Is the Labor Market Global?

Authors: Uri Dadush, William Shaw
Originally published by Current History

Nowhere does globalization strike greater fear than in the hearts of manufacturing workers. In the public imagination, globalization has become inextricably associated with outsourcing and surging imports that destroy jobs and depress wages. For three decades before the Great Recession struck, wages in the United States and most other advanced countries had been stagnant, making the recent surge in unemployment even tougher to stomach. The blame for stagnant wages is laid at the door of low-wage developing exporters beginning with China. Not surprisingly, protectionist sentiment is rife, even though nations have so far refrained from the disastrous trade policies that contributed to the depth and duration of the 1930s Great Depression.

But does globalization mean that the labor market, like goods and finance markets, has become open to competition from all comers? In other words, is the labor market global? And if it is, is that good or bad?

The labor market is clearly not globally integrated in the traditional sense. Relatively few workers migrate. And if the labor market were integrated, workers in developing countries would not be paid so much less than workers doing similar jobs in advanced countries. But these direct measures of international labor market integration fail to capture the enormous changes to labor markets across the world that have been brought about by globalization. These changes are the result of forces—technological innovation has increased trade and investment, as well as migration—that work in combination, and both directly and indirectly, to make labor markets effectively more integrated across countries.

The labor market is integrated in the sense that workers are competing for the same jobs, even if the jobs move to the workers rather than the other way around. Increased ease of transportation and communication, incentives to adopt labor-saving technologies in advanced economies, and an ongoing transfer of technologies to developing countries are part and parcel of the globalization process and are virtually impossible to separate from it. One indication that the labor market is becoming more integrated is the rapid—though very uneven—rise in wages in developing countries, whose workers account for a large part of the world labor force.

There is no doubt that increased international integration of labor markets reallocates humanity’s most important resource, labor, more efficiently along lines of comparative advantage, and thus expands the world’s production frontier, potentially improving everyone’s welfare. But globalization and its handmaiden, technological change, have also been associated with labor churning (the combination of jobs opening up and being eliminated) and a widening of domestic income distribution in most countries. Increased inequality derives from shifts of income from workers (who cannot move easily and who have become more abundant with the entry of hundreds of millions of new workers into the global market) to capital (which is highly mobile), and from shifts from unskilled to skilled labor.

It is not sufficiently appreciated that these trends are global. Many developing countries’ income distribution is deteriorating (from higher levels of income inequality than in advanced countries) although average wages are rising, while advanced economies are experiencing both rising inequality and stagnant average wages. It is evident that rising inequality calls for a policy response, especially in advanced countries. But the response should not in effect throw out the baby (efficiency) with the bathwater (inequality).

The market for top talent in a few highly competitive arenas is clearly global. For example, the top European football clubs can afford to recruit the best talent in the world, reflecting their global following and reach through television. Manchester United and Chelsea, among the richest clubs in the United Kingdom, recruit more than 60 percent of their players from outside the UK. Twenty years ago only one foreign player played on Manchester United’s top team. The reach for global talent extends to a number of other fields, from entertainment to academia.

But beyond elite groups, the evidence shows we are very far from a global labor market. Average wage rates in developing countries are much lower than in advanced countries. However, these average data reflect the varying composition of jobs in each country; and for an accurate comparison, nominal wage rates need to be adjusted for price differences across countries.

Wage gaps

One study, though somewhat dated, finds that the median wage for jobs in advanced countries is two and a half times the wage level for jobs with similar skill levels in the most advanced developing countries, and five times the level in low-income countries. US Bureau of Labor Statistics data show that in 2008 a Chinese manufacturing worker earned about one-twentieth the wages of a US manufacturing worker, and a Mexican one-sixth.

But is the gap narrowing? Data on wage growth are limited, yet there is no doubt that the big and rapidly growing emerging markets have enjoyed higher wage growth than advanced countries over the past two decades. According to the International Labor Organization (ILO), from 1999 to 2009 (the year of the worst global recession since the 1930s), average real wages rose by about 0.5 percent per year in advanced countries, compared to about 1.5 percent in Africa and Latin America, and almost 8 percent in developing Asia.

