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ISBN: 978-1-63157-614-0

International Economics Understanding the Forces of Globalization for Managers, Second Edition

Paul Torelli

Today’s news media displays an intense fascination with the global economy—and for good reason. The degree of worldwide economic integration is unprecedented. Rising globalization has lifted living standards and reduced poverty, while foreign markets and new technologies continue to present opportunities for entrepreneurs and corporations. Still, economic shocks can spread across the world in minutes, impacting billions of lives. The political framework supporting globalization is now under scrutiny, and recent elections suggest economic policies may be readjusted in the coming years.

This book will help you learn about economics in everyday language, using little or no math, giving you better tools to interpret current events as well as long-term economic and political developments. Modern economics offers a powerful framework for understanding globalization, international trade, and economic growth. You may possess years of hands-on experience dealing with business cycles and foreign competitive pressures, but lack a solid grounding in economic concepts that shed light on the forces of globalization. This book is here to help.

Dr. Paul Torelli is chief economist at Quantitative Social Science, an economic consultancy based in Seattle, Washington. He has worked with leading law firms, corporations, and political organizations, providing economic insights and expert testimony. Dr. Torelli earned a PhD and MA in economics from Harvard University and a BA in economics and mathematics from the University of California at Berkeley.

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International Economics Understanding the Forces of Globalization for Managers Second Edition

Paul Torelli

International Economics

International Economics

Understanding the Forces of Globalization for Managers

Second Edition

Paul Torelli

International Economics: Understanding the Forces of Globalization for Managers, Second Edition

Copyright © Business Expert Press, LLC, 2017.

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First published in 2013 by

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Printed in the United States of America.

To my teachers

Abstract

Today’s news media displays an intense fascination with the global

economy—and for good reason. The degree of worldwide economic

integration is unprecedented, and rising globalization has lifted living

standards and reduced poverty. Foreign markets and new technologies

continue to present opportunities for entrepreneurs and corporations.

Still, economic shocks can spread across the world in minutes, impact-

ing billions of lives. Citizens are understandably anxious in this age of

macroeconomic turbulence and overextended governments.

Modern economics offers a powerful framework for understanding

globalization, international trade, and economic growth. Many man-

agers possess years of hands-on experience dealing with business cycles

and foreign competitive pressures, yet these leaders may not have a solid

grounding in economic concepts that shed light on the forces of globali-

zation. This book explains economics in everyday language, using little

or no math, giving businesspersons better tools to interpret current events

as well as long-term economic and political developments.

Keywords

economics, human capital, financial crisis, macroeconomics, comparative

advantage, absolute advantage, emerging economy, international trade,

business strategy, economic growth, economic history, international eco-

nomics, political economy, economic development, industrialization, labor

market, convergence, New World, mercantilism, Industrial Revolution,

productivity, technology, capital control, intellectual property, research and

development, productivity slowdown, Adam Smith, factor proportions

model, gravity model, infant industry, import substitution, Asian Tiger,

trade policy, tariff, public choice, rent seeking, trade agreement, free trade,

liberalization, information and communications technology, vertical inte-

gration, supply chain, poverty trap, big push, coordination failure, indus-

trial policy, diversification, value added, managerial capital, skill biased

technological change, population growth, wage inequality, middle income

trap, tradable sector, offshoring, outsourcing, foreign direct investment,

skill upgrading, immigration, wage structure, regulation, competitiveness,

corruption, democracy, autocracy, socialism, communism, controlled capi-

talism, gold standard, natural resource curse, business cycle, collective bar-

gaining, social insurance, safety net, labor union, Washington Consensus,

multinational enterprise, exchange rate, sweatshop, spillover, human rights,

labor standard, property rights, Dutch disease, extractive industry, negative

externality, pollution haven, greenhouse gas, global warming, climate

change

viii ABSTRACT

Contents

Preface ..................................................................................................xi

Chapter 1 A Brief History of Modern Economic Globalization .........1

Chapter 2 Economic Growth, Convergence, and Trade...................41

Chapter 3 Theories of International Trade.......................................67

Chapter 4 Industrialization, Globalization, and Labor Markets ........97

Chapter 5 Politics, Globalization, and the State .............................129

Chapter 6 Poverty, Progress, and Critics of Globalization ..............157

Epilogue .............................................................................................189 Postscript............................................................................................199 Index .................................................................................................203

Preface

Now that world wide communications have been established thanks to the authority of the Roman Empire … living standards have improved by the interchange of goods and by partnership in the joy of peace and by the general availability of things previously concealed.

—Gaius Plinius Secundus (Pliny the Elder),

Natural History, 77 AD

“Globalization” is the increasing economic interdependence of all

regions of the world. Made possible through improvements in transpor-

tation and communications, globalization’s driving force is the interna-

tional movement of goods, people, capital, technology, culture, and

ideas. Although silks and spices were traded between Asia and Europe at

least as far back as Greco-Roman times, the process of intercontinental

assimilation wasn’t truly global until the 16th century, when the

Americas became part of world trade and migration routes, uniting both

hemispheres. Several centuries later, the “Industrial Revolution” opened

up new production possibilities and wrought tremendous efficiencies,

overturning the old “snail’s pace” rate of economic growth that had

previously ruled the civilized world. Globalization has played a central

role in facilitating growth, consumption, and higher standards of living,

above all when a major hegemon—such as the Roman or British Empire—

has been in place to combat piracy and provide law and order. Historians

commonly think of the “modern” Western world beginning around

1500, and this book begins with the follow-up to that date. World trade

has grown mightily since then despite wars and depressions periodically

slowing its expansion. The most recent “deglobalization” occurred during

the period from World War I to World War II, when, after a prolonged

period of peace and integration, cracks in the international economic

order fissured, and tribalism and warfare reemerged. Today the degree of

global economic connectivity is unprecedented, even greater than the pre-

vious watershed era prior to World War I.

To some extent, globalization reflects the progress of civilization and

mankind. Whereas isolation breeds stagnation, cross-cultural contact

brings new influences and technologies, which then vie against the old.

And trade—whether short- or long-distance—yields mutual gains, a fact

that has been understood and exploited since prehistoric times. It is

revealing that the ancient city-state of Athens traded abroad vigorously

and boasted a rich culture, whereas Sparta, its more introverted rival on

the Greek peninsula, did not. Market economies in ancient Greece and

Rome exchanged goods throughout vast regions of Asia and Africa. Far

larger than the territories of any Greek city-state (or even the Macedonian

Empire under Alexander the Great), the Roman Empire was partially

funded by trade and tribute over an immense land network of roads.

Its seagoing commercial ships carried Egyptian grain, Spanish copper,

Greek wine, and Asian silks. Roman traders may have reached China

by sea in the 2nd century AD, and at its peak around this time, the

Roman Empire stretched across all sides of the Mediterranean Sea and

most of Western Europe, ruling approximately 75 million people, with

at least a million living in its capital city of Rome. Roman culture

assimilated Greek ideas about philosophy, politics, art, science, and

architecture, and then modified or sometimes improved upon them.

The exceptional Roman capacity for administration—unmatched in the

West until the British Empire more than a millennium later—provided

order in an extremely violent ancient world, stimulating economic and

cultural development.

Nevertheless, even the greatest and wealthiest civilizations may col-

lapse. Toward its end, the Roman Empire had been weakening for

more than a century, with ineffective governance and a disintegrating

society. Rival generals vied for power and often required bribes to stave

off coups. The Roman government had trouble raising funds and ulti-

mately resorted to devaluing the currency, which caused a destructive

hyperinflation. Wishing to evade the state’s grasping hands, urban citi-

zens and businesses fled to the countryside, helping to pave the way for

feudalism. By the 3rd century AD, the Roman military began to suffer

embarrassing defeats by Germanic forces—part of a rural society the

Romans considered hopelessly barbaric—to the north and Persian

armies to the east. The external threats worsened in the late-4th

xii PREFACE

century, and in 410, Rome was famously sacked by an army of

Germanic barbarians known as the Visigoths. The Empire continued to

crumble in the 5th century as a number of Germanic tribes conquered

Roman territories. The final act that has traditionally marked the end of

the Western Roman Empire occurred in 476 when a Germanic chief-

tain, Flavius Odoacer, removed the last emperor, a teenager named

Romulus Augustus, from power. (The Eastern Roman Empire, later

known as the Byzantine Empire, survived until the 1453 conquest of

Constantinople by Ottoman Turks.) For centuries afterward, during the

period of conflict, disorder, and migration in Europe commonly known

as the “Dark Ages,” Middle Eastern merchants came to dominate trade

routes along the crossroads region linking the Asian and European econ-

omies. Knowledge of many key technologies disappeared, and there

were relatively few cultural achievements coming out of the West.

Written by an American economist, this book focuses on the experi-

ence of the West, albeit without ignoring the East. Based on the most

recent academic research, it provides a brief readable introduction to the

economic forces of globalization for an audience of modern managers

and executives who may have little or no background in formal eco-

nomics. By presenting key economic concepts that have withstood the

test of time, this book offers valuable insights to business practitioners

grappling with the effects of globalization, new technology, and interna-

tional trade on their organization and work force. It is conscious of the

present economic climate which follows several decades of rapid globali-

zation, and its content can provide structure for an undergraduate or

graduate course in business. Each chapter may engender classroom or

workplace discussions, given the inherent complexity of the subject mat-

ter. Although this book is not meant to be historically exhaustive by any

means, it endeavors to spark an interest in world economic history

among readers. It can be supplemented with current materials from news-

papers such as the Wall Street Journal, New York Times, and Financial Times, as well as insightful magazines such as the Economist. Relevant case studies from the Harvard Business School Press (which can be found

online) are presented at the end of each chapter.

Economists commonly concentrate on international trade integra-

tion as the primary feature of globalization, as it is relatively easy to

PREFACE xiii

measure and analyze. This book is no exception: it emphasizes the

effects of international trade as opposed to global financial liberalization

and integration. Theoretical discussions of monetary issues—such as

exchange rates, balance of payments, and optimal currency unions—are

generally ignored. This is partly because financial and monetary theories

remain controversial among economists, but more importantly—and in

line with how economics is actually taught in universities today—this book

reflects the philosophy that it is better to learn the fundamental structural

factors driving economic events first, because complex financial and mone-

tary factors can be studied later. Monetary theories of business cycle fluc-

tuations and financial crises are traditionally based on behavioral theories

of how money, credit, prices, and output interact. Interested readers are

referred to the works of John Maynard Keynes, Charles Kindleberger, and

Barry Eichengreen, among others, some of which are mentioned in

“Further Reading” sections at the end of each chapter.

Further Reading

Amemiya, T. (2007). Economy and economies of Ancient Greece. New York, NY: Routledge.

Beckwith, C. (2009). Empires of the silk road: A history of Central Eurasia from the Bronze Age to the present. Princeton, NJ: Princeton University Press.

Bernstein, W. (2004). The birth of plenty: How the prosperity of the modern world was created. New York, NY: McGraw-Hill.

Bordo, M., Taylor, A., & Williamson, J. (2005). Globalization in historical per- spective. Chicago, IL: University of Chicago Press.

Braudel, F. (1995). A history of civilizations. New York, NY: Penguin. Davies, N. (2011). Vanished kingdoms: The rise and fall of states and nations.

New York, NY: Viking. Goldsworthy, A. (2009). How Rome fell: Death of a superpower. New Haven,

CT: Yale University Press. Hansen, V. (2012). The Silk Road: A new history. Oxford, England: Oxford

University Press. Jennings, J. (2014). Globalizations and the ancient world. Cambridge, England:

Cambridge University Press. Maddison, A. (2007). Contours of the world economy 1-2030 AD: Essays in

macro-economic history. Oxford, England: Oxford University Press.

xiv PREFACE

North, D. (2010). Understanding the process of economic change. Princeton, NJ: Princeton University Press.

Richard, C. (2010). Why we’re all Romans: The Roman contribution to the west- ern world. Lanham, MD: Rowman & Littlefield.

Stearns, P. (2009). Globalization in history. New York, NY: Routledge. Temin, P. (2012). The Roman market economy. Princeton, NJ: Princeton Uni-

versity Press.

PREFACE xv

CHAPTER 1

A Brief History of Modern Economic Globalization

Introduction

The urge to exchange goods and services is a fundamental characteristic of

any economy, and human beings have traded across far-flung locales for

millennia. Archaeologists point to Mesopotamia, in modern day Iraq, as

the place where Western civilization began. The ancient Sumerians of

Mesopotamia were inveterate traders with a culture that featured writing,

mathematics, laws, and cities. Over the subsequent centuries, trade net-

works and economic integration grew to cover ever-greater regions of the

Eurasian landmass, depending on the stability and reach of existing polit-

ical regimes. The 4,000-mile “Silk Road,” a network of overland trade

routes connecting China to the Mediterranean, transferred goods and

spread ideas between the East and the West. Many scholars believe these

exchanges constitute the nascent beginnings of intercontinental economic

globalization within the “Old World.”

The rise of the Mongol Empire under Genghis Khan in the early-13th

century—several centuries before the discovery of the “New World”—led

to the “Pax Mongolica” (or Mongol Peace). The Mongol conquests unified

Central Eurasia, promoting overland trade all the way from Western

Europe to East Asia. According to some contemporary accounts of this era,

the Silk Road was safe for travel and business. Under the Pax Mongolica,

Europeans such as the Venetian merchant Marco Polo came to China

for Asian silks and spices. Chinese silks sold in Italy for no less than three

times their purchase price in China, and the markets of Constantinople

contained all the wares of Asia. Because information flowed east to west

and vice-versa, Europeans took advantage of many Chinese inventions

and scientific concepts. Meanwhile, the Mongols—who lacked culture

and craft but possessed a taste for fine textiles and other riches—forcibly

transplanted European artisans and Middle Eastern weavers back to Asia.

The Mongol Empire provided a conduit not only for trade but also for

disease. In the mid-14th century, the Silk Road trade route aided the trans-

mission of the plague from China to Europe. Economic integration

declined, and the Mongols, possessing more skill in conquest than in gov-

ernance, lost their grip on power shortly thereafter. As Europe’s population

recovered, feudalism gave way to nation-states, and seafaring adventurers

discovered the New World, sparking an unprecedented globalization

boom. Since then, the volume of world trade and degree of global eco-

nomic integration has trended upward at an increasing pace. Few today

believe that international economic integration will be reversed, although

the period from World War I to World War II was the great exception,

proving that disintegration is possible, and that taking part in globalization

is a choice that nations face, not an imperative.

Mercantilist World View

Modern economists trace their field’s origins back to Adam Smith’s

1776 Wealth of Nations. This treatise examined trade’s role in facilitating specialization and the division of labor, thereby increasing productivity

and promoting prosperity. Its content was in opposition to the popular

mercantilist beliefs that reached their apogee in the 17th century. Mercan-

tilism of that era was a nationalistic doctrine promoted by a diffuse group

of pamphleteers who advocated for specific interests and industries. Mer-

cantilist writers were usually appreciative of international trade—just not

unfettered free trade. In the 16th century, mercantilist pamphlets from

England were the first writings that treated economic concerns as worthy

of separate study, as opposed to remaining part of legal or moral concerns.

For instance, one influential English thinker of this period, Sir Thomas

Smith, emphasized the value of manufacturing raw materials at home and

having a favorable “balance of trade,” meaning that exports ought to be

greater than imports.

Compared to later economic analysts such as Adam Smith, mercanti-

lists did not focus on increased productive efficiency within or across

nations. Instead, they concentrated on the importance of amassing factor

2 INTERNATIONAL ECONOMICS

inputs, such as land, labor, and raw materials, including bullion. Mercan-

tilist principles prized national gold and silver holdings, made possible

through heavy exporting with a minimum of importing. Because foreign

colonies could supply raw resources and gold or silver bullion, mercanti-

lists advocated a strong military with colonialist ambitions. Materials could

be transported to the home nation and made into finished products for

export. The militant mercantilist outlook was responsible for many tariffs

and legal restrictions hindering international trade. It also required a

robust navy to aid in navigation, enforce maritime laws, and deal with

trade-related conflict.

Mercantilists emphasized the zero-sum aspect of economic develop-

ment and trade. Viewing the gains from trade as fixed, they intended their

own nation to capture the greater portion of them. In England and other

parts of Europe at this time, imports were normally luxury consumption

goods such as silk. Mercantilist writings regularly advocated for tariffs on

these opulent imports because their purchase did not stimulate domestic

production or increase national wealth. Yet mercantilists were in favor

of importing raw materials to stimulate manufacturing. They desired

high value-added processes such as manufacturing to be performed on

domestic—not foreign—soil. Mercantilists advocated little to no restric-

tions on exports, and a few even called for export subsidies. They

believed that higher exports stimulated domestic economic develop-

ment, manufacturing capacity, and labor demand.

Often merchants themselves, mercantilist writers were altogether

favorable toward trade and commerce, viewing state oversight as necessary

to ensure trade enriched the nation, and not just tradespersons. On the

other hand, specific mercantilist policies regularly benefitted narrow inter-

ests, such as the business owners within one domestic industry who were

all too happy to block foreign competitors through high tariffs and other

import restrictions. Although the influence of mercantilism has sharply

declined over the past three centuries, mercantilist style policies exist in

some nations today. China has been described as “neo-mercantilist”

because of its strategic protectionism, forgoing of luxury spending to save

and invest, amassing of foreign reserves, and, in lieu of military conquest,

import of raw materials for manufacturing and investment, all under

strong state administration. Other East Asian nations that have developed

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 3

successfully (such as Japan and South Korea) expanded their export-

oriented production capabilities in a manner broadly consistent with mer-

cantilist principles.

Historical Background

The backdrop to mercantilism was an enormous drop in population due to

the “Black Death,” a plague caused by the Yersinia pestis bacterium. The most common form was bubonic plague, which infected the lymphatic

system and caused swellings and discolorations, killing most victims within

a week’s time. Researchers have theorized that other types of the plague

were present, including pneumonic (which infects the respiratory system),

septicemic (which infects the blood stream), and enteric (which infects the

digestive system). Following three centuries of strong population growth

and expansion across arable lands, the Black Death of 1347 to 1353 swept

through Europe and killed at least 25 million people from a population of

80 million. The Black Death ravaged the Middle East and Far East, too.

Accounts of Egypt from that time describe depopulated towns, and

between 1330 and 1420, the population of China fell from 72 million to

50 million. The plague then recurred for centuries in waves of decreasing

intensity. Two of the last known major outbreaks in Europe were the

Great Plague of London, which commenced in 1665, and the Great

Plague of Marseille, which struck in 1720.

Unlike other disasters, the Black Death killed people but left

property intact, meaning the remaining population had dramatically more

resources to exploit. As a consequence, the Black Death brought about a

huge drop in overall economic production with a simultaneous increase in

per capita income and wealth. Because of the scarcity of labor, real wages increased—doubling in England over the next century—and peasant

revolts became more common in Western Europe. Land was now abun-

dant, so rents fell. With elevated incomes, there was an explosion in luxury

goods such as high-quality wool textiles. Given the abundance of land

relative to labor, land-intensive agricultural production such as sheep- and

cattle-rearing experienced a boom as well. New “laborsaving” technologies,

such as the printing press and firearms, may have been spurred by the

relative scarcity of labor following the Black Death. After the plague,

4 INTERNATIONAL ECONOMICS

population growth favored cities, where there was more capital to comple-

ment workers. In Europe, it would take around 200 years for the popu-

lation to return to pre-plague levels.

This period also saw the onset of the transition from feudalism to the

nation-state in Europe. Despite its tendency toward disorder and conflict,

feudalism was the dominant social structure of the later “Middle Ages”

from the death of Charlemagne in the 9th century to the early Renaissance

of the 15th century. In decentralized feudal economies, local lords retained

administrative and judicial power over dependents who worked the land

and paid homage by contributing taxes and performing military service.

By rebalancing economic and social power in favor of labor over land-

owners, the Black Death contributed to the decline of the feudal system.

Landlords were now forced to compete for labor because peasants were

able to leave for more desirable circumstances. Those who failed to offer

peasants better conditions or less onerous tasks could be faced with the

prospect of labor shortages.

Elites were conscious of the difficulty of maintaining social control

after the plague. In England, the 1351 Statute of Laborers attempted to

suppress peasant wages and free movement, which ultimately led to social

unrest and the Peasants Revolt of 1381. Modern economists have argued

that the increased power and mobility of dependents—and the diminished

authority of lords to tax them—sparked agricultural innovations and rural

economic growth in Western Europe. A more prosperous and mobile

peasantry shifted allegiance to the state, and centralized taxation and

administration grew more common. Moreover, the inability of the

Catholic Church to prevent the Black Death—along with the loss of many

clergy to the plague itself—led to a loosening of the Church’s grip on

power in Europe. Some historians maintain that the Black Death was a

primary catalyst for the eventual Protestant Reformation that began a

century and half later.

The New World

As the population recovered in the 15th century, competing European

powers grew interested in exploration. Tiny Portugal, with a population

of barely one million at the time, sought a sea route around the southern

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 5

tip of Africa and successfully made the voyage in 1488 under Bartolomeu

Dias. Another Portuguese, Vasco da Gama, was the first European to make

it to India around the Cape of Good Hope via the southern coast of Africa.

He returned to Lisbon in 1499, 2 years after his initial departure. Most

famously, Christopher Columbus—traditionally believed to be the

Genoa-born son of a wool weaver—made four round-trip voyages from

Spain to the New World of the Americas between 1492 and 1504.

Columbus discovered a continent entirely unknown to Europeans (and

Asians), whereas Dias and da Gama were aware that Africa and Asia existed

before setting off on their journeys.

Within decades of Columbus’s arrival, the Spanish had settled in

parts of the Americas. New World crops were introduced to the rest of

the world, fundamentally altering global agricultural and labor markets.

Corn and sweet potatoes were spread all the way from the Americas to

Asia, as were cocoa, tobacco, rubber, and tomatoes. Europeans brought

horses, coffee, and sugarcane to the New World. They also infected indig-

enous populations with diseases from which they possessed no immunity,

such as smallpox, cholera, measles, and typhus. As much as 95% of the

native population was killed by these Old World diseases.

By the dawn of the 17th century, European navigators had made sense

of Pacific and Atlantic Ocean wind patterns and improved upon long-

distance maritime travel to such an extent that trade to and from the

Americas occurred with relative ease. This period coincided with the mid-

dle of the “Scientific Revolution,” when Galileo was in the prime of his

career. It was the birth of truly global trade, as goods now regularly passed

en masse across the Pacific and Atlantic Oceans—and thus, around the

world. Spain founded Manila, its primary Asian trading post, in 1579. As

part of the “Manila Galleon Trade,” mammoth silver deposits in Mexico

and Peru were shipped west to the Philippines to be exchanged for high-

quality Chinese silk, at a time when the Chinese valued silver over gold.

Threatened Spanish silk growers complained to the Spanish Crown, and in

response, the Crown issued anti-trade edicts multiple times. Yet the trade

was so profitable that the edicts were ignored, and the volume of trade only

increased.

New World sugar cultivation quickly took off in the 16th century. The

“Sugar Belt” extended from Brazil to the Caribbean, drawing many

6 INTERNATIONAL ECONOMICS

Europeans in search of outsized profits. In northern Brazil, the Portuguese

initially produced sugar with native slaves, though they eventually

switched to West African slaves by the start of the 17th century. Holland,

with its West India Company, attempted to break into the Brazilian sugar

trade in the 17th century. The Dutch succeeded in capturing most of

Brazil’s northern coast for several decades, thereby controlling much

of the world’s sugar trade. However, by 1654 Holland had lost control of

Recife to the Portuguese, and they eventually withdrew from Brazil in

1661. Outside of Brazil, Spain conquered nearly all the rest of South and

Central America over the course of the 16th and 17th centuries.

East Indies Trade

During this “Age of Discovery,” European long-distance trade also opened

to the East, using the route that the Portuguese first made around the

southern tip of Africa to India and Asia. Ever since pre-Christian times,

the “Spice Trade” had brought cinnamon, ginger, cardamom, and tur-

meric from Asia to the Middle East to Europe, via camel transport along

the Silk Road. Arab traders had a lock on the Spice Trade throughout most

of the Middle Ages, an epoch when Central Asia—not Europe or

China—was the economic and cultural center of the world. By the 14th

century, the break-up of the Mongol Empire and the rise of the Ottoman

Turks had closed off overland trade routes through Constantinople. The

Europeans were initially beholden to Venetian middlemen who held a

virtual monopoly on the Spice Trade with the Middle East. The enormous

profits the Venetians made in trade were an incentive for other European

powers (such as Portugal) to find maritime routes that would allow trade

with Asia. Their search became all the more imperative after the 1453

fall of Constantinople to the Ottomans, followed by the 1479 Treaty of

Constantinople which closed the Black Sea to the Venetians.

The Portuguese continued to dominate the East Indies Spice Trade

throughout the 16th century during the zenith of the Portuguese Empire.

Portugal established ports across the coasts of Africa, the Middle East,

India, and Asia. Regular trade was even initiated with Japan after finding

Nagasaki in 1543. Nevertheless, running an extended empire from Lisbon

was always difficult. It could take 2 years for a letter to pass from Lisbon to

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 7

Goa, India, and the Portuguese Crown experienced difficulty monitoring

the predatory activities of its many merchants, who were regularly inclined

to plunder local populations. From 1580 to 1640, the Portuguese and

Spanish crowns formed a union, which helped to promote trade and sta-

bility among their territorial possessions in the Americas and Asia.

Demand for European-made luxury goods lagged as spices and other

goods from the East Indies and Americas flowed into Europe. Pepper from

the East Indies was popular among Europeans but the Portuguese strug-

gled to meet demand. The Dutch Republic, at war with the Spanish

Crown, sent expeditions from Amsterdam to the East Indies at the very

end of the 16th century. Some met with success, and in 1602, the Dutch

East India Company was founded. They soon began raiding Portuguese

territories in Indonesia and establishing outposts. Around the same time,

England established its English East India Company. It made few inroads

into Dutch-dominated Southeast Asia but was more successful in India.

Dutch Golden Age

The 17th century marked the decline of Portugal’s control over

Asian trade. The Dutch and English—with their respective East India

Companies—ascended in power and influence. In practice, these corpora-

tions acted as sovereign nations when in Asia, thousands of miles away

from the Crown. Their aim was to conquer ports, install processing facil-

ities, and reap enormous profits via sea trade between Asia and Europe.

These long-distance ventures were conducted under state-sponsored

monopolies. Specifically, the Dutch and English governments regulated

this trade by granting monopoly charters within a given foreign territory.

Risk, maritime warfare, and profits went hand-in-hand for these East India

Companies. They were frequently brutal to the native populations, though

European diseases did not cause nearly the same amount of indigenous

deaths in the East Indies as they did in the Americas.

It was the Dutch who came out ahead of the English, despite having a

population of fewer than two million and waging a war of independence

against Spain until 1648 (after which time, they fought trade wars against

England). The Dutch far outpaced any other nation in the 17th century.

They held the highest per capita income in 1600 and their lead only grew

8 INTERNATIONAL ECONOMICS

over the next century, as England did not overtake the Dutch until at

least the late-18th century. Dutch finance was unquestionably the most

sophisticated in the world. The Bank of Amsterdam supported financial

stability and was the preeminent financial institution of the 17th and

18th centuries. The Dutch financial system featured relatively low interest

rates, fractional ownership of commercial ventures, maritime insurance,

and futures markets.

Over the course of the 17th century, the Dutch Republic sent 1,770

ships to Asia, more than twice as many as the English. Much of this advan-

tage is attributed to advanced Dutch financial arrangements that promoted

efficient risk-sharing. Dutch trading colonies in Asia were relatively cen-

tralized and well run as compared to the British. This maritime East Indies

trade hastened the decline of the Republic of Venice—which had once

been the main player in the Spice Trade—and their successors, the

Portuguese. The British also overtook the Venetian textile industry by

selling their poorer quality clothing on the Mediterranean market for

much lower prices. The future of global trade lay in the Atlantic, so

European power and influence shifted away from the Mediterranean

toward nations seated on the Atlantic.

Slave Trade

One principal distinction between the West and East Indies trade was the

employment of West African slaves. Although European colonists in the

East Indies did not rely heavily on imported slaves, the British, Portuguese,

and French each transported millions of slaves across the Atlantic to

cultivate sugarcane, coffee, cotton, and tobacco in land-abundant North

and South America. The farming of these crops (especially sugar) was

highly labor-intensive, and slaves became the critical factor of produc-

tion that drove profitability. Native American populations were the pre-

dominant source of slave labor at first before being displaced by African

slaves, who were commonly bought for cloth before being shipped

across the Atlantic. Coerced labor was endemic, as considerable num-

bers of Europeans who moved to the British territories of North America

and the Caribbean were indentured servants or convicts. These migrants

endured harsh conditions during their terms of service, but in exchange,

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 9

they were able to secure small parcels of land and become subsistence

farmers.

The volume of this slave trade picked up substantially during the 18th

century. Most historians agree that at least 10 million slaves left Africa

between the 15th and 19th centuries, with more than a tenth dying en

route. As one example, historians have estimated that sugar plantations in

17th century Jamaica showed a rate of return of at least 10%, certainly

greater than the standard interest rate in England at the time which aver-

aged around 5%. To the British, Jamaica was an emerging market of great

promise and risk. Jamaica eventually became the largest sugar exporter in

the British Empire for the majority of the 18th century. Many British

people who were of common birth made massive fortunes from these West

Indies plantations powered by slave labor. These societies were based on

“extractive” institutions where a small elite possessed legal rights and held

power and wealth.

The mortality rate on the initial voyage across the Atlantic was very

high among slaves. Once on land, slaves still experienced elevated mortal-

ity rates because of the grueling nature of the work, particularly on sugar

plantations. Maintaining slave populations in the Caribbean “Sugar

Islands” was difficult. Plantation owners did not place much value on slave

children, since it would take at least a decade of care before they would be

able to provide labor. In the United States and Canada—where sugar cul-

tivation was less common—it was easier to sustain slave populations

because, with a different crop mixture, there were lower mortality rates

and higher fertility rates, meaning that fewer slaves were needed over time.

The United States finally banned the import of slaves in 1808, so that by

the Civil War, few American slaves had been born in Africa.

Age of Mercantilism

After 1500, European powers sought to acquire the territory and resources

of the New World. The prevailing mercantilist doctrines of the age dic-

tated that wealth accumulation was a zero-sum game, and that foreign

colonies exist to provide raw materials for domestic manufacturing.

Military force was a necessary instrument to support this trade. Uninter-

ested in free trade, national corporations desired monopoly control over a

10 INTERNATIONAL ECONOMICS

given trade. With ample profit margins, earnings were used to maintain

the military and state. Through trade and warfare, the English (with four

times the population of the Dutch) were driven to compete against the

Dutch Republic. Four Anglo-Dutch naval wars were fought over commer-

cial dominance during this era.

Britain’s New World territories prospered. From 1650 to 1770, the

population of British North America shot from 55,000 to 2.3 million,

while the population of the British West Indies grew from 60,000 to

480,000. The British West Indies, with an economy based on sugar, had

a population that was 90% of African origin compared to only 20% in

British North American colonies. Financially supported by commercial

growth, Great Britain’s Royal Navy was the world’s most powerful by the

end of the 17th century. British legislation certainly made use of the Royal

Navy to further business interests. The Navigation Act of 1651 ordered

that goods imported into England must be carried in ships that were either

British or from the country that originated the goods. Consequently,

American tobacco transported to England had to be carried in either

English or American ships. This legislation was intended to destroy Dutch

dominance in shipping and to protect Great Britain’s market share in mar-

itime transport and middleman commerce.

France was the third player seeking to control world trade. A land

power with more than 10 times the population of the Dutch Republic,

France resented Dutch commercial dominance in the 17th century. The

French lacked a strong navy but they fought back through tariffs on

Dutch goods shipped to France. In 1664, the French West India and

East India Companies were chartered. A trade war between the French

and the Dutch broke out, and soon a real war did as well. The French

sided with the Dutch during the Second Anglo-Dutch War of 1665 to

1667, where England was defeated. Afterward France and England were

more concerned with Dutch supremacy, and they sided together against

the Dutch during the Third Anglo-Dutch War of 1672 to 1674. The

alliance did not last forever, as France and England were intermittently

at war with each other from 1689 to 1815, in a battle of two aspiring

world empires. However, the English were better able to secure debt

funding for warfare, giving them a decisive advantage over the French

in the long run.

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 11

United States of America

Warfare, always expensive, strained the finances of the imperial powers,

even rich ones like Great Britain. Between 1680 and 1780, the British

army and navy tripled in size. By 1760, its military spending was nearly

15% of national income. British fiscal problems worsened with the world-

wide recession that followed the Seven Years War of 1756 to 1763. The

North American theatre of that war came to be known as the “French and

Indian War,” after the two main enemies of the British colonists. Great

Britain attempted to shift some of its burdens—including the cost of

defending the colonies with a standing army—to the North American

colonies themselves, where residents were among the wealthiest in the

world, having achieved an even higher standard of living than British sub-

jects back on the home island. To extract revenue, the Stamp Act of 1765

was passed, taxing newspapers, pamphlets, and legal documents. After an

outcry, it was repealed a year later. Next the Townshend Acts of 1767 were

passed, raising customs duties and transferring customs power from the

colonies to the Crown. Even after the new tax hikes, American colonists

faced tax burdens that were less than a tenth of what the British govern-

ment imposed on its own subjects at home.

Pressures mounted as the Americans resisted the Crown’s encroach-

ment on their political rights. The colonial subjects—increasingly forced

to quarter British troops—demanded political representation if they were

to be taxed by the Crown. In 1773, the Tea Act was passed. Interestingly,

the law allowed the British East India Company to import tea directly

from Asia to the colonies for the first time, undoubtedly leading to lower

prices for colonial consumers. American merchants and smugglers, who

were now cut out of the tea trade, masterminded a public relations outcry

that successfully galvanized the public (despite the cheaper tea). After

the Boston Tea Party of December 1773, a greater conflict was inevitable.

The British Parliament responded with the Intolerable Acts of 1774, and

in 1775, war broke out. The Battles of Lexington and Concord were

fought on the outskirts of present day Boston. The colonies had already

been at war with Great Britain for over a year by the time the Declaration

of Independence was approved at the Second Continental Congress on

July 4, 1776.

12 INTERNATIONAL ECONOMICS

British Cotton Industry

Like silk, cotton was a high-end good at the beginning of the 17th century

when the English East India Company was chartered. Although easy to

grow, cotton required a great deal of manpower to process. Seeds needed to

be removed from bolls. Fibers had to be arranged and packed. To produce

thread, cotton wool required spinning in a process that took many days.

India, with centuries of experience in cotton-processing and an inexpen-

sive workforce, had the lead in producing cotton textiles, especially cloth,

which was commonly exported to Europe. In England, cotton clothing

styles signaled social class. The English East India Company gave Indian

cotton freebies to the monarchy and they began to catch on among

aristocrats, and later, the middle class. By the 18th century, British fashion

held cotton in higher regard than silk or wool.

After the European market for spices became saturated at the end of

the 17th century, the English East India Company increasingly specialized

in the cotton trade with India. Within Great Britain, this generated con-

troversy. According to standard mercantilist reasoning, cotton textile-

processing ought to be performed in England, not India, to stimulate

English labor demand. Furthermore, England should not trade its wealth

for pricey Indian textile products. But the English East India Company

did not follow this logic in practice. It brought some English textile

manufacturing technologies to India, and Great Britain continued to

establish fortified trading posts throughout India, including in Madras,

Bombay, and Calcutta.

English textile workers, mercantilists, and moralists were concerned

Great Britain was facing social disruption and loss of employment and

bullion, all for the sake of clothing. They pressured the English Parliament

to pass protectionist legislation, sometimes successfully, as in the case of

laws passed between 1666 and 1680 that required the dead to be buried in

wool. In addition to political lobbying, the domestic textile industry

fought back against Indian competition by developing technological

breakthroughs. In 1733, the flying shuttle was invented, doubling the

productivity of weavers. A small mechanical device called the spinning

jenny, invented by an illiterate artisan, became available commercially

starting in the late 1760s. It was followed by the spinning frame, spinning

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 13

mule, and power loom, all creations of British inventors. These break-

throughs increased English demand for raw imported Indian cotton. Out-

put of finished English cotton clothing grew, and prices fell. It was the

dawn of the Industrial Revolution.

The cotton industry controversy sparked many pamphlets written by

English mercantilists and, opposing them, free traders. As the debate

evolved in Great Britain over the course of the 18th century, economic

thought advanced. In one notable contribution that ran contrary to the

perceived mercantilist wisdom of its day and expounded many ideas to be

affirmed by The Wealth of Nations, Henry Martyn published Considera- tions Upon the East India Trade in 1701. A British free trader who would later become Inspector General of Imports and Exports in 1715, Martyn

argued against restrictions on manufactured imports from India. He crit-

icized monopoly protection of the East India trade, discussed the division

of labor, and analyzed the gains from trade that result from laborsaving

technological advances. Far ahead of his time, Martyn stressed that a

country’s wealth was properly measured by its level of consumption, not its store of bullion.

Great Britain’s trade had truly globalized by this time. British foreign

trade was increasingly driven by newfound consumer mass markets in

tobacco, tea, and sugar. Encouraged by falling prices, the people of Great

Britaindevelopedatasteforthesestimulatinggoodsduringthe18thcentury.

By the mid-18th century, Chinese tea had become a working-class beverage

in England. British manufactures, such as nails, clocks, and firearms, were

exported to continental Europe and the Americas in larger quantities.

Although France’s volume of foreign trade nearly matched Great Britain’s

bythe1780s,Frenchvolumesweremuchsmallerinpercapitatermsbecause

of its greater population (which was roughly double Britain’s). The British

economytooktheleadduringtheperiodfrom1700to1820.Asthetotalsize

of Great Britain’s economy more than tripled, France’s economy almost

doubled, and the Dutch economy was generally stagnant.

India, China, and Europe

According to the best historical statistics available, from 1 AD to 1500, the

world population doubled from 220 million to 440 million, with India

14 INTERNATIONAL ECONOMICS

and China combined accounting for half of the total. Throughout that

millennium and a half, India and China each contained between a quarter

and a third of the world’s population and income. Because earnings were at

subsistence levels in those days, a region’s income corresponded closely to

its population. Then, over the three centuries following 1500, China’s

population and output surpassed India’s, and Europe’s economic and

technological development exploded. By the 16th century, per capita

income in leading Western European economies had risen above subsis-

tence levels, and after the 18th century, huge disparities arose between

Europe and Asia owing to Europe’s incalculable technological advantages.

The intracontinental competition between European powers—resulting

in expansionism and the inevitable sharing of information and technolog-

ical progress—contributed to the European economic edge. The same pro-

cess did not occur in India or China during the 16th to 18th centuries. In

fact, like much of Asia, China resisted outside influences and was slow to

globalize.

Ming and Qing Chinese Economy

As of the 14th century, Western Europe and China were broadly equal in

terms of living standards, with Chinese technology, the product of a rich

history, clearly superior. In power from 1368 to 1644, and following the

Mongol rule of the Yuan Dynasty, the Ming Dynasty was the final reign by

Han Chinese. The Ming period exhibited stability, with an agricultural

economy dominated by independent peasant landholders. The third Ming

emperor, Zhu Di, fortified China’s power and was aggressive in his foreign

policy, particularly against the Mongols. He ordered the 15th century

“Ming Voyages,” led by a physically imposing eunuch named Zheng He.

Consisting of seven extravagant ocean expeditions, with hundreds of enor-

mous ships and tens of thousands of sailors, the travelers reached India, the

Persian Gulf, and Africa. A backlash against the explorations resulted, even

though South China Sea trade prospered during the late Ming era. Some

large-scale industrial organizations, such as southeastern textile centers,

emerged during the Ming rule as a precursor to modern capitalism.

To the north and east, the Ming constantly worried about Mongol,

Japanese, and Korean threats. Most of the existing Great Wall was built

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 15

during Ming rule. Nevertheless, the Ming were eventually overthrown by

domestic rebels who conquered Beijing in 1644. At that time, Manchu

raiders—part of a northeastern ethnic minority—were invited to stem the

uprising in China. Yet they ended up taking control of Beijing themselves,

and then within a few decades, the rest of China as well. Called the Qing

and led by the Manchu, it was China’s last dynasty, reigning until

1911. During the Qing Dynasty, China’s population grew from about

125 million in 1680 to 157 million in 1710. It then took off in the 18th

and 19th centuries, reaching 412 million by 1850. During the 18th century,

New World crops such as sweet potato, maize, and peanuts were introduced

to China on an immense scale as part of the “Columbian Exchange” of

animals, plants, culture, and disease. As Chinese yields per acre rose,

greater populations could be supported.

Beginning in the 16th century, New World silver mined in Peru and

Mexico was sent to China. Up to a third of the American silver ended up in

China, and because of such massive inflows, silver gradually replaced cop-

per and paper notes as the dominant currency in China during the Ming

Dynasty. The Spanish eight-reale silver coin became ubiquitous in world

trade, and by the 18th century, it was the world’s first global currency.

Technology continued to be transferred between European and Chinese

statesmen and scientists. Fascinated by Chinese methods, Europeans vis-

ited China, helping to stimulate Chinese innovations. Chinese foreign

trade during the Qing Dynasty was regulated by a wary government. The

Qing restricted foreign trade to a single southern port city, Canton. This

arrangement, which came to be known as the “Canton System,” lasted

until 1842, when the Treaty of Nanking marked the end of the First

Opium War with Great Britain.

Breakdown of the Canton System

The British East India Company was the largest foreign player in the

Canton trade. The Company’s demand for Chinese tea (which primarily

came from Fujian province) took off in the early-18th century. The tea

came to be shipped on special tea clipper ships that made no stops on the

return voyage to England in order to keep the tea fresh. At first, the British

paid for the tea with silver. Later, as Europeans became more reluctant to

16 INTERNATIONAL ECONOMICS

part with silver (which they used to fund wars), Indian cotton and opium

were traded for the tea. The Canton trade between China and Europe

developed rapidly, although the British East India Company grew increas-

ingly frustrated with Qing restrictions, especially on opium. Holding to a

mercantilist outlook, the Chinese desired a positive trade balance. In 1796,

they banned the importation of opium, but the British resorted to smug-

gling. China’s “terms of trade” declined over time (meaning the price of

Chinese exports such as tea went down relative to the price of foreign

imports), and after 1806, the value of British opium imports exceeded the

value of Chinese tea exports.

Free trade reformers succeeded in ending the British East India

Company’s chartered monopoly on trade to China in 1834. Private traders

moved in and opium smuggling only grew, exacerbating tensions between

China and Great Britain. China cracked down on opium, leading to

the outbreak of the First Opium War in 1839. For years, Great Britain

had possessed the most advanced merchant ships in the world, including

artillery-wielding East Indiamen vessels measuring 40 meters long and

weighing over 1,000 tons. China’s military technology was very primitive

by comparison. With steam-powered gunboats, Great Britain’s over-

whelming naval firepower gave it a decisive advantage during the Opium

Wars. After losing the First Opium War, China agreed in the 1842 Treaty

of Nanking to open major ports to trade (including Canton), limit tariffs

on British imports, pay a large indemnity, and grant Hong Kong to the

British in perpetuity.

The Treaty of Nanking—which China viewed as unfair—failed to

resolve the contentious opium trade issue. Trafficking only escalated, and

the Second Opium War broke out in 1856. This time France joined Great

Britain in the hostilities against China, and by 1860, their technologically

superior combined forces had invaded Beijing in a decisive victory over the

Chinese. The October 1860 Convention of Beijing produced a treaty that

legalized the opium trade, established foreign diplomatic representation in

China, removed many restrictions on travel by foreigners within China,

and granted another large indemnity to the European victors. Within

China, citizens resented the ineffective response of their Manchu rulers

to the gunboat-style diplomacy practiced by the Europeans. Conse-

quently, the Qing Dynasty faced internal revolts and had difficulty

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 17

governing. The most notable insurrection was the Tiaping Rebellion, a

civil war in southern China that claimed over 20 million lives from

1850 to 1864. The crumbling of the Qing dynasty accelerated toward the

end of the 19th century, and it finally fell in 1911.

Japan’s Rapid Industrialization

Modern industry did not make its way into Asia until the late-19th

century, when Japan was the first non-Western nation to industrialize

prior to World War I. Japan’s hasty industrialization and abrupt move

toward globalization is the most remarkable story of 19th century Asian

economic growth. Although Japan had intermittently exchanged goods,

technologies, and cultural influences with Korea and China for centuries,

the Japanese economy was poor, backward, and closed prior to the mid-

19th century. It was linked to European trade routes after the 16th century

through Portuguese and Dutch merchants (with foreigners confined to a

Nagasaki enclave under threat of death). From 1603 to 1867, under the

rule of the Tokugawa Shogunate, Japan maintained a refined feudal society

dominated by rice farming, with some movement toward urbanization.

During the 18th and 19th centuries, Japan intermittently suffered famines

when successive years yielded crop failures, killing hundreds of thousands.

Fearing the spread of Christianity, the Tokugawa allowed only a minimal

amount of trade with Europeans for two centuries.

Foreign pressures to open Japan intensified as Europe and the United

States industrialized, making them hungry for raw materials and new mar-

kets. The Dutch king unsuccessfully urged Japan to open its ports to world

trade in 1844. Nine years later, the United States sent a quarter of its navy

to Japan under the guise of a humanitarian mission to lift the death penalty

on foreigners shipwrecked off Japan. Led by Commodore Matthew Perry,

the Americans presented Tokugawa officials with the draft of a treaty that

would open Japan to trade with the West. The Japanese had never seen

such modern gunboats and did not wish to fight a war. A year later, the

Kanagawa Treaty of 1854 was signed. It opened the Japanese ports of

Shimoda and Hakodate to American trade and established a permanent

American consul in Shimoda. Japan’s period of seclusion was over. How-

ever, foreign influences quickly became a source of tension and conflict

18 INTERNATIONAL ECONOMICS

within Japan. Civil war eventually broke out between Tokugawa suppor-

ters and oppositional forces (aided by wealthy urban merchants) wishing to

modernize and restore the emperor. The insurrectionists won, ushering in

the Meiji Restoration era under Emperor Meiji that began in 1868. In

spite of intense turmoil during this period, Japan’s trade rose by a factor

of 70 from 1858 to 1873.

The Meiji government set out to reconstruct Japanese society partly

based on ideas and best practices derived from the Western powers. Under

the “Iwakura Mission,” the Meiji sent diplomats abroad to study foreign

economic, political, technological, and educational systems. Armed with

new information and aided by a steady trickle of visiting foreigners, Japan

westernized its government and economy during an era of intense nation-

alism. The government abolished the caste system and promoted eco-

nomic development through coordinated industrial policies. Eschewing

foreign loans, state-owned enterprises (later privatized) adopted Western

technologies, penetrated new industries, and produced increasing levels of

value-added in goods. In the quarter century following the end of the

Tokugawa era, Japanese agricultural output roughly doubled, supporting

population growth, industrialization projects, and military modernization.

Japan achieved a striking defeat of China in the First Sino-Japanese War,

fought over Korea during 1894 and 1895, cementing Japan’s status as an

emerging global power.

British Industrial Revolution

Ascribed to mid-18th century England by most scholars, the birth of

the Industrial Revolution was a watershed in human history. For thou-

sands of years before this epoch, income per capita around the world

showed no clear upward trend. For most of humanity in 1800, their

30-year life expectancy was no different from that of hunter-gatherer soci-

eties (and height was actually shorter on average). The wealthy lived well—

especially in affluent nations like Great Britain and the Netherlands—but

the majority working in the agrarian sector was not materially better off

than their ancient ancestors. The period after the Black Death may have

been something of an exception, for among the survivors, wage rates were

high, and the population eventually recovered. By and large, however,

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 19

income per capita around the world was essentially stagnant for several

millennia prior to the Industrial Revolution.

Economic historians explain that before the Industrial Revolution

began, economies around the world were in a “Malthusian trap,” named

after An Essay on the Principle of Population by the Reverend Thomas Malthus, published in 1798. Back then, technology-driven productivity

growth was not sufficient to support improvements in living standards due

to growing populations. Since technological advance was very, very slow,

whenever incomes and living standards rose, higher rates of population

growth provided a natural offset. Specifically, new affluence led to more

births and a larger population, which in turn drove down wages and living

standards. Malthus argued that this process resulted in higher death rates

and lower birth rates. In equilibrium, the vast majority of the population

would be living at essentially a subsistence level, with little or no per capita

income growth. According to the Malthusian logic, events that increase

death rates—such as war or plagues—cause a rise in material living stan-

dards, whereas shocks that lower death rates—such as the introduction of

better sanitation—ultimately result in lower living standards.

