Speech

Lecture delivered by Anne O. Krueger, First Deputy Managing Director, International Monetary Fund
at the Kiel Institute, May 11, 2006

Good afternoon. I am very pleased to be able to be here today. We've already heard well-deserved tributes to Herbert Giersch from Professors Bhagwati and Schlesinger. But let me add my own tribute to a man I am proud to call both a friend and colleague.

Herbert Giersch has been a towering figure among economists. His prescient understanding of the role of markets and his recognition of the importance of an analytical framework and evidence-based analysis in policy formulation has had an enormous impact within the profession and on policymaking. His advocacy of sound economic policies was influential both in Germany and around the world. And his leadership of the Kiel Institute made it world-class and world-renowned. It is a great honor for me to have been invited to speak on such a special day.

The topic for this symposium, and for this lecture, is--as one might expect--both important and timely, and relevant to Giersch's work. Locational competition--the competition for economic activity--has important policy implications of the kind that Herbert Giersch has spent his life addressing. As globalization has made the world economy more closely integrated, even small changes in the relative costs of doing business can induce producers to change location. Locational competition affects a higher and higher proportion of total economic activity at greater and greater distances.

For most of history, most people have had to obtain most of their goods and services from a relatively small geographical area close to home. Locational competition had little relevance for most activities. With few exceptions, most long-distance trade was low-volume and high value-added. The high costs of transport insulated most activities from competition from those at distant locations.

Over time the costs of trade have fallen dramatically. As these costs have fallen, trade has grown and the expansion of world trade has, in turn, driven global economic growth. Since World War II, the growth of world trade and world output has been unprecedented. Millions of people around the world have seen their living standards rise to levels-and at a pace-once undreamed of. Hundreds of millions of people have escaped poverty.

I want to argue today that four factors pushed down the costs of trade over long distances and between countries and that the relative importance of these has shifted over time. At first, developments in transport and the consequent rapid fall in transport costs dramatically lowered the costs of getting goods to market and made more output "tradable". Then technological developments such as the telegraph and telephone helped lower the transactions costs of international trade in the late 19^th and early 20^th centuries by enabling quicker and lower-cost communication between buyers and sellers. In the late 1940s, transport costs were only about 25 percent of the value of exports on average and therafter the dramatic reductions in tariffs and non-tariff barriers were much more significant in lowering trade costs and fuelling trade growth. As the costs of trade were lowered, a higher and higher fraction of output faced competition from afar, and locational competition affected a higher proportion of economic activity.

Transport costs have continued to fall, of course; as have transactions costs as a result of modern telecommunications technology. And further multilateral trade liberalization has contributed to a further reduction in the costs of trade. But of increasing importance are policy-imposed costs that were earlier small relative to transport and transactions costs and which therefore had a less significant impact on locational decisions. As transport and transactions costs account for a smaller and smaller proportion of total trading costs, relative to the costs of production; and as tariff levels have continued to fall, the domestic policy environment assumes greater significance. Whether a country has achieved macroeconomic stability, whether it has an effective commercial code, the costs of labor and business regulation: all influence where firms decide to locate in the modern global economy that gives them more choice and fewer restrictions than ever before.

Transport and technology

Until the 19^th century, transport costs had discouraged all but high-value, low-volume trade. For most commodities, transport costs exceeded the price of goods in the country of origin. But transport costs fell dramatically from the early 19^th century. Douglass North cites evidence that by 1850 ocean shipping costs were only about a third of what they had been just thirty years earlier--even though shipping under sail was still the order of the day. These declines continued, as shipping technology advanced rapidly: ocean freight rates fell by 70 per cent between 1840 and 1910. Railroad freight and other transport costs also fell.

O'Rourke and Williamson describe the decline in transport costs as "amazing": they produce data implying that costs between the US and Europe fell from about 80 percent of the price of the commodity to less than 20 percent during the second half of 19^th century.