These statistics also illustrate that globalization has its limits and is only one part of the story behind rising wages in poor countries. Domestic factors also play a vital role in determining wage growth—business climate, governance, and education level, to name a few variables, matter greatly. If wage convergence were principally the result of an integrating global labor market, one would see wages in Africa, the poorest region, rise much faster than in East and South Asia, and faster yet in comparison to Latin America, where per capita incomes and wages are among the highest in the developing world.

The globalization effect

Globalization works to induce wage convergence through four main channels: migration, trade, foreign investment, and the incentive toward and spread of technology. Although economists like to think of these channels as separate, in practice the forces that integrate labor markets work through these four channels in interconnected and mutually reinforcing ways.

Migration is the most obvious way in which international labor markets become more integrated. Increased movement of workers almost certainly plays some role in wage convergence. In theory at least, emigration from developing to advanced countries should contribute to increased wages in developing countries as growth in the supply of workers there is reduced, while growth in labor supply increases in advanced countries. In practice, the few available empirical studies tend to confirm the first effect (higher wages in source countries) for some regions with high emigration—for example the south of Mexico.

This effect, however, is likely minimal in most developing countries, where emigration levels are low (the stock of migrants represents just 2 percent of developing countries’ population). Most studies have also found that immigration has had only modest long-term effects on wages in advanced countries, perhaps because immigration remains limited (typically, immigrants represent 10 to 15 percent of the labor force in advanced countries). Migrants and native workers are imperfect substitutes for one another—and may even complement each other, as migrants increase aggregate demand for the services of native workers, or because migrants reduce the price of services consumed by native workers.

Economists have long argued that, as a result of trade, wage convergence can occur even if there is little or no movement of workers. The theory is that countries with abundant labor (developing countries) export goods intensive in labor, so trade causes their wages to rise relative to those of countries with little labor and plenty of capital (rich countries), which export goods intensive in capital instead. As developing countries have opened up to international trade, the more-than-quadrupling of their manufactures exports (from 1985 to 2008) relative to their GDP almost certainly contributed to wage convergence, especially by boosting wages in middle-income countries that have typically been the most successful exporters.

More generally, once trade becomes possible, large cross-border movements of any commodity or factor of production are not necessary in order for prices to equalize. It is enough that the possibility of additional demand and supply exists at the margin to offset differences that may arise in prices between countries. For example, in the United States, imports are only 11 percent of GDP, but consumers nevertheless encounter global market prices for tradable goods. Similarly, considerable evidence exists that immigration is cyclical (rising during booms when demand for labor increases and falling during recessions), suggesting that the presence of a large available stock of labor across the border helps stabilize wages even when the actual flow of migrants is small.

Foreign investment is a third channel for wage convergence. Investment in capital-scarce developing countries can raise the productivity of workers, and thus their wages. Foreign direct investment (FDI) inflows to developing countries—representing purchases of dominant equity stakes or construction of new factories—rose from 0.6 percent of their GDP in 1980 to 3.5 percent in 2008. By transferring management skill, capital, and technologies in one package, FDI has almost certainly contributed to higher wages in developing countries, and shifted jobs that might otherwise have stayed in advanced countries.

But FDI to developing countries represents only one part of international capital flows. Over the past decade, most capital flows, which include private and official portfolio flows, have gone in the opposite direction—from developing to advanced countries. On average, net foreign investment representing 2.6 percent of developing countries’ GDP has gone into advanced countries, the bulk of which has taken the form of central bank foreign-currency reserve accumulation, mainly purchases of Treasury bills.

This type of investment did not directly generate jobs in advanced countries, in contrast with the FDI flowing predominantly in the other direction. However, had developing countries not helped fund government deficits and consumers in advanced countries, the latter might have had to borrow domestically, thus crowding out domestic investors. On balance, therefore, it is not clear whether capital flows to and from developing countries have played a large role in promoting wage convergence, though they have certainly facilitated technology transfer.

