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Structural Change and Economic Dynamics 19 (2008) 4–16

Gains and losses from sectoral relocation: A review oftheory and empirics�

Frank Barry a,∗, Frank Walsh b

a Trinity College Dublin, Dublin, Irelandb University College Dublin, Dublin, Ireland

Received December 2006; received in revised form November 2007; accepted November 2007Available online 3 December 2007

Abstract

This paper addresses the distributional consequences of international sectoral relocation. We begin by looking at the gains andlosses for individual countries by reviewing the implications, and real-world relevance, of the various trade and growth models thataddress the issue. In each case, the role of FDI in the process is explored. The second part of the paper reviews the empirical evidenceon what becomes of workers whose jobs are displaced by sectoral relocation. The ongoing policy debate on how to minimise thecosts of displacement and the length of the adjustment period is also reviewed.© 2007 Elsevier B.V. All rights reserved.

JEL classification: F15; F16; F23

Keywords: Relocation; Trade; FDI

1. Introduction

What causes sectoral production and employment to relocate across countries? Developments both within sectors(as emphasised by the product life-cycle model) and within countries (as with human capital accumulation) are clearlyimportant. Ongoing liberalisation, exemplified by the integration of China, India and Central and Eastern Europe intothe global market, is another driving force, as is the telecommunications revolution, which has made many formerlynon-traded services internationally tradable. The growth of business process offshoring provides a dramatic exampleof the latter phenomenon. Foreign direct investment is an important component of all of these processes, and FDI hasexpanded even more rapidly than trade over recent decades.

The present paper is concerned with the distributional consequences of these global developments. One focus ofanalysis is on the distribution of the consequent gains and losses across countries. This has always been a contentiousissue in public debate. Rich-country workers fear that they will be outcompeted by lower-wage workers from poorercountries, while firms from poorer countries fear that they will be unable to compete against stronger more established

� Keynote Address delivered to conference on “Relocation of Production and Jobs to CEECs: Who gains and who loses?”, Hamburg, 16–17September 2005. Final revisions: November 2007. The helpful comments of Wilfried Altzinger and the journal’s referees are gratefully acknowledged.

∗ Corresponding author.E-mail address: frank.barry@tcd.ie (F. Barry).

0954-349X/$ – see front matter © 2007 Elsevier B.V. All rights reserved.doi:10.1016/j.strueco.2007.11.004

F. Barry, F. Walsh / Structural Change and Economic Dynamics 19 (2008) 4–16 5

firms from richer countries. The other focus of analysis is on the distribution of gains and losses across factors ofproduction such as low- and high-skill labour and owners of capital.

Different branches of the economics literature deal with various aspects of the issue. We consider the followingfour strands. (i) Traditional trade theory studies the consequences of the inter-industry adjustment to which tradeliberalisation can give rise. Similar methods are used to study the consequences of liberalisation or expansion offoreign direct investment flows. (ii) New trade theory, which is based on imperfect competition and increasing returns(as is much of the recent FDI literature), focuses primarily on adjustments within rather than across industries, with theformer typically assumed to be associated with lower adjustment costs. (iii) The “new economic geography” analysesthe circumstances under which the world can be divided into a core and periphery, and assesses the consequences offalling trade costs for both areas, and (iv) new growth theory studies the cross-country distribution of the gains frominnovation and technology diffusion.

Section 2 of the paper discusses the treatment afforded by each of these various literatures, while Section 3 surveysthe state of knowledge on the consequences of sectoral relocation for displaced workers. It also considers the rangeof policy options that have been proposed to deal with the increased pace of sectoral relocation associated withglobalisation.

2. Perspectives on the gains and losses from sectoral relocation

2.1. Traditional trade theory, FDI and offshoring

Our discussion will concentrate largely on the case of small economies which have little or no influence on worldmarket prices.1 The move from protectionism to free trade entails a movement away from self-sufficiency towardsspecialisation in export sectors in which each country has a comparative advantage. This allows each country topurchase from elsewhere the goods that it cannot produce efficiently, leading to a reduction in the prices it pays. Theresources released from these declining sectors can then be transferred to other industries in which the country isrelatively efficient, with the country gaining from the expansion of its relatively more efficient sectors.2

One obvious problem that can arise in the process is when distortions such as wage rigidities prevent the inter-sectoralreallocation of resources. In this case the jobs lost in declining industries may not be replaced by job gains elsewhere.The resulting increase in unemployment can mean that the country loses rather than gains from trade liberalisation.This is clearly an important real-world problem. The theory of optimal intervention shows that this issue is best tackledat source – by removing or overcoming these rigidities so that the country can reap the benefits of trade liberalisation– rather than by leaving protectionist policies in place. These issues are discussed at length later in the paper.

The period of time that displaced workers will spend out of work – and hence the overall speed of adjustment – willalso depend on the prevailing stage of the business cycle. As Stiglitz (2002, p. 53) points out: “When trade liberalisationis done in the right way and at the right pace, so that new jobs are created as inefficient jobs are destroyed, there canbe significant efficiency gains”; however (p. 84), “trade liberalisation accompanied by high interest rates is an almostcertain recipe for job destruction and unemployment creation”.

