Globalisation and the Danish Economy

Erik Haller Pedersen, Economics

INTRODUCTION AND CONCLUSIONS

Globalisation, measured as the ever-increasing international exchange of goods, services, investments, information, people, cuisine, culture, etc., is not a new phenomenon. The development of means of transport and communication thus led to significant upheavals from the mid-19th century until World War I. In recent years a special focus area has been the growing integration into the world economy of some of the world's most populous nations such as China and India, and this process has only just begun. Another central issue is the technological progress within telecommunications and IT, which has made it possible to exchange services and information in ways that before were either not possible, or arduous and cost-intensive.

This article outlines some of the main findings from the classical theory of trade. A key point is that differences in relative levels of productivity and wages determine the advantages of the international division of labour and thereby of international trade. It is concluded that unemployment is first and foremost attributable to inflexible labour markets, rather than globalisation.

In contrast to a number of other industrialised countries, Denmark has enjoyed double globalisation gains: from substantial growth driven by increased external trade, and from improved terms of trade, since many Danish business enterprises have succeeded in selling their products at increasing prices, while import prices have stagnated. This performance can among other things be attributed to the absence of political measures to artificially keep struggling sectors and individual business enterprises alive. Furthermore, Denmark’s flexible labour market and opportunities for supplementary training, and its social security legislation, have alleviated potential disproportionally severe consequences for certain groups in society. Greater obstacles may lie ahead as low-cost countries like China and India increasingly challenge Denmark’s core production areas. A sustained capacity for innovation and readiness for change can ensure that Denmark continues to benefit from an expansion of its international trade.

Viewed in isolation, a shift in goods imports from high-cost to low-cost countries has reduced consumer price inflation in Denmark. However, in the longer term globalisation cannot generally be assumed to lead to lower inflation, but possibly to a lower price level.

GLOBALISATION INDICATORS

Globalisation is a phenomenon that can be difficult to identify precisely. One indicator of the growing integration of the world’s economies is that since 1990 the expansion of world trade has exceeded the growth in global output as a ratio of GDP, cf. Chart 1. This has been the case ever since the end of World War II. Cross-border trade in services, currently accounting for 20 per cent of world trade, has increased particularly strongly in the last 15 years. The boundaries to what is tradable have shifted in step with the progress in telecommunications and IT. Intermediate goods account for a growing share of world trade, as a result of an increased fragmentation of the international production process, due to outsourcing.

The gradual liberalisation of capital flows over the last 40 years has supported and reinforced global economic integration. Direct investments play a central role in this context as they often besides investment in new capital stock also entail the transfer of technology. This is important to enhancing the opportunities for low-income and medium-income countries to share the benefits of global growth. It is also important for the industrialised countries, since direct investments promote specialisation. Direct investments have risen significantly since 1990, cf. Chart 2.

Another key trend besides the liberalisation of capital flows has been the reduction of various trade restrictions. This is naturally a vital precondition for the expansion of international trade, and there is still quite a long way to go in this area.

The considerable wage differences among the world economies are an important force behind the increased specialisation of the production process and thereby the expansion of international trade, cf. Table 1. Today, a Danish factory worker earns 15 times as much as his Chinese counterpart, while the annual salary of a Danish engineer is almost 10 times higher. The difference is even greater for hourly than for annual wages since in China working hours are typically longer than in Denmark. According to the classical theory of trade on " comparative advantages" , cf. below, the key factor determining which jobs are outsourced is the relative wage differences rather than differences in the wage level.

Since low-wage jobs account for the largest wage differences between e.g. China and Denmark, these jobs are outsourced first. However, as a result of growing trade in services, outsourcing certain high-wage jobs is now also advantageous. It is relevant to distinguish between personal and non-personal services. Non-personal services such as IT services, consultant engineering, financial services, etc., are all high-wage areas that more and more resemble industrial goods that are traded internationally. Personal services, e.g. care of the elderly, cleaning and to some extent teaching, i.e. low-wage jobs, are less exposed to international competition.