So then, what changed at the outset of the Industrial Revolution? The

answer is productivity growth: the rate of technological progress picked up

by a large margin. Before the 18th century, technological advance hap-

pened, just at a much slower rate. Modern estimates suggest that prior to

the Industrial Revolution, cumulative annual productivity growth from

technological change was less than 0.05% per year, implying that an econ-

omy’s productive capabilities (all else equal) would increase by less than

5% every century from technological improvements. In the “First Indus-

trial Revolution,” which spanned a century beginning in approximately

1760, the technological growth rate in England picked up to about

0.5% per year and was largely driven by textile efficiencies. During the

“Second Industrial Revolution” that began around 1860 and lasted until

World War I, the technological growth rate in England was at least as high,

at closer to 1.0%. Combined with capital accumulation, such massive

increases in productivity have allowed for both population growth and

rising living standards over time.

Contrary to some popular impressions, the Industrial Revolution was

not caused by several heroic inventors and entrepreneurs. Instead, it was a

20 INTERNATIONAL ECONOMICS

gradual process driven by a great number of inventors and merchants

across many decades. Essentially, the supply of new innovations increased

during the Industrial Revolution. Each incremental improvement led to

excitement among other clever individuals on the same mental wave-

length, who were then more likely to devise complementary improve-

ments, sparking a virtuous cycle of innovation. Britain’s favorable legal,

cultural, and natural environment were a necessary prerequisite for this

boom. Compared to continental Europe, labor was scarce in Britain, wages

were high, and energy was cheap, making it all the more worthwhile to

substitute machinery for labor. During the 18th century, civil engineering

projects multiplied, and the number of books published in Great Britain

tripled. Aside from cotton textiles, the British coal mining, iron, steel,

canal building, and railroad industries all grew by leaps and bounds during

the Industrial Revolution, leading to lower transportation costs, greater

production, and lower prices for consumers, in England and abroad. Sur-

prisingly, the plucky British inventors usually shared little of the great

wealth their creations engendered, since in practice, the British patent sys-

tem provided them weak protection and their inventions were quickly

copied by others.

Rise of Great Britain

Driven by greater productivity, the population of Great Britain roughly

tripled from eight million in 1770 to 23 million in 1860. In a Malthusian

trap, this would lead to lower living standards. Yet British income per

capita actually rose and real wages grew. In fact, after 1860 British per

capita income began to grow at an even faster clip in spite of the sus-

tained population growth. Urbanization and industrialization contin-

ued in Britain so by 1860, only about 20% of the population in

England was employed in agriculture (as compared to 1% today). Given

the British population explosion, the demand for food skyrocketed.

But Britain did not possess a great deal of land, and productivity gains

in the farm sector could not keep pace with the population increase. So

Great Britain—the “workshop of the world” and an exporting power-

house—imported food and raw materials that were exchanged for their

own manufactured goods.

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 21

After the mid-18th century, land rent as a share of national income

began its long decline in England. Before this time, the amount of land per

worker had been a major factor determining per capita income growth

among world economies. However, in the modern industrial era, econo-

mies typically grow through technological advance and increases in the

amount of capital per worker. In fact, most economists today simply

ignore land per worker in economic growth calculations, and from the

experience of modern Hong Kong and Singapore, it is clear that economies

with little land are not necessarily so disadvantaged. In Industrial Revolu-

tion England, as input demand shifted toward urban metropolises, rents

on farm land declined and rents on urban land increased. Not coinciden-

tally, the power of the British landed gentry waned.

As an interesting contrast to Britain, the United States was late to

industrialize and instead concentrated on developing its massive land and

resource endowments. The westward land expansion of the United States

during the frontier 19th century greatly contributed to America’s emer-

gence as a 20th century economic powerhouse. In 1860, England had

slightly over one acre of farmland per person compared to two acres per

person throughout Western Europe. The United States, on the other

hand, contained nearly 12 acres of farmland per person. The emergence

of roads, steamboats, canals, and railroads throughout the 19th century

allowed American farm products to be transported cheaply and then sold

around the world at low prices. Agricultural products from the Americas

increasingly helped to feed the global population, which was well over one

billion by 1850. In 1820, the United States produced fewer than 2% of the

world’s total output. A century later, its share was nearly 20%.

Medieval England, along with the rest of Europe, featured interest

rates that were commonly above 10%. Yet by the dawn of the Industrial

Revolution, interest rates were down to modern levels of about 4% to 5%

in Britain, which stimulated industrial investment. Furthermore, the frac-

tion of the population living in cities in England was at least 20% by 1800.

The increase in world trade during the 17th and 18th centuries fostered

the movement to cities, although urban death rates were extremely high

because of horribly inadequate hygiene and sanitation. Real wages contin-

ued to increase, even among unskilled workers, so popular goods such as

tea, sugar, and tobacco were affordable to most 19th century British

22 INTERNATIONAL ECONOMICS

laborers. Breakfast shifted from a relatively heavy meal to a light serving

that included tea or coffee. Other modern middle-class characteristics

emerged. Literacy and numeracy were very rare in medieval Europe, but

by the start of the Industrial Revolution, these skills became progressively

more common in Britain. By the 19th century, most British men could

read, and literacy rates in France and much of continental Europe were

even higher than in Great Britain.

Diffusion of Industrial Revolution Technology

After the early-19th century, technological improvements led to rapid effi-

ciency growth in the British economy. This did not escape the notice of

other nations, since British military might and political power grew as

economic output expanded. Luckily for competitors, copying technology

is much easier than developing it anew. Within several decades, the United

States and many countries in Europe had begun to utilize British inven-

tions such as cotton mills and steam engines. England was busy building its

internal railway system in the mid-19th century, along the way generating

speculative investment frenzies (or “bubbles”) like the “Railway Mania” of

the 1840s. The United States quickly followed suit, and the first transcon-

tinental railroad—extending to the Pacific Ocean near San Francisco—

was completed by 1869. By the end of the 19th century, the United States

had laid over 200,000 miles of railroad, far more than any nation in the

world, and nearly 10 times the length of Britain’s rail lines. From 1880,

America’s income per capita began to eclipse Britain’s, and the difference

would only grow during the 20th century.

The pace of information flows quickened at a dizzying clip over the

course of the 19th century. As of 1800, information traveled over long

distances at roughly the same rate as it had for centuries—no more than

a few miles per hour. The introduction of the telegraph in 1844 allowed

information to transmit at over 100 times the old rate. The first undersea

telegraph cable between England and France was completed in 1851, and

by 1866, telegraph cable connected the United States to Europe. Steam-

powered railways and cargo ships traveled at least 10 miles per hour, and

several innovations in the middle of the 19th century greatly lowered the

cost and increased the speed of steam-powered ocean transport. Major

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 23

canals also reduced transportation costs. The Suez Canal in Egypt opened

in 1869, allowing sea transport between Europe and Asia without the need

for navigation around Africa, while the Panama Canal, opened in 1914,

created a direct maritime path between the Atlantic and Pacific Oceans.

In the United States, the 364-mile Erie Canal was completed in 1825,

dramatically cutting shipping costs from the Great Lakes region to the

Atlantic. The “Pax Britannica,” enforced by the dominant British Royal

Navy across the world’s seas, provided a safe environment for shipping and

thus promoted inexpensive ocean transport prior to World War I.

The Second Industrial Revolution stretched to World War I, yielding

many new consumer products based on scientific principles. The first

gasoline-powered automobile was patented in 1886 by Karl Benz, a

founder of Mercedes-Benz. Henry Ford, founder of the Ford Motor

Company in 1903, is credited with developing mechanized assembly line

production methods—powered by electricity—to mass produce Ford cars.

Early telephone models were developed by the 1870s, and a number of

inventors around the world patented radio transmission technologies dur-

ing the 1890s. The tabulating machine—a precursor to today’s compu-

ters—was used for the 1890 United States Census. These productivity-

enhancing inventions, combined with a wealth of domestic natural

resources utilized as material inputs, drove rapid American industrial

growth during the final decades of the 19th century. By 1900, American

manufacturing output exceeded the combined sum of its rivals Great

Britain, France, and Germany.

19th Century Globalization Boom and Divergence

Economists often give a technical definition of globalization as the inte-

gration of markets across world regions. This characterization yields some

testable propositions. For instance, as globalization increases, the price of a

good should “converge” (or become the same) across locales. In addition,

the amount of inter-regional trade should increase over time. Globalization

can be contrasted with “autarky,” where each economy is separate from

another, meaning that each economy produces all the goods and services it

consumes instead of specializing in products it makes best (like Swiss

24 INTERNATIONAL ECONOMICS

watches) and then trading. After one economy is aware of another and

accessible via foot, camel, or sail, globalization may spread for a number

of reasons, such as a fall in transportation costs, a decrease in tariffs, a lull in

warfare, or a greater specialization into smaller production niches. This

yields cost advantages and lower prices for consumers. The existence of

an international hegemon—like Great Britain in the 19th century or the

Mongols in the 13th century—can sustain overall commercial stability by

reducing piracy and lowering transportation costs.

Although globalization and international trade picked up during the

Age of Exploration, it was not until the 19th century that a giant world-

wide globalization boom truly occurred. After the voyages of Columbus

and da Gama, the volume of trade between continents grew by about 1%

annually during the 16th to the 18th centuries. In the 19th century, this

rate rose to over 3%, and it has averaged at least that level ever since. Prior

to the 19th century, foreign exports to Europe were driven by European

income growth and dominated by low-bulk luxury goods such as silks and

spices, which few could afford. Goods needed to be valuable relative to

their weight if the long, risky ocean shipping expeditions to trade for them

were to be economical. But beginning in the 19th century, a mass market

in inexpensive consumables developed in Europe, precipitated by falling

transportation costs, rising middle-class incomes, and production-side

economies of scale. Food, cheap textiles, and production inputs were

increasingly exported to Europe. Some imports such as coffee and tea were

not even produced in Europe. Their widespread consumption among

the European middle classes signified greater market integration around

the world.

Commodity prices also began to converge across the world in the

1820s during the peacetime recovery from the Napoleonic wars. Price

convergence was caused by a 19th century revolution in transportation

technology, as steamships, canals, and railroads cut shipping costs around

the globe. Such technologies increased competitive pressures, and along

with the growing influence of free trade schools of thought, these forces

fostered 19th century trade liberalization policies. In fact, prior to the

19th century, nearly all intercontinental trade was accomplished via

state-chartered monopolies—a coordinating system that raised consumer

prices and reduced overall trade and output. England was a leader in trade

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 25

liberalization after repealing the protectionist “Corn Laws” in 1846, some

30 years after they were passed. American and continental competitors

often kept up tariff barriers to help nurture their own domestic

manufacturing industries. Trade liberalization was uneven though grow-

ing until the 1870s when a globalization backlash arose, spurred by an

economic depression and a collapse in farm prices.

After 1600, global inequality began to increase between nations. Econ-

omies that had escaped the Malthusian trap early on, such as Great Britain

and the Dutch Republic, saw their income per capita and real wages out-

pace other nations. Their advantage only grew in the 18th century and

afterward. Income divergence since the 19th century is especially clear

when comparing rich versus poor economies. The former have grown

swiftly while the latter have stagnated. Global capital markets were as well

integrated prior to World War I as they would be nearly a century later.

Capital accumulation in the United States was rapid, chasing after invest-

ment returns, and high wages drew millions of migrants from Europe to the

developing Americas. Advanced economies in Europe and the Americas

were especially efficient, producing more output per worker and per unit

of capital. They drew added capital from global markets, leading to ever

larger differences in per capita output and income. Then as now, poorer

economiesstruggledtoincreasetheirproductiveefficiencyperunitofinputs.

Adam Smith, David Ricardo, and the Corn Laws

Commercial policy in Europe was dominated by mercantilism through the

18th century, although its many critics in England and France were vocif-

erous. A notable group in France called the “Physiocrats” argued for free-

dom to produce and trade, as they believed self-interest naturally led to the

greatest amount of value creation. Yet until Adam Smith’s Wealth of Nations, the many disparate arguments supporting free trade—and oppos- ing the common protectionism of the day—lacked coherence. A bookish,

absentminded, socially awkward systems builder with a reputation for giv-

ing excellent lectures, Adam Smith was able to put forth a tightly reasoned

analytical framework for thinking about trade policy.

As a leading figure in the 18th century “Scottish Enlightenment” and a

long-time professor of philosophy and political economy, Smith disagreed

26 INTERNATIONAL ECONOMICS

with the English philosopher Thomas Hobbes, who had argued a century

earlier that self-interest was essentially destructive, and consequently, man-

kind required a social contract with a powerful state to protect people from

one another. Smith contended that each individual’s private interest leads

them to employ their labor in the most profitable manner. According to

Smith, individuals with differing interests will nevertheless cooperate

through the mutually advantageous exchange of goods and services, a pro-

cess that unintentionally creates the greatest social value, as if led by an

“invisible hand.” In terms of trade policy, Smith maintained that if a good

can be imported more cheaply than it can be made domestically, it should

be purchased from abroad. In such a case, home production would be

inefficient because labor and capital inputs could be better utilized in cre-

ating other goods. Free trade also increases competitive pressures and facil-

itates the exchange of knowledge, processes that stimulate productive

efficiencies and lead to lower consumer prices.

Smith’s arguments in favor of free trade were tempered by his distrust

of commercial interests and his belief that government had an essential role

to play in any vibrant economy through maintaining law and order and

providing public goods. He was critical of mercantilist trade policies

because they favored special business interests at the expense of the general

welfare. Protectionist policies, he argued, often advantaged producers in

one industry while ignoring the benefits consumers would reap from

allowing lower-priced imports. Disapproving of the British East India

Company with its Crown monopoly, Smith warned of the collusive nature

of business interests, which sometimes extend their pernicious reach into

politics. Two centuries later, this art of obtaining wealth through political

means was termed “rent-seeking” by economists. Smith was wary of pro-

tectionist legislation since such laws typically raise consumer prices and are

influenced by the schemes of industry leaders.

Smith is credited with the theory of “absolute advantage,” which pro-

poses that countries should produce those goods for which they have an

absolute cost advantage and trade for other goods produced abroad. The

Wealth of Nations steadily grew in influence during the several decades following its publication, and its ideas were scrutinized by the most prom-

inent intellectuals of the day. The next major innovation after Smith was

the theory of “comparative advantage,” attributed to David Ricardo from

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 27

his On the Principles of Political Economy and Taxation, published in 1817. It explained why countries would import a good even if they possess an

absolute advantage in producing it. According to Ricardo, a country’s pat-

terns of production depend on its cost structure and “opportunity costs”

(meaning the amount of other goods that could have been produced

instead). Even if it has an absolute advantage in many goods, Ricardo

reasoned that a nation ought to specialize in producing those goods for

which it possesses the lowest opportunity cost. The corollary was that even

poor, backward economies should produce and trade based on their rela-

tive advantages in production.

During the first half of the 19th century, the British Corn Laws were a

lightning rod of controversy. Introduced with the 1815 Importation Act,

they created substantial tariffs on grain imported to Great Britain. Leading

British economists such as Ricardo, James Mill, and Mill’s son, John

Stuart, were opposed. The beneficiaries were large landowners, but nearly

all consumers—especially the poor—were forced to pay higher food prices.

Opposed to agricultural interests, British industrialists were increasingly

aware of the benefits from free trade. Their workshops were the world’s

vanguard, so opening bilateral trade would benefit them, given their com-

parative competitive advantages. Buoyed by ambitious capitalists and the

growing free trade ideology of the day, the Corn Laws were repealed in

1846. Almost 15 years later, the Cobden-Chevalier Treaty between Britain

and France lowered tariffs and averted another war between the two

nations. Trade between England and France more than doubled, and

France’s industry was forced to modernize.

Long Depression and Resulting Backlash

Over the century following 1820, trade integrated the world economy.

Helped along by lowered transportation costs and reduced tariffs, the

intercontinental price gap in commodity markets dropped by 80%. From

1840 to 1870, an economic boom increased the amount of world trade by

a factor of four, with trade expanding by about 5% every year. By 1870,

international trade—measured as global imports plus exports—accounted

for one tenth of all output around the world. Even so, the 1870s was a

decade of economic turmoil. The years preceding 1873 saw a massive

28 INTERNATIONAL ECONOMICS

expansion in credit across continental Europe to fund construction, pro-

voking an unsustainable bubble. Subsequently, the period from 1873 to

1896—called the “Long Depression”—was filled with “deflation” (mean-

ing negative price growth) and crisis, beginning with the “Panic of 1873,”

which was triggered by the collapse of the Vienna stock exchange in May

of that year.

In 1873, railroad construction in the United States had just absorbed

an enormous amount of investment (often bundled into dubious financial

securities). Under the weight of cheap American grain—transported from

the heartland to ocean ports via railroads—the European agricultural sec-

tor was in distress. As American farm and industrial products continued to

flood foreign markets, land rents in Europe plummeted. The Panic of

1873 spread from the European financial sector to the United States, lead-

ing to a severe 6-year economic slump. Unemployment in the United

States peaked at 14% and the downturn was even worse in Europe. As

nationalism surged, European landowners and agricultural interests called

for tariff protection, which they often won, especially in France and

Germany. During the 1880s and 1890s, the industrial economies of the

United States and most of Europe turned against free trade in the face of

economic turbulence. Deflation was commonplace, caused by technology-

driven falling production costs, weak aggregate demand, lower asset prices

induced by depression, and a gold shortage. From 1873 to 1896, prices fell

by over 30% in the United States and 20% in Great Britain.

In the United States, a populist movement led by farmers (who

commonly carried heavy debt loads) and energetic politicians such as

Nebraskan William Jennings Bryan demanded the country go off the gold

standard in order to devalue the dollar and end deflation. Yet instead of

responding to the prolonged economic downturn and deflation with an

aggressively expanded money supply—which would spark inflation and

devalue farm debts—industrial nations united in favor of the gold standard

and demonetization of silver. Such restrictive currency vehicles were not

easily compatible with loose monetary policy, as would be demonstrated

again during the “Great Depression” that began in 1929. At a time when

the unemployment rate was 14%, the anti-gold Democrat Bryan lost the

1896 presidential election to Republican William McKinley, who sup-

ported the gold standard. Aided by poor European harvests and fortuitous

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 29

gold discoveries, the American economy began to pick up, and prices

changed course as deflation turned to inflation.

Globalization at the Dawn of the 20th Century

Economic integration can grow in the face of rising protectionism if tech-

nology causes transportation costs to fall by an even greater degree. This

is apparently what happened in the final decades of the 19th century,

as world trade growth slowed yet still remained positive despite tariff

retrenchments from a globalization backlash. Powered by the stream

engine, there was growing price convergence in world commodity markets

(including developing regions). Migration policy was liberal as millions

moved from crowded regions such as Europe to land- and resource-

abundant territories with higher wages such as the Americas. These labor

flows were boosted by tragic events like the 1840s Irish famine and the

poverty and unemployment engendered by the Long Depression. Capital

also followed labor to cheap land, as investment flowed from the Old to

the New World, facilitated by faster information transmission.

By the 20th century there was truly a global division of labor in place,

with a substantial income disparity between advanced industrial regions

and the developing world. Fostered by the twin prescriptions of economic

liberalism—namely, an open international economy and an integrated

currency system—the period from 1896 to 1914 was a high point of glob-

alization and world economic integration. There were gold rushes in South

Africa, Australia, and the United States, helping to generate inflation.

From 1896 to 1913, prices increased by 41% in the United States and

16% in Great Britain. More states—including Russia, Japan, and Austria-

Hungary—flocked to the gold standard, bringing stability to international

trade and promoting investment among member nations. Yet just ahead,

the 30 years of turmoil from World War I to World War II would yield a

remarkable reversal in world trade and globalization trends.

World War I and the Great Collapse

On June 28, 1914, Gavrilo Princip, a Bosnian Serb student, assassinated

Archduke Franz Ferdinand of Austria, the heir to the Austro-Hungarian

30 INTERNATIONAL ECONOMICS

throne, sparking a chain of events that ultimately led to World War I. The

“Great War” was a prolonged conflict in which the economic resources of

each side were fundamental to victory. Among belligerents, there was

unprecedented government involvement in domestic economies. Among

warring European nations, exports fell sharply, by design, because the

military wished to stockpile goods that, in the past, would have been sold.

Each side also tried to prevent adversaries from importing goods for the

same reason. Blockades were an important tool designed to stop enemies

from accessing goods and munitions. The British Royal Navy remained

the foremost in the world, executing an increasingly effective blockade of

Germany, and naval warfare was far-reaching, including submarine attacks

on civilian ships.

European nations expanded industrial capacity in response to the war,

and the United States ramped up industrial production and exports in

spite of not officially joining the hostilities until April 1917. Primary

goods-producing countries outside of Europe augmented their export

capacities in order to meet wartime demand, a move that ultimately

spurred their burgeoning industrialization. Japanese manufacturing

boomed, as did industrial output in South Africa and Chile. Agricultural

production shifted from Europe to other regions of the world, which

would later lead to a large supply “overhang” in the 1920s. Shipping

became more dangerous, and therefore, costlier. There was a consequent

divergence in commodity prices around the world. While the effects of

World War I on trade were uneven, the overall amount of world trade

declined substantially during the conflict, probably by at least 25%.

After World War I, many European nations found it difficult to regain

market share in sectors where developing nations had caught up because of

their overtime war production. From 1913 to 1928, Europe’s share of

world manufacturing output slipped from 41% to 35%. Agricultural

interests across Europe called for protective tariff barriers in the face of

world supply gluts, leading to a wave of protectionism during the

1920s. Political developments led to the franchise being extended in many

European countries, and trade unions rose in influence and power. Labor

markets generally became more rigid and regulated, which would soon

make the vexing problem of high and persistent unemployment during

the Great Depression all the more difficult to solve.

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 31

American tariffs had been high during the second half of the 19th

century, typically over 40% after 1860, largely to encourage domestic

development and industrialization. As American industries became

more competitive by the early-20th century, the need for protection

diminished. Under Woodrow Wilson, average tariffs declined to a low

of about 8% at the outset of World War I. The war increased the need

for tax revenues, and a worldwide wave of protectionism led to double-

digit tariffs in the 1920s. Commodity prices declined in the late 1920s,

threatening American farmers, and during his victorious 1928 cam-

paign, Herbert Hoover promised them protection with a new round of

tariff hikes.

Great Depression

American economic growth was vigorous in the 1920s. During the

“Roaring Twenties,” electricity became a ubiquitous source of energy that

powered new consumer products such as radios, telephones, irons, and

refrigerators. Unfortunately, the electricity boom of the 1920s also helped

to generate a frenzied stock market expansion, similar to the internet

bubble of the 1990s. The Federal Reserve raised interest rates in 1928

and 1929 to combat excessive stock prices, but following several years of

unsustainable speculation, the American stock market finally crashed in

October 1929.

The Great Depression commenced in 1929 with the “Great Crash” on

Wall Street. It was to be the longest and most severe depression experi-

enced by the modern industrialized world. Between 1929 and 1933,

American industrial production fell by almost 50% and America’s total

output dropped by 30%. Unemployment, which peaked at over 20%,

would not fall below 10% until World War II. The magnitude of eco-

nomic decline in other industrialized countries was similarly massive.

World trade dropped off by over 50% from 1929 to 1932, recovering only

slightly throughout the rest of the 1930s.

Protectionist barriers hindering trade increased amidst the enormous

slack in aggregate demand across the world. In June 1930, the United

States passed the infamous “Smoot-Hawley Tariff,” which dictated a mas-

sive tariff increase on dutiable goods, averaging about 60%. However,

32 INTERNATIONAL ECONOMICS

tariff revenue as a fraction of total imports was only about 18% in 1931,

which was far lower than late-19th century levels because fewer goods were

actually dutiable in 1931. While the direct impact that Smoot-Hawley had

on the world economic downturn is commonly exaggerated, it was clear

that the United States, with the largest economy in the world, would not

keep its markets open in the face of economic pressures. After a financial

crisis in the summer of 1931, tariffs generally went up in Europe—partly

as retaliation to Smoot-Hawley—and then across the world, especially on

agricultural products.

After the Great Crash, a growing lack of confidence gripped the

American public. Four massive banking panics swept through the nation

from 1930 to 1932. The Federal Reserve did not respond to severe

financial sector disruptions with credit, liquidity, and accommodative

monetary policy. Instead, the money supply declined by 30% between

1929 and 1933, and many banks did, in fact, fail. In conjunction with

depressed demand, this chain of events caused deflation in the United

States. The gold standard had been prevalent among industrialized

nations since 1879, and maintaining it in member countries required

a monetary tightening to match the one that was transpiring in America.

The result of the massive monetary contraction was a downward spiral

that lowered demand and weakened financial sectors in gold standard

countries.

An economy can expand its monetary supply by devaluing its cur-

rency, and in the dire circumstances of the 1930s, this required suspend-

ing gold convertibility, known as “going off” the gold standard. Great

Britain went off the gold standard in 1931 and thereby devalued, regain-

ing competitiveness and recovering relatively early, whereas countries

that remained on the gold standard later—such as France, Belgium, and

the Netherlands—resorted to tariffs, import quotas, and currency con-

trols to a greater extent in order to shore up their domestic economies.

The United States did not devalue until 1933, shortly after Roosevelt’s

election, and its recovery began later than Britain’s. Between 1933 and

1937 the American money supply increased by about 40%, facilitating

greater access to credit and stimulating demand. The United States also

realized high tariffs were harming its recovery, so protectionism was

gradually lowered throughout the 1930s. The overall global recovery

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 33

was uneven, with Latin America and East Asia doing relatively well dur-

ing the 1930s. While Western European output recovered to 1929

levels by 1935, it took North America until 1940 to reach its pre-Crash

output.

World War II

American capital increasingly dominated the world economy during the

1920s as the United States took over Great Britain’s pre-World War I role

as hegemon. Nevertheless, the United States failed to provide the political

and financial leadership that the British once had. The United States had

traditionally been isolationist and protectionist, unlike Britain, and neither

the United States nor Britain acted as a “lender of last resort” to prevent

major commercial failures by offering liquidity to shore up the world

financial system at the outset of the Great Depression. In addition, the

European allies owed the United States billions in war debt. Many prom-

inent analysts—notably John Maynard Keyes—predicted the massive

reparations imposed on Germany in the wake of the Treaty of Versailles

(which settled World War I) were likely to lead to great trouble in little

time. The United States was unable to craft an acceptable political solution

to these debt controversies despite expending substantial effort in the

Dawes and Young Plans.

The Great Depression turned Germany’s dire economic situation into

a monumental disaster. Adolf Hitler and the National Socialists captured

power in 1933, setting in motion events that would lead to the outbreak of

World War II in 1939. Initially under the guidance of economic minister

Hjalmar Schacht, the German economy was rebuilt and largely national-

ized in the 1930s. Trade between belligerent nations collapsed during

World War II as they focused on domestic industrial and war production.

By 1942, there was almost no trade between German-controlled Europe,

Japanese-controlled Asia, and the rest of the world. Submarine warfare

along the Atlantic slowed trade and maritime transport. World trade fell,

yet trade within allied blocs sometimes increased. American industrial pro-

duction and exports boomed during the war. Allied advantages in popu-

lation and economic production only grew larger after 1942, proving to be

a decisive factor in their victory.

34 INTERNATIONAL ECONOMICS

Aftermath and Reglobalization

At the conclusion of World War II, the American economy was robust and

invigorated, in great contrast to the decimated economies of most other

wartime participants. No longer a missing hegemon, the United States

provided leadership in economic reconstruction and integration. The

“Marshall Plan” gave financial assistance to European nations in

exchange for agreeing to market reforms. The Soviet Union, along with

its sphere of influence, declined to participate. As such, the “Cold War”

had begun. In 1949, the North Atlantic Treaty was signed by Canada,

the United States, and 10 Western European nations. It committed

each nation to the armed defense of the others and brought the “North

Atlantic Treaty Organization” (NATO) into existence. European colo-

nialism in Africa and Asia was forever weakened by World War II, so that

during the 1950s, the tide turned and decolonization movements grew.

These newly independent nations were frequently hostile to integrating

with the rest of the world economy, instead focusing on state-led indus-

trialization programs.

Every nation remembered the political failures of the 1930s that had

allowed protectionism to swell as the world descended into autarky,

nationalism, and ghastly conflict. Looking toward the future, a 1944 Allied

conference at Bretton Woods in New Hampshire set up an international

monetary framework of fixed exchange rates tied to the American

dollar—a currency that was, in turn, tied to gold at a fixed rate. The meet-

ing established the “International Bank for Reconstruction and Devel-

opment” (IBRD)—more commonly known as the “World Bank”—and

the “International Monetary Fund” (IMF) as supporting institutions. The

system cemented the shift in financial power from Britain to the United

States. It would last until August 1971, when Richard Nixon—fearing an

unsustainable run on Fort Knox’s gold bullion—took the dollar off the

$35 per ounce gold peg so that it could depreciate. Although announced as

a temporary measure, this permanent move marked a new era of enhanced

exchange rate flexibility among major world currencies.

International trade rules were also set up alongside the Bretton Woods

system. Most important was the “General Agreement on Tariffs and

Trade” (GATT) signed in 1947, which aimed to facilitate multilateral

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 35

negotiations to reduce trade barriers. This agreement lasted until 1993

when it was replaced by the “World Trade Organization” (WTO). Nine

rounds of negotiation have occurred since the first round in Geneva in

1947. The latest round commenced in Doha, Qatar, in November

2001, and over a decade later, it has not yet concluded. Initial rounds

focused on lowering tariffs, particularly for industrial products, and later

rounds have involved anti-dumping regulations, intellectual property laws,

subsidies, and labor and environmental standards. Advanced industrial

nations, especially in Europe and North America, have generally lowered

their tariffs since World War II, whereas developing economies have been

less likely to scrap their protectionist policies. In essence, the “periphery” of

the world economy was closed during the first 35 years following World

War II, while the wealthy “core” remained open. Since then, trade barriers

have fallen, all the more so in the periphery.

Hyperglobalization

The 1980s sparked a renewal of trade openness and globalization (as dis-

cussed in later chapters). China initiated capitalist reform programs in

1978 under Deng Xiaopeng, triggering phenomenal growth. Commu-

nism collapsed in Eastern Europe and Russia, and “Third World” econ-

omies liberalized. Average tariffs in the developing world fell from 34% in

the early 1980s, to 22% in the early 1990s, to 13% by 2000. There was no

comparable decline in international transportation costs since the end of

World War II. Thus, political factors stimulated the resurgence in eco-

nomic integration and globalization in the late-20th century, whereas a

century earlier, technology led the very same trend. World trade grew at

a 6% annual rate during the second half of the 20th century, faster than

any other period in history, although this was partly because of catching up

after the destructive world wars. The division of labor within the global

economy grew more vertically specialized as manufacturing became more

complex, its processes performed in numerous stages, sometimes in mul-

tiple countries, as the Industrial Revolution percolated to the Third

World. Large international corporations have facilitated such specializa-

tion, with sweeping supply chains that frequently span multiple regions

of the world.

36 INTERNATIONAL ECONOMICS

Conclusion

The world has transitioned toward greater economic integration and inter-

national trade over the past half millennia, particularly since the Industrial

Revolution. The dark period from World War I to World War II was the

recent glaring exception, when deglobalization occurred amidst interna-

tional capital market strains and immense conflict. The last 30 years have

brought about a freewheeling international financial system that supports

massive flows of capital at lightning speed. Many factors, including a lack

of financial oversight coupled with a global savings glut in search of prof-

itable outlets, contributed to the recent financial crisis that occurred some

80 years after the Great Depression. The crisis proved once again that no

globalized financial system can provide an unassailable assurance of safety

and dependability to participating nations. The ensuing decades will likely

entail significant fiscal strains among European and American political and

economic systems, alongside a continued strengthening of Asian economic

and military power. As always, the direction and pace of globalization will

remain critical to understanding future business developments around the

world.

Further Reading

Allen, R. (2009). The British Industrial Revolution in global perspective. Cambridge, England: Cambridge University Press.

Allen, R. (2011). Global economic history: A very short introduction. New York, NY: Oxford University Press.

Bernstein, W. (2008). A splendid exchange: How trade shaped the world. New York, NY: Grove Press.

Chandler, A. (1993). The visible hand: The managerial revolution in American business. Cambridge, MA: Harvard University Press.

Clark, G. (2007). A farewell to alms: A brief economic history of the world. Princeton, NJ: Princeton University Press.

Crouzet, F. (2001). A history of the European economy, 1000–2000. Charlottesville, VA: University of Virginia Press.

Darwin, J. (2008). After Tamarlane: The rise and fall of global empires, 1400–2000. New York, NY: Bloomsbury Press.

Eichengreen, B. (1996). Golden fetters: The gold standard and the great depression, 1919–1939. New York, NY: Oxford University Press.

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 37

Eichengreen, B. (2008). Globalizing capital: A history of the international monetary system. Princeton, NJ: Princeton University Press.

Eichengreen, B. (2015). Hall of mirrors: The Great Depression, the Great Recession, and the uses—and misuses—of history. New York, NY: Oxford University Press.

Engerman, S., & Sokoloff, K. (2011). Economic development in the Americas since 1500: Endowments and institutions. Cambridge, England: Cambridge University Press.

Ferguson, N. (2004). Empire: The rise and demise of the British world order and the lessons for global power. New York, NY: Basic Books.

Ferguson, N. (2008). The ascent of money: A financial history of the world. New York, NY: Penguin.

Findlay, R., & O’Rourke, K. (2007). Power and plenty: Trade, war, and the world economy in the second millennium. Princeton, NJ: Princeton University Press.

Frieden, J. (2006). Global capitalism: Its fall and rise in the twentieth century. New York, NY: W.W. Norton and Company.

Hugill, P. (1993). World trade since 1431: Geography, technology, and capitalism. Baltimore, MD: Johns Hopkins University Press.

Irwin, D. (1996). Against the tide: An intellectual history of free trade. Princeton, NJ: Princeton University Press.

Kennedy, P. (1989). The rise and fall of the great powers. New York, NY: Vintage. Kindleberger, C. (1973). The world in depression, 1929–1939. Berkeley, CA: Uni-

versity of California Press. Kindleberger, C. (1993). A financial history of Western Europe. New York, NY:

Oxford University Press. Kindleberger, C. (1996). World economic primacy: 1500–1990. New York, NY:

Oxford University Press. Landes, D. (1999). The wealth and poverty of nations: Why some are so rich and some

so poor. New York, NY: W.W. Norton and Company. Mokyr, J. (1990). The lever of riches: Technological creativity and economic progress.

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1700–1850. New Haven, CT: Yale University Press. Muller, J. (1995). Adam Smith in his time and ours. Princeton, NJ: Princeton

University Press. North, D., & Thomas, R. P. (1976). The rise of the western world: A new economic

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Cambridge, MA: MIT Press. Wrigley, F. A. (2010). Energy and the English Industrial Revolution. Cambridge,

England: Cambridge University Press.

38 INTERNATIONAL ECONOMICS

Harvard Business School Case Studies

Jones, G. G., & Fernandes, F. T. The Guggenheims and Chilean nitrates, 810141- PDF-ENG.

Jones, G. G., & Gallagher-Kernstine, M. Walking on a tightrope: Maintaining London as a financial center, 804081-PDF-ENG.

Jones, G. G., & Kiron, D. Globalizing consumer durables: Singer sewing machine before 1914, 804001-PDF-ENG.

Jones, G. G., & Vargas, I. Ivar Kreuger and the Swedish match empire, 804078- PDF-ENG.

Jones, G. G., & von Siemens, B. Werner von Siemens and the electric telegraph, 811004-PDF-ENG.

Jones, G. G., Egawa, M., & Yamazaki, M. Yataro Iwasaki: Founding Mitsubishi, 808158-PDF-ENG.

Jones, G. G., Koll, E., & Grendon, A. Opium and entrepreneurship in the nine- teenth century, 805010-PDF-ENG.

Koll, E. Enterprise culture in Chinese history: Zhang Jian and the Dasheng cotton mills, 308068-PDF-ENG.

McCraw, T. K. Jay Gould and the coming of railroad consolidation, 391260-PDF- ENG.

McCraw, T. K. Railroads and the beginnings of modern management, 391131-PDF- ENG.

McCraw, T. K. Samuel Slater, Francis Cabot Lowell, and the beginnings of the factory system in the United States, 792008-PDF-ENG.

McCraw, T. K. Work: Craft and factory in nineteenth-century America, 391264- PDF-ENG.

Moss, D. A. Constructing a nation: The United States and their constitution—1763- 92, 795063-PDF-ENG.

Moss, D. A., & Gownder, J. P. Explaining the Great Depression, 799067-PDF- ENG.

Moss, D. A., & Rotemberg, J. J. German hyperinflation of 1923, 798048-HCB- ENG.

Moss, D. A., Kintgen, E., & Rafalska, A. The South Sea Company, 708005-PDF- ENG.

Moss, D. A., Lee, M., Brennan, K., & Gorin, M. Free trade vs. protectionism: The great Corn-Laws debate, 701080-PDF-ENG.

Nicholas, T. Trouble with a bubble, 808067-PDF-ENG. Rotemberg, J. J., & Lewis, L. H. Birth of modern macroeconomic policy: Sweden and

the Great Depression, 704029-PDF-ENG.

A BRIEF HISTORY OF MODERN ECONOMIC GLOBALIZATION 39

CHAPTER 2

Economic Growth, Convergence, and Trade

Introduction

If there is one question in economics that dwarfs all the others in impor-

tance, it is this: Why are some countries so wealthy and others so poor?

In 2011, per capita income was $49,000 in the United States, but only

$1,700 in Bangladesh. Economists have been grappling with this issue for

centuries. Adam Smith concluded that good governance and a well-devel-

oped division of labor were fundamental to economic growth. In the 19th

century, Karl Marx argued that in modern capitalist economies, the owner

class takes advantage of economies of scale in production and exploits labor,

generating huge profits and a concentration of capital that will sooner or

later spark a worker-led socialist revolution. Contra Marx, there is now a

broad consensus around the world in support of market economies. This

chapter discusses the main contemporary theory of long-term economic

growth, paying attention to the vital forces that support economies.

Neoclassical Growth Model

Modern economics offers a long-run framework for thinking about

economic growth across nations. Called the “neoclassical growth model,”

it has been developed and modified by economists ever since the 1950s. It

serves as a framework for explaining economic growth over the long term

(while ignoring short-term fluctuations), and has been primarily applied to

the postwar era. The neoclassical growth model starts with a production

function, Y(K,L), where Y is the economy’s output. Its level positively

depends on factor inputs of capital, K, and labor, L. Capital is, by defini-

tion, anything that enhances the abilities of workers to perform productive

labor in the economy. It is typically durable and depreciable, and includes

the economy’s buildings, equipment, tools, and other nonhuman

resources used to produce goods. (Land is an input to production, but it

isn’t normally considered capital because it wasn’t produced by people and

its supply is fixed.) An economy’s infrastructure is a type of public capital.

The level of capital in an economy increases when firms or the government

invest at a rate above depreciation. Labor is simply the amount of work-

producing human resources within an economy. It grows with population

size and declines according to retirements and deaths.

The chief characteristics of the neoclassical model’s production func-

tion governing output Y are: (1) it exhibits positive and diminishing

“marginal returns” to each separate input (capital or labor), and (2) it

exhibits “constant returns to scale” overall. Diminishing marginal returns

to each input means that the incremental effect of adding capital or labor

to production is decreasing as the economy has more capital and labor.

That is, holding all else equal within an economy, if a slight amount of

capital or labor is added, its incremental productivity effect (though always

positive) will be greater in an economy that is capital- or labor-poor, and

lesser in an economy that is capital- or labor-rich. The figure below illus-

trates a diminishing returns production function. Labor is held constant

(and ignored), and the x-axis represents capital. It shows that capital inputs yield greater incremental benefits in poor economies:

Y

K

Y(K)

Wealthy economy

Diminishing returns

Poor economy

In other words, the advantageous effect of having more of a factor

input declines as an economy matures and produces more. (Switching the

42 INTERNATIONAL ECONOMICS

places of capital and labor, the above figure would illustrate that, holding

the amount of capital fixed, there are declining returns to additional labor.)

This assumption seems reasonable: poor economies are relatively starved

for resources, so increases in inputs should yield more “bang for the buck.”

Conversely, rich countries have already found all the “low-hanging fruit”

in terms of productivity enhancements and efficient input usage, so

marginal returns within them should be lower.

Constant returns to scale means that increasing every input by the

same proportion will also increase output by that exact proportion. For

example, if both capital and labor are doubled, output will double. It

means that, by holding the technology of a production function constant,

it is possible to replicate smaller economies or industries. The following

table reflects a hypothetical constant returns to scale economy under four

different sizes:

In this example, the “Cobb-Douglas” style production function

(named after 20th century American economists Charles Cobb and Paul

Douglas) happens to be Y = K2/3L1/3. In each case, the capital-to-labor

ratio is fixed at 40%. Compared to the tiny economy, the small economy is

double-sized, the medium economy is triple-sized, and the large economy

is quadruple-sized. Total output increases in inputs, yet output per worker

remains the same, at just over one half. If some capital is added to one of

these economies, output will increase, as will output per capita. However,

because the production function exhibits declining returns in each input,

the marginal value of adding additional capital will decrease as more is

added. The example can represent an entire economy, a growing industry,

or a collection of industries. Think of the industries that you know best. It

is probable that when both factors, capital and labor, are increased pro-

portionately, output would increase by the same proportion, because the

Economy K L Y

Tiny 2 5 2.71

Small 4 10 5.43

Medium 6 15 8.14

Large 8 20 10.86

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 43

units within these industries are able to replicate their parts and scale up.

This is generally true in the construction and health care sectors, for

instance.

The constant returns property holds for any proportionate increase in

inputs, not just a doubling. It implies that if capital and labor both increase

by 1%, output would increase by 1%. It is an assumption about the scale of an economy. While it is a reasonable assumption for modern econo-

mies, not all economies exhibit constant returns to scale. For instance, a

primitive agricultural economy with a fixed amount of land would not

experience constant returns to scale: doubling the amount of labor and

capital would lead to less than a doubling of output. In this case, because

production is limited by the availability of a key resource, land, the econ-

omy would exhibit decreasing returns to scale. Manufacturing industries commonly display increasing returns to scale. Theoretically, a technology- intensive economy can exhibit increasing returns to scale in the aggregate,

although it isn’t clear that any economies today have this property.

The production function Y(K,L) captures the aggregate output of an

economy, holding technology constant at a given point in time. Within

any economy, capital and labor are assumed to flow to their most produc-

tive usages, so that their marginal returns are roughly equal across indus-

tries. Therefore, the production function really consists of many small

economies. Not every industry fits these assumptions precisely. For one,

some “high-tech” industries, like software design, may exhibit sharply

increasing returns to scale after the research and development of a product

has been completed. In the case of Windows Vista, it supposedly cost

Microsoft six billion dollars to develop the operating system, although the

cost of producing a marginal copy is close to zero. Nevertheless, the two

primary assumptions of this production function Y(K,L) seem, on the

whole, fairly reasonable in light of years of empirical research.

The basic neoclassical model includes a few other assumptions. Labor

is assumed to grow at a constant rate, which is the rate of population

growth. Workers are paid their marginal return to labor (equal to the wage

rate). Each worker consumes part of their income and saves the rest. These

savings are converted to investment via the financial sector. The interest

rate is the marginal return to capital, which is, equivalently, the “cost of

capital.” Investment goes directly to capital improvements, and it is

44 INTERNATIONAL ECONOMICS

assumed that the economy’s capital stock depreciates at a constant rate.

With these assumptions, the neoclassical growth model can be solved with

some algebra. However, interpretation is made easier by describing its crit-

ical results in words.

Steady-State Equilibrium

The model’s central result is that any given economy—no matter where it

starts from—will end up in a “steady-state” equilibrium where capital,

labor, and output all grow at the same rate, which is the population growth

rate in this simple world. Thus, output per capita will eventually be con-

stant in equilibrium. Steady-state equilibrium occurs because: (1) the

returns to capital and labor are decreasing due to the diminishing returns

to each factor assumption, and (2) the economy can sustain indefinite

growth along the steady state due to the constant returns to scale assump-

tion. The more people save, the greater output per capita is. To optimize the

well-beingofcitizens,it isbesttomaximizelong-runconsumptionpercapita,

and to achieve this, a “Golden Rule” savings rate—which is neither too high,

resulting in overinvestment, nor too low, resulting in overconsumption—

can be found analytically. The inclusion of technology is one important

modification to this model (discussed below). Technological progress causes

output per capita to grow (instead of stagnate) in the long run.

Let’s examine some examples of how economies reach the steady state

in the neoclassical growth model. First, consider an economy with low

levels of capital, such as an emerging or postwar economy (like 1950s

Europe under the Marshall Plan). A little capital may go a long way here.

The marginal return to capital is high, meaning that capital is very pro-

ductive. With a reasonably high savings rate, output will grow fast and

capital will accumulate quickly. As “capital-deepening” occurs, workers

become more productive as each one has more capital to work with. As

time goes on, however, the marginal return to capital will slow due to

decreasing returns. Eventually, steady-state equilibrium is reached, so that

the growth rate of capital, labor, and output will all be equal to the pop-

ulation growth rate. This example would also fit a New World frontier

society, where population growth may be very slow at first, making migra-

tion from elsewhere necessary for robust growth.

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 45

Now consider what happens in the opposite case, where an economy

has ample capital relative to its population. This is what occurred in econ-

omies afflicted by the Black Death of the 14th and 15th centuries that

resulted in a very high capital-to-labor ratio. After the plague, wages were

high—about three or four times subsistence—because labor was scarce

and the marginal product of labor was high. The stock of capital was spread

across fewer workers, signaling that the return to new capital investment

was low. This depressed savings and interest rates, the latter falling in

England from about 10% before the plague to 5% by 1500. In the model,

the amount of capital per worker decreases as the population recovers,

until the steady-state equilibrium—where capital, labor, and output grow

at the same rate—is reached. This process, sparked by mass deaths, is the

converse of the 1950s Europe scenario, which was kicked off by a massive

destruction of capital. With some math, you would see that according to

this model, an economy will eventually converge to the same equilibrium

regardless of where it started out, although it may take a long time.

It should be noted that this growth model, as with all economic mod-

els, is a simplification. By their very nature, economic models focus on a

select set of forces. The real world is complicated, so no model captures

every relevant factor. Even so, economic models can provide tremendous

insights by honing in on the interaction of key forces. In fact, Professor

Robert Solow—Nobel Prize winner and one of the originators of the neo-

classical growth model during the 1950s—later bemoaned the huge liter-

ature that his work spawned, since he thought most of it went beyond the

appropriate confines of his original growth model, and thereby provided

little value-added. Besides additional theory, some helpful empirical test-

ing of the neoclassical model (discussed below) has been performed over

the past half century.

Convergence

What does the neoclassical growth model imply for economic growth

around the world? The most important prediction is that there is a ten-

dency for economies to converge—or catch up—over time. Advanced industrial economies may lead the world in output and income, but if

poorer economies have access to their leading technologies (and the general

46 INTERNATIONAL ECONOMICS

output possibilities that their superior production function implies), then

these developing economies may very well catch up one day. According to

the neoclassical growth model, poor countries have lower capital-to-labor

ratios, so we may expect them to grow faster because their returns to capital

are higher. They will catch up eventually, all else being equal. Globalized

capital flows mean that leading economies can invest directly in developing

nations, increasing the poorer country’s level of technology, infrastructure,

and output. In addition, information travels very quickly today, and not

every country protects the intellectual property it uses, especially technol-

ogies that were developed abroad.

When economists dig into the data on economic growth, they usually

test one of two convergence hypotheses that derive from the neoclassical

growth model. The first is called unconditional—or absolute—convergence. The absolute convergence hypothesis is that poor countries experience

higher economic growth rates than rich countries. Its logic is that if all econ-

omies possess the same steady-state equilibrium, and the primary difference

between economies is their initial level of capital, then poor nations will

grow rapidly as they accumulate capital and catch up. There is not much

support for this notion in the data. In fact, the international data show that

wealthier countries have usually tended to grow faster than poor countries.

However, when a sample is restricted to a similar group of nations, such as

only European countries, absolute convergence does show up in the data.

This is because these countries are much more similar, and information,

capital, and labor flow more freely within a relatively small geographical

region. There are also vast differences in the growth experiences of conti-

nents. African countries have remained poor for many decades, so clearly,

comparing them to European countries will not lend empirical support to

the absolute convergence hypothesis.

