CHAPTER ONE

The Changed World Economy

THERE IS A LOT OF TALK today of the changing world economy. But—and this is the point of this chapter—the world economy is not changing. It has already changed in its foundations and in its structure, and irreversibly so in all probability.

Within the last ten or fifteen years, three fundamental changes have occurred in the very fabric of the world’s economy:

1. The primary-products economy has come “uncoupled” from the industrial economy;

2. In the industrial economy itself, production has come uncoupled from employment;

3. Capital movements rather than trade in goods and services have become the engines and driving force of the world economy. The two have not, perhaps, become uncoupled. But the link has become quite loose, and worse, quite unpredictable.

These changes are permanent rather than cyclical. We may never understand what caused them—the causes of economic change are rarely simple. It may be a long time before economic theorists accept that there have been fundamental changes, and longer still before they adapt their theories to account for them. They will surely be most reluctant, above all, to accept that the world economy is in control rather than the macroeconomics of the national state, on which most economic theory still exclusively focuses. Yet this is the clear lesson of the success stories of the last twenty years: of Japan and South Korea; of West Germany, actually a more impressive though far less flamboyant performance than Japan; and of the one great success within the United States, the turnaround and rapid rise of an industrial New England that, only twenty years ago, was widely considered moribund.

But practitioners, whether in government or in business, cannot wait till there is a new theory, however badly needed. They have to act. And then their actions will be the more likely to succeed the more they are being based on the new realities of a changed world economy.

The Primary-Products Economy

The collapse in nonoil commodity prices began in 1977 and has continued, interrupted only once, right after the 1979 petroleum panic, by a speculative burst that lasted less than six months and was followed by the fastest drop in commodity prices ever recorded.

In early 1986, overall, raw-materials prices (other than petroleum*) were at the lowest level in recorded history in relation to the prices of manufactured goods and services—as low as in 1932, and in some cases (lead and copper) lower than at the depths of the Great Depression.

The collapse of raw-materials prices and the slowdown of raw-materials demand is in startling contrast to what was confidently predicted. Ten years ago The Report of the Club of Rome predicted that desperate shortages for all raw materials were an absolute certainty by the year 1985. Even more recently, in 1980 the Global 2000 Report of President Carter’s administration concluded that world demand for food would increase steadily for at least twenty years; that food production worldwide would go down except in developed countries; and that real food prices would double. This forecast largely explains why American farmers bought up whatever farmland was available, thus loading on themselves the debt burden that now threatens so many of them.

But contrary to all these predictions, agricultural output in the world actually rose almost a full third between 1972 and 1985 to reach an all-time high. And it rose the fastest in less developed countries. Similarly, production of practically all forest products, metals, and minerals has been going up between 20 and 35 percent in these last ten years, again with production rising the fastest in less developed countries. And there is not the slightest reason to believe that the growth rates will be slackening, despite the collapse of prices. Indeed, as far as farm products are concerned, the biggest increase, at an almost exponential rate of growth, may still be ahead.*

But perhaps even more amazing than the contrast between what everybody expected and what happened is that the collapse in the raw-materials economy seems to have had almost no impact on the industrial economy of the world. Yet, if there was one thing that was “known” and considered “proved” without doubt in business cycle theory, it was that a sharp and prolonged drop in raw-materials prices inevitably, and within eighteen months to two and a half years, brings on a worldwide depression in the industrial economy. The industrial economy of the world is surely not normal by any definifition of the term. But it is also surely not in a worldwide depression. Indeed, industrial production in the developed noncommunist countries has continued to grow steadily, albeit at a somewhat slower rate, especially in Western Europe.

Of course the depression in the industrial economy may only have been postponed and may still be triggered, for instance, by a banking crisis caused by massive defaults on the part of commodity-producing debtors, whether in the Third World or in Iowa. But for almost ten years, the industrial world has run as though there were no raw-materials crisis at all.

The only explanation is that for the developed countries—excepting only the Soviet Union—the primary-products sector has become marginal where it had always been central before.

In the late 1920s, before the Great Depression, farmers still constituted nearly one-third of the U.S. population, and farm income accounted for almost a quarter of the gross national product (GNP). Today they account for one-twentieth of the population and GNP, respectively. Even adding the contribution that foreign raw-materials and farm producers make to the American economy through their purchases of American industrial goods, the total contribution of the raw-materials and food-producing economies of the world to the American GNP is, at most, one-eighth. In most other developed countries, the share of the raw-materials sector is even lower than in the United States. Only in the Soviet Union is the farm still a major employer, with almost a quarter of the labor force working on the land.

The raw-materials economy has thus come uncoupled from the industrial economy. This is a major structural change in the world economy, with tremendous implications for economic and social policy and economic theory, in developed and developing countries alike.

For example, if the ratio between the prices of manufactured goods and the prices of primary products (other than petroleum)—that is, of foods, forest products, metals, and minerals—had been the same in 1985 as it had been in 1973, or even in 1979, the U.S. trade deficit in 1985 might have been a full third less, $100 billion as against an actual $150 billion. Even the U.S. trade deficit with Japan might have been almost a third lower, some $35 billion as against $50 billion. American farm exports would have brought almost twice as much. And our industrial exports to one of our major customers, Latin America, would have held; their near-collapse alone accounts for a full one-sixth of the deterioration in U.S. foreign trade. If primary-products prices had not collapsed, America’s balance of payments might even have shown a substantial surplus.