Other technological developments also cut transactions costs associated with international trade. The development of the telegraph and the telephone, for example, made it easier to place and track orders over long distances. Getting goods to market between countries became much easier and more predictable. The cost of financial transactions also fell.

The 19^th century reductions in transport and other trade costs fuelled rapid growth in world trade--it grew on average by 3.4 percent a year between 1870 and 1914, with growth in trade in both industrial goods and raw materials. As trade grew, so did output and incomes. In the United States, the last decades of the 19^th century were described as the "gilded age", as per capita incomes are estimated to have doubled between l870 and l900. The late Victorian era was likewise regarded as a boom period in Europe as European per capita incomes and wage rates rose at even faster rates, albeit from a lower base.

The First World War and its aftermath brought an abrupt halt to the remarkable trade expansion of the late 19^th century. Although transport costs had fallen sharply other factors that restrict trade--tariff and non-tariff barriers--increased in importance. The Great Depression and the beggar-thy-neighbor protectionist policies of the 1930s resulted in an unprecedented collapse of world prices and world trade. In the United States, the Smoot-Hawley Tariff Act of 1930 ensured that by 1932 average American tariffs were 59 percent--the highest level since the 1830s. As countries competed to raise tariff and trade barriers and devalue their currencies, they prolonged the slump in global trading activity. The gold value of global trade fell by 63 percent between 1929 and 1932.

The Second World War further disrupted output and trade patterns, but as planning for the postwar era began during the latter years of the war the architects of the postwar framework were determined to avoid the mistakes of the 1930s. They were agreed that a multilateral framework would be needed to provide the international financial stability necessary to permit the expansion of trade and output: this led to the establishment of the Bretton Woods institutions, the International Monetary Fund and the World Bank. But the postwar planners also recognized that an open international trading system would be a vital pre-requisite for rapid world trade growth and the General Agreement on Tariffs and Trade was signed in 1947.

Trade growth in the postwar period

Those prescient planners were more right than they knew at the time. There were still benefits to be had from further reductions in transport and other transactions costs of trade and at the end of the Second World War it still took most people several days to cross the Atlantic, for example. But tariffs and other non-tariff barriers imposed greater costs than transport for most manufacturers and much other economic activity. It is estimated that in 1947 the average tariff on manufactures in the industrial countries was over 40 percent compared to the 25 percent transport costs already mentioned. Lowering trade barriers therefore made possible further dramatic reductions in the costs of trading goods over long distances. The progressive liberalization of trade--the dismantling of quantitative restrictions and reductions in tariffs among the industrial countries--fuelled a period of trade expansion and output growth that eclipsed the growth rates of the late 19^th century and which was spread across the globe.

The first round negotiated tariff reductions took place under the auspices of GATT in 1947, when, as I said, average tariffs on manufactured goods among industrial countries were over 40 percent. By the late 1990s, they had been lowered to less than 5 percent. According to the WTO, the volume of world trade was 22 times higher in 2000 than it had been in 1950. World trade has expanded even more rapidly than global GDP--and world output has risen at unprecedented rates over the past half century or more.

Merchandise exports have grown by an average of 6 percent a year for the past fifty years. World trade has grown from 10 percent of world GDP in 1960 to almost triple that level in 2005. If trade in services is added to trade in goods, the rise is even more dramatic. Indeed, trade in services was so small that it was not even separately estimated in the early postwar years; it is now more than one quarter of trade in goods and growing more rapidly.

In addition to the benefits derived from tariff reductions, technological advances continued apace in the twentieth century. Containerization transformed the shipping industry: Michael McLean, the shipping magnate who invented containers, calculated that in 1956 loading loose cargo cost $5.83 per ton. That same year, his first container ship cost less than 16 cents a ton to load. Containerization has also greatly lowered the cost differentials related to distance and it has greatly increased the speed with which exports can reach markets.

