[Economic Report of the President (2000)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]


 
CHAPTER 6
Opportunity and Challenge in the
Global Economy





What an extraordinary episode in the economic progress of man that age
was which came to an end in August, 1914! ...life offered, at a low cost
and with the least trouble, conveniences, comforts, and amenities beyond
the compass of the richest and most powerful monarchs of other ages. The
inhabitant of London could order by telephone, sipping his morning tea
in bed, the various products of the whole earth...he could at the same
moment and by the same means adventure his wealth in the natural resources
and new enterprises of any quarter of the world.... But, most important
of all, he regarded this state of affairs as normal, certain, and
permanent, except in the direction of further improvement, and any
deviation from it as aberrant, scandalous, and avoidable.
--John Maynard Keynes, The Economic Consequences of the Peace (1919),
writing about the pre-World War I economy



Photodisc

For centuries, rising prosperity and rising integration of the global
economy have gone hand in hand. The United States and much of the rest
of the world have never before been as affluent as today. Nor has
economic globalization--the worldwide integration of national economies
through trade, capital flows, and operational linkages among firms--ever
before been as broad or as deep. Keynes's words in the epigraph describe
London at the beginning of the 20th century, yet they ring even truer
for the United States and many other countries as we look to the 21st.
This conjuncture of rising wealth and expanding international ties is
no coincidence. The United States has gained enormously from these
linkages, which have helped drive the unprecedented prosperity of the
economy. Indeed, future improvements in Americans' living standards
depend in part on our continued willingness to embrace international
economic integration.

As Chart 6-1 shows, the involvement of several of the world's richest
countries in international trade has grown faster than their output for
roughly three centuries. The one period when trade grew more slowly than
output was from 1913 to 1950--a period that encompassed the Great
Depression and two world wars. Fortunately, despite Keynes's
characterization of the pre-World War I period as an ``extraordinary
episode,'' the rising globalization and economic buoyancy of that period
proved not to be an aberration. Rather, it was the 1913-50 period that
stood out as the extraordinary episode, one of uncharacteristically
weak growth in both output and trade. During that period, and that
period only, trade generally fell relative to gross domestic product
(GDP). After 1950 the world economy resumed its globalizing trend.
But it took time to make up the ground lost: in the United States and
elsewhere, the level of trade relative to output has consistently
exceeded early-20th-century levels only in the past few decades.
One reason why prosperity and economic globalization have risen together is that dramatic improvements in technology have contributed to both. As earlier chapters discuss, technological advances have raised living standards, enabling each worker to produce more and better goods and services.





Meanwhile innovations in transportation, communications, and information
technology have made international economic integration ever easier.
Quite apart from the impact of technology, openness to the world itself
makes us more prosperous. The freedom of firms to choose from a wider
range of inputs, and of consumers to choose from a wider range of products,
improves efficiency, promotes innovation in technology and management,
encourages the transfer of technology, and otherwise enhances productivity
growth. All these benefits, in turn, lead to higher real incomes and
wages. Through trade, countries can shift resources into those sectors
best able to compete in international markets, and so reap the benefits
of specialization and scale economies. Opening domestic markets to global
capital can improve the efficiency of investment, which can promote
economic growth. Through firms' direct investment in foreign affiliates,
countries can adopt international best practices in production,
including managerial, technical, and marketing know-how.
Given the momentum of the economic and technological forces behind
globalization, its rise may seem inevitable. But policy can play a
critical role in either helping or hindering its advance. The experience
of the 20th century reinforces this lesson. International linkages in
the United States and elsewhere were fairly well developed at the
beginning of the century: as Keynes observed, rising prosperity and
increasing economic integration had come to seem the natural state of
affairs. Yet from 1914 until mid-century, war as well as mistakes of
economic policy thwarted this normalcy. In the trade arena, governments
actively promoted protectionism through high tariff and nontariff
barriers, and so inadvertently contributed to the slowed pace of
world growth and development.
For the past half century, in contrast, policy has worked actively to
remove barriers and distortions that impede the market forces
underpinning trade and investment. For example, the General Agreement
on Tariffs and Trade (GATT) and, more recently, the World Trade
Organization (WTO) have championed trade liberalization. Since the
1970s, most industrial countries have removed most of their controls
on international capital movements, and many developing countries have
greatly relaxed theirs as well. Given the very real benefits of open
markets in both trade and finance, we should continue to embrace and
encourage this trend toward liberalization.
Of course, economic globalization is not an end in itself, but rather
a means to raise living standards. Like other sources of economic growth,
including technological progress, economic integration involves natural
tradeoffs. It provides real benefits by increasing the choices
available to people and firms, but it also raises legitimate concerns.
Increased trade re-sorts each country's resources, directing them toward
their most productive uses, but some industries and their workers may
find themselves facing sharp competition from other countries. Broader
global capital flows can increase efficiency and speed development,
but when these flows reverse course, they can temporarily upset whole
economies.
Sound policy plays an important role in ensuring that the benefits of
international economic integration are shared as widely as possible,
raising living standards within and across all countries that take
part. Even in an increasingly global economy, each nation controls
its own destiny. In large measure, active participation in international
markets for goods, services, and capital strengthens the case for
policies that make sense even without integration. Among these are
policies that encourage a flexible and skilled work force, provide
an adequate social safety net, reward innovation, and ensure that
the financial system is sound and that financial markets are deep.



The Fall and Rise of the Global Economy

The U.S. economy today is more closely integrated with the rest of
the world than at any time in history. Trade and, to a much lesser
extent, investment links were well established a century ago, but
both deteriorated during the interwar period. Over the past 50 years,
however, international trade and investment have risen sharply.
Today, global ties--through goods and services trade, through
capital flows, and through integrated production relationships --are
generally broader and deeper than ever before.



The Growing Importance of Trade

Historical statistics on U.S. trade reveal a striking pattern. A
period of rising international economic integration began well before
the 20th century but faltered between the two world wars. Although U.S.
tariffs were relatively high during much of the 19th and early 20th
centuries, the United States tended to participate actively in a
generally flourishing world trade. Internationally, nontariff trade
barriers were few. The interwar period that followed, however, was
largely one of rising tariff and nontariff barriers--in the United
States and elsewhere--and disintegration rather than integration.
Since World War II, technological developments and the gradual
international liberalization of trade and capital flows, described
below, have once again put integration on the upswing. Chart 6-2
shows that, except briefly around the time of each world war, the
ratio of trade (exports plus imports) to gross national product
(GNP) did not return to turn-of-the-century levels until the 1970s.
Recently, however, this ratio has approached 25 percent, its highest
point in at least a century.






But to look at U.S. trade only in the aggregate would miss much of the
story of this country's integration into the global economy. Important
changes have also occurred within sectors and individual industries.
Exports of both goods and services have risen much faster than
production, but each has followed its own distinct path.
Although typically small relative to aggregate production, U.S. exports
of services--including travel and transportation; royalties and license
fees; telecommunications services; education; and a variety of
financial and business, professional, and technical services--have
grown dramatically, providing further evidence of the increasing
importance of global linkages. (The United States exports transportation
services when, for example, a European tourist flies a U.S. airline to
New York, and imports transportation services when an American tourist
flies a British carrier to London.) U.S. service providers have almost
tripled the export share of their output over the past five decades.
In 1950 only about 2 percent of U.S.-produced services were exported;
in 1998 that share was about 6 percent.
Indeed, growth in exports of services has outpaced growth in exports
of goods. Not coincidentally, services have become a more important
part of the domestic economy over the same period. As a result,
services now account for about 29 percent of U.S. exports (Chart 6-3),
up from only 17 percent in 1950 and about 2 percent in 1900.





Although goods production--capturing production in manufacturing,
mining, and agriculture--has come to account for a smaller share of
the economy, it, too, has become more deeply integrated into the global
economy. The share of domestic goods production destined for export
markets has grown from around 9 percent in 1929 to 21 percent in 1998.
However, the shares for some specific industries and products are much
larger. Many high-technology U.S. manufacturing industries, such as
electronics, export 25 percent or more of their total shipments.
Imports, too, foster integration into the global economy. In fact, the
United States often imports and exports within the same categories of
products. Capital goods, for example, are the leading category of both
U.S. imports and U.S. exports (Chart 6-3). This two-way trade can also
be seen within specific industries, such as the computer industry. Some
of this two-way, intraindustry trade reflects the globalization of
production arrangements. Anecdotal evidence and recent studies document
how production processes have been increasingly divided up and
reallocated, either domestically or globally. That is, discrete
elements of these processes, such as research and development, design,
assembly, and packaging, are performed by firms in the United States
and elsewhere, based on countries' relative strengths in completing
different tasks. Part of the growth in trade may also reflect rising
vertical specialization, in which goods are imported, further processed,
and reexported.
Data from the U.S. computer industry (computer systems, hardware,
and peripherals) illustrate the extent of both intraindustry trade
and vertical specialization. According to one recent report, in 1998 an
estimated 43 percent of domestic producers' total shipments was
exported, and an estimated 58 percent of final and intermediate domestic
consumption was imported. The same report notes that more than 60
percent by value of the hardware in a typical U.S. personal computer
system comes from Asia.
Intraindustry trade may also reflect an interaction of consumers'
desire for variety with economies of scale in production. The automobile
industry provides some commonly cited examples. We observe firms in
the United States and the European Union producing and exporting
different kinds of luxury and sport vehicles for niche markets.
Because the average cost of production falls as more cars are produced,
firms try to reach as many customers as possible. This gives them an
incentive to seek out markets abroad. And when many producers in
different countries adopt the same strategy, the result is greater
satisfaction of consumers' demand for product selection. Economists
note that consumer tastes for variety help explain trade flows
among countries with similar resource and technology bases.
U.S. firms' trading partners are located around the world, but they
tend to be concentrated in industrial countries and in our closest
neighbors. Canada is the top-ranking trade partner of the United
States, accounting in 1998 for about 21 percent of U.S. merchandise
exports and imports combined. Measured on the same basis, the
European Union is a very close second, followed by Japan and then
Mexico. In the aggregate, developing countries (excluding the few
that are members of the Organization for Economic Cooperation and
Development) account for about 31 percent of U.S. trade, although
the 48 countries designated by the United Nations as least
developed account for a very small share--less than 1 percent.