Falling transport costs have traditionally been another force driving globalisation. Even though the reduction of goods transport costs has been less pronounced over the last decades than 50-150 years ago, when steam trains and later automobiles and motor vessels gained ground, transport costs as a ratio of the value of the goods continue to decrease. Over the last 15 years, new opportunities for trade in services have arisen as a result of developments in telecommunications, IT, etc., at considerably lower costs.

THE CLASSICAL CASE FOR FREE TRADE

The Appendix presents a highly simplified model of the classical case for free trade, based on Samuelson (2004). The point of departure is two " countries" , e.g. the EU and China, that each manufactures only two products: a high-tech product, e.g. pharmaceuticals, and a low-tech product, e.g. clothing. It is assumed, not unrealistically, that the EU has the highest productivity for both products, but that the advantage is relatively greatest for the high-tech product. This gives the EU a comparative advantage as a producer of pharmaceuticals.

An example shows that a shift from a hypothetical situation without trade relations between the EU and China to a trade scenario results in an increase in real incomes in both countries when each specialises in manufacturing the product that gives it a comparative advantage. The perhaps not quite obvious conclusion is that this still applies when absolute productivity is higher in the EU than in China for both products. This is the classic Ricardian result and the argument at the root of many economists' automatic response that international trade is an undisputed advantage.

The case for the advantages of international trade is deeply rooted and not just the result of a simplified model. It is important to understand that relative productivities drive the case for free trade. The underlying reason is that labour – and more generally also capital and land – as a factor of production is limited. Labour should therefore be utilised where the largest output can be achieved, which is determined by relative productivity showing how much of one product a country must refrain from manufacturing in order to manufacture one unit more of the other product. It is therefore most appropriate for the EU to use its labour force to manufacture the product for which its productivity is relatively high, and leave the manufacturing of clothing to China.

In reality, the market naturally encompasses many goods and services, and typically many different market segments, in each of which comparative advantages can be achieved. In practice, the individual countries will not opt for such extreme specialisation as assumed in the simple model. For example, the EU still has considerable production of clothing, while China has a certain production of pharmaceuticals. This does not change the overall principle, however.

In a market economy in equilibrium, relative productivities can be translated directly into relative wages since productivity determines the wage that can be paid if output is to remain competitive. The key conclusion from the preceding section and Table 1 that relative wages rather than wage levels are the central determinant again applies here. It will never be expedient to relocate all output to one country, not even when the absolute labour costs for all goods and services are lowest in that country.

Wage levels are not static, but in themselves respond to international trade. According to the factor price equalisation theorem, free trade entails harmonisation of the wage levels in countries that trade with each other. In practice, large wage differences persist for protracted periods, and even if harmonisation does occur, the actual level is still an open question. History shows that the integration of low- and medium-income countries into the world economy often brings wage levels in these countries closer to the wage levels of the high-income countries, rather than vice versa. This has been corroborated many times. A historical example is that wage levels in Europe and Japan after World War II approached those in the USA, and not the other way around, as a consequence of technology transfer, among other factors. A more recent example is the integration of many Asian economies into the global economy. The concern that free trade would generally start a race for the poorest wage and working conditions thus seems to be exaggerated, although some groups may be affected.

The classical explanation for comparative advantages is that they reflect differences in the countries' natural endowment of the production factor. For example, China and many other low-income countries often have very large populations, which give them a comparative advantage in labour-intensive production, e.g. textile manufacture. In general, however, comparative advantages and international competitiveness are increasingly created by education, creativity and innovation, and hereby the quality rather than the quantity of the labour force. The availability of natural resources also plays a role, cf. the example of Norway below.  

The classical case for free trade assumes a world with a perfect market, but in practice, the market may not always operate perfectly. For example, it may be subject to price and wage rigidities. However, such problems are not likely to be solved by establishing barriers to international trade. A more viable strategy should be to improve the framework and structure of the market, which requires suitable institutions and legislation, cf. e.g. Stiglitz^[1]. The expansion of international trade as a consequence of international specialisation has been a key driver of the global increase in prosperity since World War II.

GLOBALISATION AND TERMS OF TRADE

Returning to the theory of trade, it is possible to analyse different shocks. It can, for example, very realistically be assumed that China's productivity for the low-tech product in which it specialises will increase over time. This may be the result of new inventions, improved production methods or transfer of technology as a result of direct investments.

