Service Provision as the Next Step for Foreign Trade

Has globalisation passed its zenith? Does Germany need to bid farewell to its export-oriented economic model? This article argues that the fundamental drivers of economic integration favour continued acceleration, despite the short-term rise of protectionist trends in many national economies. Globalisation is by no means nearing its end; however, the technological and political risks for Germany’s prosperity are significantly increasing. Moving forward, we must be sure to take the right steps. By implementing reforms to secure the sustainability of the welfare state, by educating, by conquering German fears of technology. And above all by strengthening Europe. Only together can the European states enforce their visions of designing a sustainable, inclusive, and democratic world trade system for the future.

As the US turns its back on the multilateral world economic order, China increases its focus on the domestic market, and an illiberal populism is on the rise around the world, recent developments suggest that the times of booming exports have come to an end for now. However, the increasing political resistance against the global market economy should not blind us to the fact that the globalisation process has been driven by technological changes right from the start and that political processes, although inhibiting and sometimes also disruptive, ultimately did not prevent but instead helped bring about these developments. In the medium to long term, the new technological possibilities of digitalisation indicate that a new world trade boom is more likely than not.

The history of world trade runs in waves: phases of rapid globalisation are followed by longer phases of stagnation. The emerging monetary and credit economy, the development of double-entry bookkeeping, and the establishment of trade companies led to a first major globalisation boost towards the end of the Middle Ages. The times of booming exports have come to an end for now: but in the medium to long term, digitalisation indicates that a new world trade boom is likely.This was driven by changes in the private sector, which particularly originated in Italy and helped foreign trade flourish for the first time. The discovery of America played its part in enabling changes in distant regions to have a considerable influence on general prosperity, income distribution, and power relations in Europe. This resulted in a political race for colonies. their markets and resources, in further technological improvements in the shipping industry, and in the invention of the private limited company. The political environment was characterised by great uncertainty, ranging from armed conflicts to inadequate law enforcement, which majorly impeded the development of a global market economy.

World Trade Booms

The second significant boost arrived with James Watt’s fundamental improvement of the steam engine (1769) and the innovations in industry and transport that followed. After the Napoleonic wars, the advancement of new technological opportunities was joined by the Pax Britannica, which secured the international trade routes under English leadership and led to an undreamt-­of growth in world trade. As a result of political security, new scientific discoveries – David Ricardo’s development of the principle of comparative advantage in 1817 –, and the subsequent removal of tariff barriers between and within the most important states, trade skyrocketed to new heights. Between 1817 and 1866, world trade increased by an average of nearly four per cent per year and grew considerably more rapidly than global production. Openness – the relationship between international trade and the value of output – rose from about six per cent in 1830 to approximately fourteen per cent in 1872. From 1867 until the start of World War I, a considerable deceleration of trade growth as well as a gradual return to protectionist policies ensued. The introduction of tariffs on iron ore and various agricultural products in 1879 by the German Empire is just one example. Openness came to a halt and only moved laterally until 1913. But despite restrictive policies, trade grew in step with production, in part because the technological developments continually contributed to falling trade costs. The establishment of a tele­graph connection between America and England alone reduced trade costs by about eight per cent.

Globalisation: Openness of the World Economy

The samples of 1830 and 1870 comprise seventeen and twenty-seven countries, respectively. All of these are still observable today.

 

In this context, Richard Baldwin mentions a ‘first great unbundling’: worldwide trade in goods made it possible to decouple regional and national consumption structures from the local production structure. Consumption possibilities were no longer predetermined by the inevitably restricted production possibilities of a specific place. Instead, the whole breadth of the global product range became available. The welfare effects of this decoupling are obvious. It allows the regions to escape their own geographic, technological, or climatic confines. However, it is also apparent that such decoupling must occur in connection with sectoral change. The production of domestic goods available on the global market at lower prices and/or in higher quality is pushed out, and the production of competitive goods must be increased beyond domestic demand. If individual production factors – specially trained employees, factories, land, and so on – are used solely or particularly intensively in the shrinking sectors, then these will lose income and purchasing power, relatively and absolutely. Production factors that are especially relevant for the expanding sectors will experience gains, relatively and absolutely.

Resistance against this change and its distribution effects has always formed the core of the anti-globalisation movement. Following the Napoleonic wars, noble British land owners strongly opposed the abolishment of grain tariffs, as these caused them to feel the effects of continental European competition. At the same time, owners within the rapidly expanding English industry strongly supported the abolition of the Corn Laws. David Ricardo, who had written about the distribution effects of the tariffs in great detail in 1815, served as their powerful mouthpiece, and his words continue to be influential today. Modern econometric examinations show the great extent to which these classical arguments still explain modern tariff policies.