The Rise of International Capital Flows

Cross-border capital flows have likewise grown to unprecedented levels
in the United States and around the world, reflecting reduced barriers
to capital, an increased desire on the part of investors to diversify
their portfolios internationally, and a plethora of new financial
instruments and technologies. Cross-border transactions in bonds
and equities have exploded in recent decades, reaching 223 percent
of GDP in the United States in 1998, compared with only 9 percent
of GDP in 1980. One survey reports that average daily turnover on
world foreign exchange markets was about $1.5 trillion in April
1998, although not all such turnover necessarily crosses borders.
This turnover has risen from $0.6 trillion in April 1989.
These cross-border figures include substantial trading and retrading
of the same securities, and hence to some extent overstate the degree
to which ownership claims cross borders. For example, a U.S. mutual
fund might turn over its entire portfolio of foreign securities more
than once during the course of a year. Official balance of payments
data provide an alternative measure of gross flows that comes closer
to measuring the true change in cross-border ownership claims. Chart
6-4 shows these data on inflows of capital sent into the United States
by foreigners, and outflows of capital sent from the United States by
U.S. residents. U.S. outflows abroad have been rising; foreign inflows
into the United States have been rising even faster. These flows
typically amounted to 1 percent or less of GNP through the 1960s.
By contrast, flows have been much larger recently: from 1995 through
1998, for example, inflows averaged 7 percent of GNP.
Net capital flows (the difference between inflows and outflows in
Chart 6-4), measured relative to GNP, have also reached much higher
levels in recent decades. Indeed, the United States is by far the
largest recipient of net capital inflows in the world, amounting to
more than $200 billion in 1998.
The large net capital inflows of the past two decades have led to a
profound change in the net international indebtedness position of the
United States. The United States was a net debtor until the late
1910s and then a net creditor until the late 1980s. At the end of 1998,
foreign-owned assets in the United States exceeded U.S.-owned assets
abroad by about $1.2 trillion (valued at current cost), an amount
equal to 14 percent of U.S. GNP. A century ago, the net international
investment position of the United States was similar, with





net indebtedness of about 18 percent of GNP. However, the gross investment
positions were much smaller then. In 1897, for example, U.S. assets
abroad amounted to only 5 percent of U.S. GNP, compared with 56 percent
in 1998.
Economists sometimes distinguish among various broad categories of
capital flows. The main ones are foreign direct investment (FDI),
portfolio investment (such as stocks and bonds), and bank lending.
These types of capital flows differ greatly in their volatility--a
matter of concern for emerging market economies, as discussed below.
Anecdotal evidence and recent studies suggest that bank lending and
portfolio flows may be the most volatile. FDI, in contrast, may be
less fickle, because these flows arise, in part, from the
internationalization of production processes (Box 6-1). FDI occurs,
for example, when an investor sets up an enterprise in a foreign country
or obtains a large enough share (U.S. statistics, and those of some
other countries, set the threshold at 10 percent) in an existing
foreign enterprise to influence managerial decisions. Global FDI
outflows accounted for about a quarter of total international capital
outflows between 1990 and 1996. They grew from an annual average of
$181 billion between 1986 and 1991 to $649 billion in 1998.



Box 6-1. Multinational Corporations and Globalization

Globalization is played out in many arenas and by many actors, an
important one of which is the multinational company (MNC). MNCs
undertake FDI when they establish overseas operations through foreign
affiliates. They also engage extensively in international trade. Worldwide,
some 60,000 parent operations of MNCs and their 500,000 foreign affiliates
account for roughly 25 percent of global output, one-third of it in host
countries. In industrial countries, services accounted for 53 percent
of all FDI inflows in 1997, and manufacturing for 35 percent. In
developing countries, manufacturing accounted for about 50 percent
of FDI inflows in 1997, and services for 41 percent.
U.S.-based MNCs account for a large share of U.S. production, trade,
and employment. They produce about 19 percent of U.S. GDP through
their parent operations (all these figures refer to nonbank MNCs
only). In 1997 the trade associated with U.S. MNCs accounted for
about 63 percent of U.S. goods exports and 40 percent of U.S. goods
imports. Over 40 percent of these transactions involved trade between
U.S. parent operations and their foreign affiliates. The parent
operations of U.S. MNCs employed about 20 million workers in the
United States in 1997, roughly the same number as in 1977.
Although foreign affiliates of U.S. MNCs trade with their parent
operations, among others, data show that most of their sales are
local,
Box 6-1.--continued
occurring within the host country. In 1997, 63 percent of worldwide
sales of goods and 82 percent of worldwide sales of services by foreign
affiliates of U.S. MNCs were local, reflecting in part the importance
of proximity in the delivery of some products. In terms of the gross
product of U.S. MNCs' majority-owned foreign affiliates, the United
Kingdom is the most important destination for U.S. MNCs, followed
by Canada and Germany. The foreign affiliates of U.S. MNCs employed
about 8 million workers in 1997, up from 7.2 million in 1977.
Just as U.S. MNCs have reached across national borders, so foreign-based
MNCs have entered the United States. U.S. affiliates of foreign companies
account for about 6 percent of U.S. private-industry gross product. In
terms of the gross product of foreign MNCs' U.S. affiliates, the United
Kingdom is again the leader, followed by Japan and Germany. In 1997, U.S.
affiliates of foreign companies accounted for about 20 percent of U.S.
goods exports and about 30 percent of U.S. goods imports. Also in 1997,
U.S. affiliates of foreign companies employed about 5 million workers
in the United States, up from only 1.2 million in 1977.

Transactions involving U.S. entities, as either investors or recipients,
account for a large share of global FDI flows. U.S. FDI outflows amounted
to $133 billion in 1998, up from an annual average of $26 billion between
1986 and 1991. Meanwhile, U.S. FDI inflows rose from an annual average
of $49 billion between 1986 and 1991 to $193 billion in 1998. Globally,
most FDI goes to industrialized countries, but developing countries'
share of global FDI inflows is also substantial, totaling about 28
percent in 1998, although this marked a decline from 37 percent in 1997.



The Forces Behind Globalization

The forces driving globalization include technology and policy.
Technological improvements--in transportation, communications,
information technology, and elsewhere--have reduced the costs of
doing business internationally, thus lowering significant barriers
to trade and investment. These improvements have also increased the
range of possible commercial transactions, particularly in financial
markets, and have created venues for new kinds of transactions, such
as electronic commerce.
Policy has also played an active role in reducing barriers to trade
and investment. For example, over the past 50 years, policy measures
have sought to reduce tariff and nontariff trade barriers. More
recently, and especially since the 1970s, many countries have decided
to remove restrictions on capital flows. Coupled with other domestic
policies designed to promote competition among firms, these kinds of
market liberalization in trade and investment have helped reduce
costs to consumers and promote technological innovation.



