Good Economics for Hard Times

by Abhijit V. Banerjee

  The curse of low expectations can be very hard to overcome. Even if a firm chooses to deliver the highest-quality products, sufficiently pessimistic buyers will assume it is just a matter of time before the quality goes down. This is where it can be very useful to have the right connections: someone who knows you and will vouch for you.

  It is no accident that ethnic Indians and Chinese who lived and worked in Western countries played an important role in their native countries’ transition when they returned home. They used their reputation earned and business cards collected to assure buyers (often firms where they had already worked) that things would be okay.

  The presence of some success stories can set off a virtuous cycle. Buyers tend to flock to firms that have had one successful breakthrough, reassured by the fact that others have continued to do business with them. Most young sellers who get an order, recognizing this is their one chance to break the vicious cycle of low expectations, will try their best to deliver when given a chance.

  For example, in the rose export market in Kenya,37 local producers work with intermediaries to export their roses to Europe. Neither the buyer nor the seller in this industry can rely solely on formal contracts to enforce good behavior. Roses are very perishable, so upon receiving a shipment a buyer could always claim the roses were not of an acceptable quality and refuse to pay. But, on the other hand, the seller could also claim the buyer somehow spoiled the roses to avoid paying. This means that establishing a reputation for reliability is important. During a period of political unrest in Kenya after the disputed presidential election of 2007, when workers were scarce and transportation was dangerous, new producers who were yet to establish a reputation went to great lengths to continue delivering to their buyers. Some even hired armed guards to protect their roses during delivery. The buyers stayed happy and the Kenya rose market survived the unrest.

  Of course, even such desperate measures may not always save your skin. The overall reputation of the industry matters, and it may take only a few bad eggs to ruin the reputation of an otherwise high-quality industry. Governments, recognizing this, have tried to find ways to penalize individual producers who cheat on quality. In 2017, the Chinese government decided these penalties needed to be upped. China Daily quoted Huang Guoliang, director of the administration’s quality supervision department: “Current law generally imposes administrative penalties on violators of product quality law, which are too lenient… A system under which violators of the law would suffer devastating consequences would act as a deterrent [italics added].”38

  The best-case scenario in this world of fragile and interconnected reputations is often an “industrial cluster,” a concentration of firms in the same industry in one location, all benefitting from the reputation associated with the cluster.

  There have been knitwear factories in Tirupur in India since 1925, and throughout the 1960s and 1970s, the industry grew, producing mainly the white cotton tank tops Indian men wear under their shirts. In 1978, an Italian garment importer, a Mr. Verona, was desperately looking for a large shipment of white T-shirts. The association of garment exporters in Mumbai directed him to Tirupur. Happy with his first lot, he came back for more. In 1981, the first major European chain, C&A, followed him to Tirupur. Its exports were still only $1.5 million until 1985. Then they grew exponentially. By 1990, Tirupur’s export volumes had passed $142 million.39 Exports peaked at $1.3 billion in 2016, though the industry is now facing severe pressure from China, Vietnam, and other recent entrants to the market.40

  China has scores of very large specialized manufacturing clusters (“socks city,” “sweater city,” “footwear capital,” etc.). For example, the Zhili cluster in Huzhou has more than ten thousand enterprises producing children’s wear, employing 300,000 workers. In 2012, it was responsible for 40 percent of the GDP of its region. The United States has clusters too, some better known than others. Boston has a biotech cluster. Carlsbad, near Los Angeles, specializes in golf equipment, and Michigan has clocks.41

  The organization of the garment industry in Tirupur reveals the value of a name. The whole industry is organized around jobbers, subcontractors who take care of one or more stages of the production process, or even do all the stages for part of a shipment. The jobbers are the invisible people. Buyers deal instead with a smaller number of known names who secure orders and then distribute them among the jobbers. The advantage of this model of production is that it allows production at a very large scale, even if no one has the wherewithal to invest in a single immense factory. Everyone invests what they can and leave it to the intermediaries to put the pieces together. This is another reason why the industry needs to be clustered.

  A similar system operates in many large exporting clusters throughout the developing world, where the reputation of some secures the employment of many others. Intermediaries, just like Hamis Carpets in Egypt or the sellers in Tirupur, mediate the relationship with foreign buyers. They have a lot to lose if there is a problem with quality from any of the jobbers and therefore take care of quality control. And while there can be a lot of teething pain, as we saw in the case of Hamis, the eventual rewards are probably quite decent.

  Interestingly, this system may be changing. A substantial part of the business model of two of the world’s most successful companies, Amazon and Alibaba, is to insert themselves in place of these intermediaries by allowing individual producers to build their own reputations on their sites, for a price of course, thereby not requiring certification from the intermediary. This is why after you receive a package ordered through Amazon Marketplace, you get repeated entreaties for feedback from Amazon sellers. It is in pursuit of these ratings that they are selling you the socks or the toy for an absurdly low price. Their hope is that one day they will have ratings both numerous and high enough that they can name their price. Of course, it will take some time for these new marketplaces to cement their reputations as guarantors of quality (and they may yet fail). Until they succeed, it is essentially impossible for an isolated producer in the third world to start competing on the international market, however good its product is and however low its prices are.