During World War I, the global degree of openness dropped to about ten per cent; in the course of the Great Depression and the repeated rise of trade barriers, the year 1933 saw it drop all the way down to the level of 1830. The lack of a clear global power structure – steady undermining of Pax Britannica, isolationism in the US – and political power rivalries in Europe helped bring about the eventual catastrophe of World War II and the almost complete standstill in world trade. When the US assumed the role of global hegemon after the world war and gave the world economy an institutional framework in the form of the Bretton Woods Institutions, world trade experienced very rapid growth. However, the openness of the countries that had been observable since 1830 remained relatively low, at ten per cent, up until the 1970s. Only then, with increased capital mobility, did trade increase significantly faster than production, and openness rose to about fifteen per cent around 1990. Thanks to its specialisation in the production of tradable goods and its geographic location in the middle of Europe, Germany realised even higher values, which however still fall considerably short of twenty per cent.

Lower and Upper Classes Become Richer

Growth rates (in percent) of real per capita income by income group.

 

As communism faltered in Eastern Europe, the World Trade Organisation (WTO) was founded in 1995, and China opened its doors, a new era was on the horizon. The dramatic decrease of telecommunication costs and lower logistics costs proved just as important as the political changes. Presumably, the extensive introduction of container shipping had a much greater effect on decreasing trade costs than the establishment of the WTO. The world’s openness increased considerably; in 2007, it reached a value of twenty-five per cent among UN members; Germany saw its export rate (exports as a share of GDP) rise to forty-four per cent. In principle, an old phenomenon came to light more and more clearly in the process: national exports always also include imported preliminary products. Foreign value creation in German exports constitutes between a third and a quarter of goods’ value, and this amount almost doubled between 1995 and 2008.

The Globalisation Wave of the 1990s Brought Forth Defining Global Value Networks

It may be an exaggeration to speak of a bazaar economy; however, the increased international fragmentation of production processes constitutes an undisputed empirical fact. This can be referred to as a second major ‘unbundling’. In contrast to the first wave, multinational corporations now play a crucial role: they merge the technologies of leading industrial nations with the labour cost benefits of emerging nations and developing countries. This phenomenon is marked by trade in industrial intermediate products and services rather than final products. The central new trade partners in this area are and were the new EU members and China. Germany’s goods imports from China alone rose from four billion euros in 1990 to sixty-one billion euros in 2008. The established global value networks will continue to shape the world economy for decades to come. Their internal logic rests on clear economic, rather than political, criteria. This suggests that these networks are robust but will adapt to altered framework conditions in their concrete form.

Globalisation generates new sources of income, but also creates winners and losers. And this will not change. Overall, the opening of China, Eastern Europe, and other emerging nations has doubled the number of workers involved in the world economy from about one billion people to two billion. Since the price of a production factor typically drops when supply rises, this led to considerable pressure on the wages of employees in the old industrialised world. Emerging nations experienced the exact opposite.

And in fact, the developments that followed precisely mirrored those that World Bank economist Branko Milanovic impressively depicted in his famous ‘elephant chart’. Germany’s goods imports from China alone rose from four billion euros in 1990 to sixty-one billion euros in 2008. The diagram sorts the world population, irrespective of nationality, by their real per capita income in 1988 (x-axis) and then enters the growth rate of the real per capita income for every per centile up until 2008. The analysis thereby captures a period of time in which world trade saw particularly strong growth relative to global production. The ‘elephant chart’ elucidates that in the twenty observed years, nearly all income groups recorded income gains, but that these varied significantly by group. While the income of the global lower class – those wealthier than the poorest ten per cent, but poorer than the richest twenty-five per cent in 1988 – rose by at least forty per cent, the middle class – those wealthier than the poorest seventy-five per cent, but poorer than the richest one per cent in 1988 – did not record any notable income gains. The wealthiest, in contrast, experienced gains of more than sixty per cent.

The Development of Income Inequality

The phase of ‘hyperglobalisation’ is therefore one in which a global middle class emerged; worldwide income inequality decreased significantly. However, the ‘old’ middle class – especially large parts of the working class in Europe and the US – did not profit at all, or barely at best. And in the majority of countries, whether in the north or south, inequality increased during the observed time period. Particularly high earners in industrial countries benefitted from the highly profitable use of modern technologies in low-wage countries.

