The idea that the globalising wave of the last quarter of a century was mostly built on cheap energy and easy money is one that we’re now getting the opportunity to test. So far, the hypothesis is holding up. In particular, according to a story in this week’s Daily Telegraph, high energy costs seem to be having a significant impact on China’s low-cost manufacturing sectors. At the same time, Paul Krugman has been niggling away at the underlying economics. After all, as the French are supposed to say: That’s all very well in practice, but how does it look in theory?
The data are stark: 2,331 shoe factories in Guangdong, or half of the total, have closed down this year. (The Shanghai Bourse is down 46% this year as well). The reason is energy costs; Jeff Rubin, chief economist at CIBC World Markets, is quoted as saying that the Asian outsourcing game. “It’s not just about labour costs any more: distance costs money.” The furniture factories of South Carolina are experiencing a recovery as Chinese plants shut.
Economics provides a pretty good explanation to all of this, and Ambrose Evans-Pritchard’s Telegraph article has the rare distinction of using the adjective ‘Ricardian’, as in Adam Smith’s contemporary David Ricardo, who developed the theory of comparative advantage. As Evans-Pritchard explains,
Goods are shipped in a criss-cross pattern [within Asia] to exploit comparative advantage. Profit margins are wafer-thin. Products are sent to China for final assembly, then shipped again to Western markets. The snag is obvious. The cost of a 40ft container from Shanghai to Rotterdam has risen threefold since the price of oil exploded.Any low-tech product shipped in bulk – furniture, say, or shoes – is facing the ever-rising tariff of high freight costs.
In a longer article, Jeff Rubin, who’s quoted above, has argued that climbing energy costs have already made it uncompetitive to ship Chinese steel to the US market. This may be good news if you are an unemployed American steel worker, but also means that the price of steel is going to go up. The article, written with Benjamin Tal, has some compelling data on the relationship between oil prices and shipping costs.
Paul Krugman, meanwhile, has had a succession of blog posts on this subject, from the accessible to the ‘wonkish’ (his word). Among the most interesting is a reference to a study (opens in pdf) dating from 2000 which suggests that increases in energy costs decrease trade significantly. Putting some numbers on this:
In addition to the determinants of transport costs, we want to know the extent to which transport costs choke off trade. … We find that this elasticity [of trade flows with regard to transport costs] is large, with a 10 percentage point increase in transport costs typically reducing trade volumes by approximately 20%.
But actually, in the case of China, the effect is larger than this, because the goods which are eventually exported are ypically assembled from imports. So an increase in shipping costs hits twice, on the way in and on the way out again. Krugman has some back of the envelope figures which suggests that a 10% increase in transport costs could have a 30% impact on Chinese competitiveness.
Now it’s true to say that the Chinese are aware of this, which is why they have been busy investing in the development of higher value areas of production such as telecoms equipment and wind turbines. It’s also the case that China would in any case have become less competitive at producing basic goods as industrialisation pushed up wage levels. The difference is that conventional wisdom until now has been that these areas of production would move to the next low-wage low-cost producer along the line. Now it seems more likely to move back closer to its end market. (And also worth making the historical point that the reason that products used to be made close to markets was because of a combination of high transport costs, and because they were more expensive relative to income and consumer protection was primitive).
And oil prices may fall from their present levels, at least in the short term, if only because lower production in the emerging markets will mean less competition for supply.
But they’re unlikely to fall to the levels which fuelled the global trade boom, especially since there is little evidence that the oil producers can increase production by much, if at all. There’s an interesting historical analogy which suggests that conventional wisdom which says that transport costs always fall is just wrong. A paper (opens in pdf) by some economic historians which looked at the cost of international transport between 1870 and 1939. It fell up to 1914, bu then rose sharply in the 20s and 30s. The authors conclude that the increased cost of transport was a more important factor than protectionism in the decline in world trade between the wars.
Rubin and Tal argue that we’re going to see something similar this time around: similar, but different.
Globalization is reversible. Higher energy prices are impacting transport costs at an unprecedented rate. So much so, that the cost of moving goods, not the cost of tariffs, is the largest barrier to global trade today. In fact, in tariff-equivalent terms, the explosion in global transport costs has effectively offset all the trade liberalization efforts of the last three decades. Not only does this suggest a major slowdown in the growth of world trade, but also a fundamental realignment in trade patterns.