prevent de�ation of anykind that it cut interest rates to unusuallylow levels. This, argues Mr White, couldhave long-term costs because persistentlycheap money encouraged too much bor-rowing, too little saving and unsustainableasset prices. The risk is that if central bankslean against benign de�ation, they will un-wittingly accommodate a build-up of im-balances. Ironically, these could cause about of bad de�ation as they unwind.

The problem is that most central banksbase their policy analysis on Keynesian-style economic models in which devi-ations from their in�ation goal are as-sumed to re�ect excess or inadequate de-mand, requiring a change in monetarypolicy. But supply shocks such as globali-

1


2 sation can cause deviations in in�ationthat require a completely di�erent policyresponse. A more relevant model might beone based on the Austrian school of eco-nomics, developed in the late 19th century,when economic conditions were moreakin to today’s. In Austrian models themain result of excessively low interestrates is not in�ation but overborrowing, animbalance between saving and invest-ment and a consequent misallocation ofresources. That sounds like America today.

Mr White argues that if central banksfocus solely on price stability, they mightallow ever bigger �nancial imbalances tobuild up. This is why they need to watch a

wider range of indicators beyond in�a-tion, including the growth in credit,money, saving rates and asset prices. Theyshould be prepared to raise interest rates inresponse to clear evidence of �nancial im-balance, says Mr White, even if it meansthey undershoot their in�ation targets.

The other risk of holding interest ratestoo low for too long is that in�ation willsuddenly rise. This is what has now hap-pened in America, where the in�ation ratehas risen above 4%, prompting the Fed topush interest rates higher this year. If thelow bond yields were also largely due toexcess liquidity, then rising short-termrates could push yields much higher than

the markets expect. At some point rateswill rise to their higher equilibrium level.The likely consequence is a severe weak-ening or a slump in housing marketsaround the globe and a sharp slowdownin consumer spending.

Central banks have been slow to graspthe fact that the rapid integration of emerg-ing economies into the global market sys-tem requires them to rethink their mone-tary policy. If they fail to recognise benignde�ation created by positive supplyshocks, then excessively loose monetarypolicy will fuel not only �nancial bubblesbut also bigger current-account imbal-ances�the subject of the next article. 7

MANY economists have long been ex-pecting America’s widening current-

account de�cit to cause a �nancial melt-down in the dollar and the bond market.The main reason why this has not hap-pened (yet) is that emerging economieshave been happy to �nance that de�cit. In2005 this group of countries ran a com-bined current-account surplus of over$500 billion (see chart 14). A large chunk ofthat was invested in American Treasury se-curities, in what Ken Rogo� of HarvardUniversity has called �the biggest foreign-aid programme in world history�.

The �ow of capital from poor countriesto the richest economy in the world is ex-actly the opposite of what economic the-ory would predict. According to the text-books, capital should �ow from richcountries with abundant capital, such asAmerica, to poorer ones, such as China,where capital is relatively scarce, so re-turns are higher. This is what happenedduring the globalisation of the late 19thcentury, when surplus European saving �-nanced the development of America. Be-tween 1880 and 1914, Britain ran an aver-age current-account surplus of 5% of GDP.In contrast, America today has a de�cit of7% of GDP. It seems perverse that poorcountries today prefer to buy low-yieldingAmerican government bonds when theycould earn higher returns by investing intheir own economies.

So why are they doing it? One explana-tion is the so-called �Bretton Woods 2� the-sis put forward three years ago by Michael

Dooley, David Folkerts-Landau and PeterGarber at Deutsche Bank. (Bretton Woodswas the system of �xed exchange rates thatprevailed for a quarter of a century afterthe second world war.) They argue thatAsian economies are pursuing a deliberatepolicy of currency undervaluation to en-sure strong export-led growth. To holdtheir currencies down, Asian central bankshave been buying lots of American Trea-sury bonds. This reduces interest rates andsupports consumer spending in the Un-ited States, allowing Americans to buy lotsmore Asian exports�which, the authorsargue, suits both Asia and America.

