Herman Schwartz
Professor, Department of Politics
University of Virginia
"Trade and Economic Development: A Long Term Perspective"
August 1, 2002

Herman Schwartz: The first and most important thing you need to do to understand about trade and industrialization in third world countries is that you all have to stand off and take off your clothes. We are going to look at the clothing labels because the labels will tell you almost all you need to know about this topic. Are you ready? You are not going to do this? Okay, well, that is your loss.

I do recommend, however, that you go home and look through your closets. Start with your oldest clothes--look at the label--and what you will typically see is that your clothing might have been made in the U.S. As you get progressively younger clothing, you will find that it was made in places like Taiwan, Hong Kong and South Korea. And as you get progressively newer, then it moves to countries like Malaysia, Indonesia, Shrilanka, and then ultimately China. This tracks what happens in the world economy. Your clothing is the best indicator of what happens in the world economy.

To make this more academic than simply an exercise in looking at clothing (which I think is actually more interesting than the academic stuff), we are going to talk about five issues today.

One is probably the most important fact about trade and third world development in the last 30-40 years: there is a massive shift from agricultural to manufactured exports. The second issue is the question of how this shift occurred. The third issue is, why did it not occur for everyone? Then there is the question of what happens to those who did industrialize. Will they have long-term success or not? And here I am going to talk about the "China Syndrome": price meltdowns versus long-term growth prospects in third world countries. And then, of course, political implications in the U.S.

We will start with the first thing, which is the shift. If you go back to 1970 and look at third world exports, what you would see is approximately 80% of exports were raw materials--foods, rocks, lumber. Not very complicated stuff. Very low levels of processing. 80% of those exports went to rich countries. If you fast forward to 2000, it is a different picture. 70% of exports from what were considered third world countries are now manufacturers. Things like food are down to 10% of third world exports. And, if we had lots and lots of time, we could actually disaggregate those foods even more finely into high quality foods, like wines from Argentina, as opposed to low quality foods, like sugar and cocoa. This number, 70%, in a sense could be even higher since wine is a kind of manufactured export.

The second big shift is that now 44% of third world exports go to other third world countries, which is a good indicator of the fact that purchasing power has risen in those countries. They make manufactured goods and that means higher incomes. They now can afford to buy more things and, as a consequence, they have a bigger share of world trade and world markets. And this is reflected in the last thing: their total share of world trade has risen from about a quarter to a third. So, there has been a big change in the last 30 years. Third world countries, in the aggregate export and much more in the way of manufactured goods, export more to each other and have a larger share of the world trade. This is significant.

But (and there is always a but) if you look at the share of world GDP, not the share of world trade, it is net of oil, which is very volatile and I think should be taken out of the equation, that has been stagnant at about 20% over the last 30 years. So, there has been a lot of industrialization and a massive change in the export profile but it has not fundamentally changed the relative change of world income that is going to third world countries.

This can be read two ways. One way it can be read is that nothing happened. But, I think that is probably the wrong way to read it since, of course, world GDP has increased a lot since 1970. The fact that they kept the same 20% share means they have gotten a lot richer in the aggregate. But, the other way to read it, and I think that this is also true, is that, despite this massive industrialization and really high rates of growth in third world countries, there has not been, in the aggregate, a major shift in the share of world product that goes to these countries.

Because of the fact that world trade growth is now slowing, the ability of third world countries to use trade to get domestic growth and domestic industrialization will also slow. This means that this 20% share may actually drop a little lower in the upcoming years. The big caveat here is what happens to China.

How did this happen? I am big on history since my first book was historical and my second book was historical. I always like to go back and ask how did this happen, but answer it with a historical analogy. If you go back to the 19^th century and ask how did you get industrialization in third world countries like the United States, Australia and Argentina, the answer is that investment from rich countries chased cheap land. It went looking for places to grow food and other raw materials for industry more cheaply than it could be done in Europe. It went out and colonized the world. You had massive immigration to these countries to provide the labor force--at the beginning, all involuntary, and toward the end, mostly voluntary. In these new lands you had rising living standards which helped draw in these voluntary immigrants.

The result was that some, but not all, of these agricultural exporters attained self-sustaining development, which I understand to mean productivity and income gains via dynamic export expansion. They had really rapid rates of income growth that were linked to rapid rates of trade expansion and inflows of capital and labor.

What do we see in the 20^th century that might be similar? It is clear now that investment is chasing cheap labor. Companies go to China because they can hire people at sixty cents an hour, for the most part. But they only go if they can actually internationalize production. Not all production processes can be split up across the globe. Some things have to be done in one place because of the nature of the production process. Some things require highly skilled labor. So, the "if" here is important.