As shown in Appendix Table 3, not only China, but also the EU, will gain from an increase in productivity in China, although not necessarily to the same extent. The gain to the EU results from a decrease in the import price relative to the price of the EU's export product, i.e. pharmaceuticals, as a consequence of an increase in the supply of the product, clothing, manufactured in China, i.e. the EU sees an improvement in terms of trade. This gives higher real income from a given output in the EU. Conversely, China's terms of trade deteriorate, but the increase in productivity – i.e. more output for a given input of work – will probably dominate.

An alternative scenario is that China embarks on substantial production of pharmaceuticals, i.e. the high-tech product, so that the price of this product decreases relative to the low-tech product, and the EU's terms of trade deteriorate. In the example in the Appendix, the productivity increase in China is strong enough to cancel the EU's comparative advantage, and the EU suffers a direct, permanent loss of real income.

The conclusion is that globalisation is not necessarily always a win-win situation. In countries with weak development in productivity and innovation, real incomes may be subject to permanent downward pressure. Specifically, the development in China and the EU has so far mostly resembled the scenario with increasing Chinese competitiveness in the production of the low-tech product, which is also an undisputed advantage to the EU via lower import prices. The question is whether this will last, or whether the growing strength of China and other low-wage countries, such as India, will to a higher degree also challenge the West in terms of goods or services such as pharmaceuticals, software development, etc., for which the EU, or the USA, has so far held the competitive advantage. It is important to realise that the EU cannot prevent this downward pressure on income by introducing trade barriers or similar measures. The only way forward is to improve productivity.  

The model in the Appendix describes a world with complete price and wage flexibility and thereby permanent full employment, so that shifts in productivity between countries impact the terms of trade and real income. This must also be assumed to apply in the real world in the longer term. However, when the consequences of globalisation are assessed, the focus tends to be on the situation in the adjustment period, when unemployment may be rising. As a result, trade restrictions against the competitor country(ies) are sometimes called for. However, there is no shortcut to prosperity. If the country artificially raises the price of imported goods, it misses out on low-cost imports and maintains " expensive" domestic production of e.g. clothes or shoes. In the short term, this may increase employment, but to the detriment of real income in general terms. In most cases, it would be more beneficial to the economy to let the competition from abroad make its mark. Trade restrictions tend to preserve the production structure, thereby preventing the restructuring of the labour force to production with higher added value, and the country in question can easily fall into a low-wage trap. Restructuring production to new products may entail higher unemployment in the short term, but will contribute to increasing real incomes in the longer term.

The duration of the adjustment period and the magnitude of the adverse effect on employment are directly proportional to the flexibility of the labour market, i.e. how flexibly the labour force can be moved from declining to advancing sectors. All in all, the policy recommendation is to create the framework for a flexible labour market and readiness for change, rather than to introduce short-term measures such as trade barriers and restriction of business enterprises' opportunities to match the labour force to the demand for their products, etc. The Danish labour market has come far in meeting this challenge.

Liberalising capital flows makes it possible to postpone the adjustment to new terms of productivity by borrowing to finance consumption and investments for a period, but this does not in principle affect the above arguments.

SIMULATIONS ON THE MONA MODEL

A number of simulations have been made on the macroeconomic model for Denmark, Mona, to illustrate the effects of globalisation in the short and long term. The effects of shocks to export and import prices are calculated. Globalisation input to the model calculation is via (exogenous) assumptions regarding foreign markets and prices.

Import prices are assumed to decrease by 2 per cent as a result of the arrival of China and other low-cost countries in the world market (i.e. a one-off shock). The consequence for Denmark in the short term is weaker consumer price inflation and slightly higher private consumption, cf. column 1 in Table 2. A neutral fiscal-policy stance is assumed for the long term.

The lower import prices will increase the market share of imported goods, thereby pressing Danish products out of the market, with the transitional effect of lower employment. However, in the long term there is no negative effect on employment, but a positive effect on private consumption, reflecting higher real incomes in Denmark. This is fully consistent with the results of the Samuelson model where opportunities for consumption expand in step with the division of work.