Conversely, Japan’s trade surplus with the world might have been a full one-fifth lower. And Brazil in the last few years would have had an export surplus almost 50 percent higher than its actual one. Brazil would then have had little difficulty meeting the interest on its foreign debt and would not have had to endanger its economic growth by drastically curtailing imports as it did. Altogether, if raw-materials prices in relationship to manufactured goods prices had remained at the 1973 or even the 1979 level, there would be no crisis for most debtor countries, especially in Latin America.

What has happened? And what is the outlook?

Demand for food has actually grown almost as fast as the Club of Rome and the Global 2000 Report anticipated. But the supply has been growing much faster. It not only has kept pace with population growth; it steadily outran it. One cause of this, paradoxically, is surely the fear of worldwide food shortages, if not of world famine. It resulted in tremendous efforts to increase food output. The United States led the parade with a farm policy successfully aiming (except in one year: 1983) at subsidizing increased food production. The European Common Market followed suit, and even more successfully. The greatest increases, both in absolute and in relative terms, have, however, been in developing countries: in India, in post-Mao China, and in the rice-growing countries of Southeast Asia.

And then there is also the tremendous cut in waste. Twenty-five years ago, up to 80 percent of the grain harvest of India fed rats and insects rather than human beings. Today in most parts of India the wastage is down to 20 percent, the result of such unspectacular but effective infrastructure innovations as small concrete storage bins, insecticides, or three-wheeled motorized carts that take the harvest straight to a processing plant instead of letting it sit in the open for weeks on end.

And it is not too fanciful to expect that the true revolution on the farm is still ahead. Vast tracts of land that hitherto were practically barren are being made fertile, either through new methods of cultivation or through adding trace minerals to the soil: the sour clays in the Brazilian highlands, for instance, or aluminum-contaminated soils in neighboring Peru, which never produced anything before and which now produce substantial quantities of high-quality rice. Even greater advances are registered in biotechnology, both in preventing diseases of plants and animals and in increasing yields.

In other words, just as the population growth of the world is slowing down, and in many parts quite dramatically, food production is likely to increase sharply.

But import markets for food have all but disappeared. As a result of its agricultural drive, Western Europe has become a substantial food exporter plagued increasingly by unsalable surpluses of all kinds of foods, from dairy products to wine and from wheat to beef. China, some observers now predict, will have become a food exporter by the year 2000. India has already reached that stage, especially in respect to wheat and coarse grains. Of all major non-communist countries only Japan is still a substantial food importer, buying abroad about one-third of her food needs. Today most of this comes from the United States. Within five or ten years, however, South Korea, Thailand, and Indonesia—low-cost producers that are increasing food output fast—will compete with the United States to become Japan’s major suppliers. The only remaining major world-market food buyer may then be the Soviet Union, and Russia’s food needs are likely to grow. However, the food surpluses in the world are so large, maybe five to eight times what Russia would ever need to buy, that the Russian food needs are not by themselves enough to put upward pressure on world prices. On the contrary, the competition for access to the Russian market among the surplus producers—the United States, Europe, Argentina, Australia, New Zealand (and, probably within a few years, India as well)—is already so intense as to knock down world food prices.

For practically all nonfarm commodities, whether forest products, minerals, or metals, world demand itself—in sharp contrast to what the Club of Rome so confidently predicted—is shrinking. Indeed, the amount of raw materials needed for a given unit of economic output has been dropping for the entire century, except in wartime. A recent study by the International Monetary Fund* calculates the decline as being at the rate of one and a quarter percent a year (compound) ever since 1900. That would mean that the amount of industrial raw materials needed for one unit of industrial production is now no more than two-fifths of what it was in 1900, and the decline is accelerating. Even more startling are recent Japanese developments. In 1984, Japan, for every unit of industrial production, consumed only 60 percent of the raw materials she had consumed for the same amount of industrial production in 1973, only eleven years earlier.

Why this decline? It is not that industrial production is becoming less important, a common myth for which, as we shall see shortly, there is not the slightest evidence. What is happening is much more important. Industrial production is steadily switching from heavily material-intensive to far less material-intensive products and processes. One reason for this is the emergence of the new and especially the high-tech industries. The raw materials in a semiconductor microchip account for 1 to 3 percent; in an automobile their share is 40 percent; and in pots and pans, 60 percent. But the same scaling down of raw-material needs goes on in old industries, and with respect to old products as well as new ones. Fifty to one hundred pounds of fiberglass cable transmits as many telephone messages as does one ton of copper wire, if not more.

This steady drop in the raw-material intensity of manufacturing processes and manufacturing products extends to energy as well, and especially to petroleum. To produce one hundred pounds of fiberglass cable requires no more than one-twentieth of the energy needed to mine and smelt enough copper ore to produce one ton of copper and then to draw it out into copper wire. Similarly plastics, which are increasingly replacing steel in automobile bodies, represent a raw-materials cost, including energy, of less than half that of steel.

And if copper prices were to double—and that would still mean a fairly low price by historical standards—we would soon start to “mine” the world’s largest copper deposits, which are not the mines of Chile or of Utah, but the millions of tons of telephone cable under the streets of our large cities. It would then pay us to replace the underground copper cables with fiberglass.

Thus it is quite unlikely that raw-materials prices will rise substantially compared to the prices of manufactured goods (or of high-knowledge services such as information, education, or health care) except in the event of a major prolonged war.