The Role of Technology

Although our nearest neighbors remain among our most important
trading partners--Canada and Mexico together account for about
one-third of our total trade--improvements in technology have reduced
the costs of doing business overseas and made distant markets more
accessible.
The cost of moving goods has fallen over time. Studies document
substantial reductions in shipping costs in the pre-World War I
period, and some indicators suggest that costs have continued to
decline since then. This decline appears to reflect several factors,
including direct declines in some shipping rates as well as a shift
in the mix of traded goods and modes of shipping. One study reports
that average ocean freight and port charges on U.S. trade fell from
$95 per short ton in 1920 (measured in 1990 dollars) to $27 in 1960,
but then leveled off. Another recent study looks at relatively
disaggregated data since the 1950s and finds little evidence of
declines in real ocean shipping rates. But that study does find
that air shipment rates have fallen sharply: worldwide, the cost
of airfreight, measured as average revenue per ton-kilometer, dropped
by 78 percent between 1955 and 1996. In addition, the share of world
trade in high-value-to-weight products such as pharmaceuticals has
risen. Reflecting the falling cost of airfreight as well as the shifting
composition of trade, air shipments in 1998 accounted for 28 percent of
the value of U.S. international trade--up from 7 percent in 1965 and a
negligible share in 1950.
At the same time, the cost of land-based shipping may also have fallen.
Because of  the importance of Canada and Mexico as trading partners,
about 34 percent of the value of U.S. trade was shipped by land in
1998--up from about 28 percent in 1965--and even many goods that
travel by ocean-going vessel must be transported to or from the
port. Domestic deregulation in the U.S. transportation industry has
contributed to efficiency gains in land transport, and the
development of the Interstate Highway System since World War II
also appears to have reduced transport costs. In addition,
technological developments such as containerization have facilitated
intermodal transportation and improved the quality of transport
services. Containerization allows a standard-sized container to be
hauled by truck or rail and then, if continuing overseas, loaded
by crane directly onto a ship. This technology has reduced both
handling requirements and transit time for deliveries.
Improved communications and information technologies have also
facilitated international commerce. In 1930, for example, a 3-minute
phone call from New York to London cost $293 in 1998 dollars. By
1998, one widely subscribed discount plan charged only 36 cents
for a clearer, more reliable 3-minute call. This decline in
communications costs, coupled with the availability of new
technologies, has probably been particularly important in
facilitating services trade. Although market proximity is still
an important factor for many services, firms' ability to provide
customer support by telephone or e-mail at relatively low cost,
or to transmit products electronically via the Internet, has
reduced its importance in some industries. A report from the
U.S. General Accounting Office notes that technological
innovations linked to computers and satellites have influenced
how intermodal freight shipments are handled. Such innovations
include bar coding for verification and tracking, electronic
transmission of business data and documents, and in-vehicle
navigation systems that help shippers find the most direct
or least congested routes.
Improvements in information and communications technology have
also underpinned rapid technological change in the financial
sector. Recent years have seen an explosion in the range of
financial instruments, which has contributed to the massive gross
flows of financial capital discussed earlier. For example,
advances in computing technology enable traders to implement
complex analytical models (such as models for pricing options),
and this in turn allows financial firms to meet demand for new
financial instruments. Under flexible exchange rate regimes,
one source of demand for such instruments is the desire of
market participants to remove or insure against the exchange
rate risks they face in trading goods, services, or assets.
Swaps, options, and futures permit them to do so.
In addition, rising financial wealth in many countries has created
demand for instruments that facilitate international portfolio
diversification, even as financial innovation has made it easier
to supply these instruments. For example, international mutual
funds--some highly specialized by sector or region--are more
easily available today than ever before, reflecting both the
rise in demand and the ease of supply.
Information and communications technologies have also made it
easier to source inputs globally. For example, Chapter 3 discussed
the case of a firm that specializes in finding suppliers for
large custom procurement orders. After finding qualified suppliers,
who may be located anywhere in the world, the firm coordinates
online bids for the order. The process helps overcome the
informational barriers to finding reliable, low-cost suppliers.



The Role of Policy

Given the economic and technological forces behind globalization,
its rise may seem inevitable. Yet governments have taken on a
critically important role in opening markets and removing
distortions, thereby allowing market forces to play themselves out.
In the interwar period, in contrast, policy actively promoted
protectionism through high tariff and nontariff barriers. Indeed,
rising protectionism in a number of countries--including the
United States, through the Tariff Act of 1930 (Smoot-Hawley)--made
the Great Depression more severe. Despite efforts by the United
States to begin reducing tariffs at home and abroad in 1934,
through the Reciprocal Trade Agreements Act, world tariffs
remained high on average. Since mid-century, however, policy
in the United States and elsewhere has worked actively to reduce
trade barriers that limit or distort the choices available to
consumers and firms. Since the 1970s especially, governments
have been reducing barriers to capital flows as well. As discussed
later, policy can also help in dealing with the inevitable
tensions and disruptions of economic integration.
The United States has played a leading role in liberalizing trade
internationally, both by reducing its own tariffs and by encouraging
others, through a variety of market-opening initiatives, to follow
suit. The multilateral trading system, consisting of the GATT at
first, and more recently the WTO, is at the core of these efforts.
Before the creation of the GATT in 1948, trade barriers--in the
United States and elsewhere--were more susceptible to a range of
economic and political factors. Tariff rates, measured as the
ratio of duties to import values, rose noticeably in the United
States during the interwar period, partly because of new
legislation. But some of the increase shown in Chart 6-5
reflects the effect of declining import prices in the early
1930s: many tariffs were ``specific,'' in that they were imposed
as a nominal





dollar amount per imported quantity, so that when prices fell,
effective tariff rates rose. A recent study shows that the Tariff
Act of 1930 raised the tariff rate on U.S. imports by roughly 20
percent, on average, independent of the effects of price declines.
Following the creation of the GATT, and through successive rounds of
multilateral negotiations, world trade markets have become more open
and integrated, contributing to the strong economic growth of the
second half of the 20th century. Success in reducing nontariff
barriers was uneven throughout this period, but tariffs generally
declined. For example, import tariffs on industrial products in
industrial countries have dropped 90 percent over the last 50
years, from an average of about 40 percent to roughly 4 percent.
Other market-opening initiatives have also contributed to trade,
such as the U.S. ``open skies'' policy for international civil
aviation, which has helped improve U.S. air carriers' access to
passenger and cargo markets around the world. As Chart 6-1 showed,
growth of trade has consistently outpaced growth of income since
1950.
Policy developments have also contributed to the growth of
international capital flows. Most governments kept at least some
controls on capital movements from World War II into the 1970s.
Today, by contrast, restrictions on capital flows have generally
been removed in the industrial countries, and they have been
substantially relaxed in many developing economies as well.
Pervasive controls on cross-border capital flows were part of the
international monetary and financial regime adopted at Bretton
Woods in 1944. These controls were partly a response to the severe
instability of the international monetary system during the
Great Depression. The industrialized countries generally began
relaxing these controls in the 1950s, and the late 1970s saw
much more widespread liberalization. Technological developments
in a sense contributed to liberalization by making capital
controls increasingly difficult to enforce. And a rising volume
of trade conducted under flexible exchange rates spurred interest
in financial transactions to hedge exposure to currency and
commercial risk.
Moreover, recent decades have brought renewed recognition worldwide
that financial markets, like markets for goods and services,
generally allocate resources effectively. This recognition has given
impetus to considerable financial liberalization in developing
economies over the past decade. Financial liberalization has often
accompanied other favorable economic policies, such as macroeconomic
stabilization, privatization, trade liberalization, and deregulation.
Such structural reforms in a significant number of capital-scarce
developing countries have provided significant investment
opportunities, with high expected rates of return, and this has
attracted a surge of foreign capital. However, this surge does
raise some concerns, as discussed later, and it puts a premium on
adopting appropriate domestic macroeconomic policies and strengthening
domestic financial systems.



The Benefits of a Global Economy

The United States approaches globalization from a position of
considerable strength. In per capita terms, the United States has
been the world's richest major economy since overtaking the
United Kingdom early in the 20th century, and by most measures
it remains so today.
Chart 6-6 shows estimates of GDP per capita since 1900. The chart
is plotted on a ratio scale, so that a steeper slope implies a faster
growth rate. As the figure illustrates, the dominant macroeconomic
fact for both the United States and other major economies for more
than a century has been that output per person has grown. But this
growth has been far from steady. The 1913-50 period, when global
economic relations deteriorated and integration receded amid active
protectionism and instability in the international monetary system,
recorded the most volatile output growth rates in all four countries
shown in the chart. The post-World War II period of rising
globalization, in contrast, has been a time of rapidly rising
prosperity.
Throughout much of the postwar period, Germany and Japan grew more
quickly than the United States, somewhat closing the gap in GDP per
capita. But this convergence slowed after the early 1970s and had
largely ceased by the end of the 1980s. In 1998, GDP per capita
remained considerably higher in the United States than in the
other economies in Chart 6-6. Overall, the record shows that the
U.S. economy has thrived in the global mar-





ketplace. The discussion of the benefits of globalization that
follows suggests that this conjuncture of globalization and
prosperity is no mere coincidence.
International economic integration raises living standards by
improving resource allocation, promoting innovation, encouraging
technology transfer, and otherwise enhancing productivity growth.
Through trade, countries can shift resources into their most
internationally competitive sectors and reap the benefits of
specialization and scale economies. Their consumers also enjoy
less expensive and more varied products. Opening domestic markets
to global capital can help countries invest more efficiently.
FDI can lead to improved management, better technology and
training, and higher wages in local communities.
However, the same processes that bring about economic growth,
including those that work through trade and investment, can force
costly adjustments for some firms and their workers. An array of
U.S. domestic policies, such as those to assist job search and
training, address these issues, as do some elements of international
agreements that the United States has entered into. Both are
discussed later.



