Globalization’s Missing Middle

SQUEEZED

The polarized debate over the effects of free trade and international capital flows has become a fixture of world politics. Boosters of globalization assert that it is a win-win proposition for the rich and the poor, developed and developing countries alike. President George W. Bush has said that "a world that trades in freedom ... grows in prosperity," reiterating a theme Bill Clinton championed in the 1990s. But critics see a small global elite lining its pockets at the expense of everyone else. John Kerry's decrying of outsourcing by "Benedict Arnold CEOs" is this year's version of Ross Perot's 1992 forecast that the North American Free Trade Agreement (NAFTA) would make a "giant sucking sound" by drawing jobs out of the United States.

All this good-versus-evil rhetoric obscures one key fact: while globalization has benefited many, it has squeezed the middle class, both within societies and in the international system. In today's global markets, there are only two ways to get ahead. People and countries must be competitive in either the knowledge economy, which rewards skills and institutions that promote cutting-edge technological innovation, or the low-wage economy, which uses widely available technology to do routine tasks at the lowest possible cost. Those who cannot compete in either include not only the erstwhile industrial middle class in wealthy nations, but also most countries in the middle of the worldwide distribution of income, notably in Latin America and eastern and central Europe.

This tripartite account of globalization's results does not fit neatly into either of the paradigms that dominate the current debate. On the one hand, globalization's supporters—who maintain that all countries should gain from opening their economies—try to explain the poor performance of the middle-income countries by invoking factors other than globalization, such as the trauma of eastern Europe's rupture with its socialist past or endemic corruption and inefficiency in Latin America. On the other hand, critics of globalization, who refuse to accept that it has benefited anyone in the developing world save a tiny Westernized elite, fixate on various injustices (using terms such as "sweatshop labor") and discount its positive effects as the product of other processes, such as the modernization of agriculture in China. But simple evidence demonstrates that both views are inexact. In fact, middle-income countries have not done nearly as well under globalized markets as either richer or poorer countries, and the ones that have globalized the most have fared the worst.

The question is, how can they be helped? Displaced American manufacturing workers would probably rather get jobs at Microsoft or Genentech than at McDonald's or Wal-Mart. But for most of them this just is not a realistic option. On the global stage, countries such as Mexico and Poland would similarly like to compete with Japan and Germany in the U.S. market for high-value-added goods and services. But their work forces are not skilled enough and their economic institutions not sufficiently supportive of investment or innovation to take advantage of the knowledge workers they do have. As a result, the middle-income countries have been forced into unwinnable battles with China for market share in standardized manufacturing and, increasingly, with India for low-wage service-sector exports.

In the United States and the rest of the Western world, the challenge of helping the disaffected middle class "tech up" (rather than dumb down) is well understood. People must be given access to the education and training that can transform them into successful knowledge workers. Likewise, middle-income countries must be helped up the global skill chain. Meaningful educational reform is long overdue, but it is only the beginning. Middle-income countries need broad and deep institutional reforms in government, banking, and law to transform economies that stifle innovation into ones that foster it with strong property-rights regimes, effective financial systems, and good governance.

The stakes are high—and not only for politicians vying to control the electoral center in Western democracies. For more than a decade, citizens in middle-income countries have been told by international financial institutions and by their own governments that opening to the global economy will bring large and widely shared benefits. But all too often the troubling reality has been persistently high unemployment and stagnant incomes. In both eastern Europe and Latin America, the stark disjuncture between lofty rhetoric and grim reality has proved fertile ground for populist backlashes against global markets and their perceived American masters. The world's leaders must find ways to empower middle-income countries so that the fruits of globalization can be enjoyed by their people too.

ANOTHER COUNTRY

Princeton economist Paul Krugman lamented in The New York Times two years ago that "the middle-class America of my youth was another country." He was right. According to the Bureau of Labor Statistics, manufacturing employment, the quintessential American middle-class occupation, has fallen from one-fifth to one-tenth of total American jobs in just the last two decades. Meanwhile, employment in "professional and business services," which pay higher salaries to more skilled workers, has more than doubled, overtaking manufacturing in the process. At the same time, the number of low-paying jobs in "leisure and hospitality" industries has also essentially doubled and now rivals total manufacturing employment. Jobs on the American factory floor have thus been replaced, in more or less equal measure, by "junk" jobs such as flipping burgers and cleaning floors and by the new glamour professions of writing software and managing money. The result is that the distribution of income in the United States has been stretched at both the high and low ends, significantly increasing social inequality.