The second column in the Table illustrates a scenario where competition from low-cost countries relates more to Denmark's core products, which exerts pressure on Denmark's export prices, whereas import prices are unaffected. This scenario implies a permanent decrease in opportunities to consume in Denmark, while employment again is unaffected in the long term. This corresponds to the result in Appendix Table 4.

If not only Denmark's import prices, but all foreign prices, fall by 2 per cent, the long-term result corresponds to the sum of columns 1 and 2. Employment falls in the first years, when consumption is dampened by the adverse cyclical effect. In the longer term, there is no change in terms of trade and consumption effect as in columns 1 and 2. We merely adjust to a situation where consumption is unchanged at a lower nominal price and wage level. This again emphasises that the advantages of globalisation are driven by relative prices and changes therein. When changes in import and export prices are identical there is no change in relative prices, and the question is thus whether China and other low-cost countries are adapting to our wage level, as historical experience indicates, or whether we are adapting to their wage level.

This scenario, with no real impact on Denmark in the long term, implies that the low-cost countries end up manufacturing the same products as the high-cost countries, so that the latter do not benefit from the increased division of work, while the low-cost countries naturally benefit from the boost to their productivity.

The Danish labour market is characterised by high job turnover. Up to 250,000 jobs disappear each year, but a corresponding number of new jobs are created. Surveys show that approximately 5,000 of the lost jobs, or 2 per cent, can be attributed to the relocation of Danish business enterprises to abroad^[2]. However, this figure by no means reflects the magnitude of the challenge to the Danish economy from globalisation when measured as the number of jobs that have to be reallocated each year as a consequence of external competition.

GLOBALISATION AND INEQUALITY

Labour is by no means a homogeneous commodity. In practice, there are differences not only between countries, but also within countries between the segments of the labour force involved in producing respectively high-tech and low-tech products. Even though the globalisation process overall entails advantages, some groups may lose from it, as shown by the Samuelson model. This can contribute to widening internal divides within, for example, the EU between the various labour groups, since the immediate consequences of globalisation may vary considerably for each of these groups.

However, all other things being equal, it is possible for countries to compensate those who stand to lose from globalisation in the short term, e.g. via government budgets, and to prepare them for the more competitive environment by upgrading their qualifications, retraining, supplementary training and education, or similar measures. The effectiveness of the individual OECD countries in this respect varies strongly.

As a consequence of significant reallocation via government budgets, Denmark is among the countries in the world with the lowest degree of inequality of disposable incomes and in consumption opportunities for its citizens, cf. Chart 3. In combination with an active labour-market and education policy, this has to a high degree shielded the groups that would otherwise lose from globalisation. Inequality, measured by the Gini coefficient, has increased only marginally in Denmark over the last 10 years, while several other countries have seen rather strong increases. This applies to e.g. Sweden and Finland that are also characterised by a low degree of inequality in international terms. Other factors besides globalisation also determine inequality.

TERMS OF TRADE – EMPIRICAL EVIDENCE

In the case of both high- and low-income countries the consequences of globalisation for prosperity, measured as the development in opportunities to consume, are determined by factors such as the development in terms of trade. Denmark's terms of trade have been increasing for the last 15 years, also when energy is excluded, cf. Chart 4. The clearest trend has been observed for goods, while terms of trade for services have increased more moderately. In recent years this has even been reversed to a decrease as a result of such factors as declining freight rates for container shipping, which is a major Danish export.

These patterns reflect that while import prices are kept down by e.g. cheap products from China and other low-wage countries, Danish business enterprises have been able to sell their products at rising prices in the world market. Relocation of production to low-wage countries has contributed to this development by making it possible to transfer labour to the production of " up-market" products with higher added value. There has been no impact on employment, which confirms the flexibility of the labour market.

The improvement in Denmark's terms of trade is relatively broadly based and does not hinge solely on a few sectors. In many areas, the ever-increasing knowledge content of the products has enabled business enterprises to sell more at rising prices. A case in point is the pharmaceutical industry, which has seen significant growth in both prices and sales volumes over the last 10 years, cf. Chart 5. In the textile industry, prices have on the other hand receded, but an increasing share of processing has taken place in low-wage countries, so that the activity in Denmark has been up the value chain.

