World 3.0

by Pankaj Ghemawat

  The effects of borders between states or regions within the same country in limiting trade seem particularly large in the BRIC countries (Brazil, Russia, India, and China) because of their size, poor infrastructure (especially in the hinterlands), and administrative barriers to internal trade.16 In general, though, the effects of internal borders are an order of magnitude smaller than those of international borders. Thus, in 1999, Brazilian states “traded” internally more than ten times as intensely as with other Brazilian states but 280 times as intensely as with foreign countries; for Chinese provinces in 1997, those multiples were estimated at twenty-seven and more than 400 times. The point is not that internal trade flows or barriers to them are unimportant: in large countries, in particular, internal trade is often significantly larger overall than international trade and therefore even relatively small impediments to it can matter a great deal.17 Rather, the point is that if we want to “solve” the mystery of the missing trade, we ought to look at national borders, since that is where the really large drop-offs in trade are observed, not at state or regional borders. In other words, World 0.0, with its primary focus on the subnational level, turns out to be even less realistic a worldview than World 1.0.

  From Canada with Candy

  Let's dig deeper into the mystery of the missing trade by returning to the U.S.-Canadian border and focusing on a specific business trying to sell products across the border. Despite the general fascination with markets, businesses are, in many respects, the visible hand of trade. As international economist Edward Leamer observes (in the course of a critique of World 2.0):

  There are very few exchanges that are mediated by “markets” … Most exchanges take place within the context of long-term relationships that create the language needed for buyer and seller to communicate, that establish the trust needed to carry out the exchange, that allow ongoing servicing of implicit or explicit guarantees, that monitor the truthfulness of both parties, and that punish those who mislead. Many exchanges occur between colleagues who work for the same firm. Indeed, about 40% of US imports are carried out internal to multinational enterprises.18

  In other words, 40 percent of U.S. imports have the same business firm at both ends of that cross-border exchange. It's pretty clear, then, that the majority of U.S. imports have a firm—not necessarily the same one—at both ends of such an exchange, and an even larger proportion have a business firm involved as either the importer or the exporter.

  To explore what might lie behind border effects, let's look not just at a specific company, but at a smallish one; large companies often have a lot of infrastructure, capabilities, and experience that make it comparatively easy for them to cross national borders. (Note that the largest companies are much more globalized than markets in general: in 2008, the world's one hundred largest nonfinancial transnational companies had roughly 60 percent of their assets, employees, and sales outside their home markets, up 10 to 20 percentage points from 1990 levels.19)

  A company that fits the bill is Ganong Brothers, Canada's oldest candy maker and a firm roughly one-thousandth Google's size. While chocolates comprise its principal product line, what has really attracted attention are the company's attempts to sell jelly beans in the United States. Because of free trade agreements, there are no tariffs on jelly beans, and one might expect them to flow freely across the U.S.-Canadian border. And Ganong would seem well-positioned, literally, to serve the U.S. market: the state of Maine is just 1.8 kilometers away (1.1 miles for Americans) and visible from the offices of company president David Ganong. But it's not so simple.

  Take labeling as an example. In Canada, nutritional labels read “5 mg,” with a space between the number and the unit of measure. Yet Ganong's jelly beans can't get into America unless the nutritional label reads “5mg,” without the space. Likewise, the two countries calculate daily nutritional values differently. His packages of jelly beans for American consumers need to state what percentage of an American's daily allotment of iron, say, the product provides, even if this percentage varies only slightly from that provided to a Canadian (e.g., 4 percent of the daily allotment of iron as opposed to 2 percent).20

  Such bureaucratic differences may seem trivial, but their effects are not. To comply with U.S. labeling laws, Ganong has to produce jelly beans in separate runs for its American and Canadian markets; this means that production runs for each are smaller and less economical. Separate bags for the two countries elevate the costs of packaging, and the company needs to spend more money and devote more warehouse space to storing separate inventories of bagged jelly beans for the United States and Canada.21

  Lest it seem that the United States is unilaterally unreasonable, it's worth adding that Canada ties up trade in red tape as well. According to the Canada Border Services Agency, commercial importers into the country must register their businesses by obtaining a fifteen-digit business number. They must also create an accounting package for their shipments consisting of two copies of a “cargo control document,” two copies of an invoice, two copies of a Form B3 (“Canada Customs Coding Form”), any other required permits or forms, such as health certificates, and in many cases, a “Certificate of Origin” form. Once shipments are reported to the government, they are granted a unique fourteen-digit transaction number before they are released by customs and any duties or taxes are paid. To handle all this red tape, American exporters usually hire an export agent, who contracts with a shipper or carrier, who in turn deals with a clearing and forwarding agent in the destination country, who in turn deals with the buyer. Bank letters of credit are often required, as is insurance on the part of the exporter. Of course, none of this counts the documentation that is required on the American side to export goods.

  Since September 11, 2001, the barriers to trade have increased further due to the application of new layers of security and more complex rules and regulations. Processing time to enter the United States from Canada by truck (the principal mode of transportation) now takes an estimated three times as long.22 Delays have become such a problem that the Canadian government now has a Web site devoted to tracking them in real time.