One implication of this sharp shift in the terms of trade of primary products concerns the developed countries, whether major raw-materials exporters like the United States or major raw-materials importers such as Japan. The United States for two centuries has seen maintenance of open markets for its farm products and raw materials as central to its international trade policy. This is in effect what is meant in the United States by an “open world economy” and by “free trade.” Does this still make sense? Or does the United States instead have to accept that foreign markets for its foodstuffs and raw materials are in long-term and irreversible decline? But also, does it still make sense for Japan to base its international economic policy on the need to earn enough foreign exchange to pay for imports of raw materials and foodstuffs? Since Japan opened herself to the outside world 120 years ago, preoccupation, amounting almost to a national obsession, with this dependence on raw-materials and food imports has been the driving force of Japan’s policy, and not in economics alone. But now Japan might well start out with the assumption, a far more realistic one in today’s world, that foodstuffs and raw materials are in permanent oversupply.

Taken to their logical conclusion, these developments might mean that some variant of the traditional Japanese policy—highly “mercantilist” with strong deemphasis of domestic consumption and equally strong emphasis on capital formation, and with protection of “infant” industries—might suit the United States better than its own traditions. Conversely the Japanese might be better served by some variant of America’s traditional policies, and especially by shifting from favoring savings and capital formation to favoring consumption. But is such a radical break with a hundred years and more of political convictions and commitments likely? Still, from now on the fundamentals of economic policy are certain to come under increasing criticism in these two countries, and in all other developed countries as well.

They will also, however, come under increasing scrutiny in major Third World nations. For if primary products are becoming of marginal importance to the economics of the developed world, traditional development theories and traditional development policies are losing their foundations. All of them are based on the assumption, historically a perfectly valid one, that developing countries pay for imports of capital goods by exporting primary materials—farm and forest products, minerals, metals. All development theories, however much they differ otherwise, further assume that raw-materials purchases on the part of the industrially developed countries must rise at least as fast as industrial production in these countries. This then implies that, over any extended period of time, any raw-materials producer becomes a better credit risk and shows a more favorable balance of trade. But this has become highly doubtful. On what foundation, then, can economic development be based, especially in countries that do not have a large enough population to develop an industrial economy based on the home market? And, as we shall presently see, economic development of these countries can also no longer be based on low labor costs.

What “De-Industrialization” Means

The second major change in the world economy is the uncoupling of manufacturing production from manufacturing employment. To increase manufacturing production in developed countries has actually come to mean decreasing blue-collar employment. As a consequence, labor costs are becoming less and less important as a “comparative cost” and as a factor in competition.

There is a great deal of talk these days about the “de-industrialization” of America. But in fact, manufacturing production has gone up steadily in absolute volume and has not gone down at all as a percentage of the total economy. Ever since the end of the Korean War, that is, for more than thirty years, it has held steady at around 23 to 24 percent of America’s total GNP. It has similarly remained at its traditional level in all of the major industrial countries.

It is not even true that American industry is doing poorly as an exporter. To be sure, this country is importing far more manufactured goods than it ever did from both Japan and Germany. But it is also exporting more than ever before—despite the heavy disadvantage in 1983, 1984, and most of 1985 of a very expensive dollar, of wage increases larger than our main competitors had, and of the near-collapse of one of our main industrial markets, Latin America. In 1984, the year the dollar soared, exports of American manufactured goods rose by 8.3 percent, and they went up again in 1985. The share of U.S.–manufactured exports in world exports was 17 percent in 1978. By 1985 it had risen to 20 percent, with West Germany accounting for 18 percent and Japan for 16 (the three countries together thus accounting for more than half of the total).

Thus it is not the American economy that is being “de-industrialized.” It is the American labor force.

Between 1973 and 1985, manufacturing production in the United States actually rose by almost 40 percent. Yet manufacturing employment during that period went down steadily. There are now 5 million fewer people employed in blue-collar work in the American manufacturing industry than there were in 1975.

Yet in the last twelve years total employment in the United States grew faster than at any time in the peacetime history of any country—from 82 to 110 million between 1973 and 1985, that is, by a full third. The entire growth, however, was in nonmanufacturing, and especially in non–blue-collar jobs.

The trend itself is not new. In the 1920s, one out of every three Americans in the labor force was a blue-collar worker in manufacturing. In the 1950s, the figure was still one in every four. It now is down to one in every six—and dropping.

But although the trend has been running for a long time, it has lately accelerated to the point where, in peacetime at least, no increase in manufacturing production, no matter how large, is likely to reverse the long-term decline in the number of blue-collar jobs in manufacturing or in their proportion of the labor force.

And the trend is the same in all developed countries and is, indeed, even more pronounced in Japan. It is therefore highly probable that developed countries such as the United States or Japan will, by the year 2010, employ no larger a proportion of the labor force in manufacturing than developed countries now employ in farming—at most, one-tenth. Today the United States employs around 18 million people in blue-collar jobs in the manufacturing industry. Twenty-five years hence the number is likely to be 10—at most, 12—million. In some major industries the drop will be even sharper. It is quite unrealistic, for instance, to expect the American automobile industry to employ, twenty-five years hence, more than one-third of its present blue-collar force, even though production might be 50 percent higher.

If a company, an industry, or a country does not succeed in the next quarter century in sharply increasing manufacturing production, while sharply reducing the blue-collar work force, it cannot hope to remain competitive, or even to remain “developed.” It would decline fairly fast. Great Britain has been in industrial decline these last twenty-five years, largely because the number of blue-collar workers per unit of manufacturing production went down far more slowly than in all other noncommunist developed countries. Yet Britain has the highest unemployment rate among non-communist developed countries: more than 13 percent.

