Reference no: EM131134965

Case Study

Has the Growth of Newly Industrializing Countries Hurt Advanced Nations?

In the early 1990s, many observers began warning that the growth of newly industrializing economies would pose a threat to the prosperity of advanced nations. In the Case Study in Chapter 5 on North-South trade, we addressed one way in which that growth might prove to be a problem: It might aggravate the growing gap in incomes between high-skilled and low-skilled workers in advanced nations. Some alarmists, however, believed that the threat was still broader-that the overall real income of advanced nations, as opposed to its distribution, had been or would be reduced by the appearance of new competitors. For example, a 1993 report released by the European Commission (the administrative arm of the European Union), in listing reasons for Europe's economic difficulties, emphasized the fact that "other countries are becoming industrialized and competing with us-even in our own markets-at cost levels which we simply cannot match." Another report by an influential private organization went even further, arguing that the rising productivity of low-wage countries would put immense pressure on high-wage nations, to such an extent that "the raison d'etre of many countries is at stake."6 These concerns appeared to gain some intellectual support from a 2004 paper by Paul Samuelson, who created much of the modern theory of international trade. In that paper, Samuelson, using a Ricardian model, offered an example of how technological progress in developing countries can hurt advanced countries.7 His analysis was simply a special case of the analysis we have just described: Growth in the rest of the world can hurt you if it takes place in sectors that compete with your exports. Samuelson took this to its logical conclusion: If China becomes sufficiently good at producing goods it currently imports, comparative advantage disappears-and the United States loses the gains from trade. The popular press seized on this result, treating it as if it were somehow revolutionary. "The central question Samuelson and others raise is whether unfettered trade is always still as good for the U.S. as they have long believed," wrote Business Week, which went on to suggest that such results might "completely derail comparative advantage theory."8 But the proposition that growth abroad can hurt your economy isn't a new idea, and it says nothing about whether free trade is better than protection. Also, it's an empirical question whether the growth of newly industrializing countries such as China has actually hurt advanced countries. And the facts don't support the claim. Bear in mind that the channel through which growth abroad can hurt a country is via the terms of trade. So if the claim that competition from newly industrializing countries hurts advanced economies were true, we should see large negative numbers for the terms of trade of advanced countries and large positive numbers for the terms of trade of the new competitors. In the Mathematical Postscript to this chapter, we show that the percentage real income effect of a change in the terms of trade is approximately equal to the percent change in the terms of trade, multiplied by the share of imports in income. Since advanced countries on average spend about 25 percent of their income on imports (the United States' import share of GDP is lower than this average), a 1 percent decline in the terms of trade would reduce real income by only about 0.25 percent. So the terms of trade would have to decline by several percent a year to be a noticeable drag on economic growth. Table 6-1 shows how the terms of trade for both the United States and China have changed over the last 30 years (average annual percentage change over the period). The magnitude of the fluctuations in the terms of trade for the United States is small, with no clear trend from decade to decade. The U.S. terms of trade in 2008 were essentially at the same level they were at in 1980. Thus, there is no evidence that the United States has suffered any kind of sustained loss from a long-term deterioration in its terms of trade. Additionally, there is no evidence that China's terms of trade have steadily appreciated as it has become increasingly integrated into the world economy. If anything, its terms of trade over the last 30 years have deteriorated somewhat.

One final point: In Samuelson's example, Chinese technological progress makes the United States worse off by eliminating trade between the two countries! Since what we actually see is rapidly growing China-U.S. trade, it's hard to find much of a relationship between the model and today's reality.