Industrial countries also face the challenge

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1 International topics Current Issues November 21, 2007 Globalisation and distribution Industrial countries also face the challenge Since the early 1990s in the industrialised countries, capital incomes and skilled workers incomes have risen faster than compensation for low-skilled labour. Income distribution has become more unequal in the US than, say, in Germany. Here at least until recently it was unemployment that trended upward and attracted most of the public attention. A key driver of structural change is the use of new technologies. The IT revolution in particular has strongly enhanced the productivity of capital and its substitutability for labour. This has implications for the income distribution it favours capital over labour, high skills over low skills. Author Dieter Bräuninger Editor Barbara Böttcher Technical Assistant Martina Ebling Deutsche Bank Research Frankfurt am Main Germany Internet: Fax: Managing Director Norbert Walter Globalisation is accentuating these trends. But it is not triggering a race to the bottom in the sense of a wage slump. For one thing, rising wages in the emerging markets are counterbalancing this. Nonetheless, in the industrialised world, particularly Germany, the pressure for downward adjustment is especially high in the low wage sector. On balance, globalisation benefits the industrialised countries. Multinational companies, for example, can exploit distinct economies of scale with international activities. This, next to a product range in demand the world over, is one of the reasons why Germany is a globalisation winner notwithstanding persistent functional deficits on its labour market. It would be wrong to relapse into protectionism. That would reduce prosperity and place the less mobile workers bound to their national locations at an even greater disadvantage. To rise to the challenges of rapid structural change, a multi-track strategy is necessary. Income disparity among workers could be alleviated by building up and expanding capital assets. But most important is the promotion of human capital. Enabling as many people as possible to participate in the opportunities offered by change is consistent with free market principles. Education and basic and advanced training must be strengthened across the board. The crucial issue for the low-skilled is employability. Success hinges on good locational policies that provide sustainably financeable social security systems, a competitive tax system and flexible markets including the market for labour.

2 Current Issues Contents I. Income distribution a top topic in the industrialised countries...3 Two approaches to the distribution debate...3 Personal income distribution strongly influenced by institutional arrangements...4 Greater degree of income concentration...5 Decline in wage share a problematic indicator...7 II. Technological progress favours human and real capital...8 Determinants of functional income distribution...8 Production technology determines distribution shares...9 IT revolution the main cause of shrinking wage shares...10 III. Globalisation accentuates distribution problems...14 Intensive world trade creates adjustment pressure...15 Offshoring the latest phase of globalisation...17 New Trade Theory enables a nuanced view of offshoring...19 Migration also creates prosperity and generates adjustment pressure...21 Trade unions negotiating position weakened...23 IV. Not a race to the bottom, but a sustained challenge...24 Protectionism is the wrong way...24 Narrow limits to conventional distribution policy...25 V. Structural change as an opportunity...26 Problem-oriented solutions needed...26 Promotion of capital formation...27 Education the key to better income...28 Promoting employability the all-embracing core assignment...28 Income insurance question marks over an interesting idea...29 Appropriate combi-wages a constructive approach...30 Tax wedge needs to be reduced in many countries...32 Good locational and labour market policies offer the best protection against globalisation shocks...32 Further literature November 21, 2007

3 Globalisation and distribution I. Income distribution a top topic in the industrialised countries Growing scepticism towards globalisation World population below the poverty line less than USD 1 per day, by regions, m Black Africa South Africa Middle East & North Africa Latin America & Carribbean Europe & Central Asia China East Asia & Pacific excl. China 1,600 1,400 1,200 1, Source: UN 1 Although the global economy continues to expand, with high momentum in the emerging markets and brisk business activity in many industrial countries, scepticism is growing in Europe and America over globalisation. Established economists and politicians, and not just dyed-in-the-wool globalisation opponents, are questioning whether the undisputed benefits of the global division of labour are coming at an increasingly heavy cost. Environmental crisis scenarios aside (the buzzword here being climate change), debate is driven by the issue of potential social fault lines. Sustained job losses, continued erosion of the middle classes, increasing social inequality and growing poverty in the industrialised countries are cited as the collateral damage from globalisation. That is why, in Europe and the US, many critics are calling for a more protectionist economic policy and greater redistribution of income towards those that they identify as globalisation s losers. If these assessments take a firm hold, they could jeopardise market freedom and hence globalisation itself. Are these gloomy socio-political scenarios unassailable? Is society in the European countries and in Germany, too, in danger of being divided ever deeper by globalisation? How can economic policies counteract the undesirable socio-political and distributional consequences of globalisation without resorting to the blunt tool of protectionism? It is around these issues that our paper revolves. Two approaches to the distribution debate For a long time the subject of globalisation and distribution was discussed only in terms of the perceived extremes between the industrial countries in the northern hemisphere and the countries of the south. Under the influence of ideologically driven pigeonholing, the industrialised countries were often lumped together as winners and the less developed countries as losers. Even today, some critics view globalisation merely as a new form of colonialism, from which the industrial nations and a few emerging markets have benefited while many less developed countries have descended into deeper dependence. Of course, experience refutes such one-sided perspectives. Much research shows that globalisation encourages economic growth and prosperity in the countries concerned. This is particularly true of the less developed economies. The divide runs not between the North and South, but between those countries that have committed to global economic integration and those which, for whatever reasons, have integrated very little or not at all. The IMF, for example, ascribes much of the high growth dynamic in the Asian emerging markets and less developed economies to a market-oriented policy including open borders. 1 In the course of economic takeoff the number of people living in extreme poverty in Eastern Asia plummeted dramatically between 1981 and 2001 in China alone by more than 400 million. This corroborates the external trade theory. It shows that a more 1 International Monetary Fund (2006): Financial Systems and Economic Cycles. World Economic Outlook. September pp. 75 f. Results of current research by IMF staff also point to a clear correlation between economic growth and openness. They show that in the 1990s the open Asian countries expanded 1.5 to 2% p.a. faster than countries that were sealed off. Andreas Billmeier, Tommaso Nannicini (2007). Trade Openness and Growth: Pursuing Empirical Glasnost. IMF Working Paper No. 07/156. November 21,

4 Current Issues Growing per capita incomes GDP per inhabitant, in % av. growth rate p.a. Total increase World Developed economies Economies in transition Less developed economies of which: Africa America W Asia SE Asia Sources: UNCTAD, DB Research Unemployment also a distributional evil Retirement provision off kilter Shares of retirement income, % 100% DE SE NL ES IT FR 80% 60% 40% 20% 0% 1st pillar* 2nd pillar** 3rd pillar*** * PAYG state pension systems and other social transfers ** Occupational pensions plans *** Fully-funded personal provision and income from work Sources: DIA, DB Research 2 3 intensive global division of labour creates new openings for greater specialisation and the use of scale economies. In a favourable free market environment efficiency and prosperity gains result for all the countries concerned (see p. 16 f). Even if far from all critics are convinced that globalisation improves world economic perspectives as a whole, in the western industrial countries attention is now focusing on another aspect. There, many people complain that the broader international division of labour is biased in favour of recipients of capital income and high-skilled labour, while many other workers are losing out on globalisation. In Europe, debate over the negative social effects of globalisation came to the boil during the French presidential election campaign. And it is currently occupying a prominent position in Germany in view of the Federal Government s plea for enhanced inclusion. Essentially, the current distribution debate in the industrial countries is concerned with two aspects. There is mounting unease over a deepening divide between social sets, particularly between high-skilled people on good incomes and insufficiently skilled sections of the population. These concerns refer to what is known as personal income distribution. Critics also complain that globalisation is skewed towards recipients of capital income. Here, the focus is on what we call functional income distribution. This splits the social product into income for the elementary factors of production, labour and capital. Personal income distribution strongly influenced by institutional arrangements Personal distribution very much depends on the extent to which the social sets considered are able to use the different sources of income. To begin with, we need to distinguish between market incomes and the income flows triggered by the state. The incidence of capital income and the distribution of income from real estate play an important part in market incomes. However, for the majority of the working population labour income is the main source of earnings. Of particular distributional relevance in this context, next to the spread in wages and salaries, is labour market participation in the individual groups. That is to say: unemployment is also, and most particularly, a distribution evil. However, it is not market incomes or gross incomes that count with people, but their net income after state redistribution. Distributional intervention takes place chiefly through state-levied direct taxes and (income-related) contributions on the one hand and government transfers on the other (including gratuitous social services). Personal income distribution thus essentially depends on institutional arrangements and people s individual behavioural patterns. The importance of these factors is widely misjudged, particularly in respect of market incomes. But share ownership and capital income exemplify what is involved. Germany lacks a mature equity culture, with all the consequences this has on the distribution of investment income. A mere 7% of Germans own shares, compared with more than 25% in the US. This suggests that the Germans are less willing to take risks but above all, it reflects how much ground needs to be made up in saving for old age with equities and capital market products. A major reason for this is the decades-long dominance of the state pay-as-you-go (PAYG) 4 November 21, 2007

5 Globalisation and distribution Rigid labour markets often the cause of unemployment Varied types of state intervention pension system, which has been partially corrected only recently (notably with the 2002 pensions reform introducing stateincentivised, private Riester pensions). As a result, around 88% of former employees retirement income in Germany consists of PAYG state pensions and transfers. Another example is capital sharing models. Germany also lags way behind other countries in terms of employee capital sharing. According to statistics from the Federal Ministry of Economics and Technology, only 4% of companies offer their employees capital sharing schemes. In France the comparable figure is 7%, and in the UK it soars to 23%. Those who criticise that the years-long worldwide upswing on the stock markets has bypassed the majority of people in Germany should bear these factors in mind. Institutional arrangements also play an important part in the distribution of labour income. Many economists view rigid labour markets as one of the root causes of joblessness. Above all, different labour market regimes explain why exogenous shocks such as the increased global supply of labour, for example, (see p. 16 f.) lead to higher unemployment for more than just a short time in some countries but not in others. 2 Economists equally believe that the way in which pay scales are structured in other words wage spreads depends on the trade unions bargaining power. In countries with strong trade unions, earnings tend to be distorted in favour of workers drawing medium-range and low collectively negotiated incomes, because as a rule the workers involved form a large part of the non-self-employed labour force. At the greatest disadvantage are low-skilled workers, particularly the unemployed. In addition, the state influences market distribution through its tax and contributions system. Driving a broad wedge of contributions between the labour costs met by companies and workers net incomes has a detrimental effect on employment. It tends to reduce both demand for and the supply of labour. Of course, net income distribution (secondary distribution) is very much the result of state intervention. It is a well-known fact that the extent of state redistribution differs greatly from one country to another. Countries like Germany or France with progressive income taxes generating high revenues and state transfer and welfare systems involving heavy expenditure contrast with countries like America which have comparatively low state redistribution budgets. Analysis of the distributional effects of globalisation must take the impact of these institutional arrangements into account. For one, they restrict the informative value of international comparisons of personal income distribution. Secondly, they make the interpretation of relevant trends in the individual countries more difficult, as illustrated above by capital income in Germany. Appropriate care should therefore be taken with sweeping statements on globalisation and personal income distribution. Greater degree of income concentration Just how accurate is the theory of the growing inequality of income distribution? This is a question to which we can only give rudimentary answers here. There is not enough international comparative data on the distribution of market incomes. While international data is available on the distribution of net income from the 2 Wolfgang Franz, Knut Gerlach, Olaf Hübler (2003). Löhne und Beschäftigung: Was wissen wir mehr als vor 25 Jahren? In Mitteilungen aus der Arbeitsmarkt- und Berufsforschung 36. pp November 21,

