Goodbye BWII Part 2

Author: Dr. Michael Dooley | September 28, 2020

In the last piece (Link)  Opens a new window. we discussed the formation and rationale for the Bretton Woods II system. By undervaluing their exchange rate, lending dollars earned through exports back to the United States, and allowing foreign corporations to earn excess profits by using low-wage labor, China was able to industrialize quickly. Importantly, the system was an equilibrium in the sense that it proved relatively robust over more than a decade.

As we discussed, export led growth as an effective path to industrialization was known to economists and policymakers in the developed and developing world. However, most felt that growth in emerging market manufactured exports would be blocked by industrial country governments in order to protect their workers. Arthur Lewis, in his acceptance speech for the 1979 Nobel Prize, argued that developed countries would only open their markets to developing country manufactured goods during times of prosperity, as during these times jobs were plentiful enough that those displaced by foreign labor could find new jobs. However, as developed country economies slowed and unemployment rose, they would place tariffs on goods from developing countries, making it more advantageous to manufacture those products domestically, thus increasing the demand for labor and helping alleviate the unemployment problem.

Why didn’t the predicted protectionist response take hold in the U.S. until only recently? Was it that U.S. manufacturing labor was insulated from the rise of Chinese (and other developing country) exports? Surely not. The chart below shows cumulative job losses in the U.S. associated with the trade deficit for China. Manufacturing jobs accounted for more than 100% of these losses, as there were job gains in other industries.

Our view is that the protectionist response failed to materialize because neither US political party was seriously incentivized to protect domestic manufacturing workers. Simply put, by 2002 there were not many manufacturing workers left and those remaining had no union and little economic power. In contrast, immense profits were earned by domestic firms operating directly in China as well as importing Chinese goods for re-sale into the United States. These profits were used to buy influence and maintain the status quo which was packaged in a palatable free-market message. A quote from my BW II coauthor Peter Garber sums it up nicely: “China did manipulate its currency during the first ten years of the millennium, but the US ruling elite did not want to hear about it because it had such a nice piece of the action.”

The economics profession in the US also provided plausible justifications for ignoring the plight of US labor. It was clearly the case that technological change had for many years reduced manufacturing labor as a share of total employment in the US. The consensus is that the 2002 “China shock” as it is now called may have contributed to the decline in manufactured employment but a variety of statistical tests failed to show that import competition was economically important. This view is finally being challenged. A quote from the JEL is worth repeating at length:

When Drew Greenblatt bought Marlin Steel Wire Products LLC, a small Baltimore maker of wire baskets for bagel shops, he knew nothing about robotics. That was 1998, and workers made products manually using 1950s equipment. ... Pushed near insolvency by Chinese competition in 2001, he started investing in automation. Since then, Marlin has spent $5.5 million on modern equipment. Its revenue, staff and wages have surged and it now exports to China and Mexico.i

Are changes in Marlin’s employment and output driven by the availability of robots or by increased Chinese competition? What about employment and output at other Source: Economic Policy Institute producers of steel wire products, who face increased competition from both China and from Marlin? These questions are even more difficult to answer if the availability of robots is itself influenced by trade liberalization—for example, by robot manufacturers’ ability to source intermediate inputs from China.

The point is that measuring jobs directly displaced by Chinese labor likely significantly understates attributable job losses. While technological change is ever present, the China shock drastically changed incentives for adoption, thus accelerating manufacturing job losses in the United States and other industrialized countries.

The global financial crisis brought with it a collapse in housing prices and available credit for Americans who had seen their other source of wealth creation, income, either stagnate or disappear completely. The anger and despair created by the crisis and its non-inclusive recovery created powerful voting blocs (still divided by cultural issues) that enabled populist candidates from both parties to run extremely successful campaigns. A celebrity with no discernable political philosophy filled the vacuum created by the traditional political parties. Donald Trump was smart enough to see that what the displaced workers and their communities needed was a leader that promised to take care of them and punish those who had thrown them under the bus of globalization.

We see this as a watershed moment, not only for the Bretton Woods II system and China’s trade relationship with the U.S., but also for globalization more broadly. BW II as an international monetary system is gone for the foreseeable future. But the aftereffects will be with us for a long time. China is now on a sustainable development path. It probably no longer has or needs the competitive advantage of an undervalued exchange rate. Yet it remains a very large low wage economy that will dominate manufacturing output. In this environment we should expect continued and intensified protection from industrial countries.

We can see the effect of Trump’s tariffs on trade volumes below, as the CPB Merchandise Trade Volume index was essentially flat after the imposition of the tariff until the pandemic.

Importantly, and more speculative, is our expectation that the US government will try to limit direct investment in China and other emerging markets. Tariffs have been notoriously ineffective in altering trade relationships. We can see for instance that there has been little if any effect of the China tariff actions on U.S. imbalances, where the current account deficit has actually increased since President Trump took office. We think, as tariffs continue to do little in terms of moving production back to the U.S., policymakers will look to tax cross boarder financial transactions directly. These will likely prove more effective in reducing international transactions and forcing firms to move production back to domestic inputs.

There will be winners and losers in a less globalized economic world. To be sure, industrial country labor should benefit from higher wages as they no longer compete with peers globally. Those higher wages will prove costly to consumers and firms to a differing degree, depending on how much of the higher wage is able to be passed through to final product prices. Regardless, it would look as though firms currently reliant on low-priced labor will suffer a significant hit to margins and thus their earnings and ability to pay dividends. Firms already using domestically based high-skilled labor should be better able to protect margins as they will be subject only to secondary effects (for example, the effects of rising hardware costs on a SAAS company).

Internationally, however, we think other industrial countries might fare much worse than the US. Germany, the economic engine of the EU, and Japan both rely on the ability to export goods in order to maintain full employment. Both have unfavorable demographics that make it unlikely for domestic consumption to readily fill the gap should world trade continue to slow. This implies significant levels of unemployment and disinflation, if not outright deflation.

Additionally, this could prove disastrous for developing countries, especially in Asia, that have relied on export led growth. They will fall well short of graduating to developed country status and will require a large adjustment towards domestic consumption in order to continue to grow. This adjustment will lead to volatility in both currency and equity prices there.

Economist Rudi Dornbusch once said, “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” While it may take some time for the policies we envision to be enacted, we think the financial market consequences will be significant and happen quite quickly once the policy trajectory becomes clear.

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New Perspectives on the Decline of US Manufacturing Employment. Fort et al. Journal of EconomicPerspectives—Volume 32, Number 2—Spring 2018, pages 49-50