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     Apr 26, 2006
Globalization's new underclass
By Stephen Roach

(Republished with permission from Japan Focus)

Billed as the great equalizer between the rich and the poor, globalization has been anything but. An increasingly integrated global economy is facing the strains of widening income disparities - within countries and across countries. This has given rise to a new and rapidly expanding underclass that is redefining the political landscape. The growing risks of protectionism are an outgrowth of this ominous trend.

It wasn't supposed to be this way. Globalization has long been portrayed as the rising tide that lifts all boats. The surprise is in the tide - a rapid surge of information-technology-enabled connectivity that has pushed the global labor arbitrage quickly up

the value chain. Only the elite at the upper end of the occupational hierarchy have been spared the pressures of an increasingly brutal wage compression. The rich are, indeed, getting richer but the rest of the workforce is not. This spells mounting disparities in the distribution of income - for developed and developing countries, alike.

The United States and China exemplify the full range of pressures bearing down on the income distribution. With per capita incomes of US$38,000 and $1,700, respectively, the US and China are at opposite ends of the global income spectrum. Yet both countries have extreme disparities in the internal mix of their respective income distributions.

This can be seen in their so-called Gini coefficients - a statistical measure of the dispersion of income shares within a country. A Gini index (the Gini coefficient multiplied by 100) of zero represents perfect equality, with each segment of the income distribution accounting for a proportionate share of total income. Conversely, a reading of 100 represents perfect inequality, with the bulk of a nation's overall personal income being concentrated at the upper end of the distribution spectrum. In other words, the higher the Gini index, the more unequal the income distribution. The latest Gini index readings for the US (41) and China (45) are among the highest of all the major economies in the world - pointing to a much greater incidence of inequality than in economies with more homogeneous distributions of income, such as Japan (25), Europe (32), and even India (33).

While the US and China suffer from similar degrees of income inequality, they have arrived at this point through very different means. In the case of the United States, there is nothing new about elevated readings of income inequality. America's Gini coefficient has been on the rise for more than 35 years - moving up from about 35 in 1970 to more than 40 today. What is new is how America's income distribution has become more unequal in a period of rapidly rising productivity growth - a development that has been accompanied by an extraordinary bout of real-wage stagnation over the past four years.

Economics teaches us that in truly competitive labor markets such as America's, workers are paid in accordance with their marginal productivity contribution. Yet that has not been the case for quite some time in the US. Over the past 16 quarters, productivity in the non-farm US business sector has recorded a cumulative increase of 13.3% (or 3.3% per annum) - more than double the 5.9% rise in real compensation per hour (stagnant wages plus rising fringe benefits) over the same period.

It is probably no coincidence that the relationship between productivity growth and worker compensation has broken down as the forces of globalization have intensified. First in manufacturing, now in services, the global labor arbitrage phenomenon has been unrelenting in pushing US pay rates down to international norms. But the real-wage compression in the US has not been uniform across the income spectrum. In large part, that has occurred because increasingly broad segments of the US labor market are now exposed to a uniquely powerful competitive force - IT-enabled arbitrage.

Courtesy of the hyperspeed of sharply accelerating Internet penetration, the global labor arbitrage has pushed into areas that historically have been unaccustomed to wage competition. In earlier research I found that the disconnect between compensation and productivity growth during the current economic expansion has been much greater in services than in manufacturing. This once non-tradable segment of the US economy is now feeling the increasingly powerful forces of the global labor arbitrage for the first time.

The Internet has forever changed the competitive climate for most white-collar knowledge workers. Courtesy of near-ubiquitous connectivity, the output of the knowledge worker can now be e-mailed to a computer desktop from anywhere in the world. That brings low-cost, well-trained, highly educated workers in Bangalore, Shanghai, and Eastern and Central Europe into the global knowledge-worker pool. That's now true of software programmers, engineers and designers, as well as a broad array of professionals toiling in legal, accounting, medical, actuarial, consulting and financial-analyst positions.

Within this global pool of like-quality workers, a powerful arbitrage acts to narrow wage disparities. As a result, real-wage compression in open economies such as the United States has moved rapidly up the value chain - sparing an increasingly small portion of those at the very top of the occupational hierarchy. In short, the IT-enabled global labor arbitrage is a guaranteed recipe for mounting income inequality. In the US, Washington's penchant for cutting taxes on the wealthy probably hasn't helped matters either.