Globalization and Living Standards

Trade economists have long recognized the benefits of specialization
in production and of access to markets. When a country produces and
exports those goods and services that it can produce relatively
inexpensively, and imports those that are relatively inexpensive
to produce abroad, trade improves standards of living on both sides
of the transaction. For example, the United States can produce
financial services at lower cost, relative to other products that
it might produce, than most developing countries can. Costa Rica,
by comparison, can produce coffee at lower cost, relative to other
products, than can most industrialized countries. In this example,
the United States would likely benefit from producing and exporting
financial services and importing coffee. The reverse is true of
Costa Rica. Through freer trade and specialization, a country's
resources can be directed more efficiently to those uses in which they
generate the most economic value, thereby raising income.
Access to larger markets can also reduce costs and increase the
returns to innovation. Producing such goods as automobiles and
airplanes requires building large plants and installing complex
and costly equipment. By adding exports to their domestic sales,
manufacturers can lower their unit costs by extending production
runs and spreading overhead costs more broadly. Moreover, the
ability to spread fixed research and development costs may allow
globally competitive firms to be more innovative than those
confined to selling in domestic markets.
Domestic production can expand when firms export, drawing workers
into jobs in the economy's most productive and internationally
competitive sectors. Recent studies find a substantial wage
premium--on the order of 15 percent--in U.S. jobs supported by
goods exports. Moreover, opening up to trade means giving
consumers and firms greater freedom of choice about what inputs
to purchase and what goods to consume. For consumers, the
availability of less expensive and more varied products
increases the real purchasing power of domestic wages. Some
of the benefits of market opening are quantifiable. For
example, a study of the costs of protection in the United
States found that tariffs and quantitative import restrictions
in place in 1990 cost American consumers about $70 billion.
Since 1990, these costs to U.S. consumers have fallen, as
trade barriers have been reduced on some products. At the
same time, import competition creates incentives for U.S.
businesses to price their products more competitively.
Access to international capital markets can also improve living
standards. International capital mobility allows portfolio
diversification and improved risk sharing. It allows investments
to take place where they offer the highest returns, thereby
improving global resource allocation. And it allows a country
to smooth its consumption by consuming today more than it
produces today, paying for the difference by borrowing
abroad. Therefore, global investment, like trade, yields
benefits to both sides of the transaction. Capital goes to those
who are best able to make productive use of it, and the
suppliers of that capital receive a higher return for a given
level of risk than they could get elsewhere. These benefits may be
particularly pronounced in the case of FDI. Too large a volume
of short-term capital flows, by contrast, may in some cases make
an economy more vulnerable to crisis, as discussed later.
Trade and investment activities can be mutually reinforcing. For
example, FDI by U.S. companies can help pave the way for U.S.
exports. It may create demand for U.S.-produced inputs, possibly
from the parent operations. It may also offer U.S. companies a
foothold in foreign markets from which they can further expand
sales. In many cases, investment in distribution and other
essential services increases a supplier's ability to export
into a market. Trade between firms and their foreign affiliates,
so-called intrafirm trade, can be an efficient means of doing
business overseas, particularly when firms need substantial
information about suppliers, clients, or markets abroad in order
to operate effectively. Over a third of U.S. merchandise exports
and about two-fifths of U.S. merchandise imports are estimated
to be intrafirm; worldwide, intrafirm trade's estimated share
is about a third. Trade may also expand capital flows. For example,
the growth of trade has created a need for more trade-related
financing and, as noted previously, for tools to hedge risk.



Globalization and Growth

Although causality may be hard to establish, simple measures of
the correlation between the openness of an economy and its growth
suggest a mutually supportive relationship. For example, ample
evidence demonstrates that countries that actively participate in
international trade tend to have higher incomes than those that do
not. They also experience more rapid growth and productivity
improvements. Studies also suggest that countries that have adopted
outward-oriented economic policies since the early 1970s experienced
significantly higher annual growth of GDP per capita over the next
two decades than countries that remained inward-oriented.
Exposure to foreign competition gives domestic firms an incentive to
raise their productivity--and these gains recur. Once competition is
introduced, it leads to a cycle of productivity improvements and
quality enhancements that continue to benefit the economy
indefinitely. Studies of the United States and Japan find a
positive relationship between import growth and productivity
growth. Furthermore, evidence suggests that openness can induce
higher average productivity through access to a greater range of
intermediate inputs and, within a given industry, through faster
growth of those firms that achieve the highest productivity.
Increased trade and FDI can also boost productivity growth by improving
the flow of knowledge and the transfer of technology. Traded
manufactures, like all manufactures, embody knowledge and technology
and, in the case of information and communications technology for
example, may boost countries' ability to innovate. Besides providing
funding, direct investors can bring international best practices,
including managerial, technical, and marketing know-how, to the
recipient, which can then spill over into the rest of the economy.
In turn, the direct investors may also benefit from the expertise
of the recipient firms. The flow of knowledge and transfer of
technology also occur through local research and development (R&D).
Expenditure on R&D performed by foreign affiliates in the United
States accounted for about 12 percent of the R&D performed by all
U.S. businesses in 1997. The ratio of R&D expenditure to gross
product for these affiliates was 5 percent, twice the ratio for
all U.S. businesses.
For developing countries, evidence suggests that FDI, along with
high-technology trade, can play an important role in their catch-up
to the industrial countries. When industrial-country investors build,
contribute to, or acquire production facilities in a developing
country, the recipient country gains not just from expanded
production and improved job opportunities, but also from access
to more advanced technologies. Recent studies show that, in
developing countries with a sufficient stock of skilled labor,
FDI from industrial countries can contribute more to growth
than does the country's own domestic R&D.
In short, increased globalization benefits the United States and
other economies. Globalization yields gains from trade, through
specialization and through realization of scale economies in
production. And by allowing capital to flow across borders, it
lowers the cost of financing investment in the recipient country,
increases the return to saving, and allows for portfolio
diversification in the country providing the funds. Both trade
and investment contribute to the flow of knowledge and transfer
of technology.



The Challenges of Globalization

The United States has long sought to extend the benefits of trade
and investment as widely as possible, both within and among
countries, but significant challenges remain. The United States
is committed to expanding trade and investment opportunities
around the world. It is also committed to putting a human face
on the global economy, in part through greater consideration
of labor and environmental concerns and more openness in WTO
proceedings. For all the evidence that trade raises living
standards, some U.S. industries and their workers may face
difficulties adjusting to more open markets. Economists attribute
only a small share of worker dislocation (roughly 10 percent or
less) to trade, but crafting sound domestic policy to help ease
the transition for those affected poses another important
challenge. The emerging market financial crises of 1997-99
highlight yet another challenge: the risk that sudden reversals
in capital flows can in some cases be destabilizing. Finally, the
growing U.S. trade deficit raises the challenge of ensuring not
only that the United States remains an attractive location for
investment, but also that Americans are saving enough for the
future.



Spreading the Benefits of Trade

The United States has sought to open markets, extend the rule of
law, and encourage economic growth internationally through bilateral,
regional, and multilateral trade agreements. The multilateral trading
system, consisting originally of the GATT and more recently the WTO,
is at the core of these efforts. Although its achievements have
been considerable, this system remains a work in progress. The
recent difficulty in establishing a mandate for a new round of WTO
negotiations, and the public protest accompanying the WTO Ministerial
in Seattle, give a sense of the challenges that lie ahead.
Many countries continue to maintain high trade barriers, especially
in agriculture and services, but institutional concerns, such as
those relating to the WTO's accessibility and transparency and to
its relationships with international labor and environmental
organizations, have come increasingly to the fore. Much work also
remains to be done to ensure that developing countries--particularly
the least developed--enjoy improved market access and obtain the
technical assistance they need to realize the benefits that
international trade can afford. At the same time, the United
States must also address legitimate concerns about the adjustment
of domestic industries and workers. On balance, trade does raise
living standards, but there are those within an economy who may
suffer losses when more-open markets shift resources from one use
to another.



Opening Markets More Fully

The United States gains when it lowers its trade barriers, but it
gains most when other nations also lower theirs. Indeed, as one of
the world's most open economies, the United States has a particular
interest in promoting liberalization abroad. The Uruguay Round,
which lasted from 1986 to 1994, brought agriculture and textiles
and clothing more fully into the GATT and took the first steps
toward liberalizing trade in those sectors. It also brought service
trade into the multilateral system by creating the General Agreement
on Trade in Services. A series of post-Uruguay Round negotiations
have yielded additional market access commitments in financial
services, basic telecommunications services, and information
technology, opening up new opportunities in areas where the United
States is believed to be highly competitive. Yet room for
improvement remains, as many countries continue to maintain
significant tariff and nontariff barriers.
Agriculture provides a stark example. Bound tariff rates (maximum
rates to which countries commit themselves in trade negotiations)
on agricultural products average about 50 percent around the
world, compared with less than 10 percent in the United States.
Moreover, even after the European Union and Japan fully implement
their Uruguay Round commitments, they will be free to provide as
much as $78 billion and $35 billion, respectively, in trade-
distorting domestic support to their farmers each year. By
comparison, the United States will be limited to about $19 billion.
Partly because of these policies, average prices for food and
related goods are 34 percent higher in the European Union and
134 percent higher in Japan than in the United States.
To help meet the challenges of market opening, the United States is
seeking additional market access in agriculture, services, and
certain industrial products in the WTO. Notwithstanding the difficulty
in establishing a negotiating mandate during the Seattle Ministerial,
the WTO's built-in agenda calls for further negotiations on
agriculture and services to have begun by January 2000. In
agriculture the United States has proposed eliminating export
subsidies and reducing tariffs and trade-distorting domestic
supports. In services the United States has sought commitments
for more openness in key sectors such as finance, telecommunications,
and construction. In other areas--chemicals, energy products,
environmental products, fish, forest products, jewelry, medical
and scientific equipment, and toys--the United States has sought
accelerated tariff liberalization.
Rapid technological change poses additional challenges, sometimes
raising questions about the nature of trade and product development.
The United States has sought to promote the development and use of
new technologies, such as electronic commerce and biotechnology, in
ways that help spread the benefits of trade. With the strong
support of the Congress, this Administration has sought an extension
of the moratorium on tariffs on electronic commerce in the WTO. The
United States is also seeking to ensure that trade in agricultural
biotechnology products is based on transparent, predictable, and
timely processes.



