New Year's Essay 2010 - For Roland Berger - By Pankaj Ghemawat
Max Renkel - Untitled - 2008 - The Roland Berger Art Collection
Markets and globalization: Chicago, Harvard and the way forward
The financial meltdown and other recent upheavals in global markets have raised questions not only about the efficiency of markets, but about globalization as well. Anti-globalizers have sounded the death knell for what they view as exaggerated faith in financial integration, while pro-globalizers have sometimes responded by denying that significant market failures have occurred at all and by blaming governments for the crisis. Thus, in an interview in early 2009, Rupert Murdoch remarked:
"It's very easy to blame the free market but how did we get the housing bubble? We got it because of Congress pushing Fannie Mae and Freddie Mac into lending money to people who couldn't afford it and blowing up the price of housing; a Fed which was too loose with the money. It just led to this very naturally. When you get a bubble, it has to be lanced and it's painful."
Murdoch's perspective may resonate with those who are already in thrall to the magic of the markets, but it probably won't help convince anybody at the margin.
This essay makes a different, more defensible argument for globalization: it is silly to take the manifest failures of markets as evidence that cross-border integration has to be stopped in its tracks or even reversed. Understanding why market failures do not preclude further cross-border integration is important because globalization is under threat today. What is to be done, nonetheless, to promote such integration, particularly in the European context, is also discussed.
Deglobalization delusions
The crisis that has convulsed the world has spawned loose talk of deglobalization. To the extent that deglobalization merely refers to declines in various sorts of cross-border flows, it has its uses as a catch-all for a number of such movements in 2008-9. International trade is predicted to drop by 9-10% in 2009. Foreign direct investment (FDI) may decline by as much as 45% – starting from 2008 figures that were themselves 15% lower than in 2007. International air traffic will likely be 5% lower during 2009 than 2008. Anecdotal accounts suggest that even immigration flows are down; emigration from Mexico to the US dropped 13% in the first quarter of 2009 against the same period in 2008, with more Mexicans leaving the US than coming in. And the projected 15% drop in Cuban cigar exports suggests that few countries, even the relatively isolated ones, and few categories, even very exclusive niches, remain immune to these effects.
I accept deglobalization as a (short-run) descriptor. Yet I disagree profoundly when commentators extend the term to argue that the global financial crisis marks the beginning of a structural shift to a world of reduced cross-border integration. Let us first look at the data that have already come in. Since exports have historically grown faster than GDP during good times, it is hardly surprising or indicative of a structural shift that they collapse more rapidly during downturns. And even the very pronounced decline in FDI does not lack precedent – and not from some point lost in the mists of time, but from earlier in the same decade! The ratio of FDI to gross global fixed capital formation, for example, declined from 19.9% in 2000 to 12.4% in 2001 and 9.5% in 2002. That is sharper than its drop from 16% in 2007 to 12.3% in 2008 and 7-10% in 2009. We should also note that the average for 2000-2009 (11.7%) remains almost twice as high as the 1990s average (6.4%) and several times higher than averages for both the 1980s (2.7%) and the 1970s (1.7%).
What these and other data evoke for me is a world not of deglobalization, but of continued semiglobalization. Cross-border flows typically represent 10- 20% of total flows for most real variables. While these figures are too large to ignore, they are also small enough to highlight the importance of barriers at borders.i In other words, it is imperative to account for the barriers as well as the bridges between countries – just as it was before the crisis.
Deglobalization makes even less sense as a prescriptive paradigm. Many anti-globalizers simply evade the issue: they stand against markets and their cross-border integration, but have little to say about viable alternatives. And when more thoughtful opponents of markets or globalization attempt to engage with such issues, they often fire blanks. A 2009 issue of The Nation magazine dedicated to this topic provides a sampler of what is on offer. One contributor stresses "gardens and childcare co-ops and bicycle lanes and farmers' markets" – a grab-bag of projects, to be sure, but not a plan.
Another pair of authors, Barbara Ehrenreich and Bill Fletcher, ask and answer the question: "Do we have a plan, people? Can we see our way out of this and into a just, democratic, sustainable [add your own favorite adjectives] future? Let's just put it right out on the table: we don't."
