Factors Driving Global Economic Integration

IMF News, August 25, 2000

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Published: August 25, 2000

Overview and central thesis

Global economic integration has trended upward over centuries through trade, factor movements, and communication of knowledge and technology, with particularly rapid acceleration during the past half century.
Three fundamental, interacting drivers of economic integration:
- Improvements in transportation and communication technology (reducing natural barriers).
- Changing tastes that favor the benefits of integration.
- Public policies that shape the pace and character of integration (reducing or increasing artificial barriers).

Human migration

Historical role:
- Migration was the predominant mechanism of interaction for most of human history.
- Evidence from DNA: all modern humans descended from common pre-human ancestors in Africa roughly one million years ago.
- Major prehistoric migrations include the settlement of Eurasia and the crossing into the Americas roughly ten thousand years ago.
Modern patterns and drivers:
- Mass migrations driven by wars and turmoil are distinct from economic-motive family/individual migration, though overlap exists.
- U.S. immigration surge: greatest from end of the Civil War to start of World War I, especially early 1900s (see Charts 1 and 2).
- Transportation cost and risk declines (19th–20th century steamships; by 1907 passage cost down to a couple of months’ wages) reduced deterrents and enabled back-and-forth migration.
- Since World War I, pace of immigration to the U.S. slowed because:
- Income differentials narrowed for Europe-to-U.S. migration.
- Public policy restrictions became decisive (Chinese Exclusion Act of 1882; National Origins Act of 1924).
Policy implication:
- Public policies are often responsive to tastes and technology; migration policy materially shapes migration flows.

Trade in goods and services

Theory and limits:
- Hecksher-Ohlin-Samuelson view: trade in outputs can substitute for factor mobility under restrictive conditions; in practice barriers to trade (natural and artificial) prevent full factor price equalization.
Historical evolution:
- Ocean-going sailing vessels (late 15th century) expanded horizons but high transportation costs persisted well into the 1800s.
- Steam-powered iron ships (second half of 19th century): shipping cost across the Atlantic probably less than one-fifth of what it had been at the start of the century.
- Interwar period: collapse in world trade amplified by increased tariffs, notably U.S. Smoot-Hawley tariff of 1930.
Postwar era (past five decades):
- Real world GDP rose at somewhat more than a 4 percent annual rate; developing countries grew in per capita terms at about the same pace as industrial countries.
- Real living standards (real per capita GDP) improved on average about three-fold in just half a century.
- Volume of world trade in goods and services rose from barely one-tenth of world GDP in 1950 to about one-third of world GDP in 2000.
- Trade expanded at nearly double the pace of world real GDP over the postwar era.
Drivers of postwar trade integration:
- Dramatic reductions in artificial barriers (tariffs, quotas) and substantial reductions in natural barriers (transportation/communication).
- Examples of transport and communication improvements:
- Air cargo emerged as a major factor in the past fifty years for time-sensitive goods.
- Ocean shipping costs have fallen substantially (perhaps by a factor of four or five); supertankers and containerization expanded scale without crew increases.
- Communications costs for voice, text, and data have dropped enormously, greatly affecting trade in services.
Quantitative thought experiment (back-of-envelope):
- If effective average trade barriers fell from 35 percent to 5 percent for the United States, standard trade elasticities suggest imports would rise by roughly 2 percent of U.S. GDP — much smaller than the actual U.S. import share rise from under 5 percent in 1950 to nearly 15 percent in 2000.
- Accounting for global, mutually reinforcing barrier reductions could plausibly explain a doubling in world trade relative to world GDP (imports from 6 percent to 12 percent; combined imports and exports from 12 percent to 24 percent). Actual world trade shares rose by a tripling.
Structural note:
- Extent of trade relative to GDP today is, by some measures, not much greater than a century ago, but sectoral composition shifted: around 1900 roughly two-thirds of GDP was goods-producing; by late 20th century roughly two-thirds was services, implying greater goods trade relative to goods output today.
Forward-looking observations:
- Further absolute reductions in transportation costs are constrained (costs cannot go negative); proportional pace of reduction likely slows.
- Communications technology still undergoing rapid revolutions — large continued impacts expected, especially for services.
- Policy agenda:
- Industrial countries should address remaining hard cases (especially agriculture) and restrictions on services trade.
- Developing countries should reduce remaining import restrictions and seek reductions by industrial countries on products where developing countries have comparative advantage.