In the absence of such rigidities, what are the distributional implications of liberalisation? The Stolper-Samuelsontheorem tells us that, in a two-factor world, one domestic factor will gain and the other will lose, with the overall gainsoutweighing the losses. To solidify the discussion, let us consider the cases of Austria and Hungary. Since the openingup of trade between the two countries means that the factor in scarce supply in Hungary (let us call it capital) is nolonger effectively as scarce in that country (since capital-intensive goods can now be imported from abroad), Hungariancapital-owners lose while Hungarian labour gains. Austrian owners of capital meanwhile gain at the expense of Austrianlabour.3 These within-country redistributional effects underlie the study of “the political economy of protectionism”.

1 The “optimum tariff” argument suggests that large economies such as China may have an incentive to impose trade restrictions which shiftworld prices in their favour. The threat of countervailing actions by other large economies means however that such policies would frequently endup damaging the initiating countries; however, Krugman (1987).

2 Since the gains from trade arise from the resulting changes in relative export and import prices, and since these changes will be largest for smalleconomies, it is small economies that are predicted to gain most.

3 The distributional consequences of the opening up of FDI between the two economies are the same, since this should see capital flow towardscapital-poor Hungary.

6 F. Barry, F. Walsh / Structural Change and Economic Dynamics 19 (2008) 4–16

Let us now think in terms of skilled and unskilled labour rather than labour and capital as the two factors ofproduction. The evidence on recent North–South trade is not consistent with Stolper-Samuelson, which predicts thatthe rise in skilled wages in more developed countries should encourage a fall in the ratio of skilled to unskilled laborin all sectors, while relative unskilled wages should rise in the South. Both predictions are rejected by the evidencefrom both the developed and developing worlds.4

Models of production fragmentation (outsourcing etc.) can generate predictions consistent with these outcomes,though Krugman (1995) shows that changes in import prices and volumes over recent decades have not been sufficientto explain the large changes in income distribution seen in the US for example. Even if trade cannot be blamed formuch or most of the increase in income inequality generally seen in the developed world, there are fears neverthelessthat it may have played some role.

Stiglitz (2002) also notes that workers might suffer if globalisation, via an increased frequency of sectoral shocks,leads to a heightened sense of insecurity. OECD (2007) explores a number of channels through which such effectscould emerge. (i) Labour-demand volatility could rise as firms become increasingly exposed to international shocks,since firms operating in more than one market are more likely to be hit by a shock than are firms operating in moreinsulated markets. The overall impact however depends on whether shocks are positively or negatively correlatedacross countries. Risk increases in the first case while diversification benefits accrue in the second. (ii) Globalisationcould also reinforce the propagation of labour-demand shocks if international economic integration impacts on theprice elasticity of labour-demand, though Slaughter (2001) finds that changes in the elasticity of labour-demandover time are driven by technological progress rather then by globalisation per se. (iii) The OECD also points toevidence that the rents previously accruing to workers are squeezed by increased import competition, suggesting areduction in the bargaining power of workers. Some trade economists have argued by contrast, however, that globalmarket integration increases the bargaining power of workers and managers possessing talents that are in strongdemand.5

What extra effects arise in the case of FDI? Desai et al. (2005) find that higher capital expenditures on the part offoreign affiliates of US MNCs are associated with higher investments in the US by the parent companies; the implicationbeing that firms combine home production with foreign production to generate final output at lower cost than wouldbe possible without outward direct investment (ODI). This makes each stage of the production process more profitableand ultimately raises production in both locations, leading to the conclusion that home-country production and ODI arecomplements rather than substitutes. Barba Navaretti and Venables (2004, Chapter 9) report on a study of Italian firmswhich finds that even if employment declines in firms that open up new plants abroad, this decline is not larger and issometimes smaller than what it would have been had these firms not engaged in ODI. The conclusion of their literaturereview is that “foreign investments, even to developing countries and even labour-saving ones, are paradoxically agood strategy to preserve home employment”.6

This literature does not distinguish between foreign investments in different types of countries however. Brainardand Riker (1997, 2001) find, for US MNCs, that low-wage affiliates are complements and high-wage affiliates aresubstitutes for US workers.7 Braconier and Ekholm (2000) report a similar finding for Swedish MNCs. Since we areconcerned here mainly with production relocation to Central and Eastern Europe it is these findings of complementaritythat are of most relevance.8

There have been a number of formal studies analysing the labour market effects of FDI flows from Western toCentral and Eastern Europe; see e.g. Becker et al. (2005), Marin et al. (2002) and Braconier and Ekholm (2001).

4 See for example Desjonqueres et al. (1999).5 For references on these various issues, see OECD (2007, 120).6 Blomstrom et al. (1997) find, in contrast, that for US firms increased foreign production is associated with reduced employment in the parent

company, though there may be an expansion of headquarters services and high-skill employment in the home base. There need be no effect onaggregate employment in the home economy of course (i.e. across all firms) if labour markets operate efficiently.