6 Current Issues The Gini coefficient The Gini coefficient is a statistical measure of the unequal distribution of certain aggregates, such as income or wealth, within a society. It can assume any value between 0 and 1 (or 0 and 100%). The closer the value is to 1, the more unequal is the distribution, i.e. only a small section of society possesses large proportions of the income. The more the value of the Gini coefficient approaches 0, the less inequality there is. On the extreme value 0 all sets in society have equally high income. The Gini coefficient is based on the concept of the Lorenz curve, a graphical representation of distributions of, for example, incomes. For this, percentage groups of income earners are assigned the percentage of income that they earn, the groups being arranged in ascending order according to their income shares. To plot the graph, the percentages are cumulated. It is thus possible, for example, to read off from the curve what proportion of the total income the 10% (20%, 30% etc.) of the population with the lowest (highest) incomes have at their disposal. The Gini coefficient is calculated from the area between the Lorenz curve and the straight (45 degree) line produced by perfect distribution. However, even if the Lorenz curve assumes different shapes, this area can still yield identical values. For this reason the Gini coefficient is not an explicit measure. Rather, different distribution structures can correspond to a single value. Rise in income concentration Gini coefficients*, % DK SE NL FI FR DE OECD JP GB ES IT US * for the distribution of private households' net incomes Source: OECD 4 OECD or EU, for instance, a detailed analysis of the secondary distribution covering several countries would go beyond the scope of this study owing to the many different determinants that would need to be taken into account. For this reason our empirical analysis here confines itself largely to an international comparison of the development of Gini coefficients for the distribution of net income, as the established measure of income concentration. Judging by the Gini coefficient, the concentration of private households net income in the industrial countries has increased over the past decades. On average for the OECD countries the Gini coefficient of disposable household income climbed from 29.3% in the mid-1980s to 31% by the year 2000, marking an advance of 5.5%. However, the increase in concentration took place almost exclusively in the first 10 years of the period examined. Between 1995 and 2000 the distribution of net household income held constant in many OECD states. The OECD interprets the more recent development as a consequence of market-based labour market reforms in many countries. 3 In the organisation s view, these reforms unleashed two opposite effects. First, they led to increasing differentials between wages and hence market incomes. Secondly, in many countries unemployment fell particularly as the world economy enjoyed an upswing in the late 1990s. But people on low incomes derive above-average benefit from falling joblessness. However, this also shows that the development in the Gini coefficient can only be taken as a limited indicator of trends in wages for different sections of the workforce. More recent data for the EU countries suggests that the concentration of net income stepped up again in the first half of this decade in the industrial countries. This is presumably due partly to the rise in unemployment in the wake of the economic turmoil during this period (end of the New Economy boom, September 11, 2001). Yet in several EU member states, such as Finland, the UK or Italy, income concentration rose further despite a drop in unemployment, contradicting the OECD s theory as well. If we first compare the degree of concentration of net household income at the beginning of this decade (the last available data for the OECD countries) before looking at trends in the individual countries, we find considerable differences, most of which are in line with established assessments. The US and UK, both countries with less pronounced state-directed redistribution activities, show relatively high Gini coefficients, above the average for the OECD countries as a whole. However, the latter is also true of Italy and Spain. In comparison, net incomes in Germany and France are more evenly distributed. But the Gini coefficients are even lower in the Nordic countries, where state-driven redistribution is traditionally extensive. Over time, though, on the basis of the OECD statistics i.e. for 1985 to 2000 the picture is more nuanced and does not fit this pattern. Here, it is precisely Finland and Sweden that exhibit a steep rise in the Gini coefficients under examination, although admittedly from a low base level. Income concentration also increased considerably more than the OECD average in Italy and the UK. The intensification of income concentration after state redistribution in America was only slightly above average. In the period under review there was 3 Jean-Marc Burniaux, Flavio Padrini, Nicola Brandt (2006). Labour Market Performance, Income Inequality and Poverty in OECD Countries. OECD Economics Department Working Paper No November 21, 2007

7 Globalisation and distribution Comparison of standardised unemployment rates % DK FR DE IT SE GB US Source: OECD 5 Current distribution trends in the EU Gini coefficients of households' net income distribution, % DK FI NL DE FR ES IT GB Source: Eurostat Inequality* - no clear trend EU DK DE ES FR IT NL SE GB *Ratio of the total income of the 20% of the population with the highest incomes to the total income of the 20% of the population with the lowest incomes. Source: Eurostat hardly any growth in the inequality of net income distribution in Germany. And in some countries, such as France, Denmark and Spain, judging by the Gini coefficient net incomes were indeed more equitably distributed in 2000 than in the mid-1980s. In most of the bigger EU countries the longer-range trends have continued down to the present. Germany is an exception to this rule, with the EU data showing a marked rise in the concentration of net income in this decade. In Denmark, too, the Gini coefficient recently departed from the trend and began to head north. We can also read off these current developments in a comparison of the net income of the 20% of the population with the highest income and the 20% of people with the lowest income. Having fallen in many EU states in the second half of the 1990s, the ratio of the fifth to the first quintile recently moved up again. The slightly stronger increase in income concentration in Germany between 2000 and 2004 is due chiefly to a greater concentration of market incomes. Whereas the Gini coefficient of households market incomes (and pensions) ticked up only slightly between 1995 and 2000 from 33.7% to 34.7%, in the following years up to 2004 it climbed to 36.8%. This more pronounced growth was not absorbed by state redistribution on the same scale as in the 1990s. Decline in wage share a problematic indicator Economists are also particularly interested in functional income distribution, although its significance is a matter of dispute. Isolated consideration of capital income on the one hand and labour income on the other suggests a distinction between capital and labour that no longer reflects the realities of modern economies. This is demonstrated by the phenomenon of cross-sectional distribution alone. In the industrial countries capital assets have been more or less broadly spread for a long while. Most particularly, employees also possess capital income for example in the context of their retirement provision. There is another aspect, too: In modern knowledge-based economies it is becoming increasingly difficult to draw a distinct line between capital and labour. The various forms of know-how of productive knowledge constitute capital inasmuch as they are a factor of production that can be multiplied through the input of economic resources (i.e. investment in education). This finds its expression in the term human capital. And precisely this human capital is the key to growth in the 21 st century. 4 Statisticians also have difficulties with the functional breakdown of national output. 5 Only employees wages and salaries can be recorded precisely, not the compensation of self-employed persons and the members of their family who help them. And then there is a lack of statistical material for the exact registration of capital income. Statisticians therefore calculate this item as a residual from the national accounts (NA), meaning that the variable bears the flaws of the haziness and measurement inaccuracies of the NA. Nonetheless, functional income distribution is considered an important distributional indicator. The adjusted wage share has become widely established as its measure. It is defined as the per capita compensation of employees as a percentage of GDP per 4 5 Stefan Bergheim (2005). Human capital is the key to growth. Success stories and policies for Deutsche Bank Research. Current Issues. Frankfurt am Main. See Michael Grömling (2006). Die Lohnquote ein statistisches Artefakt und seine Interpretationsgrenzen. IW-Trends H 1/2006. Cologne. November 21,

8 Current Issues Adjusted wage shares - current trends % DK FR DE GB US JP Source: European Commission 8 Adjustred wage shares - long-range trends 1960 = FR US W-DE GB DE SE Source: Eurostat 9 Functional distribution fluctuates with the economic cycle person employed. 6 On the assumption that employees and selfemployed persons earn the same average income, the adjusted wage share does not alter if as customary in the real world the proportion of self-employed in the workforce fluctuates. That is an advantage when seeking to identify unadulterated distribution trends. Since the early 1990s the adjusted wage share has fallen in many industrial countries. The trend has been particularly marked in Germany, where the share has dipped from 61.4% (1992) to around 57%, and in Japan, where it has shed five percentage points to roughly 60%. In both countries the drop has been comparatively sharp in the current decade. But also in France (where the share of income accruing to labour is down from 59.6 to 57.4%), the UK (down from 67.5 to 64.5%), and the US (down from 63.6 to 61%), factor income shares over the past roughly one and half decades have shifted towards capital income. If we look at the long-term timeline since 1960, however, different patterns appear in a country comparison. For example, the labour income share in America has changed relatively little over the long term. While averaging 64.4% for the years 1960 to 1964, in the first half of the current decade the share worked out at 63.0%. And in the UK the adjusted wage share in 2005 hit exactly the same level (64.6%) as in But unlike America, the percentage fluctuated very heavily across the long period. Most notably, the share of labour income in national output in the UK, as in Germany and various other countries, soared in the mid-1970s as a result of very large pay increases. Nowhere, though, did the high shares in the second half of the 70s remain permanently at their elevated level. II. Technological progress favours human and real capital Determinants of functional income distribution The distribution of income is shifting, but the trends observed since the mid-1980s are complex. In personal distribution the trend towards greater concentration of disposable income in the second half of the 1990s was interrupted. In many countries the relative income shares of labour and capital shifted more clearly towards the latter. But this picture, too, is put into perspective in a long-range analysis over several decades. That makes it all the more difficult to interpret the development of the determinants of distribution and to assign them to definite causes. This is particularly true of the decline in adjusted wage shares in the last decade and a half, which results from complex processes overlapping one another. Short-term changes in functional distribution are often essentially a reflection of cyclical ups and downs. In periods of downturn, the distribution of the national income shifts in favour of labour income, while during an upswing the share of capital income, in other words entrepreneurial income (including profits) and property income, increases. Whilst this may seem surprising, it is because capital income, notably corporate profits, reacts more swiftly to changes in the economic situation than employees remuneration. So in the 6 The adjusted wage share can be represented by the following formula: 1) λ = [(l*l/l)/(y/e)]*100 where λ = adjusted wage share, l*l = gross earnings, where l = gross earnings per employee, L = number of employees, Y = GDP (at market prices), E = number of persons employed. 8 November 21, 2007

9 Globalisation and distribution Three fundamental determinants New technologies and globalisation drive structural change event of economic downturn sales revenue, and consequently corporate profits, are the first to collapse before adjustments are made to wages and employment. This also explains why the adjusted wage share in Germany was relatively high in the recession years 1974/75, 1981/82 and Conversely, when business activity picks up, corporate earnings first have to rise to give companies scope for pay increases and new recruitments. A notable part of the sharp drop in the German labour share, which has been particularly steep in recent years, is presumably cyclically induced. A certain correction is therefore likely in the coming years. Stripping out the cyclical influences, we are left with the fundamental factors. The received wisdom in economic theory dictates that the functional distribution of income essentially depends on three bundles of partly interdependent determinants: 1. the production technology that can be taken to describe the economy examined. The assumption in neoclassical economic theory is that production technology is the main determinant of functional income distribution consumer preferences and the level and structure of demand. Consumers crucially determine the extent of consumption and investment, i.e. capital formation, in an economy. Also relevant to distribution is how consumers divide their budgets among the relevant categories of goods, i.e. among capital intensive, knowledge-intensive and labour-intensive goods and services. This depends on aggregate demand including net exports and not just on domestic demand. 3. market forms and hence competitive intensity, particularly on the labour market. The issue of competitive intensity on markets evidently plays an important part in pricing. Consequently, profitboosting oligopolistic or monopolistic structures on goods markets favour capital income. On the other hand, where trade unions hold monopolistic positions on the labour market this can result in inflated labour shares, at least for limited periods. Globalisation, as the engine of epoch-making structural change initiating innovations, taking the international division of labour to new dimensions and fanning competition the world over, impacts functional income distribution in many respects. Of course, in respect of new technologies globalisation is more the result than the cause of change. This implies that the two determinants should be considered separately. So in the following we begin by examining the relationships between production technology, or technical progress (in production), and functional distribution. We then go on to analyse the distributional effects of globalisation. Production technology determines distribution shares With the term production technology and its mathematical specification in the form of a (macroeconomic) production function, economic theory describes the decisive relationships, in the theory of distribution, between national output and the factors of production that are input to generate it, their contribution to output and the returns on them. Most important in terms of distribution effects is how easy or difficult it is to substitute the factors labour and capital 7 Traditional theory assumes a given, constant savings rate and an unchanged consumption structure. Perfect competition on all markets and full employment are also taken as givens. In a long-range analysis and owing to the heightened intensity of competition on many markets in the wake of globalisation, the assumption of perfect competition is less problematic than it seems at first sight. November 21,