Ehrenreich and Fletcher are at least honest about their failure to articulate an alternative. Attempts that others have nonetheless made to do so range from the vague to the alarming. Thus, according to Walden Bello, to whom The Economist has attributed the term deglobalization, its key planks include:
> Co-locating production and consumption nationally and even locally
> Eliminating transnational corporations
> Replacing the IMF and the World Bank with regional institutions built on a model proposed by Hugo Chavez to "transcend the logic of capitalism"
> Deemphasizing growth
> Democratizing decision-making on all vital issues
> Institutionalizing the monitoring of government and business by civil society
It takes little imagination to realize that these measures could trigger a cataclysm combining the worst elements of the Great Depression and a global Cultural Revolution. For all their concerns about current social problems, deglobalizers seem reckless about large-scale social reengineering based on ideas that are untried, underspecified and, frankly, unlikely to work. And so we must look elsewhere for a rethink.
Market mania: Chicago versus Harvard
In marked contrast to the deglobalizers, some pro-globalizers categorically deny that market failures have occurred or that any kind of rethinking about markets or globalization is required. While Rupert Murdoch was quoted to such effect at the beginning of this essay, he was actually, as Keynes might have put it, distilling his frenzy from academic scribblers – in this case those associated with the University of Chicago. Compare Murdoch's quote with what appeals court judge and University of Chicago lecturer Richard Posner has to say in his recent book, A Failure of Capitalism:
"The mistakes were systemic – the product of the nature of the banking business in an environment shaped by low interest rates and deregulation rather than the antics of crooks and fools."
Posner does not go as far as some conservatives in pinning all blame for the crisis on government. However, he does see reregulating the financial system as "pretty small beer." He also clings to the Chicago school's core tenet as characterized thirty-five years ago by Milton Friedman: "'Chicago' stands for a belief in the efficacy of the free market as a means of organizing resources, for skepticism about government intervention into economic affairs." Due to Chicago's ascendancy in the intervening decades, this starry-eyed view of markets is the one popularly associated with economists in general. It is also one that the public generally finds distinctly unpalatable.
The misconception that all economists are given to market mania is particularly galling to me because of my personal background. Thirty years ago, I was a doctoral candidate in Harvard's Business Economics program. My field of specialization was industrial organization economics – essentially, the study of market failures and what to do about them. My thesis chairman, Richard Caves, served as the intellectual custodian of a scholarly tradition that, beginning with the early work of Harvard's Edward Mason and Joe Bain, had focused on the possibility that industry structures might often permit incumbent firms to exercise market power, raise prices and impair social welfare. This tradition also devoted considerable time to investigating possible remedies, principally regulation.
By the time I reached graduate school, the Harvard school's hegemony was already weakening under sustained attack from the Chicago school. In the realm of macroeconomics and financial markets, Milton Friedman had spearheaded a body of work suggesting that the government should do no more than tie its own hands by setting and sticking to a stable rate of growth of the money supply. And in the realm of microeconomics, the Chicago school was much more skeptical of the importance of market failures once governmental distortions of market processes had been factored out, and was inclined to see market regulation as more of a problem than a solution. The bottom line? The Harvard school had a liberal, pro-consumer focus while the Chicago school maintained a conservative, pro-producer focus.
Chicago's ascendancy in recent decades should not be allowed to overshadow what we have (re)learned, in very short order, toward the end of this decade. Economists' standard list of the imperfections that might lead markets to deliver suboptimal outcomes remains unchanged: small numbers of players associated with concentrated market structures and the like; informational imperfections and uncertainty; and externalities that are not priced into market transactions. What has changed is our collective sense of the incidence and impact of such failures. Ironically, the Chicago school had been particularly famous for insisting on financial markets' efficiency; yet the global financial crisis is a reminder that even apparently small imperfections can lead to large-scale breakdowns. And given what happened in the financial sector, the notion that market failures are rare in other parts of the economy seemingly more subject to imperfections seems quaint rather than cutting-edge.
More broadly, the Chicago school's insistence on a minimalistic governmental role ignores the recognition – starting with Adam Smith – that governments are essential to setting up and maintaining the institutions necessary for markets to work well. As Nobel Prize winner Amartya Sen recently put it,
"Adam Smith viewed markets and capital as doing good work within their own sphere, but first, they required support from other institutions – including public services such as schools – and values other than pure profit seeking, and second, they needed restraint and correction by still other institutions – e.g., well-devised financial regulations and state assistance to the poor – for preventing instability, inequity, and injustice."
Adam Smith, unlike some of his present-day successors, was smart enough to realize both the magic of markets and their limitations. Juxtaposed with the deregulatory zeal of recent decades, what stands out is his pragmatism and flexibility. Market failures and the implied need for regulation are not fatal to capitalism but integral, if unwelcome, elements of it that have to be dealt with.