  These changes have directly affected Ganong Brothers: as David Ganong related, his firm had a candy shipment delayed for five weeks so that the American government could analyze whether the yellow food coloring used in the product had been FDA approved. For four weeks, the government wouldn't reveal why the shipment was being held, what they were checking into, and what it would take to get it released.23 With Ganong's American customers expecting just-in-time delivery, surprise hold-ups such as this leave them looking elsewhere for more reliable sources.

  Jelly beans aren't even the industry hit most by red tape; other sectors with more complex production chains fare far worse. Take cars, whose production chains crisscross the U.S.-Canadian border with parts and subassemblies being shipped back and forth.24

  The red tape has prompted some efforts at reform. In 2005, the U.S., Canadian, and Mexican governments launched the Security and Prosperity Partnership (SPP) of North America to tackle issues such as regulatory harmonization—to supplement the nine hundred pages on the topic in the NAFTA treaty—as well as alleviate the impact of border controls.25 But progress has been slow, partly because of domestic political resistance that taps into a rich vein of suspicion and resentment of the United States. Thus, as one Canadian think tank put it, “SPP regulatory harmonization is a policy straightjacket [sic] that tightens with each new agreement, narrowing Canadian regulatory policy flexibility as it conforms to the dominant US regime.”26

  David Ganong, of course, finds all this very frustrating. And Canadian prime minister Stephen Harper shares his exasperation: “Is the sovereignty of Canada going to fall apart if we standardize the jelly bean? I don't think so.”27

  As if administrative barriers weren't enough, Ganong faces other hurdles in selling to the United States. One is geographic. While the company is located right on the border, it does have to deal with distan
ce within the United States. The U.S. state that it abuts from the north, Maine, is about the size of Portugal but has only 1.3 million people. It is more than 500 kilometers to Boston and nearly 900 kilometers to New York, over roads where the hazards include moose and snow. The dearth of nearby demand matters because sugar confectionery (given its relatively low value-to-weight ratio and limited scale economies) tends not to be shipped very far compared to, say, chocolate.

  And then there is the economic constraint implied by currency exchange rates. Over the last few years, the U.S. dollar has hovered at around 1.1 Canadian dollars, compared to a level of around 1.5 in the late 1990s and early 2000s. From Ganong's perspective, this represents more than a 25 percent drop in the value of each U.S. dollar the company receives. Given that the profitability of the typical business in the United States or Canada is about 5 percent of sales, this kind of exchange rate realignment would be more than enough to wipe out export profits for the average company.28 Unsurprisingly, Canadian sugar confectionery exports to the United States have stagnated in U.S. dollar terms since 2005, the last time the average exchange rate exceeded 1.2; in terms of Canadian dollars, they have declined.29

  What has nonetheless kept Ganong and other Canadian sugar confectionery manufacturers interested in the U.S. market is the staggering amount of protection afforded the U.S. sugar industry. Since 1812, the U.S. government has used a maze of tariffs and quotas to set artificially high prices for domestically grown sugar and prevent the import of sugar grown elsewhere. While this is often rationalized as protecting the U.S. customer from the roller coaster of world sugar prices, this protection is achieved by setting domestic prices so high that the roller coaster never risks running into them.

  As a result, U.S. domestic sugar prices are typically two to three times as high as world prices, and the multiple has ranged as high as seven! In this respect, the U.S. government actually seems kinder to foreigners than to its own. It subsidizes the export of products containing expensive U.S. sugar, effectively softening the effects of high U.S. sugar prices for foreign but not U.S. consumers. And it hurts U.S. sugar confectionery manufacturers by elevating their costs, but without affecting Canadian (and other) manufacturers' costs. But U.S. sugar growers make out like bandits and have been creative in finding ways of sharing some of the gains with the political establishment, which in turn looks set to carry the torch of U.S. protection of this sector into its third century.

  The United States, by the way, is not alone; the European Union and Japan also keep domestic sugar prices very high. Canada is actually the only major developed country to allow free importation of sugar. This discussion as well as the earlier discussion of regulatory harmonization suggest that the potential gains from opening up merchandise trade are still very large—a theme pursued further in the next chapter.

  Differences and Distances

  The case study of Ganong suggests that differences between the United States and Canada, while subtle, have large effects on trade and can therefore help explain the Canadian home bias multiples of five to ten cited earlier. But think of how much more different two randomly selected countries are than Canada is from the United States. Or, equivalently, think of all the ways in which Canada and the United States are atypically similar.

  Books can and have been written on this topic. Here, I'll simply summarize some of the “matches” between Canada and the United States that directly affected Ganong, and the percentage of all the possible country pairs (roughly 13,000) in my CAGE dataset that also match on that dimension.