7 Head and Ries (2002) find that for Japanese multinationals an increased reliance on affiliates in low wage countries raises skill intensity.8 Note also that richer and poorer regions will attract different types of FDI. Production fragmentation, which has been increasing in importance –

particularly in the electronics and automobiles sectors – and which accounts for much recent CEE-bound FDI, leads enterprises to retain or expandactivities at home that are complementary to the firm’s offshore activities. Technology-sourcing FDI on the other hand may be a substitute for homeHQ activities and may lead to a downsizing of domestic R&D facilities, as Blomstrom and Kokko (2000) show (though Globerman et al., 2000,argue that it can also generate positive externalities). Kottaridi (2005) shows that periphery-bound FDI is less likely to be of the technology-sourcingvariety.

F. Barry, F. Walsh / Structural Change and Economic Dynamics 19 (2008) 4–16 7

The latter provide evidence that for Swedish firms, expansion in the CEE is associated with job loss in other EUaffiliates but more so in low wage EU countries than in high wage countries.9 The tentative suggestion in this lit-erature is that, in the case of competition for foreign direct investment, low-skill workers in richer countries arevulnerable to competition from the CEE countries while more skilled workers may benefit. The integration of the CEEeconomies does more than just intensify the competition for FDI however. Dunning (1997a,b) has shown that eachepisode of enlargement and strengthened integration within the EU has increased the total pool of extra and intra-EUFDI.

While foreign direct investment is clearly an important way for firms to offshore activities, firms may also off-shore without the use of foreign affiliates (“offshore outsourcing”). Feenstra and Hanson (1999) look at the impactof outsourcing on wages in the US using industry level data, where outsourcing is measured by import penetra-tion. They find that outsourcing raises wages, especially for non-production workers, and can explain 15 percentof the large increase in non-production workers’ relative wages. Geishecker and Gorg (2005) look at the impact oftrade fragmentation on German workers. They find that low-skill workers in low-skill-intensive industries experi-ence reductions in their real wage following fragmentation activity in the industry, while fragmentation appears toyield gains to high-skill workers only when it occurs in high-skill-intensive industries. Ekholm and Hakkala (2006),using Swedish data, find evidence that offshoring, particularly to the CEEC, is associated with a labour-demandshift away from workers with intermediate skills. According to their estimated elasticities, the actual increase inoffshoring to the CEEC between 1995 and 2002 would have been associated with a 2.3 percent reduction in thedemand for workers with upper secondary education and a 5.9 percent increase in the demand for workers with tertiaryeducation.

Austria, given its proximity to the CEEC, is an interesting case study with respect to offshore outsourcing. Here, thephenomenon has been found to have been an important source of total factor productivity growth (Egger et al., 2001).Other studies such as Anderton and Brenton (1999) also find that outsourcing leads to an increase in both the wage-billshare and the employment share of skilled workers in home-economy companies. As such, it represents an upwardstep on the ladder of comparative advantage. Overall welfare effects however depend on the extent of labour marketflexibility in the outsourcing countries, as in our earlier discussion of traditional trade theory, since unemploymentmight otherwise result.

The debate on the overall costs and benefits of industrial relocation and offshoring received added impetus recentlyfrom the widely cited contribution of Samuelson (2004). Samuelson points out that when the analysis begins froman initial trading equilibrium rather than autarky, an increase in foreign productivity can be damaging to the homeeconomy when it occurs in the latter’s export industries since it leads to a reduction in the home economy’s terms oftrade.10

Samuelson offers the offshoring of call-centres as a possible example. In response, Bhagwati et al. (2004) pointedout that even quite high estimates of the US jobs lost through such processes amount to only 1 to 2 percent of thenumber of jobs destroyed and created annually.11 They also make the standard trade-theory observation that newjobs can also be created as a result in the home economy, since the availability of cheaper less-skilled workersabroad makes activities intensive in the use of high-skill workers in the United States financially feasible.12 Jonesand Ruffin (2005) show, furthermore, that the home country may gain if its reduction in comparative advantage islarge enough to wipe out its domestic industry, so that it becomes a net importer of what had formerly been its exportgood.13

9 As against this, the analysis of sectors of particular importance to Western EU periphery economies – Motor Vehicles (Spain), Textiles, Clothingand Footwear (Portugal and Greece) and ICT (Ireland) –contains more sanguine conclusions. (See Barry, ed., 2004).10 A similar argument is made by Gomory and Baumol (2001; Chapter 2).11 The McKinsey Global Institute (2005a) and the OECD have analysed the types of jobs that could possibly be offshored at present, and come

up with a substantial proportion of the developed-country labour force. These exercises of course ignore the general equilibrium considerationsdiscussed here, which determine how the industrial make-up of the developed countries will respond.12 Dedrick and Kraemer (2002) point out that whilst the move offshore reduced hardware employment in the US – by 100,000 between 1985 and

1998 – the associated reduction in the cost of hardware created demand for additional software and services, whose US employment levels increasedby around 600,000 over this period.13 As labour of varying skill types is the only factor of production in the models driving this debate, the distribution of gains and losses between

capital and labour cannot be assessed.