Dual, not duelling choices
While the Harvard and Chicago schools disagree on the importance of market failures, they agree – in their mainstream versions – on the importance of cross-border integration of markets (subject to different caveats about unregulated capital flows). Recognition of this point suggests that the perceived opposition between market integration and market regulation is false. We would do better to conceive of integration and regulation as two different kinds of choice rather than as opposites. While regulation can indeed get in the way of openness, this does not have to happen. Nor is that the primary purpose of regulation.
The dual choices involving market regulation and market integration can be represented on a 2-by-2 gameboard. The shading patterns reflect the two biases disposed of earlier in this essay: deglobalization delusions and market mania. Cell 0 is subject to both biases and embraces countries ranging from failed states to only marginally more successful local kleptocracies. Cell 1, the "walled world," involves deglobalization delusions but not market mania; it gathers up most of the antiglobalizers cited in this essay's first section. Cell 2, the "wild world," is its antithesis: market mania without deglobalization delusions – a channeling of Chicago.
While there is an ongoing dialog of the deaf between proponents of the walled world and of the wild world, the problems with each of those approaches steers attention to cell 3 in the gameboard, which combines elements of both openness and regulation along the lines traditionally recommended by the Harvard school. This relatively well-elaborated approach has been overlooked in the tug-of-war between the proponents of the walled world and the wild world. Yet it is not some wishy-washy third way: I submit that it is the way forward. Or as Margaret Thatcher used to say (about cell 2): There is no alternative.
So why hasn't the way forward in cell 3 – a pragmatic combination of regulation and openness – commanded more attention to date? At least three reasons spring to mind:
> Extreme positions generate headlines, while the middle of the road is, in US political parlance, where you find yellow streaks and dead skunks. Whereas the walled world and even the wild world lend themselves better to emotional appeals and rhetorical flourishes, the case for the way forward must rely on its real attractions.
> People think openness leaves no room for domestic regulation. With perfect integration, suppliers of capital could, in principle, constrain governments to maximize, say, competitiveness, without any room for political maneuvering (the "golden straitjacket"). Such fears nevertheless betray overestimates of cross-border integration that our discussion of FDI, etc. should have helped dispel. Given current levels of integration, the danger facing the world is not too much globalization but too little – one of the themes of the next section.
> People think regulation leaves too little room for openness. This is the mirror image of the second point and is, again, misguided. While regulation can indeed impede openness, policymakers usually apply it in an attempt to deal with market failures of various sorts. Nor are all kinds of restrictions admissible even in this regard. According to a standard decomposability principle formulated by Jagdish Bhagwati and V. K. Ramaswami,ii "if the market failure arises in domestic markets, then the appropriate policy intervention is the use of domestic policy directly targeted at mitigating the effects of the market failure, while free trade is maintained externally."
An example may help elucidate this last point. In Western countries, proposals to restrict imports are usually backed by the argument that this will help poorly paid domestic workers. Detailed analysis of the US by Robert Lawrence at Harvard's Kennedy School of Government casts direct doubt on this notion, however. Lawrence found that imports to the US compete with US industries that pay higher than average wages. This is just one indication of the bluntness – not to say wrongheadedness – of restraints on trade as policy instruments. If policymakers rightly see domestic inequality as a key issue, why not deal with it directly, rather than ineffectively but expensively through trade restrictions?
Of course, when the market failure in question is international, we may need a response that extends across borders. In the cement industry, for example, dominant international firms seem better able to push prices higher in localities than dominant local firms can. One can think of a few other markets as well in which a handful of international firms apparently achieve tacit if not explicit price collusion. In such – special – circumstances, it may be necessary to consider imposing restrictions on such firms' local market entry, capping their expansion or even restricting their prices and profitability.
The way forward, particularly for Europe
The way forward prescribes market regulation but also greater cross-border integration. While we can elaborate on either or both of these dimensions, space constraints lead me to focus on the latter. The case for regulation is already clear – too clear, maybe, in that the present danger in many countries seems to be too much rather than too little regulation. In contrast, the case for globalization has been made neither sufficiently nor well in recent times. It is worth making, however, for reasons that will simply be cited here and that are discussed in more detail in my forthcoming book, Globalization SOS:
> Protectionism presents significant risks as the wild card that could indeed significantly reduce the level of globalization in the medium to long run. While recent declines in trade in manufactures seem consistent with the drop in aggregate demand, recent reports by the Global Trade Alert and the World Trade Organization highlight a stream of protectionist measures in 2009, ranging from higher tariffs to immigration controls, state aid and export subsidies. These steps considerably outnumber pro-trade measures – a situation that could greatly worsen if unemployment stays high.