A similar process has been taking place at the global level. The world's wealthiest countries have grown richer in recent decades as a result of dramatic advances in technology, and the rate of economic advance has been even faster in the new manufacturing dynamos among the world's poorest countries. Squeezed between these two success stories, the countries in the middle have floundered.

One easy way to measure these changes is to track per capita national income worldwide according to the three major country groupings created by the World Bank. The top 25 percent of countries are labeled "high income," a category that comprises the nations in the Organization for Economic Cooperation and Development, plus a few small Middle Eastern oil exporters and trading states such as Singapore. The bottom 30 percent are labeled "low income." This group includes more than half of the world's six billion people, chiefly in the countries of Asia and sub-Saharan Africa. The remaining 45 percent of countries—almost all of Latin America and the former Soviet bloc as well as the Asian tigers and much of the Middle East—are "middle income."

In 1980 (a useful ending date for the preglobalization period), the differences in per capita income among these three groups of countries were enormous: roughly 1,000 percent both between the low-and middle-income countries and between the middle-and high-income countries. Average GDP per capita was less than $300 in the low-income group, roughly $2,500 in the middle-income group, and more than $20,000 in the high-income group (in 1995 dollars at market exchange rates and adjusted for inflation). After two decades of integration of national economies into international markets, by 2000, per capita incomes in the countries categorized as high income in 1980 had increased by roughly 50 percent in real terms, due in no small part to innovation fueled by advances in biotech and information and communications technology.

At the other end of the spectrum, the world's poorest countries fared even better—indeed much better. During the 1980s and 1990s, their real per capita income increased by more than 160 percent. This growth miracle was spurred not by sales of agricultural products (the focus of ongoing debate over the future of the World Trade Organization), but by large-scale exports of standardized manufactured goods, ranging from steel to shoes to computer hardware. Exports of all goods and services increased in the low-income countries from less than 15 percent of GDP in 1980 to 28 percent in 2000. Over the same period, the share of manufacturing in total exports tripled, rising from 15 percent to more than 45 percent.

To be sure, profound inequalities remain in the cross-national distribution of income (even if one uses comparisons based on purchasing-power parity, which substantially increase estimates of per capita income in developing countries, rather than comparisons based on market exchange rates). But the big story of the past two decades is that the income ratio between the countries characterized as high and low income in 1980 has essentially been cut in half. Moreover, the growth led by manufacturing exports seems to have benefited wide cross-sections of the population in low-income countries. As journalists Nicholas Kristof and Cheryl WuDunn have pointed out, the factories that liberals denounce as sweatshops have nonetheless provided opportunities for people with limited skills to move from subsistence farming and penury into much-better-paying manufacturing jobs.

This "modernization through globalization" has undoubtedly had its deleterious consequences, including heightened inequalities between rural and urban populations and between hinterland and coastal regions, precipitating large-scale internal migrations. As the recent elections in India showed, such problems can lead to powerful political resistance from those left behind. Nonetheless, in India, China, and other countries in which the social pie has been rapidly expanding, these difficulties are easier to handle than in more stagnant economies.

Although proponents of globalization can point to record growth in low-income countries as proof of their wisdom, they should be troubled by the economic stagnation in middle-income countries. Supporters of NAFTA are wont to label the treaty a success for middle-income Mexico because it has stimulated trade and manufacturing across the border from the United States. And it is true that exports in the middle-income world increased from less than 20 percent of GDP in 1980 to more than 30 percent in 2000, while the share of manufacturing in total exports increased from under 30 percent to more than 50 percent. But despite the export growth, this group of nations has fallen even further behind the West, defying the age-old logic of "catch up," by which poorer countries reap the rewards of technology developed in richer nations. Real per capita income in the middle-income group grew by less than 20 percent during the 1980s and 1990s, less than half of the growth rate achieved in the high-income world and less than one-eighth of that in low-income countries. As a result, the ratio of per capita incomes of high-and middle-income countries actually increased by about 20 percent during the past two decades, while the ratio between high-and low-income countries dropped by 50 percent. These figures are all the more troubling because middle-income countries tend to have better-developed economic and political institutions and more educated labor forces—which development economists consider key drivers of growth—than their low-income counterparts.