8 F. Barry, F. Walsh / Structural Change and Economic Dynamics 19 (2008) 4–16

2.2. New trade theory

Helpman and Krugman (1985) identify four major areas in which traditional trade theory is inadequate. First, mosttrade – and indeed most FDI – takes place between countries that are rather similar in their factor endowments.14

Second, much if not most trade is intra-industry rather than inter-industry in nature. Third, because traditional tradetheory is based on a perfectly competitive constant-returns world, there is little room for multinational corporationsand foreign direct investment as it is commonly understood. And fourth, as they note:

“Standard models associated trade with a reallocation of resources that increases national income in aggregatebut leaves at least some factors with reduced real income. What seems to have happened in such importantepisodes of trade liberalisation as the formation of the EEC and the US-Canadian auto pact is quite different,however. Little resource reallocation took place; instead, trade seems to have permitted an increased productivityof existing resources, which left everyone better off”.

“New trade theory” which takes account of economies of scale and imperfect competition suggest that the overallbenefits of freer trade are likely to be substantially larger than the gains predicted by traditional models.15 Further gainsarise because of increased product variety, greater competition and the exploitation of scale economies.16

Bhagwati et al. (2004) suggest that if China and India ramp up their supplies of skilled labour as rapidly as UStrade pessimists fear, it is this “intra-industry” trade model that will become more relevant. As these countries becometechnologically more sophisticated, this should lead to newer varieties of services and need not generate adverse termsof trade effects.

Even within new trade theory, furthermore, comparative advantage has regained much of its formerly dominantposition with the finding that most intra-industry trade (IIT) is of the vertical type (where the goods traded aredifferentiated by quality), with specialisation over the quality spectrum within industries explicable in terms of factorendowments.17 Vertical IIT is related to the fragmentation of production processes discussed earlier, and hence thefindings of that section apply here also.

2.3. New economic geography

Interestingly in light of current concerns in richer countries over the consequences of globalisation, most newermodels suggest that while poorer countries are unlikely to lose (because the impact of lower consumer prices is felt nomatter where the increasing-returns production takes place; Ethier, 1982), richer countries are likely to benefit morefrom the process. This issue is explored in the “new economic geography” literature.

The cornerstone of these models is that firms have an incentive to locate close to each other to benefit fromagglomeration economies, while high transport costs militate against such agglomerations. For given agglomerationeconomies, a decline in transport costs induces migration of increasing-returns industries out of peripheral regions,leading to a divergence of real wages. As transport and trading costs become very low, the advantage shifts to theperipheral location (because of lower labour costs), so it becomes cheaper to produce in the periphery and transportthe goods to the core market.

Krugman and Venables (1990) present the following example to illustrate the forces at work. For given consumptionlevels – and a given amount, therefore, of total production – let production and trading costs be as in Table 1. Productioncosts are lowest if all production takes place in the periphery (because wages are low). Total production costs are highestif production occurs in both locations (because economies of scale are forfeited). Since most demand is in the coreregion, shipping costs are highest if all production occurs in the periphery. It is clear from the table that cost minimisationdictates that production takes place in both regions when shipping costs are very high; production takes place in the corewhen shipping costs are at an intermediate level, and production is located in the periphery when shipping costs are zero.

14 Becker et al. (2005) point out that “in 2000, 63 percent of the foreign labor force of German MNEs worked in industrialized countries. Similarly, in2002, 77 percent of the foreign labor force of Swedish MNEs worked in industrialized countries.” Thus, it is clear that factors such as agglomeration,education and infrastructure are as important as cost differences in determining trade and FDI patterns.15 See e.g. the Single Market simulations of Smith and Venables (1988).16 The distribution of these gains across countries is less certain than in the models of traditional trade theory however.17 See e.g. Greenaway and Milner, eds., 2006.

F. Barry, F. Walsh / Structural Change and Economic Dynamics 19 (2008) 4–16 9

Table 1Hypothetical effects of lowering trade barriers

Total production costs Shipping costs

High Medium Low

Produce in core 10 3 1.5 0Produce in periphery 8 8 4 0Produce in both locations 12 0 0 0

Source: Krugman and Venables (1990).

The model therefore generates a U-shaped curve that depicts the share of increasing-returns industries that theperiphery captures as trade barriers are reduced, with relative wages following a similar pattern.18

Barry (1996) suggests however, on the basis of an analysis of Ireland’s adjustment to free trade, that the possibilityof welfare loss for the periphery as trade integration proceeds may be overstated. He argues that the small size ofthe pre-trade periphery market prevented local firms from exploiting scale economies and that efficiency was furtherreduced by rent seeking and lack of competition. He also shows that the move to outward-orientation stimulated aninflux of foreign-owned increasing-returns firms. In a theoretical contribution Gao (1999) shows that FDI is indeedlikely to smooth out the U-shaped curve, making it less likely that the periphery will suffer from economic integration.19

Rodriguez-Clare (1996) raises the possibility nevertheless that MNCs may have adverse effects depending on thelinkages they create per unit of labour employed compared to the linkages of the domestic firms they displace fromthe market (linkage effects are measured by the ratio of employment generated in upstream firms to the labour hireddirectly by firms). This consideration is less important in the presence of surplus labour, since such displacement isless likely to occur.