Are there any reasonable adjustments to the absolute convergence

hypothesis that fit the data better? Indeed, economists have tested a second

convergence hypothesis known as conditional convergence. The idea behind it is that by controlling for factors that influence a country’s

steady-state level of output (such as savings rates), evidence of convergence

will be found. For instance, a poor country with a low savings rate and

undeveloped financial system may grow slowly and have trouble converg-

ing in spite of a high potential return to capital. By including appropriate

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 47

control variables, it is possible to test whether very different countries con-

verge to each other over time, all else being equal. These relevant controls

include human capital levels, such as the average amount of education

within a country’s workforce; the quality of government (however mea-

sured) and infrastructure; and openness to international trade. It turns out

that empirical analyses do lend support to conditional convergence (at least

using data sets from the past half century, as data on appropriate controls

generally aren’t available before then). After controlling for important dif-

ferences across countries, lower initial output strongly correlates with

higher subsequent growth. As a result, there exists empirical support for

the neoclassical growth model: poorer countries catch up to richer coun-

tries as long as basic discrepancies between them—such as education and

governance—are accounted for.

Research on economic growth demonstrates that a number of other

forces outside the basic model can facilitate or impede growth. To be sure,

any student of history would contend that politics and government are

important to growth, and stories about the impact of politics on economic

growth are usually unhappy tales. For example, Argentina was one of the

wealthiest countries in the world in the 1920s, but then endured a period

of unstable governments (including military dictatorships) that exhibited

poor monetary and fiscal policy and implemented other policies detrimen-

tal to growth. In an extreme case, Zimbabwe has suffered from poor

growth, low investment, and hyperinflation under Robert Mugabe’s rule

since the 1980s. On the other hand, a number of East Asian nations have

recently succeeded in coordinating export-driven growth as they integrated

into the international division of labor and production. Most strikingly, at

the end of World War II, North and South Korea were both very poor,

though since then, under very different economic systems, the South has

seen explosive growth compared to the stagnant North.

Contemporary research shows that although the size of government is

not overly important to growth, its quality is. Huge deficits, hyperinfla-

tions, entrenched bureaucracies, and civil war all hamper growth. The

institutions of governance are influential. Stable markets, property rights,

and the rule of law all promote economic growth. Openness to trade and

infrastructure—such as electricity-generating capacity, the amount of

paved roads, and telephone usage—are positively related to economic

48 INTERNATIONAL ECONOMICS

growth. Given these empirical patterns, many have attempted to modify

the neoclassical growth model in various ways, even by taking into account

governance, which is arguably the most significant factor despite being

difficult to measure or model with mathematics. Human capital and tech-

nology (discussed below) are two of the most important extensions pro-

viding additional elements of realism.

Human Capital

Human capital is the set of skills and abilities that each individual brings to

their work and the labor market more generally. Human capital comes

from education, training, experience, and talent. Economists often focus

on education because schooling increases human capital, and data on edu-

cational attainment exist for many countries. The primary prediction of

human capital theory is that increased education and human capital leads

to higher wages and income, both for individuals and for nations. This is

accomplished through higher productivity. Human capital is a comple-

ment to physical capital since it makes workers more productive under

any given set of equipment and technology, meaning that workers

with more human capital are better equipped to utilize physical capital

efficiently. More human capital also implies greater research and develop-

ment, yielding better technologies, which in turn leads to higher national

output.

Consider the investment decision in the neoclassical growth model. Its

basic version only allows investment in physical capital. Adding human

capital allows for investment in education. Higher levels of education—or

equivalently, greater human capital—can be included in the production

function, which will now look like F(K,L,H), where H is human capital.

Economies with greater human capital produce more because human cap-

ital is complementary to labor and physical capital. Yet investing in human

capital is costly for a society: the opportunity cost is consumption today or

savings for later (with the latter option equivalent to investing in physical

capital via the financial intermediation sector). In developing countries,

families rarely have sufficient resources to pay for adequate private school-

ing, so public schooling is normally required to develop the national stock

of human capital. Solving the extended neoclassical growth model with

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 49

math demonstrates that countries that invest in human capital will have

higher per capita income in equilibrium. It may also take longer for poorer

countries to converge, since they will need to catch up to the higher levels

of physical and human capital that richer countries have attained. Human capital is both a cause and a consequence of economic growth.

Skilled workers not only produce more, they also generate beneficial

“spillovers” onto their local economy by achieving innovations, sharing

information, and managing others. Experience shows that as economies

progress from emerging to advanced status, greater investment in educa-

tion is common. Some economists argue that a major reason why the

United States was able to remain the dominant world economy through-

out the 20th century was because of its relatively large investments in edu-

cation during the earlier decades of that century, as public secondary

education—meaning schooling through high school—became more

accessible. Whereas the key to the 19th century industrial success was

natural resources and machinery, human capital embedded in people grew

more critical to national economic prowess over the course of the 20th

century. The United States was the leader in providing mass secondary

education in the early-20th century, when many European nations viewed

the American system as wasteful precisely because it was not meritocratic.

Under its egalitarian emphasis on general public education, full-time sec-

ondary school enrollment rates in the United States were much higher

than in Britain and the rest of industrialized Western Europe throughout

the first half of the 20th century. After World War II, the United States led

in providing mass higher education. Combined with its world-leading uni-

versities, this factor contributed mightily to subsequent technological

advances and productivity growth in the United States.

Empirical evidence shows that greater investments in education are

associated with higher economic growth rates across nations, although the

relationship isn’t as strong as some economists had expected. This finding

may be partly due to measurement difficulties, since educational quality is

tough to gauge and compare across countries. Human capital not only

makes workers more efficient, but it also enhances their ability to manage

new technologies. Indeed, one important empirical finding is that eco-

nomic growth is strongly related to the average level of schooling among

50 INTERNATIONAL ECONOMICS

adult males at the secondary and higher levels. Because workers with this

educational background are likely to be most complementary to new tech-

nologies in emerging economies, it implies a vital role for the diffusion of

technology in the development process. Other literatures show that edu-

cation has many auxiliary beneficial effects such as the facilitation of

political stability and the prevention of crime. Today, the internet is

spreading educational information at little or no cost, improving living

standards in ways that do not show up in national income statistics. Top

universities are offering more online courses every year, and these new

tools of learning may well contribute to global economic growth in the

years to come.

Technology, Science, and Growth

Technology is the other main extension to the neoclassical model. It is

defined as the modification and development of tools, techniques, and

equipment to promote the economic productivity of workers and capital.

In practice, it is the application of the functional sciences (such as engi-

neering) to industry and commerce. Including accumulated technology,

the production function becomes Y(K,L,A), where A is the level of a

country’s technology, either assumed to grow at a specified constant rate

or according to investments in research and development (possibly includ-

ing human capital). The extended neoclassical model’s main result is that

the steady-state equilibrium growth rate of per capita income will be equal

to the growth rate of technology. In other words, national wealth is driven

by technological progress.

The fundamental mechanism is that new technology leads to produc-

tivity growth, allowing more goods to be produced in less time with fewer

inputs and less effort. In the long run, growth and prosperity ultimately

stem from productivity improvements, so technological progress is essen-

tial. Across countries, differences in technology lead to differences in pro-

ductivity, and therefore incomes. Although poorer countries are expected

to converge, they must accumulate technology—and the capabilities to

utilize it effectively—in order to do so. And the larger the technology gap,

the longer it takes them to converge. In some formulations, the technology

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 51

factor is a catch-all for many different forces influencing economic growth

in a region, including its degree of entrepreneurial spirit, its research and

development spending, and its effective enforcement of intellectual prop-

erty rights. The American city of Austin, Texas provides a good example of

a region leveraging these factors—in conjunction with the resources of a

large local research university—to become a bastion of technology-driven

growth. Beginning in the 1980s, the coordinated efforts of local leaders in

government, business, and academia led to a dramatic economic boom

where thousands of tech companies were attracted to the Austin area.

Given the private sector’s intense demand for human capital, Austin has

struggled to keep up at times, leading to periodic shortages of skilled labor.

Fresh examples of the power of technology come from computers and

the internet, which are part of the scalable, knowledge-intensive high-tech

sector. New software (like Windows) and web sites (like Google) have

driven economic growth and generated immense wealth. The best ideas

and best products are embraced globally, which has a “winner-take-all”

multiplier effect on the payoff from being the absolute-best versus

thousandth-best product developer. (Think of iPhone app sales.) One key

difference between technology-driven improvements and physical capital

accumulation is that, as opposed to capital investment, funding for high-

tech research and development leads to breakthroughs that are “nonrival”

(or sharable). Ideas can be transcribed or stored at no cost. This means that

research and development can have an extremely beneficial effect on eco-

nomic growth because ideas tend to spread quickly. In a healthy economy

that innovates with scientific research, many sectors can operate at the

“technology frontier” (or current limits of technology).

Intellectual Property Rights and Growth

The history of patent law demonstrates that nations are most concerned

with intellectual property protection as a means to promote domestic eco-

nomic growth. Venice originated the modern notion of patent protection

with a 1474 statute granting 10 years of exclusive rights to inventors and

entrepreneurs who had invented or brought new technologies to the

Republic. In the 16th century, a system of patent monopolies developed

in England under the Crown. Unfortunately, Queen Elizabeth I and King

52 INTERNATIONAL ECONOMICS

James I frequently sold monopoly patent rights to raise revenue and reward

political patrons. After decades of abuse, the 1624 “Statute of Monopolies”

was enacted, providing the foundations for English patent law. It gave no

protection to foreigners and clearly aimed to encourage domestic industrial

activity, employment, and economic growth. During the early-19th

century, the United States was very lax in protecting foreign intellectual

property as it was drawing nearer to Britain, although it was actually a

forerunner in enforcing the intellectual property rights of its own citizens.

Following the 1836 passage of the “Patent Act,” technically trained exam-

iners began scrutinizing patent applications to make sure inventions were

original advances, in a system that has endured to this day. By the mid-

19th century, many observers attributed American technological savvy to

its advanced system of intellectual property rights protection.

Today an organization may spend millions of dollars on developing the

latest microchip technology, but if this information leaks, competitors may

be able to utilize it at no cost. In general, if intellectual property is not well

protected, investments in research and development could slow, hurting

economic growth in the long term, both locally and globally. Practical

perspectives on intellectual property rights depend on a nation’s level of

development and its distance to the technology frontier. A wealthy country

with many new advanced technologies and heavy research and develop-

ment spending (in both the private and public sector) may wish to enforce

very strict intellectual property laws around the world. By contrast, it is

much cheaper for developing nations to disregard intellectual property

laws and instead copy (or reverse engineer) the technologies of other coun-

tries. Chinese intellectual property enforcement is still very loose today,

which is common for a nation catching up to technological leaders. Bor-

rowing foreign know-how can support economic growth today and spur

the development of domestic technology-intensive sectors without requir-

ing a lot of spending on research and development (at least in the early

years).

Business Opportunities

The neoclassical growth model generates insights into potential business

opportunities across nations. Sometimes called the cost of capital, the

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 53

interest rate is understood to be a proxy for the profitability of business

investments and the overall returns to investment within an economy. For

a given economy, the interest rate is equal to the marginal product—or

incremental output—of capital, which, all else equal, is likely to be

decreasing as a country develops and amasses physical capital. Thus,

returns may be expected to be higher in fast-growing emerging economies

with many profitable business opportunities but scarce capital funds. In

need of capital and expertise to catch up to advanced nations, emerging

economies can be attractive regions for businesspersons and investors. On

the other hand, emerging economies do not always have first-rate political

institutions, contract enforcement, or infrastructure, so investing in them

can be risky for foreigners.

To take this one step further, consider the neoclassical growth model

with the technology factor A. Superior technology leads to higher interest

rates because productivity and the returns to physical capital are an increas-

ing function of technology. This implies that: (1) wealthier countries can

sustain higher capital returns and interest rates over the long run if they are

able to maintain their technological lead, and (2) in a globalized economy

with international investment, capital can continue to flow to advanced

economies instead of helping to build up emerging economies. Indeed,

research shows that on net, capital tends to flow to wealthier countries.

Although it is much more pronounced today, this finding of “wealth bias”

was also observed prior to World War I, the last time that global capital

markets were so well integrated. The phenomenon of capital flowing to

wealthier countries rather than poorer ones has been labeled the “Lucas

paradox” (after Nobel Prize-winning economist Robert Lucas) because it

contradicts the notion that developing nations should be relatively more

attractive places to invest due to higher expected returns on capital. Besides

stamping out corruption and building political stability and infrastructure,

emerging countries can import advanced technologies to help them com-

pete for capital in the global investment market. Given their disadvantages,

they should focus all the more on improving their overall human capital,

technological, and institutional capabilities.

Large corporations from leading economies often try to break into

emerging markets to achieve high returns on their investments, as there

may be significant advantages to being the first company to successfully

54 INTERNATIONAL ECONOMICS

serve a new market and establish brand equity. Yet accomplishing this can

be difficult in an increasingly globalized marketplace where information

flows instantaneously. Entrepreneurs in emerging markets can be quick to

copy business models devised in more advanced regions. One example is

MercadoLibre, the Latin American eBay, which was started by an Argen-

tine studying business in the United States. Emerging markets may pirate

goods from advanced economies, such as Microsoft’s software products,

which are well known to be copied throughout China and many other

regions. Even if a foreign company establishes a toehold in an emerging

market, government-enforced barriers can hinder foreign firms, and

domestic companies may spring up and attempt to compete with the

advantage of subsidies or legal protections.

Productivity Across Nations

In the neoclassical growth model, the amount of physical capital per

worker and the level of technology and human capital are the primary

determinants of an economy’s growth trajectory. When comparing coun-

tries around the world, richer countries compare favorably to poorer coun-

tries across all three dimensions: they have more physical capital per

worker, greater stocks of human capital, and more advanced technologies.

Empirical studies suggest that differences in physical capital explain no

more than a quarter of per capita income differences across countries. The

remainder is due to greater productivity in wealthier countries, caused by

superior technology, greater efficiency, deeper human capital, and better

institutions and governance. Economists call this residual “total factor

productivity” (TFP), which represents how efficiently capital and labor are

utilized within an economy.

Differences in labor quality are important in explaining productivity

differences between nations. Measured human capital can explain some of

the variation in labor quality, as can differences in the experience and

quality of managers (called “managerial capital”). Better technology

improves labor productivity and the productivity of capital. A strong polit-

ical and legal environment facilitates labor productivity since in its

absence, individuals and firms face considerable uncertainty, often have

to pay bribes, and have less overall incentive to work hard and make

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 55

productive long-term investments. In developing nations, workers are less

productive partly because they lack access to modern medicine, adequate

health care, and proper nutrition. The evidence also suggests that in poor

economies, employing more workers per unit of capital does not increase

output by much, which remains something of a puzzle.

The experience of economies decimated by World War II is instruc-

tive. Germany and Japan both grew at very high rates after their physical

economies were destroyed by the war. Germany’s work force possessed

high levels of human capital, and its economy had access to foreign capital

that was used to invest in industry. Japan improved its educational system

after the war, emphasizing on-the-job training, and focused on under-

standing cutting-edge technologies used by foreign economies. Propelled

by reverse engineering efforts and licensing agreements, it would emulate

and then improve upon these technologies, so that the productivity of

Japanese industry was among the best in the world by the 1970s. Such

favorable growth stories contrast with India, a nation that turned inward

after independence in 1947, and in its striving for self-sufficiency, failed to

develop a thriving industrialized economy.

Productivity Slowdowns

As a matter of history, productivity growth isn’t constant over time. It

picked up considerably at the start of the Industrial Revolution in Great

Britain, for example. More recently, productivity was strong in the postwar

United States in the 1950s and 1960s before slowing in the 1970s and

1980s. This phenomenon was termed the “productivity slowdown puzzle”

by economists at the time and it was heavily researched in the 1990s.

Leading explanations were: (1) it was due to a lack of new technological

improvements, because after the industrial heyday of the 1950s and 1960s,

industry had finally caught up to the frontiers of science by the 1970s;

(2) it was driven by the energy crisis in the 1970s, which caused cost infla-

tion and retarded investment and productivity growth; and (3) it didn’t

really exist, as the supposed slowdown was simply a figment of the data’s

imagination. In hindsight, the first explanation is the most promising.

Science leads to technological advancement which impacts productivity

growth, but the timing at each stage is unpredictable.

56 INTERNATIONAL ECONOMICS

Productivity growth in advanced nations started to pick up again in the

1990s, likely spurred by the information technology revolution and com-

puterization. Evidence shows that in the United States, productivity

growth from computers didn’t really emerge until it surged in the late

1990s, and then stayed solid for the first half of the following decade,

helped along by corporate cost cutting after the “Dotcom” bust.

In Europe, productivity did not accelerate in the mid-1990s, even

though new technologies were implemented (at least with a lag as com-

pared to the United States). This may be due to other changes the United

States implemented but Europe did not, such as laborsaving reorganiza-

tions, and the rise of big-box American retailers (notably Walmart) that

were savvy about using new technology and supply chain management

practices. Regardless, the debate continues. Measurement issues are

always at the forefront since productivity is not directly observed and

measures of technology utilization are never perfect, particularly in

cross-country comparisons.

Socialism

Some of the greatest extended productivity slowdowns since the Industrial

Revolution occurred in centrally planned socialist countries. Russia’s

socialist economy was governed by a series of 5-year plans until its disso-

lution in 1991. According to Western estimates, although the Soviet econ-

omy grew quickly in the first two postwar decades, it began stagnating in

the 1970s and was in crisis by the 1980s (as Russian citizens could surmise

themselves at the time). Russian living standards actually declined after the

1960s, as infant mortality rates increased and child and adult heights fell.

To the extent that there was prosperity in late Soviet Russia, it was appar-

ently not widespread. Centralized economic planning led to long-term

imbalances in investment and industrial growth, so that the Soviet econ-

omy became increasingly unsound over time. In sum, it is difficult to

restructure a command economy or develop and implement new technol-

ogies under socialism, as the great Austria-Hungary-born 20th century

economists Friedrich von Hayek and Joseph Schumpeter reasoned. Nobel

Prize winner Hayek focused on the insolvable problem of reorganization in

the absence of market price signals, and Schumpeter recognized that

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 57

capitalism’s “creative destruction” process of continual restructuring was

the essence of its dynamism.

China, the most populous socialist economy of the 20th century, pro-

vides a striking before-and-after comparison. Prior to 1979, China exhib-

ited uneven growth for decades as it maintained a command economy that

was isolated from the global economy. It relied on government directives

and 5-year plans that were often disastrous. The second such plan, called

the “Great Leap Forward,” began in 1958. In an attempt to catch up to

leading economies such as Great Britain, Mao Zedong collectivized agricul-

ture and forced millions to move into industrial production. As a result, food

production dropped sharply and tens of millions of rural peasants starved to

death. Then, starting in 1966, Mao instituted the “Cultural Revolution,”

designed to purify Chinese society by purging it of all elitist bourgeois ele-

ments. The program devastated China’s educational system, leading to a

sharp decline in human capital. (Back in the 1940s, Hayek warned that

authoritarian command economies would eventually lead to the collapse of

civilization.) Beginning in 1979 under Deng Xiaoping, China slowly opened

up to foreign trade and investment. With these reforms, China’s real per

capita “gross domestic product” (GDP) grew more than 13-fold from

1980 to 2010, and hundreds of millions were raised out of extreme poverty.

Growth Across Continents

The neoclassical growth model provides a valuable framework for measur-

ing and analyzing how poor countries grow and catch up to the wealthiest

economies. Emerging economies require active policies that foster eco-

nomic diversification and summon a shift from low-productivity sectors

such as agriculture to higher productivity activities. The rate at which this

transition occurs depends in part on the economy’s ease in absorbing

knowledge from more advanced economies. Yet there is no automatic

mechanism or policy recipe that allows any emerging economy to success-

fully transition to a wealthier state. Over the past half century, the growth

experiences of developing economies across Asia, Latin America, and

Africa provide some interesting contrasts.

Asia has been the biggest success. Hong Kong, Singapore, South

Korea, and Taiwan led the way from the 1960s to the 1990s, exhibiting

58 INTERNATIONAL ECONOMICS

GDP per capita growth rates that averaged at least 6%. These economies

invested heavily, accumulating massive amounts of physical capital. Their

populations and work forces grew, and they improved their educational

systems so that human capital increased. These relatively small countries

liberalized trade policies and promoted labor-intensive manufactured

exports. Labor shifted from agriculture to manufacturing, and rapid export

growth was a key feature of their success. After investigating the statistical

evidence behind the “East Asian Tiger” experience, economists have con-

cluded that most of their growth was due to massive factor accumulations

as opposed to extraordinary technological progress. On the other hand,

Japan, which was the original Asian Tiger, showed relatively greater tech-

nological efficiency in its postwar growth. It also had much higher human

capital levels to begin with.

The two most populous nations in Asia, India and China, have both

grown rapidly since 1980. India’s growth has been similar to the East Asian

Tigers, albeit slower. However, as opposed to growth in manufacturing, it

has been fueled by a massive expansion in service industries. China’s

growth has been driven by greater amounts of physical capital accumula-

tion and total factor productivity. Its service industries have expanded, but

crucially, its industrial sector productivity and output have exploded, in

lockstep with a major expansion in exports. India’s industrial sector has not

sustained such developments to date. Both India and China began liber-

alizing trade in the late 1970s. The share of China’s output that is exported

has remained much higher than India’s, although both have more than

tripled over the past 30 years.

Latin America, which was much wealthier than East Asia back in the

1950s, has been a disappointment. Savings and investment have remained

weak, and education has not been emphasized to the extent that it was in

East Asia. Although the region is rich in natural resources, this wealth has

not always been directed to growth-enhancing investments like education

and physical capital accumulation. Poor governance and explosive debt

crises have historically been a problem, though today most of Latin

America is ruled by democratically elected governments. In recent decades,

the region has struggled to maintain high employment shares in industries

that are liberalizing or undergoing productivity growth, so free trade has

not been a blessing to the extent it was in East Asia. One bright spot is

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 59

Brazil, where economic growth, spurred by improving governance and

high commodity prices, has been impressive over the past decade. Its expe-

rience is hopefully a harbinger of things to come for neighboring countries.

In fact, while overall growth in Latin America slowed from the 1950s to

the 1980s, it has picked up considerably since 1990.

Africa has been the worst performer. African economies have struggled

to develop a modern industrial base in large part due to inadequate gov-

ernance and institutions. Corruption in many nations is endemic and

remains a major barrier to investment and growth. Civil wars have raged

in many areas of Africa, making it difficult to attract physical capital

investment, either domestically or from abroad. Wealth from natural

resources often led to conflict instead of public sector improvements like

enhanced schooling systems, and investors have resisted choosing Africa

over other potentially profitable regions. In addition to low levels of

human capital, worker productivity has been hampered by malnutrition,

disease, and poor health care. Even when education has improved (such

as in parts of North Africa), job opportunities and growth have not

always materialized. Still, like Latin America, African political institu-

tions have improved in recent years, and economic growth rates have

increased since the 1990s.

Openness, Trade, and Growth

Conventional economic models of international trade suggest that trade

promotes growth because it allows each nation to focus on the economic

activities that it can perform most efficiently. In other words, it gives each

country more opportunities, minimizes costs, maximizes output, and leads

to a more finely tuned division of labor across the world. Trade also facil-

itates the transfer of new technologies and ideas, particularly from leading

economies to developing economies. Then again, emerging economies

may be wary of opening up their infant industries to import competition,

and even among successful exporting industries, opening trade further can

cause reallocations and social upheaval. For this reason, countries that have

successfully liberalized trade, such as the East Asian Tigers, have been care-

ful to watch out for dislocations. In recent decades, Latin American coun-

tries have not managed liberalizations with as much care and success,

60 INTERNATIONAL ECONOMICS

although Chile, assisted by subsidies to exporting industries, has achieved

considerable export-driven economic growth.

According to postwar cross-country data, increased trade is correlated

with higher incomes and greater economic growth. This does not neces-

sarily mean that trade and openness cause economic growth, because, for

instance, wealthy and fast-growing economies may have the most liberal

trade policies, or, at the very least, they have been careful to time their

openings to international trade in an optimal fashion. Recent research

scrutinizing this relationship has generally concluded that trade facilitates

economic growth and promotes investment in physical capital. Other

studies, based on specific liberalizing experiences, suggest that when a

country opens itself to trade, the most efficient plants expand and show

efficiency improvements, exporting firms expand, and import-competing

firms may contract. Consumers typically gain from an increased variety of

goods, often at much lower prices. For example, a massive influx of low-

priced Chinese imports has augmented the purchasing power of American

consumers over the past couple decades.

Opening an economy to international trade often has an uneven

distributional impact, meaning that some groups are harmed while

others benefit or notice no ill effects. A classic example is weavers in India

who were forced into unemployment by cheap textile imports from

Britain in the 19th century. Even if skilled Indian weavers were eventu-

ally able to find employment at lower wages, they were hurt in the short

and long term. Today, new international competitive pressures can dete-

riorate company margins, diminish the bargaining power of workers and

unions, and necessitate capital and technology upgrading. Among

nations that export a large fraction of their output, one downside risk

to trade openness is a greater vulnerability to global business cycle fluc-

tuations. Advanced economies that are the most exposed to international

trade have also built up the largest public sectors and safety nets to pro-

tect workers from the inherent risks of openness. At one extreme are the

United States and Japan, countries that do not rely heavily on exports,

while at the other extreme are the Netherlands and Sweden, countries

that do. Overall, the gains from allowing trade run into diminishing

returns as fewer restrictions are in place, so that distributional considera-

tions become more important.

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 61

Lowering tariffs and liberalizing international trade sometimes coin-

cides with opening an economy to foreign capital flows. Unfortunately,

economies that are open to international capital flows face the downside

risk that capital may flow out of them very quickly, depressing prices,

investment, and demand. For instance, during the 1990s, after years of

brisk economic growth, increasing foreign investment, and rising asset

prices, external shocks led to a fall in confidence and slowing growth in

Southeast Asia, so that in July 1997, Thailand was forced to devalue its

currency. The crisis soon spread to Indonesia, Malaysia, the Philippines,

and other parts of the world. The poor are the most devastated by financial

crises in developing economies. During the first year of the Thai crisis, the

percentage of poor people in rural Thailand jumped by about 50%, and in

Indonesia, manufacturing wages were nearly halved. Other Asian coun-

tries, such as China and India, made out relatively well due to their strict

controls on capital flight. Historically, high levels of international capital

mobility have led to international banking crises. The global financial crisis

that began in 2007 is the most recent example, as investors fled foreign

markets for the safety of home or prominent reserve currencies. Aided by

smart capital controls or other restrictions, emerging economies that are

liberalizing should balance the benefits from open capital flows with the

downside risks that accompany capital mobility.

Conclusion

The neoclassical growth model implies that physical capital, human cap-

ital, labor, and technology all contribute to an economy’s growth. What’s

more, emerging economies are capable of faster growth as they converge to

advanced economies. China may be the best-known recent example of this

phenomenon. Furthermore, since the 1990s developing economies have

become more integrated with the world economy and have grown at a far

brisker pace than developed economies. Globalization has undoubtedly

contributed to technology transfer and enhanced productivity in emerging

regions. Asia has been more successful than Latin America or Africa largely

because Asian economies have better navigated structural change in

expanding high-productivity, high-wage sectors. In the coming decades,

high world demand for raw materials and commodities will provide extra

62 INTERNATIONAL ECONOMICS

financial resources to developing nations, which can potentially be used to

support development through the provision of better educational oppor-

tunities and health care for their citizens. Hopefully emerging market gov-

ernments will be up for the task, so that internal political conflicts are

mitigated as these economies play to their strengths and increase exporting

capabilities.

Further Reading

Acemoglu, D. (2008). Introduction to modern economic growth. Princeton, NJ: Princeton University Press.

Aghion, P., & Howitt, P. (2008). The economics of growth. Cambridge, MA: MIT Press.

Atkinson, R., & Ezell, S. (2012). Innovation economics: The race for global advan- tage. New Haven, CT: Yale University Press.

Barro, R., & Sala-i-Martin, X. (2003). Economic growth. Cambridge, MA: MIT Press.

De Soto, H. (2000). The mystery of capital: Why capitalism triumphs in the West and fails everywhere else. New York, NY: Basic Books.

Easterly, W. (2002). The elusive quest for growth: Economists’ adventures and mis- adventures in the tropics. Cambridge, MA: MIT Press.

Galor, O. (2011). Unified growth theory. Princeton, NJ: Princeton University Press.

Goldin, C., & Katz, L. (2008). The race between education and technology. Cambridge, MA: Harvard University Press.

Gordon, R. (2016). The rise and fall of American growth: The U.S. standard of living since the Civil War. Princeton, NJ: Princeton University Press.

von Hayek, F. (1944). The road to serfdom. Chicago, IL: University of Chicago Press.

Helpman, E. (2010). The mystery of economic growth. Cambridge, MA: Harvard University Press.

Janeway, W. (2012). Doing capitalism in the innovation economy: Markets, specu- lation and the state. Cambridge, England: Cambridge University Press.

Jones, C. (2001). Introduction to economic growth. New York, NY: W. W. Norton and Company.

Leamer, E. (2010). Macroeconomic patterns and stories. New York, NY: Springer. Lerner, J. (2012). The architecture of innovation: The economics of creative organiza-

tions. Boston, MA: Harvard Business Review Press. North, D. (1982). Structure and change in economic history. New York, NY:

W. W. Norton and Company.

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 63

Rodrik, D. (2008). One economics, many recipes: Globalization, institutions, and economic growth. Princeton, NJ: Princeton University Press.

Schumpeter, J. (1942). Capitalism, socialism, and democracy. New York, NY: Harper and Brothers.

Harvard Business School Case Studies

Cool, K., Seitz, M., Mestrits, J., Bajaria, S., & Yadati, U. YouTube, Google, and the rise of internet video, KEL403-PDF-ENG.

Cross, T. Human capital strategy, UV0648-PDF-ENG. Edelman, B., & Eisenmann, T. R. Google Inc., 910036-PDF-ENG. Eisenmann, T. R., Bussgang, J. J., & Kiron, D. Predictive biosciences, 811015-

PDF-ENG. Hamermesh, R. G., Kiron, D., & Andrews, P. Gene patents, 811089-PDF-ENG. Hardymon, G. F., & Nicholas, T. Kleiner-Perkins and Genentech: When venture

capital met science, 813102-PDF-ENG. Kumar, K., & Kumar, M. Gold Peak Electronics: R&D globalization from East to

West, HKU857-PDF-ENG. Lassiter, J. B., & Kiron, D. Re-THINK-ing THINK: The electric car company,

810105-PDF-ENG. Lassiter, J. B., & Kiron, D. Highland Capital Partners: Investing in cleantech,

811009-PDF-ENG. Lassiter, J. B., Nanda, R., Kiron, D., & Richardson, E. 1366 Technologies: Scaling

the venture, 811076-PDF-ENG. Li, W. Note on central planning, UV0380-PDF-ENG. Mayo, A. J., & Benson, M. Bill Gates and Steve Jobs, 407028-PDF-ENG. Nguyen-Chyung, A., & Faulk, E. Amazon in emerging markets, W94C01-PDF-

ENG. https://cb.hbsp.harvard.edu/cbmp/product/W94C01-PDF-ENG Nicholas, T., & Chen, D. Georges Doriot and American venture capital, 812110-

PDF-ENG. Nohria, N., Mayo, A. J., & Gurtler, B. Walt Disney and the 1941 animator’s strike,

406076-PDF-ENG. Pill, H., & Mathis, D. Bahtulism, collapse, resurrection? Financial crisis in Asia:

1997-1998, 798089-PDF-ENG. Pill, H., Tella, R. D., & Schlefer, J. Financial crisis in Asia: 1997–1998, 709004-

PDF-ENG. Rodriguez, P. A note on long-run models of economic growth, UV4282-PDF-ENG. Scott, B. R., & Sunder, S. R. Austin, Texas: Building a high-tech economy, 799038-

PDF-ENG. Shih, W., Chai, S., Bliznashki, K., & Hyland, C. Office of Technology Transfer—

Shanghai Institutes for Biological Sciences, 611057-PDF-ENG.

64 INTERNATIONAL ECONOMICS

Shih, W., & Dai, N. H. From imitation to innovation: Zongshen Industrial Group, 610057-PDF-ENG.

Yang, W., & Kiron, D. Cambridge NanoTech, 610083-PDF-ENG.

ECONOMIC GROWTH, CONVERGENCE, AND TRADE 65

CHAPTER 3

Theories of International Trade

Introduction

In the centuries following the voyages of Columbus and da Gama,

European economic growth was concentrated within nations sitting just

off the North Atlantic Ocean—namely, Portugal, Spain, the Netherlands,

France, and Britain. This was no coincidence, as long-distance trade was

vital to the prosperity of these states. The opening of Atlantic trade routes

transferred economic power from the Mediterranean to Western Europe,

and merchant classes became more influential. The development of

advanced financial systems in the Netherlands and Britain sustained the

commercial growth and relative dominance of the Dutch and British. The

great powers could fund expeditions for raw materials, and domestic con-

sumers grew to enjoy a variety of goods from around the globe. Before the

18th century, long-distance trade focused mainly on “noncompeting”

goods (meaning products that must be imported because they are not

produced domestically). This included Asian spices and textiles and

South American gold and silver. As transportation costs declined and

manufacturing efficiencies multiplied in the 19th century, long-distance

trade grew at a far brisker pace, particularly in competing goods. As a

consequence, the degree of diversification among internationally traded

goods increased before redoubling during the 20th century.

This chapter presents essential economic theories of international

trade, paying attention to the political factors underlying trade policies

that governments actually choose in practice. As suggested above, coun-

tries trade with each other because economies specialize, consumers enjoy

variety, and not all goods are produced (or are naturally available) in every

region of the world. International trade barriers have declined since World

War II, in part due to a greater theoretical appreciation of the benefits of

free trade, yet in the past decade, a backlash has also developed within

many countries, including the United States and much of Europe. East

Asian nations—most notably China—have implemented successful stra-

tegic trade policies protecting some domestic industries, although it isn’t

clear that every emerging nation would be able to do the same nearly so

effectively. With the exception of comparative advantage, economic the-

ories of international trade are controversial because no single model

can successfully rationalize all data on actual trade flows. Measuring the

precise welfare implications of alternative trade policies is even more dif-

ficult. Regardless, these canonical theories of trade are central to under-

standing why—and how—nations trade their goods in the modern

globalized economy.

Absolute and Comparative Advantage

The earliest theory of international trade that modern economists freely

reference is absolute advantage from the Wealth of Nations. Adam Smith argued that it was not possible for all nations to flourish by following

mercantilist policies which favored exporting in exchange for bullion yet

frowned upon importing, since one nation’s exports were another nation’s

imports. Instead, he believed that an international division of labor was

optimal, based on the productive advantages that each country possesses. If

Switzerland can manufacture clocks with greater efficiency than France,

and France can make cheese more efficiently than Switzerland, then

Switzerland and France should specialize, and hence trade clocks for

cheese. Each country’s absolute advantage in production is determined by

its cost structure; the country with the lowest costs and greatest efficiencies

in making any good possesses an absolute advantage. Nevertheless, some

countries—especially developing ones with little capital and technology—

may have an absolute advantage in producing few, if any, goods.

The next major refinement of this theory came from David Ricardo,

the great British political economist who developed the concept of com-

parative advantage in the early-19th century. Ricardo had a remarkable

career, starting out as a stockbroker and achieving great wealth and success.

He developed an interest in economics after reading Adam Smith’s Wealth

68 INTERNATIONAL ECONOMICS

of Nations, though unlike today’s academic economists, Ricardo did not write his first economics article until he was well into his 30s. Later he was

elected into the British House of Commons. Developed in Ricardo’s 1817

book On the Principles of Political Economy and Taxation, the theory of comparative advantage is based on a comparison of each nation’s produc-

tion possibilities and the opportunity costs they face. An economy has a

comparative advantage if its opportunity cost of producing a good—in

terms of other goods—is lower than elsewhere. Comparative advantage

dictates that each economy should focus on producing those goods for

which it faces the lowest opportunity cost of production.

While absolute advantage is intuitive and useful, comparative advan-

tage provides insights in instances where absolute advantage does not.

Consider two neighbors, Frederick and Joe. Talented Frederick is a suc-

cessful plastic surgeon who also happens to be a fabulous carpenter—even

better than Joe, who is a full-time professional carpenter. If Frederick has

water damage in his home and needs a carpenter to fix it, absolute advantage

would suggest that Frederick should do the work himself, because he is a

faster and more competent carpenter than Joe. Comparative advantage, by

contrast, takes into account Frederick’s opportunity cost. He makes $1,000

per hour as a surgeon, so instead of taking off Wednesday to fix his house, he

is better off calling Joe, who charges just $50 per hour. This superior deci-

sion comes from a comparison of Frederick’s opportunity costs in deciding

to spend Wednesday operating on patients or fixing his house.

Wine and Cloth

Ricardo’s initial demonstration from Chapter 7 of his Principles involved wine and cloth production in England and Portugal. Based on Portugal’s

lower labor costs, he showed that the relative cost of manufacture was of

primary importance. A concrete example may help to illustrate the gains

from international specialization and trade. Suppose that in Portugal, it

takes 1 hour of labor to produce a bottle of wine and 4 hours of labor to

produce a unit of cloth. In England, the respective figures are 2 and 6, so

that Portugal has an absolute advantage in producing both goods. The table below summarizes these production technologies, where costs are in hourly

units of time.

THEORIES OF INTERNATIONAL TRADE 69

Ricardo’s theory of comparative advantage implies that the country

with a smaller opportunity cost of producing a given good has the relative

advantage and should therefore specialize in making that good. The logic

is as follows. Consider the opportunity cost of making 1 unit of cloth in

Portugal. It is 4 bottles of wine, meaning the Portuguese give up 4 bottles

of wine for each unit of cloth they make. In England, this cost is just 3

bottles of wine. So, England should specialize in making cloth. Now

consider the opportunity cost of making 1 bottle of wine in Portugal,

which is a quarter unit of cloth. In England, the cost is a third of a unit,

which is higher. According to Ricardo, Portugal ought to focus on pro-

ducing wine.

It may be surprising that both countries can benefit from trade in spite

of greater Portuguese efficiency in producing both goods (meaning

Portugal has an absolute advantage). However, by extending the example

above, we see that this is true. Suppose that, initially, there is no trade

between Portugal and England. Portugal produces 100 units each of wine

and cloth, at a cost of 500 hours of labor. Likewise, England produces

100 units each of wine and cloth, costing 800 hours of labor. Now, let’s

allow a tiny bit of trade and specialization: England shifts to more cloth

production and Portugal shifts to more wine production. Let’s say that

England holds off on producing the last 3 bottles of wine it usually pro-

duces each year, at a cost saving of 6 hours of labor, and makes a unit of

cloth instead. Likewise, Portugal decides not to make the hundredth unit

of cloth it usually does, and instead produces 4 bottles of wine.

In this scenario, England can trade its extra unit of cloth for 3 bottles

of wine from Portugal: England will be no worse off and Portugal will

be better off by a bottle of wine. This slight, incremental amount of trade

improves overall welfare, so we see that there are gains from trade. Now

let’s push this example a bit further. If England only makes cloth, it can

make 800 / 6 = 133.3 units of cloth. Portugal can produce up to 500 bot-

tles of wine, but assuming they don’t want to overproduce (so that all

Cost Wine Cloth

Portugal 1 4

England 2 6

70 INTERNATIONAL ECONOMICS

English and Portuguese citizens imbibe too much and can’t work), let’s

assume they stop after 220 bottles of wine. With the remaining 280 hours

of labor, the Portuguese can make 280 / 4 = 70 units of cloth. Adding up

the total output of both economies, we have 133.3 + 70 = 203.3 units of

cloth and 0 + 220 = 220 bottles of wine. Before opening trade, the total

autarkic output was 200 units of cloth and wine each, so it turns out that

there are significant gains from specialization.

England ought to be able to trade its excess cloth for wine. Say it wants

to sell 32 units of cloth, leaving it with 101.3. (In Portugal, these 32 units

would cost 32 � 4 = 128 labor hours to make.) In return, England wants 110 bottles of wine, which would cost the Portuguese 110 labor hours.

Supposing (to simplify) that there is a common currency called the

“yurow,” such that 1 labor hour is equal to 1 yurow, Portugal would agree

to the trade with England. Portugal now has 110 bottles of wine and 102.3

units of cloth. England has 110 bottles of wine and 101.3 units of cloth.

Both countries are better off with specialization and trade. Even though

Portugal has the absolute advantage in production of both goods, by spe-

cializing according to the theory of comparative advantage and allowing

trade, both countries are wealthier.

Gains from Trade

True but not obvious, comparative advantage has withstood the test of

time among economists. In fact, it is the basis for much of modern trade

theory. It implies that, as a rule, increased trade between nations or regions

will lead to greater total output and aggregate gains among all parties. As

more areas become part of a trade network, there will be more specializa-

tion and efficiency gains; perhaps Ricardo was inspired by Adam Smith’s

praises of a finely tuned division of labor in the Wealth of Nations. Com- parative advantage can be applied to individuals, firms, or cities: each unit’s

comparative advantage is their competitive advantage. In this light, com- parative advantage implies that each person should follow the career path

or line of work which they are best at, to maximize their production and

well-being, however measured. Within an organization, each member

ought to work according to his or her strengths; within each industry,

every company has its own comparative advantage giving it a relative

THEORIES OF INTERNATIONAL TRADE 71

advantage. Even if there is a leading company that holds absolute advan-

tages across every margin, other firms can compete by charging lower

prices or differentiating their product or service.

Now think of the bigger picture. In the Wealth of Nations, Adam Smith advocated the theory of absolute advantage, suggesting that nations should

focus on producing goods they can make at lower cost than other countries

can. It’s a valid point, but it doesn’t explain why countries produce goods

that other countries are more efficient at making. In other words, in the

real world, production is more diversified across the world than absolute

advantage implies. For instance, wine and cloth are made in many coun-

tries of varying efficiency today; in the example above, England produces

cloth even though it’s always cheaper to make it in Portugal. The answer

to this puzzle is that the other country, Portugal, has an even greater

advantage in producing another good, wine. Absolute advantage

cannot explain such patterns, but comparative advantage can. Therefore,

to figure out the optimal pattern of production for an individual or a

country, one must focus on relative—not absolute—advantages, specif-

ically opportunity costs.

The process of economic development can be understood in terms of

shifting comparative advantages. In emerging economies, relative advan-

tages are commonly related to lower labor costs and an abundance of raw

materials. As these economies grow and mature, they make investments in

capital and people, allowing them to incorporate more complex produc-

tion processes that involve greater physical and human capital. Subse-

quently, labor productivity and wages increase. Put another way, the

opportunity cost to producing and exporting low value-added goods

increases over time as the economy transitions to higher value-added pro-

duction. The economy’s relative advantage will shift to middle or high

value-added processes within global supply chains. Wealthy industrialized

nations compete for the lead in complex industries with advanced tech-

nologies. For them, relative advantages are often driven by technological

edges, superior design, or greater industry-specific experience. And with

globalized production, a good may be successful due to multiple sources of

comparative advantage. For instance, Apple has succeeded in combining

outstanding product development in the San Francisco Bay Area with low

production costs abroad.

72 INTERNATIONAL ECONOMICS

Impediments to trade, such as transportation costs, tariffs, or quotas,

can hinder the realization of gains due to trade. In the Ricardian example

above, if transportation or tariff costs are sufficiently high, England

and Portugal would not specialize, since trading their good of relative

advantage is not economical. Although tariffs do not always exist, trans-

portation costs surely do, so there is almost always some real world barrier

to trade. Today, the cost of shipping imported goods is about three times

higher than tariff duties (in the aggregate). Transportation costs are most

relevant to products manufactured in multiple countries under “vertical

specialization,” which occurs when a country utilizes imported inputs or

intermediate parts to produce a good that is later exported. Most trade

between bordering countries takes place over land, while most trade

between countries without a common border occurs via ocean transport.

Air transport—especially for long-distance trade in lightweight goods—is

increasingly common due to superior speed coupled with large cost

declines in recent decades. Lower transportation costs undoubtedly facil-

itate greater trade, and global productivity growth and technological prog-

ress support greater specialization, and hence, larger international trade

volumes.

Evidence on Comparative Advantage

The traditional Ricardian model is based on labor productivity differences

between nations, and it takes as given the resources used in production.

For empirical researchers, its principal prediction is that nations will pro-

duce goods in which their relative productivity advantage is the greatest,

and as a consequence, they will export a greater share of goods from rel-

atively more productive domestic industries. By and large, the evidence is

favorable to the comparative advantage model. For instance, an early study

from the 1960s by economist Bela Balassa compared the United States to

Britain after World War II. It found that America had an absolute advan-

tage in every industry, yet Britain exported just as much as the Americans

did. This was because Britain exported goods from industries where it had

a comparative—not absolute—productivity advantage.

Recent research shows that comparative advantage explains the general

pattern of trade flows from poor to wealthy nations: poor nations specialize

THEORIES OF INTERNATIONAL TRADE 73

in lower value-added products (like textiles) since their productivity is

about half as high in these industries as compared to advanced nations,

whereas in technology-intensive industries, their productivity may be only

a tenth (or less) as great as in more advanced nations. Some industries in

certain countries (such as the Japanese automobile industry) are extremely

productive, and as a consequence of this relative advantage, they generate

large export flows. Still, the Ricardian model predicts a very high degree of

specialization that is not observed in the real world. Some extensions, and

other models of trade discussed below, help to explain why.

Globalization Extensions

The Ricardian model focuses on goods produced with one input, labor.

Adding capital—an internationally mobile factor of production—may

weaken the gains from international specialization. Consider the following

reasoning. If capital investment is mobile, and technologies for the pro-

duction of a good (like blueprints for a certain factory) can be utilized in

any region, then capital may flow to low labor cost regions. Over time,

these poorer economies will develop, and their wages and labor costs will

increase, as according to the neoclassical growth model. Production costs

for any given good will tend to equalize in the long run. In the example

above, Portugal is less developed than England (at the time of Ricardo’s

writing) and has lower labor costs, which may make it an attractive area for

capital investment. Over time, its absolute advantage over England may

disappear. More generally, in the presence of capital mobility, absolute

advantages may erode, and comparative advantages may become less pro-

nounced as well.

Human capital is another factor that is not included in the basic

Ricardian model. Differences in human capital levels are a critical aspect

explaining why certain countries possess a comparative advantage in pro-

ducing a product. Research and development and technology-intensive

manufacturing are examples of activities where wealthier countries with

more human capital possess a comparative advantage. Yet poorer econo-

mies with large agricultural and low-tech manufacturing sectors can invest

in the human capital of their workers to lessen their disadvantage over

time. Social capital and culture are important as well. For instance, the

74 INTERNATIONAL ECONOMICS

sustained dominance of the United States in the development of new

internet technologies may be in large part due to its: (1) ingrained national

culture that prizes entrepreneurial risk-taking, and (2) vibrant marketplace

in new “pop culture” products reflecting the ever-changing tastes of

American consumers (which are often followed abroad).

Factor Proportions Model

The canonical 20th century theory of international trade is called the

“factor proportions” model. The name is based on the idea of fixed factor

proportions that go into making goods. The model assumes that each

economy has a given endowment of capital, labor, technology, and other

resources. It emphasizes the relative abundance of production inputs and

natural resources across nations. It was developed by Eli Heckscher and

Bertil Ohlin in the 1920s, and for this reason, it is also referred to as the

“Heckscher-Ohlin” model of trade. Heckscher was 20 years Ohlin’s senior

and had taught Ohlin economics at the Stockholm School of Economics.

Both Swedes, they were intrigued by late-19th century globalization trends

and intimately familiar with Sweden’s experience as a small open economy.

(Ohlin later won a Nobel Prize for this work, which Heckscher would have

also shared but was unable to, as he had passed away earlier and the Nobel

Prize is not awarded posthumously.) In essence, the factor proportions

model is about comparative advantages in endowments and resources.

Whenever a nation possesses a large quantity of some material or produc-

tion factor, it will intensively utilize it, rent it out, or sell it. It predicts that

the direction of trade between nations will be determined by differences in

supply-side factor abundance.

The basic model presumes that there are two countries, two goods

produced, and two factors of production: capital and labor. The two coun-

tries have the same tastes but differ in their relative supply of capital and

labor. One good requires relatively more capital to produce, while the

other requires more labor. Capital and labor are immobile, which means

they cannot move from one country to the other if there are differences in

interest rates or wages. There is free trade with no cost to the transpor-

tation of goods. Both countries have access to the same technology and

utilize the same production function, which is constant returns to scale and

THEORIES OF INTERNATIONAL TRADE 75

has diminishing marginal returns for each factor. Relaxing these assump-

tions leads to some differences in the model’s predictions, but this simpli-

fied version is a good start for analysis.

The model’s main result is that each country will produce the good

that makes greater use of the factor of production that it has in abundance.

