It’s not rocket science to make a country perform and take advantage of the opportunities that the global marketplace offers. Comparative advantage has always been a difficult concept to grasp for people not verged in economics. But countries can do it, even in the face of the industrial behemoth that is China.

For a decade or so, China’s comparative advantage in manufacturing seemed unassailable. They combined a couple of crucial forces:

• An almost endless reservoir of cheap labour, willing to put in hours and coping with conditions that would be intolerable in many other parts of the world, especially more developed ones
• Good technical education supplying scores of engineers providing the backbone of China’s industrial knowledge structure
• Very sensible long-term policies, opening the economy up to foreign capital, know-how, technologies and ideas
• Maintaining macro-economic stability
• Having a very large internal market (although that perhaps matters less today than it used to in the past).

All this seems to be combined with a sense of urgency, an optimism, a national pride, that is hard to reproduce elsewhere, especially as it is is as much sustaining the manufacturing boom as well as sustaining it in a virtuous circle.

China’s lead seems unassailable, even more so than that of Japan two decades ago. But anyone with some economic training knows that there are two sets of forces at work. One sustaining and cementing the strength of the Chinese advantage, the other set of forces are undermining it.

Economies of agglomeration

Let’s start with the forces strengthening the Chinese advantage. These are generalized under the term ‘economies of agglomeration’. Basically what they describe is that once you have a base in a certain industry, this will attract other players leading to an (almost always regional) cluster of producers and service providers that, once established, is difficult to dislodge. They become centers of production, information, and knowledge in certain areas.

Silicon Valley is a prime example. It’s not just that there are numerous high-tech producers located in a limited area, there is a host of suppliers, information and knowledge flows are fluid, supporting institutions gather critical mass, and although it is an exaggeration to say that the system functions as if it were a single organization, the whole is definitely more than the sum of the parts.

If such industrial districts remain open to new ideas, practices and learning, they can remain for decades or even longer. It’s like Hollywood in cinema. But if they’re not open enough, they can atrophy, Detroit in car manufacturing is running that risk as once again (like in the 1970s) the big three US car manufacturers were not prepared for the end of cheap gasoline and are too slow to react to it.

Comparative advantage

Economies of agglomeration work like ‘success breeding success’, they’re containing increasing returns. Once a country is good in something, the conditions are created to make it even better and more difficult to dislodge that advantage.

However, success also create conditions making future success more difficult. And it is this that we see happening in China at the moment. The very success of a country sets in motion forces that will make it more expensive.

For instance, if a country has such an enormous export success, the resulting pressure on the currency will make it move upwards sooner or later. Although China has yet to liberalize capital flows (a decision which, contrary to past IMF wisdom, has spared it much potential harm, one only have to study the Asian crisis of a decade ago to see what can happen), the upward pressure on it’s currency is real. It’s slowly rising. Too slow to the likening of US policy makers, but rising nevertheless.

What can also be perceived is that with the huge productivity gains produced by combining advanced technology with cheap labour, wages are also rising. And they’re rising at a fast pace, 10-20% a year. A combination of a rising currency and rising wages will move China up the value chain, and this has already happened to a considerable degree.

Those that argued that China’s advantage in cheap labour would continue indefinitely because of the sheer endless supply from the countryside and the absence of unions and a less than transparent political culture were basically wrong.

Adding to these complications is the rising cost of oil, which makes industrial production and shipping more expensive. This further undermines China’s advantage. From Newsweek:

The cost of sending a 40-foot container from Shanghai to San Diego has soared by 150%, to $5,500, since 2000. If oil hits $200 a barrel, that could reach $10,000, projects Toronto financial-services firm CIBC World Markets

But can other countries profit? The increasing return mechanisms described above can also work in reverse. Once an industrial (or other) base has been dismantled by other, more productive regions or by some adverse shock (rising currency, some disaster, a long-lasting strike, etc.), it’s hard to revive it.

In economics, this phenomenon is known as hysteresis. In abstracto, this refers to the phenomenon in which there exist a situation (say ‘situation A’), experiencing forces that change it, but once these forces are removed, ‘situation A’ doesn’t return.

In less abstract terms, much of America’s industrial base was competed away by Asian producers over the last three decades. But even if these forces fade, these former productive systems cannot just be revived, exactly because the whole was bigger than the sum of it’s parts.

Not only have producers left, but the information flows and knowledge, the relations between them, the critical mass enabling supporting institutions and specialist services sustaining them have withered as well.

Luckily, as the US testifies, losing out in some industries does not have to kill the whole economy. In a more globalized world, there is a premium on flexibility, being able to marshal resources to their most productive alternative uses with some speed. This is where the US excels.

Globalization does not have to be a disaster, not even in the face of formidable rising economies like China. Almost all economic theory points to that, and many successful examples exist in practice. It does require smart politics having long-term views though, and in today’s intensive media world, that’s another tall order.