> Despite all the "globaloney" to which we have been exposed in recent years – arguments about the end of nations, the death of distance, the flattening of the world, etc. – the globalization glass remains only 10-20% full. As a result, the advance of globalization continues to hold out substantial opportunities.
What specific steps should therefore be taken to manage globalization going forward? I will focus on five key implications as perceived from Europe, where I and many readers of this essay live.
> Manage imbalances. The financial crisis was preceded by a run-up in capital (and current) account imbalances to levels not seen except during the World Wars. So one clear lesson from the crisis is that the way forward will involve active management of imbalances rather than the assumption that they are self-regulating. And note that balance matters not just for trade/ capital flows but, especially in Europe, around labor as well. In coming decades, European countries will experience a demographic crunch that may be even more painful than necessary if they rely on purely local or regional responses. Active efforts must be made to maintain demographic balance by attracting immigrants from outside Europe.
> Open up and regulate. We must emphasize opening up and regulation at the same time – although opening up may end up reducing the amount of domestic regulation required. Restrictions on openness itself should be considered only in response to international, not domestic, market failures. And while both opening up and regulation are parts of the way forward, regulation levels in Europe exceed those in the United States and seem at least partly responsible for shortfalls in European labor productivity growth since the mid-1990s. For Europe at least, the part of this imperative that needs to be emphasized more is opening up.
> Push for openness in multiple ways. Let us think of opening up at multiple geographic levels, not just globally. For example, while EU-internal interactions dominate EU members' cross-border interactions (such as trade), they remain only a fraction as intense as country-internal interactions. This suggests that there is still much more room to push for a single European market. (Within-country barriers can be large as well – and should likewise be dismantled.) We need multiple instruments, especially if we are to facilitate cross-border flows rather than merely remove restrictions on them. Moreover, the existence of multiple types of flows – people, capital, services and information as well as products – can boost the gains from openness well beyond those obtained simply by freeing up trade in products.
> Coordinate rather than act unilaterally – to the extent possible. International market failures often require international coordination. Unfortunately, it has become harder to get everybody to agree on anything, as illustrated by the Doha trade round, which is still sputtering along a decade after it was supposed to start in Seattle. So while global coordination may be vital on some issues (such as global warming), regional or even more narrowly defined coordination may make more sense on others. The EU, for all its faults, is still the best advertisement for a distinctively regional approach to opening up. Unlike Doha, the Lisbon Treaty finally appears to have been clinched!
> Protect people, not jobs. In addition to educating people about the desirability of opening up and taking positive action to do so, we must also take care to include mechanisms to protect those who will lose out from greater openness. Europe, particularly Western Europe, arguably comes closer than any other region to protecting its people. Yet Europe all too often overprotects jobs as well. Witness the finding that, while the replacement of old, less efficient firms by new, innovative ones plays an important part in US productivity growth, very little such "churn" occurs in Europe. Much of European productivity growth potential is actually concentrated among very small firms with at most a few dozen employees – something that innovation policies often tend to miss. That, however, is a topic for another essay.
To conclude this essay, noisy debates about markets and globalization, particularly between believers in the walled world and the wild world, are likely to continue. But it helps to be able to look beyond this tension and understand the dual nature of the choices – market regulation and market integration – that confront us. For recognizing this duality is critical to perceiving and pursuing the way forward, which involves both regulation and cross-border integration.
Born in India in 1959, Pankaj Ghemawat studied at Harvard University and received his PhD there in Business Economics. After a stint at an international consulting firm in London, he returned to teach at the Harvard Business School, which, in 1991, appointed him the youngest full professor in its history. After 25 years on the Harvard faculty, in 2006 Ghemawat joined the IESE Business School in Barcelona, where he is the Anselmo Rubiralta Professor of Global Strategy.
Ghemawat's books include the award-winning Redefining Global Strategy (Harvard Business School Press, 2007). His new book, Globalization SOS, examines the topic of this essay in greater detail and is due to be published in 2010 by Harvard Business School Press.