Furthermore, they say, opening itsdoors to foreign direct investment (FDI)has helped China to build a world-classcapital stock. Emerging economies withpoorly developed �nancial markets are

not good at allocating capital, so they buyTreasury bonds and let American �rms dothe domestic investment for them. Admit-tedly the return on Treasury bonds is lowerthan the return on FDI, but this, the au-thors reckon, is a small price to pay formore e�cient domestic investment andhence faster long-term growth.

The bottom line of this theory is thatthe main blame for America’s de�cit lieswith Asia’s emerging economies, ratherthan with America itself. And because thearrangement is in those Asian countries’economic interest, the theory suggests,they will go on �nancing America’s de�citfor a good many years.

Lost in the woodsHowever, Morris Goldstein and NicholasLardy, at the Institute for International Eco-nomics in Washington, DC, argue that Bret-ton Woods 2 does not explain China’s be-haviour in the past, and it certainly wouldnot be in China’s interest to go on behav-ing that way in future. The �rst �aw in thetheory is that America takes only one-�fthof China’s exports, with Europe a closerunner-up. So if China were trying to keepthe yuan undervalued, it would surely dobetter to hold down its real trade-weightedexchange rate, which rose by 35% duringthe dollar’s climb from 1994 to 2001.

China’s main motive for tying the yuanclosely to the dollar has been �nancial sta-bility, not crude mercantilism. But now arigid exchange rate looks as though itmight become a source of instability. The

A topsy-turvy world

How long will emerging economies continue to �nance America’s spendthrift habits?

14Buddy, can you spare $600 billion?

Source: IMF *Forecast

Current-account balances, $bn

1996 97 98 99 2000 01 02 03 04 05 06*800

600

400

200

0

200

400

600

+

–

Developed economies

Emerging economies

1


2 large build-up of reserves that has resultedfrom currency intervention is creating ex-cess liquidity, with its attendant risks of in-�ation, asset-price bubbles and a seriousmisallocation of capital.

The dollar �peg� has forced China toadopt an excessively lax monetary policy.Real interest rates of 3% are far too low foran economy growing at 10%, but there islittle room to raise rates because thatwould attract more in�ows of short-termcapital and so require even greater inter-vention, further boosting liquidity. Chinaneeds a more �exible exchange rate so itcan regain control of its monetary policy.

Another reason why building up yetmore reserves is not in the interest of Asiancentral banks is that it would expose themto large future losses when their currenciesdo eventually appreciate against the dol-lar. Emerging economies hold 70% ofglobal foreign-exchange reserves (seechart 15), mainly in dollars, and account forfour of the top �ve holders of reserves(China, South Korea, Taiwan and Russia).By the end of this year China’s reserves arelikely to reach $1 trillion. Messrs Roubiniand Setser calculate that a 33% rise in theyuan�which is quite possible over severalyears�would imply a politically embar-rassing capital loss of 15% of China’s GDP.The longer that countries accumulate re-serves, the bigger the potential losses.

A third defect in the Bretton Woods 2theory, according to Messrs Goldstein andLardy, is that in recent years FDI has �-nanced less than 5% of China’s �xed in-vestment, clearly nowhere near enough tohave helped create a world-class capitalstock. The only way that China can ensurea better allocation of capital is by reform-ing its domestic �nancial system and byusing higher interest rates to cool over-investment. Again, that suggests it is nowin China’s own interest to allow more �ex-

ibility in its exchange rate, which meansbuying fewer Treasury bonds.

All this suggests that China now needsto set its currency free for the sake of itsown economy, rather than America’s. In-deed, a revaluation of the yuan by itselfprobably would not make much of a dentin America’s current-account de�cit, be-cause it would not solve the structural im-balance between saving and investment.America has a huge de�cit largely becauseit saves too little. Politicians, however,prefer to blame China.

The �nal nail in the co�n of BrettonWoods 2 is that the increase in China’s ex-ternal surplus has been much too small toaccount for America’s de�cit. Estimates for2006 suggest that China’s current-accountsurplus has widened by $140 billion since1997, whereas America’s de�cit has ex-panded by $720 billion. By far the largestcounterpart to America’s de�cit today isthe group of emerging oil exporters, whichhave moved from rough balance in 1997 toan estimated surplus of $425 billion thisyear�much larger than emerging Asia’s to-tal surplus of $250 billion.