Strengthening Rules and Institutions

Credibility and predictability are essential components of the
trading system. For firms to undertake the investments necessary
to serve foreign markets, they need to believe that new barriers
will not be raised and that old ones will not reassert themselves.
To rely on foreign suppliers, buyers need to believe likewise that
market access will not be disrupted. Traders need assurance that
commitments will be binding and that markets will remain open even
if circumstances change. And the rules of the trading game should
ensure that governments play fair--that they neither seek advantage
for favored interests by subsidizing their producers, nor pass
regulations that unnecessarily distort international trade, nor
otherwise circumvent international commitments. In setting these
rules and encouraging compliance with them, the WTO has tried to
strike an appropriate balance between the needs of the trading
system and those of sovereign nations. Its agreements do not
preclude the United States or other countries from establishing,
maintaining, and effectively enforcing their own laws, nor do
they prevent the United States from setting and achieving its
environmental, labor, health, and safety standards at the levels
it considers appropriate.
The WTO operates not by decree but by consensus among its members.
Through consensus, the WTO has done much to achieve both credibility
and fairness. Its rules allow nations to take antidumping
measures, countervailing duty measures, and action against import
surges, provided they follow certain procedures. The United States
has used its own WTO-consistent trade laws to combat unfair foreign
practices and to provide safeguards for domestic producers. The WTO
also provides an improved framework for resolving disputes within
the multilateral system. This framework has proved extremely useful
to the United States, which as a complaining party has so far
prevailed in 22 out of 24 cases, having favorably settled 10
without litigation and having won 12 in litigation. And the WTO
provides new rules for protecting intellectual property rights. For
the United States and many other countries, such rights convey
substantial value. In 1998, for example, U.S. exports of royalties
and license fees amounted to about $37 billion.
By and large, countries participating in the GATT and later the WTO
have adhered to their commitments. The trend toward market
liberalization since World War II, and the maintenance of
commitments not to raise barriers even in the face of international
financial crises, stand in sharp contrast to the trade policy
experience of the interwar period. The multilateral trading system
has played a critical role in maintaining and expanding economic
ties, helping make the last half century one of historically
unprecedented economic growth for the United States and many of
its trading partners.
Nevertheless, the rules of the WTO and the ways in which they are
administered can be improved. The dispute settlement process,
although much strengthened, is opaque and sometimes slow. During
the Seattle Ministerial, the United States led the call for
greater public access and participation. The United States has
sought to open the WTO's dispute settlement procedures to the
public and to allow nongovernmental organizations to file amicus
briefs. The drawn-out pace of settlement proceedings has also
caused dissatisfaction. Ordinarily, a case should not take more
than a year (15 months if it is appealed), but in practice the
dispute settlement process can continue to drag on even after the
WTO has adopted a ruling. For example, in the case involving the
EU banana import regime, the WTO found for the United States in
about 18 months from the point of initial consultation, but by
the time the United States was finally authorized to suspend
trading concessions, nearly 3 years had passed.



Promoting Growth Internationally

The United States has long advocated the use of the multilateral
trading system to promote economic growth internationally, often
with considerable success, but not all countries are well
positioned to reap the benefits that trade can afford. Steps can
be taken to help ensure that developing countries, including the
least developed, obtain the market access and technical assistance
they need to benefit more fully.
Developing countries have increasingly come to appreciate the value
of the multilateral trading system. The system not only provides
them opportunities to trade on the basis of their comparative
strengths but also reinforces market-oriented development strategies
where they have been adopted. Originally dominated by the industrial
countries, the system has witnessed growing participation as other
nations have sought inclusion. Today the WTO counts 135 members, with
over 30 nations, including China, seeking accession (Box 6-2). This
allure of the trading system supports the conviction that
international trade is not a zero-sum game: both the United States
and its trading partners reap the benefits.
Developing countries have come to account for an increasingly large
share of world trade, but some have moved ahead more rapidly than
others. Developing countries' total trade (exports plus imports)
rose at an annual rate of 9.9 percent between 1989 and 1997,
exceeding the 7.6 percent growth rate




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Box 6-2. China's WTO Accession: Opening Foreign Markets, Extending
the Rule of Law, and Encouraging Growth and Development

In November 1999 the United States and China concluded a bilateral
agreement on China's WTO accession. This agreement, which represents
a crucial step in China's accession to the multilateral organization,
addresses many of the barriers to trade and investment in China that
now impede the flow of goods, services, and capital. Upon
implementation, the agreement would benefit both U.S. and other
firms outside of China, by improving access to China's market.
China would benefit as well from wider availability of high-quality
foreign products and from the introduction of best-practice skills by
U.S. firms in areas such as finance and insurance. The agreement
would help address distortions in China's economy that have
contributed to slowing output growth there and have reduced the
prospects for future growth.
Under the terms of the agreement, China's WTO accession would
continue the remarkable process of economic reform that began there
two decades ago. China's economy has become increasingly market-
oriented and increasingly open to trade and foreign investment.
Between 1978 and 1999, China's official statistics indicate that
the country's income per capita rose at a rate of more than 8
percent per year, which, according to the World Bank, has helped
raise some 200 million people out of absolute poverty. (Some have
argued that statistical shortcomings lead to an overstatement of
this long-run growth rate, but even skeptics acknowledge that
the results have been impressive.) Trade has grown even faster
than output, with the sum of exports and imports rising from
$21 billion in 1978 to $324 billion in 1998. Over this period
more than $250 billion in FDI entered China.
Despite this substantial progress, China has continued to maintain
significant barriers to foreign trade and investment. These
barriers include high tariffs on many agricultural and industrial
products and other, less quantifiable restrictions. For example,
some products may be imported only by approved foreign trading
companies, and foreign investment is sometimes restricted outside
of particular sectors. In many sectors these barriers have shielded
inefficient state-owned enterprises--the core of the former centrally
planned economy--from competition, reducing prospects for China's
continued strong growth.
The bilateral agreement directly addresses many of these concerns,
especially as they relate to trade. China has agreed to significant
reductions in tariffs on imports of agricultural and industrial
products: for example, tariffs on U.S. industrial products would
decline from a simple average of 24.6 percent to 9.4 percent,
calculated from a 1997 baseline. The bilateral agreement would
also address many nontariff barriers. In agriculture, China would
establish large and increasing tariff-rate quotas on bulk
agricultural commodities, limit some state trading activities,
and eliminate export subsidies. (A tariff-rate quota is one in
which imports are allowed above the quota but a higher tariff
applies than within the quota.) China would phase in full trading
and distribution rights for most of its industrial sectors. The
agreement also covers a wide range of trade in services, including
banking, insurance, telecommunications, distribution, professional
activities, and other business services. The agreement also contains
a special safeguard rule, to protect against surges in China's
exports to the United States, and it specifies a non-market economy
methodology to address dumping.
As a result of these changes, U.S. firms would gain from better
access to a fast-growing market of almost 1.3 billion people, and
from greater certainty about China's economic policies in the
future. WTO accession would commit China to a path of further
economic liberalization, which could help lock in its transformation
from a centrally planned to a market-based economy and encourage
faster growth. This commitment can also help strengthen the rule
of law in China, providing more certainty for U.S. firms seeking
to do business there.
Although the bilateral agreement represents a crucial step toward
China's WTO accession, several important ones remain. For example,
China must still complete bilateral agreements with a number of
other WTO members, as well as multilateral negotiations on its
accession protocol. After that, China must complete its own domestic
procedures for accession.
----------------------------------------------------------------------------


of trade worldwide. Over this period their share of world trade rose
from 29.1 percent to 34.7 percent. Among developing countries, the
trade of those that are WTO members grew slightly faster, at an
annual rate of 10.5 percent. The 48 least developed countries
have, as a group, done less well. For these countries, many of
which are also WTO members, trade grew at an annual rate of only
6.1 percent through 1996.
As these data suggest, not all WTO members are well equipped to use
the trading system effectively. Some of the least developed members
lack the necessary domestic institutions and infrastructure to reap
the full benefits of trade. For them, capacity building and technical
assistance, coupled with additional market opening, could help spread
those benefits. Through the WTO, the international community can
make more progress in liberalization in certain priority areas, such
as agriculture and services. But developing countries, including the
least developed, can also take their own actions. In addition to
participating in multilateral initiatives, they can benefit from
increased unilateral liberalization, as free trade promotes the
movement of labor and capital into their most productive uses,
strengthens competitive forces, facilitates innovation, and raises
living standards.
The United States has proposed measures for the WTO to provide
developing countries with technical assistance in implementing
trade policy. The United States will also work to give the least
developed countries greater access to global markets, as it is
already doing through the U.S. Generalized System of Preferences
(GSP) program. The U.S. GSP program began in 1976, when the
United States joined 19 other industrialized countries in granting
tariff preferences to developing countries, to help promote economic
growth through expanded international trade. Currently, over 4,400
products and product categories are eligible under the program for
duty-free entry from designated beneficiaries--over 140 developing
countries and territories in total--and another 1,783 products are
eligible for duty-free entry from least developed beneficiaries
only. The value of U.S. GSP duty-free imports in 1998 was $16.3
billion. However, lapses in authorization of the program, which
have occurred several times over the past 5 years, have tended to
detract from its efficacy, by creating uncertainty for investors
and importers.