It is a relative comparison, so by definition, one nation has relatively more

capital, and the other has relatively more labor. The “capital-abundant”

country will export the capital-intensive good to the “labor-abundant”

country, and the labor-abundant country will export the labor-intensive

good to the capital-abundant country. In terms of applying this model to

the real world, the capital-abundant country generally possesses the

wealthier, more developed economy (think of the United States) and the

labor-abundant country features a poorer economy with less capital (think

of Mexico or India). In this model, a good is more profitable to produce if

its production costs are relatively low, and production costs depend on the

abundance of production factors. A good that requires much capital will be

cheaper if manufactured in a capital-abundant economy. This insight

drives specialization across countries. And so, the greater the disparity in

the relative abundance of the factors of production, the more trade there

will be between nations.

As opposed to the basic Ricardian model, where labor is the only factor

of production, factor proportions theory explicitly considers the level of

capital across countries, just like the neoclassical growth model. In factor

proportions theory, the basic model assumes economies all have the same

technology (although it can be extended to allow for technological leaders).

For example, the wealthier economy with more capital will typically have

better technology, so its advantage in producing capital-intensive goods is

only strengthened when we allow for differential production functions. In

both the Ricardian and factor proportions models, the relative opportunity

cost of producing one good versus another leads countries to specialize.

Moreover, in the Ricardian model there tends to be full specialization, but

not in the factor proportions model. That is because the factor proportions

model has diminishing marginal returns, which means that a country’s

relative advantage in producing one good will decline as it produces more.

This ultimately results in a more balanced (and realistic) production mix

between countries.

76 INTERNATIONAL ECONOMICS

In the neoclassical growth model, poorer countries eventually converge

to wealthier countries as they accumulate more capital per worker over

time. Although the basic factor proportions model is static, it can be

extended to allow for shifts in capital and labor over time. For example,

if immigration between countries opens up, workers will move from the

low-wage country with abundant labor to the capital-abundant country

that is more productive and has higher wages. (In the 19th century, work-

ers in search of opportunity moved to land-abundant regions that were

usually capital- and labor-poor.) Likewise, if international capital markets

open up, capital will flow to the labor-abundant country where it is

cheaper to hire workers to operate capital equipment. Over time, these

forces will lead to convergence across countries in their relative abundance

of capital versus labor as well as their production mix. Still, capital is rarely

perfectly mobile in the real world, and immigration comes with consider-

able costs. While the capital-labor mix across countries may equalize,

countries will still specialize in producing certain products due to their

natural resource endowments or history.

Distributional Issues

Similar to the Ricardian model, there are gains to trade in the factor pro-

portions model stemming from specialization and enhanced productive

efficiencies, so trade makes countries better off. However, this does not

mean that every group will benefit from trade, as there are important distri-

butional consequences to consider. It can be shown with some mathe-

matics that in the basic factor proportions model, when a country is

opened up to trade, owners of the abundant factor will be made better off,

and owners of the scarce factor will be made worse off. (Once again, whether

a factor is abundant or scarce depends on its relative abundance or scarcity as

compared to the rest of the world taken as a whole.) Production in the

international economy will shift to areas where it is cheapest, which will be

the country with a relatively abundant supply of a given factor, according to

the factor proportions model. For instance, in a capital-abundant nation,

capital owners will thrive and the production of capital-intensive goods

will boom. With international trade, capital-intensive goods will be

increasingly made in capital-abundant countries, and labor-intensive

THEORIES OF INTERNATIONAL TRADE 77

goods will be increasingly made in labor-abundant countries. As a corol-

lary, companies that use the abundant factor intensively will be better off,

and companies that use the scarce factor intensively will be worse off.

Trade causes greater specialization and enhances relative advantages.

The unequal effects that opening trade has on the return to various

factors of production is often referred to as the “Stolper-Samuelson” the-

orem, named for the two economists who developed it in 1941, Wolfgang

Stolper and Paul Samuelson, the latter a Nobel Prize winner. (Throughout

the rest of this book, the Stolper-Samuelson theorem is understood to be

synonymous with the factor proportions model.) Consider the effects of

opening trade in the capital-abundant country. Its economy will shift

toward producing more capital-intensive goods; it used to just produce

for domestic consumers but now it makes exports for foreign consumers.

Overall, this will increase demand for domestic capital, which used to be

abundant and quite cheap, bidding up its price, the local interest rate.

Therefore, capital owners, and businesses that use capital intensively, will

gain. On the other hand, labor will lose, as production of the labor-

intensive good shifts abroad. In theory, each group can be made better

off with the appropriate government policies. Here it would mean transfers

from capital owners to workers after trade is opened. Yet it is far from clear

that such policies are enacted in practice as countries open themselves up

to trade and globalization. Just as trade leads to winners and losers within

an economy, it can cause domestic political cleavages that are difficult

to overcome.

A classic example is what happens when a capital-poor developing

country begins trading with a capital-rich advanced country. According

to the factor proportions model, opening trade in the poor economy will

lead to an expansion in its sector producing labor-intensive goods (such as

textiles), implying an increase in labor demand and higher wages. All else

equal, workers in the poor economy will be better off due to enhanced

opportunities. If this country has a large agricultural sector, workers in it

may leave and move to urban areas to find factory work. In the wealthy

country, the opposite is true. Workers there will see a reduction in demand

for their services, and according to the theorem, their wages will go down,

leaving them worse off. Capital-intensive industries will expand and export

some of their goods to the poor country, so owners of capital will be better

78 INTERNATIONAL ECONOMICS

off. Governments can arrange policies to lessen the distributional

impact—such as transferring funds from capital holders to workers in the

wealthy country via tax policy—but such responses do not always take

place in fact. Still, there may be a boom in cheap consumer goods—

generally produced in emerging economies—on the world market, which

raises living standards everywhere and benefits workers in the wealthy

country.

The factor proportions model also yields a key reason why smaller or

less developed countries may benefit the most from opening their econ-

omy to free trade. Generally speaking, a larger and better-developed econ-

omy will have relative factor endowments that are closer to overall world

relative endowments. Bigger economies likely have a more diversified set of

industries. Without trade, a smaller, underdeveloped country may not

have access to many goods, and even if it has access, goods may not be

available at competitive prices. Think of the benefits which consumers in a

small economy such as Singapore gain from imports. And as mentioned

above, less developed economies typically have a relative abundance of

labor, so allowing trade can help workers by strengthening labor demand

and increasing wages.

Technology and Human Capital

Adding technology and human capital to the basic factor proportions

model has important implications for modern trade. In such a model, each

country’s production in a given sector depends on the level of technology it

possesses and the human capital of its work force. As in the neoclassical

growth model, this can be modeled by adding human capital and technol-

ogy factors—H and A, respectively—to the production function, which

generates the equation Y(K,L,H,A), where K is capital and L is labor.

Greater human capital and better technology generate more productive

possibilities for a given amount of physical capital and labor. In a sector

requiring skilled labor and technology, new research and more education

within a country lead to greater productive efficiencies, so that the domes-

tic industry produces more at a lower cost. The economy will become

more specialized in skilled labor- and technology-intensive products,

which will be increasingly reflected in their exports. Foreign competitors

THEORIES OF INTERNATIONAL TRADE 79

within the same industry will fret, and to keep their long-run costs low,

they may be forced to upgrade technology and labor skill. In this way,

international trade can cause productivity growth in the global traded

manufacturing sector to increase, benefitting consumers worldwide. In

service sectors, which are usually local and based primarily on labor inputs,

it is less realistic to expect competitive pressures from international trade

to result in productivity gains.

Changes in technology will favor owners of physical capital depending

on whether capital is a complement or substitute to technology. Typically,

technology improvements complement physical capital. If so, demand for

capital will pick up, and output and trade in sectors that utilize it inten-

sively will expand, favoring capital owners. Technology can complement

or substitute for labor, depending on the industry and type of labor. Many

new technologies, such as personal computers, generally complement

labor, especially skilled or educated labor, making workers more produc-

tive, so that the relative demand for labor increases and workers gain.

However, computers and automation equipment can also substitute for

some types of labor, particularly unskilled workers who may be made

temporarily redundant. The practice of “offshoring”—where some of a

company’s business processes and jobs are moved outside the country—is

made more feasible through technology. It can harm domestic workers

while benefitting foreign workers who are utilized instead.

Consider a technology-intensive manufacturing industry like aircraft or

scientific instrument production, where technology is complementary to

physical capital. Better technology will enhance productivity, so that the sec-

tor expands. This benefits capital owners in the industry. If the technology is

also complementary to labor so that it enhances labor productivity, workers

in the industry may also gain. On the other hand, labor may be harmed when

new technology substitutes for human labor, such as within modern

manufacturing industries that prize automation. A classic example comes

from the early-19th century textile industry in Britain. With the introdu-

ction of automated loom technology, skilled weavers started to lose their live-

lihoods to unskilled operators who were poorly paid. Some of these skilled

artisans reacted by smashing machinery and threatening industrialists.

They came to be known as “Luddites,” after a youth named Ned Ludd who

hadpurportedlydestroyedtextilemachinestoprotestlaborsavingtechnology.

80 INTERNATIONAL ECONOMICS

Greater human capital within a workforce has similar effects.

Improving the educational system will increase the supply of skilled

workers. Sectors that utilize them—such as human capital-intensive

industries—will expand and export more. Although factor proportions

reasoning suggests that sectors not relying on human capital may contract,

harming unskilled workers, economic research shows that skilled workers

generate local spillovers by creating innovations, starting companies, and

utilizing services provided by less skilled workers (such as food prepara-

tion), so that, on net, greater human capital can bring significant benefits

even to unskilled workers. In addition, human capital is usually comple-

mentary to physical capital—such as in complex equipment manufactur-

ing industries—so a skilled workforce typically benefits capital owners,

too. By and large, with more human capital, the economy restructures so

that human capital-intensive sectors expand, and the economy’s relative

advantage is in producing goods that are of increasingly higher quality

or complexity. This has been a pathway to development and wealth for

many countries.

The impact of technological change and greater human capital is often

complex, and within any industry, its effects may be challenging to disen-

tangle without a comprehensive analysis. In Silicon Valley, workers with

high levels of human capital congregate and produce new technologies,

attracting hefty capital investment flows to implement their ideas. Some-

times these technologies end up substituting for certain types of labor,

usually not highly skilled (like travel agents, who have been largely replaced

by the internet). Indeed, in recent years, technological change has generally

favored skilled labor in the United States. Evidence shows that the price of

educated labor has increased as its utilization has picked up. Based on a

traditional supply and demand framework, this suggests that demand

growth has outpaced supply growth. But not all sectoral demand shifts

have favored educated workers. During the height of the recent housing

bubble, 40% of American investment was in property, which benefitted

construction workers (as well as capital owners) in that sector.

Finally, the future direction of technology’s impact on the factors of

production is difficult to predict. The well-known “Habakkuk hypothesis”

(developed by the mid-20th century British economic historian John

Habakkuk) claims that in the 19th century, technological progress was

THEORIES OF INTERNATIONAL TRADE 81

faster in the United States than in England because American labor was

scarce. This gave American industrialists an incentive to invent laborsaving

technologies, and more generally, labor scarcity led to enhanced innova-

tion and increased mechanization in America. Government regulations

can conceivably have similar effects. The “Porter hypothesis” (formulated

by contemporary business economist Michael Porter) proposes that mod-

ern environmental regulations have sometimes triggered the discovery and

implementation of cleaner technologies. While recent economic research

has focused on technological change favoring skilled workers in advanced

economies, it is possible that future technologies—such as intensive online

educational programs, which are often inexpensive or even free—will have

very different impacts, potentially favoring less skilled workers. Only time

will tell.

Leontief Paradox

An early empirical criticism of the factor proportions model—commonly

called the “Leontief paradox”—came from Wassily Leontief, a Nobel Prize-

winning economist who pioneered input-output tables. In his work during

the 1950s, Leontief examined all products the United States was importing

and exporting, based on 1947 input-output tables. Leontief noticed that

American exports were relatively labor-intensive compared to the goods it

imported. (Specifically, he found that in the production of American

exports, $14,000 of capital was utilized per man-year of labor, while the

same figure was $18,000 of capital per man-year of labor among imports.)

Given that the United States was the most capital-abundant economy at

the time, this result was completely at odds with the most fundamental

prediction of the factor proportions model: countries with abundant cap-

ital will export capital-intensive goods and import labor-intensive goods.

Later analyses through the proceeding decades have affirmed this finding,

to varying degrees, in American trade data.

Economists have discovered that when the human capital of a work-

force is included with physical capital in the neoclassical growth model, the

measured rate of convergence matches the real world data better. Likewise,

the best apparent resolution to the Leontief paradox is to include human

capital with physical capital in the factor proportions model. American

82 INTERNATIONAL ECONOMICS

exports are particularly intensive in skilled labor, meaning they are pro-

duced with large amounts of human capital (which is relatively abundant

in the United States) and technology. Overall, American exporting indus-

tries utilize a high ratio of skilled labor to other types of labor. Goods that

the United States imports, like textiles, employ an abundance of unskilled

labor. Thus, a factor proportions model allowing for human capital and

technology differences across countries implies that a country with an

abundance of skilled labor and technology will export goods that take

advantage of their resources, even if, technically speaking, the amount of

physical capital employed is not any greater than among countries without

these endowments.

Empirical testing of the factor proportions model has been ongoing for

over half a century. Although controversial, the literature has found that as

the primary assumptions of the model are appropriately relaxed, its con-

clusions are better supported by the data on international trade flows.

Remember that the basic factor proportions model assumes that all coun-

tries have the same technology and production function, produce the same

goods, and have no costs to trade such as transportation expenses. Ideally,

differences in production technologies—as well as differences in output

quality—can be measured. For example, the world market for cars includes

many different qualities and types. In addition, transportation costs (which

can be precisely measured) are usually substantial and increase with trading

distance. When controls for these differences between countries are

included in empirical analyses, the factor proportions model seems to do

increasingly well (although the literature is certainly not settled).

Gravity Model

Consider the United States. Its top trading partners—Canada, China,

Mexico, Japan, and Germany—are very large economies with robust

exporting sectors, and Canada and Mexico are even right next door. Incor-

porating these two qualities—size and distance—into a simple model of

trade yields the “gravity model” of international trade. Recall Newton’s law

of universal gravitation from physics: any two objects attract each other

with a force that is proportional to the product of their mass, and inversely

proportional to the square of their distance. The gravity model of trade is

THEORIES OF INTERNATIONAL TRADE 83

based on an analogous equation. It states that the amount of trade (mean-

ing imports plus exports) between any two countries is proportional to the

product of their economic output, and inversely proportional to their

distance from each other. The first economist to use this model was Jan

Tinbergen, who was the winner of the first Nobel Prize for economics in

1969. Most economists agree that the gravity model has been the most

successful modern empirical model of international trade since it fits the

data on international trade flows so well.

The gravity model is elegant and based on solid intuition. Larger econ-

omies consume more, so they are likely to import more goods. They also

produce more, so their output is likely to be diverse and take advantage of

economies of scale. These factors lead to a greater volume of exports. And

due to transportation costs and other distance-based barriers, the closer

two economies are, the more trade they are likely to engage in. There are

additional factors that can be included in the gravity model, such as lan-

guage, culture, borders, and trade agreements. Countries sharing a com-

mon language are more likely to conduct business with each other, and

effective trade agreements facilitate trade. Other research has shown that

trade among rich countries is more often based on differentiated products,

as opposed to differences in factor abundance, which better characterizes

exports from poor countries. Finally, economists have demonstrated that a

number of models of trade are consistent with the gravity model; in other

words, there are many theoretical explanations of international trade that

generate empirical trade flow patterns captured by the gravity model. Some

of these theories that go beyond the traditional concepts underlying trade

are discussed below.

Increasing Returns and Trade

The Ricardian and factor proportions models of international trade assume

constant returns to scale. They predict that countries will export those

goods that they specialize in producing. In these models, countries trade

with each other because they are different, and industries can shrink or

grow seamlessly. The constant returns to scale assumption (which means

that a doubling of inputs results in a doubling of output) is realistic in

many service industries where output strongly depends on the amount of

84 INTERNATIONAL ECONOMICS

labor (and less on capital). Yet in the real world, many countries, especially

wealthy ones, trade in similar goods. For example, Japan, Germany, and

the United States produce and export cars. They also import foreign

cars. Comparative advantage models may not be the best explanation for

this type of “intraindustry” trade. Instead, economists have found that

increasing returns models of production, along with variety-preferring

consumers, are a more realistic way to understand international trade in

automobiles.

According to the technical definition of increasing returns to scale,

doubling inputs (like labor and capital) leads to more than a doubling of

output. It implies that incremental costs per unit produced are decreasing

in output, so that production is more efficient if it takes place on a larger

scale. Many manufacturing industries exhibit increasing returns to scale:

after a major capital outlay for a production facility, they can produce large

quantities of goods with decreasing labor costs per unit. This contrasts

with constant returns to scale production, where labor costs are not

decreasing and there may be many similar firms competing against each

other, which drives down prices toward production cost. Increasing

returns typically leads to imperfect competition, where fewer firms com-

pete and each has some pricing power to maintain their margins. In these

industries, technology and research and development are often important

to the production process. Consider an extreme example: the market for

large commercial aircrafts. It is a duopoly consisting of Boeing and Airbus,

which are located in the United States and Europe, respectively. In this

industry, the idea of many small firms producing large commercial jets is

not realistic due to the immense economies of scale.

On the production side of increasing returns to scale industries, size

leads to efficiencies, and firms improve as they learn over time. Sometimes

the company that is first to become established is able to capture a

large market share, a phenomenon called the “first mover advantage.”

In the 19th century, American companies such as Proctor and Gamble,

Campbell Soup, and Quaker Oats developed scale economies in produc-

tion and distribution. This allowed them to capture large market shares

which they have retained to this day. Then again, a lead can erode over time,

as competitors innovate and leaders struggle to manage their growth or

become complacent. This has happened many times within the computer

THEORIES OF INTERNATIONAL TRADE 85

and internet industries over the past several decades. Google didn’t invent

internet search engines, but it has managed to dominate this market space

for the past decade. On the demand-side, as long as consumers prefer

variety, there may be room for many firms in an international industry

(assuming scale effects aren’t too strong, as in the large commercial jet

sector). Companies can specialize in specific market segments, and

international trade will benefit consumers around the world, due to the

high degree of variety and increased competition that it facilitates.

External Increasing Returns and Geography

By definition, “external” increasing returns to scale means that a firm’s

average costs fall with industry—not firm—output. External increasing

returns are generally a local phenomenon: the larger the local industry is,

the lower the costs of firms operating within it. External increasing returns

within an industry may arise from the need for specialized capital inputs

(such as capital instruments used in manufacturing) or labor with niche

skills or experience (such as software engineers); a deeper local supply of

these specialized inputs may drive down their cost. The presence of knowl-

edge spillovers—where ideas and information are transferred between

firms and workers—can also lead to external increasing returns. For

instance, a promising new idea from a software engineer may spread to

other local companies, leading to a wave of innovation.

Given its spatial dimension, the notion of external increasing returns is

important to understanding economic geography, particularly industrial

clustering. Consider Silicon Valley, Hollywood, and Wall Street, each the

center of an American industry that is highly clustered geographically.

They require specialized equipment and workers, and there is no doubt

that knowledge spillovers occur all the time within these three areas. In

terms of international trade and competition, while every country wishes it

had a Silicon Valley, there may only be room for a few—including

Bangalore, known as the “Silicon Valley of India”—due to strong econo-

mies of scale. Industries with increasing returns to scale may also exhibit

“quality ladders,” where advanced economies innovate and make high-

quality varieties of a good and developing countries produce lower quality

variants. This, of course, is a type of specialization. The theory is that

86 INTERNATIONAL ECONOMICS

technological progress is disproportionately generated by firms in the

advanced country. Lower productivity countries may develop more prim-

itive production technologies on their own or copy outdated ones from

elsewhere.

Infant Industry Protection

Since at least the days of mercantilism, economists have argued that certain

“infant industries” need protection from foreign competition, at least tem-

porarily, in order to launch and become established. Most commonly,

these are manufacturing industries exhibiting economies of scale. Govern-

ment support may come from monopoly grants, protective tariffs against

imports, or cheap loans. The notion is that without such support, a

country’s foray into a new industry will fail either due to powerful foreign

import competition or potential pitfalls in learning unfamiliar production

processes on the fly. Although Adam Smith was dismissive of this argu-

ment, Alexander Hamilton, the first United States Secretary of the Trea-

sury, strongly supported it. In 1791, Hamilton submitted to Congress his

Report on Manufactures, arguing that the United States government must prop up its burgeoning manufacturing sector with subsidies and moderate

tariffs. These policies were adopted despite opposition from Thomas

Jefferson and the agrarian interests of the South. The United States kept

rather high tariffs throughout most of the 19th century, particularly on

finished manufactured goods. Protective strategies were likely a factor

behind the emergence of the United States as an industrial powerhouse.

The infant industry argument has waned in popularity among economists

over the past several decades, yet many (if not most) developing countries

craft protectionist policies based upon its logic.

A number of criticisms have been leveled against infant industry pro-

tectionism. Subsidizing or protecting certain industries and firms can lead

to bribery and corruption, particularly in countries that already suffer from

widespread graft. In the case of “import-substituting” industrialization,

governments encourage the domestic production of goods that had previ-

ously been imported. Even if successful in the long run, these policies lead

to higher prices for domestic consumers. The historical experience of some

countries (such as India) that have protected infant industries reveals it is

THEORIES OF INTERNATIONAL TRADE 87

more likely to be successful for light manufacturing (like textiles) instead of

heavy manufactures (like airplanes), partly because poor countries lack

many necessities for complex production, including infrastructure, skilled

labor (such as engineers and entrepreneurs), managerial capital, and cheap

financing. It can also be difficult for governments to identify the industries

which could be successful if shepherded along in the near term. For exam-

ple, in the 1970s South Korea favored chemical, steel, shipbuilding, and

automobile industries, yet after setbacks in the late 1980s and early 1990s,

it shifted focus to high-tech industries. On the whole, the experience of the

East Asian Tigers demonstrated that emerging economies can be successful

under either finely tuned state direction (as in Singapore) or minimal

government influence (as shown by Hong Kong’s commercial success).

Most analysts agree that China’s infant industry protection policies

have been highly effective. China was able to get its domestic automobile

industry off the ground in the 1980s by allowing joint ventures between

experienced foreign companies and local Chinese partners. For instance,

Volkswagen’s joint venture within China was given a near monopoly on

taxi sales for almost 20 years. The German company used to send obsolete

factory production equipment to China to manufacture outdated models

it couldn’t sell elsewhere. The Chinese automobile industry—which pro-

duced about 5,000 cars in 1985—is currently the largest in the world.

China has set ambitious goals for utilizing renewable energy resources,

including the development of a large-scale solar energy sector which has

received access to tens of billions of dollars in subsidized credit from the

China Development Bank. Observing the increasing returns to solar panel

equipment production, the Chinese government surmised that it is best to

take the technological lead before other countries do.

Infant industry considerations have surely influenced China’s tariff

policies. Since China began its bid for GATT membership in 1986, its

average tariff rate has steadily declined, from 40% in 1986 to 36% in 1993

to 10% in 2005, reflecting the greater maturity of many developing indus-

tries which no longer need help. In 1997, for example, China reduced

tariffs to 25% and 35% on refrigerators and televisions (both mature

industries), respectively, while holding automobile tariffs to 100% due to

the industry’s infant status at the time. China was accepted into the WTO

in December 2001, and from 2000 to 2010, average tariffs dropped from

88 INTERNATIONAL ECONOMICS

about 17% to under 10%, as the Chinese economy further integrated into

the international trade system.

Basic Instruments of Trade Policy

A tariff is a tax levied on imports. Tariffs effectively increase the cost of

shipping goods to a foreign country. There are two types: “specific” tariffs

level a fixed tax on imports (such as $100 per automobile) while “ad

valorem” tariffs charge a percentage of the good’s value (such as 10% on

televisions). Tariffs drive a wedge between prices in the importing and

exporting countries. In the importing country, they raise consumer prices.

Domestic producers of the good are better off as they face less competition

(and are thus protected). As opposed to other instruments of trade policy,

tariffs raise revenue for the government levying them. In the United States,

tariffs were a very important source of government revenue until the early-

20th century. Compared to trade policies of the 18th and 19th centuries,

modern governments are more likely to utilize nontariff instruments such

as import quotas, which limit the quantity of imports of a certain good, or

voluntary export restraints, which limit the amount of exports coming

from a country (and are usually requested by the importing country). By

restricting supply, import quotas raise the price that domestic consumers

pay for the imported good. Export restraints are often the result of trade

policy bargaining; in the importing country, they protect producers and

harm consumers.

Export subsidies are government payments to exporting firms. Around

the world, they are most commonly given to agricultural industries. Export

subsidies benefit producers in the exporting country and consumers in the

importing country, but they harm producers in the importing country.

Economists typically view them as reducing overall welfare, meaning the

total costs outweigh the benefits. While export subsidies can conceivably

help a country launch an industry with substantial increasing returns (such

as commercial aircraft production) so that the long-run benefits potentially

outweigh the costs, most analysts consider export subsidies to be primarily

driven by domestic special interests, specifically, producers receiving the

subsidy. One of the largest (and most criticized) subsidy regimes today is

the “Common Agricultural Policy” (CAP) maintained by the “European

THEORIES OF INTERNATIONAL TRADE 89

Union” (EU). Consuming over a third of the European Union’s entire

budget, CAP distorts many global markets in food and produce. For

instance, European sugar producers are subsidized, a practice that lowers

the world price of sugar. In turn, low-cost sugar producers in developing

countries like Ethiopia and Mozambique are harmed. In the United States,

textile companies have long complained about competitors in China and

India receiving export subsidies or other preferential treatment from their

governments. Under WTO rules, export subsidies have been increasingly

restricted, though there are significant exemptions for some developing

economies (in particular, the least developed countries which are dispro-

portionately located in Africa).

Trade-Offs in International Trade Policy

Economists generally favor free trade because allowing each country to

follow its comparative advantages without tariff or protectionist distortions

is more likely to yield efficient sectoral development and international

competition, which drives global productivity growth and lowers prices,

benefitting consumers in every country. Several important arguments for

protectionism were outlined above; these considerations are usually more

important for developing nations trying to nurture new industries. Still,

even the United States, a nation that largely favors free trade, sometimes

pushes for protectionism. In one famous example from the early 1980s,

American automobile makers were struggling to compete against Japanese

competitors who were able to squeeze efficiencies out of their advanced

production systems. With a growing market share in the United States,

Japan worried that the United States might provoke a trade war that would

potentially hurt both nations, so the Japanese assented to an export quota

on its automobiles. The restricted supply led to higher auto prices in Amer-

ica, harming American consumers who had to pay more for cars. American

car companies were happy to have less competition, and the agreement

bought them some time to catch up to their foreign competitors.

When a country pushes for a protectionist trade policy, it is commonly

aimed to support the incomes of a specific group. Centuries ago, mercanti-

lists argued for protection that favored certain commercial interests, pos-

iting that such policies were best for the country. Since then, the impetus

90 INTERNATIONAL ECONOMICS

has changed little. Interest groups traditionally consist of an industry at

large, or workers or capital owners within a sector. Theoretical economic

models show that while trade policies such as tariffs benefit specific interest

groups, the costs to consumers are usually greater. In the automobile

example, American car company workers and shareholders were helped

by the Japanese export quota, but tens of millions of American consumers

were harmed. In another example, sugar imports are restricted in the

United States, which forces prices higher than they would be under free

trade. Some may believe that these policies could never survive the

American democratic process because consumers are able to vote out of

office the politicians who support such protectionist measures. In truth,

most Americans are unaware of the sugar support program that costs the

average American an estimated $10 per year. Undeniably, it is difficult for

consumers to know how specific trade policies affect the price they pay for

a good; voters normally don’t have the time (or incentive) to research these

issues in any depth.

An important field in economics called “public choice” analyzes

the political economy of these policies. A major insight is that there is a

fundamental asymmetry between consumers and protected industries—

namely, consumers are a large and diffuse interest that is often unin-

formed, while protected industries are a concentrated interest that is very

well informed. Any single consumer faces a large cost to repealing a pro-

tectionist policy that costs him only $10 per year. Since the gains to protest-

ing protectionism are so disparate, organizing consumer opposition is

difficult to accomplish in practice. On the other hand, an interest group

(such as Florida sugar growers) is relatively small, and by organizing, lobby-

ing, and contributing to political campaigns, they may reap millions or

billionsofdollars in benefits from a certain policy. Therefore, interest groups

are better able to overcome the problem of “collective action” to maintain

protectionist policies. Critics point out that while politicians compete for

office by offering attractive policies to voters, they also require money to

market and advertise their campaign. In effect, to generate money for cam-

paign television commercials, they may be willing to trade off some amount

of voter welfare for the welfare of special interests. And as money becomes

increasingly important to winning political campaigns, more voter welfare

may be sacrificed in exchange for special interest welfare.

THEORIES OF INTERNATIONAL TRADE 91

Concentrated industry interests disproportionately influence domestic

trade policies, yet on the international stage, foreign exporters can serve as a

powerful counterweight during trade negotiations. Consider two countries

that are bargaining for a new bilateral trade agreement. Within each

country, industries that are currently protected—through import tariffs,

for example—will lobby to keep the status quo. But their foreign compe-

titors now facing these tariffs may mobilize to repeal them. Since most

nations recognize that free trade is usually beneficial to consumers—who

represent the largest imaginable interest group—trade negotiations can be

successful in reducing protectionism on both sides. In practice, lowering a

tariff benefits exporters from numerous countries. For instance, if Brazil

lowers the tariffs it charges on personal computers, China, Taiwan, Japan,

South Korea, and Singapore would all benefit. This implies that it may

be efficient to negotiate trade agreements among many countries at the

same time.

Such “multilateral” trade negotiations under the GATT and the WTO

have been ongoing since World War II. Due to the interwar protectionism

retrenchment, tariffs were fairly high at first, but then during the early

decades of the GATT, there was a stiff reduction in tariffs and other bar-

riers. These reductions continued, and under the WTO today, trade bar-

riers are generally low (especially in manufacturing as compared to

agriculture). Negotiating marginal reductions, often in industries that have

been protected for decades, is challenging. This difficulty has been illus-

trated by the current Doha Round, which began in 2001 and has pro-

ceeded intermittently for more than a decade. Its ostensible aim has

been to reduce agricultural protectionism, with an emphasis on fostering

the development of emerging economies.

Conclusion

Absolute advantage, comparative advantage, and the factor proportions

model are key conceptual building blocks to understanding trade flows in

a globalized world. A fundamental insight to the factor proportions model

is that traded goods can be viewed as bundles of the supply-side input

factors that produce them—namely, capital, labor, land, and technology.

Regions of the world abundant in one factor will tend to export goods that

92 INTERNATIONAL ECONOMICS

intensively make use of it; this is their comparative advantage. Likewise,

nations with certain raw materials may export them abroad, as according to

their absolute and comparative advantages. History and culture also influ-

ence an economy’s relative advantages. The experience of modern Asian

economic growth suggests that export expansion based on comparative

advantages can be an extremely effective development path. International

trade led by enhanced export capabilities drives domestic employment

growth, attracts foreign investment, strengthens the national currency, and

improves terms of trade.

On the other hand, according to the Stolper-Samuelson theorem,

the benefits of trade and specialization do not accrue equally within an

economy, potentially leading to political cleavages. The effects of well-

managed trade liberalizations percolate across many sectors, bringing

employment and wage growth, yet in less successful trade openings, new

international competitive pressures—particularly within competing

goods sectors—lead to wage cuts, worker displacement, and the decline

of some industries. In fact, international survey evidence reveals that

whether individuals with high levels of human capital favor free trade

depends positively on whether their nation is relatively abundant in

human capital, a finding that is consistent with the factor proportions

model. Furthermore, workers employed in sectors that do not compete

with imports are more likely to support free trade. In the future,

decreased communications and transportation costs will make global-

ized production and trade networks more pervasive. As such, anyone

planning to do business internationally ought to understand how these

forces of international trade affect their own occupation, industry, and

nation.

Further Reading

Bhagwati, J. (1989). Protectionism. Cambridge, MA: MIT Press. Feenstra, R. (2010). Product variety and the gains from international trade.

Cambridge, MA: MIT Press. Grossman, G., & Helpman, E. (1993). Innovation and growth in the global

economy. Cambridge, MA: MIT Press. Helpman, E. (2011). Understanding global trade. Cambridge, MA: Harvard

University Press.

THEORIES OF INTERNATIONAL TRADE 93

Hoekman, B., & Kostecki, M. (2010). The political economy of the world trading system. Oxford, England: Oxford University Press.

Irwin, D. (2009). Free trade under fire. Princeton, NJ: Princeton University Press. Irwin, D. (2011). Trade policy disaster: Lessons from the 1930s. Cambridge, MA:

MIT Press. Krugman, P. (1997). Development, geography, and economic theory. Cambridge,

MA: MIT Press. Krugman, P., Obstfeld, M., & Melitz, M. (2011). International economics: Theory

and policy. Upper Saddle River, NJ: Prentice Hall. Leamer, E. (2012). The craft of economics: Lessons from the Heckscher-Ohlin frame-

work. Cambridge, MA: MIT Press. Lin, J. Y. (2012). The quest for prosperity: How developing economies can take off.

Princeton, NJ: Princeton University Press. O’Rourke, K., & Williamson, J. (2001). Globalization and history: The evolution

of a nineteenth-century Atlantic economy. Cambridge, MA: MIT Press. Olson, M. (1965). The logic of collective action: Public goods and the theory of groups.

Cambridge, MA: Harvard University Press. Porter, M. (1985). Competitive advantage: Creating and sustaining superior

performance. New York, NY: Free Press.

Harvard Business School Case Studies

Abdelal, R., Tarontsi, S., & Jorov, A. Gazprom: Energy and strategy in Russian history, 709008-PDF-ENG.

Besanko, D., & Burgess, B. Subsidies and the global cotton trade, KEL348-PDF- ENG.

Bodily, S. E., & Lichtendahl, K. C. Airbus and Boeing: Superjumbo decisions, UV1312-PDF-ENG.

Devereaux, C., & Lawrence, R. The eagle and the dragon: The November 1999 US- China bilateral agreement and the battle over PNTR, HKS476-PDF-ENG.

Devereaux, C., Lawrence, R., & Watkins, M. Food fight: The US, Europe, and trade in hormone-treated beef, HKS434-PDF-ENG.

Devereaux, C., Lawrence, R., & Watkins, M. International trade meets intellectual porperty: The making of the TRIPS agreement, HKS432-PDF-ENG.

George, W.W., Palepu, K.G., & Knoop, C.-I. Novartis: Leading a global enterprise, 413096-PDF-ENG. https://cb.hbsp.harvard.edu/cbmp/product/413096- PDF-ENG

Goldberg, R. A., & Hogan, H. Can Florida orange growers survive globalization? 904415-PDF-ENG.

Iyer, L. To trade or not to trade: NAFTA and the prospects of free trade in the Amer- icas, 705034-PDF-ENG.

94 INTERNATIONAL ECONOMICS

Jones, G. G., & Gendron, A. In search of global regulation, 805025-HCB-ENG. Lam, P.-L., Yiu, A., & Wong, K.-F. Rent-seeking behavior in the power market,

HKU332-PDF-ENG. Lodge, G. C., & High, J. World Trade Organization: Toward free trade or world

bureaucracy?, 795149-PDF-ENG. McKern, B., Denend, L., Chang, V., & Reuk, K. The competitive advantage of

Russia, IB73-PDF-ENG. Moss, D. A., & Bartlett, N. World Trade Organization, 703015-PDF-ENG. Moss, D. A., Appling, G., & Archer, A. Creating the international trade organiza-

tion, 798057-PDF-ENG. Nolan, R. L., & Kotha, S. Boeing 787: The dreamliner, 305101-PDF-ENG. Roscini, D., & Marin, C. The TTIP: Bridging the transatlantic economy, 716026-

PDF-ENG. https://cb.hbsp.harvard.edu/cbmp/product/716026-PDF-ENG Rosegrant, S., & Kelman, S. Standing up for steel: The US government response to

steel industry and union efforts to win protection from imports (1998-2003), HKS075-PDF-ENG.

Shih, W., Bliznashki, K., & Zhao, F. IBM China Development Lab Shanghai: Capability by design, 611055-PDF-ENG.

Trumbull, G., Corsi, E., & Dessain, V. Common agricultural policy and the future of French farming, 707027-PDF-ENG.

Vietor, R. H. K., & Galef, J. China and the WTO: What price membership? 707032-PDF-ENG.

Vietor, R. H. K., & Thompson, E. J. Singapore Inc., 703040-PDF-ENG. Wheelwright, S. C., Pisano, G. P., & West, J. Eli Lilly and Co.: Manufacturing

process technology strategy, 692056-PDF-ENG.

THEORIES OF INTERNATIONAL TRADE 95

CHAPTER 4

Industrialization, Globalization, and Labor Markets

Introduction

In standard models of labor markets, wages are equal to the “marginal

product” (or incremental output) of an additional unit of labor. In other

words, the amount a worker earns is equal to the amount he or she can

produce. Intuitively, firms take on workers until the productivity of their

last hire is equal to the market wage rate. If the wage rate were below

productivity, firms would find it profitable to hire more workers, whereas

if the wage were above productivity, firms would have an incentive to shed

workers. Under this reasoning, more productive workers get paid more,

which implies that labor productivity growth ultimately leads to wage

growth in the long term. Indeed, empirical evidence shows labor costs and

labor productivity are strongly related across nations.

Now consider the neoclassical growth model, where economic growth

is driven by physical capital accumulation, technology, and human capital.

These factors all increase labor productivity, and hence, labor demand. In

essence, as economies grow, more manpower is required, so labor demand

increases. Provided the labor supply doesn’t expand too quickly from pop-

ulation growth, economic growth leads to wage growth in a wide class of

economic models. With the above primer in mind, this chapter investi-

gates the impact of globalization on labor markets across developing and

developed countries. It discusses common economic models of develop-

ment, industrialization, and industrial policies, focusing on domestic labor

market consequences, and it broadly analyzes the experiences of American,

Mexican, Chinese, and Indian labor markets in recent decades.

Lewis Model of Development

After World War II, many nations were rebuilding from the war or had

just won independence. This climate sparked a renewed interest in eco-

nomic theories of development. At the same time the neoclassical growth

model was being developed, in 1954 Sir Arthur Lewis devised what came

to be known as the Lewis two-sector “dual” model of development, for

which he later won a Nobel Prize. Born in St. Lucia, then a British colonial

territory in the Caribbean, Lewis was deeply knowledgeable about eco-

nomic history. He had a lifelong interest in practical development policy

and spent years in the field, advising Ghana and developing Caribbean

nations. As opposed to the broader neoclassical growth model, which

describes long-run growth and the behavior of emerging economies as they

catch up to leading economies, the Lewis model shows how a traditional

agricultural economy transforms into a modern manufacturing and

service-based economy. According to Lewis, an abundant supply of cheap

labor allows underdeveloped agrarian economies to accumulate capital and

industrialize.

While investigating the early Industrial Revolution in Britain, Lewis

was puzzled that wages had stagnated while savings, investment, and prof-

its multiplied. (Later research by other scholars challenged Lewis’s reading

of those trends; some have argued that, at least during the late Industrial

Revolution, wages soared, spurring laborsaving inventions in England.)

Lewis remarked that in standard economic models, a surge in investment

should have resulted in rising labor productivity and wages, alongside

declining returns to capital. He cleverly solved the conundrum by making

several alternate assumptions. First, he assumed developing economies

possess two sectors, agricultural, where most of the population initially

resides, and urban, where industrial activity takes place. Second, reminis-

cent of the economics of Reverend Malthus, he assumed that in the agri-

cultural sector, labor was effectively in unlimited supply. This implied that

agricultural labor productivity was minimal and wages remained at a

subsistence level. Third, he proposed that the burgeoning urban sector

possessed higher productivity with substantial capital, akin to the neoclas-

sical growth model economy. In the Lewis model, capitalists in the urban

sector pay relatively low wages because it only takes a slight premium over

98 INTERNATIONAL ECONOMICS

subsistence wages to attract workers from the country to the city. Capital

accumulation and technological advancement cause productivity to

increase in the urban sector, yet urban wages stay relatively flat due to the

rural labor surplus.

The upshot is that urban business owners are able to make ample prof-

its and invest heavily in new capital. Over time, the urban sector expands

and modern manufacturing and service industries emerge. Urban labor

demand stays strong and workers from the agricultural sector keep moving

to the big city. However, because urban growth steadily diminishes the

amount of labor in the countryside, the economy eventually reaches a

“turning point” (or labor supply constraint) when rural labor is nearly

exhausted. After the turning point occurs, wages in the city begin to

increase even faster, eating into industrialist profits. (Think of China

today.) By this time, most of the population lives in urban areas, and going

forward, the neoclassical growth model is broadly applicable. After the

turning point, labor disputes and strikes increase, since workers have new-

found bargaining power. Future generations become used to greater con-

sumption levels and have higher workplace expectations, inviting collective

bargaining and burgeoning regulatory regimes. Governments start financ-

ing more basic education, which increases human capital and enhances

productivity. As the economy becomes prosperous and more advanced, it

orients itself toward services and internal consumption, with an export

sector that produces increasingly complex goods requiring substantial

skill and technology.

Unlike traditional models, the Lewis model illustrates why:

(1) megacities in developing nations have shantytowns on their outskirts,

full of unskilled workers from the countryside looking for urban work;

(2) in developing economies, workers typically prefer regular wage

employment to self-employment but often cannot find it; and (3) many

individuals work full time yet are still poor. These observations are con-

sistent with the Lewis model. Due to the rural labor surplus, the model

predicts that developing countries feature low wages that do not increase

much initially as the population moves to cities. After the turning point,

wages may grow much faster. Higher incomes can be saved, supporting

investment and further economic growth. On the other hand, the financial

sector in emerging economies is often dreadfully underdeveloped. Workers

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 99

may find few safe havens to keep their savings, and it may be difficult to

obtain loans for new business ventures, even at very high interest rates. Due

to deficient financial intermediary institutions and a dearth of domestic

savings, developing nations may require foreign capital to finance indus-

trial investment and economic growth. In the 19th century, American

states borrowed heavily from wealthier nations abroad—to build canals,

for example—and sometimes ended up defaulting.

Poverty Traps, Big-Pushes, and Take-Offs

During the 1950s, around the time that Lewis was formulating his two-

sector theory, another famous model dominated development economics.

Called the “big-push” model of economic development, it arose out of a

paper by Paul Rosenstein-Rodan in 1943. Its key insight was that some

poor countries exist in “poverty traps” which require substantial invest-

ment to jump start economic growth. The big-push model of development

is based on the idea that poor economies suffer from “coordination fail-

ures,” meaning private sector organizations lack the necessary incentives to

adopt modern production techniques and achieve economies of scale.

Unless there is an expectation that other firms will similarly invest in

industrialization, there is unlikely to be sufficient consumer demand and

capital funding to make such costly investments worthwhile. Each com-

pany only kicks-off investment projects if the others do, yet it is difficult to

get companies to start investing all of a sudden. (Some call this type of

conundrum a “chicken or egg” problem, because it isn’t clear how one can

come into being without the other existing first.)

Consider the plight of a poor farmer in a traditional subsistence econ-

omy. He would like to improve the yield of his soil with fertilizers, so the

economy requires either the construction of a fertilizer factory or the

import of foreign fertilizer. However, a factory requires infrastructure

(such as roads, electric power, and water supply), trucks, fuel, capital

investment, engineers, and packaging. And importing requires a dock,

roads, trucks, fuel, and credit from bankers. It isn’t at all likely that any

single farmer would be able to carry out either of these scenarios. Mean-

while, ordinary citizens do not invest in education and training because

there are no jobs available that would make use of higher level skills.

100 INTERNATIONAL ECONOMICS

Foreign engineers, bankers, and lawyers may be required to fill the domes-

tic void. In this view, what is needed is a powerful entity—typically a

national government—to coordinate the decisions of firms and house-

holds to overcome market synchronization failures. This coordinating

entity would provide investment funding to the private sector to build:

(1) an industrial base with new technologies and (2) education and train-

ing facilities for workers. The economy would then “take off,” driven by

consumer demand. One classic example of a big-push success story is Meiji

Japan, when the Japanese government—propelled by Japan’s “zaibatsu,”

or pyramidal business groups—coordinated a rapid industrialization in

the final decades of the 19th century. Another instance is the postwar

American South, which received a big-push catalyst from public capital

investments to build schools, hospitals, roads, dams, and power plants

during the Great Depression and World War II.

If the least developed economies are stuck in poverty traps and face

massive coordination failures, they probably won’t be able to solve their

problems on their own since tax bases and state coffers are too small.

Development economists have frequently argued that the least devel-

oped economies need foreign aid and loans (such as from the World

Bank or International Monetary Fund) to get out of this rut. These

funds could be used for private sector investment and public goods like

infrastructure, education, and health care. If an economy is capable of

supporting an increasing returns industry, then the case for massive

injections of capital is all the stronger. Large-scale industries can support

worker payrolls, drive export growth, and provide tax revenues to gov-

ernments. With substantial foreign investment, an economy stuck in a

poverty trap will hopefully begin to grow. Then, after it has left the trap,

growth will be self-sustaining. Ideally the economy would obtain access

to foreign technologies, build domestic universities, and eventually con-

duct its own research and development. Labor productivity would grow

quickly, resulting in higher wages for both skilled and unskilled workers.

The influential mid-20th century economist Alexander Gerschenkron

argued that, driven by heavy state involvement—and the adoption of

foreign methods and borrowed technology, as stressed by American

economist Thorstein Veblen—backward countries could accelerate eco-

nomic growth.

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 101

Big-push development theory was the leading concept in development

economics throughout the 1950s and 1960s. It was thought that econo-

mies all went through the same stages of growth. The proper mix of sav-

ings, investment, and foreign aid was all that was needed to power them.

International development aid was intended to catalyze emerging econo-

mies and ignite self-sustaining growth. Big-push thinking lost favor during

the 1970s and 1980s, in part due to the apparent failure of foreign invest-

ment and aid to produce significant increases in economic growth and

productivity in Africa. The theory was displaced by market liberalization

and privatization policies, although big-push ideas—sometimes combined

with market liberalization—have reemerged over the past couple decades,

chiefly among economists in advanced nations who stress the importance

of foreign aid.

By and large, modern empirical studies lend little clear support to the

big-push model. If the poorest economies are stuck in poverty traps and a

big-push effort is essential to kindling growth, then developing nations

receiving aid should grow faster than economies receiving little or no aid.

Yet if anything, the cross-country data indicate the opposite is true.

Also, the handful of countries that successfully underwent major growth

transitions—or take-offs—over the past half century were disproportion-

ately in East Asia. Despite the fact that their governments were instrumen-

tal in fostering economic growth, these economies only received a small

amount of foreign aid on average. Big-pushes require massive investment,

but with the exception of Singapore and possibly Hong Kong, investment

was not exceptionally high at the beginning of East Asian take-offs.

Some big-push proponents have remarked that over the past two cen-

turies, the output gap between the richest and poorest countries has gotten

much larger, meaning these two groups have diverged. By and large, the

wealthiest economies prospered while the poorest stagnated. Although it is

possible many poor countries (particularly in Africa) have been stuck in a

classic poverty trap, the actual growth trends are, at best, only broadly con-

sistent with the need for big-pushes. Recent studies suggest weak institutions

are probably a better explanation for the lackluster growth of the poorest

economies over this long time frame. Many critics of foreign aid to sub-

Saharan Africa and other poor regions point to studies showing a negative

statistical relationship between the volume of foreign aid and subsequent

102 INTERNATIONAL ECONOMICS

economic growth. Based on this evidence, they argue that aid erodes insti-

tutional quality by increasing the power of kleptocratic elites and corrupt

government officials, and in practice, is really just a windfall for despots.

Proponents of foreign aid contend that such destructive outcomes can be

prevented through enhanced monitoring and accountability measures.

Industrial Policy

Big-push investment projects—whether financed with tax revenues,

domestic savings, or foreign credit—are a form of “industrial policy.” By

definition, industrial policies consist of sector-specific initiatives that

enhance industrialization, productivity growth, and national competitive-

ness, all aiming to promote the national interest. These policies have tradi-

tionally involved economic restructuring in the industrial, manufacturing,

and agricultural export-oriented sectors. Half a century ago, in line with

big-push thinking, development economists believed that forceful govern-

ment interventions were the key to industrial policy. Based on historical

evidence and theoretical developments, economists today are more likely

to stress the importance of industrial policy driven by private initiative,

albeit within a framework supported by the public sector. These concepts

are potentially relevant to all economies, whether advanced or developing,

and the optimal set of industrial policies differs according to the circum-

stances of each economy.