In China, it's a different story altogether. China remains very much a tale of two economies - a booming development model at work in the increasingly urbanized coastal part of the nation in stark juxtaposition with relatively stagnant economic conditions persisting in the rural central and western portions of the country. While fully 560 million urban Chinese are now participating in the economy's rapid development dynamic, that still leaves a rural population of some 745 million on the outside looking in.

Interestingly enough, the accelerating trend of rural-to-urban migration has done little to arrest the inequalities of the Chinese income distribution over the past 15 years. This is somewhat surprising in that urban per capita incomes in China ($1,531 in the top 35 cities in 2004) are slightly more than three times those in rural areas ($488). But the increase in China's overall Gini index from 35 in 1990 to 45 in 2003 not only reflects the impacts of an ever-widening income disparity between coastal China and the rest of the nation, but it is also a function of the increased divergence in the distribution of urban incomes. On this latter point, a recent report of China's Academy of Social Sciences notes that average incomes in the bottom quintile of urban Chinese workers are less than 5% of average incomes in the upper quintile.

Significantly, Chinese income disparities in the Internet age may well have a very different connotation than in the past. With increased information-technology (IT) connectivity in western and central China - mainly in the form of the village kiosk - the rural poor now have real-time access to the "outside world". This gives them a very vivid picture of the prosperity they are missing. In that vein, the Internet has the potential to spark resentment and social instability in China's two-track development model - the very last thing the government wants. The Chinese leadership is very focused on the income-distribution issue, and is expected to make this a major topic of debate and policy action at the upcoming National People's Congress.

That campaign has already begun. On February 21, a "new socialist countryside" program was unveiled jointly by the State Council (China's cabinet) and the Communist Party - focused on providing increased support for farmers together with improved education and health care for the rural population. The plan also gives special attention to the role of finance in stimulating rural development, especially through increased bank lending to farmers, along with increased private incentives for investments in rural credit cooperatives. This multi-year initiative is aimed squarely at the income-distribution issues noted above.

As different as the problems are in the US and China, there is no economic issue in either country that hits the political hot button like income disparities. And with both countries suffering from relatively high degrees of inequality, neither can be expected to backtrack insofar as the political response is concerned. Given the mounting trade tensions between the two nations, this poses a worrisome problem: America's increasingly populist politicians have responded to the income-distribution problem by turning protectionist - portraying China as the culprit for the pressures bearing down on middle-income US workers. Even if this view is dead wrong, for China there seems to be no immediate escape from the growing political wrath of Washington.

China, on the other hand, continues to cling to an export- and investment-led growth dynamic that not only fuels political resentment in the US but also seems to have a natural bias toward widening disparities in its income distribution. Yet this same approach drives the vigorous employment growth that is absolutely vital to provide China with the scope to keep dismantling its inefficient state-owned economy. The Chinese leadership knows full well that this is not a sustainable growth formula. Its recent focus on stimulating private consumption and services is a clear recognition that a new recipe is needed. But this will take time - and quite possibly a good deal of it.

Meanwhile, China is engaged in a very delicate balancing act between reforms, which seem to be exacerbating income disparities, and externally focused growth, which seems to be evoking a protectionist backlash. In response, the Chinese leadership is turning to the micro-management techniques of market-based socialism for answers - namely, a gradual shift in its currency policy to diffuse external pressures and targeted income support measures to counter internal pressures. Only time will tell if this is the right approach.

Inequalities of the distribution of income have long been the Achilles' heel of economic growth and development. In an era of IT-enabled globalization, that seems more the case than ever. History tells us that the pressures of widening income disparities are often vented in the political arena. The steady drumbeat of protectionism is a very worrisome manifestation of that lesson. To the extent that the risks of protectionist actions come into play, the US dollar and real interest rates would probably bear the brunt of the financial market response.

Stephen Roach is chief economist at Morgan Stanley. He wrote this article for Morgan Stanley's Global Economic Forum, March 3.

(Republished with permission from Japan Focus )

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