This favourable development is not shared by all high-income countries. The terms of trade for the EU taken as one have been unchanged since 1990, cf. Chart 6, and the adjustment process has resulted in significantly higher unemployment than in Denmark.

In Sweden and Finland, the terms of trade deteriorated during the same period, when the two countries achieved high economic growth. One contributing factor is a strong productivity improvement for some of the products for which these countries hold a comparative advantage, e.g. telecommunication products. In view of the effective competition, the productivity gains have been passed through to consumers as lower prices, including lower export prices. However, this does not change the fact that in overall terms globalisation has been an advantage to Sweden and Finland.

Norway's terms of trade have improved strongly in step with rising prices for oil and natural gas. Norway is a special case since its comparative advantage stems from a natural resource. This is only true of a few other high-income countries.

The model in the Appendix is static. In practice, economic growth will typically be positive. On comparing countries' relative economic performance, it should be borne in mind that the traditional GDP growth rates based on the national accounts do not capture the consequences of shifts in terms of trade. All other things being equal, an increase in a country's GDP at constant prices increases its real incomes and thereby its opportunities for consumption. An improvement in the terms of trade will underpin this development, while deteriorating terms of trade will curtail the underlying opportunities for consumption, cf. Box 1.

The development in public- and private-sector consumption is relevant to prosperity. Chart 7 shows the consequences of the terms of trade for consumption in the period from 1993 to 2005. While the underlying opportunities for consumption in Sweden and Finland must be adjusted downwards on correction for changes in terms of trade, the opposite applies to Denmark. Globalisation has resulted in double gains for Denmark, since it has enhanced economic growth and improved its terms of trade.

GLOBALISATION AND IMPORT AND CONSUMER PRICES

In an assessment of the price consequences of globalisation it is important to distinguish between prices of finished goods and prices of commodities, since the respective effects have diverged considerably. The strong global economic growth stemming from globalisation has thus exerted upward pressure on commodity prices in the world market, while increased imports from low-cost countries have, all other things being equal, exerted downward pressure on prices for finished goods.

The development in a broad import price index, such as the index of the domestic supply of goods, has been volatile as a result of fluctuations in commodity prices. The weighting of commodities in the index is more than 50 per cent. In recent years, price increases for imported goods have generally exceeded consumer price inflation, but there were some periods during the last 10 years when price increases for imported goods were lower, cf. Chart 8.

Since the mid-1990s, price increases for imported finished goods have been modest due to such factors as higher imports from low-cost countries such as China and the new EU member states. For finished goods, an import shift from high-cost to low-cost countries entails lower import prices^[3] that are passed through as lower consumer price inflation. On the basis of the Mona simulation in Table 2, a sustained decline in import prices by 1 per cent p.a. pushes down consumer price inflation^[4] by 0.3-0.4 per cent p.a.

However, the direct price effect of importing from low-cost instead of high-cost countries is a one-off effect that can be attributed to lower price levels in the low-cost countries. The import share must therefore increase on an ongoing basis for the effect to be permanent. Only persistently lower price increases for imports from low-cost countries can lead more permanently to lower import price increases and thereby lower consumer price inflation in the high-cost countries.

Increased openness and international trade increase exposure to competition and exert downward pressure on prices for the traded goods. This applies especially to low-tech products, while increasing productivity is vital to the development in prices for high-tech goods. It has been pointed out from several sides, including the IMF^[5], that the shifts relate primarily to relative prices. In the long term, the general price level is in principle determined by monetary policy, and thereby by the central banks. For as long as there are no changes in the monetary-policy objectives as inflation targets, or in Denmark's case exchange-rate targets, there is no reason to assume that globalisation will more permanently lead to lower inflation. The lower rate of increase in imported goods solely allows for higher price increases for other goods.