Oil exporters are determined not to re-peat their mistakes after previous oil-pricejumps. They have been much more cau-tious in spending their revenues, saving alarger share than in the past. So far, thebulk of petrodollars has probably goneinto relatively liquid dollar assets. Butthese countries have greater reason thanAsia to invest in non-dollar currencies, be-cause they trade much less with America.

And petrodollars are mostly managed byinvestment funds that aim to maximise re-turns, so oil exporters’ assets are more foot-loose than those of Asian central banksand could quickly shift out of the dollar ifit starts to slide again.

Too much of a good thingMr Bernanke has argued that America’sde�cit is the innocent by-product of a sav-ing glut in emerging economies. If the restof the world saves more than it invests (ie,runs a current-account surplus), thenAmerica has to run a de�cit. The implica-tion is that America’s de�cit is more sus-tainable than generally thought. But thisstill begs the question of why emergingeconomies have excess saving when theirreturn on investment is higher than in richcountries.

A paper presented by Raghuram Rajan,chief economist of the IMF, at this year’sannual symposium of the Federal ReserveBank of Kansas City o�ers a tentative ex-planation. Mr Rajan argues that fast-grow-ing poor countries tend to generate moresaving than they can use because of theirunderdeveloped �nancial systems.

Thus when a country experiences rapidproductivity growth, consumers savemuch of their income gains. But the oppor-tunities for transferring those savings intodomestic investment through the �nancialsystem are limited, so saving typically ex-ceeds investment and the country runs acurrent-account surplus. This also ex-plains the unexpected �nding that emerg-

15The new squirrels

Source: IMF *End May

Foreign-exchange reserves, end year, $ trillion

1990 95 2000 060

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Developed economies

Emerging economies

*

1


2 ing economies that rely least on foreign �-nance tend to enjoy the fastest growth.Faster-growing economies simply gener-ate more domestic saving.

But this means that capital �ows to theUnited States are sustainable only as longas emerging economies’ domestic �nan-cial systems remain immature and unableto o�er the usual range of �nancial instru-ments; and such shortcomings have a cleareconomic cost. In the years ahead, as thesecountries’ domestic �nancial systems de-velop, their current-account surpluses arelikely to disappear.

How long might that take? ConsiderChina, the thriftiest of them all, whichsaves almost 50% of its annual GDP. Manypeople believe that this is because Chinesehouseholds need to maintain a large �nan-cial cushion to make up for the lack of a so-cial safety net and the absence of con-sumer credit. However, Louis Kuijs, aneconomist at the World Bank, says thatChina’s household saving rate, at 16% ofGDP, is not abnormally high; in fact, it islower than India’s. What pushes the over-all rate to such exalted levels is huge savingby companies and by the government.State �rms do not pay dividends, so highpro�ts in recent years have pushed up theirsaving. Government saving is also unusu-ally high.

On the basis of current policies and ex-pected changes in income and demo-graphics, Mr Kuijs predicts that China’ssaving rate will fall only modestly over thecoming years, still leaving a substantial

current-account surplus in two decades’time. But if the government implementsreforms, forcing �rms to pay dividends,liberalising �nancial markets and spend-ing more on health and education, thenChina’s current account could be broughtinto rough balance by 2020, he says.

However, another World Bank paper,by David Dollar and Aart Kraay, suggeststhat China could be running sizeable de�-cits by then. The authors say that it doesnot make sense for China to be a large netsupplier of capital to the rest of the worldwhen its productivity is growing rapidlyand its capital-labour ratio is only one-tenth of that in America. They put this dis-tortion down mainly to extensive capitalcontrols that prevent residents from bor-rowing abroad and foreigners from invest-ing in China. If all capital controls werescrapped and the government pushedahead with economic and �nancial re-forms, China would run a current-accountde�cit of 2-5% of GDP, they reckon.

Capital-market reforms should alsobring down net saving in other emergingeconomies. In other words, at some timein the future, emerging economies may nolonger provide capital to the rest of theworld, but instead run current-accountde�cits. This will increase the global costof capital, especially in America.

