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Quantifying the Gains from Increased Global Integration

by Pankaj Ghemawat 5. March 2012 23:42

In a previous post, I presented evidence that the world is far less globalized than most people believe, which implies there is also much more headroom to expand globalization than many think. Whether we should favor a more globalized world or not, of course, is an entirely different question, requiring an honest weighing of the pros and cons. And with the Eurozone still at risk, tough talk on U.S.-China trade, and periodic threats of “trade wars” (the latest stemming from the EU’s carbon taxes), such an assessment could hardly be more timely.

In this post, I take up the pro side of the argument, laying out a rough quantification of the potential benefits of increasing integration. Ironically, because most pro-globalizers buy into the globaloney of a world that is already or soon will be perfectly integrated, they seldom bother to articulate their case in a systematic way. So, much of this will be news even to those who favor more globalization.

Start with the gains from expanding merchandise trade. The traditional economic models developed for assessing trade agreements provide estimates of how much global output would expand if tariffs and some kinds of non-tariff barriers to trade are reduced or removed. The gains such models estimate — about 0.1% of world GDP for the stalled Doha round of trade negotiations and roughly 0.5% for complete liberalization of merchandise trade — aren’t very inspiring, but they actually leave out far more than they include.

Traditional models exclude many powerful policy tools for expanding trade. One such tool alone, trade facilitation, could grow global GDP by 1%. And in calculating the benefits of additional trade, these kinds of models focus almost exclusively on growth generated by reductions in production costs as each country’s output becomes more specialized, a limited fraction of the potential gains.

To broaden the range of benefits covered, I use a modified version of the ADDING Value Scorecard, which I originally developed to help businesses evaluate international strategies. ADDING is an acronym for the following sources of value: Adding Volume, Decreasing Costs, Differentiating, Intensifying Competition, Normalizing Risk, and Generating and Diffusing Knowledge.
Because traditional models assume full employment (especially problematic in times like these) and leave out scale economies, they capture only part of the gains in the first two categories, Adding Volume and Decreasing Costs. And they leave out the last four categories entirely, whose benefits can be seen clearly, for example, in the U.S. automobile industry. Japanese entrants decades ago offered consumers differentiated (more reliable) products. Increased competition prompted U.S. automakers to improve their own quality. Now, GM sells more cars in China than in the U.S., diversifying its risks and helping it recover from the crisis. And cars are becoming “greener” faster because of international knowledge flows.

Taking this broader set of factors into account, I put the gains from expanding merchandise trade at 2-3% of world GDP or more.

Next, consider services trade. The service sector is roughly two-thirds of world GDP but only one-fifth of international trade. Barriers to services trade are more complex and some services (like haircuts) will always be delivered locally, but potential gains from opening up services trade are at least 1.5% of global GDP, putting total gains from trade liberalization at 4% of global GDP or more.

Then, look at potential gains from flows other than trade, such as people, capital, and information. Completely eliminating restrictions on migration could double global GDP, but that’s obviously not in the cards. More realistic limited increases in non-trade flows could expand GDP at least 4%, bringing the economic gains to 8% or more. And complementarities among the different types of flows push this estimate up even farther.

Finally, and more subjectively, consider non-economic benefits. Culturally, globalization expands the range of choices available to individuals wherever they live even as it blurs somewhat the distinctions at national borders. Politically, cross-border flows (especially information flows) tend to strengthen democracy. And trade ties also seem to improve national security. The parts of the world that are isolated economically experience far more military intervention by outsiders.


To summarize (see chart), the benefits of expanding merchandise trade are much larger than traditional models indicate, and to those one needs to add gains from services trade to have a complete picture of the benefits of increased trade flows. Then, on top of trade, other kinds of cross-border flows double the estimated economic benefits to at least 8% of global GDP. And beyond that there are complementarities and non-economic benefits that I find compelling but are harder to quantify in GDP terms.

I’m sure many readers by now are champing at the bit to raise offsetting concerns about globalization’s negative effects. I promise to address those in another post. But for now, what do you think of the potential upside from expanding globalization? Which benefits of globalization do you find most compelling?


ADDING Value | Globalization | Merchandise Trade | Services Trade

Financial Fears, Flows, and Globalization

by Pankaj Ghemawat 1. September 2011 15:19

As readers of this blog already know, markets are far less integrated internationally than popular views of globalization presume. So many of you are probably wondering why a game of chicken initiated in the U.S. Congress could wreak havoc as far away as Asia, or how problems in the Eurozone might cloud U.S. prospects. And of course, you want to know what is to be done.

Our current problems stem, in part, from the special characteristics of finance, which as Keynes noted, is highly dependent on sentiment and, as Hyman Minsky emphasized, therefore particularly susceptible to crises. Their conclusions are corroborated not just by empirical experience but by experimental research on asset markets by Nobel Laureate Vernon Smith, among others.

