SCHOOLS BRIEF One world? The growing integration of national economies is said to have changed the way the world works. But our first in a series of articles on globalisation shows that its extent can be exaggerated—and that it can be reversed FOR good or ill, globalisation has become the economic buzz-word of the 1990s. National economies are undoubtedly becoming steadily more integrated as cross-border flows of trade, investment and financial capital increase. Consumers are buying more foreign goods, a growing number of firms now operate across national borders, and savers are investing more than ever before in far-flung places. Whether all of this is for good or ill is a topic of heated debate. One, positive view is that globalisation is an unmixed blessing, with the potential to boost productivity and living standards everywhere. This is because a globally integrated economy can lead to a better division of labour between countries, allowing low-wage countries to specialise in labour-intensive tasks while high-wage countries use workers in more productive ways. It will allow firms to exploit bigger economies of scale. And with globalisation, capital can be shifted to whatever country offers the most productive investment opportunities, not trapped at home financing projects with poor returns. Critics of globalisation take a gloomier view. They predict that increased competition from low-wage developing countries will destroy jobs and push down wages in today’s rich economies. There will be a “race to the bottom” as countries reduce wages, taxes, welfare benefits and environmental controls to make themselves more “competitive”. Pressure to compete will erode the ability of governments to set their own economic policies. The critics also worry about the increased power of financial markets to cause economic havoc, as in the European currency crises of 1992 and 1993, Mexico in 1994-95 and South-East Asia in 1997. The aim of this series of schools briefs is to look in detail at these controversial arguments on each side of the globalisation debate. But it is necessary first of all to examine what precisely is meant by globalisation, how far it has proceeded, and whether the phenomenon is as new as it is generally held out to be. Some of the answers are surprising. Old news Despite much loose talk about the “new” global economy, today’s international economic integration is not unprecedented. The 50 years before the first world war saw large cross-border flows of goods, capital and people. That period of globalisation, like the present one, was driven by reductions in trade barriers and by sharp falls in transport costs, thanks to the development of railways and steamships. The present surge of globalisation is in a way a resumption of that previous trend. That earlier attempt at globalisation ended abruptly with the first world war, after which the world moved into a period of fierce trade protectionism and tight restrictions on capital movement. During the early 1930s, America sharply increased its tariffs, and other countries retaliated, making the Great Depression even greater. The volume of world trade fell sharply. International capital flows virtually dried up in the inter-war period as governments imposed capital controls to try to insulate their economies from the impact of a global slump. Capital controls were maintained after the second world war, as the victors decided to keep their exchange rates fixed—an arrangement known as the Bretton Woods system, after the American town in which it was approved. But the big economic powers also agreed that reducing trade barriers was vital to recovery. They set up the General Agreement on Tariffs and Trade (GATT), which organised a series of negotiations that gradually reduced import tariffs. GATT was replaced by the World Trade Organisation (WTO) in 1995. Trade flourished. In the early 1970s, the Bretton Woods system collapsed and currencies were allowed to “float” against one another at whatever rates the markets set. This signalled the rebirth of the global capital market. America and Germany quickly stopped trying to control the inflow and outflow of capital. Britain abolished capital controls in 1979 and Japan (mostly) in 1980. However, France and Italy did not abandon the last of their restrictions on cross-border investment until 1990. This is part of the reason why continental Europeans tend to worry more about the power of global capital markets: America has been exposed to them for much longer. Two forces have been driving these increased flows of goods and money. The first is technology. With the costs of communication and computing falling rapidly, the natural barriers of time and space that separate national markets have been falling too. The cost of a three-minute telephone call between New York and London has fallen from $300 (in 1996 dollars) in 1930 to $1 today. The cost of computer processing power has been falling by an average of 30% a year in real terms over the past couple of decades (see chart 1).