Even though there has been little displacement in the Irish case (because of a highly elastic labour supply), it isinteresting to note that the linkage effect is in any case likely to have been positive. Even though Irish raw materialpurchases per head are substantially higher for Irish firms, employment-intensive services purchases are equivalentlyhigher for foreign MNCs (Barry and Bradley, 1997).

2.4. Endogenous growth models

The essential property of an endogenous growth model is that there are constant returns to the factors that canbe accumulated. In the Solow model with a declining marginal product of capital, growth slows down as the steadystate is approached, and ultimately stops altogether in the absence of exogenous technical change. Several of theways in which the problem of a declining marginal product of capital can be surmounted include (a) learning-by-doing, (b) human capital accumulation, and (c) R&D-driven technological progress under imperfect competi-tion.

In this section we consider core-periphery models of each of these types, in order to analyse the dynamic effectsof international trade on growth and technical progress. The first model is due to Young (1991), the second to Stokey(1991) and the third to Grossman and Helpman (1991).

In Young’s model, trade between core and periphery raises the growth rate of the core and reduces that of theperiphery. The periphery (if small) is still likely to gain overall, because of the traditional static gains from trade,but the model clearly implies divergence. In this model there is a bound on the cumulative productivity gains fromlearning by doing (LBD) in the production of any particular good, but LBD exhibits spillovers across goods. Thusgrowth involves the production of a changing basket of goods and an evolving trade structure. With no internationaldiffusion of knowledge, the main growth effect of trade is to force periphery firms to wait in industries in which theyhave already exhausted LBD while core firms (i.e. those in regions with a technological lead) speed ahead into morehigh-growth sectors. Only after core firms exhaust the potential for LBD in these new sectors can periphery firms enter

18 Another factor that can inhibit peripheral regions from capturing IRS industries is that transport costs for differentiated products can be manytimes higher than for standardised products.19 Gao (2005) shows that, starting from a core-periphery steady state, economic integration gives rise to FDI, leads to an expansion of R&D activity

in the industrial core, increases the world growth rate and ensures that the peripheral country enjoys a rise in living standards.

10 F. Barry, F. Walsh / Structural Change and Economic Dynamics 19 (2008) 4–16

and continue their technical progress. Thus, the progress of the periphery is retarded, LBD is slower than it would beunder autarky, and the growth rate falls.

The human capital model can generate endogenous growth since both human and physical capital can be accumu-lated. A constant steady-state growth rate emerges if the return to investing in human capital is constant. In the Stokeymodel, since individuals have finite lives, the only source of steady-state growth is the externality effect whereby privateinvestment in schooling raises the social stock of knowledge, increasing the effectiveness of time spent in school bylater cohorts (knowledge, once again, does not spill over across international boundaries). Different types of labourare imperfectly substitutable, which in this model means that as aggregate human capital grows, lower quality goodsare dropped from production and higher quality goods added.

Now consider the impact of free trade on a small economy that is fairly backward relative to the rest of the world.Free trade lowers the relative price of the goods produced by highly skilled labour in the periphery, and so reduces theincentive to acquire skills. Thus, the growth rate of the economy falls (the static gains from trade may neverthelessoutweigh these losses from slower growth).

Stokey concludes her analysis as follows, referring to the Young paper and others: “If the industries in which theless developed country has a static comparative advantage are industries in which there are limited opportunities forlearning, then the effect of free trade is to speed up learning in the more developed country and to slow it down in theless developed one. The model here shows that similar reasoning applies when the external effect operates at arm’slength from the production process”.

Unlike the previous two models in which endogenous growth occurs through the presence of externalities, Grossmanand Helpman (1991) assume that increasing returns are internal to the firm, giving rise to an imperfectly competitivemarket structure which generates profits out of which R&D can be funded.

Consider first the case where technological spillovers are confined to the country in which they are generated. Thesemodels again predict that for a small lagging economy, free trade induces specialisation in low-tech goods becauseits researchers cannot compete successfully in the world technology race. This induced resource reallocation reduceslong-run output growth, and may again imply losses from free trade if the static efficiency gains are dominated by thereduced growth.

When technological spillovers are international in scope, however, the rate of innovation cannot fall in the R&D-poor country. While it enjoys faster technological progress in the most dynamic sectors of manufacturing, its overalloutput growth rate may fall since it specialises in the less dynamic sectors. Its consumption growth rate must risehowever.

These endogenous growth models then have the following implications: (i) freer trade will confine peripheral regionsto less dynamic sectors than they would have entered in autarky (though these sectors themselves may be more dynamicas a result of freer trade in technology). (ii) Learning by doing, human capital accumulation and R&D expendituresshould decline as the periphery becomes more integrated with the core, while output and productivity growth ratesmay also decline. (iii) While peripheral regions are likely to gain overall, divergence rather than convergence of growthrates is the general outcome.

Again, Barry (1996) finds – largely perhaps because of FDI – that none of these predictions held true in the Irishcase. FDI and the linkages with domestic firms that they created drew the Irish economy into far more dynamic sectorsthan prevailed under protectionism, the R&D spend of foreign MNCs per worker is far higher than is the case fordomestic firms, and diligent governance (and use of the corporation tax revenues resulting from FDI) ensured thathuman capital accumulation rose substantially under Ireland’s outward-oriented phase of development.