  WAS IT WORTH $2.4 TRILLION?

  The Italian maverick Marxist, Antonio Gramsci, once wrote: “The old is dying and the new cannot be born; in this interregnum all manner of morbid symptoms appear.”42 He could have well been writing about the post-liberalization world. As we saw, there are many very good reasons why resources tend to be sticky, especially in developing countries, and breaking into export markets is hard. One consequence of this fact is that trade liberalization anywhere may not be as much of a slam dunk as is often implied by economists. Wages may go down instead of up, even in labor-abundant developing countries where workers should benefit from trade, because everything that labor needs to be productive—capital, land, managers, entrepreneurs, and other workers—is slow to shift from the old job to the new one.

  If machines, money, and workers continue to be used in the old sectors, there will be many fewer resources moving to the potential exporting sectors. In India, the effect of the 1991 liberalization was not a massive and sudden change in import and export volumes. Between 1990 and 1992, the openness ratio (the sum of all the imports and exports, as a percentage of the GDP) only increased a little bit, from 15.7 percent to 18.6 percent. But eventually both imports and exports went up, and India today is actually more open than China or the United States.43

  Resources eventually moved and new products started being produced. And since existing producers benefitted from being able to import what they needed more easily, what they produced was of better quality and more saleable outside. The software industry, for example, benefited from the ability to import smoothly the hardware they needed, and software exports boomed. Indian firms were quick to switch to imports when they became cheap. Moreover, they also eventually introduced new product lines (for domestic and international use) to take advantage of those cheaper imports. But it took time.44
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  There is some evidence for the view (held by many policy makers) that the best way to speed up this process is to adopt “export promotion policies,” that help exporters export more. All the East Asian success stories of the postwar era—Japan, Korea, Taiwan, and most recently China—have used one strategy or the other to help exporters speed up their expansion. Most observers believe China, for example, systematically undervalued its exchange rate throughout the 2000s (until about 2010) by selling renminbi and buying foreign currencies to keep its products artificially cheap against the competing products sold in dollars.

  In 2010, Paul Krugman called China’s policy the “most distortionary exchange rate policy any major nation ever followed.” It was not cheap: China already owned $2.4 trillion in reserves and it added $30 billion to it per month.45 Given how good the Chinese were at exporting and just how frugal Chinese consumers are, China has a natural tendency to sell more than it buys, and this ought to have pushed the exchange rate up and choked off export growth. The policy prevented this from happening.

  Was the promotion of exports good economics? It is possible that it did help the exporters by raising their profits in renminbis (if you sell your shoes for the same number of dollars, the lower the exchange rate, the more local currency you get for them). This made it easier for them to afford to keep the dollar price of their exports low, which encouraged foreigners to buy Chinese, and thereby helped build the reputation of Chinese products. It also helped the exporters accumulate more capital and hire more new workers.

  On the other hand, it was at the expense of Chinese consumers who paid for those overvalued imports (this is the flip side of having a weak currency). It is not easy to say what would have happened if the policy had not been adopted. First, the Chinese government also adopted a range of other policies that also favored exporters. China continued to remain competitive when it stopped manipulating its currency after 2010. Second, even if exporters had expanded more slowly, the domestic market might have grown faster and absorbed the surplus. China even today only exports about 20 percent of its GDP; the rest goes to local production.

  Even if export promotion did work for China—and it could have—the same strategy is unlikely to work for too many other countries, at least in the near future. The problem in part is China itself. Its success and its enormous size make it harder for others to succeed. The sheer fragility of the process of acquiring a reputation, the critical importance of the right connections, and all the breaks needed to succeed also make us question whether trying to break into international trade is the way forward for the average poor country.

  THE CHINA SHOCK

  J. D. Vance’s 2016 book Hillbilly Elegy is a lament on behalf of America’s left-behind people, though reading it, one senses the author’s deep ambivalence about how much to blame the victims.46 Part of the economic hollowing out of the parts of Appalachia the book is set in occurred due to trade with China. The fact that poor people got hurt is what we would expect from the Stolper-Samuelson theorem: in rich countries it is the workers who suffer. What is surprising is how geographically concentrated the suffering ends up being. The left-behind people live in left-behind places.

  The approach taken by Petia Topalova to examine the impact of trade liberalization on India’s districts was replicated in the United States by David Autor, David Dorn, and Gordon Hanson.47 China’s exports are heavily concentrated in manufacturing, and within manufacturing they are concentrated in specific classes of products. For example, within the apparel sector, sales of some goods in the US, such as women’s nonathletic footwear or waterproof outerwear, are completely dominated by China, but for other goods, such as coated fabrics, almost nothing comes from China.