International capital movements and financial services integration

Past assessments (Mussa and Goldstein, 1993) affirmed growing integration, especially for high-grade wholesale instruments and partial progress for developing countries.
Recent developments and lessons:
- Wholesale financial markets and high-grade instruments have become more tightly linked among industrial countries; EMU eliminated exchange rate fluctuations among participating countries and reduced interest rate spreads and volatility.
- Japan experienced a spike in a “Japan premium” on international borrowing during 1997–98; government recapitalization and restructuring reduced the premium but some Japanese banks scaled back international activity.
- Emerging market linkages became visible in crises: tequila crisis (1995); Asian/Russian/LTCM/Brazilian crises (1997–99) — massive gross private capital flows to emerging markets preceded crises; flows dropped precipitously and spreads spiked with crisis onset (see Chart 5).
Policy lessons on exchange regimes and capital flows:
- For countries highly open to private international capital flows, operating a pegged exchange rate requires demanding supporting policies (monetary, fiscal, well-regulated banking).
- Experience: pegged exchange rates with open capital accounts proved unsustainable in several crises (Mexico, Thailand, Malaysia, Indonesia, Korea, Russia, Brazil), whereas some countries with strong commitments (Argentina, Hong Kong) maintained regimes.
- Flexible exchange rates generally provided better shelter for some emerging markets (Singapore, Taiwan Province of China, South Africa, Mexico post-1995).
- Maintaining some restrictions on private capital flows may be desirable for countries with weak financial systems; sudden imposition of controls in crisis differs from maintaining controls preexistingly.
Composition and resiliency of capital flows:
- Shift away from bank loans toward bonds, equities, and FDI suggests enhanced flexibility and resiliency; FDI flows to developing countries expanded and proved relatively stable in crises (see Chart 6).
- However, the resilience claim for portfolio flows is premature; international financial system problems persisted in the late 1990s.
- Domestic debt market development in emerging markets and recovery of net portfolio equity flows are positive signs.
Market discipline and information:
- Two conditions to improve discipline: full disclosure of debtor obligations (including off-balance sheet), greater transparency and accounting harmonization; and reducing perceptions of bailouts that blunt market incentives.
- Policy recommendation: accompany liberalization with strengthened supervisory frameworks and upgraded risk management, not attempts to halt liberalization.
Financial services globalization and technology:
- Rapid advances in information and communications technology are reducing costs of producing and distributing financial services by factors of two or more within two-year periods.
- Domestic financial sector boundaries (commercial banks, investment banks, insurers) are blurring; international consolidation and broader geographic scope of providers are accelerating.
- Examples:
- Dramatic fall in costs of stock exchange transactions; explosion of transaction volumes and retail investors.
- Rising bank transaction volumes relative to nominal GDP.
- Public policy largely facilitating these trends (e.g., U.S. Gramm-Leach-Bliley Act, EU directives, EMU incentives, liberalization in emerging markets).
Worry and caveat:
- Persuasive evidence linking openness in capital flows (especially portfolio flows) to stronger growth is less robust than for trade openness.
- High openness to short-term capital can be dangerous for countries with weak macro fundamentals or fragile financial systems; prudent sequencing, regulatory strengthening, and supervisory upgrades are essential.

The particular importance of communications and technology diffusion

Communication as a channel of integration:
- Not necessary to physically move goods to spread innovation — transmitting concepts and know-how suffices to drive adoption (noodles example).
- Advances in communications (printing historically, modern digital communications now) dramatically increase the reach and durability of ideas and innovations.
Implications:
- Rapid declines in communication costs are a profound force for global integration and for accelerating innovation diffusion across sectors, most visibly in financial services but broadly applicable.
- Keeping channels of communication reasonably open may be as critical as trading volumes for spreading useful innovations.

Risk of reversal: lessons from the interwar period

Interwar reversal:
- Sharp contraction of world trade during the interwar period, especially early 1930s (Contraction of World Trade, 1929–33), exceeded the decline in economic activity.
- Contributing factors: Great Depression, massive protectionism (Smoot-Hawley tariff of 1930 and retaliations), collapse of the international gold standard, capital controls and rising nationalism/isolationism.
- Change in tastes and political attitudes played a central role (U.S. isolationism, National Origins Act, broader anti-foreign sentiment).
Contemporary risk assessment:
- Globalization has detractors (e.g., Seattle protests), but conditions are judged not ripe for a broad return to isolationism.
- Postwar prosperity under policies favoring integration, and desire of currently less-integrated countries to join global systems, reduce probability of a repeat interwar-style reversal.
Policy takeaways:
- Political economy and public sentiment matter; maintaining public support for integration requires addressing distributional concerns and managing adjustment costs.

The end of empire and voluntary integration

Historical shift:
- Pre-20th century empires channeled much integration within imperial domains; by the end of the 20th century most empires had dissolved.
- Trade and capital flows that were once empire-directed now occur more diversifiedly across global partners (e.g., Britain’s trade shifted from colonies to European rivals; transition countries shifted trade away from the former Soviet bloc toward the rest of the world).
Reasons empires declined:
- Change in public policy and tastes (revulsion at war, oppression).
- Technological changes that made imperialism an inefficient means to improve welfare; domestic development through investment became a more attractive path.
Outcome:
- Global economic integration is increasingly voluntary — driven by technology, tastes, and mutually beneficial incentives rather than conquest.
- This voluntary nature provides reasonable assurance that fundamental forces driving integration will contribute to global economic improvement, absent policy backsliding.

Key policy recommendations and implications (summary bullets)

Continue to liberalize remaining barriers to trade, focusing on:
- Agricultural protection in industrial countries.
- Restrictions on trade in services enabled by communications advances.
For capital account liberalization:
- Sequence liberalization with strengthened macroeconomic policy frameworks and well-capitalized, regulated financial systems.
- Improve transparency, off-balance sheet reporting, accounting harmonization, and prompt loss disclosure to enhance market discipline.
- Avoid creating moral hazard via perceived bailouts; ensure credible frameworks for crisis management.
Strengthen supervisory and regulatory frameworks to accompany financial innovation and cross-border financial services globalization.
Invest in communications and transportation infrastructure in developing countries to reap further integration benefits.
Address political economy and distributional consequences of integration to sustain public support and reduce risks of protectionist reversals.

Italicized source attribution: Factors Driving Global Economic Integration — by Michael Mussa, Economic Counselor and Director of Research, IMF; Presented in Jackson Hole, Wyoming at a symposium sponsored by the Federal Reserve Bank of Kansas City on “Global Opportunities and Challenges,” August 25, 2000.

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