World 3.0

by Pankaj Ghemawat

  In light of these estimates, think of an elected politician, possessed of some desire to be of service to constituents, but certainly not indifferent to personal political survival. Offer such a politician a 0.5 percent boost in GDP in return for a complete scrapping of controls on merchandise trade, and see how many takers you get. There probably wouldn't be many in normal times and perhaps none during periods of high unemployment.

  That's the bad news. The good news is that the standard estimates of potential gains from globalization focus on just the tip of the iceberg. In fact, these estimates fail to capture the full potential of opening up for half a dozen broad reasons. First, we possess a more extensive set of policy instruments and levers than the models underlying these estimates presuppose. Second, while it is traditional to focus on volume and cost effects, cross-border interactions actually yield a broader array of economic benefits, as elaborated in this chapter in the specific context of merchandise trade. Third, looking beyond the usual focus on merchandise trade and including trade in services, as well as cross-border flows other than trade—flows of capital, people, and information—amplifies the economic gains from opening up. Fourth, not just economic value but also the cultural and political value of opening up must be considered. Fifth, complementarities across different channels of cross-border integration—such as between trade and migration, as described later—imply that channel-by-channel analysis will underestimate total gains. And finally, there is the commitment to cutting barriers to trade over time that has been built up over several decades of global trade negotiations. Conclusion of the Doha round would lock in some of the past gains as well as maintaining psychological momentum.

  Reviewing all these omissions and assigning very rough magnitudes to some of them (drawing on studies cited later in this chapter, among others), I reckon the potential gains from opening up to be several times as large as the estimates of $100 to $300 billion cited earlier: several hundred if not as much as a thousand dollars for everyone on the planet, every year. Beyond these or other numbers, though, the more basic point is that the models used to generate them conceive of the potential gains from opening up far too narrowly. In making this argument, it is useful to begin with a brief description of the mathematical models that underlie standard estimates of the gains from trade liberalization.

  CGE Models and CAGE Barriers

  The estimates of the gains from freeing up trade cited above are based on computational general equilibrium (CGE) models that use computers to calculate the behavior of supply, demand, and prices in the whole economy—or, in the context of trade liberalization, across multiple economies. This is a challenging task that has elicited very complex modeling efforts. Thus, the World Bank's LINKAGE model incorporates eighty-seven countries/regions, fifty-seven sectors, multiple labor skills and capital vintages, and on the order of fifty thousand mathematical equations.3

  That said, the real world is much, much more complex and so CGE models have to simplify reality a great deal.4 At the macroeconomic level, most such models assume full (or fixed) employment and zero governmental and trade deficits. The few real-world distortions that they do recognize mostly reflect state intervention. In the context of trade liberalization, these distortions include tariffs on imports and exports (or “tariff equivalents” in the form of exchange controls, quotas, etc.) and production subsidies, all of which are typically tacked onto transportation costs. The question that CGE models address is, How much would welfare rise if such distortions were removed? The models answer it by reshuffling a fixed amount of resources across industries (but within countries) to maximize cost efficiency as distortions are reduced or removed.5 The total gains from trade are the increased output observed as countries proceed to specialize in line with the principle of comparative advantage.6

  Juxtaposing the kinds of administrative changes contemplated in CGE models against the administrative barriers discussed in the previous chapter, it becomes clear that the former tackle only a subset of the latter. For instance, standard CGE models generally don't consider harmonization of regulations of the sort necessary to simplify the packaging problems confronting the Canadian jelly bean manufacturer who would like to export to the United States—although some work on this has begun. Trade facilitation measures also tend to be omitted despite estimates (in nonstandard modeling) that they might yield gains worth 1 percent of global GDP—more than the sorts of liberalization that are the usual focus of such analysis.7

  We can expand this list of administrative barriers that might be targeted to include many areas of gross administrative inefficiency within or across countries. Examples include countries in which it takes three months or more to obtain trade documents and regional trade agreements that are so complex that they have never actually been invoked. Such inefficiencies clearly dampen cross-border economic interactions by increasing internal distance but again, aren't part of the standard set-up.

  As we look beyond administrative barriers to the other broad categories of impediments highlighted in the previous chapter, cultural barriers stand out as another obvious target. Without suggesting that cultures can or should be homogenized, we can clearly engage in “cultural facilitation” to ease at least some cultural barriers—examples include insularity, hubris, and distrust of foreigners—that impede cross-border economic activity. Possible policy initiatives include broadening and ensuring more balanced coverage of foreign news, limiting nationalistic chest thumping, insisting on education, promoting second and third languages (particularly English as a language of wider communication), encouraging more cross-border trips and longer stays including immigration, and so on. Chapters 11 and 15 will deal at greater length with cultural barriers and what to do about them; the point here is that they fall outside the compass of CGE models.