Ghemawat's work has been recognized with numerous awards and honors, and he was the youngest "guru" to feature in the guide to the greatest management thinkers of all time published in 2008 by The Economist. For more information, visit www.ghemawat.org.
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The financial meltdown and other recent upheavals in global markets have raised questions not only about the efficiency of markets, but about globalization as well. Anti-globalizers have sounded the death knell for what they view as exaggerated faith in financial integration, while pro-globalizers have sometimes responded by denying that significant market failures have occurred at all and by blaming governments for the crisis. Thus, in an interview in early 2009, Rupert Murdoch remarked:
"It's very easy to blame the free market but how did we get the housing bubble? We got it because of Congress pushing Fannie Mae and Freddie Mac into lending money to people who couldn't afford it and blowing up the price of housing; a Fed which was too loose with the money. It just led to this very naturally. When you get a bubble, it has to be lanced and it's painful."
Murdoch's perspective may resonate with those who are already in thrall to the magic of the markets, but it probably won't help convince anybody at the margin.
This essay makes a different, more defensible argument for globalization: it is silly to take the manifest failures of markets as evidence that cross-border integration has to be stopped in its tracks or even reversed. Understanding why market failures do not preclude further cross-border integration is important because globalization is under threat today. What is to be done, nonetheless, to promote such integration, particularly in the European context, is also discussed.
Deglobalization delusions
The crisis that has convulsed the world has spawned loose talk of deglobalization. To the extent that deglobalization merely refers to declines in various sorts of cross-border flows, it has its uses as a catch-all for a number of such movements in 2008-9. International trade is predicted to drop by 9-10% in 2009. Foreign direct investment (FDI) may decline by as much as 45% – starting from 2008 figures that were themselves 15% lower than in 2007. International air traffic will likely be 5% lower during 2009 than 2008. Anecdotal accounts suggest that even immigration flows are down; emigration from Mexico to the US dropped 13% in the first quarter of 2009 against the same period in 2008, with more Mexicans leaving the US than coming in. And the projected 15% drop in Cuban cigar exports suggests that few countries, even the relatively isolated ones, and few categories, even very exclusive niches, remain immune to these effects.
I accept deglobalization as a (short-run) descriptor. Yet I disagree profoundly when commentators extend the term to argue that the global financial crisis marks the beginning of a structural shift to a world of reduced cross-border integration. Let us first look at the data that have already come in. Since exports have historically grown faster than GDP during good times, it is hardly surprising or indicative of a structural shift that they collapse more rapidly during downturns. And even the very pronounced decline in FDI does not lack precedent – and not from some point lost in the mists of time, but from earlier in the same decade! The ratio of FDI to gross global fixed capital formation, for example, declined from 19.9% in 2000 to 12.4% in 2001 and 9.5% in 2002. That is sharper than its drop from 16% in 2007 to 12.3% in 2008 and 7-10% in 2009. We should also note that the average for 2000-2009 (11.7%) remains almost twice as high as the 1990s average (6.4%) and several times higher than averages for both the 1980s (2.7%) and the 1970s (1.7%).
What these and other data evoke for me is a world not of deglobalization, but of continued semiglobalization. Cross-border flows typically represent 10- 20% of total flows for most real variables. While these figures are too large to ignore, they are also small enough to highlight the importance of barriers at borders.i In other words, it is imperative to account for the barriers as well as the bridges between countries – just as it was before the crisis.
Deglobalization makes even less sense as a prescriptive paradigm. Many anti-globalizers simply evade the issue: they stand against markets and their cross-border integration, but have little to say about viable alternatives. And when more thoughtful opponents of markets or globalization attempt to engage with such issues, they often fire blanks. A 2009 issue of The Nation magazine dedicated to this topic provides a sampler of what is on offer. One contributor stresses "gardens and childcare co-ops and bicycle lanes and farmers' markets" – a grab-bag of projects, to be sure, but not a plan.
Another pair of authors, Barbara Ehrenreich and Bill Fletcher, ask and answer the question: "Do we have a plan, people? Can we see our way out of this and into a just, democratic, sustainable [add your own favorite adjectives] future? Let's just put it right out on the table: we don't."