  Between 1991 and 2013, the United States was hit by the “China shock.” China’s share of world manufacturing exports grew from 2.3 percent in 1991 to 18.8 percent in 2013. To examine its labor market impacts, Autor, Dorn, and Hanson constructed an index reflecting the exposure of each US commuting zone to the China shock. (A commuting zone is a cluster of counties constituting a labor market, in the sense that it is possible to commute between them for a job.) The index is built on the idea that if Chinese exports to countries other than the US of a specific commodity are particularly high, implying China is generally successful in that industry, the commuting zones in the US producing that particular commodity will be hurt more than those producing another commodity. For example, since China’s growth in female nonathletic footwear was particularly rapid after China’s accession to the WTO, a commuting zone producing lots of footwear in 1990 would be more affected by the China shock than a commuting zone producing mostly coated fabrics, where China was not so present. So the China shock index measures the vulnerability of a region’s industrial mix to China’s strength by weighing each product type by China’s import to the EU.

  US commuting zones fared very differently depending on what they happened to produce. Those zones more affected by the China shock experienced substantially larger reductions in manufacturing employment. More strikingly, there was no reallocation of labor to new kinds of jobs. The total number of jobs lost was often larger than merely the number of jobs lost in the industries that were hit, and rarely less. This is presumably a consequence of the clustering effect we talked about. Those who lost their jobs tightened their belts, further reducing the economic activity in the area. Nonmanufacturing employment did not pick up the slack. If it had, we would have seen an increase in nonmanufacturing employment in the most affected regions. In fact, for lower-skilled workers, the increase in nonmanufacturing employment in affected commuting zones was lower than in other regions. Wages also declined in these areas compared to the rest of the country (and this was a period of stagnant wage growth overall), especially for low-wage workers.

  Despite the fact that there were neighboring commuting zones essentially unaffected by the shock (and zones that actually benefitted, say, by importing certain components from China), workers did not move. The working-age population did not decline in the adversely affected commuting zones. They had no work.

  This experience is not unique to the United States. Spain, Norway, and Germany all suffered similarly from the impact of the China shock.48 In each case the sticky economy became a sticky trap.

  CLUSTERF**K!

  The problem was exacerbated by the clustering of industries. As we already saw, there are many good reasons for industries to cluster, but one potentially negative consequence is that a trade shock may hit with particular violence, potentially affecting all the firms concentrated in the region. In one single year, between October 2016 and October 2017, exports in Tirupur, the Indian T-shirt cluster, went down 41 percent.49

  This can set off a downward spiral. Laid-off workers spend less in local businesses, such as shops and restaurants. The value of their houses declines, sometimes catastrophically, since to a large extent the value of my house depends on how nicely your house is maintained. When most of a neighborhood starts to go down, everyone goes down together. Households with larger declines in housing wealth experience a tightening of their credit limit and their ability to refinance, which further reduces their consumption.50 This hits the shops and the restaurants, and some of them end up closing. The disappearance of these amenities, the dearth of nice neighborhoods, and the catastrophic decline in the local tax base that makes it harder to provide water, schools, lights, and roads can eventually make an area so unattractive that it becomes impossible to revive. No new firm will want to move there to take the place of those that have died.

  This logic applies just as much to the manufacturing clusters in the United States as it does to those in India or China. Tennessee, for example, had a large concentration of clusters producing goods directly competing with China, from furniture to textiles. The closure of these firms has produced a series of ghost towns. Bruceton, Tennessee, which was profiled in the Atlantic, had been home to the factory of the Henry I. Siegel Company (H.I.S.). At its peak, H.I.S
. made jeans and suits in three giant plants, employing seventeen hundred people. It started winding down in the 1990s. In 2000, it laid off its last fifty-five workers. Afterward, according to the Atlantic article,

  this town has struggled to figure out how to survive. The three giant H.I.S. plants in town are empty, their windows broken, their paint peeling. A few new manufacturing operations have come, but they’ve also left. One by one, the businesses on the main streets of Bruceton and neighboring town Hollow Rock have closed, leaving modern-day ghost towns. In downtown Bruceton, the bank is gone, the supermarket and the fashion store have closed, and there’s a parking lot where there used to be another supermarket. All that’s left is a pharmacy where seniors come to get their prescriptions filled.

  The neighboring town of McKenzie lost its pajama factory and a shoe company in the 1990s. It is still trying to convince new businesses to come. Whenever the town hears a new factory wants to move, city employees call the decision maker and try to sell the town to them. They have had some interest, but no taker yet. The Atlantic article goes on:

  One reason they may not be getting bites, Holland [the town’s mayor] says, is because of the town’s depressing Main Street. One company was going to locate in McKenzie, but when executives showed up to town and saw empty businesses on Main Street, they decided it wasn’t a place they wanted their families to live.… “They said it looked like an atomic bomb went off, so they just kept walking.… They didn’t even give it a second chance.”51

  This is not a reason to try to prevent clustering, since the gains from clustering are potentially very large, but a warning to be willing to step in and deal with what happens when the cluster unravels.