Such problems are amplified in a cross-border context by decay of trust across borders and with distance described in my previous post, and exemplified by the data on Western Europeans trusting their own fellow citizens more than twice as much as citizens of other Western European countries and nearly four times as much as citizens of countries outside Western Europe. Also recall that sympathy and, one would presume, solidarity in matters such as bailouts are much more distance-sensitive. Furthermore, fear leaps borders faster than confidence. All this suggests a particular fragility of confidence in and commitment to foreign financial assets when the times get tough.

Smarter Financial Integration

The importance of dispelling the globaloney that capital respects no boundaries is the obvious first implication of the contrast between real flows and irrational fears. If investors recognize the limited real connections between economies, they should be less prone to panic at distant signs of distress.

It is also clear, or at least clearer than just a few years ago, that policymakers should favor FDI and, more generally, equity investment over other types of capital flows, because FDI is less prone to be withdrawn when an economy is in trouble, and investment in building or upgrading real productive capacity is particularly suited to spurring much-needed growth. Conversely, short-term international borrowing, especially in foreign currencies, should be treated with caution.

More controversially, international capital imbalances such as persistent current account surpluses and deficits need to be curbed as well. Before the crisis, many authors advanced frameworks in which international capital imbalances were supposed to be a "win-win" phenomenon. And indeed, it is hard to see how capital imbalances could be a problem in a world with perfect international integration of capital markets. One would simply expect ebbs and flows, whether balanced or not, to lead to the outcome mistakenly asserted 150 years ago by David Livingstone: "capital, like water, tends to a common level." Incomplete international integration of capital markets — the reality of what I call World 3.0 — is what opens up the possibility of problematic international capital imbalances.

This problem is worth stressing because imbalances may be moving back into a danger zone. For capital flows, the historical data suggest that policymakers should start paying attention when the absolute values of capital accounts add up to 3% of GDP and start getting worried when they exceed 4%. For the twelve countries with historical data reaching back to 1870, this quantity decreased from a very worryingly high 5% of GDP in 2008 to 3% in 2009, but then edged back into the danger zone by rising to 3.5% in 2010. And for a broader sample of more than 180 countries, it dropped from 5.5% in 2008 to 3.9% in 2009, before rising to 4.2% in 2010 with further increases forecast.

The need to manage international capital imbalances doesn't imply, however, that all one can or should do is blame foreigners for our present predicament. Rather, domestic problems are often at the root of international imbalances. As Lorenzo Bini Smaghi put it back when the global financial crisis first erupted three years ago, "[E]xternal imbalances are often a reflection...of internal imbalances." This does not seem to be a bad characterization of the current problems in the United States and in the Eurozone.

To summarize, the good news associated with taking World 3.0's limited levels of integration seriously is twofold. First, fear is more contagious than actual links justify. And second, contrary to common assertions, many of the problems that we face can be dealt with nationally or regionally instead of requiring global solutions. (Nothing wrong with the latter — it's just that they are very hard to achieve). The bad news is related to the recent record of politicians in the U.S. and in the Eurozone in dealing with their respective "debtacle," which does not inspire much confidence that they will manage to handle problems that still are, in principle, manageable.


Finance | Globalization

Globalization in the World We Live in Now: World 3.0

by Pankaj Ghemawat 31. May 2011 15:08

So far, 2011 has been a remarkable year. With events like those that have changed the power dynamics throughout the Arab world, or the tsunami in Japan that disrupted many global supply chains, it's easy to think that the world is becoming ever more connected and interdependent.

So this year, as in years past, to get a sense of how people are thinking about globalization, I begin many of my speaking engagements with a brief test, a simple multiple-choice question:


Did you pick the third quote? If so, you're in good company. Among the several dozen audiences to which I have administered this test over the years, that third quote, which suggests that the we live in one, integrated world — what I call World 2.0 — is the one that garners the most support, usually a majority. Spouting such attitudes — the flattening of the world, the death of distance, and the disappearance of differences across countries — seems to be considered a hallmark of global thinking.

But I prefer to think of it as globaloney.

Why? Because economic data simply don't support the view that we live in a flat, connected world, even if we are technologically connected with everyone, everywhere, all of the time. Data show that most types of economic activity that could be carried out across national borders are actually still concentrated domestically. For example, take foreign investment. Of all the capital being invested around the world, how much would you think is foreign direct investment by companies outside of their home countries? 25%, maybe? More, if you've heard the globaloney about "investment knowing no boundaries"? The fact is, the ratio was less than 9% in 2009 and, while it may be pushed higher by merger waves, has never reached 20%.

As the chart below demonstrates, the actual levels of globalization associated with telephone calls, long-term migration, university enrollment, stock investment, and trade as a fraction of gross domestic product (GDP) — look at the blue bars — resemble the data presented above: they fall much closer to 10% than the levels close to 100% that one would expect if one took the gurus of globaloney at their word.

Most people aren't, of course, quite that credulous. But globaloney does seem to have influenced their perceptions. Thus, 400 respondents to a (pre-crisis) poll about globalization levels on came up with the responses summarized in green in the chart below. Note the systematic tendency to overestimate globalization levels, and by a wide margin: the responses (the green bars) averaged 30% versus real values (the blue bars) that averaged 10%. And to aggravate matters, respondents with more than 10 years' experience actually are farther off the mark than ones with less experience!