10 Current Issues Rising capital intensity* 1960= DE** ES FR IT GB US JP * real net capital stock (at 2000 prices) per employed person ** West Germany until Sources: EU, DB Research 10 Advance of the internet Global number of users, millions Source:: Internet World Stats 11 0 for one another in the production technology characteristic of an economy. Given a constant demand structure, this substitutability (elasticity of substitution) determines the ratio in which capital and labour are input. This ratio, or capital intensity, is thus a major determinant of functional income distribution. 8 Capital input per worker has trended more or less strongly upwards over the past decades in the industrial countries. What distribution effects does this trend lead us to expect? Basically, the productivity of a factor of production decreases as relatively more of that factor is input. Consequently, increasing capital intensity would cause the rate of return on the capital, or the real interest rate, to fall. But how the distribution ratio, or the share of capital income (the product of the real rate of return and the amount of capital input) reacts to the increased factor input as a whole depends on the elasticity of substitution and hence on the production technology. Given constant production techniques, functional income distribution should follow a stable trend (cyclical fluctuations aside), i.e. the labour income share would remain unchanged or would either steadily rise or fall. But in reality that was not the case for several decades. When analysing the contraction in labour s share observed since the early 1990s it therefore seems obvious to search for possible radical technological changes. Changes in production technology are induced mainly by technical progress. In older economic theoretical models technical progress is accepted as exogenous. In the New Growth Theory, however, it is modelled as the result of endogenous factors such as investment in training and education or spill-over effects (from innovation-stimulating company contacts with research institutes, suppliers and clients and hence cluster formation) in an expanding economy. But the decision to switch from one production technology to another may also come in response to altered factor prices and/or a change in the supply of production factors. In the context of globalisation greater input of imported intermediates and the immigration of labour are potential determinants. IT revolution the main cause of shrinking wage shares The shrinkage in adjusted wage shares over the past 15 to 20 years can indeed also be interpreted as the result of a trend turnaround in technological progress. Many economists assume that production processes in the industrialised Western world have undergone a sea change since the mid 1980s. The technological revolution in IT in particular is seen as the engine of this change, giving a new and extremely powerful lift to the trend to automation in industrial production at that time and to faster and more flexible production processes. Even more fundamental were the changes in the services sector kick-started by the triumphant advance of the PC and later the internet. New ways of data and communication management unleashed a sustained productivity boost in important services industries. In the tertiary sector, and even more so in 8 Neoclassical economic theory assumes that production processes can be described by what is known as the Cobb-Douglas production function. Y = L α K β where α = production elasticity of labour and where β = production elasticity of capital and α + β = 1 On this condition, capital and labour can be substituted for one another without triggering any change in income distribution in an economy where there is no technological progress. If the ratio of wages and real interest rates or return on capital rises (falls) by, say, 1% with the given production method, capital intensity will likewise rise (fall) by 1%, i.e. relatively more capital is input than labour. 10 November 21, 2007

11 Globalisation and distribution Technological progress a key driver of the change in distribution shares Technological progress manifests itself in two ways. First, it leads to product innovations, i.e. new, better quality and/or cheaper products. Second, the term stands for changes in production technology, i.e. the means of producing and of designing operating processes more efficiently with the aid of more sophisticated machinery and plant. This advance in production engineering is a key driver of change in functional income distribution. One of the key predictions of neoclassical growth theory is that technological progress has a neutral impact on the distribution of income in the long run. In the long run equilibrium the distribution of income remains constant. 1 The fundamental neoclassical growth model (Solow-Swan model) assumes that technological progress is Harrod-neutral. This raises the (marginal) productivity of labour under constant (marginal) productivity and constant returns on capital. Harrodneutral technological progress facilitates the achievement of higher national income with less labour input. The rising labour productivity is accompanied by higher wages. This increase in wages induces firms to increase their capital stock which can substitute for some of the labour input. In order to achieve a balanced growth path on which there is full employment; capital inputs have to rise at the same rate as technological progress. The increase in capital intensity in many economies hence corresponds with the theoretical predictions of the Solow-Swan model. 2 In steady state, labour input will be constant (or if population growth is not zero, growth at the same rate as increases in labour). Both capital input and national output grow at a constant rate in proportion to technological progress and the growth of labour input. In steady state the marginal return on capital (real interest rate) is constant and hence also the share of capital income (and consequently also the share of labour income) in national output. As a glance at the international data shows, in some countries the functional income distribution really has remained relatively constant over the longer term. The prime examples are the UK and US (s. p. 8). The assumption of (Harrod-)neutral technological progress is based on the concept of productivity-oriented wage policy. For this it is assumed that labour productivity grows at a certain rate in proportion to technological progress. Accordingly, this concept postulates that wages should rise to the same extent as the improvements in productivity and efficiency (resulting from technological progress). 3 Hence, if pay rises are to have a distribution- and employment-neutral effect, they must only be allowed to trigger the substitution of labour by capital to the extent that demand for labour increases as a result of the higher economic growth induced by technological progress. However, this abstracts from the influences of external trade as reflected in alterations in the terms of trade. Theoretically and empirically, however, other types of technological progress are relevant. For example, there is the definition of technological progress by the British economist, John Hicks. Technological progress according to Hicks is linked to the idea of total factor productivity, which is a function of the marginal productivities of capital and labour. 1 Hickstechnological progress has no impact on the distribution of income if it increases the marginal productivities of labour and capital in such a way that with constant capital intensity the relationship between the marginal productivities of capital and labour (equivalent to the relationship between real interest rates and wages) remains constant. 4 Hicks capital-saving technological progress benefits the factor labour. In other words, labour is the mainstay of productivity growth, as a result of which the possibilities for substituting capital for labour tend to deteriorate. Labour-saving technological advances work in the other direction by improving substitution possibilities. As a result rising capital input per employee leads to only a relatively minor decline in the marginal productivity of capital, shifting the capital-labour ratio in favour of capital and hence to the detriment of labour Following the British economist R.F. Harrod ( ). Technological progress according to Harrod can be depicted in a stylised production function by the following formula: Y = f(k, γ(t) *L) where γ(t) is a factor rising with time that models the increase in productivity associated with technological progress. 2 In an environment of increasing capital intensity the established trend in many countries distribution remains constant if the marginal productivity of capital decreases at exactly the same rate as average productivity. With Harrod-neutral technological progress, both average and marginal productivity remain constant. On the other hand, the adjusted wage share falls (rises) in an environment of increasing capital intensity if the marginal productivity of capital decreases slower (faster) than average productivity on the increase in capital intensity. The distribution shares are consequently determined by the possibilities for substituting the factors of production. 3 It is evident from 1) (p. 8, footnote 6) that in a closed economy the adjusted wage share depends on average gross earnings per employee I and average labour productivity a: 2) λ = l/a, where a = Y/E Differentiating (2) by time, we obtain for the growth rates 3) Wλ = Wl Wa, where Wλ or Wl and Wa = rate of change in adjusted wage share or in average earnings and average labour productivity 4 Technological progress according to Hicks ( ) can be depicted in a stylised production function by the following formula: Y = y(t)*f(k, L) November 21,

12 Current Issues Adjusted wage share: decent from the summit % west Germany whole of Germany Source: European Commission Step-like rise in unemployment* % industry, the IT revolution rendered many jobs, particularly the more basic occupations, obsolete. It had a massively labour-saving effect. In Germany in particular, greater use of labour-saving technologies, especially in the 1990s, was presumably due to years of misguided wage policies. This is indicated by an examination of the longerrange development in the adjusted wage share. Before the labour income share began its sustained decline in the 1990s, it had previously soared during the 1970s and in the years 1991/92. In the 1970s pay increases, some of them at double-digit levels, caused income ratios to shift in favour of wages. But this aggressive wage bargaining came at a cost, causing companies to resort to more capital-intensive production methods. Labour, especially less productive work, was replaced by plant and machinery. This is illustrated by the massive rise in unemployment in the mid-70s and the first half of the 80s. 9 Similar pressure to substitute capital for labour resulted in the 90s from steep pay settlements at the beginning of the decade and the sharp rise in state-administered non-wage costs, i.e. social security contributions. Also in the 1990s ( ), cost constraints forced up unemployment (yet further). 10 This experience also reveals the unsuitability of taking the drop in labour s share as an argument for expansive wage policies. Insofar as the contraction results from workers being made redundant, with the consequence of a steeper rise in (lay-off) productivity than employee compensation, a falling share of wages, or the fact that wages are lagging productivity, is not indicative of unexploited scope for distribution. * Unemployment rate of the dependent civilian labour force in Germany Source: Destatis 13 9 In both periods, but most particularly in the early Eighties, unemployment was greatly exacerbated by the social partners failure to respond to the shrinking scope for distribution resulting from the skyrocketing price of oil at that time and the attendant deterioration in the terms of trade. 10 Koeniger and Leonardi dispute this account by pointing out that the employment of skilled and unskilled workers did not differ significantly in the period examined. In the light of these findings the two authors take another explanatory approach. According to their research the increase in capital intensity in Germany in the 1980s and 1990s is less the outcome of the substitution of capital for (unskilled) work and chiefly the result of capital deepening (greater input of capital per employee) to boost productivity as the consequence of a relative drop in the cost of capital. But in the authors view the productivity gains do not lead to corresponding pay increases in the lower wage brackets. This is because wages in that segment are already above their market-clearing level partly as a result of the years-long trend to wage compressing so that the labour supply curve exhibits high elasticity in this segment. See: Winfried Koeniger, Marco Leonardi (2006). Capital Deepening and Wage Differentials: Germany vs. US. IZA Discussion Paper No November 21, 2007

13 Globalisation and distribution The Hornstein, Krusell and Violante model Hornstein, Krusell and Violante presented a theoretical analysis of the impact of technical progress on both the development in functional income distribution and on the wages of different groups of workers and unemployment. 1 Their complex approach is based on the New Labour Market Theory. This explains unemployment as the result of rational search behaviour by companies and unemployed workers on imperfect labour markets on which frictions and information deficits exist. Owing to the frictions, workers who have been laid off as a result of technical progress, for example, and (innovative) companies wishing to fill a newly created position find one another only with a time lag. Unlike traditional theory, the model thus takes the efficiency of the labour market into account as an important determinant of unemployment. In the model, employment or unemployment and wages result from job creation and job destruction processes. Before positions can be filled, companies must spend financial resources and time to select the best applicants for their purposes from the large number of differently skilled workers. The more applicants there are for each vacancy, the easier it is for firms to hit on the right applicant. The ratio of the job vacancy rate to the unemployment rate, which shows how tight the labour market is for businesses, consequently plays an important part in modern labour market theory. Corporate behaviour is driven by the aim of maximising profits. Towards this end companies closely scrutinise the earnings gains that might potentially result from eliminating one job and creating a new, more productive one in its place. On the other hand, when people seeking employment find a job offer, they are faced with the choice of accepting that offer or continuing to seek a better, notably a better paid position. Basically, they will find it all the easier to prolong their search, the higher the state transfers they receive in their unemployed status. Of course, the longer they seek work, the more wages they forgo. Wages are negotiated between the company and workers. What is formally at stake here is distribution of the returns that accrue to companies and workers from filling a job vacancy. Various factors will impact the outcome of the negotiations, most particularly labour productivity, the situation on the labour market (with regard to the skills sought), and the amount of state unemployment benefits. In the model analysis considered here, two factors are particularly relevant to the rate at which labour is shed: technical progress and the level of wages, which in turn is partly determined by the state transfers available. In the opinion of Hornstein et al. one of the special features of the IT revolution is that IT-based technical progress is firmly linked to the respective jobs. If a technology becomes obsolete, the job it involves is destroyed. Moreover, companies can only implement the latest, most efficient technologies by creating new jobs staffed with external labour. This is why, in the (model) economy considered, a spectrum of jobs exists equipped with different technologies (the so-called vintage approach), with the most modern, recently created jobs exhibiting the greatest productivity. This is also reflected in employee compensation. The specialists working with the newest technologies are paid more than workers in older jobs. However, the higher wages do not entirely erode the productivity gain because technical progress is assumed to be labour-saving. The layoff rate consequently depends on how long the new jobs created within a certain period (e.g. calendar year) can be used to meaningful economic effect. The higher the rate of technical progress, the shorter the useful life of the jobs will be. Technical progress works here in two ways. It offers companies an incentive to give up the oldest jobs and focus instead on the latest technology. And for labour, too, the exit alternative is more attractive because when switching to a new, more productive position, workers have the chance of higher wages. What is more, jobs become obsolete more quickly if state unemployment benefits increase, because this also makes the exit option more attractive to workers and wages climb without labour having become more productive. On the other hand, the economic life of a job increases with the rigidity of the labour market because the alternative establishment of a new position and the switch to it involves higher search costs for companies and workers Andreas Hornstein, Per Krusell, Giovanni L. Violante (2002). Vintage Capital as an Origin of Inequalities. CEPR Discussion Papers November 21,