	The second driving force has been liberalisation. As a result of both the GATT negotiations and unilateral decisions, almost all countries have lowered barriers to foreign trade. Most countries have welcomed international capital as well. Although liberalisation has proceeded at different speeds in different places, the trend is worldwide. Only a handful of renegades still try to isolate themselves. Over the past decade, trade has increased twice as fast as output, foreign direct investment three times as fast and cross-border trade in shares ten times as fast (see chart 2). The trend towards globalisation is clear. But its extent can be exaggerated. Consider in turn the markets for products, capital and workers. One measure of the extent to which product markets are integrated is the ratio of trade to output. This has increased sharply in most countries since 1950. But by this measure Britain and France are only slightly more open to trade today than they were in 1913, while Japan is less open now than then (see chart 3). Another gauge of the degree of product-market integration is the extent to which prices converge across countries. In theory, free trade should push prices together as competition forces high-cost producers to lower their prices. Studies show, however, that large divergences in price often persist for long periods. Laptop computers and Levi’s jeans, for example, are consistently cheaper in America than in Europe or Japan. This reflects a variety of factors, including tastes, transport costs, differences in taxes and inefficient distribution networks. But some of the difference is due to the persistence of import barriers. Product markets are still nowhere near as integrated across borders as they are within nations. Consider the example of trade between the United States and Canada, one of the least restricted trading borders in the world. On average, trade between a Canadian province and an American state is 20 times smaller than domestic trade between two Canadian provinces, after adjusting for distance and income levels. For all the talk about a single market, the Canadian and American markets remain substantially segmented from one another. For other countries this is truer still. The financial markets are not yet truly integrated either. Despite the newfound popularity of international investing, capital markets were by some measures more integrated at the start of this century than they are now. During the 30 years before the first world war, when most currencies were tied to gold, huge sums flooded from Western Europe into North America, Argentina and Australia. The net outflow of capital from Britain (ie, its current-account surplus) averaged 5% of GDP over the period 1880-1913, reaching almost 10% of GDP at its peak. In comparison, Japan’s notoriously “excessive” current-account surplus has averaged only 2-3% of GDP over the past decade. Foreign direct investment, involving control of businesses or property across national borders, is no new phenomenon either. Today, it equals about 6% of the total domestic investment of rich economies. In the decade before 1914, by contrast, direct investments of British capitalists abroad were almost as big as their direct investments at home. Chart 4 shows that European countries’ stocks of outward direct investment are much smaller in relation to their GDPs than in 1914. Home work While product and capital markets have become increasingly integrated, labour markets have not. Tens of millions of people currently work outside their home countries. Yet labour is less mobile than it was in the second half of the 19th century, when some 60m people left Europe for the New World. Even within the European Union, which gives citizens of any member state the right to work and live in any other, only a small proportion of workers ventures across national borders. Language, cultural barriers, and incompatible educational and professional qualifications all combine to keep labour markets national. This does not mean that globalisation is just a myth. In some new and different ways the world economy is becoming more internationally integrated than it was at the turn of the century. For one thing, large parts of the world did not participate in the pre-1914 global economy. Today, more economies than ever before have opened their borders to trade and investment. Not only developed countries, but developing countries in Asia and Latin America have embraced market-friendly reforms. A second difference is that whereas 19th-century global-isation was driven by falling transport costs, it is now being driven by plunging communication costs. This has created new ways to organise firms at a global level, with closer international integration than in the past. Cheap and efficient communication networks allow firms to locate different parts of their production process in different countries while remaining in close contact. Modern information technology also reduces the need for physical contact between producers and consumers and therefore allows some previously untradable services to be traded. Any activity that can be conducted on a screen or over the telephone, from writing software to selling airline tickets, can be carried out anywhere in world, linked to head office by satellite and computer. Even medical advice or education can now be sold at a distance over telecoms networks. A third difference is that although net flows of global capital may be smaller than in the past, gross international financial flows are much bigger. For example, daily foreign-exchange turnover has increased from $15 billion in 1973 to $1.2 trillion in 1995. Cross-border sales and purchases of bonds and equities by American investors have risen from the equivalent of 9% of GDP in 1980 to 164% in 1996. As yet, the world economy is still far from being genuinely integrated. In future, however, new technology is likely to encourage further integration. The Internet and its companion technologies, for example, are expected to help to make markets more transparent, allowing buyers and sellers to compare prices in different countries. Telecommunication prices will fall even more sharply over the next decade. So technology will continue to power the globalisation train. This poses a challenge for governments. By allowing more efficient use of world resources, globalisation should boost average incomes. However, the costs and the benefits will be unevenly distributed. Many people—notably unskilled manufacturing workers in rich economies—will find the demand for their labour falling as the jobs they used to do are performed more cheaply abroad. This raises the risk of a political backlash against free trade and capital flows. Could the trend towards globalisation be reversed a second time? Doing so might be more difficult than before. New technology and new types of financial instruments make it tricky for governments to impose effective capital controls. Likewise, the growth of multinational firms that can switch production from one country to another would make it harder to erect effective trade barriers. New technology also creates distribution channels that protectionist governments will find it hard to block. A French government that wanted to shelter its film industry from American competition by restricting imports may find it impossible to stop foreign films being beamed by satellite or passed over the Internet. Foreign films will be able to squeeze through electronic windows that cannot be closed. Another reason to suppose that globalisation is more durable this time around is that free trade is built upon firmer institutional foundations than earlier in this century. At that time, free trade proceeded largely through bilateral treaties rather than multilateral institutions such as the WTO. Withdrawal from the WTO would not be done lightly. Nonetheless, past experience shows how quickly faith in markets and openness can be overwhelmed by big economic shocks, such as the Great Depression of the 1930s. Faced with another severe downturn, some governments may still be foolish enough to try to use protectionism and capital controls to shield workers and firms from global forces. That would also shield economies from powerful sources of growth.