Five potential effects of the corona pandemic on the international division of labor

The spread of the coronavirus (COVID-19) has triggered a global economic crisis. This far-reaching event will bring long-term changes to our economic life. In terms of the international division of labor, five changes seem to be particularly relevant as things stand today.

#1: The extent of international division of labor is declining

The international division of labor has been strongly based on locating production sites where costs are lowest. However, experiences in the wake of the Corona crisis include an interruption of global supply chains and change the basis on which companies have made these decisions. Efficiency considerations are likely to become less important, while greater crisis resilience will play a bigger role in decision-making.

The unplanned loss of input products represents additional costs for the affected companies. They have had to find substitutes in the short term, reduce or even completely stop production. If these costs considered in future cost-benefit analyses, this can lead to the economically sensible decision to forgo external procurement of preliminary products – even if this means an increase in production costs. Reshoring as the relocation of production steps from low-wage countries to high-wage countries is already increasing. However, the practical implementation of this step is by no means trivial.

#2: A socially desirable relocation of production needs state support

The establishment of new domestic production capacity to reduce dependence on imports is likely to require the protection of the suppliers concerned. Otherwise, a classic prisoner’s dilemma will arise: Even if, for example, the people in Germany agree that a specific input product should be produced domestically at higher costs, the incentive remains for each individual German company to work with the cheaper inputs from abroad because this increases individual competitiveness. The more expensive German inputs will be used only in case of an emergency. Since all German companies will behave like this, nobody asks for the inputs produced in Germany – so nobody offers them there either.

Various government measures to establish a domestic supply are conceivable: state subsidies, higher import duties, or the establishment of state-owned companies that compensate for losses incurred with tax money. However, all these measures are interventions to the principles of the market economy. They also mean that consumers at home will no longer be able to buy the cheapest products from abroad. The higher costs involved represent a real loss of welfare, which in these cases has to be paid as a price for the lower dependence on imports.

#3: The importance of industrial policy is increasing

Since the announcement of the strategy “Made in China 2025” in 2015, it has become clear: China wants to become one of the world’s leading suppliers in important sectors – and is promoting this goal by using government funds worth billions. If this strategy works, Chinese companies could become global market leaders in key industries such as electromobility, robotics, biomedicine, etc., in the near future. The US is also providing considerable government support to promote its industries, for example, through the Defense Advanced Research Projects Agency.

Without corresponding efforts by Germany, there is a risk that German companies will lose ground. The consequence would be a dependence on imports from those countries that provide state support to their companies.

#4: The importance of low wages as a competitive advantage is declining

One expected reaction to the Corona pandemic is that companies worldwide are increasingly using machines, robots, and other digital technologies in the production process. This automation replaces human labor and thus reduces dependence on it. As a result, the loss of workers due to illness will have less impact on the production capacities of some companies.

The trend towards a higher intensity of capital and technology in the production processes is not new, but it is likely to receive an additional boost from the current pandemic. However, if capital, and technologies are increasingly used worldwide, low labor costs will lose relevance for companies’ location decisions – at least for those who can finance the necessary investments. For industrialized countries like Germany, it will, therefore, become more attractive to relocate production closer to the domestic market. This will give an additional boost to the trend towards reshoring.

#5: Developing countries poor in raw materials are in danger of being even further left behind

As the Corona crisis promotes the use of capital and technology instead of human labor, this has far-reaching consequences for developing countries that do not have access to economically valuable raw materials:

• When cheap labor is no longer a decisive element for competition, low-wage countries lose their central competitive advantage. This makes it even more difficult for them to provide the competitive jobs needed to generate income for their citizens.
• As a rule, low-wage countries do not have the necessary savings to invest because of their low level of economic development. Revenues from raw material exports are also not available due to the lack of natural resources.

Without capital inflows from abroad, low-wage countries will not succeed in building the infrastructure necessary to provide the domestic population with adequate jobs. This threatens to impoverish large sections of the population. To avoid this, migration will probably increase.

Outlook

The biggest challenge for the international trading system is likely to be that the desire of individual economies to reduce their dependence on imports could be the starting signal for a global protectionalism race. This would ultimately result in real economic costs for each country that would be higher than the potential benefits of reduced dependency on imports.

Note: This is an abridged version of the article “Five possible effects of the corona crisis on the international division of labour” published on April 1st 2020 by the German online economic policy magazine Makronom.