But before that happens, emergingeconomies’ investment in foreign assets islikely to change its composition, favouringcorporate assets rather than low-yieldingTreasury bonds. The snag is that American

politicians are most reluctant to allow Chi-nese, Russian or Middle Eastern �rms tohave a controlling interest in American�rms: witness the failed attempt byChina’s CNOOC, a state-owned oil com-pany, to buy Unocal last year, and DubaiPorts World’s aborted takeover of severalAmerican ports this year. As long as Amer-ica depends on foreign capital, it needs tobe less picky.

The world’s present external imbal-ances are neither desirable nor sustain-able. Those who argue that poor countrieswill continue to �nance America’s current-account de�cit long into the future seem toforget that one day it will have to pay backthe money.

Nor are the current arrangements inthe long-term interest of America’s econ-omy. By buying dollar assets, Asian cen-tral banks are subsidising American con-sumers, encouraging too little saving, toomuch spending and excessive investmentin housing. Asia’s central banks haveturned o� the usual market signal of risingbond yields which should be tellingAmerica to put its house in order. As longas America can get cheap money fromabroad, it has little incentive to rebalanceits economy.

When global imbalances are eventu-ally unwound, the process will hurt evenmore. Unless America reduces its de�citbefore emerging economies lose interest inaccumulating reserves, the dollar, Trea-sury bonds and the whole American econ-omy are likely to su�er a hard landing. 7

ALEXIS DE TOCQUEVILLE once ob-served that the French hate anybody

who is superior, and the English like tohave inferiors to look down upon. Thesetwo nations were long ago knocked o�their pedestals. Now it is the Americanswho fret about losing their economic su-premacy. If China continues with its re-forms, one day it will become the world’sbiggest economy. Should America care?

Being the biggest economy has its at-tractions. It helps to provide military secu-rity and gives a country more clout inglobal economic a�airs. Being the main re-serve currency is also useful. America’sability to borrow and to settle its imports

in dollars has saved it from paying more in-terest to �nance its pro�igate ways.

However, remaining number one can-not be an end in itself. The goal of econ-omic policy should be to improve livingstandards, which depend on a country’sabsolute, not relative, rate of growth. In-deed, an obsession with remaining num-ber one could lead America to adopt poli-cies that are likely to hasten the day Chinapulls ahead. Trade barriers, subsidies andrestrictions on o�shoring merely shield in-e�cient �rms that need to become moreproductive if America is to thrive.

If rich economies raise import barriersin the misguided belief that they will pro-

tect Western living standards, they coulddestroy the main source of wealth-cre-ation in the 21st century. They could alsodeny better living standards to hundredsof millions of people in the developingworld. It is rich countries’ fear of emergingeconomies’ success, not that success itself,that is the real danger to the world econ-omy. It would be ironic if the triumph offree trade and market economics in theemerging economies were to turn the richworld more protectionist and interven-tionist. If they continued down that path,today’s rich countries might even end upas tomorrow’s (relatively) poor ones.

That might sound far-fetched, yet

Playing leapfrog

If today’s rich world does not watch out, it could become tomorrow’s relatively poor world

1


2 China, once the world’s technologicalleader, provides a sobering lesson on howeconomies can slide down the interna-tional league table. In the 18th century itwas the world’s biggest economy, with aGDP seven times as large as Britain’s. But itkept its doors closed to foreign goods, so itwas left behind by the industrial revolu-tion and the explosion in global trade.

In 1793 Lord George Macartney wassent to Peking by King George III to estab-lish a permanent British presence andopen up trade relations with China. Butthe Chinese emperor Qianlong informedhis visitor that �we have not the slightestneed of your country’s manufactures.�China’s economic isolation was to last foralmost another 200 years, during whichreal incomes fell. By 1950 China’s GDP perperson had shrunk by a quarter comparedwith Lord Macartney’s day; Britain’s hadrisen �vefold.

