The World is Flat

Richard Baldwin The Great Convergence- Information Technology and the New Globalization

Economic globalization since the late 18^th century explained in a highly insightful and immensely readable book. Breath-taking in its theoretical ambition and its empirical richness.

At the core of Baldwin’s book is the idea that there were two different globalizations which took place since the late 19^th century. He introduces those two globalizations in the first part of his book.

A first globalization in the 19th century was triggered by the massive lowering of transportation costs through the introduction of steam power. Railroads and steamships allowed to move goods at a much faster rate and reduced costs. This first globalization caused production and consumption, which had been co-located since the beginning of humankind, to geographically un-bundle. In a global perspective, the first globalization produced urbanization and concentrations of factories in Western Europe, but deindustrialization in traditionally productive areas such as China or India. A massive divergence thus set in between the Northern and the Southern hemisphere. Temporarily set back by two world wars and the world economic crisis inbetween, globalization took up speed again after 1945. The General Agreement on Tariffs and Trade, or GATT, locked in the principles of a rules-based world trade system. Another key technological factor lowering shipping costs and hence promoting trade has been containerization. Shipping in standard-sized steel containers has become increasingly far-spread since the 1960s. It avoids the delays historically faced by the loading and unloading at ports and focuses activity at the harbors on giant cranes moving standardized boxes. 

A second globalization begun in the late 1980s and allowed for an unbundling of previously tightly integrated production processes. Firms began to offshore whole production stages across borders. The revolution in the Information and Communication Technologies (ICT) and the growing importance of air cargo were key factors in this second unbundling. Three “laws” help us understand the ICT revolution: Moore's Law indicates that computing power grows exponentially, with computer chip performance doubling every 18 months. Gilder's Law that bandwidth grow three times more rapidly than computing power, doubling every 6 months. Finally, Metcalfe's Law postulates that the usefulness of a network rises exponentially with the number of its users. In summary, ICT spread at a revolutionary speed and facilitated the second globalization. Another key factor in the second unbundling was the spread of air cargo since the mid- 1980s. While air cargo remains significantly more expensive than other means of transport, it is both speedy and reliable and thus offers international production networks certainty they can receive intermediate goods they critically depend on.

The second unbundling resulted in a shift of manufacturing, to include jobs, from the traditional industrial powerhouses, the G7, to what Baldwin calls the Industrializing 6- China, Korea, India, Indonesia, Thailand and Poland. Those 6 countries account for an increasing share of the world's GDP. Trade between the I6 and the traditional manufacturing giants, the United States, Japan and Germany has grown significantly along the lines of international production chains. At the regulatory level, the emergence of international production chains was eased by increased protection of Foreign Direct Investment, particularly through Bilateral Investment Treaties.

The second part of the book aims to provide a more in depth understanding of the drivers behind the two “unbundlings”. Baldwin's model of globalization rests on three different types of costs wich affect production processes: the costs of moving goods through trade; the costs of moving ideas through ICT; and the costs of communicating face to face by moving people. 

• The first globalization entailed a massive reduction in transportation costs, allowing for the unbundling of production and consumption. This led to the rise of long-distance trade, with nations specializing along the lines of their comparative advantages. However, somewhat paradoxically, while production and consumption became unbundled and long distance trade rose in the 19th century, production processes tended to cluster. The reason behind this can be found in the theory of the New Economic Geography: Clusters offer the advantage of scale economies and particularly faster innovation by bringing together different people working on similar problems. The types of cluster arising in one nation, in turn, determined what the nation would be exporting. 
• The second globalization, in turn, was driven by a massive reduction in ICT costs. Production processes no longer had to be concentrated in one location, but could be distributed across borders. Still, with face to face coordination remaining high, offshoring remained regionally limited, usually to places which could be reached in a day of travelling. For example, German manufactures offshored to Poland, US manufactures to Mexico, and Japanese manufacturer to China and South Korea and later Vietnam.