Ehrenreich and Fletcher are at least honest about their failure to articulate an alternative. Attempts that others have nonetheless made to do so range from the vague to the alarming. Thus, according to Walden Bello, to whom The Economist has attributed the term deglobalization, its key planks include:
> Co-locating production and consumption nationally and even locally
> Eliminating transnational corporations
> Replacing the IMF and the World Bank with regional institutions built on a model proposed by Hugo Chavez to "transcend the logic of capitalism"
> Deemphasizing growth
> Democratizing decision-making on all vital issues
> Institutionalizing the monitoring of government and business by civil society
It takes little imagination to realize that these measures could trigger a cataclysm combining the worst elements of the Great Depression and a global Cultural Revolution. For all their concerns about current social problems, deglobalizers seem reckless about large-scale social reengineering based on ideas that are untried, underspecified and, frankly, unlikely to work. And so we must look elsewhere for a rethink.
Market mania: Chicago versus Harvard
In marked contrast to the deglobalizers, some pro-globalizers categorically deny that market failures have occurred or that any kind of rethinking about markets or globalization is required. While Rupert Murdoch was quoted to such effect at the beginning of this essay, he was actually, as Keynes might have put it, distilling his frenzy from academic scribblers – in this case those associated with the University of Chicago. Compare Murdoch's quote with what appeals court judge and University of Chicago lecturer Richard Posner has to say in his recent book, A Failure of Capitalism:
"The mistakes were systemic – the product of the nature of the banking business in an environment shaped by low interest rates and deregulation rather than the antics of crooks and fools."
Posner does not go as far as some conservatives in pinning all blame for the crisis on government. However, he does see reregulating the financial system as "pretty small beer." He also clings to the Chicago school's core tenet as characterized thirty-five years ago by Milton Friedman: "'Chicago' stands for a belief in the efficacy of the free market as a means of organizing resources, for skepticism about government intervention into economic affairs." Due to Chicago's ascendancy in the intervening decades, this starry-eyed view of markets is the one popularly associated with economists in general. It is also one that the public generally finds distinctly unpalatable.
The misconception that all economists are given to market mania is particularly galling to me because of my personal background. Thirty years ago, I was a doctoral candidate in Harvard's Business Economics program. My field of specialization was industrial organization economics – essentially, the study of market failures and what to do about them. My thesis chairman, Richard Caves, served as the intellectual custodian of a scholarly tradition that, beginning with the early work of Harvard's Edward Mason and Joe Bain, had focused on the possibility that industry structures might often permit incumbent firms to exercise market power, raise prices and impair social welfare. This tradition also devoted considerable time to investigating possible remedies, principally regulation.
By the time I reached graduate school, the Harvard school's hegemony was already weakening under sustained attack from the Chicago school. In the realm of macroeconomics and financial markets, Milton Friedman had spearheaded a body of work suggesting that the government should do no more than tie its own hands by setting and sticking to a stable rate of growth of the money supply. And in the realm of microeconomics, the Chicago school was much more skeptical of the importance of market failures once governmental distortions of market processes had been factored out, and was inclined to see market regulation as more of a problem than a solution. The bottom line? The Harvard school had a liberal, pro-consumer focus while the Chicago school maintained a conservative, pro-producer focus.
Chicago's ascendancy in recent decades should not be allowed to overshadow what we have (re)learned, in very short order, toward the end of this decade. Economists' standard list of the imperfections that might lead markets to deliver suboptimal outcomes remains unchanged: small numbers of players associated with concentrated market structures and the like; informational imperfections and uncertainty; and externalities that are not priced into market transactions. What has changed is our collective sense of the incidence and impact of such failures. Ironically, the Chicago school had been particularly famous for insisting on financial markets' efficiency; yet the global financial crisis is a reminder that even apparently small imperfections can lead to large-scale breakdowns. And given what happened in the financial sector, the notion that market failures are rare in other parts of the economy seemingly more subject to imperfections seems quaint rather than cutting-edge.
More broadly, the Chicago school's insistence on a minimalistic governmental role ignores the recognition – starting with Adam Smith – that governments are essential to setting up and maintaining the institutions necessary for markets to work well. As Nobel Prize winner Amartya Sen recently put it,
"Adam Smith viewed markets and capital as doing good work within their own sphere, but first, they required support from other institutions – including public services such as schools – and values other than pure profit seeking, and second, they needed restraint and correction by still other institutions – e.g., well-devised financial regulations and state assistance to the poor – for preventing instability, inequity, and injustice."
Adam Smith, unlike some of his present-day successors, was smart enough to realize both the magic of markets and their limitations. Juxtaposed with the deregulatory zeal of recent decades, what stands out is his pragmatism and flexibility. Market failures and the implied need for regulation are not fatal to capitalism but integral, if unwelcome, elements of it that have to be dealt with.