Investment will chase cheap labor because it is a lot cheaper to hire someone in China at sixty cents an hour to sew shirts together than someone in South Carolina at six dollars an hour. Chinese productivity in the manufacturing of shirts is high enough that sixty cents mean there is a lot of profitability. You can do that for shirts because you can segment the shirt manufacturing process. You can't do that for other things. So, in the 20^th century, investment is chasing cheap labor, not cheap land.

But the result turned out to be pretty much the same. Some of these exporters of manufactured goods have achieved productivity and income gains that are dynamic, via dynamic export expansion, but not all. The result is a fragmentation of the third world that I will talk about at the end.

The "how" is pretty much the same and I can give you a little theoretical explanation of the "how." Part of the story is the usual story about liberalization and comparative advantages that economists tell. Countries do better if they specialize what they are good at and liberalizing trade does rise, in the aggregate, everybody's income. The problem is this is a once off gain. If everyone were to liberalize trade at once, you would get a one-time gain, incomes would rise and it would not necessarily create dynamic expansion. The reason is that dynamic expansion is related to productivity gains--if you cannot make things better, faster, cheaper, you do not have rising incomes. The history of capitalism is the history of better, faster, cheaper. That is why your standard of living is unbelievably better than most of your great-great-great-grandparents. That is why most of you are here. Most of you would actually be dead if you had your great-great-great-grandparent's standard of living. I'd be an old guy at my age instead of being able to pretend that I'm a young guy.

Productivity and income gains are the important thing. How do you get these productivity and income gains? Without going into a long song and dance, what industrial sociology shows us is something called Verdoorn's Law, which is when companies need to create rapidly rising output from their production processes they will figure out ways to do this without making additional capital investments because they are expensive. They try to get more from the existing capital stock. The result is higher levels of productivity.

The critical story here is a story of rapidly rising output triggering rapid gains in productivity, which translate into rapid incoming creases. These rapid incoming creases become self-sustaining because they flow to workers, sometimes, and workers then use this money to buy things, which creates additional demand, which creates rising output for local markets, more productivity gains, higher incomes, etcetera.

Here is the problem with the third world. The problem in the third world, number one, is that, even if you have rising volumes, what third world producers face is falling prices. In third world countries there is a race between rising productivity from rising volumes and falling prices for the products they export. If the productivity side of that race loses, then all you have is falling prices, falling incomes, stagnant of falling local demand, no rising volumes locally, therefore less incentive to seek productivity increases.

The second problem, which I will not talk very much about at all, is that in the rich countries and the poor countries there are high levels of protectionism. You do not actually have that one-time gain from liberalization and comparative advantage. This is especially true for the kinds of things that third world countries are good at producing--food and clothing.

The third problem is that, although we can say as a general rule rising volume leads to rising productivity, it is not so simple. It is not so simple because it is a function of what management is doing, what states are doing to encourage firms to create productivity, and the relationship between firms and their workers. There are a lot of things going on in third world countries that mean that even when you have rising volumes you do not necessarily get rising productivity gains. The question of who owns production equipment and who owns the channels that distribute goods back to the rich countries and other third world countries becomes really important for connecting volume increases to productivity gains. That is why the last problem is a problem with indiginizing (?) control over investment.

Why falling prices? There is an easy, obvious answer to why there are falling prices for third world exports. What are the easiest businesses to get into? Obviously low technology, labor-intensive manufacturers. This is what third world countries should be good at if you look at classical economic theory. They have a lot of cheap labor so they should specialize in labor intense manufacturers. They do not have a lot of highly educated labor and, therefore, it should be low-tech.

Finally, because most third world countries are located at some distance from rich countries, something with a segmented production process--something you can pick up, move somewhere else and process--is ideal. That is why clothing is a classic third world export. You can make the fabric somewhere else, ship it in pieces or in bulk, sew it somewhere and bring it back. It does not disrupt the production process.

What do we mean by labor intense, low-tech and low skill? If you go to Mexico, the average Mexican has an educational attainment of somewhere between 4^th and 5^th grade in the American system. You are not going to do high tech stuff there because you just will not find the workers.

When Ford builds car factories in Mexico, they hire people with high school degrees. The equivalent in this country would be if Ford went out and hired people with U.Va. degrees. That is how rare those people are in the economy and why Ford pays them a lot of money by Mexican standards, not by ours. The ideal thing are these low tech, labor intense manufacturers that allow easy entry. But the problem is that if it is easy for you then it is easy for everyone else. Anybody with a few sewing machines can set up a factory.