In Chapter 5 of his book, Baldwin attempts to answer the question what difference the second globalization made. Production processes changed fundamentally during the second globalization and became organized across borders rather than in single factories. Trade diversified away from the previously dominant trade in goods and came to include trade in components, the movement of entire production facilities and the services needed to facilitate cross border production. Another fundamental change in international manufacturing since the 1980s is described by the so-called smile curve. Production chains can be split into three different areas: pre-fabrication, to include design or finance, fabrication or the actual manufacturing activities, and post fabrication, which includes sales and marketing. The smile curve indicates that since the 1990s, the relative value added of pre- and post-fabrication services has increased. The reason behind this is the decrease in production costs associated with this second stage of production. Another consequence of the second unbundling is that in industrialized countries, blue collar workers in the middle-income range were most negatively affected by offshoring. On the contrary, workers in service industries were not affected by off-shoring, while workers in knowledge-intense professions tended to profit. Overall, it is important to realize, though, that the new globalization has more individualized and less predictable effects than the old globalization: the effect of international competition is no longer felt sector by sector, but rather production stage by production stage and sometimes even by different jobs.

In Chapter 6, Baldwin introduces four different economic theories to help him account for the second globalization (or unbundling)'s impact.

Comparative advantage: David Ricardo's theory of the comparative advantage indicates that as long there is a difference in relative prices for goods between nations, market participants stand to gain from trade. In practice, opening to trade means a rise in the prices of goods a country is good at making and hence exporting; and a fall in prices of the goods a country was less good at making and hence importing. Trade openness may result in a more efficient industrial structure, with firms attempting to merge in search of economies of scale. Ricardo’s theory also has something to say about the winners and losers of globalization and the resulting societal conflicts. On one hand, increased trade openness may pit consumers and producers against each other: imports of a certain good, say cotton, benefit consumers, as they will lower prices, but will also hurt the domestic producers of cotton. On the other hand, globalization may also put whole sectors which stand to gain from enhanced trade openness against those which stand to lose.

New Economic Geography: Baldwin introduces the logic of the “new Economic Geography” to explain firm’s location choices. Theories of this school distinguish between forces dispersing economic activity and those driving its agglomeration. Wage gaps are one major dispersion force - skill intensive industries such as the IT industry need high-education labour usually situated in high-wage nations, while the opposite holds for labor-intensive industries, such as textile.  Local competition also has a dispersive effect: firms try to settle in locations where they face less competition for their products. On the agglomeration side of things, the New Economic Geography school points to the effects of circular causality (or what economist Albert Hirschman had called backward linkages). Firms have incentives to move to places where there are already other firms, both to be near to potential consumers demanding their products or to other firms producing their intermediate inputs.

Endogenous Growth Theory: Endogenous growth theory views innovation as the primary driver of economic growth. On the contrary to physical capital, knowledge does not face diminishing returns. As has been proven since the industrial revolution, adding more knowledge will always increase growth at the almost same rate, while adding physical capital faces diminishing returns.

Supply Chain unbundling: Baldwin also introduces a theoretical model on what globalization does to the different elements of a firm’s production chain and their respective geographic locations. His idealized version of production chains distinguishes between tasks- “the full list of what must get done to make the product”, occupations- the list of tasks performed by individual workers; and stages- groups of occupations related to each other. A central challenge in managing production processes is how to deal with the coordination-specialization trade-off. Based on this framework, Baldwin argues that the massive strides in information and coordination technology since the 1980s have had a double-edged impact on production chains: on the one hand, ICT makes the coordination of various tasks easier, thus favoring worker to specialize on fewer tasks. On the other hand, ICT also makes it easier for one and the same worker to take over more tasks. In sum, the number of tasks per occupation may decrease or increase as a result of the ICT revolution. In picking geographic locations in turn, firms try to meet a trade-off between production and separation costs. Offshoring obviously reduces firm’s production costs, but it also creates separation costs: goods need to be transported, ideas transmitted and people need to travel between factories. A typical equilibrium would involve production stages requiring high skill labour being bundled in “headquarter economies”, say in the United States, and production stage requiring a lot of low wage labour being brought together in factory economies, say in Mexico. Another factor influencing firms is that coordination costs are at their highest when half a company’s production stages are offshored. Companies often delay initial offshoring decisions, but then suddenly offshore most production stages.