And air freight assumed an increasingly important role in global trade, as costs fell. In 1965, only 6 percent of US imports and 8 percent of exports by value were carried by air: within three decades those figures had risen to 22 percent and 29 percent respectively. The cost of air freighting goods as a proportion of their value fell by almost 3.5 percent a year between 1973 and 1993.

But the drop in transport costs has been so large, and their share of the cost of goods is now so small, that by definition further cost reductions can only have a small impact on end-costs.

Transactions costs have plummeted too. In 2001, two economists from the Federal Reserve Bank of Chicago noted that in constant 1998 prices the cost of a three minute phone call from New York to London had been $293 in 1931 and had by 2001 fallen to around $1 for a much better quality connection. In 2006 that same call costs just a few cents. The internet and other telecommunications advances have furthered lowered the costs of financial transactions. They have made it easier for firms to communicate with and understand even far-distant markets and they have made it cheaper for goods and, increasingly, services to be moved around the globe.

Falling transport costs and advances in technology have resulted in many more goods and services being tradable and have enabled the "chopping up" of the value added chain. It is now relatively cheap to spread the manufacturing process across several countries and to produce each component in the cheapest location. Goods are more easily and more cheaply shipped than ever before. Modern telecommunications technology, with the reduced cost of that technology, enables firms to track both the manufacturing process and product shipments. It is also easier for firms to trade with each other, and spread ownership of the manufacturing process.

The result has been a sharp rise in the shipment of components. Alexander Yeats has shown the very large increase in trade in parts and components-a roughly fivefold increase in the value of such exports from the OECD countries between 1978 and 1995. Borga and Zeile have estimated that exports of US parent companies to their foreign affiliates for further processing increased from 8.5% of total U.S. exports of goods in 1966 to 14.7% in 1999.

Technological developments have made it possible to outsource services as well. Indeed, the reductions in telecommunications costs have benefited services more because they account for a larger element of total costs. A study by McKinsey last year estimated that the offshoring of services to emerging markets will have averaged annual growth of 30 percent between 2003 and 2008, taking the offshoring share of total services trade from 3 per cent to 10 percent.

There are plenty of examples of the intense competition for the location of manufacturing sites in the late 20^th century. European countries and, later, American states, worked hard to attract Japanese car manufacturers. Later, southeastern states in the US competed for European car plants. Asian countries have successfully competed for microchip production. And Ireland has been remarkably successful both as a location for electronics manufacturing in the 1990s and, more recently, as a major center for the provision of offshore services. Indeed, Ireland and India are the current world leaders in the provision of offshore services. McKinsey estimates that even in 2003, Irish offshore services exports amounted to around $8.5 billion, with Indian offshore services exports in excess of $12 billion.

New determinants of economic activity

The extent of the reductions in trade costs resulting from falling transport and transactions costs and the lowering of trade barriers inevitably diminishes their role in reducing trade costs in the future. There are continuing gains to be had from the further liberalization of trade and I want to return to this. But in addition to inherent comparative advantage, domestic economic policies are playing an increasing part in determining the costs of economic activity and, in consequence, affecting the decisions about where such activity is located.

The new competitive environment

In 1981, David Morawetz produced a ground-breaking study providing important insights into some of the new factors that determined the location of economic activity. He chose as his example Colombia's weak performance in clothing exports in the 1970s compared with several Asian countries.

Morawetz pointed out that in the 1970s, Hong Kong, Korea and Taiwan, province of China, had a total population equal to only one quarter of that of Latin America: yet each exported as many goods as the whole of Latin America. Clothing exports from these three Asian economies were almost equal to the total of Latin American manufacturing exports. Yet Morawetz pointed out that only a decade earlier, Korea and Taiwan province of China had together exported less clothing that did Colombia alone in the mid 1970s. In other words, the Asian economies had achieved spectacular growth in exports compared to Latin America.