In America today the drumbeat of pro-tectionism is getting louder. As this surveyhas argued, that is because althoughglobalisation bene�ts economies as awhole, the gains are unevenly distributed,and the costs�job losses and lowerwages�are much more visible than thewider bene�ts to consumers generally.Workers tend to be better organised andmore vocal than consumers.

In recent years, as pro�ts have surged,most workers’ real incomes have been �ator even falling; only those near the top ofthe tree have enjoyed big pay rises. Global-isation has shifted the balance of poweragainst workers and in favour of compa-nies. But unless ordinary folk are seen toshare in the gains from globalisation, therewill be growing demands for import barri-ers or much higher taxes on booming com-pany pro�ts.

The trouble is that, in a globalised econ-omy, policies aimed at �eecing companieswill fail to spread the rewards morewidely. Firms will simply move to a more

congenial environment. The best way toboost national economic prosperity is tomake labour and product markets workmore e�ciently, speed up the shift of jobsfrom old industries to better-paying newones, and improve education and trainingto prepare workers for tomorrow’s jobs.

But that may not be enough. Govern-ments may need to tackle sluggish wagegrowth and increased inequality more di-rectly. Rich economies as a whole gainfrom the new wealth of emerging ones, sogovernments have ample scope to com-pensate the losers, but they rarely do. Yetthere may be a case for helping out thosewho lose their jobs or have to manage onlower pay in order to ensure continued po-litical support for free trade. The challengefor governments is to �nd ways to shareout the fruits of globalisation more fairlywithout undermining the economy’s abil-ity to reap the bene�ts.

Shifts in economic power tend to be as-sociated with disruptions in the worldeconomy, and are rarely smooth. Theglobalisation that followed the industrialrevolution was brought to an end by twoworld wars, high protectionist barriersand the Great Depression. Now the rise inemerging economies is once again alteringpower relations among states and creatingnew geopolitical risks. This new revolu-tion, too, is bound to bring forth its share ofdisagreements.

How should the world’s policymakersrespond to the developing world’s grow-ing economic power? Big emerging econo-mies will need to be given a larger stake inthe smooth running of the world econ-omy. As the world’s fourth-biggest econ-omy in dollar terms (and second-biggest atPPP), China should be a full member of allinternational economic policy forums,such as the G7 and the OECD. Yet theseorganisations remain �rmly in the handsof the old rich economies. How can gov-ernments sensibly talk about pressing is-

sues such as global imbalances or energyprices without China being present? TheG7 should be pruned to a G4, consisting ofAmerica, Japan, the euro area and China;and the status of the G20, which alreadyincludes emerging as well as advancedcountries, should be elevated.

IMF members meeting in Singaporethis month are expected to agree to givemore votes on the organisation’s board tosome of the bigger emerging economies, inrecognition of their growing weight in theworld. Several developing countries, espe-cially in Asia, are hugely underrepre-sented, whereas rich European economiesare overrepresented. China currently hasonly 3% of the total vote, not much morethan Belgium (with 2.2%), even thoughChina’s economy is seven times larger atmarket exchange rates and a lot bigger stillat purchasing-power parity.

America v EuropeWhich developed economies will gainmost from the emerging economies’ neweconomic muscle? Conventional wisdomhas it that America’s economy is copingmuch better than Europe’s with compe-tition from emerging economies, thanks toits �exible labour and product markets. Ac-cording to this view of the world, Europe ishaving a tough time dealing with globali-sation, burdened by high minimumwages, extensive job protection, high taxesand generous welfare bene�ts. Many peo-ple blame the euro area’s sluggish growthin output and jobs in recent years on itsloss of global competitiveness.

But conventional wisdom may havegot it wrong. Since 1997 employment in theeuro area has grown slightly faster than inAmerica. Over the past decade, European�rms have been much more successfulthan America in holding down unit labourcosts and thus remaining competitive.And since 2000 the euro area’s share ofworld export markets has risen slightly, to

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17%, whereas America’s share hasslumped from 14% to 10%. Thus, by manymeasures of competitiveness, Europe ap-pears to be coping better with the emerg-ing economies than America.

