An Economic Tsunami

Three Billion New Capitalists: The Great Shift of Wealth and Power to the East by Clyde Prestowitz (Basic Books, 278 pages, $26.95)

Globalization: Why It Works by Martin Wolf (Yale University Press, 398 pages, $30.00)

Will the United States benefit from the new wave of globalization sweeping the economy, as it did from earlier ones? Or will America instead see its prosperity and economic power slip away as jobs, technology, income, and wealth shift to Asia?

In his new book, Clyde Prestowitz argues that there is a new and threatening dynamic at work with the rapid emergence of China and India as major forces in world markets just at the moment when communications and transportation technologies allow for the rapid movement of production across national borders. And Prestowitz is not optimistic about the outcome -- unless policy-makers embrace a major new agenda to enhance America's competitiveness and to counter the onslaught of new low-cost Asian producers.

Prestowitz's analysis taps into widespread anxieties about the rise of China and India that are hardly irrational. But the picture is complicated, and the United States may end up benefiting more than it loses. Understanding how China and India affect American interests is crucial to getting both our domestic and foreign policies right in the future.

At the heart of Prestowitz's analysis lies the fact that the world's labor force has effectively more than doubled over the past 15 years as a result of the entrance of China, India, and the former Soviet Union into the global system of production and trade. Most of these workers are unskilled and have brought little capital with them. So labor, especially unskilled labor, has become relatively more abundant, and capital has become relatively more scarce. Indeed, the ratio of global capital to global labor has fallen by nearly half in just a few years -- an event without historical precedent. Because this ratio determines the relative returns to capital and to labor, its precipitous drop partly explains recent trends in the United States such as rising profits as a share of national income and the failure of real wages to match the growth in productivity.

Overall, the doubling of the global labor force will put downward pressure on the wages and employment levels of American workers for years to come. Initially this pressure will be greatest for unskilled workers, who have already suffered relative and absolute declines in their earnings as a result of both imports and immigration during the last quarter-century. And as China and India improve the skills of their workers, even many skilled and highly educated Americans will find themselves competing with foreigners who are equally productive but willing to work for lower pay.

Prestowitz is surely right in his conclusion that the entry of low-cost Asian workers into world markets will cause painful job dislocation and stagnant -- or even falling -- real wages for many Americans. But the future may not be as dire as he suggests, for three reasons posited by Martin Wolf in his optimistic book on globalization.

First, most jobs in the United States are in the service sector, and most services are still produced and consumed locally. The McKinsey Global Institute estimates that only about 11 percent of the 1.46 billion service jobs worldwide could be performed abroad in the foreseeable future.

Second, capital -- defined as including social and human assets -- is not nearly as mobile across borders as many of Prestowitz's alarming examples suggest. Social capital includes relationships of personal trust and cooperation; human capital includes education and language skills. Many workers in the United States who possess these advantages will continue to enjoy a substantial edge in productivity and wages over their foreign counterparts -- and an even greater number will be able to do so if the United States upgrades education and worker training and increases its investment in research and development, as Prestowitz recommends.

Third, there are still very few truly multinational American companies that can integrate their production around the globe, and even those that do continue to locate more than three-quarters of their production, employment, and capital spending in the United States. That fraction has not changed during the past decade of rapid globalization. Prestowitz's cases focus on American companies moving production from high-cost U.S. locations to low-cost sites in Asia. But this evidence is misleading: A job created abroad does not necessarily mean a job lost at home. Between 1991 and 2001, American multinationals added 5.5 million jobs at home, or about five jobs in the United States for every three jobs they added overseas.

Even if the entry of billions of new Chinese and Indians into global labor markets harms a significant fraction of American workers, does that mean America's overall economic well-being will suffer? The answer to this question is not nearly as simple or as certain as Prestowitz's analysis suggests.