Although implementing industrial policies involves controversy and

risk, the rewards can be enormous. Government officials and private firms

can work closely together to implement efficient restructurings, though in

practice, these alliances may also increase corruption. One classic industrial

policy is the subsidization of a brand new industry: governments may pro-

vide infrastructure, low-cost capital, or even protection from overseas com-

petitors in the form of trade barriers. For example, in recent years China

has given favored domestic firms free land, subsidized energy, low-interest

loans, insider information, and favorably rigged bids. If successful, new

industries take off, resulting in demand spillovers across other domestic

sectors, which generate even greater employment and output.

Critics argue that industrial policies are likely to be disastrous because

governments are poor candidates to predict which industries will thrive.

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 103

For one, the venture capital industry has trouble forecasting which projects

will ultimately be successful, so it is difficult to see how a government

agency, using taxpayer funds, could do better. Even if the bureaucracy in

charge of an industrial policy project is honest and relatively efficient,

critics contend that it probably wouldn’t be able to execute ventures with

nearly the same resourcefulness and drive as private sector businesses.

Furthermore, once an industrial policy directive is underway, it is difficult

to gauge the success of long-term projects or thwart the rent-seeking efforts

of powerful private sector agents. There is certainly evidence from past

industrial policy failures to support these charges. With its “Cassa del

Mezzogiorno” (or Fund for the South) program to develop and industri-

alize its backward southern economy after World War II, Italy experienced

tremendous waste and corruption. At least a third of the funds were esti-

mated to have been squandered. Factories never became operational and

sham enterprises existed only to collect government grants. In post-

colonial Africa, bureaucracies have often been dominated by political,

tribal, and family influence, leading to a long list of failed industrial policy

projects across many nations.

Other countries have succeeded with their industrial policies in the

past. Japan’s “Ministry of International Trade and Industry” (MITI) coor-

dinated industrial and trade policy after World War II, supporting the

development of the petrochemical industry in the 1950s, the electronics

industry in the 1960s, the computer industry in the 1970s, and the

biotechnology and aviation industries in the 1980s and 1990s. China

has picked a number of winners in its manufacturing sector. If not for

generous public assistance, it is possible that some Chinese industries

would be much smaller or not exist at all today. Chile is another exam-

ple. Chilean grapes, forest products, and salmon are all successful export

industries that were aided by government assistance and subsidies.

Industrial policies may take different forms within an industry over

time. In Mexico, the motor vehicle and computer industries were ini-

tially supported by import-substitution policies that encouraged local

production to take the place of imports. Later they benefitted from pref-

erential tariff policies under NAFTA. Finally, governments must mon-

itor subsidized industries and quickly phase out the support of failures.

This is difficult to do in practice. East Asian governments have been

104 INTERNATIONAL ECONOMICS

much more successful than Latin American governments at this aspect

of industrial policy.

Restructuring, Diversification, and Development

Economic development requires a shift from subsistence agriculture

to modern industries exhibiting higher productivity levels. At low

levels of development, economic growth entails a decreasing degree of

concentration—meaning production becomes more diversified across

sectors. At this stage of development, sectors within an economy exhibit

vastly uneven productivity and growth. Entrepreneurs and businesses are

discovering their own cost structures and learning how to improve their

bottom line.

Research shows that when economies reach per capita income of

approximately $15,000 to $20,000 in today’s American dollars, they reach

a tipping point: their economies start to become more concentrated and

less diversified. At this stage of growth, economies have found their com-

parative advantages, and they are leveraging economies of scale. Their

export sector is usually well developed, concentrating on a small number

of manufactured goods that are highly popular with buyers around the

world. Historical patterns of production, resource advantages, superior

entrepreneurship, and pure chance all play vital roles in determining the

basket of goods an economy specializes in producing and exporting. As these

economies grow and prosper, their production shifts to complex goods that

exhibit complementarities in production—meaning high-quality labor and

capital inputs are necessary—and provide greater value-added.

In economies that develop successfully, labor moves from less produc-

tive activities to more productive ones, raising output and wages. This can

be achieved by sectoral reallocations, such as transitioning from agriculture

to manufacturing. In fact, labor in developing countries is about three to

four times more productive in manufacturing than in agriculture, and

wages are consequently higher. By successfully expanding the manufactur-

ing sector, a developing economy can raise productivity and output, even

in the absence of major technological improvements. Over the past several

decades, this is precisely what happened in developing Asian nations

such as China, India, the Philippines, and Indonesia. These economies

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 105

benefitted from labor productivity growth within certain sectors, stem-

ming from more capital, better technology, greater training and experi-

ence, and increased foreign direct investment. Import-substitution

policies to promote industrialization—which saw their heyday in the

1960s and 1970s—were also successful in many countries, including

Mexico (discussed below), Turkey, and Brazil.

In recent decades, however, developing economies in Latin America

and Africa have struggled to shift labor from less productive to more pro-

ductive sectors—if anything, the reverse has happened. At least labor pro-

ductivity within sectors has grown, though not as much as in Asian

economies. Some unsuccessful trade liberalization policies also contributed

to Latin American and African structural “devolution.” In Argentina and

Zambia, for example, many manufacturing jobs were lost following import

liberalizations when fragile domestic firms had trouble competing. This

“shock treatment” ultimately discouraged broad economic growth.

Managerial Capital

Managerial capital is defined as the organizational and managerial abilities

required to run organizations and scale them up. It is a type of specialized

human capital that developing nations lack. Managerial capital leads to

greater efficiencies within companies, allowing firms to improve the pro-

ductivity of their capital, labor, and technology inputs. Skilled managers

are better able to: utilize equipment efficiently; motivate and train employ-

ees; deploy effective sales, marketing, and advertising campaigns; restruc-

ture organizations and deploy capital when necessary; and access capital

funding necessary for expansion. Such skills can be honed through school-

ing and on-the-job experience.

In wealthy economies, upper-level managers are broadly skilled and

amply paid. As business operations have globalized and become more com-

plex, the demand for the services of top managers and executives has grown

among large companies. Compensation has been bid higher and higher,

with incentive pay increasingly tied to short-term firm performance.

Critics argue upper-level executives and boards of directors are too close

for comfort, so much of the compensation growth is actually caused by

collusion due to poor corporate governance.

106 INTERNATIONAL ECONOMICS

At the other extreme, the absence of managerial capital in emerging

economies can impede economic growth and entrepreneurship. As emerg-

ing economies grow and develop educational institutions, their stock

of managerial capital builds. To bridge the gap in the meantime, they

can import foreign managers, copy the best practices of multinational

managers, or hire consulting firms to increase managerial capital.

Industrialization and Population Growth

There is no doubt that industrialization is responsible for the massive

increase in world population over the past two centuries. During the early

Industrial Revolution, the British were able to maintain their living stan-

dards despite rapid population growth because industrialization and inter-

national trade created such robust demand for their domestic labor. In the

early-19th century, after the Industrial Revolution ignited in Britain then

spread elsewhere, there were one billion people on the planet, compared

to over seven billion today. Just in the past 50 years, the world population

has doubled (although world population growth rates have steadily

declined after peaking in the 1960s). All developing nations go through

the “demographic transition” process: first death rates decline due to better

living conditions and medical care, and thereafter birth rates fall due to

lower infant mortality rates and more work opportunities for women.

Economic development also extends life expectancy. Today it ranges from

about 80 years at birth in the United States, Japan, and much of Europe, to

50 years in parts of Africa, such as Zimbabwe and Somalia.

Theory of Globalization and Labor Markets

In canonical economic growth models, wages increase as economies

develop. Emerging economies accumulate capital and improve their tech-

nologies, thereby increasing labor productivity and boosting labor demand

and wages. At the same time, an increased labor supply resulting from

population growth puts downward pressure on wages during the industri-

alization process. By and large, the evidence suggests development leads to

higher wages in spite of population growth, at least after a Lewis turning

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 107

point is reached. Accordingly, there is a strong positive relationship

between labor productivity and wages across nations.

To analyze the distributional consequences of transitioning labor mar-

kets, economists typically study wage differentials between skilled and

unskilled workers. Useful, hard-to-develop skills—usually derived from

education and training—lead to higher wages in the labor market. Even

in the face of high demand, these skills are in relatively short supply due to

the barriers of acquiring them, which include inadequate educational sys-

tems and a lack of interest and financing among prospective students.

Skilled workers fill out professional and managerial occupations, while

unskilled workers perform manual labor and basic service occupations that

do not require advanced education or training.

As a practical simplification, economists commonly distinguish skilled

and unskilled labor by the completion of a college degree. Education

increases a worker’s human capital, and it also leads to higher productivity

and earnings. As economies develop, they customarily improve their edu-

cational institutions and increase aggregate schooling levels. International

empirical evidence shows a strong positive relationship between a nation’s

level of income and the average years of schooling its workers complete. As a

consequence, advanced nations tend to be relatively abundant in skilled

(meaning educated) labor, while developing nations are relatively short of it.

The factor proportions model and associated Stolper-Samuelson theo-

rem predict that trade between developed and developing nations benefits

owners of the relatively abundant factor of production and harms those in

possession of the relatively scarce factor. Accordingly, opening trade would

benefit skilled workers in advanced economies and unskilled workers in

developing nations, though it may hurt unskilled workers in advanced econ-

omies and skilled workers in developing nations. In terms of wage inequality

within nations, the factor proportions model implies that opening trade

around the world would lead to increased inequality in wealthy countries

and lowered inequality in developing nations, all else being equal.

Evidence on Globalization and Labor Markets

Traditional economic theories of international trade propose that the

effect of globalization on domestic labor markets depends on whether an

108 INTERNATIONAL ECONOMICS

economy is developed or undeveloped. Many economists have attempted

to test these theories in recent years, and the literature is ongoing. Before

proceeding, two facts about developing nations are worth mentioning:

(1) comprehensive micro data measuring labor market inequality in devel-

oping countries is less likely to be available for periods prior to the 1980s

and (2) before the 1980s, most developing countries were not open to

trade. Openness grew more popular beginning in the 1980s, so that the

fraction of nations considered relatively open increased roughly three-fold

over the next 25 years (particularly after the collapse of the Soviet Union in

1991). Because of these two factors, most of the empirical evidence on

developing economies and the impact of globalization on their local labor

markets is derived from trade liberalization episodes after 1980. For devel-

oped nations, higher quality data going further back in time exist, so there

is more evidence on wage trends, and trade openness (already rather high

in 1980) increased only gradually thereafter. To summarize, comparative

economic research on globalization and local labor markets is largely based

on evidence from the hyperglobalization era of the past 30 years.

The key finding is that since 1980, income inequality expanded in

most nations and regions, especially in middle- and high-income coun-

tries. Likewise, the demand for skilled and educated labor generally

increased relative to other groups, particularly in advanced nations.

Although globalization and inequality have both increased over the past

30 years in most countries, correlation does not prove causation. Another

factor, technology, has been implicated by most economic researchers as

the force that primarily drove the increase in inequality globally. Many

have argued that the proliferation of new information and communica-

tions technologies since the 1980s—such as personal computing and the

internet—has resulted in strong labor demand for skilled and educated

workers who best know how to utilize these tools.

Called the “skill biased technological change” hypothesis, it proposes

that changes brought about by new technology have increased the relative

demand for high-level skills. Its proponents point out that skilled profes-

sionals are the first to know about new economic opportunities and the

best able to take advantage of them. Possessing superior training and

resourcefulness, professionals also benefit from higher quality networks

and greater access to capital and government policymakers. In addition,

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 109

capital flows and financial openness both relate to technology. Capital

has become more likely to cross borders, and since capital is usually com-

plementary to human capital and skill, countries that attract the most

capital may exhibit increasing wage inequality. And contrary to Stolper-

Samuelson, globalization can benefit an elite group of skilled insiders in

emerging economies if they are able to access foreign capital flows and the

benefits of a transitioning economy while outsiders cannot, due to political

corruption and weak institutions. This is what happened in Russia during

the 1990s.

Recent empirical research is suggestive, with the caveat that it is chal-

lenging to disentangle the effects of globalization, technology, and capital

accumulation on local labor market inequality. Based on an international

panel of countries beginning in 1980, trade liberalization and export

growth are associated with greater wage equality in developing economies,

consistent with Stolper-Samuelson. In these nations, increased agricultural

exports reduce inequality because they strengthen low-skill labor demand

in economies with a large agricultural employment share. In developed

nations, the results are mixed (as discussed below). Foreign capital invest-

ment and the enhanced use of technology are generally associated with

increasing inequality. Skilled and educated workers (such as managers,

entrepreneurs, designers, researchers, and engineers) have the knowledge

and talent to make use of technology and foreign capital, so their produc-

tivity and wages are boosted.

While the incomes of both skilled and unskilled workers have grown

over the past three decades in most countries, the returns to skill and edu-

cation have increased, widening some disparities. In the United States and

other advanced English-speaking economies (such as England, Ireland,

and Australia), the share of income going to the top one or five percent

of income earners has gone up, which is also consistent with enhanced

technology favoring their skill sets. On the other hand, the share going

to top earners has remained relatively flat in Japan and continental Europe,

indicating that political and cultural factors are fundamental to explaining

these trends.

The full effect of globalization on inequality in developing countries is

not clear-cut because export growth typically reduces inequality to some

extent, whereas technology and capital upgrading increase inequality.

110 INTERNATIONAL ECONOMICS

Furthermore, export growth, technological progress, and capital upgrading

frequently take place at the same time as trade liberalization or capital

liberalization episodes. Research has demonstrated that exporting and

import-competing firms tend to be larger, more skill-intensive, more pro-

ductive, and pay higher wages. After liberalizations, efficient exporting

firm expand and sometimes upgrade their technology and capital, while

less efficient exporters fail. This occurred in Brazil and Argentina during

liberalization episodes in the 1980s and 1990s. Likewise, import-competing

firms become either more efficient or exit. Thus, if a developing economy

is not quite ready for the competitive pressures of international trade,

domestic firms may fold, and the benefits of liberalization may accrue only

to the most productive firms with efficient, skilled workers. As a result, the

overall wage effects of globalization are difficult to predict. It can favor

skilled workers, due to technology and capital improvements from trade,

or it can favor unskilled workers if labor-intensive exporting sectors, such

as textiles or agriculture, expand. Studies have uncovered a variety of

responses to specific trade liberalization episodes. In fact, contradicting

Stolper-Samuelson, wage inequality increased or stayed the same in many

developing countries after they opened trade during the 1980s and 1990s.

Research on the impact of globalization on wealthy country labor mar-

kets is broadly consistent with the factor proportions model. As interna-

tional economic integration steadily progressed, wage inequality in most

affluent nations has increased since the 1980s. Most of the change in

inequality in these nations occurred at the top of the distribution, meaning

skilled workers have done particularly well. Factor proportions logic

implies that skilled and educated workers gain from globalization because

their abilities are in relative abundance in wealthy nations. Opening their

domestic market to international trade and capital flows creates more

demand for their skills. Cheaper travel and telecommunications enable

highly skilled workers living in affluent countries to cooperate more exten-

sively in production with workers in emerging markets. The story is dif-

ferent for unskilled laborers in wealthy nations, as they are substitutes for

unskilled workers in developing economies. Facilitated by technology,

production has become more fragmented across borders, and globalization

has caused certain low-skill tasks to move to developing nations. This has

occurred through the growth of multinationals in developing economies,

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 111

as well as through offshoring and the “outsourcing” of tasks to external

contractors and suppliers abroad. Since the 1970s, these developments

have reduced the relative demand for middle-to-low skilled labor in

wealthy nations.

Finally, one major event, not to be repeated in the future, had an

enormous impact on the global supply of labor and demand for capital:

one and a half billion Chinese and Indian workers joined the world econ-

omy in the 1990s. This doubling of the global labor supply was an unprec-

edented shock to the world’s factor markets. It applied downward pressure

to the wages of unskilled workers around the world. It also affected global

capital markets: since physical capital is needed to build factories and infra-

structure, capital poured into emerging markets in the 1990s. The late

1990s Asian financial crisis marked a turning point, however. In its wake,

capital flows shifted toward advanced economies. Interestingly, emerging

economies, led by oil-rich regions and China, became net exporters of

capital beginning in 2000, instead of net capital importers, as they had

been before. Human capital complements industrialization and technolog-

ical innovation, so these developments increased the relative demand for

skilled labor, which is still scarce in most parts of the world. Because the

integration of China and India was a one-time event, the degree of pressure

globalization places on the wages of less skilled workers across the world’s

labor markets is likely to be lower in the future than it has been in the

recent past.

Globalization, Influence, and the American Labor Market

Throughout the 1950s and 1960s, American industry led the world as

Europe and Asia were rebuilding from the destruction of World War II.

American output per worker was twice that of Europe and six times that of

Japan. In the pre-microprocessor era, strong American economic growth

rates complemented a large and growing manufacturing base, rapidly ris-

ing educational attainment, and high unionization rates. Yet by the 1970s,

parts of Europe and Asia had begun to catch up. Japan and some East

Asian nations had perfected technologically sophisticated production pro-

cesses and closed the productivity gap with the United States in some

112 INTERNATIONAL ECONOMICS

industries. Production began to globalize, too. Global supply chains slowly

emerged. Lower value-added processes, performed with unskilled labor,

moved to emerging economies, and higher value-added processes, increas-

ingly complex due to technology, remained in advanced economies. The

comparative advantage of the United States evolved toward more difficult,

technologically-intensive procedures, as emerging economies took over

simpler tasks and began their gradual ascent up the value-added chain.

Over the past 40 years, as the United States further integrated with the

world economy, new technologies profoundly impacted most sectors of

the American economy. This is especially true in the “tradables” sector

(which, by definition, produces goods that can be traded abroad). This

sector has become more efficient, and labor productivity within it has

grown rapidly due to accumulated capital and technology. Many low and

middle value-added tasks have shifted offshore, and on net, employment in

tradables has slowed. Employment growth has instead been concentrated

in the much larger “nontradables” sector, which is dominated by local

service jobs in government, health care, retail, and food service. It is more

difficult for technology and capital to make workers more productive in

the service sector, which is driven by labor inputs. (Think of the produc-

tivity of an elementary school teacher.) Overall demand shifts have favored

educated and skilled workers in both the tradables and nontradables sec-

tors. These higher income workers are better able to absorb and spread new

technologies, raising aggregate productivity. As opposed to unskilled work-

ers, skilled workers commonly perform nonroutine problem-solving tasks

that are harder to digitize, automate, or outsource. Educated and skilled

workers have done relatively well throughout the American economy,

while less skilled workers have shifted from manufacturing to service

jobs as the manufacturing sector has progressively declined in relative

importance.

The American private sector led many global innovation trends.

After struggling in the 1970s—a decade that offered negative stock

market returns after adjusting for inflation—American corporate profits

rebounded in the 1980s. Many corporations in the United States restruc-

tured, looking for efficiencies that would allow them to beat foreign

companies that had caught up. The world-leading American information

and communications technology industry has been a principal catalyst for

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 113

technological change throughout the international economy. These devel-

opments attracted massive inflows of foreign capital, and not just during

the late 1990s Dotcom boom. The United States is now the world’s largest

recipient of foreign direct investment. The share of American output

traded internationally has grown gradually, and its new technologies have

facilitated global supply chains and outsourcing. More and more imports

come from developing nations, particularly China. In Europe, economic

changes have been broadly similar, although they began later and have

been less pronounced, especially in continental economies. The labor

market impacts of technology and globalization have led to relatively less

wage inequality and more unemployment in European economies, due

to less labor market flexibility and greater regulation and collective bargain-

ing there.

In the United States, globalization and changes in technology are inter-

related, and have trended in the same direction in recent decades. An

important literature examines whether technological progress, interna-

tional trade, or other factors such as “deunionization” have caused the

relative demand for skilled and educated workers to strengthen since

the 1970s. Research has shown that demand shifts favoring educated

workers—in a process called “skill upgrading”—were pervasive in the

United States and other advanced nations, despite the fact that the price

of skilled labor was increasing. Industries that undertook larger invest-

ments in computerization also exhibited greater skill upgrading. Another

essential piece of evidence is that low-income countries account for only a

small fraction of manufactured imports to the United States. This suggests

that unskilled workers in emerging economies are not primarily responsi-

ble for the sluggish demand for unskilled labor in the United States.

These findings point to a commonly held view among labor econo-

mists that technological change played a central role in driving the

observed expansion in wage inequality, with globalization and trade sec-

ondary. Although trade has harmed some groups of workers in certain

industries, the aggregate gains from increased trade, while incrementally

diminishing, have outweighed the costs. Trade with developing nations

like China has helped keep the price of consumer staples low in the United

States. In fact, trade has disproportionately increased the purchasing power

of lower income Americans because they spend a larger share of their

114 INTERNATIONAL ECONOMICS

income on goods that have become cheaper due to low-priced imports,

such as clothing and electronics sold at Walmart. This purchasing power

effect goes a long way toward compensating certain unskilled American

workers for any sluggish wage and employment growth caused by foreign

competition.

The recent “Great Recession” reduced world trade by about 20%,

including the foreign trade of the United States, an economy which

accounts for a tenth of all international trade. American exports quickly

rebounded to prerecession levels, though imports have taken longer to

recover. American consumer demand has been slow to bounce back. In

the corporate sector, companies have shed workers and restructured,

upgrading capital equipment with investments in automation, digitiza-

tion, robotics, and other machinery that substitutes for labor. With lin-

gering anxiety about future growth prospects and capital equipment

relatively cheap compared to labor, postrecession hiring has been slow.

Taking their cue from Germany, some American policymakers have begun

calling for a renewed emphasis on vocational training programs and

apprenticeships because many American companies—including interna-

tional powerhouses like Apple—complain about shortages of specialized,

blue-collar niche labor in the United States.

A number of encouraging new trends have emerged. The capital

investments American businesses are making will inevitably lead to pro-

ductivity gains for many years into the future, whilst labor costs in China

and India are rapidly increasing. Given vast American productivity advan-

tages, work has started to shift back to the United States. There are also

highly favorable tends in American energy supply capabilities and costs.

Finally, the middle classes in India, China, Brazil, and elsewhere are grow-

ing rapidly, and their consumer demand will help boost American eco-

nomic growth in the years to come.

Globalization, Industrialization, and the Mexican Labor Market

After World War II, Mexico sustained strong economic growth for over

30 years, transitioning from an agrarian society to a semi-industrial econ-

omy with most of the population living in cities. As part of Mexico’s

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 115

development strategy, the government protected infant industries and pro-

moted import-substitution policies, where high tariffs encouraged consu-

mers to buy products made in Mexico. To advance industrialization, the

export sector was supported. As a prominent example, beginning in the

1960s, the government established the “maquiladora” sector in a special

free trade and investment area for Mexican export-processing plants

located in the north near the United States border. Maquiladora factories

are able to import materials and equipment on a duty-free and tariff-free

basis for processing, assembly, or manufacturing, provided the output is

subsequently exported.

During the 1970s, the discovery of oil reserves—coupled with high oil

prices—encouraged populist Mexican governments to spend heavily.

They accumulated large debt loads, which eventually led to the Mexican

debt crisis of 1982. The 1980s came to be known as a “lost decade” for the

Mexican economy, in spite of growing efforts to modernize and integrate

internationally, which included privatization and trade liberalization. The

“North American Free Trade Agreement” (NAFTA) was enacted in 1994,

the same year Mexico experienced a currency crisis precipitated by political

turmoil. A recession followed. Mexican economic growth picked up during

the 1990s and exports have continued to increase. Today, combined

imports and exports represent more than half of Mexico’s economic output.

Maquiladoras produce about half of Mexico’s exports, most of which are

manufactured goods. The United States is Mexico’s top trading partner,

accounting for over 80% of Mexican exports and half of Mexican imports.

In addition to NAFTA, Mexico joined the GATT in 1986 and the

“Organization for Economic Cooperation and Development” (OECD) in

1994, as Mexico’s industrial policy shifted from heavy state intervention to

a market orientation with open trade. Foreign direct investment, the pres-

ence of multinational corporations, and outsourcing inflows all shot up in

Mexico following reforms initiated after the 1982 debt crisis. According to

the factor proportions model of trade, because Mexico is relatively abun-

dant in unskilled labor, trade liberalization and increasing globalization

would lead to rising employment, wages, and production in unskilled

labor-intensive industries, with the reverse happening in skilled labor-

intensive sectors. Yet numerous studies have shown that in Mexico, wage

inequality and the skill premium actually went up until the mid-1990s.

116 INTERNATIONAL ECONOMICS

An alternative theory is that technological change—induced by

privatization and foreign competitive pressures stemming from trade

liberalization—caused the relative demand for skilled and educated labor

to increase through the mid-1990s. In this view, during the first half of the

postreform era, Mexican companies were adjusting to the new economic

climate and moving up the value-added production chain by utilizing rel-

atively more educated and skilled labor, especially in the northern border

regions. This notion is supported by the data through the mid-1990s.

Empirical research shows that many Mexican companies upgraded their

technology and production quality during this period of increasing expo-

sure to international competition and globalized production sharing.

The mid-1990s gave way to the NAFTA era. Following NAFTA, wage

inequality trends reversed course, so that the skill premium started to

decline alongside growing real wages and incomes. Overall Mexican

income inequality has fallen—in part due to increased social transfers and

remittances—and average real wages have grown. Under NAFTA, Mexico

integrated with the United States and Canada, countries that are relatively

abundant in skilled labor. Research suggests that NAFTA’s effect on

Mexican wages was consistent with the factor proportions model. It

benefitted the multitude of unskilled Mexican workers, and wage inequal-

ity between skilled and unskilled labor decreased. Regions that were more

exposed to international trade and had stronger links to the American

economy—such as the northern and border states—showed greater

declines in the skill premium and more overall wage growth after NAFTA.

However, agricultural workers were more likely to be displaced after

NAFTA, and total agricultural employment declined, though this was

partly caused by other changes in the agricultural sector, including pro-

ductivity-enhancing technological and capital improvements.

More than a decade after its implementation, NAFTA is viewed favor-

ably by a majority of Mexicans. Although large income disparities remain

across Mexico, most of its 115 million citizens consider themselves middle

class. Demographers point out that Mexican immigration to the United

States has declined after peaking in 2000, principally due to Mexican eco-

nomic growth and falling birth rates. Mexico has managed to increase the

educational attainment of its labor force, despite the inefficiency of its

educational sector. Combined with capital upgrading and additional

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 117

international economic integration, these developments are a sign that

Mexico’s middle class will continue to expand as the “Aztec Tiger”

emerges.

Globalization, Reforms, and the Chinese Labor Market

The Chinese economy underwent profound changes after major reforms

were authorized in 1978, following Mao’s 1976 death. Most remarkably,

China transitioned from a closed system based on central planning to a

market-oriented economy that is a dominant force in international com-

merce. Beginning with the phasing out of socialized agriculture, China

liberalized its market pricing system, gave more autonomy to state enter-

prises, and opened itself up to foreign trade and investment. Due to the

reforms, instead of hewing to Soviet-style production, millions of Chinese

workers began following economic incentives that encouraged effort, effi-

ciency, and productivity. Trade-oriented “Special Economic Zones”

(SEZ) were opened from 1980 onward to attract foreign investment and

technology transfer. Tariff barriers were high in the 1990s before coming

down substantially over the following decade.

The Chinese government was careful to design industrial policies that

encouraged the development of import-competing firms and exporters,

frequently in new industries. Rapid productivity growth in the nonagri-

cultural private sector has driven much Chinese economic growth. China

has accumulated ample capital, financed by a very high domestic savings

rate as well as foreign investment, and shifted labor from the country to the

city, resulting in productivity gains and growth. A large income gap

between rural and urban areas has persisted historically. Today, a little over

half of China’s 1.35 billion residents live in cities, and urbanization efforts

continue, leading to productivity growth coupled with social strife and

endemic public policy challenges. Extreme pollution and corruption are

widespread throughout China, though the government has begun major

clean energy initiatives.

Exports have been an engine of Chinese economic growth, particularly

since the 1990s. Government policy—such as the maintenance of an

undervalued currency and the extension of cheap credit—has supported

the export sector. Chinese households maintain very high savings rates of

118 INTERNATIONAL ECONOMICS

over 25%, among the highest in the world. These funds have been used for

state-directed capital investment and infrastructure spending instead of

personal consumption. China continues to build domestic infrastructure

on a massive scale, intended to support future economic growth and

urbanization efforts. The present challenge is to initiate the transition to

an economy sustained by domestic consumption and innovation, as

opposed to export growth and capital formation.

For decades, the Chinese industrial sector has been a low-cost producer

unafraid to imitate (and then improve upon) foreign technologies, intel-

lectual property, and best practices. China is known for its sophisticated

supply chains, massive scale economies, and dynamic production lines that

can ramp up output in a matter of hours. However, China does not have a

track record of developing major innovations (at least in the modern era),

so it has begun spending billions on research and development, including

the retooling of its university system. Mirroring cities in wealthy industri-

alized nations around the world, Shanghai and other large urban areas are

full of young, upwardly mobile workers hoping to find well-paying work

and possibly finish college or even a Master of Business Administration

(MBA) degree. Early reforms in the 1980s benefitted rural households

engaged in agricultural work, while later reform policies since the 1990s

have led to faster urban income growth and a large new class of ultra-

wealthy Chinese in coastal regions. Still, China’s financial sector is largely

state-controlled, and a substantial portion of its manufacturing and service

sector consists of state-owned enterprises.

China’s greatest comparative advantage during its explosive growth

phase of development has been its abundance of low-cost labor, which has

made it globally competitive in producing inexpensive, labor-intensive

manufactures. Although the Chinese labor cost advantage has narrowed

considerably, it still remains vast compared to the United States. For

instance, among manufacturing companies in 2010, the hourly cost of

labor in China was less than $2, compared to $34 in the United States.

As a result, manufactured products utilizing cheap unskilled labor consti-

tute a significant share of China’s trade, which is precisely what the factor

proportions model of trade predicts. With the rise of offshoring and

declines in trade barriers, a substantial portion of China’s imports

come from parts and components that are assembled into finished

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 119

products—like consumer electronics and computers—and later exported.

The value added to most of these products by Chinese workers is small

compared to the total value of the product after it is shipped abroad. For

instance, while Apple’s iPhone is primarily manufactured in China, the

cost of Chinese labor for components and assembly represents just 2%

of an iPhone’s final retail price.

Since the 1990s, China has been unique among developing nations in

its extraordinary ability to move up the “product ladder,” meaning an

increasing share of China’s production comes from higher quality goods

that utilize capital-intensive, higher value-added processes. China contrasts

with stagnated emerging economies at the bottom of the product ladder

that primarily export raw materials (in Africa) or perform basic assembling

of manufactured goods (in Central America). China’s success may be

largely due to savvy industrial policies and superior strategic timing and

coordination. Overall, economic policymaking in China has been much

more effective than in other developing regions. Economic research shows

that in wealthier countries, firms that directly compete with Chinese

companies have made greater investments in upgrading technology and

innovation to lower their long-run costs by enhancing productivity.

Studies of the Chinese labor market have uncovered a number of

valuable findings. Most importantly, Chinese workers have broadly expe-

rienced strong wage growth. Under periods of rapid economic growth and

convergence, such a pattern is expected. Wage setting and employment

policies, which used to be controlled by the government, have been grad-

ually liberalized to reflect market forces. Rural incomes grew faster than

urban incomes in the 1980s, largely due to agricultural reforms. Urban

incomes then outstripped rural incomes from 1990 to 2010, particularly

after China joined the WTO in 2001. In the 1990s, minimum wage,

unemployment insurance, and worker injury insurance reforms were

enacted, and the labor bureau stopped allocating jobs to college graduates.

The skill premium for college-educated workers, which was very low in the

1980s, has risen so that it now matches the United States.

All segments of the population, including the uneducated poor in rural

inland areas, have experienced income growth, although the largest gains

have accrued to those with higher income and education in urban coastal

regions. As a result, while poverty rates have declined, overall income

120 INTERNATIONAL ECONOMICS

inequality has increased since 1979 by most measures. The increase

in wage dispersion stands in contrast to a key prediction of the factor pro-

portions model of trade, which is that, due to its abundance of unskilled

labor, China’s integration into global markets would benefit its unskilled

workers and possibly harm skilled and educated workers, with wage

inequality generally declining. Indeed, taken as a whole, the evidence sug-

gests that globalization and trade have not been the dominant factors

behind changes in the Chinese wage structure. Instead, structural reforms

and technological upgrading—undoubtedly spurred by international

trade—have been more important drivers. And given recent news of

strong wage growth, increasing demands by workers, and a surge in labor

shortages and social unrest, a Lewis turning point has, in all likelihood,

already been reached in China.

Many analysts point out that China’s development strategies may

eventually run out of steam. Moving the population from the country to

the city causes large productivity gains, but half of the Chinese population

is already in urban areas. The international evidence on economic growth

shows that once fast-growing economies transition to middle-income

levels, they are likely to experience slower growth, particularly if they pre-

viously maintained an undervalued currency to promote exports. Called

the “middle-income trap” by economists, this slowdown has commonly

occurred once economies attain per capita income in the range of $10,000

to $20,000 in current American dollars. (China is expected to reach the

lower end of this level by about 2015.) To combat it, countries must accu-

mulate ever more advanced technologies, perform higher value-added pro-

cesses, ensure more workers complete college, and build a larger, more

sophisticated services sector. However, a sizeable retired population rela-

tive to the work force tends to exacerbate the growth slowdown, and due to

population control strategies such as the one-child policy instituted in

1979, China is one of the most rapidly aging nations in the world. This

change in the age profile of the Chinese population will shift resources

away from capital investment and lead to tighter labor markets, eroding

China’s cost advantages in production.

The health of China’s state-dominated financial system—which is not

as sound or advanced as Japan’s was at a similar level of development—is

also questionable. Households have little choice but to park their savings in

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 121

accounts paying minimal interest. With these funds, the government pro-

vides cheap credit to support development. Capital has disproportionately

gone to the state sector, yet research shows that returns to capital have been

far superior in the private sector. Hopefully there will be no forthcoming

financial sector meltdown, such as the one that occurred in Japan, a coun-

try which enjoyed decades of strong export-driven growth, helping to prop

up a massive real estate and asset price bubble that peaked in 1991. After it

collapsed, Japan faced two decades of minimal growth in spite of massive

monetary and fiscal stimulus. China has unquestionably learned from the

growth experiences of other nations, and it has strategically maintained cap-

ital controls and regulations on real estate purchases to help prevent such a

scenario. The Chinese economy will ideally be able to maintain healthy

growthbyshiftinginvestmenttothenon-statesector,transplantingsuccess-

ful economic policies to the poorer inland regions, and supporting a

consumer culture that will power domestic demand for years to come.

Globalization, Development, and the Indian Labor Market

After independence from Britain in 1947, India achieved slow and steady

growth for the next three decades. From 1950 to 1980, India’s annual

income per capita growth rate was 1.7%, a pace one Indian economist

famously dubbed the “Hindu rate of growth,” as it was far below East

Asian nations outside of communist China. India’s economic policy was

protectionist, featuring import-substitution industrialization, heavy regula-

tion of the private sector, and a colossal bureaucratic public sector. In 1980,

Indira Gandhi returned to power for a fourth term as Prime Minister,

this time with an orientation more favorable to markets, instead of hostile

as before. Change was in the air in India during the 1980s. Market reforms

were initiated, such as a curbing of price controls and corporate taxation,

making it easier for businesses to grow. India did not initiate a massive

accumulation of capital and technology at this time. Instead, the new pol-

icies allowed India to slowly tap into its latent potential and increase its

productivity per worker.

India’s output per worker grew more than four times as fast in the

1980s than it did during the 1970s. Protectionism increased somewhat

122 INTERNATIONAL ECONOMICS

throughout the 1980s before significant liberalization policies were

enacted in the 1990s, facilitating India’s entry into the world economy.

The changes occurred when India’s ability to pay a massive foreign debt

load was called into question in 1991, which sparked a financial crisis. The

IMF bailed India out, yet it required economic restructuring and liberal-

ization policies as part of the deal. Trade was liberalized, foreign invest-

ment allowed, and the “License Raj”—one major source of red tape,

corruption, and frustration throughout the private sector—was effectively

abolished. After stagnating throughout the 1980s, Indian trade as a frac-

tion of total output increased 50% during the 1990s.

India’s growth since the 1980s has been driven by an immense expan-

sion of the service sector. This contrasts with the traditional Asian path of

development based on low-wage industrial production and export growth.

In India, labor has shifted from agriculture to services and (to a lesser

extent) industry. Its information and communications technology indus-

try based in Bangalore, the Silicon Valley of India, has boomed. Yet India

has failed to maintain high investment levels and its infrastructure remains

very poor. In this respect, India contrasts with China, where growth has

been driven by greater amounts of physical capital accumulation and new

infrastructure.

India’s industrial sector is relatively undeveloped, and the export share

of its economy remains much lower than China. Trade constitutes a

quarter of India’s economy, compared to half of China’s, and India has

not benefitted from a savvy and far-reaching industrial policy. Although

Indian and Chinese income per capita was roughly the same in 1990, over

the last two decades, China’s economy has grown much faster and it has

experienced a slower rate of population growth. As a result, China’s

income per capita is now more than double India’s. India’s rural-urban

transition lags China, as a third of Indians live in cities versus half of

Chinese. India also fares less well according to most health and education

measures. For instance, life expectancy at birth is 66 years in India versus

74 years in China; India’s adult literacy rate is 74% versus 94% in China;

and government spending on health care is nearly fives times greater in

China than in India.

The factor proportions model implies that by opening up to world

markets, globalization would help India’s unskilled and poor workers and

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 123

reduce income inequality. In addition, India’s fast economic growth would

help raise incomes for nearly all workers. Research shows that average

incomes have risen throughout India since liberalizations began over

30 years ago, and India’s poverty rate has been cut in half since 1980,

despite substantial population growth. Nonagricultural workers have done

the best. But contrary to the factor proportions model, there is evidence

that, following the early 1990s reforms, income inequality increased, par-

ticularly in urban areas, in a manner consistent with a rising relative

demand for skill. This is potentially due to greater technology utilization.

Income growth has been more rapid among skilled workers.

Economic growth has brought greater benefits to the poor in regions

of India with greater financial development and access to credit. In the

rural sector, wage growth has been sluggish over the past decade despite

strong economic growth, as the expanding supply of unskilled workers—

most still operating in the informal sector—has overwhelmed demand.

In regions with more stringent labor market regulations, the poor have

done less well, as some laws have hindered manufacturing growth that

would benefit unskilled laborers. Research also suggests improving edu-

cation and infrastructure would help poor workers in India. Compared

to China, India’s labor force is much less structured and less likely to

work in state-run enterprises. Over 90% of India’s labor force remains

in informal employment, versus about 50% in China. At the top end, a

new class of super wealthy Indian entrepreneurs and businesspersons

has emerged since the 1990s, similar to China. Today, India has about

50 billionaires, compared to roughly 100 in China and 400 in the United

States.

As India integrated into the world economy alongside China, the

global supply of labor effectively doubled. Based on standard economic

growth models, whether wages in these two countries converge to

advanced country levels in the long run depends on the amount of phys-

ical capital—in the form of machinery and computers—they accumu-

late, as well as their capacity to educate their workforce and absorb

technologies. As these enormous developing countries amass factors of

production, unskilled labor will become scarcer, driving up its wages.

China has much more capital per worker than India, due to China’s

lower population growth rate and higher investment rate. China’s

124 INTERNATIONAL ECONOMICS

capital per worker may eventually converge to wealthy nations such as

Japan and the United States, though it would take decades longer for

India to do so.

Since modern information technology allows work to move from

wealthy countries with high labor costs to emerging markets like India and

China, offshoring may grow in the future, particularly as India and China

improve their educational systems. These forces may slowly shift the locus

of global innovation in technology-intensive industries to cities such as

Bangalore and Beijing. However, technology and growth can also be a

recipe for income inequality and social unrest. Globalization can harm

those in less productive organizations that struggle to compete internation-

ally, while skilled entrepreneurs and employees working in ultra-modern,

export-oriented companies benefit the most from integration with

advanced nations. In the future, India will hopefully make better use of

informal sector workers, reduce bureaucracy, and create structural reforms

that lead to broadly shared benefits.

Conclusion

The factor proportions model of trade is a useful guide to understanding

how trade impacts different types of workers and affects the relative

demand for skilled versus unskilled labor within a given economy. But it

is also imperfect. Experience demonstrates that economic integration can

lead to economic growth benefitting most workers regardless of their edu-

cation and skill set. Perhaps most importantly, globalization can help

power the transition from agriculture to industry in developing countries,

lifting millions out of poverty, as in the cases of post-NAFTA Mexico and

post-Mao China. It can also benefit skilled workers in emerging markets,

such as information technology professionals in India. On the other hand,

globalization can harm domestic workers through inadequately managed

trade reforms, leading to worker displacement and greater inequality,

regardless of a country’s level of development.

Overall income inequality between nations has declined in recent

decades due to the rapid economic growth of developing nations such as

China and India. At the same time, income inequality within most econ-

omies has proliferated, principally driven by technological factors favoring

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 125

skilled and educated workers. Global supply chains and the impact of

information and communications technologies have integrated produc-

tion processes to an extent that few would have imagined a century ago,

during the last pinnacle period of globalization. The result is an increase in

the overall efficiency of the global economy, generating lower consumer

prices in the long run. In the coming years, emerging economies will per-

severe in their efforts to move up the technology ladder and value-added

chain. By increasing their national stock of human capital, building infra-

structure, and reforming regulatory and taxation policies, developing

nations can enhance competitiveness, leading to greater labor market

opportunities for their domestic workers.

Further Reading

Banerjee, A., Benabou, R., & Mookherjee, D. (2006). Understanding poverty. Oxford, England: Oxford University Press.

Bell, D. (1973). The coming of post-industrial society: A venture in social forecasting. New York, NY: Basic Books.

Bhagwati, J., Blinder, A., & Friedman, B. (2009). Offshoring of American jobs: What response from U.S. economic policy? Cambridge, MA: MIT Press.

Brynjolfsson, E., & McAfee, A. (2012). Race against the machine: How the digital revolution is accelerating innovation, driving productivity, and irreversibly trans- forming employment and the economy. Lexington, MA: Digital Frontier Press.

Bulmer-Thomas, V. (2003). The economic history of Latin America since independence. Cambridge, England: Cambridge University Press.

Chandler, A. (1969). Strategy and structure: Chapters in the history of the American industrial enterprise. Cambridge, MA: MIT Press.

Chang, H.-J. (2003). Kicking away the ladder: Development strategy in historical perspective. London, England: Anthem Press.

Cohen, S., & Zysman, J. (1988). Manufacturing matters: The myth of the post- industrial economy. New York, NY: Basic Books.

Ehrenberg, R., & Smith, R. (2011). Modern labor economics: Theory and public policy. Upper Saddle River, NJ: Prentice Hall.

Feenstra, R. (2009). Offshoring in the global economy: Microeconomic structure and macroeconomic implications. Cambridge, MA: MIT Press.

Gershenkron, A. (1962). Economic backwardness in historical perspective. Cambridge, MA: Harvard University Press.

Haber, S. (1995). Industry and underdevelopment: The industrialization of Mexico, 1890–1940. Palo Alto, CA: Stanford University Press.

126 INTERNATIONAL ECONOMICS

Haber, S., Klein, H., Maurer, N., & Middlebrook, K. (2008). Mexico since 1980. Cambridge, England: Cambridge University Press.

Moretti, E. (2012). The new geography of jobs. New York, NY: Houghton Mifflin Harcourt.

Lewis, A. (1955). The theory of economic growth. Homewood, IL: Richard Irwin. Lin, J. Y. (2011). Demystifying the Chinese economy. Cambridge, England:

Cambridge University Press. Lin, J. Y. (2012). New structural economics: A framework for rethinking development

and policy. Washington, DC: World Bank Press. Naughton, B. (2006). The Chinese economy: Transitions and growth. Cambridge,

MA: MIT Press. North, D. (1990). Institutions, institutional change and economic performance.

Cambridge, MA: Cambridge University Press. Perkins, D., Radelet, S., & Lindauer, D. (2006). Economics of development.

New York, NY: W. W. Norton and Company. Ray, D. (1998). Development economics. Princeton, NJ: Princeton University Press. Rostow, W. (1960). The stages of economic growth. Cambridge, England:

Cambridge University Press. Schultz, T. (1964). Transforming traditional agriculture. New Haven, CT: Yale

University Press. Todaro, M., & Smith, S. (2011). Economic development. Upper Saddle River, NJ:

Prentice Hall. Williamson, J. (2009). Globalization and the poor periphery before 1950.

Cambridge, MA: MIT Press.

Harvard Business School Case Studies

Abdelal, R., & Tarontsi, S. Russia: Revolution and reform, 710030-PDF-ENG. Alfaro, L., & Iyer, L. Special economic zones in India: Public purpose and private

property, 709027-PDF-ENG. Comin, D., & Vietor, R. H. K. China “unbalanced,” 711010-PDF-ENG. Froot, K. A., & McBrady, M. 1994–95 Mexican peso crisis, 296056-PDF-ENG. Iyer, L., & Donovan, G.A. Urbanizing China, 713037-PDF-ENG. https://cb.

hbsp.harvard.edu/cbmp/product/713037-PDF-ENG. Iyer, L., & Vietor, R. H. K. India 2012: The challenges of governance, 712038-

PDF-ENG. Jones, G. G., & Bud-Frierman, L. Weetman Pearson and the Mexican oil industry,

804085-PDF-ENG. Jones, G. G., & Gallagher-Kernstine, M. The American challenge: Europe’s response

to American business, 804057-HCB-ENG.

INDUSTRIALIZATION, GLOBALIZATION, AND LABOR MARKETS 127

Jones, G. G., & Lefort, A. McKinsey and the globalization of consultancy, 806035- PDF-ENG.

Mathis, F. J., & Keat, P. G. India: The promising future, TB0265-PDF-ENG. Musacchio, A., Tella, R. D., & Schlefer, J. The Korean model of shared growth,

1960-1990, 712052-PDF-ENG. Musacchio, A., Vietor, R. H. K., & García-Cuéllar, R. Mexico: Crisis and compet-

itiveness, 710058-PDF-ENG. Oi, J., Bebenek, C., & Spar, D. L. China: Building “capitalism with socialist

characteristics,” 706041-PDF-ENG. Pill, H. Mexican debt crisis of 1982, 701111-PDF-ENG. Pill, H. Mexico: The tequila crisis—1994-95, 702093-PDF-ENG. Pill, H. Mexico: From stabilized development to debt crisis, 797096-PDF-ENG. Pill, H. Portfolio capital flows to emerging markets, 796129-PDF-ENG. Rithmire, M. The “Chongqing model” and the future of China, 713028-PDF-ENG. Scott, B. R., & Matthews, J. L. China’s rural leap forward, 703024-PDF-ENG. Scott, B. R., & Matthews, J. L. One country, two systems?: Italy and the Mezzogiorno,

702096-PDF-ENG. Scott, B. R., & Leight, J. Chile: The conundrum of inequality, 907411-PDF-ENG. Shih, W., & Wang, J.-C. Upgrading the economy: Industrial policy and Taiwan’s

semiconductor industry, 609089-PDF-ENG. Tella, R. D., & Vogel, I. Inequality and the “American model,” 703025-PDF-ENG. Vietor, R. H. K. Low-carbon, indigenous innovation in China, 712061-PDF-ENG. Vietor, R. H. K., Rivkin, J. W., & Seminerio, J. The offshoring of America, 708030-

PDF-ENG. Vietor, R. H. K., & Veytsman, A. American outsourcing, 705037-PDF-ENG. Vietor, R. H. K., & Thompson, E. J. India on the move, 703050-PDF-ENG.

128 INTERNATIONAL ECONOMICS

CHAPTER 5

Politics, Globalization, and the State

Introduction

For peaceful globalization to take place, much less succeed in the end,

political will is necessary. Politicians, whether supported by ordinary citi-

zens or vested interests, must believe they have something to gain by open-

ing trade or liberalizing their economy and culture. Thereafter, restraints

are lifted and their local area is awash in new goods and influences. Over

the first major wave of globalization during the 100 years prior to World

War I, many states made just such a wager. Capital and labor flowed to the

New World where returns—and risks—were higher. Then, from World

War I to World War II, barriers went up amidst economic turmoil and

global warfare. Following postwar international accords like the Bretton

Woods system, the Marshall Plan, and the GATT, the 1950s heralded a

new age of economic growth, trade, and globalization. The pace only

picked up after the 1970s, so that today, tariffs in many countries, includ-

ing the United States and China, are minimal. Still, a recent backlash

against globalization among many constituents around the world has

prompted a rethinking of its rules. Few seem to desire a return to high

tariffs, as workers in middle- or high-income nations have gotten used

to buying cheap imports from developing nations at their local Walmart

(or equivalent).

