American Market Failure or Distributional Issue

In describing these trends, we have been asked several times what the nature of the market failure is. The answer seems fairly clear. There is no major market failure in the way economists normally use the term.

Multinationals, businesses that operate in the global economy, and those who have a role in creating and managing global supply chains are good at what they do and getting better all the time. They are knowledgeable about doing business in multiple national environments (an important capability).

They identify and respond to market and supply chain opportunities. The transactions costs of complex and geographically disperse supply chains are coming down because of a combination of management expertise and information technology that allows efficient coordination of complex, geographically dispersed systems.

The costs of remoteness are declining, or, as Thomas Friedman would say, the world is becoming more flat. The global economy has an abundance of human resources and they are becoming more accessible as time goes on. They deepen in human capital and skills as the emerging economies develop.

The portions of the supply chain in which these economies have the potential to be competitive are growing. Multinational companies, which operate in a way that gives them access to these assets and to growing markets, are doing exactly what one would expect them to do.

The resulting efficiency of the global system is high and rising. So, there is no market failure. The system is complex and constantly evolving, but the operatives in the system adapt to the shifting sands of comparative advantage and market size, and move economic activity (think of parts of the value-added or global supply chains) to the places where it can be performed at high efficiency and low cost. If the issue is not about efficiency or market failure, what then is the problem?

The answer is that market forces have distributional consequences in employment opportunities and incomes. Subsets of the world’s population, including those within individual countries, may experience adverse effects.

Table 2. Measure of Income Distribution in Selected Economies

One way to think about what is going on is that global markets are becoming more integrated in tradable sectors and functions, whereas before they were separated geographically by high transactions costs and policy barriers. When markets merge, or partially merge, there are effects on prices, wages, and incomes. Some rise and others fall. Not everyone is happy.

This seems fairly clear in the U.S. economy. The most educated, who work in the highly compensated jobs of the tradable and nontradable sectors, have high and rising incomes and interesting and challenging employment opportunities, domestically and abroad. Many of the middle-income group, however, are seeing employment options narrow and incomes stagnate. Recent surveys suggest that people have doubts about the opportunities available for future generations.

This may be pessimism induced by the tremendous shock of the crisis, high unemployment, and a difficult recovery. But it appears that the declining employment opportunities in the tradable sector for middle-income employees predate the crisis. Uncertainty about both the quantity and quality of the employment opportunities for this group is considerable.

The distributional changes within the United States are mirrored by those between nations. In most of the postwar decades, advanced countries did well. War-damaged economies recovered and advanced economies grew at respectable rates (on the order of 2.5 percent in real terms per year). By and large, they did not have major unemployment problems. Meanwhile, the developing countries, admittedly with numerous false starts and different starting points, began to grow.

The pattern of that growth spread. Poverty reduction has been tremendous, and more is yet to come. The arrival of China and India (at different times) in the high-growth group was a major turning point because of their large populations (almost 40 percent of the world’s population between them). But even then, because they were relatively poor and economically small, in the early stages of their growth, their global economic impacts were also small. That is now changing. Over time, at growth rates in excess of 7 percent a year (which implies doubling or more every decade), their economies are becoming larger and richer, and beginning to have a systemic impact.

During the postwar period, the distributional effects of globalization were largely benign, but we now appear to be at a crossroads. The major emerging markets and the developing countries more broadly are collectively, and in some cases (like China) individually, systemically important, in terms of both macroeconomic and financial stability and the effect they have on the structure of other economies.

Many of those effects are positive. Consumer goods, for example, are less expensive than they would be in a less open environment. But the distributional effects may be negative. Within countries, inequality may rise. Between countries, the success of the emerging economies may impose costs on richer ones, straining public support for globalization.

Implications for Policy

One possible response to these trends would be to assert that market outcomes, especially efficient ones, always make everyone better off in the long run. That seems clearly incorrect and is supported by neither theory nor experience. It is true, as in the United States, that many goods and services are less expensive than they would be if the economy were walled off from the global economy, and that the benefits of lower prices are widespread.

But these cost savings do not necessarily compensate for diminished employment opportunities, and it would be presumptuous in the extreme for policymakers to tell voters what their values and preferences should be. People might trade cheaper goods for assurances that a wide range of productive and rewarding employment options would be available, now and in the future, for themselves and their children and grandchildren, even if the cost of goods they consume were to rise.

A second position acknowledges the distributional effects. If we want to use the market system in the context of an open global economy, distributional implications are inevitable, but we have to accept them. Why? Because, the argument goes, the alternative is not having an efficient market system operating in a relatively global open economy, which would be far worse.