APPENDIX – KEY POINTS FROM THE INTERNATIONAL THEORY OF TRADE

This Appendix presents a brief overview of some principal findings from the classical theory of trade which are key to an assessment of the consequences of globalisation. The review is based on a very simplified model of the type that has been used in the literature since the time of the British economist Ricardo in the early 19th century. This review is based on Paul Samuelson's article from 2004^[6]. Samuelson was one of the first recipients of the Nobel Prize for economics, in 1970.

The point of departure is two " countries" , e.g. the EU and China, which are both self-sufficient to begin with, i.e. they have no trade relations. China's labour force is assumed to be 1,000, and that of the EU is assumed to be 100. This assumption is not decisive to the qualitative results, but probably to the quantitative results such as a breakdown of the gains from international trade between the countries.

Each country manufactures two products: one high-tech product (product 1) and one low-tech product (product 2). There is equal demand for the two products, at identical levels in both countries. This means that half of the labour force in each country manufactures product 1, and the other half manufactures product 2. Only one factor of production is applied, i.e. labour, and a Ricardian assumption of constant full employment is made.

A key assumption is that productivity (unit of GDP per unit of labour) in the EU is on average 10 times the level in China, but the difference is less than factor 10 for product 2, and more than factor 10 for product 1. This gives the EU a comparative advantage in manufacturing product 1 (high-tech), and China a comparative advantage in manufacturing product 2 (low-tech). A numerical example is shown in Table 1.

As appears, real income per employee is 10 times higher in the EU than in China. If the two countries are opened up to international trade, they can both increase their real incomes by specialising, and thus solely manufacturing the product that gives the country a comparative advantage. The key point, which goes back to Ricardo, is that this will be the case even though the EU in absolute terms accounts for the highest productivity for both products. In our stylised example, free trade doubles employees' real income in each country relative to a situation with self-sufficiency, cf. Table 2.

In our example, the prosperity gains from free trade are distributed equally between the EU and China. This need not necessarily be the case. For example, an interesting aspect is that an increase in China's population relative to the EU reduces China's real income per employee in relation to the EU when there is a shift from self-sufficiency to free trade. The larger the population of a country entering the world market, the greater the advantage to the high-cost countries in terms of an increase in terms-of-trade gains. This is probably the opposite of the popular view.

Tables 1 and 2 illustrate the key point of the international theory of trade, which is the basis for most economists' recommendation that free trade is an advantage for all parties. The following Tables serve to qualify this view.

Table 3 illustrates a situation with an exogenous increase in China's productivity (from 4/20 to 16/20) for product 2, i.e. the low-tech product, that gives China a comparative advantage. As the Table shows, this increases real incomes further in both China and the EU.

Table 3 shows a terms-of-trade loss for China as a consequence of the increased productivity for product 2, which the country manufactures. This means that part of the advantage falls to the EU since imports from China become cheaper measured in product-1 prices. In the example, the productivity increase in China offsets the terms-of-trade loss, so real income also rises in China. However, situations can be envisaged^[7] where the loss on terms of trade is so great that China's position is less favourable than before the productivity increase. This phenomenon is called " immiserizing growth" in economic literature.

The last scenario, Table 4, illustrates a situation with an exogenous increase in China's productivity (from 1/20 to 16/20) for product 1, i.e. the product that so far has given the EU a comparative advantage. In order to make the point clear, the productivity increase is assumed to be of a magnitude that erodes the EU's entire comparative advantage, so there is no longer a basis for international trade. This brings the EU back to the same situation as when it was self-sufficient, while real incomes in China rise.

A more realistic model than the simplified Samuelson model would include a smooth transition whereby increasing productivity for the high-tech product in China will increase the country's real income per employee as a result of both the increasing productivity and improved terms of trade. All other things being equal, the consequence for the EU will be a terms-of-trade loss and thereby downward pressure on real incomes.

The model reviewed is as stylised as possible in order to make the points clear, but it is also relevant in more general and thus more realistic situations with more products, including non-traded goods, more countries, and an expansion of the production function to include capital. The assumption of full employment entails that the consequences of productivity changes in the model impact on terms of trade and real incomes, rather than unemployment. This disregards the adjustment process that the economies normally have to undergo in the event of productivity changes. The model thus focuses on the long term.