With unemployed teenagers leading protests and old regimes falling in

the Middle East, recent events have highlighted trends that favor the

expansion of political rights and economic freedoms in repressive states.

Change can come quickly: a century ago, women had the right to vote in

only a few nations. Technology such as cell phones and the internet have

permeated most societies around the world, especially among the young.

Modern information and communications technology was indispensable

to the “Arab Spring” of 2011, where major protests occurred in Algeria,

Oman, Iraq, Bahrain, Kuwait, Morocco, Lebanon, and Syria, and govern-

ments were overthrown in Egypt, Libya, Yemen, and Tunisia. These

North African and Middle Eastern political movements began in

December 2010 when Mohamed Bouazizi, a young street vendor in the

Tunisian town of Sidi Bouzid, set himself on fire. He passed away from the

injuries a month later. The human rights organization Amnesty Inter-

national has argued that the leak of American diplomatic correspondence

by WikiLeaks in 2010 was the necessary catalyst for the Arab Spring. The

internet-based transmission of WikiLeaks documents shed light on

the corrupt regime of Zine El Abidine Ben Ali in Tunisia, who would flee

the country in January 2011 with his family, before being convicted and

sentenced (in absentia) to 35 years in jail by a Tunisian court months later.

This sort of monumental political change had not occurred since the

fall of the Berlin Wall in 1989, which paved the way for the end of the

Cold War in 1991 when the Union of Soviet Socialist Republics (USSR)

dissolved. Today all organizations face the reality, mandated by modern

technology, that sunlight is the best disinfectant. Within minutes, photos

and written documents can go viral worldwide, acting as powerful catalysts

for social change. Combined with youthful populations, these forces may

continue to topple other absolutist governments in the future; more than

half the world’s population currently lives under an autocratic regime, so

there is plenty of room for progress. Yet the future of authoritarianism is

hard to predict, and it is doubtful that modern information and commu-

nications technology spells ultimate doom for political repression in the

long run. Insights from political and economic research are useful here. For

decades, political scientists have grappled with globalization’s impact on

governance. Economists have now joined the debate, armed with cross-

country statistical evidence that is increasingly sophisticated, as more indi-

ces measuring the political and institutional aspects of nations become

available. Research shows that globalization clearly influences domestic

political alignments, the likelihood of military conflict, and the size of

governments around the world. The literature grows quickly, and many

more findings will undoubtedly come to light in the coming years. This

chapter, intended as an overview of important ideas and findings, discusses

some political aspects of globalization from an economic perspective.

130 INTERNATIONAL ECONOMICS

Democracy and Economic Growth

It’s no secret that there is a strong correlation between national wealth and

democratic rule. Economists and political scientists alike remark that all

OECD countries are democratic and wealthy, while many nondemocratic

states are in the poorest regions of the world, such as Africa and the Middle

East. Over the past 40 years, democratic rule has spread across the globe. The

numberofelectoraldemocraciesgrewfromroughly30to120nations,sothat

over half of the independent states around the world are now democratic. At

the same time, many nations have also gotten much richer. These patterns

prompt a natural question: does democratic rule lead to economic growth?

And conversely, does economic growth increase the likelihood of a demo-

cratic transition? Correlation does not prove causation, and over the past

century, the statistical evidence that this correlation between income and

democracy is causal is actually quite weak. At least there is some evidence that

higher levels of education—which are more likely to occur in wealthy

nations—lead to more democratic politics, although even this is contested.

Over the very long run, the statistical evidence supporting a relation-

ship between growth and democracy is a bit stronger. At the start of the

19th century, after the Industrial Revolution had spread from England to

other regions, very few countries were democratic. Since then, democra-

tization has come together with growth. Some scholars have argued

democracy requires a certain level of economic development—otherwise

it will not last—and economic growth forecasts democratic rule. Going

further back to some 500 years ago, countries that moved toward democ-

racy also grew the most. At the time that Dias, da Gama, and Columbus

were voyaging from Europe to faraway continents, there existed certain

political constraints on monarchs in some European nations, whereas

outside of Europe, absolutism still ruled. Some countries have embarked

on paths embracing democratic rule and economic growth, while

others have not, remaining absolutist and relatively poor. The empirical

research is contentious and unsettled, though many prominent political

scientists—including Robert Dahl, Samuel Huntington, and Seymour

Martin Lipset—have maintained that the long-run link between democ-

racy and income is indeed causal, perhaps best exemplified by the experi-

ence of Western European nations and their “offshoots.”

POLITICS, GLOBALIZATION, AND THE STATE 131

Globalization and Democracy

Just as wealth and democracy have proliferated around the world over the

past two centuries, globalization has also spread. The belief that globali-

zation and democracy go hand-in-hand is very common among policy-

makers, scholars, and government leaders. It’s easy to see why. Many

economies in Central and Eastern Europe joined the global economy

after Soviet authoritarianism collapsed. In Latin America, the twin forces

of democratization and globalization have expanded since the 1970s.

At the other extreme, despotic North Korea maintains a closed economy

that is—not coincidentally—deeply impoverished and backward. Other

nations present case studies that don’t fit neatly into standard categories.

Singapore is one of the most globalized and open economies in the world

despite not being a full electoral democracy (at least according to most

Westerners). Hong Kong, also an affluent globalization leader, is not a full

democracy (though it does have a high degree of autonomy from mainland

China). Globalization doesn’t always bring democracy, either. The non-

democratic government in China has remained strong despite opening

trade. Some even argue that economic growth powered by trade actually

makes Chinese democratic reforms less likely—similar, perhaps, to

Singapore’s experience in some ways. And democracies don’t always create

pro-globalization policies. For instance, in Bolivia and Peru, democratiza-

tion fueled populist measures opposing free trade.

Think of the distribution of political power in democratic versus abso-

lutist governments. Democratic governments allocate political power

broadly across the population, enfranchising ordinary workers and the

poor. They distribute political power to most citizens, so that even those

with minimal resources are represented. (In theory, communist govern-

ments do the same, claiming to represent workers and labor interests above

all else, yet based on their track records, they are inefficient, repressive, and

often fail to support the interests of common citizens, benefitting connected

party members instead.) Progressive income taxes are common in democ-

racies, as voters demand some redistributive aspects to their tax systems.

Research shows that democratization leads to more social spending on edu-

cation and health. Balancing the interests of many groups, democracies fre-

quently enact policies regulating capital, landowners, natural resources, and

132 INTERNATIONAL ECONOMICS

workers. In the end, voter sentiment generally determines whether a dem-

ocratic nation opens itself to free trade and foreign investment.

By contrast, absolutist regimes maintain power in the hands of a ruling

elite, whether a single ruler (as in autocracy), a small clique (as in oligar-

chy), or a large class of party members (as in some socialist states). These

systems frequently restrict trade and international influences. They feature

concentrated political and economic power favoring the owners of nonla-

bor factors of production such as capital, land, and natural resources. For

instance, the aristocratic landed gentry in pre-industrial England owned

large tracts of land, living off their rental income, and possessed dispro-

portionate political power for centuries. In China today, the ruling

Communist Party has 80 million members, and most capital flows to

state-owned enterprises which monopolize key industries and charge

higher prices than would be possible under a more competitive economic

environment. In Bolivia and Venezuela, wealth and power emanate from

the possession of bountiful natural resources such as oil, natural gas, and

lithium. Since absolutist governments may be expected to enact global-

ization policies consistent with the interests of the ruling class, if the

factor of production that the elite control is relatively abundant, the state

may push for free trade. If it is scarce—such as land in small, backward

European nations during the 19th century—they may not. And com-

pared to democracies, the interests of labor are likely to be given less

weight in absolutist states.

The factor proportions model of international trade yields some pre-

dictions about governance in developing nations. Under democracy in

poor developing countries that are full of unskilled labor, voters would

support opening trade, since it would drive their wages up. However, cap-

ital owners may not support globalization, because capital is usually scarce

in poor countries and foreign investment may drive down their rate of

return. Thus, opening trade can reduce inequality, attract foreign invest-

ment, and generate growth, though not every powerful interest group

would support it. Since democracies give relatively more political power

to unskilled labor, democratic regimes should be more likely to foster glob-

alization and trade in developing countries.

An important case—quite relevant to Africa, Latin America, and the

Middle East—occurs when ruling elites control a domestic supply of

POLITICS, GLOBALIZATION, AND THE STATE 133

exportable natural resources (like oil and gold) that is the country’s abun-

dant factor. The ruling government would support opening trade and then

cash in. By supporting education and health spending in developing

nations, resource wealth can be a blessing. Yet the possession of natural

resources can also lead to friction, instability, and conflict among domestic

factions, which retards economic and political progress. This situation is

sometimes called the “natural resource curse,” and it has afflicted a number

of developing countries (such as Nigeria and Cote D’Ivoire, which are rich

in oil and cocoa, respectively). Under democracy, voters might push for

nationalization if they believe the benefits of their country’s resources are

not fairly shared. However, in a weak state, regardless of the type of polit-

ical system, concentrated natural resources invite graft and corruption.

Partly for this reason, democracy may be difficult to enact in the first place

in these resource-rich developing nations. They are also commonly pla-

gued by strong currencies, since foreigners buy large quantities of the

domestic currency when they trade for the local natural resource, which

hampers the export of other goods.

The empirical evidence supports the notion that democratic rule is

more likely to promote globalization in developing nations, as openness

would increase demand for unskilled labor. Potential exceptions are labor-

scarce poor nations—such as frontier economies—or Latin American

states where workers are worried about job losses from international com-

petition. The case is less clear for affluent developed nations. Worried

about low-wage competition abroad, rich state voters may not support free

trade. Antiglobalization voices might hold more sway in a democratic

regime, particularly in recent decades, as globalization has often come with

an increased skill premium. On the other hand, rich nations are usually full

of capital, and wealthy capital holders—who typically have a lot of clout

under any type of government—would be expected to support globaliza-

tion. Capital owners may be even better connected to ruling elites in

wealthy nondemocratic states, giving them influence to help enact pro-

globalization policies. There is also the issue of interest group pressure and

protectionism. Narrow industry interests are frequently influential in

democracies because voters lack information and politicians need funding.

In wealthy absolutist countries, special interests can have influence if the

ruling elites are aligned with them—or, without such an alliance, they may

134 INTERNATIONAL ECONOMICS

have no influence at all. Statistical research across developed nations yields

mixed conclusions: wealthy countries are commonly democracies, but

democratic governance does not necessarily make them more likely to

globalize.

Reversing the causal arrow, there is also the question of whether glob-

alization and trade foster democracy in nondemocratic nations. As dis-

cussed in the previous chapter, opening trade and liberalizing finance

can enhance economic development and lead to a growing middle class,

making a democratic transition more likely. Trade liberalization also

brings new products and ideas which may increase the demand for democ-

racy. However, trade can exacerbate income inequalities and cause signif-

icant employment dislocations. In some cases, openness may shift power

to the wealthy and connected, strengthening the rule of an autocracy that

clamps down on potential insurrections and democratic revolutionaries.

A number of studies have yielded contradictory findings so far, indicating

that there is no consistently measurable effect of globalization on democ-

racy, at least according to international statistical evidence. Even so, there is

probably some positive effect stemming from exposure to the cultural influ-

ences and ideas (including consumerism) of democratic societies. In fact, in

the 18th century, Kant proposed that globalization spreads democratic

ideals. Like developing a taste for blue jeans, trade and globalization—

when combined with information and communications technologies—can

lead to pro-democracy attitudes among the general public. And as societies

get richer, citizens demand more political rights. Indeed, political scientists

have long considered political rights to be a luxury good. These forces

may eventually lead to greater democratic reforms in China.

Winners, Losers, and the Demand for Regulation

The logic of the Stolper-Samuelson theorem dictates that when a country

opens up to trade, the domestic production of goods that intensively utilize

the country’s relatively abundant factor will go up. The price of the abun-

dant factor of production will be bid up, and those who own it will gain

from free trade. Using the reverse logic, owners of the relatively scarce

factor of production will lose. The resulting prediction is that individuals

whose income depends on scarce factors will fear free trade, and those

POLITICS, GLOBALIZATION, AND THE STATE 135

controlling abundant factors will welcome it. An interesting 19th century

example is the United States, a democratic developing nation with high

tariff barriers to trade. It was labor- and capital-scarce, but it did have a lot

of land. Many natives were skeptical about free trade and immigration

because they feared it would drive down their wages. Agricultural interests

welcomed both, as land was abundant and all the more profitable with

additional immigrant labor. Organized labor was generally weak, so that,

favored by business (capital) and farming groups (landowners), open

immigration was allowed. (It wasn’t until 1875 that the first federal law

restricting immigration—the Page Act—was passed, aimed at Asian

migrants.) After the United States had amassed an abundance of capital

and the population had grown sufficiently, tariffs were eventually lowered,

despite opposition from labor and capital. America’s late-19th century

agrarian competitors in Western Europe responded with a backlash that

raised tariff barriers.

As the legendary Paul Samuelson, namesake of the Stolper-Samuelson

theorem, liked to point out, although trade is beneficial in the aggregate

and generates gains for certain interests, it will probably harm some other

interests, and in practice, the winners may not compensate the losers,

either because they cannot or they do not wish to. In theory, governments

can take funds from the winners to compensate the losers. However, it can be

politically difficult for the government to make such transfers. For example, if

American sugar tariffs are abolished, American consumers would win, yet

sugar workers might be devastated. In practice, sugar workers who lost their

jobs might receive some public assistance, though probably not enough to

make up for their troubles. Along these lines, economists commonly argue

that modern mature economies have developed entrenched interest groups

that lobby for inefficient policies, such as the maintenance of specific types of

protectionism or the elimination of beneficial regulations. Like barnacles on

an ocean liner, collusive political groups accumulate during prosperous dec-

ades. This notion certainly applied to the overextended British Empire prior

to World War I. Political shake-ups, economic turmoil, and war can serve as

catalysts for reform, but until such events transpire, the result can be

“institutional sclerosis” which retards growth.

In the United States, during the 25 years preceding the Great Reces-

sion, the abundant factor capital did well in many sectors. The economy

136 INTERNATIONAL ECONOMICS .

was further opened to trade and the financial system was liberalized,

attracting billions of dollars in foreign investment. The size and profitabil-

ity of the American financial sector increased dramatically. A handful

of innovators in the information technology sector reaped millions (and

sometimes billions) when their risky start-ups hit pay dirt. Labor struggled

at times, especially lesser skilled workers who were substitutes for low-cost

labor overseas, automated machinery, or computers. Overall income

inequality in America returned to levels that had not been experienced

since before World War II. The factor proportions model and Stolper-

Samuelson theorem offer an insightful way to understand these trends

leading up to the Great Recession. Relatively abundant in capital, technol-

ogy, and skilled labor, the United States further integrated with the world

economy. Owners of these factors of production favored globalization, for

good reason. Influenced by lobbying, regulatory oversight of the financial

sector became more lax. Heavy transaction volumes coupled with leverage-

magnified bets generated hefty financial sector compensation. When bub-

bles burst to end the cycle, conventional strategies soured and the govern-

ment was forced to intervene, supported by public funds.

The typical American family saw its wealth decline significantly in the

wake of the Great Recession, and many voters have begun to question the

fairness and adequacy of past policies. The situation in Europe is broadly

comparable. International survey evidence suggests that since 2009, more

citizens have grown to feel that economic benefits and burdens are not

fairly distributed. Although most respondents firmly support capitalism,

their call for retooled regulation has intensified. Some scholars, such as

Nobel Prize winner Joseph Stiglitz, have gone as far as to argue that the

benefits of capitalism and globalization have actually gone to the most

skilled in rent-seeking, due to insufficient regulation in many countries.

This argument suggests that, instead of progressing, the political process in

many advanced nations has regressed. Recall the days of the English and

Dutch Indies Companies from the 17th to the 19th centuries, when

monopolies were granted by the state and benefits flowed to elites.

Although democratic governments don’t baldly sanction overseas trading

monopolies by military force today, the end result may be similar because

of moneyed special interests and polarized political systems. During

Roman times, the historian Plutarch stated that “an imbalance between

POLITICS, GLOBALIZATION, AND THE STATE 137

rich and poor is the oldest and most fatal ailment of all republics,” so this

challenge of governance is hardly new.

The period of hyperglobalization may have slowed for now as populist

backlash pressures build. Survey evidence indicates that in the United

States, Europe, and many other regions, voters and politicians are reeval-

uating the role of regulatory controls (such as banking supervision) that are

designed to protect the public from downside risks caused by global mar-

ket turmoil and international business cycles. The current age of fiscal

strains and limited government funds makes it all the more important that

the legal and regulatory aspects of market economies are improved and

updated. Citizens are also reassessing their support for free trade and open

capital markets. The trend even extends to China, a nondemocratic state

where inequality has grown and a lack of environmental oversight has

allowed pollution to explode (though top officials now acknowledge that

these problems do pose threats to social stability). As part of China’s effort

to develop its capital markets and financial system, state authorities are

enhancing regulation of the domestic stock market so that citizens feel

comfortable investing in it. Fortunately, the world is much richer and less

militaristic than it was a century ago, so popular discontent is less likely to

turn outward and create military conflict. In poorer regions of the world,

economic progress undoubtedly has the potential to bring shared prosper-

ity and fund public sector budgets, as emerging economies accumulate

physical and human capital stocks to complement their abundant supply

of unskilled labor.

Popular Support for Free Trade

The factor proportions model is a rather accurate predictor of people’s

trade preferences. International survey evidence shows that in nations with

plenty of skilled workers possessing human capital, individuals with more

skill and human capital favor free trade. Yet in countries where human

capital is relatively scarce, these same workers oppose free trade. In line

with a given worker’s self-interest, comparative advantage affects views on

trade. Compared to those in nontradables sectors, workers in tradables

sectors that do not possess a comparative advantage internationally are less

likely to support free trade. Globalization is also worrisome for poorer

138 INTERNATIONAL ECONOMICS

workers; those who consider themselves of lower relative social standing

and wealth are less likely to support free trade. Thus, an individual’s place

within their country’s income distribution predicts their attitudes toward

globalization. This is consistent with the evidence that, contra the factor

proportions model, globalization can exacerbate inequalities even in

developing nations, possibly due to the effects of technology and capital

upgrading that favor skilled workers. Even in the free-trading United

States, most citizens, including professionals and those with higher

incomes, have become progressively more skeptical of globalization since

the 1990s. They recognize the benefits but are concerned about the pres-

sures it places on job security and compensation. And Europeans gener-

ally believe that globalization has benefitted corporations at the expense

of domestic workers.

Survey respondents who have confidence in their nation’s political

institutions are more likely to favor free trade. This isn’t surprising: a

poorly governed or corrupt country will have trouble enacting trade pol-

icies that yield broad benefits. The experience of Latin America, where

governments have not always managed economic integration well, illus-

trates this result. In many instances, elites have disproportionately benefit-

ted, and the underclass has learned that, without sufficient market

development in key industries, local economies may not be able to with-

stand competitive forces that come with trade and globalization. Subse-

quently, Latin American support for globalization has dropped. There has

been a resurgence of leftist populist politicians in the region, including

Chávez in Venezuela, Lula in Brazil, the Kirchners in Argentina, Morales

in Bolivia, García in Peru, and Correa in Ecuador. Many of these politi-

cians have vowed to redistribute natural resource wealth. The evidence

suggests that these leaders have not so much reversed globalization as

expanded the public sector and social welfare state to help labor cope with

the risks that accompany globalization. Given the region’s rich supply of

natural resources (which Chinese and Indian economies crave), Latin

American nations have plenty of incentive to maintain intercontinental

economic integration and improve their infrastructure. With a bit of luck,

perhaps Latin American entrepreneurial and creative talent will be better

utilized in the future, once citizens are given a stronger political foundation

for starting businesses and creating intellectual property.

POLITICS, GLOBALIZATION, AND THE STATE 139

History, Political Coalitions, and Trade

International trade can facilitate domestic economic growth yet it is not

welcomed by every interest group. Motivated by their own economic

concerns—as according to the factors of production that they own and

control—domestic political factions have commonly fought international

trade, calling instead for protectionist policies. The factor proportions

model and Stolper-Samuelson theorem specify the incentives which each

political coalition faces. Consider nations with a relative abundance of

land—again, relative to international averages—like 19th century frontier

societies in North America, South America, and Australia. Here land-

owners would support trade, allowing them to sell their inexpensive

labor-intensive agricultural products globally. Labor and capital, both

scarce (and pricey), are more likely to oppose opening trade. Landowners

may also back infrastructure investments like railroads, which lower the

cost of transporting agricultural exports, and approve of foreign capital

inflows, which lower their cost of capital in making improvements. Of

course, political coalitions are complex, and land is not as important as it

once was, yet the example still generalizes. The political economy of trade

integration and interest group alliances was fleshed out by an American

political scientist, Ronald Rogowski, in the 1980s. This section discusses

ideas presented in his seminal book Commerce and Coalitions, which shows

how the factor proportions model yields powerful insights into globaliza-

tion and the unfolding of history.

Best understood as a description of long-run tendencies, the factor

proportions model suggests that opening trade helps domestic owners of

the abundant factor—whether land, capital, or labor—as well as compa-

nies that intensively use the abundant factor. In effect, after allowing trade,

foreign sources increase demand for the locally abundant factor which is

relatively inexpensive and often used in exporting industries, thereby

bidding up its rental price. In the above example, free trade helps the 19th

century American landowners and the agricultural sector. The opposite is

true for holders of the scarce factor: they feel threatened by free trade

because it is cheaper to rent their factor abroad. Production in their sector

will shift overseas under free trade, and inexpensive imports could injure

their livelihoods. For owners of scarce factors, it makes sense to demand

140 INTERNATIONAL ECONOMICS

protectionism and fight trade. In the early-19th century United States,

capital was relatively scarce, so industrialists, trying to build up a budding

manufacturing sector to compete with Great Britain, demanded tariffs on

imports.

As illustrated in the table below, any economy can be classified accord-

ing to whether capital and land are abundant relative to labor. A backward

economy is primitive and developing, meaning there is little capital per

worker. An advanced economy is mature and industrialized, so that the

capital-to-labor ratio is high. And keep in mind that land interests are rural,

while capital holders are mainly situated in urban areas.

On the eve of the first great globalization boom, which began after the

Napoleonic Wars and lasted until World War I, the United States would

be represented in the lower left quadrant, signifying backward frontier

economies that are full of land. (This quadrant also covers the rest of the

Americas at that time.) In these societies, rural agricultural interests gen-

erally favor free trade but urban industrial and labor interests do not, lead-

ing to an urban-rural cleavage. This scenario is illustrated by the “Tariff of

1828,” which increased the price of imported goods and marked the high

point of American import tariffs prior to the Civil War. Southern agricul-

tural interests were vehemently opposed, calling it the “Tariff of Abomi-

nations.” However, favored by Western and Mid-Atlantic states, the tariff

contributed to the growth of the American manufacturing base. From

1833 to the Civil War, the Whig Party (which was superseded by the

Republican Party) supported modernization, protectionism, and the

growth of manufacturing; it was the party of Northern business interests

and the professional class. They were opposed by the Democratic Party,

which was dominated by large-scale Southern farmers, urban labor, and

immigrants. Interestingly, the Whigs backed railroads, canals, public

Economy High land-labor ratio Low land-labor ratio

Advanced Abundant: Capital & Land Abundant: Capital & Labor

Scarce: Labor Scarce: Land

Backward Abundant: Land Abundant: Labor

Scarce: Capital & Labor Scarce: Capital & Land

POLITICS, GLOBALIZATION, AND THE STATE 141

education, and national banking, believing that in the long run, these pol-

icies would promote American industrialization and economic growth.

They were right. Trade, growth, frontier expansion, and the rapid devel-

opment of the nonagricultural sector during the mid-19th century played a

decisive role in the ascendance of the North and West. With its relative

power declining, the agrarian South was defensive, and in opposition, the

North and West moved closer together politically. Southern states started

to secede in late 1860, shortly after Abraham Lincoln’s election. The

Northern Union possessed an overwhelming resource advantage, and

by the summer of 1865, just weeks after Lincoln’s assassination, the

Confederacy was defeated and the Civil War was over.

Now consider backward economies that are land poor, in the lower

right quadrant: they are abundant only in labor. Much of Eastern

Europe—such as Poland, Romania, and Bulgaria—provided a good exam-

ple until recently. Today, Bangladesh, India, and the Philippines are all

developing nations with a low land-labor ratio. In these economies, labor

supports free trade while capital and landowners are more likely to band

together in favor of protectionism. Instead of an urban-rural conflict, there

exists a class struggle between poor workers and commercial interests. This

dynamic is one reason why socialism has continued to survive in India.

Germany’s experience during the second half of the 19th century is a good

illustration of shifting alliances that accord with the factor proportions

model. In the middle of the 19th century, the German economy was back-

ward, with plenty of labor but a relative scarcity of capital. Workers sup-

ported free trade and industrialists sought protectionism. Landowners

(called the “Junker”) favored free trade, given Germany’s successful export-

ing of agricultural products. However, by the 1870s, American grain was

underselling German grain in every market; with a new railroad system

and cheap land throughout the United States, it was impossible for

Germany to compete. In response, German capital owners and landowners

formed a successful protectionist alliance (called a “marriage of iron and

rye”), made all the more urgent due to the onset of the Long Depression in

1873. Germany continued to industrialize, and by the 1890s, it was

advanced, with ample capital and higher wages. Now in the upper right

quadrant of the table above, German industrialists became more free trade-

oriented after the turn of the century, in tune with workers. Spain, by

142 INTERNATIONAL ECONOMICS

contrast, stayed backward throughout the 19th century and beyond, as

labor constantly fought against capital and landowning interests.

During the early-to-mid-19th century, nations rich in capital and

labor—represented in the upper right quadrant—were concentrated in the

developed regions of Western Europe. Great Britain was the global leader

in industrial maturity, trailed by Belgium and Switzerland. There were

urban-rural social divides in all three nations. As world trade took off in

the 1820s, Britain was at the forefront, with urban capital and labor united

to repeal protectionist policies supported by rural landowners, most nota-

bly the Corn Laws. Capital and labor ultimately won that battle, as the

Corn Laws were abolished in 1846, ushering in an era of free trade and

robust economic growth. In response to new foreign competition, the

British agricultural sector upgraded its technology and capital, and was

able to thrive for several decades until a torrent of cheap American food-

stuffs swamped global markets. Belgium’s mid-19th century history par-

alleled Great Britain, albeit with a lag. Supported by industrialists and

urban labor, the Liberal party succeeded in winning free trade by 1861.

They were opposed by the Catholic party, which was dominated by rural

landowners and Flemish labor. Both Belgium and Switzerland were free

trade- and export-oriented during the second half of the 19th century,

policies which supported economic growth and further industrialization.

The sway of labor grew as well, so that universal male suffrage was achieved

in both nations by the early-20th century. Lagging behind Belgium and

Switzerland, France’s 19th century capital accumulation and moderniza-

tion was uneven. French manufacturers and landowners in backward

regions opposed free trade, although by mid-century urban workers, finan-

ciers, and industrialists in wealthy districts around major cities such as Paris

and Marseilles supported it.

Prior to World War I, the United States and Canada appear to be the

only nations that were capital and land abundant yet scarce in labor (in the

upper left quadrant). The United States did not achieve advanced status

until about the turn of the 20th century, while Canada took a little longer.

After a bout of protectionism during the Long Depression, American busi-

ness interests called for free trade, and tariffs diminished after 1900. Since

the United States had become an industrial juggernaut, Canada was wor-

ried about American competition and consequently kept import tariffs

POLITICS, GLOBALIZATION, AND THE STATE 143

high on American goods (while easing tariffs on European imports). The

case of pre-Bolshevik Russia illustrates an additional category that is not

shown in the above table, namely, economies rich in land and labor but

short of capital. Russia quickly built railroads after 1850 so that foodstuffs

grown across its large landmass could be transported and sold in foreign

markets. Between 1860 and 1880, Russian grain exports tripled, and from

1850 to 1900, the Russian population doubled. However, the Russian

czarist government held firm to industrial interests and urban develop-

ment, enforcing policies that squeezed both land and labor and contrib-

uted to famines during the 1890s. Land and labor remained in opposition

to the government, and after 1900, peasant revolts and urban strikes

became more common, leading up to the Russian Revolution of 1917

that resulted in a new communist government entrusted to uphold labor

interests.

Factor Coalitions Across Globalization Eras

All the aforementioned examples are taken from the prewar period

when—spurred by reduced transportation and communications costs—

international trade and global economic integration was expanding. In

such epochs, momentum favors the abundant factor, since it typically

has more to gain from opening trade than the scarce factor has to lose.

(Furthermore, even if tariffs remain constant, diminishing transportation

costs will lead to increased trade volumes, benefitting owners of the abun-

dant factor.) To capture the latent surplus from trade, abundant factor

coalitions are expected to be aggressive in their support of free trade. In

opposition, political alignments between scarce factors emerge; they are

defensive and protectionist. As the case of post-serfdom Russia demon-

strates, although abundant factors can be resisted for many years, they may

well accumulate sufficient strength to prevail in the long run.

These forces are consistent with political developments during the

16th and 17th century globalization boom. Though lacking in land, lead-

ing economies like England and Holland possessed plenty of capital and

labor. Conversely, the Americas were abundant solely in land. After settlers

moved to the New World, they realized labor power was a critical engine

for growth, but given its scarcity, landowning colonists often resorted to

144 INTERNATIONAL ECONOMICS

forced labor such as slavery to maintain their economic and social domi-

nance. Back in Europe, both the flourishing Dutch Republic and Britain

under the Tudors were dominated by an alliance of capital and skilled

labor, which eroded the power of the traditional landowning aristocracy.

In the lightly populated regions of Eastern Europe and Russia, trade aided

landowners, keepers of the sole abundant factor, serving to support the

“Second Serfdom” that lasted into the 19th century.

Political dynamics were reversed during the 20th century interwar

period of declining globalization and autarky, when abundant factors were

on the defensive. International trade disintegrated, empowering scarce fac- tors, first economically and then politically. In the United States, where

only labor was scarce, restrictive immigration acts were passed in the

1920s, and emboldened workers sought favorable reforms such as the New

Deal. Across the wealthy economies of Western Europe, land was the sole

scarce factor, so that agricultural and landed interests gained power. In

Germany, Italy, and Austria, these rural elites supported a rightward turn

toward fascism. In fact, almost all interwar dictatorships were founded on

pre-industrial sources of social power, such as the monarchy, aristocracy,

church, and military. Fascist movements became extremely dangerous

when the wealthy old aristocracy was able to align itself with the working

class. With mass appeal to the working poor, the Nazis were first enabled

by German agricultural interest groups. Once in power, they raised import

tariffs on food products, created agricultural cartels, and preached rural

values. The climate in Belgium was similar, though the Belgian fascist

party (called the “Rexists”) did not ultimately prevail. Great Britain pro-

vides a stark contrast. Although its domestic factor proportions were

broadly parallel to Germany, British agriculture had negligible influence

by World War I, as British labor and capital came to dominate domestic

affairs during the 19th century globalization explosion. Consequently, a

reactionary turn in England favoring country landowners was simply not

feasible during the Great Depression.

Between the wars, across regions of Europe that remained backward—

namely the South and East—scarce capital and land formed alliances to

suppress abundant and defensive labor. A May 1926 coup in Portugal

would result in dictatorship; the Greek monarchy was reinstated in

1935; and in Spain, dictatorship followed a devastating civil war during

POLITICS, GLOBALIZATION, AND THE STATE 145

the 1930s. Political structures underwent upheavals in Latin America,

which was land-rich but capital- and labor-poor. The power of the landed

aristocracy declined, replaced by populist movements that supported urban

interests and industrialization. Most of Asia was densely populated during

the interwar era, with relatively little capital and land, sparking a dynamic

favorable to commercial interests but potentially damaging to workers.

Even in Japan, the wealthiest and most advanced nation in Asia, industri-

alization was not yet complete by World War I, and half of the work force

remained in agriculture. Beginning in the 1920s, Japanese labor faltered

while landed elites, business interests, and the military promoted imperi-

alistic fascism.

Backward China—which, like Russia, contained powerful landed

interests, a tiny middle class, and a docile bureaucracy—also endured tre-

mendous turmoil between the wars. Not long after the 1925 death of Sun

Yat-Sen, President of the post-imperial Republic of China, communist

forces led by Mao Tse-Tung, representing peasants and workers, began

waging war against the Kuomintang led by Chiang Kai-Shek, who favored

status quo capital and landowning interests. The two parties continued

fighting, though they were united in their opposition to the partial

Japanese occupation from 1931 to 1945. By 1949, Mao and the commu-

nists had beaten Chiang and the Kuomintang, who were thereafter rele-

gated to Taiwan. In neighboring Vietnam—also relatively full of labor but

lacking in capital and land—communists fought against old elites and

gained ground as postwar trade expanded, eventually becoming a socialist

state after the 1975 capture of Saigon by the communist North.

The end of World War II ushered in another era of expanding glob-

alization across much of the world. Among advanced economies after the

war, land was not nearly as important to economic development as it once

was. Agriculture’s employment share, already low, continued to decline.

Instead, led by the United States, the wealthiest economies were capital-

abundant and full of new technologies. Some rebuilding economies had

plenty of labor and industrial know-how, like much of Western Europe

and Japan, where rapidly increasing trade volumes melded together coali-

tions of labor and capital in support of open trade as well as democracy.

Aided by the election of socialist governments, trade unions became more

powerful in prosperous European nations. In backward areas of Europe

146 INTERNATIONAL ECONOMICS

and Asia abundant only in labor, worker movements surged. On the other

hand, in the relatively labor-scarce United States, where a ubiquitous fear

of communism helped restrict the development of left-wing politics, orga-

nized labor never achieved quite the same degree of influence.

Beginning in the 1980s, the era of hyperglobalization brought about a

renewed interest in market forces, integrated global capital markets, and

minimal trade barriers. These trends favored advanced economy profes-

sional classes, especially propagators of commercial technologies and finan-

cial sector interests, such as those within the strongholds of New York,

London, Tokyo, and Hong Kong. Human capital and physical capital are

often abundant in the same regions; within these wealthy economies, the

professional and managerial classes tend to align with capital in urban

areas, supporting open trade and the spread of new technologies. Unskilled

labor in wealthy economies—relatively scarce compared to international

averages—has been defensive and less welcoming of these developments.

In the United States, economic and political influence has shifted toward

financial and commercial elites, resulting in an overall political drift to the

right.

Globalization and Government Size

Without question, globalization has not diminished the size of govern-

ments. A century ago, government spending in industrialized nations

accounted for less than a tenth of national income. For example, in the

United States, federal spending was under 3% of income in 1900.

National income taxes—in the relatively few places they existed—were

much lower back then, and governments (especially in younger nations)

used to rely more on tariffs for revenue. The situation today is very dif-

ferent. Government spending now accounts for almost half of national

income in advanced economies. Even in the United States and Japan,

countries with relatively small public sectors, about a third of national

income is devoted to the state. The wealthier and better-developed a coun-

try is, the more of its national income is directed toward government

spending. In other words, richer countries not only have better function-

ing markets, they also have larger governments, suggesting that markets

and governments are complements, not substitutes. As emerging countries

POLITICS, GLOBALIZATION, AND THE STATE 147

grow in the coming years, they will distribute more resources to their pub-

lic sector to provide for infrastructure, education, health care, pensions,

and defense. In many wealthy nations, the political influence of elderly

pensioners will grow due to their relative abundance. In spite of the dete-

riorating finances of European sovereigns and the American federal gov-

ernment, it seems very unlikely that public sectors in these countries will

shrink to levels seen a century ago. Communism may be dead almost

everywhere in the 21st century, but the social welfare state is certainly not.

Empirical research by economists and political scientists has shown

that openness to international trade is a key factor in explaining why gov-

ernments have become larger in advanced nations. In fact, one important

reason why the United States and Japan have smaller governments relative

to other wealthy nations is that their economies are not as dependent on

trade. At the other extreme, Scandinavian welfare states like Sweden and

Finland have historically been very reliant on international trade. The

demand for social insurance among voters explains much of this relation-

ship. The more vulnerable workers are to the vagaries of external econo-

mies and the international business cycle, the more likely they are to

demand government benefits like unemployment insurance and social

security (at least in affluent economies that can afford such programs).

These safety net provisions help ordinary workers face the downside risks

inherent in economic globalization. They even act as substitutes for pro-

tectionist trade barriers. During the 1930s, when tariffs went up around

the world, social safety nets were in their infancy in the wealthiest countries

such as the United States. Today, instead of agitating for tariff barriers,

struggling workers now receive government benefits during powerful eco-

nomic downturns. In the absence of welfare state policies, it is likely that

more extensive trade barriers would have gone up as a result of the Great

Recession. Open economies also tend to be more industrialized and possess

private sector institutions that are able to transfer risk away from workers.

They have stronger labor federations, higher rates of unionization, and

more collective bargaining; Germany provides a good case in point. Mod-

ern financial markets, offering life insurance and annuities, provide some

risk mitigation that is commonly supported by the public sector.

Globalization affects the costs and benefits of a country’s size. People

usually think of nations as fixed objects, yet there are more nations now

148 INTERNATIONAL ECONOMICS

than ever before. After World War II, there were 74 independent countries

in the world, whereas today, there are about 200. The four wealthiest

nations on the planet on a per capita basis—Liechtenstein, Qatar, Luxem-

bourg, and Singapore—are also among the tiniest, while the United States

and Japan are the only wealthy nations among the ten most populous—

which are, in order, China, India, the United States, Indonesia, Brazil,

Pakistan, Nigeria, Bangladesh, Russia, and Japan. Is this only a coinci-

dence, or is economic growth easier to achieve in small countries? Recent

economic research has highlighted some of the size trade-offs that coun-

tries face, and how globalization affects them. Small nations benefit from

having homogeneous populations that are less prone to internal conflicts.

Political policies can be tailored to suit most of the population within a

small country, facilitating efficient governance which promotes peace and

growth. For tiny countries, international trade acts as a necessary lifeline.

By globalizing, they can get away with staying small, because in a world of

global supply chains, they only need to specialize in a few chain links to

prosper. According to this reasoning, globalization can lead to separatism,

which is consistent with the postwar evidence, as the number of nations

has increased alongside growing globalization. On the other hand, if econ-

omies of scale are important to economic growth, larger countries are

advantaged. They are able to provide public goods (like defense and infra-

structure) more efficiently, and they also derive economic benefits from

having a larger domestic consumer market. In the absence of international

trade and globalized capital financing, it may be better to be a large country

with a big diversified domestic market.

Brief History of Modern Warfare

The Prussian general and military theorist Carl von Clausewitz famously

declared in his posthumous 1832 magnum opus On War that war is “a continuation of politics carried on by other means.” Since Columbus set

foot on New World soil, international wars fought by the most powerful

nations have become less common and less lengthy. After the European

population had recovered from the Black Death, the 16th and 17th

centuries were replete with major wars between Spain, France, Portugal,

England, and Holland. Military force and economic dominance were

POLITICS, GLOBALIZATION, AND THE STATE 149

deeply linked in those mercantilist days. Among the European powers,

labor was common but land was scarce, so the Crown could make gains

by conquering new territories. Colossal battles between wealthy European

nations subsequently declined during the 18th and 19th centuries—with

the most glaring exception the devastating Napoleonic Wars from 1799 to

1815—as economies and populations expanded and overflowed to the

New World. Under the peaceful century of the Pax Britannica, from the

end of the Napoleonic Wars to the start of World War I, British naval

dominance lowered the risks of trade and transport. World trade exploded,

new technologies spread, and international wars were relatively brief.

Growing rivalries between the industrialized powers of Europe led to

World War I and then World War II, initiating a new era of modern

warfare by global powers. Battles became bloodier than ever with new

technologies like machine guns, poison gas, and tanks. Although precise

figures are difficult to pinpoint, there were over 10 million casualties in

World War I. World War II featured even deadlier technologies such as

long-range fighter planes, bombers, and nuclear weapons. It was the great-

est atrocity in world history, resulting in over 60 million casualties. In just

6 years of conflict, about 2.5% of the world’s population perished—half

on the battlefield, half outside it—with mortality rates much higher for

younger cohorts.

Since the end of World War II, no military conflicts have come close to

matching its scale and lethality, and the volume of deaths caused by war has

remained relatively low. The timeline above implies that—whether due to

technology, economic growth, or globalization—warfare among major

powers has drastically changed over the past two centuries. Rudimentary

economic reasoning implies that the costs and benefits of fighting another

powerful nation have shifted because of technology. Production technolo-

gies have advanced enough to make land and natural resource scarcity less

relevant, so the benefits of conquering a foreign power have declined. On

the cost side of the equation, more powerful weapons have made war much

more deadly, at least among great powers, implying that the potential costs

of waging large-scale war have skyrocketed. Thus, as new technologies have

made wars more lethal if they do break out, governments are less inclined to

fight them. With global armed conflicts between wealthy nations more

risky, fewer are fought. (Civil wars in small nations, discussed below, are

150 INTERNATIONAL ECONOMICS

a somewhat different story.) Of course, while there are limits to assuming

rationality on the part of governments, advanced nations that possess the

most formidable militaries seem to be the most rational.

Globalization and Warfare

Trade and globalization have influenced war, though perhaps not to the

same extent as technology. During the Enlightenment era, when influen-

tial thinkers in the West destroyed the notion that kings had a divine right

to rule, two 18th century philosophers, Kant and Montesquieu, argued

that trade between nations naturally brought about peace. Kant believed

that “Durable peace could be built upon the tripod of representative

democracy, international organizations, and economic dependence.”

Trade and globalization make states dependent on each other and there-

fore less likely to fight a mutually destructive war. Quantitative economic

research in this area is mounting and it is difficult to make definitive con-

clusions as yet. Nevertheless, empirical studies suggest that the number of

violent interstate conflicts—among all nations, not just global powers—

has stayed roughly constant over the past century. This includes the post-

war period when the degree of trade openness rapidly increased around the

world. Moreover, military conflicts have apparently become more localized

since World War II. So it isn’t clear at first glance whether Kant and Mon-

tesquieu were precisely right about the postwar globalization experience.

According to statistical evidence, when it comes to bilateral trade between two nations, increased trade does indeed reduce the likelihood

of military conflict. Consider that the volume of trade between two part-

ners is a measure of the opportunity cost of conflict: the higher their trade

flows, the more incentive they have to avoid violence. This is consistent

with Montesquieu’s observation that “Two nations who differ with each

other become reciprocally dependent; for if one has an interest in buying,

the other has an interest in selling; and thus their union is founded on their

mutual necessities.” Yet other research suggests that multilateral trade openness has the opposite effect, increasing the likelihood of conflict. The

theory is that countries which are more internationally integrated to global

trade flows may be less dependent on trade with any single partner. When

a potential conflict arises, they have less incentive to avert escalation by

POLITICS, GLOBALIZATION, AND THE STATE 151

making concessions, so that in the end, greater multilateral trade openness

can make countries more prone to war. One surprising implication is that

bilateral trade flows reduce the probability that the two nations fight each

other, but may increase the likelihood of conflict with third party nations.

Other research suggests that the postwar globalization boom actually

increased the overall likelihood of conflict among countries that are close

to each other (meaning, in other words, the multilateral trade effect has

dominated the bilateral trade effect). This result is important because most

interstate military conflicts today are local. They commonly stem from bor-

der or ethnic disputes, because populations that are more closely related

share a greater set of common issues that can lead to major disagreements.

This may also explain why the rate of violent interstate conflicts generally

hasn’t decreased since World War II. Moreover, since multilateral trade can

be used to supply arms, strengthening multilateral trade routes to a given

region may make war more likely. This is all the more relevant because the

globalarmstradedisproportionatelysendsweaponsfromdevelopednations

to the developing world. To offset the negative effects of globalization,

regional trade agreements can strengthen trade relations among nearby

nations facing the greatest potential for conflict. This conception was a driv-

ing force behind the “European Economic Community” (EEC), the fore-

runner of the present European Union. Enhanced trade links were

established to try to ensure that France and Germany would never go to

war again, as they had done three times in the preceding century.

Parallel research on civil wars sheds light on how globalization can lead

to internal conflicts. Frequently relapses from previous conflicts, civil wars

are much more likely to occur in countries with a large population of

young uneducated males, and where one ethnic group outnumbers the

rest. Within a given country, international trade raises the cost of a civil

war, making it less likely to happen since violent conflict would place the

gains from foreign trade at risk. But international trade can weaken eco-

nomic dependence between groups within a country; during a civil war,

each faction can turn to foreigners to trade for resources, including arms.

Indeed, civil wars are more likely to be fought in regions rich in natural

resources like oil and valuable minerals such as diamonds. The international

statistical evidence indicates that since World War II, civil wars have

become more frequent and much lengthier, lasting 4 years on average. And

152 INTERNATIONAL ECONOMICS

as mentioned above, there are more than twice as many sovereign nations

today as there were at the end of World War II. Part of this tendency must

be due to the fact that the great powers aren’t as imperialistic as they once

were. As Plato once said, “the number of citizens should be sufficient to

defend themselves against the injustice of their neighbors.” If dominant

neighbors become less threatening, small nations are more likely to survive

on their own—and thus, more likely to attempt to break free.

To generalize, consider again the benefits and costs of state size. Large

nations benefit from economies of scale—related to infrastructure, police,

and defense spending, for example—but they face costs when various

populations don’t agree on governance policies—due to, for instance,

regionalism or ethnicity. Given the postwar decline in imperialist warfare

by powerful states, small- or medium-sized nations may not achieve the

same military economies of scale that they once did. Since the benefits of

staying intact have faded, they’re less fearful of breaking up, making civil

war more likely. Trade could be one factor driving the trend, as it facilitates

low-intensity civil wars by giving warring parties easier access to foreign

resources. Globalization can also generate sudden slumps in national

income that lead to domestic friction. Evidence indicates that in countries

which export raw materials, civil war is more likely to break out when there

are large drops in the international price of their primary commodities.

This mechanism is particularly relevant to sub-Saharan African nations

that are dependent on revenues from a few commodity exports. Uganda,

a major coffee exporter, is an illustrative example; the world price of coffee

fell before Ugandan civil wars that began in 1981, 1991, and 2002.

Conclusion

Globalization offers a menu of new options to citizens and governments:

novel or cheaper goods to choose from; jobs for relatively inexpensive

domestic workers; foreign buyers of domestic goods and resources; an

expanding export sector; new sources of investment funds; access to for-

eign technologies; increasingly sophisticated industries, products,

and services; integration into global supply chains; and larger state tax

revenues. Yet globalization also comes with potential costs. It can lead

to: new international competitive pressures; sectoral dislocations or

POLITICS, GLOBALIZATION, AND THE STATE 153

“deindustrialization”; employment losses; capital outflows; domestic eco-

nomic conditions increasingly dictated by international business cycles;

massive swings in the value of domestic currencies; wealth windfalls for

connected elites; immigration inflows and foreign cultural influences; and

international restrictions and regulations.

Trade-offs are inevitable as modern governments attempt to integrate

their economies globally while balancing the interests of domestic coali-

tions. Some scholars even argue that nations cannot have democracy,

national determination, and economic globalization at the same time. For

example,bymaintainingaglobalizeddemocracy,acountry necessarilygives

up freedom to pursue certain goals of national determination and auton-

omy, such as full employment and capital restrictions; in recent decades, the

United States and Canada are both examples. An autonomous democracy

willcloselymanageitsinternationaleconomicintegration,lestforeignecon-

omies dictate domestic outcomes; India is an example here. And a self-ruled

globalized state governed by technocrats willhave little room for democratic

policies mandated by the public; China is one such example.

International economic integration strengthened from the end of

World War II through the 1970s under the Bretton Woods system, which

allowed for national determination and growing prosperity among rich

nations. This framework helped shape a collective political will that was

ever more accepting of globalization. After the economic turmoil of the

1970s, many states shifted to favor economic globalization at the expense

of national determination and—to a lesser extent—democracy. Compre-

hensive state industrial policies and capital controls went out of favor, even

though under globalized capital markets, financial difficulties in one coun-

try are more likely to spread to other countries, faster than ever before.

With the late 1990s East Asian financial crisis, governments were reawa-

kened to the dangers of liberalized capital flows. Developing Asian econ-

omies (most notably China) subsequently maintained high savings rates

and accumulated massive sums of international reserves (mainly dollars),

which facilitated investment and lessened the need for foreign debt financ-

ing, in a kind of self-insurance. But the massive surpluses also contributed

to low interest rates in the United States and Europe, helping to generate a

global credit boom that led to the most recent global financial crisis. In the

coming years, a new balance will likely be struck in an emerging multipolar

154 INTERNATIONAL ECONOMICS

world, as nations reevaluate their place in the global economy and craft

policies that respect the competing goals and interests unique to each econ-

omy, thereby regaining the support of citizens.

