Lessons from Old India: When an economy just doesn't get better

Commentators have often compared the recent Great Recession of the United States and Europe to the Great Depression of the 1930s.

In both cases, asset prices tumbled, financial systems turned insolvent, and demand plummeted. One difference is that in the recent case, we mounted a swifter rescue effort than we did in the 1930s; for instance, Ben Bernanke, as chairman of the Federal Reserve in the recent crisis, drew upon his academic research in supporting bailouts and reflating the economy.

This comparison is intriguing, but we may be neglecting other, less obvious and yet more unsettling historical parallels for today’s global economy. For all the talk of the Great Depression, we might look at a different exemplar for modern times, 18th and 19th century economic history in India. That country’s economic retrogression during that era may help us understand the quandary that some parts of the world face today.

In 1750, India accounted for one-quarter of the world’s manufacturing output, but by 1900 that was down to 2 per cent. The West became more productive as a result of the Industrial Revolution, and India lost much of its leading export sector, textiles.

While the data is fragmentary, the best estimates show that India’s living standards declined through the middle of the 19th century and that its economy retrogressed, even as it borrowed some technological improvements from the West. India just didn’t do enough to move toward production on a larger scale or with better machines.

This story of India’s loss to foreign competition is documented in “Deindustrialization in 18th and 19th Century India,” a paper by David Clingingsmith, an economics professor at Case Western Reserve University, and Jeffrey G Williamson, an emeritus professor of economics at Harvard.

Economists are accustomed to emphasizing the benefits of international trade, and these arguments are largely correct. But in India, internal regulations and underdevelopment, combined with British colonial depredations, prevented Indian resources from being redeployed productively. The lesson is that a sufficiently large international trade shock can lead to decades of economic decline in a major economy, especially if that economy isn’t geared to mounting a flexible response.

Today, we’re not used to the idea of declining living standards because growth throughout the 20th century was the global norm for economies that were not at war. International trade grew rapidly after World War II, but, at least in the early postwar years, most of that trade was among countries with roughly comparable technologies and real wages. And that trade spurred growth, rather than damaging laggard economies.

In the last 20 years, the economic surge of Asia, especially China, has brought a large trade readjustment to the world, one with few parallels with the possible exception of the rise of the Western economies several centuries ago.

China’s per capita income, less than $300 in 1984, is now in the range of $10,000. The country is now the world’s second-largest economy, and becoming the largest by one measure.
Who are some of the possible losers in this radical transformation in the  global economy?

Italy, which is producing less today than it was in the middle of 2000, is undergoing a triple-diprecession. Croatia is in its sixth consecutive year of recession - and joining the European Union didn’t help it much. In France, the economy has slowed to a crawl, but because taxes there are already high, there isn’t much room for further budget adjustment. French citizens expect a great deal from their government, and strikes are a common response to reduced wages or benefits.

These economies have a few features in common: They try very hard to preserve old jobs at high real wages; they are not very flexible at adjusting, and they have not engaged in a major economic restructuring. While China is not the main problem of these economies, Chinese export growth and wage competition may have been a kind of final straw that made old ways unsustainable.

If either France or Italy, much less both, is in for 15 or 20 years of economic stagnation, it’s hard to see how the eurozone will avoid another major financial crisis. Portugal and Greece, both of which have been de-industrialised over the last few decades, are also possible candidates for continuing, rather than temporary, retrogression.

In Asia, the most likely future candidate for this problem is Taiwan, where real wages were largely stagnant from 2000 to 2011. In 2012, Taiwan’s trend was even more disturbing: Its economy grew 1.3 percent, but real wages fell 1.6 percent, both adjusted for inflation.

Taiwanese capital has flowed into China, creating a new class of Taiwanese millionaires, but hollowing out the country’s manufacturing base as capital was reallocated to the mainland.

What about the United States? The chance of an overall economic reversal here is very slim. The American economy is relatively flexible, and various candidates for future growth are strong: technology, health care research, energy and higher education. Despite its slow recovery, the United States probably still has the best fundamentals of any major economy.

That said, this same model of deindustrialisation may apply to some parts of old industrial America and to some segments of the American middle class. The median individual income of Americans has not risen since 2000, and more recently median household income is still lower than it was when the economic recovery began in June 2009. Downward wage pressure has been strongest where there is competition from Chinese exports.

It was once an unthinkable question, but we’ve arrived at the scary point where it needs to be asked: What if American median income over the next 15 years keeps stagnating — or maybe even falls?

Our Social Security system, whose receipts are based on wage taxation, could then prove to be a bigger fiscal problem than Medicare.

Asset prices would most likely prove overvalued, possibly setting off another financial crash or at least damaging many Americans’ retirements. And the rate of household formation would most likely remain slow, depressing the housing market for the foreseeable future.

India’s economy started to reindustrialize in the late 19th century, but growth remained subpar until the 1990s — a truly long recovery lag. This may sound strange to say, but when it comes to some parts of the Western world, the Great Depression may offer the cheerier analogy.

(Tyler Cowen is a professor of economics at George Mason University)