The British example indicates a new but critical economic equation: A country, an industry, or a company that puts the preservation of blue-collar manufacturing jobs ahead of being internationally competitive (and that implies steady shrinkage of such jobs) will soon have neither production nor steady jobs. The attempt to preserve industrial blue-collar jobs is actually a prescription for unemployment.

On the national level, this is accepted only in Japan so far. Indeed, Japanese planners, whether those of the government or those of private business, start out with the assumption of a doubling of production within fifteen or twenty years based on a cut in blue-collar employment of 25 to 40 percent. And a good many large American companies such as IBM, General Electric, or the big automobile companies forecast parallel development. Implicit in this is also the paradoxical fact that a country will have the less general unemployment the faster it shrinks blue-collar employment in manufacturing.

But this is not a conclusion that politicians, labor leaders, or indeed the general public can easily understand or accept.

What will confuse the issue even more is that we are experiencing several separate and different shifts in the manufacturing economy.

One is the acceleration of the substitution of knowledge and capital for manual labor. Where we spoke of mechanization a few decades ago, we now speak of robotization or automation. This is actually more a change in terminology than a change in reality. When Henry Ford introduced the assembly line in 1909, he cut the number of man-hours required to produce a motorcar by some 80 percent in two or three years: far more than anybody expects to happen as a result even of the most complete robotization. But there is no doubt that we are facing a new, sharp acceleration in the replacement of manual workers by machines, that is, by the products of knowledge.

A second development—and in the long run it may be fully as important if not more important—is the shift from industries that are primarily labor-intensive to industries that, from the beginning, are primarily knowledge-intensive. The costs of the semiconductor microchip are about 70 percent knowledge and no more than 12 percent labor. Similarly, of the manufacturing costs of prescription drugs, “labor” represents no more than 10 or 15 percent, with knowledge—research, development, and clinical testing—representing almost 50 percent. By contrast, in the most fully robotized automobile plant labor would still account for 20 or 25 percent of the costs.

Another, and highly confusing, development in manufacturing is the reversal of the dynamics of size. Since the early years of this century, the trend in all developed countries has been toward larger and ever larger manufacturing plants. The “economies of scale” greatly favored them. Perhaps equally important, what one might call the economies of management favored them. Up until recently, modern management seemed to be applicable only to fairly large units.

This has been reversed with a vengeance the last fifteen to twenty years. The entire shrinkage in manufacturing jobs in the United States has been in large companies, beginning with the giants in steel and automobiles. Small and especially medium-size manufacturers have either held their own or actually added people. In respect to market standing, exports, and profitability too, smaller and especially middle-size businesses have done remarkably better than the big ones. The same reversal of the dynamics of size is occurring in the other developed countries as well, even in Japan, where bigger was always better and biggest meant best! The trend has reversed itself even in old industries. The most profitable auto-mobile company these last years has not been one of the giants, but a medium-size manufacturer in Germany: BMW. The only profitable steel companies worldwide have been medium-size makers of specialty products, such as oil-drilling pipe, whether in the United States, in Sweden, or in Japan.

In part, especially in the United States,* this is a result of a resurgence of entrepreneurship. But perhaps equally important, we have learned in the last thirty years how to manage the small and medium-size enterprise—to the point that the advantages of smaller size, for example, ease of communications and nearness to market and customer, increasingly outweigh what had been forbidding management limitations. Thus in the United States, but increasingly in the other leading manufacturing nations such as Japan and West Germany, the dynamism in the economy has shifted from the very big companies that dominated the world’s industrial economy for thirty years after World War II to companies that, while much smaller, are still professionally managed and, largely, publicly financed.

But also there are emerging two distinct kinds of “manufacturing industry”: one group that is materials-based, the industries that provided economic growth in the first three-quarters of this century; and another group that is information- and knowledge-based, pharmaceuticals, telecommunications, analytical instruments, information processing such as computers, and so on. And increasingly it is in the information-based manufacturing industries in which growth has come to center.

These two groups differ in their economic characteristics and especially in respect to their position in the international economy. The products of materials-based industries have to be exported or imported as products. They appear in the balance of trade. The products of information-based industries can be exported or imported both as products and as services.

An old example is the printed book. For one major scientific publishing company, “foreign earnings” account for two-thirds of total revenues. Yet the company exports few books, if any; books are heavy. It sells “rights.” Similarly, the most profitable computer “export sale” may actually show up in the statistics as an “import.” It is the fee some of the world’s leading banks, some of the big multinationals, and some Japanese trading companies get for processing in their home offices data sent in electronically from their branches or their customers anywhere in the world.

In all developed countries, knowledge workers have already become the center of gravity of the labor force, even in numbers. Even in manufacturing they will outnumber blue-collar workers within fewer than ten years. And then, exporting knowledge so that it produces license income, service fees, and royalties may actually create substantially more jobs than exporting goods.

This then requires, as official Washington has apparently already realized, far greater emphasis in trade policy on “invisible trade” and on abolishing the barriers, mostly of the non-tariff kind, to the trade in services, such as information, finance and insurance, retailing, patents, and even health care. Indeed, within twenty years the income from invisible trade might easily be larger, for major developed countries, than the income from the export of goods. Traditionally, invisible trade has been treated as a stepchild, if it received any attention at all. Increasingly, it will become central.