Addressing Concerns About Adjustment

As markets become more open, some domestic industries will expand
while others may contract. Although globalization provides benefits
overall, the adjustments that businesses and workers in shrinking
industries may undergo can be costly and painful. Although, as
noted above, economic studies typically find that trade is a small
factor in U.S. job displacement, some workers may face short-term
unemployment, and others may even face permanent wage reductions
if they are unable to find comparable jobs in expanding sectors.
Trade, like other sources of economic growth, therefore presents
challenges at home. But the fact that trade produces additional
income means that, in principle, resources are available to help
those who are hurt--either to adapt by becoming more productive and
competitive at what they were already doing, or to switch activities.
One way to help in the transition is to develop programs that
directly address the problems of dislocation. Another is to
encourage trade while limiting the pace at which change occurs,
as the United States has done by phasing in provisions of the WTO
agreements and applying safeguard measures. Such gradualism may
be desirable under certain circumstances, but trying to prevent
liberalization altogether would be counterproductive. Permanent
protection inevitably costs more, in terms of benefits forgone,
than it saves. The key lies in maintaining an economy that is
sufficiently flexible and vibrant to meet the challenges of
reaping those benefits.
To address problems of worker dislocation, regardless of cause,
the Administration has developed new programs to assist in job
search and training. These programs add to the assistance already
available to displaced workers through the Federal Trade Adjustment
Assistance program. The Workforce Investment Act of 1998 retains a
funding stream for dislocated workers and promotes customer access
to services and information, as well as customer choice, through a
One-Stop delivery system and through Individual Training Accounts.
The Administration is also acting to ensure that Lifetime Learning
tax credits and scholarships are available to assist workers in
preparing for new jobs. Federal job and talent banks are meanwhile
providing mechanisms for helping millions of U.S. workers find new
jobs. For example, on a single day in January 2000, America's Job
Bank listed over 1.5 million jobs.
The WTO agreements and U.S. trade laws also provide a cushion during
periods of adjustment. For example, key features of the Agreement on
Agriculture and the Agreement on Textiles and Clothing phase in
gradually over periods of 6 to 10 years. Moreover, the WTO agreements
allow countries to use certain forms of safeguards to protect
themselves temporarily against import surges that seriously injure
or threaten to seriously injure a domestic industry. The United
States has invoked its own safeguard provisions three times since
the creation of the WTO, in cases involving corn brooms, wheat
gluten, and lamb meat.



Addressing Concerns About Core Labor Standards and the Environment

During the Seattle Ministerial, some participants and observers
raised important questions about the relationships between trade
and labor and between trade and the environment. The Administration
is committed to ensuring that the benefits of trade are shared broadly
and do not come at the expense of core labor standards or the
environment. Economic evidence, presented below, suggests that
trade can support labor and environmental objectives rather than
obstruct them.
Over time, the United States has developed strategies to address
international labor and environmental considerations through a
variety of means. For example, preferential U.S. trade programs
contain criteria for workers' rights: legislation for the U.S.
GSP program states that the President shall not designate any
country a beneficiary developing country if ``such country has
not taken or is not taking steps to afford internationally
recognized worker rights to workers in the country. . . .'' The
North American Free Trade Agreement contains side agreements on
labor and the environment. At the same time, the United States
has sought to promote core labor standards and environmental goals
through multilateral institutions such as the International Labor
Organization and the United Nations Environment Program. During
negotiations in Seattle, the United States proposed to strengthen
the WTO's links to these and other relevant international
organizations. The United States is also seeking to create a
working group on trade and labor in the WTO, to better understand
the linkages between them. And just before the Seattle Ministerial,
the President issued an executive order for the United States to
conduct environmental reviews of certain kinds of trade agreements.
Economic evidence suggests that trade can support both labor and
environmental objectives, in part through its positive effect on
economic growth. For example, analysis using wage, employment,
and income data to study the relationship between economic
development and working conditions in Hong Kong, the Republic
of Korea, Singapore, and Taiwan has found that these conditions
generally improved as the economies developed. Studies of the
relationship between pollution and income per capita are also
revealing: in several cross-country analyses of emissions
patterns of air and water pollutants, emissions seem to increase
with income at low incomes and fall with income at high incomes.
As countries become wealthier, they may eventually become cleaner,
perhaps because of increased demand for environmental protection.
Recognizing that trade and environmental objectives can be mutually
supportive in even more direct ways, the United States is seeking
to eliminate fishery subsidies that contribute to overfishing and
to eliminate tariffs on environmental goods.
Nevertheless, international trade occurs in the context of domestic
policy. Although sovereign nations bear responsibility for adopting
sound domestic policies, the international community can contribute
its expertise. In this regard, the United States has proposed
measures in the WTO to provide technical assistance on implementing
trade policy and on strengthening institutions in developing
countries responsible for trade, labor, environmental, and other
policies that influence the gains to living standards from trade.



Managing Capital Flows and the Macroeconomy

Globalization raises other challenges as well: flows of goods,
services, and capital can be the source of macroeconomic shocks. To
take an extreme example, the crisis in emerging markets that began
in Thailand in 1997 demonstrated the potential adverse consequences
of volatile capital flows. The crisis also highlighted the need for
developing countries to strengthen their domestic financial systems
and adopt appropriate macroeconomic policies, including consistent
monetary and exchange rate policies, to cope with this volatility.
Such policies allow countries to capture more fully the benefits
of an increasingly global financial system and to minimize their
vulnerability to crises. Of course, for some very poor countries the
challenge is not that capital flows are too volatile, but that they
are insufficient. Recent policy initiatives, discussed below, aim
to distribute the benefits of global capital flows more broadly.