However much one might wish otherwise, it is impossible to fully compensate those whose employment opportunities or incomes are adversely affected. This stance is more realistic than the first one. There probably are real choices between aggregate income levels and efficiency on the one hand, and distributional equity and employment opportunities on the other.

But, to complete the assessment, one needs to explore policies that may improve the trade-off. In principal, one could restrict access to the domestic market by foreign suppliers. This generally falls under the heading of protectionism, risks reciprocal action, and sets an escalating pattern almost certain to cause more harm than good.

Further, it raises prices for many goods for the whole population. It is not a good idea when carried out aggressively on a broad front. The G20 is right to caution repeatedly about widening protectionism. A preferable approach is to accept globalization but to look for domestic policies that will reduce the distributional impact at home.

Admittedly, no simple policy fix will achieve this. Addressing inequality is a complex challenge; almost certainly a multipronged approach will be needed. But the challenge should not be ducked, because the availability of quality employment and the rising gaps in income distribution are politically and socially salient issues, and opportunity is a core piece of the social contract.

The absence of rewarding employment opportunities in the lower- and middle-income ranges breaks an important part of the social contract in America, which holds that you are largely on your own but that if you work hard the opportunities will be there. The second part of that contract is now in question. The follow-on question is what practically speaking can be done to shift the evolving global structure in our favor without causing excessive damage to the overall system or to others.

This analysis indicates that part of the answer must come from altering the trends in the tradable sector. Market forces operating in the global economy are powerful. It is not reasonable to define the challenge as resisting or overriding them. But the goal must be to shift incentives at the margin so as to improve the distributional effects in U.S. favor. What follows is not meant to be a full discussion of policy options but rather a suggestive starting point.

On the supply side of labor markets, the state and individuals can invest or co-invest in physical capital (infrastructure), institutions, human capital, and the knowledge and technology underpinnings of the economy. These investments generally have the effect, in advanced and developing countries alike, of raising the return to private investment, causing the latter to expand in scale and scope and employment along with it.

What type of investments would make sense? Maintaining the U.S. lead in higher education is a starting point. The high value-added jobs, especially the higher paying ones in the tradable sector, generally are filled with highly educated people with college degrees and above.

Making sure that the United States does not fall behind in this regard makes sense as part of a portfolio of policies. Of course, it does not guarantee that the number of jobs is significantly expandable, given the scope of the tradable sector, but it might promote job growth and, with more scientific and engineering degrees, the scope might expand too. There is some evidence that U.S. leadership in education has been eroding in some areas.

Next, Washington should continue to support fundamental research. The public-sector investment in knowledge and technology is large in the United States, and has been an important foundation for driving new technology, growth, and productivity. But, in some areas, given budget constraints and competing obligations, this investment is on the decline. Human capital is a byproduct of the research investment, and many think that the byproduct is as important as the direct knowledge output.

It is probably a good idea to explicitly target some of the public-sector investment at technologies with the potential to expand the scope of the tradable sector and employment. Coinvestment with the private sector, which has relevant knowledge about where these opportunities might be, would make sense. This public investment would have the effect of shifting private incentives so that they are better aligned with social objectives.

Multinational firms operating in the tradable sector have access to abundant supplies of relatively low-cost labor in the global economy. In this kind of environment, the payoff to investing in capital-intensive technologies that increase labor productivity in high-income countries in the tradable sector is minimal. However, that incentive can be shifted somewhat with public-sector coinvestment that would lower the private sector’s cost of investment. The shift of incentives would expand the employability of domestic citizens in the tradable sector.

Infrastructure should also be part of the portfolio. It directly adds employment and improves competitiveness and efficiency in a wide range of sectors. Given the difficult current fiscal situation, it will be hard to find the fiscal space to expand investment in these areas.

Exploring public-private joint ventures to build or upgrade infrastructure may therefore be a useful avenue. There is a growing body of experience with the public private partnership approach to infrastructure in developing countries, which often want to accelerate infrastructure investment to support growth, but which have limited and constrained fiscal resources.

Finally, tax reform would help if in addition to eliminating waste, complexity, and perverse incentives, it were to clearly favor investment in a broad range of productive assets of all kinds, including hard and soft infrastructure and human capital.

The evolution of economic structure differs across advanced countries. The forces are similar but the market and policy responses have varied. We envision a broader study of structural evolution in a broad range of major economies in collaboration with a major private-sector institution with global research and data collection capacity. Right now this is beyond our resources.