Why has globalization been disappointing for countries in the middle? The answer seems to be that they have not found a niche in world markets. They have been unable to compete in high-value-added markets dominated by wealthy economies because their work forces are not sufficiently skilled and their legal and banking systems are not sophisticated enough. As a result, they have had little choice but to try to compete with China and other low-income economies in markets for standardized products made with widely available and relatively old technologies. But because of their higher wages, the middle-income nations are bound to lose the battle.

These economic woes have been compounded by the speed with which middle-income countries opened their financial markets to the outside world, particularly in the 1990s. In theory, developed-world capital can fuel development in lagging economies. But in reality, capital account liberalization in Latin America and eastern Europe, as well as in Asia, has brought instability, volatility, and, on more than one occasion, full-blown financial crisis. Now, even the International Monetary Fund (IMF) admits how misguided was its blanket support for liberalizing financial markets in developing countries with weak domestic financial institutions and fixed exchange rates (implemented in response to high inflation). The new orthodoxy thus favors sequencing: developing strong domestic financial markets and banking systems first and opening to international financial markets later. But this rethinking is of little comfort to countries recently ravaged by boom-and-bust cycles of hot money.

SEARCHING FOR EXPLANATIONS

The success of globalization in both high-and low-income countries can be readily explained by mainstream economics. Technological change and the international integration of markets have spurred growth in high-income nations, reversing the slowdown of the 1970s. Low-income countries have exploited their comparative advantage in cheap labor to gain large shares of the global marketplace.

The failure of middle-income countries to compete in global markets for either knowledge or low-wage products is decidedly less well understood, however. It flies in the face of many economists' core belief that all countries should gain from opening their markets to the outside world by doing what they do best, even if they do not do it as well as their competitors. As a result, supporters of "free trade for all" try to explain the poor performance of middle-income nations by pointing to causes other than their inability to find a productive niche in the global economy. These true believers argue that the integration of the middle tier into international markets is not at fault for these countries' recent dire economic record and that freer trade has ameliorated, not exacerbated, their problems.

One common argument brackets the experiences in the 1990s of the countries of the former Soviet bloc. For all the promise of their velvet revolutions, their transition from communist pasts to capitalist futures has been painful, and it would be a stretch to portray globalization as the principal culprit in this difficult birth of free-market democracy. Yet, even excluding ex-communist nations, per capita income in the remaining middle-tier countries increased by only 25 percent from 1980 to 2000, half the growth rate of the top tier and one-sixth that of the bottom tier. Blaming the problems of all middle-income countries on the collapse of the Soviet system is thus not persuasive.

Another attempt to resuscitate the classic case for free trade juxtaposes middle-income globalizers and nonglobalizers to argue that, whatever the problems of the middle-income group, the globalizers in it have fared better. In fact, the opposite is true. According to World Bank data, middle-income countries that cut tariffs less during the 1980s and 1990s grew more than those that opened up faster to globalization and cut tariffs more. A comparison of the experience of Latin America and eastern Asia, for example, casts serious doubt on a central shibboleth of development economics: that underperforming Latin American states are victims of their insularity and protectionism whereas overachieving eastern Asian states are the beneficiaries of their wholesale endorsement of global markets.

As careful observers such as Alice Amsden and Robert Wade pointed out long ago, it is misleading to characterize the first Asian tigers as having "open" economies. Japan, South Korea, and Taiwan all pursued the same strategy in their takeoff phases: nurture infant industries such as electronics and automobiles with preferential credit and protection from international competition and then do whatever possible to find export markets for these products. Since removing protectionist barriers to the home market is a critical expression of a state's move toward free trade, the eastern Asian countries cannot be held up as paragons of virtuous globalization. During the Cold War, because of security imperatives, the United States nonetheless allowed these countries unfettered access to U.S. markets. It was only in the mid-1980s, when Asian competition came to be seen as a threat to the U.S. economy, that Washington pushed hard for reciprocal access to eastern Asian markets.