This is because there is an oversupply of cheap labor with basic skills. Ultimately, the low wage labor segment of the market is defined by China--a billion plus people at sixty cents an hour wage cost means that, unless you get productivity increases, it is hard for Mexico, Malaysia or India to price their labor higher than that sixty cents floor.

We have this oversupply of labor. The result is that there are falling prices even with rapidly rising volumes. The terms of trade, the price of third world exports relative to the stuff they import from rich countries, have fallen across the board about 20%. Think about things like clothing, toys, shoes, lighting. If you go out and buy things for your kids or grandkids at Target, you can buy a knit turtleneck for three of four dollars made in China, made in Shrilanka. This is the falling price phenomenon--it is because of the ability of manufacturers for these kinds of goods to go out and get really cheap labor.

This is the China syndrome. You have price meltdowns in these goods. It used to be that if you wanted to get one of these turtlenecks (my mother tells me because I do not remember) they were expensive and would be, in today's money, $20 to $25 dollars. To go from that price down to the $3 to $4 turtleneck at Target is pretty amazing. What this means is falling prices and less revenue for these third world economies. Less revenue means, again, less local demand, less rapidly rising output and, therefore, lower productivity gains.

The important thing to note is that this is true even for the most developed of the third world economies. If you look at the four most highly developed Asian newly-industrialized economies--Hong Kong, Singapore, Taiwan, South Korea--from 1996 on, they too have suffered a 22.2% decline in prices. You see this in the concentration ratios, which are a measure of market power. Across the board, the average concentration ratio for third world country manufacturing exports is 600. For all manufactured exports globally, it is about 960. They have one third less pricing power than the average manufactured export in world markets.

Now we can look more finely. Have there been volume gains? There have. Even with high-tech manufacturers, the third world has gotten a larger share. But the caveat to that story is that they have gotten a larger share because they are putting together high tech stuff from pieces made in other countries. When you go home today, another thing you can do is take your cordless telephone off the wall (another thing whose prices have fallen steadily from about $100 to $30 for a basic phone), turn it over and you will see "Made In China." What does that mean? What that means is that some plastic parts locally made were slapped together with some electronic parts made in the U.S. (or Taiwan or Japan) and re-exported back. This shows up as a high tech export because it is telecommunications equipment in the tables. But, it is really a low tech labor intense export, a labor intense manufacturing thing. There have been volume gains but not gains in value added in the value of these things because what they are simply doing is adding labor, not anything else.

If you look at the OECD, manufacturing value added (MVA) is about 180% of manufacturers exports. For less developed countries, manufacturing value added in the economy is about 55% of manufactured exports. They are doing a lot of labor intense processing. This is why, even though there have been huge volume gains, there has not been much in the way of price gain or productivity levels for most of these third world countries.

The last thing is, notwithstanding everything that I have just said, even the little gains that have happened have been highly concentrated. Most of the gains have gone to the big Asian five, which again is Singapore, Taiwan, South Korea, Hong Kong and Southern China. The rest of the ASEAN group--Philippines, Indonesia, Thailand and Malaysia--make up only about 12% of manufactured exports from the third world. Mexico and Brazil make up about 7%. Central Europe and Turkey make up 4%, and then all the rest, about 140 countries, make up 36%. The gains have been highly concentrated mostly in Asia, and within Asia, mostly within the big five. This shows up in the income gains and the productivity gains that we can see in economies like South Korea.

Why? This comes down to a question often of who controls investment. The basic rule of thumb here is that if you do not control investment in trade flows you pretty much cannot control prices. Think about your basic clothing exports--a very typical and major export from the third world. If you do not control the decision to invest in a particular production location, if you do not control the flow of goods back to rich country markets, if you do not control the distribution channels, then you are totally at the mercy of the company doing the investment and that controls the distribution channel. Wal-Mart, for example, could say, "Well, we could source from China, Shrilanka, or Mexico. How de we make our decision? It is based on the relative cost of producing in any one of these countries, so we will look at wages multiplied by productivity to get a relative unit labor cost, and then we will think about our transportation, distribution costs--bringing stuff back from these countries. So we will go where it is cheapest in terms of total costs."

If you look at what Wal-Mart historically did, they first sourced from countries like Hong Kong and South Korea and when wages began to rise there, they then shifted out to countries like Malaysia, Indonesia, and China. Now, interestingly enough, they are coming back to Mexico. The reason is not that Mexican workers are more productive or cheaper than Chinese workers, but other costs in production--moving goods.

