Race to the Bottom?

If Wikipedia is to be believed, the term Race to the Bottom was popularized by Justice Louis Brandeis in reference to regulatory competition between states in the US. In general, the problem states faced was that , if other states enacted more lenient regulations, businesses would flock to those states. This gave states incentives to undercut each other regulations to attract business or at least lower their regulatory controls to keep what businesses they had. Hence, states were engaged in a race to the bottom. Preventing such a race became a rationale for federal regulatory standards which would establish a floor to this competition.

Today, the term is often applied to nations in a globalized world. globalization. Among others, Daniel Tonelson used the term in his 2002 book, The Race To The Bottom: Why A Worldwide Worker Surplus And Uncontrolled Free Trade Are Sinking American Living Standards. Tonelson argues that there is a global competition among nation to have the lowest wages, environmental standards, and labor regulations in order to win investments from the US and Europe.

Daniel Drezner addressed this so-called 'Race to the Bottom' in a 2000 Foreign Policy article and was emphatic in his rejection of it:

The race-to-the-bottom hypothesis appears logical. But it is wrong. Indeed, the lack of supporting evidence is startling. Essayists usually mention an anecdote or two about firms moving from an advanced to a developing economy and then, depending on their political stripes, extrapolate visions of healthy international competition or impending environmental doom. However, there is no indication that the reduction of controls on trade and capital flows has forced a generalized downgrading in labor or environmental conditions. If anything, the opposite has occurred.

Drezner argues that, if the Race to the Bottom hypothesis were true, we should see two trends. First, states that are more open to trade should have lower levels of regulation. Second, foreign direct investment (FDI) should be flocking to nations with the lowest levels of regulations. In arguing that there is little evidence of these trends (and often evidence of the reverse), he make the following points:

• A 1996 OECD study found that "successfully sustained trade reforms" led to improvements in labor standards and that multinationals pay higher wage rates to recruit better workers. Indeed, the study argued that multinationals, who are used to working in better regulated environments, welcome host nation improvements in labor standards as they give the multinational an edge over local firms who lack such experience. 
• He notes that OECD nations are the most open to trade and have the toughest environmental and labor regulations. Also, the overwhelming majority of FDI is directed at the same OECD nations. 
• He argues that multinationals invest in nations for reasons other than low production costs, most notably access to large markets in or near the host nation. Because this market access makes investment in the host nation desirable, it provides the host nations government with significant leverage when negotiating with multinationals.

Despite this lack of evidence, Drezner argues the Race to the Bottom hypothesis will persist because it is a useful rhetorical device. In his words:

Given this dearth of evidence, why does the race to the bottom persist in policy debates? Because the image is politically useful for both pro- and antiglobalization forces. Unfortunately, by perpetuating the belief in a nonexistent threat, all sides contribute to a misunderstanding of both the effects of globalization and how governments in developing and advanced economies should -- or should not -- respond.

William Olney comes to a different conclusion in a 2013 Journal of International Economics article. Noting that there has been a lack of evidence supporting the existence of a Race to the Bottom (and Olney's review of the evidence provides a good survey of the empirical research), he argues that the previous research did not rigorously test the two key assumptions of the Race to the Bottom hypothesis, which he describes as follows:

There are two implicit assumptions in the race to the bottom hypothesis. The first is that multinationals increase FDI in response to reductions in employment protection rules in the foreign host country. The second assumption is that countries competitively undercut each other's labor standards in order to attract FDI. (Olney, 2013, p 203)

Therefore, he conducts two analyses. To test the first hypothesis, he looks at US FDI in OECD nations to see whether it tends to go to nations with lower labor protections as indicated by the OECD's composite employment protection index for the receiving nation. To test the second hypothesis, he looks for a correlation between the employment protection index of each nation and the average employment protection index of its nearest competitor nations. As a result of these analyses, he reaches the following conclusions:

The empirical results presented in this paper are consistent with both predictions of the race to the bottom hypothesis. First, employment protection rules have a significant negative impact on FDI. In addition, employment protection rules have a more negative impact on the relatively mobile types of FDI. Specifically, employment protection legislation in the host country has small impact on horizontal FDI, amore substantial negative impact on export-platform FDI, and a large, negative impact on vertical FDI. These results are consistent across a variety of different estimation strategies. 