A key issue is how Asia's rise will affect America's terms of trade, that is, the ratio of its export prices to its import prices. If this ratio rises and the U.S. terms of trade improve as Asia's share of global markets increases, America will be better off because it will be able to buy more from the rest of the world with what it produces at home. Unfortunately, it is difficult to predict how Asia's growing role in the world economy will affect America's terms of trade. As China has displaced other higher-cost sources of labor-intensive goods such as South Korea and Hong Kong, it has driven down the relative prices of the manufactured goods it exports. That has had a positive effect on the U.S. terms of trade: Labor-intensive manufactured goods imported into the United States have become cheaper relative to capital-intensive, technology-intensive manufactured goods that the United States exports. In recent years, however, China's rapid economic growth has also pushed up world prices for oil and other raw materials -- and that, as we can all now see at the gas pump, adversely affects the United States. So China's net effect on the American economy has become more difficult to assess, although most economists believe it has been positive to date.

But the next chapter in this saga could be worse. As China and India become more significant producers and exporters of technology-intensive, capital-intensive products on global markets, the result could be to drive down the price the United States can get for its exports relative to the prices it pays for imported raw materials. Consequently, as the economist Paul Samuelson recently cautioned, the emergence of large-country, low-cost competitors such as China and India in U.S. export markets could adversely affect America's terms of trade and its overall economic welfare.

Nonetheless, such proponents of globalization as Wolf and Jagdish Bhagwati are quick to point out that even a dramatic deterioration in America's terms of trade would have a modest negative effect on American's aggregate economic welfare given the relatively small role of imports and exports in the overall American economy. And the positive effects of innovation produced in India and China, or triggered by competition from them, could more than offset any adverse terms of trade.

Prestowitz believes that America's relative economic superiority is eroding rapidly as a result of the rise of China and India. In the face of these challenges, he asserts that the first priority of America's leaders -- even more important in his view than fighting terrorism or spreading liberty -- should be to ensure America's long-term competitiveness, and he proposes a comprehensive policy agenda with that aim. The agenda includes the introduction of a value-added or consumption tax to increase national savings, a national health-insurance plan, a portable pension system, and a comprehensive energy policy. He also argues strongly for new investments to upgrade education at all levels and to bolster research and development in order to create more high-productivity jobs to replace the ones moving to lower-cost Asian workers. And he suggests a more generous and comprehensive wage-insurance system to help individual workers who are displaced as a result of foreign competition.

A strong case can be made for Prestowitz's domestic economic agenda even if his concerns about the rise of Asia prove to be unwarranted. When he talks about American competitiveness, he often means America's ability to raise living standards, which depends in turn on America's ability to sustain strong productivity growth, regardless of what other nations are doing. Even if the rise of Asia means a relative decline in America's share of some key global industries, America's standard of living will continue to grow as long as its productivity does. And most of the domestic policies recommended by Prestowitz would boost productivity.

Prestowitz's recommendations on foreign economic policy are less convincing. He argues that the United States should work to reduce the role of the dollar as a reserve currency without demonstrating that this role has harmed, or will harm, the U.S. economy. He argues that the North American Free Trade Agreement should be extended to include the rest of Latin America and Japan, and that it should be turned into an economic and political union along the lines of the European Union, without explaining how this would help the United States address the competitive threat posed by China and India. He even suggests that the United States should negotiate a free-trade agreement with India. It is hard to see the link between any of these policy recommendations and the analysis of most of his book.

Although Prestowitz sees the rise of China and India as an economic challenge, it is also an opportunity. The entry of Chinese and Indian workers into global markets may cost American workers bargaining power and income, but the economic development of China and India will also bolster global demand and growth and create new jobs in the United States and around the world.

Geopolitical power may be a zero-sum game -- the more one nation gains, the more another loses. But the global economy is not zero-sum. Even if the rise of China and India means that America's share of the global economy declines, America's prosperity and living standards can continue to grow provided America's leaders pursue the right policies. Ultimately, the nation's competitiveness depends not on what other nations do but on what we do at home. Prestowitz is deeply concerned that our leaders are not doing the right things. I agree with him. His book makes compelling and sobering reading.

Laura D'Andrea Tyson, chair of the Council of Economic Advisers under President Clinton, is a professor of economics and business administration at the University of California, Berkeley's Haas School of Business.