Another implication of the uncoupling of manufacturing production from manufacturing employment is, however, that the choice between an industrial policy that favors industrial production and one that favors industrial employment is going to be a singularly contentious political issue for the rest of this century. Historically these have always been considered two sides of the same coin. From now on, however, the two will increasingly pull in different directions and are indeed becoming alternatives, if not incompatible.

“Benevolent neglect”—the policy of the Reagan administration these last few years—may be the best policy one can hope for, and the only one with a chance of success. It is not an accident, perhaps, that the United States has, next to Japan, by far the lowest unemployment rate of any industrially developed country. Still, there is surely need also for systematic efforts to retrain and to replace redundant blue-collar workers—something that no one as yet knows how to do successfully.

Finally, low labor costs are likely to become less and less of an advantage in international trade, simply because in the developed countries they are going to account for less and less of total costs. But also, the total costs of automated processes are lower than even those of traditional plants with low labor costs, mainly because automation eliminates the hidden but very high costs of “not working,” such as the costs of poor quality and of rejects, and the costs of shutting down the machinery to change from one model of a product to another.

Examples are two automated U.S. producers of television receivers, Motorola and RCA. Both were almost driven out of the market by imports from countries with much lower labor costs. Both then automated, with the result that their American-made products successfully compete with foreign imports. Similarly, some highly automated textile mills in the Carolinas can underbid imports from countries with very low labor costs, for example, Thailand. Conversely, in producing semiconductors, some American companies have low labor costs because they do the labor-intensive work offshore, for instance, in West Africa. Yet they are the high-cost producers, with the heavily automated Japanese easily underbidding them, despite much higher labor costs.

The cost of capital will thus become increasingly important in international competition. And it is the cost in respect to which the United States has become, in the last ten years, the highest-cost country—and Japan the lowest-cost one. A reversal of the U.S. policy of high interest rates and of high cost of equity capital should thus be a priority of American policymakers, the direct opposite of what has been U.S. policy for the past five years. But this, of course, demands that cutting the government deficit rather than high interest rates becomes our defense against inflation.

For developed countries, and especially for the United States, the steady downgrading of labor costs as a major competitive factor could be a positive development. For the Third World, and especially for the rapidly industrializing countries—Brazil, for instance, or South Korea or Mexico—it is, however, bad news. Of the rapidly industrializing countries of the nineteenth century, one, Japan, developed herself by exporting raw materials, mainly silk and tea, at steadily rising prices. One, Germany, developed by “leapfrogging” into the “high-tech” industries of its time, mainly electricity, chemicals, and optics. The third rapidly industrializing country of the nineteenth century, the United States, did both. Both ways are blocked for the present rapidly industrializing countries: the first one because of the deterioration of the terms of trade for primary products, the second one because it requires an “infrastructure” of knowledge and education far beyond the reach of a poor country (although South Korea is reaching for it!). Competition based on lower labor costs seemed to be the way out. Is this way going to be blocked too?

From “Real” to “Symbol” Economy

The third major change is the emergence of the symbol economy—capital movements, exchange rates and credit flow—as the flywheel of the world economy, in the place of the real economy: the flow of goods and services—and largely independent of the latter. It is both the most visible and yet the least understood of the changes.

World trade in goods is larger, much larger, than it has ever been before. And so is the invisible trade, the trade in services. Together, the two amount to around $2.5 to $3 trillion a year. But the London Eurodollar market, in which the world’s financial institutions borrow from and lend to each other, turns over $300 billion each working day, or $75 trillion a year, that is, at least twenty-five times the volume of world trade.

In addition, there are the (largely separate) foreign-exchange transactions in the world’s main money centers, in which one currency is traded against another (for example, U.S. dollars against the Japanese yen). These run around $150 billion a day, or about $35 trillion a year: twelve times the worldwide trade in goods and services.

No matter how many of these Eurodollars, or yen, or Swiss francs are just being moved from one pocket into another and thus counted more than once, there is only one explanation for the discrepancy between the volume of international money transactions and the trade in goods and services: capital movements unconnected to, and indeed largely independent of, trade greatly exceed trade finance.

There is no one explanation for this explosion of international—or more accurately, transnational—money flows. The shift from fixed to “floating” exchange rates in 1971 may have given the initial impetus (though, ironically, it was meant to do the exact opposite). It invited currency speculation. The surge in liquid funds flowing to Arab petroleum producers after the two “oil shocks” of 1973 and 1979 was surely a major factor. But there can be little doubt that the American government deficit also plays a big role. It sucks in liquid funds from all over into the “Black Hole” that the American budget has become* and thus has already made the United States into the world’s major debtor country. Indeed, it can be argued that it is the budget deficit which underlies the American trade and payments deficit. A trade and payments deficit is, in effect, a loan from the seller of goods and services to the buyer, that is, to the United States. Without it the administration could not possibly finance its budget deficit, or at least not without the risk of explosive inflation.

Altogether, the extent to which major countries have learned to use the international economy to avoid tackling disagreeable domestic problems is unprecedented: the United States, for example, by using high interest rates to attract foreign capital and thus avoiding facing up to its domestic deficit, or the Japanese through pushing exports to maintain employment despite a sluggish domestic economy. And this “politicization” of the international economy is surely also a factor in the extreme volatility and instability of capital flows and exchange rates.

Whatever the causes, they have produced a basic change: In the world economy, the real economy of goods and services and the symbol economy of money, credit and capital are no longer tightly bound to each other, and are, indeed, moving further and further apart.