The main reason why America’s econ-omy has been growing faster than Eu-rope’s is that sluggish real wages have beeno�set by large capital gains on homes, mas-sive borrowing and an unsustainable fallin saving, all of which have boosted Amer-ican household spending. If (when) houseprices fall and consumers wake up to thefact that they are not saving enough, con-sumer spending will weaken perceptibly.Americans need to prepare for a recessionor, at best, a prolonged period of below-trend growth.

In a few years’ time, the relative econ-omic fortunes of America and the euroarea could be reversed. A report by IXIS, aFrench investment bank, suggests thatGermany and Japan are much betterplaced to bene�t from growth in emergingeconomies than America or Britain. Ger-many and Japan export 7-9% of their GDP

to emerging economies; the equivalent �g-ure for America and Britain is only around3% (see chart 16). France and Italy are some-where in-between. The euro area’s exportsto emerging economies have grown by anannual average of 14% since 2000, twice asfast as America’s.

A report by Goldman Sachs also �ndsthat by some measures Europe has bene-�ted more than America from trading withthe BRICs. The bank concludes that Ger-many and France are set to enjoy big gains.Italy, Greece and Portugal are less wellplaced because the make-up of their ex-ports is closer to that of the BRICs, so theywill face head-on competition.

For globalisation to bene�t economies,resources must be reallocated towardshigher-value-added goods and services.So to reap the full gains, Europe must ur-gently push ahead with making its mar-kets more �exible and open. A study by theEuropean Commission concludes that, ifthe European Union were fully to embracethe rise of China and India, its GDP perperson by 2050 could be up to 8% higherthan it would otherwise have been, imply-ing a boost to average annual growth of0.2% over the period. If, on the other hand,EU countries lurch towards more protec-tionist policies, GDP per head could be 5%lower than in the base case.

Japanese �rms and workers have evenless reason than American and Europeanones to fear China’s economic might. Ja-pan has been a major bene�ciary of re-

gional integration in Asia, and China islikely to overtake America as Japan’s big-gest trade partner by the end of this year.Japanese �rms have invested heavily inChina, shipping capital-intensive compo-nents there to be processed and assembledby cheap labour before being re-exported.Exports to China have played a big part inJapan’s export growth in recent years,helping to spur its economic recovery. Asurvey by the Nihon Keizai Shimbun foundthat most big Japanese �rms think a largeappreciation of the yuan would not be intheir interest because they have moved somuch of their production to China.

Coming of ageThe fact that people in rich countries arefretting about the emerging economies’success, rather than just their poverty, is it-self a remarkable tribute to the progressthose economies have made. Poverty inthe third world is still rife, but rising in-comes there should be welcomed by all.

As long as they continue on their path ofreform, there is an excellent chance thattheir rapid expansion can be sustained forseveral more decades.

China and India o�er immense oppor-tunities, but they also bring new risks. Ifthese economies stumble, or even if theysimply decide to sell their American Trea-sury bonds, the world will certainly no-tice. Because of the emerging economies’increased economic weight, a crisis therewould have a much bigger impact on theglobal economy than formerly.

It is important to keep a sense of per-spective. America still remains the world’sbiggest manufacturer, some way ahead ofChina. On visiting Beijing and Shanghai,many foreigners conclude that China is al-ready a wealthy economy, yet China andIndia have more poor people than Africadoes. Conversely, sceptics who try todownplay the importance of China andIndia underestimate the huge adjustmentsthat lie ahead. China’s vast labour forceand its unusual openness to trade meanthat its global impact is bound to increase.One day it will regain its place as theworld’s largest economy. And China isonly one among scores of emerging econo-mies that look set to prosper.

When your correspondent started as ajournalist at The Economist is 1985, theworld economy she was writing aboutconsisted largely of the G7 economies.Twenty-one years later the emerging econ-omies have come of age. To understandthe world economy, it is now necessary tounderstand and track the new world, espe-cially Asia. That is why this correspondentis about to move herself and her economictoolkit from London to Hong Kong. 7

16Sluggish Anglo-Saxons

Source: IXIS

Exports to emerging economies as % of GDP

1999 2000 01 02 03 04 050

3

6

9

United States

Britain

Germany

Japan

Future surveys

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