Second, this paper examines whether labor standards in other foreign countries affect the employment protection rules in the foreign host country. Regardless of the weighting method or the estimation strategy, the results indicate a significant positive impact on the host country's own employment protection rules. Thus, there is evidence that countries are competitively undercutting each other's labor standards in order to attract foreign investment. Overall, this paper finds support for both predictions of the race to the bottom hypothesis. Multinationals invest in countries with lower labor standards and countries respond by competitively undercutting one another's labor standards in order to attract FDI. At the very least, the results in this paper indicate that a race to the bottom in labor standards cannot be easily dismissed by economists, as is often the case. (Olney, 2013, p 203)

All in all, Olney looks at exactly what one should look at to test the two hypotheses which, as he says, are the two pillars of the race to the bottom hypothesis. He also has exactly the results that one would expect from the conceptualization of the process as a race, i.e., that a 1% drop in competitors employment protection yields a greater than 1% decrease in a nation's own employment protection.

However, when one eyeballs the graphs he provides of the various nations' employment protection indexes, a different picture emerges. First, consider the graph of all nations' employment protections below.

 Note that the graph starts out in 1985 with the nations spread out vertically from close to .5 to over 4. As time goes on (and we move left to right), we see many downward movements and a few upward movements so that we end up with a slightly narrower range and a cluster of nations with employment protections around 2 (and perhaps some other smaller clusters around 1 & 1.5, and a very loose one around 3). This suggests a loose convergence on that level (or those levels) rather than a race to the bottom. This impression is reinforced when one looks at his graphs of the nations with the largest declines and largest increases in employment protect below.

Note that, with the exception of Denmark, all the nations in the graph above start at an employment protection level above 3 and all but Denmark and Italy end up above 2 (though Italy is quite close to it). So the story here is that the largest declines were in nations with initially high levels of employment protection.

Here we see that, with the exception of France, all the nations with large increases in employment protection start out below 1.5. However, with the exception of Poland, they do not get close to 2, and their increases are generally smaller than the declines seen in the previous graph.

The overall story these graphs suggest to me is that nations started out the period with levels of employment protection largely driven by differing domestic factors and that competitive pressure may have driven the nations with higher levels of protection to adjust their policies towards the mean. Nations with relatively low levels of protection do not appear to have faced pressure to lower their levels of protection further and instead many have edged their protections up (presumably for domestic policy reasons).

Furthermore, all the nations with largest declines in employment protection are members of the EU and most of their declines in employment protection were between 1992 and 1997, a period which includes the  implementation of the Maastricht Treaty. So one has to wonder how surprised we should be that policies are converging in Europe or that European nations are feeling more competitive pressure at that point in time. Indeed, one could argue that, by extraordinarily leveling the playing field among EU members, the Europeans knowingly created a situation in which they would have to converge or compete with one another in policy areas not directly covered by the Maastricht Treaty. So, if there is a race to the bottom, they fired the starting gun.

On a more tangential note, one can't help but note that France sticks out in the bottom graph as the only initially high protecting state that makes a large increase in employment protection.  Yet, France was the source of Olney's illustrative example in the second paragraph of his article. Olney's choice of Hoover's 1993 decision to move operations from France to Scotland is a reasonable one since it was a highly visible event and seems to be a smoking gun of "social dumping". However, looking at France's employment protections in comparison to all others, we see that France was going in the opposite direction of the trend both before and after the Hoover decision.  Therefore, the anecdote is somewhat more atypical than it first appears.

More broadly, one questions how generalizable Olney's result are, especially to cases of FDI in developing nations. By looking only at FDI and Employment protection in OECD nations (i.e., highly developed nations), there is very little variation in  factors other than labor rules, such as rule of law, business climate and workforce characteristics,  that are thought to affect the decision to invest in developing nations. As a result, Olney is looking at a dataset that is most prone to exhibit a race to the bottom, especially among the EU nations that make up the bulk of the nations in the sample. the results here strongly suggest that the EU is in a situation analogous to that of the United States, which Brandeis described as a Race to the Bottom. Whether the rest of the world is in such a position is still as doubtful as it was before.