  Culturally, Canada and the United States share the same dominant language (English), without which cross-border sales would have been even more challenging for Ganong. Communicating across a language barrier, even with a good (and hence expensive) interpreter, is still very hard—especially around subtleties like building trust, delivering constructive criticism, and motivating people. By way of comparison, the probability that a randomly selected country pair will exhibit a linguistic match is only 10 percent.30

  Administratively, Canada and the United States are part of NAFTA (the North American Free Trade Agreement), which helped Ganong by eliminating formal trade barriers. Only 11 percent of all possible country pairs involve common membership in such a trading bloc. And Canada and the United States also (mostly) had a common colonizer, England, which has eased contracting and trade by fostering similarities in areas such as legal systems: both follow the traditions of English common law.31 By contrast, 22 percent of all possible country pairs share a common colonizer, and 39 percent share a common legal origin.32

  Geographically, Ottawa and Washington are only 738 kilometers from each other, almost exactly one-tenth the average distance between the capital cities of a pair of randomly selected countries (7,270 kilometers). And Canada and the United States also share a common land border—something that only 2 percent of all possible country pairs can claim. These geographic factors did more than all the others to induce Ganong's focus on the United States as its major export market, even though the company has recently been attempting to secure agents in other parts of the world.

  We can summarize these data by excluding the continuous geographic distance measure and focusing on the five dimensions on which Canada and the United States matched. Multiplying the five percentages above (and assuming that they are independent) implies just a .002 percent probability that a randomly selected country pair would match on all five dimensions that Canada and the United States did! Dropping the independence assumption increases this probability but it seems pretty clear that Canada and the United States are about as close as two countries get in a world of about two hundred.

  Beyond these factors that impinged specifically on Ganong's exports of jelly beans, all sorts of other commonalities between Canada and the United States have been cited as mattering for trade in general. More than one hundred thousand Americans and Canadians each live in the other country, a tie shared by only 1 percent of all pos- sible country pairs. The two countries also share the same dominant religion, Christianity, although most Canadian Christians are Cath- olic, unlike their American coreligionists. The probability of matching coreligionists—past the usual 30 percent threshold—in a randomly selected country pair is 51 percent. Canada and the United States also align in a number of cultural groupings, ranging from Samuel Huntington's eight civilizations (the United States and Canada are both Western) to Geert Hofstede's six different cultural groupings (the United States and Canada are both Anglo-Saxon). Only one-quarter to one-fifth of country pairs match in such terms.33

  Based on Hofstede's four dimensional schema for assessing national culture, the United States ranks second out of sixty-seven other countries/regions in terms of cultural proximity to Canada, behind Australia, and Canada is third closest to the United States, behind Australia and the United Kingdom.34 This proximity is backed up by polling data. In one 2007 survey, 46 percent of Canadian respondents claimed that Canada's “values and goals” were “very similar” to those of Americans, higher than in Britain, Australia, and France.35 U.S. citizens tend to agree and, in many surveys, they rank Canada as their favorite foreign nation.36 Even U.S. politician Sarah Palin, no xenophile, has cited Canada as one of two trustworthy foreign countries (the other is Kuwait). But that said, the United States focuses far less on Canada than Canada does on it—which is unsurprising given their relative sizes.

  The Canadian focus does contain an undercurrent of suspicion that sometimes boils over into overt U.S.-baiting. In a recent election campaign, former prime minister Paul Martin accused his opponent, then prime minister Stephen Harper, of being “an extremist with ties to the United States.”37 Sounds a lot like how American politicians describe terrorists! Harper denied the charges, was reelected, and continued on with his pro-integration agenda.

  In addition, economic integration generates international tensions of its own. Of the forty-eight disputes before the World Trade Organization in which Canada is listed as c
omplainant or respondent, the United States figures in twenty—less than its share of Canadian trade but not indicative of complete amity either. Still, the absence of such disputes is more worrying, for lack of integration tends to go hand in hand with the militarization of problems, as we will see in the next chapter.

  But despite ongoing trade disputes and occasional political grandstanding, the U.S.-Canadian political relationship remains basically friendly. By comparison, take India and Pakistan. Since the Indian subcontinent was partitioned at the time of independence, in 1947, this relationship has been marked by overt and covert conflict as well as open hostility. As a result, Indo-Pakistani trade is just a fraction of what might be expected based on the patterns across other countries—only 2 to 4 percent, according to one study from 2004.38 Emotions about other countries still matter.

  Our discussion of Canada and the United States has so far focused on international distance, and pointed out that Canada and the United States are far closer than most country pairs. To complete the picture, one should look at internal as well as external distance. Thus, treating Canada, the world's second largest country, as a point mass is clearly inappropriate; as William Mackenzie King, who served as Canadian prime minister over much of the interwar years complained, “We have too much geography.” The effects have been alleviated by the fact that 90 percent of all Canadians live within 250 kilometers of the U.S. border. Nonetheless, ignoring residual internal distance within Canada to the border with the United States leads to overestimation of the latter's effects.39

  More subjective internal factors have also been shown to affect trade. A good example is the extent to which a country's culture is insular. Marshall McLuhan (a Canadian) once asserted that “Canada is the only country in the world that knows how to live without an identity.” Although this statement and its cruder cousin—the jibe about Canada being the fifty-first (U.S.) state—are obvious exaggerations, Canada does, as a nation of immigrants, seem much more open to outside influences in general than, say, much of western Europe, not to mention East Asia. Toronto and Vancouver, to name two of my personal favorites, are particularly vibrant, multicultural cities.