Dual, not duelling choices
While the Harvard and Chicago schools disagree on the importance of market failures, they agree – in their mainstream versions – on the importance of cross-border integration of markets (subject to different caveats about unregulated capital flows). Recognition of this point suggests that the perceived opposition between market integration and market regulation is false. We would do better to conceive of integration and regulation as two different kinds of choice rather than as opposites. While regulation can indeed get in the way of openness, this does not have to happen. Nor is that the primary purpose of regulation.
The dual choices involving market regulation and market integration can be represented on a 2-by-2 gameboard. The shading patterns reflect the two biases disposed of earlier in this essay: deglobalization delusions and market mania. Cell 0 is subject to both biases and embraces countries ranging from failed states to only marginally more successful local kleptocracies. Cell 1, the "walled world," involves deglobalization delusions but not market mania; it gathers up most of the antiglobalizers cited in this essay's first section. Cell 2, the "wild world," is its antithesis: market mania without deglobalization delusions – a channeling of Chicago.
While there is an ongoing dialog of the deaf between proponents of the walled world and of the wild world, the problems with each of those approaches steers attention to cell 3 in the gameboard, which combines elements of both openness and regulation along the lines traditionally recommended by the Harvard school. This relatively well-elaborated approach has been overlooked in the tug-of-war between the proponents of the walled world and the wild world. Yet it is not some wishy-washy third way: I submit that it is the way forward. Or as Margaret Thatcher used to say (about cell 2): There is no alternative.
So why hasn't the way forward in cell 3 – a pragmatic combination of regulation and openness – commanded more attention to date? At least three reasons spring to mind:
> Extreme positions generate headlines, while the middle of the road is, in US political parlance, where you find yellow streaks and dead skunks. Whereas the walled world and even the wild world lend themselves better to emotional appeals and rhetorical flourishes, the case for the way forward must rely on its real attractions.
> People think openness leaves no room for domestic regulation. With perfect integration, suppliers of capital could, in principle, constrain governments to maximize, say, competitiveness, without any room for political maneuvering (the "golden straitjacket"). Such fears nevertheless betray overestimates of cross-border integration that our discussion of FDI, etc. should have helped dispel. Given current levels of integration, the danger facing the world is not too much globalization but too little – one of the themes of the next section.
> People think regulation leaves too little room for openness. This is the mirror image of the second point and is, again, misguided. While regulation can indeed impede openness, policymakers usually apply it in an attempt to deal with market failures of various sorts. Nor are all kinds of restrictions admissible even in this regard. According to a standard decomposability principle formulated by Jagdish Bhagwati and V. K. Ramaswami,ii "if the market failure arises in domestic markets, then the appropriate policy intervention is the use of domestic policy directly targeted at mitigating the effects of the market failure, while free trade is maintained externally."
An example may help elucidate this last point. In Western countries, proposals to restrict imports are usually backed by the argument that this will help poorly paid domestic workers. Detailed analysis of the US by Robert Lawrence at Harvard's Kennedy School of Government casts direct doubt on this notion, however. Lawrence found that imports to the US compete with US industries that pay higher than average wages. This is just one indication of the bluntness – not to say wrongheadedness – of restraints on trade as policy instruments. If policymakers rightly see domestic inequality as a key issue, why not deal with it directly, rather than ineffectively but expensively through trade restrictions?
Of course, when the market failure in question is international, we may need a response that extends across borders. In the cement industry, for example, dominant international firms seem better able to push prices higher in localities than dominant local firms can. One can think of a few other markets as well in which a handful of international firms apparently achieve tacit if not explicit price collusion. In such – special – circumstances, it may be necessary to consider imposing restrictions on such firms' local market entry, capping their expansion or even restricting their prices and profitability.
The way forward, particularly for Europe
The way forward prescribes market regulation but also greater cross-border integration. While we can elaborate on either or both of these dimensions, space constraints lead me to focus on the latter. The case for regulation is already clear – too clear, maybe, in that the present danger in many countries seems to be too much rather than too little regulation. In contrast, the case for globalization has been made neither sufficiently nor well in recent times. It is worth making, however, for reasons that will simply be cited here and that are discussed in more detail in my forthcoming book, Globalization SOS:
> Protectionism presents significant risks as the wild card that could indeed significantly reduce the level of globalization in the medium to long run. While recent declines in trade in manufactures seem consistent with the drop in aggregate demand, recent reports by the Global Trade Alert and the World Trade Organization highlight a stream of protectionist measures in 2009, ranging from higher tariffs to immigration controls, state aid and export subsidies. These steps considerably outnumber pro-trade measures – a situation that could greatly worsen if unemployment stays high.