3. Sectoral relocation and displaced workers: the costs of adjustment

The relocation of sectoral production and employment across countries will lead to some displacement of workersas firms, processes or occasionally even entire sectors migrate abroad. If labour markets are flexible then the processneed not entail net job loss but some workers will clearly be disadvantaged. We turn shortly to a discussion of thecharacteristics of such workers.

Compensating dislocated workers cannot only smooth the cost of frictional unemployment but can also help defuseopposition to ongoing globalisation. Might a possible alternative be to attempt to block further globalisation? The caseof the Selective Employment Tax is instructive in this regard. The tax, levied solely on service-sector employment,was introduced in the UK in 1966 by the then labour government due to fears that manufacturing employment was

F. Barry, F. Walsh / Structural Change and Economic Dynamics 19 (2008) 4–16 11

being displaced (the tax was abolished when a new government came to power in 1970). Given that services, for mostdeveloped economies, have provided virtually all of the net employment growth of the last few decades, such a policyof inhibiting market-driven adjustment appears with hindsight to have been extremely misguided.

Nor is there a case for the subsidisation of automation in the home country, for example, in order to combat thepressures that lead to offshoring. Subsidisation is efficiency-enhancing only if market failures mean that the marketoutcome is suboptimal. No such market failures have been identified in the present case. Hence, we confine ourdiscussion to policy options that seek to minimise the costs of adjustment and the length of the adjustment period.These include trade adjustment assistance, flexicurity, and other forms of labour market interventions.

3.1. The cost of job displacement

The literature on displaced workers suggests that displacement causes long-term losses, particularly for olderworkers with longer job tenure. The latter reflects the depreciated value of firm-specific and industry-specific skills.While workers displaced in the US between 1969 and 1983 were almost as likely as a comparison group to have a job 4years after displacement, they nevertheless suffered a wage disadvantage of more than 10 percent (Ruhm, 1991). Farber(2005), in a study of displaced worker surveys from 1981 to 2003, finds a wage loss of 17 percent, including foregoneearnings growth. Post-2001 earnings losses are found to be much larger for the better educated. He also confirmsRuhm’s earlier finding that about one-third of displaced workers will not have found a job 1 year after displacement.

Burda and Antje (2001) finds that while average losses for displaced German workers are small and most displace-ment affects the lower end of the distribution, there are large reductions in wage growth for displaced workers in thehigher percentiles of the wage distribution. Lefranc (2003) finds wage losses of 10–15 percent for French workers 2years after displacement, which is only slightly less than in the US case. He also finds higher relative losses for themore highly skilled.

Kletzer and Lori (2004) summarises the main findings of the literature on displaced workers in the US in thefollowing stylised facts:

• Import-related job loss is a sizeable share of US manufacturing job loss, and a much smaller share of economy-widejob loss.

• Similar to manufacturing workers displaced for other reasons, import-competing displaced workers are older, lessformally educated and with longer tenure than displaced non-manufacturing workers. Generally, these characteristicsare not associated with success in training programs.

• The probability of re-employment is low for import-competing displaced workers (relative to non-manufacturingworkers), with sizeable earnings losses on average.

• Import competition is associated with low re-employment rates because the characteristics of displaced workersare associated with difficulty in gaining re-employment. These characteristics include low educational attainment,advancing age, high tenure, minority status and marital status. Workers with high tenure and/or low skill may faceserious skill-related adjustment problems. Given the lost wage premium, unemployment benefits will be relativelygenerous, which is associated with slower job search.

• For most workers, the costs of job loss occur as re-employment earnings losses. Less formally educated workersexperience the greatest difficulty maintaining earnings. More generally, re-employment earnings losses rise withage, fall with education and rise with length of tenure.

• Re-employment in manufacturing tends to be associated with lower earnings losses, while re-employment in servicesis associated with the greatest losses in earnings.

3.2. Trade adjustment assistance

It is widely recognised that compensating dislocated workers, besides smoothing the cost of frictional unem-ployment, can help defuse opposition to liberalisation by distributing some of the gains to these groups.20 The

20 The survey evidence provided by Scheve and Slaughter (2001) is apposite in that it indicates that a majority of American workers would be infavour of further liberalization provided that those who are harmed receive compensation or assistance.

12 F. Barry, F. Walsh / Structural Change and Economic Dynamics 19 (2008) 4–16

main policies that have been advocated in this regard are training subsidies and other active labour market poli-cies, enhanced unemployment benefits, and employment/or wage subsidies (the latter collectively known as tradeadjustment assistance).21

As Baicker and Rehavi (2004) document, trade adjustment assistance (TAA) in the form of extended unemploymentassistance has been on offer in the US since 1962, when it was adopted to compensate workers for tariff cuts underthe Kennedy Round of multilateral negotiations. Eligibility for US TAA was expanded in 2002 to include secondaryworkers at an affected firm’s upstream suppliers and downstream customers. More recently, the European Union hascreated a D 500 million Globalisation Adjustment Fund which offers job counselling, training and other help to eligibleworkers who lose their jobs because of “structural changes in world trade patterns”.

