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Sunday, March 13, 2005
Price Indexing for the People?

(Please note: I'm no economist. I have somewhat of a general grasp of how things work, but that's it. So the following is just noodling, and if I happen to get something right, it's probably by accident.)

Andy Xie of Morgan Stanley has an interesting hypothesis (scroll down), that China's size, fast growth rate, and functionally limitless pool of labor will make it a fundamentally different influence on the developed world economy of the future than previous arrivistes such as Japan and South Korea:

When a small economy like South Korea begins to develop, it is quite reasonable to assume that its prices (e.g., wages, property prices, or the cost of a haircut) will rise to the same levels as in developed economies.  South Korea has a population of fewer than 50 million.  If it invests to join the global economy, global demand will be met by Korean supply at the margin.  As South Korea’s labor force is less than 5% of the OECD labor force, it will reach full employment quickly -- and the extra global demand will pull up its wages to international levels.  Rising wages will cause inflation, and asset and goods prices will also converge towards international levels.

The price trends in China will be very different from those in Japan or South Korea at similar stages of development, in my view.  China’s labor force is bigger than the OECD labor force.  When it can make a product more cheaply than others can, even if all the production of that item relocates to China, its wages will not increase.  China has developed remarkable strength in light manufacturing.  Already, many products are made mostly in China (e.g., shoes, toys, PCs).  China’s exports have quintupled in the past decade and reached 35% of GDP last year.  But the wages at the coastal export factories have barely changed in the past decade.

The challenge is that the size and growth of China’s underemployed labor force limit its bargaining power.  China had a population of 1.3 billion and a labor force of 760 million in 2003, according to official statistics: 256 million were employed in cities, 153 million were employed in non-agricultural activities in rural areas, and 325 million worked in farming.  I believe a conservative estimate would put excess labor at 150 million.  China created 9 million jobs last year when the economy was overheating.  The labor surplus is likely to remain for the foreseeable future.


In summary, the global financial markets are speculating in China-related assets, in the belief that Chinese prices will rise to OECD levels.  I believe that OECD prices are more likely to fall towards Chinese levels.

This idea takes its place alongside recent wage trends in the United States (and, possibly, the rest of the developed world, although I don't know enough about it to say), which has of late experienced flat or slightly negative real wage growth in an expanding economy. This has variously been attributed to companies arrogating to themselves productivity gains that have historically gone to labor, globalization (see China and India), weak labor organization, and the destruction and withering away of labor-friendly regulations, among other factors.

With none of these trends looking likely to reverse themselves any time soon, it's difficult to see where real wage growth in the U.S. is going to come from in the future.

On top of this, the U.S. economy is looking ripe for a big interest rate hike, further currency depreciation, and a massive squeezing-out of investment in favor of debt service. In other words, inflation is coming.

All of this is prelude to a reexamination of a central liberal tenet in the Social Security debate: that indexing benefits to prices instead of wages, as the Bush administration advocates, is a Bad Thing. If the above-noted trends continue, workers in the abstract could find themselves better off under price indexing if wage growth slows or stops in an increasingly inflationary environment. If wages are flat and inflation high, the current system of wage indexing would provide progressively lower and lower payments to retirees.

Of course, in the real world, there will be a huge temptation on the part of an increasingly straitened federal government to game inflation numbers, and any significant rise in SS benefits relative to inflow (and the balance of the non-SS budget) would eventually necessitate higher taxes or benefit cuts. Maybe continuation of wage indexing is the pragmatic course, not because it would provide SS beneficiaries with higher payouts, but the reverse, which would tend more toward the system's future solvency.

I don't know which would be the better course to follow, or favor any particular approach, but I haven't seen this idea mooted in the SS debate, and think it's worth a look by those better informed than I.