> Despite all the "globaloney" to which we have been exposed in recent years – arguments about the end of nations, the death of distance, the flattening of the world, etc. – the globalization glass remains only 10-20% full. As a result, the advance of globalization continues to hold out substantial opportunities.
What specific steps should therefore be taken to manage globalization going forward? I will focus on five key implications as perceived from Europe, where I and many readers of this essay live.
> Manage imbalances. The financial crisis was preceded by a run-up in capital (and current) account imbalances to levels not seen except during the World Wars. So one clear lesson from the crisis is that the way forward will involve active management of imbalances rather than the assumption that they are self-regulating. And note that balance matters not just for trade/ capital flows but, especially in Europe, around labor as well. In coming decades, European countries will experience a demographic crunch that may be even more painful than necessary if they rely on purely local or regional responses. Active efforts must be made to maintain demographic balance by attracting immigrants from outside Europe.
> Open up and regulate. We must emphasize opening up and regulation at the same time – although opening up may end up reducing the amount of domestic regulation required. Restrictions on openness itself should be considered only in response to international, not domestic, market failures. And while both opening up and regulation are parts of the way forward, regulation levels in Europe exceed those in the United States and seem at least partly responsible for shortfalls in European labor productivity growth since the mid-1990s. For Europe at least, the part of this imperative that needs to be emphasized more is opening up.
> Push for openness in multiple ways. Let us think of opening up at multiple geographic levels, not just globally. For example, while EU-internal interactions dominate EU members' cross-border interactions (such as trade), they remain only a fraction as intense as country-internal interactions. This suggests that there is still much more room to push for a single European market. (Within-country barriers can be large as well – and should likewise be dismantled.) We need multiple instruments, especially if we are to facilitate cross-border flows rather than merely remove restrictions on them. Moreover, the existence of multiple types of flows – people, capital, services and information as well as products – can boost the gains from openness well beyond those obtained simply by freeing up trade in products.
> Coordinate rather than act unilaterally – to the extent possible. International market failures often require international coordination. Unfortunately, it has become harder to get everybody to agree on anything, as illustrated by the Doha trade round, which is still sputtering along a decade after it was supposed to start in Seattle. So while global coordination may be vital on some issues (such as global warming), regional or even more narrowly defined coordination may make more sense on others. The EU, for all its faults, is still the best advertisement for a distinctively regional approach to opening up. Unlike Doha, the Lisbon Treaty finally appears to have been clinched!
> Protect people, not jobs. In addition to educating people about the desirability of opening up and taking positive action to do so, we must also take care to include mechanisms to protect those who will lose out from greater openness. Europe, particularly Western Europe, arguably comes closer than any other region to protecting its people. Yet Europe all too often overprotects jobs as well. Witness the finding that, while the replacement of old, less efficient firms by new, innovative ones plays an important part in US productivity growth, very little such "churn" occurs in Europe. Much of European productivity growth potential is actually concentrated among very small firms with at most a few dozen employees – something that innovation policies often tend to miss. That, however, is a topic for another essay.
To conclude this essay, noisy debates about markets and globalization, particularly between believers in the walled world and the wild world, are likely to continue. But it helps to be able to look beyond this tension and understand the dual nature of the choices – market regulation and market integration – that confront us. For recognizing this duality is critical to perceiving and pursuing the way forward, which involves both regulation and cross-border integration.
Born in India in 1959, Pankaj Ghemawat studied at Harvard University and received his PhD there in Business Economics. After a stint at an international consulting firm in London, he returned to teach at the Harvard Business School, which, in 1991, appointed him the youngest full professor in its history. After 25 years on the Harvard faculty, in 2006 Ghemawat joined the IESE Business School in Barcelona, where he is the Anselmo Rubiralta Professor of Global Strategy.
Ghemawat's books include the award-winning Redefining Global Strategy (Harvard Business School Press, 2007). His new book, Globalization SOS, examines the topic of this essay in greater detail and is due to be published in 2010 by Harvard Business School Press.
Ghemawat's work has been recognized with numerous awards and honors, and he was the youngest "guru" to feature in the guide to the greatest management thinkers of all time published in 2008 by The Economist. For more information, visit www.ghemawat.org.
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