Technology gaps

Studies suggest that the most important reason by far that productivity and thus wages are lower in developing than in advanced countries is that workers in the former have more limited access to technology. Indeed, the transfer of technology through FDI, international trade (imports of machines and learning from competitors and sophisticated customers), and migration (via contacts with diasporas and returning migrants) provides an enormously important opportunity for raising productivity, and thus wages.

Technology originating in advanced countries does not flow easily across borders. Remaining barriers to trade and investment, as well as inefficiencies in transport and communications, continue to impede its spread. Most significant, however, are big structural limitations to the absorption of technology in developing countries, such as insufficient levels of education, and business climates that discourage investment and risk-taking in the ventures that could adopt technologies.

In fact, in enhancing productivity and wages in developing countries, the relevant technologies are overwhelmingly not new technologies; they were invented long ago in advanced countries and are already available in developing countries. However, in many poor countries, machines, appliances, electricity, sanitation, rail travel, and other amenities that are taken for granted in advanced countries are only available in selected locales and to elites, or are used only by a few firms.

So, much of the technology adoption that contributes to wage convergence in developing countries is actually internal. The challenge is bringing backward regions, inefficient firms, and disadvantaged groups up to the level of their more advanced counterparts in the same country. This again underscores the importance of local factors in determining the speed at which development happens and wages increase.

Technology produces wage shifts and convergence not only by facilitating trade and raising productivity in developing countries, but also through its differentiated impact on labor demand in advanced countries, typically favoring skilled workers and managers at the expense of the unskilled. In turn, increased trade with and competition from developing countries spurs the adoption of technologies in advanced countries that save on unskilled labor. These complex interactions between technology and trade illustrate how difficult it is to separate globalization’s effect on wages and jobs from that of technological innovation.

Service worker, too

The forces promoting wage convergence are easiest to recognize in manufactures and agriculture, sectors that are heavily exposed to international trade and in which the domestic demand for labor crucially depends on the ability to compete internationally. However, increased demand for workers in manufacturing and agriculture in developing countries will also indirectly raise the wages of service workers. Moreover, technologies adopted in traded sectors—such as advanced communications and transportation—can spread to the non-traded sector, affecting labor productivity in those sectors directly and also potentially spurring new demand for services.

Conversely, in advanced countries, reduced demand for workers in manufactures and agriculture—whether due to technology or trade or a combination—may also be reflected in lower wages (and higher profits and returns to capital) in the non-tradable service sector.

But wage convergence in many service sectors has probably become more rapid in recent years because advances in technology have sharply increased the share of services that are tradable. The Princeton economist Alan Blinder estimated recently that these technological trends could make about 30 percent of all US jobs potentially “offshoreable,” and he found a negative correlation between the potential to offshore a particular sector and wage growth in that sector. Examples include low-paid jobs in call centers. But they also include the electronic provision of highly paid consultancy jobs (affecting a wide variety of professions, including medicine, law, architecture, and accounting); financial services; and tourism, including medical tourism, as transportation costs fall and information becomes more widely available.

The increased tradability of many services and their “offshoring” represent particularly powerful illustrations of how technology, trade, and foreign investment (usually also involving temporary migration of specialized staff) can combine to arbitrage labor across countries even if very few workers actually move.

The inequality trend

Openness to trade, investment, and technology, as well as increased migration toward advanced countries, have been associated with rapidly rising living standards in many developing countries. The share of the population in developing countries living in absolute poverty fell from half in the early 1980s to a quarter in 2005. Advanced countries have much higher levels of real income (about five times higher on average), but have seen much smaller increases in living standards. Still, average incomes in advanced countries have not stagnated—they have continued to grow at an annual rate of nearly 1 percent, comparable with their post–Industrial Revolution average.

However, in many advanced countries, these averages deceive: Low-skilled wages have remained flat or even declined, while high-skilled wages have increased significantly. Moreover, labor income has fallen as a share of GDP, while capital’s share has increased. Gini coefficients, which provide an aggregate measure of income inequality, rose from the mid-1980s to the mid-2000s in all Group of Seven countries except France. For industrial countries as a whole, average income growth in the highest income quintile outstripped growth in the lowest quintile from the mid-1980s to the middle of the past decade.