What is the evidence on the effectiveness of such active labour market policies (ALMPs)? Boone and van Ours(2004) assess the ALMPs in operation in the OECD between 1985 and 1999. They find that training has a significanteffect in lowering the unemployment rate, whereas public sector employment or targeted employment subsidies haveno effect. Calmfors et al. (2001), in an evaluation of Swedish ALMPs operating between 1986 and 2000, found thattraining programmes did not increase employment probabilities while subsidised jobs had large displacement effects.22

Overall, the literature on ALMPs indicates that their performance has been disappointing. Some groups of workersmay gain at a micro level but there are significant displacement effects in macro evaluations. An important qualificationis that the main objective of most of the policies in the empirical literature on ALMPs is to increase employment whilethe objective in the trade displacement literature is to compensate the losers from structural adjustment. Nevertheless,the conclusions of Boone and van Ours (2004) – that training is the most effective program to bring down unemployment,while employment subsidies do not work – are very different from the policy conclusions of Davidson and Matusz(2006), Kletzer and Lori (2004) and others discussed below.

The relative benefits of the various forms of trade adjustment assistance which might be offered continue to generatecontroversy. The European Economic Advisory Group (2005) recommended a partial conversion of the welfare statefrom paying replacement wage income to subsidising wages and compensating victims of factor price equalisation.The McKinsey Global Institute (2005b) advocates re-employment subsidies, which Kletzer and Litan (2001) suggestmight lead to more valuable on-the-job training than that received under current US programmes.

A new pilot scheme, as proposed by Kletzer and Litan (2001), was introduced in the US in 2002 for workers aged50 and above. This scheme provides displaced workers with cash benefits equal to 50 percent of the difference betweentheir new and old salaries if reemployed at lower wages within 26 weeks of separation, subject to earnings of less thana set amount, and also offers temporary subsidies to help pay for health insurance. Germany and France offer similarschemes with varying degrees of restrictiveness.

Davidson and Matusz (2006) revisit the issue of optimal adjustment compensation in an attempt to devise a schemethat fully compensates declining-sector workers while imposing the smallest distortion on the economy. Their proposalconsists of a wage subsidy to those who switch sectors after liberalisation, combined with an employment subsidy to thedeclining sector. The logic is as follows. Since the average worker who shifts to the expanding sector has higher abilitythan the marginal worker, a wage subsidy has a relatively large impact on the welfare of the average mover and hencerequires only a modestly sized program. The average low-tech worker who remains in the declining sector (because ofthe difficulty in acquiring the skills required for high-tech jobs) earns a lower wage than the marginal worker. Hencean employment subsidy targeted at the low-tech sector generates a smaller distortion than a wage subsidy granted tothis sector.

Certain possible adverse effects of these various types of schemes are identified by Baicker and Rehavi (2004).Noting the well-documented spike in the likelihood of an unemployed worker being reemployed at the time thatbenefits expire, they point out that increasing the generosity and length of time for which TAA benefits are availablecould increase the average duration of unemployment, while the wage subsidies offered to bridge the gap betweenworkers’ new and old salaries reduce the incentive to seek out the highest-paying available jobs. They also point outthat US firms may be induced to lay off workers seasonally because they pay less in unemployment insurance taxesthan workers receive in benefits for each layoff.

21 We present this extensive discussion of trade adjustment assistance and active labour market policies because the same issues arise whether theinternational relocation of production is driven by trade, FDI or offshore outsourcing.22 Swedish ALMPs consumed between 1.1 and 1.9 percent of GDP, about twice the EU average.

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An important factor that appears to have been neglected in this literature however is the impact that trade adjustmentassistance of any form might have on the likelihood of job loss. The theoretical models used, such as that of Davidson andMatusz (2006), generally assume that wages are set competitively. Many well-known labour market models however– such as the efficiency wage and union bargaining models – are based on imperfect competition. In this case the wageis a function of workers’ outside options, which are in turn influenced by the presence or absence of a trade adjustmentassistance program. This insight accords well, in fact, with the logic of TAA as a way of defusing opposition to tradeliberalisation. If workers are more likely to support trade liberalisation in the knowledge that they will be compensatedin the event of job loss, it implies that fear of displacement, and hence the perceived outside option, is affected by thepolicy. Trade adjustment assistance, by lowering the cost of unemployment and raising the value of the outside option,increases the equilibrium wage thereby making outsourcing and job loss more likely (Barry et al., 2007). If labourmarkets were competitive this objection would not arise. On the other hand the case for trade adjustment assistancewould be much less compelling.

A further worry arises as to the distributional consequences of re-employment wage subsidies. As noted, theempirical literature suggests that employment subsidies create few additional jobs. To the extent to which they increasethe employment prospects of displaced workers who lose relatively good jobs, they will displace other low-paidworkers. The latter, not having had long tenure in relatively good jobs, may well be poorer than the assisted workerswho displace them.

3.3. Flexicurity

OECD (2007, 142) concludes from a survey of the empirical evidence that trade has made a modest contribution tothe upward trend in inequality in recent decades. It goes on to argue however that “recent experience confirms that theright mix of domestic policies can generate strong labour market performance, even in very open economies”. It warnsthough that “international economic integration increases the urgency of enacting pro-growth and pro-employmentpolicies which also ensure that political support for open trade and investment will not be eroded by excessively highlevels of insecurity or inequality.”

