The biggest lesson we may learn from the current global economic crisis is that mainstream economic theories that have guided thinking for the last four or so decades have serious flaws. In sum these theories advocated the idea that things should be left to the markets and, the market via, the “invisible hand” would ensures that gains from trade and investment liberalization would “trickle down” to society. However, significant evidence, which had largely been ignored before, suggest that there was inadequate trickle down and, in some cases, there was “trickle up”, that is, resources flowing from the poor to the rich.

Imbalance between returns to capital and labour

The global economic system is today, because of these policies, characterized by colossal income inequality both between and within countries. What is most striking is the imbalances between the returns for capital as opposed to return for labour. The era of “leave it to the market” immensely rewarded capital often at the expense of labour. Competition for capital has been fierce among countries, especially developing countries that the price was paid by reducing social protections including labour standards.

Loss of automatic economic stabilisers

With capital overvalued and labour undervalued, the view that seems to have gained currency during the last four or so decades was that labour market rigidities were the stumbling block for smooth functioning of the market. This view led to the dismantling of labour market institutions and policies such as unemployment benefits and social protection. Consequently, as the Nobel Laureate economist Joseph Stiglitz eloquently explained during his address to the ILO Governing Body on 12 March 2009 (see video), the dismantling of these institutions and policies has deprived the global economy of important automatic stabilisers. Automatic stabilisers, economists explain, are important countercyclical tools that stimulate aggregate demand during periods of economic slowdown while they prevent the economy from overheating during periods of economic booms. The dismantling of these automatic stabilisers therefore should be seen as one, if not, the root cause of the current economic crisis. The International Labour Organization (ILO) Director General, Juan Somavia, has called the problem “sub-prime work” crisis.

Trade theories and labour markets

Trade theories often make simple and unrealistic assumptions about the labour market. As a result, most of these theories have not been useful in helping us understanding the linkages between trade policies and the labour markets. The lack of credible empirical evidence for the strong positive effects that most mainstream trade theories claim about the employment creation, wage and productivity effects of trade liberalisation have long put into question the adequacy of existing trade theories for analysing the labour market implications of trade policy reforms. This suggests that the trade liberalisation and market deregulation agenda of the last few decades was pushed without adequate attention being paid to the labour market implications of trade and investment policy reforms. More specifically, little attention was paid to the mechanisms by which trade policy reforms or trade shocks affect labour markets in various sectors. The result has been a lack of knowledge and understanding which has undermined our ability to ex-ante anticipate and address the effects of trade on labour markets. In fact, some thoughtful observers have argued that trade liberalisation, when it goes too far and too fast, could be detrimental for economic development.

The road to economic recovery – Investing in understanding the trade-labour linkage

If there is a clear understanding of how labour markets react to changes in trade policy, if there is a clear understanding about the linkages between trade and employment, the transmission mechanisms of the effects of trade on employment at sectoral and inter-sectoral level, then policy makers would be in a better position to anticipate and address labour market challenges that may arise from either trade policy reforms or trade shocks. In thinking about economic recovery a key focus could therefore be on the question of trade adjustment and labour.
Work in this area should be aimed at assessing what theory says about the employment effects of trade and weighing these with the empirical evidence. The examination would help us understand better whether the theory itself makes proper assumptions on labour markets, e.g. labour market rigidities, imperfect competition and so on. Both labour economics and trade economics have grown a great deal during the last two decades but in isolation from each other. It is about time to bring the two together to make sense of how labour markets adjust to trade shocks, such as those being experienced with the current economic crisis.
While it is encouraging that the ILO and the World Trade Organization (WTO) are starting to engage (see e.g., joint study) more serious theoretical and empirical work is required to both help us on the road to recovery from the current crisis and to be better prepared next time. Somavia argues that “The ILO has a unique opportunity to play a central role in an emerging system of global governance combining financial stability, investment for development with fair trade and decent work”. But to do this, ILO will have to invest in robust research that is properly translated into policy ideas and communicated robustly.