14 Current Issues In an economy in which the unemployed receive generous benefits, a higher rate of technical progress leads to longer unemployment and thus pushes up the jobless rate. In a more flexible economy jobs have shorter life cycles and more labour is thus shed. This generally weakens labour s position in pay negotiations. In a country with lower welfare standards and relatively low wages, like the US for example, less productive jobs endowed with older technology remain profitable for longer and are thus preserved for longer. This means that the heterogeneity of jobs, and hence wage differentials, tend to be greater. When productivity increases, companies in countries with ample transfers for the unemployed, such as Germany, are compelled to shed the existing jobs after a relatively short period and replace them with new, more productive positions. But since the life cycle of jobs in the welfare states unlike America is already comparatively short, companies will be prepared to make that investment only if they retain a higher share of the return on the newly created jobs. The corresponding shift in distribution shares occurs as a result of relatively fewer new jobs being created than old ones shed. Consequently the (average) length of unemployment rises and companies tend to gain a better bargaining position in pay settlements. All in all, IT-based technical progress in welfare states thus drives up unemployment and shrinks the share of wages or income accruing to labour, while the pay scale remains relatively narrow. In contrast, in countries with a comparatively low level of social protection, such as the US, wage differentials widen. However, unemployment and functional income distribution are affected relatively little. The results of the model analysis by Hornstein et al. thus broadly concur with the actual development in personal and functional income distribution from the mid-1980s to the middle of this decade in the US and in European welfare states like Germany and France. A recent econometric study by the BIS confirms the high explanatory value of the model described here in respect of the distributional trends in many countries. The BIS analysts conclude from this that the shifts in distribution shares observed in recent decades in the industrial countries presumably result far more from the triumphant advance of modern IT-based technologies than from globalisation. 2 Of course, such an assessment should not disregard the fact that some of the assumptions in the model devised by Hornstein et al. are highly simplified and occasionally questionable. This applies in particular to the central assumption that new technologies are implemented only through the creation of new, externally staffed positions, thereby altering the labour market churn and the bargaining constellations Luci Ellis, Kathryn Smith (2007): The global upward trend in the profit share. BIS Working Papers No III. Globalisation accentuates distribution problems Globalisation of labour There are thus various reasons behind the empirical record of labour s contracting share. It would be wrong to blame globalisation alone. That said, the dispute over the distribution effects of globalisation is not a phantom debate. The rapid transformation in the international division of labour and the fusion of markets, as core economic elements of globalisation, evidently have a very direct impact on such distribution-relevant determinants as wages and salaries, productivity and employment. The distribution debate focuses most particularly on the globalisation of labour. The International Monetary Fund (IMF) uses this term to describe the huge increase in the number of workers available in the global economy. 11 The larger pool of labour results partly from the fall of the Iron Curtain and, even more so, from integration of the population giants India and China into the international division of labour. This could become even more effective as the revolution in transportation and most particularly in 11 International Monetary Fund (2007). Spillovers and Cycles in the Global Economy. World Economic Outlook. pp. 161 ff. 14 November 21, 2007

15 Globalisation and distribution Dynamic world trade Worldwide exports, 1980 = 100 Services Goods Sources: UNCTAD, DB Research 14 Word trade shares Shares in exports of goods, 2006, % other Asian LDE** 20.2% remaining LDE** 8.6% TE*** 4.1% DE 9.2% US 8.7% CN 8.1% remaining IC* 35.8% * Industrial countries ** Less developed economies *** Transition economies Emerging markets on course for expansion Shares in imports of goods by the industrial countries, % China Transition economies JP 5.4% Source: UNCTAD telecommunications has crucially expanded the technical possibilities of dividing labour worldwide in space, time and cost dimensions. According to the IMF the global labour force has risen fourfold since the beginning of the 1980s. 12 The most significant increase has taken place in the supply of unskilled judging by western standards workers. While some emerging markets even large countries are making considerable efforts to improve the skills of their workforce, it will presumably be many years before shortage ratios in the global supply of labour experience any substantial shift. The historically unique growth in the supply of global labour is having a threefold impact on the world economy and the industrial countries: by causing trade flows to swell strongly; by triggering extensive foreign direct investment, specifically the build-up of global value chains (under the heading of offshoring); and through millionfold migration. All three forms of the globalisation of labour also influence income distribution. Intensive world trade creates adjustment pressure World trade in goods has expanded by an average of 7.1% a year since 1980, growing almost sixfold in less than a generation. In the process the less developed economies have lifted their share of global exports of goods by more than a quarter from 29.4% to 36.8%. The gain results from a strong expansion both in trade within the group of emerging markets and less developed countries and in South-North trade. Since 1995 alone the emerging markets and less developed countries have succeeded in boosting their share of the industrial countries imports of goods by a third (to 31.5%) and by fully 43% (to almost 30%) in the sub-category of industrial products. In particular, this reflects the success of Chinese goods on the industrial countries markets. The share of goods from China in shipments to the industrial countries jumped in this period from 3.6% to 9.2%. The People s Republic s share of industrial goods soared from 4.3% to 12.2%. The range of exports by the emerging markets and less developed countries is concentrated on relatively labour-intensive (consumer) electronics and electrical engineering products, such as television sets, computers and computer screens and electronic components, as well as games, sports goods and textiles. Nonetheless, these countries have also captured a considerable share of the market in technology- and research-intensive goods since For example, they have doubled their share of world exports of medical and pharmaceutical products to more than 3%. But world trade in services has grown even faster than in goods, by an average of 7.8% p.a. Today, it is seven times higher than in The new opportunities of the IT revolution and progress in the liberalisation of trade are impressively in evidence here. As yet, the emerging markets and less developed countries play a more modest part in services trade, with a world share in 2006 of 24.5%. Nevertheless, individual countries have recently notched up remarkable growth in services exports. Most noteworthy are the rates of increase in China and India averaging 25% p.a. and almost 30% p.a. respectively in the first half of this decade. Other Asian less developed economies Remaining less developed economies Source: UNCTAD Number of people in each national labour force weighted by the respective country s GDP share of external trade. November 21,

16 Current Issues Theory and experience demonstrate that trade and the specialisation and differentiation it involves, along with keener competition, advances prosperity for the countries concerned (see p. 17 f.). 13 Globalisation has opened up new sales markets holding out enormous potential promise for companies from the industrialised world. In the longer run, these companies have the chance to secure valuable economies of scale. But the main beneficiaries of flourishing world trade are consumers. They reap the advantages of a varied supply of goods and services at attractive prices. This notwithstanding, deeper trade also presents a big challenge, putting severe competitive pressure above all on companies and workers that manufacture labour-intensive products in the industrial countries. Certainly, international trade has always entailed a need to adjust; but the headlong pace of expansion in trade and the enormous differences in factor endowment and factor prices that exist between the industrial countries and the emerging markets and less developed countries are piling on the pressure. Correspondingly high are the demands made on the affected workers occupational adaptability and mobility and on labour market flexibility. In their traditional jobs many of these workers are unable to maintain their absolute income, and most certainly not their position in the income structure. Warnings of growing inequality as a result of globalisation cannot therefore be dismissed out of hand unless it is possible to offer these workers the prospect of a more productive occupation. Admittedly, there is nothing very spectacular about this statement; it is supported even by the commonplace theory of foreign trade. 13 As Paul A. Samuelson and other economists have demonstrated, in certain circumstances trade may unilaterally benefit only one partner, namely the emerging market, while the other partner, the industrial country, suffers wealth losses. This can happen if the emerging market, with China as an illustration, achieves strong productivity gains in sectors in which it has comparative disadvantages and therefore imports goods from the industrial country, as well as in domestic non-tradable goods sectors. The emerging market then steps up its own production of the imported goods, and most particularly of the non-tradable goods, and produces less of the goods it exports. This pushes up the relative price that industrial countries have to pay for their imports from the emerging market. Consequently the industrial countries have to export more in order to pay for their imports. Admittedly, the assumption that the emerging market will only boost its productivity in respect of imported products and domestic goods is not very realistic. On the assumption of productivity gains in the emerging market s export sector too, the familiar outcome the prosperity-enhancing effect of trade is again achieved for both partner countries. See Jürgen Matthes (2007). Weltkrieg um Wohlstand und pathologischer Exportboom? Warum Deutschland auch weiterhin von der Globalisierung profitiert. IW Analysen No November 21, 2007

17 Globalisation and distribution Trade creates prosperity the traditional model The Heckscher-Ohlin model developed by Swedish economists Eli Heckscher and Bertil Ohlin and precisely demonstrated and refined by the US economist Paul A. Samuelson serves as the standard approach for explaining trade between industrial and less developed economies. It ascribes trade to the fact that the trade partners are differently endowed with factors of production. In the model, the industrialised economy examined is characterised by relatively ample endowment with capital (both real capital and human capital) and a lesser proportion of (lower-skilled) labour. In the emerging economy the situation is reversed. This is reflected in the structure of production. Whereas the industrial country produces mainly capital-intensive goods, the emerging economy focuses on labour-intensive products. In this situation it makes sense for both countries to engage in trade in such a way that the industrial economy exports capital-intensive products to the emerging market and obtains labour-intensive products from it. 1 That way, both countries can drive their specialisation forward. Domestic and international productivity increases and the supply of goods available also grows. Both countries the developed and less developed economy alike are therefore able to enhance their prosperity through trade and to benefit from the exchange. However, this is not to deny that within the individual countries there are winners in the trade equation and there are losers. In a developed economy greater specialisation of production initially causes more workers to be laid off in the labour-intensive sector than are needed to expand production in the capital-intensive industry. On a flexible labour market the rate of pay consequently falls. This in turn prompts companies to substitute labour for capital in the production of both types of goods. That creates a new equilibrium. Full employment once again exists, but the wages (for unskilled work) are lower than in the original situation. That is the core statement of what is known as the Stolper-Samuelson theorem, according to which trade leads to an increase in the real rewards on the factors of production used relatively more to produce the goods exported. Insofar as the industrial countries export mainly capital- and knowledge-intensive products to the emerging markets and purchase labour-intensive products from them, the relative prices of real capital and skilled labour (human capital) will climb in the industrialised world. On the other hand, the prices of the factors input to manufacture goods that compete with imports in other words compensation for low-skilled work will come under pressure This way the relative prices of goods in both countries, i.e. the terms of trade between capital-intensive and labour-intensive goods, and relative factor prices converge. Under certain conditions product price ratios and factor price ratios may even achieve complete equilibrium. Rapid growth in global FDI 1980 = 100 Direct investment Goods exports Sources: UNCTAD, DB Research 0 17 Offshoring the latest phase of globalisation Global foreign direct investment has escalated even faster than world trade. In 2005 it reached a level of USD 916 bn compared with a mere 55 bn at the beginning of the 1980s. However, the exchange of international equity capital, like trade, is still predominantly a matter between the industrial countries. It is true that in recent years the emerging markets and less developed countries have gained greater prominence as recipients of FDI. On average for the three years 2003 to 2006 upwards of 34% of inflows of foreign direct investment were channelled into these countries (as well as 4.3% into transition countries such as Russia or Ukraine). Of course, this trend was due mainly to the swelling tide of FDI within this group of countries themselves. Direct investment flows from the industrial countries to the emerging markets and less developed countries have therefore (so far) been of minor importance. The Central Eastern European reform countries and the emerging markets and less developed countries together account for around 15% of Germany s total foreign direct investment. Along with its expansion, the nature of foreign direct investment has also changed. Traditionally, businesses engage in activities in other countries chiefly for two reasons. For one, they seek access to natural resources not available in their home country. But even more important is the better development of foreign markets through November 21,