We do know, however, that the German economy’s structure on the tradable side is really quite different from that of the United States, as is the current account situation. This may in part be the result of replicable policy choices; German reforms of the past decade have been designed with competitiveness and employment in mind. One element is particularly noteworthy: wage increases have been low for the best part of a decade. That appears to have had a material effect on export competitiveness in a range of manufacturing industries, such as industrial machinery.

Subject to more detailed investigation, it looks as though the preservation of employment was part of a broad agreement among business, labor, and government, and that sacrifices were made to achieve this objective in the area of income growth. Interestingly, the income distribution in Germany is much flatter and appears not to have moved adversely, as it has in America.

Recovering manufacturing activity that has departed will not be easy. Manufacturing competitiveness is supported by skilled labor and by training and technical institutions. Once these institutions are gone, it is difficult to get them back. One implication is that long-term policy frameworks should include an evolving assessment of competitive strength and employment potential across sectors and at all levels of the human capital and education spectrum, and a goal of steering or nudging market outcomes to achieve the social objectives. The structural evolution of the economy matters and can be influenced in relatively efficient ways.

This recommendation is not as radical as it may sound. Despite much comment to the contrary, the sharp line between intervening to influence market outcomes over time and a hands-off approach is an illusion. Most countries (advanced and developing) adopt policies and invest public resources in assets that increase human capital, the technological base of the economy, and its competitiveness.

That will and should continue. It is a benign form of competition among nation states, which increases productivity everywhere, provided that the markets for final and intermediate goods and services remain open.

The alternative is to use more blunt and destructive forms of intervention, generally falling under the heading of protectionism. And the incentive to resort to that kind of “solution” increases as the distributional effects on employment opportunities and incomes become more adverse.

International Dimensions

Although most of the heavy lifting on these issues of structural change, diversification in the tradable sector and distribution needs to be carried out at the national level, certain dimensions are international as well. If a relatively open global system is going to survive in a world in which nation states are the principle decision-makers with respect to policy, then it will have to be managed and guided by a set of principles designed not just to achieve efficiency and stability (important as those are), but also to try to ensure that, as the system evolves, the benefits are spread equitably across countries and subgroups within countries.

What is needed is an understanding of the distributional issues and their structural underpinnings and an ability to discriminate between destructive national policy responses, those that threaten the openness of the system, and those that are relatively benign in the sense of imposing limited costs on other countries. Although the World Trade Organization is the arena where rules are negotiated, the G20 is where the priorities and guiding principles for policy coordination are set.

Looking Forward

In the United States, it is hard to predict how these issues will be addressed as the economy evolves. Given the condition of municipal, state and federal budgets, long-term public-sector investments in growth and employment are likely to be deferred. But the central unknown is how the employment situation will evolve.

If employment bounces back with growth and if the trends reverse in the tradable sector, or the nontradable sector continues to have high absorptive capacity, then from a political point of view, the issue will be less important and the political support for an open global economy will be easier to sustain. This scenario does not seem to be the most likely one.

It is more likely that growth bounces back to some extent but that unemployment remains stubbornly high. This is consistent with the fact that value added increased briskly in the tradable sector while employment in the tradable sector stagnated. Growth and employment are set to diverge. Eventually the frictions and lags in labor markets will be overcome, and the unemployment problem will more into a employment opportunity and income distribution problem.

In this kind of environment, politics will probably become divisive and polarized, and the inclination to use protection and market access to expand employment options will increase. Because that will undoubtedly provoke responses by other countries, the openness of the global economy will be at risk.

Easy answers appear to be missing. Investing in hard and soft infrastructure with an explicit focus on employment is almost surely the right way to get started. But it isn’t possible to know in advance how effective this will be in expanding employment options. Experimenting is only the way to solutions.

These structural issues deserve attention and debate sooner rather than later. A broad discussion involving policymakers, business, labor, universities and research institutes, and concerned social organizations is needed, in part because the knowledge required to create and evaluate possible responses is highly decentralized. The president has appointed a distinguished business leader, Jeffrey Immelt, the CEO of GE, to head a commission to tackle these issues with a focus on employment. It is an important step forward and it is well targeted.

Assuming that the markets will fix these problems by themselves is not a good idea; it may be approximately true for the global economy as a whole, but is not necessarily for its parts. In truth, all countries, including successful emerging economies, have addressed issues of inclusiveness, distribution, and equity as part of the core of their growth and development strategies. Now advanced countries will need to follow suit. Confronting the tension between efficiency and distribution and attempting to strike an appropriate balance is critical.

The late Paul Samuelson once said that every good cause is worth some inefficiency. Morally, pragmatically, and politically that seems right. Delivering on the opportunity part of the social contract is one such cause.