  Unlike administrative and cultural barriers, the geographic barriers highlighted by the CAGE framework might seem immutable, but even here, there is room for remediation. Consider Africa, whose trade performance, interregional as well as intraregional, has lagged that of other regions. Part of the problem is that Africa is very far away from major world markets, so that when one divides foreign market sizes by geographic distance (i.e., assumes a distance sensitivity of -1) and adds them up, sub-Saharan African countries can access one-third the foreign demand that European countries can. We can't do anything about this geographic reality. Yet distance to markets isn't the only factor underlying very poor African trade performance.

  African exports to the United States illustrate the interregional problems: these exports experience transport costs three times as high as those from developed countries. Some of that higher cost reflects the incidence of landlocked countries, but much also seems related to ports that are among the slowest and costliest in the world—about which something could presumably be done.8

  Africa's intraregional trade is also low, and reveals even more clearly the influence of very bad infrastructure. By one estimate, if all the interstate roads in West Africa were paved, that might as much as triple trade within the (sub)region!9 And that estimate does not include the effects of, for instance, reducing the checkpoints on roads that are paved. More than a dozen of these checkpoints typically crop up between one capital city and the next, adding to corruption as well as transportation costs and times.10 Landlocked countries in sub-Saharan Africa are hit particularly hard by such problems: they incur inland transport costs that are more than four times as high on average as those experienced by coastal countries in the region.11

  Note that this discussion of geographic barriers has circled back toward administrative barriers, reminding us that the categories of barriers discussed in the previous chapter have a tendency to intertwine.12 Instead of focusing further on different types of barriers, then, I will simply point to the existence of a broad array of policy instruments and institutions that represent levers for increasing openness.

  These levers aren't fully accounted for in CGE modeling, and their effects are of
ten viewed too narrowly. The usefulness of the CAGE framework in this context, as Supachai Panitchpakdi, secretary-general of UNCTAD, put it to me, is that it helps expand what he calls the policy space. And according to him, the need for more policy space to implement appropriate development strategies has only gone up since the crisis.

  ADDING Value Through Merchandise Trade

  My own perspective on models of the gains from trade reflects my graduate training in economics—micro rather than macro—at Harvard, followed by twenty-five years on the faculty at the Harvard Business School, and now at IESE Business School in Barcelona, studying business and global strategy. I've come to think that business is fertile in insights about the derivation and distribution of value from globalization for society generally (although, obviously, such insights have to be adapted to focus on the public interest or total welfare rather than just private interests or profits). This is because of the business world's general emphasis on value creation and capture (my own textbook on business strategy is organized around these themes13) as well as its extensive experience with internationalization. As discussed in chapter 2, businesses, especially large ones, exhibit greater levels of cross-border activity than markets in general and are key intermediaries in trade as well as in other types of cross-border flows.

  Figure 4-1 presents a simple scorecard that I developed to help businesses assess the private economic value created or destroyed by cross-border operations. I use it here to understand the social value of increased openness. The scorecard parses value creation into six components—volume, cost, willingness to pay, intensity of competition, risk, and knowledge dynamics—that, with a bit of wordsmithing, lend themselves to the acronym of ADDING value. Pascal Lamy, director-general of the World Trade Organization, was a discussant when I presented the ADDING value scorecard at the World Export Development Forum 2010 in Chongqing, China, and provided a powerful summary of the action implications: Focus on value, not on volume. He also pointed out that while businesses had figured out this value proposition decades earlier, trade professionals had yet to fully take it on board.

  I contend that standard estimates of the gains from opening up focus on the first two components of the scorecard, adding volume and decreasing costs (the shaded ones in the figure), but miss out on the other four. Let me elaborate.

  Figure 4-1: The ADDING value scorecard

  The first component of the scorecard, Adding volume or growth, is the one that is most evident in discussions of trade liberalization. Thus, in their introductory economics text, Paul Samuelson and William Nordhaus observe that to arrive at the total gains from trade, you need to add up all the consumer surplus and producer profits generated by the increased trade, or more roughly, all the increased output you see from specialization and production.14 When you hear people say, “Trade liberalization will expand GDP by 0.5 percent,” that's the logic they're following.

  This added volume does, in a sense, depend on the second component of the scorecard, Decreasing costs; more cost-efficient allocations of resources underlie the expansion of output in CGE models. But the typical treatment of cost effects in such models is narrow. They don't consider investments in cost reduction, such as improving the infrastructure that seems the real bottleneck in sub-Saharan African trade. And since economies of scale—broadly speaking, negative relationships between volume and costs—can't easily be squeezed into general equilibrium models (they are a distinct potential source of market failure that I will revisit in chapter 5), they tend to be ignored as well.