In contrast, when, after decades of stifling protectionism, Latin American countries opened their economies with a vengeance in the 1980s and 1990s, they scored decidedly mixed results. They did exactly what the U.S. Treasury, the IMF, and the World Bank told them to do—open up, deregulate, privatize—arguably liberalizing more thoroughly than any other region in the developing world. (Average tariff rates in Latin America were cut in half from the mid-1980s to the late 1990s, compared with reductions of about 10 percent in other middle-income countries and 30 percent in low-income nations.) If the conventional diagnosis of Latin America's historical problems were correct, the continent would have reaped large rewards from liberalization or, at least, larger rewards than other middle-income countries that opened up less. But in fact, economic growth was even slower in Latin America than in the rest of the (already underperforming) middle-income world. Per capita incomes in Latin America increased by less than 10 percent from 1980 to 2000, compared with almost 30 percent for the remaining middle-income nations. Within the region itself, moreover, the countries that cut their tariffs the most grew the most slowly.

UNCONVENTIONAL WISDOM

Proponents of openness tend to square their predictions with the experience of Latin American states by blaming domestic conditions such as widespread corruption, poor infrastructure, and underdeveloped economic institutions. Most Latin American countries could no doubt use better policies and better institutions. So too, of course, could low-income countries that suffer from political problems, such as civil wars and coups, that most Latin American countries have finally put behind them. If low-income countries have benefited from liberalization at least in part because it generated pressure for domestic reform, why, proponents of globalization might ask, have those in Latin America not similarly benefited?

Conventional economic analysis offers no clear answer to this question. One theory ventures that the true anomaly is not the relative underperformance of middle-income countries, but exceptional cases among low-income countries that have led analysts to find a spurious correlation between openness to trade and economic success. It suggests that a couple of gargantuan outliers, China and India, could skew the figures in favor of the low-income category.

With one-third of the world's population between them, China and India do loom large in any discussion of recent economic development. After three decades of Maoist rule, the Chinese government began economic liberalization in 1978, spurring more than 20 years of double-digit growth rates. India's liberalization came more than a decade later, but dropping long-standing quasi-socialist policies also brought the country spectacular results. In both cases, economic openness, particularly tariff reductions, was essential. From the mid-1980s to the late 1990s, China cut its average tariff rate in half, to 20 percent, and India cut its rates from around 90 percent to 30 percent. Thus, it is far from clear that these countries should be excluded from an analysis of the effects of globalization on the low-income world.

But even when the staggering achievements of China and India are discounted, it is still true that remaining low-income countries fared better in the 1980s and 1990s than did the middle-income world (with increases in per capita income of 55 percent against 20 percent). Savvy observers of the world economy might find these figures difficult to believe: after all, virtually all sub-Saharan African countries qualify as "low income," yet their recent record has been anything but miraculous. Per capita incomes in poor sub-Saharan Africa have indeed stagnated in recent decades, for reasons ranging from pestilence and disease to ethnic heterogeneity to dictatorships to mineral wealth. But even so, overall, African countries seem to have benefited from liberalization and integration into international markets.

Consider, again, the impact of tariffs. African economies today are still less open to international markets and less globally integrated than other low-income countries: tariffs in sub-Saharan Africa as a whole were no lower in the late 1990s than they had been in the mid-1980s. Thus, one reason some African states have not benefited from globalization is that, unlike China and India, they have not jumped into world markets with both feet. But where it has been implemented in Africa, freer trade has helped. Although their positive effects have been minimal so far, lower tariffs may eventually stimulate African exports in agriculture, raw materials, and even manufacturing. In highly competitive global manufactures markets, Africa's low-wage work force will continue to offer an advantage over middle-income nations.

FROM MISSING TO MODERNIZED

Counter to mainstream economic expectations, middle-income countries have struggled economically in the last two decades, and those that have opened their markets more have fared even worse. Yet a return to protectionism is unlikely to do any good. The pace and pervasiveness of technological change make it difficult, if not impossible, to put the globalization genie back in its bottle. But the formula of "more free-trade agreements"—bilaterally, regionally, and multilaterally—is unlikely to work, either.

The challenge for the middle-income world is to find ways to "tech up" and enter the global knowledge economy, so as to escape the trap of having to dumb down to compete in standardized manufacturing and, increasingly, standardized services. This will require educational reforms geared toward producing a large pool of skilled and creative labor, as well as good government, secure property rights, and strong financial systems to fight corruption and inefficiency. Such reforms would give entrepreneurs incentives to take advantage of newly minted knowledge workers, fostering innovation. But such a transformation will be expensive and difficult to execute, and the countries of Latin America and eastern Europe are not likely to be able to achieve it on their own. The transition to democracy has not itself proved the necessary catalyst. Instead, it has raised popular expectations that politicians find increasingly difficult to satisfy.