International Financial Crises and the New Financial Architecture

A particular concern is the potential role of sudden swings in
capital flows in precipitating a financial crisis--a phenomenon
marked by extreme financial market volatility and macroeconomic
instability. An economic crisis can, of course, occur in a country
that is closed to trade and capital flows, but adding an international
dimension to the crisis can in some cases make the situation even
worse. We have seen how international capital flows provide important
benefits in allocating resources efficiently and promoting growth.
But sometimes capital--especially short-term capital, such as
overnight bank loans--can flow out of a country very quickly. For
example, capital might leave a developing country in response to
new information about the country or to a change in industrial-
country interest rates. But whatever drives them, rapid outflows can
force a sudden and costly adjustment in financial markets and the
real economy.
A series of crises in emerging market economies in the 1990s have
brought these issues to the fore. In Mexico in 1994 and 1995,
policy shortcomings, weakness in Mexico's balance sheet, and
financial market volatility combined to create a sharp liquidity
crunch and a steep fall in output. The crisis that began in
Thailand in 1997 seems to fit the same pattern. That crisis quickly
spread to other Asian developing economies in 1997 before it began
to ease in mid-1998; it then, however, revived and spread to
Russia, Brazil, and several other Latin American countries in 1998
and early 1999.
Many emerging markets had exchange rate regimes that, to a greater
or lesser extent, involved pegging the value of the domestic
currency to the dollar while retaining latitude to adjust the
pegged rate or even float the currency. For these economies the
initial manifestation of the crisis was a sharp fall in reserves,
which forced abandonment of the pegged rate; the currency's value
then fell precipitously. Stock markets also dropped sharply.
Severe declines in output soon followed. For example, annual output
growth had averaged about 7 percent from 1990 to 1996 in the five
``front-line'' Asian crisis economies (Indonesia, Korea, Malaysia,
the Philippines, and Thailand). By contrast, in 1998 output fell
on average by 7 percent in these economies. Large swings in
capital flows required corresponding adjustments in the current
account balances of these five economies, which shifted from
combined deficits of $54 billion in 1996 and $25 billion in 1997
to a combined surplus of $69 billion in 1998.
Last year's Economic Report of the President discussed the recent
emerging markets crisis at length. The crisis and the virulent
contagion that ensued did not have a single, simple cause.
Nevertheless, in some Asian countries, structural weaknesses,
particularly in financial intermediation, appear to have been a
key source of vulnerability. Weak financial systems intermediate
resources poorly, so capital is not allocated efficiently. The
combination of lax financial supervision and regulation, a tradition
of lending to politically favored borrowers, and poor corporate
governance, led in turn to considerable lending to low-
productivity projects. In some cases, domestic and international
capital liberalization may have exacerbated the problems caused
by these distortions, by allowing banks and firms to borrow more
money at lower rates in international markets than was advisable.
Insufficiently prudent management of the national balance sheet
compounded these weaknesses. Too many countries involved in recent
crises were seeking short-term capital from abroad. In Thailand,
for example, the Bangkok International Banking Facility enabled
Thai banks and firms to borrow heavily abroad in foreign currency
at very short maturities, and the government decided to mortgage
its foreign exchange reserves in forward markets. Fixed but
adjustable exchange rates in some countries gave the illusion
of currency stability, and low levels of usable reserves created
vulnerability to a sudden turn in confidence that ultimately
became self-perpetuating. As the psychology of the market shifted,
the opportunity to fix the underlying problems that triggered
the crisis without up-ending the economy drained away.
These weaknesses interacted with an inadequate focus on risk on the
part of banks and investors in industrial countries, which had
contributed to the rapid inflows of capital in the first place.
This combination of structural weaknesses, policy biases that
favored risky forms of finance, and an insufficient regard for
risk led ultimately to an abrupt collapse in confidence that spread
outward from Asia in 1997, as investors realized the extent of
their exposure. Once confidence was lost, the problems in the affected
countries were compounded by rapid and self-fulfilling outflows of
capital.
How can countries and the international financial system retain
the benefits of capital flows discussed earlier while making
crises both less likely and less virulent? The debate over the
new international financial architecture, as it has come to be
known, seeks to address this question. The Mexican crisis of
1994-95 sparked the search for policies that could prevent large
swings in capital flows, but the emerging markets crisis of 1997-99
gave it particular urgency. The United States has taken the lead
in these efforts.
The quest for a more stable global financial system is important
for industrial economies as well as for emerging market economies.
After all, the emerging markets crises had effects on both the
real and the financial sector in the United States and in Europe
and Japan. Together with continued weakness (indeed, outright
recession) in Japan in 1997 and 1998, the crises reduced income
growth abroad, which in turn cut U.S. exports. Some sectors of
the economy--agriculture and manufacturing in particular--
clearly suffered from the loss of export markets and from
increased import competition. At the same time, weakness in
the currencies of the crisis-stricken countries implied an
appreciation of the dollar in both real and nominal terms, which
made foreign products more competitive both abroad and in the
United States. The crises overseas have at times also had significant
repercussions on U.S. financial markets. In the period following
Russia's default on its sovereign debt in August 1998, U.S.
asset prices declined and considerable financial market stress
followed.
At certain junctures, the weak external environment and the
possibility of further financial market turmoil posed a clear
risk to the continuing strong performance of the U.S. economy.
The downside risks for the United States did not materialize,
however, in part because of the policy response of U.S. authorities
in the fall of 1998 and the financial packages assembled by the
International Monetary Fund. Most Asian emerging market economies
resumed growth in 1999. However, for much of this period the
world economy was essentially flying on one engine: the robust
performance of the U.S. economy. Indeed, during this period,
the openness of the U.S. market helped cushion the adverse
effects of the crisis on output and employment abroad.  Thus
events abroad create important policy challenges at home. For
this reason, promoting the new international financial architecture
is in America's own self-interest.
A consensus is emerging on the broad outlines of this new
architecture (Box 6-3). A central lesson of the crises of the
1990s is that countries largely shape their own destinies.
Hence, building a sound global financial system requires that
individual countries work to ensure that their financial systems
and macroeconomic policies are sound, consistent, and
transparent. Improving transparency, for example, requires
improved accounting standards and timely reporting of data. These
steps can minimize the information problems that contribute to
swings in capital flows. In addition, the recent crises demonstrate
the critical importance of the choice of exchange rate regime in
reducing a country's vulnerability to crisis. Whatever regime is
adopted should be credible and supported by consistent macroeconomic
policies and robust financial systems.




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Box 6-3. The New International Financial Architecture
The international community, under U.S. leadership, has proposed a
set of reforms to strengthen the international financial system. On
the general principle that a market-based system provides the best
prospects for a sound global economy, these reforms seek to improve
crisis prevention and the international community's response to
crisis in ways that allow markets to operate effectively.
Last year's Economic Report of the President described the background
behind the major reform proposals and outlined their chief features.
Since then, work has continued within the Group of Seven (G-7)
large industrial countries and with key emerging market countries
to explore ways to improve and implement these reforms. The United
States has continued to play a leading role in these efforts. At
its June 1999 summit in Cologne, Germany, the G-7 released a
report on financial architecture. The report emphasized reforms
in six areas:
 Strengthening and reforming the international financial
institutions--the International Monetary Fund (IMF) and the World
Bank--and arrangements for international cooperation
 Enhancing the transparency of financial institutions and
markets and promoting best practices, to enable market participants
to make informed judgments about risk and provide greater
incentives for policymakers to implement sound policies
 Strengthening financial regulation in industrialized
countries, so that creditors will act with greater discipline and
assess more prudently the risks associated with their lending
 Strengthening macroeconomic policies and financial
systems in emerging markets, to allow borrowers in emerging markets
to benefit fully from integration into the international financial
system
 Improving crisis prevention and management and involving
the private sector, to ensure that all participants will expect to
bear the consequences of the risks they take, and to reduce the risk
of financial market contagion
 Promoting social policies to protect the poor and most
vulnerable.

The Administration has pushed forward with this effort in several
ways. It has made the terms of exceptional financing support more
market-based through the creation of the IMF's Supplementary Reserve
Facility and, most recently, its Contingent Credit Line (CCL). It
has also helped countries develop stronger national financial
systems, including through the incentives embodied in the terms
of the CCL.
In addition, to promote dialogue on key economic and financial
issues, a new informal mechanism known as the G-20 (a group of key
industrial and emerging market economies that account for more than
80 percent of world GDP) met for the first time in December 1999.
This group will be focusing on how countries can further reduce
their vulnerability to modern capital account crises.
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Improvements in national policies are necessary to strengthen the
international financial system, but not sufficient. Policies and
incentives must also be appropriate at an international level, as
discussed in Box 6-3.  These reforms seek to reduce the incidence
and severity of future crises by providing suitable incentives for
the effective working of a market-oriented system.
When reversals of capital flows do occur, an important task is to
keep the damage to a minimum. Several actions can help in this
regard. First, it appears clear that countries should avoid policy
biases that encourage excessive reliance on short-term, foreign
currency-denominated debt, since it is those flows that can flee
most quickly. Second, ensuring that the financial system is sound
can enable a country to cope with capital and exchange rate movements
without excessive damage to financial intermediation.



Debt Relief for Developing Countries

An important goal of the proposed reforms of the international
financial system is to ensure that countries realize the substantial
benefits of open markets in trade and investment. However, some of
the world's poorest nations are not benefiting from globalization.
Many developing countries have unsustainable debts and policies
that are not conducive to economic growth and development.
Recognizing the need to integrate these countries into the global
economy, the United States has actively pursued several multilateral
and bilateral initiatives to reduce their debt burden.
Most recently, the United States helped forge an international
consensus among the G-7, the International Monetary Fund, the World
Bank, and other creditors to provide broader, faster, and deeper
debt relief to many of the world's poorest, most heavily indebted
nations. Together with previous debt relief commitments, the June
1999 Cologne Debt Initiative, which expanded on the Heavily
Indebted Poor Countries (HIPC) Initiative of 1996, may reduce
these countries' combined nominal debt by as much as $90 billion,
in return for genuine reforms aimed at reducing poverty and
encouraging long-run economic growth. The combined external debts
of the 33 HIPCs most likely to benefit from the Cologne Debt
Initiative were estimated at $127 billion in 1998, or nearly
120 percent of their combined GNP.
The key objective of the initiative is to strengthen the links
among poverty reduction, debt relief, and sound economic policy
so as to foster development. Countries seeking eligibility for
debt relief must meet several requirements. They must undertake
macroeconomic reforms, such as inflation stabilization. They
must place increased emphasis on channeling the benefits of debt
relief to poverty reduction, especially in the areas of health
care and education. They must make efforts to improve governance,
especially in establishing participatory processes with civil
society and ensuring transparency. In consultation with the
International Monetary Fund and the World Bank, eligible countries
will design poverty reduction strategies that allow them to use
the savings from debt relief to fight poverty effectively.
Openness has increased opportunity and prosperity in both
industrialized and developing countries. In order to benefit,
however, countries must have policies in place that are conducive
to economic growth, and they should not be held back by
unsustainable debts. As the Cologne Debt Initiative encourages
growth and stability in return for debt reduction, it will benefit
creditors and debtors alike by creating new opportunities for
trade, investment, and the development of human capital.



