Michael Pascoe: The graph that explains this century

Michael Pascoe says the US-China tension is only just beginning.

Michael Pascoe says the US-China tension is only just beginning.

A picture may be worth a thousand words, but the accompanying graph is worth millions of them.

It tells the biggest story of the first two decades of this century and presages the key driver for most of the rest of it.

It shows what the rise of China really is and the stagnation of the US working class – the stagnation that has given rise to Trumpism.

It explains both the surge in Australia’s wealth and a large part of why our real take-home wages have flatlined.

Look closely and you can see portents for the coming decades, promises of continuing friction between the world’s two economic super powers.

To underline it for the non-graphically minded, 20 years ago US wages were 35 times that of Chinese wages. In 2018, that multiple was down to just five and would be lower again now.

This is globalisation at work. That ratio is being compressed by Chinese wages rising and American wages falling.

The former is a beneficent force, hundreds of millions of people rising out of poverty, becoming customers for the global market, a win-win for the world, certainly a win for Australia given our particular trade relationship – or what used to be our relationship before it was trashed.

The latter reason for compression is a malignant force, the cause of political dissatisfaction and upheaval, fertiliser for populist nationalism.

For the disinterested observer, all other things being roughly equal, there is no reason why an American worker screwing a nut on a bolt should be paid five times what a Chinese worker is for screwing a nut on a bolt.

Chinese workers in Nantong make dry-type transformers for domestic and international markets. Photo: Sipa USA

The American worker of course doesn’t see it that way – whipped along by Trumpists, “it’s not fair, Chine-ah stole our jobs”.

In practice, it’s not that simple. There are productivity relativities and increasingly nuts are screwed on bolts by robots anyway.

I’ll come back to the productivity question, but first where the graph came from:

It leapt out at me from a Martin Wolf column in The Financial Times wherein he was reviewing a new book by Charles Doodhart and Manoy Pradhan, The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival. Yes, economists do come up with catchy titles.

The wages ratio graph is but one part in the authors’ much bigger thesis that ageing populations will reverse the downward drift of inflation and interest rates.

That is a very big and brave call. Given the almost incomprehensibly massive level of government debt and what will happen to central banks’ balance sheets if bond prices fall, it deserves careful consideration.

It’s a bigger question than can be addressed here right now, but I suspect the book underestimates the impact of the next wave of technology and human ingenuity, given the right opportunities, in the countries with strong population growth.

For today, it’s the wages ratio suppression that best illustrates what has been happening under our noses and driving resentment and conflict.

The Great Demographic Reversal (I don’t have a copy – it’s yet to be released) appears to be an expansion of a 2017 Bank of International Settlements working paper by the same authors.

That paper’s abstract summarises the thesis:

Between the 1980s and the 2000s, the largest ever positive labour supply shock occurred, resulting from demographic trends and from the inclusion of China and eastern Europe into the World Trade Organisation.

This led to a shift in manufacturing to Asia, especially China; a stagnation in real wages; a collapse in the power of private sector trade unions; increasing inequality within countries, but less inequality between countries; deflationary pressures; and falling interest rates.

This shock is now reversing. As the world ages, real interest rates will rise, inflation and wage growth will pick up and inequality will fall.

What is the biggest challenge to our thesis? The hardest prior trend to reverse will be that of low interest rates, which have resulted in a huge and persistent debt overhang, apart from some deleveraging in advanced economy banks.

Future problems may now intensify as the demographic structure worsens, growth slows, and there is little stomach for major inflation.

Are we in a trap where the debt overhang enforces continuing low interest rates, and those low interest rates encourage yet more debt finance? There is no silver bullet, but we recommend policy measures to switch from debt to equity finance.

It is challenging big-picture stuff – and forecasting is always easier to do in retrospect – but therein lies another standout phrase of relevance to us and every other country: “increasing inequality within countries, but less inequality between countries”.

As globalisation and demographics have lifted poor countries – a very fine thing – those at the top have hoovered up the productivity dividend. Average workers may have gone backwards, but the wealth of the wealthy has soared.

That leads to another well-travelled path of policy debate: How to reduce inequality within countries when the wealthy have been driving policy for decades to protect and increase their wealth with “trickle-down economics” under its various euphemisms.

Goodhart and Pradhan think globalisation is in decline. They were making the call before COVID and the pandemic has seen plenty jump on the bandwagon.

World trade has been battered, but the great arbitrage that is globalisation is irresistible. Reverting to protectionism would be unjust and, ultimately, self-harming when the challenge should be to develop domestic policies to spread the benefits.

And there’s the productivity drive mentioned earlier. I sent the wages ratio graph to an economist friend who replied:

“I suppose it implies a few things that are not explicitly evident. If Chinese wages have risen by a factor of seven relative to those in the US, other things equal, I think that also means, at full employment, the productivity of your average Chinese worker has also gone up by a factor of seven relative to the average US worker. There’s America’s problem.

“It may be that the average productivity of the average US worker is still five times that of the average Chinese. But I doubt it and, if it is, it won’t be for long.

“Secondly, in a globalised world, that ratio should approach one, either by US wages falling or by Chinese wages rising or by a combination of both. As production goes to the source of cheapest labour, it doesn’t look good for the US.

“That means there’s either a lot more adjustment to go, or gravity-defying policy tries to stop the process of globalisation. So chances are there’s more pain to come, with the potential to compound it all by putting up tariffs.”

Australia has been riding the boom of China’s growth, made wealthier by Chinese workers’ rise from dire poverty.

With the foreshadowed trade pain ahead, it will be even more important to work out where self-interest lies, as well as what policies need to change to handle internal wealth inequality.

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