What can the West do to help? For much of eastern Europe, entry into the European Union, long and drawn out as the process of accession has been, may well be the answer. Poland, Hungary, and the other formerly communist countries that were admitted this year hope that membership will bring to them what it has brought to Greece, Portugal, and Spain over the past 20 years: access to western European markets, capital, and development assistance, as well as other, less tangible, but equally important advantages. New members must adopt the acquis communautaire of the EU: the full range of its laws, regulations, and institutions. Although it has often been derided as overly bureaucratic and sclerotic, over time, the acquis has aligned the domestic institutions of these nations with common European practice, bringing the EU's poorest members stability, predictability, and credibility—and an environment conducive to the emergence of the knowledge economy—far more quickly than they could otherwise have expected.

Although the EU's latest members from the east are starting from even further behind than were Greece, Portugal, and Spain, they can expect accession to help them build relatively quickly the foundations for successful competition in the knowledge economy. It goes without saying, however, that the helping hand of EU membership is not being held out to all postcommunist countries. Most conspicuously, Russia will likely remain on the outside looking in, even though it needs the shape-up that membership would bring more acutely than most of the countries that acceded this year.

Latin American nations have aggressively pursued closer economic relations with the EU, but membership is obviously not an option for them, and they have no analogous organization on the continent. NAFTA is more than a mere free trade agreement, but its rules and regulations are rudimentary compared with the EU's. The United States, moreover, has been reluctant to extend the treaty's reach, choosing not to integrate more deeply with its NAFTA partners or to extend the NAFTA model. Meanwhile, Latin American countries have been pushing in all directions for more free trade agreements: bilaterally, regionally, and with other parts of the world. Yet in rushing to do so on almost any terms, they risk reinforcing the damaging dynamic that trade liberalization has wrought on them and the rest of the middle-income world.

If unalloyed free-trade agreements alone cannot do the job and an EU-like organization is a pipe dream, what can be done for Latin America? The World Bank has been promoting smart development assistance, focusing on the creation of knowledge economies. So far, however, it has remained largely ineffective as an agent of change in the middle-income world. The United States recently launched the Middle East Partnership Initiative to foster educational, financial, and judicial reform in the middle-income countries of that region. Such efforts should be replicated in Latin America and all middle-income countries to counteract the economic stagnation and rising popular frustration that threaten these nations' openness and stability.

The problem today is that U.S. policymakers have more pressing things on their mind than Latin America's economic woes. In the early Cold War era, the Marshall Plan advanced U.S. foreign policy by creating democratic and capitalist bulwarks against communism in Europe. Bailing out Russia and Mexico also made sense in the years following the Cold War, when traditional security issues receded into the background. But since the September 11, 2001, attacks, achieving political goals through economic means has been given a much lower priority than the war on terrorism. And if a new Marshall Plan is created, it will focus on the Middle East.

The ultimate irony facing globalization's missing middle may be that the more the free trade project founders in Latin America, the greater will be the pressure on people in the region to migrate to the United States. Migration will, in turn, squeeze employment and wages for the American manufacturing middle class even more and force the U.S. government to think creatively about growing economic problems south of its border. After all, the flow of former East Germans into western Germany motivated Chancellor Helmut Kohl to invest massively in the formerly communist part of the newly unified country. Rapid increases in the number of eastern Europeans looking to live and work in western Europe also strengthened the case for the EU's eastern expansion. Much like East Germans did, eastern Europeans will benefit because western European investment will speed their transition to the knowledge economy. Perhaps, then, migration into the United States from Mexico and the rest of Latin America will ultimately help the continent move into the knowledge economy.

Before September 11, the disagreement over globalization was the principal fault line in world politics. Even today, ensuring that globalization's benefits reach all parts of the world would provide a bedrock upon which peace and prosperity in the twenty-first century can be built. Unfortunately, so far the middle-income nations have been left out. The United States and the EU must help Latin America and eastern Europe develop competitive knowledge economies. This project may seem banal compared with the war on terrorism, but over time, ignoring those pushed aside by globalization will have immense implications—economically and politically.