Traditional international economic theory is still neoclassical and holds that trade in goods and services determines international capital flows and foreign-exchange rates. Capital flows and foreign-exchange rates these last ten or fifteen years have, however, moved quite independently of foreign trade and indeed (for instance, in the rise of the dollar in 1984/85) have run counter to it.

But the world economy also does not fit the Keynesian model in which the symbol economy determines the real economy. And the relationship between the turbulences in the world economy and the domestic economies has become quite obscure. Despite its unprecedented trade deficit, the United States has, for instance, had no deflation and has barely been able to keep inflation in check. Despite its trade deficit, the United States also has the lowest unemployment rate of any major industrial country, next to Japan. The U.S. rate is lower, for instance, than that of West Germany, whose exports of manufactured goods and trade surpluses have been growing as fast as those of Japan. Conversely, despite the exponential growth of Japanese exports and an unprecedented Japanese trade surplus, the Japanese domestic economy is not booming but has remained remarkably sluggish and is not generating any new jobs.

What is the outcome likely to be? Economists take it for granted that the two, the real economy and the symbol economy, must come together again. They do disagree, however—and quite sharply—about whether they will do so in a “soft landing” or in a head-on collision.

The soft-landing scenario—the Reagan administration is committed to it, as are the governments of most of the other developed countries—expects the U.S. government deficit and the U.S. trade deficit to go down together until both attain surplus, or at least balance, sometime in the early 1990s. And then capital flows and exchange rates would both stabilize, with production and employment high and inflation low in major developed countries.

In sharp contrast to this is the “hard-landing” scenario. With every deficit year the indebtedness of the U.S. government goes up, and with it the interest charges on the U.S. budget, which in turn raises the deficit even further. Sooner or later, the argument goes, this then must undermine foreign confidence in America and the American dollar: some authorities consider this practically imminent. Then foreigners stop lending money to the United States. Indeed, they try to convert the dollars they hold into other currencies. The resulting “flight from the dollar” brings the dollar’s exchange rates crashing down. It also creates an extreme credit crunch, if not a “liquidity crisis,” in the United States. The only question is whether the result will be a deflationary depression in the United States, a renewed outbreak of severe inflation, or, the most dreaded affliction, stagflation, that is, both a deflationary, stagnant economy and an inflationary currency.

There is, however, also a totally different “hard-landing” scenario, one in which it is Japan rather than the United States that faces a hard—a very hard—landing. For the first time in peacetime history the major debtor, the United States, owes its foreign debt in its own currency. To get out of its debt it does not need to repudiate, to declare a moratorium, or to negotiate a rollover. All it has to do is to devalue its currency, and the foreign creditor has effectively been expropriated.

For foreign creditor read Japan. The Japanese by now hold about half of the dollars the United States owes foreigners. In addition, practically all their other claims on the outside world are in dollars, largely because the Japanese have so far resisted all attempts to make the yen an international trading currency lest the government lose control over it. Altogether, the Japanese banks now hold more international assets than do the banks of any other country, including the United States. And practically all these assets are in U.S. dollars—640 billions of them! A devaluation of the U.S. dollar thus falls most heavily on the Japanese and immediately expropriates them.

But also, the Japanese might be the main sufferers of a hard landing in their trade and their domestic economy. By far the largest part of Japan’s exports go to the United States. If there is a hard landing, the United States might well turn protectionist almost overnight; it is unlikely that we would let in large volumes of imported goods were our unemployment rate to soar. But this would immediately cause severe unemployment in Tokyo and Nagoya and Hiroshima and might indeed set off a true depression in Japan.

There is still another hard-landing scenario. In it neither the United States nor Japan—nor the industrial economies altogether—experiences the hard landing; this will be suffered by the already depressed primary-products producers. Practically all primary materials are traded in dollars; thus, their prices may not go up at all should the dollar be devalued. They actually went down when the dollar plunged by 30 percent between June 1985 and January 1986. Japan may thus be practically unaffected by a dollar devaluation; all she needs her dollar balances for, after all, is to pay for primary-products imports, as she buys little else on the outside and has no foreign debt. The United States, too, may not suffer, and may even benefit as American industrial exports become more competitive. But while the primary producers sell mainly in dollars, they have to pay in other developed-nations currencies for a large part of their industrial imports. The United States, after all, although the world’s leading exporter of industrial goods, still accounts for one-fifth only of the industrial goods on the world market. Four-fifths are furnished by others—the Germans, the Japanese, the French, the British, and so on. Their prices in U.S. dollars are likely to go up. This then might bring on a further deterioration in the terms of trade of the already depressed primary producers. Some estimates of the possible drop go as high as 10 percent, which would entail considerable hardship for metal mines in South America and Rhodesia, and also for farmers in Canada, Kansas, or Brazil.

There is, however, one more possible scenario. And it involves no “landings,” whether soft or hard. What if the economists were wrong and both American budget deficit and American trade deficit could go on and on, albeit perhaps at lower levels than in recent years? This would happen if the outside world’s willingness to put its money into the United States were based on other than purely economic considerations—on their own internal domestic politics, for instance, or simply on escaping political risks at home that appear to be far worse than a U.S. devaluation.

Actually, this is the only scenario that is so far supported by hard facts rather than by theory. Indeed, it is already playing.

The U.S. government forced down the dollar by a full third (from a rate of 250 to a rate of 180 yen to the dollar) between June 1985 and February 1986—one of the most massive devaluations ever of a major currency, though called a readjustment. America’s creditors unanimously supported this devaluation and indeed demanded it. More amazing still, they have since increased their loans to the United States, and substantially so. There is agreement, apparently, among international bankers that as the United States is the more creditworthy the more the lender stands to lose by lending to it!