Income inequality has also increased in Germany; however, it has mainly moved laterally since 2005. If we look at the total population’s gross labour income, we can even observe a clear decline since 2005. Germany also presents an interesting example in that the country has succeeded in profiting from the last wave of globalisation like no other. In contrast to many other OECD countries, Germany did not experience a strong decline of the relative and, in part, even absolute size of the industrial sector. The expansion of German value creation networks to Eastern Europe helped secure and develop its competitiveness, despite wages remaining high; on balance, Germany benefitted from China’s rise, since it enabled the acquisition of a major new sales market.

Nevertheless, the openness of the German national economy has not increased since 2010; there were even a few years in which trade grew at a slower pace than the value of production. Internationally, policy analysts spoke of a ‘global trade slowdown’.

Although world trade is again experiencing stronger growth than the global GDP as of 2017, it remains unclear whether this represents a permanent return to the conditions before the major economic crisis. The proportion of structural compared to cyclical reasons responsible for the at least temporary deceleration is disputed among economists. Income inequality has also increased in Germany; however, it has mainly moved laterally since 2005.It can be said with certainty that China’s increased orientation towards the domestic market played a very crucial role. However, there are also strong indications pointing towards an increase in protectionist policies since 2008; as illustrated by the comprehensive reporting of the Global Trade Alert (GTA) project at the University of St. Gallen or the clear expansion of the use of punitive and protective tariffs. While these may sometimes legally comply with WTO regulations, their designation as trade defence mea­sures can only be described as overly euphemistic.

Trade theorists agree that the growth rate of world trade can only outperform global GDP if the transaction costs of cross-border business fall more significantly than those within nations, if new countries actually manage to enter the global economy market, or if the demand for tradable goods rises faster than the demand for non-tradable goods. These conditions were regularly met between 1970 and 2008. In times in which (nearly) all countries are already members of the WTO, trade policy is not taking steps towards liberalisation and disproportionate trade growth is not to be expected – unless we experience technological advances that allow the costs of international trade to fall below those of intranational trade.

Since the economic crisis, the latter has been the case in China: as a result of the massive expansion of the transport infrastructure – especially in rural China –, as well as the rapid increase of Internet usage and the elimination of regulatory barriers, China is now placing a stronger focus on domestic trade. According to the World Bank, China’s openness rose from less than five per cent in 1971 to more than sixty-five per cent in 2006 – a truly extraordinary value for a country of its size –, but has since fallen again, to a value of thirty-seven per cent in 2016.

This can particularly be attributed to restrained growth in exports. The relative stagnation in world trade is therefore strongly related to China’s normalisation, which in turn is related to the expansion of the Chinese domestic market. This argument also suggests that the disproportionate world trade growth between 1970 and 2008 describes an exceptional phase in history that will not repeat itself in the near future. Nonetheless, it can be expected that on average, world trade will grow faster than global production. This, in turn, is attributable to digitalisation.

Explosion of Global Data Traffic

What trade data – and other conventional indicators of economic openness, such as investment and migration flows – fail to depict is the explosive growth of transnational data flows. From 2005 to 2014, these have increased by a factor of forty-five and, according to estimates by Bughin and Lund, will again increase by a factor of at least nine by 2021. At least one eighth of global goods trade is already being initiated and completed on digital platforms; in China, this figure is probably twice as high. Even back in 2014, more than fifty per cent of US trade in services was processed digitally; in the meantime, this number has certainly risen further. It can be assumed that in the foreseeable future, one hundred per cent of trade in goods and services between developed nations will be facilitated by digital means and that the number of services ‘delivered’ digitally will rise rapidly.

Dynamic Cross-border Data Flows

2005-2014 based on data; 2015-2021 based on estimates.

 

Digital trade is facing significant problems in recording and measuring. Many countries exclude cross-border bagatelle deliveries from customs duties, which means that they often do not appear in the statistics. Additionally, many international services are provided for free, for example, the services of social networks. In return, users grant providers access to their data. Transactions like these do not entail any traditional payment flows. As a result, the phenomenon remains systematically underreported in official statistics.

Charges for the Use of Patents

In addition, the extreme international mobility of immaterial economic assets – for example, patents – means that these goods are often legally located in countries in which they were not produced. At least one eighth of global goods trade is already being initiated and completed on digital platforms. As a result, charges for the use of patents may fail to appear as international trade in services and are instead recorded as revenue for foreign subsidiaries of multinational corporations. They do not appear in the trade statistics but are included as primary income in the trade balance. The higher the proportion of services and the greater the number of immaterial economic assets that are mobile on an international scale, the more difficult the precise statistical measurement of cross-border transactions becomes.