Further Reading

Acemoglu, D., & Robinson, J. (2006). Economic origins of dictatorship and democracy. New York, NY: Cambridge University Press.

Acemoglu, D., & Robinson, J. (2012). Why nations fail: The origins of power, prosperity, and poverty. New York, NY: Crown Publishers.

Alesina, A., & Spolaore, E. (2003). The size of nations. Cambridge, MA: MIT Press.

Baker, D. (2016). Rigged: How globalization and the rules of the modern economy were structured to make the rich richer. Washington, DC: Center for Economic and Policy Research.

Bernstein, W. (2013). Masters of the word: How media shaped history. New York, NY: Grove Press.

Chandler, A. (1994). Scale and scope: The dynamics of industrial capitalism. Cambridge, MA: Harvard University Press.

Downs, A. (1957). An economic theory of democracy. New York, NY: Harper and Row.

Frieden, J., Tomz, M., & Pastor, M. (2000). Modern political economy and Latin America: Theory and policy. Boulder, CO: Westview Press.

Huntington, S. (1968). Political order in changing societies. New Haven, CT: Yale University Press.

Huntington, S. (1991) The third wave: Democratization in the late 20th century. Norman, OK: University of Oklahoma Press.

Lipset, S. M. (1960). Political man: The social bases of politics. New York, NY: Doubleday and Company.

McCarty, N., Poole, K., & Rosenthal, H. (2006). Polarized America: The dance of ideology and unequal riches. Cambridge, MA: MIT Press.

Moore, B. (1966). Social origins of dictatorship and democracy: Lord and peasant in the making of the modern world. Boston, MA: Beacon Press.

Olson, M. (1982). The rise and decline of nations: Economic growth, stagflation, and social rigidities. New Haven, CT: Yale University Press.

Ostrom, E. (1990). Governing the commons: The evolution of institutions for collective action. Cambridge, England: Cambridge University Press.

Polanyi, K. (1944). The great transformation. Boston, MA: Beacon Press. Rogowski, R. (1989). Commerce and coalitions: How trade affects domestic political

alignments. Princeton, NJ: Princeton University Press.

POLITICS, GLOBALIZATION, AND THE STATE 155

Harvard Business School Case Studies

Andrews, M. Effective revenue collection in Nomburo (or not), HKS441-PDF- ENG.

Badaracco, J. L., Jr., & Useem, J. Exporting American culture, 396055-PDF-ENG. Cadieux, D., & Conklin, D. W. The Great Recession, 2007–2010: Causes and

consequences, 910M08-PDF-ENG. Chu, M. Microfinance in Bolivia: A meeting with the President of the Republic,

307107-PDF-ENG. Colpan, A. M., & Jones, G. G. Vehbi Koc and the making of Turkey’s largest business

group, 811081-PDF-ENG. Conklin, D. W., & Cadieux, D. Hugo Chavez’s public policy vision for Venezuela:

Rooted in the past, doomed in the future?, 906M59-PDF-ENG. Conklin, D. W., & Cadieux, D. Mekong Corporation and the Vietnam motor vehicle

industry, 907M74-PDF-ENG. Conklin, D. W., & Cadieux, D. The 2007–2008 financial crisis: Causes, impacts

and the need for new regulations, 908N14-PDF-ENG. Daemmrich, A. A., & Kramarz, B. Denmark: Globalization and the welfare state,

709015-PDF-ENG. Jones, G. G., & Ghanem, L. Elia Nuqul and the making of a Middle Eastern business

group, 813052-PDF-ENG. Jones, G. G., & Lluch, A. Ernesto Tornquist: Making a fortune on the Pampas,

807155-PDF-ENG. Koehn, N. F. Abraham Lincoln and the Civil War, 805115-PDF-ENG. Mathis, F. J., Albqami, R. A., & Rogmans, T. Foreign direct investment in the

Middle East: Riyadh and Dubai, TB0269-PDF-ENG. Mayo, A. J., Nohria, N., Mendhro, U., & Cromwell, J. Sheikh Mohammed and the

making of ‘Dubai, Inc.,’ 410063-PDF-ENG. McCraw, T. K. Labor movement between the wars, 391257-PDF-ENG. McKern, B., Meza, P., Osayande, E., & Denend, L. The business environment

of Nigeria, IB90-PDF-ENG. Musacchio, A., Werker, E., & Schlefer, J. Angola and the resource curse, 711016-

PDF-ENG. Rangan, V. K. Corporate responsibility & community engagement at the Tintaya

copper mine, 506023-PDF-ENG. Trumbull, G. Creation of the European Union, 703032-PDF-ENG. Vietor, R. H. K., & Comin, D. South Africa: Stuck in the middle?, 711084-PDF-

ENG. Werker, E., & Beganovic, J. Liberia, 712011-PDF-ENG. Zuckerman, E., & Feldstein, J. Venture capital in Israel: Emergence and globaliza-

tion, SM88-PDF-ENG.

156 INTERNATIONAL ECONOMICS

CHAPTER 6

Poverty, Progress, and Critics of Globalization

Introduction

At the very end of the 20th century, massive protests surrounded a WTO

conference during the infamous “Battle of Seattle.” These loud voices con-

demned the treatment of poor nations ostensibly beholden to Western

corporations and international financial organizations (such as the IMF).

Protesters saw the spread of globalization as tantamount to exploitation of

the developing world. They believed it benefitted a small class of insiders at

the expense of powerless citizens. Fans of globalization—many of them

economists—responded by elucidating the virtues of international eco-

nomic integration, which include enhanced economic opportunities and

poverty alleviation in the least developed nations.

Today, over a decade later, the debate has shifted. Following the global

financial crisis, critics—who were ultimately unsuccessful in arresting

globalization—protest the power of global capital even more vociferously.

Yet they are forced to acknowledge that economic growth in emerging

markets has been brisk over the past decade, drawing tens of millions out

of extreme poverty. China has achieved rapid growth based on an idiosyn-

cratic program of carefully managed liberalization reforms allowing it to

globalize piecemeal. Meanwhile, proponents concede that globalization

entails important costs such as lower job security. There also exist severe

macroeconomic risks, even for rich nations, when massive tidal waves of

liquidity are allowed to travel across the world in the blink of an eye.

Given recent developments, globalization is now being questioned

by many, and it isn’t clear if the hyperglobalization era will continue

indefinitely. Although world trade flows have recovered from the last

global financial crisis, there has been a reversal of financial globalization;

cross-border capital flows today are approximately half their peak volume

reached just prior to the crisis. The lingering weakness of the “eurozone”

banking sector and European economy has contributed to this turnabout.

The decisions of government policymakers remain difficult to predict, but

the debate over globalization’s merits will surely persist in the coming

years. This chapter is a modest discussion of some of the most pressing

criticisms of globalization, informed by contemporary economic research

and international statistical evidence.

Foreign Direct Investment, Multinationals, and Growth

Research has shown that within emerging economies, foreign direct invest-

ment (FDI) inflows generate economic growth in manufacturing sectors,

at least among countries that possess well-developed financial institutions.

In addition, FDI that brings new technology leads to higher local growth,

as long as domestic human capital levels are sufficiently high. Therefore, as

long as developing countries have sufficient absorptive capacities to make

use of it, FDI can lead to local economic growth and help economies move

up the value-added chain.

Multinational enterprises (MNE) are the conduit for most global FDI

today. By definition, MNE are firms that control and manage commercial

operations in more than one country. These MNE provide FDI by creat-

ing new foreign firms, buying foreign companies, or forming cooperative

ventures with firms already operating in foreign markets. A major compar-

ative advantage of MNE is that they are able to transfer intangible

assets—such as intellectual property or managerial capital—across borders

and along vertically integrated production operations, often via FDI. MNE

based in wealthy countries (such as Intel) commonly engage in FDI by

movingcertainstagesofproductionabroadtocheaperlocations,inaprocess

called “vertical” FDI. However, few realize that most FDI actually occurs

through “horizontal” FDI, when MNE move roughly the same production

activities from their home to a destination market in order to save on trade

and transportation costs. For example, when Toyota builds an automobile

manufacturing plant in the United States, it is engaging in horizontal FDI.

Governments in emerging markets have become much more open in

allowing MNE to enter over the past several decades, and ever since, the

158 INTERNATIONAL ECONOMICS

presence of MNE in emerging economies has exploded. Accounting for

over two-thirds of global business research and development spending,

MNE are important agents of economic innovation and productivity

growth. To a great extent, they are the principal force behind the deep-

ening integration of the global economy. They can attract foreign invest-

ment capital, new technology, expanded business networks, new prospects

for domestic entrepreneurs, managerial capital and know-how, and train-

ing opportunities for local workers. On the other hand, MNE can also

crowd out domestic firms, causing some to close, and conceivably reduce

domestic employment through dislocations. In spite of the potential

growth enhancing opportunities that MNE can offer, economists still

debate whether MNE play an essential role in generating economic growth

among developing economies. For instance, neither MNE nor FDI per se

were indispensable to Japan’s rapid growth in the 20th century, though

Japan certainly made use of foreign know-how via licensing and subcon-

tracting agreements, among other means.

Foreign Capital and Emerging Economy Labor Markets

Many antiglobalization activists argue that in developing economies, for-

eign MNE prey on the local population of unskilled workers by offering

unacceptably low wages, horrendous working conditions, and unbearably

long hours. More generally, some critics of globalization maintain that MNE

operations and foreign capital flows into developing nations lead to declining

labor market conditions for domestic workers. The political economy of this

mechanism is that foreign organizations and domestic elites conspire to sup-

press the wages of unskilled local workers, weaken trade unions, and allow

workplace exploitation and human rights abuses, especially in countries

where the legal system offers workers little protection. The presence of MNE

and foreign investment may generate negative health consequences, due to

increased local pollution combined with a lack of effective health care. In

short, these critics argue that foreign capital flows and FDI harm domestic

workers in developing nations. The pecuniary benefits instead accrue to

foreign capital holders, local business owners, and foreign consumers.

The other side of the debate—commonly advanced by economists—

holds that in poor nations, MNE and foreign investment stimulate

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 159

economic growth, increase domestic labor demand, and drive wage

growth. They also bring new technologies and managerial know-how,

which are both likely to spillover onto the local area over time. Foreign

investment and production can increase local tax bases, providing revenue

for public education, health care, and industrial investment. Wages are

often low in exporting sectors, though they are typically higher than in

the informal sector or other local industries. Factory work conditions in

poor countries may be unpleasant, yet they are no worse—and often

better—than the alternative local work options. Finally, although it is dif-

ficult for MNE to monitor the behavior of all their contractors, pressures

coming from consumers in wealthy nations have sometimes led to reforms

that benefit workers in developing nations. Research shows that these con-

sumers are often willing to pay a premium for products made under good

work conditions.

Both sides of the debate can agree that “sweatshop” conditions exist

inside many business operations in developing nations, and there may be

abjectly poor work environments within MNE or their subcontractors,

especially among textile and apparel manufacturers. In one famous exam-

ple from the 1990s, Nike began monitoring their shoe production con-

tractors in Indonesia after Indonesian newspapers ran stories describing

clear violations of local labor laws, such as workers being paid less than

the minimum wage. The episode dragged on for over a decade and was a

public relations nightmare for Nike, an American company which had

always relied on outsourcing shoe production so that the cost savings could

be spent on marketing and advertising. The United States government

even pressured Indonesia to address local labor abuses, and they responded

by increasing the minimum wage. Although regulating international labor

standards has proven difficult to achieve, American and European govern-

ments have long pressed developing nations to strengthen human rights

and environmental protections when they appear to be lacking, sometimes

by threatening to revoke favorable trade policies.

But is Nike (circa 1990) representative of other MNE that operate or

subcontract in poor nations? This is a critical issue because FDI is the

largest source of external finance for many developing economies—twice

as large, on average, as foreign aid gifts and 50% larger than remittances—

and the stock of global FDI now totals more than $20 trillion. Economists

160 INTERNATIONAL ECONOMICS

have attempted to measure how MNE and FDI affect local labor markets

in developing nations. Empirical research shows that in developing coun-

tries, workers employed by MNE or their subcontractors are paid signif-

icantly more on average than other domestic workers in comparable

employment. This may be partly due to a tendency (all else equal) for

higher quality laborers to work at MNE or their affiliates; such individuals

are more productive and earn more, too. Higher wages could also be paid

by MNE to induce greater effort and productivity among local workers.

It is important to note that alternative employment in developing nations

is often in agriculture, which offers meager wages and unpleasant work

conditions.

FDI in developing countries has traditionally taken the form of newly

constructed establishments exhibiting technologies that are not widely

available in the recipient country. Research suggests that in facilities sup-

ported by FDI, workers generally earn higher wages. The premium is even

greater for skilled workers. In part, this is because FDI flows to higher

paying domestic industries and larger firms in developing countries.

Operations within these production sites are more sophisticated and

demanding than at other local employers, so they pay rather well. Other

evidence suggests that FDI leads to relatively greater demand for skilled

and educated workers within the local area, driving up their wages. This

makes sense if these workers are needed to manage or supervise multiple

unskilled laborers, possibly with the help of additional training. Such

a mechanism can also raise the level of local labor market inequality

in emerging economies. In recent decades, relatively more FDI has orig-

inated in cross-border mergers and acquisitions. Some evidence shows that

when foreign groups take over domestic operations in developing coun-

tries, wages increase slightly, though work conditions do not necessarily

improve, on average.

Foreign Investors and Respect for Local Worker Rights

One common contention is that MNE and foreign investors seek out poor

countries that do not respect human rights or labor standards, including

the right of workers to establish unions. In such regions, the reasoning

goes, MNE are able to pay as little as possible for sweatshop labor output,

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 161

beefing up their bottom line. Yet according to surveys of MNE managers,

in determining where to locate production, labor costs are less important

than many other factors—namely infrastructure, political stability, labor

quality, and the legal system. Research indicates that foreign investors

prefer high-quality regulation and are not attracted to developing coun-

tries that do not respect worker rights. Nations that are politically stable

and respect worker rights are presumably more attractive to foreign

investors, because they are more likely to enforce foreign ownership

rights and contracts, given their stronger legal structures. For example,

American investment flows to developing nations favor democracies and

are deterred by child labor utilization, in spite of higher labor costs.

Likewise, nations that respect human rights are more likely to attract

FDI. Since foreign investors have many options to choose from, it may

not be surprising that (all else equal) they generally prefer stable, non-

autocratic political regimes respecting worker rights, human rights, and

the rule of law.

Evolution of Foreign Investment

Some analysts have pointed out that the behavior of MNE and foreign

investors has undergone a historical shift over the past century. Through

World War I and II, world powers backed by military force conquered

backward regions rich in raw materials, or alternatively, set up local insti-

tutions designed to extract them. By the mid-20th century, following

World War II and numerous independence movements, foreign corpora-

tions had become intent on establishing ties with local governments to

protect and control valuable natural resources. Decades later, it became

increasingly feasible for MNE to move production offshore to emerging

economies. The advantage was not only cheaper labor, but also access to

foreign consumer markets. Emerging nations wishing to attract more for-

eign investment have been able to signal their commitment to liberaliza-

tion policies by joining international trade agreements such as the GATT

or trade organizations such as the WTO. By the 1990s, students and acti-

vists in rich nations were determined to publicize the behavior of MNE

that violate labor standards, take advantage of child labor, or utilize uneth-

ical subcontractors abroad. Today, many American companies advertise

162 INTERNATIONAL ECONOMICS

that they only buy products from foreign suppliers which respect environ-

mental regulations and worker rights.

One ever-present concern is whether governments in resource-rich

emerging regions are willing and able to negotiate favorable terms with

extractive MNE and then use the funds for effective developmental pro-

grams to help their middle and lower classes. For example, China is

currently trading infrastructure investment funds for African natural

resources, though it isn’t clear that African governments are getting as

much in return as they could be, and more importantly, whether the funds

are being efficiently utilized for projects that benefit the public at large.

Resource extraction usually doesn’t stimulate as much local job creation as

other types of exporting industries (like textiles) and tends to last only as

long as the resource itself, so the employment effects of foreign investment

in mining, for instance, have frequently been disappointing.

When expensive raw materials are exported in large quantities, demand

for the domestic currency by foreign purchasers can lead to currency

appreciation, which harms other exporting industries such as manufactur-

ing. Called the “Dutch disease,” this process is named after an episode

from the 1960s and 1970s when the Netherlands found natural gas depos-

its in the North Sea. Gas exports caused the Dutch currency to appreciate,

making goods from their manufacturing sector more expensive and there-

fore less competitive as exports. Fortunately, countries that have experi-

enced oil and mineral booms are more likely to benefit from the wealth

than become cursed by the political and social instability it sometimes

brings, according to new research. In Africa today, foreign money and

influence will hopefully be used to build stronger institutions and enhance

economic development, so that comparative advantages can shift from the

export of raw materials to human capital-intensive procedures.

Foreign Capital, Globalization, and Poverty

FDI has come to trump all other types of financial flows to developing

countries, even debt. It has been instrumental to economic growth in

many countries, including Ireland, Singapore, Malaysia, Thailand, and

China. More countries clamor to attract it than ever before. It seems rea-

sonable that greater FDI, which often leads to growth, has the potential to

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 163

reduce poverty, since economic growth should raise the incomes of the

poorest, even if not proportionately. Growth and poverty reducing effects

may come from several mechanisms. FDI spreads foreign technology and

other best practices from abroad, which increases productivity and allows

emerging economies to catch up faster. Foreign firms that bring invest-

ment tend to focus on labor-intensive goods; they are often larger, more

productive, and more likely to produce higher quality goods than are

domestic firms. These changes tend to drive up the wages of unskilled

workers. Foreign investment also generates a larger tax base that can be

used for social programs benefitting the poor and destitute (although this

mechanism depends on good governance, which is commonly lacking in

developing countries). Conversely, FDI can lead to difficult labor market

adjustments and dislocations, which disproportionately harm unskilled

workers in emerging economies.

In practice, FDI inflows tend to come with other policy changes (such

as opening trade and financial market liberalization), so it is difficult to

isolate its effect on growth and poverty reduction. Nevertheless, cross-

country evidence suggests that FDI is correlated with diminished poverty

and increases in local wages. Studies indicate that in a number of devel-

oping countries, FDI has spurred local employment and poverty reduc-

tion, especially when it is used to develop labor-intensive industries. For

example, it has driven export growth and diminished poverty in Indonesia

and Mexico. FDI has been less successful in improving the situation of

local workers: when it is concentrated in extractive industries (such as oil)

that typically employ a small set of skilled workers; where there is little

capacity for the investment to create local spillovers, due to a lack of

human capital, infrastructure, or economic development; or where local

governments have not bargained effectively with foreign investors to

extract maximal benefits for domestic workers and organizations. Research

indicates that in Latin America, FDI has crowded out domestic investment

in the past. In some instances, FDI has probably harmed developing host

economies on net, and in others, such as oil- and diamond-abundant

Angola, the economic benefits have been unevenly distributed at best.

Overall, FDI has the potential to bring benefits to emerging economies

in many situations, though based on its historical record: it has brought

negative dislocation spillovers at times; it has proven less effective when

164 INTERNATIONAL ECONOMICS

entering sectors reliant upon import-substitution programs; some regions

simply do not have sufficient absorptive capacities to benefit from FDI;

and it has not always been managed fairly or efficiently by local govern-

ments and foreign companies. The effects of FDI in developing countries

differ from opening trade, which can benefit workers in exporting sectors

yet hurt workers in import-competing industries (as in the cases of

Colombia and India in the 1990s). By contrast, FDI is likely to increase

employment and wages (both directly and indirectly) in exporting and

import-competing sectors, thereby reducing domestic poverty. For

example, without foreign investment and know-how, unsophisticated

local industries may have trouble exporting to markets in the developed

world, which are sometimes protected or subsidized, particularly in food

products and basic manufactures. And while foreign capital flows to

emerging markets can lead to financial market volatility, FDI is much

less likely to contribute to financial crises—and better able to ride out

market volatility—as compared to other types of capital such as portfolio

investment in stocks and bonds. This is because FDI involves real invest-

ment in firms, and its mobility is severely limited by its dependence on

local physical assets, infrastructure, human capital, supplier networks,

and institutions.

Trends in Global Poverty

The incidence of poverty across the world has steadily fallen in recent

decades. About half of the developing world population was under the

World Bank poverty line in the early 1980s, compared to less than a quar-

ter today. East Asia—dominated by China’s huge population and low per

capita income—used to have the highest poverty rate at over three quar-

ters, but now fewer than one in six are below the poverty line. During the

1980s and 1990s, sub-Saharan Africa showed an increasing level of pov-

erty, but since then it has progressively declined, so that less than half of

the population now falls under the poverty line. According to the most

recent data available, in spite of the recent global financial crisis, poverty

incidence has continued to fall in the developing world. Relatively strong

growth in China, India, and Brazil—combined with high commodity

prices—has buoyed economies in the least developed regions, which

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 165

continue to make their transition from low-wage agriculture to better-paying

industrial and service activities.

Economic globalization has expanded as poverty has fallen, but has

globalization played any role in poverty alleviation? Most economists

believe that globalization has, on net, been a major contributor to declin-

ing poverty. For one, poverty has declined more in developing nations that

have globalized than in those that have not. A growing consensus suggests

that benefits to poor countries can be substantial, provided that interna-

tional economic integration is managed carefully and strategically (with

China as a case study in success). Policies of opening trade, allowing for-

eign investment, and liberalizing finance have given emerging economies

room for new choices that can bring economic growth despite attendant

costs (such as financial crises) which are sometimes colossal. Still, as the

least developed nations shift to industrial and service production (follow-

ing the past achievements of the Asian Tigers), expanding urban areas and

a robust exporting sector can generate better job opportunities for millions.

Globalization, Pollution, and Public Health

In the language of economics, pollution is a classic “negative externality,”

meaning that its negative effects are commonly not “internalized” (or taken

into account) by the party emitting it. Air pollution, groundwater contam-

ination, and chemical waste are common negative externalities that are

byproducts of industrial activity. International evidence on environmental

quality and development suggests that there is a greater level of environ-

mental degradation and pollution as the initial stages of economic devel-

opment progress in a transition from agriculture to industry. In poor

countries, generating income growth through industrialization is typically

considered more important than controlling pollution.

At early stages of economic development, it is difficult to regulate envi-

ronmental degradation due to a lack of well-defined property rights, insuf-

ficient legal remedies and technology, and public and private sector

corruption. Yet environmental quality has a substantial impact on quality

of life, so developing economies begin to trade off income for costly pol-

lution reduction as they become wealthier. Once a certain level of devel-

opment is reached, and a substantial middle class has emerged, political

166 INTERNATIONAL ECONOMICS

pressure for comprehensive policy interventions aimed at improving envi-

ronmental quality is likely to expand in line with further economic growth.

Emerging economies in the midst of their catch-up development (such as

China today) often exhibit the worst environmental quality, and research

indicates that as national income grows, the degree of environmental

regulation increases. One possible exception to this pattern is the volume

of carbon dioxide emissions (which make up the majority of global

greenhouse gas emissions). Nonelectric automobile travel, coal-generated

electricity, and other fossil fuel burning activities emit carbon dioxide.

Carbon dioxide production generally increases with income up to a rather

high level of national income. However, as economies become wealthier,

they normally shift from industrial to service activity (which pollutes less),

and they frequently implement technologies to reduce their environment

impact.

Because greenhouse gas emissions contribute to global warming and

climate change regardless of the source location, they are negative exter-

nalities at the global level. Unfortunately, instituting cross-border property

rights is not feasible for this market. As a consequence, to reduce global

carbon dioxide emissions, the best mechanism is to forge international

agreements where nations multilaterally commit to costly emission reduc-

tions. One such attempt to extend economic globalization to environmen-

tal policy was initiated in the 1990s with the Kyoto Protocol, which set

variable targets for most developed countries to either reduce or limit

increases in their greenhouse gas emissions. Ratifying countries have had

mixed success, with some managing to meet or exceed their targets (includ-

ing many European nations and Russia) while others have not. The United

States—formerly the largest net emitter of greenhouse gases before being

overtaken by China, and still one of the highest emitters in the world on a

per capita basis—signed it, never fully ratified it, and then withdrew from

it in 2001. (Canada later withdrew in 2011.) Global carbon dioxide emis-

sions have continued to grow over the past decade. Still, the Kyoto agree-

ment helped to initiate international emissions trading, which has the

potential to reduce global pollution efficiently through a pricing mecha-

nism. This approach forces nations to internalize their pollution external-

ities, and it may facilitate other multilateral agreements in the future.

Currently there is a major international push to substitute toward clean

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 167

energy sources (such as solar and wind power) and alternative transporta-

tion (such as electric cars).

On the whole, globalization and trade have contributed to pollution

and environmental degradation around the world. In China, economic

development and the accompanying pollution wouldn’t have been as rapid

and severe in the absence of international trade. However, in China as

elsewhere, pollution is a byproduct of industrialization and growth, and

would have occurred even under autarky. The wealth derived from eco-

nomic development can also be used to reduce environmental degradation

and clean damaged land and waterways. Restricting pollution in develop-

ing countries has been a very contentious issue for decades (including dur-

ing the Kyoto Protocol discussions). Growth in greenhouse gas emissions

and other harmful pollutants is expected to come disproportionately from

emerging economies in the future. Poor nations invoke their sovereign

rights, arguing that they are simply following the same growth trajectories

that other economies achieved decades before. Indeed, large-scale federal

regulations in advanced nations were not implemented in force until the

1970s. Today, many developing countries export goods that are pollution-

intensive to produce, so by restricting their allowable level of pollution,

they may not be able to capitalize on their comparative advantages, and

thereby suffer lower growth.

The idea that sectors producing pollution-intensive goods tend to

migrate to developing economies with laxer environmental standards is

called the “pollution haven” hypothesis. It implies that the lack of envi-

ronmental regulations in poor countries attracts dirty industries, and that

by strengthening regulatory oversight, these economies would necessarily

sacrifice output growth. Despite its intuitive appeal, empirical support

for the pollution haven hypothesis has been mixed. There is some

evidence indicating that countries with weaker environmental regulations

tend to export more in pollution-intensive industries. However, pollution-

intensive industries are often in heavy intermediate goods (such as metals

and industrial chemicals) that are unattractive to export, and environmen-

tal compliance costs are typically only a small fraction of total costs, even in

countries with stringent environmental protection. Other studies have

found that FDI flows to China have benefitted the local environment by

bringing cleaner, more efficient production technologies, and crowding

168 INTERNATIONAL ECONOMICS

out inefficient domestic firms. Scholars are concerned that in the future,

least developed nations may boldly attempt to spark growth by acting as a

pollution haven for China, India, and other middle-income nations trying

to lower their own domestic pollution. Still, countries open to interna-

tional trade have been found more likely to agree to multilateral environ-

mental protocols, and by attracting foreign investment, they are better able

to implement new technologies to reduce environmental degradation.

Globalization and Disease Transmission

Diseases have been spread along trade routes since ancient times. One

prominent example from the past century is the Spanish influenza epi-

demic that began in 1917 and lasted until 1920, infecting over a quarter

of the world’s population. It is estimated to have killed up to 50 million,

making it deadlier than World War I. More recently, Acquired Immune

Deficiency Syndrome (AIDS), caused by Human Immunodeficiency

Virus (HIV), is believed to have originated in African primates before its

transmission worldwide. It was first recognized as a new disease in the early

1980s. Since then, it has caused over 25 million deaths.

Other pandemic viruses have caused widespread fear but resulted in far

fewer fatalities. Severe Acute Respiratory Syndrome (SARS) is a viral respi-

ratory disease that killed almost 800 people in 2002 and 2003 after an

outbreak originated from Hong Kong. The Avian Influenza (or Bird Flu)

continues to kill humans sporadically, though only several hundred deaths

(disproportionately in Asia) have been reported as yet. The West Nile

Virus has killed a hundred Americans on average each year since 2000.

However, less than 1% of the infected show any severe illness, and most

show no symptoms at all. In 2009, humans picked up an influenza strain

through contact with pigs in Mexico, called Swine Flu, which was quickly

spread and resulted in at least 15,921 deaths within a year.

On a brighter note, economic growth has brought better nutrition and

sanitation, while vaccines, antibiotics, and other pharmaceutical break-

throughs have reduced the incidence of illness and death. The spread of

modern health technologies has led to greater life expectancy in almost all

countries. Over the past two centuries, the average global life expectancy at

birth more than doubled, from about 29 years to 68 years. Throughout the

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 169

developing world, life expectancy has slowly continued to converge to

wealthier countries. In Africa, life expectancy today is more than 50 years,

higher than it was in wealthy countries a century ago.

Population Growth, Natural Resources, and Commodity Prices

World population broke seven billion in 2011, and the majority of the

world (about 60%) now lives in Asia. Almost all population growth today

comes from developing countries, and the rate of growth is the highest in

Africa. Many developing countries are undergoing the demographic tran-

sition, where public health improvements lead to lower mortality rates

(which increases population) followed by reductions in fertility rates

(which decreases population). In the long run, once countries are devel-

oped, the result is often a fertility rate below the level of replacement—at

slightly over two children per woman—which, if not offset by increased

migration, can lead to a drop in population. This is precisely what has

happened in Japan and Germany, which are both experiencing slight pop-

ulation declines.

Demographic research shows that fertility rates in Africa and Asia have

been falling for decades, and that the global population growth rate has

already begun to slow. The most recent official projection by the United

Nations proposes that the world population will reach 9.3 billion by 2050

and then add fewer than a billion more over the following 50 years. Of

course, predicting population levels decades into the future is an imperfect

science, not least because so much depends on national political policies

and social attitudes. For instance, China’s population growth has slowed

relative to India, primarily due to the enactment of differential policies

such as one-child rule fertility restrictions. Changing views toward mar-

riage and the family have also led to significant drops in birth rates in

Spain, Portugal, and Italy.

Many environmental scholars worry that population growth will

put excessive strain on global resource supplies and exacerbate climate

change. Globalization plays some role here. In its absence—that is, under

autarky—economic development and population growth would likely be

slower, and the world’s natural resources would not be extracted and

170 INTERNATIONAL ECONOMICS

utilized at the same rapid rate as they are now. On the other hand, public

health technologies such as contraceptives have been spread around the

world, leading to lower fertility rates, and hence, slower resource depletion.

As poor nations become wealthier, their consumption of agricultural pro-

ducts, energy, metals, and concrete will become higher. The most prom-

inent example is China, which has been growing faster than advanced

economies by a wide margin.

Global commodity prices began rising steeply in the early 2000s after

slumping in the 1980s and 1990s. The change was largely driven by eco-

nomic growth in emerging economies, particularly China. As a response to

the commodity boom, investment in agriculture, energy, metals, and other

raw materials has picked up, which will help accommodate future com-

modities demand. However, the increased supply of commodities may not

be enough to keep pace with demand if emerging economies continue to

develop rapidly. Many analysts believe that new technology has made it

easier to industrialize quickly, implying that growth in the least developed

nations could accelerate in the near future. In one unfortunate scenario,

natural resource prices could remain high in the long term if drought con-

ditions become increasingly common due to global warming and weather

instability around the world. (This has occurred of late in Australia,

Mexico, and the American Midwest.)

In 1980, the issue of population growth and natural resource supply

came into the public eye in the United States. Biologist Paul Ehrlich and

economist Julian Simon made a famous wager. Ehrlich was a pessimist

who thought that population growth would soon lead to disaster, with

astronomically high commodity prices in the near future. Simon believed

that markets—due to the dynamic innovation and efficiencies they wring

out of production—would be able to supply basic materials in sufficient

quantity to keep up with global economic development and population

growth. The bet was simple: Ehrlich chose five commodities—chromium,

copper, nickel, tin, and tungsten—that he believed would go up in price

over the next decade. By 1990, the price of all five metals had declined after

adjusting for inflation, and Ehrlich mailed Simon a check, conceding his

defeat.

What is fascinating to observers today is that if they had agreed to the

same bet in 2000—or if it had run for 31 years, not 10 years, beginning in

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 171

1980—Ehrlich would have won due to the great run up in commodity

prices after 2002. Compounding the risk of high food prices, many ana-

lysts are predicting that water shortages are going to become more likely.

People in wealthy nations take clean water for granted, yet in much of the

world, water supplies are dangerously inadequate because of shortages,

poor quality, and inadequate distribution and disposal systems. Over a

tenth of the global population lacks access to clean drinking water, and

more than a third of the world lives in areas without access to proper

sanitation. Driven by proper price signals, innovative supply, sanitation,

and distribution technologies may be able to ease pressures.

Walmart, Low Prices, and Globalization

In the late-19th century, mass-market retailers Sears Roebuck and

Montgomery Ward reached American consumers with mail order catalo-

gues, taking advantage of railroads as their main channel of distribution.

Appealing to small town residents in underserved consumer markets, they

offered a massive selection of goods at low prices. After World War II,

shopping malls and discount department stores popped up across the

United States, driven by suburban sprawl. One such discounter, Walmart,

started in 1962 with a single store in Rogers, Arkansas. Its founder, Sam

Walton, realized the potential in opening large low-cost retail stores in

small Southern towns. His business strategy was successful, and by the

1990s, Walmart had become a very profitable national chain. Walmart is

now the largest private employer and largest retailer in both the United

States and the world. To this day, it has continued its expansion interna-

tionally into Mexico (as Walmex), Japan (as Seiyu), and India (as Best

Price). The experience of Walmart illustrates many of the issues raised by

critics of globalization.

Walmart is known for its low prices, which is why customers keep

coming back. Although Walmart has maintained low net margins of under

4% over the past decade, it has become progressively more profitable due

to its mammoth sales volume, which continues to expand. Walmart has

been a leader in implementing retail store information technology and the

efficient control of inventory, logistics, and distribution. It has also been

aggressive in pursuing cost savings and forging new supply chain

172 INTERNATIONAL ECONOMICS

relationships across the world. Some studies suggest that Walmart saves the

average American household a substantial amount of money each year,

partly because the presence of a Walmart lowers the prices that local com-

petitors charge. Although the exact amount of savings is difficult to pin-

point, Walmart’s role as consumer products importer and distributor has

been an important factor in lowering the cost of living since the 1990s,

particularly among low-income populations which can now afford DVD

players and large screen televisions. In terms of productivity growth,

Walmart has contributed to greater retail productivity in the United States

and around the world, both directly (through its normal operations) and

indirectly (through imitation by competitors).

Still, the company has its many critics. They believe Walmart has been

far too aggressive in keeping operating costs low, especially when it comes

to human resource practices. These critics maintain that Walmart pays

unreasonably low wages to retail employees, with inadequate health insur-

ance benefits. (Large retailers have been criticized on similar grounds for

nearly a century.) Among Walmart’s largely female workforce, the average

employee is paid no more than about $20,000 each year. Some of

Walmart’s competitors—such as Costco, which has far lower employee

turnover—pay their workers more and give them more training, too. His-

torically, Walmart has taken a firm antiunion stance, sometimes closing

stores after employees voted to unionize. Over time, such hard-line tactics

by a large industry powerhouse may have increased the overall bargaining

leverage of employers throughout the American retail sector. Empirical

evidence suggests that a Walmart opening drives several general merchan-

dise stores out of business on average, yet the overall effect within a region

is not large, given that there are about 200 such stores in a typical county.

Other studies have shown that the local employment effect of a Walmart

opening appears to be small or negligible. There is also evidence that

the presence of a new Walmart—which can be considered a type of

amenity—increases housing prices within a mile of the store.

At the local level, the opening of a new Walmart can be extremely

controversial. In some regions, local governments have subsidized new

Walmart locations through tax exemptions and funds for job training and

infrastructure. However, in other areas, usually large cities, Walmart has

met stiff resistance from local residents after announcing its intentions to

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 173

open a store. At the national level, Walmart has devoted an increasing

amount of time and money to lobbying for free trade policies, given its

heavy utilization of low-cost foreign suppliers. At the same time, detractors

have argued that Walmart’s monitoring of foreign suppliers is deficient; for

example, some Walmart goods containing wood may have been produced

with illegally harvested timber from China, Russia, and Brazil. Amidst a

growing chorus of criticism from corporate watchdog organizations over

the past decade, Walmart has responded by altering some of its business

practices. The company has been concerned about its tarnished reputa-

tion, which was apparently hurting sales. As the Walmart CEO publicly

admitted in 2005, the “critics are sometimes right.” Walmart is now one of

the top corporate charitable cash contributors, and it is currently engaging

in a large-scale program to reduce all greenhouse gas emissions associated

with the manufacture, distribution, and usage of their products. Like many

other corporations in recent years, Walmart is attempting to manage its

reputation and build brand equity by enhancing the social responsibility of

its practices before actively publicizing the changes.

Globalization and Labor Unions

The first thing to understand about trade unions is that their prevalence

varies widely around the world. In Sweden, Denmark, and Finland, nearly

70% of the workforce is a member of a union, and many nonmembers are

represented by unions in collective bargaining agreements. In these three

countries—collectively part of the “Ghent system” with Belgium and

Iceland—unions distribute welfare payments (including unemployment

insurance benefits), and workers have an incentive to join them. At the

other extreme, just over 10% of American workers are union members,

and the union membership rate is less than 20% in New Zealand, Japan,

and South Korea. In continental Europe, public policies and large-scale

employment agreements frequently cover employees at nonunion estab-

lishments. France, a country with rigid labor markets and a strong socialist

history, is an instructive data point: less than 10% of French workers are

union members though 90% of the workforce is covered by collective

bargaining agreements. While membership rates are a proxy for the general

bargaining power of unions in a society, coverage rates are a better measure

174 INTERNATIONAL ECONOMICS

of union reach in providing basic employment protections and income

benefits. Due to extensive centralized collective bargaining practices, cov-

erage rates tend to be much higher than membership rates in most of

continental Europe. A number of European countries also have “works

councils,” giving workers at larger companies the right to influence certain

organizational decisions.

The experience of American labor unions provides an interesting case

study in industrial relations. The labor movement in the United States—a

labor-scarce country with no feudal tradition—has never been particularly

strong. American unions reached their peak years of influence from the

mid-1930s—when the National Labor Relations Act was passed—

through the mid-1950s. Union membership rates then started to decline,

falling steadily from about 35% following World War II to about 12%

today (which is the same level as the early 1930s). The change was driven

by falling membership rates in the private sector, which employs about five

times as many workers as the public sector. Whereas private sector mem-

bership rates exhibited a gradual decline, public employee rates actually

exploded upward in the 1960s—when legal restrictions on public sector

unions started to ease—and have remained at slightly under 40% since the

late 1970s. Some economists believe that American business was relatively

unpopular in the public eye back when unions were powerful, but an

antiunion backlash began in the 1980s, when many middle-class workers

were struggling and the public began to question why only the unionized

should be afforded exemplary protections. Another peculiarity is that labor

bargaining is relatively decentralized in the United States, so very few non-

members have their terms of employment covered (or represented) under a

collective bargaining agreement.

Many American commentators have attributed the decline in union-

ization to trade and technology. The idea is that manufactured imports

from low-wage countries have put downward pressure on wages for many

Americans, which (along with global capital mobility) has increased the

bargaining power of large private employers in the United States, especially

in the manufacturing and retail sectors. On top of that, technology has

stoked the demand for highly skilled professionals who know how to uti-

lize it, without helping other groups quite as much. However, what’s fas-

cinating is that the international data do not square with this story. Among

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 175

advanced nations that have been broadly subjected to the same forces of

globalization and technological progress as the United States has, there is

tremendous variation in union membership and coverage rates, implying

that the degree of union influence has diverged. Consider Canada, a coun-

try similar to the United States in many important ways. In 1960, union

membership (and coverage) rates were both about a third in the two neigh-

boring nations. But since then, the rate has stayed approximately the same

in Canada. In other wealthy English-speaking market democracies (like

the United Kingdom, Australia, and New Zealand), union membership

rates started to decline in the 1980s.

Such patterns demonstrate that political factors are fundamental to

understanding the prevalence of unions across countries. Within affluent

regions where political systems are similar, unionization rates are broadly

comparable. In the Ghent system nations, union pervasiveness is the high-

est, and it has stayed the same or even increased over the past 50 years. In

Continental European market economies—which fall in between Ghent

system nations and liberal free market economies like the United

States—union membership rates have remained constant (as in Italy) or

fallen somewhat (as in Switzerland, France, Germany, and Holland).

Union coverage has fared better; in Austria, for example, coverage actually

increased in spite of dramatically falling membership rates. The same

pattern occurred in Spain in the late 1970s (after Franco), although in

Portugal, both membership and coverage declined (after Salazar). As the

empirical evidence shows, wealthy nations that trade more tend to have a

higher union prevalence, in part because unions help cushion the impact

of the global business cycle on local workers. In this respect, there is a

positive relationship between globalization and unions. This correlation

doesn’t appear to have been driven by technology adoption, either. For

instance, the United States and Japan are technologically sophisticated

economies that have been in the vanguard for decades. But the same can

be said of Scandinavian economies, where—contrary to the United States

and Japan—unions are very powerful.

In the developing world, collective bargaining systems are weaker and

unions play a smaller role. Perhaps this isn’t surprising, since poor nations

have relatively fragile political institutions, and most workers remain in the

informal sector where governments have trouble monitoring employment

176 INTERNATIONAL ECONOMICS

practices. Because labor market institutions like unions and collective bar-

gaining arrangements reduce wage dispersion among comparable workers,

one consequence of weaker unionism is relatively greater wage inequality

in emerging markets. Although international empirical evidence is lacking,

critics of globalization argue that capital mobility can lead to greater work-

place insecurity in poor and developing countries, diminishing unionism

and labor protections. On the other hand, workers can clearly benefit from

globalization and capital mobility: as developing nations become richer

through trade and foreign investment, political institutions can be stabi-

lized and suitable labor market regulations can be formulated, including

collective bargaining. As developing economies grow, their citizens are

likely to call for greater political control and sovereignty, including new

labor market institutions that could potentially conflict with export-based

growth policies requiring low wages. These scenarios involve a rebalancing

favoring democracy and national determination over economic globaliza-

tion, and China is a case in point: workers there are now demanding

greater protections, and unions could help bring about major democratic

reforms someday.

Rise of Globalized Finance

Following World War II, the Bretton Woods system provided the foun-

dation for international finance throughout the industrialized world. It

coordinated currencies by instituting pegged (yet adjustable) exchange

rates which the IMF was tasked with overseeing. The value of each cur-

rency was fixed against the American dollar, and in turn, the dollar was

worth $35 per ounce of gold. Some have called the subsequent quarter

century a “golden age of controlled capitalism”: under Bretton Woods,

another depression did not occur; Europe was able to rebuild successfully;

exchange rates were stable; and inflation was relatively low. However, ten-

sion within the currency system built throughout the 1960s, as American

macroeconomic policy, military commitments, and balance of payments

deficits led to the dollar becoming overvalued. In 1971, the United

States—fearful of a run on its gold supply—suspended the dollar’s con-

vertibility into gold. By 1973, most major world economies had stopped

setting their currency’s value to a fixed rate against others—meaning that

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 177

currencies within the system started to “float.” The Bretton Woods system

of pegged exchange rates was over, and luckily the adjustment did not

cause a major financial crisis. Still, oil prices rose steeply in the 1970s,

contributing to inflationary pressures, and the decade was characterized

by economic instability, relatively low growth, rising unemployment, and

high inflation—a state of affairs commonly termed “stagflation.” Interna-

tional capital mobility increased in some advanced nations during the

1970s (such as the United States, Germany, and Switzerland), though

the overall degree of mobility remained fairly limited, consistent with the

designs of the Bretton Woods founders.

The 1980s marked a turning point. At the start of the decade, the

Federal Reserve ramped up interest rates to unprecedented levels in an

effort to end double-digit inflation. Although this strategy led to a severe

recession, it successfully curbed inflation, and the American economy soon

stabilized. Capital mobility increased as burgeoning political trends around

the world supported the integration of global financial markets. Even

emerging economies—which had traditionally curtailed inflows of foreign

capital through taxes, legal restrictions, and prohibitions—became more

likely to lift capital controls. Following decades of support, governance

based on strong social welfare states and robust regulatory regimes fell out

of favor in a backlash movement in many regions. Instead, the public

became more sympathetic to market-oriented approaches to growth and

governance, with politicians pledging lower taxes, new privatization, less

regulation, the curbing of unions, and enhanced globalization. This move-

ment was symbolized by Margaret Thatcher’s election as Prime Minister of

the United Kingdom in 1979, followed by Ronald Reagan’s 1980 victory

to become President of the United States. It even extended to India and

China, two countries that were far from free market sanctuaries (both then

and now). They initiated distinctive liberalization programs that were usu-

ally inconsistent with contemporary prescriptions from Western economic

specialists.

Deeper international financial integration programs persisted through-

out the 1990s and afterward. The IMF and World Bank commonly

advised struggling lower- or middle-income countries to follow a set of

structural adjustment policies commonly referred to as the “Washington

Consensus.” This paradigm was derived from the prevailing conventional

178 INTERNATIONAL ECONOMICS

wisdom among Washington D.C. policymakers involved in foreign

economic development issues. In practice, the Washington Consensus

advocated market-oriented measures that included trade liberalization, lib-

eralization of inbound FDI, competitive exchange rates, fiscal discipline,

privatization, deregulation, and secure property rights. Critics have sug-

gested that such policy recommendations were too simplistic and did not

give enough weight to crisis avoidance or the challenges in jumpstarting

recessionary economies without fiscal stimulus. The policy prescriptions

were embraced after many Latin American economies suffered through

devastating debt crises and recessions in the early 1980s triggered by a

combination of high borrowing, oil price shocks, and rising interest rates

in the West. However, the country originating these prescriptions for

financial and economic soundness—the United States—did not appear

to follow them. With growing budget deficits and a consistently negative

balance of trade in the 1980s and 1990s, the United States began borrow-

ing from international capital markets on a massive scale.

It remains very controversial whether Washington Consensus policies

provided any advantage to developing countries in many instances. This

picture is further clouded by the fact that some critics have publicly con-

flated the original Washington Consensus policies with additional

“neoliberal” prescriptions such as monetarism or a minimal state. And

although most financial economists maintain that the benefits of global-

ized financial markets have largely outweighed the costs—at least when

capital inflows are reasonably well managed—this issue also remains con-

tentious. The evidence suggests that capital inflows (such as FDI) to

emerging economies can help them grow, at least once they have achieved

a minimal level of development. On the other hand, when financial mar-

kets are global and capital controls are weak, the result can be increased

financial instability, particularly in countries with weak or inconsistent

macroeconomic policies or inadequately regulated or capitalized financial

systems; for one, it is easier for crises to be sparked and then spread across

borders when there are no controls in place. A prominent case in point is

the Asian financial crisis of the late 1990s. Earlier in the decade, Thailand,

Indonesia, Malaysia, and the Philippines dropped their capital controls in

an attempt to attract FDI. They were successful in drawing international

capital, but a large proportion of it was in the form of short-term, highly

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 179

liquid flows known as “hot money,” which could easily be withdrawn if

investors lost confidence. This is exactly what happened in early 1997,

when anxious investors, reacting to a rapidly deteriorating Thai real estate

and financial sector, began to withdraw funds in local currencies for dol-

lars. The panic quickly spread and local currencies crashed, leading to

severe recessions. It is also clear that international financial integration

contributed to the recent global financial crisis.

Elites, Concentrated Power, and Globalization

In the United States, the financial sector’s share of the total economy has

steadily grown since World War II, more than trebling in that time. From

the 1940s through the 1970s, financial and banking occupations were

unexciting, with unexceptional compensation, and graduates from elite

universities did not gravitate toward Wall Street. But starting in the

1980s, finance began to hire more skilled workers, paying them gener-

ously. This decade was the beginning of a boom period in complex

corporate financing and the proliferation of new financial products. Finan-

cial deregulation and newly globalized capital markets brought fresh

opportunities, and highly skilled individuals—armed now with personal

computers—were most able to take advantage of them. Financial sector

compensation rose, particularly among professionals working in invest-

ment banks and hedge funds. Since the 1970s, tremendous financial sector

growth also occurred in other major advanced nations such as the United

Kingdom, France, and Germany. Many analysts believe that the financial

sector of the industrialized world now holds excessive economic and polit-

ical power. Given its practical function of allocating capital to other sectors

of the real economy, critics argue that its size is too large to be justified.

The challenge is to craft new rules and regulations that will keep the finan-

cial sector functioning without another major crisis in the years to come.

New regulatory frameworks are expected to stabilize capital allocation,

preventing excessive risk-taking as well as too-big-to-fail levels of financial

concentration.