And a major reason for this Alice in Wonderland attitude is that our biggest creditors, the Japanese, clearly prefer even very heavy losses on their dollar holdings to domestic unemployment. For without the exports to the United States, Japan might have unemployment close to that of Western Europe, that is, at a rate of 9 to 11 percent, and concentrated in the politically most sensitive smokestack industries in which Japan is becoming increasingly vulnerable to competition by newcomers, such as South Korea.

Similarly, economic conditions alone will not induce the Hong Kong Chinese to withdraw the money they have transferred to American banks in anticipation of Hong Kong’s “return” to Red China in 1997—and these deposits amount to billions. The even larger amounts, at least several hundred billions, of “flight capital” from Latin America that have found refuge in the U.S. dollar, will also not be lured away by purely economic incentives, such as higher interest rates.

The sum needed from the outside to keep going both a huge U.S. budget deficit and a huge U.S. trade deficit would be far too big to make this scenario more than a possibility. Still, if political factors are in control, then the symbol economy is indeed truly uncoupled from the real economy, at least in the international sphere.

And whichever scenario proves right, none promises a return to “normality” of any kind.

One implication of the drifting apart of symbol and real economy is that from now on the exchange rates between major currencies will have to be treated in economic theory and business policy alike as a “comparative-advantage” factor, and as a major one to boot.

Economic theory teaches that the comparative-advantage factors of the real economy—comparative labor costs and labor productivity, raw-materials costs, energy costs, transportation costs, and the like—determine exchange rates. And practically all businesses base their policies on this theorem. Increasingly, however, exchange rates decide how labor costs in country A compare to labor costs in country B. Increasingly, exchange rates are a major comparative cost and one totally beyond business control. And then, any firm at all exposed to the international economy has to realize that it is in two businesses at the same time. It is both a maker of goods (or a supplier of services) and a financial business. It cannot disregard either.

Specifically, the business that sells abroad—whether as an exporter or through subsidiaries in foreign countries—will have to protect itself against foreign-exchange exposure in respect to all three: proceeds from sales, working capital devoted to manufacturing for overseas markets, and investments abroad. This will have to be done whether the business expects the value of its own currency to go up or to go down. Businesses that buy abroad will have to do the same. Indeed, even purely domestic businesses that face foreign competition in their home market will have to learn to hedge against the currency in which their main competitors produce. If American businesses had been run that way during the years of the overvalued dollar, that is, from 1982 through 1985, most of the losses in market standing abroad and in foreign earnings might have been prevented. These were management failures rather than acts of God. Surely stockholders, but also the public in general, have every right to expect managements to do better the next time around.

In respect to government policy there is one conclusion: Don’t be clever. It is tempting to exploit the ambiguity, instability, and uncertainty of the world economy to gain short-term advantages and to duck unpopular political decisions. But it does not work. Indeed—and this is the lesson of all three of the attempts made so far—disaster is a more likely outcome than success.

The Carter administration pushed down the U.S. dollar to artificial lows to stimulate the American economy through the promotion of American exports. American exports did indeed go up—spectacularly so. But far from stimulating the domestic economy, this depressed it and resulted in simultaneous record unemployment and accelerated inflation, the worst of all possible outcomes.

Mr. Reagan then, a few years later, pushed up interest rates to stop inflation and also pushed up the dollar. This did indeed stop inflation. It also triggered massive inflows of capital. But it so overvalued the dollar as to create a surge of foreign imports. As a result, the Reagan policy exposed the most vulnerable of the old smokestack industries, such as steel and automotive, to competition they could not possibly meet with a dollar exchange rate of 250 yen to the dollar (or a D Mark rate of three to the dollar). And it deprived them of the earnings they needed to modernize themselves. Also, the policy seriously damaged, perhaps irreversibly, the competitive position of American farm products in the world markets, and at the worst possible time. Worse still, his “cleverness” defeated Mr. Reagan’s major purpose: the reduction of the U.S. government deficit. Because of the losses to foreign competition, domestic industry did not grow enough to produce higher tax revenues. Yet the easy and almost unlimited availability of foreign money enabled the Congress (and the administration) to postpone again and again action to cut the deficit.

The Japanese, too, may have been too clever in their attempt to exploit the disjunction between the international symbol economy and the international real economy. Exploiting an undervalued yen, the Japanese have been pushing exports, a policy quite reminiscent of America under the Carter administration. But, as earlier in America, the Japanese policy failed to stimulate the domestic economy; it has been barely growing these last few years, despite the export boom. As a result, the Japanese, as mentioned earlier, have become dangerously over-dependent on one customer, the United States. And this has forced them to invest huge sums in American dollars, even though every thoughtful Japanese (including, of course, the Japanese government and the Japanese Central Bank) knew all along that these claims would end up being severely devalued.

Surely these three lessons should have taught us that government policies in the world economy will succeed to the extent to which they try to harmonize the needs of the two economies, rather than to the extent to which they try to exploit the disharmony between them. Or to repeat very old wisdom: “In finance don’t be clever; be simple and conscientious.” But, I am afraid, this is advice that governments are not likely to heed soon.

Conclusion

It is much too early even to guess what the world economy of tomorrow will look like. Will major countries, for instance, succumb to the traditional fear reaction—that is, retreat into protectionism—or will they see a changed world economy as an opportunity?

Some of the main agenda are however pretty clear by now.