In Chapter 7, Baldwin ties together the story of the two unbundlings, using the theories he previously laid out. During the first globalization, which started in the late 18^th century, once growth had taken off in the Northern hemisphere, circular causality reinforced industrialization and growth in the Northern hemisphere, while the global South, to include ancient civilizations like India and China, specialized in non-industrial goods. As long as the movement of ideas remained costly, innovation-driven (“endogenous”) growth was mostly limited to the Northern hemisphere. Urbanization was also a phenomenon mostly found in the Northern hemisphere, as cities represented a good way to economize on communication costs. On the contrary, the second globalization led to Southern industrialization, or at least industrialization in those countries which participated in global production chains. The rapid decline in communication costs weakened previously existent agglomeration forces. At the same time, some countries in the global South with sufficient natural resources to sell, such as Brazil or parts of sub-Saharan Africa, did not get to industrialize but still profited from a hike in global commodity prices.

In the final part of the book, Baldwin assesses the implications of his argument about the two globalizations for developing and developed countries. A central tenet of his is that too much economic thinking and policy advice is still based on economic theories developed based on the first unbundling. Baldwin, instead, aims to offer policy advice for a world in which production processes have increasingly become unbundled.

For economically advanced nations, Baldwin recommends governments to focus their competitiveness policy on promoting production factors which combine low international mobility, so that a country can have an actual advantage from investing in that factor, and a positive spill-over, so that an increase in the production factor translates in higher economic growth. Such production factors include highly-skilled labour, tacit knowledge which is difficult to codify, and social capital. Industrial policy should no longer focus on promoting manufacturing per se, but rather manufacturing-related service jobs which provide the highest added value. Also, governments should promote cities, as they are the right place for innovation driven by the clustering of high-skill labor. Rather than attempting to preserve specific jobs, social policy should concentrate on helping individual workers adjust. As for trade policy, the emphasis will need to shift from helping companies sell goods abroad to supporting global value chains. Possible measure include protecting companies’ intellectual property and supporting the connectivity of production facilities spread over different countries.

In Chapter 9, Baldwin discusses how developing nations can adjust their policies to the second unbundling. Traditional development policies aimed at a “big push” in order to move countries out of an agricultural equilibrium into an industrial one. Often with the help of import substitution policies, nations then aimed to climb up value chain by developing whole industrial sectors, from at first manufacturing non-durable consumer goods (e.g. clothes), to durable and intermediate goods, (e.g. cars) and (e.g. car engines). Whole regions like East Asia could be climbing up this value chain together, a phenomenon described by the so-called flying geese paradigm. On the contrary, development policy after the second unbundling should no longer prescribe that a developing country would have to promote whole industrial sectors. What counts instead is participation in global production chains. Rather than championing a national car industries, countries could instead focus on participating in certain, particularly labour-intensive stages of car production. Developing countries could enhance their competiveness by protecting the intellectual property of potential investors and by assuring that cross-border flows between countries can be kept open.

In his concluding thoughts, Baldwin outlines factors which could decisively change the world economy in coming years: a change in trade costs, for instance through rising protectionism; further changes in the costs of moving ideas enabled by ICT; and a change in the costs of moving people. A most likely scenario for a third globalization would be if the costs for face-to-face interaction, traditionally high due to high costs for moving people, plummeted massively. Telepresencetechnology could become a key enabler for even further separating the separation of production processes.

Overall, an absolutely fascinating read. Easy to read, the book still helped me better understand the development of the world economy, particularly since the 1980s. The only minor criticism is possibly that Baldwin’s model of globalization may be overtly focused on technology. While difficult to assess in its relative importance, politics may be as much of a factor in determining the costs of the movement of people, goods and ideas. The pax Brittanica may have had an important effect on the first globalization in the 18^th and 19^th century; the rise of populist protectionism in the Trump era may be massively harmful to multinational companies operating global production chains.