DP12069 | Structural Change and the China Syndrome: Baumol vs Trade Effects

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In the process of economic development, the share of manufacturing in total employment first increases and then declines after incomes per capita have passed a given threshold. Advanced economies are all beyond that threshold and thus experience a secular decline in the share of manufacturing. Baumol explained such a process of deindustrialization as resulting from faster productivity growth in manufacturing relative to services. More recently, trade with emerging economies, especially with China, is often identified as the main determinant of deindustrialization in advanced economies. Disentangling the trade channel from the traditional productivity channel is a complicated task. In this paper, we develop a simple model of structural change in an open economy to derive empirical implications, which we analyze for a sample of OECD countries. The model is based on trade between advanced and emerging economies. In a closed economy framework, faster productivity in manufacturing induces a fall in the share of manufacturing in total employment but not in total value added. By contrast, in open economies, what matters is not only the relative growth of productivity in manufacturing versus domestic services, but also relative productivity growth of domestic versus foreign manufacturing. When productivity growth of domestic manufacturing is faster than that of services but slower than that of foreign manufacturing, the share of manufacturing in advanced economies may fall, both in terms of value added and of employment. We call this phenomenon "twin deindustrialization." We exploit the comparison between estimates for the employment and value added shares to identify the relevance of the trade channel relative to the pure productivity channel. We find significant and quantitatively relevant effects of trade on structural change in advanced economies. Furthermore, we show that the strength of the trade effect depends on the nature of technological progress occurring in emerging economies.