High among them will be the formulation of new development concepts and new development policies, especially on the part of the rapidly industrializing countries such as Mexico or Brazil. They can no longer hope to finance their development by raw-materials exports, for example, Mexican petroleum. But it is also becoming unrealistic for them to believe that their low labor costs will enable them to export large quantities of finished goods to the developed countries—which is what the Brazilians, for instance, still expect. They would do much better to go into production sharing, that is, to use their labor advantage to become subcontractors to developed-country manufacturers for highly labor-intensive work that cannot be automated—some assembly operation, for instance, or parts and components needed in relatively small quantities only. Developed countries simply do not have the labor anymore to do such work. Yet even with the most thorough automation it will still account for 15 or 20 percent of manufacturing work.

Such production sharing is, of course, how the noncommunist Chinese of Southeast Asia—Singapore, Hong Kong, Taiwan—bootstrapped their development. Yet in Latin America production sharing is still politically quite unacceptable and, indeed, anathema. Mexico, for instance, has been deeply committed—since its beginnings as a modern nation in the early years of this century—to making her economy less dependent on, and less integrated with, that of its big neighbor to the north. That this policy has been a total failure for eighty years has only strengthened its emotional and political appeal.

But even if production sharing is used to the fullest, it would not by itself provide enough income to fuel development, especially of countries so much larger than Chinese city-states. We thus need a new model and new policies. Can we, for instance, learn something from India? Everyone knows, of course, of India’s problems—and they are legion. Few people seem to know, however, that India, since independence, has done a better development job than almost any other Third World country: the fastest increase in farm production and farm yields; a growth rate in manufacturing production equal to that of Brazil, and perhaps even of South Korea (India now has a bigger industrial economy than any but a handful of developed countries!); the emergence of a large and highly entrepreneurial middle class; and, arguably the greatest achievement, progress in providing both schooling and health care in the villages. Yet the Indians followed none of the established models. They did not, like Stalin, Mao, and so many of the Africans, despoil the peasants to produce capital for industrial development. They did not export raw materials. And they did not export the products of cheap labor. But ever since Nehru’s death in 1964 India has encouraged and rewarded farm productivity and sponsored consumer-goods production and local entrepreneurs. India and her achievement are bound to get far more attention from now on than they have received.

The developed countries, too, need to think through their policies in respect to the Third World—and especially in respect to the hopes of the Third World, the rapidly industrializing countries. There are some beginnings: the new U.S. proposals for the debts of the primary-products countries that U.S. Treasury Secretary Baker recently put forth, or the new lending criteria which the World Bank recently announced and under which loans to Third World countries from now on will be made conditional on a country’s overall development policies rather than based mainly on the soundness of individual projects. But these proposals are so far aimed more at correcting past mistakes than at developing new policies.

The other major agenda item is, inevitably, going to be the international monetary system. Since the Bretton Woods Conference at the end of World War II, it has been based on the U.S. dollar as the “reserve currency.” This clearly does not work anymore. The reserve currency’s country must be willing to subordinate its domestic policies to the needs of the international economy, for instance, risk domestic unemployment to keep currency rates stable. And when it came to the crunch, the United States refused to do so, as Keynes, by the way, predicted forty years ago.

The stability the reserve currency was supposed to supply could be established today only if the major trading countries—at a minimum the United States, West Germany, and Japan—agreed to coordinate their economic, fiscal, and monetary policies, if not to subordinate them to joint, and that would mean supernational, decision making. Is such a development even conceivable, except perhaps in the event of worldwide financial collapse? The European experience with the far more modest European Currency Unit (ECU) is not encouraging; so far, no European government has been willing to yield an inch for the sake of the ECU. But what else could be done? Or have we come to the end of the 300-year-old attempt to regulate and stabilize money on which, in the last analysis, both the modern national state and the international system are largely based?

Finally, there is one conclusion:Economic dynamics have decisively shifted to the world economy.

Prevailing economic theory—whether Keynesian, monetarist, or supply-side—considers the national economy, especially that of the large developed countries, to be autonomous and the unit of both economic analysis and economic policy. The international economy may be a restraint and a limitation, but it is not central, let alone determining. This “macroeconomic axiom” of the modern economist has become increasingly shaky. The two major developed countries that fully subscribe to it in their economic policies, Great Britain and the United States, have done least well economically in the last thirty years and have also had the most economic instability. West Germany and Japan never accepted the macroeconomic axiom. Their universities teach it, of course. But their policymakers, both in government and in business, reject it. Instead, both have all along based their economic policies on the world economy, have systematically tried to anticipate its trends, and to exploit its changes as opportunities. Above all, both make the country’s competitive position in the world economy the first priority in their policies—economic, fiscal, monetary, and largely even social—to which domestic considerations are normally subordinated. And these two countries have, of course, done far better, both economically and socially, than Great Britain and the United States these last thirty years. In fact, their focus on the world economy and the priority they give it may be the real “secret” of their success.

Similarly the secret of successful businesses in the developed world—the Japanese, the German carmakers like Mercedes and BMW, ASEA and Ericsson in Sweden, IBM and Citibank in the United States, but equally of a host of medium-size specialists in manufacturing and in all kinds of services—has been that they base their plans and their policies on exploiting the world economy’s changes as opportunities.

From now on any country—but also any business, especially a large one—that wants to do well economically will have to accept that it is the world economy that leads and that domestic economic policies will succeed only if they strengthen, or at least not impair, the country’s international competitive position.

This may be the most important—it surely is the most striking—feature of the changed world economy.

(1986)