Morawetz analyzed why Colombian clothing exports had risen sharply in the mid 1970s and then tailed off. Some factors he categorized as cultural. But many he ascribed to domestic economic policies that affected the ability of Colombian clothing exporters to succeed. A crucial factor was the high price of inputs for Colombian exporters which put them at a major competitive disadvantage. Domestic textile manufacturers enjoyed substantial import protection enabling them to charge clothing firms prices well above the prevailing world market price for textiles. Poor labor productivity in Colombia also meant that clothing firms did not benefit from wage rates that were lower than in Asia because total unit costs were higher. And because Colombian firms relied heavily on their domestic consumers they were less attuned to the quality control and punctuality requirements of more demanding export markets.

The factors Morawetz identified carry increasing weight in today's more competitive global market. Buyers have a much wider range of competing suppliers, and modern technology and transport systems mean they can switch suppliers much more quickly; and suppliers can switch location more rapidly. Firms need to be able to compete on price and to meet the demands of sophisticated consumers who want cheaper, better quality goods and more variety. Broda and Weinstein have estimated, for example, that the US imports 4 times as many varieties of goods in 2002 as it did 30 years ago.

Domestic economic policies are increasingly important in determining the location of economic activity. The McKinsey study I mentioned earlier noted that the sharp rise in outsourcing activity owes much to the perception of a reduced risk of operating in developing countries. In part, at least, this must be a result of the progress made in achieving macroeconomic stability in many developing countries and which has led to significant drops in inflation. As recently as the 1990s, inflation rates in developing countries averaged 80 percent: in the last 5 years the average rate has been only 6 percent, and the IMF is projecting a further fall in developing country inflation, to 5 percent next year.

But it is not just what we traditionally regarded as macroeconomic policies that are important. In a world of highly mobile capital, a range of other factors now influence those making decisions about the location of economic activity. A sound institutional and legal framework is vital: firms want to invest in countries that have well-functioning public institutions, where strong efforts are made to combat corruption, where there is an effective independent judiciary and where property rights are respected and contracts easily enforceable. The costs of domestic transport and communications are also crucial. And cumbersome red tape is a strong disincentive for some locations.

Each year, the World Bank publishes a guide called Doing Business which ranks the performances of most countries on a range of indicators. The differences among countries set out in the 2006 edition are striking. Just a few examples give both a sense of the variation and the disincentive effects of undesirable economic policies. Take the costs of establishing a new business: cumbersome procedures raise the cost of starting a business and can be an important influence on firms' choice of location. Here in Germany, the World Bank reports, it requires 9 procedures and takes 24 days to set up a new business. In Venezuela 13 procedures are involved, and the process takes 116 days. In Mozambique it is 14 procedures and 153 days.

An effective, user-friendly commercial code is also important. If firms cannot be sure that they can enforce contracts and collect debts, for example, they are likely to be leery of conducting business in a country. To enforce a contract in Germany it takes 26 procedures and 175 days, and the cost averages about 10 percent of the debt involved. In Denmark, it is even easier, and cheaper: only 15 procedures and 83 days, and costs about 5 percent of the debt being collected. But in Guatemala it takes 37 procedures and 1459 days and in Italy it takes 1390 days; and in Indonesia, Malawi and elsewhere the costs involved are significantly greater than the original debt. That makes doing business in these countries riskier and costlier than elsewhere and is a locational disadvantage.

The smaller the impact factors such as distance and international transport costs have, the greater is the incentive for firms to choose carefully on issues such as these.

The same is even more true for labor market regulation, or the sophistication of domestic financial systems. Again, Doing Business 2006 is packed with information that vividly illustrates this. The economic evidence is clear. Labor market rigidities raise the cost of hiring workers and act as a disincentive to firms. If a firm cannot lay off employees in a downturn, they will be reluctant to hire them in the first place and are more likely to look elsewhere when planning to increase output or build a new plant.

The World Bank has constructed several indicators measuring labor market flexibility. In New Zealand, for instance, there is no cost to the employer in laying someone off; nor is there in the United States. Here in Germany it costs 67 weeks of salary to fire someone. But in Ecuador it costs 131 weeks of salary and in Sierra Leone the cost is 188 weeks of salary.