These considerations have led to much discussion in Europe in recent times of the advantages of the systemof “flexicurity” originally introduced in Denmark in 1993. This system emphasises worker security rather than jobsecurity. Interestingly, despite high levels of job mobility and low average job tenure, Danish employees are found to feelmore secure than is the case for workers across Europe more generally. The Danish system comprises three elements:

• Weak employment protection legislation facilitating the easy hiring and firing of workers and ensuring high mobilitybetween jobs.

• A comprehensive social safety net with a high level of unemployment insurance, and• A strong emphasis on active labour market policies, offering the possibility to upgrade skills through training and

motivating work search on the part of the unemployed.

Many commentators feel however that the high levels of social welfare payments and taxation associated withflexicurity may not be feasible outside Scandinavia. Other less radical initiatives to enhance worker security couldalso be considered. An article in Business Week (2004) that reports on the debate among trade economists sparkedoff by the publication of the Samuelson paper states that “until now the pain of globalisation has been borne by lessthan a quarter of the workforce, mostly lower-skilled workers, whose wage cuts outweighed the cheaper-priced goodsglobalisation brings. But the other three-quarters of American workers still came out ahead, since they weren’t affectedby foreign wage competition. If blue and white-collar employees alike are thrown into the global labor pool, a majorityof workers could end up losing more than they gain in lower prices. Then the benefits of increased trade would goprimarily to employers.” Dani Rodrik is quoted as agreeing, saying that “it’s entirely possible that all workers will loseand shareholders will gain”.

This suggests that workers should be encouraged to diversify their savings into the stock market to a substantiallygreater extent than pertains at present. Governments could facilitate such diversification through education on themechanics of share purchasing or though initiatives to reduce the management costs associated with funds that trackthe market. These funds would appear to require less portfolio management time than more interventionist funds butdo not appear to bear equivalently high discounts at present.

14 F. Barry, F. Walsh / Structural Change and Economic Dynamics 19 (2008) 4–16

3.4. Tackling labour- and product-market rigidities

Koedijk and Kremers (1996) construct measures of the extent to which national EU15 product and labour marketsare over-regulated, and find that both measures – and particularly those associated with product-market regulation –have negative effects on real output growth. Ireland, the booming economy of the period, emerges as the least regulatedof the 11 EU economies studied.

The Spanish labour market reforms of the 1994–97 period, furthermore, – which tackled restrictive work practicesand reduced firing costs – saw Spanish unemployment finally fall from the very high levels relative to the EU averagethat had prevailed over the previous 15 years. The policy implications (though not the politics of how to implementthem) seem clear.

3.5. Education

Whether the increase in inequality in developed countries is due to trade or to technological change, it is generallyagreed that the best way to respond to the decline in the demand for unskilled labour is through reducing its supply viaan expansion in educational attainment.

Nickell and Bell (1996) argue that the (West) German system of education and training allowed that country toavoid many of the adverse consequences of the decline in the demand for unskilled labour that had appeared in the USand the UK. Germany’s success in this regard is ascribed to the strong emphasis in the German schooling system on“sustaining a high level of performance on the part of the bottom half of the ability range”, plus the comprehensiveGerman system of vocational training.

There is little evidence however on what precise kinds of education may be most beneficial in facilitating inter- andintra-sectoral adjustment and thus minimising the adjustment costs borne by displaced workers. This would appear tobe a fruitful area for further research.

4. Conclusions

Industrial relocation can be triggered by shifts in comparative advantage associated variously with liberalisation oftrade and FDI, reduced trade costs, innovation and technological diffusion. The present paper surveys the consequencesthat arise in models emanating from traditional and new trade theory, new economic geography and growth theory.The general consensus, with Samuelson (2004) as a notable exception, is that the entry of new players into the globaltrading system is beneficial for both newcomers and incumbents, over the longer term at least.

The distributional consequences within incumbent countries are the subject of much research. Leaving to one sidethe wider debate over whether the relative decline in the welfare of less skilled workers has arisen as a consequence oftrade or technology, it is clear that both the trade and FDI dimensions can, under certain circumstances, be detrimentalto the interests of less-skilled workers. Those who suffer most from trade displacement tend to be older, less formallyeducated, and with relatively long periods of tenure in the displaced jobs.

Trade adjustment assistance is advocated as a way of helping to defuse the opposition to further globalisation. Thereis little consensus however on what form TAA might best take. Some analysts advocate training subsidies, though theempirical literature on active labour market policies suggests that there are strong displacement effects which mightharm workers who are even less well-off than those assisted. Others advocate enhanced unemployment benefits andemployment and/or wage subsidies as methods of compensation. Problems can arise with respect to each of thesemethods as well, however.

Improving the flexibility of the labour market and raising the educational attainment of the population appear torepresent the best routes to minimising the adjustment costs associated with sectoral relocation. As evidenced by thereaction to recent French attempts at labour market reform, however, increased labour market flexibility can be difficultto engineer at the political level. With regard to education and training, furthermore, there is little evidence availableon the precise forms that best facilitate inter- and intra-sectoral adjustment.

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