The Trade and Current Account Deficits

Throughout the second half of the 1990s, the U.S. trade and current
account deficits rose steadily. In the third quarter of 1999, the
current account deficit (a comprehensive measure that comprises not
only the trade deficit in goods and services but also net income and
transfers) reached a record relative to GDP--even as the U.S.
unemployment rate stood at its lowest level in 30 years. It is
worth recalling that the benefits of openness, including higher
real incomes, are realized no matter what the size of the external
deficit. By themselves, external trade and current account deficits
are neither inherently good nor inherently bad. What matter are the
reasons for the deficits. The main reason for the deficits today
appears to be the strength of the U.S. economic expansion relative
to the slow or negative growth in many other countries.
By definition, a trade deficit occurs when a country's domestic
spending exceeds its domestic production. The shortfall is then made
up by importing more goods than are exported. When the United States
runs a trade deficit, foreigners buy less than a dollar's worth of
U.S. goods for every dollar they earn from their export sales to us.
The natural question to ask is, What do foreigners do with the
dollars left over after they buy those U.S. goods? In practice,
they typically invest those excess dollars in U.S. assets. The
desire of foreigners to purchase attractive U.S. assets--in
essence, to lend us the money needed to finance a trade deficit--
makes the deficit possible. In other words, there is necessarily
a link between the international flow of goods and services and
the international flow of financial resources. In fact, one can
as readily argue that the desire of foreigners to acquire
attractive U.S. assets is responsible for the U.S. trade
deficit as the reverse.
This link between the flow of goods and services and the flow of
financial resources highlights another way of looking at the trade
and current account deficits. From a national accounting
perspective, a country's current account balance equals the
difference between national saving and domestic investment (plus
a statistical discrepancy and after minor adjustments). When
the demand for domestic investment in the United States exceeds
the pool of national saving, borrowing from foreigners--a rise
in national indebtedness--makes up the difference. Conversely,
when saving exceeds investment, the surplus is invested abroad.
Is it good or bad for a country to get into debt? The answer
obviously depends on what the country does with the money. What
matters for future incomes and living standards is whether the
deficit is being used to finance more consumption or more investment.
In this respect, the deficit in the 1990s differs radically from
that in the 1980s. The United States experienced large current
account deficits in the mid-1980s (Chart 6-7), when net domestic
investment fell as a share of GDP, and net national saving fell
even faster. By contrast, in the current expansion the deficit
has been associated with rising shares of GDP devoted to both
investment and saving. The deficit's growth indicates that the
rise in national saving, due to reduction of the Federal budget
deficit, has not kept pace with the increase in investment. It
signals rising investment rather than falling saving.
That a falling trade balance can coincide with a robust economy
is no surprise; indeed, both economic theory and empirical
observation lead one to expect such a pattern. A strong economy
raises demand for imports and is generally associated with high
demand for investment. As Chart 6-8 shows, GDP growth in the
United States' trading partners as a group fell sharply in 1998,
reflecting weaker growth in Europe, recession in Japan, and
outright crisis in emerging markets. By contrast, U.S. growth
remained robust. Since the end of 1997, the U.S. trade deficit
has risen from about 1 percent of GDP (its average throughout
the mid-1990s) to about 3 percent. The dramatic difference
between U.S. and foreign growth appears to be the primary
cause of the increase in the deficit, as demand grew more rapidly
for all products, including imports, in the United States than
elsewhere. From the perspective of capital flows, expected
returns on investment have been relatively attractive in the
United States. As a result, the United States has absorbed
substantial net inflows of capital. Whether viewed as a
phenomenon in the international flow of goods and services or
as a phenomenon in the international flow of financial resources,
the result of these recent devel-




opments was that the U.S. trade and current account balances swung
much more sharply into deficit.
Exchange rate movements, reflecting in part the desirability of
U.S. assets, have also contributed to the rising trade deficit by
affecting the relative price of imports and exports. Chart 6-9 shows
that, over the past several decades, the trade deficit has tended
to rise when the dollar has strengthened. Between 1995 and 1998
the dollar appreciated, although by less than in the 1980s.
In addition to these factors, some of the recent increase in
the trade and current account deficits (and in the corresponding
capital inflows) may reflect other, more persistent factors. A
possible explanation for such a ``structural'' current account
deficit, as well as for some of its recent increase, is faster
U.S. productivity growth, as discussed in Chapter 2. If
productivity growth has risen more in the United States than
in other countries, this fact tends to make the United States
a particularly attractive place for investment, since the expected
returns to capital then rise. Capital may then flow into the United
States to finance this higher investment. To the extent this story
applies to the United States today, it again emphasizes the relative
strength of the U.S. economy.
Clearly, then, large trade and current account deficits can easily
coincide with a strong and robust economy, as they do today. Hence,
a trade deficit does not by itself have implications for the overall
level of employment. Nevertheless, some sectors of the U.S. economy,
such as manufacturing, may be harmed by increased competition from
foreign imports and from reduced




demand for exports. It would be a mistake, however, to simply equate
a manufacturing trade deficit with job loss in that sector. The
inflows of capital into the United States that finance the trade
deficit have allowed the economy to operate at higher levels of
domestic investment than it could have otherwise. Higher investment,
in turn, helps boost demand for manufacturing output.
Nevertheless, since the onset of the Asian financial crisis,
manufacturing employment does appear to have been adversely affected
by the reduced demand for U.S. exports. Between the first quarter
of 1993 and the fourth quarter of 1997, U.S. manufacturing firms
added about 700,000 workers to their payrolls. However, between
the fourth quarter of 1997 and the fourth quarter of 1999,
manufacturing employment fell by about 440,000 workers. The
economy has remained at a high level of employment throughout
this period--and has added more than 20 million new jobs since
January 1993--which suggests that many of these displaced
workers have found jobs elsewhere in the economy. As discussed
earlier in this chapter, policy may also be able to help ease
the adjustments resulting from trade.
In sum, although some adjustments have been necessary, today's
trade and current account deficits reflect the relative strength
of the U.S. economy. These deficits are essentially a macroeconomic
phenomenon, reflecting a higher rate of domestic investment than of
national saving. They have allowed U.S. firms to continue to
invest at high rates even in a high-employment economy.
A vast array of factors affect the level of the deficit, by
influencing the decisions of private individuals and firms, so
it is very difficult to be precise about the ``appropriate'' level
of the deficit. Nevertheless, for any given level of the current
account deficit, one must keep several principles in mind.
First, the better are the United States' terms of trade--that is,
the higher the prices we receive for our exports, and the lower
the prices we pay for our imports--the higher Americans' incomes
will be. Working to open large foreign markets can stimulate exports
and improve the terms of trade. By contrast, closing markets in the
United States through protectionist measures is counterproductive
and should play no part in the policy response to the current account
deficit. Measures such as higher tariffs and quotas do discourage
imports by making them more expensive, but they also make our economy
less efficient and reduce national income. Besides making Americans
poorer, such protectionist measures would not necessarily have much
effect on the current account balance, because they are unlikely to
have much effect on either saving or investment.
Second, for any given level of the current account deficit, the
United States is better off if it remains open and attractive to
foreign investment, provided these capital flows are channeled
into productive uses. Chapter 3 discussed the role of policy in
nurturing innovation, which in turn leads to productive investment
opportunities for the private sector. In addition, it is important
to continue prudential regulation of the financial system, to help
it remain sound and keep pace with new technology and deregulation.
The strong U.S. financial system is well positioned to channel
capital inflows into profitable uses, and it is important to
maintain that strength.
Although, again, the appropriate level of the current account
deficit is difficult to assess, at least two principles are
relevant should it prove necessary to reduce the deficit. First,
the United States has an interest in policies that stimulate foreign
growth, since it is better to reduce the current account deficit
through faster growth abroad than through slower growth at home. A
recession at home would obviously be a highly undesirable means of
reducing the deficit. The cyclical component of the deficit, caused
by declines in global demand in recent years, should reverse itself
as the world economy recovers. For the future, the new international
financial architecture, discussed earlier, should help maintain
stronger and more stable foreign growth.
Second, any reductions in the deficit are better achieved through
increased national saving than through reduced domestic investment.
If there are attractive investment opportunities in the United
States, we are better off borrowing from abroad to finance these
opportunities than forgoing them. On the other hand, incomes in
this country would be even higher in the future if these investments
were financed through higher national saving. The United States
needs policies that make saving more attractive. Indeed, the
Administration has proposed substantial tax cuts to promote saving,
especially among low- and moderate-income families who currently
save relatively little. The United States also needs to maintain
prudent fiscal policies. Here again, the Administration's proposals,
which would lead to large and growing budget surpluses in the decade
to come, are highly desirable.
A growth strategy for the United States based on continued prudent
fiscal policy would also extend macroeconomic assistance to the
problems faced by the manufacturing sector. By increasing national
saving, such a policy would allow interest rates to remain lower
than they would otherwise be. Lower interest rates would lead to
higher domestic investment, which, in turn, would boost demand for
equipment and construction. For any given level of investment,
increased saving would also result in higher net exports, which
would again raise employment in these sectors.



Conclusion

Over the long term, increasing the standard of living in the United
States requires that Americans embrace change. We should not retreat
from the constant succession of new opportunities that arise in an
ever-changing world economy. The United States has long welcomed the
opportunities that integrating with the world economy provides.
Growing international integration has benefited Americans profoundly,
contributing to our increasing prosperity. It is clearly in our
interest to forge ahead, both promoting and guiding the process of
international economic integration.
Yet at the same time we must confront the very real challenges that
arise from economic globalization. We must find ways to share its
benefits as widely as possible, both at home and abroad.
International policy on trade and capital flows plays an important
role in ensuring that we capture the benefits of international
economic integration.
Ultimately, however, our prosperity in the global economy depends
primarily on our policies at home. The right policies for this
task include those that encourage a flexible and skilled work
force, that build an economic system in which innovation is
rewarded, and that ensure that the U.S. financial system is
sound and deep.