Understanding globalisation and economic development

Let us first appreciate some impressive facts about global economic trends since the early nineteenth century (from Angus Maddison, OECD). World GDP grew 40-fold between 1820-1992 with a corresponding 8-fold growth in income level per person (but with divergent regional trends). The volume of global trade increased by a breathtaking 540-fold. In 1820 the income spread between the richest and the poorest regions, Western Europe and Africa, was 1:3. This inequality widened steadily to 1:16 by 1992 suggesting we are collectively worse off than ever in terms of income distribution.

In fact, these are the best of times. The increasing divergence between the richest and the poorest nations evokes a sense of despair, but even the poorest nations are on average better off. Per capita income in Bangladesh has increased by over 250 percent in the last two decades. Bangladesh's human development indicators exhibit equally impressive gains. It is therefore amusing to hear the frequent claim that the quality of life was better in past generations. In raw economic development terms this is clearly not the case for the typical Bangladeshi.

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How do we then link globalisation to economic development? Globalisation refers to the increased interconnectedness of nation states through networks of trade, travel and communication. Some basic economic theory (primarily related to trade and capital flows) can explain how global integration affects economic performance. There are essentially two types of economic effects. The first is a one-time effect on welfare that results from moving from a closed economy to a relatively open economy. The second is the effect on long-term growth performance -- a permanent change in the rate of growth following greater openness. We deal with each of these in turn.

Overall economic well-being increases with greater openness to trade simply by increasing the total production of goods and services available for consumption. Economists recognise there may be welfare losses for some individuals due to market-dictated changes in income distribution. Even in the scenario with economic losers, it is theoretically possible to make everyone better off by some policy-induced form of income redistribution. In reality this is not easily practicable. But greater openness can only explain an increase in intra-country income disparity; it does not explain the increase in differences in income levels between the rich and the poor regions of the world. So how does trade affect economic growth? Is the effect different for rich and poor countries?

The safest answer to almost any question in economics is "it depends." This is true for the question "is free trade good for growth?" Independent of the choice of growth model and empirical evidence (no single growth model is universally accepted by economists), there is reasonable agreement that technology is a significant determinant of growth. Therefore, to the extent that globalisation facilitates the exchange of knowledge, capital (through foreign direct and portfolio investments), and labour, it also increases the transfer of the associated technologies relevant for increasing productivity. This extends to technologies in medicine, agriculture and nutrition, which increase lifetime human cognitive potential. But what does the empirical evidence suggest?

There is a vast extent of research literature that affirms a positive relationship between trade-inducing policies and economic growth. Notable authors that proffer such evidence include Jeffrey Sachs (Columbia University), Jeffrey Frankel (Harvard University) and David Romer (University of Maryland). The IMF and OECD unequivocally endorse global integration as a necessary condition for economic growth and convergence -- the process by which poor countries close the gap between themselves and richer countries. However, the direction of causality remains unresolved: Does growth result in conditions conducive to increased trade? Or do policy-induced increases in trade engender more rapid economic growth? Dani Rodrik (Harvard University) and others argue that methodological problems leave the results "open to diverse interpretations." Many related questions simply remain unanswered, but it is clear that openness to trade has been relatively favourable to countries that were relatively wealthy to begin with; hence the widening gap between the rich and the poor nations. Again, this does not mean that poor countries were necessarily hurt by integration.

In 2003 the McKinsey Global Institute analysed the effect of multinational companies (MNCs) on productivity in multiple industries in four large developing countries (Brazil, Mexico China, and India). In almost all cases, investments in developing countries by multinational companies fostered innovation and productivity increases. Therefore, barriers to foreign investment and trade can create a competitive disadvantage for industry in developing nations. On the other hand, targeted incentives, by creating distortions, rarely have a positive effect and often create harmful unintended consequences. The policy implication is that "governments can more effectively grow MNC investments by putting the basic building blocks of productivity in place, through strengthened power, transportation, and legal infrastructures, and the enactment and enforcement of clear and consistent official policies."

In a gloomier account, globalisation may be linked to increased turmoil in the financial markets of developing countries. The third generation model of currency crises (Paul Krugman) is partly attributable to contagion -- the phenomenon where crises in one country set off a similar crisis in another. Contagion has increased with greater integration of financial markets. The frequency and severity of such financial crises increased particularly during the turbo-charged period of globalisation that began in the early 1990s. Mexico (1995), Southeast Asia (1997), Russia (1998), Brazil (1998), Turkey (2000, 2001), and Argentina (2001) have all experienced crises stemming from high levels of external indebtedness and sharp reversals in capital flows. These characteristics are directly attributable to the tighter integration of financial markets. Many proponents of globalisation would argue that the problem does not lie in globalisation, but in the absence of an international financial architecture that mitigates the effects of such crises.

The lesson for policymakers in countries like Bangladesh is that trade policy should not form the basis of an overall growth and development strategy. A country's development strategy must be constructed around country-specific characteristics in a manner that efficaciously manages the trends associated with globalisation; this does not necessarily dictate greater economic integration through increased trade and capital flows. Two shining examples of countries that benefited from conscious efforts to restrain the forces of integration are Chile (following its stabilisation plan in the 1970s) and Malaysia (following the Asian Crisis), countries that instituted draconian capital controls. Globalisation is an inescapable reality that offers choices for national economic policies; these polices must be made consistent within a framework of principles that appreciate individual country characteristics. If policymakers are able to maintain these perspectives, the best of times are indeed ahead of us.

Nehad Chowdhury is a Harvard-trained economist. Experienced as an economist with Goldman Sachs, the Central Bank of the Republic of Turkey and the World Bank, he was most recently an Associate with McKinsey & Company.