It is likely that the officially measurable dynamics of globalisation processes will continue to lag in relation to the processes actually taking place. Today, we can only estimate what technological potential exists for further reducing trade costs. A more in-depth look at the service sector is crucial for a proper estimation.

The Next Wave of Globalisation

In most countries, the service sector constitutes seventy to eighty per cent of overall economic production. At the same time, the share of services in international trade represents just thirty per cent. This makes it very apparent that the degree of openness in the service sector continues to remain minimal compared to the industrial sector. If we succeeded in significantly improving the tradability of services, we would experience a new wave of globalisation with unforeseeable effects, both good and bad.

Empirical literature very clearly demonstrates that language barriers impede international trade. This applies to trade in goods, but especially to trade in services, as interpersonal communication between the service provider and the service recipient play a crucial role. The tremendous advances already made in this area through the use of artificial intelligence – particularly neural networks – give reason to believe that overcoming linguistic distance by means of technology is a realistic goal. If language barriers are eliminated, we can expect a service trade boom that could dwarf all previous growth phases.

China and India Will Dominate the World Economy

Real GDP of selected economies in US dollars, 2010 PPP.

 

The digital wave of globalisation could accelerate global convergence but increase inequality within Germany. Completely new population groups from emerging and developing countries would be able to participate in the international division of labour. This would affect professions in which direct communication between the provider and recipient of a service plays an important role – such as the medical sector, the field of vocational training and further education, tax and legal consulting, as well as many other business services – and could cause a globalisation process similar to the one that software programming has already experienced. This would lead to another convergence of global income distribution because large sections of social classes in the poor south would start to be integrated into the international division of labour.

Poorer countries will benefit less from their low labour costs as a result of automation in the industrial sector, but this fact pales in comparison with the effects globalisation would have on the services sector. Global GDP would increase significantly, and we would see great strides in poverty eradication in emerging and developing countries. Particularly countries with relatively good basic education, for example, in South Asia (India, Indonesia) or South America, could profit from this.

But at the same time, these developments would presumably lead to a further rise in inequality in the old industrial countries, where sectors that had previously been cut off from global competition could come under pressure. It is impossible to predict whose wages and jobs would be at stake: new opportunities are emerging in all segments because the sales platforms, knowledge, and networks of service providers in the north could be leveraged with the help of legwork from the south. However, only those who can actively utilise these opportunities – meaning people who have leverageable advantages – will benefit; the others will lose out because foreign competitors can offer similar quality at cheaper prices.

Sectors in which interpersonal communication is insignificant but physical presence is indispensable – such as cleaning services, security services, certain healthcare professions (nursing) – would not be affected by a decrease in the costs of cross-border interpersonal communication. Currently, these areas pay below-­average wages, while sectors in which communication skills are highly important offer better pay. Consequently, ­developing improved translation technologies can lead to further ‘hollowing out the middle’ in income distribution. Automation and the increased use of robots in the industrial sector will presumably have similar consequences.

Globalising large parts of the service sector would create resistance. Various attempts at curbing the process of digitisation through regulations are already underway, especially when the beneficiaries are foreign corporations. The same applies to areas in which new technologies help bring customers and service providers together, for example, passenger transport (Uber) or temporary living space rentals (Airbnb). In its coalition agreement, the current German government has decided to ban online pharmacies because they could jeopar­dise the quality of consultations.

It is conceivable that this problem could be solved with technology; nonetheless, the industry will resist an attack on what has been a very profitable business model. Many other industries are facing similar situations. Therefore, we must expect a high number of new protectionist tendencies in the future that will plead for legitimate concerns such as the safety of consumers and their data, the environment, social standards, et cetera, in order to exclude foreign providers from participating in the competition.

Digitalisation – especially the opportunities provided by artificial intelligence – could therefore lead to a far-reaching globalisation of the services sector for the first time in history. In the industrial sector, however, a reverse trend is conceivable. Empirical literature very clearly demonstrates that language barriers impede international trade. Due to advancing automation and the use of artificial intelligence, machines are replacing manual work. The share of labour costs within production costs is declining. This development is also reducing the appeal of outsourcing production to low-wage countries. Additionally, the synergy of automation and the seamless integration of order, procurement, and production data could make increasingly small batch sizes and customised offers possible – not just in the clothing and shoe sector. This would change companies’ location policies: concentrating production at a few locations while exploiting scale economies would take a back seat, and quickly fulfilling personalised customer wishes would become the focus.