  This is a big mistake. Economies of scale, while perhaps not as pervasive as businesspeople often assume, are more important than economists, particularly international economists, have allowed. But even the latter are starting to shift perspectives. Thus, a recent study covering several dozen countries over two decades found that a third of the manufacturing and natural resources industries studied showed increasing returns to scale, one-third showed constant returns, and one-third did not exhibit a clear pattern.15 The industries most highly affected by economies of scale experienced a 10 to 20 percent cost reduction with each doubling of output. These are large numbers compared with the numbers we've looked at so far. If increased openness does unlock greater scale economies in industries where they matter, then that's an added benefit that is left out of standard modeling efforts.

  The third way trade can add value is through its role in Differentiating the products or services available to buyers, thereby improving their willingness to pay. CGE models do allow goods to be differentiated in a very particular way, by country of origin; otherwise, however, they focus, like most economic models, on costs as opposed to other product attributes. But as my thesis adviser, Nobel Prize winner Michael Spence, used to tell us in graduate school, differentiation is 90 percent of what business competition is about. In this context, trade can help expand variety, improve available quality, or promote upgrading over time.16 And particularly for small countries, the very availability of a scale- sensitive product may hinge on integration with world markets. The cost of trade restrictions that lead to products being unavailable can be an order of magnitude larger than those associated with tariffs, that is, products being available at a higher cost.17

  A fourth way more openness can add value is by Intensifying competition.18 CGE models generally assume that competition within an industry is perfect: that it features many small businesses individually incapable of influencing market outcomes. Or occasionally, they allow for monopolistic competition: a slightly less perfect form of competition that involves some fixed costs, and, as a result, a large but finite number of differentiated producers, each with a limited amount of market power.19 Models of monopolistic competition have been particularly helpful in understanding intraindustry trade in variety, with different varieties produced in a few (different) locations due to fixed set-up costs but then traded internationally to satisfy within-country preferences for diversity.20 But they do not allow for concentrated industry structures featuring just a few competitors. The study of scale economies cited earlier and a lot of other research, not to mention common sense (think Toyota or Google), suggest that this is a bad idea: while not all parts of the economy are concentrated, some surely are.

  With concentrated structures, there are very few competitors, in effect, and competition may become sluggish and market performance suffer due to high prices and—this is probably even more important—greater technical inefficiency. The question here is how greater openness affects this small-numbers problem. Both economic logic and empirical evidence suggest that openness generally helps allay the problem, as discussed at greater length in chapter 5. So does practical experience. Thus, at a WTO workshop in Geneva where I presented the ADDING value scorecard, my fellow panelist, Eduardo Pérez Motta, the head of the Competition Commission of Mexico and previously its envoy to the WTO, stressed the intensification of competition as perhaps the biggest benefit of trade liberalization, especially in a country rife with cozy domestic oligopolies.21

  These arguments all focus on industry-level competition. Openness can also provide a tonic to competitive vitality in a broader sense. In closed economies, businesses and industries tend to lobby—and spend money on—securing purely pecuniary (and private) advantages from trade restrictions. Such “rent-seeking” uses up real resources but doesn't actually produce anything, and as such, represents a huge hidden cost of protectionism—and a huge benefit of openness. The classic example is Anne Krueger's estimate in the early 1970s that such pursuits may have swallowed up as much as 40 percent of Turkish GDP!22

  A fifth way openness can add value is by helping Normalize risks. Most models used to estimate the gains from opening up presuppose a risk-free world: economic agents are fully informed about future events, have access to a complete set of contingent markets, and can compute benefits and optimize across all courses of action. But to discuss issues of social welfare without taking risks into account seems, especially in the aftermath of a
crisis, more than a bit limiting.

  What my scorecard emphasizes is normalizing or balancing risks instead of simply trying to minimize them. This reflects a basic trade-off. In a world where markets are semiglobalized, diversification across national markets still washes out “unsystematic” risk, but connecting them up does create the risk of contagion. Minimizing one type of risk and ignoring the other usually doesn't make sense—even though there is a natural tendency to (over)emphasize contagion risk in the wake of a global economic crisis. I elaborate on these points and on the management of global risks in chapter 7. In addition to capital risks, chapter 7 focuses, within merchandise, on the risk-sensitive category of food grains—where market integration affords significant risk diversification benefits whereas moves to close off markets through measures such as export bans raise riskiness.

  The sixth way trade can add economic value is by helping Generate and diffuse knowledge faster. Economists have been interested in technological progress, in particular, since Nobel Prize-winner Robert Solow's landmark finding more than half a century ago that productivity gains explain more than 80 percent of U.S. economic growth.23 Standard estimates of the gains from trade liberalization have little to say about this engine of economic growth because they describe the differences between two “steady states” but don't really address changes over time.24 Conceptually, though, openness should increase incentives to innovate by expanding the market and permit quicker diffusion of innovations. In addition, given cross-country diversity, openness might add to the creativity of the innovation process, as discussed later in this chapter. And finally, there is the argument about extra competitive pressure cited earlier.