18 Current Issues German direct investment destinations* other Asian LDE*** 4% CN 2% sales-oriented activities such as the build-up of their own distribution channels abroad. Even today, the latter motive is still the main reason why many companies make direct investment abroad. In Germany, for instance, 70% of foreign investment is still marketingmotivated, according to a recent survey by the DIHK Association of German Chambers of Industry and Commerce. 14 However, in recent years another motive has moved into focus: building up crossborder value chains, and hence the globalisation of companies themselves. More and more firms are grasping the opportunities offered by new technology to break down business processes and decentralise their location as a means of optimising corporate structures across national borders. Unlike traditional direct investment, which broadly complements external trade and hence fosters employment and prosperity in both the home country and abroad, the effects of the current phase of globalisation are the subject of controversial debate. The shifting of production processes into countries with low labour costs, for which the term offshoring has been coined, attracts particular criticism as a source of job losses. 15 This criticism has intensified since the offshoring of services has also become an issue. 16 Even some economists paint a bleak picture of a future in which millions of jobs are lost irretrievably as the result of work being outsourced to low-wage countries. In these critics opinion it is not only jobs in the narrower low-wage sector that are affected, but increasingly also skilled occupations. A much-cited example is the outsourcing of software development activities to India. This presupposes that the industrial countries are not able to create other positions for the jobs sent abroad. What many critics fail to see, of course, is that the reasons behind the creation of global value chains also differ. So far at least, the relocation of isolated stages of production processes to low-wage countries known as vertical direct investment tends to be less significant, as direct investment statistics show. But the consistently strong flows of foreign direct investment between the industrial countries (termed horizontal direct investment) point to motives of a different kind. These include the avoidance of commercial costs such as exchange risk, the quest for proximity advantages with a direct local presence and the exploitation of scale economies at the corporate level. However, because of the different distributional implications it is necessary to differentiate between the motives and explanations for direct investment. Applying the established theory of foreign trade based on the Heckscher-Ohlin approach, vertical direct investment can be interpreted as a substitute for trade. Consequently it triggers similar effects. Viewed in this light, industrial countries direct investment in the emerging markets is motivated by the higher rates of return on capital there. Owing to the FDI, the supply of capital in the industrial country runs (relatively) short and the relative price of capital rises. This pushes up the relative price of the more capital-intensive products, and their output is expanded while that of the more labour- remaining IC** 38% remaining LDE*** 5% TL**** 2% FR 6% * Shares of total portfolio of FDI in 2005 ** Industrial countries *** Less developed economies **** Transition economies excl. EU-10 US 22% GB 10% NL 11% Sources: Bundesbank, DB Research 18 Vertical and horizontal direct investment 14 DIHK (2007): Investment abroad. Results of a survey conducted by the Association of German Chambers of Industry and Commerce (DIHK). February In principle offshoring weakens workers income position inasmuch as it leads to productivity gains in which the workers do not participate, or only to a very minor extent. 16 See Thomas Meyer (2007). Offshoring work, not jobs. Deutsche Bank Research. Economics 61. Frankfurt am Main. 18 November 21, 2007

19 Globalisation and distribution Consistent explanation of multinational businesses activities Companies globalisation makes scale economies possible intensive products is cut back. In the labour-intensive sectors imports from the emerging market replace domestic output. But on flexible markets the workers that have been laid off find employment again because the relative drop in pay induces more labourintensive production in all sectors. However, the share of labour income in national output declines as a result of the altered factor price ratios (Stolper-Samuelson theorem). But at the same time the greater specialisation associated with offshoring stimulates domestic productivity, and overall prosperity increases. If one drops the assumption of flexible markets and the economy s perfect ability to adjust, strictly vertical direct investment can by all means involve an at least temporary rise in unemployment. Of course, the traditional explanatory approach does not take adequate account of either the varied motives for direct investment nowadays or the fact that this investment is made mainly by multinational companies. New Trade Theory enables a nuanced view of offshoring New Trade Theory (NTT) delivers a consistent explanation of multinational corporations varied activities. 17 NTT maintains that multinational enterprises are distinguished by their ability to obtain competitive advantages through going global and the associated provision of company-specific headquarter services. These services exhibit three main characteristics: 1. They cannot be purchased in the marketplace. 2. They are intangible goods that can be used in different fields and at different locations within the company also in parallel. Examples of such services (which can be regarded as companyspecific public goods) are a successful management culture, reputation, results of research and development activities, patents, branding that facilitates sales, and credit ratings making it easier to access funding. Since increased use of headquarter services entails no or very little additional expense, the company can obtain scale economies through expansion. 3. They are knowledge-intensive and require greater use of skilled employees than production of the company s actual goods or services. In this view, multinational enterprises direct investment entails not only capital exports but also the export of inputs in the form of headquarter services. The new approach can be taken to explain both horizontal and vertical direct investment. According to NTT, the build-up of crossborder networks in countries similarly endowed with factors of production is most worthwhile if the market in the target country is comparatively large, so that scale economies can be exploited and/or commercial costs such as transport expenditure or exchange risks reduced. On the other hand, multinationals use FDI in countries with different factor endowment than the home country to optimise production processes featuring different capital, knowledge and labour intensities. From the perspective of New Trade Theory, the statements on the effects of foreign direct investment according to traditional theory need to be modified. For instance, on NTT assumptions the shifting of labour-intensive production processes is less pronounced than 17 See Henning Klodt, Björn Christensen (2007). Home Market Effects of Foreign Direct Investment: The Case of Germany. Aussenwirtschaft 62 (1). pp. 63 ff. November 21,

20 Current Issues Companies activities abroad enhance prosperity in their home country Significance of offshoring often overestimated Offshoring has very little impact on US labour market from the traditional viewpoint. Also, the increased production of headquarter services that accompanies foreign direct investment additionally boosts the employment of skilled staff in the home country. A company in, say, Germany may outsource parts of its production or IT services to eastern Europe or India. But this gives rise to productivity increases, providing the company with financial scope that can be used to expand its marketing or R&D activities in Germany. So New Trade Theory also finds that foreign direct investment leads to a shift in employment and income shares in favour of skilled labour. But the scale economies in the production of headquarter services generate additional prosperity. For this reason the new theory postulates that, even in a country with less flexible labour markets, notable prosperity and employment gains can arise from which low-skilled workers also benefit. In reality offshoring is still by no means as important as one might expect in view of the rapid surge in FDI and lively public debate on the issue. The IMF calculates that in the eight highly developed industrial countries which it examined the share of imported intermediate goods and services relative to these countries total intermediate goods and services (known as the offshoring intensity) is around 10%. Relative to total input, i.e. including the costs of capital and labour, it is 5%. In conformity with the findings of New Trade Theory, the bulk of intermediates come from the developed countries. Moreover, offshoring like trade in goods accounts for a greater share in small countries such as the Netherlands, at 12%, than in the big economies. Marked differences also exist between products and economic sectors. For instance, service offshoring is still widely underdeveloped. Whereas the ratio of imported intermediates to gross output of industrial products rose from 6% to 10% between 1980 und 2003, the ratio in services in 2003 was still only about 1%. Of the bigger industrial countries, offshoring intensity is among the highest in Germany. So far, the relocation of industrial production processes has played a far more important part than service offshoring. According to a study by Hohenheim University, the share of imported intermediates in selected sectors of industry in 2002 was around 17%. However, in the services examined (notably corporate services) offshoring intensity in 2002 was a mere 3.6%, although the momentum was greater there. While offshoring intensity in goods has climbed by an average of 1.3% p.a. since the beginning of the 1990s, in services it has jumped by 8.4% p.a. As a result the ratio more than doubled in the period under review. 18 But particularly with regard to the doom and gloom scenarios augured for the labour market, criticism of offshoring needs to be put into perspective. Empirical studies demonstrate that offshoring in the industrial countries can indeed involve employment gains. For the US this is documented in a study by Mary Amati und Shang-Jin Wei, 19 who found that manufacturing industry in America owes a notable part of its productivity gains in the period considered ( ) to offshoring. According to the paper, the outsourcing of services contributed 11% and the offshoring of industrial manufacturing 5% to the growth in labour productivity in American 18 Deborah Schöller (2007). Service-Offshoring: Eine Herausforderung für die Beschäftigung in Deutschland? Wirtschaftsdienst Vol. 87. No. 4. pp. 249 ff. 19 Mary Amati, Shang-Jin Wei (2005). Service Offshoring, Productivity and Employment: Evidence from the United States. IMF Working Paper No. 05/ November 21, 2007

21 Globalisation and distribution Growing number of migrants Total in millions South* OECD North ex OECD** * Less developed economies ** Industrial countries excluding OECD countries Source: World Bank 19 industry. Slightly negative employment effects are apparent only in a deep disaggregation into 450 sectors. However, the negative effects disappear when sectors are aggregated. That is to say that the job losses observed at the deeper level of disaggregation are compensated by stronger employment growth in other sectors at a higher level of aggregation (96 sectors). Amati and Wei found no evidence in the UK either to confirm the theory that offshoring is harmful to employment on balance. 20 For Germany, however, the study by Hohenheim University quoted above does produce negative findings with a similar methodological approach, i.e. on the basis of a comparison of offshoring intensities. According to the Hohenheim research, service offshoring has a slightly negative impact and offshoring of primary and intermediate products a more negative impact on employment in manufacturing industry in Germany. This could be due, as the author herself establishes, to the German labour market s inadequate flexibility. 21 In contrast, recent research by Henning Klodt and Björn Christensen from the Kiel Institute for World Economics sends out an upbeat message. 22 The two authors examine the effects of German FDI on employment with reference to data collected by the Bundesbank. They identify a positive correlation between the foreign investment activities of multinational firms from Germany and the number of jobs provided by these companies in Germany. The study reveals significantly positive effects on domestic employment from direct investment in the EU-15 partner countries, in other industrial countries, in the central and east European reform countries and in the less developed economies. However, no significant correlation exists with direct investment in China. These positive findings confirm results of corporate surveys by the DIHK, for one: 23 At present 18% more of the German industrial enterprises active abroad plan to expand rather than reduce their workforce. Of all the industrial firms surveyed, however, the corresponding balance works out at only 11%. The two positive values naturally also reflect the current upbeat cyclical component. Migration also creates prosperity and generates adjustment pressure Migration highlights the globalisation of labour particularly starkly. According to World Bank statistics, in 2005 some 190 million people worldwide were living as migrants in another country. The figure in the industrial countries of the north is 113 million. Of the 91 million migrants living in the OECD countries 62 million have migrated from the less developed economies. In 1985 the number of immigrants in the OECD countries was just 48 million. On average, 1.85 million people p.a. net have migrated to the EU-15 in the past few years ( ), concentrating most recently on Spain and Italy. In both countries together, the statistics registered about a million more immigrants than emigrants between 2002 and The immigration surplus was on a similar scale in the late 1980s and early 1990s in Germany. However, in the past few years net immigration to Germany has been comparatively low, at 130,000 p.a. That is likely to alter, though, particularly if economic activity remains brisk. The 20 Mary Amati, Shang-Jin Wei (2004). Fear of Outsourcing. Is it justified? IMF Working Paper No. 04/ Deborah Schöller (2007). op. cit. p Henning Klodt, Björn Christensen (2007).op. cit. 23 DIHK op.cit. November 21,