These developments signal bad news for emerging and developing countries that do not have any locational advantages other than low labour costs; they could slow the convergence process and draw its focus to countries with large domestic markets. The convergence would presumably not come to a complete halt, since processes with the reverse effect – for example, in the service sector – would take effect simultaneously. Although the old industrial nations would profit from ‘reshoring’ value creation, the old industry jobs would not return, because this change is driven precisely by an increase in the capital intensity of production.

New Power Distribution in Global Trade

What does this development mean for the most significant trading powers, and what does it mean for Germany? The last figure shows how important world regions’ shares of global GDP have developed from 2000 to 2007 and how they could continue to develop over the next forty years. The most important driver is demographic development, which can be predicted fairly accurately – although migration flows may cause surprises. The second key driver is the development of the total factor productivity: the rate at which the available resources (human capital, land, the accumulated physical capital) are converted into output. Technological transitions, such as those discussed in this article, are not included in the projections; neither are dramatic political changes.

The timeline up until 2060 depicts four central events: in 2011, China overtook the eurozone (fifteen countries); however, despite decades of growth, the per capita income still lies thirty per cent below the European level. From 2021 onwards, the size of the Chinese national economy will surpass that of the US. And around the year 2045, China will have reached the peak of its relative economic power. An interesting point: according to OECD prognoses, the transatlantic economy (US plus eurozone) will still be larger than the Chinese national economy by 2060. Another interesting point: China’s rapid ascent is expected to see a considerable deceleration. In the next thirty years, the country’s GDP share will rise by approximately four per cent from about twenty-one per cent to just above twenty-five per cent; in the past thirty years, it grew by seventeen per centage points.

India’s share currently comprises about seven per cent of global economic output, even though, similar to China, the country is home to about eighteen per cent of the global population. But while the size of China’s working population has already surpassed its peak, India’s still lies in the distant future. Just before the year 2057, India could finally also overtake the US. The dynamics of the Indian national economy are potentially immense. The subcontinent is still restrained by internal growth-inhibiting forces – excessive bureaucracy, the caste system, poor infrastructure. But if technological changes were to lead to a considerably improved tradability of services, India would be the greatest profiteer.

If the eurozone’s economic influence were to be cut in half – measured by its share of the global GDP – between 2000 and 2060, then Germany’s share would drop to one third. This is connected to the very sharply declining dynamics of Germany’s working population – a circumstance that could be strongly mitigated through migration. In any case, the image very clearly depicts that Germany’s already modest global political influence would fall behind that of Brazil, Indonesia, and Russia. If Europe wants to remain relevant, its countries must work together. This is a necessary but not yet sufficient condition. In the future, Europe will have to form coalitions if it wants to implement its own defining global plans. The continent needs to look to Washington D.C. or Beijing, and in the more distant future also to New Delhi, capital of the world’s largest democracy: here lies the economic power that will shape the future world economic order in a major way.

The Future of Foreign Trade

How We Must Act

  • Globalisation is a process mainly driven by technology. Protectionist policies can have a disruptive effect, but digitalisation will ensure a new globalisation boost in the long term – one which will continue to dismantle global inequality, but boost inequality within the old industrial nations. Germany must prepare for this transition – especially by securing a sustainable social welfare state. The automation of industrial production could return value creation to Germany; however, this will not bring back the old industrial jobs. Defensive technology policy is not a policy for the future.
  • Asia continues to advance; however, China’s relative importance will reach its peak in the mid-2040s and will not achieve the significance of the transatlantic national economies, even in the long term. Europe can successfully design the rules of the world economy if it is willing to form partnerships. The US must remain the first point of contact. In the future, the largest democracy in the world – India – will become another natural partner of Europe.
  • One crucial challenge for the future lies in shaping the global digital economy. This entails resolving the difficult conflict of objectives between efficient data exchange, data protection, and the taxation of digital companies in agreement with international partners, as well as resisting the trend towards digital protectionism. Germany, with its tradition of engaging in a cooperative dialogue between companies, politics, and civil society, can take the lead here, but must first conquer its deep-seated fear of technology.

Prof. Dr. Gabriel J. Felbermayr (42) is the Director of the ifo Center for International Economics at the ifo Institute in Munich and a leading expert in matters of global governance, particularly regarding international trade, investment, and migration policy. In the spring of 2019, he will assume the role of Director of the Kiel Institute for the World Economy. He regularly advises the German government and the European Commission as well as parliaments and international institutions. Currently, he is primarily focusing on the question of how to modernise and strengthen the world trade system.