It is important to note that the inequality trend is not observed only in advanced countries; inequality has increased in many developing countries as well. According to the ILO, of the 28 developing countries for which data are available, 21 experienced increased income inequality from the early 1990s to the mid-2000s. Some of the same factors appear to be at work in both the developing and developed worlds: Greater trade and foreign investment have increased the relative return to skilled labor and capital, while reducing the relative return to unskilled labor. Indeed, some (but not all) analyses find that trade and financial liberalization episodes, or openness in general, have contributed to worsening income inequality, at least in middle-income countries.

The link between openness and inequality is not automatic; it depends, for example, on a nation’s policies, as well as the structure of its economy and its initial income distribution. But whether or not inequality has increased, average incomes in most developing countries have increased rapidly. And while the wages of unskilled workers have increased less rapidly, they nevertheless have risen at a fair clip and at an accelerated rate—unlike in advanced countries.

Policy options

Even though labor markets remain much less integrated internationally than the market for goods and for capital, globalization—together with technological change—is effectively making labor markets more integrated while contributing to labor churn and relative wage shifts that challenge countries at all levels of development.

Developing countries, though they are seeing average incomes and wages rise rapidly, are very sensitive to this process’s impact on economic losers. Developing countries have weak social safety nets and their income distributions tend to be more unequal than in advanced countries to start with. However, they are seeing high rates of investment and are in good fiscal shape, having been spared the worst effects of the Great Recession. This means that they can, over time, build the safety nets that are available to workers in advanced countries.

Workers need to be protected if they are unemployed or injured, but governments would be ill advised, for example, to erect the barriers to firing common in many advanced countries, barriers that reduce the overall demand for labor in formal (that is, decent) employment. Moreover, numerous studies are finding that social assistance is more effective if it is more targeted, and closely linked with incentives that reflect broader social needs and the needs of the recipients themselves. For instance, making support for the poor conditional on sending girls to school works better than building schools and making attendance mandatory.

The labor challenge facing advanced countries, despite their wealth still mired in high unemployment in the wake of the global financial crisis, is more daunting. Wages there have long grown at a snail’s pace and, with income inequality rising, a large part of their labor force is seeing little or no advance in living standards.

Identifying the correct policy response is made more arduous by the difficulty of attributing with any precision the worsening of income distribution to globalization, technology, demography (increased female participation in the labor force, for example), or other factors such as the increased importance of the financial sector.

What is certain is that both trade and technology represent a way to get more for less (the former through more efficient specialization, the latter by boosting productivity directly), and that both increase the size of the available pie. Thus, international wage convergence should not be read as a zero sum game, in which gains for laborers in developing countries are losses for workers in advanced countries.

So, the answer cannot be to stop technology or trade. In coming decades, developing countries are likely to be home to the vast majority of the global middle class—people with significant disposable income. As a result, the opportunities available to advanced countries from international trade and technological innovation are likely to increase greatly. At the same time, competition in technology-intensive sectors will intensify as developing countries learn, forcing an even faster pace of innovation in advanced countries.

The worsening income distribution in some countries, beginning with the United States, has clearly been exacerbated by changes in tax policy that disproportionately favor the better off. One effect of this is to impair social cohesion, and possibly to undermine the political sustainability of sound fiscal policies and growth-oriented initiatives such as trade agreements. Inequality has risen despite the fact that governments retain significant redistributive power.

The most obvious remedy in the United States is to make the tax code more progressive. But tax changes are only part of the solution. Erosion in the quality of public goods has also driven poverty. Most importantly, public education in many advanced countries, beginning with America, no longer offers the same opportunities for advancement that it did in the first half of the twentieth century. Increased investment in education and training is all the more important in light of rapid technological progress and shifts in market demand for workers of various skill levels.

It may no longer be possible to provide the kind of security enjoyed by manufacturing workers in the 1950s—technology and globalized markets are changing too quickly. But a much better job can be done to help workers adjust to these changes.