Free exchange | Geography

Empty America?

Is there no money to be made selling to markets outside Asia?

By R.A. | WASHINGTON

NOAH SMITH turns to a line of theory near and dear to my heart to discuss a potential source of American economic stagnation—the increasing returns literature on trade and geography that won Paul Krugman his Nobel prize. When there are increasing returns to scale, a firm or place with an initial advantage in production keeps and increases that advantage as it grows. In a model of economic geography, for instance, there are increasing returns to agglomeration—when firms bunch together, they become more productive. This means that in a city with an initial advantage (like one more firm than a rival) there is no incentive for any firms to move away while there is a significant incentive for firms from other places to move in. In the resulting equilbrium, the first place attracts all the firms while the second deindustrialises.

This theory can be extended to explain periodic episodes of catch-up growth. Here's Mr Smith:

Capital can flow relatively easily across borders (i.e. you can put your factory anywhere you like), but labor cannot. If you start with a world where everyone's a farmer, agglomeration starts in one country, but that country gets maxed out when the costs of density (high land prices) start to cancel out the effect of agglomeration. As transport costs fall and the economy grows, the industrial Core spreads from country to country. Often this spread is quite abrupt, resulting in successive "growth miracles" that get faster and faster (as each new industrial region starts out with a bigger global customer base). The evidence strongly indicates that agglomeration is the driver behind developing-world growth.

During episodes of catch-up, the original core may temporarily find itself worse off. Mr Smith takes this line of thinking even further, however. He muses:

Suppose all of those people had the same purchasing power. If you were a factory owner, and you wanted to minimize transport costs, where would you put your factories? The answer is a no-brainer: China and India. Some others in Europe, Japan, and Indonesia. Perhaps a couple on the U.S. East Coast. But for the most part, you'd laugh in the face of any consultant who told you to put a factory in the U.S. The place looks like one giant farm!

He adds that if relocation caused America's industrial core to fall below a critical mass, it could deindustrialise entirely, leaving Americans with little to do aside from growing corn for the industrial behemoths of Asia. This, I think, is a misreading of the theory.

It's not clear what story Mr Smith is telling. On the one hand, he argues that transportation costs are high enough that it's worth it for manufacturers to move to Asia to be near its massive, growing markets. If this is the case, however, then America has little to fear. The North American market is home to over 500m people, many of them very rich. If transport costs are so high that North American manufacturers can't affordably serve Asia, then they're also sufficiently high that Asia can't serve North America, and there will continue to be room for a large North American industrial sector to serve the domestic market.

If, on the other hand, transport costs are low enough that a single manufacturing hub can produce for a global market, as seems to be the case, then it's unlikely that firms are relocating to Asia just to be near its markets. Instead, they're likely attracted by low labour costs, lax regulation, and generous government incentives. In that case, America's lower population is not a reason to fear total deindustrialisation, particularly since these Chinese advantages are likely fleeting.

In fact, the economy is just more complicated than simple models indicate, and different stories apply to different kinds of industries at different times. Within some sectors, there are no longer big gains to agglomeration such that falling transport costs free activity to move to wherever it's cheapest to produce. America has lost many such industries, and China will be losing them soon enough. In other sectors, the gains to firm concentration remain. We observe concentration in these sectors where there are...concentrations of economic activity, as you might expect. If we look at the tradable sectors in American cities, we see things like finance, management, technical consulting, high-tech research and manufacturing, information, systems design, and so on—that is, human-capital intensive industries on the innovative frontier. Collections of smart people are good at taking new ideas, turning them into workable business models, and marketing those businesses around the world.

There are a lot of ideas to go around, and I'm not inclined to argue that American cities are "vulnerable" in the sense that Silicon Valley is on the verge of evaporation and reconstitution in India. At the same time, it's clear that agglomeration is important in these industries and that there are increasing returns to scale. So in the end, Mr Smith's policy recommendations are the right ones; economic success now depends on loosening immigration rules, making it easy to build in cities, in part by investing in the infrastructure that supports them, and continuing to support research and education.

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