The current discussion about the proper role of finance is closely

related to a broader debate about the power of global elites. During the

age of hyperglobalization, a select group of executives and equity owners

180 INTERNATIONAL ECONOMICS

capitalized on new opportunities that technology and globalization pre-

sented. Many view the resulting wealth accumulation as fair and natural,

while others—citing financial sector deregulation such as the 1999 repeal

of the Glass-Steagall Act—contend that the gains were induced through

political influence peddling. Informational disparities seem to be part of

the problem. Finance is largely a kind of information brokerage, and as it

has become more complex, the gap in knowledge between leading finan-

cial professionals and the general public has widened. Such a disparity can

be used by insiders for their benefit, by selling flawed products to the

public, or by lobbying for favorable laws. More generally, as advanced

economies become more complex, it is natural that the division of labor

becomes more specialized—experts are needed to make decisions, so their

overall influence has increased. Yet, as many American commentators now

insist, difficulties arise when a sufficiently large portion of the specialized

elite professional class is incentivized to behave in a recklessly self-inter-

ested manner that is overly focused on short-term gain. In fact, in the years

leading up to the Great Depression, the American financial sector was full

of highly skilled, highly paid professionals, but after President Franklin

Delano Roosevelt took office in 1933 and pushed through new regulatory

measures, finance became staid, with less potential risk (and reward) for

bankers.

The political problem, in sum, is how to align the interests of elites and

insiders with the rest of society. To the long-term detriment of some econ-

omies, adequate solutions are not always found. In the cautionary tale of

medieval Venice, the sustained rise in wealth brought about by new for-

eign trade opportunities produced excessively concentrated political power

and contributed to the republic’s long-term decline. Beginning in the 10th

century, Venetian merchants grew wealthy by pursuing long-distance trad-

ing and shipping opportunities. For over two centuries, political power

wasn’t tied to heredity, and Venice’s sophisticated institutions and inno-

vative financing systems allowed its economy to flourish. But in the early-

14th century, a small group of ultra-wealthy merchants used their power to

restrict political participation and trade opportunities to a privileged elite,

based on family heritage. Land-poor Venice—for centuries a business-

minded haven from agrarian feudalism—now possessed a governing class

of hereditary nobility. The resulting “plutocracy,” which led to political

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 181

rent-seeking and inadequate entrepreneurialism, weakened Venice’s mar-

itime power. Over the subsequent centuries, Venice lost its lead as the

greatest banking center in Europe, and it was never again such a dominant

force, although it did remain quite wealthy.

Concern that well-connected elites possess excessive influence and

power isn’t novel; this very issue drove many individuals to move from

the Old to the New World. The primary author of the American Decla-

ration of Independence, Thomas Jefferson, was deeply worried about the

potential political influence of a “moneyed aristocracy” of financiers, argu-

ing that “banking establishments are more dangerous than standing

armies.” Accordingly, he favored an economy of independent, small-scale

farmers. Throughout the 19th century, Americans remained worried that

northeastern banks held too much sway over the rest of the nation. State

banking regulations helped to keep the financial sector decentralized, and

before the Federal Reserve was founded in 1913, the United States had

been without a central bank for three quarters of a century. In the early-

20th century, a major progressive movement swept through the United

States, pressing for political rights (such as women’s suffrage) as well as

enhanced business regulations (such as child labor laws). Today, another

massive populist political outcry of that size and reach isn’t likely to take

place, though a political and economic rebalancing, which includes new

regulations and accountability measures, seems to be occurring in the

United States and Europe.

The forces of globalization can encourage the concentration of power,

but they can also promote institutional dynamism and change. Although it

is difficult to reform political cultures overrun with rent-seeking, globali-

zation can act as a long-run catalyst by forcing competition through trade

and mobility. In other words, inefficient states fall behind in a globalized

world, giving their citizens and leaders an incentive to initiate reforms. In

developing countries—where oligarchies are more common—globalization

has spread the concepts of market economies, democracy, and human

rights, which can help chip away at the power of corrupt rulers over time.

England’s history during the Middle Ages shows it to be a forerunner in

bestowing modern rights of liberty, property, and due process upon its

citizens. The 1066 “Norman Conquest” of England by Scandinavian

and French forces contributed to changes in governance and economic

182 INTERNATIONAL ECONOMICS

dislocations that were unpopular with the natives, leading to marked hos-

tility toward the monarchy, and a century and a half later, the weak King

John, in his struggle against rebellious barons, acquiesced to the 1215

“Magna Carta” (or Great Charter), which limited his power. Then as now,

capital tends to flow to regions which treat it well, so global financial inte-

gration can prompt states to modernize and provide protections to inves-

tors and other property holders. And the creative destruction of capitalism

can not only wipe out old fortunes, but also generate new wealth to sup-

port reforms. These are just a few of the currents that will impact regimes

in the future, as the world shifts to a multipolar system exhibiting a wider,

more varied orbit of political influence.

Growth, Happiness, and Globalization

Economists commonly equate happiness (which they technically call

“utility”) with financial well-being. This is obviously a simplification, and

the empirical evidence indicates that there is more to the story. Back in the

1970s, American economist Richard Easterlin uncovered the first major

empirical finding about happiness, known as the “Easterlin paradox.” His

research indicated that wealthier citizens within any given country were

more likely to report themselves as being happy. So far, so good. The

paradoxical finding was that this positive relationship did not hold up

when comparing nations: there was no correlation between a nation’s

income and the average happiness of its citizens. Moreover, Easterlin

found that in the 25 years following World War II, Americans became

richer, but not happier, on average. Based on recent research, Easterlin

contends that in both rich and poor countries, there is no long-run rela-

tionship between happiness and income, implying that economic growth

does not ultimately make citizens happier. (Still, Easterlin has never denied

that short-run fluctuations in income have a positive effect on happiness.) His theory is that the happiness of an individual depends on their income

and circumstances relative to others, and that over time, people adapt to

changes in income and living standards.

Easterlin’s results remain contentious. New findings from psychology

indicate that people in different countries do not fully adapt to their level

of prosperity, and other studies—analyzing nations over the span of a

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 183

decade or more—have provided stronger evidence that income does

indeed have a positive long-term effect on happiness. Some critics question

the validity of self-reported happiness, which may be susceptible to cul-

tural biases and therefore fragile. Along these lines, precisely how happi-

ness is measured appears to make a difference. Besides self-reported

happiness levels, other measures include overall life satisfaction and “best

possible life” queries (where respondents are asked to compare their life

today versus the best possible life they can imagine for themselves). It turns

out that income tends to be most correlated with best possible life mea-

sures and least correlated with self-reported happiness, with life satisfaction

in the middle. This may be because people believe that having more

money would allow them to improve their lives in tangible ways, while

it is less clear that their momentary level of happiness is directly related to

long-term income. Afghanistan is a case in point; recent survey evidence

shows that although Afghans are surprisingly happy, they do not indicate

they are living their best possible life, for obvious reasons.

After several decades of research, it is clear that life satisfaction in poor

countries increases with national income (especially up to middle-income

levels), and that poor people in poor countries become more satisfied with

their lives (and less stressed out) as they are able to buy necessities. In fact,

new research shows that people around the world tend to have similar

notions of a good life, and they consider financial resources to be an impor-

tant part of life satisfaction. Higher incomes and economic growth bring

greater self-reported life satisfaction levels across most nations, and life

satisfaction is the highest in rich countries. On the other hand, ultimate

happiness depends on other factors that are largely nonfinancial, such as

spending time with family and friends, having good health, being satisfied

with work, and being married; it turns out that these factors are actually

more important to happiness on a day-to-day basis. Other work has shown

that business cycles influence happiness, as people are happier when infla-

tion and unemployment are low.

Globalization can affect happiness in a number of ways. Although—as

Easterlin would point out—economic growth does not guarantee happi-

ness, globalization and trade can spur growth in the least developed

nations. By bringing many out of extreme poverty, globalization has

almost certainly raised overall world happiness, and has the potential to

184 INTERNATIONAL ECONOMICS

do the same for many more. Since the marginal effect of income on hap-

piness seems to decline as people become wealthier, the gains to the poor in

poor countries should be greater than any adverse effects on rich country

workers (as according to Stolper-Samuelson). However, if globalization

isn’t managed well, it can lead to employment dislocations and financial

crises in those same countries, which disproportionately harm the poor

and diminish their happiness. Moreover, as economies develop, they are

better able to provide education and health care for their citizens, and

research shows that better educated and healthier individuals are reported

to be happier, even after holding income constant. As nations become

wealthy, they erect social welfare states, and new findings have shown that

social insurance makes people happier on average. For example, the gen-

erosity of unemployment benefits is related to happiness, among both the

unemployed and employed. Politics matter: citizens living in countries

with less corruption and more freedom report being happier. And indivi-

duals in more equal societies tend to be happier, which partly explains why

egalitarian Scandinavian countries score the highest on national happiness

around the globe.

Conclusion

The above topics are amenable to economic and statistical analysis, though

other controversies are more difficult to scrutinize through traditional

research methods. For instance, it is challenging to quantify any losses in

utility from the global “monoculture”—dominated by Western and Amer-

ican products—that has crowded out native cultures in some regions, and

the spread of the Western diet has contributed to higher obesity rates around

the world. On the other hand, there are benefits to cultural assimilation—

namely, the proliferation of human rights and democracy—and modern

food supply chains have the potential to stop wastage, eliminate food

poisoning, and feed more people at a lower cost.

It’s even possible that in evaluating the effects of globalization, the

importance of intangibles ultimately outweigh the tangible, material ben-

efits and costs. To wit, the greatest piece of good fortune to come from

globalization may be its role in fostering peace through trade. In Europe,

the common currency project of the euro has been a symbol of this

POVERTY, PROGRESS, AND CRITICS OF GLOBALIZATION 185

transformation. Globalization also continues to spread the tools of eco-

nomic growth to backward regions around the world. This suggests that

the moral case for globalization is strong, as it can sustain peace among

powerful nations and reduce poverty in developing countries. Learning

from past failures, as long as countries manage their liberalizations effec-

tively with carefully crafted policies—understanding that one-size-fits-all

policy prescriptions are rarely optimal—they should be able to employ the

forces of globalization to the long-run benefit of their citizens.

Further Reading

Bartels, L. (2008). Unequal democracy: The political economy of the new gilded age. Princeton, NJ: Princeton University Press.

Chandler, A., & Mazlish, B. (2005). Leviathans: Multinational corporations and the new global history. Cambridge, England: Cambridge University Press.

Chang, H.-J. (2012). 23 things they don't tell you about capitalism. New York, NY: Bloomsbury Press.

Cowen, T. (2004). Creative destruction: How globalization is changing the world’s cultures. Princeton, NJ: Princeton University Press.

Deaton, A. (2013). The great escape: Health, wealth, and the origins of inequality. Princeton, NJ: Princeton University Press.

Easterly, W. (2007). The white man’s burden: Why the West’s efforts to aid the rest have done so much ill and so little good. Oxford, England: Oxford University Press.

Frey, B. (2010). Happiness: A revolution in economics. Cambridge, MA: MIT Press. Frieden, J., Lake, D., & Broz, L. (2010). International political economy: Perspectives

on global power and wealth. New York, NY: W. W. Norton and Company. Galbraith, J. L. (1958). The affluent society. New York, NY: Houghton Mifflin. Graham, C. (2010). Happiness around the world: The paradox of happy peasants and

miserable millionaires. Oxford, England: Oxford University Press. Harvey, D. (2007). A brief history of neoliberalism. Oxford, England: Oxford Uni-

versity Press. Klein, N. (2002). No logo. New York, NY: Picador. Klein, N. (2008). The shock doctrine: The rise of disaster capitalism. New York, NY:

Picador. Layard, R. (2006). Happiness: Lessons from a new science. New York, NY: Penguin. Luttwak, E. (2000). Turbo-capitalism: Winners and losers in the global economy.

New York, NY: Harper Perennial. Moore, M. (2003). A world without walls: Freedom, development, free trade and

global governance. Cambridge, England: Cambridge University Press.

186 INTERNATIONAL ECONOMICS

Putnam, R. (2000). Bowling alone: The collapse and revival of American community. New York, NY: Simon and Schuster.

Rodrik, D. (1997). Has globalization gone too far? Washington, DC: Institute for International Economics.

Rodrik, D. (2016). Economics rules: The rights and wrongs of the dismal science. New York, NY: W. W. Norton and Company.

Sen, A. (1999). Development as freedom. New York, NY: Random House. Singer, P. (2002). One world: the ethics of globalization. New Haven, CT: Yale

University Press. Stiglitz, J. (2003). Globalization and its discontents. New York, NY: W. W.

Norton and Company. Stiglitz, J. (2007). Making globalization work. New York, NY: W. W. Norton and

Company. Wolf, M. (2004). Why globalization works. New Haven, CT: Yale University

Press. Wolf, M. (2010). Fixing global finance. Baltimore, MD: Johns Hopkins University

Press. Yergin, D., & Stanislaw, J. (2002). The commanding heights: The battle for the world

economy. New York, NY: Touchstone.

Harvard Business School Case Studies

Abrami, R. Worker rights and global trade: The U.S.-Cambodia bilateral textile trade agreement, 703034-PDF-ENG.

Alfaro, L., Dev, V., Allibhoy, F., & Spar, D. L. Botswana: A diamond in the rough, 703027-PDF-ENG.

Bose, I., Banerjee, S., & Robbe, E. V. Wal-Mart and Bharti: Transforming retail in India, HKU845-PDF-ENG.

Conklin, D. W., & Cadieux, D. Transformations of Wal-Mart: Experimenting with new retail paradigms, W11056-PDF-ENG.

Diermeier, D. Wal-Mart: The store wars, KEL658-PDF-ENG. Hannan, M., McMillan, J., Podolny, J., & Warren, M. A. World Trade Organi-

zation and the Seattle talks, IB41-PDF-ENG. Jones, G. G., & Brown, A. Thomas J. Watson, IBM and Nazi Germany, 807133-

PDF-ENG. Jones, G. G., & Reavis, C. Multinational corporations in apartheid-era South Africa:

The issue of reparations, 804027-PDF-ENG. Jones, G. G. Brazil at the wheel, 804080-PDF-ENG. Jones, G. G. Multinationals as engines of growth?, 803108-PDF-ENG. Konrad, A., & Mark, K. Staffing Wal-Mart stores, Inc., 904C06-PDF-ENG.

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Neeley, T. Language and globalization: ‘Englishnization’ at Rakuten, 412002-PDF- ENG.

Pill, H., & Sprague, C. Uganda and the Washington Consensus, 798047-PDF-ENG. Pill, H. Mexico: Reform and crisis—1987–95, 797050-PDF-ENG. Pill, H. Recycling problem: International bank lending in the 1970s, 796131-PDF-

ENG. Plambeck, E., & Denend, L. WalMart’s sustainability strategy, OIT71-PDF-ENG. Ramanna, K., Lenhardt, J., & Homsy, M. IKEA in Saudi Arabia, 116015-PDF-

ENG. https://cb.hbsp.harvard.edu/cbmp/product/116015-PDF-ENG Spar, D. L., & Burns, J. Hitting the wall: Nike and international labor practices,

700047-PDF-ENG. Subramanian, S., Dhanaraj, C., & Branzei, O. Bayer CropScience in India: Against

child labor, 910M61-PDF-ENG. Teagarden, M. B., & Schotter, A. Blood bananas: Chiquita in Colombia, TB0245-

PDF-ENG. Wells, L. T., Jr., & Sprague, C. Background and agreements on foreign direct

investment, 796148-PDF-ENG. Werhane, P., & Mead, J. Abbott and the AIDS crisis, UV1157-PDF-ENG. Werker, E. Foreign direct investment and South Africa, 707019-PDF-ENG.

188 INTERNATIONAL ECONOMICS

Epilogue (2013)

Economists … are the trustees, not of civilization, but of the possibility of civilization.

—John Maynard Keynes at his retirement toast

from the editorship of Economic Journal, 1945

Inspired by the sentiment above, the preceding six chapters have explored

economic concepts that should be helpful to businesspersons operating in

today’s deeply interconnected global economy. To recap: the process of

truly global economic integration stretches back some 500 years to the

discovery of the New World, its pace quickening over the last two centu-

ries (see Chapter 1). To understand the process of long-run growth as

economies develop and globalize, the neoclassical growth model—

with a special focus on the role of human capital and technology—is an

invaluable framework (see Chapter 2). Comparative advantage and

the factor proportions model provide key insights into the structure of

international economic specialization and the global division of labor (see

Chapter 3). The impact of globalization on local labor markets depends on

the level of economic development within a nation, including its stock of

human capital (see Chapter 4). Domestic political coalitions often have

sharply divergent views on whether their economy should liberalize and

integrate internationally (see Chapter 5). And although its benefits are

broadly appreciated, there are many critics who point out that globaliza-

tion has frequently encouraged environmental degradation and exacer-

bated social inequities (see Chapter 6). Right now, these criticisms are

all the more evident because during the recent era of hyperglobalization,

the gyrations of the global economy ended up overwhelming the capacity

of international institutions to accommodate change.

Core, Periphery, and Convergence

Over the past two decades, new technologies providing personal comput-

ing power and effortless global connectivity have become available to a

substantial fraction of the world population. Spurred by these modern

information and communications technologies—as well as FDI and a

richer appreciation for market-driven growth strategies—the periphery has been able to catch up with the core at a rapid pace. Imitation, replication, and coordination are fundamental to this process.

While today’s pace is new, the interplay between core and peripheral

economies stretches back to pre-modern times. Historians have long

debated why the Roman Empire fell in the 5th century AD, but one undis-

puted cause is the growing strength of barbarian forces northeast of impe-

rial borders along the Rhine and Danube Rivers. At the beginning of the

first millennium AD, Roman commanders concluded that the backward

regions of Europe dominated by Germanic tribes—constituting the poor

undeveloped periphery of that era’s economy—were not worth conquer-

ing. Yet the population and wealth of the external tribes multiplied over

the subsequent centuries, leading up to the great raids on Roman territo-

ries by Hun and Gothic armies in the 4th century. With mounting archae-

ological evidence, some historians argue that the barbarian forces only

grew to such strength—with modes of economic production that were

ever more sophisticated and diversified—because of their repeated trade

and contact with the Roman core economy, which fueled technology

transfer and imitation. Thus, Rome’s success contributed to its downfall,

as backward regions near the imperial border began to catch up, indicating

that globalization’s reach extends well before the Middle Ages.

The rapid convergence of many developing economies today generates

further trade integration, making conflict less likely (even if the outbreak of

war remains unpredictable). Technology and expertise from advanced

economies spills over onto emerging economies in this process. With each

passing year, knowledge becomes more important to national competitive-

ness, and land less so. As opposed to the Roman practice of paying tribute

to Germanic armies threatening to invade as a containment strategy to

keep the peace, wealthy nations today give free aid to the least developed

economies partly out of altruistic motivation, given the immense differ-

ences in living standards. Altruism is less relevant to China’s development,

which was driven by a sharp change in ideology that allowed for market

reforms and foreign trade. China’s rapid ascent would not have been pos-

sible without globalization: the Chinese leveraged an enormous pool of

190 EPILOGUE

cheap domestic labor and bargained for access to foreign technologies and

know-how. Many contend that China had long laid claim to the world’s

grandest civilization, with the exception of the past two centuries when it

pursued deglobalization.

In the coming years, emerging markets will provide growth opportu-

nities for established products and businesses. Residents of many develop-

ing countries will enjoy rising living standards as their economies converge

toward those of wealthy nations. Walmart and other likeminded distribu-

tors will undoubtedly supply them with the finer goods of middle-class life.

Each successful businessperson’s story is different, but it is often the case

that tapping into expanding consumer markets leads to greater profitability

than other strategies. As financial traders say, the trend is your friend.

Taking advantage of momentum can lead to outsized gains, and emerging

markets are a potential source of exceptional sales growth.

Advancedeconomiesonthetechnologicalfrontierwillcontinuetodrive

innovation, with fits and bursts of productivity growth coming from unex-

pected sources. Much attention has been paid to sluggish American real

wage growth, but there is cause for optimism in the United States. There

may well be a forthcoming revival of American manufacturing, as tradable

sector work shifts from China back to the United States, given rising Chi-

nese labor costs and enormous American productivity advantages. China is

new to the club of middle-income countries, and to become as rich as lead-

ing economies, it must carry out decades of social transitions and policy

reforms. No matter how successful they are in the near term, other devel-

oping countries (such as Vietnam) cannot become China redux, for the

simple fact that China’s size and history make it truly unique.

State of Globalization Today

Governments around the world are now adjusting policies in the wake

of the last global financial crisis that began in 2007. It threatened to

grind the financial system to a halt, setting off a new global depression.

Some reforms have been enacted so far, yet the world’s financial infrastruc-

ture remains largely intact. With so many complex financial products in

existence, an underlying compensation structure that is arguably

EPILOGUE 191

incompatible with prudent risk management, and an overall lack of trans-

parency, many economists believe that additional restructurings are nec-

essary because taxpayers remain exposed to excessive systemic risk. There is

also the sobering fact that modern economic crises are highly contagious.

Despite these enormous policy challenges, the governments of rich

nations—including those within the EU—appear committed to the glob-

alization project.

Even if serious conflict between global powers were to break out again,

the contemporary Western mindset stands in great contrast to ideologies of

the interwar deglobalization period from 1914 to 1945 (which very few

alive today experienced as adults). The instability of that era was shaped by

the interests of reactionary elites whose power had long been on the wane

yet were still highly influential. In wealthy nations of the West today, the

power of archaic aristocratic elites has expired. Few prevailing coalitions

call for a robust deglobalization—as the reactionary aristocrats and socialist

labor leaders of yesteryear did—much less with a compelling message that

appeals to ordinary citizens. Some analysts argue that the void has been

filled by the titans of the contemporary information economy, some of

whom head MNE. Critics insist that too many of these moguls are dan-

gerously adept at rent-seeking, dubious “shadow banking” practices, and

other activities with potentially adverse social consequences.

The current debate about economic policy doesn’t concern the

merits of capitalism versus socialism as it did throughout much of the

20th century, when great tragedies were manufactured by anti-capitalist

totalitarian rulers such as Stalin and Mao. Today’s debate, reflecting a

pragmatic state of mind, is much narrower: how best to create a sustainable

market-based global economy that has the support of participating citizens

and can adapt in the face of serious threats such as global warming. In fact,

the greatest threat to long-run prosperity may be “anthropogenic” (mean-

ing human-caused) climate change. The quality of the global environment

is a public good, so maintaining it requires a concerted multilateral effort.

Yet due to the absence of preemptive collective action, greenhouse gas emis-

sions have escalated, threatening to wreak environmental devastation (even

if the full set of consequences has not been firmly established at this time).

Shifting from fossil fuels to clean energy sources will be very costly, and

given the deteriorating fiscal situation of many wealthy nations, funding

192 EPILOGUE

clean energy investment is problematic. Combating climate change would

likely slow international trade flows, because under current technologies,

the shipping and transport of goods relies on fossil fuels. At least there is a

growing recognition of global warming stemming from mounting evidence

that polar ice caps are melting, sea levels are rising, extreme weather events

are increasingly common, and the world’s food supply chain is threatened.

Some degree of political progress has been made over the past several years.

For instance, as part of the 2010 “Cancun Agreement,” 193 nations con-

sented to the goal of keeping global temperature increases under 2°C (as

compared to temperatures before the “Industrial Age”), and to date, over

90 nations have made voluntary pledges to reduce their emissions for 2020.

The governance of the international economy is currently under heavy

scrutiny. At the same time, the public lacks faith in corporations, politi-

cians, and regulators. Given the present age of disarray, some commenta-

tors have made comparisons to the global economy’s last great period of

transition: from approximately 1973 to 1983, the United States and other

affluent nations shifted from reglobalization supported by the Bretton Woods style of controlled capitalism to free markets and hyperglobaliza- tion. A new framework has not yet emerged; the extent of cross-border economic integration could diminish, though a true deglobalization seems unlikely. Western economists still favor free and open trade, recognizing

that the gains from globalization—while incrementally diminishing—

have been considerable in the aggregate. As usual, much depends on

politics, which are fickle, and capable leadership.

Over the last several decades, analysts of all political persuasions have

frequently argued that economic growth and globalization have eroded

social cohesion within nations. After the long stretch of economic expan-

sion from 1983 to 2007, advanced nations such as the United States are

experiencing growing pains as they debate political and social reforms

designed to provide greater equality of opportunity and stabilize the qual-

ity of life for middle- and working-class citizens. The “old-age dependency

ratio”—defined as the number of elderly per working age citizen—is set to

increase substantially throughout much of the world, including the United

States, Europe, Japan, and China. The economic drag caused by the aging

of prosperous societies will strain public sector budgets for years to come.

Luckily many leading scientists working in biology, clean energy, and

EPILOGUE 193

nanotechnology are optimistic about new breakthroughs that could cata-

lyze productivity growth.

Over a billion people have been lifted out of poverty since 1980, and

the worldwide poverty rate now falls by at least one percentage point every

year. Globalization has played no small role in this transformation. Brazil’s

recent development has demonstrated that an open economy can see both

growth and a diminishing gap between rich and poor. Under the savvy

political leadership of Presidents Cardoso and Lula da Silva—and owing

much to the global boom in commodities—Brazil stepped up expendi-

tures on education and welfare, which spurred growth and reduced pov-

erty. With an economy now larger than the United Kingdom’s, Brazil has

disproven the fatalistic adage that it is “the country of the future and always

will be.” Africa’s economic prospects have brightened. Foreign investment

has soared over the past decade, partly due to a mining boom, and the

quality of governance in many countries has improved. The continent still

has a long way to go, as most Africans live on less than two dollars a day,

and education, infrastructure, and basic services such as electricity and

water remain inadequate.

Even as globalization has helped to reduce poverty in the poorest

nations and generate immense wealth, its impact on the world economy

can be destabilizing and anxiety-inducing. The world is still in the midst of

political uncertainty, heightened financial turbulence, and transition to a

multipolar orientation, with relatively less power centered in the United

States and Europe, the latter a weak link in the recovery from the last global

economic crisis. As of mid-2013, the eurozone economy is well into its

second year of recession, marking Europe’s longest postwar slump, with no

vigorous recovery in sight until the debt crisis is resolved. EU leadership

has repeatedly vowed the euro will be saved, reflecting their belief in the

value of pan-European political and economic solidarity. Today’s over-

whelming degree of economic interdependence means that globalized

nations simply have too much to lose from separatism, which would dra-

matically reduce living standards, giving them all the more incentive to

avoid conflict (or paralysis) by assenting to reasonable consensus policies

of international governance and trade.

194 EPILOGUE

Further Reading

Banerjee, A., & Duflo, E. (2012). Poor economics: A radical rethinking of the way to fight global poverty. New York, NY: PublicAffairs.

Barofsky, N. (2012). Bailout: How Washington abandoned Main Street while res- cuing Wall Street. New York, NY: Free Press.

Chinn, M., & Frieden, J. (2012). Lost decades: The making of America's debt crisis and the long recovery. New York, NY: W. W. Norton and Company.

Eichengreen, B. (2011). Exorbitant privilege: The rise and fall of the dollar and the future of the international monetary system. Oxford, England: Oxford Univer- sity Press.

Freeland, C. (2012). Plutocrats: The rise of the new global super-rich and the fall of everyone else. New York, NY: Penguin Press.

Heather, P. (2012). Empires and barbarians: The fall of Rome and the birth of Europe. Oxford, England: Oxford University Press.

Johnson, S., & Kwak, J. (2012). White House burning: Our national debt and why it matters to you. New York, NY: Pantheon.

Khanna, R. (2012). Entrepreneurial nation: Why manufacturing is still key to America's future. New York, NY: McGraw-Hill.

Koo, R. (2009). The Holy Grail of macroeconomics: Lessons from Japan's Great Recession. Hoboken, NJ: Wiley.

Luttwak, E. (2012). The rise of China vs. the logic of strategy. Cambridge, MA: Belknap Press.

Mahbubani, K. (2013). The great convergence: Asia, the West, and the logic of one world. New York, NY: Public Affairs.

McCormick, M. (2001). Origins of the European economy: Communications and commerce AD 300–900. Cambridge, England: Cambridge University Press.

Moore, M. (2009). Saving globalization: Why globalization and democracy offer the best hope for progress, peace and development. Hoboken, NJ: Wiley.

Moss, T. (2011). African development: making sense of the issues and actors. Boulder, CO: Lynne Rienner.

Pisano, G., & Shih, W. (2012). Producing prosperity: Why America needs a manufacturing renaissance. Boston, MA: Harvard Business Review Press.

Radelet, S. (2010). Emerging Africa: How 17 countries are leading the way. Washington DC: Center for Global Development.

Rodrik, D. (2011). The globalization paradox: Democracy and the future of the world economy. New York, NY: W.W. Norton and Company.

Roett, R. (2011). The new Brazil. Washington DC: Brookings Institution Press. Schlesinger, A., Jr. (1986). The cycles of American history. New York, NY: Houghton

Mifflin Company.

EPILOGUE 195

Stiglitz, J. (2010). The price of inequality: How today's divided society endangers our future. New York, NY: W.W. Norton and Company.

Harvard Business School Case Studies

Abdelal, R., & Tarontsi, S. Natural gas, 713020-PDF-ENG. Abdelal, R., & Tuthill, K. Romney vs. Obama and U.S. energy policy, 713050-PDF-

ENG. Alfaro, L., & White, H. Brazil's enigma: Sustaining long-term growth, 713040-

PDF-ENG. Alvarez, J. B., & Johnson, R. Doug Rauch: Solving the American food paradox,

512022-PDF-ENG. Alvarez, J. B., Riis, J., & Salmon, W. J. H-E-B: Creating a movement to reduce

obesity in Texas, 512034-PDF-ENG. Burgelman, R. A., & Schifrin, D. Nissan's electric vehicle strategy in 2011: Leading

the way toward zero-emission, SM189-PDF-ENG. Ceranic, T., Montiel, I., & Cook, W. S. Sierra Nevada Brewing Co.: End of incen-

tives, NA0156-PDF-ENG. Clendenen, G., Thurston, P. W., Zhao, F., & Kidwell, S. Coal, nuclear, natural

gas, oil, or renewable: Which type of power plant should we build?, NA0007- PDF-ENG.

Daemmrich, A. A., & Musacchio, A. Brazil: Leading the BRICs?, 711024-PDF-ENG. Hawarden, V., & Barnard, H. Danimal in South Africa: Management innovation at

the bottom of the pyramid, 910M99-PDF-ENG. Hoyt, D. W., & Reichelstein, S. REI's solar energy program, BE17-PDF-ENG. Khanna, T., & Palepu, K. G. Emerging giants: Building world-class companies in

emerging markets, 703431-PDF-ENG. McKern, B., & Denend, L. The business environment of Brazil: Navigating the

financial crisis, IB96-PDF-ENG. Musacchio, A. Brazil under Lula, 707031-PDF-ENG. Musacchio, A. Inequality in Brazil, 711086-PDF-ENG. Palepu, K. G., & Bijlani, T. Bharti Airtel in Africa, 112096-PDF-ENG. Pill, H., & Vogel, I. John Maynard Keynes: His life, times, and writings, 702092-

HCB-ENG. Rao, H., & Elkin, G. Chez Panisse Foundation: Scaling up a delicious revolution,

HR33-PDF-ENG. Reinhardt, F., Casadesus-Masanell, R., & Nellemann, F. Maersk Line and the

future of container shipping, 712449-PDF-ENG. Rice, C., Zegart, A., & McMurdo, T. L. Political risk in the Kaesong Industrial

Complex, IB103-PDF-ENG.

196 EPILOGUE

Scott, B. R., Potvin, S., & Adams, A. Capitalism and democracy in a new world, 706030-PDF-ENG.

Zerio, J., & Conejero, M. A. Brazil's waste: A big emerging market, TB0231-PDF- ENG.

EPILOGUE 197

Postscript (2017)

There is nothing permanent except change. —Heraclitus (5th century BC)

The year 2016 offered two bombshell elections with twin results no one

had anticipated: Great Britain collectively decided to exit the European

Union, and Donald Trump was voted President of the United States.

Although electoral margins were extremely slim, British and American

citizens were expressing frustration with hyperglobalization, notably its

failure to provide widely shared economic benefits to those disconnected

from wealthy high-tech hubs such as London, New York, and San

Francisco. A strong case can also be made that ostensibly non-economic

factors—such as irritation with pluralism, open borders, and weakened

national identities, particularly among older voters—were the primary

forces underlying election results. Today in February 2017, some prom-

inent Western politicians (such as Marine Le Pen in France) are actually

calling for deglobalization. More than a few analysts have argued that 2016

marked the end of the postwar “Pax Americana” era—lasting roughly a

lifetime—and a new period involving the readjustment of trade and immi-

gration policies may be afoot.

In the United States, Europe, and elsewhere, the crux of the political

and economic conflict revolves around labor. Aggravated workers are able

to vote (unlike capital itself, even if wealthy capital-owners do retain a

disproportionate influence on the political system). As compared to inter-

est rates, wages, and earnings—meaning the returns to labor—have a

much larger impact on human well-being across a broad cross-section of

any society. Middle-to-lower-income workers—who now take Walmart

for granted—have helped fuel a populist backlash against globalization,

which so many concluded was a free-for-all. Historians enjoy analyzing

parallels with the last great populist revolt against globalization that

occurred in the late 19th century, paving the way for an extended period

of progressive reform. Even among elites, there is a growing awareness that

inequality within rich nations presents a persistent social problem that may

require an enhanced “social contract.” A desire for new solutions appears to

be spawning a vigorous debate at last, even if labor economists have been

analyzing income inequality in exhaustive detail for over 30 years.

Finding the right policy balance properly reflecting national interests is

difficult to achieve within Western democracies because domestic coali-

tions have sharply divergent interests, just as the Stolper-Samuelson

theorem implies. In contrast, autocratic governments (such as the

Communist Party of China) have an easier time coordinating and imple-

menting sweeping reforms. The United States now appears to be in the

process of reevaluating its industrial policy, yet economists are skeptical

that momentous changes will prove beneficial in the long-run given the

law of comparative advantage, to say nothing of political traps such as rent-

seeking. When it comes to struggling “Rust Belt” labor markets, the

empirical evidence shows automation is far more important than free trade

in explaining why the number of jobs in the US manufacturing sector has

been declining (a pattern Germany also experienced). And if the flow of

immigrants—who are disproportionately younger—is restricted, there will

be fewer working age contributors to Social Security pension funds, which

is economically unhelpful due to the demographics of an aging society,

among other reasons.

Contrary to the scathing political rhetoric, economic research demon-

strates that globalization has had only a moderate effect on wage inequality

within the United States and other affluent Western nations. Technolog-

ical change has been a far more important force driving inequality, and

when it comes to national economic health, subpar productivity growth is

the dominant concern. While globalization as measured by trade intensity

has stalled, the volume of cross-border electronic data flows has actually

continued to grow at an increasing rate. Technological progress cannot be

stopped, and it is unlikely that international economic integration will

unravel. Yet with the political uncertainty that lies ahead, many urgent

questions are impossible to answer at this date: Will the post-Brexit EU

hold steady, or gradually break apart? Will the populist wave rise, merge

with a new progressive movement, or simply bomb out? Will a worldwide

neo-Silk Road Pax between China, Europe, and the United States emerge

in due time—or remain just a chimerical notion? What’s clear is that the

economics—and politics—of globalization are more important than ever

to understanding international business and world events.

200 POSTSCRIPT

Further Reading

Atkinson, A. (2015). Inequality: What can be done? Cambridge, MA: Harvard University Press.

Bessen, J. (2015). Learning by doing: The real connection between innovation, wages, and wealth. New Haven, CT: Yale University Press.

Bourguignon, F. (2015). The globalization of inequality. Princeton, NJ: Princeton University Press.

Bremmer, I. (2016). Superpower: Three choices for America's role in the world. New York, NY: Penguin.

Ferguson, N. (2014). The great degeneration: How institutions decay and economies die. New York, NY: Penguin.

Ford, M. (2015). Rise of the robots: Technology and the threat of a jobless future. New York, NY: Basic Books.

Goodwyn, L. (1978). The populist moment: A short history of the agrarian revolt in America. Oxford, England: Oxford University Press.

Hofstadter, R. (1955). The age of reform. New York, NY: Random House. James, H. (2012). The creation and destruction of value: The globalization cycle.

Cambridge, MA: Harvard University Press. Judis, J. (2016). The populist explosion: How the Great Recession transformed Amer-

ican and European politics. New York, NY: Columbia Global Reports. King, M. (2016). The end of alchemy: Money, banking, and the future of the global

economy. New York, NY: W. W. Norton and Company. Lindert, P., & Williamson, J. (2016). Unequal gains: American growth and inequal-

ity since 1700. Princeton, NJ: Princeton University Press. Milanovic, B. (2016). Global inequality: A new approach for the age of globalization.

Cambridge, MA: Harvard University Press. Müller, J.-W. (2016). What is populism? Philadelphia, PA: University of Pennsyl-

vania Press. Piketty, T. (2014). Capital in the twenty first century. Cambridge, MA: Harvard

University Press. Shipman, T. (2016). All out war: The full story of how Brexit sank Britain's political

class. London, England: William Collins. Smick, D. (2017). The great equalizer: How main street capitalism can create an

economy for everyone. New York, NY: PublicAffairs. Stiglitz, J. (2015). The great divide: Unequal societies and what we can do about them.

New York, NY: W. W. Norton and Company. Stiglitz, J. (2016). The Euro: How a common currency threatens the future of Europe.

New York, NY: W. W. Norton and Company. Wolf, M. (2014). The shifts and the shocks: What we've learned—and have still to

learn—from the financial crisis. New York, NY: Penguin.

POSTSCRIPT 201

Index

Absolute advantage, international trade, 68–69

Absolute convergence hypothesis, 47 Acquired immune deficiency

syndrome (AIDS), 169 AIDS. See Acquired immune

deficiency syndrome American labor markets, 112–115 Anglo-Dutch War, 11 Avian Influenza, 169

Balance of trade, 2 Bang for the buck, 43 Big-push model, economic

development, 100–103 Bilateral trade, 151 Bird Flu. See Avian Influenza Black Death, 4, 5 Bretton Woods system, 177, 178 British cotton industry, 13–14 British industrial revolution, 19–21 Business opportunities, 53–55

Canton system, breakdown of, 16–18 CAP. See Common agricultural policy Capital-abundant country, 76–78 Capital-deepening, 45 Capital-to-labor ratios, 46, 47 Cassa del Mezzogiorno program, 104 Centralized economic planning, 57 Chinese intellectual property

enforcement, 53 Chinese labor markets, 118–122 Cobb-Douglas style production

function, 43 Cobden-Chevalier Treaty, 28 Commerce and Coalitions (Rogowski),

140 Commodity prices, 170–172 Common agricultural policy (CAP),

89–90

Comparative advantage, international trade, 68–69

evidence on, 73–74 Concentrated power, globalization

and, 180–183 Conditional convergence hypothesis,

47 Considerations Upon the East India

Trade (Martyn), 14 Constant returns property, 44 Convergence, 46–49 Corn Laws, 26–28, 143 Cost of capital, 44, 53 Cultural Revolution, 58

Democracy and economic growth, 131 globalization and, 132–135

Disease transmission, globalization and, 169–170

Diversification, economy, 105–106 Dutch Golden Age, 8–9

Easterlin paradox, 183 Easterlin Richard, 183 East Indies trade, 7–8 Economic development, 105–106 Economic growth

business opportunities, 53–55 convergence, 46–49 democracy and, 131 growth across continents, 58–60 human capital, 49–51 intellectual property rights and

growth, 52–53 neoclassical growth model, 41–45,

46, 47, 49, 51, 53, 54, 55, 58, 62

productivity across nations, 55–56 productivity slowdown puzzle,

56–57

204 Index

socialism, 57–58 steady-state equilibrium, 45–46 technology, science, and growth,

51–52 Economy labor markets, 159–161 Economic policymaking, China, 120 EEC. See European Economic

Community Elites, 180–183 An Essay on the Principle of Population

(Malthus), 20 European Economic Community

(EEC), 152

Factor coalitions across globalization eras, 144–147

Factor proportions model, 75–77, 108, 133, 140

FDI. See Foreign direct investment Foreign capital, 159–161, 163–165 Foreign direct investment (FDI),

158–165 Foreign investment, evolution of,

162–163 Foreign investors, 161–162 Free trade, support for, 138–139 French and Indian War, 12

GATT. See General agreement on tariffs and trade

GDP. See Gross domestic product General agreement on tariffs and trade

(GATT), 35–36 Ghent system, 174, 176 Glass-Steagall Act, 181 Global commodity prices, 171 Globalization

extensions, international trade, 74–75

government size and, 147–149 growth, happiness and, 183–185

Globalized finance, rise of, 177–180 Global poverty, trends in, 165–166 Gravity model, international trade,

83–84 Great Depression, 29, 32–34 Great Leap Forward plan, 58 Great Recession, 115, 136, 137

Gross domestic product (GDP), 58, 59

Growth across continents, 58–60

Habakkuk hypothesis, 81–82 Heckscher-Ohlin model of trade, 75 HIV. See Human immunodeficiency

virus Hot money, 179–180 Human capital, 49–51

international trade, 79–82 Human immunodeficiency virus

(HIV), 169 Hyperglobalization, 36, 138, 147 Hypothetical constant returns, scale

economy, 43

IBRD. See International Bank for Reconstruction and Development

IMF. See International Monetary Fund

Import-substituting industrialization, 87

Indian labor markets, 122–125 India’s poverty rate, 124 Industrialization and population

growth, 107 Industrial policy, 103–105 Industrial revolution technology,

diffusion of, 23–24 Infant industry protection, 87–89 Instruments of trade policy, 89–90 Intellectual property rights and

growth, 52–53 International Bank for Reconstruction

and Development (IBRD), 35 International Monetary Fund (IMF),

35, 178 International trade

absolute and comparative advantage, 68–69

basic instruments of trade policy, 89–90

distributional issues, 77–79 economic theories of, 67–92 evidence on comparative advantage,

73–74

Index 205

external increasing returns and geography, 86–87

factor proportions model, 75–77 gains from trade, 71–73 globalization extensions, 74–75 gravity model, 83–84 increasing returns and trade, 84–86 infant industry protection, 87–89 Leontief paradox, 82–83 technology and human capital,

79–82 trade-offs in, 90–92 wine and cloth, 69–71

Intolerable Acts, 1774, 12 Iwakura Mission, 19

Japan’s rapid industrialization, 18–19

Labor-abundant country, 76–78 Labor markets

American, globalization, 112–115 Chinese, globalization and reforms,

118–122 Indian, globalization and

development, 122–125 Mexican, globalization and

industrialization, 115–118 theory of globalization, 107–108

Labor unions, globalization and, 174–177

Leontief paradox, 82–83 Lewis two-sector “dual” model of

development, 98–100 License Raj, 123 Local worker rights, 161–162 Long depression, 28–30 Low-hanging fruit, 43 Lucas paradox, 54 Luddites, 79–82

Magna Carta (Great Charter), 183 Malthusian trap, 20 Managerial capital, 55, 106–107 Manila Galleon Trade, 6 Marriage of iron and rye, 142 Mercantilism, 87

age of, 10–11 Mercantilist World view, 2–4

Mexican labor markets, 115–118 Ming and Qing Chinese economy,

15–16 Ministry of International Trade and

Industry (MITI), 104 MITI. See Ministry of International

Trade and Industry MNE. See Multinational enterprises Modern economic globalization

Adam Smith, David Ricardo, and the Corn Laws, 26–28

age of mercantilism, 10–11 British cotton industry, 13–14 British industrial revolution, 19–21 Canton system, breakdown of,

16–18 Dawn of the 20th Century, 30 Dutch Golden Age, 8–9 East Indies trade, 7–8 Great Depression, 32–34 historical background, 4–5 hyperglobalization, 36 India, China, and Europe, 14–15 Industrial Revolution technology,

diffusion of, 23–24 Japan’s rapid industrialization,

18–19 long depression, 28–30 mercantilist World view, 2–4 Ming and Qing Chinese economy,

15–16 The New World, 5–7 19th century globalization, boom

and divergence, 24–26 reglobalization, 35–36 Rise of Great Britain, 21–23 slave trade, 9–10 United States of America, 12 World War I, 30–32 World War II, 34

Modern warfare, history of, 149–151 Mongol Peace, 1 Multilateral trade, 151 Multinational enterprises (MNE),

158–162

NAFTA. See North American Free Trade Agreement

206 Index

National Labor Relations Act, 175 NATO. See North Atlantic Treaty

Organization Natural resource curse, 134 Natural resources, 170–172 Navigation Act (1651), 13 Neoclassical growth model, 41–45,

46, 47, 49, 51, 53, 54, 55, 58, 62, 74, 76, 77, 79, 82, 97–99

assumptions, 44–45 production function, characteristics

of, 42 Neo-mercantilist, 3 Norman Conquest, 182 North American Free Trade

Agreement (NAFTA), 116, 117

North Atlantic Treaty Organization (NATO), 35

OECD. See Organization for Economic Cooperation and Development

Offshoring practice, 80 On the Principles of Political

Economy and Taxation (Ricardo), 27–28, 69

Openness, trade, and growth, 62–64 Organization for Economic

Cooperation and Development (OECD), 116

Patent Act, 1836, 53 Pax Britannica, 24 Pax Mongolica, 1 Peasants Revolt of 1381, 5 Physiocrats, 26 Political coalitions, 140–144 Pollution, economics, 166–169 Pollution haven hypothesis, 168 Population growth, 170–172 Porter hypothesis, 82 Poverty, 163–165

trends in, 165–166 Poverty traps, 100–103 Price convergence, 25 Productivity across nations, 55–56 Productivity slowdown puzzle, 56–57

Progressive income taxes, 132 Public choice analyzes, 91 Public health, economics, 166–169

Regulation demand, winners and losers, 135–138

Residual total factor productivity, 55 Restructuring, economic, 105–106 Rexists, 145 Ricardo, David, 26–28 Rise of Great Britain, 21–23

SARS. See Severe acute respiratory syndrome

Scottish Enlightenment, 26 Severe acute respiratory syndrome

(SARS), 169 SEZ. See special economic zones Silicon Valley of India, 86, 123 Silk Road, 1, 2 Slave trade, 9–10 Smith, Adam, 26–28 Smoot-Hawley Tariff, 32–33 Socialism, 57–58 Special economic zones (SEZ), 118 Spice trade, 7 Spillovers, 50, 81 Stamp Act, 1765, 12 Statute of Laborers, 1351, 5 Statute of Monopolies, 1624, 53 Steady-state equilibrium, 45–46 Stolper-Samuelson theorem, 78, 108,

135, 136, 140 Sugar Belt, 6–7 Swine Flu, 169

Take-offs, economy, 100–103 Tariff of Abominations, 141 Tea Act, 1773, 12 Technology, international trade,

79–82 Technology, science, and growth,

51–52 Townshend Acts, 1767, 12 Trade liberalization, 135 Trade-offs, international trade, 90–92 Traditional Ricardian model, 73, 74 Treaty of Nanking, 17

Index 207

Walmart globalization and, 172–174 low prices, 172–174

Warfare globalization and, 151–153 history of, 149–151

Washington Consensus policies, 177–179

Wealth of Nations (Smith), 2, 14, 26, 27, 68–69, 71, 72

Wine and cloth, international trade, 69–71

World Bank, 35, 178 World Trade Organization (WTO),

36 World War I, 30–32 World War II, 34 WTO. See World Trade Organization

Yersinia pestis bacterium, 4

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International Economics Understanding the Forces of Globalization for Managers, Second Edition

Paul Torelli

Today’s news media displays an intense fascination with the global economy—and for good reason. The degree of worldwide economic integration is unprecedented. Rising globalization has lifted living standards and reduced poverty, while foreign markets and new technologies continue to present opportunities for entrepreneurs and corporations. Still, economic shocks can spread across the world in minutes, impacting billions of lives. The political framework supporting globalization is now under scrutiny, and recent elections suggest economic policies may be readjusted in the coming years.

This book will help you learn about economics in everyday language, using little or no math, giving you better tools to interpret current events as well as long-term economic and political developments. Modern economics offers a powerful framework for understanding globalization, international trade, and economic growth. You may possess years of hands-on experience dealing with business cycles and foreign competitive pressures, but lack a solid grounding in economic concepts that shed light on the forces of globalization. This book is here to help.

Dr. Paul Torelli is chief economist at Quantitative Social Science, an economic consultancy based in Seattle, Washington. He has worked with leading law firms, corporations, and political organizations, providing economic insights and expert testimony. Dr. Torelli earned a PhD and MA in economics from Harvard University and a BA in economics and mathematics from the University of California at Berkeley.

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International Economics Understanding the Forces of Globalization for Managers Second Edition

Paul Torelli