The Bear’s Lair: The world may become too flat for comfort

In Western countries, we have assumed since the late eighteenth century that technological advances will continue to increase our living standards, and that any living standards convergence with emerging markets will be overwhelmed by greater prosperity for all. About five years ago I questioned this view in the short term, believing that modern communications technology was allowing emerging markets to compete for Western business, narrowing differentials. However I then assumed that this narrowing was a temporary process, and that once the Internet’s effects had been absorbed, differentials would remain, at perhaps half their previous level. Given UNCTAD’s latest figures on foreign investment, however, I now think that may have been too optimistic (from a Western point of view.)

For the past 200 years Western living standards have been higher than those elsewhere, because of Westerners’ better access to capital and the latest technologies. The West was able to exploit its advantages to dominate emerging markets as suppliers of raw materials and labor. Only a few countries, such as Japan and later the growth economies of East Asia, were able, by means of saving, good government and intensive application of Western know-how through education, to accumulate capital and reach standards of living that were more or less Western.

This began to change with the advent of modern telecoms and the Internet. Suddenly it was much easier to construct global supply chains for goods and services, in which routine work was outsourced to countries with low labor costs, notably China. At first, this appeared to be win-win; Western countries got cheaper goods while Chinese workers improved their living standards. You only have to look at the extraordinary decline in real prices of garments and shoes in the last quarter-century to see the benefit of this.

However, as was entirely in their rights and entirely predictable, the emerging markets workers participating in global supply chains quickly acquired new capabilities of their own. The software writers became fully fledged engineers, even designers. The garment workers became designers and production managers. It turned out those vaunted Western skills weren’t so unique after all.

Still, as of five years ago, it seemed likely the new world would settle down with the gap between Western and Third World earnings narrowed but not eliminated. After all, the West still had vastly more capital and an education system that produced huge numbers of people with very expensive degrees. It would surely take several decades for emerging markets to compete with those endowments, and meanwhile global living standards could continue increasing to a level at which Westerners were still getting richer, just not as quickly as others.

That comfortable assumption may need to change. For one thing, the belief that rich countries would retain a large advantage in their capital endowment now appears to have been mistaken. It should always have been suspect – poor countries have had higher savings rates than rich ones for decades. However UNCTAD’s annual survey of foreign investment for 2014 indicates just how rapidly the balance is tipping. In that year, foreign direct investment from emerging economies hit $484 billion, up 30%, with emerging Asia accounting for $440 billion of this, while conversely FDI from developed economies was flat at $792 billion. Emerging markets’ share of total global FDI was thus 36%, up from 24% in 2010 and only 14% in 2005. In other words, there has been a 22% swing towards emerging markets as capital providers in only 10 years.

At this rate emerging markets’ share will exceed 50% in 2020. In other words, by that date, developed market dominance as providers of capital will be gone entirely. Admittedly the population of emerging markets is some 7-8 times’ that of developed markets, so the capital provided per capita will still be much less. Even so the power of developed markets to determine the shape of the global economy will have disappeared, and with it their citizens’ power to earn much more than their poorer cousins. Rather than declining asymptotically to a level perhaps half that in 1995, the income differential between developed and emerging markets seems likely to disappear altogether.

This was not inevitable, but instead is caused by a sclerosis that sets in among countries that become rich, which makes them uncompetitive and saps their ability to maintain their wealth.
Their state sectors expand, driven by the twin forces of demand for welfare and regulation. Welfare itself would have little directly adverse economic effect (though it weakens incentives and reduces savings) if only it were well designed and administered, but it never is.

Welfare payments that reach the intended recipients remain in the private sector, because the recipients spend them according to the alternatives offered by the market. However the massive administrative burden caused by the welfare system expands the percentage of the economy determined by non-market forces, as does the growing percentage of welfare that is creamed off in various scams.