22 Current Issues South-South and South-North migration Totals in millions, 2005 South OECD Other North Total Migrants from South OECD Other North* Totals * Other industrial countries excluding OECD Source: Dilip Ratha, World Bank High immigration to southern Europe Migration balance, in ' DE ES FR IT GB Source: Eurostat 21 Positive effects of immigration bulk of mainly low-skilled migrants to Europe come from North Africa, central eastern and eastern Europe and Turkey. As with foreign direct investment, in traditional trade theory migration can also be considered a substitute for trade between the industrial countries and the less developed economies only in this case labour migrates from south to north instead of capital moving in the other direction. Higher productivity and higher wages in the industrial countries attract labour from the populous regions of the south. As a result of immigration on flexible markets the relative price of (low-skilled work) in the industrial country falls. Lower wages and the increased supply of labour cause companies to adopt more labour-intensive methods of production. This means they can boost their output with the given capital endowment, whereby the production of relatively labour-intensive goods is stepped up more than that of capital-intensive goods. Consequently the relative price of capital-intensive goods rises. This way migration can work towards balancing factor and goods prices, as happens with trade according to the Heckscher-Ohlin theorem. Moreover, the adjustments guarantee a return to full employment. The immigration country thus reaps the benefit of the increased supply of labour in the form of greater prosperity. However, the incomes of (low-skilled) native workers will be lower than before immigration. Applying this analytical approach, the following can also be said of migration: On inflexible markets immigration will lead, above all else, to rising unemployment and is unlikely to create prosperity. Of course, no more than trend statements can be inferred from this rather basic theoretical approach. Complex reality differs in various respects. For example, more recent theories consistent with experience show that labour migration is certainly not a substitute for trade rather the reverse. More intensive trade is often accompanied by increased migration. 24 Similarly, the assumption commonly made in conventional theory that migrants exhibit the same economic characteristics as similarly skilled domestic workers can scarcely be substantiated. Young people who migrate to grasp opportunities on the jobs market as assumed in traditional theory are often highly motivated. Most importantly, in their search for work they frequently display great occupational and geographic mobility. This includes the willingness to accept jobs that domestic workers would not take on at all, or only for much higher pay. Particularly in countries such as Germany, where demographics are leading to more rapid aging, these are key advantages. However, if migrants do not replace native workers as traditional theory assumes, but complement them instead, migration triggers different, far more positive effects than those traditionally observed. This is demonstrated for California in a recent paper by Giovanni Peri. 25 Almost 30% of the total immigrant labour force in the US lives in California. In the period from 1960 to 2004 examined by Peri the share of foreign-born workers in the total supply of labour in California jumped from just over 9% to more than 33%, with a far greater increase in the percentage of unskilled workers from 13% to almost 67%. Strong immigration notwithstanding, Peri identified no 24 Jan Hofmann (2006): Technology boosts trade boosts migration. On the interplay of three key globalisation phenomena. Deutsche Bank Research. Demography Special. September Giovanni Peri (2007). Immigrants Complementarities and Native Wages: Evidence from California. NBER Working Paper No November 21, 2007

23 Globalisation and distribution Declining unionisation of workers DGB members, millions Source: DGB 22 Insider/Outsider problem negative effects on the labour market to the detriment of native workers. Across the entire schooling spectrum, inward migration thus increased neither the risk of unemployment for native workers, nor their withdrawal from working life; nor did it make them more inclined to leave California. Even wage trends tended to be influenced positively by the immigrants. Admittedly, the skilled natives benefited more than the less skilled; and fresh immigration put slight pressure on the wages of less-skilled earlier immigrants. While it may not be possible to transfer the findings for California, with its powerful growth dynamic, one-for-one to other countries, the example does illustrate the positive impact of immigration if the institutional framework is right. Most studies for Germany conclude that inward migration has a relatively small impact on the labour market. 26 Although various researchers have identified a negative correlation between the share of foreign workers and wages, particularly in the low-skilled sector, the effect is rated relatively low. This also holds for the employment effects, with recent research suggesting that immigration does not significantly influence the employment of lowskilled native workers. Trade unions negotiating position weakened The wage effects of globalisation are accentuated by the fact that trade unions in the industrial countries have tended to lose influence not only, but partly because of the new possibilities in the international division of labour. The dwindling number of trade union members in Germany and other countries supports this theory. However, the decline in the trade unionisation rate, particularly in Germany, is presumably due chiefly to the changes in the structure of the workforce resulting from the IT revolution. This structural effect tends to enhance the distributional effects of IT-driven technological progress described in the Hornstein, Krusell and Violante model. This notwithstanding, altered constellations in wage bargaining cannot necessarily be taken as an explanation of distribution trends in their own right. Of course wage policy can have an effect on personal income distribution; but as far as functional distribution is concerned, this is only ever possible temporarily temporarily meaning for as long as employment does not completely react to wrong wage signals. As a rule, if wages exceed the scope for distribution, companies invest more in rationalisation, substituting capital for labour. This reaction may quite possibly take some time, but for that it can then be all the more vehement. Countries like Germany, where institutional constraints make it more difficult for companies to adjust their employment just in time, are susceptible to this. But wages that are out of line with market conditions can also work through to personal income distribution in the longer term. This happens when inflated wages are not corrected despite rising unemployment. Such a misguided wage policy plays to the advantage of established employees and to the detriment of the jobless and job-seekers. Labour and management possess the power of distribution in this sense only where they can pass on the costs of the unemployment they have caused to third parties, such as the state. Of course, tax and contribution payers willingness to 26 See Max Steinhardt (2006). Arbeitsmarkt und Migration eine empirische Analyse der Lohn- und Beschäftigungseffekte der Zuwanderung für Deutschland. HWWI Research Paper, and the literature cited there. November 21,

24 Current Issues finance unemployment that has been induced by pay policies will always have its limits. In such circumstances increased business competition can indeed expedite the necessary wage corrections. Moderate latter-year wage policy in Germany can presumably be explained at least in part by such a constellation. IV. Not a race to the bottom, but a sustained challenge No downward spiral in low-skilled pay Growing number of bilateral trade agreements problematic The deeper international division of labour in the industrial countries is hastening a structural shift towards the production of capital- and knowledge-intensive goods and services. This is also reflected on the markets for labour. While employment opportunities and compensation are increasing for skilled workers, in many cases the less skilled can find work only if they are prepared to forgo similar pay rises. Globalisation is thus heightening trends like those that also result from technological progress. However, the distributional implications are not as dramatic as some critics of globalisation imply. A race to the bottom in terms of a downward spiral of pay for low-skilled work is hardly likely if only because wages are expected to pick up significantly in the emerging markets. Most particularly, the older trade theory overstates the need for adjustment with the hypothesis of perfect product- and factor-price equalisation. An unrealistic abstraction of the theory lies in the fact that it does not capture the scale effects of trade-induced specialisation. But in modern, knowledge-based economies these play an important part. Moreover, trade, foreign direct investment and migration are interdependent. They mutually complement and enhance one another, from which scale effects and corresponding welfare gains can also result. Finally, even in the age of globalisation the international division of labour is not a free lunch. Instead, language barriers, transport costs and country and exchange risks prevent the equalisation of factor prices. Nonetheless, the pressure on compensation for low-skilled workers is a persistent problem for the industrial countries, which merits attention. This is particularly so in countries like Germany, where there is an ever-latent risk of unemployment given the continued constraints of structural change. Protectionism is the wrong way In this situation some people seem very tempted to throw sand in the cogs of the international division of labour. They advocate state intervention to put the brakes on globalisation. Certainly, international trade is protected against arbitrary intervention by multilateral agreements, notably the principles and work of the WTO, and the average global burden of trade tariffs is relatively small on industrial goods it is around 4%. 27 Even so, international organisations and other observers caution against the dangers of creeping protectionism, perceiving the growing number of bilateral trade agreements as symptomatic of this. Professor Langhammer from the Kiel Institute for World Economics, for one, observes an almost exponential rise in such bilateral accords. 28 This weakens the 27 Some sectors are still heavily protected. The average duty on textiles trade in the industrial and less developed countries works out at 7.5 and 17% respectively; in agriculture the global average duty is even in the region of 17%. 28 Rolf J. Langhammer (2006): Welthandel auf dem Weg in neuen Protektionismus? Online at: 24 November 21, 2007

25 Globalisation and distribution ES IT GB EU-15 FR DE DK NL SE Huge collateral damage from protectionism Limited poverty risk Poverty-endangered in % of population*, * Poventy threshold: 60% of median equivalent income Source: Eurostat 23 multilateral system of non-discrimination, he says, and creates an incubator with which to pressurise smaller countries. Professor Langhammer identifies specific tendencies towards reversing the trade liberalisation achieved so far through greater recourse to optout or emergency clauses. These include restrictions for the purpose of consumer or environmental protection. With these so-called grey area measures there is a danger of understandable safeguard objectives being abused to stave off rival products from abroad. This could lead to the resurgence of quantity restrictions. Attempts to protect labour-intensive sectors are misguided. At the most, interventionist policies can arrest market forces only temporarily and at high consequential costs as the EU farm policies illustrate only too well. But the most powerful argument against protectionism is the inevitable collateral damage such a policy would cause. By erecting new trade barriers the industrial countries could jeopardise economic momentum in the emerging markets and, even worse, disrupt catch-up processes in the less developed countries. Not only would it be unfair to place obstacles in the way of more growth and prosperity in the poorer countries, there would also be likely repercussions on the industrial countries. For balance of payments reasons alone the countries affected by import restrictions from the North would, in the longer run, be forced to cut back their demand for industrial-country products. What is more, the bigger emerging markets in particular would hardly be likely to sit back and tolerate protectionist tendencies in the industrial countries without retaliating. But a new protectionist spiral would not only pose a threat to the prosperity gains made possible in recent years by trade. Even worse would be the danger to international cooperation going beyond the realm of trade and poisoning the world economic climate. That can be in no one s interest. In distribution terms nothing would be gained quite the contrary. Protection for individual sectors, a temporary achievement at best, would come at the expense of severe prosperity losses. In an age of globalisation, that could hardly fail to have consequences for decisions on the location of mobile factors of production. But once investors and skilled labour turn their back on a location, the less mobile employees are doubly disadvantaged. Narrow limits to conventional distribution policy The adjustment tasks facing the industrial countries must be resolved there, too. In many western countries it has become standard practice over the past decades to support groups under particular adjustment pressure as a result of structural change. In the welfare states of Continental Europe this is done chiefly through government redistribution. Essentially, two institutions serve this purpose: 1. progressive income taxation as a fundamental means of financing state benefits, notably transfers to people with lower or no market income; 2. the state welfare protection systems, i.e. the basic security, health and retirement pension systems. As a result of state redistribution, income differentials that manifest themselves in primary distribution are significantly reduced in many countries. Germany is a prime example. The concentration of net November 21,

26 Current Issues Strong support for lowincome groups* Poverty endangered in % of population after transfers Before ES IT GB EU FR DE DK NL * Poverty threshold: 60% of median equivalent income Source: Eurostat 25 income there is relatively low (see p. 6 f), and poverty is also a manageable phenomenon. But this leads us to question the extent to which government can continue redistributing income in future. Observers that not only see distribution shares drifting farther apart, but also fear a general erosion of prosperity in the industrial nations, are particularly sceptical. It is correct that the less national output grows the more difficult redistribution becomes. However, the scenario of an international division of labour that no longer fosters prosperity is not very likely. 29 But even in the event of further GDP growth, it is true that the constraints on government redistribution have tended to increase. Precisely the factors of production that benefit most from globalisation and technological change, namely capital and skilled labour, are extremely mobile and in demand the world over. That imposes new, narrower limits on the taxation of these factors. Certainly, taxation and contribution rates will not converge towards minimum levels either. There are always two sides to location decisions: the costs, in the form of taxes and contributions, as opposed to the country s specific merits, foremost among which is the provision of public goods and services. Nonetheless, heightened global competition for capital and brainpower does reduce the scope for redistribution. An OECD study finds that corporate taxation within the OECD countries has a significant impact on business location decisions. 30 It is no coincidence that many EU countries have lowered their corporate tax rates in the past years. Whereas in 1995 effective corporate tax rates in the EU-15 still stood at 34%, they are now on 23%. 31 Admittedly, in many countries the corrections in tax scales were accompanied by a broadening of the tax basis, a pattern that the reform of corporate taxation recently approved in Germany also follows. If we consider the revenues from business taxes or taxes on profits over time, there can be no question of their erosion, at least as matters stand at present. V. Structural change as an opportunity Problem-oriented solutions needed Given the restrictions described, to predict that in many countries the share of expenditure on redistribution among the active generation will decline relative to GDP still does not seem to be leaning too far out of the window. 32 It is true, though, that such a trend is not yet firmly established. While social security spending as a percentage of GDP in the EU-15 was scaled back in the second half of the 1990s from 27.7% to 26.9 %, in 2005 it returned to its 1995 level. This movement presumably strongly reflects cyclical economic activity. Nonetheless, policy-makers should adjust to the altered fiscal circumstances. 29 But this does not mean that strong earnings like those obtained in recent years in some industrial countries, notably Germany, can be extrapolated in the future. 30 Dana Hajkova et al. (2006). Taxation, Business Environment and FDI Location in OECD Countries. OECD Economic Department Working Papers No Margit Schratzenstaller (2007). Company Tax Coordination in the EU Status Quo and Perspectives. Intereconomics. May/June pp We must also bear in mind here that the distributive elements of national budgets in many countries are facing the challenge of greater intergenerational redistribution from the active generation to pensioners and retirees. This affects the countries with extensive state retirement pension schemes based on pay-as-yougo systems, such as Germany, Italy and Spain. 26 November 21, 2007