Doing Business doesn't just rank countries: it highlights where improvements are being made. The 2006 edition, for example, identifies 25 countries that during 2004 improved the way credit information is shared: such information is a crucial part of an effective and well-managed system for lending according to risks and returns and cutting business costs. 31 countries eased business entry in 2004, with significant progress being made in some parts of Latin America. And Germany was the top reformer in 2004 in the field of labor market regulation. All this is evidence of two things: first, the growing recognition in many countries that the appropriate policy framework is a key tool for success in the competition for economic activity; and second, the playing field is not staying level--as some countries improve their policies, the competitive pressure switches to others who are falling behind.

Of course, as I implied earlier, the increasing focus on these "new" influences on locational competition should not mean we lose sight of those factors contributing to trade growth that have delivered so much in the past. In particular, there is scope to do more to liberalize global trade. In some areas, tariffs could be lowered further; market access could be improved; and export subsidies reduced or eliminated. In both agriculture and services there is the great opportunity for further liberalization, although many developing countries could significantly lower their tariff rates on manufactured goods and the industrial country could lower their tariff peaks on manufactures.

These are all issues on the agenda for the Doha Round of trade negotiations and the potential gains from a successful outcome are enormous. A significant lowering of barriers to agricultural and services trade, and further liberalization of trade in manufactures, could provide a boost to world trade and, in turn, global growth. And the developing countries would gain most from a successful Doha outcome. Of course, they would benefit from increased access to industrial country markets and the reduction of agricultural subsidies in the industrial countries. But by far the biggest gains for developing countries would result from a lowering of trade barriers among themselves. The World Bank estimates that around two thirds of all the gains from a good Doha agreement would go to developing countries--and those gains could run into hundreds of billions of dollars over a ten year period.

A Doha agreement would greatly strengthen the global trading system. Even more important, a failure would weaken it and give encouragements to protectionists who mistakenly believe that economies gain from erecting trade barriers against other countries. Without a Doha agreement global growth would be slower; and the world economy could be less resilient in the face of shocks. This in turn could have a negative impact on the other determinants of economic activity and its location, to the detriment of all.

Conclusion

Let me briefly conclude. As Herbert Giersch was the first to note, locational competition has existed since man was able to travel from one place to another. But for thousands of years, technological limitations and the cost of transport ensured that such competition was relatively limited and affected only a small range of goods. As man has progressed, however, more and more economic activity has become tradable and the world economy is increasingly integrated, with great benefits.

The recent era of globalization has had a dramatic impact. From the 19^th century onwards, advances in the speed of transportation and transactions and the simultaneous reduction in transport costs have spurred the growth of trade. The liberalization of international trade from the late 1940s led to an unprecedented expansion in world trade and output. A more liberal trading system accompanied by technological advances made possible the very rapid growth of trade, unprecedented growth rates of output and rising living standards.

As locational competition has intensified, domestic economic policies have increasingly come into play. Economic policies--including what were traditionally thought of as microeconomic policies--can be critical in the competition for economic activity. To benefit from accelerated growth and higher living standards that technology and trade liberalization have made possible, economies must integrate with the world economy. They must pursue macroeconomic stability and establish institutional and regulatory frameworks that facilitate and encourage business investment.

The history of the past sixty years has shown what enormous benefits globalization can bring. More people in more countries are better off than ever before. The rapid growth of global trade and output that falling trade costs made possible have enabled most countries to raise living standards and dramatically reduce poverty.

Falling trade costs help ensure that the benefits of globalization can be available for all and the growth of world GDP sustained. Yes, challenges remain: a satisfactory outcome to the Doha Round is vital. Many countries need to press on with domestic reforms to enable them to take full advantage of the more competitive environment for the location of activity. But as history has shown, the potential gains are huge. This is not a zero sum game, as Professor Giersch taught us. Globalization means that armed with the appropriate policies all countries can be winners.

Thank you.