Even though there are many skeptics, as I was recently reminded when the Economist presented some of these data in its Schumpeter column, stirring a lot of skeptical commentary online, the fact is that the world is far from being completely integrated and that the rhetoric of globaloney is far removed from reality.

Why are smart people so susceptible to globaloney? One reason is that we tend to believe whatever we most desire or fear. For businesspeople, there is the big draw of unbounded profits in a borderless world. And for many others, there are deep seated fears that globalization might be exploitative, harmful to our cherished cultures, dangerous for the natural environment, and so on. In reality, both of these perspectives are misguided. Increasing cross-border integration offers the potential for huge economic and other gains, but not through the development of stateless corporations that sell the same things to everyone, everywhere. And most of the prevalent fears about globalization are also overblown, or otherwise amenable to mitigation.

If you were as surprised by these data as some of the folks in my audiences this year so far, what do you make of it? Are you, too, susceptible to globaloney?

Pankaj Ghemawat is the Anselmo Rubiralta Professor of Global Strategy at IESE Business School in Barcelona, and the author of World 3.0: Global Prosperity and How to Achieve it (HBR Press, 2011).


Globalization | World 3.0

Stretching Your Global Mindset

by Pankaj Ghemawat 28. April 2011 12:55

How well do you really understand the world beyond your own country's borders? Do you value all human beings equally or are you more sympathetic toward people who are closer and more similar to you? What does it matter for business and for society?

Several readers of my previous post have commented that mindsets or perceptions about globalization can be at least as important as actual levels of globalization. I agree. Mindsets matter. They have big real world consequences, particularly as is the case now with Europe's debt crises and bailouts, when collective prosperity depends on the extension — as opposed to contraction — of cooperation, trust, and sympathy across borders and distances.

Consider the following data on trust levels based on surveys conducted in various Western European countries. As the graph below shows, more than twice as many Western Europeans trust their own fellow citizens "a lot" as compared to citizens of other Western European countries (48% vs. 20%). And only 13% place the same level of trust in citizens of countries outside of Western Europe.

Ghemawat Fig 11-3.png

More systematic research shows that bilateral trust decreases with geographic, linguistic, religious, genetic, and somatic distance (measured by an index of body type differences) as well as with income differences and a history of wars — findings that hit on all four dimensions of my CAGE framework (Cultural, Administrative, Geographic, and Economic), with particular focus on the cultural dimension. And levels of trust influence more than just whom you're inclined to lend to, to bail out in a crisis. Moving from lower to higher levels of bilateral trust has been shown to increase trade, direct investment, portfolio investment, and venture capital investment by 100% or more, even after controlling for other characteristics of a pair of countries.

It's easy to say you trust foreign people on a survey, but what about actually doing something that reflects how much you care about distant and different people? Data on foreign news coverage and foreign aid provide some indication of how much human sympathy declines with distance. As it turns out, trust is relatively insensitive to distance in comparison to sympathy.

Ghemawat Fig 15-2.png

First, some disturbing data about news coverage, which given the importance of ratings probably provide a reasonable reflection of what the general public cares about. A study of more than 5,000 natural disasters suggests that from the standpoint of U.S. media coverage, each dead European is "worth" three South Americans, 43 Asians, 45 Africans, or 91 Pacific Islanders. To summarize in rough terms, as shown on the graph above, news coverage indicates we care about people in neighboring countries about 10% as much as we care about our own fellow citizens, and this figure declines to 1% as you move to countries farther from home.

Then, consider actual willingness to help distant people in need. Compare aid to the domestic poor versus official development assistance (ODA) to the rest of the world's poor, using the approach outlined by Branko Milanovic. Based on weighted per-person averages for fourteen developed OECD economies, national governments spend 30,000 times as much helping each domestic poor person as each poor foreigner. Or put differently, when it comes to aid, the foreign poor are valued at 0.003 percent (1/30,000th) as much as the domestic poor. And if you're wondering where this would stand if the rich countries all gave 0.7% of their GDP in foreign aid, as they promised to do in 1992 at Rio de Janeiro, that would only mean the foreign poor would receive 1/15,000th as much as the domestic poor. Hardly a promise to value every human being equally.

A host of business and social problems could be solved more easily if people broaden their mindsets and shift their own personal sympathy decay curves a little closer to horizontal. In business, imagine how much better multinational corporations could function if there was more trust between headquarters and far flung country operations. In the social sphere, an interesting study by David Anthof and Richard Tol relates carbon prices to levels of sympathy, showing that it would be far easier to address climate change if we placed more weight on the harms inflicted on others.

What do your own trust and sympathy decay curves look like? What curves are embodied in the values of your organization and its workforce?

Please click the button below and answer the survey questions. In a future post, I'll report back the results.

Or try out the full Global Attitude Protocol (GAP) from which these questions were drawn. For more suggestions on how to change individual mindsets, see the last chapter of my new book World 3.0: Global Prosperity and How to Achieve It, and for ideas for corporations on how to foster this mindset shift within their organizations, refer to my most recent HBR article, The Cosmopolitan Corporation.


Globalization | trust


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