Regulation is more serious, because it is imposed without proper cost controls, and can make entire economic sectors disappear. The fracking business in the northern sector of the Marcellus Shale that revivified Binghamton NY, making it an economically vibrant hub of high-paid blue-collar jobs – it doesn’t exist, because New York Governor Andrew Cuomo, driven by the crazed environmentalist left, banned fracking in New York State.

U.S. productivity growth declined from 2.8% per annum in the period 1948-73 to 1.8% per annum in 1974-2010 to 0.6% per annum in 2011-15 – almost entirely owing to regulation rather than to public sector bloat, which has increased only moderately since 1970. However the EPA and other big regulatory agencies date to the 1970s, and coincide eerily with the end of the post-war U.S. productivity bonanza. Monetary policy, by distorting the free market’s asset allocation process, undoubtedly bears part of the responsibility for the further post-2011 slump in productivity, but there’s no question the Obama administration’s thirst for regulation has made matters worse. Only in retrospect will we be able to allocate blame accurately between the two factors.

As well as a bloated public sector and excessive regulation, there are other ways in which rich countries increasingly diverge from the free-market ideal. Infrastructure projects’ costs are outrageous in modern Western economies, a large multiple in real terms of their costs 50 or 100 years ago. That’s not because we have got less efficient at laying concrete or building bridges. It’s because of the tangled mass of regulations on safety, environmentalism, workforce and other matters, none of which are costed properly, each of which adds substantially to the expense and delay in building infrastructure, and the combination of which is devastating.

Another pernicious addition to modern Western economies is the charitable sector. This has expanded to about 7% of GDP in the United States, driven by innumerable unjustifiable tax exemptions that allow the very rich to pay a fraction of the taxes paid by middle class people. These charities mostly bring benefits of only a tiny fraction of their costs – the Clinton Foundation, devoting only 3% of their tax-deductible donations to genuine charitable purposes, is all too typical. However charities’ activities in diverting resources to themselves and providing political support for the worst political boondoggles makes their cost to the economy far greater than even their direct absorption of resources. Western economists complain about the inefficiency of fuel subsidies in poor countries such as India and Venezuela; in reality charity tax subsidies in the West are just as economically damaging.

Modern intellectual property rules, with innumerable competing patents and copyright lives stretching towards a century, reduce the level of true innovation and turn the tech and creative sectors into pure rent seekers. In these sectors, profitability is maximized not through innovation but by forcing competitors out of the market through copyright and patent manipulation, thereby prolonging the super-profitable lives of old innovations and creative works.

Finally the ultra-low interest rates of the last 7 years have sapped Western savings (a tendency exacerbated by generous welfare systems). With savings inadequate, the capital endowments of Western economies have shrunk and have also been diverted into unproductive speculation and asset investment. Anyone who thinks the current level of London house prices does anything at all for the true wealth and productivity of the British economy is living in economic dreamland.

There’s no question: some emerging markets are so badly run or so mired in civil war that they will never grow rich under their present management. One thinks of Venezuela, in which petroleum revenues prop up a government worse than any other in Latin America, in a potentially rich country. However even the poorest of countries, Democratic Republic of Congo, can now achieve growth of close to 9% annually, according to IMF figures, in the middle of a civil war. With a cellphone network in place, small entrepreneurs are able to start doing deals in the intervals between gun battles.

Thus modern technology has reduced the ability of bad Third World governments to keep their people down. As emerging markets in general get richer, their example will ensure that the pockets of true despair get smaller and smaller, so that eventually the whole emerging market world will have living standards converging on those of the West.

The West in turn, appears likely to attract more and more barnacles to its economy, slowing economic performance and dragging living standards down to Third World levels. The example of Japan suggests that even emerging markets that attain wealth will develop Western-style barnacles, and begin to sink back again towards their poorer peers.

For us Westerners, living standards equality with the Third World appears inevitable, probably within the next 20 years. The only question is whether emerging markets will in turn acquire Western “barnacles,” thereby reducing the entire planet’s living standards to a level at which the Industrial Revolution might just as well never have happened.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)