27 Globalisation and distribution Ratios of social protection expenditure still high Social spending in % of GDP DE DK ES FR GB NL SE EU Source: Eurostat Development of fully-funded provident institutions makes sense No erosion of social protection Change in percentage of social spending in GDP, IT FR GB DK ES DE NL Sources: Eurostat, DB Research State provision of permanent financial support for broad sections of the working age population is not/no longer a realistic option. But it should be possible to reduce the need for redistribution significantly with intelligent, long-range policy making. For this, global structural change must be widely perceived and seized as an opportunity for growth and higher income. Reasons of efficiency, and not only distribution aspects, argue in favour of empowering as many people as possible to share in the upward trend and limiting the negative impact of change for the other groups. This is a complex mission, which we can do no more than outline here with particular regard for economic-policy requirements. The main tasks are: 1. the promotion of capital formation by broad sections of the population; 2. training for young people in particular; 3. promoting the employability of labour negatively impacted by structural change; 4. (financial) support for the needy; 5. the removal of institutional impediments to economic growth with good locational policies. Promotion of capital formation One opportunity of globalisation and of technological progress in general is the positive development in capital income in the longerterm. Greater capital formation by broad sections of the population can therefore contribute to a more balanced distribution of income. Most importantly, by building up capital assets, individuals gain additional personal protection against social risks. By promoting capital formation, a policy seeking answers to the distribution problems of the times can achieve quite a lot. Primarily, it is a matter of putting in place appropriate (tax) framework conditions for private institutional precautionary saving and other forms of personal capital formation. For some years, many countries in the EU, Germany among them, have successfully been offering greater incentivisation to build up capital, at least for retirement provision. These efforts must be intensified and expanded. In particular, capital formation should be encouraged as personal provision for healthcare including long-term nursing. The method of choice is the deferred taxation (EET system) of private provision. Subsidies for low earners and people with children, like those granted in Germany for Riester pensions, can help make precautionary saving possible and attractive for broad sections of the population. Another way is the incentivisation of employee capital sharing, a scheme already relatively widespread in some countries. In principle, it would therefore be good for Germany to follow suit with models appropriate for all employees. Deferred taxation and/or premiums are suitable tools for the promotion of capital sharing models, too. Government should act consistently in its promotion of private provisioning. If legislators keep changing the institutional framework for this, as was recently the case in Germany with cuts to the savers allowance, the impact of other state savings incentives is likely to be limited by a general lack of public confidence. And of course, high taxes and social security contributions that skim off household income stand in the way of a more widespread build-up of capital assets. November 21,

28 Current Issues EU general education benchmarks* 1. The share of school dropouts should not exceed 10%. 2. The share of students with poor literacy skills should be reduced by at least 20%. 3. At least 85% of young people should have completed upper secondary level. 4. The number of tertiary-level mathematics, science and technology graduates should be raised by at least 15% and the gender imbalance redressed at the same time % of adults should participate in lifelong learning. * Benchmarks for 2010 adopted in 2003 in addition to the Lisbon targets Source: European Commission School dropouts in the EU* 2005, % DK DE GB FR IT NL SE EU- 15 EU- 25 * Percentage of year-olds not taking part in education or training in the total age group Source: Eurostat Training must be seen holistically Education the key to better income No less important than broad capital formation is the increased build-up of human capital. This is evident in an age in which the knowledge intensity of production is constantly rising. The correlation between individual qualifications and personal income is high. Most importantly, education and training acts as an effective shield against unemployment. That is why education researchers and international institutions point emphatically to the need for greater efforts in education at all levels. Promoting the skills and competences of the labour force is one of the four cornerstones of the employment strategy proclaimed by the OECD. 33 And as part of its Lisbon Agenda the European Union set noteworthy education targets, one focus of which is the avoidance of skills deficits. 34 But there is still room for improvement here in many countries. In its 2006 progress report the European Commission stresses that progress towards the Lisbon objectives in the field of education and training is still inadequate. 35 In general, it should not be tolerated that in some of the major industrial countries, such as Germany, Italy and the United States, skills of great importance to young people say in reading or maths are no more than on a par with or, indeed, below the OECD average. Another problem is that in Germany, for example, 9 to 10% of school-leavers quit general education each year without a school-leaving certificate. Over an individual s lifetime, education and basic vocational training naturally need to be enhanced by further training. Yet lifelong learning in particular remains more a catch phrase than real-life practice. Promoting employability the all-embracing core assignment Whereas education initiatives are vitally necessary as preventive measures against social inequality, the third point listed above is concerned with improving prospects for workers negatively impacted by structural change. Above all, the less skilled must be empowered to become more occupationally flexible. Employability is the key concept here. What form can consistent employment promotion take in times of globalisation? The OECD sees the need for an overall activating labour market policy concept. 36 Essentially, such a concept consists of two key components, namely training programmes and institutions to secure incomes. Training should be seen holistically, meaning it should include individual-related measures to improve personal skills and social competences as well as other aids geared to removing personal impediments to employment (mobility aid, childcare etc.). Training programmes are most likely to bear fruit if the initiative to take part in them comes from workers themselves. Nonetheless, labour market policy should be able to make transfer payments conditional on the recipients of those transfers playing an active part in qualification programmes, as is already the practice in many countries. It has emerged that learning by doing in regular employment on the primary labour market frequently produces better results than conventional state-administered training programmes. 33 OECD (2006): Employment Outlook. Boosting Jobs and Incomes. 34 European Commission (2007). A coherent framework of indicators and benchmarks for monitoring progress towards the Lisbon objectives in education and training. Communication from the Commission See OECD (2007). Employment Outlook. Chapters 1, 4 and November 21, 2007

29 Globalisation and distribution Different perspectives in distribution debate Wage insurance only as a privately organised institution Keeping people in work or finding timely new employment for them on the primary labour market after they have lost their job, is therefore the central mission of activating labour market policies. This should also be the objective of income-securing institutions and other social security systems. They should provide basic social protection without adding (too much) to the cost of labour and without endangering the recipients motivation to work and achieve. Income security as the second component of a modern employment strategy is naturally to the forefront of the distribution debate. Depending on the tradition and perceptions of the welfare state, this issue is discussed from different angles and with differing points of emphasis in the various industrial countries. Economists and politicians in the US, for example, are engaging with the issue of whether and how workers should be protected against income losses when switching jobs. 37 Implicit here is the idea of compensation for those placed at a disadvantage by structural change. Whilst similar considerations are also aired in the European welfare states, labour there has (so far) been shielded more effectively against demotion in the pay scale. However, this is an important contributive factor to the relatively high unemployment in Europe. Consequently, the subject of wage insurance enters the European agenda by the back door, so to speak, when unemployment insurance is put up for scrutiny. That aside, the viewpoint in the traditional welfare states, notably Germany, is different. At the moment they are focusing on the issue of securing the basic livelihood, i.e. on how to guarantee an income that will cover the basic necessities of life for people in work. Those that consider this the duty of the business community are demanding adequate minimum wages. Others advocate state-subsidised top-ups on wages, or combi-wages, for which there are different approaches. Income insurance question marks over an interesting idea The idea of wage or income insurance has quite a lot going for it. When switching to a lower-paid position, workers negatively affected by structural change would be compensated for a limited period (e.g. a year) for part of their loss of income (e.g. 50%). This cushions them at least temporarily against all too severe curtailment of their income and gives them time to adjust their lifestyle to the altered situation. Most importantly, financial compensation of this kind will arguably make people more willing to move to lower paid jobs, with the effect of increasing labour market flexibility. Organising a wage insurance scheme privately would be consistent with market-based principles. It is doubtful, however, whether there would be sufficient supply to cover the breadth of the workforce and, most importantly, that would also be affordable for the low skilled. A wage insurance scheme of this kind would be faced with a strong cumulation of risks that could only be covered or spread at considerable cost. But it would be worth examining whether market failure could be rectified if the government were to grant low earners financial assistance towards their insurance policies. 37 See, for example, Lori G. Kletzer, Robert E. Litan (2001). A Prescription to Relieve Worker Anxiety. Institute for International Economics. International Economics Policy Brief Lori G. Kletzer, Howard Rosen (2006). Reforming Unemployment Insurance for the Twenty-First Century Workforce. The Brookings Institution. November 21,

30 Current Issues Unemployment insurance commonly a core element of social security Consistent carrot and stick policy necessary Securing basic livelihood is up to social policy But as a compulsory state scheme, wage insurance would raise many critical questions, regardless of its positive external effects. Who is supposed to pay the insurance contributions? And who would receive the benefits? How high should these benefits be, and how long would entitlement to them last? No, as a collective compulsory insurance or a tax-funded state welfare benefit, wage insurance is a no-go. The state cannot, as a matter of principle, be expected to protect people against loss of income. That would overstretch its already limited scope for redistribution and place intolerable burdens on the public purse. Government should therefore confine itself to offering minimum cover. Cost factors and distribution considerations suggest this should only be granted to the needy. Basically, all these considerations also apply to wage-related unemployment insurance. Admittedly, in many countries compulsory unemployment insurance is a widely accepted core element of the social security system. Also, the social benefit the positive external effects of compulsory temporary protection against the total loss of income is arguably greater than with wage insurance. Unemployment insurance creates financial scope for people who are out of work and facilitates their search for the job best suited to them. It thus encourages the match-up of human capital on offer and in demand on the labour market. Even so, it would be misplaced to take this or supposed fairness considerations as reasons to demand maximum levels and duration of support for the unemployed. There is no hard and fast economic justification for this. Indeed, positive experience from Scandinavia shows that from an incentive aspect less attention should be paid to the amount than to the duration of support and to the terms on which benefits are granted. Findings by the OECD indicate that the intensity of the search for a new job declines with the length of support. Another argument against longer-term periods of support is that the longer a person is out of work the greater is the risk of their skills becoming compromised. Moreover, support for the unemployed should be linked to their willingness to search intensively for work and to (re)train. Appropriate combi-wages a constructive approach We need to distinguish between transfers linked to previous income (wage replacement payments) for people placed at a disadvantage by structural change and needs-based assistance for individual social groups, notably people on low incomes. Of course, needsbased income support is an elementary social-policy task going beyond purely distributive purposes, even if this task has become more charged as a result of structural change. This type of support aims to secure a basic income and should be designed accordingly. That implies, for example, taking family status and most particularly the number of children into account when calculating the level of the transfer. The costs of healthcare insurance should also be included. How to provide for incomes that will secure the basic necessities of life has been a subject of robust debate in Germany for some time. 38 Some observers entertain the illusion that minimum wages could serve to guarantee minimum living standards. But even in the past, wages have often failed to do this. Low-skilled workers with larger 38 Urban Mauer (2006): Kombilohn Was es für den Erfolg braucht. Chancen für den Arbeitsmarkt nutzen. Deutsche Bank Research. Aktuelle Themen 366. Frankfurt am Main. 30 November 21, 2007

