The Davos Disconnect

For a great number of major industrial nations the share of economic rewards going to labor stands at a historic low. This is not sustainable.

By Stephen Roach

Feb. 5, 2007 issue - This year's World Economic Forum was the most optimistic in years. Four years of booming global growth and surging financial markets put the attendees in a giddy mood. The Davos consensus was convinced that more of the same lies ahead in 2007. The optimism is understandable. After years of agonizing over the implications of terrorism, geopolitical instability, higher oil prices and ever-mounting global imbalances, the world economy never even flinched. This resilience stands in sharp contrast with the vulnerability that many, including yours truly, have long feared.

The Davos consensus was heartened by the equally euphoric state of financial markets. Particularly encouraging was the froth in what traditionally have been some of the riskiest of assets—emerging market debt and high-yield corporate credit. Sharply reduced volatility in major equity, bond and currency markets was the icing on the cake. Just as the markets were betting on a riskless world, those gathered at this year's World Economic Forum were prepared to do the same.

Yet beneath the surface, there was an undercurrent of concern. Even the optimists admitted that many problems were festering—especially rising income inequalities, unfunded retirement obligations of aging developed nations, America's chronic saving shortfall and increasingly contentious trade frictions. Therein lies the contradiction of Davos: in the end, a baseline forecast of a riskless world dismisses any complications that might arise from social, political and economic tensions.

I suspect the resolution of this contradiction is likely to take the form of an important power shift in the global economy—a realignment that could add a good deal more risk into the equation than is the case at present.

The reason: the pendulum of economic power is at unsustainable extremes in the developed world. For a broad collection of major industrial economies—the United States, the euro zone, Japan, Canada and the U.K.—the share of economic rewards going to labor stands at a historic low of less than 54 percent of national income—down from 56 percent in 2001. Meanwhile, the share going to corporate profits stands at a record high of nearly 16 percent—a striking increase from the 10 percent reading five years ago.

This divergence is not sustainable. The angst of workers in the developed world has become a major source of tension. Yet with labor unions on the decline and with workers from China, India and the former Soviet Union representing a doubling of the global labor supply in the last 15 years, workers in the developed world don't have much of a leg to stand on. They have chosen, instead, to express their displeasure in the polling booth, with the result that the pendulum of political power is now swinging to the left in countries such as the United States, France, Germany, Spain, Italy, Japan, Australia and yes, even Switzerland.

A shift in political orientation is likely to prompt an equally important pro-labor swing in the pendulum of economic power. With the Democrats now in control of both houses of the U.S. Congress, America is leading the way. Among the topics now on the table are increased minimum wages, higher taxes on the energy industry, and new scrutiny of corporate compensation and excessive returns going to hedge funds and private equity firms. These are early warning signs of a looming shift in America's reward structure—away from the excesses going to capital and back toward labor.

The biggest risk is the rising threat of protectionism. Politicians throughout the developed world view trade liberalization increasingly as a serious threat to job and income insecurity. That's especially the case in Washington, where Congress has connected America's record trade deficit with pressures on real wages and employment growth. With fully 29 percent of the U.S. trade deficit currently made in China, China bashing is going from bad to worse.

This is a tough blow to the spirit of Davos. Nowhere has the "win-win" mantra of globalization garnered greater adulation than at the World Economic Forum. Yet the angst of labor in the developed world now draws this vision into serious question. Yes, workers in poor developing countries are winning big time, but in the more prosperous developed world, the win has gone more to the owners of capital rather than to the providers of labor.

How this plays out worldwide is anyone's guess. But the point is that the risks of the great global power shift are rising—at precisely the time when the Davos consensus and world financial markets are paying precious little attention to risk. Something has to give. My guess is it's the markets. The Davos disconnect has an ironic footnote. The preselected theme of this year's gathering was "The Shifting Power Equation." It's as if the Davos elite senses what's coming, but doesn't want to admit it. You might call that denial.

Roach is chief economist at Morgan Stanley.

© 2007 Newsweek, Inc.

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