Even in a labor intense industry like clothing today, only about 20% of costs are direct labor costs. The rest is logistics--return on capital and things like that. It is cheaper and faster to source clothing from Mexico than it is from China. If you make clothing in Northern Mexico you can get it to Charlottesville in less than 2 days. If you make it in China, it has to be containerized, go onto a boat and then shipped to Charlottesville. That is a week and a half to two weeks when you are not making any money on the clothing. What Wal-Mart would like to do would be to literally sell the shirt and then materialize (like through Start Trek beaming down) a shirt right back onto the shelf. That is the ideal.

What happens is, if you are a third world country trying to get rich selling shirts, you do not control the production process or the distribution channels and you cannot ensure that wages will be stable. Entrepreneurs in your country are going to scratch their heads and say, "why should I invest in a bigger tortilla or chopstick factory to serve these workers who may not have jobs tomorrow?" They will say that they should not do that. So, you do not get dynamic of more demand, more investment, rising output, more productivity, rising income and so on.

Here is the reality. About 65% of trade is internal to multinational corporations or merchant networks. The question is, then, will they stay and reinvest? Will they keep buying? The answer is that you do not know. This is why they gains have been pretty irregularly distributed in the third world. Some countries have been able to push up wages and skill levels at the same time. The result is that they become more and more attractive because their productivity gets higher and higher. This is Singapore's story.

Singapore's story is a story of gradually pushing up wages but, at the same time, even more rapidly pushing up education and skill levels so that they always looked good to companies that wanted a higher skilled workforce. Companies consistently went to Singapore with more and more technologically complex jobs.

Contrast that with Shrilanka. Shrilanka pushes up wages in garment assembly. Why should we stay here? Bangladesh is right around the corner and so is China. Transportation costs are about the same. There is a limited ability to translate rising exports into rising local demand. If you cannot upgrade your wage and skills mix, you are not going to get more investment.

Investment and the China Syndrome. I have already told you this story, but now you can put the pieces together. If you are an investor and you search globally for cheap wages, you end up ultimately in China, which has a billion people at sixty cents an hour and huge internal migration. People are moving from places where there are no jobs, like the interior of China, down to these coastal areas. As a result, if you are trying to compete with China and you have no skill advantage, you cannot compete. Or, if you try to compete, you have to compete at sixty cents an hour. The result of this is that China has sucked up growth from the rest of the third world and this is reflected in its market share. China's share of the U.S. import market is up 25% since 1996. Its share of Japan's import market is up 50% and this has largely come at the expense of other Asian and Mexican exporters of cheap goods.

The result is that you get this fragmentation of the third world. Even though I gave you these gross aggregate numbers at the beginning that seemed to show that the export manufactured goods incomes are rising overall, you actually have a fragmentation. There are four different categories of countries.

The first are Leaders. These are the ones with sustained productivity gains, with rising value added in their output. These are the four newly industrialized Asian economies--Taiwan, Korea, Singapore and the Southern Chinese Regional economy. I lump Hong Kong into that, in the same way that we would not think of Manhattan as separate from metropolitan New York economy. These are the four leaders--where you see really dynamic productivity gains, rising value added, rising incomes and rising shares of world market.

Again, if you want to do a little audit in your house, you can see this. Turn your microwave oven and VCR over and see where they were made and then think back. Now they are mostly made in Korea, but if you went back years ago they would have been made in Japan or the U.S. These are serious, relatively complicated goods that are now made in these four leaders.

Laggards. Now you are going to start to worry because if they are laggards, then it must get worse (and yes, my point is that, in fact, it does get worse). These are countries that are primarily doing labor intense but medium-skilled manufacturing with relatively low levels of value added. This is Malaysia, Turkey, Brazil, Costa Rico, Mexico, Hungary and the rest of China. Why are they Laggards? They are making gains but the leaders are way ahead of them. For them to become leaders they would have to make sustained investments in locals skills that would allow them to produce the more complicated goods.

Labor Intense Losers. These are the ones who are stuck doing low skill, low value added manufacturing. This is the rest of China and you think about China, again, in terms of our telephone, but there is still a lot of China that is simply stitching things together--putting together the three dollar clothes for Target, putting together ten dollar halogen lamps, putting together cheap luggage. These countries, Shrilanka and Tunisia, export manufactured goods. It looks like they have done a big change from where they were, but there is not actually a change. The value added is really low--it is nothing more than the sewing.

Land or Resource Intense Losers. These are the real losers for the most part. These are the places that do not even have manufacturing, where you have exports based on the export of one to three raw materials. In most of these countries that one to three raw material constitutes more than 50% of exports. This is in the Ivory Coast where cocoa is the primary export. This country is totally at the mercy of volatile prices. It has both China Syndrome, gradually falling prices, but also incredible volatility.