31 Globalisation and distribution Minimum wages send out wrong signals Different combi-wage models Group-specific support in the US EU globalisation fund families, say, have traditionally been dependent on state aid. In the wake of globalisation the number of people affected has undoubtedly increased, even if the broadened low-wage sector in Germany can by no means be equated with the working poor. Nonetheless, minimum wages send out the wrong signals. Wages in excess of productivity force employment into the shadow economy or abroad. Good intentions cannot cancel out these effects. Precisely in Germany with its strong tradition as a welfare state, there is a severe risk of minimum wages being set at a high level or of politicians finding themselves under constant pressure to do so. The minimum wages abroad touted by protagonists cannot dispel these concerns. In France, for example, minimum wages are deemed a major cause of high youth unemployment. In the UK government-set wages refer to only small sections of the workforce; moreover, experts say they are undermined by other factors such as longer working hours. The means of choice for income support is not therefore stateimposed minimum wages but the (needs-based) augmentation of market wages, for which the term combi-wage stands. Combiwages are intended to top up the low market wages for lowproductivity workers with state supplements. There are various combi-wage models. 39 We can confine ourselves here to two aspects, which are also the subject of international discussion. One feature of combi-wages is where they kick in. As a rule, models of this kind entail the government s topping up productivity-linked compensation by means of direct transfers to low earners. However, exactly the same distributional effect can be achieved with payments to companies. For this, the government would make grants to companies that recruit low-productivity workers, enabling firms to pay wages above the marginal value product of labour. But despite the similar effect on incomes, there are powerful arguments here for direct transfers and against grants to companies. For one thing, it is far easier to gear direct support to personal circumstances, particularly the recipient s neediness, whereas payments to companies are fundamentally exposed to a higher risk of imploding into freeloading effects or even worse of triggering revolving door effects (replacement of non-subsidised by subsidised workers). What is more, the award of funds to companies may involve considerable administrative work to check that the grants are used for the intended purpose. That is the case, for instance, when companies receive government funding to train less productive employees. A second aspect refers to the range of support. Should this be granted to all the working poor or focused on specific target groups? Proposals for group-specific support naturally go beyond plans to top up labour income to a level guaranteeing minimum living standards. Besides more generous income support for a limited period along the lines of income insurance most models also provide for training. An illustration is the Trade Adjustment Assistance programme established in the US. Taking its lead from this, the European Commission has set up a Globalisation Adjustment Fund. This is aimed specifically at workers or companies in sectors that have come under pressure from imports, whereby the competitive pressure can be measured by, say, the share of foreign intermediates relative to sectoral output (offshoring intensity). In 39 See Urban Mauer (2006) op.cit. November 21,

32 Current Issues Group-specific support problematic Tax wedge* 2006, % DE FR SE IT NL DK ES GB US JP Income tax Employee contributions Employer contributions * Income tax plus social security contributions by employees (average earner with no children) and employers in % of labour costs Source: OECD 28 Germany there are specific combi-wages for older and younger workers which the mainstream parties wish to see expanded. However, such specific support has its problems. Target groupfocused or sector-related (vertical) assistance may be more attractive as far as the public purse is concerned, because the costs can be kept better in check than with general (horizontal) programmes open to all the needy. But it has serious downsides. For one, vertical assistance naturally benefits the target groups one-sidedly a state of affairs that is generally difficult to justify. Moreover, special programmes can fragment the benefits landscape, resulting in a lack of transparency and undesirable, unsystematic cumulative effects of general and specific support measures. The rules on supplementary earnings by recipients of unemployment benefit under the Hartz IV system in Germany serve as a cautionary example. Most importantly, with specific support government distorts competition. Companies or industries that employ workers receiving direct or indirect support are placed in a better position at the taxpayers expense and to the detriment of other companies and consumers in particular. The negative consequences are especially serious if the state specifically protects entire sectors with subsidies. This impedes structural change. Capital and labour are kept in less productive activities and competitive sectors have greater difficulty expanding. Tax wedge needs to be reduced in many countries Funding is part of any social protection design. Ideally, it is important not to relate financing contributions to labour income. That would create the danger of funding negatively impacting employees motivation to work while at the same time pushing up the cost of labour and thus further weakening domestic workers competitiveness. This argues for the broadest possible market-based and privately organized coverage of social protection. Private institutions operate on the market principle of give and take. Insofar as this principle of equivalence applies, social protection spending does not distort any other economic decisions by the populace, and most particularly not their provision of labour. Nor does spending filter through to labour costs. Of course supplementary state transfers enabling people on low incomes to finance a minimum level of protection will form part of such an arrangement. In as much as the privatisation of social protection systems is not politically acceptable, state systems should aim for maximum equivalence of benefits and financing contributions. Good locational and labour market policies offer the best protection against globalisation shocks This brings us to the fifth and last assignment listed above, the removal of institutional impediments to growth. The business community and individual citizens, who are being called on to exhibit greater commitment than ever in acquiring skills and turning them to account at their place of work will engage with all the investment in jobs, real capital and human capital needed to cope successfully with the rapid pace of structural change only if this commitment offers the prospect of a commensurate return. But such a perspective is predicated on the promise of sustained economic growth. What is therefore required is good locational policy fostering business dynamics with liberal framework conditions and a positive investment climate. Among the main elements of such a policy are 32 November 21, 2007

33 Globalisation and distribution open, flexible goods and services markets, a competitive tax regime and efficient, sustainably financeable social security systems. Much also depends on smooth functioning of the labour market. An efficient labour market fosters structural change and minimises friction and the attendant distortions in income distribution shares resulting chiefly from unemployment. The elements of good economic policy in an age of globalisation are familiar and do not need to be discussed in depth here. 40 But it is also evident that countries such as Germany still have some catching up to do in this respect. This holds for deregulation of the labour market, cutting back on red tape, further reduction in tax rates and making the health system future-proof, to name but a few reform assignments. The reform backlog should be tackled robustly. Dieter Bräuninger ( , 40 See Norbert Walter, Klaus Günter Deutsch (Ed.) (2003). Mehr Wachstum für Deutschland: Die Reformagenda. November 21,

34 Current Issues Further literature Amati, M., Wei, S.-J. (2005). Service Offshoring, Productivity and Employment: Evidence from the United States. IMF Working Paper No. 05/238. Amati, M., Wei, S.-J. (2004). Fear of Outsourcing. Is it justified? IMF Working Paper No. 04/186. Althaus, D. (2007). Solidarisches Bürgergeld. Bergheim, S. (2005). Human capital is the key to growth. Success stories and policies for Deutsche Bank Research. Current Issues. Frankfurt am Main. Billmeier, A., Nannicini, T. (2007). Trade Openness and Growth: Pursuing Empirical Glasnost. IMF Working Paper No. 07/156. Burniaux, J.-M., Padrini, F., Brandt, N. (2006). Labour Market Performance, Income Inequality and Poverty in OECD Countries. OECD Economics-Department Working Paper No DIHK (2007). Investment abroad. Results of a survey conducted by the Association of German Chambers of Industry and Commerce (DIHK). February Ellis, L., Smith, K. (2007). The global upward trend in the profit share. BIS Working Papers No European Commission (2007). A coherent framework of indicators and benchmarks for monitoring progress towards the Lisbon objectives in education and training. Communication from the Commission. Franz, W., Gerlach, K., Hübler, O. (2003). Löhne und Beschäftigung: Was wissen wir mehr als vor 25 Jahren? In Mitteilungen aus der Arbeitsmarkt- und Berufsforschung 36. pp Grömling, M. (2006). Die Lohnquote ein statistisches Artefakt und seine Interpretationsgrenzen. IW-Trends H. 1/2006. Cologne. Hofmann, J. (2006). Technology boosts trade boosts migration. On the interplay of three key globalisation phenomena. Deutsche Bank Research. Demography Special. September Hajkova, D. et al. (2006). Taxation, Business Environment and FDI Location in OECD Countries. OECD Economic Department Working Papers No International Monetary Fund (2006). Financial Systems and Economic Cycles. World Economic Outlook. September International Monetary Fund (2007). Spillovers and Cycles in the Global Economy. World Economic Outlook. April Kletzer, L. G., Litan, R. E. (2001). A Prescription to Relieve Worker Anxiety. Institute for International Economics. International Economics Policy Brief Kletzer, L. G., Rosen, H. (2006). Reforming Unemployment Insurance for the Twenty-First Century Workforce. The Brookings Institution. Klodt, H., Christensen, B. (2007). Home Market Effects of Foreign Direct Investment: The Case of Germany. Außenwirtschaft 62. Jg. H. 1. pp. 63 ff. 34 November 21, 2007

35 Globalisation and distribution Koeniger, W., Leonardi, M. (2006). Capital Deepening and Wage Differentials: Germany vs. US. IZA Discussion Paper No Langhammer, R.J. (2006). Welthandel auf dem Weg in neuen Protektionismus? Matthes, J. (2007). Weltkrieg um Wohlstand und pathologischer Exportboom? Warum Deutschland auch weiterhin von der Globalisierung profitiert. IW Analysen No. 28. Mauer, U. (2006). Kombilohn Was es für den Erfolg braucht. Chancen für den Arbeitsmarkt nutzen. Deutsche Bank Research. Aktuelle Themen Nr Frankfurt am Main. Meyer, T. (2007). Offshoring work, not jobs. Deutsche Bank Research. Economics No. 61. Frankfurt am Main. OECD (2007). Employment Outlook. OECD (2006). Employment Outlook. Peri, G. (2007). Immigrants Complementarities and Native Wages: Evidence from California, NBER Working Paper No Sachverständigenrat zur Begutachtung der Gesamtwirtschaftlichen Entwicklung (2006). Arbeitslosengeld II reformieren: Ein zielgerichtetes Kombilohnmodell. Expertise im Auftrag des Bundesministeriums für Wirtschaft und Technologie. Schöller, D. (2007). Service-Offshoring: Eine Herausforderung für die Beschäftigung in Deutschland? Wirtschaftsdienst Vol. 87. No. 4. pp. 249 ff. Schratzenstaller, M. (2007). Company Tax Coordination in the EU Status Quo and Perspectives. Intereconomics. May/June pp Steinhardt, M. (2006). Arbeitsmarkt und Migration eine empirische Analyse der Lohn- und Beschäftigungseffekte der Zuwanderung für Deutschland. HWWI Research Paper. Walter, N., Deutsch, K.-G. (Ed.) (2004). Mehr Wachstum für Deutschland: Die Reformagenda. Campus. Frankfurt am Main. November 21,

36 Current Issues ISSN X Coping with climate change: The role of financial markets... November 15, 2007 Housing finance in Germany: Four major trends... November 1, 2007 Germany 2020 New challenges for a land on expedition... October 3, 2007 Germany cresting the wave A reform agenda for the Grand Coalition... September 27, 2007 Asia trip report 2007 AAA: Affection, Analysis, Appreciation... September 11, 2007 Spain 2020 the success story continues... September 11, 2007 Sovereign wealth funds state investments on the rise... September 10, 2007 The energy sector in Latin America: Key prospects, risks and opportunities... September 7, 2007 Banking in South Eastern Europe: Moving into the spotlight...august 27, 2007 Russia s financial sector: Financial deepening will support long-term growth...august 20, 2007 All our publications can be accessed, free of charge, on our website You can also register there to receive our publications regularly by . Ordering address for the print version: Deutsche Bank Research Marketing Frankfurt am Main Fax: Copyright Deutsche Bank AG, DB Research, D Frankfurt am Main, Germany. All rights reserved. When quoting please cite Deutsche Bank Research. The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the author, which do not necessarily correspond to the opinions of Deutsche Bank AG or its affiliates. Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by Deutsche Bank. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made. In Germany this information is approved and/or communicated by Deutsche Bank AG Frankfurt, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht. In the United Kingdom this information is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange regulated by the Financial Services Authority for the conduct of investment business in the UK. This information is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. and in Singapore by Deutsche Bank AG, Singapore Branch. In Japan this information is approved and/or distributed by Deutsche Securities Limited, Tokyo Branch. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Printed by: HST Offsetdruck Schadt & Tetzlaff GbR, Dieburg Print ISSN X / Internet and ISSN

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